Too Low, Too Long: How zero-interest policy inflated the biggest bubble in human history

After the Great Financial Crisis of 2008-2009, central banks embarked on a period of monetary experimentation which has totally deformed modern capitalism to its core. The most understood elements of that experiment were the rescue of the banks. In late 2008, following the collapse and sale of Bear Stearns, US policy makers wrestled with how to stop 'contagion' from affecting the entire financial system. As the effects of the subprime crisis began to metastasize across Wall Street, the US government worried about moral hazard of continuing to rescue bank after bank, and as a result the US Treasury allowed Lehman Brothers to collapse in a disorganized bankruptcy, which acted as a true catalyst for the crisis.

The next day the 'credit crunch' began as interbank lending stopped, multiple banks around the world began to struggle to finance their balance sheets, and the world entered a full blown financial panic. The US Congress and the Federal Reserve were ultimately able to re-capitalize the US banks with $700B in funds provided by the US taxpayer, and the Federal Reserve began their Troubled Asset Relief Program whereby the exchanged cash for billions in toxic financial products.

Following the stabilization of the crisis, the US economy began a free fall as not only did the housing industry face serious challenges in the wake of the subprime crisis, but the US economy as a whole began to struggle in an environment of limited access to capital. Having weathered the crisis, banks were not lending to anyone but the most creditworthy borrowers and as a result the economy crashed. To shore up the economy, the US Congress passed the Recovery and Reinvestment Act which was designed to support state and local governments. As property taxes made up much of the revenue for local governments, the housing collapse dramatically reduced the tax receipts of those governments and they would have laid off millions of civil services to balance their budgets. The stimulus package was in the end, mostly a backstop.

After the $700B TARP 'bailout', and an $800B stimulus program, Congress had little appetite for additional spending programs as the size of the national debt began to create political challenges. As a result the Fed took over the role of stimulating the economy.

With the economy on the brink of a deflationary spiral, the Fed felt they had aegis to stimulate the economy through less conventional means. The experiment described as Quantitative Easing, is easily described as the central bank prints new money to buy assets, usually government debt with the goal of injecting money directly into the economy. From 2009 to 2014, the Fed bought more than $2T in mortgage-backed securities and US Treasuries, directly injecting a tremendous amount of capital into the economy and aiding the recovery.

The Fed, while stimulating the economy, was also offering a deal of a lifetime to business. They could borrow money for free.

The Fed had dropped interest rates to zero in an effort to shore up the credit markets and encourage businesses and individuals to borrow money to stimulate the economy. This worked dramatically well, as the amount of corporate debt began to skyrocket.

Unfortunately, by 2014 when QE3 began to ebb, corporate debt was already hitting new highs. Rather than begin to wean business off of cheap money, the Fed struggled to maintain a balance. Every time the Fed would try to raise rates, the stock market would react with a 'taper tantrum' because increase costs of debt would slow future growth. As such, the Fed continued to take a very dovish tone on interest rates, and in Europe, central bankers at the ECB were flirting with negative interest rates and what they dubbed QE Infinity, the idea that the ECB will print money indefinitely to stimulate the economy.

From 2014-2018, the zero-interest rate policy (ZIRP) created huge bubbles. In markets that hadn't seen a collapse in housing post the subprime crisis, prices skyrocketed. In countries like Netherlands, Australia and Canada, house prices began rising 20+% YoY as free money flooded the market.  

With such monumental returns, other buyers began flooding into the market hoping to flip homes for quick money, and this process continued until 2017 when the bubble began to peak.

As 2018-2019 began to saw the inevitable decline in home prices, governments around the world were looking for ways to stabilize their housing markets to avoid another US-style market crash. Central bankers are also concerned that with so much free capital and easy access to debt, that when the next recession hits, there will not be any tools available to government to stabilize and stimulate the economy, 

The same logic has applied to the stock market, where financial companies and individuals  have been actively buying stocks through a tremendous bull market led largely by ZIRP. 

Rise of the Internationalist (Part 1)

In 1991, Alan Greenspan testified that ‘job insecurity’ is beneficial to the economy. Arguing that workers are likely to be more productive if they believe that their job is in jeopardy.

In 2008, CalPERS, a retirement fund for government workers in California, declared almost $100 billion in losses as a result of poor investments prior to the US subprime mortgage crisis. These two events are fundamentally linked by the rise of globalization and of liberal economics.

Most financial instruments in use today are not based on an asset or collateral, but are effectively 'bets' on value of underlying assets. Initially, this appeared mathematically to reduce risk, as the bank could 'bet' against it's own assets as a way to hedge the downside. As this practice expanded, banks began to make money through these instruments by selling them to each other. What originated as an idea to reduce risk ended up compounding it exponentially, which led to the worst financial crisis since the Great Depression.

While the 2007-2008 losses on US subprime mortgage bonds created mounting losses for US pension funds, corporations and financial institutions, as that crisis mounted, a supplemental crisis began to hit. In September-October 2008, loses on US subprime mortgage bonds and mortgage-backed securities began to trigger credit calls.

