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Irreparable Cracks in the Financial System. by Mark Faber 1/11/2007
http://www.lewrockwell.com/orig6/faber3.html
Below is Faber's little allegory that for me rather much ties together a lot of what I have read on iTulip and elsewhere. After I read it a couple of more times, I think I will have the best picture of what has gone on and may continue to unfold for the US. I expect minds smarter than mine can pick at something he says, so please do.
Believe it or not, the quote is not the entire article, and that part that isn't quoted, I also found explanatory as to how liquidity expands.
http://www.lewrockwell.com/orig6/faber3.html
Below is Faber's little allegory that for me rather much ties together a lot of what I have read on iTulip and elsewhere. After I read it a couple of more times, I think I will have the best picture of what has gone on and may continue to unfold for the US. I expect minds smarter than mine can pick at something he says, so please do.
Believe it or not, the quote is not the entire article, and that part that isn't quoted, I also found explanatory as to how liquidity expands.
Originally posted by Marc Faber
There is one more point to consider. Liquidity isn't evenly distributed. Let's say that on an island there are two tribes. Ninety-nine percent of the population are the "Bushes" and 1% are the "Smartos." The two tribes arrived on the island at about the same time and had little capital at the time. So, initially, both tribes worked very hard in industry and in commerce to acquire wealth. But because of the Smartos' superior education and skills, their frugality, and also partly because of their greed and immorality, they soon acquired significantly more wealth than the Bushes, who, for the most part, were likeable but quite inept. After 50 years, most of the island's businesses were therefore in the hands of the Smartos, who make up just 1% of the population. Being clever, the Smartos generously gave some of their wealth to the tribal leaders of the Bushes, who controlled the entire government apparatus, the military establishment, and much of the land.
For a while this system functioned perfectly well. Among the Bushes there were also some smart people, and they were encouraged to accumulate wealth as well. However, they had to pay an increasingly high price to acquire assets, since most of the island's assets were owned by the Smartos and by the elite of the Bushes who, because of their wealth, never really had to sell any assets. Cracks in the system began to appear because more and more of the wealth began to be increasingly concentrated in fewer and fewer hands. (According to the Financial Times, the concentration of wealth is extremely high in the United States, with 10% of the population currently holding 70% of the country's wealth, compared to 61% in France, 56% in the UK, 44% in Germany, and 39% in Japan.)
However, the Smartos then stumbled upon another avenue to wealth: globalization. The island was opened to foreign trade and investments, which allowed the business owners to shift their production to low-cost foreign countries and, at the same time, to keep the masses among the Bush tribe happy through the imports of price-deflating consumer goods. In the same way that, in the 18th and 19th centuries, the European settlers of America had exchanged with the Indians worthless beads and booze for land, now the Smartos and the elite of the Bushes exchanged cheap imported goods, whose supply they controlled and from which they earned handsome margins, for assets. As a result, the majority of the population of the Bushes experienced a relative wealth decline compared to the wealth of the Smartos.
Again, this worked perfectly well for a while: the populace was happy to buy deflating consumer goods (like Mr. Faber's wife who, whenever a favorite shoe store holds a sale, immediately buys three pairs instead of one), but it overlooked the fact that its wages and salaries were decreasing in real terms because manufacturing jobs and tradable services were increasingly shifting overseas. For some time this wasn't a problem, because the Smartos had bought the island's central bank. They made sure that sufficient money was made available to the system to sustain the consumption binge, which was largely driven by inflating asset prices. Plenty of liquidity and rising asset prices created among the Bushes the "illusion of wealth." Naturally, the island's trade and current account deficit began to worsen as it consumed significantly more than it produced, but initially that wasn't a problem, for the Smartos had encouraged the Bushes to engage – in the name of all kinds of good, just, and well-meant causes, and without any self-interest whatsoever – in overseas military expeditions, which led foreign creditors to believe in the island's economic and military might, and social stability.
For a time, they were, therefore, perfectly happy to finance the island's growing current account deficits. At the same time, the increase in defense spending shifted wealth from the masses to the elite of the Bushes, who largely controlled the military hardware and procurement industries. As a result, wealth and income inequity widened further as the masses became largely illiquid and had difficulty in maintaining their elevated consumption, while the Smartos and the elite of the Bushes accumulated an ever-increasing share of the national wealth. But never at a loss when it came to creating additional wealth, the Smartos devised another scheme to enrich themselves even further: lending to illiquid households (read sub-prime lending). Not that the Smartos would have lent their own money to these uncreditworthy individuals (they were far too clever for that); for a fat fee, they arranged and encouraged this novel type of financing. Credit card, consumer, and mortgage debts were all securitized and sold to pension funds and asset management companies whose beneficiaries were the majority of Bushes, who accounted, as indicated above, for 99% of the population.
