The current financial crisis: three falling dominos

Just a few thoughts on the banking crisis and its effects on the currency markets and the real economy. It seems to this observer that you can divide this crisis into three parts, or dominos, with one already falling and threatening to knock over the other two:

1. The first domino to fall was the banking system which, as I see it anyway, was the victim of a bursting bubble effect of asset prices, particularly house prices, exacerbated by the pyramid scheme type effect of modern fractional reserve banking and related derivatives trading. One way of looking at it is that a sudden increase in unproductive asset prices, ie house prices, was always going to lead to a bubble effect on the economy. Its not as if the increase in house prices was going to lead to some brilliant long term thriving economy, because it was always the case that the asset prices were increasing only because people were borrowing more and more and then bidding against each other. Hence a bubble was just been created here that had to burst at some point. This effect was then exacerbated by the multiplying effect of modern reserve banking and especially the leveraging of asset prices by modern derivatives trading. For example its reported that quite a lot of the shares on the Irish Stock Exchange (which has collapsed like the house prices) were held by people who only invested a tiny fraction of the purchase price of the shares, they essentially borrowed the rest. This borrowing, or leveraging, has the effect of increasing the asset value dramatically in the short term, and increasing the profits of the holder, but likewise will fall very dramatically when it turns down, and will cause colossal debts in the holders. The point is anyway that maybe these modern banking practises are creating a kind of accordion effect in that they expand out an economy, multiplying out the available money and prices in the good times, and crashing them back in suddenly in the downturn times. I guess banking has always had this effect somewhat but we have had such a long run on asset prices that it has created an abnormally large bubble this time, and modern banking has learned to exist on very small margins, and in some derivatives trading on very small reserves, which then increases the multiplier effect of the banking and hence the suddenness and steepness of the fall. Such is my tuppence worth anyways, the point being that a lot of what is happening now is that in this downturn banks are scrambling for 'real' money, as it were, to pay back the debts incurred during the expansion of the accordion, so to speak. What I mean is that basically, as I see it anyway, a lot of what is happening is very like the collapse of a pyramid scheme, the system could only hold together as it went up, it doesn't go down so much as collapse exposing the holes in the financial fabric. In a way they have leant out more money than actually existed, as Gareth Duffy points out in the Sunday Independent:
"But the world's banks have extended more credit than there is money in the system."(1)
As an illustration of how much these financial transactions are divorced from 'real money' consider the example of Dublin based Structured Credit Company (SCC) which collapsed in December 2007:

"SCC was just a couple of years old and was one of a new brand of Credit Derivative Product Companies (observation: these companies should use a "skull and crossbones" as their corporate logo). It had no credit rating (although HCM would not have been surprised to see it obtain one since the rating agencies were handing out ratings left and right during this period) and $200 million of capital on top of which it wrote $5 billion of credit default swaps. We will save our readers from doing the math – that is 25-to-1 leverage (significantly less than many Structured Investment Vehicles, just to place this insanity in some kind of context). Low and behold, when the credit markets collapsed last summer and SCC was required to post additional collateral on its trades, there was – to quote Gertrude Stein – "no there there.""(2)

