THE RISK OF A DEPRESSION HAS ESCALATED
ALL CUSTOMER DEPOSITS of any size, in any German bank, are to be guaranteed by the German government.
This pronouncement probably saved the European banking system from at least two big German bank failures this past weekend. Unfortunately, it is probably too late to have a long term effect on the German and the world banking systems. The international response to the crisis has been much too slow, and the politicians have not grasped the consequences behind the events.
We have found that even some of our very successful investment manager friends, especially those who come from sales or trading background, do not understand how the world banking system works. Those who have an analytical background and some economics training have a better understanding. In our opinion, it is now imperative that all of our readers who want to protect themselves learn how the banking system works and learn a few rudiments of economics.
To this end, we have posted on our website, www.guildinvestment.com, an article from the October 4th issue of The Economist titled “Blocked Pipes”. This clear and simple article paints a rudimentary picture of how liquidity flows between banks, and describes why today’s banking system can not be easily repaired.
BECAUSE THE BANKING SYSTEM CANNOT BE EASILY REPAIRED…WE ARE CHANGING OUR EXPECTATION FROM A SERIOUS RECESSION…TO A DEPRESSION
We do not take this action lightly. We know that no one wants to hear this news.
Unfortunately, one need only understand how the world banking system works, to see that the current problems cannot be easily repaired. The repair will take years, and until then, the credit systems will not function correctly. If the credit system does not function, all the money that is being printed by the U.S. Federal Reserve and other central banks will not be able to move into the system to re-liquefy it. If it were to move into the system, it could create an end to the credit crunch and banking crisis that we currently have in the world. Unfortunately, it is not moving into the system…and has not moved into the system for months.
THE HISTORICAL SOLUTION
Historically, when massive waves of liquidity have been unleashed by the central banks to stave off a credit crisis, they reappear later as asset bubbles and inflation.
WHY THE HISTORICAL SOLUTION HAS NOT WORKED
For years, we have been warning of the possibility of a deep crisis. As the crisis began to unfold in August 2007, we looked at the amount of liquidity being pumped into the system worldwide, and expected that this liquidity would eventually reach consumers and businesses, leading to an economic recovery…and to higher inflation. Because the banking system is frozen and lending is not taking place, the liquidity is not reaching consumers and businesses. A continuing lack of liquidity, such as we have seen (and which we expect to continue), will undoubtedly impede a recovery.
In summary, this credit crunch is combined with a banking crisis so severe, and marked with the use of so many derivatives, that the normal mechanism used to correct the problem, which is additional liquidity flowing through the banking system, is not working.
YOU SAY THAT A DEPRESSION IS APPROACHING…What is a depression?
A depression is often referred to as a decline in GDP for more than two sequential calendar quarters. A recession is a decline in GDP which is limited to two sequential quarters. Much of the world has been in recession for at least two quarters. Our view is that some countries are already slipping into depression, especially in Eastern Europe. If the global banking problem is not solved soon, more will slip.
We believe that it could take years (several more quarters) for business to start to get the liquidity and loans that it needs to begin to grow again.
An economic depression usually refers to a period of sustained downturn in an economy. GDP and output fall more severely than in a recession, which is seen as a normal downturn in the business cycle. A depression is characterized by: large increases in unemployment and bankruptcies, restriction of credit, reductions in investment, trade, and commerce, with either price deflation or hyperinflation, and violent currency decline. Several of these already are taking place; reductions in investment and trade, and a restriction of credit.
A SOLUTION EXISTS…UNFORTUNATELY, IT INVOLVES GOVERNMENT
In order to solve the problem, we will need many national governments to lend directly to business.
To circumvent the clogged banking system, governments will eventually begin to make loans directly to companies and individuals. In other words, the pipes in the banking system are blocked, so they must build a new set of pipes using direct government-to-business loans. At that time, existing credit card and consumer finance companies will borrow from the government, and re-lend to individual consumers.
When national governments begin to realize the magnitude of the problem, they will begin such a program. Unfortunately, national governments have repeatedly shown their ineptness in dealing with these types of issues. Thus, the implementation of this solution will take some time. Until this or another solution is implemented, global economic activity will shrink. A second necessity is for one central bank to take world leadership in rescuing banks globally. We will discuss this more in detail later.
Please remember, even periods of depressed economic activity are marked by stock market rises and falls, often very large ones. Will we get stock market rallies? Even during the Great Depression from 1929 through the early 1940’s there were many stock market rallies ranging from 10% to 130%. We will get stock market rallies. We will also get stock market declines. The question is what to do when the market rises or falls. Many great fortunes were made and lost by wise and unwise actions during that period.
Thanks for listening
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