The Fed's Actions: What's Next?

Posted by: Michael Mandel on August 17

The Fed has finally flexed its “lender of last resort” muscles. The question, though, is what comes next. There’s a good chance that the liquidity squeeze in the U.S. is effectively over, especially since the Fed stressed that it “will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. “ Yes, a lot of mortgage companies will still go under, a lot of financial firms will absorb big losses, and a lot of homeowners, unfortunately, will lose their houses. But the Fed has clearly put a cushion under the U.S. markets.

But the discount rate cut doesn’t mean the global financial crisis is over. Nor does it mean that the U.S. economy (as distinct from the financial markets) is out of the woods. In particular, I’m worried about two things—the fragility of the Chinese financial system, and the slowdown in U.S. productivity growth.

Let me take U.S. productivity growth first. The recent revisions in the economic statistics suggested that productivity growth in recent years has been significantly slower than thought (for example, only 1% in 2006, via 1.6% as previously thought). What’s more, the analysis in my offshoring cover suggests that even these figures may be significantly overstated.

If productivity growth is slower, that means the present value of the economy’s future output is lower. As a result, the economy can comfortably support less borrowing than previously expected. That may be one reason why the financial markets suddenly seized up. If so, then we are likely to go through a considerable work-out period in the U.S., to get debt in line with the new expectations for growth.

My second worry is the Chinese financial markets. During the Asian financial crisis of the 1990s, the Fed was strong enough to protect the global economy with its rate cuts. That’s not true any more. The Fed is capable of cushioning the U.S. financial markets, and working in concert with the ECB, the broader markets in the developed countries.

But the conditions are in place for a big financial crisis in China. Markets are overheated, investment is happening at a breakneck pace, and the financial system is weak and nontransparent. If the slowdown in the U.S. leads to a slowdown in Chinese exports and the broader economy, we may be looking at an emerging market bust that makes the recent turmoil in the U.S. look like a picnic.

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Reader Comments

Kartik

August 17, 2007 01:23 PM

What form would a crisis in China take? What might their GDP growth slow to?

Mike Mandel

August 17, 2007 02:02 PM

Negative. As I've said before, China has a first world economy, a third world financial system, and a communist government, running one of the biggest capitalist bubbles in history. A slowdown in growth will uncover all the bad loans that have been made over the years to unprofitable businesses, including the billions poured into the construction of buildings that can't possibly make money.
Then the question is whether the gov't has the popular legitimacy to take the necessary steps, including closing down the unprofitable state-owned businesses and banks.
Frankly, I would be surprised if the crisis didn't happen there eventually.

Kartik

August 17, 2007 03:30 PM

So China would go from 11% growth to negative growth? That would shatter the world economy, far more than a mere US recession would. It could even lead to a new Great Depression....

Mike Mandel

August 17, 2007 05:53 PM

Depends. Remember that China's exports show up as a negative to GDP in other countries. Plus my suspicion, based on my analysis of the data, is that there is a lot of double counting in global gdp.

Vinod

August 17, 2007 06:59 PM

Double counting? Can you give an example of this.

Reno@Reno

August 18, 2007 02:46 AM

Worried about China's financial system? Gimme a break! We've got the biggest financial black hole in the history of mankind and you're ... voicing concern over China's. That's very good.

joesun

August 18, 2007 03:58 AM

Do you think that the chinese government are not aware of the siruation mention by Mike Mandel? Yes they do. A lot of economic minister are American and european educated from most prestigious school. Chances of a meltdown would be unlikely under normal cicumstances, may be a war or natural calamity would cause a meltdown

Brandon W

August 18, 2007 10:07 AM

I definitely agree that productivity and growth are both well-overstated. I also believe that inflation is well-understated. Additionally, I think that the top 10% are operating in a very different economy than the other 90%; i.e. growth is great in the top 10% (and inflation understatement is a much less important factor). Income growth for the bottom 90% has been pretty stagnant for the past 6 or 7 years assuming the reported inflation numbers; however, if inflation really is understated then real income growth is negative for the latter group. These are all things to consider. As I stated in another recent comment here, I've given up on trying to bring attention to this for the purpose of fixing it. I now discuss this with the purpose of encouraging people to operate in the Top 10% Economy(tm). Few will listen, and in this case that is a benefit. The top 10% need lots of desperate, brainwashed workers to keep costs down.

