posted July 4, 2008
The Continuing Financial and Economic Crisis in America

The Continuing Financial and Economic Crises in America
By Dr. Jack Rasmus
Copyright 2008

In July 2007 lightning struck the financial system in America, setting off a conflagration in the subprime mortgage market that spread like wildfire to other credit markets—e.g. commercial paper, collateralized debt, high yield corporate and junk bonds, commercial property, prime mortgage, leveraged loans, municipal bonds, student loans, industrial and commercial loans, and so on. In the months that followed, credit market after market retreated, collapsed or virtually shut down.

Initially banks attempted to smother the flames on their own with a blanket of self-financed emergency funding—which proved insufficient. The Federal Reserve (FED), the U.S. central bank, then brought out its gardenhose of short term interest rate reductions—to no effect. The FED quickly replaced that with a wider hose, called the Term Auction Facility, in December 2007, making money directly available to banks at below market rates which it hoped would douse the flames of financial instability—it didn’t. Sovereign wealth fund fire departments from Asia and the Gulf states were subsequently called in to provide aid, but sent only token support.

Losses from the fire mounted into early 2008. By February the crisis spread to the municipal bond markets, student loan markets, and the ‘monoline’ bond insurer companies. Bond insurers are supposed to cover banks losses when they occur. However, grossly undercapitalized to begin with, and having themselves over-speculated in the same subprime and related markets and having multi-billion dollar losses of their own, the bond insurers were also in trouble. With barely a collective $50 billion of funds between them as a group, they could hardly begin to put out the more than $1 trillion dollar conflagration of estimated losses accumulated by the banks. By March 2008 the stakes rose even higher. The financial crisis began to approach the $60 trillion credit default swaps (CDS) market, threatening to engulf it in flames as well.

One of the biggest players in the CDS market, the investment bank, Bear Stearns, stood directly in the path of the firestorm. If it burned and collapsed, it promised to take numerous additional structures with it, setting off countless additional financial fires elsewhere and a potential chain reaction of bank failures. Faced with a crisis rapidly spreading and deepening, the Federal Reserve (FED) in mid-March opened the floodgates of its reserves and threw half of its total remaining water supply of capital—roughly $412 billion—at the fire. $29 billion for Bear Stearns. Roughly $60 billion for European banks holding dollar reserves. And more than $320 billion for the rest of the U.S. banking system. The FED’s unprecedented (and unauthorized by law) desperate action checked the fire’s advance. But it did not put it out. It only drove it underground—and elsewhere.

Despite declarations in April by bank CEOs, government officials and the business press that the firestorm had passed, it nonetheless continued to smolder. Bank losses continued to grow. Feverish attempts by banks, mortgage lenders, and others to ‘recapitalize’ to offset losses during April-May—by selling off assets at firesale prices, by issuing new stock despite diluting values for existing investors, and by offering investment deals to private equity firms and hedge funds on extraordinarily favorable terms to the latter—proved insufficient to cover growing financial losses. Of the more than $1 trillion in remaining bank losses estimated by the International Monetary Fund, barely $400 billion had been covered by June by newly raised capital.

Throughout June 2008 institution after financial institution reported larger than expected losses and announced the need to raise still further amounts of capital. By late June 2008 a general awareness of continuing financial instability began to emerge once again: In the U.S. regional banking system. Among U.S. mortgage lenders. In consumer credit companies like General Motors’ consumer auto financing arm, GMAC. In money center banks like Citigroup, Lehman Brothers and Merrill Lynch and European banks like the Swiss UBS, France’s Societe General, Britain’s Barclays, the Belgo-Dutch Fortis.

The most important direct consequence of financial crisis over the past year has been a scorched earth of credit contraction amounting to several trillions of dollars that is progressively grinding the U.S. economy into a new kind of historic stagnation and long term decline. That stagnation and decline we have elsewhere called an ‘Epic’ Recession*—a recession unlike any previously in the post-1945 period; a recession that has begun to share characteristics of a classic depression without yet having become such; a recession that can ‘tip’ either back to a containable recession typical to the postwar period or toward the direction of a classic, global depression.

