The River of Liquidity is Frozen

When big banks that were considered solid last year now suddenly are going under then almost any financial institution get very afraid of lending each other money.

I remember getting my first banking job in the end of the last banking crisis in Norway. I was hired as a junior trader assistant on the USD fixed income derivatives desk. We were sitting next to the people funding part of the banks operations in the USD money market, the local NIBOR market was basically completely frozen and very few international banks wanted exposure to Norwegian banks. Banks that a few years before all had been AA or AAA rated had all been bailed out by the government in one way or the other.

Often people at our desk that were supposed to focus on USD: swaps, caps, floors, and swaptions had to spend some time helping the USD funding desk of the bank. The government had just re-capitalized the bank, but still the full trust had not returned, I can just imaging how bad it must had been in the middle of the crisis. Often I got handled over a long list with foreign bank names from the head of the funding desk. I then contacted all these banks over Reuters asking for overnight loans (O/N) in USD. Most banks told no interest, a few banks gave us overnight loans at high money market rates (due to the global credit crunch), often + an additional mark up. This part of the job I found less interesting at that time, now I figure out this was some of the best training I could get.

The same is going on now, but on a much larger scale globally. Many banks are now mainly funding their operations overnight, by rolling overnight loans or T/N: Tom Next (Tomorrow next loans). Hopefully the bail out package will help.

Unfortunately this is not like many European politicians have assumed, a US banking crisis with a few side effects spilling over to Europe. This is a global credit contraction. The European real estate is likely in the beginning of its fall. Now that liquidity is freezing up the real estate prices will accelerate to the down side. And also many over borrowed corporations in US and Europe will not survive. The collateral European banks helped spiraling into a gigantic bubble by issuing more and more credit have just started to bust. The equivalent of FDIC insurance is lower in many European countries than in US, it just went from 100k to 250k USD in USA. In other words major danger of big bank runs in Europe, we already had a few.

Well noting is for sure, but I think this is a likely scenario based on a few back of the envelope calculations. It will hopefully turn out much better than this, but it could also turn out much worse.

The River of Liquidity is frozen and we are probably heading for a very cold and very long winter, I am not even sure there will be a summer next year, but I strongly hope so. As a Norwegian I am am quite used to ice and snow, I was almost born on the ice so to say. In a financial melt down do not panic, cool down!

Charles Conant 1899: ”The two fundamental elements of credit are confidence and time. The word itself is derived from the Latin credere, to believe, and the term used on the European continent for the circulation of banks of issue is the fiduciary circulation, the former begin derived from the Latin fiducia (trust) related to fides (faith).

100 billion there, 200 billion here and 700 billion dollars there in faith-money can hopefully restore some faith, but do not forget the second most important aspect of credit is time. It is possibly we only have reached the end of the beginning of the credit crunch?? For every day faith is fading around the globe. If faith at some point over the next few years should collapse completely it could go from ugly to extremely ugly. Let's not hope so, lets have faith in the system ;-)

The only “good” thing is after faith in a system has collapsed and we have gone through some great stress we will always end up with faith in something new, the big question is in what? In another system with the illusion of low risk, where risk is pushed under the carpet for a while, or a system where risk is taken serious, something we not should hide, but something we should understand and respect and yes to some degree tame.

Well first we have to try to save the current system with its current tools, the more faith is fading the more faith-money need to be pumped into the system.

To trust a system based on faith is good. Not to trust such a system, is far better.

A quick blog draft in NorwegianEnglish:

Are we now witnessing government and central bank panic? Just google the news over last few years and read how the same politicians and central banks have kept telling us “the financial system is sound”, “the economy is sound”, relax!

Are they now reaching out in “panic” forbidding short selling?

Lets go back to my home country in the late 1980’s. The Vikings were barbarians and did not develop modern financial markets before recently. Short selling of shares was not allowed yet in the 1980’s (there were few OTC forwards); there were no stock futures trading and no equity derivatives. Did this stop the Norwegian stock market from crashing massively in 1987? No it crashed Massively!.

