The international news networks treated this breaking news with the same drama and urgency as the assassination of Benazir Bhutto. The surprise decision of the US Federal Reserve to cut its key interest rate by three quarters of a point was treated with the proper awe and reverence before it was called an act of desperation in the light of a global stock market slump that arose out of fear of a US recession.
For much of Tuesday evening, one analyst after another tried to explain the meaning of the Fed rate cut. Two words used by most of the analysts stayed in my subconscious: panic and desperation. Some of the analysts expressed surprise that the Fed didn’t wait for the scheduled meeting next week and they were surprised too about the magnitude of the cut.
But they all somehow expressed worry that the Fed is about to lose its firepower. What happens now, many of them asked, if the market continued its slide and the economy continues on its recession mode… what else can the Fed do? I thought of Japan during its decade of deflation when even with interest rates at zero, the economy still didn’t respond. Indeed, what else can a Central Bank do?
I asked Ray Orosa, the first boss I ever had in banking (with the then PCIBank), what he made of the situation and could he make his explanation as basic as possible.
Markets, which set the value of stocks among other things, Ray explained, is ruled by two emotions, fear and greed… except that to disguise the fundamentally disagreeable connotation of these emotions, the industry has called them instead bulls and bears. It is a bull market when optimism-fueled greed has taken the upper hand and a bear market when fear has gained the reins.
In the situation we are in now, Ray continued, “fear took control because of the seeming inevitability of a recession in the American economy. In other words, the blind optimism generated by politicians about the great American economy was finally exposed with the sub-prime meltdown.”
A recession or the so called dreaded “R” word, on the other hand, is that part of an economic cycle that generally serves as some sort of purgative or curative, for excesses that have been built into the economy but were unrecognized or dealt with inadequately. But, Ray pointed out, recessions are a political no-no because of the financial pain recessions inflict on a lot of people. This explains why there is much pressure on Central Banks or the Federal Reserve to do anything to prevent it from happening.
Thus, there is a tendency to take short term measures that would, for example, stop the free fall in stock market prices supposedly by trying to win back investor confidence. In the US this was accomplished by a low interest policy from the time Greenspan took over the Fed some ten years ago.
Cutting interest rates is intended to give quick relief… build confidence as well as lower cost of money for business and consumers. It also encouraged all kinds of lending and economic activity. In the case of the US this resulted in what has commonly become known as the housing bubble, meaning housing values going well beyond the ability of wage earners to afford them except through the relaxation of credit standards on the mistaken belief that prices of homes will forever rise. For quite a few years, much money was made which fueled this bubble to proportions that had only one way to go and the inevitable happened.
The second development that gave rise to our present circumstances has to do with money supply. Defined traditionally, it has grown over the last ten years in the area of 20-25 percent annually, Ray pointed out. This was greatly in excess in the growth rate of the world economy of about four percent annually. The creation of this huge pool of liquidity had to find its own outlet and soon developed a life of its own.
Ray explains that “when liquidity rises so much faster than production, it is a formula for trouble anywhere. But it is as though all the central bankers tended to take the easy way out through an easy money policy that was literally printing money for its own sake. Well, the growth of this pool of liquidity resulted in the creation of fancy financial services, initially a hedging operation against risk, until the complexities became such that even George Soros said he did not understand some of them.”
The development of the financial derivative market has become a game unto itself, Ray points out, and it is estimated that it totals annually about $500 trillion when the aggregate of the world’s production is only about $50 trillion. “It should be remembered that no money is required to buy and sell derivatives. No economic activity underlies such activities. It is one big massive crap shoot that has gone beyond the limits of sensibility and common sense. It is interesting though even Greenspan in Congressional testimony had said that even he no longer understood the meaning of money.”
So the confluence of all these events led the world to a “sudden” realization, Ray explains, that the rules in the financial markets have changed. The decline in the value of some assets caused some panic because no one could tell how or when the market drop will end. One thing which has been exposed is the myth that Central Banks can control economies considering their rather limited options.
Our situation, Ray explains, “is like someone threw a monkey wrench into the gears of the circulation and flow of money which had become so plentiful and knew no boundaries or barriers. What we have now is also a financial liquidity crisis because the fundamentals of the world economy are not in sync with the financial transactions undertaken by all the financial institutions and the situation needs correction.”
Ray’s views were shared by some analysts interviewed by the networks. They said the US Fed is obviously acting under extreme political pressure as it is faced with a looming depression and a burst housing bubble that will not go away quickly in an election year. The analysts wondered if this crisis of confidence from a burst bubble can be cured by the financial equivalent of aspirin.
Like influenza, this financial malady must run its course, assuming what we are facing is influenza as we know it and not bird flu. Problem is, the analysts are saying, the Fed is using its usual remedies for what looks like an entirely new and more malevolent disease. “As it is,” Ray observes, “the answer of the Fed has been to pump so much liquidity into an already overly liquid market and it has not worked.” With food and energy prices going up, expect inflation or stagflation to further complicate things.
What’s an ordinary fellow to do? Just hold on tight, I guess, and don’t do anything in panic. As one analyst on one of the international networks remarked, it is always horrible in the middle of a storm and that’s where we are now. These things go in cycles and we should eventually emerge from all our current troubles. The big question is, when?
Or try to profit from a bear market by doing some bottom fishing, a topic for another future column.
Watching the business news channel isn’t a good idea if you seriously want a good night’s sleep these days. It didn’t help me that my astrologer friend texted me Wednesday morning: “what did I tell you about 2008? Ain’t seen nothing yet!!”
Stock investor’s glossary
SHORT POSITION: A type of trade where, in theory, a person sells stocks he doesn’t actually own. A short position is what a person usually ends up being in ( i.e. “The rent, sir? Hahaha, well, I’m a little short this month.”).
COMMISSION: The only reliable way to make money on the stock market, which is why your broker charges you one.
MARKET CORRECTION - The day after you buy stocks.
INSTITUTIONAL INVESTOR - Past year investor who’s now locked up in a nut house.
LIQUIDITY - a problem faced by investors who fail to make it to the bathroom in time after making a bad trade.
Boo Chanco ‘s e-mail address is bchanco@gmail.com