The great expansion is over and the deleveraging of the global economy has begun in earnest. This is not a minor event that may lead to a mild recession, but a systemic financial crisis that is already well on the way to ushering in the second Great Depression.
Leverage can carry an economy a long way up by borrowing from the future in order to create the impression of great wealth, but that wealth is illusory. Once the speculative process of bidding up the value of assets comes to an end, leverage kicks into reverse and begins to magnify losses to the same extent it once magnified gains. What appeared to be wealth becomes nothing more than a pile of worthless IOUs.
The credit which has long functioned as a money substitute is now evaporating, reducing the effective money supply. This is credit deflation, and its effects will drag down asset prices across the board. Those assets had been bid up in apparent value through speculation, on the assumption that whatever one paid, there would always be a greater fool who would pay more.
The bidding process, fueled by borrowed money available on easy terms, drove prices into the stratosphere, even though there was no material change in the underlying assets. That is the effect of leverage. People take far larger risks with someone else's money than they would with their own. The boom and bust cycle has happened countless times before in history and the end result is always the same - not only is the speculative increase in value always wiped out during the bust, in fact prices always dip below where they were at the beginning of the boom.
The difference this time is one of scale. There has never been so large a boom as the one driven by globalized finance and underpinned by cheap fossil fuels, and the coming bust should be proportionate. There has also never been such an interconnected financial system where incidents in one country can so readily be transmitted to others through financial contagion.
The financial wizards thought they had risk under control, but in reality their attempt to eliminate risk resulted in magnifying it and spreading around the globe. We are now all hostages of each other, as the effects of the early bank failures begin to reverberate through the system. Europeans and Asians will suffer the consequences of the American house price collapse, while Americans and Europeans will suffer from the unwinding of the yen carry trade and the bursting of the Chinese productivity bubble.
Assets prices will be going back where they came from before the advent of easy money, which in many cases means they will fall by 90% or more, just as tulips did in Holland in the 1630s, or shares in the South Sea company did in the 1720, or dotcom shares did in recent years. Equities, real estate, long bonds, commodities, collectibles and others have a long, long way to fall in order to reverse the speculative excess.
Whereas manic buyers bid up the prices during the boom, a lack of buyers will now drive a relentless asset prices decline. Those few buyers who do emerge will set new benchmarks at lower levels all the way down, repricing entire asset classes - for everyone who owns them - all along the way. Cash will be king at a time when very little of it will be available.
There is nothing the Fed or other central banks can do to prevent this. Once a market becomes dominated by hoarding (whether of cash, gasoline, bread or anything else), it becomes almost impossible to keep it adequately supplied. Whatever liquidity is injected into the system ends up being taken off the table almost immediately by whomever is in a position to do so. Credit deflation will run its course and we would all do well to prepare to the extent that we can.