Excess liquidity to keep asset prices up - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 16 January 2014
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Baltimore, Maryland

Now our nerves are settled. We can sleep at night. There's nothing more to worry about. Christine Lagarde, director of the IMF, has reassured us.

Madame Lagarde tells us that a Fed taper wouldn't mean a thing, as long as the Fed goes about its tapering in a gradual, measured way, which of course they would.

    "We don't anticipate massive, heavy and serious consequences," she said.
But wait. She must be wrong about that. If the Fed were to continue tapering, the stock market and the economy would both go into withdrawal shock. The economy will wobble. Stocks will fall. Janet Yellen will go into a huddle with other Fed governors and come out with an announcement: more QE!

Yesterday, the Dow rose another 108 points. All right so far.

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We don't know whether Ms. Lagarde is aware of it or not. Fed economists must be. They must know that the only thing keeping the economy from slipping into recession is money from the Fed.

The following figures were shown to us by Richard Duncan. He spelled it out for us.

Here's how it works:

Since the 1980s, we have an economy that grows on credit. In 1964, the entire US economy owned only $1 trillion. Since then, credit multiplied 50 times. And now, the economy depends on it. When credit growth slows, so does the economy.

How much credit growth does it take to keep the economy chugging ahead? Mr. Duncan says it needs an increase of at least 2% after inflation, or the economy goes backward. Every time credit growth has fallen below 2%, he says, we have had a recession. No exceptions.

A growing, expanding economy naturally leads to more credit. Households borrow for new homes and appliances. Businesses borrow for new plants and machinery. Investors borrow to finance start-ups and speculations. Government borrows too, to cover deficits. And all this borrowing is what leads to new demand, new jobs, and new output.

Instead of stimulating a real, healthy recovery, however, the feds have only been able to simulate one. The real economy limps along. Real disposable incomes are barely increasing. The personal savings rate is only 4% (it was 10% in the '80s). There is little natural credit creation. People have little extra money to lend...and little desire to borrow.

While the feds have been unable to do much about the real economy... in the financial economy they've wrought wonders! That's the secret to understanding the markets, Duncan explains. It depends on the difference between how much credit the economy needs and how much credit the Fed provides. The excess is what drives up asset prices.

That's why the rich have gotten so rich lately. The markets take the Fed's excess liquidity and convert it in asset prices. Stocks rise. Real estate goes up (the average house is back over $200,000). Household net worth - heavily concentrated in the upper reaches of the socio-economic pyramid - rose $8 trillion in the last 12 months, says Duncan. It's now greater than it was in '07. And that huge increase appears to be the only thing keeping the economy from sinking.

Take away the QE and you take the biggest single buyer out of the marketplace. Bonds fall. Stocks fall. Housing falls. And the economy, no longer buoyed up by the phony 'wealth effect,' is suddenly pulled under by a real 'poverty effect.'

Duncan tells us that all borrowers put together are likely to ask for $2.2 trillion worth of credit this year. That is a 3.8% increase. But that's before inflation. Take off 2% for rising prices, and the real increase falls short of the 2% needed to avoid recession.

So, here's what happens. The Fed has to add liquidity, or the economy falls into recession. Some of it is absorbed by the credit market (mostly US federal deficits). Anything more than is needed to fund credit demands is the 'excess liquidity' that drives the asset markets. Stocks soared in 2013 because the Fed over-funded US credit demands (the US budget deficit declined).

"The Fed is driving the economy," says Duncan.

The feds broke it. Now, they own it.

Over the next 6 months Mr. Duncan sees no problem. There will be enough excess liquidity to keep asset prices moving up. But then, watch out.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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