Deflationary Collapse More Likely Now than in 2007

Janet Tavakoli makes some excellent points on how 2 years of endless money pumping, government bailouts, and stimuli and have accomplished the exact opposite of what was intended: Matters have gotten far worse, and the financial system is now in a much more explosive condition than back then.

Part 1

Part 2

Her book Dear Mr. Buffett sounds like a great read. I will definitely check it out.

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Housing/Credit Crisis – Why There Is More Pain To Come

Some of the slides and statements that caught my attention on T2 Partners’ Overview Of  The Housing/Credit Crisis And Why There Is More Pain To Come:

Home Equity vs. Debt:

home-equity-history
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Debt and Financial Profits:

debt-and-financial-profits
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Mortgage Delinquencies Soaring in Q1 2009:

mortgage-delinquencies-q1-2009
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Mortgage Losses To Come (note the whopping 3.5 trillion for commercial mortgages):

mortgage-losses-moving-forward
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Recent Signs of Stabilization Are Likely the Mother of All Head Fakes:

Rather than representing a true bottom, recent signs of stabilization are likely due to two short-term factors:

1. Home sales and prices are seasonally strong in April, May and June due to tax refunds and the spring selling season

2. A temporary reduction in the inventory of foreclosed homes

– Shortly after Obama was elected, his administration promised a new, more robust plan to stem the wave of foreclosures so the GSEs and many other lenders imposed a foreclosure moratorium

– Early this year, the Obama administration unveiled its plan, the Homeowner Affordability and Stabilization Plan, which is a step in the right direction – but even if it is hugely successful, we estimate that it might only save 20% of homeowners who would otherwise lose their homes

–The GSEs and other lenders are now quickly moving to save the homeowners who can be saved – and foreclose on those who can’t

–This is necessary to work our way through the aftermath of the bubble, but will lead to a surge of housing inventory later this year, which will further pressure home prices

$2.5 Trillion Alt-A Mortgage Resets Are Only Still Ahead of Us:

alt-a-resets-ahead
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Option ARMs by State (Good Night, California!):

option-arms-by-state
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Home Prices Need to Fall 5-10% to Reach Trend Line:

home-prices-trendline
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…but after they reach the trendline, what keeps them from falling deeper? Markets always overshoot in both directions.

Comments From Mark Hanson, The Field Check Group, May 5, 2009:

California housing – at the low end – is ‘bottoming’ mostly because: a) median prices are down 55% from their peak over the past two years, thereby making the low end affordable; b) foreclosures have temporarily been cut by 66% through moratoriums reducing supply; and c) demand is picking up going into the busy season.

But the moratoriums are ending and the number of foreclosures in the pipeline is massive – they will start showing themselves as REO over the near to mid-term. The Obama plan held the foreclosure wave back, creating a huge backlog and now the servicers are testing hundreds of thousands of defaults against the new loss mitigation initiatives. We presently see the Notice of Defaults at record highs and Notice of Trustee Sales back up to nine-month highs – there is no reason for a loan to go to the Notice of Trustee Sale stage if indeed it wasn’t a foreclosure. However, the new ‘batch’ are not only from the low end but a wide mix all the way up to several million dollars in present value.

Because the majority of buyers are in ultra low and low-mid prices ranges, the supply- demand imbalance from foreclosures and organic supply will crush the mid-to-upper priced properties in 2009. We already have early seasonal hard data proving this. As the mid-to-upper end go through their respective implosions this year and the volume of sales in these bands increase as prices tumble, the mix shift will raise median and average house prices creating the ultimate in false bottoms. We also have data proving this phenomenon.
After a year or so the real pain will occur when the mid to upper bands are down 40% from where they are now, and the price compression has made the low to low-mid bands much less attractive – the very same bands that are so hot right now. Rents are tumbling and those that bought these properties for investment will be at risk of default (investors have been buying all the way down). Investors have just started to get taken to the woodshed from all of the supply and this will get much worse. Mid-to- upper end rental supply is also flooding on the market making it much better to rent a beautiful million dollar house than putting $300,000 down and buying.

