Inflation will follow Freddie Mac and Fannie Mae bail out
US treasury secretary Henry Paulson was honest enough when he admitted that the true cost of the nationalization of the US mortgage agencies Freddie Mac and Fannie Mae is impossible to assess. These agencies guarantee more than $5,000bn in US home loans, and this is a considerable addition to the national debt, however you choose to account for it.
How much new money will the US treasury have to print to cover losses on this liability? How great will the losses be? It certainly looks like becoming the most expensive bail out in US economic history, and that will have implications for the money supply, and therefore both the value of the US dollar and inflation.
Yet we should all be relieved at one level: the US has chosen to go down the path of 1970s style inflation, rather than 1930s style deflation. The alternative route of letting banks fail produced the Great Depression of the 1930s and nobody wants to make that mistake again.
But choosing the least bad option is far from ideal, and will have major and unavoidable consequences for the world economy. The immediate response of capital markets will be a relief rally as a serious uncertainty has been addressed. The market rise also has some logic as inflation can mean higher share prices in nominal terms even if they are worth less in real terms or devalued US dollars.
However, investors and businesses should now prepare for two consequences of the bail out of Freddie Mac and Fannie Mae: higher general price inflation; and a resumption of the devaluation of the US dollar, especially against hard currencies like gold and silver.
You also have to ask, what comes next in the US economy? How many banks will now need rescuing? Is the US going to nationalize any financial institution that gets into trouble? And more than a hundred banks are now listed as potential bankruptcies by sector analysts, including several very big banks.
At the same time the US economy is showing no sign of recovery as last week’s worse than expected unemployment figures demonstrated. House prices are still falling, and as Mr. Paulson candidly admits there will not be a bottom until they do stop falling. In this situation US stock prices are still far too high and if there is not a major correction soon then this will be without historic precedent.
How will UAE stock markets respond? I suppose that a global panic will be mirrored by a rush to the exit in the UAE. But this may prove short-lived. The US will cut interest rates from two to one per cent in a stock market crash, and that will support the oil price – as the cut to two per cent did so spectacularly over the past year – and boost the local real estate sector.
Let us not forget that in the late 1970s the global economy went through a terrible time, and stock markets experienced a huge crash in 1974 and poor performance throughout that period. But the Middle East experienced what was its greatest ever Oil Boom, until the one we are living through today.
In inflationary times – and to my mind that is what the bail out of Freddie Mac and Fannie Mae just has to forecast – commodity prices will go up, and the best investment performing investment class will be gold and silver, just as it was in the late 1970s. However, oil stocks and the UAE bourse should also do extremely well in these circumstances, and local investors who take advantage of the Ramadan dip to buy into the market will be very happy with the result.
It does, of course, take some courage to buy while foreign investors are pulling out. There are no prizes for being the first to try to catch a falling knife, as a few have no doubt discovered over the past few days, particularly on Black Sunday.
But you can not have a situation where the UAE economy weakens significantly when oil revenues are so high, and the level of domestic infrastructure investment is so huge. So any fall back in local stocks will represent a very attractive buying opportunity for anybody who has the cash to hand or the borrowing facilities available.
Only if you think that the US is about to allow the world to go into a deflationary spiral and experience a second Great Depression should you be pessimistic about the UAE, and even then the relative economic performance of a country with the Emirates breadth and depth of wealth would clearly be much better than poorer countries. But inflationary times are coming and under these conditions the UAE will be at the very top in terms of economic performance.
[...] find useful: A wider U.S. financial bailout could fuel inflation – International Herald Tribune Inflation will follow Freddie Mac and Fannie Mae bail out « Peter J. Cooper’s Weblog Government Bailouts Mean More Inflation and Worthless [...]
Bailout - Good, Bad, Ugly? - InformedTrades
September 19, 2008 at 9:09 pm
Eric – I am not sure that the 70s was such a walk in the park! In the Middle East we definitely have seen very high wage inflation this year, for example. The UAE government staff got a 70% rise and even my freelance rates jumped for the first time in a decade. People in a position to bargain will get more money and that will fuel inflation. Incidentally buying of physical gold trebled in Abu Dhabi last month, so you can see where the money will go! Both gold, and especially silver are huge buys at these levels. The US financial system is cracking up – just like in the mid to late 70s. Inflation is the only policy option they have.
peterjcooper
September 10, 2008 at 8:51 am
Volatility is why you get high returns with precious metals – you have to hold and do not sell right now (and buy more if you can) – this is a tough ride, that is why it works out so profitable in the end. But do not use borrowed money or more than you can comfortably afford to see drop (and then bounce much higher). We saw this last year and prices went from $650 to $1000 in six months – but there is a downside to such an upside, and this is it right now.
peterjcooper
September 10, 2008 at 8:27 am
Aargh, I’m losing hope in this market and beginning to doubt myself having invested in Precious Metals. Nothing makes sense anymore.
Black is white.
Day is night.
etc.
What should make the dollar tank does the opposite!!!
What should make PMs skyrocket in price does the opposite!!!
I just don’t know anymore and am feeling very lost right now. Am also tired of reading about “experts” saying how we should all keep buying gold/silver when silver has HALVED in value in the last couple of weeks.
SIGH.
siw
September 10, 2008 at 12:25 am
go cop the album, young jeezy – recession. Its hard sh*t, it tells us about the current administration, the future administration, oil prices, inflationary pressures, and how to hustle in these hard times. Smoke a spliff whilst listening to it, Young Jeezy speaks the truth, all these fake as* economists dont know nuffin.
young jeezy
September 9, 2008 at 10:42 pm
I’m not so sure inflation can be “pushed through” though, as was the case in years past. In the U.S. and elsewhere, wages have been abysmally stagnant – unlike in the 70’s, you hardly see workers getting higher wages and better benefits – au contraire. Inflation adjusted, workers are getting less, and as such, can afford less. In addition, the spectre of rising unemployment has made most workers afraid to demand more. Couple that with the dramatic fall-off in home values, which has caused the loss of the proverbial HELOC piggy bank, and you have a situation where consumers are experiencing “empty wallet shock”: cutting non-essentials, generally buying less, and fundamentally looking for value- or cut-priced goods. (I found myself shopping at discounter K-Mart yesterday, muttering to myself at some of their high prices!)
In addition, I think the recent trend of driving less and cancelling vacations will continue. Oil (and prices at the gas pump), though it’s come down off lofty recent high prices of nearly 150 per barrel, is still considered bruisingly too high by already cash-strapped consumers, and echoing their other spending trends, I think you’re going to see people driving way less. Here in Seattle, public buses for the first time ever are so crowded that bus drivers are forced to drive away full, leaving some people waiting at the curb. Amtrak is full-up with riders like never before.
I’ve heard it said before that the best cure for high prices is more high prices: eventually demand drops off so dramatically, that prices have to collapse. I feel that oil prices may have to adjust dramatically downward to accomodate a very sluggish – nay, moribund – global economy.
I agree that the Fannie/Freddie bailouts will cause massive printing of dollars (i.e., inflationary), but I suspect it will be hard to push that inflation into oil. That’s already been tried this past summer, and it has backfired. I’d like to see gold and other precious metals shine in this environment, but it seems to me that they *should* already be much higher. Gold seems to be flopping around here. Manipulation going on? Who knows? In any case, stay tuned, stay safe, and be careful. We live in interesting times. Indeed.
Eric in Seattle
September 9, 2008 at 10:22 pm