The Worst Recession in 25 years?

On September 18 the Fed cut its target for the fed funds rate by 50 basis points (0.5 percentage points), from 5.25% to 4.75%. The move surprised many analysts who had been expecting a more modest cut of 25 basis points.

For those versed in the Austrian theory of the business cycle, as developed by Ludwig von Mises and elaborated by Friedrich Hayek, the aggressive Fed "stimulus" is ominous indeed. Not only will it pave the way for much higher price inflation than Americans have seen in decades, but it will also exacerbate what could be the worst recession in twenty-five years.

How the Fed "Sets" Interest Rates

Before discussing the history of interest rate manipulation by the Fed, a primer will be useful. When people say the Fed did such-and-such to "interest rates," they are specifically referring to the Fed's target for the federal funds rate. The Federal Reserve itself is neither a borrower nor a lender in this market; the fed funds rate is the interest rate that banks charge each other for overnight loans of reserves. Recall that in our fractional reserve banking system, the Fed mandates that banks keep a certain amount of reserves (either cash in the vault or deposits with the Fed itself) in order to "back up" their total outstanding deposits. At any given time, some banks have more reserves than they need, while others have less. The banks with excess reserves can thus loan them to those with deficient reserves, and the (annualized) interest rate is the fed funds rate.

Now a further complication: the Fed itself does lend reserves to banks, but it does this at the so-called "discount window," and the relevant interest rate is the discount rate. In recent years the Fed has traditionally maintained a margin between the fed funds target and the discount rate, in order to encourage banks to borrow from each other, rather than coming hat in hand to the (more expensive) Fed. Some readers may recall in mid-August that the Fed slashed the discount rate (not the fed funds rate) and encouraged banks to borrow from it in an effort to restore liquidity and calm to the credit markets.

It is clear enough how the Federal Reserve can set the discount rate: since the Fed is the one loaning these reserves, it can insist on any rate it wants. (Of course, if the rate were too high it might not get any takers.) But how does the Fed influence the federal funds rate, if it doesn't directly participate in this market? Is the target enforced the way, say, the government in some areas controls apartment rents or minimum wages?

The process is much more complicated. Very briefly: the Fed can control the quantity of reserves held by banks, and thus indirectly can control the price the banks charge each other for lending out reserves. If the Fed thinks banks are charging each other too much for reserves — in other words, if the actual fed funds rate is higher than the target — then the Fed will engage in an "open market operation," buying assets such as US Treasury bonds from banks. The Fed pays for these purchases by adding numbers to the accounts the selling banks have with the Fed.

This is the precise point of entry for the new money that the Fed creates out of thin air. To repeat: When the Fed buys (say) $1 million in bonds from Bank XYZ, Bank XYZ surrenders ownership of the bonds but sees that its deposits of reserves at the Fed go up by $1 million. But the Fed didn't transfer this money from some other account. No, it simply increased the electronic entry representing Bank XYZ's total reserves on deposit. There is no offsetting debit anywhere in the banking system. Bank XYZ now has $1 million more in reserves, while no other bank has less. Bank XYZ is now free to go out and loan more reserves to other banks, or to make loans to its own customers. (In fact, due to the fractional-reserve system, the bank could make up to $10 million in new loans to customers.) The money supply has increased, putting upward pressure on prices measured in dollars.

But back to our original theme, the injection of reserves obviously increases their supply and thus (other things equal) pushes down the rate Bank XYZ will charge other banks who might want to borrow reserves from it. The open market operation has thus achieved the Fed's goal of pushing the actual fed funds rate down to the desired target. Of course, going the opposite way, if the actual fed funds rate were too low, the Fed would sell assets to the banks, thereby destroying some of the total reserves in the system.

Austrian Business Cycle Theory

According to Ludwig von Mises and his followers, the boom-bust cycle is not inherent in the free market, but is rather caused by the government's interference in the credit markets, specifically its manipulation of interest rates. The government causes the boom period when it injects new credit into the system (pushing down rates), and then the unsustainable, non-economic investment projects put into motion necessitate a bust at some future date. (Here is a reading plan for this topic.)

The following chart illustrates the Misesian explanation. Note the chart does not include the recent September cut.

