The Mental Nature of the Credit Crisis

Yesterday, the Dow fell 187 points. Oil slipped to $70. The dollar rose to $1.37. And gold lost another $12 – to $928.

The rally may run through the summer; it may not.

Asked about the rally on Wall Street, Barron’s latest Roundtable panel had various views about how far and how fast it would take us. But all were sure of one thing: the worst is over. We will not go below the lows set this past March.

This recovery is for real, they believe…and so is the bull market on Wall Street.

Investors believe it too. Analysts believe it. Economists believe it.

And why not? The ‘Committee to Save the World,’ part II, is on the job. And here are two of the three committee members writing in the Washington Post. “We have nothing to fear but fear itself,” they would have written. But that line had already been taken:

Like all financial crises, the current crisis is a crisis of confidence and trust. Reassuring the American people that our financial system will be better controlled is critical to our economic recovery.

By restoring the public’s trust in our financial system, the administration’s reforms will allow the financial system to play its most important function: transforming the earnings and savings of workers into the loans that help families buy homes and cars, help parents send kids to college, and help entrepreneurs build their businesses.

Get it, dear reader? The slump has nothing to do with bad investments and bad businesses…or with too much debt…or with too many producers making too much stuff for too many people who can’t pay for it.

Instead, it’s all in our heads! And if we can make some ‘reforms’ that cause the public to think everything is all right, well…heck…everything WILL be all right.

Except that it’s not all right. You can pull as much wool over the public’s eyes as you want, GM still won’t be a going concern. Nor will any of the other problems go away. And until those problems are worked out, there won’t be enough earnings and savings to push the economy forward.

As for the feds’ confidence tricks, they only make the situation worse. If the public spends more money…it just goes even deeper in debt!

Our old friend Rick Ackerman has no more faith in this recovery than we do. It’s “just like the recovery of ’31,” he says. Of course, as regular DR sufferers know, there was no recovery in ’31. Instead, it was a head-fake upwards, followed by a major drive to the bottom in ’32. The ’29 crash was just the beginning. The Dow reached its peak of 381 in September ’29. It crashed in October…but then bounced back for the following five months. By April 17th the bounce was exhausted at Dow 294. Then, too, people thought the ‘worst was over’ and that the initiatives of the Hoover administration had put the economy back on track for growth and prosperity. But then stocks headed down again and the economy sank. On July 8th, 1932, the Dow hit 41 – its low for the Great Depression.

Why won’t history repeat itself? The run-up in debt in the ’90-’07 period exceeded even the debt build-up of the ’20s. Many other features are similar too – a huge expansion of global trade…new inventions…suburbs…financial innovation. Why would it be different this time?

“Because the government has taken aggressive action to correct the problem!”

That’s what most people think. But here’s what Rick has to say about the feds’ rescue:

Bailing out the economy and the banking system has been such a brazenly corrupt, mendacious and, ultimately, doomed enterprise that one could almost forget for a moment how very clever the perpetrators are. If we needed proof that these guys are the slickest behind-the-scenes spin-doctors around, consider the following two headlines that ran on successive days atop the Wall Street Journal’s front page. “Rate Rise Clouds Recovery” was the grim news that greeted us last Thursday, on day one. The article described how, despite the Federal Reserve’s explicit strategy of buying as much Treasury paper as it takes to hold market rates down, particularly in the mortgage sector, rates are rising anyway, and steeply. In fact, 30-year fixeds climbed to 5.79% from 5.00% just two weeks earlier, suggesting that market demand for mortgage paper is drying up despite the Fed’s strategy of direct monetization of Treasury debt (a.k.a. “quantitative easing”).

But get this: On day two, as if to reassure us that [the] Treasury’s borrowing is well under control despite the fact that the opposite is true, the spinmeisters co-opted the Journal’s front page with this well-timed policy leak: “Fed to Keep Lid on Bond Buys.” Are we actually being asked to believe that, absent the acceleration of direct purchases of Treasury paper by the central bank, demand from other sources will suffice to keep rates from rising further?

Yesterday, we saw a chart that showed the effectiveness of the Fed’s efforts. When the Fed intervenes to buy Treasuries, yields tend to go down – that’s the whole idea. Low yields help people borrow…and pay their debts.

But the chart clearly shows that each subsequent intervention has less effect. This is very bad news…though just what you’d expect. It’s why a little bit of monetary inflation has a tendency to become a lot of consumer price inflation. On a more philosophical note, it is how people get trapped into doing things they really don’t want to do – because the alternative is even worse.

Here’s the dilemma. The feds buy US bonds to keep interest rates down. If they don’t buy them, the government’s huge demand for credit drives up yields: greater supply of bonds leads to lower prices (higher yields). But if they do buy them, investors begin to fear inflation. Then, they sell bonds…driving up yields: less demand leads to lower prices (higher yields).

That’s why the Fed is talking about “keeping a lid on bond buys.” It’s expected to reassure investors.

So far, everyone seems to be playing the part he has been given. In today’s news is word that the Japanese and Russians are one hundred percent behind the dollar and US bonds. The Japanese even say their faith is “unshakeable.”

These comments helped send bonds back up…after yields on the 10-year note had reached 4% last week.

But do you believe them? C’mon, dear reader, you know better than that. The Japanese and Russians have two of the biggest piles of US bonds in the world. Only China has more. What would you say if you owned $800 billion worth of bonds? Wouldn’t you tell the world what a great investment they were…and then sell them quietly, when no one was looking?

Most likely, the feds will be forced to do what they don’t want to do. They’ll have to buy bonds to keep rates down. Then, they’ll have to buy more…because others will be selling them. Finally, they’ll have to monetize a huge percentage of them…ultimately causing inflation rates to soar.

When and how that will happen is the financial drama that will occupy these Daily Reckonings for many months to come.

“Man lives in closet in Delray Beach,” was a headline that caught our eye. We wondered what sort of man would live in a closet. But there was the photo… He looked like a very ordinary man.

Indeed, he seemed proud of what he had achieved. Downsizing is in style; he is a trendsetter.

Beneath the big financial headlines, there’s a huge aesthetic change taking place in America. Small is becoming fashionable. Less is becoming more. Ostentation…big spending…and luxury are out. Charm…making do…and innovation are in.

Pick up a copy of Cottage Living magazine and you’ll see what we mean. A couple of years ago it was the “wow factor” that sold houses. Clients were meant to drive up to a façade that looked vaguely impressive…like a bank with a bad architect. They walked into an entry way and saw a huge hall with a chandelier hanging on a chain. The more expensive McMansions had sweeping marble staircases. “Wow,” prospective buyers were supposed to say…reaching for their checkbooks.

Now, the McMansions are hard to sell. Cottages are more popular. They tend to be plain and uninteresting when they are purchased. But now people are taking pride in making them nice places to live – with shutters…larger windows…fireplaces…reading nooks, and so forth. They’re using imagination and elbow grease instead of credit cards.

People are downsizing – slimming away the unwanted, trimming off the unnecessary, and skimming off the best of what remains. They are making – or trying to make – their lives more manageable, more affordable, and more secure.

In a way, this is ‘back to the ’70s,’ when wood stoves became popular ways to heat a house. Wood stoves practically disappeared in the ’90s. But they’re back. And so are back-yard gardens…bicycles…chickens…canning…saving and many other things our grandparents took for granted.

Until tomorrow

Bill Bonner
The Daily Reckoning