I love to read the "Zero Hedge" blog - it is brilliant, quirky, irreverent... and constantly questions its own assertions (and they use one of my favorite movie lines ever at the head line of their blog: "On a long enough time line the survival rate of everyone drops to zero". Isn't that just delicious?)
To cut to the chase, the following is a quote from a recent post that you should read in its entirety (and that I found to be the most disconcerting thing I have ever read - because I DID assume "that the existing liquidity pyramid would persist"):
As the above Gordian Knot chart indicates, there is much as stake here, and much reason for the authorities to distract the general populace with such silly concepts as a Consumer Protection Agency and Healthcare Reform. Indeed, shadow economy investors stand to lose over $70 trillion dollars should the traditional-shadow banking linkage be broken and the cash flow transfer process be disrupted. The bigger question: how much longer will such cash flows sustain in the current day and age when real demand has collapse courtesy of record domestic unemployment. The biggest question: what happens when there is a secular change to the prevalent level of capital flows into shadow banking. One of the primary reasons for the massive expansion in the money system (via the credit pyramid), has been precisely the shadow banking system, which is second only to the credit and interest rate derivative market (incidentally we were fascinated by the race to the currency bottom, and the technical associated short squeezes in the Dollar and Euro, in May 2009, long before anyone even considered such now daily discussion pieces).Yet should shadow baning disappear, the tranche above it (or below it by seniority) would disappear as well. And with 90%+ of global liquidity gone, and no additional source of "credit" money to fill the Fed's infinite demand for monetary supply, asset prices will explode (forget about gold - one apple will be $6,000 an ounce). Deflationists are right that ceteris paribus asset prices will decline, and that the Fed is powerless to stop this. Yet deflationists take one huge variable for granted: that the existing liquidity pyramid will persist. It is obvious that should another systemic stress episode emerge and money contract by a massive amount, the end consumer will matter little when total global credit collapses from $600 trillion to mid double digits, thereby decimating the real shadow monetary base, and realligning global assets with a liability side in flux. After all, the key offset to CPI going stratospheric over the past 30, 50 and even 100 years has been precisely the emergence of the alternative banking system, with its influx of tens if not hundreds of trillions of "shadow" dollars, which almost ceased to exist in the 2007-2009 crisis. The netting of intangible money to tangible currency in circulation would be a forced explosion in the money multiplier by the same amount as the shadow economy has sucked out in a vacuum of expiring credibility overnight.For this, and much more we recommend a read of the attached "Q&A about the Financial Crisis" in which Gary Gorton discusses before the US Financial Crisis Inquiry Commission, in very clear language, the big dangers still facing shadow banking.
Ouch. (BTW... "ceteris paribus" = all things being equal).
This is a critical point, and one that I thought would be an issue further out on the time line. This requires some noodling.
41 comments:
I read this last night... I downloaded the PDF and will read it later today. I thought about some of the recent back and forth here with bureaucrat as I read this post. It basically spelled out why I think bur can be very right and very wrong at the same time. Yes, everything is overflowing right now but if the scenario spelled out here came to pass it could also go to hell very quickly, thank you Credit Swap Derivatives...
I worked for Moody's for 5+ years in the late '90s and It was there, publishing their research that I got my education in finance. I would read about ABS, MBS, CDOs and all the other assorted BS and till this day, the best I can understand it, coming from an art background, was to think of MDY as a couple of bookies a la Randolph and Mortimer Duke. But the horror I see in Credit Swap Derivatives is more akin to 'Goodfellas.'
"Paulie could do anything. Like run up bills on the joint's credit. And why not? Nobody will pay for it anyway. Take deliveries at the front door and sell it out the back at a discount. It doesn't matter. It's all profit. Then finally, when there's nothing left... when you can't borrow another buck from the bank... you bust the joint out. You light a match."
Unfortunately, the U.S. of A. is the Bamboo Lounge and I haven't a clue who 'Paulie' is.
Requires a LOT of noodling as I have a master's degree and I barely understood any of this. It is "shop talk" for people who maybe understand such complexities (people that got us into this mess). If something is THAT important, it can be explained simply. When something tries so hard to "look like a PhD dissertation on right-quark physics," it loses its power.