After investors are punished — and with move-up buyers gone for years – it will leave first-time homeowners to fix the housing market on their own. Good luck and good night. Five years from now when things look to be stabilizing, all of these terrible kick-the-can-down-the-road modifications that leave borrowers in 5-year-teaser, ultra-high-leverage, 150% LTV, balloon loans will start adjusting upward and it will be Mortgage Implosion 2.0. These loan mods will turn millions of homeowners into over-levered, underwater, renters and ensure housing is a dead asset class for years to come.

Due to a confluence of events including a national foreclosure moratorium and near-zero sales in the mid to upper end during the off season, the broader housing data show signs of stabilization. Taken in context, it is a blip. There are no silver linings or green shoots in housing whatsoever other than by these first-time homeowners – former renters – who now find it cheaper to own than rent. This is a very good thing, but it only applies to a small segment of the population and will not be able to support the market. In addition, the first-time buyers who come out of the rental market put continuous pressure on rents.

Our data shows that the mid-to-upper end housing market is on the precipice of the exact cliff that the market fell off of in 2007, led by new loan defaults. What happens to the economy when you hit the mid- to-upper end earners the same way the low-to-mid end was hit with the subprime implosion? We will find out soon enough. When we look back on housing at the end of 2009, anyone that made positive housing predictions this year will not believe how far off they were.

…as I already noted in March, there is a Major Collapse in High End Properties Underway.

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True Money Supply – September 09th 2008

As you can see above, the intermediary money supply data for September 08 indicates a further slowdown in true money supply growth. The effects of the bailouts of Fannie May, Freddie Mac, and AIG are not yet included in the data available, as this is from 09/08/2008.

It will most likely be available with the next set of data.

Over the past three months the impact of the slowdown of the true money supply has finally reached commodities and consumer prices, in addition to the already declining home and stock prices.

The overall outlook for the next months is a further lowering of stock, real estate, commodities, stock prices.

The US is facing a major credit crunch and an unprecedented economic correction. Rather than allowing the correction to occur freely, the government has embarked upon a path that it will not be able to back down from. One financial institution after another is being bailed out with public funds.

The Federal Reserve Bank has already filled up close to 50% of its balance sheet with bad debt. Policymakers have realized this and hence suggested setting up a completely separate entity to do just that: Buy bad debt from troubled banks, backed by taxpayer money.

I assume their reasoning is that they want to avoid turning the FED, it being the supposedly trustful lender of last resort, into a junk deposit which would sooner or later have to write down delinquent mortgage loans and factually declare bankruptcy. Instead they are trying to spread the garbage evenly across different institutions: Large banks (BofA with Countrywide, JP Morgan with Bear Stearns), the FDIC (Indymac), the Federal Reserve Bank (AIG and various bad debt instruments acquired against treasury bills in the term auction facility), and presumably the soon to be established Treasury sponsored entity.

Of course all these measures are bound to fail. With every intervention the final shakedown is merely being postponed and aggravated.

The main actors involved are clueless about the essence of the problems of credit expansion, the credit boom, and the credit crunch: The President has completely extricated himself from the process; Hank Paulson, the Treasury Secretary has fully endorsed a policy of interventionism as the panacea to the crisis; Congress leadership is hopelessly lost (as Senate majority leader Harry Reid said: “no one knows what to do”) and will most likely go along with anything that the President’s Working Group on Financial Markets will suggest, no matter how much it will cost the taxpayer. The SEC is about to announce another pseudo measure tomorrow: banning short sales on financial institutions. More prestigious businesses will be in line for bailouts shortly, in particular Citigroup, General Motors, Ford Motors, and General Electric are likely candidates.

