[CrudeAwakening]

Regarding inflation/deflation and bank runs etc - contrary to what many people believe, when a borrower defaults on a loan issued by a bank, the credit associated with that loan remains in the system, (having been spent and transferred to someone elses's account) with the hit being taken by the bank's equity position. Thus, widespread loan defaults that are not significant enough to cause banks to go under, do not cause deflation of credit. If a bank goes under, however, the associated bank deposits disappear from the system (a very sudden deflation of credit).

So, credit deflation will not occur through default, unless banks go bankrupt in the process. Deflation of credit will require repayment of loans, or bank collapse. Although, of course, widespread loan default, in so far as it reduces bank solvency further, only increases the likelihood of bank runs and further insolvencies, and asset deflation is likely to occur even in the absence of credit deflation as collateral is sold off on default.

Am I missing anything here?

[cube]

$this->bbcode_second_pass_quote('CrudeAwakening', '.')..
Am I missing anything here?

[patience]

The near term effect that concerns me is what I might call credit contraction (not being an expert here?), as is occurring now. That is, as banks are forced to take bad loans back onto their books, the losses to the banks result in a drawdown of the funds they have to loan. Thus, we see loan standards tighened, but overall there is simply less money to be loaned out.

The Fed can address that by adding liquidity, but since there is fear of impending solvency problems within the banks, they hoard their cash, making less available to the public for loans. So, ole Joe 6 Pack can't find as much easy credit for spending, and since his spending is 70%+ of the economy, less credit for him greatly impacts the GDP.

The leveraging effect of fractional reserve banking (they loan 9 x assets) works both ways. Loans increase 9 or 10 x increasing deposits, but they also decrease at the same multiple, whatever it is. Things can change very quickly here.

So, a bank crash isn't needed to really start a winding down--it's more of a continuum slowdown until some bank(s) hit critical mass on insolvency, then, game over for them, and dominoes start to fall.

Critique please, as I'm learning here.

[SchroedingersCat]

$this->bbcode_second_pass_quote('patience', 'T')he leveraging effect of fractional reserve banking (they loan 9 x assets) works both ways. Loans increase 9 or 10 x increasing deposits, but they also decrease at the same multiple, whatever it is. Things can change very quickly here.

[joewp]

$this->bbcode_second_pass_quote('SchroedingersCat', 'W')hen debt is expanded, there isn't actually more money created, just more debt. When the markers are called in, there isn't money in circulation to cover them. I think this is a new area of economics and might be a contributing factor to why this situation will be so hard to contain.

[CrudeAwakening]

$this->bbcode_second_pass_quote('cube', '
')So how is deflation created? Suppose Joe Sixpack finally pays off his $500,000 mortgage to the branch bank. The branch bank then pays off it's loan to the central bank. The money disappears back to where it came from --> thin air. The money supply contracts by $500,000.

summary:
creating debt -> inflation
paying off debt -> deflation

[cube]

To: CrudeAwakening

Don't worry....Americans aren't paying off their debts. It's just not happening!

I'm the only person I know (within my age group) who is 100% debt free.

[I_Like_Plants]

$this->bbcode_second_pass_quote('cube', 'T')o: CrudeAwakening

Don't worry....Americans aren't paying off their debts. It's just not happening!

I'm the only person I know (within my age group) who is 100% debt free.

[CrudeAwakening]

Cube, you're right. But I think it's important to remain open to all possibilities.

Mish has this to say about inflation/deflation:
$this->bbcode_second_pass_quote('', '
')Simultaneous Inflation and Deflation are Not Possible

TIF, in order to have a meaningful discussion, participants must agree with definitions.

According to Austrian economic theory inflation is a net expansion of money and credit. Deflation is the opposite, a net contraction of money and credit. If one accepts those terms, then it is impossible to have inflation and deflation at the same time, in aggregate.

If one chooses to separate the components, then yes, we can have inflation in money supply and deflation in credit. In fact those are the exact conditions I expect to happen. That is also an extremely good environment for gold.

There is no way consumer debt loads can be paid back given falling asset prices, and rising unemployment. Increasing foreclosures and rising defaults on credit cards are proof. Debt that cannot be paid back will be defaulted on. That is deflationary.

It is important to note that credit dwarfs money supply. In deflation, credit will contract at a far greater rate than the Fed prints. This happened in Japan and this also happened in the great depression. I expect it to happen again.

Those who claim gold is signaling inflation are mistaken. Gold is signaling a destruction of fiat credit and a rise in the value of real money. Things That "Can't" Happen, are about to. The Fed has no magic powers to stop deflation in spite of what most think. For more on this point please see No Helicopter Drop For Failed Banks.

Very few have been bullish on gold, bullish on treasuries, and bearish on financials. I have been and remain in that camp. At some point, a massive unwind of leverage in hedge funds may cause a steep selloff in gold. I am not guessing when that might occur, but if it does I suspect gold will be among the first things to rebound.

One look at a chart of treasuries shows price action and credit conditions far removed from the stagflationary 70's and 80's. This is no 70's rerun. One look at any number of charts shows Money Supply Trends Are Deflationary.