Real Yr/Yr GDP Growth (blue, right) vs. Real Effective Fed Funds Rate (red, left)

Generally speaking, the chart indicates an inverse relationship between the two series. This accords with the commonsense view that cutting interest rates provides a stimulus while hiking them is contractionary. However, what the Austrian approach provides is the understanding of the real forces behind the boom-bust cycle. In other words, most financial commentators think that today's interest rates affect today's economic growth, end of story. But if a previous boom period has led to massive malinvestments, there must be a bust period to liquidate the various projects (for which there is an inadequate capital structure to complete).

To put it another way, many commentators seem to believe that if the Fed held interest rates low indefinitely, then we'd never have high unemployment, just rampant price inflation. And yet, the recent experience shows that this is dead wrong. The Fed didn't cause the recent problems by "responsibly" hiking interest rates. No, rates had been steady at 5.25% for some time, and then the housing bubble burst and the mortgage market faltered, thus "forcing" the Fed to take action.

Looking back at the chart above, we can see why the worst may be yet to come. In (price) inflation-adjusted terms, the early-2000s levels of the actual fed funds rate is the lowest since the Carter years. And many readers may recall the severe recessions of 1980 and 1982 that followed that period.

Conclusion

In the Austrian view, the boom-bust cycle is caused by the Fed's maintenance of artificially low interest rates, which causes businesses to expand, hire workers, buy other resources, and so forth, even though these projects are not justified by the true supply of savings in the economy. The greater the "stimulus" the worse the malinvestments.

From 2001–2004, the Fed kept (real) rates at the lowest they've been since the late 1970s. One of the consequences that has already manifested itself is the housing bubble. But a more severe liquidation seems unavoidable. The recent Fed cut may postpone the day of reckoning, but it will only make the adjustment that much harsher.

The Con That Turned the World Against America

The world’s financial system came precariously close to seizing up these past couple months.

In fact, as far as some big banks and financial institutions were concerned, for a moment in time, the system was in a full-blown cardiac arrest. Liquidity, the flow of money—the lifeblood of today’s economic structure—came uncomfortably close to clotting up.

Defibrillators sizzling and money flowing, central banks around the world acted in concert to jump-start financial markets, slashing lending rates and injecting a half trillion in dollar steroids into the economic pulmonary system.

But contrary to what the big media outlets may have reported, it is actually inconsequential whether or not central bankers succeeded in temporarily stabilizing markets.

Irrevocable damage to America’s economic system has taken place.

And because the world’s largest economies are so closely intertwined, the effects will not be limited to the United States. Confidence in the world’s financial system—a system based on the dollar as the reserve currency—is failing, not because of a liquidity crunch, a popping housing bubble, or the myriad of other commonly spouted economic causes, but because of broken faith. The result will be a new world financial order—one without America at the head.

Here is what happened and why you need to know about it.

The world’s economic system is built on trust. Money is no longer backed with tangible assets. The only thing giving that Jackson in your wallet purchasing power is the perception that it will be able to buy a similar batch of goods tomorrow as it can today. But here is the catch. There is no standard that determines what a dollar is worth—ultimately it’s all relative. Its value could disappear overnight.

The same is true for every currency, whether yen, ruble or peso. Each is backed by confidence—confidence that the government will act responsibly, confidence that the government will honestly pay its debts (not just print more money), and confidence that the currency will remain a store of wealth.

When that confidence is broken, faith-based economic systems go into meltdown. Investors and international banks flee, currency values plummet, inflation runs rampant and economies are destroyed.

In August, when fallout from America’s popping housing bubble began to hit the market, trust in America cracked—and with it, so too did confidence in the global economic system.

Hamid Varzi, writing for the International Herald Tribune, summarized world opinion this way: “The U.S. economy, once the envy of the world, is now viewed across the globe with suspicion” (August 17).

He continued: “The ongoing subprime mortgage crisis … presages far deeper problems in a U.S. economy that is beginning to resemble a giant smoke-and-mirrors Ponzi scheme. And this has not been lost on the rest of the world.”

Trust in America is quickly disappearing. Why? Because America single-handedly brought the international financial system virtually to its knees by foisting off fraud-ridden subprime debt on an unsuspecting world, which resulted in the ensuing credit crunch.

