“The air will be clean within the next one month and we can get a fairly good rebound starting from the middle of October until the spring of next year,” he said in a Bloomberg Television interview.

Faber also warns that AIG (NYSE:AIG) may be a “much bigger problem” than Lehman…

In June Faber said, “If I’m a bad businessman and I go out of business, who’s gong to help me? But Bear Stearns and the Wall Street elite, because they are tied into the Treasury and the Federal Reserve and they have lunch together, it’s a club and so forth, they’re bailed out. It’s a joke!”

“I think a lot of banks are already bankrupt … but they hide their rotten assets … in categories where you don’t really need to value them,” Faber said. “I think the financial sectors, by-and large, has much larger problems than is perceived by the investment community and the stock market to some extent is telling you that.”

Investors should go into gold as its price did not rise as fast as that of other commodities while the central bank keeps printing money, Faber said.

The Fed has been “misleading” investors on wanting a strong dollar, Faber said, as it kept lowering the interest rates. “When it comes to action, they show no concern about inflation.”

He also blamed the central bank for forcing investors to abandon safe deposits in banks for riskier strategies by keeping rates so low.

“The Federal Reserve is the greatest speculator—they force people to speculate,” he said.

“I think they should have stopped cutting rates at say 4 percent … you could stop cutting rates and pursue a tight monetary policy. You can take other measures, mop up liquidity,” Faber added.

Back in college, most of us took microeconomics before we took macroeconomics. In fact, at Grinnell College where I went, microeconomics was a prerequisite for macroeconomics. The reason was simple: microeconomics begins with the concepts of supply and demand, an essential starting point for the study of macroeconomics. But you only know you’ve mastered both when you intuitively grasp that macroeconomics is not just the summation of microeconomic outcomes, but rather the interaction of microeconomic outcomes.

For me, a simple concept brought this realization: the paradox of thrift. For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

This principle is part of a whole range of macroeconomic concepts under the label of the paradox of aggregation: what holds for the individual doesn’t necessarily hold for the community of individuals. Understanding this paradox is absolutely vital to understanding macroeconomics and even more so to understanding what is presently unfolding in global financial markets.

Double Bubbles Bust

Once the double bubbles in housing valuation and housing debt burst a little over a year ago, everybody, and in particular, every levered financial institution – banks and shadow banks alike – decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense.

At the collective level, however, it has given us the paradox of deleveraging: when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed. Put differently, not all levered lenders can shed assets and the associated debt at the same time without driving down asset prices, which has the paradoxical impact of increasing leverage by driving down lenders’ net worth.

This process is sometimes called, especially by Fed officials, a negative feedback loop. And it is, though I prefer calling it the paradox of deleveraging, because the very term cries out for both a monetary and fiscal policy response, not just a monetary one. Lower short-term interest rates via Fed easing are, to be sure, useful in mitigating deflating asset prices, particularly if they serve to pull down long-term rates, which are the discount rates for valuing assets with long-dated cash flows.

But monetary easing is of limited value in breaking the paradox of deleveraging if levered lenders are collectively destroying their collective net worth. What is needed instead is for somebody to lever up and take on the assets being shed by those deleveraging. It really is that simple.

Time to Lever Up Uncle Sam’s Balance Sheet

As Keynes taught us long ago, that somebody is the same somebody that needs to step up spending to break the paradox of thrift: the federal government, which needs to lever up its balance sheet to absorb assets being shed through private sector delevering, so as to avoid pernicious asset deflation. That’s a fiscal policy operation and, fortunately or unfortunately, fiscal policy is not made by a few learned technocrats above the political fray of the democratic process, but is squarely in the hands of the legislative branch, consisting of 535 politicians, with far more lawyers than economists among them.

Yes, I know that Congress passed a properly Keynesian stimulus package earlier this year, the benefit of which we are feeling now, sending over $100 billion in rebates to the citizenry, borrowing the money to do so and levering up the Treasury’s balance sheet with debt in an equal amount. So, yes, I may be too harsh when I challenge the economic literacy of Congress: they do understand that Uncle Sam should borrow and spend, directly or indirectly through tax rebates to citizen spenders, to truncate the paradox of thrift (even if they don’t know what that is).

But levering up Uncle Sam’s balance sheet, to buy assets to break asset deflation resulting from the paradox of deleveraging still seems to be a foreign, if not a sinful proposition. This need not be, and should not be. Yet we hear endlessly that any levering up of Uncle Sam’s balance sheet to buy assets must be done in a way that “protects tax payers.” By definition, levering Uncle Sam’s balance sheet to buy or guarantee assets to temper asset deflation will put the taxpayer at risk – but will do so for their own collective good!

