In the course of 2006 and last year, the financial bubble that is now bringing down once-mighty financial institutions peaked. Banks' balance sheets were by then filled with vast amounts of risky mortgages, packaged in complicated forms that made the risks hard to evaluate. Banks began to slow their new lending and defaults on mortgages began to rise. Housing prices peaked as lending slowed and prices then started to decline. The housing bubble was bursting by last fall, and banks with large mortgage holdings started reporting huge losses, sometimes big enough to destroy the bank itself, as in the case of Bear Stearns.
With the housing collapse lowering spending, the Fed, in an effort to ward off recession and help banks with fragile balance sheets, has been cutting interest rates since last fall. But this time, credit expansion is not flowing into housing construction, but rather into commodity speculation and foreign currency.
The Fed's easy money policy is now stoking US inflation rather than a recovery. Oil, food and gold prices have jumped to historic highs and the dollar has depreciated to historic lows. A euro now costs around US$1.60, up from US$0.90 in January 2002. Yet the Fed, in its desperation to avoid a US recession, keeps pouring more money into the system, intensifying the inflationary pressures.
Having stoked a boom, now the Fed can't prevent at least a short-term decline in the US economy and maybe worse. If it pushes too hard on continued monetary expansion, it won't prevent a bust but instead could create stagflation -- inflation and economic contraction. The Fed should take care to prevent any breakdown of liquidity while keeping inflation under control and avoiding an unjustified taxpayer-financed bailout of risky bank loans.
Throughout the world, there may be some similar effects, to the extent that foreign banks also hold bad US mortgages on their balance sheets, or in the worst case, if a general financial crisis takes hold. There is still a good chance, however, that the downturn will be limited mainly to the US, where the housing boom and bust is concentrated. The damage to the rest of the world economy, I believe, can remain limited.
Jeffrey Sachs is professor of economics and director of the Earth Institute at Columbia University.
Copyright: Project Syndicate
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