One step forward, three steps back. That’s what the trading action looks like in the markets now. For every big one day advance of 1% to 5% or more, you’re going to get a corresponding sell off equal or greater to that.
It’s not normal to see these kinds of one-day moves. But these aren’t normal times. Traders love volatility. But if you’re going to trade this market, your timing had better be exquisite.
We’re back on the edge of a credit abyss. Just when investors were convinced that the Gordon Brownification of the world’s banking sector had put the credit crisis behind us, we have more bad news.
Brown’s plan to recapitalise British banks by directly inject money into them has been widely adopted. But the money (which isn’t the same as capital at all) is not going to be enough to replace the “wealth” being destroyed by debt deflation. It’s sort of the opposite of bailing a flooded ship out. In order to keep asset prices from sinking, the bankers need to pump more money into the global sea of liquidity.
But even that does not keep bad debts from sinking to their intrinsic value. Reuters reports that Standard&Poor’s may cut its credit rating on over US$351.7 billion worth of residential mortgage backed securities that are secured by Alt-A loans. These aren’t subprime loans. They are supposedly loans made to more credit worthy borrowers. But S&P notes that losses on Alt-A loans of five-years or more with fixed interest rates will rise from 35% to 40%.
You can’t make this stuff up. As we pointed out, the core of the capital in the banking system is directly tied to securities whose value is tied to the price of U.S. houses. With U.S. house prices falling, more mortgage owners are underwater. More are in default. More will be foreclosed on. The securities tied to those mortgages will need to be marked down.
Until the connection between U.S. housing values and the banking sector is severed, the credit crisis isn’t going away. Merely flushing more paper money into bank coffers doesn’t improve the bank’s solvency. You can’t fix a solvency problem with more liquidity any more than you can keep a leaky bathtub full by pouring more water into it.
Stocks now face the dual challenge of an extended global recession (bad for corporate earnings) AND the possibility that it may not be so easy to simply ‘recapitalise’ the banking system with funny money.
Don’t forget. The Keynesian economists running the global financial system are engaged in a giant game of poker with the rest of us. They want us to believe in money backed by nothing but confidence. And they want you to believe that the government can simply increase spending (of money borrowed into existence) to stimulate business activity. If banks and consumers show their doubt by hoarding cash, then the Central Bankers will have to go “all in.”
“All in” is another rate cut or two. But more than that, “All in” is direct government support of stock prices (and house prices, and corporate debt, and frankly anything which needs buying to prop up its value). How soon will Paulson, Bernanke, Trichet, Brown and the rest of this gang go “All in?” It won’t be long now, at this rate.
“Perhaps what we need is to go back to the first Bretton Woods, to go back to discipline,” says ECB head Jean-Claude Trichet. Sound money you say? Hmm. “It’s absolutely clear that financial markets need discipline: macroeconomic discipline, monetary discipline, market discipline.”
“If we don’t discipline ourselves, the world will do it for us,” wrote Wiliam Feather. When you don’t have access to credit, you are forced to live within your means. Expenses must be lower than income. Or else. But it hasn’t been that way for years. Credit has enabled us all to live well above our means. Is that era ending?
Are you witnessing the last stand of the Keynesians? Our friend Gary North wrote earlier this week, “The heart of original Keynesianism was its commitment to government deficits as a way to stimulate consumer demand. Keynes also recommended central bank monetary expansion, but the heart of his economic theory was fiscal imbalance [deficit spending].”
Governments, being inherently political animals, want to promote growth at any cost via inflation. Meanwhile, it is vogue to blame poor regulation and greed. But politicians have to paint the bankers as greedy in order to justify the huge sums of money being transferred from the taxpayer to the banking industry. As Gary writes, “In justifying this immense transfer of taxpayer wealth to the commercial banks, politicians have promised a new era of regulation. They have all blamed American regulators for not regulating the securities market.
“No one is pointing to the main culprit: expansionist Federal Reserve monetary policy under Greenspan, which was matched by central bank policy around the world. Central bankers inflated their national currencies to support the domestic export markets. They did not want the [U.S.] dollar to fall, thereby reducing imports from foreign nations.”
“It was the mercantilism of central bank policy that produced the asset bubbles, especially the largest one: residential real estate. This is the ultimate carry trade: borrowed short (months or weeks) and lent long (30 years). When it popped, it removed consumer demand around the world.”
The borrowed money went to consumers to buy houses. Now those are falling in price. The whole global supply chain is locking up: from finished goods consumed in America, to capital goods manufactured in China, to raw materials inputs in Australia.
Is the Keynesian answer really the way out? No. The Keynesians always confuse money with capital. What we have on our hands is a historic misallocation of capital on residential real estate. Whole economies grew up around the housing industry in many countries. Tremendous leverage was employed to buy securities related to real estate. It’s all crumbling in a great destruction/deflation of value.
You don’t simply prevent that by printing more money. Real capital is land, labour, an asset, or entrepreneurship that’s capable of generating new wealth. The Fed’s low interest rate policy-followed by global central banks everywhere-led investors and consumers and businesses to speculating on higher house prices rather than investing in real economic activity.
You don’t restructure a global capital structure easily. As Roger Garrison writes, reviewing the work of the great Anti-Keynesian Friederich Hayek, “The costs of restructuring capital are easily absorbed during a policy-induced boom when credit is cheap and profit expectations are high. But after the bust, the costs of undoing the misallocations caused by unduly cheap credit take the forms of business losses, bankruptcies, and unemployment.”
Gee. That sounds familiar. We are now finding out that artificially low interest rates badly skew prices and the information they normally communicate. Not only that, but the low rates have led to a disastrous global misallocation of capital in bogus assets. Houses are tulips full of copper.
“If the interest rate is held below its market, or ‘natural,’ rate by credit expansion,” Garrison writes, “the decisions of producers will be inconsistent with the preference of consumers. The economic expansion will be unsustainable. The boom will end in a bust. Only with a market-determined rate of interest can cyclical variations be avoided.”
Markets are telling us the price of money should be much higher, given the huge risks in the global economy. Global regulators are telling us that money is free, and that more of it is all we need to solve the problem. They will keep loaning and printing until the whole world is drowned in a sea of fiat money.
Who do you think is right?
Markets and Money