The Credit Crunch Is the Solution, Not the Problem

Since roughly October 2007, the world’s financial institutions have trembled, credit markets have seized, and as the government bailouts arrive, a consensus view has developed that the root cause of our recent misery is the greed of over-levered, under-regulated financial institutions, helpless in the face of overwhelming losses caused by indefensible gambles on sub-prime mortgage loans for over-valued residential housing.

While reasonable conversations can take place regarding the root cause of mortgage lending standards (e.g. the Community Reinvestment Act in the Carter era), the simple truth is that the true nature of the economic crisis has been obfuscated. Most Americans believe they are in for a severe recession caused by the unwise decisions of bankers. They may not understand they are coming out of a severe recession facilitated by the very government now coming to the rescue.

Theme I: We’ve experienced a much more severe inflation shock than reported.

Let’s keep it simple. When we greatly expand the number of dollars that exist, each of them will be worth less (i.e. prices will rise). The facts are clear:

- Most official measures of the U.S. Dollar money supply show a recent record of minor, very stable growth – all the hallmarks of a concerned steward of stable prices. In fact, in March 2006 the US government stopped reporting “M3” a critical component of the money supply which helps indicate how much money supply growth is attributed to commercial bank lending via institutional deposits, money funds, and Euro dollars, etc. While official monthly money supply measures (M2) show the supply of US Dollars growing in a 4-6% range since 2003/04, private individuals who have continued estimating M3 growth show that the world’s commercial banks have increased the growth rate of dollars by up to 16%.

- That’s OK, you say. The government carefully measures inflation, ensuring that swift and prudent action is taken the minute money supply growth impacts the stability of the prices for this we must buy as part of our daily lives. Now I ask, does that sound like the U.S. federal government to you? The government does continue to measure price inflation, but they have made two significant changes since our last inflation shock in 1980 when Paul Volker killed inflation by raising interest rates. Back then, the rampant, unacceptable inflation rate touched 15% . Of course, this time in the worst of it (2008) we only touched 5 ½ %... except that we changed how we measure it. If you still measured inflation the way we did in 1990, before the Clinton-era changes, we experienced 9% inflation in 2008. If we measure it the way we did in 1980, we touched 13% - almost to the Volker era highs. You weren’t crazy. Did you get a 13% annual pay raise?

- And the markets weren’t fooled for a minute. Gold (priced in dollars) rose 235% from 2005 through 2008. Oil by 247%. Now, U.S. GDP only rose 11% from 2005-2007, Adjust for the ‘new’ inflation numbers and you find the line you hear in the media. “We’re not quite in a recession yet”. Adjust GDP for something approximating the way we measured inflation in recent history and you see that we’ve been in a rather severe recession for some time now. Ask yourself – hasn’t it felt that way?

- And, as it always does, capital flowed to more hospitable places. It doesn’t matter if you looked at U.S. investment in anything overseas (especially emerging markets), anything not priced in dollars, or if you just flat out look at the currency. The US dollar dropped in value (against a basket of other currencies) by more that 40% from its peak in 2002 to trough in 2007.

Theme II: This time we didn’t need to raise interest rates

In 1980, the Volker fed needed to raise interest rates to extremely high rates to break the back of inflation. I’m sure we can all agree we’d prefer not to incur borrowing costs in excess of 15% - so why do we get to avoid that pain?

In this case, the cause of the problem (the rampant creation of too many dollars by the commercial banking system) seems to have been corrected by the market itself. After peaks in 2008:

- The U.S. Dollar has risen 14% in 2008 from its lows.
- Gold has declined 21% from its highs
- Oil has declined 34% from its highs
- Credit creation by commercial banks has declined from 18% to 2%.

In other words, the current “credit crisis” is in fact the source (commercial banks) of the problem (inflation caused by M3 supply growth) correcting itself (reversing through the refusal to extend credit) through market forces (which question the real value of the collateral e.g. houses) for the loans.

Theme III: The Return of America

So how do we interpret the current state of our economy? The majority of media outlets repeat the standard line that the lack of available credit will negatively impact the earnings potential of U.S. equities. They claim that the best expectations for growth continue to lie in emerging markets - and that we are still in for a ‘deep’ recession, not coming out of one.