What has been keeping the dollar strong recently is the fact that the federal reserve has not yet resorted to the ultimate weapon: hyperinflation. The money supply, as shown here has been slowing down. Most likely the Federal Reserve officials are not even aware of this because they are using wrong data to monitor the money supply. The question is if this trend will hold up with the interventionist path that the government continues to move forward with. We will keep monitoring the money supply closely.

Events indicate that we are approaching the collapse of the global financial system as we know it. As Libertarians and Austrian Economists have been warning again and again, and have been ridiculed for again and again: A fiat money paper currency system, facilitated by a central bank, will ultimately lead to the destruction of the paper currency and the collapse of the financial system.

One can only hope that once all this is over and decision makers will have to get together and frame a new financial system, maybe, just maybe people will at least sit down for a second and listen to the common sense solutions that we have been asking for over the years:

– Abolish the Federal Reserve Bank
– Allow for free market competition in the money market
– Let the market return to a gold standard
– Significantly downsize the federal government
– Abolish the federal income tax
– Abolish unconstitutional (and wasteful) federal institutions, in particular the IRS, the SEC, the Department of Homeland Security, the Department of Education
– Phase out the federal social security and medicare programs and let people manage their money themselves (one can only hope that at this point people realize what the government will do to your money)
– Reduce US troop presence around the globe, strengthen the defense of the homeland against foreign enemies (which is the first and foremost task of the federal government)
– and finally: legalize the US Constitution

It is disturbing that the crisis is giving me hope that people will listen. Common sense should lead people to these conclusions. Unfortunately common sense has not been very popular over the past decades.

(This article was first posted on 09/19/2008)

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Credit Expansion Policy

Objectives of Credit Expansion

Credit expansion is the policy where the central bank produces additional money in order to purchase debt from the government or from entrepreneurs, such as banks. In a system where gold is used as money there exist strict limits for money producers when it comes to credit expansion, due to the natural scarcity of the precious metal. In a fiat money system there are no natural limits on the amount of additional money produced. As a result, the interest rate for additional credit transactions drops.

The policy of credit expansion is broadly accepted as a measure to make people prosperous.

It is its declared objective to make credit abundant. New credit is said to spur business activity, capital becomes inexpensive, entrepreneurs can borrow more money for investments, commerce flourishes and soon all of society is permeated by the magical boon that the credit boom bestows upon it. Everyone is supposed to enjoy all the consumer goods they have been longing for under the stingy policy of tight credit.

This idea is based on the substantially flawed assumption that capital can be created out of nothing. Capital can only exist when factors of production are produced. Every investment necessitates the use of factors of production that turn out more or higher valued goods after a roundabout process rather than consuming fewer or less valuable goods immediately. Factors of production can only exist if people have generated savings. Savings are generated if one forgoes immediate consumption for the prospect of future consumption. Foregoing present consumption can only be feasible if one considers the future remuneration he gets in return more valuable than the immediate consumption he forgoes. This is what is called time preference. Time preference is expressed on the market in the form of interest rates.

This causality ensures that market interest rates always provide an indication of the time preferences of the individuals in that market, and hence the willingness to forgo present consumption of consumer goods for future consumption of goods created by new factors of production. While prices give entrepreneurs an indication as to which consumption goods are desired more and which less at a specific moment in time, interest rates provide a measure as to when they are desired or needed in the future. It creates an environment where entrepreneurs have an incentive to fulfill demands based on value preferences and time preferences at any given point in time.

The Effects of Credit Expansion

It is now necessary to examine what the process of credit expansion entails. The central bank that creates money does not own any capital, it does not create factors of production. The only thing it channels into the market is fiat money.

