Thursday, 7 January 2010

US economy: Why it is not working

John Mangun
Outside the Box
Business Mirror

IT is important to clearly, as completely as possible, understand the situation in the world’s most important economy.

It is important to understand what is happening to that economy, to understand what the US government policy is, and to understand why the economic polices of the last two years have been and will continue to be an unqualified failure.

The US banking system came to disaster because of bad assets. A portion of those assets were loans for properties, and those loans became nonperforming as housing prices dropped and loan defaults rose.

In 2008 the US government pumped nearly $800 billion into the banking sector through basically buying shares and ownership of the banks. The theory behind this move was that, with a massive infusion of capital to offset the nonperforming loan portfolios, the banks would then loan out money to worthy creditors who would spend and spend, and thereby stimulate the overall economy.

The government, in effect, bought many of the bad housing loans from the banks, hoping to make it more attractive for the banks to loan to home buyers. The hope was that this intense stimulation of the economy would, in turn, reach quickly into the property sector with renewed buying and renewed appreciation of houses, thereby canceling out a good portion of the nonperforming loans.

This did not happen. Here is why.

The housing industry is so vitally important to the US economy, accounting for at least 20 percent of their gross domestic product. Stimulate housing; stimulate the economy.

The $800 billion accomplished almost nothing at all to help the economy. It did, however, put a tremendous amount of cash into the hands of the banks.

Why was this program a failure at economic stimulation?

In every country, there is a limit to the number of people who can afford to buy a house under any condition. The percentage of home ownership in the US had peaked prior to the collapse of home prices. In a real sense, there was virtually no one left to borrow money to buy a house in late 2008. No property recovery; no economic recovery.

Another $1.2 trillion was put into the banking sector in 2009 through continued buyouts, bailouts and takeovers of failed banks. Here again, one would think that all this money would show some economic results. After all, in the 1980s 700 banking institutions, the savings and loan companies, were closed and the government took over the bad loans. The loans were defaulted upon, the government took any recoverable assets, and then sold them at a deep discount to financially stable companies and individuals. Crisis solved very quickly, all things considered.

But in our current case, the bad loans were never completely taken off the banks’ books. Take note of this very well: because of pressure on the US government, the banks were and are allowed to carry the loans on their books at higher values than they are realistically worth. A $100,000 loan on a house now worth only $50,000 is not a loan worth $100,000. But the accounting magic makes the banks seem financially sound.

The housing-loan crisis is only the tip of the iceberg when it comes to bad bank assets. US banks are carrying hundreds of billions of dollars of worthless assets known as derivative contracts. Derivatives are complex and varied but basically they are “bets” that the bank made on the rise in price of an asset, primarily real estate and real-estate loans.

The banks are allowed here again to carry these derivative “bets” on their books at a totally unrealistic value.

It works something like this.

Imagine last month, I let you “bet” on Mayon Volcano erupting. You gave me P10 and whenever Mayon blows off, you get P100. A month ago, that betting slip was worth at least P10, since someone else would probably be willing to buy it from you and it might be worth P100.

What is it worth today? Yes, maybe someday Mayon will erupt and you get P100. But I doubt that betting slip could be sold today for even P10.

The banks are being allowed to keep their “betting slips” valued on their books at near the purchase price even though no one in their right mind would pay them full price, if anything at all, for their derivative contracts.

If all the nonperforming loans and all the derivative contracts were carried on the banks’ books at what they are actually worth, the US banking system would completely fail.

The US government knows this as a fact.

The government believed that more lending, coupled with more economic growth, would eventually put the banks in a position to be able to write off all those bad assets.

The monetary base of the US has increased 250 percent since 2007. The monetary base is the amount of actual currency, paper and coins. That should have a massive stimulus effect on economic growth, immediate and broad based. A very large amount of this money was coursed through the banking system.

However, the money in circulation, the “money supply,” has gone up only 26 percent since 2007.

It is the money supply that can stimulate the economy, since that is the money that is actually being used in the economy.

At least $1 trillion of newly printed dollars, plus another $1.2 trillion from the budget deficit, has disappeared at least in the sense of never reaching the street-level economy.

Where has all this money destined for economic stimulation gone to, and why?

Come back next Tuesday.

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