The Financial Fire Trucks Are Gathering

Thoughts from the Frontline (11/26/2008)
"All of the signs of upheaval were there. And now many portfolios are down by 50%. And the fire of a credit crisis is blazing all around us. The firemen in the form of the Fed, the US Treasury, and central banks all over the world are trying to put it out.

And while the stock market may enjoy a serious rally over the next few months, we are not out of the woods. The fire is still raging and we are witnessing ever-more aggressive attempts to get the fire of the credit and housing crisis under control.

Yesterday the Treasury announced yet another huge $800 billion bailout, but this one has a different flavor. Much of the previous bailout money has come from the Treasury either borrowing money and buying assets (which does not create new dollars) or simply taking assets onto the national balance sheet, guaranteeing the debt. With this latest move, the Fed is going to buy $600 billion in mortgage bonds by monetizing, or creating, new dollars.

Normally this would set off more alarm bells, over worries about inflation. But these are not normal times. With the twin bubbles of the credit and housing crises still imploding, we are seeing a massive deleveraging and the disappearance of multiple trillions of dollars from consumers and businesses. And the bond market clearly expects more softening and maybe even deflation. The 10-year bond is below 3%. I wrote 10 years ago that we could see the 30-year US bond below 3% by the end of this decades-long cycle, which we began in the early '80s with Paul Volker.

As I wrote last April, the velocity of money (how fast a dollar moves through the economy) is slowing rather dramatically. It could fall another 10% and just get back to the average for the last 107 years. Given the growth in population, inflation, productivity, and other factors, the money supply will need to grow by 7% annually for the next several years to keep the economy at equilibrium."

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