Supplying never-ending drugs till stagflation

November 23rd, 2007

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Recently, fear and panic about the credit-crunch is resurfacing again. When the US Federal Reserve started cutting interest rates a few months ago, the market suddenly found a new wave of optimism, believing that the worst is over. Consequently, stocks bounced back. But today, the market is realising that the credit crunch is worse than initially thought.

That wave of optimism was based on nothing but a hope (or wishful thinking). In reality, in this world of globalised maze of inter-connected finance, nobody truly understands how it all works (see Financial system?messy, tangled ball of yarn) or where the risks truly are. Therefore, any declaration of victory (in the belief that the worst is over) is premature and foolhardy. As we said before at the end of August (see Is the worst over yet?), the worst is not over. In fact, it was just the beginning. There are still serious questions on to the solvency of some of the major US financial institutions (see How solvent are some of the major US financial institutions?). There are too many unanswered questions.

Our feeling is that there are many more losses worth billions of dollars (possibly hundred of billions) yet to be confessed. The next question is, can this malaise spread? There is no doubt about this- it will definitely spread. The question is how far and wide.

What can happen, looking forward? We explain…

Traditionally, to gain access to money (which is the lifeblood of businesses), one has to go to the bank. Recall that we said in Collateral Debt Obligation?turning rotten meat into delicious beef steak,

Back in the old days, the nexus between lenders and borrowers was strong. Before the bank lends you money, it has to know your financial health intimately and ensure that you are credit-worthy enough for a loan. You had to dress in a suit to impress the bank managers enough to convince him or her to give you credit. Indeed, in the old days, accumulating bad debt was bad business.

Today, through the financial ?innovation? of securitisation, the link between lenders and borrowers were broken. It has developed to the point whereby the one who is lending you the money is not the one who has to bear the loss or clean up the mess when you default on the loan. As the loan travels down the chain from the lender to the ultimate owner, intermediaries along the way collect fees and charges. Thus, lenders make profits the moment they make a loan. After that, they pass the risk of bad debt down the chain like a hot potato.

That’s where the trouble starts. Securitisation seems to reduce risk for the individual lender. But overall, it does not reduce risks for the financial system. Instead, it spreads the risks further and wider over a larger area. Since securitisation makes it far too easy to borrow and lend money, the global financial system ran amok on an overdrive of debt and credit creation, escalating the overall level of risks to dangerous toxic levels.

Now, the trouble with credit and debt is that it is like a drug. The more you abuse it, the more dependent you are on it for ever decreasing amount of kicks. We believe that much of the global growth is dependent on this drug. What if the supply of this drug is cut off? There are two options:

  1. Go cold turkey and suffer now for the future benefit of being drug free.
  2. Get more drugs, by hook or crook to avoid as much pain as possible.

From what we know, the world would rather choose the second option. As we said before in A painful cleansing or pain avoidance at all cost?,

But will the Fed follow the Austrian recommendation?

We believe it is highly unlikely. Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

Central bankers have the power to open the floodgates of never-ending supply of drugs (i.e. fiat money). Students of the Austrian Schoolof economic thought will understand that indiscriminate ‘printing’ of money (i.e. lowering of interest rates) will worsen the plague of mal-investments and structural damage in the economy. Like drugs, the more you ‘print’ money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively anymore no matter how much money is being ‘printed.’ That is the nightmare of stagflation (low or negative real growth with sky-rocketing price inflation- look at Zimbabwe).

We believe that in the days ahead, you will see increase in volatility in the market as each threat of cold turkey (e.g. recession, collapses, deflation) is being soothe by even more drugs (e.g. injection of liquidity, bail-outs, cutting of interest rates) from the central banks.