From Karl Denninger at http://market-ticker.denninger.net/ Monday, December 3, 2007 The Money/Credit Cycle.... I'm going to "spend" my ticker today talking about something that you're not taught in school, yet is critical to understanding where we are - and where we're headed in the markets. That is the money and credit cycle. Let us think for a moment about what money really is. Gold is often called "real money", with the implication that other things used as money aren't "real". Yet money, in the simplest (and most correct) definition is simply "a medium of exchange." Through the years feathers, bones, foodstuffs and jewels have been used as money. But - how is money created? Clearly, money must be controlled somehow, right? Otherwise you could walk over to your closest copier and run some off for yourself..... as much as you'd like. That would anger people, don't you think? The first thing to get your mind around is that money, credit and debt are all interchangeable. In the world of economists these are known as "fungible" - that is, interchangeable without limit. Today, when you go to the store and swipe your debit card, you are actually spending credit. Let's say you walk into a restaurant and eat lunch. At the instant you order, you are in debt for $10 - the cost of the lunch. When you pay with your debit card, you settle that debt by moving $10 worth of credit from your account at the bank to the account at the restaurant. So far so good. But - where did the $10 you spent come from? It was created through credit - that is, debt! Let's start with a world where there is no money but some people own land. With land I can grow a crop to feed my family, but I first must acquire some seeds. Joe down the street has seeds, but he does not have land. We would both like to eat. Therefore, I issue a debt to Joe in exchange for some seeds; I create money! I give him a promise to pay him part of my crop if he will give me some seed. He does; what he holds in his hands is, in fact, money. I have created it out of thin air by putting myself in debt. Now what's the problem with that? Well, what happens to Joe if there is a drought? He has given up his seeds, but there is no crop! He loses. That's called risk. Because of this risk, he will charge me "interest". That is, he wants somewhat more than the value of his seeds to cover the chance that I will in fact produce nothing with them. And from this - risk - we sow the seeds of what ultimately causes headaches for the monetary system. Let's say that today you wish to buy a car. You go into a bank and get them to agree to issue you a loan to buy that car. Let's say the loan is for $20,000. You sign a contract promising to pay back the $20,000 plus a rate of interest, which is charged so that the bank is covered for the risk that you won't pay them, and the value of the car at that time might not be as much as you owe. The car is the "security" for the loan - if you fail to pay, they will come and repossess it. You now have $20,000 in your pocket, and you purchase the car. (We'll get back to how the $20,000 came to be in a minute.) If these were the only two transactions in the world, you would soon recognize a serious problem - there is only $20,000 in money in the world, but you owe more than $20,000! The interest you must pay means that you somehow must acquire more money than exists in the world over the life of that loan in order to pay it back. There is only one solution to this problem - the amount of money in the world must increase. So the government will just print some more, right? After all, the can do anything they want. Uh, no. If the government were to do that then the value of all the money currently in existence would go down by the exact amount that they printed. You could pay your debt but the bank would be in serious trouble because the money they got paid back with would not be worth as much as the money they gave you! So where did the money come from? It was created by the bank because some people trusted THEIR wealth to the bank to "hold" it for them - that is, they deposited some funds with the bank, and through the system of fractional reserve banking, the bank was thus able to "create" a certain amount of credit for each dollar on deposit. If that system was short-circuited by a "raw printing" of money by the government, this would result in everyone "upstream" of you being hosed! This of course is not acceptable to anyone (except you!) - the bank and auto manufacturer, along with the bank's depositors, specifically, would shortly say "no way!" and remove their funds from that system, choosing instead to do something else with it. While many people believe that raw printing of currency is how governments respond to the need for "more money" or "more liquidity", with the exception of dictatorships this simply doesn't happen. Instead, more money is created not through direct inflation, but rather through the pledging of more assets - that is, the creation of more credit/debt! If the government wants to spend more it issues more debt (Treasury Bills/Bonds) which are then sold into the market - with interest attached. Due to fractional reserve banking once those bonds are purchased the funds can then be lent out at a multiple of the money received. But wait a minute........ Isn't there a limit to this? Ah, now there's the rub. THERE IS! See, there are only so many assets available to pledge. While human industry creates more over time - that is, we get better productivity through innovation and technology - there is a natural limit to the pledging of assets. What's worse, the growth of money required to be able to meet interest and principal demand is an ever-increasing function. The "power" of compound rates of return is the damnation of compound interest, and in this case, its working against the system as a whole. When the limit is reached - that is, there are insufficient remaining owners of credit-worthy assets who will (or can!) pledge them in return for more credit (money) being issued to them the system will fail and reset. This is what happened in the 1930s. It should have happened after the Tech Wreck in 2000. But it did not, because when the velocity of money slowed precipitously in the tech wreck and Greenspan followed that velocity down by cutting Fed Funds to 1%, he managed to entice homeowners into pledging their HOUSES as collateral for yet another round of "reflation" in credit! So the "reset" was avoided - for a while. But - you saw what happened. House prices exploded upwards as credit standards were thrown out and anyone who had a pulse qualified for a huge mortgage. The house was thought of as "security", making the loan cheap. Or was it? What did the mortgage companies and banks that made these loans know? Well, what do you think they knew? They sold those loans off into the marketplace, keeping only a little - or none - of the risk for themselves. Why? Continued in Part II
Because they know what likely lies ahead - a monetary system "reset"! This "last phase" marks a desperate reach for one more group of "suckers." It is this phase which precedes the reset as debt merchants realize that they are in fact granting credit (creating money) to people who do not really qualify for it and have a high risk of default. As a consequence they will do everything in their power to collect as much of the "spread" (interest) as they are able, but lay off as much of the risk of the "reset" (default) as they can. "Securitization" can be an element of misleading people into funding debt that will never be repaid because it allows yet another cycle of "credit reflation" while the risk is laid off on those unwitting market participants. While "securitization" has its place in the credit cycle, when regulation is intentionally ducked by the government or worse, lending limits such as the existing "23A" exemptions are used like heroin given to an addict, the depth of the "reset" to come is grossly enhanced and the number of individuals and organizations that take the pain from the default cycle to come is significantly increased. Unfortunately the ever-growing interest payment monster is now running into the hard reality that we're just about out of pledgable assets to put behind more credit. WE ARE NOW FACING A "RESET" IN THE SYSTEM! What happens in a "reset"? 1. The rate of credit creation slows precipitously as the list of assets that can be pledged dwindles down. 2. The interest and principal payments due on existing debt get close to and ultimately exceed the amount of money in the system, as the rate of credit (money) creation slows. 3. Those who detect this while they still have money pay off their debts, (correctly) deducing that a "reset" is about to take place - and that cash (assets) will have value, while debt will be a millstone that will drag you underwater. 4. Those who are unable to pay off their debts will find that a contracting credit (money) supply leaves them with insufficient funds to pay their debts. Debt defaults at a rapidly increasing rate. 5. The creditors (who granted the credit) will repossess the assets pledged for the debt in lieu of payment, while the debtors are financially destroyed. 6. The destruction of outstanding credit via default shrinks the money supply further, and we go back to #1. This continues until equilibrium is reestablished, and the cycle begins anew. Does this sounds kinda like what's going on? It should - because it is. Housing loans are defaulting. This is not "contained" to subprime and cannot be. As these loans default at a rate far beyond what was originally envisioned they contract the total amount of money in the system. This then forces defaults in other classes of debt - credit cards, automobiles, and various sorts of commercial credit as the money in the system is insufficient to service the debt that is owed. This cycle will continue until equilibrium is restored. The depths to which we must go before equilibrium is reached, and exactly when it will initiate, is not possible to know in advance, but that we absolutely are going to undergo this process is known with certainty! Creditors will end up with all the assets that are pledged on debts that default. Debtors will end up broke. This is a natural cycle and cannot be prevented; it is an inherent and necessary function of any financial system which involves return for risk (commonly known as interest), and it is not possible to have a lending system that does not compensate for risk! Whether you're on a gold standard or not is IMMATERIAL, whether there is a Federal Reserve is IMMATERIAL. This is not taught in school, but it damn well should be. WE ARE TALKING ABOUT BASIC MATHEMATICS HERE. Mathematics is the only TRUE science AND IT DOES NOT LIE. How do you deal with this as a PRUDENT individual? Bluntly, you should avoid debt to the maximum extent possible, especially long-term debt, because it is not possible to predict exactly when a "reset" will occur - but that resets WILL happen is a mathematical certainty. For most people, avoiding all debt is simply unreasonable. But when you start to live your life in such a fashion that you are financing your standard of living with long-term obligations you are at severe risk of being bankrupted outright when a "monetary reset" occurs - and odds are, there will be one at some point during each of our lifetimes. Obviously, governments desire to prevent "resets", because they are terribly disruptive to the economy. They destroy those who have chosen to employ leverage in their financial lives, both corporate and personal, almost without exception. They contract GDP severely as the monetary velocity slows precipitously, and cause huge ramps in unemployment. In extreme cases they can lead to civil unrest or even radical changes in the form of government in a nation (e.g. the rise of Adolph Hitler), especially if the government mismanages the reset process or attempts to bail people out through "direct" monetary inflation. By the way, before you believe that the government will simply "print money", should that be attempted (or some resemblance of it - e.g. government issues Ts, The Fed buys them and injects the money) the response in the market will be an instantaneous shutdown of private (and outside-US) buyers of debt, as the demand for yields will go parabolic to a degree that the government will be effectively priced out. Since the government needs debt market access to be able to continue to operate, this idea is a non-starter and the government knows it. The sad reality is that each attempt to prevent a "reset" through meddling in the markets simply makes the ultimate event worse, as the amount of credit that must default to restore equilibrium ratchets higher with each new intervention. We avoided the "Reset" in 2001/2003, but in doing so we insured that an even bigger one would occur. Are we now in the beginning of the next "big" reset after the 1930s? It is not possible to know until we are in the depths of it whether the snowball will gain enough momentum so that it smashes attempts at intervention. Once you can identify with certainty that a "reset" is underway it is too late to position yourself for it. The risks of this event are now higher than they have been at any time in the previous 50 years. To believe that we will avoid this event, you have to figure out where the next set of assets will come from that can be pledged for another cycle of credit relfation. Without that new, unencumbered set of assets, the process of the monetary reset is assured. Oh, in the news of the day Paulson outlined his "plan" to try to avert foreclosures. Two things: 1. It won't work. Basically everyone who is in trouble is in trouble because they were sold loans that the originators knew they couldn't afford. There is no fix for this; they are due to get a personal "reset." This scheme of giving money to anyone who has a pulse is how the credit expansion was played for "one more round" after 2000; that can't be fixed. 2. Trying to finance this with tax-free munis is a non-starter. Among other things, the coupon required to float those will be obscene, which will kill it right there (you can't loan for less than you pay.) Oh by the way, Paulson knows about the Credit/Money Cycle. He's NOT stupid. You won't hear him talk about it, because if was to do so he would be quickly backed into a corner where he'd be forced to either dissemble or admit that indeed, we are very likely facing that very "reset" that he claims he has a way to avoid. Finally, we would have gotten a new Hindenburg except that the 10W Moving Average, if I'm reading the chart correctly, is falling (and this is one of the requirements); the New High/Low numbers were hideous today. Oh, 4Q estimates from Thompson for the S&P 500? Now estimated at 1.2% - new update today. Estimates were 11% just a few weeks ago. Guess what happens when the street gets its arms around this? Uh, yeah. What's the P/E/G on the S&P 500 with profit growth of 1.2%? Insane, that's where - 10+!?!
On the bright side there could be thousands of YM /ES points to be made on the way down without so much as breaking a sweat. How much will market liquidities and tradeable volatility dry up is a big question for a trader. Edit: this insanity is pretty interesting too http://news.yahoo.com/s/ap/20071203/ap_on_go_ot/nation_in_debt_4 It's about $20/day per family of 5 in the US... I need to net 4 more YM points a day just to break even!
Money is debt. http://www.youtube.com/watch?v=hfXavRTM4Fg&feature=related http://www.youtube.com/watch?v=_yvRZoM-2r8&feature=related
Hrm.... what I am interested to know is : isn't this true for all recessions and depressions? It is just a different degree of money flow.
glancing at the article, it seems a little simplistic - for example, in 2004 roughly 2/3 of the US deficit was bought by Japan with money at 0 interest. Do a search for Bernanke's speech in Japan on interbank cooperation, particularly because it might be happening again. In addition the national debt owed by the government to the Fed (trillions) can be thought of as zero interest because it doesn't have to be repaid. Finally, any currency depreciation can be thought of as debt default, the dollar was eased down by half against Europe and Asia's likely next. So the point is 'resets' happen, are happening and not necessarily through direct monetization of debt as described in the article