The Butterfly Effect – Seeds of the Meltdown

The Butterfly Effect – Seeds of the 2008-2009 Meltdown
By Navin Doshi, April 19th, 2010

In the last two decades, we have experienced the bursting of two bubbles- the first in technology in 2000 and the second in housing in 2008. When exactly were the seeds planted for the current American suffering with close to 20% combined unemployment and underemployment? Even those who are employed do not feel quite comfortable about their job security. Unemployment is much higher for those fresh graduates coming out of schools and universities. Senior citizens living on fixed income are suffering because the interest and dividend income on their savings and IRA funds have shrunk drastically. The purchasing power of the dollar has been steadily declining, causing increasing hardship to those who exist on meager income. The average household net worth has shrunk because of the depressed home prices.

The butterfly effect is a metaphor that encapsulates the concept of sensitive dependence on initial conditions in chaos theory; namely, that small changes in the initial condition of a dynamic system may produce large variations in the long-term behavior of the system. Chaos theory is a field of study in mathematics, physics, and philosophy concerning the behavior of dynamic systems that are highly sensitive to initial conditions. Here the dynamic system is the American economy, and we are trying to explore and determine what seeds were planted that caused the 2008-2009 chaotic meltdown and a deep recession. Simply stated, the fluttering of butterfly wings in Spain causes a hurricane in Florida.

Some would say that these seeds were planted in the 1980’s and ’90’s with financial deregulation. Some would say that it was due to the Fed’s easy monetary policy designed to stimulate economic growth by lowering short-term interest rates and making money less expensive to borrow. I would argue that the seeds were first planted in the 1970’s and later reinforced in the 1990’s when the market regulations were either removed or not implemented properly.

During the 1992 election, Ross Perot’s role as a third party candidate caused George H. Bush to lose to Bill Clinton. Bush lost the election for two reasons- high unemployment and high interest rates. Fed Chairman Alan Greenspan raised interest rates to tighten the money supply to bring some economic discipline whereby good businesses would survive and bad businesses would fail. In a free-enterprise capitalist system, economic cycles are natural. It allows the “dead wood”, that is, poorly run businesses, to die while the strong, more efficient businesses survive. The conservative vote got divided between Bush and Perot, giving the presidency to Clinton. There was some validity to Ross Perot’s argument in relation to NAFTA (North American Free Trade Agreement). Perot had argued that NAFTA would cause the loss of jobs without sufficient control, as cheap labor became more available from south of the border.

It was during the late 1990s when the CFTC (commodity futures and trading commission) chairperson, Brooksley Born, had proposed to regulate the exploding and out-of-control derivative market. However, she had hit the stone wall erected by then Fed chairman Greenspan and treasury secretary Robert Rubin, also supported by President Clinton. Under great pressure, she resigned the post. Ever since then, the derivative market of over $500 trillion, is the big elephant in the room. Warren Buffett has described it as a financial instrument of mass destruction. Just to put the size of the elephant in perspective, the yearly GDP of USA is about $14 trillion and the entire world GDP is about $65 trillion, while J.P. Morgan, one too-big-to-fail bank, holds derivatives of about $85 trillion. Derivatives do provide useful function of controlling the price movement of securities, similar to a closed loop feedback system to control the movement of a parameter like speed of a vehicle. However there has to have some safety mechanism to insure the system stability.

Going back to 1969, the Nixon administration expanded the war in Vietnam, which led to much greater death and destruction in Indo-China. Due to the excessive spending for the Vietnam War and providing arms and ammunitions to Pakistan, the value of the dollar began receding. Countries holding dollars demanded gold for dollars since the dollar was convertible to gold at a rate of $35 per ounce. Half of the gold reserves stored in Fort Knox, about 9,000 tons, were delivered to the holders of dollars. With 9,000 tons of gold remaining, Nixon officially removed the gold standard. That action created tremendous inflationary pressure, resulting in gold peaking at over $800 per ounce in 1980. The price of all commodities, most importantly oil, rose to the stratosphere, thus creating the terrible inflation of the 1970’s. The Yom Kippur war of 1973 had created an oil cartel that had put additional pressure on inflation. A gradual degradation of auto and steel industries due to the cheaper imports from abroad, accelerating manufacturing job loss, added more misery to the people. (Refer to articles including, Dysfunctional Detroit, and Sweat, Think and Philosophize, at http://www.nalandainternational.org).

The second misfortune for America was the Watergate scandal that caused the country to go through the long-drawn process of impeachment. Watergate was a political scandal in which a break-in into the Democratic National Committee headquarters resulted in the eventual resignation of Richard Nixon. Recorded conversations in President Nixon’s offices revealed his involvement with the break-in along with members of his staff. Before Watergate, the United States government was basically considered “God” in the eyes and minds of most Americans. I recall a few of our American friends considered it sinful to evade paying taxes to the American Treasury. This blatant show of corruption changed the attitude of many Americans and created a pattern of cynicism that still exists today.

Thirdly, Nixon is responsible for opening the floodgate of cheap labor from China. He had a very high admiration for Mao Zedong, the leader of Communist China. Nixon was incredibly anxious to meet him and asked his National Security Advisor Henry Kissinger, to arrange a meeting. Pakistan, being friend of both America and China, helped to arrange the meeting. We do know that India and Pakistan have an existing conflict over Kashmir ever since they became independent in 1947. These conflicts escalated as the people of East Pakistan, now Bangladesh, began en-masse to migrate to India from East Pakistan due to the atrocities committed by the Pakistani Army.

West Pakistani elites could not accept Bangladeshi leader Sheikh Mujibur Rahman, who had won the election, as the prime minister of the whole country. Nixon had provided more arms to Pakistan for its defense. Additional arms helped Pakistan perform great atrocities through “Operation Searchlight” against the Bangladeshi people, killing as many as 3 million and creating 5 million refugees. These events led to the India-Pakistan war of 1971 and later, to the creation of Bangladesh. Nixon’s dislike of India’s Prime Minister Indira Gandhi is well-known. He went as far as sending the U.S. Navy’s mighty 7th fleet to the Bay of Bengal to pressure India and help the Pakistani army to save them from defeat. He even encouraged China to invade India to avoid dismembering Pakistan with no success. During the meeting with Mao Zedong, Nixon spoke, “This was the week that changed the world. We will do in the years ahead to build a bridge across 16,000 miles and 22 years of hostilities that have divided us. And what we have said today is that we shall build that bridge.” This “friendship” of sorts literally opened up the floodgate of cheap labor as American corporations went overseas to increase their profit. This has been the main cause of the transfer of manufacturing jobs for the last 35 years. Nixon resigned in 1974 before he was impeached by the congress.

So how does the future look on Wall Street? A UBS technician, Peter Lee, sees a correction of about 10 to 15 percent in the coming summer months, then a rise of about 40 percent going into 2012. Then he believes the market should test the March 2009 low of DJI of 7000 before 2012 ends. There are two views on interest rates that may influence the stock market. Goldman Sachs projects the interest rate of a 10-year treasury to remain around 3.75 % going into 2011, while Morgan Stanley projects the interest rate of the same to be around 5.5 %. None of the outcomes seem to be very bullish in the view of the writer. Now that Goldman Sachs has been indicted by SEC, the knowledge of market manipulation has entered into the mainstream, which may foreshadow dark times ahead. Europe is already experiencing dark days and may be even dark times, thanks to the volcanic irruption and Greek debt problem.

(Mr. Doshi, a writer, trader, and a philanthropist, posts his articles at http://www.nalandainternational.org)

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