Roller-coaster ride

Malaysian Business, Oct 16, 2008 by Rajen Devadason

ON Monday, Sept 29, the US House of Representatives, one of two parts of the US Congress, voted 228 to 205 against a bailout package for the US financial sector.

Since then, a plan has been put in place. There isn't much choice in the matter.

If something isn't done to clear the clogged arteries of America's reeling credit market, a major part of that globally crucial economy will grind to a halt. Given the grim alternative, I'm certain a compromise will be structured by the powers-that-be - including US Treasury Secretary Henry Paulson, better known as Hank Paulson, and Federal Reserve Chairman Ben Bernanke - which will be acceptable to the American voters and their elected representatives. Also, as I write, speculation is rife that Bernanke will cut interest rates again.

On that bleak Sept 29, the Dow fell 777 points. It was the largest ever point-fall (as opposed to the largest percentage drop) in history. (Even after the infamous 9-11 attacks in 2001, the Dow fell 684 points only.) Thankfully, a day later, on Sept 30, when it looked clear that fresh attempts to revive Paulson's bailout package would ensue, the Dow jumped 485 points, clawing back more than 60% of its previous day's collapse.

Admittedly, Malaysia is an insulated economy. Still, even our local Bursa Malaysia can experience some kneejerk whipsawing. So, in the midst of this scary investment environment, what should regular Malaysians do?

I believe the wisest thing to focus on today is our personal economic identity.

The world can be divided in two in many ways: Men and women; rich and poor, smart and stupid; the list is endless. But most importantly, from an economic perspective, the best way to demarcate humanity is investor and consumer. In the age of fiat money, which is currency backed only by confidence in the issuing government, one of two major differentiators between the rich and the poor, the investors and the consumers, is information. The other differentiator is attitude. Let me deal with the second first:

ATTITUDE

Those who are willing to sacrifice short-term pleasure for long- term gain have the right attitude and are rewarded accordingly. They end up rich.

The masses that tend to remain ignorant of the way our global financial system, in general, and the US financial system, in particular, function, and who consistently spend money they haven't yet earned - meaning they draw cash from the future through time warping `magical' instruments like credit cards and home equity lines - often end up poor.

INFORMATION

The current financial crisis grew out of the dangerous excesses inadvertently caused by the US Federal Reserve Board under Bernanke's predecessor, the still well-respected Alan Greenspan.

Let's spend some time looking at the important Fed Funds Rate. It's defined as the rate at which a depository institution, say a bank, lends money overnight to another such institution. The funds in question being lent and simultaneously borrowed are electronic ledger entries within the Federal Reserve System.

The Federal Reserve Board's FOMC or Federal Open Market Committee usually convenes eight times a year, about once in six weeks. There, 12 smart people determine the direction of US monetary policy, specifically its credit and interest rate initiatives. The most important number that emanates from these meetings is the oft- quoted Fed Funds Rate.

Interestingly, though, the Fed has no ability to directly cast in stone its desired Fed Funds Rate. Instead, what the FOMC does is set the Fed Funds Target Rate. Then, the Fed goes to work through open market activities of buying or selling huge quantities of US government debt- denominated paper to ratchet up or down the market- determined Fed Funds Rate. The paper bought or sold during open market activities are US Treasury and federal agency securities. So, for instance, to lower interest rates, the Fed needs to expand the supply of money in the system. (Remember interest rates are merely the cost of money, so basic supply and demand relationships apply!) To get more money into the system, the Fed buys US debt-denominated paper by issuing fresh currency, which it creates out of thin air through the power vested to it by the US Congress in 1913 at the Fed's formation. Conversely, to raise interest rates, the Fed sells some of its debt paper and receives cash, thus extracting it from the total money supply of the US.

Note: Between May 2000 and June 2003, Greenspan's Fed lowered the Fed Funds Target Rate 13 times, bringing it from 6.50% on May 16, 2000 to 1.00% on June 25, 2003. The target rate stayed at that low point for a year, before being raised to 1.25% in June 2004. Further hikes saw the end of June 2006 target rate reach 5.25%. (Bernanke took over from Greenspan as Fed Chairman on Feb 1, 2006, when the Fed Funds Target Rate was 4.50%.)

Because interest rates represent the cost of money, when rates are low, this encourages borrowers of dubious financial strength to take advantage of the easy credit extended by bankers focused on that quarter's financial results! So, when interest rates in the US fell, as they did from mid-2000 to mid-2003, hordes of gullible or greedy people were enticed to borrow more and more money from the equity of their existing homes or to buy much larger houses than they could prudently afford.