12345, When you have a massive credit expansion, then the accumulated debt will either be liquidated by deflation ( the preferable option) or hyperinflation ( the worse option) or hyperinflation followed by deflation (the nuclear option).
The Fed's panic action last week is an indication it would like to liquidate it by inflation, but it is only a half hearted move at the moment. The discount rate is the rate at which the Fed lends to banks, not the Fed funds rate which is more akin to the BOE base rate ie the rate at which banks lend to each other. However I expect this to follow next week.
The problem is America doesn't control its own interest rates as the US is the world's largest debtor nation. If China and Japan and a few other oil producing nations (eg Saudi Arabia) don't like what America does they can just sell their vast stocks of US Treasury bonds and force up US interest rates. Speculators can also do the same thing using derivatives but unlike the aforementioned crediter nations they will then be short and have to buy them back
Likewise mortgage rates are not decided by the Fed or even the mortgage company's/ banks they are decided by the buyers of the Mortgage Backed securities, or collateralised debt obligations. If those buyers have massively rerated the default probabilty, as they will almost certainly have done in the last few weeks, then they won't be asking 8% for subprime loans, they'll be asking 18% or 28%. There will also be a rerating of the prime loans as well as we enter a real estate bear market. Thus there is a limit to what the Fed can do.
"Helicopter Ben Bernanke" made his reputation by studying the depression and has said in the past he would chuck money out of helicopters in order to stop another one. He is unfortunately in for a a rude awakening as China and Japan are not going to allow that.
After my PhD I postdoc ed in Germany for a year and the stories that made such an impact on me were those about the East front (particularly Stalingrad) and those about The Weimar republic. You may be unfamiliar with what happened under the Weimar republic, but if Ben starts raining money down from helicopters, there won't be enough helicopters in America to keep up. The US will have an inflation rate exceeding Zimbabwe's.
The best that can be hoped is that this is staved off for another cycle. ie if the Fed eases and the money ends up being borrowed to bid up the price of some other speculative commodity (shares, land, tulip bulbs etc etc). If it ends up bidding up the price of food, fuel, clothes etc then the Fed will have to raise rates as soon as they drop them.
I personally believe we have reached then end of the road. People are so endebted they just can not borrow anymore, but precisely how quickly this unravels and what precisely happens is anyone's guess. My advice to you or anyone else reading this is to work hard, pass your exams, be nice to people as you may need them over the next few years, save your money (in T-bills not in banks) and for god sake rent a flat don't buy a house.
Be in no doubt Britain is in a lot worse position than the US
Last edited by a moderator: Aug 19, 2007