DRESSED
UP FOR THE PROM
by Parker
Eales
February 12,
2005
The great danger from the massive borrowing by consumers in the United
States is that they have a personal savings rate of zero. What this
means is that their entire sense of security and wealth is riding on
stock prices and that if there is a drop in stock prices, the effect
would be a significant slow down in consumption by consumers and that
would have an immediate and terrible impact on the U.S. economy.
What can make this scenario even more horrific is if the Federal Reserve had any reluctance to increase the money supply and lower interest rates in order to cushion such an event. There is widespread faith in the Federal Reserve and that the Federal Reserve can work the necessary miracles, not only in the United States but throughout the world, by simply changing interest rates. Essentially, there comes a time where lowering interest rates is actually the antidote to the wrong poison. We can wind up in a situation where we have a false prevention of an incipient financial crisis. One of the great dangers of what is happening in our current environment is that the market is slowly melting down and the suspicion that I have is that the faith in the market and the philosophy of buying and hold for the long term will reach its ultimate challenge when the losses reach the point where it eats into the original principal they initially put into the market place. Once people begin to realize they have lost all their glorious gains and now are starting to lose what they had initially put in, I believe that there could be the phenomenon that you see in the sky with a flock of birds. When you watch a flock of birds, you will notice that seemingly in an instant they all know to make the exact same turn at exactly the same time. That phenomenon I believe is what we see in the stock market occasionally when seemingly everyone gets up one morning and sells the same stock. I believe that there is a possible scenario ahead where the market will reach a certain point where confidence will finally be broken and massive numbers of individuals will begin cashing out of their money market funds and out of their stocks.
It has been my belief that this boom that we have recently experienced has essentially been a boom of borrowed money. The dangerous expansion of debt in our financial system has reached an unprecedented and historic level and will have a number of consequences, some of which are fairly predictable. What is intriguing to me is the fact that we have been led to believe that there is this enormous financial sophistication that exists in order to predict risk and protect from risk and that this financial sophistication ultimately will protect and save the investor. My belief is that this financial sophistication in reality is just a complexity, which has gotten totally out of human control and really hides the true extent of the worst kind of dangerous risk.
There is also a very misguided belief on the part of the average American to believe in the fiduciary responsibility of our central bank. The world of economics has constructed sophisticated financial markets and infrastructure and has really adopted this in a different role than they had historically. Central banks were the guardians of the financial system and now have become victims of the financial system. Basically, the global credit hysteria is reaching its limits and credit quality has basically gone to the dogs. It is estimated that the global gross debt is somewhere in the neighborhood of 90 trillion dollars.
The explosion of corporate debt in the United States is truly staggering with very few investors understanding that there are well over 800 corporations that have more debt than equity in them. The corporations have debt financed over expansion in the pursuit of competitive advantages. They have also used debt in order to buy back stock to improve their stock value, which has proven to be a really horrible business decision. These corporations were also been involved in a terrible malinvestment in the Telecom and Internet sectors. We poured unbelievable amounts of resources into these sectors and not realized that we are squandering resources that are needed for other critically needed components of our economy. We have overbuilt the Telecom and Internet industry to a point where it imploded.
The other phenomenon that is intriguing is that American consumers have maxed out on their credit cards and have turned to refinancing their homes at 125% of value in order to keep right on spending. Additionally, people have refinanced their homes and taken equity out of their homes at unprecedented levels in order to continue to spend well beyond their means. There is a point where the lending is at its maximum point and that this debt becomes a tremendous millstone around the necks of individuals if the economy slows down any.
The worst-case scenario is for corporations and individuals to be caught with a historic maximum debt at a time when the economy truly goes into a protracted recession/depression. This would create the worst of all possible scenarios in which real estate values would collapse along with contraction of employment and an implosion of the ability of individuals to repay their loans. The inability of the American consumer at this point of history to imagine a difficult period of time is amazing.
The reality that we have a global banking system, which is in tremendous distress, is something that is poorly understood. The possibility of a systemic bank failure really would produce catastrophic effects. We have experienced in the last number of years unprecedented banking failures around the entire world. We have had no less than 127 bank failures in 94 countries between 1970 and 1995. The harsh reality is that many banks are truly insolvent despite any appearances that suggest otherwise. What the world’s financial community has learned is how to “dress up for the prom” in order to attract hot money and investment capital through their nations banks. The fact that there are not any real standards for accounting and banking policies that are universal throughout the world means that essentially people are putting money into banks that they really don’t understand nor fully appreciate.
In the United States, we had gasoline thrown on the fires of liquidity as we flipped the calendar from 1999 to the year 2000 due to the inability of the experts to quantify the real impact of the Y2K phenomena. To put it quite simply, no one really knew what was going to happen and how bad it might be. The fact that it turned out to be a nonevent was cheerful, however, the Federal Reserve had pumped enormous amounts of money into the banking system to prepare for the possibility of the computer systems freezing up assets. The effect of this was truly explosive in its effect to stimulate the economy and more borrowing and lending than had already been recklessly done.
Another phenomena that is very important to understand is what is called the “secularization” of the creation of money. What has happened is that the banking system used to be the exclusive creators of money by borrowing money from the Federal Reserve and lending out ever increasing amounts of money to the public. What has happened is that non-regulated industries have cropped up, such as money market funds and companies like General Electric who have gotten into the money creation and money lending business in a huge way and essentially are creating money in our society apart from regulatory control. This ability of the “secular” community, which is not regulated as intensely as the banks to create ever-increasing amounts of money electronically, is creating a new phenomenon, which I don’t believe is understood well by anyone.
