Creation of the Economic Bubble, and Its Bursting

By Dr. A. S. Nakadar, CEO and Publisher of TMO

When President Bush took over from President Clinton in 2001, the budget had a surplus of $230 billion, the largest in US history. That reduced the national debt level to about $5 trillion.

The terrorist attack on 9/11 provided Bush a pretext to invade Afghanistan in October of 2001, and Iraq in March of 2003. These wars derailed the economy.

Haunted by the Vietnam War and its aftermath, it was necessary for Bush and his neocon cohorts to avoid public anger and disenchantment against these new wars. The best way, they thought, was to keep the money supply spigot fully open, to keep people happy and contained, while the huge cost of the war continued to drain the treasury.  This created an economic bubble which ultimately burst with devastating impact, not only in the US but world wide.

Initially, the Iraq war was billed as a walk-over, with an estimated cost of a few billion dollars. Now, the Congressional Budget office estimates the cost at $1 to 2 trillion, and the occupation is becoming a nightmare. Economists Linda Bilmes and Joseph Stiglitz dispute these figures, and according to their estimates, the cost of war and occupation is around $3 trillion. This alone forms the biggest Bush era budget deficit.

Creation of a Bubble

Do you remember what President Bush said after the terrorist act of 9/11? Rather than asking for sacrifices, he said, “Get down to Disney world in Florida, take your families and enjoy life, the way we want to be enjoyed.” According to Boston University historian Andrew Bacevich, President Bush encouraged financial irresponsibility. Looking back, it seems this was a broader pattern of encouraging financial spending. This was a calculated move to drive people for a credit-fueled consumer binge.

The individual tax cuts and the reduction in capital gains tax was the first step in this direction. This provided extra money for people to spend. But when this extra money started to run out, with the hint of an economic slowdown, Allan Greenspan, chairman of the Federal Reserve began the second phase of money supply. He sufficiently lowered the prime lending interest rates. This encouraged people to refinance their homes, and they did that, to the hilt, because of lower interest rates and because of liberal lending policies. This fueled the credit binge further. 

People lined up to refinance their homes. It freed up their built-in equity. People felt instantly rich. They spent this extra cash on purchasing bigger and more expensive houses. They all hoped to make a quick buck by selling the house again in a year or two in the rising housing market. This speculation drove the house prices higher and higher. People borrowed more than the actual value of the house, and more than they could afford.

This extra cash also fueled the stock market. In the last quarter of 2002, the Dow Jones Industrial Average (DJIA) was at 7.552. Five years later in the last quarter of 2007 the DJIA reached 14,000.  It almost doubled in 5 years. Consumer spending on goods and services continues unabated.

This false sense of economic well-being propelled Bush to his second term in office.

In the third phase, banks were encouraged to give mortgages to less creditworthy people. People with financial defaults and with questionable credit received mortgages.

People started taking out mortgages they could not afford. They got it because they all wanted to get rich. The mortgage companies targeted people who couldn’t afford a down payment and had poor credit, so called “sub prime borrowers.” With no shortage of eager borrowers, whose only desire was to get rich, business boomed and the lending institutions made millions of dollars.

The Bubble Bursting

These subprime mortgages, later came to be known as “toxic mortgages” as they affected the over all financial health of the institutions that held them.

By 2008, these “toxic mortgages” had affected all the major investment firms. The largest financial institution and the largest lender in the world created by the government to make loans on affordable houses, Freddie Mac and Fannie Mae, with about $15 trillion asset, cracked, because it held over $5 trillion in “toxic mortgages.”

In the investment banking system they are all connected, it is a huge web, and every one is plugged in to other. Thus its failure created a domino effect.

Other giant firms like American International Group (AIG) and Bear & Sterns, apart from involvement in toxic mortgages, had also committed “credit default swaps” meaning the firm insured payment on mortgage default to other banks who bought the bundle of mortgages from them.

When AIG, connected to practically every bank and insurance company in the world, became insolvent, the government had to bail it out by nationalizing it and injecting $85 billion. the demise of AIG could have been devastating to the world’s financial structure. Can you imagine nationalizing a bank or insurance company by the government that touts for a free market enterprise?

We have been borrowing, borrowing and borrowing again, above our head. We borrowed more than we could afford. We borrowed (mortgages) from US banks and they sold your mortgages to larger investment banks. We provided the financing by buying their shares.  They also sold their “mortgage bundles” to overseas banks with insurance (credit default swaps) that is guaranteeing the payment in case of default by the mortgage payee.  Can you see how a default by the mortgage payee could lead to a cascading effect?

Household debt in 1982 was 60% of our income, while in 2007 it zoomed to 130%. What do we expect? It is time for the payback and the day of reckoning.

Causes and Cures of our economic mess will continue next week. I will discuss the effect of “economic stimuli package”. What, in my opinion, we should do to guard ourselves. I hope you have been reading Investment page of Bob Wood. If you have been following his advice, I am sure you have benefitted from it.

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