Monday, May 30, 2011

Are your dancing shoes fire proof?

Americans all know that depressions start when the stock market collapses. Add that bit of popular wisdom to the long list of failures of our education system. Depressions used to be called bank panics because they are caused by banks and now days by bank like institutions. The current Depression started in 2008 and nothing has been done so far to stop it.

The ongoing policy of the Federal Reserve is to pump trillions and trillions into the system to stay ahead of the grim reaper of deflation. Lately they’ve  been trying to jump start the economy by pumping still more money into the financial system in order to actually create inflation. In an economy based entirely on monetary policy the only way to stimulate big business is to force them to think about doing something productive to make money by causing their existing money go away through inflation.

This appears to have been a dismal failure. Corporations have taken advantage of all the loose money and extremely low interest not to do anything productive, but to amass huge war chests. The two trillion in cash they have on hand (that they haven’t been spending) is really money they had borrowed from issuing corporate bonds, they aren‘t really in very good shape. The amount of money in these junk bonds continues to skyrocket as institutional investors load up on these “investments” instead of going into the stock market. Bonds seem safer than the potential of a Black Monday flash crash of the DOW.

The interest these bonds pay is incredibly low from tenths of a percent for “investment” grade bonds up to 2 or 3% for outright “junk” bonds. At some point the secondary market is going to have to deal with trillions of dollars in bonds that don’t pay enough to cover normal inflation. Institutional traders find themselves trapped, a popular phrase is “you have to keep dancing while the music keeps playing”. Fund managers need to show a competitive return and this means buying junk bonds then holding their breath while dancing and smiling for the investors.

At some point this pile of paper in the middle of the dance floor will start to smoke, there will be a rush for the door and not everybody can get out. This wouldn’t be such a big deal except for the shear size of the conflagration. It will spread to the adjoining dance halls as the losses build and the panic will spread.  Credit will freeze up, business will start cutting losses, then cutting staff, dumping inventory, prices begin to fall and it all reinforces itself spreading out of control.

Remember nothing has been done fix the fire code violations of 2008, in fact everything is worse than it was then. The too big to fail banks are even bigger and less stable. Is this an absolute prediction how things will play out? No, there other dance halls with the exits blocked just waiting to ignite first all up and down that sleazy part of town know as Wall Street.

The rumor was that Obama would do a recess appointment of Elizabeth Warren to head the new agency to crack down on the companies that own these financial fire traps. The Republican response was to keep Congress technically in session over the holiday to make sure this didn’t happen. (the Senate can’t recess for more than 3 days without permission from the House) The Republicans get a big cut off the operation of these fire traps and they aren’t the ones who will get burned.