"Real demand has collapsed"? While demand for granite countertops has definitely collapsed (a good thing), not a lot has. People were still in the American Girl store (yesterday) buying $200 dolls and getting their dolls' hair cut (yes, such places exist). Michigan Ave. in Chicago, where all the upscale shopping is done, was not deserted at 2pm.
"Record domestic unemployment"? Yes, 10% is very high and probably is in reality higher still, but the Federal govt., for one, still has LOTS of people at their desks, being overpaid as always, spending as always. And I'll bet we aren't alone.
The piece starts out with extreme platitudes and continues with technical gobbeldy gook. :) They are right about one thing -- there won't be another extreme change in the financial picture until we have another extreme event like Lehman. Till then ... sideways rules.
I read this yesterday. It's back to the concept that money is a belief; if I believe this piece of paper is worth $100 and you believe its worth $100 we can swap goods to that value.
But the moment one of us stops believing that, the whole system collapses.There is no residual value to the bits of paper (or the ones and zeros in the computer memory).
Shadow banking is the biggest belief system since Jesus. All you financial agnostics may soon see be seeing the harsh light of atheism!
I agree with Bur. Is there a simple explanation why prices will rise if 90% of the money disappears? This is more the description of a complete credit collapse. Very deflationary. Probably a do-over. Bondholders get nothing. I fail to follow the logic.
Regards,
Coal Guy
I had to plow through it line by line (if you need something canned, I'm your girl but economics is NOT my field). Still, I needed not noodling but Pepto Bismal.
And for you empiricals out there, while the Dow has continued to rise, commodity prices (including oil prices), the building blocks of the economy, have been sideways since last June.
Re: "Flat since June"
Well, the average monthly spot price in June, 2009 was $70, versus $78 and $76 for January & February, 2010 and around $80 currently. Note that the January/February, 2010 price was almost twice what we saw in January/February, 2009.
But here is the annual spot crude oil price chart:
http://tonto.eia.doe.gov/dnav/pet/hist/LeafHandler.ashx?n=pet&s=rwtc&f=a
Relative to the annual price of $14 in 1998, in 2009 we saw a 14%/year rate of increase from 1998 to 2009, down from the 20%/year rate of increase that we observed from 1998 to 2008. It's interesting to compare how a basket of auto, housing and finance stocks have performed over the same time frame.
Re: "While the Dow has continued to rise"
Correct me if I am wrong, but isn't the Dow below the level we saw 10 years ago?
In March, 2000, the monthly spot crude price was $30, versus around $80 currently.
And doesn't the Dow have a "Survivor's Bias," with low performing stocks kicked off the index?
Bureaucrat is correct.
As long as there are Hostess Twinkies on the shelf at 7-11 and government drones are busy at their desks, we have absolutely nothing to worry about.
And the twinkies are still there! :)
As far as the market bull-bear goes, it always depends on your starting point. The Dow is down if you look back 10 years. :) But for the last nine months, since the S&P 500 low last March of 666, the Dow has been rising -- some say they only entity that can possibly have the money available to push up the Dow now is the Fed, so it is likely a phony rally, but a rally nonetheless.
The oil price has been overall flat since last summer, after the phony rally to 147 in '08 and the crash afterward to 30ish. Since last summer, it has been going sideways (up-down-up-down-up-down).
Bur,
I'm of the opinion that the stock market is up because there is no other game in town. There is no return on any short term debt. Long term is too risky versus the return, as interest rates have nowhere to go but up, and expecting to hold a 10 or 20 year note to maturity in this climate is insane.
Anyone,
I still don't understand this guy's conclusion. How does a credit collapse cause inflation? This article reads like one of those fabricated doom things on the gold sites.
Regards,
Coal Guy
So, if the stock market and oil prices stay flat from here for 2010, the Dow Jones (with a survivor bias--we have to see who was kicked off in the past 10 years) is negative relative to 2000, while annual oil prices would have risen at about 10%/year?
Regarding the "phony rally" to $147, almost no one actually paid this price in the physical market. The monthly high was $134, and a far better indication of what producers actually received and what consumers actually paid was the average annual price of $100.
In any case, here is a chart of annual oil prices versus annual net oil exports from the (2005) top five net oil exporters:
http://www.theoildrum.com/files/slide1.png
Basically, importers bidding against each other for declining net oil exports bid the price up until aggregate demand (temporarily) fell below the supply of net exports. Not much of a mystery here.