In 2005-2006, US insurance giant AIG began insuring against a fall in mortgage bonds. These credit default swaps (CDS) were paid for in premiums by investment banks and other financial institutions. As house prices began to drop and more and more US mortgage holders failed to make their payments in 2007-2008, AIG was forced to pay out on insurance policies backing hundreds of billions of dollars.

In 2005-2006, US investment banks Goldman Sachs, Lehman Brothers, Bear Stearns, Merrill Lynch & JPMorgan began to trade heavily in an investment derivative, a collateralized debt obligation (CDO). In an effort to contain risk from MBS, investment banks sought to offset risk by creating synthetic credit notes. These notes were designed to spread any risk from a mortgage default across a wider pool of investor. Rather than spread risk, it resulted in exponentially greater risk to the bank balance sheet if house prices began to decline. When US subprime mortgage borrowers began to default en masse in 2007-2008 and the mortgage bond market began to suffer serious defaults, the structures of the CDO market required massive write-downs at major US banks.

In March 2008, investment banking giant Bean Stearns began to enter financial distress as hundreds of billions of dollars of MBS and CDOs began to default. The SEC, Federal Reserve Bank and the US Treasury were required to step-in to facilitate a purchase of Bear Stearns by JPMorgan Chase were the US taxpayer would backstop any losses on MBS and CDO products, also known as ‘toxic assets’, or assets of unknowable value in a non-functioning market worth trillions of dollars.

When the size of the crisis became more clear, global banks began to review the potential damage from the fallout of the collapse of Bear Stearns. Global banks like Citigroup, UBS, Barclays and Deutsche Bank began to review their exposure to US subprime mortgage defaults. Pension funds and investment funds began to dig into the quality of the financial products they had been sold by US investment banks. Upon inspection, many banks began to ‘mark-to-market’ their ‘toxic assets’. When they began to seek pricing in the opaque market for MBS and CDS, they began to see large instances of defaults and prices quickly plummeted as financial institutions of all kinds began to unload their ‘toxic assets’ onto the market.

In September 2008, investment bank Lehman Brothers began to suffer tremendous losses on their mortgage-backed assets and CDOs, and at the close of business ended without enough cash to resolve their accounts, resulting in their bankruptcy.

The US Treasury Secretary, Hank Paulson, defined what he called ‘moral hazard’ if we were to bailout Lehman Brothers or backstop any potential losses from ‘toxic assets’ on the balance sheet as they had with Bear Stearns.

Failing to find a buyer for Lehman Brothers without support of the US Treasury and taxpayer, the investment bank went bankrupt September 15, 2008. As the counterparty to hundreds of billions of dollars of trades, when Lehman Brothers entered an unstructured liquidation of assets, trillions of dollars of assets began to decline in value precipitously. Other US investment banks began to discharge their mortgage assets and CDS creating a disorderly market and a desperate raise to raise cash to ensure solvency for the bank. Eventually the markets stopped working as no buyers could be found and market makers had exited. That evening, when the banks reconciled their books, massive write downs were required, essentially bankrupting large sectors of the US financial system.

As Congressional legislators and the US Treasury sought a resolution, a supplemental crisis was looming in investment giant AIG. AIG had ignored their own risk management group’s advice, and bought heavily into the MBS and CDS market near the peak of the asset bubble. Crushingly, the insurer, following the guidance of investment rating companies Standard & Poor’s and Moody’s, had calculated that the risk of a decline in US house prices or a wide-scale default on mortgages was negligible and sold hundreds of billions of dollars of insurance policies against declines in US home prices, as well as other securities and CDS. The credit default swaps would destroy the value of the insurer overnight, and with it bankrupt the US financial system.

Vowing to ‘use the bazooka’ to protect the US financial system, US Treasury Secretary Hank Paulson sought at $700 billion bailout package for the banking system. A number designed by Treasury Department officials as enough to cover the decline in the value of ‘toxic’ mortgage assets.

September 19, 2008, the US House of Representatives voted against the $700 billion bailout fund designed by the US Treasury. By the end of trading, the US New York Stock Exchange saw a decline in the Dow Jones Industrial Average of 777 points, one of the largest declines in market history and ended down nearly fifty percent before stabilizing in 2009.

The severe decline in the stock market led to massive declines in US pension funds, and with losses nearing 50% in 2008-2009, many funds began to lack the solvency to pay current pensioners, or lacked a long-term strategy to return to solvency for future benefit recipients.

The US subprime mortgage crisis created a ripple effect in global banking. In 2007, US mortgage assets were classified as ‘AAA’ investment grade for bank collateral, pension funds seeking moderate returns were able to stock up on ‘AAA’ bonds paying higher yields and reaping rich returns for the funds. International banks from Australia to Switzerland to Iceland to Japan began to feel the ripple effects as the recognized the new true value of the assets on their balance sheets. Icelandic bank Landsbanki saw writedowns on its balance sheet that led to insolvency at the bank. UK banks, Northern Rock, RBS and Barclays saw writedowns on their US subprime related assets resulting in their insolvency. Swiss bank UBS and Germany’s Deutsche Bank suffered losses on their books leading to their insolvency. By seeking to globalize risk in the US subprime mortgage markets, the financial institutions tied the global financial system and the financial systems of key trading partners, Japan, UK, France and Germany to US assets. As these assets were rated ‘AAA’ and US house prices had continued to rise for decades, banks failed to calculate the cost of a severe rise in defaults on assets viewing them as a ‘safe’ asset class for their balance sheets.

