Contagious Dollar (Extract)

By SHLOMO MAITAL
Extract from an article in Issue 10, September 1, 2008 of The Jerusalem Report. To subscribe to The Jerusalem Report click here. World economics is like a tower of dominoes. The world is a complex interdependent global economy. When one country gets into hot water, other countries are burned - just like those domino displays, where one domino topples another. A decade ago, Asia was in trouble. Their demand for oil declined. That hurt Russia, an oil exporter. Russia defaulted on its debts in 1998. This, in turn, knocked over Brazil and Argentina. When investors saw Russia crumble, they pulled money out of South America as well. America is the latest domino to fall. Because it is the world's biggest economy, this crisis is the most serious of all - the worst since the Great Depression. America will topple many other 'dominoes.' Israel will not escape. Can you explain America's crisis in simple language? It is about bubbles. Bubbles are markets where prices rise so high they lose touch with reality. America created a housing bubble. How do we know it's a bubble? When the value of a house based on its rental value is half or less the going market price. But all bubbles burst eventually. This one burst a year ago. Inside America, one domino topples another - as one bank gets in trouble, depositors panic and this topples other banks. In financial crises, greed turns to fear. In America, greed has turned to widespread fear. Can you explain the cause-and-effect more clearly? On March 9, 2000, America's previous bubble - the 'dot.com' bubble - burst. Stocks plummeted. The NASDAQ stock index, comprised of high-tech stocks including over 100 Israel companies, quickly lost three-quarters of its value. Financial crises always become economic crises. There was a global economic slowdown - in Israel, too. The head of America's Federal Reserve, or central bank, Alan Greenspan, began slashing interest rates and expanding credit to boost the economy. He did this explicitly to stimulate the housing market. He cut interest rates from over 6 percent down to only 1 percent. He overdid it. He created the bubble. Other countries contributed, too. There was an unprecedented abundance of capital, as China and other Asian high-savings economies pushed money into the world. Euphoria overcame reason. And, above all, investors, even very savvy ones, began to ignore risk - always a perilous mistake. Why did they ignore risk? I thought investing is all about risk vs. return? Geoff Colvin, writing in Fortune magazine, says that worldwide economic prosperity and easy money created a problem. "People began to believe that the more they borrowed, the better off they would be. Their thinking was: "With the cost of capital so low and asset prices rising steadily, risk was evaporating." But risk never evaporates. It simply hides, bides its time, then clobbers its victims when they are least prepared. This is now happening to some of the supposedly smartest financial wizards in the world. They lost touch with reality. Could this crisis have been foreseen? Americans have lived beyond their means for two decades. America's government now owes $9 trillion. The interest alone on that debt is four times America's total education budget. Even the United States, whose currency is the global money and it can print it freely, must one day come down to earth. "When U.S. consumers began living within their means," Colvin notes, "they shut down the profit machine." Crisis was inevitable. In June 2007, investors realized the bubble was just that. They began bailing out of high-risk investments, such as mortgages owned by those who could not afford to pay. The result was an avalanche of selling and a financial crisis. How are those two kids, Fannie Mae and Freddie Mac, involved? Well, they aren't really kids, they are huge financial institutions. They are government-sponsored enterprises, whose shares are owned privately but whose debts are tacitly guaranteed by the government. They play a key role. They buy up mortgages from banks, then package those mortgages and sell bonds with the mortgages as collateral. This enables pension funds and other investors to invest in mortgages when, otherwise, they could not. It channels new funds continually into mortgage banks. It is a system that enabled millions of Americans to buy their own homes. Israel lacks it - and needs it. But the system was flawed. When Americans began defaulting on their mortgage payments, Fannie Mae and Freddie Mac had to cover the losses banks incurred. Shareholders began dumping their shares. The market value of their shares fell from $140 billion in 1999 to only $10 b. recently. They were broke. The American taxpayer had to bail them out. The value of the bonds issued by Freddie Mac and Fannie Mae totals a staggering $5 trillion. Had they defaulted in payment of those bonds, there would have been instant worldwide collapse. This is definitely a problem. Extract from an article in Issue 10, September 1, 2008 of The Jerusalem Report. To subscribe to The Jerusalem Report click here.