Phoey! The run up in energy and commodity prices was largely due to these commodities being priced in the free-falling dollar (doubt me? check a chart of oil priced in Euros or gold compared to dollars) . The strengthening in the dollar caused by the fact that commercial financial institutions no longer have the capital to debase the currency represents a massive tax cut for productive US industry. US industry, whose consumers have already seen the worst of a very deep economic recession.

- In terms of momentum there is no better currency in the world.
- There is a flight to the quality of the US, both in terms of currency and equity of commercial and real assets that will be levered for foreign investors by the continuing strength of the dollar.
- For the undervalued US Equities, expect a new era of “going private” and/or the ‘new conglomerates’ as balance sheet cash and real dollar profits are put to work buying over-levered or foreign assets.

As markets adjust from the paradigm of a weak dollar we are:

- Long Volatility (VIX)
- Long US Dollar (USDX)
- Long US Equities (SPY)

- Short World Equities Ex-US (especially the Euro zone) (VGTSX)
- Short Commodities priced in dollars (DBC)
- Short the US Government, not a having truly independent measurement of monetary statistics.

Comments

[Moon Kil Woong:]

Righto. The US will only get better once it curbs it's profligate spending and expansion of money supply. How do we know the end of the market declines, when the US gives up printing $ to get out of this and when people are encouraged to save rather than tell them all everything is fine and to keep borrowing even more money.

So far... we are far from "capitulation" which actually means facing the facts that we are much worse off than 10 years ago (maybe even 20 years ago) and adjust to it.

2008 Oct 20 05:58 AM

[Al-USA:]

If the author's figures are correct, at 13% inflation using 1980 metrics, hell yeah the average working stiff is far behind where his parents were. No wonder the massive increase in credit cards, home refinancings, etc, just to keep up.

This is an outrage... Vote every clown out of office this Nov 4, 2008 who voted for the $700 billion bailout.

2008 Oct 20 08:09 AM

[tomatden:]

Your analysis of the problem and the current, natural market forces at work make perfect sense, but your investment recommendations do not. Governments throughout the world are doing just about EVERYTHING they can to reverse the natural and much needed credit contraction. Most people represented by these governments agree that it must be done, so I'm betting they will succeed. I will take the other side of your long dollar, short commodity trades.

2008 Oct 20 09:41 AM

[Chelsea:]

The fundamental problem is that most Americans consider it their right to consumer glutony as constitutional. This has lead to the collapse of financial markets as American institutions "Once again" find new ways to undermine the world market and take everyone on this ride. When will they learn that the basics of fiscal responsibility have never changed. What gave them the right to play with economic principles to the demise of the rest of the world. Greed...............

2008 Oct 20 11:15 AM

[JasonC:]

I have looked at oil priced in Euros, and it was another typical bubble of tulip bulb proportions, completely unexplained by objective changes in either its own market or the value of dollars.

So were all the other commodity bubbles currently going splat all over the world.

The markets bet on a hyperinflation that never occurred.

The reason why it didn't occur is the Fed refused to play.

From the spring of 2005 to the spring of 2008, the Fed did not let M1 grow at all. That is the measure the Fed directly controls, because banks are legally required to have reserves only against their checkable deposits. CDs and savings accounts require *no* reserves at the Fed, and banks can extend or contract their issuance purely as savers are willing to accomodate them.

After the Fed took away the punch bowl, refusing to let M1 move, and raising rates, the banks continued to increase broad money to the tune of $2 trillion, and speculators betting on hyperinflation and against the dollar blew all their bubbles skyward with trend following abandon.

But it never had the slightest basis in reality. If M1 doesn't move, that new money cannot be spent. As soon as someone tries to move savings, net, to spendable forms and spend it, the banks need new reserves and must call in loans. In reality, though, very little movement or even pressure in that direct occurred.

All of the "inflation" was in asset markets, not in spending. No one was repudiating the currency, trying to reduce savings balances, trying to get rid of dollars as fast as they could, or any of the other signs of a fall in the objective exchange value of money. *Speculators* were *betting* that people would, but they flat didn't.