Unable to borrow credit at reasonable costs due to credit contraction, U.S. businesses have begun increasingly to raise prices to cover higher borrowing costs while simultaneously laying off workers and reducing hours of work for those still with jobs. Unemployment rose by a million workers in 2007 and twice that is projected for 2008. For those still with jobs, hours of work are being cut drastically and many workers ‘converted’ from full time to part time work. Confronted with rising commodity (food, raw materials, oil, gas, metals) prices, businesses have begun to pass through commodity costs into prices as well, squeezing American consumers still further.

The financial crisis has thus been responsible for much of what is called ‘core’ inflation (energy and food) in the U.S. This has occurred in two fundamental ways: First, by lowering interest rates since last September FED action has resulted in an accelerated devaluation of the U.S. dollar. Dollar devaluation has raised commodity prices in turn, and in so doing provided a further opportunity for global commodity speculators to push prices even higher by leveraging the devaluation. Second, by raising long term interest rates, and thus business borrowing costs, the financial crisis has led business to offset costs of borrowing by raising prices.

* see ‘The Emerging ‘Epic’ Recession’, “Z? Magazine, v. 21, n. 6, June 2008, pp. 38-41, at

The financial crisis in the U.S. has also simultaneously provoked deflation, i.e. falling prices. The most serious deflation thus far has been occurring in housing markets, where
consumers have faced a 20%-40% drop in the price of their homes. Meanwhile, more than two million US homeowners face foreclosure and loss of their homes, while more than half of all homeowners now owe lenders more than their homes are worth. Deflation has begun to spill out from the housing market to the commercial property market as well, and to seep into the auto industry in the form of both falling auto prices and an even more dramatic fall in auto workers wages. Finally, as corporate defaults begin to occur in large numbers later in 2008 and 2009, price deflation may spread as well to other markets. Inflation creates great hardship, especially for workers. But deflation is the stuff that depressions are made of, and is one of the premier hallmarks of a classic depression.

Confronted with record price hikes in food, gasoline, education, and health care, with rising unemployment, and with falling home prices and millions of anticipated foreclosures, it is not surprising that American consumers in mid-2008 were in full retreat. The most recent consumer confidence surveys show, for example, the sharpest fall in U.S. consumer confidence since records were first kept.

Much of the Congress’s recent $168 billion tax rebate will do little to alleviate growing consumer distress. Estimates are only a third, around $50 billion, will be new spending. And much of that will be spent on higher energy and food prices, effectively transferring the rebate from U.S. taxpayers to energy companies like Exxon and other companies in the food and raw materials supply chain. Even a $100 billion of injection into the economy pales in comparison to the $775 billion some sources estimate will be ‘extracted’ from the economy due to credit contraction this year.

Riding the false wave of optimism that the U.S. economy had somehow stabilized in April-May, the major U.S. stock market, NYSE, rallied significantly during the two months—and then collapsed even more dramatically in June, falling at a rate that has not been seen since 1930!

Behind the June freefall in stock prices lies the realization that several U.S. big banks are still very much in trouble, that U.S. regional banks may be in even more trouble, and that hedge funds next month may record their worst performance on record. By year end 2008 corporate defaults are expected to more than triple, producing further financial sector losses. The auto industry (in particular General Motors whose stock fell more than 10% on June 26) may be facing multiple bankruptcies, placing it high on the ‘sick man’ industries list alongside Housing and Banking. All three industries are experiencing some degree of deflation. Meanwhile, jobs losses continue to grow, the dollar continues to fall, the FED has few remaining cards to play, and Congress is gridlocked in terms of any bailout legislation until after the November elections.

The worst of the financial crisis in the U.S. may be yet to come. And odds that the U.S. economy will transition to an ‘Epic’ recession in 2009 have risen further at mid-year 2008.

Dr. Jack Rasmus
June 23, 2008

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