By Mike Whitney ICH 9/9/06

There’s growing concern among economists and market-savvy pundits that the global financial system is hanging by a few well-worn threads that could snap at any time. The $10.4 trillion real estate “bubble” has attracted the most attention, but the shaky derivatives market, hedge funds, and falling dollar are equally worrisome. 20 years of deregulation has created an economic monster which is increasingly unmanageable and threatens to bring down the whole system in a heap.

As Gabriel Kolko said in a recent counterpunch article (“Why a Global Economic Deluge Looms”), “The entire global financial structure is becoming uncontrollable in crucial ways its nominal leaders never expected. Instability is increasingly its hallmark….Contradictions now wrack the world’s financial system, and if we are to believe the institutions and personalities who have been in the forefront of the defense of capitalism, it may very well be on the verge of serious crisis.”

Deregulation has reduced market transparency and created a plethora of financial instruments which are relatively untested and extraordinarily volatile. By eliminating the “rules of the game” the market big shots have raked in hefty profits but reshaped the economic landscape in a way that no one can predict what the ultimate outcome will be. The new investment-regime includes such opaque standards as credit derivatives, credit derivative futures, and collateralized debt obligations. Hedge funds are now loaded with these over-leveraged debt-instruments that promise a generous return in an “up-tempo” market, but certain doom in an economic downturn. Now, that the indicators are all pointing toward a slowdown or recession, the potentially devastating effects of this new “liberalized” system will soon be felt throughout the global economy.

Kolko’s article is a “must-read” for anyone who wants to get a better idea of the fragility of the present system. Americans have dumped trillions of their hard-earned savings into risky hedge funds which have only been in existence for a short period of time. No one knows what the future holds for these “flash-in-the-pan” investments. As Kolko says, “The credit derivative market was almost nonexistent in 2001, grew fairly slowly until 2004 and went into the stratosphere, reaching $17.3 trillion by the end of 2005.”

That’s right; a whopping $17.3 trillion, enough to sink the entire economy if the market takes a nosedive.

This whole idea of re-selling debt is a relatively new phenomenon and fraught with peril. Hedge funds can bundle together a slew of Adjustable Rate Mortgages (ARMs) and make a handsome profit, but when the housing market starts listing, the investor is trapped on a sinking ship with little hope of recouping his losses.

Deregulation is characterized in the business-friendly media as a way of lifting the burdensome restrictions on the free flow of capital. This is nonsense. Deregulation is, in fact, the removal of the laws which traditionally protect the public from the hucksters and scam-artists who create lofty-sounding investments which are nothing more than Ponzi-schemes. (The purchase of “credit derivative futures” definitely falls within this category of dicey investments) Deregulation has gravely undermined the long-term prospects for western capitalism to succeed. By removing the safeguards to investment, the business and banking communities have created what many call “casino capitalism,” an anarchic structure with few protections that is hurling the markets toward a system-wide meltdown.

Similar problems plague the sagging real estate market. In recent years a buyer could pick up a house with no down payment, an “interest-only” loan, a low ARM, and be reasonably certain that the next year it would increase 20 to 30% in value. This allows the buyer to refinance his home, use his “presto-equity” as discretionary income, and begin the cycle all over again next year. With wages stagnating since the 1970s, the increase in home equity has been the preferred method for most Americans to “get ahead”. Housing prices have steadily increased since the 1980s and skyrocketed in the last 5 years. This has created a feeding-frenzy for low interest loans and attracted millions of speculators and (traditionally) unqualified applicants to the real estate gold rush.

It’s been a great deal for the banks, too. Mortgages make up the bulk of the banks loans in America, more than $400 billion last year alone. If it wasn’t for the steady steam of mortgages many banks would have seen negative growth in the last decade. Now that housing prices are flattening out and expected to fall (precipitously) the easy money has dried up and many over-leveraged homeowners are facing the dismal prospect of having to pay off an asset that is quickly losing its value. Economist Michael Hudson calls this phenomenon “negative equity”, that is, when the current value of the house falls beneath the amount that one has to pay on his mortgage. It is a predicament which now faces an estimated 30 million Americans who are drowning in red ink and skittering towards a life of indentured servitude.

The magnitude of the housing bubble is shocking and unprecedented. According to the Federal Reserves own figures, “The total amount of residential housing wealth in the US just about doubled between 1999 and 2006 up from $10.4 trillion to $20.4 trillion.”(Times Online) This tells us that the Fed had a clear idea of the size of the equity balloon their low interest policies were creating, but decided not to take corrective action. It also tells us that there will be no “soft landing”. When the market begins to fall, no one knows when it will hit bottom. $10 trillion is more than a “little froth”, as Greenspan opined; it is an earth-shaking, economy-busting catastrophe that will put millions at risk of foreclosure, bankruptcy and ruin.

