The Collapse

For roughly the last eighteen months I have confessed my personal worries about the distinct possibility that an economic calamity lurks on the horizon. I fear this economic meltdown could be of a greater magnitude than the one that occurred eighty years ago.

My concerns have revolved around the Austrian thesis of inflated money credit. It is a theory that has been discussed often on this site. Since Mark Thornton provides an excellent explanation of money credit and how it creates economic bubbles, I will dispense with any further discussion on the basics of booms and busts.

Unlike the technology stock bubble back in 1999-2000, the current bubble has encompassed nearly all asset classes. As one analyst stated several months ago, it seems like the whole world is a bubble. Over the last five years we have experienced dramatic rises in the prices of oil, commodities, gold, stocks, foreign currencies and until recently, real estate. In addition, somewhat reminiscent of the events leading up to the Great Depression, the amount of leverage throughout the world has increased to unfathomable levels.

The non-government debt in this country consists of over a trillion dollars of questionable mortgage paper and one trillion dollars of credit card liabilities. The fallout from the housing boom is beginning to surface in the form of write downs by major financial institutions. It is speculated that the final tally of theses write downs may approach $500 billion. It is not clear whether the $500 billion includes the non-liquid paper held by hedge-funds or government pension accounts.

It must be remembered that hedge-funds are not bound by the same transparency regulations that apply to other financial entities. Furthermore, the margin requirements that apply to hedge-funds allow them to leverage their assets four or five to one; a scenario not too different than that seen during the run-up to the 1929 stock market crash. One final note about hedge-funds, the other part of the bubble has been the numbers of hedge-funds. A decade ago the number of hedge-funds totaled a couple hundred; today there are over 9,000!

With all of this as a backdrop, the perplexing actions of the Federal Reserve, which has cut rates and injected hundreds of billions of dollars into the economy over the past six months, becomes apparent to their purpose. Federal Reserve Chairman Bernanke holds to a belief that the financial markets are the keys to economic growth. Therefore, everything must be done to insure the continued upward movement in financial prices. Chairman Bernanke’s decisions are based on what economist term the “wealth effect”.

The concept is rather simple to imagine since many of us have fallen prey to it. As your hard assets, real estate or stocks for example, increase in paper value, the individual feels wealthier. This sense of wealth entices the individual to spend more, save less, and in some cases take on additional debt. We witnessed this effect recently in the explosion of home equity loans. People borrowed against the hypothetical increase in the value of their homes. I say hypothetical because there is no real value in an asset until a transaction occurs. People may do the same in regards to their stock portfolio or 401K. When stock prices rise appreciably, individuals will behave in a similar manner as with an increase in home values.

The economic consequences of the “wealth effect” as the bubble inflates are debt at an almost unserviceable amount. The orgy of spending has depleted savings and the capital stock. As assets decrease in value, the “wealth effect” works in reverse and economic activity declines. With the housing market plummeting in value, Bernanke is desperately trying to support the other leg of the “wealth effect”, the stock market. For if the market tumbles, then a chain of events will begin that could lead to a complete collapse of economic confidence.

-To be continued-

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