Monday, October 6, 2008

The Financial Crisis Goes Global While Solutions Evaporate

Bank bailouts are all the rage in Europe these days, with Germany, the United Kingdom, Belgium, the Netherlands, Luxembourg, Ireland and even Iceland getting into the act. The U.S. Federal Reserve has gone global, lending dollars to European central banks that are re-loaned to credit crunched European banks. The stock market is having a hissy fit, dropping to levels first attained in 1999. In other words, if you bought stocks in 1999 and held them until now, you'd have gone nowhere. Indeed, you'd have lost money because of inflation.

The Federal Reserve has become the de facto central bank for the rest of the world. It is backed up by a line of credit from the U.S. Treasury, and in the worst case scenario, could literally print money. News reports indicate that the Fed is considering buying commercial paper, short term unsecured debt issued by financial firms, businesses and municipalities. This is the kind of debt used to meet payrolls and pay suppliers. Without it, commerce grinds to a halt. Even some governments may grind to a halt. Two states, California and Massachusetts, have requested loans from the federal government because they are having trouble selling short term debt.

To meet all these needs, especially those of the multi-trillion dollar commercial paper market, the Fed will have to print money. Foreign investors, the only people with serious amounts of excess cash, won't lend enough additional money to the U.S., not after the losses they've already taken. If the U.S. offered really high interest rates to borrow more, it would trigger losses in the existing dollar-denominated portfolios of foreign investors. (Recall Bond Investing 101: a marketwide rise in interest rates causes existing bondholdings to drop in value.) The more the U.S. tries to borrow, it more it damages the portfolios of the people it's trying to borrow from.

But printing money triggers inflation. Even though oil prices have been pulling back, they remain very high by historical standards. And food prices keep rising. Printed money will only make things worse. Profligacy in the real estate and mortgage markets turned out to be a bad idea. Profligacy in the money markets, even if seemingly necessary for the sake of expediency, won't turn out any better. Not in the long run.

None of the various governmental bailouts in the U.S. or Europe have accomplished much, and the U.S. Treasury can't do much more. The failure of last week's $700 billion bailout to stabilize the stock market for even one day (there was a 369 point drop in the Dow on Monday, Oct. 5, 2008, the next trading day after the bailout was enacted; there's gratitude for you) has destroyed the Bush Administration's credibility. Secretary Paulson can't go back to Congress and ask for hundreds of billions or trillions more. Not when he doesn't have a track record of getting the job done.

There is talk of a bailout organized by European nations. And of a coordinated interest rate cut by all the major central banks. These things might happen. But it seems doubtful that they'll make much difference. The problem is that there remain perhaps several trillion dollars and Euros of losses emanating from bad real estate loans, and these losses must be taken by someone somewhere--banks, investors, taxpayers, somebody. They won't magically disappear, regardless of how much governments do. The $700 billion bailout may eventually help absorb some of these losses. But it won't solve the problem by itself. Tread cautiously in the stock markets, and keep some cash in the cookie jar. Many unknowns remain ahead.

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