Before examining the purchase of credit instruments it makes sense to take an intermediary step and look at the simple purchase of consumption goods. For example, if it were to purchase houses with the newly printed money, its governing board could decide to supply the homes to all its officials. They will be able to enjoy the houses before their prices rises and hence they will not be available to other would-be buyers who would have purchased them at a lower price that would have represented their value preferences. The entrepreneurs selling the homes, too, benefit because they are the first ones to receive the new fiat money and get to spend it before other prices go up and before others get to spend it. Those who receive the new money later will suffer from the prices that have already gone up. While on the market, people can only buy goods when producing demanded goods in return, and while all transactions are based on voluntary exchange and value preference, the central bank does not act under these constraints. Its fiat money can be produced cheaply and the government enforces its acceptance and outlaws competition. Goods are hence violently withdrawn from those who actually produced demanded goods in exchange and end up in the hands of those who didn’t. Now, entrepreneurs will begin producing more homes, while withdrawing factors of production from other, more urgent, uses. If this plan were to be carried out to completion, at one point the majority of entrepreneurs would employ workers and resources in the production of houses for those who printed and enforced the money while a shortage of other demanded goods for all other individuals would ensue.

The equivalent, however, occurs in the sphere of time preference if the central bank purchases debt on the market. People who demand credit on the market issue credit instruments such as merchant bills, governments issue government bonds and bills. The credit instruments purchased by the central bank will go up in price after each additional purchase, interest rates drop as a tendency. Other providers of credit on the market whose time preferences were matched by the credit instruments offered will abstain from entering into the corresponding credit transaction. Now the central bank has withdrawn future money from the market that would have gone to those who were outbid by it in the process of purchasing the debt. They were not able to enter into a transaction that would have represented their time preferences.

On top of that, the interest rates for the loan contracts purchased drop below the market rate that represents actual time preferences of those operating in the market on a voluntary basis. This has the effect that the entrepreneurs’ assessment of time preferences is skewed. They think that present goods against future goods are valued less than actual voluntary time preferences warrant. Those roundabout projects, that were not being embarked upon, because interest rates indicated time preferences in favor of less roundabout projects (whose goods would be consumable earlier) now appear to be feasible. Entrepreneurs begin embarking upon more roundabout projects that yield an output in the farther future. At the same time they set aside those less roundabout projects which the market interest rates would have induced them to begin, had the credit expansion not taken place. The result is now precisely that consumers are again not supplied with products as desired as per their time preference.

The Credit Boom

Since no additional capital has been created via real savings, prices for factors of production used for the longer term will rise. The stock market, it being the main market for factors of production, will see a price increase, primarily in those stocks for businesses whose projects yield a later output. In particular, a lot of businesses incorporate, that are currently not producing anything, nor plan to produce immediately, but are rather aiming to turn out goods a few years down the road, after spending time on roundabout research and production processes. As a tendency, the labor force of society becomes employed in roundabout, long-term projects.

The same holds true if the credit instruments that are purchased are largely used to finance a specific consumption good, such as owning a home. By purchasing home credit instruments, the central bank will create an environment where many individuals who have not produced enough to exchange against a home will nonetheless obtain a home. Prices of homes will rise since the credit expansion has not at all expanded the amount of homes produced on the market. It is only after this initial expansion that more and more entrepreneurs will begin employing more and more workers in the home construction business.

The Credit Crunch

The labor force, however, at the same time represents the bulk of the consumers whom those products are intended to be produced for. But their time preferences have not changed in reality. While being employed in very roundabout projects and processes, they still desire present goods over future goods more strongly than the entrepreneurs expected based on the lowered interest rates. After the credit expansion is completed, consumer spending and saving habits will not be in line with those expectations. They demand more present products than are available and hence bid up their prices. Due to their shortage, an overall tendency towards rising prices for present consumption goods, such as food and gasoline, ensues. People will need most of their money to buy these consumption goods and hence cut back on spending it elsewhere or making it available in credit transactions. Market interest rates will now readjust in accordance with real time preferences again, based on real savings. They will move up to the market level again. Incorporation of companies with overly roundabout projects will decline. Some entrepreneurs, who are in the middle of overly roundabout projects will not immediately realize this. They will keep employing factors of production in these projects.

