Thursday, January 29, 2009

Soros' Solution is More Credit and Inflation

The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.

Actually, it doesn't need to be prevented. Forced liquidation and deflation are the natural consequences of malinvestment and manipulation of the debt markets. The so-called wealth destruction is illusory because the created wealth was an illusion caused by excess credit sloshing around the system. If the banking system can be susceptible to crashes like this, then maybe we should rethink how it works starting with the elimination of the central bank and fractional lending.

What else should you expect from him? Debt as a percentage of GDP is going to go from 360% to over 500%. Banks should be recapitalized with debt taken on by the government, thereby increasing the debt burden on the producers of the country. I agree that this is how it will likely play out, but that doesn't mean I like it one bit.

At least he got the narrative right:

In the past, whenever the financial system came close to a breakdown, the authorities rode to the rescue and prevented it from going over the brink. That is what I expected in 2008 but that is not what happened. On Monday September 15, Lehman Brothers, the US investment bank, was allowed to go into bankruptcy without proper preparation. It was a game-changing event with catastrophic consequences.

For a start, the price of credit default swaps, a form of insurance against companies defaulting on debt, went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.

But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to “break the buck” – stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing.

And then he goes into short selling:
What is the proper role of short-selling? Undoubtedly it gives markets greater depth and continuity, making them more resilient, but it is not without dangers. As bear raids can be self-validating, they ought to be kept under control. If the efficient market hypothesis were valid, there would be an a priori reason for imposing no constraints. As it is, both the uptick rule and allowing short-selling only when it is covered by borrowed stock are useful pragmatic measures that seem to work well without any clear-cut theoretical justification.

His argument makes sense given our fraudulent financial system. If we did not have fractional banking, short selling would not be self fulfilling as banks would have plenty of deposits to back the assets that they carried on their balance sheet.

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