The Crash is past. Comes now Inflation.

-- originally posted 2008-03-02 20:23:36 -- bumped, cho

Seems to me a lot of people don’t realize the worst financial crash since 1929 has already occurred. I suppose they are waiting for a big explosive fireball and a lot of noise like in a Hollywood movie, or for the nightly news on their wide-screen televisions to show pictures of desperate bankers and brokers splattered on the sidewalks in front of 60-story temples of finance.

This diary is my humble little attempt to let these people know that the crash has already happened. It began in August. I guess they didn’t notice, but a number of financial markets have already collapsed. First, of course, there was the derivatives based on sub-prime mortgages. That seems to be about where the common consciousness stops. But before U.S. Secretary Treasury Hank Paulson and Federal Reserve Chairman Ben Bernanke (a.k.a., Captain Carnage) even lifted a finger to try and sort out the sub-prime mortgage mess, they first had to deal with the collapse of the market for Structured Investment Vehicles. Since these two crises began last summer many other financial markets have also collapsed: corporate junk bonds, asset-backed commercial paper, municipal bonds. This last was saved just last week by New York State Insurance Commissioner Dinallo basically forcing Moodys, S&P and Fitch to give AAA ratings to the monolines insurers. All these markets have pretty much ceased functioning, with not even the banks that created some of this stuff willing to buy their own product. Financial institutions have also been disappearing, especially a number of hedge funds, the most recent being this past week: Peloton, a London-based hedge fund specializing in asset-backed bonds.


So, this is it. The financial system has crashed. Now we're finally seeing the Republican's cherished "trickle down" theories begin to work – and with a vengeance- as the damage spreads into the real economy. The basic mechanism for this is the contraction of credit, which is cutting off funds for real economic activity. Goldman Sachs and others estimate that the financial crash has contracted lending by about $2 trillion--and our economy is $15 trillion in GDP. Banks and other institutions are simply unwilling to lend. Here’s the results we know of so far:

Credit for auto loans is also drying up. A friend of mine applied for an auto loan at Wachovia, and was told they were not making loans. I thought it might be racism, so I called a different branch myself and was advised that if I wanted to buy a car my best option was to take out a line of credit on my home equity. Poof! There goes the auto industry, and all its supplying industries like steel, glass, plastic, machine tools, and so on.

As a wag on European Tribune noted a month or two ago, now we have peak credit to add to our worries over peak oil.

On a number of blogs last week, a number of people asked what can be done. Well, the truth is the chance for fixing it – at least fixing it in a way we might find acceptable - is past. Bush, Paulson, and Bernanke, and the governments and central banks of the G-7 have already embarked upon the course they will follow over the next year to three years - they are inflating. Remember that the week before Christmas a number of central banks - the Fed, the Bank of England, the National Bank of Switzerland, the Central Bank of Europe, the Bank of Canada and a few others, had a coordinated effort to prop up the financial markets. In three days they poured nearly $1 trillion of liquidity into the system. Let me repeat that, folks: $1 trillion in three days. Since then, the U.S. Federal Reserve alone has been pouring in an estimated $15 billion each week, largely through the Fed’s emergency Term Auction Facility launched December 17. One of the side effects of the TAF is that U.S. bank reserves have fallen below zero; there is currently a quiet debate going on whether or not negative bank reserves is a problem or not, given the emergency measures the Fed has implemented.

Whatever. The point is, this is the crash. We’re in it now. And the people in charge have decided that the priority is to save the financial system. And they’re pouring in liquidity in do it.

This presents us with two problems. First, this financial system is not worth saving, because the financial system itself is the cause of the problems. We need to radically alter it, not save it in its present form. For over thirty years, as the U.S. deregulated its banking and financial systems, hedge funds and other “players” that wanted to speculate or arbitrage were able to raise tens of billions of dollars in days, while companies and entrepreneurs working in new technologies, such as bio-engineered fuels, struggled to find a few million. Speculation and arbitrage have become the focus of the U.S. financial system rather than supplying credit to the real economy. As a result, the future has been starved of investment.
When new companies and entrepreneurs look for financing in the U.S., where do they go? They don’t go to Wall Street, which is preoccupied with trading for its own accounts. They go to the venture capitalists of Silicon Valley, where a new pool of capital was created by the computer and internet revolutions. This pool of money has not yet been assimilated into and corrupted by Wall Street. You really don’t find capitalism on Wall Street anymore – just the insistence that you do.

As a comment on econbrowser noted a day or two ago:

Throughout the world there has come to be a crystal-clear understanding regarding the dishonest, deceitful and duplicitous characteristics of United States central banking, investment banking and yes, even commercial banking.

The USA is widely perceived as little better than "a country made of con men" creating "fictitious wealth" and selling valueless paper, including but not limited to the currency.

