Fannie Mae Wants a Bit of Northern Rock

Notions that the first wave of the economic crash was over has been dashed surely by the collapse of the California-based IndyMac Bank and the crash in share values of Freddie Mac and Fannie Mae in the United States.

The old joke is that if you owe your bank a hundred pounds it is your problem but if you owe your bank a million pounds it is its problem. The problem rather is that selling debt produces liquidity because institutions start to own financial assets that, actually, no one owns at root. This means massive money supply expansion and reduced interest rates, until someone calls in the root debt and the whole lot vanishes. That means money supply crash, and depression never mind recession if it collapses fast without compensatory action.

We also have some nutcase economics going on at present. Oil prices going sky high and higher affects everything and produces inflation, and central banks react in an anti-inflationary manner. But, actually, cost push inflation is not inflationary at all. What it does - and this needs to be thought through - is ram up prices for the commodity going sky high and what it affects, and this diverts money from other sectors where prices must crash. They cannot, of course, but there will not be the business and many businesses will close. Cost inflation, say because a commodity is scarcer, simply diverts resources and makes people less well off. To tackle this in an anti-inflationary manner just makes the wealth diversion effects on the suffering sectors all the worse.

Oil has also also turned into a speculative commodity, being something to buy as the economy suffers. This is a self-defeating spiral, and a kind of reverse bubble to the one we have seen regarding cheap money. Eventually the oil price rise hits a ceiling because demand must contract, and the speculative sense is overcome - but the consequences are fairly horrendous in the meantime.

Over ten years Western economies have benefited from cheap Chinese and some Indian imports, and all this has been fine but uncompetitive. Western finance first went into Chinese and Indian expansion and this was returned to its financial sector, but the Western consumer continued on a spending spree financed by the general wealth effect but not by the work of the consumer. There are no mechanisms of redistribution (taxes don't do it) and wealth has been transferred via debt. Then the Chinese and Indians raised much of their own finance, finance that has gone into Western public and private debt as the merry-go-round continued. Property prices had to inflate to take in that wealth effect, but financed by nothing at root. In addition, the Americans have had a war in Iraq and not raised taxes, and in Britain taxes have been raised only by stealth. The Far East is paying for the War but the debt has to be repaid: circulating it around and around the financial system doesn't stop that fact when the money goes pop it does go bang.

The United States has a flexible market economy, but its heavy industry is fundamentally uncompetitive: as production method and with pension liabilities. The British economy shed much industry long ago, and one has wondered how long a service economy has been able to pay high wages compared with China and India. Of course debt has kept this going: lots of people employed to sell people things they are buying, but with no basic product. Yes, there is value added in more ways than via making combustables, but the value added starts from a merry-go-round.

A few months back the British government signed an open cheque of a number of National Health Service budgets a year to keep Northern Rock afloat, and the Bank of England created huge liquidity reserves to keep banks lending. The latter had little effect, and now the institutions are such that the sums would have to be more massive than available. House prices must shed the wealth effect gone into them; people will be left with mortgages that, if unfinanced say by unemployment, will leave a debt without an asset. That is the hidden reality - always there - realised.

It seems that Western economies are going to take a huge hit, and the lay-offs are starting.
In the end the banking system will be forced to invent liquidity to try to stave off severe shocks, but all that will result is stagflation. Otherwise prepare for a crash, and lower level economic activity after stabilisation.

Gordon Brown when Chancellor championed the end of boom and bust economics: this was sustained growth. It never was. It was debt-fuelled expansion. Yes, you can get growth out of easy finance, and there may be a beneficial result here and there in real economic terms (value added). The public sector that was massively expanded (where did all those jobs appear?) does add value too. But for the most part it was a whirl of consumer spending and property based finance. His claim was rubbish, and what made it rubbish was shown in one way he financed public spending. The Private Finance Initiative was public spending on the cheap because it was mortgaged. It looked good on paper, regarding public debt because it was in private hands. That was irresponsible because it comes back to the public purse in order for it to be financed. We have better buildings now - hospitals and schools - but as the crash has come they still need paying for. Gordon Brown was and is all about appearances - a fix here and a fix there - and now his disastrous period as a Chancellor is coming home to roost. Let's nail the idea that he was a good Chancellor: he was not. He was spendthrift on invented money and believed in smoke and mirrors, much of which has revealed itself now that times are tough.