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Central Banks and Speculative Froth

It has been the pattern over the past two decades, after every major bust, for the US Federal Reserve and other central banks to cut interest rates and liquefy credit markets. Such decisions have softened the blows to the global economy but they have also created speculative bubbles. Financial institutions and speculators have thus learnt to put pressure on central banks to bail them out, most recently from the housing bust in the US. But at some point the rescue measures will not work and the result will be major global economic and geo-political problems.

INSIGHTEconomic & Political Weekly november 24, 200743Central Banks and Speculative FrothIgnatius ChithelenAs yet another bubble in the US economy deflates, namely in the housing market, it raises a question about the role of the Federal Reserve Bank as well of central bankers in many countries. Do they (and finance ministryofficials) actively fuel specula-tive bubbles, in addition to their stated goals of pursuing monetary policies for maximum sustainable long-term eco-nomic and employment growth and containing inflation? Alan Greenspan, former chairman of theUS Federal Reserve Bank, has recently had to discuss the issue a great deal as he goes about promoting his book,1 amidst a deflating US housing market. “History tells us it’s far better to have people periodically going to excess with its ad-verse consequences than to try to block it off in the beginning”, he said.2 Refer-ring to the crisis that typically follows thecollapseof bubbles, Greenspan noted, “theseadverse periods are very painful but they are inevitable if we choose to maintain a system in which people are free to take risks...”.3 Greenspan says a central bank’s role is to take measures to prevent a collapsing bubble from hurting the economy, and not to try and deflate developing speculation.4The economic devastation of the great depression of the 1930s, which followed the 1929 crash of a stock market bubble,5 influenced the macroeconomic debate and policy in its wake. For several decades thereafter, the argument that speculative bubbles are good for an economy had thus no credibility. During the 1970s, a steep collapse in the stock market and economic stagflation followed the speculative froth of the 1960s.6 This crisis, the second worst economic collapse in the US during the 20th century, revived the discussion of the link of speculative bubbles and major eco-nomic problems, though some blamed the Arab embargo and the resulting spike in crude oil prices.Following another boom, the US stock market collapsed 23 per cent on Octo-ber19, 1987. There was wide discussion in financial circles and the media about whether, as with the 1929 crash, this would lead to a depression. But the stock market bounced back and the economy continued growing.7 The stock market and the economy also bounced back from several other post-1987 crises, including the prolonged internet and technology collapse from 2000 to 2002.8The span of benign economic history, which Greenspan refers to, must hence cover roughly his Fed chairmanship from 1987 to 2006. During this period, there was a big financial disruption, caused mostly by deflating speculative froth, roughly every three years but no major economic collapse.9 At the onset of each crisis, Greenspan cut the key Federal funds rate, the overnight interest rate at which banks lend to one another, provid-ed easy access and ample funds to banks and institutions to liquefy credit markets and also took other actions like pressuring institutions to avoid actions that may add to stock market and financial turmoil. Due to repeated use of this policy, re-ferred to as the Greenspan put, there is now little fear in financial markets of extensive losses and economic damage from the bursting of speculative bubbles. In fact, at the first sign of losses from a collapsing bubble, considerable pressure quickly builds on the Fed, through the me-dia and other channels, to implement the Greenspan put, as happened during the subprime housing crisis this past summer.Meanwhile, the generation that lived through the 1930s depression has passed away and the 1970s crisis has almost faded from public memory. Greenspan’s implicit view, that overall the benefits to an economy from speculative bubbles are greater than the costs of handling the crises following their collapse, is now common amongst US policymakers. For instance, Edward M Gramlich, who served with Greenspan on the Board of the Federal Reserve, argued “when the It has been the pattern over the past two decades, after every major bust, for the US Federal Reserve and other central banks to cut interest rates and liquefy credit markets. Such decisions have softened the blows to the global economy but they have also created speculative bubbles. Financial institutions and speculators have thus learnt to put pressure on central banks to bail them out, most recently from the housing bust in the US. But at some point the rescue measures will not work and the result will be major global economic and geo-political problems.Ignatius Chithelen (igch@btcapital.biz) is managing partner of Banyan Tree Capital Management, New York.
