Credit Boom ……..Busts

The credit inspired boom of the last 15 years is now over. Markets are in severe dislocation and whilst underlying economies are very sound there is a serious problem in global banking liquidity.

On the good side we have record low unemployment and company profits are in good shape. But the driver of that has been consumption driven by an expanding money supply which has driven up asset prices and created a wave of paper wealth.

Interest rates have been hiked up to halt this boom. It’s too late. The record low rates in the US over the last 5 years created easy money that was too good to refuse. As rates were jacked up people realised they hadn’t done their sums properly.

Wave after wave of derivative offers, capital guaranteed notes and other “too good to be true” offers have come pouring forth. There is nothing so easy as making money out of money.

But mathematics will always intervene. Compound interest takes no prisoners in its tsunami like advance across personal and corporate balance sheets.

The central banks now have no option but to step in and sort this mess out. The risk of systemic crash is clearly a possibility now, not just in stock markets but banking systems.

Whether markets can recover from here is a moot point. They always do eventually whether its months or years.

If the consumer goes to sleep expect a recession plain and simple. It wont matter where you are or what you do.

The important point is that our financial systems need a serious revamp. The gross expansion of the global money supply, condoned by the global central banks, needs a full inquiry.

Nothing less will do.

The Great Lolly Scramble

For those not in New Zealand a lolly scramble comes at the end of the party when you throw heaps of sweets amongst the children and watch them go beserk. Of course once they have gorged themselves they fall in a heap as the sugar high follows by a big crash.

What we are seeing in the global markets is nothing short of a major fiasco. Banks wont lend to each other so the central banks have flooded the market with cash.

Come and get it they say. This is now starting to get silly.  They were at it again last night as well. When is it going to end?

Goldman Sachs came in with a $3bln bailout for a fund last night as well talking the deal up as a winner. Well of course there will always be distressed sellers in a credit crunch. We’ve seen it here in New Zealand with finance companies going bust with alarming regularity over the last couple of years.

The problem is that we haven’t even started to see the real pain. The real economy is quite strong globally as the spin offs from the asset price boom feeds through in consumption. But how long is that going to last. In New Zealand we are seeing housing activity level off and prices come off the top. Today we saw weak retail sales.

What I observe here is that many properties remain unsold as people will not take lower prices. This is not reflected in the data. Many properties are withdrawn unsold or just sit around in the hope some mug will pay up for them.

So at the moment we are in the distressed phase of the market sell down. People who have to sell must sell and we are starting to see that. The question is whether it slowly spirals out in the main market. We are clearly at a turning point in the economic cycle. Years of asset price increases, consumption driven higher on the back of that wealth effect, central banks with no control over the money supply, late to raise rates, now hammering rates rises home as prices peak, people locked in at high prices and high rates, wages and labour very tight………it’s a recipe for recession.

This is why the central bankers are still talking tough on inflation. They don’t want to start talking in worrying terms in case they “cause” a slowdown.

So expect the lolly scramble to continue.

But there will be a price to pay afterwards.

Global Markets: The Dragon stirs

The ongoing spat between the US and China over the rate of yuan appreciation has boiled over into something more interesting.

Last night Chinese officials threatened the possibility of selling down their US treasury holdings and thereby consigning the US$ to the trashcan. The Chinese are experts at promoting the maxim “don’t throw stones in glasshouses”. They are very astute at pointing out inconsistencies in arguments no doubt employing age old Confucian wisdom.

How the relationship between China and the US will pan out is anyone’s guess but we can be clear about one thing and that is the balance of power has shifted ever so slightly. The phenomenal success of the Chinese economy, based mostly on a large manufacturing base, has given the Chinese are strong foothold in global affairs. Whereas once it was a sleeping dragon content to rule its own domain now it is a major player.

At the same time it has built a strong domestic economy and plays host to the Olympics next year. It seems the US may need China more than China needs the US.

The situation doesn’t look too good for the US. Collapsing credit markets need a steady government security base to hold it all together. Any sell of in the US Treasury market would be a real disaster sending stocks down as well as the dollar.

To some extent we’ve been through this before with the Japanese. In the mid 90s Fred Bergsten hit the headlines calling for a stronger yen. This caused the $ to fall to a record low of 79.65. He was still making this call back in 2002 when he outlined strong reasons for abandoning the Clinton “strong dollar” policy.