As all global banks sought safety in cash, global asset prices plunged and credit and interbank lending ceased, resulting in a rare, or ‘black swan’ economic event known as a credit crunch. The financial system fails as markets cannot find buyers and prices plummet, credit stops and businesses begin to fail as short-term credit is called in and businesses are unable to make their payroll resulting in their bankruptcy.

Seeing the national and global effects of the financial crisis, the US House of Representatives, lead by House Speaker Nancy Pelosi, resolve a $700 billion bailout fund to support US financial firms from entering bankruptcy. The FDIC raises deposit insurance coverage to $100,000 and the US Federal Reserve opens its overnight window to allow all US financial institutions to borrow at extremely low interest rates.

In coordination with the IMF and World Bank, the US government begins negotiations over requirements on US-denominated mortgage bond assets. US banking institutions are able to move their toxic assets off of their balance sheets to the Federal Reserve Bank to be valued at a future date when market liquidity is returned.

By bailing out the US banks, the US Congress and the Bush Administration’s Treasury Department were able to free up credit markets and forestall the breakdown of business lending.

Customers queue at Northern Rock branch in hopes of
securing cash in the event of a bank collapse.

In the UK, the required bailout of Northern Rock, RBS and Barclays amounted to $850 billion, more than the US bailout, in a much smaller economy. As a result, the UK government was required to issue a tremendous amount of new bonds, creating economic turbulence and resulting in losses on the UK FTSE amounting to greater than 50%, heavily impacting union funds, pension funds, government pension funds and the investments of retirees like the US.

Within the EU, things were even more dire. Ireland, Spain, Portugal and Greece all saw their banks invest heavily into the high yielding US subprime market, but they also witness subprime mortgage bubbles of their own. Using cheap credit from the US and northern Europe, these countries saw speculative property bubbles form. When the global financial crisis started and credit dried up, the property market collapsed and mortgage holders began to default on their debts en masse. The combined effects of the collapse in US and domestic European assets led to tremendous losses at Spanish, Irish and Greek banks. The resulting bank bailouts required financing from the IMF and World Bank as they represented an amount greater than the domestic GDP of the countries.

In 2009, the United State Federal Reserve Bank began to purchase assets with newly created cash, seeking to remove more ‘toxic assets’ from bank balance sheets and reopen credit market liquidity.

As the US Fed dropped its bank lending rate to 0.05%, and began purchasing government bonds and municipal bonds, the ECB also dropped its rate as did the central banks of other EU countries.

The final casualty of the financial crisis was Fannie Mae and Freddie Mac, the gargantuan, government backed, publicly traded company. Entering government conservatorship wiped hundreds of billions out of investors, such as large pension funds. Fannie Mae and Freddie Mac have been forced to write down hundreds of billions of dollars, but with government guarantees, was able to value assets at a fixed price to begin market making and to seek value of the assets.

Value of deposits in Icelandic banks.

In Iceland, loose financial regulation and close connections with US and EU financial institutions meant that small banks such as Landsbanki and IceBank we able to borrow very cheaply in US dollars and then sell loans and mortgages to customers in the UK, Spain and other countries for a low rate which still yielded a higher margin for the bank. The banks maintained their credit growth by betting heavily on US subprime mortgages, using the ‘AAA’ rating as a the required margin for their risk calculations and the higher yields to net even greater growth. By 2008, the Icelandic Banking system was critically larger than its economy and after rejecting a bailout of the banks became completely insolvent. The resulting economic collapse required the nation of Iceland to renegotiate unilaterally on the conditions of their debt, temporarily removing themselves from the ability to issue new debt.

Icelandic bank defaults led to tremendous losses for UK and Spanish depositors who lost savings during the crisis. This compounded the 50% losses in the stock market to lead to the threat of bank defaults. Some US, UK and Spanish banks saw runs of withdrawals, but were backed by central banks so as to finance any withdrawals.

In 2010, Greece began to reach the upper limit of its debt threshold, whereby their tax revenues were not sufficient to pay the interest payments on their outstanding debt. As a result this created a debt crisis in Greece and interest rates for Greek debt skyrocketed making the situation critical and requiring intervention from Germany, Italy and France and the EU and the ECB to lend to Greece at a lower rate to ensure they could maintain essential services. Greece entered negotiations with the EU, IMF and World Bank to determine how to reform government services to reduce the deficit to a sustainable level. As the Greek economy began to stagger and government cutbacks became felt, business investment ceased and workers were laid off.

As the Greek debt crisis worsened, Greek negotiators sought to dramatically cut their debt to creditors, while German bondholders, still reeling from the US subprime crisis and credit crunch, were not sympathetic to allow for ‘haircuts’ to bonds.

With the possibility of another sovereign default imminent, holders of Euro denominated debt began to examine the possibility of the collapse of the Eurozone and the ECB and began looking at other countries at risk of a debt default.