However, when they announce their new earnings expectations they will have to take into consideration the fact that most consumers will not have enough money left to purchase their products. They will have to let the capitalists know that their capital will not yield the return expected. This will cause a downward pressure on the prices of those factors of production used for overly roundabout processes. Correspondingly the prices for shares in such companies decline. They will be sold at prices that reflect true time preferences again. However, the time that resources have been employed in overly roundabout projects has been wasted. The true yield of their output did not match the capitalists’ expectations. The capitalists have suffered a loss.

Some of the factors of production and workers will have to be released from their current employment and need to be employed in new lines of production where they contribute towards the production of more urgently demanded consumer goods. Flexible resources will be aligned accordingly and the supply of those goods will increase again and hence their prices will drop back to market levels. Other resources however, which are fixed and specific to one particular project and are merely half finished may be forever lost, in particular this will be the case for huge construction or manufacturing projects that involve the erection of factories, machinery, etc. which have turned out to be useless. A credit contraction will occur and the money supply will be reduced to lower levels in a healthy deflationary process which induces people to save and spend as time and value preferences mandate. The market, once again, returns from an inflationary, regressive resource misallocation to progress and a move toward market equilibrium.

Depending on the amount of excess credit channeled into the market and depending on the duration of the credit expansion, the repercussions can be anything between mild and disastrous.

It is a fact that the correction of the allocation of labor and other factors of production is highly unpopular with the populace. As a rule, individuals, in particular entrepreneurs from businesses employed in unprofitable lines of production, will be in favor of continuing the credit expansion. The positive term “correction” will be replaced by the unpopular word “recession”. A prudent government should not fall for this fallacy. If the process of readjustment is not hampered with, the problems caused by the credit expansion will be within limits. The market will quickly recover, albeit, at a level that is less desirable than where it could have been at without credit expansion. If, however, the government doesn’t allow for the correction to occur, the misallocation of factors of production will be kept up and aggravated until it all culminates in a devastating collapse.

Conclusion

The objective of credit expansion, namely to ensure that more capital is generated in order for the market to provide more of what consumers demand, fails. In fact, it has the opposite effect. It skews the entrepreneurs’ judgment and makes them align resources to produce products that consumers are not demanding and makes them use factors of production for processes that turn out products later than consumers are demanding them while withdrawing them form those production processes that would have been in compliance with consumers’ time preferences.

Historical Relevance

The policy of credit expansion has been pursued by governments time and time again. It has become prevalent in the United States under President Woodrow Wilson after the establishment of the Federal Reserve Bank under the Federal Reserve Act during the Christmas Holiday of December 1913. Since then, it has caused major credit booms and crunches in the form of asset booms and subsequent crashes and economic booms and subsequent recessions. In particular this has been the case in the years of 1929, 1987, and 2001, and will be visible in 2008 and the following years. It has always precipitated precisely the effects outlined above. Its workings and effects have been fully explained by this theory of the business cycles. No one has ever refuted the correctness of this theory.

Yet, to date economists and politicians appear completely riddled as to what causes booms and crashes. It is claimed to still be a matter of discussion amongst experts. It has been attempted to impute it upon humans’ greedy nature and natural exuberance. Whenever a crisis emerges the pundits, experts, central banks and politicians will try and regulate the market to stave off the impending crunch. They forget or don’t have the intellectual capacity to understand that it has been their own policy that has caused the crisis in the first place.

As long as the central banks keep pursuing this policy, there is no need to be surprised when the next credit crunch occurs. Neither is there any need to be surprised about the fact that all countermeasures taken by the government will turn out to be utter failures that will accomplish nothing but aggravate the crisis. For if the cause of the problem has been too much government intervention, then more government intervention will only add to it.

Update: I refined the process and added much more detail in the post The Business Cycle.

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