Perspective

With the so-called subprime credit crunch spilling over into Europe and then the rest of the world, I think we need to take one step back to gain some perspective.

First, let's dispense with two common misconceptions - or outright lies, if you prefer:

1. It is not a "US subprime credit crunch", but a credit crunch, period. The trouble surfaced first at low-quality mortgage loans because that was the weakest in a long series of weak links. The problem, taken as a whole, is too much debt assumed by too many borrowers who cannot hope to service it without relying on constantly higher asset prices. In other words, it is a classic asset-credit bubble, only this time it is not contained within one country but it spans nearly the entire globe.
2. Liquidity is not a stash of cash sitting in an account, looking for assets to buy. Liquidity is (a) access to reasonably cheap credit and (b) the ability to sell assets at reasonable prices, quickly and in size.

The corollary from (1) above is that the current credit crunch is not a "spreading out" from sub-prime to other sectors, but the initial phase of what is likely to be a long, drawn-out process of declining debt and asset prices. It could happen in one fell swoop (aka Crash), but that's what central banks are for, as we saw yesterday. They cannot stop the process, but they can act as lenders of last resort to slow it down. However, even if there is a "sudden event", I expect it will be followed by many more years of aversion to debt and risk. There is simply too much reliance on debt and asset appreciation in the global economy for it to go away in one step, however severe.

The proof to (2) above has been brewing for weeks, but finally made headlines yesterday as the ECB, Fed and BOJ had to intervene to provide... liquidity (if there was so much to begin with, where did it all go?). Liquidity is directly connected to credit because if everyone demanded cash in exchange for all goods and services the economy would immediately collapse into Medieval mode. Credit is a function of trust, i.e. the expectation of repayment, and thus liquidity is a function of trust - or confidence, if you like.

Bubbles of all sorts are phenomena of excessive confidence vs. the cash generating capacity of the underlying assets that are being inflated and they pop when excess confidence evaporates. We are now in the first stages of a credit - liquidity - confidence crunch, brought upon by the final realization that asset prices have moved so high that they cannot satisfy their debt loads out of cash flow.

And thus, Fed's Fearsome Phantasm (I couldn't resist) is raising its ugly head: persistent deflation that cannot be cured by lower interest rates. A liquidity trap, as is known to central bankers. Most scoff at the idea that we could actually experience falling prices in the US, but they are clearly mistaken and the evidence is all around us, though usually misinterpreted by the casual observer. Just a couple of examples because I have to catch a boat (ah, summertime...):

(a) House prices are now dropping in absolute terms, the first time since the Great Depression. A quarter of US GDP is related to housing activity.

(b) Because of China's huge manufacturing overcapacity, most consumer goods are cheaper today than years ago. If final demand fails to keep up with production (already happening, look at retail sales) we will see even lower prices and business failures.

(c) Negative saving rates and no access to credit means purchases must be curtailed and/or assets sold. That's deflationary.

(d) ..and finally, if anyone still believes that modern-era fiat currencies can be inflated to kingdom come to avoid the trap, think of Japan.

Have an interesting weekend...though the Chinese would consider this a curse.