The interest rate for sovereign debt of Spain, Portugal and Ireland skyrocketed as investors re-assessed the ability of the country to reduce its deficits long-term. The European debt crisis ensued and crushed the markets of those countries. Eventually the ECB and IMF negotiated with backing from the US government, the Fed, France and Germany by providing and guaranteeing low interest rate purchases for Eurozone bonds.

As the Eurozone crisis created risk, US and international banks began to move into US dollar denominated assets, driving up the cost of US dollars and undermining the US Fed mandate to ensure ‘full employment’. As US interest rates were already essentially zero, the Fed entered a policy of printing new cash to analyze and write down the toxic assets on the balance sheet, to purchase government bonds on the open market and to support other assets. All this in an effort to reduce the exchange rate of the US dollar to provide an export advantage to US companies.

By settling into a period of ‘forward guidance’ that the Fed was buying bonds, this allowed the largest financial institutions to reap high rewards by front running the Federal Reserve to acquire US Treasuries. This has been a source of profit to begin to restore bank balance sheets.

By acting to support the US labor market and manipulating the currency to favor US exporters, the Fed neglected the greater importance of US imports and how higher import costs would affect US consumers who represent two-thirds of the economy. This combined with the significant loss of household wealth due to the collapse of home prices and the stock market, led to a depression in the US economy that was exited in 2012 resulting in a loss of $14 trillion dollars in US wealth.

An uncertain legislative agenda involving investigations into the financial crisis and the Dodd-Frank reforms led banks to become more conservative. In 2012 the Doha III round of talks international governments passed new rules and regulations for international assets following the investigations into failed risk management, poor oversight and accountability at rating agencies, a lack of due diligence and a failure in government oversight.

After successfully stabilizing global financial markets, the tripartite of the ECB, the US Fed and the IMF entered a period of prolonged monetary experimentation. By 2013, US bank balance sheets had been restored, the $700 billion bailout had been repaid to the US Treasury and banks began the slow process of adjusting to a new low interest rate environment with the new constraints of regulations. As the recession continued, international policy makers decided to continue the process of quantitative easing, or printing new cash, to purchase assets. US fiscal policy entered into severe deficits in the years following the financial crisis as the Obama Administration attempted to provide fiscal stimulus by providing cash-starved state and local governments with an infusion to ensure that essential services were not jeopardized as a result of the depression.

By 2015, the process of quantitative easing (QE2, QE3, QE4) had led to an appetite by European and Asian governments to monetize the debt of the nation as a policy tool to counter deflation. With interest rates near zero percent, and the US depressing the exchange rate value of the dollar to support exports and fight deflation, the euro and yen began to rise and exports from Eurozone and Japan lost competitiveness. To counter these effects, Japan began to print yen to monetize their sovereign debt, driving up yields. While this had the effect of supporting the Japanese Nikkei stock exchange, it did not provide growth to GDP.

Japanese banks had been deemed ‘zombie banks’ since their financial crisis in 1990, and had been on long-term state support hampering their growth for decades and depressing Japan’s economy. Debt-financed state funding for economic development failed to provide real results for the economy and the servicing on the massive two hundred percent of GDP debt have led the Japanese economy to become sclerotic, the entire banking system slowed by a ball-and-chain of debt.

Japan requires major fiscal and monetary policy changes as well as structural reforms to its economy to gain productivity and growth in the economy. Japan also needs to address the long-term structural problems in regards to its state pension and health care entitlements.

Eurozone countries also began to feel the burden of a strengthening euro on their exports and began to call for monetary policy to equal the playing field. Germany opposed the deal as it was deemed to be a way to spur euro inflation. With countries like Spain, Italy and Greece looking to monetize their debt to restructure their national balance sheets, Germany did not support the proposal.

With long-term structural deficits now becoming an international problem, investors began to flee sovereign debt of Greece, Portugal, Ireland, Spain and Italy, but as well France. At this point, with the German taxpayer directly buying Eurozone bonds to support other economies, Germany allowed the ECB to being a process of quantitative easing to pass through cash to investors through asset purchases.

To facilitate this, Germany required technocratic governments to administer the countries and restore their balance sheets to order. In Spain, the sudden collapse in government fiscal spending coupled with banking weakness and business failures led to a Spanish Great Depression that has lasted since 2009, with unemployment nearing 30%. Greece as well suffered under the German requirements for fiscal austerity. Greece’s punishing debt servicing cost and inability to refinance or reduce its overall debt load has left Greece with barely enough cashflow to run essential services and still relies on foreign cash injections. With government spending reduced substantially, the Greek Depression that hit in 2010, and continues, has seen tremendous emigration into the northern European Union countries.

The Eurozone now has a crisis of systemic proportions brewing. Countries are facing three profound challenges: an aging population and declining childbirth are increasing burdens on working people slowing economic growth; reduced tax income resulting in larger deficits as the aging population draws upon their savings and draw on the entitlements they were promised.

