Saturday, August 9, 2008

Credited Out

Before I sound too much like a broken record posting a litany of pessimistic news from the financial sector, I just want to say there is method to the madness. It does relate to the value of the dollar.

To recap, I have argued the value of the dollar will rise as the amount of credit in the system falls. In support of this, I proposed that the inventory of available goods for sale is exactly equal to the money supply ("the cash-inventory equivalency") except for errors of pricing, which are common but equilibrate over time. I also accept the general notion that money supply is the sum of printed currency plus outstanding credit. So, in short, as credit declines, then total money in the system declines. With less money in the system, prices have to fall to capture the rare cash that is left, else increasing inventory goes unsold. In this way, the value of the dollar increases with the demise of credit.

Now, recent legislation has promised us endless liquidity, in the form of credit, originating from the U.S. tax base—at least as far as houses are concerned—with the bailout of Fannie Mae and Freddie Mac. They buy or insure a sizeable percentage of all mortgages in America and as of July 30, 2008 have an unlimited stream of capital from the Treasury Department to accomplish this. So, would this keep credit high? Would this allow the pattern of borrowing and spending so characteristic of the first half of this decade to continue unabated?

There will come a day where banks are unwilling to lend, and borrowers cannot or will not take on more debt regardless of how favorable are the terms. This is the point where the system is "credited out."

Now, credit expands when it is lent out by banks and contracts when it is paid back or defaulted on. If terms were made so favorable that much of the credit capacity of the system was lent between 2001-2006, then subsequent years will no longer see anywhere near as much credit shoveled in to the economy. Worse, incomes will be consumed by paying off debt. So, where before the economy was flush with easy money, soon it will be starved with debt repayment. Where there was once free-flowing credit to boost incomes and lubricate consumerism, soon payments on interest and principle will squeeze out sales of all but the basic necessities.

The backlash of the credit mania is nigh, and the repercussion will be felt for years. The only solution is not to get into this mess in the first place.

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