INSIGHTnovember 24, 2007 Economic & Political Weekly44dust clears there is financial carnage…but there are often the fruits of the boom still around to benefit productivity. The canals and railroads (of the 19th century booms and busts) are still there and functional … and we still have the Internet and all its capabilities.”10Unlike the recentUS experience, the Japanese economy suffered over a decade of stagnation, deflation and job losses, following the collapse of bubbles in Japa-nese stocks and real estate during the late 1980s. So no former Japanese central banker or finance official is saying that speculative froth is good for an economy, at least not in public.11 Serial Bubble BlowerGiven the contrasting experiences of the US and Japan, some analysts praise Greenspan for skilfully navigating the US economy out of numerous crises dur-ing his long tenure. This is also the legacy that Greenspan projects in his book. But to critics, Greenspan was a serial bubble blo-wer, getting out of the mess of one deflat-ed bubble by blowing a different one, the latest being housing. The Greenspan put is also criticised for bailing out speculators from losing money on their bad bets. Back in 2000, the internet and techno-logy based stock market bubble began de-flating, hurting the US economy. In Janu-ary 2001, Greenspan began reducing the Federal funds rate from its then high of 6.5 per cent.12 He kept on cutting, a total 11 times that year including seven before the September 11 terrorist attacks, lower-ing the rate to 1.75 per cent. But the Fed rate cuts and George W Bush’s series of tax cuts had little economic impact. Losses from the collapsing stock market bubble were mounting,13 there was excess capa-city in many businesses and collapse of several companies, especially in the inter-net and technology area, and business and consumer confidence were hit by the September 11 attacks. Reflecting the con-tinuing weakness, the percentage of the US population 16 years or older who said they were employed dropped from around 64 per cent in 2001 to 62 per cent in 2004. In June 2003, 30 months after he first cut rates, Greenspan lowered it further to a multidecade low of 1 per cent, trying to spur housing demand and prices and thereby jolt the economy. While home sales account for only about 5 per cent of annual gross domestic product (GDP), roughly 68 per cent of households in the US owned homes in 2000. The total value of homes was then estimated to be around $15 trillion, 150 per cent of GDP, and ac-counted for roughly a third of household assets. Rising, or falling, home prices is thus an important determinant of con-sumer confidence and, with consumer spending accounting for two thirds of the economy, an important factor in the US economy. The Fed rate cuts lowered the inter-est rate on 10-year US treasury notes to around 3.2 per cent by mid-2003, the lowest since the 1960s. Rates on mort-gages or loans to buy a home, typically priced off 10-year treasury notes, dropped sharply. The rate on a 30-year fixed inter-est rate mortgage fell to around 5.2 per cent in mid-2003 from nearly 9 per cent in mid-2000. This steep drop meant that, in addition to sizeable tax advantages of homeownership,14 the annual mortgage costs for a home buyer in 2003 was nearly half that of purchasing a house with the same price three years earlier. Demand and prices for houses picked up, boosting economic and job growth, and also lifted consumer confidence and spending. Subprime MortgagesWith Greenspan maintaining the Fed funds rate at 1 per cent for another year, cheap mortgages and the prospect of gain from rising prices enticed more households to buy their first homes or sell and move to bigger homes as well as buy second homes for vacation, retirement or specula-tion. The median home price15 rose from $ 1,87,900 in June 2003 to $ 2,29,600 in December 2004. The roughly 10 per cent rise in both 2003 and 2004 were the fast-est annual gains in 25 years. The average yearly gain since 1960 was around 6 per cent, slightly above inflation. A growing army of brokers and will-ing lenders expanded sales of mortgages to subprime home buyers, that is those recently bankrupt, defaulting on debts or highly indebted. Subprime borrowers, with little or no savings, were able to buy homes because they could also borrow to pay for the owner’s equity, typically 20 per cent of the purchase price an owner pays to qualify for a mortgage. The len-ders reasoned that rising prices lifted a subprime owner’s equity, even for those putting up no money, and also provided added safety by enlarging the value of the collateral backing the mortgage. In addi-tion, subprime lenders charge rates that are normally 20 per cent to over 100 per cent higher than on comparable prime mortgages, on grounds of greater losses on these risky loans. While $ 135 billion in subprime mort-gages were issued in 2000, from 2004 to 2006, some 2,500 banks and other lend-ers made $1.5 trillion of such loans. Nearly two-thirds of African Americans and 42 per cent of Latinos bought homes using subprime debt. Some affluent households too used the high cost debt, to borrow more than they could from prime lend-ers, and bought bigger houses and multi-ple homes. Subprime mortgages were packaged into securities, with some given investment grades by credit rating agen-cies, and sold to eager buyers worldwide.16 The banks, funds and other institutional buyers of such inherently risky securi-ties were chasing yields higher than that paid byUS treasuries or corporate debt of comparable duration. “Once you package those things and sell them through major investment banks, discipline leaves the system”, notes Warren Buffett, the highly successful investor and major philan-thropist.17 Overall, including subprime mortgages, about $6 trillion of the $8 tril-lion inUS home loan debt outstanding is estimated to have been securitised. Adjustable Rate MortgagesIn June 2004, Greenspan started raising the funds rate. As rates on fixed mortgages began rising, the real estate food chain – sales and mortgage brokers, lenders, home builders and lawyers – began heavily pro-moting adjustable rate mortgages(ARM). ARMs carry a low initial interest rate, which resets higher or lower, typically af-ter one to three years, in line with rates on benchmark one year bank debt. The sales pitch for ARMs was that interest rates will soon fall back to their 2003 lows, at which point a homeowner can switch to a lower cost fixed rate loan or continue with anARM. Greenspan himself advised
