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The Credit Cycle Is Not Over


Backstops, government-lending won't naturally lead to private-sector growth.

Editor's Note: This was originally posted on the Buzz & Banter. It's being republished here for the benefit of the Minyanville community.

I was asked about my thoughts on an article arguing about the bullishness of the credit markets and how it will drive the next leg of an equity rally (before it all comes to a terrible end).

I think basically, the same argument was made in Japan for years -- that banks had little incentive to sit on reserves and would kick-start credit growth with a helping hand from the Ministry of Finance/Bank of Japan (MOF/BOJ). In fact, that didn't occur, as bank lending ended up contracting monthly year-over-year for years, as bad debts were the match to build up in reserves.

The cyclical credit argument is appropriate only to the point that a credit peak (i.e. 100-year mortgages) hasn't been reached and a shift in psychology toward debt hasn't occurred. That's not the case in the US, as exemplified by one, continuous excess reserve buildup at the Fed; and two, the 50-year year-over-year contraction in consumer credit (albeit a smaller chunk of entire credit circle, but it feeds up the chain into larger credit). The role of fiscal expansion, irresponsibly, is exactly economist Gauti Eggertson's argument from circa 2002, of which Bernanke is quite familiar. The Fed is following that blueprint.

The problem is that the argument ignores first, the total global credit pyramid; second, the degree to which the Fed/Treasury balance sheet can be expanded to offset private credit contraction; and third, the degree to which household balance sheet contractions influence credit aversion.

I disagree strongly that the credit cycle is essentially over for all the reasons I've written about over the last year. There are people who think the government keeping credit growth going (via backstops, via government-lending, etc.) is a good thing and will naturally lead to private-sector credit growth. This goes 100% against the Austrian theory of business cycles -- the same theory that allowed me to see the bust process coming in the first place (unlike the traditional analysis just about every other traditional economist employs). One person wrote, ''Banks now use record-high reserves to buy government debt and recapitalize." This
isn't correct; their excess reserves sit earning 0.15% at the Fed.

If these monies were to come out of the Fed and start to be lent by those banks, then we might be able to make the case that the credit cycle has turned. Whether equities have another leg up from there after a 50% straight up move is another analysis altogether.
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