Government's Panicked Response to This Economic Crisis

We now know a little more about the global financial crisis from the terrible experience of 2008, and can trace its causes back to cheap credit after the dot-com crash of 2000 and a huge volume of bad lending in the US housing sector which spread like a cancer around the world by the securitization of mortgages.

Hedge funds have represented the apogee of leverage upon leverage, and a deleveraging world is the antithesis of an economic boom, an economic depression or super-severe recession if you prefer.

Governments have been slow to respond, and should have taken action to restrict credit growth years ago when house prices first soared to wild income multiples.

Panic measures

And what we have seen is a series of panic initiatives to stop a deflationary debt implosion by shoring up banks with massive injections of public money, as well as other ad hoc measures to prevent business collapses and stimulate consumer spending.

But the crisis response is too late to stop the impending economic slump, and it is obvious to even the most casual observer that creating more credit is no solution to a problem caused by too much credit in the system. It is a panic measure to head off the very worst of the slump but nothing more.

Indeed, the aftermath of the cure is likely to be almost as bad as the slump it is trying to prevent. The analogy of a person pulling a brick on a piece of elastic is sometimes used to explain how economic stimulus works: you pull and pull and nothing happens, and then suddenly the brick flies up and hits you in the face.

It will be the same with stimulus and bank bailout packages. At first the public and the banks will hoard each wad of cash that comes in their direction, refusing to spend or commit to new investments.

Inflation returns

Then the economic cycle will begin to correct, and all that money will be released into the economy in a sudden burst, creating a sudden inflation. Central banks would have you believe that they can fine-tune their policy to eliminate inflation but experience suggests they will be no more successful than they were in preventing the kind of asset price meltdown we saw in 2008.

Actually inflation is probably what central banks would like to create as a means of rebalancing the global economy, most particularly by reducing the burden of debt now imperiling economic stability. The hard part is that once the inflation genie is out of the box it is tough to get it back in again.

That was the experience of the 1970s, and it could be many years before central banks feel confident that interest rates can be used aggressively to squeeze inflation out of the system.

Lost decade

In the meantime, investors will face another lost decade: Stocks will suffer from the impact of inflation on company profits as prices tend not to rise fast enough to fully offset rising costs; bonds will crash because inflation will wipe out their miserable yields and turn them negative in real terms; house prices may recover a little but higher interest rates will persist and discourage buyers.

The only winning asset classes in this environment are going to be cash, and by far and away the best performer will be precious metals.

Comments

[RSAAKS:]

I agree with most of what you say, except for the last sentence "only winning asset classes in this environment are going to be cash,". How can cash outperform anything in high inflation period. When inflation is high, only materials and hard assets can protect you-and cash turns into trash quite fast!!

Jan 07 08:57 AM

[andy93109:]

Can someone explain the transition from deflation to hyperinflation? Somehow it seems you snap from one to the other via stimulus and low interest rates.

Jan 07 09:59 AM

[Steve in Gr...:]

User 55065 says: "I agree with most of what you say, except for the last sentence "only winning asset classes in this environment are going to be cash,". How can cash outperform anything in a high inflation period?..."

I think what Mr. Cooper is saying is that now (and for the short run) we are in an initial deflationary period and during this initial phase "cash is king". To use his analogy, we are just stretching the elastic band in the short run.

When the economy begins to recover, we will begin to see inflation again (the brick will start to rise) and then we need to shift away from cash to hard assets and selected equities.

Jan 07 10:01 AM

[DougM:]

As long as you keep your cash in relatively short vehicles, you can redeploy it at higher interest rates when inflation returns. Then, assuming the government tries to get inflation back under control, you can ride down the backside with bonds paying sky-high rates. Indeed, we are arguably at the top of exactly such a bond bubble that began in the early 80s. Holders of long-dated bonds have made a killing because they locked in high interest rates while inflation fears were still fresh in people's minds.

Jan 07 10:28 AM

[Glen L.:]

Mr. Cooper seems to be well-versed in Austrian economics, or at least has drawn the same conclusions about the causes and eventual effects of this mess. I'm seeing more and more Austrian-type comment on the blogs. Hurray!

Jan 07 01:21 PM

[axelrod608:]

Cash is a winner because it is instantly liquid. It allows one to be nimble and move quickly. In a whipsaw market one needs that to take advantage of opportunities.