Continued in Part 2

How the Great War Shaped the World

November 11, 1918 was the end of the Great War. It was a European war, a war that was a conflict between imperial Europe (France and the United Kingdom) against the constrained Central Powers who saw empire as a path to prosperity. In the breakdown of the Central Powers, you have three countries that each have their own imperatives: The Ottoman Turks were economically weak, having lost their empire in the late 19th century to the French (Algeria, Libya) and British (Egypt), they sought to regain their lost empire; The Austria-Hungarian Empire was sclerotic, with a political class under the Hapsburg Dynasty that longed for a return to the royal system of the 18th and 19th century; and the Germans, unified by the Prussian North into a hegemony under the Kaiser, economically emergent under a strong policy of industrialization. 

The Triple Alliance, meant to maintain the balance of power of Europe, presented a contradiction: France and Britain were at the height of their global empires, while Russia under the Czar was a country stuck in a neo-medieval feudal system, struggling to industrialize. 

The war was disastrous for Europe. When the German Schlieffen Plan failed in the first months of the war, that plan to capture France, then turn resources toward Russia, ended up creating a protracted trench war of attrition that the Germans were destined to lose. The Central Powers were now fighting a war on two front, an unenviable position, but the Germans wanted to do as much damage to the Allied Powers, to ensure a fair peace.

The Price of Peace

When peace was finally achieved on November 11, 1918, Europe was shaken and the systems that had lasted generations began to fail. The Allied Powers were victorious, but at great cost. Even minor players, such as Italy, were left badly weakened by the war.

In 1917, following heavy losses on the Eastern Front, and massive food shortages at home, Russia descended into the darkness of the Russian Revolution as the Bolsheviks took control of the seat of government in Petrograd (St. Petersburg). While this helped bring the war to conclusion, it was disastrous for Russia.

France, having been the battlefield of the Western Front, suffered terribly. As many as 1.6 million French died as a result of the combat, and much of France's industrial capacity was devastated. While new territory was won, France would struggle to maintain its empire because of the war's economic costs.

Britain suffered less, as it was supported with food and supplies from the United States, but paid heavily in loss of life. The aristocracy was decimated by the war, and the Victorian systems began to falter. While the loss of a great many men would result in an increase in the influence of women and the rise of woman's suffrage, the economic effects were systemic. Like France, territorial gains in the Middle East created an additional economic drag that left Britain weak, and ultimately it ceded world economic leadership to the United States as the standard bearer of the Gold Standard. It also took resources away from Ireland, providing the political vacuum that allowed the Irish Independent movement to form in 1921.

The Cost of Loss

For the Central Powers, the Treaty of Versailles was debilitating. The Empires of German, Austria and Turkey were dismantles and new countries were formed: Czechoslovakia, Hungary, Yugoslavia, Rumania, Bulgaria, British Palestine, French Syria.

In the end, the devastation left much of Central Europe in economic and political turmoil until the start of World War two, a decade later.

America's Peace and Prosperity

The end of the Great War, led the United States to power in the global system. The rebuilding of Europe gave America a de facto stimulus program as much of Europe's industrial capacity was destroyed. During this period, the United States even supported counter-revolutionary forces in Russia. Along with the France and Britain, the US supported the Whites against the Bolshevik Red Army, continuing the Russian Revolution and the suffering of the Russian people. Exhausted by the Great War, the Western powers didn't have the political will to fight a long civil war in Russia, and so it was lost to the Bolsheviks and the Union of Soviet Socialist Republics (USSR) was formed.

America during this period was mostly distracted by pleasure and economic growth. The Roaring 20s created a massive boom in America, fuelled by exports to Europe and the power of credit growth as the new global reserve currency. The fledgling US central bank, the Federal Reserve, formed in 1913, was now able to leverage it's status as the Gold Standard.

In the interwar period, to stabilize exchange rates, European currencies were floated against the US dollar. This made the dollar the global reserve currency and provided a massive monetary stimulus to the US as well, which in turn led to the massive stock market bubble of the late 20s.

The Dawes Plan however setup a system that was unstable and unsustainable. A type of global Ponzi scheme of payments based on German war reparations and Allied Power debt payments to the US.

Under the Weimar Republic in Germany, this system led to a period of relative prosperity. The economy began to improve and global trade began to normalize. This system was ultimately untenable (see left). When the US stock exchanged collapsed in 1929, this system unravelled.

Unable to borrow from the US to pay reparations, Germany needed to print money. This led to a period of hyperinflation that destabilized the German economy. Combined with the affects of the US Great Depression on global trade, economic hardship was ubiquitous.

America's Pain is Globalized

In the wake of the 1929 stock market crash, economic policy makers make a number of disastrous mistakes. In a period of deflation, the decade-old Federal Reserve began to contract the money supply, limiting credit and making efforts to sustain the banking system. Between 1929-1932, the world convulsed, and production, prices, trade all declined massively.

	United States	Great Britain	France	Germany
Industrial production	–46%	–23%	–24%	–41%
Wholesale prices	–32%	–33%	–34%	–29%
Foreign trade	–70%	–60%	–54%	–61%
Unemployment	+607%	+129%	+214%	+232%

A weak United States, Great Britain and France left a vacuum in the global system. The pain in Germany would critically weaken the Weimar Republic and pave the way for the National Socialist Party. The seeds of World War II were planted in the peace of 1918.

