Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 11-Aug-07
Fed pours money into Wall Street, avoiding a total rout

Web Log - August, 2007

Fed pours money into Wall Street, avoiding a total rout

Every time the market fell on Friday, the Fed would "inject" more money.

When I was going to school in the 1950s, my teachers often talked about the Great Depression, and how horrible it was. The events of the last few days reminds me of one particular story that has stuck in my mind all these years, probably because the teacher was close to tears as she told it. Her story went something like this:

"Before the crash, everybody was frightened about what was going on in the stock market. Every time that things looked very bad, someone with a lot of money would step in and buy stocks, and the market would go back up briefly. Then one day no one stepped in, and the market crashed."

I don't know specifically who she was referring to, but in the 1920s there were corporations that were wealthier than the U.S. Government. (That seems strange today, but it was by design prior to the 1930s. It changed with the F.D. Roosevelt administration.)

Reading through John Kenneth Galbraith's book, The Great Crash - 1929, which I've quoted many times on this web site, one can see that everything that's happening today happened in 1929 -- the mania for mergers and acquisitions, the drying up of liquidity, the breathtaking volatility. The comparisons are really dramatic, and they put to shame all the idiots who claim "this time it's different." They even had hedge funds in those days -- only, they were called "investment trusts," and they were just as abused as hedge funds are today. Really, everything that's happening today is an almost exact repeat of 1929. I'll quote some more of that book in the next few days.

Anyway, that's what's been happening this week, with the role of savior played by the central banks of the world, including America's Federal Reserve. The stock market fell 250 points when it opened on Friday morning, and the Fed injected billions of dollars, saying that it was "providing liquidity to facilitate the orderly functioning of financial markets." When the market fell again, the Fed pumped out more money. They did this three or four times, and by the end of the day, the Fed had poured $38 billion into the financial system, after injecting $24 billion on Thursday.

Central banks in the U.S., Europe, Japan, Australia and Canada, coordinating with one another, added about $136 billion to the banking system in an attempt to avert a crisis in global credit markets. Asian and European markets fell 2-3%, on top of earlier losses, but the New York markets pretty much recovered losses, as a result of a surge in the last 20 minutes.

Nouriel Roubini posted an article on Thursday analyzing the details of what's going on. He points out that what's going on now is much worse than the "liquidity crisis" that pundits have been describing.

Long-time readers may recall that I frequently talk of "exponential growth of public debt" in the United States. I use this phrase all the time to make a particular point, in response to people who question why this web site can't be more specific in its predictions of dates.

The criticism that I get is usually worded something like the following: "When can you ever be wrong? If nothing happens in 2004, then you can just say it will happen in 2005, and then 2006, and then 2007, and so forth. You can always say that the crisis is coming 'soon', and so you're never wrong."

I respond to such criticisms as follows: "Public debt has been increasing exponentially, and cannot continue to do so. If public debt ever levels off and starts falling, then at that point I will have to admit that I'm 'wrong.' In the meantime, a major financial crisis is 100% certain. It might happen next week, next month, next year, or thereafter, but it's absolutely certain."

Well now you can see those warnings come to fruition. For years I've seen the stock market bubble grow, the housing and credit bubbles grow, public credit and global account imbalances grow exponentially. I could predict with certainty that it couldn't last, and that a global financial crisis MUST come. And I explained the timing by means of generational changes -- from the generation that survived the Great Depression to the generations born AFTER the Great Depression. All of these things put together meant that a return to a 1930s style Great Depression MUST happen, but I could never predict exactly when.

But now the time is close. As Roubini points out, many of today's major institutions are not just having a "liquidity" or cash flow problem, that can be solved with a temporary infusion of cash. Instead, their debts are growing exponentially, and they can only be saved by exponentially growing additional infusions of cash.

I said for five years that this day was coming with 100% certainty, and now it's finally close.

An actual liquidity crisis did occur in 1998, when a very large hedge fund, Long-Term Capital Management or LTCM, collapsed, causing a domino effect that almost bankrupt a number of other institutions. Many airheads are claiming that what's happening today is similar to the LTCM episode, and that all the Fed has to do is lower interest rates by 1% or so, and the problem will be solved.

