We Haven’t Seen Anything Yet!

The real US financial crisis has yet to begin

Editorial Desk

http://www.nationmultimedia.com/  The Nation (Thailand)

Publication Date: 23-03-2009    

During his visit to London more than a week ago, Thai Prime Minister Abhisit

Vejjajiva got the impression from business people and investors there that the United States did not have enough political will to take on its banking crisis once and for all. They told Abhisit that if the US had recognized the total estimated losses of the banking system and come up with the money to plug the leaking hole, it would have restored confidence and set the stage for an economic recovery. This sounds plausible, but the whole point is how much of the losses of the US banking system can really be quantified. Is it US $30 trillion, US $50 trillion or more?

The size of the US financial bubble that has gone bust is so large that it is impossible to quantify the losses due to the lack of transparency. The US banks,

backed by the power of the Federal Reserve to issue paper currency without any limit, had over the past several decades gone global in raising money, issuing debts and all kinds of instruments in their proprietary trading and investment. They had several dozen times over-leveraged their capital. Wall Street and US banks' easy money, fuelled by a low interest-rate policy during the Greenspan era, created a bubble economy.

In fact, it is not totally correct to assume that the current problem can be traced back to the Greenspan era alone. The US has walked away from manufacturing since the 1970s and shifted its policy toward consumption and financial services, backed by its superpower status to issue paper currency. The dollar has been floated around the world to become the de facto medium of international transactions without presumably any cost.

The US consumers went on a consumption binge, enjoying one of the world's best

living standards. Wall Street executives made filthy bonuses every year. The Wall Street model has become the fixation of American business - how to make quick money from thin air.

But we all know that there is no free lunch. The dollar paper issued to the creditor institutions, funds and sovereign governments worldwide is now starting to backfire. The global economic imbalances, characterised by overconsumption in the US and overproduction by the emerging-market economies, including Japan, are now going through a correction.

US over-consumed by issuing debt to finance its consumption, while other countries re-channeled their reserves back to the US so that US consumers

would continue to buy their cheap goods. Now exports to the US have collapsed. Creditors are shying away from subscribing to US debt. They are cutting losses in their US dollar asset holdings.

The US banks have made things worse by offering easy lending to the real-estate sector. Real-estate loans were bundled as mortgage-backed securities, on top of

which other dubious financial products were created. This is not to mention other financial products that US banks have issued like currency only because they have their brand names attached. Currency and paper are treated without any difference. The bubble was in full swing until the sub-prime debacle hit the US in August 2007. After that the US financial system and the US economy started to go downhill.

The US banks and financial institutions have been relying on the Federal Reserve's

Temporary Auction Facility to raise their liquidity. They have been facing a run, with foreign depositors and scared individuals withdrawing their money. Without the Fed's intervention with liquidity, US banks and financial institutions would have been totally broken down by now.

But the worst has yet to come. With a loss of confidence in the US financial

system, creditors and investors are dumping dollar-denominated instruments.

They are willing to cut losses. The US banks, who issue the instruments, have to take their debts back. Since they do not have the liquidity because the credit market has already ground to a halt, they can only rely on the Federal Reserve. As a result, the balance sheet of the Federal Reserve will continue to balloon.

US Treasuries, traditionally recognized as risk free, are now under pressure. Russia,

China, India and other countries are discussing a possibility of dumping the US dollar as a reserve currency. They have proposed a return to the Special Drawing Rights issued by the International Monetary Fund.

In the meantime, the US federal government will find it tough to finance its deficit spending. Recent projects have put the deficit for 2009 at a record US $1.8 trillion. This would complicate President Obama's efforts to pass his US $3.55 trillion budget plan for 2010. The deficit would continue for several years to come. Where will this money come from?

The US won't be able to finance the deficit of this magnitude. The US Treasury

doesn't have any money. The Americans are also losing their savings and

investments in the meltdown of the stock market by at least 50 per cent last

year alone. They are also saddled with consumer and mortgage debt. So the US ends up with only two options left: Borrowing from the foreign creditors or resorting to the printing press.

Under the current condition, foreign creditors will be more cautious or unwilling to subscribe to US debt. They already have toxic financial instruments in the books of their banks more than they can handle. So the US has only one option left, which is to inflate away the debt by printing money. By doing so, the  US Treasury will issue bonds directly to the Federal Reserve, which will issue the money in return. The Treasury will use the money to meet its budget or other spending obligations.

This US money-printing, the Bank of England, the Swiss National Bank, the Bank of Japan, have warned is threatening hyperinflation afterward. The dollar will head for a decline. Once inflation is off and running, the printing press dollars will only have goods made in America to chase after. The real crisis has not yet begun.