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Reply #15: What is happening with the economy? By Dr. Abbas Bakhtiar [View All]

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Demeter Donating Member (1000+ posts) Send PM | Profile | Ignore Tue Mar-18-08 07:29 AM
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15. What is happening with the economy? By Dr. Abbas Bakhtiar

Original Content at http://www.opednews.com/articles/genera_dr__abba_080316...




the madness begins with those who have high tolerance for financial risk. That is to say they are rich and can afford greater financial loss than others. They speculate and make money, lots of money. Soon the less wealthy see this and join the crowd and before you know it the whole country is involved. When President Bush entered office he gave one trillion dollars (tax cut) to the wealthy. In effect he increased the tolerance for financial risk of the wealthy individuals and companies even further. Later, he started the Iraq war, pouring billions of dollars into the economy. One should not forget that when the US government spends about $2 billion a week in Iraq, most of that money finds its way back into the US economy (salaries, armament, etc). But all these monies were borrowed money (deficit spending), and all the growth and feeling of well being was illusory.
The money pumped into the economy had to find some channel for investment. So banks and financial institutions began to push money in hope of getting incredible returns. Easy credit was the solution. You want to buy a house? No problem, we finance 90% of it. You want to have a new car? No problem, we give you a loan. This push suddenly made it possible for millions of people to buy houses, putting pressure on the housing market. House prices sky-rocketed, increasing the illusion of increasing wealth, which in turn allowed people to borrow more money. All the time, banks and credit institutions were jubilant at the sight of extraordinary returns on their investments. A normal credit company charges around 18% to 23% on the dollar while they borrow the same money for 8% to 9%. It is a great business. The banks also had a good time. Cheap money was lent to people backed by assets that were appreciating in value. The risks were spread by selling mortgages to other banks and institutions. Before you knew it every bank, insurance company and god knows who else were rushing in to take their piece of the action.Growth in housing construction represents a substantial part of general US economic growth. So with easy credit and continuing increase in housing prices, US showed a good growth rate, giving the illusion of well-being.

But as with Tulips and DotComs manias, there comes a time when there is no more room for illusory growth and demand. The bubble bursts and asset prices crash. The banks are left with depreciating asset guarantees for their loans and before you know it the whole financial system is in trouble. Usually when this happens, it takes a few years for the companies and individuals involved to go bankrupt, after which the cycle starts anew. Hopefully with lessons learnt. But this time it is different. When a recession starts, the government has a few tools at its disposal to deal with the economic downturn: Interest rate, the budget and war. It reduces interest rates to stimulate economic growth. It can also start large infrastructure projects such road building, constructing bridges etc, to reduce unemployment and stimulate the economy (deficit-spending). There is another sure way of kick starting the economy and that is WAR. Wars are good for businesses and reduce unemployment and stimulate (for US) important parts of the economy. However, all three tools have been already used prior to the recent recession. US has huge trade deficit and is involved in two wars (Afghanistan and Iraq). It has also reduced its tax revenues by giving huge tax-cuts to the rich. Large trade deficit, low tax revenue, tremendous debt, wars and low interest rates make it extremely difficult for the government to do much to help the economy.

If this was not enough its currency the mighty dollar is losing its position as the preferred international reserve and trading currency. The Federal Reserves keeps pumping dollars into the market, while at the same time keep reducing interest rates. This means only two things, a devaluation of dollar and an increasing inflation. Countries such as China, Japan, oil producing countries and others keep their reserves in dollar. These reserves are in the order of trillions of dollars. Imagine a 15% decline in value of dollar will translate to $150 billion dollar loss for the Chinese government alone. How long will these countries tolerate this loss is anyones guess, but surely there comes a time when these countries will react and begin to switch to other currencies. It is then that we will see the real collapse of the US economy.

There is already some ominous sign of this. A few days ago, Venezuela declared that it will no longer sell its oil in dollars. Currently there are Iran, Venezuela, and Russia that have decided to trade their oil and gas in other currencies. In addition, some Arab countries have started to de-peg their currencies from dollar. For these countries peg to dollar has meant importing inflation and they are trying to stabilise their economy. As dollar decreases in value and more and more raw-material producers switch away from dollar, this de-pegging will only increase. This will put further pressure on the dollar contributing to its decline. This, of course is not good for the US consumers. When times were good (illusory) US kept its inflation in check by importing goods from countries such as China, India, and other places; where imports were paid with dollars. Now some stuff has to be paid for in Yen and Euro both of which are appreciating in value against the dollar. At the same time oil and gas prices have increased tremendously, not only in dollar term but also in other currencies. All these things mean that US has to pay many more dollars for the goods that it imports. In simple terms, US inflation is rising rapidly. In my opinion, the US government is not telling the American people the real truth, fearing further collapse in confidence.

