From this morning's reading ...

The Credit Crunch Is the Solution, Not the Problem
October 20, 2008 | Jason LaValley | Seeking Alpha

Since roughly October 2007, the world’s financial institutions have trembled, credit markets have seized, and as the government bailouts arrive, a consensus view has developed that the root cause of our recent misery is the greed of over-levered, under-regulated financial institutions, helpless in the face of overwhelming losses caused by indefensible gambles on sub-prime mortgage loans for over-valued residential housing.

While reasonable conversations can take place regarding the root cause of mortgage lending standards (e.g. the Community Reinvestment Act in the Carter era), the simple truth is that the true nature of the economic crisis has been obfuscated. Most Americans believe they are in for a severe recession caused by the unwise decisions of bankers. They may not understand they are coming out of a severe recession facilitated by the very government now coming to the rescue.

Theme I: We’ve experienced a much more severe inflation shock than reported.

Let’s keep it simple. When we greatly expand the number of dollars that exist, each of them will be worth less (i.e. prices will rise). The facts are clear:

- Most official measures of the U.S. Dollar money supply show a recent record of minor, very stable growth – all the hallmarks of a concerned steward of stable prices. In fact, in March 2006 the US government stopped reporting “M3” a critical component of the money supply which helps indicate how much money supply growth is attributed to commercial bank lending via institutional deposits, money funds, and Euro dollars, etc. While official monthly money supply measures (M2) show the supply of US Dollars growing in a 4-6% range since 2003/04, private individuals who have continued estimating M3 growth show that the world’s commercial banks have increased the growth rate of dollars by up to 16%.

- That’s OK, you say. The government carefully measures inflation, ensuring that swift and prudent action is taken the minute money supply growth impacts the stability of the prices for this we must buy as part of our daily lives. Now I ask, does that sound like the U.S. federal government to you? The government does continue to measure price inflation, but they have made two significant changes since our last inflation shock in 1980 when Paul Volker killed inflation by raising interest rates. Back then, the rampant, unacceptable inflation rate touched 15% . Of course, this time in the worst of it (2008) we only touched 5 ½ %... except that we changed how we measure it. If you still measured inflation the way we did in 1990, before the Clinton-era changes, we experienced 9% inflation in 2008. If we measure it the way we did in 1980, we touched 13% - almost to the Volker era highs. You weren’t crazy. Did you get a 13% annual pay raise?

- And the markets weren’t fooled for a minute. Gold (priced in dollars) rose 235% from 2005 through 2008. Oil by 247%. Now, U.S. GDP only rose 11% from 2005-2007, Adjust for the ‘new’ inflation numbers and you find the line you hear in the media. “We’re not quite in a recession yet”. Adjust GDP for something approximating the way we measured inflation in recent history and you see that we’ve been in a rather severe recession for some time now. Ask yourself – hasn’t it felt that way?

- And, as it always does, capital flowed to more hospitable places. It doesn’t matter if you looked at U.S. investment in anything overseas (especially emerging markets), anything not priced in dollars, or if you just flat out look at the currency. The US dollar dropped in value (against a basket of other currencies) by more that 40% from its peak in 2002 to trough in 2007.

Theme II: This time we didn’t need to raise interest rates

In 1980, the Volker fed needed to raise interest rates to extremely high rates to break the back of inflation. I’m sure we can all agree we’d prefer not to incur borrowing costs in excess of 15% - so why do we get to avoid that pain?

In this case, the cause of the problem (the rampant creation of too many dollars by the commercial banking system) seems to have been corrected by the market itself. After peaks in 2008:

- The U.S. Dollar has risen 14% in 2008 from its lows.
- Gold has declined 21% from its highs
- Oil has declined 34% from its highs
- Credit creation by commercial banks has declined from 18% to 2%.

In other words, the current “credit crisis” is in fact the source (commercial banks) of the problem (inflation caused by M3 supply growth) correcting itself (reversing through the refusal to extend credit) through market forces (which question the real value of the collateral e.g. houses) for the loans.

Theme III: The Return of America

So how do we interpret the current state of our economy? The majority of media outlets repeat the standard line that the lack of available credit will negatively impact the earnings potential of U.S. equities. They claim that the best expectations for growth continue to lie in emerging markets - and that we are still in for a ‘deep’ recession, not coming out of one.

Phoey! The run up in energy and commodity prices was largely due to these commodities being priced in the free-falling dollar (doubt me? check a chart of oil priced in Euros or gold compared to dollars) . The strengthening in the dollar caused by the fact that commercial financial institutions no longer have the capital to debase the currency represents a massive tax cut for productive US industry. US industry, whose consumers have already seen the worst of a very deep economic recession.

- In terms of momentum there is no better currency in the world.
- There is a flight to the quality of the US, both in terms of currency and equity of commercial and real assets that will be levered for foreign investors by the continuing strength of the dollar.
- For the undervalued US Equities, expect a new era of “going private” and/or the ‘new conglomerates’ as balance sheet cash and real dollar profits are put to work buying over-levered or foreign assets.

As markets adjust from the paradigm of a weak dollar we are:

- Long Volatility (VIX)
- Long US Dollar (USDX)
- Long US Equities (SPY)

- Short World Equities Ex-US (especially the Euro zone) (VGTSX)
- Short Commodities priced in dollars (DBC)
- Short the US Government, not a having truly independent measurement of monetary statistics.