America will not escape unscathed. You can’t cheat the very people you rely upon to lend you money without a backlash.

Here is how American greed ripped off the rest of the world.

In 2000, America faced a recession. But rather than letting the economy rebalance, the Federal Reserve decided to slash interest rates to artificially stimulate the economy—even though it knew that doing so would probably create even bigger problems later.

Consequently, mortgage rates in America plummeted and, suddenly, millions more Americans could buy homes. House prices skyrocketed: tripling and quadrupling in many areas. The bubble fed on itself as prospective homeowners, often acting more like speculators, rushed to buy homes as quickly as possible to capitalize on further price appreciation.

As home values rose, fewer people could afford traditional loans. To keep their profits growing, banks and lenders began offering easy-to-get subprime mortgages—mortgages to borrowers normally considered too risky due to credit history, income status and other factors.

Oftentimes these loans were adjustable-rate, or had initial teaser rates that would ratchet up later. Often the loans were given without any applicant background checks at all. As long as a borrower could write his own name and yearly income (regardless of whether or not it was true), he could get a loan.

And everyone was happy. Record house prices fueled a building boom and jobs were created. Borrowers were glad because they got huge loans and could purchase homes that were rising in value. Real-estate agents were pleased because the bigger the house sold, the bigger their profit. Lenders and loan brokers were cheerful too because they each got their cut of the action.

But there was just one problem: The whole boom was based on artificially low interest rates. What would happen when interest rates rose, homes stopped appreciating and borrowers had more difficulty making payments?

American banks, understanding the risk involved in holding so many chancy (and possibly largely overvalued) subprime mortgages on their own books, decided to get rid of them. But who would want to buy all the risky mortgages? Certainly not Americans who were already maxed out on subprime debt. The answer was foreigners.

But here was the catch. To make the sales profitable, the risky mortgages had to be marketed as a “safe” investment.

So American banks sliced and bundled their subprime mortgages together into packages. Using complex computer models, and by geographically and otherwise diversifying the bundled mortgages, American banks convinced world-renowned and trusted American investment-rating agencies like Moody’s and Standard & Poor’s to give the mortgage securities higher valuations than regular subprimes would typically rate.

Later it became public knowledge that these same ratings agencies, which foreign investors were relying on for impartial advice, were being paid by the very banks and lenders that were bundling and selling the subprime mortgages—a huge conflict of interest that produced some terribly misleading data for foreign investors.

It has also emerged, at least in Moody’s case, that the agency knew for years that the mortgages securities they rated as safe were more than 10 times as risky as other similarly rated bonds (Daily Reckoning, September 3).

But at the time, even the banks were happy. They could merrily issue subprime mortgages (and still collect all their fees) because they were able to both quickly remove the mortgages from their books and get top dollar for them, thanks to the high ratings. And foreign investors (as well as domestic investors) confidently purchased these supposedly safe mortgage investments.

That is, until interest rates started to rise—and subprime borrowers began defaulting in droves.

As with all parties, the fun and games eventually end. Suddenly the world woke up to the fact that subprime mortgages were just that—subprime—regardless of what American ratings agencies and banks pretended. As the U.S. housing market slumped, suddenly nobody wanted any American mortgage securities anymore, let alone subprime ones.

Investors around the world tried to sell American mortgage securities, but by this time, the shoddy credit ratings had become public knowledge. American credit-rating agencies embarrassingly began to issue massive ratings downgrades, and foreign investors found that to even get any bidders on their American mortgage portfolios, they had to accept steeply marked-down prices.

Hedge funds and other investment vehicles began to seize up as people tried to pull their money out of any and all businesses associated with U.S. mortgages. Panic ensued.

As the credit crunch spread, it became evident that the “made in America” economic crisis was not contained. America’s trade partners would also take the hit for the moral breakdown in America, a breakdown that could have been avoided had greed not been such a big factor.

Banks and mortgage lenders across Europe and America began to fail.

German, French and British banks, as well as stock market investors around the world, got hit especially hard as the credit crunch and fears of new restrictive lending practices shook international bourses. Investors lost billions.

Things got so bad in Germany that the government had to step in to save two banks from failing. In France, bnp Paribas, one of the nation’s largest banks, had to suspend redemptions from three investment funds it managed.

