Economy Watch:  While most commentators harp about rising inflation, I believe the largest threat looming over the market is that of deflation…an uncontrolled systemic deleveraging.  I put the presentation below together March 7, a stripped-down version of which we gave to some of our advisors on March 11.  In it I hit on what I believe are three of the four big threats to the financial system: the continuing fall/deflation in house prices; the chain reaction in the credit markets following the subprime blowup; and the massively over-leveraged position of ALL the Wall Street investment banks.  These three factors point to the threat of debt deflation, which leads to asset deflation, which eventually leads to price deflation.  The other big threat is that of the falling currency, which is inflationary and currently masks the deflationary effects of the deflating housing/debt bubble.

Download market_update_31108.pdf

The key point is that Merrill, Morgan Stanley, Lehman, and to a slightly-lesser extent Goldman all have leverage ratios similar to what Bear Stearns had.  While the other banks may have managed their liqudity and liabilities better than Bear, and have a more diversified set of assets, they all operate with the kind of leverage that killed the LTCM hedge fund in 1998.  A shout-out to Portfolio Magazine for clueing me in to this back in October.

Anyway, in this weekend’s actions the Fed may have averted the worst of the disaster scenarios: the uncontrolled collapse of a major counterparty to credit default swaps, prime broker and holder of mortgage securities that would have cascaded through the system.  The free-market ideologues (and this comes from someone who is about as free-market as they come) that say the government shouldn’t have gotten involved are completely underestimating the risk of total disaster that hangs over the markets like the sword of Damocles.

The rescue of Bear Stearns’ creditors and customer accounts was important, but another Fed action over the weekend may ultimately prove to be more important: making Fed credit directly available to the brokers.  In this, the Fed has acknowledged that much of the financial system’s credit is now created by brokers and their hedge fund clients.  This is likely the first step of a process that will bring brokers and potentially hedge funds under Fed supervision, forcing them to delever and likely to end up being merged into commercial banks.  For the broker/hedge fund universe to be operating at an overall leverage ratio of 30:1 to beyond irresponsible and puts the whole American economy at risk.  The risk management models used by the investment banks have underestimated the risk of disaster and have led to the type of hubris that could bring the entire financial system to its knees.

Inflation is created by the expansion of credit.  The Wall Street investment banks and hedge fund community expanded their leverage outside of Fed supervision, so that while M1 was flat for years, inflation was running rampant through the housing and commodity sectors and credit creation was leading to artifcially stimulated demand and an ever-wider trade deficit.  Those distortions have lead to unstable currencies, increased protectionism, militarism and anti-immigrant sentiment…the same toxic mix from which emerged the right-wing populism and communism of the 1930s.

A wholesale re-thinking of monetary policy is required.  Currency stability should be given more primacy, so as to prevent the rolling financial crises, volatile commodity prices and large trade deficits that we have experienced over the last twenty-five years.  That means interest rates should be more stable.  Instead, the Fed should target leaning against the wind on credit creation itself, particularly via bank reserve requirements, repo collateral requirements and derivative exposure.  If we don’t start brining some order to the global financial casino and the instability that goes with it, we risk giving rise to alternative ideologies to capitalism that will ultimately destroy prosperity.