Tuesday, 23 October 2012

The financial doomsday solution

John Mangun
Outside the Box
Business Mirror

In the middle of 2007, the US economy started to flatten out after a strong and steady rise in the gross domestic product from 2000. Normal business cycles operate that way. At the same time, gasoline prices increased from about $2 per gallon at the start of the year to over $3 by May 2007. By May 2008, gas prices were over $4. Historically, this would have been a manageable problem. This time high gas prices helped cause a calamity.

Because the average American was over-leveraged and had taken on too much debt to buy houses, a large group of people were forced to re-allocate funds from their mortgage payments to pay for gasoline and the subsequent rise in prices throughout the economy caused by high fuel costs.

The housing market froze and this accelerated the economic slowdown as housing and related industries accounted for almost 30 percent of the US economy.

All the major banks were faced with carrying an enormous amount of non-performing housing loans. By summertime 2008, major financial
institution Lehman Brothers was in serious financial trouble due to holding billions of dollars of these now defaulting mortgages that they had originally purchased by borrowing money. It was a double debt disaster.

The US government stepped in to help the banks by creating the Trouble Asset Relief Program (TARP), which bought bad loans from the banks. At the same time, the government thought that this infusion of cash to the banks would be loaned out thus stimulating the falling economy.

When Obama took office in early 2009, he began the wildest government spending spree in history, raising the budget deficit from $400 billion to over $1 trillion. Tax revenues also declined in the falling economy and the US borrowed to pay its expenses. The Federal Reserve doubled its “money printing” from holding $800 billion of government debt to $1.7 trillion. That was Quantitative Easing 1 (QE1).

Had the bad banks, even the major ones, been allowed to go down in 2008-2009, all that TARP and QE1 money could have been used to pay back depositors, perhaps better stimulating economic activity. Instead, now three to four years later, the banks are still carrying enormous amounts of bad loans and the government has spent another $4 trillion financed in part by QE2. The economy has flat lined and we are now into QE 3.

When I wrote last week about the future negative consequences of QE3, someone tweeted me, “Sounds like a doomsday scenario. Yes, it could be possible. But I could sense sitting powers to intervene.”

Please understand this very clearly. QE3 is not the doomsday scenario; QE3 is the doomsday solution.

Western governments have two options. They can let the holders of the bad loans suffer the losses that would cause large economic shrinkage, reducing western standards of living by perhaps 30 percent or more. Alternatively they can print enough money to monetize the debt, meaning to create enough new money to pay off old debt. That is what QE is doing and will continue to do.

Almost part of our genetic code, humans anticipate tomorrow being better than today even though we know that there will always be ups and downs; rain, sun, rain in an endless cycle.

Nonetheless, since World War II, the world has experienced a constant economic growth pattern fueled in part by advances in technology and we have come to expect never-ending economic improvement. The iPhone 2 must be followed by number 3 and then 4 and beyond.

This is not new. Since the beginning of the Industrial Revolution in the mid-1700s, the average human standard of living and wealth creation has followed an upward trend. We have seen downturns due to wars and natural disasters, but particularly in the last three generations, it has been up, up, up.

If governments now allow this upward economic trend to stop by
forcing economies to shrink in order to pay off the global debt, there would be immense social upheaval and chaos. It is already happening in Greece and Spain.

To avoid a collapse of the global economy and literally global mass rioting in the streets, QE is the only solution.

Western governments have let the cancer of bad bank and government debt go too far. To let them fail at this point could potentially collapse the global financial system.

However, QE is like chemotherapy for cancer patients. Chemotherapy pumps poisons into the body, which will hopefully kill the cancer cells before the poisons kill the body. The side effects include a tremendous weakening of the immune system and a potential damaging of vital organs. I will look at more “side effects” on Thursday.

E-mail to mangun@gmail.com, Web site is www.mangunonmarkets.com and Twitter @mangunonmarkets. PSE stock-market information and technical analysis tools provided by COL Financial Group Inc.

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