Our nation and our world would be much better off letting this useless, rotten financial system be euthanized and put out of our misery.

Of course, that is not what is happening, which leads to the second problem. All the liquidity being poured in to save the financial system means that we are now headed down the path to classic hyper-inflation. People have already seen prices escalating at the grocery store, but the worst is yet to come:

We've seen some quite remarkable movements in commodity markets the last two months. The graph below plots the price of 14 that I could get my hands on quickly through Webstract, with each price normalized at 100 for January 1. Every single one of these prices has risen dramatically since then. The most tame among the group has been zinc, which is up a mere 6.5% over the last two months, or 39% at an annual rate. Topping the group is wheat, up 46% over two months; I won't try to translate that one into an annual inflation rate because I don't want to scare you.


In a post on The Agonist a few days ago, Stirling Newberry has an excellent comment in a which he discusses three different types of inflation:

There are, empirically, three kinds of inflation, all of them recognized by Smith and Hume, though not labeled as such.

The first kind of inflation is macro-inflation. Macro-inflation is caused by an increase in currency base over supply of denominatable goods and services. . . .

Macro-inflation is the most clearly recognized kind of inflation, and the one which conservatives would like to blame all inflation on. It is capable of the greatest extremes of inflationary activity, hyper-inflation and deflationary spirals. As a consequence getting macro-inflation wrong is a deadly sin for a central banker.

The other kind of inflation which is easily labelled is micro-inflation. Micro-inflation comes from using monopoly power, withholding of information or other market anomoly, to increase the price of a good or service without a tendency to equilibrium. This last is important, because usually exercising market pricing power is either going to generate equilibrium, or is a move towards equilibrium from artificially low prices. . . .

The third kind, also recognized in Smith, is meso-inflation. Meso-inflation is when incentives become out of alignment between productive and unproductive labor in Smith, but more generally when incentives no longer send the correct signals to allocation of activity in an economy. A simple and obvious example of meso-inflation is a government over or under taxing. . . .

What we have been seeing is meso-inflation in the form of devaluation of the US Dollar to fund the war in Iraq and shifting of money from the middle class to the wealthy. . . .

All three kinds of inflation are not entirely evil. Some macro-inflation introduces necessary risk to holders of currency. That is it gets them off their butts and investing, lest they lose the buying power they have. Sucking money out of the mattress is a good thing, but once that is accomplished, macro-inflation has done its discounting work. Micro-inflation is often a periodic spur to innovation - when some good or service becomes a roadblock, the ability to increase its "customary rate of profit" without generating more competition, can force people to search for alternatives. Meso-inflation is, likewise, often a normal part of a market economy coming back into balance.

The key is whether the inflationary pressures are generating equilibrium pressures in return. If macro-inflation is spurring investment sufficient to increase production, then it is good. If micro-inflation is spurring the search for alternative supply, then it is good. If meso-inflation is reshaping the economy to produce a higher pareto optimality, and thus equilibrium with the increased profits being taken, it is good. Beyond this, they are bad.

The job of most policy makers most of the time is to maintain equilibrium in the broader economy, while promoting it in small sections of the economy where disruptive technologies are entering. Macro-stability is produced by micro-instabilities.

The underlying charge against late Greenspan and Bernanke is that they have created meso-inflationary pressures which do not tend towards equilibrium, and instead continue to spiral. The US spends on bombs and billionaires, devalues the dollar to pay for this, increasing the prices of resources, which increases the wealth of oilarchies and substitute production, which is met with spending on bombs (to get the resources, specifically oil) and billionaires (to keep assets in national hands), as well as greater protectionism (such as forbidding the Chinese from buying out American companies). This reduces production even more, while increasing demand for oil, which fires the cycle all over again.

So, essentially, what we’ve done over the past 30 years of deregulating banking and finance is create incentives for speculating and arbitrage, while creating disincentives for actual investment of capital in the real economy. We have shifted from industrial capitalism to financial capitalism. Rather than building a new economy of alternative energies and green technologies, Wall Street, U.S. elites, and the oilarchies have dug in to defend what they have. They have dug in to defend the past.

Other than the process of vetting a doctoral dissertation, defending the past is never a winning choice for an extended period of time. For Wall Street and U.S. elites, defending the past has led us into the worst financial crises since the Great Depression. But, worse, they are attempting to continue defending the past by pouring billions of dollars in new liquidity into the rotting financial system each day, creating a classic case of macro-inflation. I.e., wheat prices jumping 46% in just two months.

What this means is our standard of living will be declining ten to twenty percent a year, each year, for the next several years. Here is one of the first glimmers of how this is going to play out:

Soaring Food Prices Pose Threat to U.S. Aid Federal government to scale back donations and reduce number of recipient nations, complicating already strained efforts to combat global hunger.