Did this stop what used to be AAA Norwegian banks from going bankrupt and be bailed out from the government? No almost every big bank in Norway had to be saved by the government. The Norwegian banks did not go under because speculators and hedgers shorted their shares, but because the banks had lent out too much money and used similar non-robust risk-management models as most of them still use do today (but now under new fancy names). Yes there is more to the story: the unstable monetary system.

What the politicians and government now are doing by forbidding short sales is possibly adding more chaos to the system. Short selling is actively used for hedging as well as speculation. (Pure naked short selling were you not have been lending the shares I am not familiar with so excluding this from my analysis here).

Why will investors buy convertible bonds anymore and in this way help companies with their financing. Tomorrow or already today hedging some of the risk in convertible bonds by for example by shorting shares against them could or already is suddenly forbidden? (country dependent etc.).

There is also a lot of blaming on free market forces these days. And yes banks and financial institutions were creating all to much credit (leveraging) relying on housing prices as collateral. Housing prices they themselves helped spiraling-up in the expanding credit boom. But the problem is more complicated than this. The main reason for the bubble was probably not from free market forces, but to a large degree from lack of free market forces in the most central part of the so called market based economy. What is the largest of all markets in the world?

Oil? No,

Shares? No

Currency derivatives? No.

Credit derivatives? No.

The largest of all markets in the world is MONEY.

The supply and demand for money was (and still is) only partly controlled by market forces. A handful of central banks (which again is controlled by a handful of people, selected by the government or otherwise...) did years back set the price of money artificially low, to a large degree by relaying on lagging inflation measures. One has to expect banks and homeowners to be greedy or at least naïve? As we have seen time over again reading the history; homeowners borrow as much as they can, and surprisingly(?) banks also tend to lend out as much as they can. There could never have been so much credit created if it not was for the fractional FIAT money system where the central banks were setting the price of money artificial low, even in periods with relatively good economic conditions. Very low rates should at least be saved for extreme credit crunches. Well if the price for money (in a non fractional monetary system) had been set by the market in the first place we would not have got this gigantic credit bubble. Yes there would have been bubbles, but nothing like the one that now has started to burst.

On one hand modern economic theory talks about how it is almost impossible to beat the market, because the market always collectively have more information than a single investor or a handful of investors. At the same time the supply and demand for the largest of all markets — money — to a large degree is controlled by central banks, that is a handful of people.

It would be much better to have the politicians and central banks and government regulatory bodies spent more time on regulating the top of what supposedly should be market based economy. That is they should long time ago have stopped certain toxic loans to be pushed to often naive homeowners. Homeowners that often have entrusted the bank sales man or women to also be their financial advisor. The current monetary system is built to artificially regulate the fundament of the so called market economy: Money. The market does only partially control the price of money and thereby the supply and demand for money. Would anyone that had worked hard and saved up some cash 5 years ago actually have lent out his or her money to home owners at 4% or 5% if market forces had controlled the price of money? Probably very few. However if the central banks to a large degree were setting the price of money artificial low you had little or no choice, but to accept the few percent the bank offered you in a deposit account. The larger the demand was for borrowing the more credit the banks created (only possible in a fractional FIAT money system). Instead of the price of money quickly going up and dampen the demand for loans, the rates went down and the demand just kept increasing. The markets were flooded with cheap credit. Credit created based on increasing house prices, that themselves where driven by expanding credit. It was all crazy, there was plenty of warnings. And now the crazy credit expansion has turned into the madness of what can be described as an almost uncontrollable credit contraction.

Of course the central bank ministers are often themselves operating under restricted mandates given by the politicians, so it is hard to say exactly who is doing a good job and who is doing a bad job. Politicians (and bankers) founded our modern unstable monetary system long time ago, probably in good belief. Now again we see the result of a monetary system where the fundament of a so called market economy not is controlled by market forces. Yes now that the monetary system is out of control the best is possibly that the central banks steps in and helps clean up the mess that they also were a big part of creating. The question is if they will be able to do so when the system seems to be flawed in the first place.

