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The Great Deleveraging

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April 19, 2009 – Comments (10)

Big Picture has copied a post from John Mauldin titled "the Trend May Not Be Your Friend."

Something that I have said in the past is that I think the banks need the money that has been put into them just so you can go to your bank and get your money out.  Without the money that has been put in I believe the system would have collapsed and the crap the media is feeding us is just media bites that sound good.

In John's piece I take out this quote:

It’s a bit misleading to talk about money supply, because what money really is is roughly $2 trillion of cash and then $50 trillion in credit. Because what do the banks do? They take deposits in and then they borrow money to leverage them up. I take my credit card and I spend with it. I borrow against a house. I have an asset that rises, and I borrow against it.

We have two trillion dollars of actual cash propping up $50 trillion in credit. If we all decided to settle and pay off everything, we couldn’t do it because there is not enough cash. There would be massive asset deflation. We, as a nation, are levered 25 to 1, or we were. Now, that $50 trillion is in a real sense the money supply because that is what we are all pretending is real money. I lend you money and you pretend you are going to pay me back. Then you pretend he [pointing at another attendee] is not going to call your debt for cash, and we are all going to keep the system going. Because if we all try to pay each other back at once, we are all collectively — and this is a technical economic term — screwed.

For the economy to be healthy and fundamentally strong leverage should probably not exceed about 1 to 10 and 1 to 8 is better.  As near as I can tell the whole securitization process simply increases leverage without reserves and I am not sure that its leverage effect is calculated into this mess.  It would be when looking at an individual financial institution that is holding some that they intend to sell, but once it is out there and not being held by an institution I don't see how the leverage effect gets measured.  I tend to think the degree of leverage is understated.

So, leverage is declining and that reserve is simply being used up, for example, tons of loans have been called and the cash is being applied to the debt.  The reserve that is there now is new care of the government and I think the only reason the financial system hasn't collapsed because there would be no cash to keep the system going otherwise.

I have also made comments in the past on the money supply in that it is so enormous for prices to actually catch up to what was there, well, we would have to see about 500% increases.  The declines in the past year suggests to me that we still have "wealth" stored in various assets and if we all tried to trade them in for usable goods today or at the same time we'd see price increases in the 250% range.

If you double the reserves, you halve the leverage is one thing that is happening, so for current credit reserves need to triple, and that is without the hidden leverage.  Also if the cash pays debt, then the calculation completely changes. If you took half the reserves and applied to debt, well, you'd have 24 leverage of half the amount, or you'd have leverage of 48 on the credit left. If it is all used you end up with undefined leverage, but say you replace 100%, well, now you've reduced the leverage to 23 from 25.

The pulling money out of credit and paying down debt really removes cash from the system and only marginally reduces leverage.  I think this would be a simplification of the "velocity" of credit contraction versus money supply.   This kind of thinking is what put me in the deflation camp about 2 years ago.

Other things that keep in the deflation camp is inablity to raise wages in an employer's market and homes still are not affordable relative to wages.

To now see an inflation will depend on monetary policy.  If end up adjusted so leverage is in the range of 10 to 1 and then do not ensure that it is not abused again through monetary policy, well, you can get massive inflation.

But I doubt that some running of the printing press will  cause inflation at all because the velocity of deleveraging is so much faster then the printing press and is destroying money supply.

 

10 Comments – Post Your Own

#1) On April 19, 2009 at 9:35 AM, outoffocus (22.81) wrote:

Other things that keep in the deflation camp is inablity to raise wages in an employer's market and homes still are not affordable relative to wages.

Now when you say deflation, do you mean the government's numbers or whats actually going on? Because my understanding is home prices were not included in inflation numbers over the past 10 years. 

As far as inflation is concerned, I believe the inflation we will experience will be external rather than internal, leading to stagflation.  In other words, home prices will fall to levels not seen in ages.  But commodities will explode due to a devalued dollar.  We are still largely an import economy.  That imbalance (though improving) will not change completely over night.  In the meantime, prices for everything from oil to food will increase dramatically, making it harder for us to stretch our stagnant wages.  Therefore the need for some kind of preparation for hyperinflation is still there. Its just a matter of where you focus your preparation.

 

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#2) On April 19, 2009 at 10:09 AM, soycapital (< 20) wrote:

Good find dwot, been reading John Mauldin for several years and I highly respect his views. It seems to me he has a good grasp about what happened and where we are headed. I also think inflation not in the cards in the near future, we need to deal with a huge black hole of debt first. Thank you, Dave

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#3) On April 19, 2009 at 10:24 AM, alstry (35.09) wrote:

At this point, with the current Fed, none of us know where this is going.

We do know that debt infects most aspects of the World's economies....now to levels that simply can't be paid back.

As populations scramble to pay down debt, economies will implode...here is a current article from the WSJ:

BOAO, China -- Finland's government debt level will rise significantly as it seeks to combat a global downturn that is likely to shrink its economy by at least 5% this year, its prime minister said in an interview.

But Prime Minister Matti Vanhanen also said his government is taking measures to control Finland's hefty spending on social welfare, to maintain a strong financial position and keep its triple-A credit rating.

Speaking on the sidelines of the Boao Forum for Asia, Mr. Vanhanen said he expects gross domestic product for Finland, a European Union member, could come in below the government's already weak expectations this year.

"The latest prognosis has been that our GDP will fall 5%" in 2009," Mr. Vanhanen told The Wall Street Journal. "But there is a risk that the figure will be even worse, because in the first months of this year the trade has fallen in a dramatic way." Next year, he added growth "will still be minus something."

