A friend happened to ask about the economic crisis, and I replied with a lengthly write-up. I guess I'll just put it here for those who want to read. Don't want to let it rot in the 'sent' folder. Note: I typed these off the top of my head and has done very little editing.
Question:
My main objective is to write an article to explain why the US is in the current situation it is in. Starting with the subprime crisis and then going through the details of how the monetary policies were implemented and why we don’t see the results . I’m sure there are other reasons that could explain why the policies aren’t working, but I think I’m supposed to just talk about the possible liquidity trap scenario
1. The question I have is that I want to know how the liquidity trap in the US can be used to explain why the US’ s monetary policies are not working. I also want to know what the purpose of QE is. I know its for printing money and for the government to use the money to buy long term 30 year bonds but I don’t know why they are buying the thirty year bonds and how that plan was supposed to stimulate the economy in the first place.
2. Based on monetarists theory I’m using the the MV=PY equation. I don’t know how to find the velocity . cause I think if out put is not moving, money supply is increasing and inflation is growing, then V is either stationary or decreasing. How can I prove this ?
3. Then I also want to understand how a steep yield curve in the bond market is bad for housing markets.. my lecturer made a brief statement on it but I wasn’t sure of what he means
Answer:
I'm not well-versed with the economics equations, but I'll offer my thoughts if you would like to indulge me.
1. The problem (which most economists and Obama wrongly diagnosed) with the economy was and is not about a lack of credit or liquidity. There are several dimensions to this economic problem, which I will attempt to discuss below:
The problem was that there was too much of those in the first place. In the 1990s, the Fed printed lots of money, which results in the dot.com bubble. The bubble burst around the year 2000. President Bush inherited this bubble from Clinton, and wanted to 'solve' it. With the help of the then Fed-chairman Alan Greenspan, a lot of money was printed and flooded into the economy. The result was a drop of interest rate to 1%, a few companies were saved, the housing sector picked up, and the nation never really suffered a recession. Bush prided himself with his achievement in stopping the crisis, and blamed the free-market on the bubble. Little did he know that this money printing had led to increased speculation in other areas of the economy, namely the housing sector. People borrowed money because it was so cheap. They undertook projects that would otherwise have not been started under free-market conditions. They built homes all over the place. The Americans, flooded with this magic money, went on the biggest spending binge in history. Housing sales went up, motor sales went up, imports went up, and savings went down. It used to be that one works hard and save for a house. Now the situation has turned into one in which if you lose your job, you just go and buy a vacation house, because you expect the price to go up.
The government also came in with various programs to help the people own homes, even those with bad credit-ratings. They set up Fannie Mae and Freddie Mac to guarantee mortgages. Together with the deposit-insurance scheme which the govt had come up with to protect customers' deposits in the banks (same as those in Singapore), these 2 entities create a huge moral hazard in the financial sector. Banks do not care what they do with depositors' money, because they have the govt on their back. Depositors do not care what the banks do with their money, because they have the govt on their back.
The market is greedy, but greed is supposed to be countered with fear and competition. With all these guarantees by the govt, the fear and competition was effectively REMOVED. Banks do not compete based on the soundless of their deposits anymore! Worse is that depositors do not care too. Think about it, an average person will spend more time researching on a cell phone that he/she is planning to buy, compared to spending time researching on a bank in which he/she wants to deposit his/her money. This is bad bad moral hazard!
So anyway, the economy looks to be booming at a dizzying pace. Greenspan, noticing this economic 'growth' (an illusion created by money-printing, really), slowed down his money-printing in the ensuing years. As a result, interest rates start to rise. Businesses which had depended on the preceding artificially low interest rates started to fold. Home loans start to go bad because people were unable to service the higher interest rates. So in 2007, we have the bursting of the housing bubble.
Obama and Bernanke inherited this bubble, and what do they do? Repeat the mistake! They printed even more money (thus lowering interest rates to 0%) and spent even more on government programs. They encouraged Americans to spend on new houses, and reward them with rebates if they buy a new house. They encouraged Americans to trade in their used but fully-paid cars for a new car, and gave $3000 incentive for anyone who does that. They destroyed the engines of the old cars (you can watch all this madness on youtube) and loaded Americans with new debt because they bought new cars.
To your point on the purpose of QE, they did that precisely to lower the interest rates to "save" the banks and companies dependent on it, and to allow the government to spend more and service its debt. It's madness. It's mathematically impossible for the Fed to stop printing and expect no economic collapse. There's always a consequence. If the Fed stops printing, the interest rates will rise again and the banks and the govt will be bankrupt again (i have figures to back these up). Anyway the bubble they have built up now is the govt bond bubble. Now there's a mania in the US govt bond, but most people still haven't realised that.
So, to summarise, QE won't stimulate the economy. The only thing that it will stimulate is the price of gold. LoL. We can discuss the simple mathematics on why QE doesn't work at all if you want to. People have to stop worshipping paper money and stop thinking that it is real money just because the govt says it is legal tender. I treat paper money as just another commodity which people just happens to have faith in (albeit wrongly) right now. It is a commodity which has been created in massive quantities in the past 40 years ever since the dollar was de-linked from gold in 1971.
2. Sorry, i'm not familiar with the equation, so I can't answer it quantitatively. But correct me if I'm wrong: you're saying that M rises, P rises, and Y is unchanged? I would think Y is dropping though. I think they measured Y by considering growth of GDP and amount of inflation. So in my mind it's not accurate. GDP can be bumped up simply by printing more money and more govt-spending. Inflation is very obviously understated by official numbers (the real statistics can be found at shadowstats.com, but we have to subscribe to see it).
Qualitatively, I think right now, the money-velocity is not high yet. There's still faith in the USD around the world, although some countries are increasingly moving away from USD. When people start to spend all those USD, when China starts to spend all their USD, then the chickens will come home to roost in the US. Inflation will be sky-high. What the US had printed up in monetary base in the past 200 years (and have a resulting 97% loss in the purchasing power of the USD), Bernanke managed to double it in just 1-2 years. It's incredible.
3. The yield curve shows the interest rates that the govt has to pay for its debt. I'm not sure what your lecturer said, but I know of 2 reasons:
- When yield curve becomes steep, many of the floating-interest-rate loans will become harder to service. A lot of bank loans' interest rates are tied to the govt bond yield. So as the yield rises, so will the interest rate on the loans. This means more people will default on their mortgages. This was what happened in the years leading up to 2007.
- I think the housing market has been dependent on government-entities like Fannie and Freddie to stay afloat artificially (they now own over 60% of all US junk housing mortgages, and buys up 90% of new mortgages). I think they have liabilities in the trillions. I have not done much research on the figures, but I see quotes saying that Fannie and Freddie adds like $5 trillion to the national debt (of course, this is off-budget and not reported by the govt's phony, unscrupulous accounting methods). When the yield curve is steep, the govt will no longer be able to spend as much on these entities to support the housing market. So they may have to release millions of homes into the market, and prices will collapse.
I don't agree that a steep yield curve bad for housing though. It's good for housing actually. Prices need to go down to its natural level, and not stay at one induced by the Fed's money-printing and govt's artificial support. Home builders need to go bankrupt, because they are using the nation's scarce savings and resources on projects that are unsustainable. Under a free-market condition, interest rates would have risen dramatically and said STOP to these home builders. Capital will then be more efficiently allocated to more productive parts of the economy.