What are the track records of central bank policy in modern time? Not long ago most central banks believed in a fixed currency exchange rate policy. Yes it created an illusion of exchange rate stability over a long period of time. Again market forces were not allowed to control the supply and demand for money at a fundamental level of the so called market economy (in this case the exchange rates). Slowly, but certainly supply demand imbalances were building up. At some point the system could not take it anymore. One country after another had to devalue in a burst of volatility. Then the central banks came up with a another new and what they thought better solution: controlling supply and demand for money based on adjusting the rates based on lagging inflation measures. You cannot stop a river by building a dam, only for a limited period of time, the bigger the dam, the bigger the burst. Neither can you stop market forces by building the illusion of low risk. The bigger the illusion the bigger the collapse.

I promises you there will always be such things as economic upturns and downturns (at least as long as there are civilizations). Chaos is the seed of order, Order is the seed of chaos. However a system where the market forces control at least the fundament of the market economy: the price of money, this will likely reduce the size of the booms and the bust "cycles". Today’s system is not a market economy, the fundament of the system is not controlled by market forces. I would not be surprised if this all will be blamed on market forces, but nothing could be further from the truth. The biggest of all markets are only partly controlled by market forces.

A full reformation of the monetary system is needed. My best guess would be the politicians some years down the road will consider to reform the monetary system, or possibly but not for sure (and hopefully not) be forced to do so by a "total" market melt down. The question is will they then simply reform one bad system into another bad system, just like they did by going from fixed exchange rate policy to a lagging inflation measure controlled policy. They do not understand or discuss that the fundament of the system: the price for Money itself must be controlled by market forces for a market economy to work well, and this is not the case. Each country could and possibly should have stronger regulation on the top of the system, but should not regulate the fundament of the market economy as they have tried doing now for generations. Protecting home owners from certain types of toxic loans, a more transparent derivatives market are probably all good stuff, but a market economy will never avoid massive boom bust cycles as long as the fundament of the system not is controlled by market forces. Yes we can create the illusion of stable system, but that is all an illusion that will burst.

If we go back in the history we will see short selling, options and several forms of financial instruments got forbidden in bust cycles, this is nothing new. Now everyone looks for a place to blame the credit crunch, I mentioned this on my blog back in 2006, looks like we could approach the left hand tail of the distribution where short selling, and options get blamed for the bust. The credit crunch is related to a series of problems:

- The fundament of the so-called market economy — Money — was (and still is) only partly controlled by market forces. This together with a fractional money system is the recipe for building massive bubbles. Such bubbles will burst, and we are now likely in the middle of the burst. (real estate in big parts of Europe probably in the beginning of the burst).

- Homeowners, banks, where all "greedy" and or "naive". But market forces should have controlled “greed” at least to some extent if market forces had controlled the price of money, but market forces only partly, and very weekly, controlled the price of money and thereby the supply and demand for money. Yes in the credit crunch market forces will in much larger degree control the price of money, this is when central banks loose control, well they also lost control in the credit expansion.

— Central banks and politicians according to what they have said over the last few years (the economy is sound bla bla bla) seems like they must have been relaying on Gaussian type models.

- Banks and financial institutions were relaying on Gaussian type risk management systems, or they had improved probability models where they though they took into account fat-tails with high precision. This without understanding the fat-tails not can be estimated with precise probability models (yes Nassim has written a lot on this). This even if fat-tails have been empirically discovered in finance already in the early 1900.

- The Bonus system has been built in such a way to encourage leaders and traders etc. to take massive risk (that they could move in front of them for a while). And it seems few people had high moral standards or knowledge to overrun the flawed system.