There are a couple of issues.. and I am by no means even remotely done "noodling" this (I'm a bit slower than I used to be, but I grind more finely), and, as always, I will be calling on some of my "brain trust".
But:
As Donal points out Money is belief
and
it seems "Tyler Durdan" believes.... if the multiplier mechanism forces the traditional system to replace lost shadow money supply with traditional money supply that the effect would be very very inflationary...
And getting back to the "liquidity pyramid"... each debt in a fractional reserve banking system backs another debt ad infinitum .... if that pyramid fails, then perhaps the Fed fails... and those things in your pocket are called Federal Reserve notes...
like I said... I gotta think about this a little more...
Greg,
Still noodling, too. It looks to me like there is a secondary derivative market for every traditional debt instrument, and the banks have repackaged and sold much of their traditional debt into this shadow market. The cash flows from this repackaged debt have to continue for the banks to remain liquid from day to day.
So, if investors lose faith the the derivative markets, the returns that support the traditional institutions will cease. The banks will become insolvent on a scale that is so massive that it is beyond salvation, and the whole house of cards comes down.
It doesn't look like an inflationary event to me. It more looks like 90% default, and no one has any cash. If the Fed tries to make everyone whole, I guess that would be inflationary. I think that is what you just said. I don't have the knowledge of how these markets work to take this any further.
That does seem to follow the general plan to keep the bondholders whole and hang the debtors out to dry.
Regards,
Coal Guy
$147 was easy to explain. I am 42 years old, and I'm just like the average traders out there who were looking for "the investment of the century." Peak Oil is universally believed to result in supply problems very soon. There is no cheap substitute for oil. However, 6.5 billion people worldwide can't live like "Americans" without an oil-driven economy. So, if you are the average 42-year old trader, and you want to lock in the inevitable oil profits, and you have LOTS of low-interest borrowed money, you watch with glee as the oil price goes up and up, and you jump in fast, pushing the price even higher.
Hell, I was doing it too! I gained $30,000 in my IRA in 1-2 years just from mutual fund oil stocks. It was exciting! And every person with disposable income was throwing money at it.
Supply and demand for oil had almost NOTHING to do with it. What happened was what has happened every 75 years or so -- an "asset bubble" -- "irrational exuberance" times ten. Excited people with too much money and stagnant incomes for 30 years (in the U.S.) trying to somehow solidify their retirement.
That is why oil prices traded at $147/barrel, and also why it came crashing down just as fast to $30/barrel two months later. That's why we can say it wasn't a supply thing -- by how fast it came crashing down.
Asset bubbles participated in Crash of '29, the John Law Louisiana bubble, the South Seas bubble, the Tulip bubble, and every other bubble in the 500 years of recent human history.
We were BADLY SERVED by the economic historians and the mainstream media out there, who should have all known better -- especially that parasite Greenspan! He coined the term "irrational exuberance," but kept the interest rates low -- he poured gasoline on a fire.
If I'm wrong, where is the lack of oil supply now? :) We're swimming in both oil and natural gas. It was an asset bubble, people. Simple.
Re: Bur
Again, annual oil prices do a far better job of indicating what producers actually received and what consumers actually paid.
For example, if you are on commission, and you make $50,000 in January and $10,000 for the other 11 months, what is a better indication of your income, the monthly peak of $50,000 or the annual total of $160,000?
The key point about 2006, 2007 and 2008 is that we did not see a positive crude oil supply response as annual oil prices rose from $57 to $100. Instead, we saw cumulative shortfall in world crude oil production, and more importantly, a cumulative shortfall in net oil exports (both relative to the 2005 rate).
In 2009, aggregate demand fell below supply (partly because of the economic contraction resulting from the runup in oil prices necessary to balance demand against contracting supply), but the annual price only fell to $62--higher than all annual prices prior to 2006.
IMO we are in the process of transitioning from a combination of voluntary + involuntary reductions in net oil exports to mostly involuntary reductions in net oil exports.
Consider the simple fact that the current price of oil is higher than all previous annual oil prices, except for 2008.