In addition, these securitized products were sold to some credulous foreign investors. By doing so, the Smartos achieved three objectives. They earned large fees, and unloaded the risks indirectly onto the very people who borrowed the money, and onto foreigners. But most importantly, they provided the Bush tribe with a powerful incentive to support their expansionary monetary policies, which ensured continuous asset inflation. After all, any breakdown in the value of assets would have hurt the Bushes the most, since they carried most of the risks by having purchased all the securitized lower-quality financial instruments. But not only that!
The Smartos knew that as asset prices increased, their prospective returns would diminish.
But this wasn't an immediate problem, as they promoted increased leverage to boost returns to the investors and at the same time their own fees. This strategy worked, of course, for as long as asset prices appreciated more than the interest that needed to be paid on the loans. On first sight, the debt- and, consequently, asset inflation-driven society of the island seems to work ad infinitum. But in the real world this isn't the case. Sooner or later, the system becomes totally unbalanced and entirely dependent on further asset inflation to sustain the imbalances. It is at that point that even a minor event can act as a catalyst to bring down asset prices and produce either "total," or at least "relative," illiquidity in the system, because a large number of assets whose value has declined no longer cover the loans against which they were acquired. "Total illiquidity" occurs when the central bank, faced with declining asset prices, doesn't take extraordinary measures to support asset prices.
"Relative illiquidity" follows when the central bank implements, in concert with the Treasury, extraordinary monetary and fiscal policies (cutting short-term interest rates to zero, and the aggressive purchase of bonds and stocks) in a desperate effort to support asset prices. In both cases, a degree of illiquidity occurs and depresses asset prices, but in different ways. In the case of "total illiquidity" (1929–1932 and Japan in the 1990s), asset prices tumble across the board in nominal and real terms with the exception of the highest-quality bonds and, possibly, precious metals (flight to safety). In the case of the island's central bank taking extraordinary monetary measures, asset prices don't necessarily decline in nominal terms, and in fact can even continue to appreciate.
However, they collapse in real terms, and against foreign currencies and precious metals. How so? Above, we have seen that the island's asset inflation led to excessive consumption and to growing trade and current account deficits because the Smartos and the elite of the Bushes were quick to understand that much larger capital gains could be obtained by playing the asset inflation game and by manufacturing overseas, than by investing in new production facilities and producing goods on the island.
The growing trade and current account deficits of the island were not immediately a problem, because they were offset by external surpluses in other parts of the world, which were frequently and erroneously labeled as "surplus savings" or a "savings glut." But whatever one wishes to call these surpluses or reserves, it is interesting to note that where they accumulated (mostly in China, Japan, Taiwan, Singapore, and Switzerland), they led to an interest rate structure that was lower than on the island. For the Smartos, this was an extremely fortuitous condition. For one, it was easy to convince the recipients and holders of these rapidly accumulating reserves to invest them in higher yielding assets on the island. In addition, it was for a while extremely profitable to borrow in low-yielding foreign currencies and to invest in relatively high-yielding assets on the island.
Obviously, this all changed when asset prices began to decline and the island's central bank had to take extraordinary measures by aggressively cutting short-term interest rates and supporting asset markets through bond and stock purchases. The interest rate cuts immediately narrowed the spread between the interest rate on the island and foreign currencies and led to a run on the island's currency, not only by foreigners but also by the Smartos, who had known all along that the asset inflation game would one day come to a bitter end. The deleveraging of this carry trade led to "relative illiquidity," which the island's central bank had to offset with even more liquidity injections, which while stabilizing asset prices led to even greater loss of confidence in the soundness of the island's currency, and in its bond market, which by then was mostly owned by foreign creditors.
