The World Our Leaders Hve Brought Us; The Perfect Economy Created By The Unshackled Free Market

First, in case you didn’t already know it, we’ve got big economic problems, and by we, I don’t just mean the US. Global financial markets have been tumbling recently based on a number of factors:

--they too are holding bad debt related to our mortgage crisis. The Bank of China just disclosed that the might have to write off $8 billion more in bad loans;

--they’re worried about an American recession. Contrary to the theory of the “great decoupling,” globalization has made markets more, not less, interdependent. Foreign markets are betting that the US consumer is unlikely to continue to financing their expansions.

--the weakening dollar means diminished US demand for exports, because they are now more expensive to us.

All of this adds up to greater uncertainty about what’s ahead, and that’s spooking markets here and abroad. Each week, market players and policy makers keep expecting to hit bottom, only to find some new, deeper problem surface. Most recently, it’s the companies that insure bonds. Due to their large payouts and their own exposure to bad debt, they too are being downgraded, and when that happens, the debt they underwrite gets downgraded as well.

Second, while I’m glad the Fed is finally on the case, their actions are unlikely to be as effective as we’d all like them to be. I fear they’re “pushing on a string:” cutting the price of credit at a time when too few people want to borrow. Why not? See above: until we hit bottom, borrowers will remain too risk averse to borrow even cheap money.

Also, stock holders have been fleeing to the safety of the bond market, as this has already lowered interest rates, and that too takes some stimulative edge of the Fed’s move (greater demand for bonds raises their prices and lowers their yields).

Finally, one of the main channels of monetary stimulus is through juiced-up activity in the housing market. That ain’t happening.

Which brings us to Hank Paulson and the administration’s stimulus plan. See my recent commentary on the strengths and weaknesses of the White House plan. At this point, the stakes are awfully high to getting this right, and it must be recognized that the administration’s tax rebate leaves out over 50 million households. As EPI will feature in a snapshot later this week, preliminary research by the Brooking-Urban Institute Tax Policy Center shows that over 70% of the Bush tax rebate goes to the top 40% (average income: $134,000) and less than 10% reaches the bottom 40% (average income: $14,300).

Yes, this is inequitable, but it’s also ineffective. We’ll get much better bang for the buck if we target the rebate at those more likely to spend the money. Paulson spoke about the need for bipartisan cooperation, and the White House does appear to have dropped its efforts to hijack the stimulus debate in the interest of long-term, permanent tax cuts. But if they’re not willing to listen to those of us trying to craft a more effective growth package, I’m afraid the economic pain will be a lot greater than it needs to be.

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These are wild days on Wall Street. The broad S&P 500 index is already down 11 percent in January and almost 20 percent from its peak last fall. This decline corresponds to a loss of $4 trillion in wealth, more than $13,000 for every person in the country.

Of course the carnage has not been easily distributed. The financial sector has been especially hard hit. Citigroup’s stock price is down almost 60 percent from its year ago level, corresponding to a loss of $160 billion in stock value. Merrill Lynch is down by 48 percent, which translates into a loss of $40 billion in stock value. And Countrywide Financial, the wizard of the subprime mortgage world, is down by almost 90 percent, costing shareholder more than $25 billion.

The cause of the chaos is no mystery; the housing bubble is bursting

It was easy for any competent macroeconomist to recognize that the housing market was in the midst of an unsustainable bubble. By its peak in 2006, the run-up had generated more than $8 trillion in housing bubble wealth. It was inevitable that this bubble would burst and wreak the sort of havoc that we are now seeing.

The housing bubble was allowed to expand to such dangerous proportions because the Fed was not run by a competent macroeconomist. It was run by Alan Greenspan, who used to be the greatest central banker of all time. Greenspan did nothing to stem the growth of the bubble. In fact, he encouraged its growth by recommending that people take out adjustable rate mortgages. He also dismissed the views of the competent macroeconomists who tried to warn of the bubble, assuring the markets that everything was under control.

The Fed is right to cut rates and President Bush is right to cry for fiscal stimulus (even if he has the mix wrong). However, at this point, there is no way to avoid a great deal of pain. The bloodletting on Wall Street has just begun. (They still think that their losses are just in the subprime market – the boys and girls over there are real slow learners.) Tens of millions of homeowners will see much of their life’s savings disappear in this crash. The best we can hope to do is get the economy back on its feet as quickly as possible -- and then change the rules so that the bastards can’t do this to us again.

Link.