I read this report also and I have to say it made my brain hurt. I can't figure it out at all because as the Coal Guy says. 90% of money disappears overnight and we are supposed to have 6000 dollar apples?!!!? How the heck does this happen. Having more money being generated by the shadow banking system has been helping to keep inflation DOWN?!!? This is Alice in Wonderland kind of logic to me and I only have two MBA's (one was an executive one from Stanford so doesn't really count). This sounds important and fits into the gloomy mindset of "the thing is about to blow" and it may be correct but it just doesn't pass the sniff test at first perusal. I would think that this is about as deflationary as it can get at least in the short term. If there is a hyperinflation later on or not is anybody's guess but economics 101 dictates that shortage of money or credit does not inflation make.
Best,
Chuck H.
Yeah but a dollar is worth less now too. You have to use inflation-adjusted or gold-euro-dollar-index something to see what a barrel of oil is really worth over time.
I have no complaints (yet) with the oil export model you have worked on. :) I'm a simple guy. It is a simple concept & simple graph. But like I said before, it seems like oil supply is constrained so much by incompetence these days, it is hard to see a geological dropoff. :)
You guys just don't seem to get it. Money isn't REAL, there's nothing real holding it up in the air, it just sits there as long as YOU believe its there. If YOU will accept a bit of paper for your house or your car, then the paper is 'worth' the house or the car. But its only a piece of paper!
The shadow banking market has no reality - if I owe you $5,000 and you owe me $5,000 it isn't $10,000 of money, its nothing!
Try this; http://www.chrismartenson.com/crashcourse/chapter-7-money-creation
No wonder we're all in so much trouble!
Why don't we price oil in terms of Citigroup stock? It looks like a barrel of oil would have cost about 0.75 shares of stock in 2000, but about 20 shares of stock currently--a 26 fold increase. (Or we could use Apple stock for a different picture I suppose.)
But if we want to compare inflation adjusted prices, we can, but we need to apply it to the Dow Jones too, and IMO, we need to account for the Survivor's Bias inherent in the index, whereas a barrel of light, sweet crude has the same BTU's now that it had in 2000.
Regarding incompetence, it didn't seem to be a factor from 2002 to 2005, as crude production and net exports showed large increases--as oil prices rose. But then from 2005 to 2008, we had cumulative shortfalls--as oil prices continued to rise.
2005 was coincidentally the year that Deffeyes predicted to be the most likely for a final production peak.
Chuck H. and Coal Guy:
Guys, I have been a deflationist... and losing 90% of the "cash" in the system sure sounds deflationary at first blush...BUT the more I thought about the "liquidity pyramid" the more I think about what disconcerted the sh*t of me the first time I read it...
What if the demolition of the pyramid causes the Fed to fail - then you would have $6000 apples... or even if the Fed does not fail, but has to bail out the the system through "QE" or just plain give aways... same outcome.
BTW I forgot to include a link to the other part of "disconcerting" ...
here it is:
http://www.zerohedge.com/sites/default/files/Q%20and%20A%20on%20the%20Crisis%20Feb%202010.pdf
The more I think about it the more I come back to my original thought: That irrespective of governments to support their currencies by demanding that taxes be paid in said currency, a failure of the "liquidity pyramid", to my mind, means that the loss of the liquidity provided by the non-banks would need to be replaced the Federal REserve system. IF, and its a big IF, they were successful, they would set of rampant inflation because, much as the current environment of bank reserves that are not getting into the system are NOT causing inflation, a successful replacement of the shadow's liquidity WOULD be very inflationary, and a failure would be beyond inflationary.
At least that's what I was thinking when I first saw this...
I also think it helps to have the schematic in front of you when you think about this...
Donal:
We can't help ourselves! Of course you are right... some people buy the puzzle already assembled... what's the fun in that?
Coal Guy:
I did not out and out say "the fed will make everyone whole" but I guess in the end that is exactly what I said... I wasn't looking at it that way, but that is how they would most likely have to do it.
OK Greg:
I will go back to the report to study it some more. Hopefully it makes more sense. In effect what you are saying is that if the shadow banking system collapses it will result in total failure of the banking system, the fed and currency. I also have a hard time seeing how we are going to get hyperinflation out of that. If Fed has failed how the heck can they create more money? Anyway, I will think about it a bit more.
Best, Chuck H.