Jan 07 01:33 PM

[Carl Spackler:]

I am shocked by how many people think that this entire economy will instantly go from deflation to inflation in a matter of months. Everyone usually pulls out the old line that they will just start the printing presses and presto - we have inflation. Japan tried for over 10 years to defeat delation. They used all the same tricks with near zero interest rates and quanitative easing tricks, yet they were still firmly in the deflation camp 10 years later. Economies are like big battleships - they turn very very slowly. The delation momentum is very strong and it could take years to break it. Same was true of the 70's and inflation - how long did that take to defeat? Answer is nearly 13 years. Wake up America - this problem does not have some 6 month solution!

Jan 07 02:27 PM

[Did U Think...:]

"Economies are like big battleships - they turn very very slowly. "

Generally true, but the battleship has turned from going north at full speed in November 2007 to going south at full speed by Dec 2008. Since we are talking about the global economy here, that is one fast moving battleship if you ask me.

Jan 07 02:47 PM

[RSAAKS:]

It is obvious from response to my comments that a number of you folks believe we are stuck in deflation. For last 6 months or a year, yes perhaps we have been, but from a somewhat longer term-say over last 5 years, I doubt anyone can make the deflation case-and the same, in my view will be true for next 5 years-not deflation-I think we will see REAL inflation in most assets. It is possible that one or another commodity may not bounce as much, or gold may even drop, but the prices paid by real people for virtually everything will be, and have been HIGHER. Wages may not keep up with that inflation, and even production and demand may go down somewhat, but not the prices. And yes, cash may be king for a few more months, but I doubt that cash will buy more food or more energy or more healthcare or any thing people need. I will believe in the deflation momemtum when gasoline regularly begins selling for 99c, and my utility company send me a letter saying that my new rates will be cut 20% effective....

Jan 07 02:51 PM

[Jason Rines...:]

Haha. Funny point on utilities. I audit by bills carefully each month and spend five hours on phone correcting them. For example my sewer bill literally doubled in one month and I have one less person in the house. Still working with the city to determine how that one happened. But we know what happened. The city and other utilities squeezing paying customers for the drop in revenue from those whom can't. The little guy has really gotten a raw deal this decade. And no, I don't feel bad for $50k family income earners that went on a credit binge. Shame I am forced to pay for them also.


On Jan 07 02:51 PM User 55065 wrote:

> It is obvious from response to my comments that a number of you folks
> believe we are stuck in deflation. For last 6 months or a year, yes
> perhaps we have been, but from a somewhat longer term-say over last
> 5 years, I doubt anyone can make the deflation case-and the same,
> in my view will be true for next 5 years-not deflation-I think we
> will see REAL inflation in most assets. It is possible that one or
> another commodity may not bounce as much, or gold may even drop,
> but the prices paid by real people for virtually everything will
> be, and have been HIGHER. Wages may not keep up with that inflation,
> and even production and demand may go down somewhat, but not the
> prices. And yes, cash may be king for a few more months, but I doubt
> that cash will buy more food or more energy or more healthcare or
> any thing people need. I will believe in the deflation momemtum when
> gasoline regularly begins selling for 99c, and my utility company
> send me a letter saying that my new rates will be cut 20% effective....

Jan 07 03:16 PM

[Carl Spackler:]

The economy began slowing down mid 2007 - not exactly a lightning quick move. It seems sudden because the stock market reacted so suddenly to it. As for gas, $1 a gallon may become a reality at this pace.

I see that no one wanted to give a counterpoint on how Japan fought this problem for 10 years and was unable to turn the battleship. I do not think anyone can argue that the deflationary winds are not present right now. Without a doubt, your dollar is buying more each day. My only point is that everyone is too quick to assume that the Fed can re-inflate everything quickly. It is not a given, and if the market realizes this it will fall quickly.

Jan 07 05:09 PM

[Marc Courtenay:]

That is a valid point. Cash is king during deflationary times.


On Jan 07 08:57 AM User 55065 wrote:

> I agree with most of what you say, except for the last sentence "only
> winning asset classes in this environment are going to be cash,".
> How can cash outperform anything in high inflation period. When inflation
> is high, only materials and hard assets can protect you-and cash
> turns into trash quite fast!!

Jan 07 05:11 PM

[prudentinve...:]

In summarizing the effects of inflation, you say "Stocks will suffer from the impact of inflation on company profits as prices tend not to rise fast enough to fully offset rising costs; bonds will crash because inflation will wipe out their miserable yields and turn them negative in real terms"

I agree, but you forgot one other significant factor with inflation, that is prices will likely rise ahead of wages, especially so when unemployment is high, and where employees are expensive in a global economy (i.e. US, Europe, Japan). This can, unfortunately, create social unrest.

Jan 07 09:10 PM

[Gem Hudson:]

Handing out more stimulus is not only deficit spending. It is also dying more of a deficit death.

Jan 08 10:10 AM