Sep 27 2007
Middle of Road Bernanke Hit by Two-Way Traffic
“Some economists argued that inflation may have helped Germany by stimulating the building of capital plant and the rationalization of industry. But much of this investment proved to have no value except in the dream world of inflation. Most of the inflation combinations fell apart after stabilization. On the whole, much energy and wealth was wasted in unproductive channels–speculation, paperwork and unprofitable equipment. The working capital of industry was largely dissipated, making that much harder the eventual process of economic rebuilding and rationalization.”– The Nightmare of German Inflation
As you read, the Fed and the world’s banking systems are working overtime in an attempt to support asset values that were ginned up with what amounts to nothing more than Ponzi finance. Thanks to great flood of liquidity earlier this decade, fractional reserve fuel stores were filled and used to bid up asset prices — such as housing and equities. As those asset prices went up, those assets were pledged as collateral against other assets, whose price went up. Assets whose prices were bid up further in the cycle were then repackaged as derivative asset backed debt, which when assigned with overzealous investment -grade ratings as high as AAA, were presumed to be synonymous with liquidity (e.g. redeemable upon demand as cash), and pledged further and further against other assets and debts.
As such, the recent lock up in credit appears far more clear for what it is: There is not sufficient real cash to back up the over-inflated Ponzi values being held on the books. Worse yet, this is not credit crisis. At its core is a massive insolvency issue — the great misallocation, induced by inflation, has been exposed as unsustainable on its own, and its begging to be cleared… But will the inflationists in the banking system and at the Fed and in Washington D.C. allow it? Don’t bank on it!
Still, there is currently a minor divide among the sober Credit Bubble critic crowd. There are a few prominent observers pointing out that the Fed’s recent .50% Fed Funds rate cut has been offset by the Fed selling securities back into the system. That means that, although the Fed is creating liquidity through one window of the Central Bank, through another it is collecting dollars by selling off Fed held assets. In other words, that amounts to a neutral policy and not the flood of liquidity so many pundits and bloggers have been writing about over the last few weeks.
True enough, that is what the Fed has been doing. But it needs to be held in context of bleeding price inflation and the Fed’s oft stated fear of letting inflation get out of hand.
No doubt the Fed was talking hard-nosed about not catering to flood the system with liquidity, which is why the .50% drop in rates took so many off guard. But the Fed clearly is worrying about inflationary pressures and the fine line being walked relative to the dollar and, more importantly, the willingness of foreign lenders to provide a well below average interest rate environment to U.S. consumers and governments. (A flat out subsidy to maintain the current flow of trade.) Hence, what we’re sniffing here is an attempt by the Fed to do a little “head fake” with hopes that the markets will believe that liquidity is as ready as a .50% decline implies — thus hoping that restored confidence provides sufficient lubrication to the markets to delay a real liquidity injection. After all, the much of the gridlock in markets has been a fear of falling asset prices, and hence an unwillingness of lenders to throw money into the credit market void at rates sufficient to keep prices where they had been.
However, this can only work temporarily. That’s because what is at the root of the problem is not simply a credit lock up. Rather, this is a massive insolvency issue. Let’s face it. Hundreds of billion of dollars were sunk into projects and assets that were only plausible in the fiction — the Dream World from the quote above — that goes hand in hand with large inflations.
Our bets are that the Fed knows that this is an emerging problem as much as anyone. One need only read Mishkin’s comments made in Jackson Hole a few weeks back to get a touch of what Bernanke — his good friend from days at Columbia — might be thinking. Mishkin is pretty clear in an assessment that housing is truly in for a rough ride and could very easily send the economy into a recessionary abyss not seen since the Great Depression. We find it no coincidence that Gary Schiller was invited to speak about his views on U.S. housing –which he suggested could vent off anywhere from 25% - 50% of its value.
Meanwhile, we cannot forget whose hundreds of $ billions were assumed to be worth 100 cents on the dollar, and are now being exposed to be worth far less — if not worthless amid the locked market. The biggest players among the big presumed many of their AAA rated securities now in trouble were synonymous with liquidity and interchangeable with cash. Their use of leverage assumed as much, and now there’s a clear shortfall of real cash to back up those values. That’s a large part of what’s being exposed. While some contemplate that a credit meltdown could lead to deflationary pressures vs. the dollar because the largest players would never want to see the money they’ve loaned to consumers paid back with cheaper inflation dollars, don’t forget that these same players leveraged themselves up on asset values dependent on expanding inflation. Once that inflation ran out of fresh gas… Poof! Credit lock up. It would seem logical to us that these same players — the ones always benefiting from every bailout — will have something to say about how the Fed solves this problem.
Regardless, when contemplating what might happen, it is important to consider the difficulty that the Fed is in. Bernanke is in the middle of a super highway, with a recession caused as malinvested $ billions drop in value causing many to lose jobs and wealth speeding one direction, and inflationary pressures — a dropping dollar, rising prices, and the end of foreign bank subsidized low interest rates speeding in the other.
Unfortunately for Bernanke, there’s no easy way to get from one side to the other. In fact, we’d say he’s going to get hit going one way or the other — and that’s something that can and ought to be planned around as a vigilant investor. Don’t be a Fall Guy!
