US Economy To See A Painful Correction

Source : The Business Times, Jul 15, 2008

FOR a while it seemed as though there were some signs of light at the end of the long economic tunnel. In Washington and on Wall Street, one could sense that both officials and investors were contemplating the possibility that the worst of the financial meltdown was perhaps behind us, that we were going to see indications of economic rebound around the corner, and that from now on, the Fed would have to focus on dealing with the expectations of inflation.

In fact, former Senator Phil Gramm, who is serving now as the top economic advisor to presumptive Republican presidential candidate John McCain, explained to reporters last week that the American economy was basically doing quite well. He said that the US country was not in a true recession but in a 'mental recession', adding that Americans 'have sort of become a nation of whiners' when discussing the state of their economy.

'You just hear this constant whining, complaining about a loss of competitiveness, America in decline,' Mr Gramm said.

Mr Gramm, who is an economist, was probably correct in arguing that based on the common definition of a recession - two consecutive quarters in which the economy contracts - the American economy which grew last quarter was not in a recession, and it's not clear if it is soon to enter into one.

But this is a week in which the headlines in US newspapers were screaming about rising concerns over the financial stability of housing finance giants Fannie Mae and Freddie Mac and whether they might need a federal bailout. Shares of the two companies are sinking and perpetuating the bearish mood on Wall Street. And did we mention the rising oil prices?

So, sounding bullish about the American economy and suggesting that the American people needed to see a psychiatrist, places Mr Gramm, and by extension his boss, in the company of the French queen Marie Antoinette, who after being told that the French peasants had no bread to eat, said in jest: 'Let them eat cake.' In fact, the latest news about Fannie Mae and Freddie Mac are just the latest in a stream of depressing reports about the American economy.

Indeed, the reports that the federal government was preparing emergency steps to rescue Fannie Mae and Freddie Mac came on the same week that federal regulators were forced to seize California-based IndyMac Bancorp, a major home lender, after a run by depositors led to the second-largest failure ever of a US financial institution. The bank, which was taken over by the Federal Deposit Insurance Corp, became the first major bank to shut down since the savings and loan crisis of the 1980s. That the troubles facing Fannie Mae and Freddie Mac have been sending shockwaves among investors is not surprising. The two firms are the largest buyers of home loans in the US.

These companies are chartered by Congress to help make money for home mortgages more readily available. Together they hold or guarantee about US$5 trillion worth of mortgages which is equivalent to about half of all the mortgage debt in the US.

And in addition to being leading players in the housing market, their quasi-governmental status explains why their problems acquire a political significance for both the Republican administration and the Democratic-controlled Congress as well as for the two leading presidential candidates. Unlike the somewhat shady sub-prime mortgage lenders, Fannie Mae and Freddie Mac have had the reputation of being the gold standard of the US housing market. But they have been suffering from the current problems facing the entire mortgage industry, posting combined losses of about US$11 billion and their shares have been dropping for months and raising questions about their ability to raise more capital to sustain their operations.

While the law doesn't stipulate that the federal government should guarantee their loans, the fact that the two are guaranteeing trillions of dollars' worth of loans is the reason why their fate is perceived to be so critical in both Washington and on Wall Street. Hence, the two institutions are seen too financially big (by investors) as well as too politically-connected (to politicians) to fail. It just ain't going to happen. Period.

But at the same time, any move by the federal government to help the two firms could end up creating a moral hazard, in which investors who expect the government to bailout the institutions are provided with incentives to continue making decisions that would be considered irresponsible based on pure free market considerations.


State rescue plan

And indeed, even the current Republican administration which has continually stressed its commitment to free market principles concluded that it had no choice but to the come to the aid of Fannie Mae and Freddie Mac, announcing on Sunday that it would ask Congress to give it the authority to inject billions of dollars into the two struggling firms. The rescue package could come to more than US$300 billion.

Congress and the two presidential candidates are set to support the rescue package for the two companies based on the rationale that their collapse could result in huge losses throughout the global financial system and devastate the entire American economy. The US federal government move falls short of full takeover of the companies but it means that the American tax-payers will have to cover the huge losses on the mortgages that Fannie Mae and Freddie Mac guarantee or own. And no one is sure this move alone would solve the companies' long-term problems.

In short, the American economy is now entering a long and painful correction that will affect more than just the 'mental' faculties of American businesses and consumers who will probably continue 'whining' for quite a while.