The global financial bubble that has been slowly leaking air for over a year has recently reached a tipping point. As bubbles are Ponzi schemes, based on large scale swings of positive feedback - starting slow and gathering momentum into a crescendo - this is exactly what one would expect to see. As bubbles are grounded in human nature, and that has not changed, we can look to previous instances in order to understand what is coming.
For a background look (from last August) at how we arrived at this point, and where the Ponzi dynamic inevitably leads, see The Resurgence of Risk. For on-going coverage, seven days a week, see The Automatic Earth.
The aftermath of a bubble (the hangover) is roughly proportionate to the scale of the excesses of the mania which preceded it (the party), and this has been the largest mania on record by a wide margin. The crash at the end of the Roaring Twenties, which led to the Great Depression, was similar in nature, but much smaller in scale. The most recent event of a comparable, though smaller, scale was the South Sea Bubble that collapsed between 1720 and 1722, leading to decades of upheaval. This time, we have seen a derivatives market go from essentially nothing to a notional value of some $700 trillion - a large multiple of global GDP - in a mere twenty-five years. This is casino capitalism at its most unbridled, but those bets are now going wrong on an alarming scale, and are threatening to bring down much of the financial system.
We have lived through a great credit hyper-expansion in which leverage has carried us to great economic heights, but there is always a price to pay for borrowing from the future. Leverage may carry you a long way up, but deleveraging on the way down drives a decline very quickly. That is what we are now witnessing in the credit markets, as liquidity dries up with the loss of confidence. No matter how much liquidity central bankers inject into the system, it disappears into a black hole in short order. At the same time, financial values are being decimated, as we have seen recently with Bear Stearns. This is the beginning of a global credit deflation.
Credit expansion and inflation differ in important ways. Although money and credit have been used interchangeably for a long time, they are not the same thing. Currency inflation amounts to dividing the real wealth pie into ever smaller pieces in a form of forced loss-sharing. Credit expansion instead creates multiple and mutually-exclusive claims to the same pieces of pie. It creates a perception of great wealth where there is in fact only a pile of IOUs, most of which end up being worthless. A fight then ensues over the underlying real wealth that has served as collateral, as there is nowhere near enough real wealth to meet the competing claims.
As we are seeing now, a self-reinforcing spiral begins, involving margin calls, defaults, sales of distressed collateral, lower prices and more margin calls. Assets which have long been given a notional (mark-to-make-believe) value on banks' balance sheets end up being marked-to-market in a firesale of assets. Under such circumstances, assets values typically fall to pennies on the dollar. The sale of Bear Stearns for about 1% of its value from a mere two weeks ago, or about a fifth of the value of its headquarters alone, is a case in point. The market smells blood and will pick off banks and hedge funds, all of which have been playing the leverage game, one by one. (As credit spreads widen to record levels, watching credit default swap prices for various institutions gives a good indication of where trouble is brewing.)
The Fed, and other central banks, have been trying to inject liquidity, but under conditions where trust is gone, they are pushing on a piece of string. Welcome to the liquidity trap. The Fed midwifes credit rather than printing money, but that requires willing borrowers and lenders, and those are disappearing. As debt is repaid, or more likely defaulted upon, the money supply contracts, and that contraction will outpace the actions of the Fed.
With short term interest rates falling rapidly, and due to fall further, the Fed has little room left to lower the price of money. Even a nominal rate of zero would not be low enough under conditions of money supply contraction, as the real rate (adjusted for negative inflation) would still be high. To make matter worse, longer term rates are not going to follow short term rates down due to the increasing risk, and therefore risk premiums. Longer terms rates are set to increase substantially, putting further pressure on the mortgage market and other debts. This will aggravate defaults, and cause huge losses due to leverage higher up in the financial food chain. The deflationary dynamic will support depression, while depression will support deflation.
For ordinary people this means a loss of access to credit, and quite likely margin calls and the calling in of loans. Cash will be king at a time when most people have very little liquidity and a great deal of debt. As interest rates will be high, debt will become unpayable very quickly, gutting a middle class destined to lose most of its assets. A systemic banking crisis, and the second Great Depression, have begun, and they threaten jobs, benefits, savings, investments, homes and the fabric of society.