Michael Yang

August 18, 2007 10:09 AM

I doubt the point you make that buildings in China couldn't possiblely make money as the fact is clear that the real estate price is consistently growing at a rate around 20% annually for the past 10 years.

Mike McCune

August 18, 2007 01:09 PM

How does the aging and subsequent eligibilty for Social Security payments affect productivity growth? I handle my retired parents' taxes and I have to wonder while my wife and I keep working harder and longer for less yearly pay, my parents (in their 70's) keep getting cost of living increases (several thousand dollars on the State pension annually) while having retirement income roughly double my family. There is very little productivity increase from my parents. And they pay less in State income tax than my 11 year old!

Also, why in such a strong adaptable market does 6% interest rates cause the Fed to have to go into action despite what Peter Coy's Business Week article (the Bernanke Agenda) reports about Bernanke being "one soft-spoken professor who knows how to say no."? I believe its not nominal inflation that is the problem, but rather "complexity inflation" that is not being measured, but felt. Two generations ago my grandfather with just an eighth grade education could keep a new Buick in the garage every couple years and have a vacation cabin in the Ozarks to eventually retire to. Our CPI only measures the price changes in the eighth grade education, and the new Buick, and the cabin in the Ozarks, but fails to capture the "inflation of complexity" in modern society that an eighth grade education will not buy you what it once did. But Grandpa worked through the Great Depression; if the Fed keeps protecting the big money I'm afraid future generations won't be allowed that accomplishment.

Kalvin

August 18, 2007 01:17 PM

I don't think it requires tremendous foresight to predict there would be a crisis "eventually" in China. Even in a "first world financial market" such as in the US, there has been several major crises in the last 10 years alone. In fact, even as major economies were hit hard in recent years China was able to insulate their economy.

The biggest capitalist bubbles in history? I don't have the stats but China's market cap is still a tiny fraction of the world's total market cap despite being soon to be 3rd largest economy in the world and the world's fastest growing. Most of the money in the Chinese stock marekt are from normal people who otherwise would have put them in savings account. As far as the real estate market is concerned, the high valuations are concentrated in the wealthiest cities of China. And Chinese people are in general more prudent when it comes to taking out mortgages. (Many pay cash). HK is not exactly China but even in the aftermath of Asian financial crisis where most homeowners owed more on their house that it is worth, default rates were surprisingly low, something that cannot be said about the US. This is in addition to the fact it's not exactly easy to get a mortgage in China, which is again, something that can't be said for a "first world financial market" that the US is.

You made it sound like the US and ECB were the only powers that healed the world in the Asian financial crisis. Sure the US and ECB did what they needed to do to protect their economies but don't discount the important and stabilizing role China also played, the most notable acts of which was keeping their currency stable despite calls from all over the world to devalue. Remember also, the global economy was weak in the early 2000s and China's economy and financial markets were far less developed, less transparent and more reliant on exports than they are today. Yet, China made it out ok and in fact made strong contributions to global growth by financing much of the world, particulary the US, in the years since.

Most Westerners somehow see the Communist party as a liability but those who truly understand China's economy and its people would realize that the government must play a strong hand to prevent the very crises that most people fear. The country is still too poor and its systems underdeveloped to let off its leash without leading to chaos. Sure the lower ranks of the government is among the most corrupt in the world but there are changes undergoing that most people do not see. Besides no government is perfect. Even the US system has major flaws with many politicians seeking votes by promising policies that have unintended consequences that they can't comprehend or taking contributions from major corporates for favorable policies but all that is fine because there is always someone to scapegoat in Americn politics. At least in China, the Communist party has to take full responsbility for anything bad that happens.