Those who are looking at prices as a measure of inflation are simply barking up the wrong tree. I will explain why in great detail in my response to CB below.

Prices of Oil, Groceries, Etc.

CB, I never said falling home prices (or falling prices of any kind) constitutes deflation. However, I have said falling home prices are deflationary. Furthermore, we can be 100% sure why home prices are falling: Psychology of lenders and borrows changed dramatically and there is a mammoth supply of housing relative to demand.

Similarly, I have never stated exactly why oil prices are rising. However, I have pointed out some of the parts. A part of rising oil prices is peak oil. A part has to be geopolitical concerns. A part has to be the war in Iraq. A part is lagging effects of past monetary policy. A part is due to current monetary policy. Yet another part is due to economic policy of other central banks. Can you figure out the percentages? I can't. In fact, no one can.

Let's consider food prices. A part of food prices has to be misguided government policies especially on ethanol. A part can be changing demand. A part can be drought, and a part can be practically anything if you think about it, including policies of China and expanding economies.

This is the problem with a focus on prices. Putting a focus on prices is putting the cart before the horse. Here is another way of looking at it:

What can the Fed do about?

* Drought
* Famine
* Hurricanes
* Peak Oil
* Changing consumer preferences
* Rising standard of living in China
* Economic policies in Japan, China, and Emerging markets
* Strikes
* Pestilence
* Lags in economic policy
* Government policy decisions
* Productivity improvements
* Innovation

Feel free to add to that list. Every single one of the above influences prices. There is not a single one of the above the Fed can do anything about.

But wait. The problem gets worse. Not only is it impossible to state with any degree of accuracy why prices in general are rising, it is also impossible, in many cases to know if they are rising at all!

Consider median home prices for example. How much of the rise (when things were going up) could be attributed to larger rooms, granite counter tops, incentives, etc. What about dual pane argon filled low-e windows? How does one compare historic prices to something that not too long ago was not readily available? What about improved safety features in cars? What are those worth?

About the only prices that can be accurately measured are commodity prices, energy prices, and food prices. Yet the Fed is concerned with consumer prices in general, not caring much about the few prices that can reasonably be measured. Sheeesh.

But wait. The problem gets still worse. The one and only thing the Fed does not discuss that influences prices in general is the supply of money and credit. We have a Fed that sets interest rates yet never discusses money!

Wait still more: There is still one more factor influencing prices. That factor is the lagging effect of past Fed guessing about what interest rates should be.

[patience]

Maybe Mish means that the debt defaults are reducing the amount of 'CREDIT" which by his definition (money supply=money+ credit) is contracting the money supply.

[Iaato]

Expanding the money supply is inflationary. War is inflationary. Diminishing energy resources is inflationary. Making endless IOUs on future generations is inflationary. Ponzi finance systems are inherently inflationary. Nationalizing the mortgage business is inflationary.

What Mish doesn't see is that there are two economies paralleling each other here. There is the real production/consumption economy, which is basically based on money as currency, and then there's the pretend, let's-make-it-all-up FIRE economy (Financials, insurance, real estate), that is almost exclusively made up of credit and make pretend paper documents such as SIVS, MBS, CDOs and other increasingly worthless garbage. The pretend FIRE economy is fixin' to just up and disappear, leaving a limping, inadequate real production/consumption economy to get inflated in order to deal with explicit short-term promises such as FDIC insurance.

Mr. Bill would be sure to disagree with me on all of this, but he's a real inside-the-box thinker, and that kind of thinking is not only what got us into this mess, but is also not going to get us out of it.

Here's a discussion I had elsewhere on this topic, with my arguments, if you're interested.

http://boards.fool.com/Message.asp?mid= ... e#26251897

[CrudeAwakening]

Yes, I'm sure that's what he means too - defaults will tend to cause a reduction in bank lending, and hence reduced credit creation. But defaults don't actually directly destroy credit AFAIK.

[threadbear]

Govts inflate in an attempt to stay solvent when their currency starts weakening in response to other currencies and gold. It is both a cause and effect of inflation, actually.

Mish also doesn't take into account that even if the govt did quit printing as much currency, there could still be rising prices in commodities if the supply of commods is sharply reduced, due to any number of reasons. The standard thinking that reduction in money supply ushers in an age where price has to drop to the level of affordability is wrong, particularly in a sharply bifurcated economy where there will be many many poor and some super wealthy.

In this case we are talking about 2 levels of society with prices being set for the upper level at prices that the producers can afford to set them. It won't necessarily be price gouging, just the new reality of doing business on a hurting planet with too many people.

[patience]

Iaato, I agree with your take on the state of affairs. And it looks like a whopper of a shock coming to us, as the financial house of cards comes tumbling down.

One place I differ a bit, is the possibility that gold and silver could take a fall as those financials go down, if there are people hedged with gold that have to dump it to cover their positions. Then I'd expect it to recover some, but maybe not for a long time, although it may retain it's store-of-value status relative to the dollar. I dunno.

Doesn't matter much to me, as I don't have enough to speculate on that anyway. For hedging against price increases (I don't want to risk calling it inflation here), we are putting our spare cash into more solar, terracing another garden, fruit trees to expand the orchard, and steel stock for the shop biz.

