4 Reasons to Worry About the Economy

Four big stories topped this week's economic news: Fannie and Freddie, oil finally dropping, high inflation, and banking turbulence. None of them are too comforting to discuss, especially when so many people's well-being relies on them.

I'm reminded of a quote from Berkshire Hathaway (NYSE: BRK-B  ) co-chairman Charlie Munger, from a speech he gave while discussing what he calls his multidisciplinary approach. When you drill down to the basics of subjects, Munger said, you "realize everything is so damn interconnected."

Fair enough. Let's see how this week's four major economic news events are all interconnected.

Fannie and Freddie might become your business
I hate to drown in hypotheticals, but let's go out on a limb and assume that government-chartered mortgage behemoths Freddie Mac (NYSE: FRE  ) and Fannie Mae (NYSE: FNM  ) need some sort of bailout involving widespread government intervention. If -- and again, I said if -- the government had to take control of these organizations, the $5 trillion in mortgages they own and guarantee would presumably be transferred onto the books of the U.S. of A. That's an awful lot of potential liability -- more than $15,000 for every citizen -- and if a lot of that paper turns out to be bad, it could cause the budget deficit to balloon, putting substantial downward pressure on an already beaten-down U.S. dollar.

More oil, please
In case you haven't noticed over the past several years, let's remember what happens when the value of the dollar plummets. First, it makes you feel like a peasant when traveling abroad. Second, it increases the price of worldwide commodities priced in dollars -- particularly oil. 

On its website ExxonMobil (NYSE: XOM  ) states, "From January 2002 to March 2008, the price of Brent crude increased in nominal dollar terms by about 430%, compared to about 200% in euros." Behind the argument over who's to blame for oil prices -- Big Oil, speculators, consumers, whomever you choose to blame -- lies an inconvenient fact: The value of the dollar has a huge impact on the price of oil, and the dollar is worth a lot less than it was in the past. Give it a good catalyst to fall even more, and, well, I'll let you ponder the consequences.

The inflation nation
Moreover, oil isn't the only burgeoning nightmare. Wednesday brought news that inflation at the retail level grew at the fastest pace in 26 years, with food prices joining energy as major contributors to the rise. Meanwhile, wholesale prices surged 9.2% in the past year -- 1.8% in the last month alone. I don't need to remind you that inflation is threatening the economy in ways we haven't seen in years, if not decades.

No worries there, though. As anyone who believes what they learned in Econ 101 will tell you, there's an easy tool to zap the chains of inflation: Just raise interest rates. As rates rise, lending becomes more expensive, which puts the brakes on consumers and businesses who had access to as much cheap money as they could get their hands on.

Phew! So that whole inflation thing isn't a big deal. Just raise rates and the economy returns to bliss … right?

Don't bank on it
The other big news of the week involves the ongoing turmoil in the banking sector. IndyMac went belly-up last weekend. WashingtonMutual (NYSE: WM  ) and Bank of America (NYSE: BAC  ) saw enough volatility to give an astronaut vertigo. Meanwhile, the Federal Reserve reported that its emergency bank lending window, which gives investment banks like Goldman Sachs (NYSE: GS  ) and Morgan Stanley the ability to draw funds at 2.25%, has regained popularity.

Despite some good news from Wells Fargo this week, many banks are already struggling to tread water as it is. With banks' profits reliant on the difference between the low short-term rates they pay for capital and the higher long-term rates they earn on loans, jacking up interest rates could well be the last straw that sends some struggling banks into a black hole, some mediocre banks into bankruptcy, and even some strong banks into disorder.

Connect the dots
There are four problems hanging over the economy like the sword of Damocles. Each might seem detached from the others, but when it comes down to it, they're all connected in one way or another. To solve any of them for good, we'll eventually have to solve them all.

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Fool contributor Morgan Housel owns shares in Berkshire Hathaway. Bank of America is a Motley Fool Income Investor recommendation. Berkshire is a Motley Fool Inside Value selection and a Stock Advisor pick. The Fool owns shares of Berkshire, and has a disclosure policy. Try any of our Foolish newsletters today, free for 30 days.


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  • Report this Comment On July 18, 2008, at 9:55 PM, JPMillerHOU wrote:

    The incidents you mention are more tightly coupled than you suggest in the article. Richard Salsman in his book "Breaking the Banks:" makes a good case that the Fed's too-big-to-fail policies, low reserve requirements, bans on stock ownership and outlawed forms of diversification and finally deposit insurance all encourage banks to take on much too risky investments. Then from multiple sources has come the information that lenders were strongly encouraged by the government to lend to unqualified home buyers under threat of lawsuits for "redlining." Further the loan guarantees for mortgages by the FHA and VA made these loans appear low risk to Freddie Mac and Fannie Mae and to the likes of Bear Stearns. Further yet the treasury through the Fed is the only entity that can increase the money supply (inflation) that usually leads to price increases such as for oil, housing and food. What results is a perfect storm of misallocations in the market not caused by capitalism and free trade but by the inappropriate attempts of government to control the economy. They are tied together all right - by the knots of government intervention.

    I am not so much worried about the economy as the government intervention in it. So who takes over Bear Stearns? Who is likely to take over Freddie and Fannie? Who is going to bail out a lot of unwise homebuyers? Who is going to try to strip the oil companies of profits to "better" invest the money? Why the very scoundrels who caused the problems in the first place.

    I think a bunch of Motley Fools could do much better.

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