- Also investors where greedy and they should be “greedy“, but this combined with trusting flawed risk measures like Sharpe ratios and VaR to pour money into strategies that gave the illusion of low risk (short tail risk in credit or otherwise) helped fueling the credit bubble and is in general a recipe to go bust (often at around the same time).

- Researchers have produce a series of models based on flawed assumptions, the models are not robust for breaks in the assumptions. Many or most of them tend to think the same (following their 'leaders' or the so called 'accepted theories'). They have been able to strongly marketing such non-robust models as robust to financial firms etc. Investors and bank managers that often have limited quantitative skills themselves have bought into this non-robust models, and in some cases probably cynically abused them to get investors to pour money into illusionary low risk trades. Also many (most?) of the MBA and master of finance programs spend all to little time talking about the non-robustness of many of these models. They are pouring out Gaussian or extended Gaussian risk managers and quants with little or no market experience often set to develop credit derivatives models.

- Lack of transparency in the OTC derivatives market, more derivatives should probably be exchange traded. In particular the credit derivatives market seems to have been very non-transparent.

More on this later! I am afraid the credit crunch not is over, I have run to secure some assets; there is a lot of hidden risk out there. A “new-old risk” is now added to the system: sudden panic-changes from the governments. The same people short term ago claiming the Banking system was sound and stable. Tell that to someone that lost big parts of their savings when "their" bank went bust.

According to Greenspan we are basically in a recession. I think he is right.

The FED is trying to solve the problems by injecting liquidity (indirectly letting the printing press run). We have a money contraction (credit contraction from faltering housing market) and at the same time FED tries to fix this with money injection around the heart of the economy. Will the money flow where it is most needed? Or will in congest around the heart? We have a problem that people was well aware of back in time. In 1879 after a period of FIAT in USA with high inflation and price instability there was a big discussion if one should keep inflating the money supply to solve the problems, or return to the gold standard. The debate was quite harsh between the opposite views.

Thomas Nicole secretary of the The Honest Money League, delivered at Faneuil Hall Boston, Oct 5. 1878, the following view:

“The fiat-money men also tell us that money is the blood of commerce, the free circulation of which makes commercial life and health. We answer: there is abundance of this blood of currency, more than ever before. But we are told it is congested around the great commercial centers, leaving the country in the condition of a man with his blood congested around his heart, while his extremities suffer for want of blood. Then we want such a course of treatment as will draw this blood away from the centers and send it flowing through the great arteries of commerce outward to the extremities of the nation. We don’t want a stream of artificial money injected into the business of extremities of the country, any more than the patient, with the blood congested around his heart or in his head, wants a stream of cheap liquid injection into his extremities to cure congestion. Just as sure as such a course would still weaken or kill the patients, so sure would the injection of the artificial money into the extremities of the commercial body weaken, and, if persisted in, destroy the commercial life of the body. And we are all members of that one body, and when the body suffers, you know, the members all suffer.”

And yes they ended up returning to the gold standard.

The tax rebates is an attempt to get today’s FIAT-blood out in the extremities of the nation (the cheques are now in the post). Will it cure the patient? I hope so, but I am afraid it is far from the best medicine, some medicines have ugly side effects...... Only time can tell, but it helps reading the history.

"When the New York banks suspended specie payments on Monday, December 30th, 1861, gold coin at once commanded a premium in paper money."

A civil war combined with FIAT money was probably main reason for wild price fluctuations and high inflation in USA from 1862 (but I have not read too much about this period, please correct me if I am wrong):

Source Wesley Michell 1908, he was probably also the first to observe fat-tails and high peak in price data (1915). Wesley's 1908 book has a lot of valuable price statistics, the table from his book, look how stable prices in England and Germany in same period (numbers are a price index of a series of commodities).

USA returned to the gold standard in 1873 (79?).

USA 1785-1861 - Gold standard

1861-1873 FIAT currency, runaway inflation and price instability...

