It all hangs together

Peter Bernstein -- whom I esteem highly, by the way -- had a column in the Times business section this last Sunday in which he noodles on the way various forces have aligned to mess with the US consumer: food, gas, housing. He sees coincidence at work: "At least the moves in oil and food share a common explanation, but what in the world to they have to do with the end of the boom in housing?"

Hmmm. Let me think. Would the answer be "China" (and other emerging economies), by any chance? Lets see, the world gets richer, needs more food and gas. Land is taken out of food production to grow a proxy for gas. Lets go back a step. How was the world getting richer? China and others were making stuff, selling it to us through WalMart and other big boxes. We stopped making stuff. Emerging markets developed large surpluses but lacked investment acumen, and so bought T-bills, holding interest rates, including mortgage rates down, pumping up house prices. That's all pretty linear.

A side step. After the dotcom bust recession of 2001, investors got risk averse and started hunting for yield in places like mortgage-backed securities. But inflows from emerging market treasuries held yield down. How to get it? Go for more risk. Securitize any cashflow that walks.

In 2003, Fannie and Freddy got slapped in accounting scandals and were forced to put more capital aside to account for bad loans. From 2004 forward, therefore, their hands were tied and investment banks stepped in and began to fund more of the secondary mortgage market. Giddy on cheap money and full of all the hubris that quantitative finance can provide, they created "sophisticated" new products...

But back to my main point: movements in oil, food, and housing are connected, and they are connected via the emergence of a changed world economy, which we haven't quite figured out. The United States new economy started making fewer things and more ideas. This worked as long as the ideas were good. The recent generation of financial innovation has not proven to be that. We can't really go back to making things. But then again, we have a reasonable shot at figuring this whole world economy thing out, if we can survive that long.