INSIGHTEconomic & Political Weekly november 24, 200745homebuyers that ARMswere a better op-tion than a fixed rate mortgage, ignoring the fact that a rise in rates could lift costs beyond what subprime ARM borrowers could pay.18 Many subprime buyers usedARMs, with rates teasingly below 2 per cent for the initial period, to buy houses their incomes could not support through a fixed mort-gage or even a regularARM. Some of them expected to make a profit by selling before their ARM reset higher, others expected rates to drop or their incomes to rise and cover the higher payments after reset and some were victims of fraud.19 Sale of teaserARMs, with initial rates of less than 2 per cent, rose from $ 48 billion in 2004 to $ 197 billion in 2005 and was $ 182 bil-lion in 2006; they constituted the bulk of the $ 270 billion inARM loans sold in 2005 and $ 329 billion sold in 2006. Housing ManiaWith an easy availability of cheap credit, rising demand and rising prices for homes fed off each other and spiralled upwards. Lured by stories of great deals made by relatives, friends and others, a buying frenzy developed in Florida, California, Nevada, the north-east, mid-Atlanticstates around Washington DC and some other regions.20 In 2004 and 2005, the media carried numerous stories of buyers eu-phoric over gains made on homes bought online or over the phone, without visit-ing the cities or, in the case of foreigners mainly Europeans, without setting foot in theUS. There were also reports of buyers making enormous profits by pyramiding up with leverage, using rising equity in their homes as collateral for new loans to buy more homes.Home prices in the booming areas rose at an annual rate of 20 per cent, 25 per cent or more. From 2001 to 2005 home prices at least doubled in such areas and insome sizzling markets the rise was far greater, exceeding 300 per cent.21 It is perhaps not an accident that Las Vegas, the gambling capital of the world, was the most specu-lative market with some home prices dou-bling in nine months during 2005.22 Overall in theUS, sales of existing homes rose to 7.2million units in 2005,from5.1million units in 2000, while sales of newly built homes nearly doubled to 1.4 million units. Starting in late 2005, rates on some sub-prime teaserARMs were reset from below 2 per cent to over 7 per cent, in some cases over 10 per cent. This was due to the higher rates normally charged on subprime debt and the overall rise in mortgage rates, because Greenspan had raised the funds rate to 4 per cent. Many subprime ARM borrowers found their incomes could not support the reset, higher monthly costs. Around the same time, prices of homes were flattening or dropping in several hot areas due to lack of new buyers, ris-ing supply and critical media stories about the housing mania. Households with zero or low equity in the home, and little or no savings, realised that selling their home to get rid of their reset subprime ARM bur-den meant coming up with money to cover losses. Even if they managed to sell the home for its purchase price and pay back the mortgage, they would have to pay closing costs, fees, pre-payment penalties and sales commission to a broker.23 Financial TurmoilAs more subprime ARMs were reset high-er, more borrowers stopped paying their monthly mortgage bills, with some going bankrupt. Subprime lenders were also going bankrupt and subprime securities, holding defaulting ARMs, were hit by loss-es. For over a year, the news of rising de-faults and bankruptcies and falling home andARM securities prices were viewed by most financial analysts and policymakers as a marginal problem. When subprime losses deepened and spread widely this summer, global finan-cial markets were rattled by the surprise. By this June, roughly one out of seven subprime ARMs were delinquent, that is more than a month late in making pay-ments. Also, about 160 subprime lenders had gone bankrupt. Prices for billions of dollars of subprime securities kept falling and liquidity dried up, as there were no buyers. Fearful banks demanded additional cash from funds, to which they had lent money, to cover funds’ losses in subprime securities. Some highly leveraged funds, run by major institutions in the US andUK, were wiped out since they could not meet the margin call. Then in July and August, credit monitoring agencies cut ratings on some 5,000 subprime mortgage securities to negative. This action, while much delayed, led to a further slide in prices. Some banks, funds and institutions, in-cluding in the US, Canada, Germany, France, UK, Australia, China and Ireland, confessed they were holding problem sub-prime securities and took losses. But many others did not reveal their exposure, ap-parently hoping that a cut in the Fed funds rate, rising financial markets and perhaps, a resurgence in home prices may bail them out.Meanwhile, in August, 2,44,000 homes – one inevery510US households – where owners had defaulted on mortgage pay-ments were foreclosed, that is re-possessed by banks, up 36 per cent from July. There were rumours of major funds and banks hiding big losses. Stock mar-kets worldwide declined and banks and funds did not want to lend to one another not knowing what losses the other party was hiding.24 The lack of transparency over risk of loss meant that even high qua-lity banks, corporations and funds could not borrow anywhere along the duration spectrum from overnight loans to 10-year plus bonds.25 Asked why the Fed did not raise rates sooner and faster in 2004, Greenspan said that would not have been acceptable “to the political establishment” given the very low rate of inflation. He also said that “the presumption that we were fully independent and have full discretion was false”.26 So in effect, Greenspan is say-ingthat,while central bankers like him arefree to implement interest rate cuts and other measures to generate economic booms, the government pressure prevents them from trying to curtail such excesses from blowing into bubbles and creating damage. Bernanke’s Fed Fund CutsOn August 17, Ben Bernanke, Greenspan’s successor as chairman of the Federal Re-serve, tried to calm markets by several measures, chiefly a half point cut to 5.75 per cent in the interest rate charged on money lent through the Fed’s discount window to banks.27 Since August, the Eu-ropean Central Bank(ECB) and other cen-tral banks have injected over $ 400 billion of emergency funds into money markets to smooth inter-bank lending.
