The economics of booms and busts

The ostrich is back and singing the denial tune again! Consider Bubbleland, a country experiencing the following macro-economic context:

1. The current account deficit is at 6.1% of GDP or $857 bn and is growing
2. Trade deficit for 2006-07 was $827 bn
3. The total external debt is over $ 4 trillion
4. Foreign Central Banks finance more than 60% of the current account deficit
5. Foreigners own $ 2.2 trillion of Bubbleland's Government Treasury Bonds
6. Gross Domestic Household savings, as a percentage of GDP is on negative territory. Consumers are on a consumption binge, financed by borrowing and the wealth effect of capital gains on equities and housing.
7. Interest rates at historic lows, as also bond yields
8. Private sector investment is at an all time low. Corporate spending as a share of GDP is at its lowest in 25 years.
9. With peak capacity utilization, corporate profits are at their highest. But the companies are utilizing the profit surplus to buy back their shares and for takeovers.
10. Bubbleland's currency is at its weakest in decades, declining against all the major currencies.

If the aforementioned macroeconomic characteristics and context were placed as a case study in an Eco 101 class, there could be only one prognosis. A hard landing, with the possibility of a fairly long recession. Now replace Bubbleland, with United States of America, and your Eco 101 fundamentals take a u-turn! Even distinguished financial managers and academicians like Hank Paulson and Ben Bernanke claim that things are under control, and there is no need to panic. There can be only two answers to this conundrum. Either Eco 101 is wrong, in which case let us consign Paul Samuelson to the dustbin, or Ben and Hank are imitating the ostrich, in which case, we have a serious real world economic problem staring at us!

America does not do anything in half measures. In the past two decades, the American economy has been through a roller-coaster ride of booms followed by busts. The late nineties saw an IT and corporate investment splurge and a stockmarket boom, generously assisted by 16 consecutive doses of the Greenspan medicine of interest rate cuts. When the dotcom bubble burst deflating the equity markets, the real estate market heated up. The resultant wealth effect spawned a massive consumption binge. The low interest rates fuelled a massive credit boom, which in turn led to frenzied mortgage lending, share buy-backs, Mergers and Acquisitions (M&As) and Leveraged Buyouts (LBOs).

Nouriel Roubini says, "There is a difference between crises of liquidity and crises of insolvency. Liquidity crises are those in which firms and individuals have a cashflow problem; interest rate cuts help them through the tough times. Insolvency crises are much more serious; slashing rates makes no difference when people are going bust. The LTCM collapse was a liquidity crisis, and what's happening now is an insolvency crisis."

The list of those who have gone insolvent or on the verge is impressive - household consumers, mortgage lenders, real estate agents, investment banks dealing in credit derivatives, hedge funds and private equity firms who traded structured credit derivatives backed by mortgage loans...!