There are no disagreements that business cycles are to be expected in China and elsewhere but I disagree that only if business cycles happen in China, it must be because the Communist party is doing something bad (ie: creating the biggest capitalist bubble in history) or that Chinese people just don't know what they're doing. I think the Chinese deserves more credit for their role in improving the lives of people not just in China but also the rest of the world. They should be treated as a responsible adult going through some issues rather than an immature and unintelligent child.

Thomas A. Coss

August 18, 2007 09:15 PM

Michael et. al.

How does this current situation compare to the Savings & Loan Crisis of the 1980's? That, as I recall, was about a $150 billion dollar problem that seemed to have worked its way through the economy, though not without pain, are there any lessons there or comparisons which are useful?

Mike Reardon

August 19, 2007 02:04 AM

In the face of national financial crises most western nations for the last century put forward government assured national development. China and India can be seen as needing development at so many local levels that extended finance of their social infrastructures is a natural process still going well into this century. There demand to fill their infrastructures is not going to be extinguished by any nations commodity trading floor. They still have our debt service and currency reserves in their treasures and banks as a cushion to leverage in banking centers world wide. Nothing changed in this demand over the last year the oil and minerals for construction will be found to fill these further demands and both western an Asian nations can agree on standing up the finance to make it be. Try another international decade of world development, based this time on newly extracted commodities and assured social development the last one has already transferred massive wealth into the hands of the developing world.

Mike Mandel

August 19, 2007 07:13 AM

>>Worried about China's financial system? Gimme a break! We've got the biggest financial black >hole in the history of mankind and you're ... voicing concern over China's. That's very good.>>

What we have today is a bunch of loans that are going to go bad. They are, however, backed up by real collateral in the form of houses that people are living in. In addition, many of the loans were sold to foreigners in the form of CDOs and mortgage-backed securities, so the pain is going to be diffused around the world.

China has a much bigger problem, relative to the size of its economy

Mike Mandel

August 19, 2007 07:15 AM

>>I doubt the point you make that buildings in China couldn't possiblely make money as the fact is clear that the real estate price is consistently growing at a rate around 20% annually for the past 10 years.>>

Michael,
The price of homes in the U.S. have been rising for the past 10 years as well. Now look at them. As the saying goes, past returns are no guarantee of future performance.

Besides, you've just made my point for me: 10 years of 20% price increases is the very definition of a bubble.

Mike Mandel

August 19, 2007 07:18 AM

>>Double counting? Can you give an example of this.>>
Vinod...
Sure. If you look at my offshoring cover, you'll see that a portion of U.S. imports from China are being mistakenly counted as part of U.S. production. They are also being counted as part of Chinese production.

I'm going to come back to this point in a future article.

Kalvin

August 19, 2007 08:44 PM

>

I agree with this argument partially but the loans on real estate in China is also backed by real collateral. Just because the houses are in China doesn't mean it's not worth anything. While it's true that loans in the US are sold all over the world, China is still largely a cash economy, which means that when people buy houses, they're not doing 100% (or more) leverage. They actually have a lot of equity in their properties. In places where you see ridiculous prices, it's because wealthy Chinese are buying them (and paying cash), not regular people who are barely making ends meet. They also certainly cannot draw equity from their property like its an ATM the way Americans do. So in that sense, the risk to the economy during a housing downturn is much less severe in China than it is in the US.

The person who made the comment about 20% growth pa for the last 10 years is probably just throwing numbers out, but the point is understood. And even if it is true, I agree that in most economies, that could be considered a bubble but China's economy has averaged double digit growth for the past 10 years. There is real wealth being created in that country, wealth that is able to support housing growth. In addition, a square meter built today in China is probably 100 times better in quality than a square meter 10 years ago, whereas most people would agree that houses in the US built today have not shown much improvement and in some cases, probably even worse than houses built in previous decades. But the most important thing that needs to be considered again is that even in a housing downturn, Chinese people are not going to default on their mortgages the way Americans would because in addition to cultural differences, there is also lot more equity in Chinese properties.