Yeah, I can't go along with Mr. Bill's views on the outcome here. Maybe I'm a "finance doomer"?

[Iaato]

$this->bbcode_second_pass_quote('patience', 'D')oesn't matter much to me, as I don't have enough to speculate on that anyway. For hedging against price increases (I don't want to risk calling it inflation here), we are putting our spare cash into more solar, terracing another garden, fruit trees to expand the orchard, and steel stock for the shop biz.

[LoneSnark]

The chart above shows annual bank failures from 1934-2007 using data from the FDIC. Several facts:

1. There have only been two years since 1934 when NO U.S. banks failed: 2005 and 2006.

2. Only 3 U.S. banks failed in 2007.

3. Besides the 2005-2007 period, there has never been another three-year period since 1934 when only 3 U.S. banks failed.

4. Even at the peak of the S&L banking crisis when more than 1,000 banks failed in 1988 and 1989, at a rate of more than 2 every business day for two consecutive years, the economy survived without going into a recession.

[Twilight]

We know S&L got a bailout. It doesn't matter. It is already clear there will be a severe recession. It is possible there will be bank runs. Hence positioning. Nothing more complicated than that.

[IslandCrow]

Good graph...does it show the calm before the storm?

The graph shows the number of banks failing. However, another important dimension of this is the size of the banks. Also, if recently there has been a lot of consolidation then in any crash the number of banks failing may not be as high as before, yet the effect could be more.

[patience]

MrBill, Would you comment on this?

SEE: http://www.fdic.gov/about/learn/advisory

This from the meeting minutes of the FDIC Advisory Committee:

"FHLB's 'super lien' against assets of banks to which they make advances", and they are

"Superior to the rights of depositors, and even the FDIC afteran institution fails."

From another blogger's research, the FHLB had loaned about $750 billion to various banks, including $95 bil to Citibank, $50 bil to Countrywide Financial, and $40 bil to Washington Mutual.

Those don't seem like good risks to me. I' ve read speculation that if/when these banks fail, the DEPOSITOR is #3 in the pecking order to get their money, and thus could be out of luck, negating any value to FDIC insurance. Mind boggling in the implications of this!

Grandpa told me he would never trust a bank as long as he lived....

[MrBill]

Sorry I am not an expert on US banking laws, but in general the customer's deposits are mixed-up with the bank's own money (shareholder equity) which, of course, is the cornerstone of fractional banking where the bank puts its customers' money to work to generate a return so that they can afford to pay interest.

That is different than a brokerage account where the client's money is segregated from the bank's or broker's own funds. In the case of a broker bankruptcy the client's money is safe-guarded. There is usually a third party insurance scheme administered by the regulator or supervisor that makes sure a small fraction of all capital goes towards an idemnity fund just in case a broker fails.

In the case of Refco they were dipping into customers' accounts to pay their own bills and keep their balls in the air. That is called fraud. Even then we were able to get our money back from Refco Overseas London (segregated account), but lost money with Refco Securities (non-segregated account) although there was fraud involved there as well.

The FDIC or other insurance only applies up to 'X' amount per customer. It varies from country to country. In Germany it is 23 million euros per customers I believe? In the UK is substantially less. I think 100% of the first GBP 3000 and then 90% of the next GBP 37.000? Don't quote me on that. I did not have time to re-check my facts.

The Fed or central bank, of course, is the lender of last resort to the bank. It would be up to them to make-up any shortfall or risk systemic collapse. Again it varies from country to country. In the UK the BOE is not the lender of last resort, so any bank bailout has to come from the government or Treasury itself. I believe Germany has again a private insurance plan that all banks pay into. They had one bank bankruptcy in the 1970s - Bankhaus Herstadt - that prompted them to totally revamp their banking and insurance laws (for the better).

So it would be my understanding that if the FDIC or another were to lend funds to a bank that they would have a claim over the bank's assets before bond holders or common shareholders. But if the bank went bankrupt that the depositor would only get back that 'X' insured amount. Anything over and above that would be treated as a common creditor and come in-line after any secured creditors or prefered shareholders.

I am not a bankruptcy lawyer, but some standard legal contracts - like ISMA/ISDA - between Interbank counterparts set-out rules in case there is insolvency. So things like repurchase agreements are covered or segregated, but unsecured loans would not be. It is kind of tricky.

The best would be to only keep X funds in any one bank, so that they are 100% covered by FDIC insurance. Then move the balance to another bank or keep it in a segregated brokerage account. Check to make sure the broker is also a member of a compulsary insurance scheme. Most are if they are licensed. But check. Especially if you are dealing over the Internet with a foreign broker for example. You may think you are dealing with Broker AG only to find out that the account is actually with Broker AG's Caymann subsidiary and they are only acting as the Caymann's agent. Similiar to what happened with Refco Securities or Bear Sterns' offshore hedge fund. I am not suggesting there was fraud involved only that clients were putting money into an offshore vehicle and not into Bear Sterns NYC.

In reality governments are under enormous pressure to make good on customer deposits in failed banks. And they control the printing presses. But still it is better to be cautious than sorry as Northern Rock customers found out.