As Mao Tse Tung had observed much earlier, there was by then "great disorder," but the situation was "excellent" for the Smartos. On the short end, interest rates had been cut so much that they were in no position to compensate for the continuous depreciation of the island's currency. So, the Smartos and the Bush tribe's elite began increasingly to borrow in the island's currency and to invest in foreign assets and precious metals. In fact, the island's central bank, by its market-supporting interventions, encouraged this process. Stocks and bonds were dumped on to the central bank and the Treasury's plunge protection team at still high prices, and the proceeds were immediately transferred to foreign assets and precious metals, which appreciated at an increasing speed compared to the island's assets, which suffered from the continuous depreciation of the currency.
And in order to facilitate this trade, the Smartos, who controlled both the Fed and the Treasury, continued to make positive comments about "a strong currency being in the best interest of the island." Sure, it would have been in the best interest of the island to have a strong currency, but it was certainly not in the best interest of the Smartos, who had devised their last grand plan: shift assets overseas and into precious metals, let the currency of the island collapse, and then repatriate the funds and buy up the remaining assets of the Bush tribe's middle and lower classes at bargain prices since they had never understood that their currency had collapsed against foreign currencies and against gold.
For a while this system functioned perfectly well. Among the Bushes there were also some smart people, and they were encouraged to accumulate wealth as well. However, they had to pay an increasingly high price to acquire assets, since most of the island's assets were owned by the Smartos and by the elite of the Bushes who, because of their wealth, never really had to sell any assets. Cracks in the system began to appear because more and more of the wealth began to be increasingly concentrated in fewer and fewer hands. (According to the Financial Times, the concentration of wealth is extremely high in the United States, with 10% of the population currently holding 70% of the country's wealth, compared to 61% in France, 56% in the UK, 44% in Germany, and 39% in Japan.)
However, the Smartos then stumbled upon another avenue to wealth: globalization. The island was opened to foreign trade and investments, which allowed the business owners to shift their production to low-cost foreign countries and, at the same time, to keep the masses among the Bush tribe happy through the imports of price-deflating consumer goods. In the same way that, in the 18th and 19th centuries, the European settlers of America had exchanged with the Indians worthless beads and booze for land, now the Smartos and the elite of the Bushes exchanged cheap imported goods, whose supply they controlled and from which they earned handsome margins, for assets. As a result, the majority of the population of the Bushes experienced a relative wealth decline compared to the wealth of the Smartos.
Again, this worked perfectly well for a while: the populace was happy to buy deflating consumer goods (like Mr. Faber's wife who, whenever a favorite shoe store holds a sale, immediately buys three pairs instead of one), but it overlooked the fact that its wages and salaries were decreasing in real terms because manufacturing jobs and tradable services were increasingly shifting overseas. For some time this wasn't a problem, because the Smartos had bought the island's central bank. They made sure that sufficient money was made available to the system to sustain the consumption binge, which was largely driven by inflating asset prices. Plenty of liquidity and rising asset prices created among the Bushes the "illusion of wealth." Naturally, the island's trade and current account deficit began to worsen as it consumed significantly more than it produced, but initially that wasn't a problem, for the Smartos had encouraged the Bushes to engage – in the name of all kinds of good, just, and well-meant causes, and without any self-interest whatsoever – in overseas military expeditions, which led foreign creditors to believe in the island's economic and military might, and social stability.
For a time, they were, therefore, perfectly happy to finance the island's growing current account deficits. At the same time, the increase in defense spending shifted wealth from the masses to the elite of the Bushes, who largely controlled the military hardware and procurement industries. As a result, wealth and income inequity widened further as the masses became largely illiquid and had difficulty in maintaining their elevated consumption, while the Smartos and the elite of the Bushes accumulated an ever-increasing share of the national wealth. But never at a loss when it came to creating additional wealth, the Smartos devised another scheme to enrich themselves even further: lending to illiquid households (read sub-prime lending). Not that the Smartos would have lent their own money to these uncreditworthy individuals (they were far too clever for that); for a fat fee, they arranged and encouraged this novel type of financing. Credit card, consumer, and mortgage debts were all securitized and sold to pension funds and asset management companies whose beneficiaries were the majority of Bushes, who accounted, as indicated above, for 99% of the population.
In addition, these securitized products were sold to some credulous foreign investors. By doing so, the Smartos achieved three objectives. They earned large fees, and unloaded the risks indirectly onto the very people who borrowed the money, and onto foreigners. But most importantly, they provided the Bush tribe with a powerful incentive to support their expansionary monetary policies, which ensured continuous asset inflation. After all, any breakdown in the value of assets would have hurt the Bushes the most, since they carried most of the risks by having purchased all the securitized lower-quality financial instruments. But not only that!
