From a Former Insider: Crisis Is Not Nearly Over

February 03, 2010 "Information Clearing House" -- Readers ask if the financial crisis is over, if the recovery is for real and, if not, what are Americans’ prospects. The short answer is that the financial crisis is not over, the recovery is not real, and the U.S. faces a far worse crisis than the financial one. Here is the situation as I understand it:

The global crisis is understood as a banking crisis brought on by the mindless deregulation of the U.S. financial arena. Investment banks leveraged assets to highly irresponsible levels, issued questionable financial instruments with fraudulent investment grade ratings, and issued the instruments through direct sales to customers rather than through markets.

The crisis was initiated when the U.S. allowed Lehman Brothers to fail, thus threatening money market funds everywhere.The crisis was used by the investment banks, which controlled U.S. economic policy, to secure massive subsidies to their profits from a taxpayer bailout and from the Federal Reserve. How much of the crisis was real and how much was hype is not known at this time.

As most of the derivative instruments had never been priced in the market, and as their exact composition between good and bad loans was unknown (the instruments are based on packages of securitized loans), the mark-to-market rule drove the values very low, thus threatening the solvency of many financial institutions. Also, the rule prohibiting continuous shorting had been removed, making it possible for hedge funds and speculators to destroy the market capitalization of targeted firms by driving down their share prices.

The obvious solution was to suspend the mark-to-market rule until some better idea of the values of the derivative instruments could be established and to prevent the abuse of shorting that was destroying market capitalization. Instead, the Goldman Sachs people in charge of the U.S. Treasury and, perhaps, the Federal Reserve as well, used the crisis to secure subsidies for the banks from U.S. taxpayers and from the Federal Reserve. It looks like a manipulated crisis as well as a real one due to greed unleashed by financial deregulation.

The crisis will not be over until financial regulation is restored, but Wall Street has been able to block re-regulation. Moreover, the response to the crisis has planted seeds for new crises. Government budget deficits have exploded. In the U.S. the fiscal year 2009 federal budget deficit was $1.4 trillion, three times higher than the 2008 deficit. President Obama’s budget deficits for 2010 and 2011, according to the latest report, will total $2.9 trillion, and this estimate is based on the assumption that the Great Recession is over. Where is the U.S. Treasury to borrow $4.3 trillion in three years? This sum greatly exceeds the combined trade surpluses of America’s trading partners, the recycling of which has financed past U.S. budget deficits, and perhaps exceeds total world savings.

It is unclear how the 2009 budget deficit was financed. A likely source was the bank reserves created for financial institutions by the Federal Reserve when it purchased their toxic financial instruments. These reserves were then used to purchase the new Treasury debt. In other words, the budget deficit was financed by deterioration in the balance sheet of the Federal Reserve. How long can such an exchange of assets continue before the Federal Reserve has to finance the government’s deficit by creating new money?

Similar deficits and financing problems have affected the EU, particularly its financially weaker members. To conclude: the initial crisis has planted seeds for two new crises: rising government debt and inflation.
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