1873 (1879?) Gold standard

"Gold of it self in Philosophy is a fire that if it be raised and increased one hundred degrees in quality it may seem to prove the greatest fire in the world." J.

I have for a long time been quite negative to the world economy and the housing market. But everything comes to and, even a credit contraction, after day there is night and after night comes another sunny day. I am so happy that the credit contraction finally is over. All that was needed was inflating the money supply and some political stimuli’s. Great, now we can all leverage ourselves up again and pump our money into stocks and real estate and just wait to harvest the big profit.

Oh by the way what day is it today (check when this blog was posted)?

Yesterday I was buying a robotic vacuum cleaner (generation 5 cheaper and more reliable than human housekeeper) at a good rebate in a store that is closing down. Prices on “luxury gadgets” are now coming down, several "luxury gadgets" retail store chains have noticed falling demand, they need to reduce inventory and close some of their doors. Old news but for example Sharper Image are closing half of their 184 stores. I talked with store manager and he told they still had big inventory that had to get out quickly, they will probably soon need to cut prices further (in the stores they have decided to close). Food prices and energy are up and now the price of “luxury gadgets” are dumped. If you ask me this looks like the early fingerprints of Stagflation.

Expect more rainy days! That someone paint the sun on the wall is no guarantee for the sun to come out yet.

How robotic vacuum cleaners work

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I was just waiting on some of these FX carry trades starting to blow up. Carry traders where putting money into high yield currencies borrowing in low yield currencies hoping to not get hurt by the currency. They would anyway get out in time at least they thought so. The Icelandic krona is a classical example of how carry trades can blow up in your face, within weeks the currency has lost 20% of its value for example against the EURO. In last six month it has gone down by more than 30%. Even with 15% interest rate annually it is very expensive to loose 20% in a few weeks and 30% in some months. Yes for a long time it gave a great Sharpe ratio, and I know for sure some investors increased their bet based on that. If you have any clue about FX carry trades you knew the end would be a blow up, no I did not know when it would blow up, but I strongly try to avoid bets where money likely ticks in slowly, but with a considerably risk could blow up at any time.

This is simply the global credit contraction that no longer simply is a housing and banking problem but is spreading to become a country problem.

I think we could see more FX carry trades blowing up this year, not only FX trades, any carry trade has a high probability of blowing up when credit dries up. Of course there could be times when you should pick up cheap pieces if you have deep enough pockets and low enough leverage, but cheap can get much cheaper. Crowded carry trades are very dangerous in times like this.

Draft 0.81 part 1:

Sorry I do not write in English, but in NorEnglish, there is no typos in my writing, if you think so there is just a lack of your knowledge in NorEnglish ;-)

Conclusion: Politicians and Central bankers have focused on trying to keep the volatility low and in this way in the long run created excessive Volatility of Volatility that we now probably just have seen the beginning of. (I am not speaking about the volatility as simply standard deviation hear, standard deviation is a flawed measure of volatility, I am talking about fluctuations in a wider sense.).

In most scientific (and even non-scientific) disciplines great progress have only been made possible through defining and developing accurate methods and standards of measuring things. That is accurate measure sticks. In economics we have now for a long period moved in the opposite direction. Economic growth, return on your savings, they pay out on derivatives, present value, and your wealth are all measured in Money. The problem is money have once again (over time) become extremely elastic. The government, the central banks can inflate or contract the FIAT money supply dramatically. The financial institutions can based on today’s system of fractional banking (a very old system indeed) inflate the money supply as long as there are people that will sign their name on a piece of debt-paper. The fractional banking system is more elastic than ever. The fraction behind the fraction is itself highly elastic, in the old times at least the fraction itself was highly stable and close to impossible to duplicate.

The money contraction is often more difficult to control (more stochastic) as it typically consist of contraction the measure stick in one end (the credit contraction from housing bust and financial institutions blowing up) and at the same time expanding the measure stick in the other end (the inflating money supply from rate cuts, liquidity injection, tax rebates etc.).