Is a Democratic President likely to change all this? Each of us will have our own answer.

My answer at this time is "no." Because of a number of reasons. First, the financial system and the rich own the political process at this point, and for the foreseeable future. This explains why neither Obama nor Clinton are talking about how serious the financial and economic crises has become.

Second, the pain is going to be felt at the bottom first, and the poor and the working class have long been left out of the political equation in the United States.

Third, there is still something left of the safety net that was created after the first Great Depression. The Reagan Revolution and the Bushites may have done their best (worst) but the fact is that social security, veterans benefits, Medicare and Medicaid, and food assistance, though hobbled and enfeebled, still exist. As does unemployment insurance. If these programs had been terminated, we may have seen riots in the streets by now.

Fourth, the real economy of the U.S. already is, and has been, in a depression for the past three decades - manufacturing is about half what it used to be in the 1960s. Some industries have disappeared entirely, such as textiles, clothing, footwear, shipbuilding, printing equipment, power generating equipment, and foundries. Even U.S. employment in computer and peripheral equipment manufacturing is has fallen 17.8% in the past two decades, from 367,000 in 1990 to 199,000 in 2006. For the real economy, the old blues song applies: been down so damn long it looks like up to me.

Fifth, a lot of liquidity has poured in, and will pour in, as large chunks of the U.S. economy are sold off to foreign investors - the Chinese, the Saudis, Dubai, etc. Since the crash began last summer, a notable new trend is that large chunks of the financial system have begun to be sold off. U.S. elites don’t like, but they are desperate to save the system – and to keep you and me from upsetting their apple cart they’ve enjoyed for so long.

As Stirling Newberry wrote two days ago:

Are there solutions? At this point, not really. What's going to happen here is that the powers that be are going to inflation tax their way out of this downturn, that's what they keep saying they will do, and since they get to vote raises for their own salaries, there's no reason to believe they won't. After the downturn is over, it will be a very slow recovery. Then, at some point, you, the public, will be sick and tired of being sticked and fired, and will do almost anything to get rid of the corrosion of your money. You'll demand pain, and you will get it.

The question you have to ask yourself is, what are you going to get for this? I mean, several times in the last generation there have been bail outs and pain, and each time you've said that you are too busy watching American Idol to run things, so let the wealthy ruin them. The next no strings attached bail out will be your last, because after that, you'll be working for people in Dubai and Beijing.

And when monarchies and oligarchies give orders, they expect to have them carried out.


is to clean one room at a time. Where they begin I don't care...just begin.

Any solution is going to require the imposition of taxes on all financial transactions in order to dampen speculation and put economic incentives back on course to favoring real investment:

Currency Transactions Tax – List of Papers, including the original Tobin Tax proposal

Destabilizing Speculation and the Case for an International Currency Transactions Tax

Why the U.S. economy now depends on asset inflation bubbles - Thomas Palley

More reading on why the financial system is inherently bad

Credit Crisis May Make College Loans More Costly
Some Firms Stop Lending to Students

By David Cho and Maria Glod
Washington Post Staff Writers
Monday, March 3, 2008; Page A01

Many college students across the nation will begin to see higher costs for loans this spring, while others will be turned away by banks altogether as the credit crisis roiling the U.S. economy spreads into yet another sector, student lenders and Wall Street firms say.

but thank you for these... I find the ostrich attitude about the economic situation interesting... although I append rba's caveat -- UNLESS SOMETHING IS DONE.

People really need to start to diversify their sources of income even selling stuff on ebay is helpful it sounds stupid but it's always good for some quick cash, i have some other sites that bring in customers from around the world so any local economical situation doesn't really affect me. One thing i learned was after looking for cfd providers and trying out the trading/betting was you can make money with almost anything if you look for a way. You dont even buy a stock you bet the spread.

Unfortunately when the the feds and Wall Street talk about inflation--they mean only wages. The consumer has a very different view. Wages for the middle have been stagnant for years. The plunging dollar is raising prices. Nice combo.

I think we haven't seen anything close to the crash yet.

We're in for some serious hurt. Those on a fixed income are really going to suffer, especially if the fed again lowers rates as expected.

One reason I'm more pessimistic is foreclosures are lagging. We haven't begun to see foreclosures from ARM resets yet. Current foreclosures are for Jan-Jun 2007. Jul-Dec 2007 are past due but not in foreclosure yet. A sizable number of ARM resets are in Jan-Jun 2008 -- so we're still fairly far out from seeing how many will go into foreclosure. Meanwhile, credit keeps tightening.

draws the comparisons to the era of the Robber Barrons when the country ceased making things and started merely speculating through fancy, for that time, financial instruments intended for 'cough' -- investment -- (perhaps more accurately termed speculation, gambling, pyramid schemes, etc.).