It seems appropriate at this point to discuss deposit insurance and the crucial role that it plays in our economy. The FDIC deposit insurance has a number of problems. It encourages risk taking by insured institutions to a degree that they probably would not do if they did not have this government safety net. It also causes a certain neglect by depositors who simply don’t worry about their money being in a fragile bank because they are convinced that the government will print the necessary money to pay them off if the bank fails. The whole deposit insurance scheme actually backfires in that it removes market discipline and encourages a certain degree of recklessness and lack of prudence. In a world in which financial institutions are in crisis and the developing world is in disarray, it seems that we are experiencing a dramatic consolidation of the financial industry in the United States and this is creating a banking sector vulnerability and instability that could lead to a crisis of confidence. Most individuals never think that their bank is actually a private company that they have given their money to and that that private company could in fact go bankrupt and not be able to return to them their money. What a lot of people don’t consider is how long would it be before a severely understaffed FDIC could actually figure out all of these liabilities that the bank owes and actually figure out how to get all this money to these individuals. If there was a massive failure, it might take years before the FDIC could actually figure out how to get the necessary dollars to individuals. No one considers the fact that if such a scenario developed by the time you got the dollars, they might be worthless. To consider the government as the lender of last resort and the ultimate bale out of all financial emergencies is to seriously misunderstand the complexity of what can converge. Simply printing money to neutralize a crisis doesn’t necessarily have the effect that people think it does. The positive insurance at the end of the day creates a willingness on the part of banks to take a lot of risks and make an unstable system even more unstable. Also, the issue of who ultimately bears the financial burden of any insurance pyramid. Ultimately who pays for the FDIC insurance if not you? Also, once the government enters the picture to bail out anything, a whole new set of political considerations enter the issue and there is the inevitable melt down and investigations that go with government intervention.
Banking is a very risky business and ironically deposit insurance makes it much more risky. The truth is that many schemes are put in place to give people the kind of confidence they need to basically take all their money and give it to somebody else to utilize in all kinds of risks that they would never personally dream of doing themselves. This whole scenario works well until there is a crisis and we see on CNN Russians lined up outside their banks beating each other up trying to get a better place in line in the pathetic hope that they might be able to withdraw a ruble, which turned worthless.
One of the symptoms to look for in a liquidity crisis is for the major money center bank stocks to begin having a crash in the value of their stocks. This would likely be the canary in the coal mine that would let you know that a serious liquidity problem is about to be experienced. The United States has had some incredible liquidity crunches that have not been noticed by the general public. These liquidity crises could have brought about enormous consequences since corporations could not keep the feeding frenzy going to maintain their borrowing. Corporate bonds, better known as junk bonds, literally got frozen and were illiquid. No one simply wanted to buy these things and it created a liquidity crisis, which is not very well appreciated by most people. If corporations cannot get access to continue their profligate borrowing then the entire dance could come to a stop in the worst possible way. One of the interesting questions is what is the role of the Federal Reserve? Is it to protect the banking system as it’s first and foremost priority or is it to protect the U.S. economy and keep the stock market going? A lot of people have not quite realized that its first and most important role is to protect the banking system of the United States and other minor roles flow from that essential reality. What this means is that the Federal Reserve may be willing to sacrifice the stock market in order to save the essential banking institutions, which it must safeguard as its primary mission.
One of the things that I am certain most people ask themselves is where does all this money come from that people have to lend? The amazing part of the story is that literally by liberalizing the financial world around the globe, we have created a scenario in which the world has been driven to invest its money in the United States as a safe haven from all the turbulence and risk that they are experiencing in their economies. This amazing investment of the world’s money in the United States has created a glut of liquidity to loan to everybody for everything. It has created the illusion of a great financial success, which in fact would not exist for the fact that foreigners are pumping all of their wealth into the United States. It strikes me as very ironic that the poorest nations of the world have their elite taking the money from those economies and sending it to the United States. The United States is lending this money for every unimaginable purpose at interest rates that are very favorable and this has created the illusion of endless prosperity and wealth. The problem with this wealth effect is that people do not truly understand that all of this money has got to be paid back with interest and that no amount of delusion will stop the inevitable moment when all of this must be paid back.
The problem is going to come when it becomes apparent to the rest of the world that the United States has got serious problems and that they will need to repatriate their money back to their countries in order to protect it from a huge U.S. dollar devaluation or a possible disaster in the financial community of the United States. When foreigners begin to repatriate their money back home, liquidity will begin to dry up astronomically within the United States financial community and there will be a profound need by the Federal Reserve to raise interest rates in order to keep the money from leaving the United States. This absolute need to keep the tremendous amounts of currency in the United States necessary to run our fragile economy will create this enormous interest rate hike which will have the effect of dooming our economy to an inability to invest and grow as we have been used to. This will cause a slowing of everything and a shut down of consumer confidence the likes of which we have not seen.
We have been told that inflation is well under control, but in fact there is really an occult explosion of inflation that has been occurring despite whatever the government numbers have been telling us. The inflation in stock prices, the inflation of the money supply, and now the inflation of energy prices of all kinds as well as the beginnings of tremendous cost inflation are apparent. The problem is that we are forcing an inevitable dramatic inflation given our needs to sustain such enormous liquidity.
So no matter how dressed up you are for the prom, “when the paddy wagon comes it takes the good girls and the bad girls alike.”
© 2005 Parker Eales
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Parker Eales
Raleigh, NC
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The opinions of FSU contributors do not necessarily reflect those of Financial Sense.
