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The Fed is Keeping the Top Spinning


The Fed and Wall Street have been able to keep the top spinning longer and longer not by changing the nature of the top, but of the surface on which it spins.

While the world is looking for the bottom of the correction in stocks and credit and any rally as a signal to such an end, I view current market conditions more as a "spinning top slowing down and starting to wobble".

The law of inertia tells us that you can't speed up a top's spin once it begins to slow down: you have to wait for the top to lose control and topple before starting it spinning again. The Fed and Wall Street have been able to keep the top spinning longer and longer not by changing the nature of the top, but of the surface on which it spins. Instead of the top spinning on, let's say, wood, they have changed it to glass, creating less friction and allowing the top to spin longer. But a toppled top slides more on glass than on wood.

The top is the U.S. economy, the spin or inertia is credit, and the glass is derivatives.

The "strong U.S. economy" has been pushed and pushed along by 25 years of hyper credit expansion fostered by the Federal Reserve. When witnessing the tumultuous results of just a slowing down of the credit expansion, one can only imagine the problems that will surface once credit begins to contract in earnest. The only way there will be new "money" coming into the markets to buy up assets is if the top can be set to spinning again in the middle of its topple; this requires credit expansion to miraculously begin again just as investors are anxious to shed debt. The reason this is so is that the world has confused money with credit. Let's try to straighten this concept out.

Money is a medium of exchange accepted by all parties in an economy. Look at that sentence carefully. "Accepted" connotates that money is a store of value that everyone agrees upon. Money is created in an economy by productivity: excess that produces income that can be saved or invested. Money is real liquidity and can be looked at as the total of savings and investment.

Also implicit in the statement is that the "amount of money in a system should be roughly equal to the total real value of assets in a system" in order for the value of the exchange to be agreed upon. Otherwise the prices of real assets will fluctuate only because the accepted value of money is fluctuating.

But this is not quite true. Actually the value of all assets is about equal to the amount of money plus the amount of debt. Debt is artificial liquidity, re-distributing future real liquidity from the future to the present. Debt should only be incurred when it is estimated that future income from productivity can support it. This is what investors do: estimate those probabilities and arbitrage with their own money.

And here lies the crux of the matter: what the Fed has done over the last 25 years is artificially decrease the relative value of real money in the U.S. system while increasing the relative value of debt. It has done so with no concern for the level of income generated to pay that debt back. The Fed through their hyper expansionary credit policy and Wall Street through financial engineering have loaded the system with debt not supported by a commensurate level of future (present) income.

If you look at any historical measure, the amount of debt relative to real money is extremely high. The actual real money in the system is a mere 0.2% of what people call the total "money supply". When we try and calculate broad money measures and say they are growing (at least until recently) at 10-12% we are really saying debt is growing by that amount. We have had debt growing almost five times faster than GDP. We now have total debt in the U.S. at 3.5 times GDP (and these statistics are using the government's own bloated GDP calculations in fact); the closest ever to that number was 1929's 2.9 times. Of course back then we didn't have "derivatives": we only had wood, not glass.

Credit is something much different. Credit is those with "money" giving someone else the right to spend that money. Normally that credit is rationally evaluated by investors who parcel it out carefully with their own money on the line. But there have been massive changes in the way "money" is lent over the last several years, such as pension managers buckling to severe pressures to perform, such as mutual and hedge fund managers running other people's money and taking too much risk, such as the massive expansion of derivatives to slice and dice risk so as to give a false impression that risk is reduced, and such as banks having lower and lower margin requirements to hold capital against loans.

One key element, however, is the Fed's insistence to keep real interest rates negative (the BLS clearly under-states price data to make this so). "Free" credit is hard to turn down, especially by speculators. I remember listening to a prominent Wall Streeter and hedge fund manager saying, "Investors have rationally taken that free money and spent and invested it." I thought at the time he was wrong, that free money comes with a hidden cost called risk. The market now is starting to realize this is true.

But the Fed has been able to accomplish what it has only because investors, for the above reasons, have lost sight of this hidden risk. The Fed doesn't really have the power to create more and more of this artificial liquidity called debt; they need investors to cooperate. Here is why.

The Fed really only can do two things (Prof. Succo has explained this situation, but let's go over it again). They can lower margin requirements for banks, the amount of capital they have to hold to make loans. That it has already driven to basically zero. So the Fed cannot allow banks any more "leeway" than it already has.

They can also perform open market money operations like REPOS and coupon passes. The Fed calls up big banks and buys their government bonds out of their portfolio. But they don't buy them with real money; they buy them with credit newly created just for that purpose. The big bank can then lend that credit out in a much greater amount because the Fed only requires them to keep a small fraction of that credit to support whatever the bank wants to lend out. This is our wonderful fractional reserve system. If everyone went to the bank to get their "savings" at once they would find that they could get out less than 1%.

But here is the key. The bank must ultimately be willing to lend it and then find some investor to borrow it. This has been no problem whatsoever over the last several years. Now most investors realize that they have too much debt, that their level of income cannot support it. Banks realize this too and have increased their lending requirements. The last borrower is always the most aggressive speculator.

So most market participants are now looking for ways to pay back debt (deflation) just when the Fed is desperate to get investors to borrow more (inflation).

The top is only beginning to wobble. When people tell me "there is so much money out there" I tell them that no, there is so much credit out there. This will be a muli-year process of debt reduction and deflation to correct what the Fed has wrought.

Best regards,
Mr. Practical
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