Joe Cushing

August 21, 2007 11:21 AM

Everyone is so freaked out about China's growth rate. I think there is a key difference between a developing country and a developed country that means we don't know what a safe growth rate is. The difference is this; in the U.S. we have to invent new technology or new processes in order to grow GDP per capita while in China, all they have to do is implement technology that we invented. The difference between the two is a huge cost and risk on the U.S. growth compared to Chinese growth. I don't think anyone has made an effort to quantify that. We simply don't know how fast a developing country can safely rise. There haven't been enough of them to study.

mark

August 25, 2007 01:12 PM

Next Step:

The bubble did exist and is bursting. Time to look into the future. The US financial system is not functioning now: Banks have no money to lend, mortgage nor credit cards. Consumers has no means of indulging without frozen credit limits on the credit cards.

The Iraqi war is ending and government spending is slowing. So recession is coming and it will further increase mortgage and consumer debt delinquencies and make debt backed securities more junky.

The current Fed and Treasury is imitating the Japanese after their bubble burst 15 years ago, forgetting that Japan has still not come out of the continuous recession since.

Unless we clean up all these junky “AAA” debts, kick off all un-qualified borrowers, and take all non-performing loans from the banking system, this society will stagnate. There won’t be enough capital to fund any new ideas or worthy ventures.

By the Fed fiddling with interest rates, this society will never learn the necessary moral lesson from this bubble – that we have to earn our money like our ancestors. America has build and created almost everything worthy of mankind itself for the past 200 years, both materialistically and in ideas.

Other than satisfying envy and greed, this real estate bubble failed to create anything that benefits human kind – the first time this country has fail to do so.

Maybe if we lower the interest rate to zero, like the Japanese did, we can “fix” our problem for a little while. But that will only be breeding the next and bigger bubble. All fund will rush back to real estate. Ideas and dreams will still be unfunded.

THE RIGHT THING TO DO IS A GOVERNMENT BAILOUT NOW

The federal government needs to come in now to take ALL mortgage debts off the banks’ books, then foreclose, forgive and auction every single default loans and underlying collaterals.

This may cost the government around $300 billion (a few months spending at Iraq), but it will save the country a recession, which can cause trillions, and allow the banking system to function again. New ideas will get funded without the unfair competition of money from the real estate madness. The 7 million or so delinquent borrowers will also gain a chance of starting over with a more responsible life,

This society will be “decent” again.

mark

August 25, 2007 01:14 PM

Next Step:

The bubble did exist and is bursting. Time to look into the future. The US financial system is not functioning now: Banks have no money to lend, mortgage nor credit cards. Consumers has no means of indulging without frozen credit limits on the credit cards.

The Iraqi war is ending and government spending is slowing. So recession is coming and it will further increase mortgage and consumer debt delinquencies and make debt backed securities more junky.

The current Fed and Treasury is imitating the Japanese after their bubble burst 15 years ago, forgetting that Japan has still not come out of the continuous recession since.

Unless we clean up all these junky “AAA” debts, kick off all un-qualified borrowers, and take all non-performing loans from the banking system, this society will stagnate. There won’t be enough capital to fund any new ideas or worthy ventures.

By the Fed fiddling with interest rates, this society will never learn the necessary moral lesson from this bubble – that we have to earn our money like our ancestors. America has build and created almost everything worthy of mankind itself for the past 200 years, both materialistically and in ideas.

Other than satisfying envy and greed, this real estate bubble failed to create anything that benefits human kind – the first time this country has fail to do so.

Maybe if we lower the interest rate to zero, like the Japanese did, we can “fix” our problem for a little while. But that will only be breeding the next and bigger bubble. All fund will rush back to real estate. Ideas and dreams will still be unfunded.

THE RIGHT THING TO DO IS A GOVERNMENT BAILOUT NOW

The federal government needs to come in now to take ALL mortgage debts off the banks’ books, then foreclose, forgive and auction every single default loans and underlying collaterals.

This may cost the government around $300 billion (a few months spending at Iraq), but it will save the country a recession, which can cause trillions, and allow the banking system to function again. New ideas will get funded without the unfair competition of money from the real estate madness. The 7 million or so delinquent borrowers will also gain a chance of starting over with a more responsible life,

This society will be “decent” again.

Thank you for your interest. This blog is no longer active.

 

About

Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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