This was defacto what the Federal Reserve did when it put up $29 billion on nonrecourse terms to buy assets so as to facilitate the merger of Bear Stearns (NYSE:BSC) into JPMorgan (NYSE:JPM). As I said at the time, and wrote about two months ago, this was a fiscal policy operation, conducted by the Fed. Logically, it should have been conducted by the Treasury using appropriated spending power from Congress. But alas, that “right” solution was not legally available to the Treasury, whereas the Fed did have the power to act: Section 13(3) of the Federal Reserve Act of 1932 gave the Fed the power to lend to essentially anybody against any collateral, so long as it declares it is necessary to do so because of “unusual and exigent circumstances.”

But make no mistake, it was a fiscal policy action demonstrated by (1) the fact that the Fed sold a similar amount of Treasuries from its portfolio, increasing the supply of Treasuries in the market by the same amount, and (2) the fact that any losses the Fed experiences on that $29 billion will reduce dollar-for-dollar the amount of seigniorage profits that the Fed remits to the Treasury. At the end of the day, there are $29 billion more Treasuries on the open market than otherwise would be the case, and the Treasury is, one small step removed, on the hook for any losses the Fed experiences on the $29 billion of non-Treasury assets it now de facto owns.

Yes, that $29 billion is actually a loan to a Limited Liability Corporation (LLC) set up to hold the Bear assets, with JP Morgan providing a $1 billion subordinated loan (sometimes called the “first loss” tranche) to the LLC. But that is merely a technical detail – the bottom line is that we the taxpayers bought $29 billion of Bear’s assets.

What was behind the mass sell-off? Well, two big factors were oil prices hitting a record, and fresh fear stalking the banking sector. Oh, and Goldman Sachs (GS) reckons that General Motors (GM) is a ‘sell’.

So business as usual, then…

Stock markets around the world dived yesterday, taking a lead from the US. The Dow Jones hasn’t seen a June this bad since the Depression, according to Marketwatch. The US blue-chip index is down nearly 1,200 points this month, or 9.4%. In June 1930, it fell 17.7%. The Dow also broke its March low of 11,731, which occurred amid the Bear Stearns (BSC) Bust.

So what was so bad about yesterday? Well, oil hit a fresh record for a start, jumping above $140 a barrel to a high of $140.39. That’s partly because of comments from Opec president Chakib Khelil that the price could go as high as $170 a barrel this summer. But it probably had more to do with the dollar weakening, because people aren’t stupid enough to believe that Federal Reserve chief Ben Bernanke actually gives a damn about a ‘strong dollar’ (for more on this, see yesterday’s Money Morning: Buy gold now – before they ban it).

The reality is that the Opec prediction wasn’t that scary by today’s standards. Despite his headline-grabbing prediction, Mr Khelil went on to point out that he didn’t think oil would hit $200 a barrel as predicted by Goldman Sachs, and would in fact “probably fall a bit towards the end of the year.” He did throw in the traditional caveat, aimed no doubt at the US, about how prices would of course shoot up if there was a halt to production in Iran, but that’s nothing we didn’t know.

But it seems that people are starting to realise that high crude oil prices are actually a problem for the economy. “One thing is for certain, if crude continues to rally, stocks are dead,” is what Dale Doelling of Trends in Commodities told Marketwatch. Mr Doelling reckons that if stocks pull a similar performance today, “then the fallout next week could include government intervention in the markets.”

Now to be fair, a similarly bad day looks unlikely, simply because after big falls like this you get all the ‘bargain’ hunters piling in. If you don’t, that’s when you realise that we really have hit capitulation point.

Anyway, with oil prices soaring, it’s perhaps no surprise that Goldman Sachs reckons that General Motors is in trouble. The investment bank warned investors to dump the stock, lowering its price target to $11 a share from $19 a share. To be honest, Goldman was a bit behind the curve on this one – the share price was less than $13 at the start of trading yesterday. But the note certainly seemed to do the trick – the stock fell nearly 11% by the end of the session.

Goldman reckons the iconic motor group will need to raise more money, by issuing more shares, or cutting its dividend. Again, no big surprise. GM is on the wrong side of the environmental debate – and more importantly, on the wrong side of high fuel prices. Consumers can’t afford new cars, and even if they can, they are buying smaller, more fuel-efficient ones.