This delicate game was fictionalised by Tom Clancy in his book “Debt of Honour” which told of a plot to destabilise the US economy by crashing the Treasury markets and the $. Of course the US won in the end but in real life who knows what would happen. The US authorities run some major interference in the markets when required and i am sure that any severe destabilisation of financial markets would see national security considerations apply (well if they haven’t got that sorted they should!). Sadly many of Clancys’ novels end up happening in real life.

The Chinese are very tactical and astute in their political strategy and very protective of their sovereignty. It will be interesting to see how this plays out but more weakening of global markets cannot be ruled out and with the end of the credit fuelled asset price boom added into the mix cash will be king.

Monetary Policy 101: time for a rewrite?

Local government rates go up followed by interest rates.

Energy prices go up followed by interest rates.

So people are made worse off by increases in prices for goods and services that they cannot easily deflect or cut back on. That’s hard.

But wait there’s more, like a boxer climbing off the floor after a big punch they are hit again even harder by interest rate rises.

And to cap it off it’s all their fault.

I must be missing something here.

The only result of this type of policy is a regular cycle of boom and bust with more and more people forced into bankruptcy for no good reason.

It could be argued that interest rates should be cut in this scenario so that people are not forced to seek higher wages to compensate.

The main concern in the inflation issue is asset and commodity prices. But really its asset prices that are the culprit. They have been driving the global economy for many years now, most notably since financial deregulation in the 80s.

Talk has surfaced recently of the Treasurer invoking a clause in the Reserve Bank Act to move the inflation target aside in order to focus on the exchange rate. Whilst this is a bit far fetched it is another symptom of the policy malaise NZ is facing.

The Reserve Bank Governor has made the same mistake many others have before him: not understand the role and process of bank credit.

It’s as simple as that.

Using an inflation target to manage an economy is like riding a bike with one eye closed. Eventually you have a write off.

Internet Banking: Coming Soon

I’ve been following the spread of microfinance for a while and have been getting involved with Kiva which has been a great experience. I have also noted the rise of social lending businesses such as Zopa, Prosper and even Facebook. Jason has written a good piece on the rise of new forms of financing.

What interest me further is whether all finance can move to a P2P platform and seriously eat into the major lending markets currently controlled by the commercial banks.

I think it could do. This crosses the web with money and complimentary currencies.

Remember that anyone can create “money” if they really want, it just can’t be in the form of bank notes issued by the Reserve Bank. Commercial banks create bank loans by a simple bookkeeping entry. Only 2% of the money supply in NZ is in the form of notes and coin so banks don’t actually hold any money other than a bit of cash.

My point is that P2P finance could take off in a very big way once we get the hang of it. My guess is that the firms currently involved don’t realise how big this could be.

Expect the central banks to cast their beady eyes over these operations once they get a roll on. For now it’s just some web bizness but this feels like 1694 all over again.

Hedge Funds and Global Liquidity

Oh dear it seems as if Bear Stearns may be in a little trouble as it coughs up $3.2bln to support one of its hedge funds exposed to the US subprime market.

This is not good news at all but the market has been through this before with the Long Term Capital meltdown in 1998 and of course the 1995 collapse of Barings Bank by Nick Leeson. So it won’t be in complete panic but this is a big move to Bear Stearns and perhaps just a taste of what can go wrong when the music stops.

Hedge funds are heavily leveraged and so when a big move goes against them the losses can be astronomical. In theory risk models are supposed to flash warning lights at set points but the reality is that these models are not foolproof (after all we designed them) and traders can often disguise bad positions. And from my experience all risk is underpriced since it is based on average volatility and not the heavy meltdowns that come with increasing regularity.

The last 10-15 years has seen a huge amount of money created by the worlds’ banks and much of that finds its way back into the financial markets to be invested or used as speculative margin. The numbers are so huge that the Fed in the US has decided it would rather not publish money supply numbers anymore.

So when the market goes into reverse it can cause major losses which have knock on effects around the whole system.  It will be interesting to see how this situation pans out but at some point there will be a serious contraction unless new demand can be conjured up.