Thursday, August 30, 2007

Business? Why Business?

Disclaimer: I am only an armchair economist, this is purely my own opinion.

As the title suggests, this post won't necessarily touch recent issues, like the departure of Bush administration zealots like Alberto Gonzalez and Karl Rove. Instead, the purpose of this post is something far more important: The American Economy. The economy is so important because it literally determines the future of every American, and to some degree, every person in the world.

Recently, we watched the fall out over the sub-prime mortgage market plague the U.S. economy and the larger economies in Europe and Asia. Essentially, sub-prime exponentially expanded the availability of credit to those who couldn't otherwise afford the loans provided to them. This was largely driven by the inflation in real estate prices, and the low interest rates of 2004 and 2005. Arguably, real estate is one of the few American commodities that tracks real value juxtaposed currency value. The other commodity is Gold. If you look at both of these commodities next to one another, I imagine you will see a similar appreciation over the last five years. Arguably, this increase in value is due largely to inflation. As our debt load has increased, the value of the dollar as decreased. This isn't due entirely to the value of sub-prime, but also to the federal deficit. When we create debt, we create more money, even if that liquidity is a fiction created by increased debt.

Sub-prime started to show its weakness when the two year limit on many of these inexpensive loans came due. The net result was a substantial increase in foreclosures. To understand the next step, it is important to understand how investments in commercial paper, essentially the trade of debt. Banks buy and sell loans based on the interest rates, and the amount they can collect over the principal. When the debt is bought and sold, but goes into default, those investments are essentially worthless, absent the value of the collateral. The result is a mad rush to collect on worthless debt, and the acceleration of payments up the chain of debt, from one bank to another, until you reach the bank holding the note on the collateral. Unfortunately, the substantial increase in foreclosure has devalued collateral because of an increased supply.

The catalyst for this chain reaction came from an increase in interest rates. Those sub-prime loans became more expensive, and the borrowers were no longer able to pay. The purpose of that increase in interest rates is attributable to one thing...Inflation.

The purpose of this explanation of why the Federal Reserve should not lower the short term interest rate at its meeting in about a week and a half. Generally, a decrease in the rate will push the economy back to the previous cycle and not fix the core problem of inflation. If anything, rates should remain the same, and this market correction should be allowed to proceed. While there will be a substantial decline in large purchases, like automobiles and property purchases with more risk, this correction will hopefully balance the credit market and heal some of the damage caused by unchecked inflation in the last couple of years. While this won't necessarily result in a more valuable dollar, it should provide some stability for the volatile market.

Solving inflation, though, is an entirely different issue that is dependent on the ability of the government to balance their budget and create a sustainable financial system. For more on interesting economic issues outside of recent financial news, check out this scary video.

More on Rove and Gonzalez in the future, I promise.

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