Thursday, June 19, 2008

The hamster and the spinning wheel

The low interest rates and lax credit standards of the last seven years led to the largest liquidity boom in history. As more banks lent more funds - more investment banks, funds, and investors borrowed to turbo-boost returns on their investments and speculation.

The multiplier effect of the leveraged finance transactions led to huge run-ups in assets that were the targets of these investor/speculators.

With the collapse of the leveraged finance market, many creditors have been demanding money back from the borrowers. This has led to the reverse-multiplier effect, where asset price increases, previously funded by the growth of liquidity, decline in price as margin-called investors sell their portfolio.

This is supposed to be just another example of the intended effects of market correction.

But many regular consumers got caught tied up in this latest credit crunch. Many had bought houses, which was the most visible beneficiary, and then casualty, of the credit boom-bust.

To save these consumers, many of whom suddenly had trouble keeping up with their mortgage payments, the Fed has had to orchestrate a large expansion of money supply.

To save regular consumers caught up in the financial market’s latest bubble, the Fed has had to replace artificial currency (created by the multiplier effect of bank lending), with actual currency. This monetary expansion has been a large component that fuelled today’s inflation.

Now people’s problems have come from an inability to afford paying their debt, to having an inability to afford basic goods. For these people, these measures were just enough to keep staying where they are, much like the running hamster on a spinning wheel.

The people who had benefited from the boom have likely already gotten their money out. Those early leveraged investors, those who sold assets before the fall.

Now, these people hardly need the Fed’s bailout. If anything, the recent government measures could be fuelling their next investment boom. We are already probably seeing this in the current commodities market.

They are making the spinning wheel run faster, and the poor hamster on it is going to get swept up, no matter how fast he runs.

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