The Arrival Of The Credit Crisis

Those of us who closely follow the credit cycle should not be surprised by the current slide in equity markets. It was going to happen anyway. The timing had recently become apparent as well, and in early August I was able to write the following:

“The timing for the onset of the credit crisis looks like being any time from during the last quarter of 2018, only a few months away, to no later than mid-2019”. [i]

The crisis is arriving on cue and can be expected to evolve into something far nastier in the coming months. Corporate bond markets have seized up, giving us a signal it has indeed arrived. It is now time to consider how the credit crisis is likely to develop. It involves some guesswork, so we cannot do this with precision, but we can extrapolate from known basics to support some important conclusions.

If it was only down to America without further feedback loops, we can now suggest the following developments are likely for the US economy. Warnings about an economic slowdown are persuading the Fed to soften monetary policy, a process recently set in motion and foreshadowed by US Treasury yields backing off. However, price inflation, which is being temporarily suppressed by falling oil prices, will probably begin to increase from Q2 in 2019. This is due to a combination of the legacy of earlier monetary expansion, and the consequences of President Trump’s tariffs on consumer prices.

After a brief pause, induced mainly by the threat of an unstoppable collapse in equity prices, the Fed will be forced to continue to raise interest rates to counter price inflation pressures, which will take the rise in the heavily suppressed CPI towards and then through 4%, probably by mid-year. The recent seizure in commercial bond markets and the withdrawal of bank lending for working capital purposes sets in motion a classic unwinding of malinvestments. Unemployment begins to rise sharply, and consumer confidence goes into reverse.

Equity prices continue to fall, as liquidity is drained from financial markets by worried investors, but price inflation remains stubbornly high. Consequently, bond prices continue to weaken under a lethal combination of foreign-owned dollars being sold, increasing budget deficits, and falling investor confidence in the future purchasing power of the dollar.

The US enters a severe recession, which is similar in character to the 1930-33 period. The notable difference is in an unbacked pure fiat dollar, which being comprised of swollen deposits[ii] (currently 67% of GDP versus 36% in 2007), triggers an attempted reversal of deposit accumulation. The purchasing power of the dollar declines, not least because over $4 trillion of these deposits are owned by foreigners through correspondent banks.

One bit of good news is the US banking system is better capitalized than during the last crisis and is unlikely to be taken by surprise as much it was by the Lehman crisis. Consequently, US banks are likely to act more promptly and decisively to protect their capital, driving the non-financial economy into a slump more rapidly by calling in loans. Price inflation will not subside, because that requires sufficient contraction of credit to offset the declining preference for holding money relative to goods. Any credit contraction will be discouraged by the Fed, seeking to avert a deepening slump by following established monetary remedies.

The Fed’s room for maneuver will be severely restricted by rising price inflation, which it can only combat with higher interest rates. Higher interest rates will become a debt trap springing tightly shut on government finances, forcing the Fed to buy US Treasuries under cover of monetary stimulation. The true reason for QE will be that with a rapidly escalating budget deficit exceeding $1.5 trillion and more, the Fed will want to suppress borrowing costs compared with what the market will demand. Economic conditions will be diagnosed as a severe case of stagflation. In reality, the US will be ensnared in a debt trap from which the line of least resistance will be accelerating monetary inflation.

It will prove difficult for neo-Keynesian central bankers to understand the seeming contradiction that an economy can suffer a slump and escalating price inflation at the same time. It is, however, the condition of all monetary inflations and hyperinflations suffered by economies with unbacked fiat currencies. The choice will be to rewrite the textbooks, discarding current groupthink, or to soldier on. We can be certain the neo-Keynesians will soldier on because they are intellectually unable to reform existing monetary policy in a manner acceptable to them.

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Carol W 9 months ago Contributor's comment

you certainly paint a very biased bleak picture but I would expect no less from a gold bug. Good grief why am I even reading this stuff! Oh and please alert Mr Buffet about the impending doom of the US banks. He's been buying them with both fists.

Carol W 9 months ago Contributor's comment

Since when has inflation surfaced when commodity prices are at all time lows? I get that the #tradewars can ignite inflation If #Trump does not fix the disaster he started.