Thursday, January 15, 2009

Fire and Ice

"Some say the world will end in fire,
Some say in ice.
From what I've tasted of desire
I hold with those who favor fire.
But if it had to happen twice,
I think I know enough of hate
To say that for destruction
Ice is also great
And would suffice."

-Robert Frost

Economically, inflation is fire and deflation is ice.

What the world lacks is high-quality capital. That is why the developed world is in the lowest interest-rate environment in history. But only for the (perceived) highest-quality debt- national governmental debt.

This is a big, big thing. What we have now is ice (we'll leave the poem's reference to 'hate' out of an economics blog). The fire of the 1970's into the 1980's has burned itself out.

It has burned out because the world went on a debt binge. Now, there is so much productive capacity that with the down-side of the debt binge, equity is needed to allow growth of production and consumption.

For those of us watching the markets regularly, the implosion of Citigroup, BofA, and the wrecks of last year have happened as if in slow-mo. But in reality this has happened rapidly, despite the hopes of the companies, regulators, etc. It's a tragedy with no precedent in modern history. Because it is so unprecedented, rules of thumb, such as buying stocks when the public gets very gloomy etc. have not worked and are at best irrelevant.

Now that BofA clearly has huge amounts of toxic assets on its balance sheet, my comments that it could be next after Citi are coming true, and rapidly. What possessed them to gamble on Countrywide and Merrill? Perhaps BofA was already in such trouble that it had to double down, and also did the acquisitions in coordination with Mr. Paulson and Dr. Bernanke.

In any case, it would appear that the best we can hope for from the large financial institutions is a Japan-style zombie status. I continue to favor a Swedish solution. (In happier times, this would mean something very different!) Now it means nationalization of the insolvent institutions. Those who lent money to those institutions should lose all their money if that's what the financial story really is. The protection of bondholders and preferred stockholders of insolvent financial companies being kept alive with taxpayer largesse is one of the scandals that hardly gets mentioned.

Dr. Roubini, on CNBC's Squawk Box today, raised his estimate of worldwide credit losses to $3 T. A year ago, his prediction of credit losses of $1 T seemed extreme. He attributed half the credit losses to US institutions and concluded that the banking system as a whole is insolvent.

This may well be a financial environment where the best risk-reward is to accept that the Government may be able to prevent you from beating inflation or from keeping all but Government-guaranteed assets secure in a deflation; and we must consider the possibility of a mixed inflation-deflation. Houses and municipal bonds, which you may own, can continue down in price and the cost of a haircut or cereal, which you purchase can go up. You can lose both ways.

Fire and ice.

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