The Politics of Debt

With gold about to retest the previous high and the Dow Jones average at less than 200 points from the previous high, I will look at two different scenarios and their possible implications for the consumer market. As I pointed out before, Bernanke’s solution to the “liquidity crisis” is utterly destructive because it implies more inflation down the road.
I never thought there was a liquidity crisis to begin with because for a liquidity crisis to exist (in the traditional sense) money should have real value. A liquidity problem can only exist if any liquid instrument is scarce. This happened in the past when central banks limited the emission of money to the funds that they had saved to back that money. In the post Bretton Woods era, central banks have not such limitation and the only way for a liquidity crisis to exist is during hyperinflation.

Liquidity crisis only during hyperinflation

This idea may seem counterintuitive, but I think that it is right. During hyperinflation what you have is an excess of fiat currency, such excess reduces the value of the money (the relative value with respect to other goods) until it gets to a point when it does not matter how many bills you carry around (or their denomination in Bretton Woods era money), nobody will accept the bills as payment. In that case, you would have a real liquidity crisis and you would see yourself in the same situation you would have seen yourself in during a liquidity crisis in the Bretton Woods era: enough money to pay for goods is nowhere to be found.

Back to fundamentals

If the Dow Jones Industrial Average breaks the previous high, there is a distinct statistical possibility that the average will enter a parabolic rise. New highs in the markets have a way of fuelling themselves thanks to the gambling nature of the stock market. When you hit a new high, a number of players will bet that the market will go down (on a double, triple, or some other kind of top) and short the market. If the market goes up, they need to buy the stock they borrowed and sold short, which makes the market go a little higher. This, at the same time, gives encouragement to the players who betted the market was going higher, and they ad funds to the market, bidding it higher.
Normal bull markets (yes, including the housing market), based on improving economic conditions will have a nice steady slope that will reflect the improvement of the underlying conditions. Since human activity is limited in its capacity to create wealth, the improving conditions are normally limited to the rate of wealth creation of the society.
Parabolic rises, on the other hand, are not a reflection of improving fundamentals (it’s really hard to create quarterly 100% return rates in real life) but the reflection of a retro feeding process in a particular financial market. These processes are inflationary by nature, and they cannot be sustained for long periods of time. To see typical examples of parabolic rises, take a look at the Nasdaq in the period 1998-2000 or the housing prices in California or other “hot” real estate markets during the past 3 years.
For a number of market participants, these inflationary processes may create wealth or the illusion of wealth if they are not lucky enough to exit the markets on time. However, these runs tend to end in a crash of some sort, a correction in the parlance of Wall Street. The reason for these crashes is the actual liquidity crisis created by ever-rising prices. To give an example, let’s say the stock market goes up 50% a year indefinitely. At some point, everybody will be rich, paradise found, socialism by way of financial speculation of the masses… Problem is that things do not seem to work quite that way. When everybody has money in the capitalist society, the value of the money diminishes with the perceived wealth. In a world with limited resources, when money is more abundant than the resources at hand, the perceived value of the resources rises (in actuality, it is the value of money that diminishes), but that is a moot point because the effect is the same. As the value of the money diminishes, the prices keep going up, including the prices of the stock in the market. They go so high that at some point, buying anything is pointless because there is no relative gain. When that happens, you have a real liquidity crisis: it does not matter how much higher an issue may go because there is no enough money in the world to buy it.

If we see a double top on the Dow Jones and Gold, the markets will be pointing to a recession, if there is a clear break out we will be facing the first scenario, a new wave of “ever increasing” prices in commodities, housing and the stock market, with a correction in the future.

It is too soon to know which path the markets and the American society will take, my guess is that the desire to accumulate large quantities of money, regardless of its value, will prevail, and we will see a parabolic rise in the price of the Dow Jones, Gold and other metals, and commodities in general.
By the way, remember this is just an opinion and not a piece of financial advice. The proper disclosures are in the About page.

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Tags: America, bank, banks, Bernanke, bretton woods, central banks, consumer market, Dow Jones, Dow Jones Industrial Average, Economics, Economy, fiat currency, gold, hyperinflation, inflation, liquidity, liquidity crisis, liquidity problem, money, nasdaq, new highs, real value, United States, value, Wall Street