Roubini contrasts what's happening today to what happened in 1998:

"The 1998 LTCM crisis was mostly a liquidity crisis: the US was growing then at 4% plus, the internet bubble had not burst yet, we were in the middle of the "New Economy" productivity boom, households were not financially stretched and corporations were not financially stretched with debt either. In spite of those sound and solvent fundamentals the collapse of Russia – a country then with the GDP of a country such as the Netherlands – caused a global liquidity seizure and crisis of the type experienced by credit markets in the last few weeks: sudden demand for cash liquidity, sharp increase in the 10 year swap spread, sharp increase in the VIX [volatility index] gauge of investors’ risk aversion, liquidity drought in the interbank and euro-dollar market, deleveraging of highly leveraged positions, reversal of the yen carry trades. With the exception of the credit event in Russia, this was not a credit/insolvency crisis. And since it was a liquidity crisis, the Fed easing – 75bps [75 basis points = 0.75%] – was successful in restoring in a matter of weeks calm and liquidity in financial markets. Even that liquidity episode had painful credit fallout: it is not remembered by most but the entire subprime mortgage industry went bankrupt in 1998-99 following the LTCM liquidity crisis. So a liquidity shock event triggered massive credit events then."

Roubini's point is that in 1998, public debt was still well under control. From the point of view of Generational Dynamics, this is because there were still a few survivors of the 1929 crash and 1930s Great Depression, just enough people to maintain at least a little common sense in controlling debt.

However, those few remaining survivors disappeared completely in the early 2000s, and public debt reached a state of total debauchery, by new generations of Boomers and Generation-Xers who had/have no common sense whatsoever.

Roubini lists a number of institutions that are insolvent today:

Roubini points out that normally the Fed and other central banks are the "lenders of last resort," meaning that they can intervene only when other mechanisms fail, and even then cannot provide more than a temporary solution.

He points out that the International Monetary Fund (IMF) serves as a "lender of last resort" when an entire country is having a liquidity crisis, as in the cases of Mexico, Korea, Turkey and Brazil. Those were real liquidity crises, and the injections of IMF funds worked to resolve the temporary imbalances.

But other countries -- Russia, Argentina, Ecuador -- had actual "insolvency crises," and the injection of IMF funds "only postponed the inevitable default and made the eventual crisis deeper and uglier."

He adds that "provision of liquidity during an insolvency crisis causes moral hazard as it creates expectations of investors’ bailout." That's certainly what we're seeing today, as pundits and politicians increasing call for a bailout. The most talked-about example was the hysterical rant from CNBC's Jim Cramer, earlier this week.

Roubini concludes:

"Thus, while the Fed and the ECB had no option today but to provide massive liquidity in the presence of a most severe liquidity crunch and run, they should not delude themselves that this liquidity injections can resolve the deep insolvency problems of many overstretched borrowers: households, financial institutions, corporates. Insolvency/credit crises lead to financial and economic distress – hard landing of economies – and cannot be resolved with liquidity injections by a lender of last resort. And now the vicious circle of a weakening US economy – with a housing recession getting worse and a fatigued consumer being at the tipping point - and a generalized credit crunch sharply has increased the probability that the US economy will experience a hard landing. We are indeed at a "Minsky Moment" and this recent financial turmoil is the beginning of a much more serious and protracted US and global credit crunch. The risks of a systemic crisis are rising: liquidity injections and lender of last resort bail out of insolvent borrowers - however necessary and unavoidable during a liquidity panic- will not work; they will only postpone and exacerbate the eventual and unavoidable insolvencies."

I agree with everything that Roubini says, except for the indefiniteness of his conclusion: The "generalized credit crunch sharply has increased the probability that the US economy will experience a hard landing."

From the point of view of Generational Dynamics, the US will experience much more than a "hard landing," and with more than a mere "probability" -- it will experience a new 1930s style Great Depression, with 100% certainty.

From the point of view of Generational Dynamics, a generational stock market crash is overdue. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: Tulipomania bubble (1637), South Sea Bubble (1721), French Monarchy bankruptcy (1789), Hamburg Crisis of 1857, and 1929 Wall Street crash. We're now overdue for the next one. It's beginning more and more now to appear to be coming very soon. (11-Aug-07) Permanent Link
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