Friday, October 03, 2008

Cash is again king

Question is, which kind of cash?
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.