The American Economy Problem
Posted by Robert Farrell on Tue, Jan 27, 2009 @ 04:07 PM
How did the American economy get turned upside down so quickly? To understand the answer to this question one must accept there are two main economic stimulants to the American economy; namely, consumer spending and government spending. One must also acknowledge America and the world are Debtor Societies. As such, we pay for goods and services not with cash at consumption (point of sale) but through formal or informal promises to pay our debts within specific terms and at specific or variable rates of interest. When the two above economic stimulants stop or slow they invite economic slowdowns. This economic slowdown can introduce economic events such as inflation, recession, deflation and stagflation! Surely, the American public has heard these four words communicated through the media over the past several months.
What are inflation, recession, deflation and stagflation? There are several accepted definitions for these four words. Let us deal with the most common definitions and the economic impact they have on our economy.
(1) Inflation is best defined as a decline in the real value of money that equates to a loss of purchasing power. Inflation is usually brought about by excessive growth in money supply, the printing of money. Therefore, the value of the American currency declines against the world currency. We spend more (cost) for what we want to purchase!
(2) Recession is a significant decline in economic activity spread across the Nation's economy, Gross Domestic Product (GDP), for at least two consecutive quarters.
(3) Deflation is a persistent decrease in the general price level of goods and services but only measured when annual inflation is below zero percent. Deflation should not be confused with a temporary fall in prices; instead, it is a sustained fall in general prices.
(4) Stagflation is best defined as a period of rising prices and unemployment but little growth in consumer demand or business activity. There are essentially two causes of Stagflation. First, stagflation can result when an economy is slowed by an unfavorable supply shock such as an increase in the price of oil which trends to raise prices at the same time it slows the economy by making production less profitable. Second, is from inappropriate macroeconomic policies; namely, when central banks cause inflation by permitting excessive growth in money supply and the government simultaneously causes stagflation by excessive regulation of goods market and labor markets (price controls). We recently observed the above Stagflation definitions via recent high prices in a barrel
of crude oil which resulted in higher gasoline prices. Stagflation is at hand through our government's bailout of select private businesses but at the potential dangerous demise of The Free Enterprise System!
There are several adverse economic by-products of the above two stimulant reductions but I will only address two. The first is the erosion of real estate values and equity. The real estate issue is best defined as the reduction of the main asset and economic safety net of all American consumers, the equity in their homes. This man made tragedy has not reach its climax of hardships and no stabilization of real estate values is in sight.
How did R/E equity erode? For thirty-five years, America depended on the safety and soundness of Fannie Mae that was established as a Federal Agency in 1938. In 1968, Fannie Mae was chartered by Congress as a private stockholder owned company. Fannie Mae is a government sponsored enterprise that provides liquidity and stability to the housing and mortgage markets. Fannie Mae operates in the secondary mortgage markets.
Rather than making mortgage loans direct to the consumer, they work with mortgage bankers, brokers and primary mortgage markets partners to insure funds are available to finance the acquisition of conforming residential mortgages and rental property at affordable costs.
To insure Fannie Mae is liquidity sound for providing mortgage funds to be lent, they fund their mortgage investments primarily by issuing debt securities in the domestic and international capital markets. Fannie Mae packages their instruments in $500MM increments for sale into the secondary markets. When mortgage lending standards of Fannie Mae was constant, from 1938 through 1968, there was never a problem with home values, required return on investment or a lagging American dollar. Prudent lending and investment standards were wrongly altered in 1972, under the Carter Administration. Mortgage lending standards were further decimated in the 1990s, under the Clinton Administration. President Clinton insisted that banks approve any mortgage loan to
any borrower. To do so, the value of homes ere artificially increased to meet the loanto value ratio while providing the economic and lending cover to offset down payment and closing cost requirements. This is the main reason home values were artificiallyincreased and the consumer's R/E equity has subsequently eroded!
The second issue is overzealous Congressional legislators and legislation! Legislators removed proven real estate lending procedures and replaced them with new socialistic and failed legislation processes. The motivation was to allow everyone to financed a home to live in regardless if they could afford it. This flawed process has resulted in and continues to breed bankruptcies and foreclosures throughout America. The Federal Government legislates how banks must operate from a financial and fiduciary standard of safety and soundness. To stay in compliance with Federal regulations, banks must meet these federal mandates. Sometimes in complying with these mandates, banks forgot the money they lend is not theirs but belonged to depositors, taxpayers and stockholders.
Congressional Legislatures voted to approve The Community Re-Investment Act (CRA), introduced by the Carter Administration. CRA legislation forced banks to approve mortgage loans to low and low/moderate income families under less qualifying mortgage loan standards than conventional mortgage financing requirements. Need I say more?
CRA gave birth to Freddie Mac underwriting standards so non-conforming loans can bepackaged and sold into the secondary mortgage markets much like the Fannie Mae conventional mortgage loans. The Clinton Administration forced more modified open ended poorly conceived credit processes upon the banking industry for the mandatory financing of residential mortgages to low and low/moderate income families. This new
legislation led this Country into a failed and stalled credit crisis which strangles the economic life from balance sheets and income statements of businesses, industries and individuals! These now leveraged banks and other industries are being "bailed out" by the same government legislators who allowed this economic nightmare to happen. One more point of fact, this "bail out concept", if allowed to continue, will destroy the Free
Enterprise System that has rescued this Country's economy from worse scenarios than we are now facing.
If these socialistic economic concepts are allowed to continue there will be no recognized difference between excellence and failure. There will be no difference between an excellent worker and a job taker, no difference between telling the truth and telling a lie, and no difference between those who always give that extra effort to succeed in everything of importance to them and those who do not give a darn about how their performance defined them! In short, we will remove the words INCENTIVE and MOTIVATION from the dictionary. America's economy will fall into a "Welfare Economy" for both individuals and businesses. That is why the final chapter has yet to be written about the American Economy and how it will affect you and me. Stay tuned, America.