Wednesday, July 1, 2009

Karl Denninger On Credit-Driven Ressession (and Swipe at Dennis Kneale)

On his Market Ticker on Tuesday, Karl Denninger took a swipe at CNBC's Dennis Kneale, whose harangue against bloggers has been widely disseminated over the Internet (like my post below). But his ticker also has a very good explanation of why the current resession may be very different from the previous recessions in the U.S., except for the Big One in 1930s.

Here is his take on "inventory-driven ressession" and "credit-driven recession". We are in the latter, credit-driven recession.

To Dennis Kneale: You're An Idiot (6/30/09 Market Ticker)
[emphasis is mine]

"Inventory-driven recessions are primarily about excessive industrial capacity for demand. That is, manufacturers and suppliers of services get too bullish about prospects, build too much capacity and inventory, and wind up engaging in a destructive price war in an attempt to "win". This drives down profits and ultimately forces the weaker firms out of business, ergo, recession - GDP and employment decline. Having cleansed itself of the excess, the economy recovers. The trigger for these recessions is often (but not always) an external shock such as the oil embargo in the 1970s or the collapse of the Internet fraud-and-circuses games in 2000.

"The second sort of recession is a credit-driven recession. Excessive credit creation - that is, loans going too far toward "fog a mirror" qualifications (and in some cases, such as the most recent event, actually reaching "fog a mirror") drives one or more asset bubbles. These pop when effective interest rates in the economy reach an effective level of zero, usually because the amount of leverage available becomes for all intents and purposes infinite (Bear and Lehman at 30:1, Fannie/Freddie at 80:1, AIG at god-knows-what, and duped "home buyers" buying with zero down for a true infinite leverage ratio.) This excessive credit creation drives a speculative asset bidding war which in turn causes prices to go sky-high for one or more types of asset."

"Recessions cannot end until the conditions that caused the recession are removed from the economy. This is elementary logic and obvious to anyone with an IQ larger than their shoe size.

"For an inventory recession growth returns when enough capacity is destroyed through layoffs and inventory selloffs to bring capacity and demand back into balance. Employers then hire new workers and the economy recovers.

"For a credit recession, however, there is a much larger problem: The reason real interest rates went negative is that debt has a carrying cost and consumes free cash flow; so long as the debt taken on in the credit binge remains the cash flow impact also remains.

"Default and bankruptcy clears excessive credit (debt) from the system - if it is allowed to occur. But if it is not, then the bad debt remains on the balance sheets somewhere and the cash flow impact remains in the economy. Employment remains weak, capital spending restart attempts falter as demand fails to return and credit quality continues to remain insufficient to support new credit demand."

So, when we see the inventory number reduced and unemployment number stop going down further, and we say "Look, the economy bottomed!", we are looking at TOTALLY WRONG PARAMETERS to assess our CREDIT-DRIVEN RECESSION.

Almost all economists being paraded on TV, or writing for big newspapers and magazines, take it for granted that the recession we are in is INVENTORY-DRIVEN recession, the one most of them are familiar with. If Denninger is right (I think he is), it doesn't matter if the inventory level is reduced to zero or the unemployment number stops going down. Until the bad debt is purged from the system somehow, there will be no recovery. As Denninger says, at best we'll be turning Japanese. At worst, worse than the Great Depression.

In addition, Denninger has this to say about U.S. consumers "saving": [emphasis is his]

"Consumers are not saving, they are paying down debt in a furious attempt to avoid defaulting on nearly $1 trillion in outstanding credit card balances that have gone from 11% interest to 29.6% along with OptionARMs that are experiencing a tripling of payments while the home's value is underwater and precludes refinance, all while consumers are being laid off by the hundreds of thousands monthly."

In other words, consumers are barely treading water. And the likes of Dennis Kneale are wondering why consumers are not spending, so that we can get out of this inconvenient pesky little recession. Hope and fortitude. LOL.


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