Having an elastic measure stick is creating confusion and additional wealth transfer and little more. The alternative is not simply trying to create a risk free price system or society, such only exist in the dreams of people that do not understand the physical laws of uncertainty. Everything is uncertain (except where time stands still): risk-free is only something finance professors believe in, gold can only be risk free relative to gold and nothing else, a paper dollar can only be risk free relative to a paper dollar, a green fresh apple picked today is only risk free against a equal green fresh apple picked today in the same location, risk-free hedging is only risk free because it transfer something into dollars (or whatever currency you are looking at) and paper dollars are risk free against paper dollars, paper pounds against paper pounds etc. A fixed price system will only create the illusion of stability in a time period for then to build up pressure that sooner or later will explode into massive volatility. Fixed price systems have to some degree been tried out in throughout history, it was a disaster and always ended in exploding chaos and volatility.

Not long ago central banks all focused on fixed exchange rate policy. It gave extremely low volatility currencies for a long period of time. Then it all felt apart in bursts of massive volatility, in massive interest rate and currency shocks. Then they came up with solution to let exchange rates be highly elastic (good) but also to let measure stick itself be highly partly random partly deterministic. That is the money supply be more elastic than almost any other time in history. This is just another flawed system that worked well for a time (giving illusion of price stability). There is no perfect systems but I am quite sure there is something much better.

My point is that out of whole series of possible money measure stick systems we have today chosen probably one of the most elastic and unstable possible. The society has chosen a partly deterministic partly stochastic measure stick as the very fundamental measure stick for all economic measurements.

Change the definition of a meter or foot into a partly deterministic and stochastic process; does this make your house bigger or smaller? Now think of a such a meter stick that is growing partly randomly in one end and at the same time contracting partly randomly in the other end. Think how frustrating it would be to measure the length of rigid object with such a measure stick, try to construct a house with such a measure stick. Possibly such a meter stick would help you rip of someone in the housing market that not could do calculus as well as you, but the elastic money stick is good enough to accomplish this.

Change the definition of the measure of speed of light (in vacuum) to follow a partly deterministic and partly stochastic process and ask yourself if this will make the GPS system more accurate, and will it help you travel faster?

Today’s money system is a system that gives long periods with illusion of stability that sooner or later turns into massive eruptions of instability and chaos. No matter money system there will always be economic cycles, periods with stability and periods with economic chaos, upturns and downturn. Having an accurate measure stick will however help everyone calculate about where they are and then help more people to take "proper" action based on this. Most people do not have the time to study the elastic money stick in detail, and even people that do so have difficulties measuring economic related activity (for example the central banks themselves with their lagging and limited inflation measures). Elastic measure sticks moving around partly random (deterministic and stochastic) based on inflating (and contracting) the money supply is making the world more chaotic after periods of artificially low volatility (illusion of low risk and price stability) , it transfer wealth both in a deterministic and stochastic way.

Politicians and central bankers have been focusing on volatility (stability in their lagging inflation measures over a short period of time), not volatility of volatility that only will show up over longer periods of time. Central bankers and many academics have possibly tried to developed a more stable economic system. What they probably have created is periods reducing the volatility (giving illusion of stability) that at some point will spill over in massive volatility, they created more volatility of volatility by deciding to use a measure stick that makes it hard for people to measure. They have also created a system with positive partly stochastic drift in the measure-stick (known as inflation). If you not can measure as accurate as actually is possible how can you then make the best decision for the future. We have entered the Age of Turbulence.

More stable moderate volatility is for most humans highly preferably above periods of very low volatility that suddenly explodes into massive volatility and chaos. An illusion of economic stability makes people forget we live in a uncertain world where they need savings. I have little doubt that a rigid money measure stick would create more stable moderate-volatility economic system. To plan the best step ahead you need the most accurate measure stick attainable. This has been important in almost any human progress in almost any other field.