The Challenge of a Low Interest Rate Environment

In 2001 when G.W. Bush was sworn into office, interest rates were 6.6%. The dot com bubble had popped in 2000 and the economy encountered a short recession. In response to the recession, then Federal Reserve Chairman Alan Greenspan began to cut interest rates to spur economic growth. 

The rate cuts of early 2001 were an effective central bank policy and were working to spur consumer demand, but the black swan event of September 11, 2001 changed the economic paradigm. To address the major economic impact of the terrorist attack, the Federal Reserve continued a policy of lowering interest rates. This policy was important: after 9/11 the United States invaded Afghanistan, in March 2003 it invaded Iraq. The combined cost of these wars was immense, and the Republican-led Congress determined that the economic recovery could not be sustained with tax increases - thus a period of deficit financing began.

Debt-financed wars are not uncommon, but with deficits entering the hundreds of billions, the Federal Reserve had to act to ensure that interest payments on the debt would not be crippling to the US federal budget.

There are long-term impacts to the large amount of debt brought on my the Bush tax cuts and the wars in Iraq and Afghanistan. By 2019, the legacy of those policy decisions will account for nearly half of public debt.

As a result of this massive increase in public indebtedness, the Federal Reserve under Greenspan continued to cut interest rates to assist in financing the tax cuts and wars. This is standard central bank policy dating back to World War I. The interest payments on a low interest rate vs. a nominal interest rate can save billions for the government.

Unintended Consequences

This policy, while prudent, created "externalities". This low rate environment that the Fed perpetuated created a correlated low rate environment in the mortgage market. Between 2001 and 2007 interest rates declined substantially, increasing home affordability and creating increased demand for housing.

Overall, this would be considered a good thing, but President Bush created a problem for central bank policy when he began began promoting the "ownership society". Bush policy fomented the bubble because in a period of historically low interest rates, home affordability was already producing a hyper-cyclical growth rate in house appreciation. Between 2001-2005, the economy and home price increases were actually within historical norms, it was only the creation of the subprime market, as a result of regulatory changes, that in 2005-2007 that created the bubble, which resulted in the crash, credit crunch and financial crisis of 2008.

Global Externalities

This US low-rate environment created challenges for other central banks. The Bank of Canada, the European Central Bank, the Bank of Japan, all cut interest rates in correlation with US monetary policy. They had to. If they had not, US dollar inflation would have increased the price of Canadian, European and Japanese exports. This created a "race-to-the-bottom" with interest rates that have fueled global bubbles. Hot money flowed into emerging markets and the BRIC countries (Brazil, Russia, India, China) saw extraordinary growth between 2002-2012. This hot money also flowed into global housing markets. China, Canada and the Netherlands being the most prominent bubbles.

The Canada Conundrum

In Canada specifically home pricing have increased dramatically as a result of the increased affordability granted by low interest rates as well as hot money inflows from the US, China and Europe.

From 2000-2012 Canadian home prices more than doubled. The average Canadian residential property in 2000 was $152,000. In a decade that home has ballooned to over $350,000 and the growth continues at ~5%/yr.

This makes sense from an affordability standpoint.

For example in 2000, a $150,000 mortgage at 7.2%, cost $1235/mo. in mortgage and interest financing.

In 2012, at $350,000 mortgage at 2.87% cost only $2000/mo. in mortgage and interest. In effect, while the value of the asset increased 200% between 2000-2012, the cost of owning the asset grew at a much slower pace, 62%.

This low interest rate environment is creating bubbles in many markets, but none so obvious as housing. This is a very troubling asset class to have a bubble, because unlike the dot com bubble, this bubble hits consumers most, not speculators. In addition, houses are often used as retirement savings accounts and so any decrease in value can have very deleterious effects on wealth.

The Turn

A low interest rate environment is likely to persist for the foreseeable future. The Bank of Japan is using negative interest rates as the first arrow of Shinzo Abe's plan to exit deflation and return Japan to growth, the European Central Bank is dealing with the sovereign debt crisis in the periphery and requires ultra-low interest rates to ensure the Euro doesn't collapse as a currency, and the US has not even exited "extraordinary measures" and quantitative easing (buying Treasuries with newly printed money). Overall this indicates that ultra-low interest rates will persist for the foreseeable future. However, they can't continue forever and there is a very real risk of stagflation.

What happens when interest rates begin to rise? If you look at the cost of mortgages, you can immediately see the implications. Increase the ultra-low rate of 2.87% to a low 5.5% interest rate and the home affordability index changes substantially. The $350,000 mortgage now increases from $2000/mo. to $2500/mo. If they return to a normalized 7.5% interest rate, $2951. This will leave many people overextended. 

While a 30% decrease in affordability is not dangerous, and will not lead to a crash in the Canadian market, it does change the long-term outlook for housing as most people buy a house based on what they can afford monthly. 

For example, the couple that could afford a $350,000 home at 2.97% interest rates, can only afford a $240,000 home at a normalized rate.

When you look at the cost in the Greater Toronto Area (chart below), or any other metro area, that puts home affordability out of reach for a large segment of the population. As a result, this will lead to a long-term secular bear market for housing in Canada. 

