The way out of this mess
The financial crisis in the US has spread out to the other sectors of the economy. The collateral damage of this crisis is, inevitably, the consumer spending contraction. The fallout of consumer spending (another shoe drop?) will have a wider impact on the economic slowdown than the financial crisis does.
The Federal Reserve has to lower the interest rates in the coming months. This may not necessarily be the right move given the economic conditions but is the only move that the Fed has to take. And worse yet, it will not put down the fire in the house right away. It takes time for the monetary easing and the liquidity that the Fed injected into the market to stimulate the economy. There are a lot of discussions that how much Fed easing on money supply is needed to fight the economic decline but very few people consider how much time is needed before the Fed policy starts to show a positive effect.
The root cause of the current economic trouble in the US comes from the housing market. House prices, aided by the easy mortgages and reckless lending by financial institutions, have been on a rapid ascendance in the past several years. When lending gets tight, housing markets get softer. With lower house prices and rising mortgage defaults, the securities backed by the mortgages become problematic. Financial institutions that make money off these loans by issuing and trading these securities suffered huge losses on these financial instruments. Billions of bonds suddenly became hot potatoes and nobody wanted them anymore. The market for these instruments simply evaporated. Banks and mortgage companies that held these securities, billions of them, had to write them off.
Before housing markets across the US stabilize and start to turn up, the mortgage market, which was the significant source of banks’ revenues, has to revitalize. However, it is very likely that the part of the mortgage market that consists of SIV (structural investment vehicle) or CDO (collateral debt obligations) will no longer come back. Without a healthy mortgage market, the housing market gets no support from home buyers. It is a difficult process to reengineer the housing market.
The Fed’s role in this process is just limited. Despite the Fed’s monetary easing and liquidity injections, the fundamental problems of the housing market and financial institutions will not go away overnight. That is probably how much the Fed can do. The Fed owns the print presses of the dollar bills but not the housing markets. Even though it can pump billions of dollars into the financial system, this liquidity will not flow into the housing market any time soon.
The only person who reminded us that we need time to fix the housing market and financial system and hence to rein the economic decline is treasury secretary Paulson. He is probably right on this – no quick fix, and time is essential to heal any wound.
