Monday, March 09, 2009

Deja vu

Can anyone explain to me how a problem can be fixed by repeating what caused it in the first place?

That's what's happening to fix the meltdown in the world's economy and I can't find any sense in it.

The root cause of the problem was ludicrously low interest rates.

The problems we're now facing stemmed from those rates. The access to easy money they presented was the catalyst.

The relaxation of regulation and oversight added to the problem because it allowed human nature, such as personal greed, free reign.

People are blaming the banks and greed for the crash, but they came later. Without the low interest rates none of it would have happened.

As a result of rates as low as zero (Japan) and several other major economies at one and two percent the world was awash with cheap, easy money. Billions of dollars were being poured into the stock markets and as a result listed companies were valued at up to a hundred times earnings. They were never worth that much and it was unsustainable, but fund managers didn't know where else to put their weekly flood of money - the Australian superannuation funds are a good example.

Because money was so cheap and therefore easy to get, retailers of larger ticket items were advertising 'no deposit, no interest, no payments for twelve months' deals.

People could get money easily and looked for things to spend it on. That demand meant that under the rules of supply and demand house prices were pushed to unsustainable levels.

Living on credit, living beyond your means, can only last a limited time. At some stage the bills have to be paid.

The day of reckoning came and suddenly no-one had money, demand for products plummeted...and the old rules of supply and demand came back into play. But this time they drove prices down.

Property, such an important underpinning solid asset of many countries' economies, plunged in price. People, financial institutions, companies now had negative equity - their debts were larger than the assets guaranteeing them.

Companies earlier valued at many times their earnings now find themselves in some cases valued at less than the cash they have in the bank.

Crash.

So to fix the crisis our leaders have come up with answer. Put the rates back to the levels which caused the problem in the first place.

I believe they're doing it because they simply don't know what else to do. We need a new financial model but no-one's come up with one.

Interest rates need to be in a neutral range, between six and seven percent in my opinion.

That gives a reasonable return on investment for everyone, individuals and companies. It means that people such as the rapidly growing number of self-funded retirees can live on their investments. They don't need to ask for pensions or social security payments from government.

It means that people who are credit risks are less likely to be given loans, including for mortgages which are beyond their real means.

I know there are furious arguments about what the right action to take is. As far as I'm concerned reducing interest rates back towards zero is the very worst action.

1 comment:

The Spear said...

Got this by e-mail today:

Financial Crisis explained in simple language
Linda is the proprietor of a bar in Cork. In order to increase sales, she decides to allow her loyal customers - most of whom are unemployed alcoholics - to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans). Word gets around and as a result increasing numbers of customers flood into Linda's bar. Taking advantage of her customers' freedom from immediate payment constraints, Linda increases her prices for wine and beer, the most-consumed beverages. Her sales volume increases massively. A young and dynamic customer service consultant at the local bank recognizes these customer debts as valuable future assets and increases Linda's borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral. At the bank's corporate headquarters, expert bankers transform these customer assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then traded on markets worldwide.
No one really understands what these abbreviations mean and how the securities are guaranteed. Nevertheless, as their prices continuously climb, the securities become top-selling items.
One day, although the prices are still climbing, a risk manager (subsequently of course fired due to his negativity) of the bank decides that slowly the time has come to demand payment of the debts incurred by the drinkers at Linda's bar. However they cannot pay back the debts. Linda can not fulfil her loan obligations and claims bankruptcy. DRINKBOND and ALKBOND drop in price by 95 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %. The suppliers of Linda's bar, having granted her generous payment due dates and having invested in the securities are faced with a new situation. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor.
The bank is saved by the Government following dramatic round-the-clock consultations by leaders from the governing political parties (and vested interests). The funds required for this purpose are obtained by a tax levied on the non-drinkers.
Finally an explanation I understand...