What will happen when credit disappears?

Mar 4, 2015

- By Bill Bonner

Bill Bonner
Gualfin, Argentina

Dear Diary,

US stocks fell yesterday. The Dow lost 85 points. No biggie. The biggie is still ahead.

Our guess is that the smart money is selling to the dumb money. That is, the people who take the trouble to figure out what something is really worth are unloading. People who just think they should be "in the stock market" are buying.

Prices are at record levels. But why? Because they represent good value for money? Or are they propped up by zero rates and a flood of QE money, now coming from Japan and Europe?

Global growth is slowing. Sales are weak. Profits are falling. Europe is in danger of coming apart in June, when the Greeks have to face up to make a big payment on their debt. And China looks more and more like a massive case of mal-investment on the verge of going bad.

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Chris Martenson interviewed Grant Williams of "Things that make you go hmmmm:"
    We don't know how it will end, but something has to give. It's a question of what it will be. Because when you start playing with the forces of nature you can suppress them for a while, but they will eventually overwhelm you. We've seen this constantly throughout history. .
Stocks can...and will...fall. They always do.

Richard Russell gives more detail:

    Many an investor will be wiped out if he insists on waiting to find out if the bull market has topped out in hindsight. The way around this is to limit yourself to conservative positions in the market.

    The bearish nightmare could be as follows: one day the market opens with the Dow gapping down 1000 points. The exchange decides to close for three days. Bearish rumors and fantasies flood the media. With the market closed, there is no liquidity, and stockholders are locked into positions that are unknown in terms of what their positions are worth. Fear takes over, and when the market opens again, it gaps down in an erratic series of crashes. This is a bearish scenario but one that has occurred to me. It also makes the case for subscribers holding very conservative positions in stocks or ETFs. This is not a time for genius. It's a time for modesty, small or no positions in stocks, and peace of mind.

When the crash comes, everybody rushes for the door. The sellers are all there; but where are the bidders? They disappear.

The other thing that disappears is credit...then cash.

One of the great mysteries of this post-crisis period was why consumer prices failed to rise. The Fed was 'printing money' by the trillions. According to classic theory, a larger volume of money should lead to higher consumer prices.

It took a long time for us to figure it out, but finally we realized: the Fed is not really 'printing money' at all. It is providing credit. Both programs - ZIRP (zero interest rate policy) and QE (quantitative easing) accomplish the same thing: they add credit - not hard cash - to the system.

Since 1971, cash and credit have appeared almost indistinguishable. You can buy a steak dinner with a credit card, or with cash. And as long as credit continues to expand, a credit card will be as good as cash.

Adding credit to the system, rather than cash, is how Wall Street got rich. It sold credit!

And it is why the rich got richer, too. They were creditworthy! They could take the credit and bid for stocks and bonds - driving up asset prices.

All the plain people could do was to borrow money to buy a car or, if they couldn't find a job, get a student loan. They could go deeper in debt, but they couldn't benefit from the rise in asset prices - because they didn't have any assets. The top 5% of the population owns 75% of financial assets. The bottom 80% owns less than 5%.

But there's a big difference between cash and credit. In a crisis, credit evaporates.

Cash - even cash backed by nothing - nevertheless has a physical, tangible presence. If the stock market gets cut in half, those Jacksons and Lincolns are still there. You can still use them to buy beer and cigarettes. But what happens in a real credit crisis? What happened in '08-'09? Every bank on Wall Street would have gone broke, had not the feds intervened so vigorously.

Credit works on trust. A friend of ours had a huge line of credit at Lehman Bros. in 2008. In 2009 he was out of business - his credit had vanished.

Now, imagine the next crisis. We've already seen what happened to dot.coms, housing, and energy. What would happen if all asset classes were affected at once? The collateral of the whole banking industry would drop. The banks would look at each other and wonder whose credit was still good. Merchants would look at your credit card and wonder if its issuer was still in business. House sellers would check out your mortgage company to see if it was still solvent.

Trust would disappear. Along with it, credit would disappear too. The economy would go into freefall.

And then the big surprise...instead of the inflation or hyperinflation that we expected - suddenly the dollar...the almighty dollar...the old fashioned, paper, greenback buck...would be more valuable than gold itself.

That is not the end of the story, however. It is just the beginning. Stay tuned.

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

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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