The US Federal Reserve's desperate attempts to keep the US economy from sinking are remarkable for at least two reasons. First, until just a few months ago, the conventional wisdom was that the US would avoid recession. Now recession looks certain. Second, the Fed's actions do not seem to be effective. Although interest rates have been slashed and the Fed has lavished liquidity on cash-strapped banks, the crisis is deepening.
To a large extent, the US crisis was actually made by the Fed, helped by the wishful thinking of the Bush administration. One main culprit was none other than Alan Greenspan, who left the Fed Chairman Ben Bernanke with a terrible situation. But Bernanke was a Fed governor in the Greenspan years, and he, too, failed to diagnose correctly the growing problems with its policies.
Today's financial crisis has its immediate roots in 2001, amid the end of the Internet boom and the shock of the Sept. 11 terrorist attacks. It was at that point that the Fed turned on the monetary spigots to try to combat an economic slowdown. The Fed pumped money into the US economy and slashed its main interest rate -- the Federal Funds rate -- from 3.5 percent in August 2001 to a mere 1 percent by mid-2003. The Fed held this rate too low for too long.
Monetary expansion generally makes it easier to borrow -- and lowers the costs of doing so -- throughout the economy. It also tends to weaken the currency and increase inflation. All of this began to happen in the US.
What was distinctive this time was that the new borrowing was concentrated in housing. It is generally true that lower interest rates spur home buying, but this time, as is now well known, commercial and investment banks created new financial mechanisms to expand housing credit to borrowers with little creditworthiness.
The Fed declined to regulate these dubious practices. Virtually anyone could borrow to buy a house, with little or even no down payment and with interest charges pushed years into the future. As the home-lending boom took hold, it became self-reinforcing. Greater home buying pushed up housing prices, which made banks feel that it was safe to lend money to non-creditworthy borrowers. After all, if they defaulted on their loans, the banks would repossess the house at a higher value. Or so the theory went.
Of course, it works only as long as housing prices rise. Once they peak and begin to decline, lending conditions tighten and banks find themselves repossessing houses whose value does not cover the value of the debt.
What was stunning was how the Fed, under Greenspan's leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash. There were a few naysayers, but not many in the financial sector itself. Banks were too busy collecting fees on new loans and paying their managers outlandish bonuses.
At a crucial moment in 2005, while he was a governor but not yet Fed chairman, Bernanke described the housing boom as reflecting a prudent and well-regulated financial system, not a dangerous bubble. He argued that vast amounts of foreign capital flowed through US banks to the housing sector because international investors appreciated "the depth and sophistication of the country's financial markets [which among other things have allowed households easy access to housing wealth]."
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
When I was in Ukraine filming for an upcoming documentary, I was surprised at how frequently my mind naturally tended to map Ukraine’s war experience onto Taiwan, where I have lived for the past 10 years. There are obvious parallels of an imperial nuclear superpower asserting itself over a smaller non-nuclear state, but there are also small mundane things that would impact everyday life. When I saw Ukrainian elderly people filling jugs of water at a church in sub-zero temperatures and hauling it back to their homes which might not have electricity, I imagined the difficulty of a Taiwanese senior
This is the Year of the Dragon. At the beginning of the year, the Chinese government announced that “dragon” is to be translated as long (龍), in a move meant to erase the supposed negative connotations of dragons. In many Western cultures, dragons are often seen as wicked or demonic. This is not just a mere linguistic adjustment. It is symbolic, representing a change in China’s current political culture. Under the overbearing leadership of Chinese President Xi Jinping (習近平), the Chinese government has been undergoing a cultural policy of “de-Westernization.” Although this change in semantics is just one of many
An online petition started by a doctor in Taichung called on lawmakers to halt an amendment that would shorten the time needed for Chinese spouses of Taiwanese to gain citizenship in Taiwan. The amendment could put a strain on Taiwan’s already burdened National Health Insurance (NHI) system, Cheng Ching Hospital thoracic surgery division doctor Tu Cheng-che (杜承哲) said. Doctors have seen many Chinese spouses bring their relatives to hospital emergency rooms, asking for full checkups, he added. “They [Chinese spouses] even tell their relatives that healthcare in Taiwan is free and is easily accessible, and that healthcare providers in Taiwan
On Feb. 15, the UK’s Economist Intelligence Unit released its latest report on the state of democracy around the world. Out of the 167 countries and territories covered by the report, titled Democracy Index 2023: Age of conflict, Taiwan is considered a full democracy, ranking first in Asia and 10th around the world. The index showed that global democracy regressed last year, yet Taiwan countered this trend, a fact that all Taiwanese should take pride in. The report sheds light on the rising tide of authoritarianism, with groups consolidating power within and forming alliances with authoritarian powers without. The international order