Greenspan and the privately-owned fed played a major role in putting us in this mess by rubber-stamping the new system of precarious loans (no down payments, interest-only loans, ARMs) and perpetuating their “cheap money” policies. Greenspan admitted this a few months ago when he said that current housing increases were “unsustainable” and would have corrected long ago if not for the “the dramatic increase in the prevalence of interest-only loans…and more exotic forms of adjustable rate mortgages that enable marginally-qualified, highly leveraged borrowers to purchase homes at inflated prices.”

Greenspan’s circuitous comments are tantamount to an admission of guilt. The fallout from the fed’s policies are bound to be widespread and devastating. The country has been buoyed along on $10 trillion of borrowed money which has created the unfortunate sense of prosperity which is not reflected in the general economy. The increase in housing prices has not come from wages (which have actually decreased under Bush) or from demand (inventory is now at a 10 year high) It has merely been the availability of low interest loans and the promise of getting rich quick. As the market cools, millions of Americans will either face foreclosure or be shackled to a mortgage that is higher than the dwindling value of their home. It is a grim picture of 21st century debt-slavery.

Industry trade groups now believe that the falling housing market will trigger “a softening of capital spending which will cause a slowdown in US manufacturing next year”

“The housing market has turned; it’s going to be down this year and even more sharply next year,” said Dan Meckstroth, chief economist an Arlington, Virginia-based trade group. (Reuters) As the housing bubble deflates, economic growth will slump, and the anticipated recession will steadily deepen.

Alas, the deregulated “matchstick” markets and the housing bubble are just two of the three worms which now infect the American economy. The last of the fiscal demons is the falling dollar. Since, Bush took office the dollar has dropped a whopping 30% against the euro. At the same time Bush has added another $3 trillion to the national debt and increased the trade deficit to an astonishing $800 billion a year; 6.5% of GDP. The US now needs $2.5 billion per day just to cover its trade deficit. No one believes that this will go on forever, in fact, Greenspan sagely noted that it was “unsustainable”. The Bush administration seems to think that if they corner the global oil-trade by integrating Iran and Iraq (60% of world oil will come from the Middle East by 2020) into the US economic system, they can forestall the demise of the greenback as the world’s “reserve currency”. As long as oil continues to be denominated (mainly) in dollars, the dollar will remain the de-facto international currency and western elites will maintain their role as the stewards of the global system. However, as America’s debts continue to mushroom, the US produces fewer manufactured goods, and the oil-producing countries become more hostile to Bush’s belligerent foreign policy, there’s a real chance the dollar will be abandoned as the main unit of foreign exchange. If this happens, then the $3 trillion that is currently held in central banks overseas will flood the US triggering hyper-inflation and economic disaster.

Most people understand now that our involvement in Iraq had a lot to do with oil supplies, but that is only part of the story. The administration is trying to maintain US dollar-hegemony so they can preserve the system whereby fiat money is traded for precious resources. That system is under growing strain and bound together by the tattered webbing of military force. If the mission in Iraq fails, the dollar-system, which has dominated the world since the Second World War, will quickly unravel sending tremors through America’s economic heartland.

Doug Casey, president of Casey Research, comments on the fate of the dollar in uniquely apocalyptic terms in a recent article in “Review and Focus”. He says:

“Foreign owners of the big green mountain of US dollars have become uneasy and are generally looking to sell. There’s no dumping, at least not yet. When it comes, the flight from the dollar will come slowly, and then gain momentum before moving into a blow off. Like a glacier sliding toward a cliff, movement that seems inevitable may take a puzzlingly long time to get underway. But once it does, things speed up at a surprising rate….Given the choice between (A) a dead housing market and a scorched earth depression in the US or (B) a collapsing currency, which at least has the virtue of reducing the real cost of paying off all those Treasury bonds, I’m forced to believe the US government will choose to sacrifice the dollar.”

Casey does not mince words, but his sentiments are becoming more mainstream as the Bush administration continues to increase its “dollar-savaging” deficits and reckless economic policies.

Many of America’s fiscal troubles could have been mitigated by prudent management or judicious leadership, but that won’t change things now. The system is not in the control of the elected representatives and the deeply rooted problems are likely to persist until a calamitous event precipitates a fundamental change. The imbalances are now so humongous that everyone agrees that something has to give. The system is on its last legs as manifested by its increasing tendency to express itself in terms of repression at home and militarism abroad; the ominous signs of an injured beast in its death throes.

From the cratering hedge funds, to the faltering dollar, to the fizzling housing bubble, western-style capitalism is in the advanced stages of collapse. Deregulation and liberalization have only hastened its decline.

The mighty locomotive of global growth is slowly grinding to a standstill, bogged down by the accumulated weight of it own inconsistencies and inequities. Change is coming, for good or bad.