In Britain, Northern Rock Plc., the nation’s fifth-largest lender, experienced an unprecedented bank run as customers lined up for hours to clamor for their money when it was revealed that it was having trouble accessing enough credit to continue normal operations. The Telegraph compared the scene to something out of Zimbabwe.

And the few big-name collapses experienced so far may be just the beginning.

You can be sure that billions in losses—all as a result of what amounts to a con—will not pass without a response. International backlash is growing.

“The entire world is growing in its disgust for having been defrauded,” says economic analyst Jim Willie. “French, British, German, Japanese and Chinese banks have been harmed from ingesting falsely labeled food items. What was sold as ‘AAA’ rated milk products was actually highly toxic acid ….”

For example, in a foreign-policy speech on August 27, French President Nicolas Sarkozy called for an enhanced global rule book to avoid financial crises—a rule book governing America. Sarkozy, who has vowed to “moralize financial capitalism,” said America’s crisis could recur if “the leaders of major countries” did not take “concerted action to foster transparency and regulation of international markets.”

Peter Bofinger, a member of the German government’s economic advisory board, agrees. “We need an international approach, and the United States needs to be part of it,” he said.

Dick Bryan, a professor of economics at the University of Sydney, says the world must respond as well. “[T]here is the need to challenge the sovereignty of national regulators—why should the rules of lending in the U.S. be left to U.S. regulators when the consequences go everywhere?” he said. In this globalized world, “a problem in one location is a problem everywhere.”

If and how long Washington can resist international pressure is unclear. So far the response from Washington is that it wants “no form of oversight.”

But a new global rule book may be the least of America’s worries.

While regulators in the U.S. have been unreceptive to international monitoring, Europe and Asia, unlike in years past, now have growing financial leverage up their sleeves.

What if foreigners stopped lending to the U.S.? Worse, what if they started dumping U.S. debt in the form of treasuries and bonds?

“America depends on the rest of the world to finance its debt,” Bofinger reminds us. If foreigners stopped buying America’s financial products, it would be a catastrophe.

Foreign willingness to purchase U.S. debt has kept interest rates low in America—thereby creating millions of jobs in real estate, home construction, remodeling and other associated industries. America has become so dependent on foreign money that if foreigners stop lending to America, the America you know today would not survive.

Even now, the foreign backlash is beginning to be felt. The U.S. dollar is dropping to lows never before experienced. In September, the dollar fell to the lowest it has ever been against the euro. Against the Canadian dollar it hit a 31-year low, making the two dollars almost equal in value.

So while U.S. officials continue to brag that all will work out just fine and that the credit crunch is contained, they are missing the bigger point: America cheated the very people it depends upon for loans. Now, foreigners are voting with their feet and are choosing to reduce investment in America. They are abandoning the dollar.

As Jim Willie warns, we “might be in the early stages of … a boycott of U.S.-dollar-based financial assets.”

But who can blame them?

Greed and corruption have been exposed for being endemic to so many levels within America’s economy. Who is to say that even U.S. government bonds more closely resemble subprime mortgages than their conventional reputation as a safe investment?

The world is approaching an end of an era. America’s moral collapse now lies exposed to all—a virtual death sentence to an economic system based on trust. Confidence lost, America’s reputation as a financial safe haven is being replaced with subprime status—and as foreigners have found out, subprime risks just aren’t worth it.

By Robert Morley

After kidnapping

Some days ago our foreign community of Kabul was alarmed: a German lady was kidnapped from a small fast food restaurant. This place is close to parliament and to my husband’s working place. Only fifteen minutes earlier my husband Andres bought bread from a bakery, just around the corner.
Although the Afghan police’s operation succeeds – the kidnappers are captured a day later – I feel quite uncomfortable. There are some rumors that some other foreign ladies have been targeted as well. Maybe those rumors are produced by fear? Was it only one gang or are there some more criminals who got now a bright idea how to earn money?
Yes, at the moment we are saturated with kidnapping stories – there are no news about nineteen Korean or a German engineer -, but those incidents happened outside of Kabul. Last kidnapping in Kabul took place two years ago. Until recently I have been quite relaxed about walking around alone here.
I remember what we were told during security training just after we landed. Is it good news that statistically I have 60% chance of survival? Or the fact that mostly the kidnappers are interested in men– but last incidents show that kidnappers are have started to target females. I have followed the basic rules: always be cautious and not to walk the same streets at the same time. But I have ignored the recommendations about going out alone or not walking in dusk.
It is for the first time - after one and half year – which I am sitting voluntary behind walls, reading books and feeling, bored. I need to wait for some more days to be sure that the crisis is over. But the worst thing is that you never know. It is Afghanistan. Things just happen here.