The Soft Landing

While the Bank of Canada is doing what they can to ensure a soft landing for the housing market,  this soft landing is going to be maintained through "asset price stability". What that means is that the cost of an asset will remain the same, but not keep up with the decline in purchasing power as a result of inflation. This way the banks will avoid a downturn in the market, even though fewer people can purchase a home and prices will be falling in real terms. Basically creating a wealth illusion to avoid a hasty rush to the exits.

Hot Money in Canada

The big question is the foreign hot money - when the growth slows, will they stay in the asset class? To date, global central banks have pumped almost $7 trillion in liquidity into the market. That money is chasing returns, as 1% in bonds is not enough for high net worth individuals or institutional investors to counter the inflationary effects of QE. As long as the housing market is growing faster than that, Canadian homes will be viewed as a bit of a safe haven. As soon as growth slows to 1-2% from the current 4-7%, the view of the asset class will change and there may be a meltdown, especially in the condominium market which has absorbed the majority of foreign wealth (Vancouver, for example, has an entire condo development that is sold, but only 25% occupied).

Threading the needle is very difficult, and the meltdown will likely start in 2016-17. Will this lead to a crash or just a long period of stagnation in Canadian housing? Ceteris paribus, stagnation. However, with concerns about shadow banking in China, the Chinese housing bubble, the fate of the Euro, the unwinding of QE the world remains a very difficult place to navigate.

Mark Carney gives a great speech on Inclusive Capitalism

The New Spice Route (and the Role of America)

After the Second World War, the United States was the unrivaled leader of the "free world", with only the economically unstable Soviet Union offering a counter-balance to US global hegemony.

As the post-Soviet world begins to reshape into a  multi-polar world order, with China and the EU as the new main participants, control over the New Spice Route is going to become a continuing theme in global affairs. 

The most existential threat to global economic growth in 2014 is concerns about the global trade in hydrocarbons. Some of the worlds most important economies, and largest contributors to global growth rely on imports of hydrocarbons to fuel their growing economies. This is the great challenge to Asia especially as many Asian nations have very limited domestic supplies of oil and gas.

The existential crisis is most prevalent for Japan, following the Fukushima-Daichi nuclear plant disaster. Much of the Japanese Economic Miracle of the 1970s-1990 is due to relatively low cost of inputs from one of the world's largest systems of nuclear power. Following Prime Minister Yoshihiko Noda's decision to wind-down Japan's aging nuclear power plants, Japan has been spending large amounts importing oil and gas, specifically from the Middle East. This is putting pressure on global oil prices and making Japan's exports less competitive. 

Japan is an example to other Asian nations, like South Korea, Taiwan, Vietnam and Malaysia, as to the importance of the global hydrocarbon trade and the dangers of Chinese militarism in the South China Sea. Essentially, for these nations, if China is able to displace American naval superiority in the South and East China Seas, then they will be completely dependent on China, and face a crisis as China would have the ability to stop economic activity in the Asia-Pacific with an oil embargo.

As much as two-thirds of global trade flows through the Strait of Malacca and is managed through the major international ports of Kuala Lumpur and Singapore. This is trade from Asia bound for European consumers and Middle Eastern hydrocarbons headed toward energy-starved Asian nations.

Control of the Strait, as well as the Adaman Sea and the South China Sea is key for globalization to continue in the 21st century.

This is the most important global pinch-point and a geo-strategic imperative for the United States to ensure remains free to global trade. However, recent discoveries of hydrocarbon fields off-shore in the sea have led to a scramble to harvest those resources. Malaysia, Vietnam, Phillipines and China all claim ownership of the resource rights in the South China Sea. China (not shown on map) claims the entire South China Sea and this will be a cauldron of diplomacy in the coming decades. US and European engagement is necessary to counter-balance Chinese growth and protect the economic interests in the region.

The New Pharaohs 

The second strategically volatile region for global trade is the Red Sea. An overlooked concern of the Arab Spring and the overthrow of President Hosni Mubarak in 2011 was the Suez Canal. While the West received some guarantees from the Egyptian military that access to the canal would be maintained, this remains an concern for global trade as political uncertainty remains.

The Red Sea contains two main choke points, the first at the Suez Canal, the second at the Gulf of Aden. Currently, the Gulf of Aden is the most insecure area to navigate on the New Spice Route. Regional instability in Yemen, Sudan, Eritrea and the failed state of Somalia make this a difficult area of influence for the United States and European allies. This is an area the Global War on Terror has destabilized even further. Adding to the complexity is the question of nuclear negotiations with Iran and the concern in the Persian Gulf and specifically the strategically important Strait of Hormuz. 

As the center of the global hydrocarbon trade, the Arabian Kings in Saudi Arabia, Kuwait, UAE and Oman will continue to wield outsized influence and will become a more important military power in the 21st century as the war-weary United States winds down engagements in the region post-Iraq War.

It would be the expectation that US military-industrial complex will be investing heavily with American regional allies on the peninsula, and that the US Congress will allow a larger amount of arm sales to produce a counterweight to Iran, as well as allow for more domestic counter-terrorism activities.

