1. The Debt Crisis is Simple
Awash as we are in a sea of Federal Reserve- and Treasury Department-sponsored financial acronyms, it would be easy to assume the complexity of the debt crisis is beyond the comprehension of the average person. After all, who, apart from a wonkish cadre of financial engineering geeks, can be bothered with trying to sift through the details of things like the Primary Dealer Credit Facility or an array of seemingly sketchy repurchase agreements? Yes, it would be easy to assume the complexity is beyond comprehension; easy, but wrong.
Recently, I ran across a long-winded, chart-filled screed haranguing the Federal Reserve for single-handedly taking over the entire capital market. The claim actually made a certain kind of hysterical sense, perhaps because it appeared in bold typeface, even if it missed the point; outrage over the Fed intervening in equity markets is akin to expressing outrage over what color sack the robbers are using to haul away their loot. At what point did we all become armchair central bankers?
The reality is that the Federal Reserve is simply following the Irving Fisher debt-deflation game plan and doing exactly what the vast majority of US central bankers have always insisted they would be doing if trying to prevent a full collapse into a deflationary depression; that is, try and reflate.
2. When Did We All Become Armchair Central Bankers?
The various mechanics of this reflation attempt are only worth arguing about among armchair central bankers and the various banking system participants concerned with how big of a slice they're getting of the great reflation pie. For everyone else, things are far less complicated and, sorry to spoil a good conspiracy theory, far more bureaucratic and mundane. In order to understand it, let's go to the source.
Toward the end of the Great Depression, economist Irving Fisher outlined a nine-step sequence of events that followed a debt bubble, which became known as his Debt-Deflation Theory of Great Depressions. Believe it or not, the St. Louis Federal Reserve actually has available for download a very easy-to-read 21-page paper by Fisher outlining this theory here.
The paper consists of what Fisher called his "creed," consisting of 49 "articles." Among the most important for our purposes is number 20, covering "over-indebtedness":
Over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.
3. The Debt Bubble Sequence
In that brief article, Fisher handily summarizes why this is no ordinary recession. This debt bubble, over-indebtedness, was fueled by borrowed money, which was made too cheap for too long, and which resulted in massive over-investment, over-speculation, and over-confidence.
But everyone knows that. After all, it's how Alan Greenspan became a household name, appeared on the cover of Time magazine, and became known as The Maestro in the first place, and it's why all those accolades will ultimately be for nought as we continue to try and transfer the excessive corporate and public debt incurred during Greenspan's tenure, and which accelerated under Ben Bernanke, to government debt. More on that in a moment.
The debt bubble sequence Fisher described is very intuitive, which is why you don't need to know much about structured finance or the precise mechanics of Federal Reserve operations to see it play out.
According to Fisher, assuming over-indebtedness exists, the following chain of consequences will result in nine steps that are easy to understand, if a bit more complicated in their inter-relations: Step One
: Debt liquidation leading to distress selling. Step Two
: A contraction of deposit currency as bank loans are paid off, and a slowing down of the velocity of circulation.Step Three
: A fall in the level of prices, or a swelling of the dollar (assuming this fall in prices is not interfered with).Step Four
: A still greater fall in the net worth of businesses, leading to bankruptcies.Step Five
: A decline in profits, which leads to...Step Six
: A reduction in output, trade, and employment, which lead to...Step Seven
: Pessimism and loss of confidence.Step Eight
: Hoarding of money, slowing down still more the velocity of circulation, which conspires to cause...Step Nine
: Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in real, or commodity, rates of interest. 4. So, What to Do?
It's obvious, isn't it? Let's go back to Step Three in the sequence for a moment, "A fall in the level of prices, or a swelling of the dollar (assuming this fall in prices is not interfered with)."
Fisher writes, "assuming this fall in prices is not interfered with," an important observation. Later, he explains, "when over-indebtedness stands alone, that is, does not lead to a fall of prices, in other words, when its tendency to do so is counteracted by inflationary forces (whether by accident or design), the resulting 'cycle' will be far milder and far more regular."
And so there you have all you need to know about the Federal Reserve's game plan for ending the unwinding of the debt bubble. The answer is simple: reflate, reflate, reflate, by all means necessary reflate. 5. Will it Work?
Federal Reserve Chairman Ben Bernanke has been even more explicit than Fisher, who was writing more than 70 years ago, in the types of policies he believes the Federal Reserve should pursue in attempting to reflate and, it is hoped, avoid a deflationary depression.
Unless we're intent on debating specific monetary transmission mechanisms and the intricacies of trying to force feed more credit into the system, we can leave the actual mechanics to the armchair central bankers. What's important from our standpoint is one thing: Will it work?
Looking at the market through the lens of complex systems theory, the problem is actually one of time. On short-term time scales, the Fed and Treasury think they are rock stars, "The Committee to Save the World"... indeed. But on longer-term time scales we know they have simply made the problem worse. The question, then, becomes: How much longer?
Going back to Fisher's Debt-Deflation Theory, the dollar is the real canary in the coalmine because during aggressive debt deflation the value of the dollar "swells," to use Fisher's term. And I suppose that's what keeps me up at night. When I look at the dollar with long-term DeMark indicator studies applied, they're pointing to a high probability of multi-scale alignment by the first quarter of 2010 and a major bottom for the US dollar. Currently, there's a weekly TD Buy Setup that has been perfected, so the next four weeks for the US dollar look higher, after which we need one more move lower, preferably below 72.509, for a major bottom.
If the dollar does bottom, then it will become quite clear that reflation attempts have failed, and then we face the heart of the debt deflation where the swelling of the dollar competes simultaneously with debt destruction and where debt levels increase in dollar terms faster than they can be paid down.
Make no mistake, debt-deflation will conclude with an inevitable sharp rise in inflation as monetary policies designed to battle deflation remain in place even as excessive debt is eventually destroyed, but the outlook for the dollar says that isn't today's business. Be careful which scenario you're preparing for because those who anticipate inflation before the debt-deflation has fully run its course will find themselves digging out of a deep and painful hole.