It wasn’t just GM. Goldman’s analysts had the scent of blood in their nostrils. Another warned that Citigroup was going to face more writedowns for the quarter just past, a full $8.9bn. That hurt the banking sector.

But the truth is that there wasn’t any real reason for stocks to take fright yesterday rather than the day or the week or the month before. The idea that car companies might suffer when oil prices are at record levels isn’t exactly a contrarian insight. And the idea that banks might run into more trouble isn’t a big surprise either, given that we’re just at the start of what looks like a recession in the US, and of course in the UK.

And over here in Britain, we are in a worse position than most. Our consumers are the most over-indebted, and they’re running out of ways to fund their spending. The Times reported yesterday that the number of pay-day loans being taken out is rising – that is, borrowing money to tide you over from one wage packet to the next, which of course, is a recipe for sliding into a black hole of never-ending debt.

It’s hard not to see this continuing. In fact, in the latest issue of MoneyWeek, out today, my colleague David Stevenson has a look at just how long the bear market could last.

Source: Are stock markets waking up to reality?

Financial stocks continued bounced off the bottom today. The S&P Banking Index (BIX) was up 3.3%, as investors await today’s Fed decision.

But before we get carried away, remember that this rebound comes after the index hit an 11-year low on Monday. The BIX is at half the value it was at a year ago.

Bill Bonner is not surprised by the slump. History has a habit of repeating itself…

Bubbles… Busts… Bubbles… Busts…

By Bill Bonner

The beat goes on – one sector gets pumped up…and then it gets whacked.

Jim Cramer says he’s never seen anything like it…

Not the crash of Drexel Burnham Lambert in the ’80s…not the Asian currency crisis…not the LongTerm Capital Management blowup…not the dotcom bust…

Now, he says, the mood of gloom on Wall Street just gets worse and worse…with no sign of let up. Thousands of layoffs. Stocks in steady decline.

That makes us a little sad, here at The Daily Reckoning headquarters. We don’t like to kick an industry when it is down…and we like kicking Wall Street.

But you can see why the former Masters of the Universe are so blue – their bonuses are falling. So is the value of their stock options.

“Banks struggle to get capital,” begins an article in the Wall Street Journal.

When JP Morgan bought Bear Stearns, for example, everyone thought they had stolen the company. It was clearly the bottom – or so they believed. And they had a $30 billion guarantee from the feds. What could go wrong?

But the whole financial sector has continued to sink…and now J.P. Morgan’s deal is looking less sure.

(Even the best of companies – such as Warren Buffett’s Berkshire Hathaway – are getting beaten down. Berkshire traded at over $1,500 last December. Now, the share is down to $1,220.)

Yesterday, the Dow held steady. But last week was a bad one…with stocks losing 3.8% and the Dow falling below 12,000. Oil gained another $1.38, bringing the going rate for a barrel of crude to $136.

The dollar gained against the euro, and gold fell $16.

What is amazing about Cramer’s point of view is that he seems to be surprised. What did he think? That the bubble in the financial industry could expand forever? Or that the Fed could pump it up again, even after it sprung a major leak?

Sorry, Jim, it just doesn’t work that way.

The financial industry used to represent about 10% of the entire stock market’s earnings. Then, as credit grew, the financial sector invented new ways to separate people from their money. During the period known as the Great Moderation, the percentage of earnings coming from Wall Street rose to 40% of the total. Now it’s coming back down. It’s over.

We don’t have to tell you, but the ‘Great Moderation’ was a big fraud. There was nothing moderate about it. Instead, it was a period of extravagance…excess…over-the-top consumption and borrowing…and outlandish claptrap. It was claimed, for example, that the Wall Street firms were “adding value” by packaging subprime mortgages into securities and peddling them to towns in Norway. And it was believed that the Fed really had learned how to smooth out the business cycle and could henceforth avoid serious downturns. And inflation? That was a problem of the ’70s…not of the 21st century.

But every bubble pops. And the force of a correction is equal and opposite to the deception that preceded it. Naturally, the correction in the financial industry would have to be substantial. Nor is the Fed able to stop it. When a bubble bursts, the Feds can pump as hard as they want; the new cash and credit will go into a new bubble, not the old one.

You haven’t seen another bubble in the dotcom industry, have you? That one blew up eight years ago. It hasn’t come back – despite the best efforts of central banks all over the world. And don’t expect another bubble in housing either. We’ve seen the highest prices for housing – in real terms – that we will probably see in our lifetimes.

