Each Day Brings More Evidence of a System-Wide Credit Breakdown

The stock market took another wallop on Friday.

But the bad news came in the jobs report. "Jobs Data Suggest Already in Recession," says a headline in the Wall Street Journal.

Another headline from Bloomberg rounds out the picture: "Gasoline at record $3.20 a gallon."

We will put 2 and 2 together. Falling employment means families have less to spend. Rising prices mean they will need to spend more to stay in the same place. And here, Dear Reader, do you see what has happened? The immoveable force of deflation has run smack into the irresistible force of inflation right in Americans' own backyards. And we will tell you how the smash up will resolve itself: standards of living will fall.

And here comes the New York Times with even more bad news. "Seeing an end to the good times," begins its report. Then, it allows as how the good times weren't really so good after all. The median household earned $49,244 in '99. Now, it earns $48,201. It is a strange boom that doesn't boost family incomes. But heck, we've been saying that it was a freak and an imposter all along.

Inevitably, the feds have to react to the weakening U.S. economy. They can't allow people to realize that their living standards are going down - not in an election year! In theory, they can boost economic activity by lowering the cost of credit. In practice, things often turn out much differently.

We take a step back this morning to admire the intricate natural mechanisms of a market economy. Finely tuned, carefully balanced, exquisite gears, divine workmanship...the finest watchmakers of Geneva can't even come close. But nature's handiwork has more than wheels and levers - it has a quality that man cannot reproduce...nor even understand.

George Soros calls it 'reflexivity.' Mathematicians try to describe it with chaos theory and feedback loops. But what it means is that while prices look random, and professors of economics earned Nobel Prizes for proving that they were random, they really are not. Nor are they fixed...nor do they respond to simple, mechanical manipulation. You may push on Lever A...but you might get either Result B or Result Q...or something entirely unexpected.

As we say here at The Daily Reckoning, and you may quote us: prices are neither fixed, nor random, but subject to influence.

The Fed is desperately pulling on levers. Each day brings more evidence of a system-wide credit breakdown. The Fed intends to stop the meltdown in the only way it can - by pulling on the lever of inflation; that is, by introducing more 'liquidity' into the marketplace.

This might work, if the problem really were merely a lack of available cash and credit. But consider the problem in housing. A man's house goes down in price. He has a mortgage to pay. He notices that the mortgage is greater than the value of the house. In the past, he may have been too embarrassed or too proud to do it, but now he is likely to resort to what is being called 'jingle mail.' That is, he's likely to put the keys in the mailbox...and walk away.

What can the feds do about this? The problem is not liquidity. You could offer to lend the man more money on his house, but that doesn't really help his situation. And to whom would you lend more money, with the value of the collateral falling? As the value of the collateral falls, so do the value of the derivative assets and the institutions that hold them. All up and down the credit capital structure, losses whack into one another like balls on a billiard table. Hedge funds...banks...lenders...borrowers - as one takes a loss, the next one in line takes a hit...which causes the third to lose money too.

It is not a liquidity problem, in other words, but a solvency problem. Too much debt has led to too much lending to too many people who can't pay it back. And this lending was secured by too many assets that aren't worth what investors hoped they'd be worth. The losses are there. They are real. They won't go away - even if you offer more credit.

"Turmoil in the credit derivatives markets is having an increasingly brutal impact on the wider financial system," reports the Financial Times this morning, "as a vicious cycle of forced selling drives risk premiums on company debt to new highs."

Now, here's one of those curve balls that nature's markets like to throw. The Fed decreases rates - but actual borrowing costs go up! Mortgage rates are higher today than they were when the Fed began cutting last September. As asset prices slip...and the financial industry takes losses...lenders are afraid that they might not get repaid; they want higher yields to justify the risks. And since the real cost of borrowing is going up, real business activity is going down. The economy is sinking...along with the value of the collateral.

Meanwhile, the feds do the only thing they can - lower rates and come up with schemes to put more money in circulation. This produces the financial world we have come to know and love, with inflation on the one side (coming from the feds) and deflation on the other (coming from a natural market correction). Our hypothesis continues to be that the feds cannot reflate the real economy. The problem is debt - too much of it. Offering to lend more won't help. On the other hand, the feds' inflation will drive up commodity, gold, oil and consumer prices.

How long this trend will last, we don't know. But it is a dangerous time to buy stocks...or hold treasuries. Stick with gold and cash.

Bill Bonner
The Daily Reckoning Australia

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