The outlook for the US economy

When recession hits, the government usually starts deficit spending to increase employment. At the same time the interest rates are reduced to stimulate economic growth. United States is now in an unenviable position of entering recession with very low interest rates, huge deficit and declining dollar... the government has not the ability to meet its existing financial obligations to the American people, let alone starting infrastructure projects to reduce unemployment or help the economy.

With regards to the interest rates, the Federal Reserves has very little room for manoeuvre. Already the real interest rates are in negative territory (lower than inflation), although the government and the experts say otherwise. Further interest rate cuts will only increase inflation and devalues the shaky dollar even further. But this is exactly what the Federal Reserves is doing. This is most likely to rescue big financial institutions, the very institutions that were earning huge profits from unsuspecting American consumers. In effect, the Fed is abandoning the poor and helping the rich. If the government was serious in helping the working American, it would have paid the money directly to the people, so that they could pay their debt. Instead it is pouring hundreds of billions of dollars into the banks. If you count the monies that have been poured into the financial markets, youll see that $160-$200 billion dollar tax rebate to the people was only mere peanuts as compared to what banks and others have received.

All in all, one can say that this recession, if it doesnt turn into a depression, will be severe and will last at least 2 to 4 years. Technically a recession may last one year, but the effect of that recession on families may last a decade. Some lose their homes, some their jobs, some families will break-up and so on and so forth. The human misery of technical recession lasts much longer than the recession itself. Anyway, if the price of the houses is dropped by 40% in two years, how many years of growth will it take to retake that 40%? Usually much longer than people think.



The World Economy

It is said that when the US sneezes the world catches cold. This was true before but the world has started to think that it can decouple itself from the US economy. Here the umbilical cord is the US dollar; once that is cut, slowly but surely the decoupling will take place; with dire consequences for the US. As I mentioned before, already some important oil producing nations have decided to abandon the dollar. Others have decided to de-peg their currencies. Others such as China have started thinking about reducing their reserves in dollars. Once others begin to do the same the dollar will cease to be the international reserve and trade currency of choice. Meanwhile, major trading partners have to just bite the bullet and accept the consequences of holding to the dollar.
...But they dont do this out of love. They just need stability to reduce their dollar holdings gradually and hence save as much of their reserves as possible. If they mention this openly, the dollar will collapse over-night and they lose. So the long-term plan would be to reduce their exposure to the dollar as gradually and as quietly as possible. This of course doesnt mean that the value of dollar will not fluctuate; it simply means that over time dollar will become just like any other currencies and will be treated similarly. The Federal Reserves will no longer be able to just print money and refuse to publish the M3 statistics. US will also need to begin building reserves in other currencies. Today US dollar has no backing. People accept dollar on faith alone. Imagine if that faith suddenly disappears. Will you exchange 1 kg of green paper for 1000 Microwaves? I doubt it.

But meanwhile the worlds economy will experience the negative effects from the US economic downturn. The case for the European Union is straight forward. A flight from dollar to Euro makes the EUs export much more expensive, just when one of its biggest trading partners US goes into recession. European Union will also feel the pains of financial crisis of the US. Many EU financial institutions had invested in US and now they will have to accept the losses. So we will see a down ward trend in Europe, but not as severe as the one in US. In addition European Central Bank has still a lot of room for manoeuvre. It can reduce interest rates substantially. EU also has smaller total deficit than US. Most importantly, most of the EU countries have solid social security nets in place which will dampen the effects on their citizens.

Of course this is not written in stone. The US government may come to its senses and decides to act responsibly and allow many companies and banks to go under. It may try to support dollar. It may try to cut the budget deficit or the trade deficit. It may even decide that its war in Iraq was not and is not such a good idea and withdraw its troops. It may even try to get friendly with Venezuela and Iran, thereby reduce both the price of oil and pressure on the dollar. The truth is that it is the US president that can do these things and not the Federal Reserves. We just have to wait for the elections and see who is elected as the next president.







Authors Bio: Dr. Abbas Bakhtiar lives in Norway. He works as a management consultant.He is also a contributing writer for many online journals.
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