Tuesday, September 9, 2008

How the Economy Caught FIRE

A fire is a chemical oxidation reaction. It's products are heat, light, and carbon dioxide. When a small amount of combustible material, a match, for instance, reaches a threshold temperature, a chain-reaction ensues. The fire feeds on itself and keeps itself going until it runs out of fuel.

Think of debt as a combustible material. When entire classes of debtors default on their loans , as has occurred with the U. S. sub-prime mortgages then banks and mortgage companies that hold large portions of these debts become vulnerable to their own creditors. This can create a chain-reaction of bankruptcies where the value of all debt holdings, even the ones with AAA credit ratings go up in smoke as everyone tries to sell at once. This kind of “deflation” in value doesn't stop burning until it runs out of combustible material unless the government steps in and buys up the bad loans, letting taxpayers foot the bill.

The above scenario is getting played out, more and more frequently, as huge financial behemoths like the hedge fund “Long Term Capital”,Bear Sterns, and now the two mortgage giants Fannie Mae and Freddie Mac have had to be successively bailed out by the U.S. Government. These two private companies hold five trillion dollars in home loans, one half of the U. S. Total. This time, it's the biggest and costliest government bailout in U.S. History.

It's as if the government has been busy snuffing the fires without really putting them all out. And for years they have been adding to the amount of combustible material by loosening restrictions on credit and finance, allowing private debt to became a larger and larger proportion of the economy. The United States Government has been supporting the Financial, Insurance and Real Estate industries – the “FIRE” Economy – at the expense of other important sectors of the economy, such as manufacturing. That's the thesis of American pundit, Kevin Phillips, in his recent book Bad Money.

According to Phillips, between 1987 and 2007 debt became America's largest fastest growing business. In that period, credit market debt quadrupled from $11 trillion to $48 trillion. “ The financial services sector...muscled past manufacturing to become the largest sector of the U. S. Economy.” By 2005 financial services made up 20 % of U. S. GDP while manufacturing was only 12%. “Instead of seeking to restore the older manufacturing industries or build the new technological sector, Washington steadily protected and advanced banking and finance.”

During the eighties and nineties U. S. Corporations “downsized their labour force by eliminating five million jobs and shifted production overseas or south of the border, sharply lowering their tax burden. By doing so they were able to triple their profits and increase their value on the stock market eightfold. Shareholders and CEO's benefited but obviously workers did not. That explains why the top 1% have become immensely richer while everyone else's income has stagnated.

Since the 1970's economic growth and social health indicators have diverged from each other. The problem with a large portion of economic growth in the last thirty years is that is too focused on financial markets which is too narrow a base to build a stable economy on. For instance, over the last five years the U.S. Housing sector provided 40% of growth in GDP and that was fuelled by a huge expansion in mortgages. No country can remain a major economic power by increasing the number of houses it builds. The focus on financial markets at the expense of manufacturing, and skilled jobs, Phillips argues, has been endemic to the steep decline of previous European Empires, namely the Spanish, Dutch, and British. “ The Dutch of the 18 th Century polarized into a nation of rentiers in which the wealthy lived off interest, while industry, fishing, and shipping declined.”

In the United States, the Great Depression of the 1930's followed a similar expansion of credit and widening gap between the rich and the poor in the 1920's, but it was reversed by the policies of FDR, leading to a huge increase in the average American standard of living during the 50's and 60's During the 1980's and 90's successive right wing administrations dismantled FDR's regulatory system while keeping interest rates artificially low, leading to excessive credit expansion and the crash and burn eras of the savings and loans fiasco, the Nasdaq tech stock bubble bursting, and most recently the sub-prime mortgage debacle.

Not only does this make the U.S. Economy more and more vulnerable to crashing, it puts the entire globe at risk. The BC lumber industry is dying because of bad mortgages in the United States.

We need to avoid the vicious cycles of deregulation and government bailout, that leads to burning up and wasting our national wealth. Our government can make our economy more self-sufficient by encouraging us to produce real manufactured goods, instead of encouraging us to buy more stuff on credit. That way we'd have more jobs, higher skill levels and economic growth would be benefiting a wider base of population, leading to a more stable economy.

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