PS note how fully armed I am against the Venusian threat!
Dang display names. Now I am a girl. Crud.
I think Hugo Chavez is just another communist screwup, and he's destined to fall. He appears to be doing everything wrong even now. Once he gets dispatched, and if we are lucky enough to get there first, and jump on the Orinoco Belt first, we'll see just how depleted they really are. :) Mexico is one small step from failing, and they would be an easy invasion too. Or, maybe they have both peaked and nothing is to be done. But that just isn't the optimistic American way!! :)
Well, I for one am glad I came back tonight to read all the comments because I don't feel so inferior as I had this morning when I first read the column.
Years ago when I took the various Economics courses that I did, I used to look at high inflation or deflation as opposites, and of course, to a point they are. What I didn't understand, however, until recently, is how similar they are too. That is, they are both highly destabilizing to the economy and faith that people put in fiat money if the rate of inflation or deflation is too great.
I liken the area the money economy is operating in now as something akin to the "coffin corner" part of the performance envelope of a subsonic (usually jet) aircraft. http://en.wikipedia.org/wiki/Coffin_corner_%28aviation%29
What happens in the "coffin corner" is, that as an aircraft climbs higher in the sky, the air thins out. This increasingly thin air means two things happen. First, the stall speed of the airplane (the point at which the airflow breaks away from the wing/airfoil and stops providing lift) drops as one continues to gain altitude. At the same time, the speed of sound is dropping (the Mach number.) Now an aircraft designed for subsonic flight can and will encounter GREAT difficulty flying into air at greater than the speed of sound. Ailerons and other control surfaces malfunction. All kinds of turbulence set up. Airframe failure is also quite possible if the aircraft is pushed too hard past Mach 1. But flying up to and then above the speed of sound becomes a requirement, because recall, the stall speed is increasing. So an airplane must increase speed to stay above stall, but must stay below the speed of sound. Eventually flight becomes nearly impossible because the margin for error becomes too small. Even maneuvering becomes impossible because turning and banking - actions that impart even greater loads on the wing and stabilizer airfoils - raises the stall speed even further. In short, the plane enters an operating zone where almost any action is destabilizing except to descend into thicker air.
Unfortunately, up, up, and away and into thin air is where our money economy is headed, where we have inflationary pressures on one side, and deflationary on the other. Destruction of large parts of the money supply would cause deflation, except that credibility in that money is now so suspect we could easily whipsaw into hyper inflation as we attempt to pull out of the deflation.
How the government and the fed back the money economy down back into thicker air....? Well that's the question, if it can even be done at this point.
By the way, I am NOT a pilot, but merely a long time wannabee. I hope I explained the coffin corner thing more or less accurately.
I think the comparison is fairly apt.
Grrrr,
I mispoke a bit on that coffin corner thing.
The start of my fourth paragraph should say:
"What happens in the "coffin corner" is, that as an aircraft climbs higher in the sky, the air thins out. This increasingly thin air means two things happen. First, the stall speed of the airplane (the point at which the airflow breaks away from the wing/airfoil and stops providing lift) INCREASES as one continues to gain altitude. At the same time, the speed of sound is dropping (the Mach number.)"
Stall speed goes UP, sound barrier goes down as altitude increases....further gains in altitude and flight itself become impossible.
Sorry I can't type.
Lots of poor logic, first he states:
“…banking panics continued. They continued because demand deposits were vulnerable to panics.”
Panics do not happen because they can happen.
“Subprime started significantly deteriorating well before the panic… Moreover, subprime was never large enough to be an issue for the global banking system. In 2007 subprime stood at about $1.2 trillion outstanding, of which roughly 82 percent was rated AAA and to date has very small amounts of realized losses. Yes, $1.2 trillion is a large number, but for comparison, the total size of the traditional and parallel banking systems is about $20 trillion.”
Subprime was 6% of the market and 82% of it was AAA. That is not an insignificant amount of grift. What does that do to trust? It’s worth noting our entire economy is built on trust.
“The parallel or shadow banking system is essentially how the traditional, regulated, banking
system is funded.”
