Reply #37: Cracks in the financial system ( I LIKE this one)

[54anickel]

http://www.dailyreckoning.co.uk/article/100120072.html

snip>

Let us examine the differences between the "real
economy" and the "asset inflation economy" more closely.
The real economy is typical of people's daily lives,
their income, and their spending. If there is a boom in
the real economy, wages and prices will tend to increase
and the increased demand will be met by corporations'
increased capital spending. The overheated economy
eventually brings about a slowdown or a recession,
because money becomes tight irrespective of the central
bank's monetary policies. The recession then cleans up
the system and allows the next expansion to get under
way. Put very simplistically, this is the typical
business cycle.

In the asset inflation economy, we are dealing with a
totally different phenomenon. The higher the asset
markets move, the more the increased asset prices can
create liquidity. Let us assume an investor owns a real
estate or stock portfolio worth 100 and that his
borrowings are 50. For whatever reason (usually easy
monetary conditions), the value of the portfolio now
doubles to 200. Obviously, this allows the investor, if
he wants to maintain his leverage at 50% of the asset
value, to double his borrowings to 100. With the
additional 50 in buying power, the investor can then
either spend the money for consumption (as the US
consumer has done in the last few years) or acquire more
assets.

If he acquires more assets, the investor will drive the
asset markets - ceteris paribus - even higher, which
will allow him to increase his borrowings further. Now,
I am aware of some economists who will dispute the fact
that rising asset markets create liquidity. They argue
that the seller of a portfolio or real estate or stocks
at an inflated price will have to be met by a buyer at
the inflated price. So, the increased liquidity of the
seller is offset by a diminished liquidity of the buyer.

However, the situation isn't quite that simple......

snip>

There is one more point to consider. Liquidity isn't
evenly distributed. Let's say that on an island there
are two tribes. Ninety-nine percent of the population
are the "Bushes" and 1% are the "Smartos". The two
tribes arrived on the island at about the same time and
had little capital at the time. So, initially, both
tribes worked very hard in industry and in commerce to
acquire wealth. But because of the Smartos' superior
education and skills, their frugality, and also partly
because of their greed and immorality, they soon
acquired significantly more wealth than the Bushes, who,
for the most part, were likeable but quite inept. After
50 years, most of the island's businesses were therefore
in the hands of the Smartos, who make up just 1% of the
population. Being clever, the Smartos generously gave
some of their wealth to the tribal leaders of the
Bushes, who controlled the entire government apparatus,
the military establishment, and much of the land.

For a while this system functioned perfectly well. Among
the Bushes there were also some smart people, and they
were encouraged to accumulate wealth as well. However,
they had to pay an increasingly high price to acquire
assets, since most of the island's assets were owned by
the Smartos and by the elite of the Bushes who, because
of their wealth, never really had to sell any assets.
Cracks in the system began to appear because more and
more of the wealth began to be increasingly concentrated
in fewer and fewer hands. (According to the Financial
Times, the concentration of wealth is extremely high in
the United States, with 10% of the population currently
holding 70% of the country's wealth, compared to 61% in
France, 56% in the UK, 44% in Germany, and 39% in
Japan.)

However, the Smartos then stumbled upon another avenue
to wealth: globalization. .....

more...