Tuesday, 24 March 2009

The greatest financial gamble

John Mangun
Business Mirror

The United States 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.

On Wednesday (Thursday, Manila time) the US Treasury announced it will buy $750 billion worth of mortgage-backed securities from the banks and about $300 billion in outstanding US Treasury debt. This is going to be complicated but, I assure you, it is vital to your personal wealth to understand what is going on.

The US government believes, correctly or incorrectly (and this is the key point), that the problem with the US economy is that people have stopped buying things, and this is because they cannot borrow the money to make those purchases. This seems to completely ignore the fact that reckless borrowing and subsequent spending is what got the United States into the economic problem in the first place.

However, let’s give them the benefit of the doubt on that point. Sitting here in the Philippines or in China or Europe, the rest of the world is like the bar or brothel owner catering to the American sailor on shore leave. If the sailor sells his shoes or robs a convenience store, no one cares as long as he uses the money to purchase our goods or services.

The $1.15-trillion Treasury move, in effect, dumps that amount of money into the economy in one giant shot. It is designed to immediately lower the most important interest rates, the two- to 10-year tenor, over which the Federal Reserve (Fed) has virtually no control. The way the interest-rate market works is that the Fed can control the shortest-term interest rates based on what they charge the banks to borrow money from the ultimate lending source, the Fed. The assumption is that the banks will then lower the longer-term rates that they charge borrowers.

By buying back the bad mortgages, the Fed will clean up the balance sheets of the banks by replacing bad assets with cold, hard cash, which the banks are now supposed to loan out. By buying existing Treasury debt from the open market, here, too, the Fed is replacing paper assets with cash. But the banks do not put that $1.15 trillion cash in their vaults. They go right back out and buy Treasury debt in the open market. Because the Fed has removed a large amount of existing debt from the market, these huge purchases from the banks drive interest yields and, therefore, rates down. The 10-year note interest rate fell from 2.95 percent to 2.5 percent. That is a huge drop, especially since it took only less than one hour to happen.

The purpose of this Fed move is to lower the interest rates that consumers must pay for house mortgages, car loans and the like. But this policy action is the biggest experiment of monetary policy in history. The Fed has increased the cash in circulation by nearly 50 percent. That is a tremendous amount of monetary inflation. The financial markets responded immediately by dropping the value of the dollar from €1.31 to €1.35. The dollar opened in Asia yesterday at €1.365.

“What no one really knows yet is the exact linkage between the formation of new money, and the formation of new credit. [Fed Chairman Benjamin] Bernanke and his Fed are gambling that a giant pulse of monetary inflation will reignite private lending. For every lender, there’s a borrower. The Fed will succeed if the problem in credit markets is the reluctance of lenders to write new loans. But if the problem turns out to be a lack of demand for credit, then all we’ll get out of this is stagflation”—Commentary Magazine.

Let me tell you a silly story. You car stalls at an intersection, not moving, just like the US economy. The boys run out to sacrifice themselves to push the car. Only, just hard work and sacrifice will not get the car (economy) going. At some point you must release the clutch and jump-start the situation by providing extra credit and cash. But if you release it too soon, not enough sacrifice has been made by the people (the car is not moving fast enough for the clutch to start it) and the car does not start simply with the clutch (extra credit and money). If you wait too long, though, the boys run out of their own energy and you cannot jump-start no matter how much clutch (money and credit) you use.

If this Fed move is premature, all that will happen is a massive depreciation of the dollar and very high US inflation because of too much money in circulation. The oil, gold and strategic metal markets are saying both will occur. If the Fed is wrong on its gamble, we will see $100+ oil and rising prices for other dollar-denominated global commodities.

But do not start panicking. The peso will then be at 20 to a US dollar. More analyses on the local effects on Thursday. Stay tuned. This is very important.

PSE stock-market information and technical-analysis tools were provided by CitisecOnline.com Inc. E-mail comments to mangun@email.com.

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