Walking in dusk

Before going to Afghanistan, I had the same dream for many nights. I walked alone in darkness in the middle of narrow quiet streets, surrounded by high walls. Somehow I knew that it is Kabul. At that time I had no idea how the streets of Kabul look like in daytime, not to mention the night time. I remember clearly my feeling of despair after security training: it seems that there is no possibility to walk around. Fortunately, we overcame our fears shortly.
My husband and me, we walk quite often at sunset time: to visit friend, for shopping or to go to restaurant. It has been a little bit dangerous not because of criminal gangs, but because of undeveloped city environment: there are no streetlights and deep canalization ditches edge the streets. In addition there is breathtaking stench, those ditches are truly terrifying: one can easily to step into sewage water or even break a leg.
Huts of chaokidars’ (guards in Dari language) block the sidewalks, so one has to step on motorway. Usually there is some light coming from their cabins: guards are looking at their TVs. I really wonder when this idiotic practice will finish that an army of young Afghans spends their days “guarding”, i.e. lazing in their huts, drinking tea, watching TV or playing with their guns. We have seen how bored guys just hurl their guns in the air – like a circus artists do.
Summer nights in Kabul are somehow charming as heat of the day is gone. The wind weakens and breathing is easier. There is some illumination at the vegetable and fruit stalls and windows of bakeries. Hurrying clients buy last pieces of naan while the bakers are preparing for the night, brushing cheap carpets. They sleep where they work.

Holidays in Kashmir

Why are you planning to go to Srinagar? It is unsafe like Kabul, said one Indian guy. Other colleague of my husband – a young guy from Pakistan - remarked that Srinagar is “occupied territory”. Well, I have never seen so many men with guns as in Kashmir – far more than in Afghanistan. And there were four security checks at a small building of Srinagar Airport before we boarded our plane to Delhi.
Most of foreigners working in Afghanistan have their short holidays in Dubai, because there are two flights a day and you can do those things what are almost impossible in Kabul: shopping, swimming, sunbathing, drinking. Personally I do not like Dubai, it seems to me like a weird Arab style Disneyland. So we decided to go to northern India. Srinagar is quite close to Kabul – same distance like Mazar-e Sharif. But we had to take two planes, because there is no possibility to travel directly.
We found some similarities, but lots of differences as well. First of all, there are lush green landscapes: lots of trees, lakes and rivers. We stayed on a boathouse on lake Dal. It is an extraordinary lake with islands, countless birds and more than thousand houseboats for every taste and price level as well. Boathouses have funny names like Aristoteles, Miss America, Hollywood etc. Our houseboat name was Chicago – it was hard to imagine a more unsuitable name for such a lovely carved piece of art.
I was surprised about local wooden architecture: it reminded me old houses in Europe. We took a rides on water taxis – shikaras – in order to see locals’ marketplace in the early morning in the middle of lake and to admire lotuses and floating gardens. And a fort built by an Afghan governor towered on the hill on the other side of lake.
There are marvellous gardens next to the lake. Indian Moslem lords – moguls – used to build terraced gardens with fountains, flowers, maple trees and garden pavilions. Gardens are opened to visitors. Ladies frolic around the fountains, such kind of behaviour is out of question in Kabul.
Although the Kashmir is mainly a Moslem region, ladies do not cover themselves with burkas. Instead there are colourful veils and dresses. The atmosphere in Srinagar is relaxed.
Our boathouse manager advised us to go for trekking in the mountains near Pahalgam Valley. I have done a lot of hiking during in my life, but never in in such a luxury. We had three horses, two horsemen and a guide who was also a cook. There were two tents and lots of food on horsebacks. Even two chickens were taken along with us. And water pipe was important for our guides, as we discovered soon.
The people look similar to Afghans, especially men. Women’s scarves are more colourful but otherwise they are quite reserved and do not like photographing. They have small huts up in the mountains where they pasture horses, cows (for milk) and sheep.
We had some sort of intellectual game to find familiar words in Kashmiri and Dari languages. Kashmiri language is influenced by 14 languages, so we heard often similar words: sardi (sard – cold in Dari), garmi (garm – warm is Dari), bacha (guy in Dari).
It was like a journey to paradise: we walked under high old pine forests. Trees were so tall and strait that reminds me of redwood trees in northern California. There were lots of wild flowers along Liddar River. And I stop worrying about possible mines around on the second day of our hike.
PS. More images can be found on website Kabuli päevik http://qnne.blogspot.com/ (August 2007)