INSIGHTnovember 24, 2007 Economic & Political Weekly46In mid-September, with stock markets still down, credit availability frozen and a fear of further losses and bankruptcies,28 financial analysts and the media built up public pressure that, if the Fed did not cut the funds rate soon, the financial turmoil would worsen and the US economy would fall into a deep slump. On September 18 Bernanke cut the crucial Federal funds rate by a larger than expected 0.50 per cent to 4.75 per cent. Stock markets in the US and worldwide ran up sharply following this cut and the credit markets thawed, with several com-panies being able to raise debt, includ-ing riskier and leveraged businesses. The perception is that the subprime mess is getting cleaned up, as more banks and institutions reveal their exposure to prob-lems and take losses – so far total losses announced exceed $ 20 billion.29While Bernanke’s September Fed funds cut soothed financial markets, housing demand and prices in the US are expect-ed to drop for at least another year, and some say till 2010. In part due to inflation worries, the long-term interest rates have risen and with it home mortgage rates. The initial rate on a normal subprime ARM is now around 6 per cent. An estimated $ 600 billion of ARMs will be reset higher by the end of 2008, with slightly more than half being subprime. The estimates of problem mortgages range from $ 100 billion to over triple that amount. Existing home sales have fallen back to an annual run rate of 5.5 million units and new home sales are down to 8,00,000 units. Two million households are expected to default on their mortgages before the cur-rent cycle ends, leading to at least a 10 per cent drop in theUS home prices, “an asset deflation never seen since the Great De-pression,” points out Bill Gross, the highly successful bond investor who runs $ 700 billion, PIMCO, the world’s biggest bond fund manager.30 Some of the formerly sizzling markets will likely to see a pro-longed slump with prices dropping by 40 per cent or more, similar to what happe-ned in parts of the US following the last housing collapse in the early 1990s. While attention is focused on the sub-prime mess, problems may soon emerge in the high yield debt market, which funds leveraged buyouts (LBO) of companies. As the LBO frenzy peaked in the summer, in-stitutions eagerly bought such debt even though the yields provided little protec-tion from the normal loss rate.31 Currently the odds are high that theUS will fall into a recession within a year. There is though a wide expectation in financial markets that the Federal Reserve will cut rates further, to try and prop up the housing market, the US economy and financial markets world-wide. Many expect the Fed funds rate to drop by a point to 3.75 per cent in 2008. This is firing up speculators, who seek to profit from central bank and finance ministry actions in fuelling bubbles. The strategy is now so common that, soon after the September Fed funds rate cut, The Wall Street Journal ran a story listing emerging markets and commodities as likely areas for the next bubble.32 But both these assets have had big recent gains. For instance, the MSCI Emerging Markets In-dex is up over 400 per cent over the past five years, compared to the roughly 100 per cent gain in theUS stock market. So, while there may be some more gains to be made, much of the profits may have al-ready been made.Global Repercussions Due to rising globalisation of trade and money flows in recent decades, markets in the developed countries, former com-munist countries and emerging countries are increasingly linked. So not only does a seemingly domestic crisis in subprime mortgages in the US have global reper-cussions33 but solving it too requires joint efforts of the central banks and finance officials of the US European Union (EU), Japan, China and Russia. So far they ap-pear to be working together. Economists point out that the major reasons for the depression in the 1930s was the conflict-ing policies followed by the major powers, trade protectionism and global trade wars after the 1929 stock market crash. A major sign of trouble in the global consensus may be what happens to the US dollar. So far it appears that the Bush ad-ministration, while talking about a strong dollar policy, is content to see the curren-cy decline. Since its recent peak in 2001, the dollar has fallen by roughly 22 per cent against an index of the currencies of 19US trading partners, including a decline of 38 per cent against the Canadian dollar, the largest trading partner. This drop is shielding US businesses from competing imports while strengthening US exports. Exports rose from $75 billion monthly in 2001 to around $ 140 billion in recent months, narrowing the trade deficit. Also, a falling dollar cuts the cost of servicing theUS growing foreign debt burden. To date, the US dollar’s decline has been orderly and some analysts expect an addi-tional 20 per cent drop against the index of currencies. The dollar has slipped 40 per cent against the Euro since 2001, inclu-ding a somewhat sharp 4.5 per cent fall after the Fed rate cut in September. The slide also pulled down the Chinese yuan against the euro, since the yuan’s value is linked to the dollar. European officials are under increasing pressure to halt the dollar’s slide, from local business doubly hurt by a sinking dollar and yuan. Mean-while, the ECB is seeking greater transpar-ency and oversight of American collateral debt securities, including mortgages, and related derivative markets, banks and rat-ing agencies. The ECB argues that the loss-es to investors in other countries suggest that American regulators are not properly monitoring financial products or alerting investors to the risks the US is exporting. Another sign of potential trouble is like-ly to be what happens to China’s attempts to productively invest its dollars, or failing this, to reduce its dollar holdings. The US owes the rest of the world an estimated $ 10.7 trillion, with China its largest creditor. China’s foreign reserves, mostly dollar holdings, are around $1.4 trillion and Japan’s $940 billion. The returns on short-term US government debt, where much of the Chinese (and Japanese) dollars are invested, have been low. Two-year treasury notes currently yield around 4 per cent, indicating losses to the Chinese if this income is measured in euros or yen and after inflation. The Chinese ScenarioSome argue that China has no option but to keep investing its dollars in short-term US debt. Maintaining good trade relations with theUS is more important, as exports employ its growing workforce. While this may be the case, China appears unwilling to let a major asset lose value, while
