The examples cited about real estate bubbles and speculative exuberance are the aftermath of an extensive period of business expansion. This is usually followed by a period of reduced economic activity, which can be quite severe, like the depression of the 1930’s or very mild like the recession in the early 1990’s or the 2001 slow down. In addition to the reduction in economic growth which diminishes tax receipts and puts strains on the government budget, there are also social consequences. Unemployment grows, compounding the economic difficulties and casting a negative psyche on the consumer. As business contracts, politicians, fearing they will be booted from office and forced to find new employment, resort to programs they feel will jump start the economy.

In the 1930’s FDR subscribed to the theories of John Maynard Keynes. Government spending would revive a faltering economy was their theory, and spending for whatever cause would revitalize the economy. After the financial melt down in 2008, the new administration commenced spending much like a drunken sailor on leave. In January of 2009, the new US Congress passed a $787B spending bill without even reading the bill.  Spending was the objective, and just as the debate over the success of FDR’s has continued unsettled for 75 years, it is likely a dispute over current stimulus plan will remain for a long time. There were programs like Cash For Clunkers, both in the United States and Europe to expand auto production and sales. To reduce the inventory of unsold homes in the United States, tax credits were offered to “first time” home buyers.  While these programs boost demand for cars and houses during the time frame of the plan there is little evidence to conclude that the aggregate demand is increased. Instead it may merely bunch demand into a time frame that corresponds with the time frame of the program.

This spending bill was passed without debate, in the wee hours to avoid scrutiny, and contained many perks for the friends of those politicians in power. As the US recession continues state tax revenues are suffering. It was reported that during the first nine months of 2009, state tax revenues dropped 13.3 percent or $80B. This has put state governments in a bind.

California, for example, has a $21B deficit that the Governor is hoping the federal government will fix. Combined state and local government budgets are estimated to be $193B for 2009. It appears that much of the US Federal government stimulus plan will be used to subsidize those state and local governments with friends in Washington.

How does all of this influence the value of a currency? Well, remember that the value of a currency is judged in relationship to something else, goods and services, products, or another countries currency. If the management and spending of one country is judged to be frivolous, inefficient, or exceptionally corrupt, the currency of that country will lose value compared to other currencies. Judgment of many of the factors that result in the strength of a country and its currency is subjective; therefore psychology and perception are important.

During 2009 most global economies were struggling to recover from the recession that had caused business activity to contract. Hoping to jump start a lethargic economy countries engaged in an expansionary monetary policy. Cheap interest rates, the expansion of credit, and the money supply and expanded government spending have been the popular antidote for the business ills during the current recession.

Recovery from a recession does not come at a uniform pace, and with a recovery comes different monetary policies. In 2009 the Australian economy was one of the quickest to recover. As a commodity producer and a major supplier of coal and iron ore to China, Australia was able to participate in an early recovery from the 2008/09 recession. The resilient economic recovery in Australia enabled their central bank to raise the core interest rates several times. As the rates increased, so did the value of the Australian dollar. From March 2009 until the high at the end of November, the AUD increased from 63 to about 93 in relationship to the USD.

With the AUD as related to the USD, we clearly have different rates of growth, and the resulting change in currency valuation is dramatic. Many currencies do not have unique economies such as Australia, however, and the changes in relationship to other countries and their currencies are much more subtle. For example changes between the British pound and the Euro, or the Swiss franc and the Euro are much more subdued. In some ways it seems like the further the geographical distance between two countries, the greater the currency fluctuations.

Interest rates differ by country for many different reasons. A country that is rapidly expanding such as Brazil may have very high interest rates caused in part by a demand for money to develop the private and public sectors of their economy. In Brazil the population is young, and the rate of savings is low. Contrast Brazil with Japan, where you have a mature country and economy, and an aging population that has accumulated a lifetime of savings.  Japan’s current capital needs to build highways, bridges and tunnels are now small, as they were constructed and paid for in years prior. As might be expected, interest rates in Japan are normally lower than those in Brazil.

Forex markets are more concerned with future changes in the interest rates than the present actual rate. Though we are dealing with the spot, or actually cash market for immediate settlement, the markets are looking forward, trying to sense the future direction of rates and when they may change. The current rate is old news. What moves markets is the perceived change in economic strength of a country and how this will affect its currency.

If the economy of a country is vibrant and growing rapidly, the central bankers may start to reign in the growth. Traditional methods are higher interest rates, larger bank reserves which may reduce the availability of credit, and threats of further action to slow the economy.

Unbridled growth can lead to speculative bubbles, and they can destabilize economies when they break. Some of the experts think that the hot real estate markets that occurred from 2000 to 2007, and culminated with a crash in the market is a good example of a bubble. Ample credit and government enforced relaxed credit standards got the building boom started. As prices increased, speculators bought at ever increasing prices, in hope of selling at even higher prices. Builders, responding to increased sales, constructed even more units and the boom continued until the bubble broke, leaving thousands of unsold homes and disillusioned speculators.

Today, three years after the bubble has broken, the financial mess left behind is still unsettled. A record number of banks have been declared insolvent and closed, personal bankruptcies have soared, and foreclosures continue at a record pace. Even home owners, who were prudent, putting the conventional 20% down, are now in trouble as real estate prices tumble.

Theoretically this was a situation that the Central Bankers should have tried to deter, with tighter credit and higher rates. Follow the money trail as they say and you will discover why a tighter credit policy was not pursued. Most real estate loans were processed and guaranteed by Fannie Mae and Freddie Mac, two quasi government agencies. As the real estate market grew so did the business of Fannie and Freddie, and the bonuses paid to former political figures became immense. Franklin Delano Raines, former Director of the Office of Management and Budget in the Clinton administration, was paid over 100 million during the 1999 to 2004 period. Jaime Gorelick, who also served in the Justice Department during the Clinton administration, despite no financial training, was appointed in 1997 as Vice Chairman of Fannie Mae and remained there until 2002. Gorelick was permitted to keep her salary of over $26 million despite improper accounting that resulted in $9 billion of losses during that period. Political contributions from Fannie and Freddie flooded into both Democratic and Republican parties.

In 2001 and again in 2005 the Bush administration proposed some regulations that might have curtailed the expansive credit provided to almost anybody, by Fannie and Freddy. Politicians on both sides of the aisle had been receiving generous donations, and they were bought off with the quasi public money. After Fannie and Freddy became insolvent, the government had to bail them out. By this time the US real estate markets had collapsed, sending financial reverberations around the globe. The market imposed a harsh dose of reality necessary in large partly because the politicians had failed to prudently act. Now several years later losses in the real estate market continue to drain Fannie and Freddy and the coffers of the US government.

Business Cycles and the Relationship to Interest Rates

Leave a Reply

Your email address will not be published. Required fields are marked *