by Jim Rickards, Daily Reckoning:
Is there a financial calamity worse than a severe recession in early 2023? Unfortunately, the answer is “yes” and it’s coming quickly.
That greater calamity is a global liquidity crisis. Before considering the dynamics of a global liquidity crisis, it’s critical to distinguish between a liquidity crisis and a recession. A recession is part of the business cycle.
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It’s characterized by higher unemployment, declining GDP growth, inventory liquidation, business failures, reduced discretionary spending by consumers, reduced business investment, higher savings rates (for those still employed), larger loan losses, and declining asset prices in stocks and real estate.
The length and depth of a recession can vary widely. And although recessions have certain common characteristics, they also have diverse causes. Sometimes the Federal Reserve blunders in monetary policy and holds interest rates too high for too long (that seems to be happening now).
Sometimes an external supply shock occurs which causes a recessionary reaction. This happened after the Arab Oil Embargo of 1973, which caused a severe recession from November 1973 to March 1975. Recessions can also arise when asset bubbles pop such as the stock market crash in 1929 or the bursting of a real estate bubble caused by the Savings & Loan crisis in 1990.
Whatever the cause, the course of a recession is somewhat standard. Eventually asset prices bottom, those with cash go shopping for bargains in stocks, inventory liquidations end, and consumers resume some discretionary spending. These tentative steps eventually lead to a recovery and new expansion often with help from fiscal policy.
Global financial crises are entirely different. They emerge suddenly and unexpectedly to most market participants, although there are always warning signs for those who know where to look. They usually become known to the public and regulators through the failure of a major institution, which could be a bank, hedge fund, money market fund or commodity trader.
While the initial failure makes headlines, the greater danger lies ahead in the form of contagion. Capital markets are densely connected. Banks lend to hedge funds. Hedge funds speculate in markets for stocks, bonds, currencies and commodities both directly and in derivative form.
Money market funds buy government debt. Banks guarantee some instruments held by those funds. Primary dealers (big banks) underwrite government debt issues but finance those activities in repo markets where the purchased securities are pledged for more cash to buy more securities in long chains of rehypothecated collateral.
You get the point. The linkages go on and on.
The Federal Reserve has printed $6 trillion as part of its monetary base (M0). But the total notional value of the derivatives of all banks in the world is estimated at $1 quadrillion. For those unfamiliar, $1 quadrillion = $1,000 trillion. This means the total value of derivatives is 167 times all of the money printed by the Fed.
And the Fed money supply is itself leveraged on a small sliver of only $60 billion of capital. So, the Fed’s balance sheet is leveraged 100-to-1, and the derivatives market is leveraged 167-to-1 to the Fed money supply, which means the derivatives market is leveraged 16,700-to-1 in terms of Fed capital.
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