INSIGHTEconomic & Political Weekly november 24, 200747producing negligible income, So far, the Chinese efforts to buy major assets in the US have been unsuccessful, due to strong opposition from American business,politi-cians and the public, especially in areas seen as even remotely related to US defence, technological and other vital economic in-terests. The most visible case was the ina-bility of the China National Offshore Oil Corporation (CNOOC) to buy the US oil and gas company Unocal in 2005, despite ini-tially bidding about $ 600 million more than the $ 17.9 billion price paid by the acquirer Chevron, another US company. Yet China is in effect the lead banker to theUS. In the recent subprime crisis, this banker has supportedUS policy without seeking better terms, at least publicly. Like any banker or moneylender, the Chinese leadership keeps trying to figure out how best to profit from the plight of its largest borrower. In September, the China Invest-ment Corp(CIC) was set up to invest $ 200 billion of foreign currency reserves, for higher returns with low risk in theUS and elsewhere. China apparently hopes invest-ments byCIC and the Chinese banks, in which CIC is injecting $ 67 billion, will be viewed as opportunities being pursued by independent business and not as actions of the Chinese government. Meanwhile, major Chinese banks and companies, most of which are controlled by various govern-ment entities or arms of the Communist Party and the army, are using the indirect route of buying stakes in theUS private equity companies and also teaming up with them in theLBO of US companies.34 Speculative BubbleChina though has its own speculative bubble, which could weaken its clout. Since about 2000, the Chinese authorities were trying various ways to fire up the nation’s dormant stock markets, including through public announcements of major investments of government funds. The goal was to set up institutions that will provide a major local source for capital formation by harnessing savings, raise funds for new and growing companies, clean up hundred of billions of dollars in bad debt at banks and financial institutions and provide a global measure of the increasing clout of consolidating major Chinese banks, insurers and other companies. Evidently the efforts of Chinese officials have worked better than expected, and that too without any funds from foreig-ners who are barred from investing in the domestic exchanges. The stock markets in China have risen over fourfold in the past two years, including a 45 per cent gain for the Shanghai exchange in the third quar-ter of 2007 alone. Every week there are reports of major Chinese companies exceeding the stock market capitalisations of mostUS and Eu-ropean based rivals. Prices of stocks listed in Shanghai and Shenzhen exceed 50 times 2007 estimated earnings, nearly twice the valuation in Hong Kong. On dual listed stocks, speculators in China have bid up the premium to around 100 per cent over the price at which the same stock trades in Hong Kong. The Chinese corporations and financial institutions have joined in the speculation in a big way. A pyramid-ing spiral of rising stock prices and rising earnings – and hence, the illusion of lower valuations – is in evidence.During the first half of 2007 the boom-ing stock market was responsible for half the earnings growth of 7 per cent report-ed by companies listed on the two major Chinese exchanges. As an analyst noted, “the sort of cross holdings in the market means profits are often counted twice. If the market turns down, or even levels off, earnings will evaporate.”35 As for in-dividual investors, there are reports of Chinese households pawning their homes to village moneylenders to borrow money and speculate in the stock market bubble. There are then several mini bubbles in the areas ranging from urban real estate to art to tea leaves. Meanwhile, inflation in China has accelerated recently, running at an annual rate of 6.5 per cent the highest since 1996, blamed on rising food prices, mainly pork. While fighting inflation, the Chinese government is also trying to deflate the stock market bubble. It tripled the tax on share transactions. In September, even as Bernanke was forced to cut rates, the Chi-nese Central Bank – whose actions have to be pre-approved by the government – raised rates on one year deposits to 3.87 per cent and the one-year lending rate to 7.29 per cent, the fifth such increase since March. Also in October, China raised the ratio of reserves banks must hold with it to 13 per cent, the eighth rise this year. Some financial analysts are of the view that the Chinese authorities will not take major steps to deflate the stock bubble, till after the 2008 Olympic Games being held in Beijing. The government, they say, will not want to do anything that may arouse social unrest and hurt the nation’s image-building process. In a sign of Chinese, and perhaps emerging, markets being near the top, Warren Buffett is selling his compa-ny’s stake in PetroChina, even as the oil and gas company’s stock rockets upward, following its recent China