I keep hearing – albeit mostly from Republican sources – about the impending inflation that will eat away all of our savings and drop the US credit rating.
True, this definitely is a potential problem. But not for a while. And here is why I think so, beginning with a quick recount of the financial crisis.
In my eyes, the financial crisis was created because of poor incentives to manage risk, coupled with very cheap money supply from Japan and the US. Low interest rates encouraged investors to look for alternatives to CD and Treasuries, and as a result they went into stocks. Banks and hedge funds, awash in cheap money, kept looking for ways to loan money, coming up with all kinds of creative schemes to get more people to borrow more, from home equity lines, to cheater loans, to balloon ARMs to whatever one can conceive.
The securitization of loan products, e.g. the bundling of mortgages into securities that were sold as investments to banks, investment funds, and individuals moved the risk away from the loan generators (banks, mortgage companies), who no longer held the loans, and into the lap of the owner of the securities.
Pressures on rating agencies by banks and investment houses resulted in AAA ratings of financial products of dubious value.
When the market turns, we all found out that the king had no clothes, or as Warren Buffett put it, when the tide went down we found out who was swimming naked.
So what happened? To sum it up, banks, holding companies, investment houses, individual investors and businesses who kept their excess cash invested in stocks and bond funds, found themselves with a $3 trillion hole in their balance sheets.
If you are a bank, and you suddenly find out that your balance sheet is off by $500,000,000, even it it does not lead you to bankruptcy, my guess is that you won’t have much taste for making more loans, unless you are assured against more defaults. And whatever your inclination as a bank, you don’t have that much money left to lend. Hence the credit crunch, and the vicious cycle that took place. I am not going to elaborate because this is really not news any more, and neither is it the focus of this post.
So what does the US Government do? It pumps truckloads of cash into the economy in all conceivable forms of credit lines, bail outs, tax rebates, etc. to plug that huge hole. Which to me says that they are essentially putting the banking and investment systems on life support, to make sure that that money that evaporated when investments because ‘toxic waste’ is partially replenished.
Since, with the exception of some speculative trading and leveraging, banks (traditional) business model is as profitable as it ever was, and even more so now that the government is keeping interest rates so low, banks are slowly refilling their coffers – the equivalent of a car’s gas tank – that would allow them to return to business as usual in a couple of years.
So the first fact is that all that government money is not sloshing around and causing a rise in inflation.
As bank go back into the black, they start paying off their bail out loans, and even generate some profits for the government. That means that the money supply in the market is drained as it rises, again working against future inflation.
Right now, individuals and businesses are in financial decline. You can’t raise prices when your customers are poorer and less employed. This again points that inflation is unlikely in the short term.
Finally, it is quite clear that when things improve, and probably after the next election cycle, interest rates would go up, and the government will get back the money by calling back its loans and most likely by increasing taxes in one way or another.
So far, I have no reason to doubt the competence of either the Federal Bank or the Administration, or their intentions. So for now I am not worried. But I am watchful.
I hope you stay vigilant too, but not panicked.