Roughly 5% of that new funding is fraud it’s not hard to figure out what that does to the other 95% regardless of its true value. Trust is gone. I would consider this to be massively deflationary however; the chart on page 10 shows the government is on the hook for up to 11 trillion through the FDIC and up to another 40 trillion via PBGC. How can they fund that??? I know it will not all come due, but still…
Also what does deflationary collapse do to the MBS that the FED is stuffing on the asset side of its balance sheet against the currency on the labiality side? It also would limit the government’s ability to raise income via taxes. That is important not just for government funding of amongst other things Bureaucrats salary, but also because other pillar supporting the currency is T-bills, and T-bills are supported by the government’s ability to tax us.
I still think he is off by a mile though.
Doh,
did not mean to post first three lines at 5:56 decided he is not totaly FOS, just misguided, and changed direction.
Well... I am glad we got this sorted out.....
Gary Gorton's Q&A make perfect sense as an explanation of what happened in the financial crisis and the shadow banking system.
The comment about gold and the $6000. apple are Tyler Durden's of Zero Hedge Blog words in his essay commenting about Gary Gorton's work. Big difference.
It would be interesting to see if Gorton has anything to say about gold and commodities, but in the Q&A these things are only addressed tangentially.
Good link, Thanks, keeps the brain ticking along!
Cheers
Here's a second dose:
The Emperor has no clothes, but you believe that he has.
You believe it because the Fed is the one telling you how beautiful the clothes are.
You guys are discussing the colours, the style and the quality of the clothes.
If you no longer believe in the clothes, then everything falls apart and the Fed is dust!
Think Weimar. Not a retraet, but a collapse, only shadow banking makes it bigger.
But we'll all be ok, just keep believing. Wow, look at those pretty colurs!!
I am apparently not alone in experiencing headaches while contemplating monetary policy, but I do find it interesting that even most hard core deflationists agree that it is when, not if, that we experience inflation/hyperinflation.
IMO, constrained oil supplies are acting as an accelerant, pushing us faster along the path toward inflation/hyperinflation.
I wonder if the basic point of the article is that loss of faith in the value of currency can happen very quickly? I believe that the German hyperinflation occurred very quickly.
I've compared it to reverse game of musical chairs, where people gradually move out of cash holdings to assets like food & energy, and the last person holding most of the cash when people lose faith in currency is the loser.
Westexas:
RE: the "point" of the article.
That was my take away... that removing the "shadow" system from the entire system would lead to a breakdown in the "liquidity pyramid"... leading immediately to hyperinflation.
I moved to the deflation camp almost 2 years ago, but my partner, the MS, believes that at some point we go from Deflation to worthless currency in very short order...
To ALL:
Thank you for your comments and thoughts on this very difficult to understand issue... always best to have several minds thinking on an issue...
Every episode of hyperinflation in the past has had a "backstory" to it as to why it happened. Governments don't just start printing for laughs. In the case of Weimar Germany of the 1920s, the hyperinflation occurred because Germany, after it lost WW1, was required to pay back the allies for their losses, and so the Germans printed currency to pay them back. Why not? They had lost, nobody was listening or thinking, so they had no other choice. Hyperinflation didn't come out of nowhere. Every nation knows what happens when you print/devalue their currency. They don't do it unless forced to or their head of state is an idiot (like in Zimbabwe). That "hyperinflation" term gets thrown around way too easily.
If the international market for Treasuries dries up, we will have the "event." If the Fed has to monetized $1T year after year, there may not be hyperinflation, but there will be inflation.
Regards,
Coal Guy
I came to the conclusion that we were in for a hyperinflationary collapse right after Paulson asked congress for TARP. The problems were intractable and one does not drop 1 trillion and then walk away (700B TARP + 400B Fannie & Freddy).
While I came to the opinion that it will not happen immediately, after taking my lumps, however, I still think it is the end game. Strengthening that opinion is Karl Denninger’s point that government benefits are indexed for inflation, thus unless social security, etc., are cut any inflation the govt. manages to create in an effort to ameliorate the problem, in actuality only compounds the problem.
Compound that with Mike Shedlock’s frequent postulation that wages do not keep up with inflation, whitch means the tax base will not keep up with inflation, and we are even more SOL.
I am as part of your camping connected with enlightened home interest. Some will revenue in this particular, let the brightest, most difficult working people get. I've got no trust within government's method to high of everything, as well as I could truthfully not concur a lot more concerning the.alternative currency
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