Expansion, Contraction and Collapse

Consumer credit rose by an astounding $14.3 billion dollars in June.  That’s the largest percentage growth in nearly a year and puts current outstanding credit by American consumers at $2.5 trillion.  Want some perspective? American outstanding credit just passed France’s GDP, the world’s sixth largest..

This alarming statistic carries some very serious implications.  First and foremost, anyone with a non-biased point of view can see that a

Expansion of Sorts
I would like to look a little deeper into the real implications such a debt load carries on our economy.  The answer is not really black and white.  You see, while our economy is expanding and credit is cheap, the negative implications are minute.

As long as the government can roll excess liquidity from one bubble to another, excessive credit expansion actually fuels growth.  This is not to be looked upon as a positive, because the more the growth is exasperated in the first place, the more it must contract in order to revert to the mean.

The main side effect of this sort of excessive growth is moderate inflation.  It remains moderate for two reasons.  The first is that the general public doesn’t yet see it.  Inflation expectations remain anchored and funds have yet to flow into tangible assets.
The second reason is not independent from the first.  The Federal Reserve has cleverly been able, until recently, to keep excess liquidity as a result of massive credit expansion away from commodities and tied up in specific market bubbles.

In recent times, we have seen this via the dot.com boom and bust, and more recently in the housing bubble.  The Federal Reserve is very good at rolling excess liquidity from one bubble into another.  It’s a simple notion.  Recession is imminent… that is, if we aren’t already in one.  And if that’s true, how will this affect monetary policy?

Contraction on the Way
A bubble in financial markets results from ultra low interest rates (negative real) and inflation via growth in the monetary base.  When a bubble pops, such as the dot.com bubble did, the Federal Reserve reacts by re-lowering interest rates to negative real levels.  This creates another liquidity glut.  Now, whether it the Shanghai Composite trading at 40x earnings, or U.S. home prices rising at 10-15% on a per annum basis, excess liquidity always finds a home.

This, dear reader, is Keynesian economics.  Keynesians believe in the notion of wealth creation through debt creation.  As a reader of B&B, you know that I view this as criminal, immoral, and the anti-Christ to sound economic policy.  Here’s why:

Politicians love Keynesian economics for the above mentioned reasons.  It results in a period of over exaggerated economic growth in the near term.  As it is, our beloved politicians can’t seem to process beyond whose leg they are going to fondle under the bathroom stall or who they are going to have an affair with, much less the long term results of the policies the implement.

The problem is that Keynesian economics is like a politician’s game of Russian roulette.  The longer it goes on, the more likely the bullet will be in the chamber.  As each bubble is popped, another is created.  As each new bubble is created, it affects more people.  That also means that each bubble is more deflationary by nature.  Given that, it is more and more difficult, and requires more and more liquidity to create the next financial bubble.  Eventually we get to the point when it is no longer possible to create a bubble and this dangerous game of Russian roulette is over.  It appears either John McCain or Barrack Obama will be holding the gun with the bullet in the chamber and neither one of them knows it. 

Collapse?…Possibly
Here’s the deal.  I’m a straight shooter, so I’m going to give it to you strait.  We are faced with two essentially scenarios that aren’t mutually exclusive, and neither of these two scenarios are very rosy.

Bernanke and company could face fact and let the necessary deflation occur in order to flush the financial system of all the excess liquidity that has been created over the years.  This is the equivalent of ripping the band aid off with one quick motion

The other option is to try and inflate another bubble.  The problem is that our financial system can’t withstand another bubble.  Our Federal Reserve is like an alcoholic.  For the alcoholic, booze is often both the problem and the solution.  For the Federal Reserve, it’s inflation that acts as both the problem and the solution. 

It is beginning to be very apparent that our financial system cannot absorb another bubble.  Just look at outstanding debt and the rate at which the investment banks borrow from the discount window.  Credit lines are simply tapped out.  Given that, if our Federal Reserve tries and create a bubble where one can’t be created in order to prevent the necessary deflation, they risk a complete collapse in the faith of the U.S. dollar as well as the domestic banking system.

It appears the Federal Reserve has already made up their minds as to which path they will attempt to pursue.  Here’s a term that you better get used to: inflationary depression.

Nicholas Jones
Analyst, Bourbon & Bayonets