Saturday, March 29, 2008

Where did it all start and can the Fed deal with it ?

Fed's responsibility is to promote maximum employment and to maintain stable purchasing power. Thus, it is responsible for maintaining the balance between inflationary and recessionary forces in the economy. Practically speaking, in these times of liquidity crunch, Fed is serving as a banker of last resort, widening the discount window for troubled banks further and further.

Back to basics, Feds do have very limited control on the economy, in terms of factors like improvements in productivity, growth in education level, industrial, scientific and agricultural development etc. so, all the fed can do is to control the supply of money via increasing or decreasing the fed funds rate. Being more creative in bad times can arrange for bailouts and financial insurance (The BSC example).

What is making the job difficult for the Feds these days is the mist created by financial engineering (like structured products); and the diminishing line between the financial asset and money. They have led lead to a difficult count of money supply in the economy.

It seems it all started in 2001, when Alan Greenspan had cut the interest rates 11 times, to its lowest level in decades, in an attempt to revive the economy from the dot-com burst. This 1% fed funds rate led to another housing bubble, specially because of the ARM’s(adjustable rate mortgages), which were dependent on short-term interest rates. The increased demand in mortgages made banks lend money without giving due-diligence for the income of the borrower. This also artificially stimulated the housing market and the real estate prices rocketed up, not in sync with the developing GDP’s.

Also, these mortgages further created false-liquidity and money supply using structured products like MBS and CDO’s and CDO-squares and all. It isn’t clear but the slowdown in housing market started somewhere, and this made individuals to default as the remaining loan/mortgage values exceeded the real-estate prices. The effect was exponential because of the structured markets. It isn’t just the real estate that is affected, but the credit crunch took slowed the merger/acquisition activity, the industrial production and consumer spending.
The NYTimes - The Decider
Picture taken from image search google

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