To be fair to the Irish Central Bank they long ago drew attention to this bubble in the housing market but they could do nothing about it because their hands are now tied by the European Central Bank. Obviously when we had our own currency the Central Bank would have put up interest rates when it saw, as it did and said so in its reports, asset prices increasing in this bubble fashion, so choking off the bubble before it got too bad. But now we are set to European interest rates and can no longer do that, a fact which could now cost us much more than all the EU payments we have ever received put together.
But there is another striking phenomenon here, I respectfully submit that the government are deliberately letting the banks hang out to dry here. If you follow some of the commentary, in Ireland especially but also in the UK and maybe even in the US, you will see that these governments have done everything except give genuine hard cash to the banks to help them out of their difficulties. Maybe this is just an impression, but it seems that all the schemes that are out there have been conspicuous in not giving money to the banks, as such, (especially in the Irish case) or delaying it so long that they are deliberately allowing the banks to fail? Don't forget that there are many devious political advantages for corrupt governments to control the banking system, which is what is happening as the banks increasingly face bankruptcy. The likes of the Independent Newspaper Group, and even (real) opposition TDs and journalists, have need of finance from time to time and who is to say that a bit of political gamesmanship might not now be necessary to get money from these new nationalised banks? Its striking too that the media glare has turned with a vengeance onto the banking executives and their pay etc (which is unjustifiable I admit but caused no problem for the powers that be until their sudden conversion), exactly in the same way that the Neary episode was hyped up just before the government took control of the Medical Council (3), and the way the Lynn saga was spun out just before the government took control of the independent legal bodies (4). Maybe all that is happening here is that the people who run the state apparatus are making sure that they control all industries and professions, so that if anybody crosses them they can threaten to sack them or deny them work in their profession, exactly as a senior Fianna Fail figure was able to threaten Royston Brady.(5) It seems there is always a silver lining for some people!lol

2. The second domino is the effect on the 'real economy' of a credit squeeze. Most, otherwise perfectly sound, small and medium businesses need ongoing credit facilities to function normally. Say a farmer needs some credit to buy cattle in the spring that he can then pay off when he sells the cattle in the autumn, or a bookshop needs credit to stock up on books before the Christmas rush, loans that they can pay off easily in the New Year etc etc. Pretty much all businesses are like this and this sort of borrowing is no big deal and not an intrinsically bad thing I don't think. The problem is that if banks cannot give out credit at all, because they cannot get credit with the turmoil on the financial markets and the effect of the housing and stock market crashes on their balance sheets and reserve requirements, then they cannot lend out any money for this perfectly normal lending. Hence the farmer generates no income and will have to lay off any labourers he employs, and the economy gets no benefit from the export of the cattle, and that bookshop will have to lay off staff as will the book publishers because nobody is buying their Christmas stock etc etc. So on top of the effect of the normal slowdown of the economy, and the serious and totally unfixable problems of the declining housing and construction markets, this credit squeeze within the small and medium enterprise area could really tip the economy into a huge depression. That people are now openly talking about this you can see from the remarks of Dr Morgan Kelly of UCD:

"What makes bank crises economically catastrophic is that they cause credit squeezes which drive profitable firms out of business. Every company in Ireland relies on a credit line to pay wages and other expenses between payments from its customers.

Established firms (outside construction) rarely go out of business because they are unprofitable, but because they have problems with cash flow; and any firm that loses its bank credit line is effectively dead.....Already many smaller firms are finding it harder to get overdrafts, and the worst is yet to come.....This means that without immediate Government action to recapitalise the banks, bank lending will fall by three-quarters, driving most companies in Ireland out of existence."(6)

It seems to this observer that we should look upon the state of 'credit' in Ireland today exactly like we would look upon a scarcity of any normal, but essential, product. Like water for example. It seems to me that we are like the citizens of a city who are hearing about turmoil up in the mountains, where the reservoirs are that house the essential water supplies of the city. We hear that the big reservoir owners have run out of water, but it hasn't sunk into us in the city yet that that water shortage will soon effect us down here, we are still using water like we always did thinking that somehow those big problems will solve themselves before the water actually runs out in all our taps.
I respectfully submit that we are in a fools paradise here with respect to this shortage of credit, just like those city dwellers would be with respect to water? The money has dried up, the banks don't have it and they could only absorb the crisis for so long by drawing on their reserves, so how can we expect the economy to function normally? What needs to happen is that the government should recognise that this scarcity will begin to grow in the real economy and they should simply ration, or channel, the available credit to essential needs. In this case the essential needs are those normal (meaning money for cyclical business needs, not for expansion or takeovers etc) requirements by Small and Medium Enterprises, because these industries would survive otherwise and would keep the economy going and provide essential services (like food production and distribution) which will otherwise go the wall if they cannot get credit. Instead whats happening is that the government is spending sums like 500 million to prop up house prices, a scheme which will further indebtedise first time buyers, money that will be sorely missed when this real economy crisis hits.