The Smartos knew that as asset prices increased, their prospective returns would diminish.
But this wasn't an immediate problem, as they promoted increased leverage to boost returns to the investors and at the same time their own fees. This strategy worked, of course, for as long as asset prices appreciated more than the interest that needed to be paid on the loans. On first sight, the debt- and, consequently, asset inflation-driven society of the island seems to work ad infinitum. But in the real world this isn't the case. Sooner or later, the system becomes totally unbalanced and entirely dependent on further asset inflation to sustain the imbalances. It is at that point that even a minor event can act as a catalyst to bring down asset prices and produce either "total," or at least "relative," illiquidity in the system, because a large number of assets whose value has declined no longer cover the loans against which they were acquired. "Total illiquidity" occurs when the central bank, faced with declining asset prices, doesn't take extraordinary measures to support asset prices.
"Relative illiquidity" follows when the central bank implements, in concert with the Treasury, extraordinary monetary and fiscal policies (cutting short-term interest rates to zero, and the aggressive purchase of bonds and stocks) in a desperate effort to support asset prices. In both cases, a degree of illiquidity occurs and depresses asset prices, but in different ways. In the case of "total illiquidity" (1929–1932 and Japan in the 1990s), asset prices tumble across the board in nominal and real terms with the exception of the highest-quality bonds and, possibly, precious metals (flight to safety). In the case of the island's central bank taking extraordinary monetary measures, asset prices don't necessarily decline in nominal terms, and in fact can even continue to appreciate.
However, they collapse in real terms, and against foreign currencies and precious metals. How so? Above, we have seen that the island's asset inflation led to excessive consumption and to growing trade and current account deficits because the Smartos and the elite of the Bushes were quick to understand that much larger capital gains could be obtained by playing the asset inflation game and by manufacturing overseas, than by investing in new production facilities and producing goods on the island.
The growing trade and current account deficits of the island were not immediately a problem, because they were offset by external surpluses in other parts of the world, which were frequently and erroneously labeled as "surplus savings" or a "savings glut." But whatever one wishes to call these surpluses or reserves, it is interesting to note that where they accumulated (mostly in China, Japan, Taiwan, Singapore, and Switzerland), they led to an interest rate structure that was lower than on the island. For the Smartos, this was an extremely fortuitous condition. For one, it was easy to convince the recipients and holders of these rapidly accumulating reserves to invest them in higher yielding assets on the island. In addition, it was for a while extremely profitable to borrow in low-yielding foreign currencies and to invest in relatively high-yielding assets on the island.
Obviously, this all changed when asset prices began to decline and the island's central bank had to take extraordinary measures by aggressively cutting short-term interest rates and supporting asset markets through bond and stock purchases. The interest rate cuts immediately narrowed the spread between the interest rate on the island and foreign currencies and led to a run on the island's currency, not only by foreigners but also by the Smartos, who had known all along that the asset inflation game would one day come to a bitter end. The deleveraging of this carry trade led to "relative illiquidity," which the island's central bank had to offset with even more liquidity injections, which while stabilizing asset prices led to even greater loss of confidence in the soundness of the island's currency, and in its bond market, which by then was mostly owned by foreign creditors.
As Mao Tse Tung had observed much earlier, there was by then "great disorder," but the situation was "excellent" for the Smartos. On the short end, interest rates had been cut so much that they were in no position to compensate for the continuous depreciation of the island's currency. So, the Smartos and the Bush tribe's elite began increasingly to borrow in the island's currency and to invest in foreign assets and precious metals. In fact, the island's central bank, by its market-supporting interventions, encouraged this process. Stocks and bonds were dumped on to the central bank and the Treasury's plunge protection team at still high prices, and the proceeds were immediately transferred to foreign assets and precious metals, which appreciated at an increasing speed compared to the island's assets, which suffered from the continuous depreciation of the currency.
And in order to facilitate this trade, the Smartos, who controlled both the Fed and the Treasury, continued to make positive comments about "a strong currency being in the best interest of the island." Sure, it would have been in the best interest of the island to have a strong currency, but it was certainly not in the best interest of the Smartos, who had devised their last grand plan: shift assets overseas and into precious metals, let the currency of the island collapse, and then repatriate the funds and buy up the remaining assets of the Bush tribe's middle and lower classes at bargain prices since they had never understood that their currency had collapsed against foreign currencies and against gold.
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