listing. Buffett has made around $ 3.5 billion on this double bet on China and crude oil, an impressive 700 per cent profit in about four years.There are several possible scenarios of what may happen when the Chinese stock bubble bursts. The Chinese authorities could engineer a slow, soft deflation with little harm. Or, after a quick collapse, they could devise their version of the Green-span put. China’s housing, automobile and other asset markets may not be ad-equately developed to boost the economy. But cheap exports and its growing foreign currency holdings could do the work. For this option to be feasible, China will need the cooperation of the US and the other major powers. The extreme scenario is of severe eco-nomic crisis and wide social unrest in China, due to a global slowdown, Chinese policy errors, trade wars and protection-ism in the US, Europe and elsewhere. Given world history of the 1930s and 1940s this outcome and its economic and geopoliti-cal consequences are grim to ponder over but worth keeping in mind as events in China unfold. ConclusionAs is known, booms and busts are common to most businesses. Periods of supply shortages, rising demand, growing profits, new investments, and often, build up of speculative froth, are followed by years of excess output and capacity, losses and bankruptcies. Over the past 20 years though, soon after a major bust, the US Federal Reserve Bank and other central banks cut interest rates and liquefied credit markets. These actions, while off-setting hits to theUS and much of the
INSIGHTnovember 24, 2007 Economic & Political Weekly48Centre for the Study of Developing Societies29, Rajpur Road, Delhi – 110054The Centre for the Study of Developing Societies (CSDS), a premier institute of Social Science research, invites applications for the post of Senior Accounts/Finance Officer, in the scale of Rs. 10,000-325-15,200/12,000-420-18,300 with allowances admissible in a Central University. (Adds upto Rs. 26,750/- & Rs. 31,880/- respectively at the beginning of the scale.)Senior Accounts/Finance Officer shall report to the Director. The incumbent would be responsible for managing-administering all finance and accounts related matters, maintain accounts-records to meet legal requirements and stipulations by funders/granters/research collaborators. In addition s/he would be expected to independently supervise all aspects of the audit process, budgeting, administering corpus investments etc.Candidates should possess at least intermediate level qualification in Chartered Accountancy, or B.Com (Hons) with atleast 10 years of relevant work experience of which, at least three years should be in a supervisory capacity in a computerized accounting environment, preferably in a research/educational institution or an NGO. Candidates should posses sound knowledge of transparent accounting procedures and fluency in written-spoken English.Vacancy is open to all, preference however will be given to women and to those belonging to SC, ST or OBC.Applications on plain paper with requisite supporting documents should reach CSDS by 15th December 2007 either at the above address or by email: csdsmain@csds.inCentre for the Study of Developing Societies29, Rajpur Road, Delhi – 110054Centre for the Study of Developing Societies (CSDS), a premier institute of Social Science research, invites applications for the post of Academic Secretary in the scale of Rs. 10,000-325-15,200/12,000-420-18,300 with allowances admissible in a Central University. (Adds upto Rs. 26,750/- & Rs. 31,880/- respectively at the beginning of the scale.)Academic Secretary to CSDS shall report to the Director. The incumbent would be responsible for coordinating-administering research projects, programmes, conferences, lectures and other academic activities. In addition, the Secretary would also be responsible for liaison work with ICSSR, funders/granters/research collaborators and CSDS research network comprising individuals and institutions in India and abroad.Candidates should possess a masters degree in a social discipline with five to ten years of relevant work experience in administration/research/coordination of research related activities in research institutions/colleges/research oriented NGOs and publishing houses. Candidates should posses sound familiarity with higher education and research institutions in India and abroad. Candidate with knowledge and understanding of the range and direction of contemporary social science research would be preferred.Vacancy is open to all, preference however will be given to women and to those belonging to SC, ST or OBC.Applications on plain paper with requisite supporting documents should reach CSDS by 15th December 2007 either at the above address or by email: csdsmain@csds.in
INSIGHTEconomic & Political Weekly november 24, 200749global economy from the bust, led to a series of speculative bubbles. Financial institutions and speculators, saved from losses on their past bad decisions, now boldly pressure central banks to bail them out, most re-cently from the housing bust in the US. At some point in the future, the rescue meas-ures will not work due to rising inflation, conflicts over the US dollar or amongst major central banks, trade wars and pro-tectionism. The bigger these obstacles, the deeper will likely be the resulting global economic and geopolitical problems. Notes1 AlanGreenspan,The Age of Turbulence: Adventures in a New World, The Penguin Press, New York, 2007. Greenspan was reportedly paid an advance of $ 8.5 million to write the book.2 ‘The Fed and the Credit Boom: Greenspan, Others Re-flect,’The Wall Street Journal, August 6, 2007. Green-span refers to excesses or froth instead of using the term bubbles.3 Ibid. Greenspan’s belief in individual risk taking as being necessary for economic growth is based on Ayn Rand’s ideas. In his book Greenspan briefly discusses Rand’s popular fictionThe Fountainhead, to