From the August 2004 Idaho Observer:

U.S. economic collapse looming for 2005

by William Engdahl

The U.S. Senate just reconfirmed 78-year-old Alan Greenspan to an unprecedented fifth term as chairman of the world's most powerful central bank, the Federal Reserve, or the Fed as it is known. The fact that President Bush renominated Greenspan underscores how vulnerable the global financial edifice is, and not how excellent a central banker Greenspan is.

Perceived global economic growth tied to U.S. dollar

On the surface, world growth appears to be expanding finally, after severe recession and the 60% fall of the U.S. stock market in 2000-2001. The Federal Reserve says it is so confident that growth in the U.S. economy is taking firm hold, that it raised its key interest rate from a record low 1% to 1.25% last month, signalling it would slowly bring rates up to “neutral” levels of 3.5-4.5% over coming months.

Around the world, strong growth of exports are being reported from Brazil to Mexico to South Korea. Growth in China is so strong the government is worried it is overheating. In Europe, the UK is expanding at the fastest pace in 15 years. France expects GDP to grow by 2.5%, and even Germany is talking about stronger export growth.

The problem with this optimistic picture is the fact it is entirely based on the dollar and unprecedented creation of cheap dollar credit by Greenspan and the Bush Administration. Their only short-term goal has been to keep the U.S. economy strong enough to assure re-election for George Bush in November. Washington reports are that Bush made a deal to re-appoint Greenspan on the promise Greenspan would keep the economy growing until the elections. They have done this by a combination of historic low interest rates, rates only seen before in times of war or depression, and by stimulating the economy by record budget deficit spending and issuing government bonds to finance it. The world has been flooded with cheap dollars as a result.

What is clear now is that this unsustainable effort is likely to come to an end sometime in 2005, just after the elections, regardless of who is President. Given the scale of the money-printing by the Fed and the U.S. Treasury since 2001, it is pre-programmed that the “correction” of the latest Greenspan credit excess will impact the entire global financial and economic system. Some economists fear a new Great Depression like the 1930s. The world today depends on cheap U.S. dollar credit. When U.S. interest rates are finally forced higher, dramatic shocks will hit Europe, Asia and the entire global economy, unlike any seen since the 1930s. Debts that now appear manageable will suddenly become unpayable. Defaults and bankruptcies will spread as they did in the wake of the 1931 Creditanstalt collapse in Germany.

The U.S. home bubble

The official U.S. myth is that the recession of 2000-2001 ended in November 2001 and “recovery” has been underway ever since. The reality is not so positive. Using record low interest rates, the Fed has lured American families into debt at record rates, creating what might be called a “virtual recovery,” financed by record amounts of new consumer debt. There has never been a recovery in which debt levels increase!

The American dream of owning your own home has been the source of the record lending, helped by the lowest interest rates in 43 years. Greenspan has often boasted this has been what has propped up the U.S. economy since 2001.

When families buy a home, they buy furniture, employ construction workers, electricians, engineers, and the economy grows. Record low interest rates have made it very easy for families to get a bank loan, using their home equity as collateral or guarantee. These loans, tied to the rising real estate prices, allowed American families to finance new furniture, cars, and countless other items.

In 2003 banks made a record $324 billion in such home equity loans, on top of $1 trillion in new mortgage loans.

All this economic consumption has created the illusion of a recovering economy. Behind the surface, a huge debt burden has built up. Since 1997, the total of home mortgage debt for Americans has risen 94% to a colossal $7.4 trillion, a debt of some $120,000 for a family of four. Bank loans for real estate purchases have risen since 1997 by 200%, to $2.4 trillion. Average U.S. home prices have risen by 50% in the period since 1998. In 2003 alone a record total of $1 trillion in new mortgage loans were made. In 1997 mortgages totalled $202 billion.

In many parts of the U.S., home price inflation has become alarming. An apartment in better parts of Manhattan is now above $1 million. Home prices in Boston have risen by 64% in five years. California real estate prices are soaring. On average U.S. home prices have risen 50% in six years, an unprecedented rise, driven by Greenspan's easy credit. In seven years to 2004, prices of U.S. homes had risen on paper by $7 trillion to a total of $15 trillion, the highest in U.S. history. The problem is so obviously dangerous that Greenspan recently was forced to deny existence of any real estate “bubble,” much as he denied a dot.com stock bubble in 2000.