Maintaining the Balance in the Mediterranean

The final leg of the New Spice Route is Europe's backyard. The Mediterranean is a region traditionally controlled by European powers. While the Strait of Gibraltar is the most secure pinch point in global trade, recent Russian movements have changed the dynamics of the sea and created a geopolitical crisis as Russia's annexation of Crimea can be seen as a threat to the West as it grants the Russians broader access to the Mediterranean basin and the ability to disrupt global trade in any future conflict.

This is where the Crisis in Ukraine extends to become a geo-strategic concern. Incorporating Crimea and the Port of Sevastopol into the Russian Federation grants Russian de facto control of the Black Sea. This creates challenges for NATO, as Turkey is a linchpin of that alliance, and this starts a balance of power situation for the region.

As Turkey continues is economic rise, it may seek broader assurances for its security by acting alone. Turkey faces many challenges on its Eastern flank as nationalist Kurds look to form a state in Northern Iraq and Syria. This is a domestic political concern for Turkey, home to 14 million Kurds.

Turkey also faces a refugee crisis as the Syrian Civil War extends into its third year. Add al Qaeda-linked organizations like Islamic State in Iraq and Syria (ISIS) and continuing unrest in the Levant, and Turkey becomes a more vital ally to the West in the new world order. Not only as a counter-balance to Russia, as it was during the Cold War, but also as a barrier to radical militants in the Middle East en route to Europe.

Overall, this bodes well for the continuation of American economic and political might in the 21st century.

Historical movies in chronical order

Quest for Fire
The Ten Commandments
Troy
The Odyssey
Alexander
Spartacus
Rome
Empire
The Passion of the Christ
Ben-Hur
Nero
Gladiator
Augustine: The Decline of the Roman Empire
Ancient Rome: The Rise and Fall of an Empire
Curse of he Golden Flower
Macbeth
Kingdom of Heaven
Robin Hood
The Name of the Rose
Joan of Arc
Braveheart
The Conclave
Mongol
Marco Polo
Conquest 1453
1492: Conquest of Paradise
The Borgias
The Tudors
The Other Boleyn Girl
Apocalypto
Elizabeth
Elizabeth: The Golden Age
The Merchant of Venice
Shōgun
The New World
The Devil's Whore
Charles II: The Power and The Passion
The Red Violin
Rob Roy
Roots
Marie Antoinette
Amadeus
The Last of the Mohicans
Brotherhood of the Wolf
The Duchess
The Patriot
Marie Antoinette
Farewell, My Queen
The Madness of King George
Vanity Fair
Master and Commander: The Far Side of the World
War and Peace
Amazing Grace
Les Misérables
The Count of Monte Cristo
The Alamo
The Young Victoria
Mrs. Brown
Amistad
Gangs of New York
The Charge of the Light Brigade
Ride with the Devil
12 Years A Slave
Gone with the Wind
Glory
Gettysburg
Cold Mountain
Lincoln
Wyatt Earp
Dances with Wolves
Anna and the King
Deadwood
The Last Samurai
The Assassination of Jesse James by the Coward Robert Ford
Tombstone
Butch Cassidy and the Sundance Kid
Gandhi
1911
Meet Me in St. Louis
The Battleship Potemkin
Titanic
Doctor Zhivago
Ararat
All Quiet On The Western Front
Joyeux Noel
Flyboys
Gallipoli
A Very Long Engagement
Lawrence of Arabia
Michael Collins
The Lost Battalion
Kundun
The Last Emperor
The Wind that Shakes the Barley
Chariots of Fire
Evita
Legionnaire
The King's Speech
Casablanca
Australia
Road to Perdition
The Flowers of War
Schindler's List
The Pianist
Tora! Tora! Tora!
The Pacific
The Bridge on the River Kwai
The Thin Red Line
Empire of the Sun
Letters from Iwo Jima
Paradise Road
Band of Brothers
Enemy at the Gates
The Imitation Game
Patton
The Longest Day
Saving Private Ryan
Valkyrie
A Bridge Too Far
Flags of Our Fathers
Letters from Iwo Jima
Downfall
Nuremberg
Fat Man and Little Boy
Emperor
Seven Years in Tibet
The Reader
The Godfather
LA Confidential
The Shawshank Redemption
The Good Shepherd
The Right Stuff
Good Night, and Good Luck
Che
The Motorcycle Diaries
Quiz Show
JFK
The Godfather: Part II
J. Edgar
Thirteen Days
Ghosts of Mississippi
Mississippi Burning
We Were Soldiers
The Doors
Platoon
The Deer Hunter
Full Metal Jacket
Apocalypse Now
Born on the Fourth of July
The Deer Hunter
Bobby
Nixon
Apollo 13
All the President's Men
Goodfellas
Zodiac
Taxi Driver
Milk
The Last King of Scotland
Munich
Balibo
Frost/Nixon
Summer of Sam
Goodbye Bafana
Catch a Fire
Argo
Charlie Wilson's War
Jarhead
Three Kings
Black Hawk Down
Hotel Rwanda
Invictus
Behind Enemy Lines
Blood Diamond
The Queen
W.
Lions for Lambs
The Hurt Locker
The Social Network
Green Zone
Too Big to Fail
Margin Call
Zero Dark Thirty