illustrate Rand’s idea of driven individuals pursuing capitalist enterprises with reason and enlightened self-interest and succeeding against major odds. He also acknowl-edges his debt to Rand. “I was intellectually limited until I met her…I was a talented technician, but that was all .. Rand persuaded me to look at human beings, their values, how they work, what they do and why they do it, and how they think and why they think”, Greenspan,The Age of Turbulence, op cit, pp 52-53.4 ‘A Global Outlook’,The Financial Times, September 16, 2007.5 For an insightful recounting of the speculative mania and the crash see John Kenneth Galbraith,The Great Crash 1929, Penguin Press, new edition, New York, 1998.6 For a witty sketch of the speculators and the 1960s stock market excesses see Adam Smith’s Supermoney, Wiley, New York, new edition 2006. The book was written under a pseudonym by the business journalist and investor George Goodman.7 While most financial analysts and economists argue that the economy dictates what happens in the stock market, some – most notably the highly successful speculator George Soros – say that booms and busts in the stock market also impact the economy. See George Soros, Soros On Soros: Staying Ahead of the Curve, Wiley, New York 1995. For a complex and somewhat abstract discussion of the argument see George Soros, The Alchemy of Finance, Wiley, New York, 2003.8 When Bill Clinton was the president (1993-2001), the Federal Reserve Bank cut interest rates and pumped in liquidity several times: after the 1994 Mexican peso crisis, the 1997 Asian financial meltdown and the Russian crisis and the collapse of a major hedge fund in 1998 – actions that largely fuelled the internet and technology bubble of the late 1990s. Clinton’s treas-ury secretary Robert Rubin points out that focusing on these and other crises meant that the president’s goals of tackling major social problems like reducing poverty had to be neglected. See Robert Rubin and Jacob Weisberg, In an Uncertain World: Tough Choices from Wall Street to Washington, Random House, New York, 2003. The book provides an insight into how economic and finance policy was formulated and implemented under Clinton.9 The post-1987 series of crises and the US economy appearing to emerge stronger from them also pro-vides the context for the recent popularity of Joseph Schumpeter’s theories about waves of creative de-struction sweeping out obsolete and weak parts of a capitalist economy and nourishing the up and coming areas. Greenspan is one of these admirers. “I read Schumpeter in my twenties and always thought he was right…I have watched the process at work through my entire career”, Greenspan,Age of Turbu-lence, op cit, p 48.10 Edward M Gramlich ‘Boom and Busts, The Case of Subprime Mortgages’, Federal Reserve Bank of Kan-sas, Jackson Hole, WY conference, August 31, 2007. Federalreserve.gov. 11 Some analysts argue that Japan’s tight liquidity policy during the 1990s is to blame for bringing about the deflation of the 1990s. The Japanese deflation experi-ence, Greenspan says, led him to accept the manageable risk of higher inflation in the near future over even the smaller probability of far worse, potentially unmanage-abledeflation. ‘The Fed and the Credit Boom’, op cit. 12 Typically during recessions or weak economic condi-tions the Federal Reserve relies on cuts in the Federal funds rates to boost the economy. Lowering the rate reduces the costs of borrowing for banks, corpora-tions and funds thereby increasing availability of credit. More important, Fed rate cuts also lower interest costs for consumers buying homes and cars, boosting demand for these two biggest purchases in the consumer-driven economy. In this text banks refers to commercial and investment banks.13 The technology heavy Nasdaq stock market index fell by 80 per cent from the highly inflated peak of 5,133 in March 2000 to 1,100 by October 2002.14 In this text homes refers to single and multi-family houses and also apartments in buildings. In normal market conditions a homeowner in the US typically pays 20 per cent of the price, the owner’s eq-uity interest in a home, and borrows the other 80 per cent from banks and lending institutions. This loan or mortgage offers sizeable tax advantages to owning over renting, a major economic benefit when home prices stay flat or rise. An owner pays less in income tax than a renter with the same level of income. Annual interest costs on mortgages of up to $ 1 million, as well as property taxes, are both deductible from income for calculating the amount of income tax paid by a household. An owner also does not pay the 20 per cent capital gains tax on up to $ 5,00,000 in profits made on the sale of a home. For the leverage offered by mortgages see notes 21 and 23 below.15 The median home price serves only as an indication of price trends because home prices in the US range from around $ 1,00,000 to some over $ 100 million. Reflecting prices in affluent cities and suburbs, in New York City’s Manhattan borough the median price is currently well over $ 8,00,000. Manufactured or mobile homes, which sell for about $ 40,000 on up, are not included in the discussion. This type of low end housing is a very small part of the overall home market, with only about 2,00,000 homes sold each year. Mobile homes have different landownership, borrowing and other characteristics compared to the housing market. 