Economics Tricks

The new resolution and the optimism of the new year 2008 for the economic growth is dented by the unemployment report last week at 5%. This has prompted Fed to sooth-saying the market that the interest rate cut is imminent and is able to prop up the economy. However, one may wonder why the decision is announced after so many falls and news about the sub prime crisis have prevailed and how effective the previous policies on the market?

The mortgage crisis came to everyone's scrutiny since 2005 and 2006, and the question asked is; the lending policies were too lenient and outright lagging the prudence professed by the developed worlds which blamed the Asian financial crisis 1997 on the developing worlds, mostly Asian Economies. However, the stack of mortgage loans and its weaknesses were further prolonged by the hedge fund companies which introduced the novel instrument to allay the fear of spiraling bad debts through CDO, collateral debt obligations. CDO is an instrument to sell short term securities and buy higher return and longer term loan papers. When the market was awashed with potential bad debts, the introduction of the instruments became hot cake.

This instrument was guaranteed by financial companies, in the event of non-performance, the holders are guaranteed the investments. But why the guarantee? It is because the hedge fund guarantees to buy the potential bad debts from the institutions and of course there are fees involved. And since the packaged securities were guaranteed and graded highly by the international agencies, the shot term papers were selling fast in the market, due to the attractiveness and the potential of cushioning the write downs, it drew in much money market funds. And as long as the price of the paper was booming and the sentiment was positive, no one will withdraw their money from the pyramid type investment. It is pyramid type because the early investors reap the profit in the expense of the later investors.

The mechanism caused more selling of mortgages and the borrowings were made very easy, as the money became cheaper. This in turn drove up the house prices, holding off defaults and foreclosures. Therefore, everyone was happy, as there was always someone who comes in later to take up the risk by buying the short term papers. Therefore, the prevalence and the worries of potential write downs of the mortgage loans were allayed and the problem enhanced and prolonged.

When this fragile mechanism imploded and proven to be non-sustaining, the spiraling effect proves to be non-ending, the agencies exposed to the mechanism are spread across the world, and its seriousness and end are still no where to be seen. To cushion the effect; the credit squeeze (banks are now reluctant to lend, the inter bank lending dropped because the exposure of the banks to the problem is still not known), Fed and ECB, announced trillions of loans to the affected parties, to boost the lending and thus to rejuvenate the economy. However, the problem faced is the damaged balance sheets, and thus the loans given by the central banks are barely heeded by the banks. Although the loans helped to boost the sentiment, the drop of interest rate was meager. Many of the banks focused on non financial related money, mostly from Asia and Middle East.

The crisis affected the value of the currency, and have lowered the price of the country's export, and thus helps to boost the local manufacturers and exporters. However, price of wholesale is increasing, and the country risks the potential of inflation as wholesalers will tend to pass the increase to the final products. And since US is the main importer and user of oil, the increase of oil will further fuel the tension and worries of stagflation.

The offer and auction of loans to the conventional banks are proven to be non effective in ensuring liquidity in the market. The offer was mainly of the opinion that the effect on the price increase is less than the cut of interest rate. However, the recent announcement by Fed of potential interest cut was completely in contrast with the stand made earlier. What guarantee that the cut can rejuvenate the economy and what is the different between the policies in cushioning the squeeze? Is the Fed fire fighting instead of getting to the root of the problem? Is the Fed putting on the fireman hat every time when the problem emerged instead of approaching the problem with a more sustainable policies?