Debts keep bubbling along

But that is exactly what he has created with his low interest rates. The dot.com bubble has been transformed into a larger and more threatening real estate bubble. Families have been convinced to invest in a home as an alternative to buying stocks for their pension years.

The rise in home prices has been driven by cheap interest rates and banks rushing to lend with abandon. Two semi-government agencies, the Federal National Mortgage Association (known as FannieMae) and the Government National Mortgage Association (or GinnieMae) buy up the banks' mortgage contracts, taking the risk from the local banks. As a result, the local lending bank is more flexible in arranging loans to higher-risk customers.

The U.S. Congress has passed new laws making it even easier for banks to help families to buy homes without requiring them to use any of their own money as a “down payment.”

This has meant a huge rise in mortgage loans to economically marginal or risky families. The number of such risky or “sub-prime” mortgage loans has risen by 70% this year alone, and now makes up 18% of all U.S. mortgages. Many of these risky mortgages are made under “adjustable rate mortgages.” Today adjustable rates are low, just above 4%. Because of this some 35% of all new mortgages are adjustable today.

So long as rates stay low, the roulette wheel of debt rolls on. The problem begins when interest rates rise and families, lured into buying a home with variable interest rate payments, suddenly find their monthly cost of paying the mortgage has exploded as interest rates rise. At that point, U.S. banks will face a serious bad loan problem, far worse than that of 1990-92 when several of the largest U.S. banks were on the brink of failure.

U.S. interest rates began to rise significantly in May, and the Fed was forced to raise its official rate on June 30 for the first time in four years. Many banks have loans written in adjustable mortgage rates. A wave of mortgage defaults will likely be triggered as U.S. interest rates continue to rise over the next 12 months or so. Some industry experts fear a “bloodbath” in 2005.

Institutionalized American indebtedness

The American family is highly indebted, not just for their home. The Federal Reserve data show a total U.S. debt level now above $35 trillion, or some $ 450,000 for a typical family of four. Average consumer debt for credit cards, autos and such is at record highs. Car makers continue to offer car loans, with loans for up to six or even seven years. Many Americans owe more on their car than it is worth.

As long as Fed rates are at 43 year lows, the debt is manageable. When U.S. rates rise, it becomes unmanageable for many -- and the rise has begun. There are two ways rates are likely to rise from here.

First, the Fed itself has been forced to act, raising its Fed funds rate, for the first time in four years, to 1.25% from 1% on June 30. It had no choice. Greenspan has claimed for months that the U.S. recovery was “strong” and that rates would return to “normal” soon. It was a calculated bluff. Had he not acted as U.S. jobs data convinced investors recovery might be real, he faced a major crisis of confidence in the dollar.

The Bush administration reportedly manipulated employment statistics to show better job growth for the election.

A trapped Fed

Ever since raising rates, Greenspan has calmed nervous markets by stating that future rises will be ever so gradual. In other words: don't worry, speculators. But if he is to keep the confidence of the large bond markets, he must convince them that he is still vigilant against inflation. That is tough when prices for everything from copper to oil to lumber to soybeans and scrap steel are rising from 50% to 110% over recent months. His only anti-inflation tool is higher interest rates, or promise of same. The longer he fails to raise rates as prices rise, the greater the risk of a dollar crisis, as foreign investors fear the worst, namely that the U.S. economy is in far worse shape than officials admit. The Fed is in a trap.

Higher interest rates threaten to explode the $3 trillion dollar home mortgage debt bubble, where home values are estimated to be at least 20% overvalued nationally.

U.S. debt for sale

When private bond investors such as major pension funds and banks lose confidence in Greenspan's inflation commitment, the only other source of support for low interest rates would be the willingness of Japan and China above all, to pour billions more of their dollars into buying U.S. bonds.

The largest buyers of U.S. government debt have been the central banks of the Asia-Pacific. The central banks of Japan and China alone hold more than $1 trillion of U.S. Treasury bonds as foreign currency reserves.