At some point the world (or a parts of it) will probably move forward (or backward) to a much more accurate measure stick of money, even a fully rigid measure stick is potential obtainable, something the world probably never have seen yet. I am not sure it will happen in 1 year, 4 years or 200 years from know, but also the money system will change, it has always done and it will always do. A rigid money measure sticks would give more stable moderate-volatility. That is it would very likely reduce the volatility of volatility over long periods of time).

In front of me (see picture) a beautiful piece of ever lasting gold that I just got almost for free, and now I can turn around and sell it for a fortune? is it that easy to make money? No it is not gold, it is Pyrite (iron sulfide FeS2) better known as fool’s gold. Many inexperienced gold diggers have through time been fooled by fool’s gold. Yes also fool’s gold is shiny and beautiful, but it is plentiful, it just iron sulfide. Anyone that has touched real gold knows the difference; real gold is much heavier, much shinier. Much more important all the gold ever mined from earth could be stored in a large barn. All gold in the world is in quantity (tons) the same as the US. Steel industry turns out in a few hours (See Bernstein "The Power of Gold: The History of an Obsession")

The price of Gold has passed $1000 per troy ounce, there is several reasons for this, first of all flight to quality, and yes even according to Greenspan Gold is a good indication of expected inflation. Inflation is closely linked to the printing press.

Today’s FIAT money system is backed with nothing but faith; the faith is again based on not printing too much money (keeping inflation under control). One of the widest measure of money supply is M3.

FED stopped reporting M3 back in 2006

According to several economists (private institutions) M3 has exploded to upside and is now at 12 to 18% annualized in USA. FIAT is more plentiful than even Fool’s gold.

Years back in the last global risk/position meeting I was invited (before leaving) I told Gold likely would explode and even could go to $1000, there was some laughter …

Can FED solve the fundamental problems of the economy by keep increasing the money supply? There are many opinions on this. Only time can tell, but it really helps if you know what exactly time is, and few do.

PS: Iron pyrite is by superstitious people believed to be a very protective stone. It should be carried when performing dangerous work. Most rational people would naturally think this is foolish, many of the same "rational" people could naturally not see the difference between fake gold and real gold if you put it in just front of them.

The global credit contraction keeps rolling forward. FED keeps pumping money into the system to try offset the credit contraction. The foreclosure rate is just increasing; real estate prices keeps falling. In Europe we are just at the beginning of the bust in the housing market.

There is far from fully random walk over the larger credit-cycles. In credit expansion the electronic printing press of the commercial banks drives up the housing prices (and typically also other investment assets). The same houses are used for backing the loans, now higher house prices gives higher collateral, now the banks can increase their lending, and more loans will typically give even higher housing prices and higher collaterals. When the bubble at some point starts to inflate the process is simply the reverse, and it is very hard to stop when contracting.

Many investors have recently been buying more stocks the worse the fundamentals, and the stock market has kept up remarkably well. The idea is basically the worse the fundamentals the more liquidity the FED will inject (more and bigger rate cuts etc.). For a country in deep debt this is nothing else than indirectly letting the printing press running for ”full machine”. Among smart money there is an ongoing escape from the inflating FIAT into gold, silver, platinum and commodities. Another side effect from FED’s policy is exploding food prices and energy prices. There are naturally also other reasons for this, but trying to inflate yourself out of the fundamental problems is one of them. Sooner or later FED will run out of bullets. Do they have enough bullets to save the stock market? Remember if you plan to spend your expected profits from the stock market on buying food, then you will need the stock prices to explode just to keep up with the food price-inflation.

The little art-piece is Drawing-Hands from Escher (I added some text) and it illustrates the credit expansion. The banks lending practice, their collateral, and the FIAT money system is closely connected to each other, it is far from random walk (except from in most credit derivatives models).

The credit contraction would be Drawing-Hands in reverse, that is Erasing-Hands (or Destroying hands) (artist needed to Draw/Erase-this, would love to add it to my quant-art gallery ).