Sunday, December 9, 2007

Why the Fed Can't Solve the Liquidity, let alone, the Insolvency Crisis

You may have seen this chart before. Central banks can only affect the bottom two parts of the chart, high powered money and M3. M3 the Federal Reserve is growing as fast as it can in order to indirectly support the much larger problem of securitized debt and derivatives but risking a return of inflation pushing long term yields up and bond prices down.

These two phenomenal pockets of debt are supported by asset prices: when asset prices (which act as collateral) decline, the credit market contracts & liquidity gets sucked out of the system. So the purpose of pumping new money into the system is to keep nominal asset prices up to protect collateral values of the real problem of leverage in the system that the Fed cannot directly control. It takes more and more money & the creation of new debt to do this because people are having huge problems servicing the debt they already have.

So we have two huge forces fighting each other right now: central banks desperately attempting to re-flate (increasing the money supply & giving lenders fresh cash to create more debt) and the market grudgingly but purposefully attempting to deflate by paying back (which the bureaucrats are trying to help with) or more likely destroying (write-offs) that debt. We have extremely high volatility as these two forces fight it out.

Looking at the chart, which do you think will win? The Federal Reserve or the contracting credit market.