Worldwide foreign central banks hold some $1.3 trillion of U.S. government debt. If private debt is added, the United States is the world's largest debtor nation, with some $3.7 trillion in net foreign debt as of the start of this year. It is likely to have increased to well over $4 trillion by now.

In 1980 when Ronald Reagan was elected, the U.S. was the world's creditor with a plus of $1 trillion.

Nations depending on the large U.S. export market, recycle their trade surplus dollars back into buying U.S. Treasury debt to keep their currency fixed to the dollar. Because Japan and China and others continue to buy record sums of U.S. debt, paying with their hard-earned trade dollars, U.S. interest rates can remain far lower than what would be realized without foreign “investment” through purchase of U.S. bonds. Were foreign buying of U.S. bonds to reverse or even slow, the U.S. Treasury would have to offer higher interest rates to lure investors to buy the debt. That would make interest rates on homes more expensive very fast. Millions of homeowners would face default. Prices would collapse in many regions, leading to higher unemployment.

This will not be like the dot.com crash, which was a deliberate crash caused by the Fed raising rates to deflate that bubble. In 2000 interest rates were 6.5% and the Fed had room to lower to 1% and create the housing bubble alternative for money to keep the economy afloat on a sea of debt. This time, rates are at historic lows, debt at historic highs and U.S. economic dependency on continued foreign capital is unprecedented.

Speculation has become global as never before. The cheap credit in the dollar world has led to cheaper credit worldwide. The economies of Brazil, Mexico and even Argentina benefit from banks and speculators like George Soros who borrow at the super low U.S. or Japanese interest rates to invest in bonds in high interest rate lands like Brazil or Turkey or Argentina.

These so-called emerging markets have been booming in the past year on Greenspan's promise to keep U.S. rates so low. That now is beginning to look very risky. As well, Bush Administration talk of possible terror attacks around election-time is making many major investors fear risking investments in U.S. stocks or bonds. They are instead beginning to cash in their recent profits from the Greenspan stock boom of 2003-04, and holding it in safe cash.

Myth of recovery

That is a major reason the U.S. stock and other markets have been falling steadily in recent weeks. The U.S. debt bubble depends on maintaining the myth of a U.S. recovery to lure foreign capital to invest, helping keep the dollar from collapsing. Should foreign pension funds of the central banks of China and Japan be convinced the U.S. recovery is in danger, there could be a major shift of funds out of dollars.

Yet China and Japan, fearing the dollar crisis, have recently begun heavy buying of commodities, from oil to iron ore to copper to gold. They are using their trade dollars to buy real commodities, instead of U.S. Treasury debt, which is mere paper. Chinese panic buying of oil for stockpiling reserves is a major factor pushing oil prices again to record levels of $42 a barrel despite two major OPEC quota rises. Steel prices have also exploded due to China demand.

When Bush became president he inherited a federal budget in surplus, largely owing to the taxes from a booming dot.com stock bubble economy. Since then he has created the largest deficits in U.S. history, near $500 billion in 2004 and estimated to reach $600 billion in 2005.

In 1971, when Nixon took the dollar off the gold standard and opened the way for printing unlimited volumes of dollars, the Federal budget deficit was an “alarming” $23 billion.

These huge deficits are financed by the U.S. Treasury selling government bonds or similar paper to investors. Since 2001, the central banks of Asia, led by Japan and China, have bought huge sums, some 43% of all U.S. government debt. They in effect recycled their trade dollars gained from exporting cars, electronics, textiles and other goods to the U.S. consumer.

In the 12-month period from April, 2003 to April, 2004, the Bank of Japan spent a record $200 billion to buy U.S. dollar bonds or, in effect, to finance the cost of Bush's Iraq war. The Banks of China, South Korea and Taiwan have spent nearly as much on dollar bonds as the Japanese.

They did this for clear reasons: Their currencies are linked to the dollar, and were the dollar to fall against the Yen or the Yuan, Asian exports would suffer a decline, endangering their economic growth and leading to explosive rises in unemployment across Asia. By recycling their trade dollar surplus into buying U.S. Treasury debt, they argue they are looking after their own needs. Should a dollar crisis in early 2005 occur, a global financial crisis would likely follow.