He said debt owed by the state, currently at a little over €50 billion, will increase by about €10 billion this year, as the government tries to stimulate its economy. Overall government debt levels, currently around 30% of gross domestic product, "will rise at least to 50%," Mr. Vanhanen said.

Finland's economy is heavily reliant on exports, which have been devastated by the global economic downturn. Nokia Corp., the country's largest company, on Thursday reported a 90% drop in first-quarter profit. In January, the country's GDP fell by 9.8% compared with the same month of 2008.

"I believe the whole year will be quite difficult for our export companies," Mr. Vanhanen said.

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#4) On April 19, 2009 at 10:42 AM, broxburnboy (< 20) wrote:

If the deflationary scenario is the ultimate outcome, then the results will be more severe than the Japanese experience which has resulted in 20 years of stagnation. The yen was not the default world currency and could be manipulated through central bank policy for the benefit of the Japanese economy. Japanese banks were stabilised and propped up through an ongoing favourable balance of trade. The USA has no such luxury, it has enjoyed the benefits of exporting its inflation with the US dollar trade imbalance.

The current monetary and fiscal policies of government are aimed to specifically prevent  the bankruptcy of the banks. So far money has been thrown at them, accounting regulations have eased and bank losses have been nationalised. I think we can expect this trend to continue until either the banks are delevered to sustainable capital ratios, or the economy collapses in a self stoking circle of bankruptcies and a tidal wave of newly printed money.

Eventually foreign holders of US dollars will want to trade them for something of value while they still can. This should bring an influx of foreign money which will finally reverse the balance of trade, but result in the hollowing of corporate America and foreign ownership of many vital industries. This will be the ultimate price for decades of profligacy on the part of Americans and their "leaders".

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#5) On April 19, 2009 at 10:48 AM, dwot (52.34) wrote:

outoffocus, inflation is a measure of money supply.  Right now there is so much existing money supply I personally do not believe prices have kept up with it at all.  Home prices and a number of commodities priced themselves to the money supply.  Commodities corrected downward rapidly.  I was looking at some this week and they looked fairly priced to me. 

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#6) On April 19, 2009 at 10:49 AM, broxburnboy (< 20) wrote:

If the deflationary scenario is the ultimate outcome, then the results will be more severe than the Japanese experience which has resulted in 20 years of stagnation. The yen was not the default world currency and could be manipulated through central bank policy for the benefit of the Japanese economy. Japanese banks were stabilised and propped up through an ongoing favourable balance of trade. The USA has no such luxury, it has enjoyed the benefits of exporting its inflation with the US dollar trade imbalance.

The current monetary and fiscal policies of government are aimed to specifically prevent  the bankruptcy of the banks. So far money has been thrown at them, accounting regulations have eased and bank losses have been nationalised. I think we can expect this trend to continue until either the banks are delevered to sustainable capital ratios, or the economy collapses in a self stoking circle of bankruptcies and a tidal wave of newly printed money.

Eventually foreign holders of US dollars will want to trade them for something of value while they still can. This should bring an influx of foreign money which will finally reverse the balance of trade, but result in the hollowing of corporate America and foreign ownership of many vital industries. This will be the ultimate price for decades of profligacy on the part of Americans and their "leaders".

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#7) On April 19, 2009 at 11:20 AM, ralphmachio (24.95) wrote:

Another couple of aspects to the equation, Oil in Euros from Iran, or China and Russia push harder for one world currency. Oh, what about an all out dollar dump by these nations, and maybe a couple others? 

How did we get here? (rhetorical, do not answer)

I feel like the American people are going to be scapegoated, even though the ultimate responsibility for government and bank actions does rest in their hands, Where do I sign up to help create more responsible social and fiscal policy? I have no debt, and don't consume much. 

 

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#8) On April 19, 2009 at 12:44 PM, anchak (99.84) wrote:

Dwot....I read it also....its true - the issue is the govt is trying to do a masssive deferment exercise - and hoping that thru reflation - it will be able to take care of most of the obligation by devaluing it down.

The smart ones -would be who at least will emerge out of this debt-free and with some savings ( specifically tied to commodity linked/rich nations - like yours).

We live in interesting times.

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#9) On April 19, 2009 at 1:17 PM, dwot (52.34) wrote:

ralphmachio, I am not American and I would have a different opinion on the scapegoating...

 For example, Canada was hit with over $30 billion in losses on the mortgage paper, and many other allies have been hit similarly.  I would tend to think that many other countries have a reason to be resentful and would probably be more aggressive in negotiating.  American companies and their drive for profit truly give America a bad name and perception around the world.  They behave so badly and as something to dislike very much and I think the people get the backlash when they travel.  I do my best to show myself as Canadian when I travel and I know I have experienced some of the backlash traveling when people think I am American.

 broxburnboy, you certainly do bring up one of the reason why current prices do not reflect monetary supply, the holding of US dollars by other counties.  It means the US has been exporting their dollars for years which temporarily (could be a generation or two in terms of years, not months or days) takes the money out of circulation and prevents prices from increasing at the rate they would without the export of dollars.

I think it is grossly under appreciated the priviledge American has enjoyed due to holding being a world reserve currency and that priviledge has been grossly abused to the rest of the world. It will also be interesting to see how things develop as other nations lose interest in American dollars and I would tend to think return to holding an asset like gold as a reserve.  Ability to increase the gold supply is much more limited then the ability to run the printing press...

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#10) On April 19, 2009 at 1:21 PM, kaskoosek (67.10) wrote:

Can some one point to some Canadian income trusts.

It seems like an interesting idea. 

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