3. The third domino to fall is that the turmoil in the bank credit markets will now spill over into the government debt markets, and possibly cause a collapse in most worldwide paper currencies. There seems no good reason why a credit scarcity (and bear in mind again that the credit scarcity is caused inho, at least in part, by the pyramid scheme collapsing effect, hence its not a question of money 'staying on the sidelines' and moving from one asset class to another, as some spin it, its money spent that never existed and hence causing a global credit crunch effect across all asset classes) will not also impact on the markets where governments borrow money, simply because there is, if you like, simply a global scarcity of money. Also other effects will surely now come into play:
a) Some governments have been borrowing very heavily for decades, and look just as indebted as banks and developers. This is true of the US especially, with many people predicting for years that this was bound to effect the dollar and the ability of the US to tap the capital markets, and now many other governments are borrowing heavily to get them through this crisis, not least Ireland. This then makes these governments bad credit risks which would naturally cause their currencies to wobble and increase the interest they have to pay to attract money.
b) Since everybody now accepts that the world is entering into a severe recession (some say depression) this is naturally going to dramatically worsen the finances of many governments (because obviously they have to pay more in social welfare and will receive less in taxes), and investors know this and will again mark down the credit worthiness of governments accordingly.
Anyway it looks like the dollar will collapse at some point soon, even within a year, a collapse that as I say people have been predicting for years. Also it might in fact be the case that some in the US government will deliberately let the dollar slide, because it might be seen as a way out of their debt problems. The thing is that the US is almost unique in that their debts are nearly all denominated in their own currency, dollars, so if they print dollars and allow inflation to take hold, even a German style hyper inflation, it will collapse the real value of their debts. But if the dollar started collapsing like this it would probably trigger a worldwide currency panic which would impact on all currencies and sovereign debts, including the euro. I know this probably sounds alarmist but there are people out there talking that way, like the Swiss economist Dr Marc Faber, who in an interview on Bloomberg on the 3rd of October last stated simply that:
"I guarantee you that the US government will go bankrupt, its only a matter of time."
Over at politics.ie they have 'youngdan' who has become legendary for his predictions and is now saying that:
"Mark my words there is a currency crisis fast approaching."(7).
And in that he does include the euro, collapsing presumably sometime after the dollar.

Anyways for what its worth I respectfully submit that the current government policy is ruinously the wrong one. What the government should be doing is paddling its canoe as fast as it can in the opposite direction from the shipwreck of the banking system, in order that it isn't dragged under with it. Instead with its 500 billion euro guarantee it has gambled the credit worthiness of the Irish state in the financial markets, and threatens to bankrupt the state in the much the same way that is now occurring in Iceland. Hence they may be allowing one domino, the fall and partial bankruptcy of the banks, to hit and knock over this third domino, the Irish state and its financial arrangements, when they ought to be trying to prevent a domino effect. Meanwhile their decision not to inject hard cash into the banking system, as opposed to the guarantee, will doubtless ensure that the first domino knocks over the second and lands us in real trouble.

You ain't seen nothing yet folks!!!lol

Footnotes
1. Gavin Duffy Sunday Independent 12 Oct 2008 p.5.

2. http://www.marketoracle.co.uk/Article3371.html .

3. http://www.imt.ie/opinion/2008/03/council_elections_loo....html .

4. http://soapboxireland.blogspot.com/2007_10_01_archive.html .

5. Chapter 11 footnote 17 http://oireland.tripod.com/conspibk.pdf .

6. http://www.irishtimes.com/newspaper/opinion/2008/1024/1....html .

7. http://www.politics.ie/economy/19036-iseq-crash-deepens....html .