Thursday, 26 March 2009

The greatest financial gamble, Part 2

John Mangun
Business Mirror

The US government just took the biggest financial and policy gamble in the history of the civilized world. That is not an exaggeration. And win or lose, the US Treasury’s move last week will determine the next five years of the US economy, the global financial condition, and will affect you right here in the Philippines.

The US Treasury is embarking on a financial scheme to buy the bad loans of approximately 30 large banks using non-budgeted funds. That means that, in effect, the Treasury will be printing money to pay for some $700 billion of these loans.

The immediate effect was seen in the 6-percent spike in the New York stock market as the banking and financial stocks led the rally. However, the stated purpose of this plan is not to bail out the banks but to provide more funds for consumer and business lending.

If the purpose were to merely prop up the financial institutions and the stock market, this is a great idea and it will work. But if the purpose is to jumpstart a falling US economy, it is doomed to failure. Here is why.

The economic growth of the United States in the last 10 years was accomplished by borrowing money at all levels, consumer, business and government. In 1998, the total amount of household debt was 6 $6 trillion; in 2008, that amount had ballooned to $16 trillion. Now here is something very interesting. During that same period, the amount of workers as a percentage of the total population declined from nearly 65 percent to now just over 60 percent. What this means is that wealth was not being created by people making things, providing services or even pushing paper around. “Wealth” was being created by borrowing. All those houses, cars, DVD players, were not paid for by working but by borrowing. In reality, the economic growth of the exporters like China was also paid for by Americans borrowing, not producing.

As I said on Tuesday, the Treasury plan is based on the assumption that the only way to get the American economy moving is for Americans to start spending. And the formula is to encourage by whatever means possible American consumers to start borrowing to start spending. As a method to jumpstart the economy, it is doomed to failure. The problem is not that the banks cannot lend, but that borrowers have borrowed too much.

The US economy crashed because Americans had taken on too much debt over the last 10 years. This plan will not help the housing market because 90 percent of those who lost their homes could not afford to handle the debt payments in the first place. They cannot do it now, either. Rising unemployment has moved more people out of being able to borrow more. Even those who are financially sound and secure are unlikely to add more debt in any significant amounts.

One way to reduce the overall debt burden is to create inflation by printing more money. If inflation starts going up, nominal wages will also rise, creating more money to pay off debt. Imagine if your income suddenly increased by 10 percent but all prices increased also. You would have more cash to pay off your credit card because that balance would not go up. With inflation, all wages and prices will rise and the purchasing power will go down, but the debt level will drop. And that is already happening. Oil is up from $35 to $55.

What happens to the world? China is severely damaged, to put it politely. Its $1-trillion plus foreign reserves just lost 5 percent of their value and will lose more. The nominal rise in the price of oil is going to leave Americans with less cash to buy Chinese products. And those products will cost more for Americans.

Global stock markets will benefit much more than the United States. The potential for further depreciation of the dollar will make countries like the Philippines, Brazil and similar others that are not dependent on the US consumer see much higher stock markets.

The Philippines outsourcing business will grow even faster as wage inflation in the United States takes its toll on companies seeking to reduce costs. Further, with anticipated tax increases, companies will look for opportunities to do business in nations that offer tax incentives like the Philippines.

A depreciating dollar will cause the Philippine peso to appreciate, reducing the cost of our imported items such as oil. And because our exports have very small impact on the overall economy, we will not suffer as the major exporting countries.

There will be a gradual and increasing inflow of foreign money into the Philippines for both the stock market and as a place to park funds. Our comparatively high interest rates will attract short-term bank deposits and the purchase of government debt.

Unwittingly, the US plan will have greater benefits for the global economy than for its own. By flooding its economy with inflated currency, the United States has made other currencies more valuable and, therefore, other economies more valuable. As inflation increases in the United States, money will look to non-inflationary economies. As the United States cuts back on its imports, nations like China will be forced to reduce prices on their products.

The United States catches cold and the Philippines only sneezes. Buy pesos, not dollars. Buy Philippine stock-market issues. I guarantee you will be richer by year-end. Oh, and as always, buy local, not imported.

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