< Files 9:10 Fri Mar 21 Chapter+11-Public+Goods+and+Common+Res... The Economic Catch-22 By Robert J. Samuelson We are now in the "blame phase" of the economic cycle. As the housing slump deepens and financial markets swing erratically, we've embarked on the usual search for culprits. Who got us into this mess? Our investigations will doubtlessly reveal, as they already have, much wishful thinking and miscalculation. They will also find incompetence, predatory behavior and probably some criminality. But let me suggest that, though inevitable and necessary, this exercise is also simplistic and deceptive. -- business It assumes that, absent mistakes and misdeeds, we might remain in a permanent paradise of powerful income and wealth growth. The reality, I think, is that the economy follows its own Catch-22: By taking prosperity for granted, people perversely subvert prosperity. The more we managers, investors, consumers - think that economic growth is guaranteed and that risk and uncertainty are receding, the more we act in ways that raise risk, magnify uncertainty and threaten economic growth. Prosperity destabilizes itself. This is not a new idea. Indeed, it explains why terms such as "the business cycle" and "boom and bust" survive. But it gets overlooked in periods of finger-pointing: now, for instance. The housing downturn and credit fears are undeniable. Someone or something must be held responsible. Here's a rundown of popular suspects: · The Federal Reserve. It allegedly held short-term interest rates too low for too long. From late 2001 to late 2004, the overnight Fed funds rate was 2 percent or less. Credit was supposedly "too easy." ⚫ The Chinese. They funneled their huge export surpluses (mostly in dollars) into U.S. Treasury bonds. That kept long-term interest rates low even after the Fed began raising short-term rates in 2004. China's foreign-exchange reserves now exceed $1.3 trillion. Mortgage bankers. They relaxed lending standards for weak borrowers, which led to numerous defaults. In 2006 about 90 percent of new "subprime" mortgages had adjustable interest rates. That exposed borrowers to future rate increases which many now can't afford. -- Wall Street. The mortgage bankers got giddy only because they could sell the loans to pension funds, hedge funds and others as mortgage- backed securities (bonds created by bundling loans). Credit rating agencies. Moody's and Standard & Poor's which rate the creditworthiness of bonds -- allegedly weren't tough enough on subprime mortgages. That fanned investor appetite. Lending standards were clearly too lax aliu Tauitg agencies too VPN 7% EDIT < Files 9:10 Fri Mar 21 Chapter+11-Public+Goods+and+Common+Res... ... Lending standards were clearly too lax and rating agencies too uncritical. Still, the rating agencies have downgraded fewer than 5 percent of subprime mortgage-backed securities issued in 2006 (by dollar volume). This suggests that many investors knowingly bought risky mortgage bonds, thereby inflating the housing bubble. Just why they did this is less clear. Did the Fed foster easy credit for too long? Maybe. But economist Mark Gertler of New York University argues that if this were so, inflation would have exploded. It didn't. From 2003 to 2005, it rose modestly, from 1.9 percent to 3.4 percent. What seems to have happened was a broad and mistaken reappraisal of risk. Bonds that were once considered highly risky were judged much less so. China's appetite for Treasury bonds may account for some of this. It may have lowered interest rates on Treasurys and sent investors scurrying into riskier bonds with higher rates (corporate "junk" bonds, mortgage bonds and bonds of "emerging market" countries such as Brazil). But that can't fully explain the extraordinary drop of interest-rate "spreads" -- the gap between rates on riskier bonds and safer Treasurys. In early 2003, junk bonds carried rates eight percentage points above Treasurys; early this year, the gap was less than three percentage points. Somehow, junk bonds were no longer so risky; therefore, it was okay to accept lower rates. Paradoxically, the fact that the U.S. economy grew in spite of so many daunting obstacles -- corporate scandals, 9/11, higher oil prices -- may have created a false sense of confidence that it could overcome almost anything. Sophisticated investors and ordinary consumers alike seem to have fallen under the spell of this logic. Believing risks had declined, the first group actually adopted ever-riskier investment strategies -- and unknowingly increased financial risk. The second, believing in continuing economic growth and rising home prices, assumed ever-heavier debt burdens - and created potential obstacles to future spending. In 2000, household debt was 103 percent of disposable income; in 2007 it's 136 percent. -- -- Mistakes and misdeeds do not occur in a vacuum. The ultimate culprit here may be irrational exuberance. As economic expansions lengthen, people become more complacent and careless. The very fact that the economy has done well creates conditions in which it may at least temporarily do less well. Prosperity inevitably interrupts itself with losses, popped bubbles and recessions. This produces recriminations and promises to do better, but there is always a next time. Q1. Explain what economic catch 22 is. -- VPN 7% EDIT