Wed Oct 1 08:16:38 PST 2008

The Credit Crisis and the Financial Merry-Go-Round - What Happens Next?

How did the current credit crunch happen and what will its result be? Here is a simple analysis which indicates that financial meltdown has been avoided and the lessons learned will prove valuable in the future. This article was originally published on Associated Content

For the first time in many years, people in the US are worrying about the economic future of the country. The underlying reason for this worry is a realization that the secret perpetual motion engine of the economy has run short of what you might call 'fuel', for want of a better word. Here are the key steps in this critical cycle in the economic life of the nation:

1. US consumers buy foreign goods

2. Part of the profit from these sales is invested in additional foreign goods to be sold to US consumers and the remainder is invested in US financial institutions

3. The financial institutions lend the dollars to US consumers

4. US consumers buy foreign goods (that is, we return to step 1)

This is a positive feedback loop. If it were an electronic circuit it would whine. If it were a nuclear reactor, there would be a chain reaction and the nuclear fuel would be rapidly used up. However, in the case of the US economy, although the cycle has been going for many years, the effects of the positive feedback have been slow to be appreciated.

The reason for this is that loan amounts were pegged by property prices and in the US, property prices were, traditionally, comparatively low. However, with low interest rates, the amounts that mortgage companies were prepared to lend increased, and when loans increased property prices increased in tandem. Purchases then increased, the level of debt increased, and the level of foreign ownership of US financial institutions increased.

Still, all was well with the positive feedback loop of steps 1-4 for a while. And, for a while, politicians were happy to bask in the warm, but slightly worrying, glow of the feedback loop. Goods and debt were transported into the US economy, while credit and jobs were transported to foreign countries. However, US standards of living and the 'feel good' factors were rising, so there was little incentive to moderate the feedback loop.

However, the recent increase in the price of oil left US consumers struggling to pay the interest on their loans. As consumers have started to experience increasing difficulties, with almost 1 in 10 mortgage payers having a hard time making payments, the feedback loop reached a limit; it had almost consumed all of its fuel.

However, when a feedback loop such as this is discovered it can be rapidly damped. The performer points the microphone away from the speakers and the howl immediately dies down. The control rods are dropped into the reactor, each free neutron leads to the production of less than one neutron and the nuclear reaction is rapidly quenched.

The same thing happens in financial markets. Steps 1-4 have been starkly apparent to savvy politicians such as Ross Perot and Ron Paul for many years. However, now steps 1-4 are apparent to even the most superficial political performers, some of whom are in current political office, and some of whom soon will be. Accordingly, creative, if not strictly capitalist, measures are being employed to damp steps 1-4 of the economic merry-go-round. Financial institutions are being rescued rather than being allowed to fail, to the relief of nervous foreign investors. The intention is to prevent an equivalent of the South American loan fiasco that hurt many international lenders in years past.

However, there are other potentially beneficial perspectives. For example, in domestic politics, there is now, in some political circles at least, an understanding that living within the country's means and investing in education would be a useful forward looking step.

In fact, just as in our own households, there may be a realization that debt should be reserved for property and education, not satellite dishes and wide screen televisions. Hopefully the immediate spending policies for the US would be investment in programs, not necessarily academic, which drive innovation and the investment of modern infrastructure. For example, a program to reduce the cost of high bandwidth communication to every home would pay great dividends in productivity. If the politicians could avoid the temptation to legislate the maximum number of hours of YouTube watching, everybody in the country could benefit from the collective knowledge and knowledge sharing of the web, not just the spoiled middle class kids of suburbia.

A swift investment in education could be made by allowing PhD students from around the world to settle in the US on finishing their studies. These potential new recruits who have been largely fed and educated by foreign countries can then contribute to the US economy during the working lives.

So, astonishing and comically flawed as steps 1-4 may be, it appears that the US will avoid an economic disaster, learn from its dalliance with circular economics, and move on a stronger and chastened nation.

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