Time and again we hear commentators in the business section talk about financial panic as if it were some sort of collective irrational response to a set of difficult circumstances. It conjours up images of hard-nosed stock traders suddenly having a bout of 'the vapours,' swooning like Victorian ladies at the sight of uncovered piano legs (and yes, they used to put dresses on them to prevent such an occurence!) It suggests that if only those involved were made of sterner stuff, the crisis would pass.

How ridiculous!

What's happening in the financial markets right now is not an excess of hyperemotional sensitivity, but a general contraction of overleveraged credit. Henry Liu, in the January 26th edition of Asia Times, notes the following: "As economist Hyman Minsky (1919-1996) observed insightfully, money is created whenever credit is issued. The corollary is that money is destroyed when debts are not paid back. That is why home mortgage defaults create liquidity crises.... While the Federal Reserve commands a monopoly on the issuance of the nation's currency in the form of Federal Reserve notes, which are "legal tender for all debts public and private", it does not command a monopoly on the creation of money in the economy. The Fed, through the fractional reserve, is responsible for the creation of some money: with a 10% reserve requirement, a $1,000 initial deposit can be loaned out 45 times less 10% reserve withheld each time to create $7,395 of loans and an equal amount of deposits from borrowers. But money can be and is created by all debt issuers, public and private, in the money markets, and the total notional value of all this credit reached a record $681 trillion in the 3rd quarter of 2007!"

This number exceeds the total real value of the world's annual GDP by a factor of ten. This edifice of debt and credit is swiftly collapsing. It started with subprime loans, but it is fast affecting other debts as the value of assets continues to shrink. This article from the LA Times hints at far more trouble ahead, even with heretofore solid loans: <link>.

As this vast skein of credit unravels, more trouble emerges: <link> and <link>

As a result, the crisis is far from over. All indications, the temporary rise in stocks notwithstanding, point to worse to come. <link>

This panic is not some passing psychological craze. It is the hard reality that as losses pile up, banks and other financial institutions have to cover for them by pulling back on loans, shoring up their balance sheets. Failure to do so spells insolvency.

As the behavior of the Bank of England in shoring up Northern Rock, a bit player in the world financial arena, indicates, the insolvency of any major player could lead to a catastrophic cascade of bank failures.

What we have in place now is a vicious cycle powered by ever-increasing losses and ever-declining values of assets. No one yet knows where it will end ... or even how it may proceed a month from now.

"As economist Hyman Minsky (1919-1996) observed insightfully, money is created whenever credit is issued. The corollary is that money is destroyed when debts are not paid back."

I have to disagree with that. The money is destroyed when the debt is paid back. When it isn't paid back, the debt associated with the credit still exists; it just turns from good debt to bad debt. Only something like bankruptcy would destroy it in that case. One can understand why the issuers of all that credit were anxious to constrain the opportunities for bankruptcy.

People like Minsky should have stuck to burlesque. If I lend Revrick $1,000, my money supply goes down by $1,000, and Revrick's goes up by $1,000. He issues me an IOU for $1,000 from his paper stock, but his IOU is hardly money. However, I could sell his IOU to a bank, which could resell it ad infinitum; but that would not be money -- it would be credit and debt.

Somehow, economists don't know the difference between money and debt. It's good to have a lot of money, but bad to have a lot of debt, unless there's inflation in excess of the interest rate on the debt.

Nevertheless, the recent real estate inflation created a lot of increased asset valuations, based upon which a lot of people got loans or cash profits from sales. If the loans can't be repaid or sustained, whoever put up the money is out that money unless govt comes in and hands out new money, usually printed out of thin air.

Money supply has about 13 definitions for economists, but only one for human beings, which could make one ask if economists are human beings. Economists sure can't do arithmetic! They seem confused by infinite series.

What I just love is how Bush and Congress are now sending out $150 Billion, where they are striving mightily to make the boobs think that they didn't just print it up. It's a "taxcut"!

Gevalt!!!!!!

Ah! yes. And if the Chinese and Japanese become shakey with all of the Treasurery Debt they hold and refuse to buy that 150 billion of new issue--what then?

Phil,

When I take out a loan from the bank, they count it as an asset and when the proceeds of that loan get deposited in another bank(s), it can be used to create more loans, so if I fail to pay my loan, not only does my bank take it on the chin, but so do all the rest in the chain that lent out money based on that worthless asset. If I pay back my loan, the bank turns that around into other loans.

Our interest rates will have to rise sufficiently to tempt them back.

Sov,

Good to have you back.

Yeah, the average joe's definition of money would be the cash in my pocket and what's in checking and savings (or could be had temporarily through one's credit card).

Your scenario involves just two non-bank parties. But a bank can take my $1000 deposit (my loan to the bank) and lend out $900 of it, which becomes deposits at other banks generating other loans. By the work of fractional banking the original grand becomes over 7G's.

rev,

I think you just agreed with me in my disagreement with Milken.

At present, a lot of the $900 loans wil be used to buy Chinese-Japanese digital TVs, which sends money muliplying outside the USA system. Or their cars. Even if the $150 Billion got spent, it won't multiply much inside the USA. A lot will go to repay credit cards and mortgages.

f course, textbooks expound the multiplier-effect, but it's simplistic. And when real estate valuations go down, that has an effect on the sum total of money perceived by the aggregate population.

Govts can't get away from needing physical tangible outputs to support a currency. USA's output just ain't there.

Well, I can agree 100% that our economy stands on some shaky ground. We've outsourced our productive capacity and if the world economy slows there won't be much demand for Caterpillar tractors or Boeing jets, the only two good things we do have to sell.

Phil, I don't think so.

Econ 101 teaches that commercial banks create money through the magic of loans paired with fractional banking. When I deposit $1000 in my checking/savings account, I expect to get it back somewhere along the line, with a little extra thrown in. But it doesn't just sit there.

The bank takes my grand, sets $100 aside and loans out the rest, which becomes bank deposits somewhere else, which form the basis of other loans... etc. Potentially, my original $1000 deposit becomes $7,000+ worth of loans. But it all works in reverse as well.

The losses of $300 billion dollars banks have incurred through the sub-prime mess (which has spread far beyond it now) translate into several trillion dollars in loss of credit! If that isn't the destruction of money, I don't know what is.