16 In their most basic form US mortgage securities con-sist of loans, taken on by households to buy homes, packaged together and sold to institutional investors in the US and abroad. There are then derivatives of increasing complexity, layered on top of these mort-gage securities, created and sold by banks including ones that provide payments only from the interest collected. The securities are given a range of grades by credit rating agencies, depending on various measures includ-ing size, the credit history of the underlying home-owners, the amount of homeowner’s equity, duration of the loan, interest rates and whether the rates are fixed or variable and pre-payment penalties, if any. Fannie Mae and Freddie Mac are the biggest buyers, packagers and resellers of mortgage debt. Being US government-sponsored entities, originally set up to enable minorities and the poor to buy homes, their securities are rated the highest. The assumption is that the government would bail them out of any trou-ble. So, while their borrowing costs are lower their securities offer a lower return than those issued by rival banks. The two agencies can currently buy and securitise mortgages of up to $ 4,17,000, up sharply from the $ 2,52,700 limit in 2000. This reflects the recent rise in home prices as well as their transforma-tion into supporting middle class home buyers. Secu-rities issued by them total about $ 4 trillion, roughly two-thirds of the securitised mortgages outstanding. For a brief exploration of the history of housing finance in the US see Ben Bernanke ‘Housing Finance and Monetary Policy’, speech by the Federal Reserve Bank chairman, Kansas City Economic Symposium, Jackson Hole, WY, August 31, 2007, Federalreserve.gov.17 ‘Subprime Crisis Not Big Threat: Buffett’, Market-watch, May 5, 2007. Also, as the highly successful bond fund manager Bill Gross notes, derivatives “multiply leverage like the Andromeda strain. When interest rates go up the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets”, ‘Looking for Contagion in All the Wrong Places,’ PIMCO Bonds – Investment Outlook – July 2007 on the web site PIMCO.com. Gross who runs PIMCO, the world’s largest bond fund manager with roughly $700 billion in assets, is one of the most astute analysts of economic and investment issues and his monthly commentary is highly recommended reading.18 “In February 2004, only months before the Fed start-ed to raise its rate, in a speech titled ‘Understanding Household Debt Obligations’, Greenspan demonstrat-ed next to no understanding. His advice to American homeowners was not that they lock in a fixed-rate mortgage while the locking was good, but rather that they consider an adjustable-rate model. He who set the rates got it backward. …”.James Grant in a review of Greenspan’s book,The Banker Looks Back, The Wall Street Journal, September 18, 2007. Grant describes Greenspan as “a consulting economist of no special attainments….”19 The media is now full of stories of subprime house-holds being swindled into buying homes they could not afford by unscrupulous operators. This fraud is also hinted at by former Federal Reserve governor Gramlich: “...the subprime market was the Wild West. Over half the mortgage loans were made by independent lenders without any federal super-vision”, ‘Boom and Busts’, op cit, p 3. 20 For instance, in California the frenzy was reflected in licensed real estate brokers rising from around 3,00,000 in 2001 to over 5,00,000 in 2005. 21 A typical home buyer pays only 20 per cent of the cost of a home, their equity and borrows the rest. This 4:1 leverage means that a household has a gain – or loss – from a sale which is several multiples of the owner’s equity put up to buy a home. Assuming a household bought at the bottom and sold near the top – highly unlikely – the gains in the hot markets were a massive 500 per cent to over 1,500 per cent and that too in only about four years. But as many homeowners are finding out, see note 23 below, use of leverage magni-fies losses on the downside too. 22 The US housing bubble had all the signs of a classic speculative mania. For an analysis of the major speculative bubbles through history see: “Charles P Kindleberger, Robert Aliber and Robert Solow Manias, Panics and Crashes: A History of Financial Crises, Wiley, New York, 2005. Also, Charles Mackay Extraordinary Popular Delusions and the Madness of Crowds, Harriman House, New York, New Ed, 2003.23 There are legal, insurance and other costs, mortgage fees and transaction taxes incurred on both the sale and purchase of a home. These closing costs vary from 3 per cent to 5 per cent of the home price. Then, there is the commission paid to real estate brokers, ranging up to 6 per cent. So a household buying and selling a home incurs total transaction costs of 10 per cent to 16 per cent. Due to these costs, the quick resale of a home for the purchase price or even 10 per cent higher, leads to an overall loss. The costs do not include penalties on prepayment of mortgages often imposed by lenders or the economic cost of owner’s equity, in terms of lost income on the money. Also ex-cluded is any tax benefits enjoyed by owners. The transaction costs are much higher for subprime borrowers due to additional and higher fees and pen-alties. Such households with no savings, who also borrowed to pay for the 20 per cent owner’s equity, end up owing money to lenders even if a home is sold at the purchase price due to the transaction costs in-volved. With prices dropping in the former hot areas – some declines of as much as 30 per cent reported recently in Arizona and Las Vegas – the loss on a sale is higher, especially if the home was bought near peak prices. 24 Transparency is essential to the smooth operation of credit markets. “Financial institutions lend trillions of dollars, euros, pounds and yen to and among one an-other. In the US, for instance, the Fed lends to banks, which lend to prime brokers such as Goldman Sachs and Morgan Stanley, which lend to hedge funds, and so on”, writes Bill Gross, ‘Where’s Waldo’, Fortune, September 3, 2007. 25 For instance, as problems with subprime loans surfaced in July, banks in the US found they could sell only a few billion of the $ 330 billion plus in loans they promised to private equity funds for theirleveraged buyouts of companies. Also, see Note 29 below.

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