There being no extension of M1 to accomodate the assorted ballooning bubbles, none of the outsized price increases stuck. Real estate prices didn't stick, oil prices didn't stick, ags didn't stick, none of it stuck.

The banks' extension of $2 trillion in extra credit on the same, unmoving M1 base merely resulted in $1.4 trillion in loan losses practically immediately - and counting.

The Fed played it correctly. Arguably it was a year late and a bit slow in the rises around 2004, worst that can be said. But the banks, instead of retrenching as soon as the Fed signalled they ought to do so, with plenty of warning, instead binged and doubled up and bet on mega inflation and bubbles.

And they were comprehensively wrong. All the end of the world traders were wrong. All the commodity bulls were wrong. All of them were pretending that dollars and dollar denominate debts aren't worth anything, only "real" things are, that at *any* nominal price, anything real is worth more than dollar debts used to carry it.

And that was nonsense, all along. The debts were worth more than the bubbles blown on them. Everyone long the real and short the debts at the bubble tops has blown out. All the real assets belong to the lenders. Dollars are real, not fake. The Fed is responsible, not irresponsible.

And it was all nothing but guff and slander, from begining to end.

2008 Oct 20 12:11 PM

[robert.b.fe...:]

Good observation Jasonc. However there is still $12T in uncollateralized bad debt on the global market which is roughly four times the GDP of the global economy. This bad paper will have to be dealt with as well.

2008 Oct 20 04:44 PM

[robert.b.fe...:]

My bad that is $600T in bad paper!

2008 Oct 20 04:47 PM

[JasonC:]

Nonsense, the IMF has done the triage and the bad debts will amount to $2 trillion tops. A third of that has already been "eaten", another sixth was raised as private capital before the authorities intervened, and their intervention easily covers the rest. Also, the world economy is over $50 trillion a year, not $3 trillion. The total hit to the US came to only about 2% of household net worth from the bad debts alone. The bigger hit has been to stock prices and to present values by raising the rates on everything, due to higher perceived risk.

There is no way the scale of bad debts we have see sink anything but a few individual institutions. The silliness being peddled by the end of the world traders is just utter nonsense, they don't seem to have any idea what asset there are, who owns them, or any of it. All they can do instead of breathlessly repeat some notional value of unnetted derivatives - you know, the stuff that is supposed to kill us all tomorrow with the Lehman CDS's settle. Anybody think they are going to kill us tomorrow? Want a bridge?

2008 Oct 20 05:58 PM

[L2wireless_...:]

How is the debt consolidation industry affected by our current state of affairs, and the foreseeable future of our economy? Thinking back I remember noticing a correlation between the rise of debt consolidation companies, and mortgages becoming much easier for higher risk borrowers to get. Thus creating an illusion of obtaining things out of our financial reach much easier to obtain. I wonder how debt consolidation companies will withstand our spiraling black hole of an economy which relies so heavily upon credit; and/or, if these "debt consolidation" firms were in cahoots with the scheming credit industry? (which decieved our nation by easing any fears the American people had about digging themselves into debt, encouraging them to dig deeper and deeper.) Or will these companies flourish by the simple fact of the increased debt and panic throughout the American economy?

-Chris A.
check out my website: L2wireless.com -Private and Commercial.
800.581.5001 ext. 211

2008 Oct 21 12:07 AM

[HealthInsur...:]

Many thousands of people have been made redundant. Even those who are still in employment have had their income cut. Some employers have asked their workers to take a pay cut, as it is the only way to survive until the economic climate improves.

Other workers are working five days per week, but are only being paid for four.

The more fortunate among us who are being paid fully for a working week may not now be doing the overtime they did in the past, and which was needed to maintain their standard of living and pay all their outstanding credit monthly. Those debt consolidation services also can help you reduce your debt and act as your agent to help negotiate terms to settle your debt for what you owe. If you are very behind on your payments, or have credit lines that are in default and have tons of fees in addition to your original debt, these consolidation services can negotiate to settle your debt for pennies on the dollar. In many cases that can halve or even reduce your debt by up to a third of what you owe!

Aug 15 03:40 AM