The Current Financial Crisis and its Likely Outcome

As the current credit market crisis continues to unfold, it goes from bad to worse. Credible commentaries are now emerging in the mainstream press citing estimates as high as $500 billion(1) of losses that financial institutions may incur before it runs in course. It is unclear to me what the actual implications will be of a systemic loss of this magnitude, and indeed, since none of us has a perfect crystal ball, it can only be the subject of conjecture and speculation. That there will be an increase in insolvencies, massive economic displacement, and economic restructuring is appearing to be more and more a given. We appear to be at a global economic watershed point. If history is any guide, previous bouts of monetary folly have resulted in hyperinflationary environments, followed by collapse(2). In the past, however, there was relative economic containment because of the absence of the degree of globalization and economic integration we currently have in the world, with the exception, possibly, of the Great Depression era. In any event, an economic crisis of the magnitude we are currently facing, quickly becomes a political crisis. In considering possible strategies which may be attempted, short of the transparent charade recently proposed of the SIV Super Bailout fund, it appears the corner strategy will be monetization of the debt through hyperinflation. Indeed, we have already seen the evidence of this occuring, and it is well known that it is not a peripheral strategy for Ben Bernanke.

If we assume, for purposes of discussion, that this is the direction in which economic history will move, it becomes useful to consider some of the implications of this scenario for asset deployment purposes. While there is a great deal of discussion regarding the demise of the US dollar, it is often followed by considering other currencies as a safe harbor refuge. This may be a false sense of security. Considering that one of the reasons for the US dollar's problem is the lack of monetary discipline because of the fiat nature of the currency, the same problem exists with other currencies. There appears to be an inherent instability with a fiat monetary system. Consequently, in my opinion, it is a mistake to believe that other currencies might be anything other than a temporary refuge.

Let us also consider the question of debt. The initial reaction is to want to minimize indebtedness in a financial crisis. This may well, generally, be the prudent course to take. However, as circumstances amoung market participants differ, holding a fixed liability during a time of hyperinflation can become an asset as long as the ability to service the debt remains in place. For example, if I have a mortgage of $300,000, a hyperinflationary environment will reduce the value of that liability, in real terms, while at the same time possibly increasing the value of that asset in nominal terms. If I have a fixed mortgage payment of $1,500 per month which I can continue to service, a hyperinflationary environment may reduce that nominal figure in real terms, ie adjusted for inflation.

Let us also consider assets which might best retain or increase in value. It seems clear, and current market behavior suggests there is growing recognition of this, that assets which have a real use value, such as commodities, energy, food, water, etc. will continue to be in growing demand. At the same time, the constraints on the supply of these resources continues to grow. Economics 101 would suggest that a highly probable way to successfully deploy assets would be to own assets which are in growing demand and diminishing supply.

Traditonally, institutional creditors would be the one's to lose big time in inflationary environments. Nowadays, these institutions also appear to be some of the biggest debtors.


(1) Banks Face $100 Billion of Writedowns on Level 3 Rule, John Glover Nov. 7 (Bloomberg)
(2) Manias, Panics, and Crashes, A History of Financial Crises, Charles Kindleberger.