Separated worlds of women and men

Afghan landlord holds a party in our shared garden. After thorough preparations nokar (servant) sets two tables: one for women and the other for men. We can hear a dignified talking through our living room window and there is endless cheerful laugh coming from our bedroom window. Even if it is a modern Afghan family, men and women are separated.
There is one favorite question, often asked: do you really believe that one can find happy women in Afghanistan? Of course I do. From my point of view, local traditions are so different from west, but it does not mean that all women are automatically miserable. Feminists like to tell sad stories about western ladies who had married to Muslims and moved to Muslim countries. I read some of those books in Estonia and unavoidably the question emerged: where is a story about normal marriage? There is one basic problem with those biographies: they are written by persons who were not prepared to live in Muslim environment. It is a different culture, which has strict customs and ancient traditions. It is naive to believe that family will change because of a foreigner.
The biggest difference – in my mind – is the fact that most of the time he or she is with people of the same sex. In western world it is common that we spend most of the (spare) time with our spouses. But here, in Afghanistan, the wife spends her time with her husband’s mother, sisters, aunts and other female relatives. It can be quite difficult, even unimaginable for a lady grown up in west.
The second biggest difference is living in an expanded family. I know of only one family in Afghanistan who lives in their own: my friend Waheed lives with his wife and a little daughter. Uncharacteristically he took care of his little daughter while her wife was at a conference in Iran. Generally speaking, different generations live together. I met on high official in Kunduz who has 22 children, all of them born to one wife. He complained that he cannot even remember his children names, but there are daughter-in laws and grandchildren living in his house as well…
Old people enjoy the advantages of expanded families. The oldest male – head of household – decides all-important questions. Also he manages family budget. For example, if a married young son works, then he gives his salary to his father. Father decides how much the son will receive for his needs and how much will go to others. The grandmothers I have met in Afghanistan were very dignified. Their experience is valued; younger family members serve them with respect and their orders are followed quickly. If I compare the old generation here to our grandmothers in Estonia, then I see that Afghans get much more love and support because there are always younger generations around them.

Breadmaking

I walk into a local bakery - just around the corner – to buy a naan-e usbeki (flat round bread). Giuseppe, Italian colleague of my husband, suggested me to use this type of bread to make pizza. I get a hot bread what was a moment ago pulled out of a stove; so I dandle it between my fingers when walking back to our house. Price of bread is 8 afs (ca 16 US cents) – so I got change of 2 afs from 10 afs note.

During my first half-year in Kabul, I never saw any Afghan coins. It seemed that the smallest unit of currency is one US dollar. Now, when I walk around to buy vegetables and fruits from small local stands, the shopkeepers often give me back coins. If I refuse, then they offer me a fruit as a bakshesh (gift).

Bread is the main foodstuff for poor Afghans, so on rush hours there is even a queue in front of bakeries. One can see beggars or soldiers buying their main meal, but there are as well rich guys with their fancy four-wheel drive cars. Bread is unavoidable part of diet in Afghanistan. Rory Stewart, who walked from Herat to Kabul, had mainly eaten only bread.

In Bamian kind Hazaras invited me inside their bakery. Half a dozen men were shaping different kind of breads at unbelievable speed. In the middle of the room there was an oven what looks like a glowing hell. One young skilful guy placed bread – in just half of a second - to inner wall of the oven. After some minutes another person pulled bead out. He used special fork and spatula and his moves looked like a sophisticated way of dancing.

Their motions were so fast that I was not able to focus my camera properly.