Bubbles…busts…bubbles…busts…the beat goes on. One sector gets pumped up…and then it gets whacked.

Source: Bubbles… Busts… Bubbles… Busts…

The underlay of these two emotions are complacency and lethargy, respectively.

The current rally which took the sensex up from 14,700 to 17,700 may lead investor to become complacent, or sanguine, for old times sake. They ought not to. Better buying opportunities should come later.

The reason for the caution are that both domestic and global factors warrant a display of caution. General elections at the Centre are due next year, but expected to be called late this year as the ideological strains of smiling for a family picture will start telling and as a coalition Government turns into a collision Government. States like Karnataka are going to the polls shortly.

Governments, except under severe pressure as in 1991, tend to take foolish economic decisions. As elections approach, they compete even harder for foolishness, bordering asininity. Parties in Karnataka are promising things like free power, a complete waiver of farm debt and other things, in order to curry political support. This largesse, of course, comes from Government (hence tax payers) coffers and not from party coffers which, logically, it should. One way to bring a measure of sanity would be to ask political parties to bear a part of the cost (say 10%) of electoral promises from party funds!

Foolish decisions take their toll on companies and on the economy; thus on stokmarkets. The subsidy provided for petroleum products is estimated at Rs. 77,000 crores, comprising petrol (7,300), diesel (35,700) PDS kerosene (19,100) and LPG (15,500). This is borne by the Government and upstream and downstream oil & gas companies who are partly compensated for the losses through issuance of bonds. The downstream companies such as IOC, BPCL and HPCL are financially haemorrhaging and have become highly leveraged. They do not now, have money to import diesel without which road transport would come to a halt and economic growth would not be the expected 8.5% or more.

With crude oil prices relentlessly rising (they hit $ 126/b) the subsidy burden can only balloon and the foolishness of the subsidy policy only exacerbate. A rebalancing of our energy mix is needed and the main hope is gas, which, fortuitously, we have discovered in good measure. Gas, however, would remain buried under the sea until its pricing, now in dispute, is expeditiously resolved. We cannot afford the luxury of a slow moving judicial system; the issue has to be settled soon and with finality.

The foolishness of Government interference and its impact on companies is also evident in the telecom sector. In Mar 2006 BSNL, a wholly owned Government telecom company, launched a tender for some 45m lines. Being a Government entity, the tendering process was subjected to challenge by writ, and finally the tender was drastically pruned on ministerial instruction. BSNL, which then had 17.6m customers, grew to 40.7m customers two years later. Private sector Bharti Airtel, not subjected to meddling, has grown from 19. 5 to 62m customers in the same period.

Bharti is now seeking to expand overseas, by trying to acquire MTN of South Africa (not to be mistaken with MTNL, which Bharti would be reluctant to acquire, given the differences in work culture). BSNL is now opening a new tender for 93m. lines, worth some Rs. 40,000 crores, which would have equipment suppliers salivating and one hopes that the Government has learnt the errors of micromanaging and doesn’t do anything foolish to interrupt it.

Yet other examples of Government pre election actions are in its arm twist of steel companies in both public and private sector, to bring down prices, never mind higher input costs, which they have agreed to now. The prices would, naturally, play catch up once elections are over. Or in the ban on future trading in agro commodities in order to contain inflation is another. Even though a Government committee found no link between prices and futures trading, this was banned. Consequently prices of soya oil, e.g. have soared, instead of fallen!

In fact there is now an illegal market in Indore, called dabba market, which trades in commodities like soya oil and settles trades through the unofficial hawala route. The ban is completely irrational and only a gesture towards containing inflation, without success. The market for the commodity is being exported. If this is not Kafkaesque, what is?

In corporate news of interest, L&T is undertaking a restructuring which would involve hiving off of a dozen operating subsidiaries, thus unlocking a lot of value. The parent company would have a board to guide these subsidiaries and to manage the L&T brand, which is estimated to be worth $ 2b. It is one way to protect the company from takeover; perhaps the trigger was the likely sale by SUUTI (the SPV formed to take over distressed UTI 64 assets) of its 9.1% stake in L&T.

The US $ slid against the Euro and other major currencies, but, surprisingly, especially with elections around the corner, has strengthened against the rupee, which went up to over Rs. 41.5 to the dollar. Perhaps due to massive RBI intervention in buying the greenback.

Globally, too, there is need for caution. Warren Buffet has warned of further pain in the financial system, though not, thankfully, of a panic. Panic was caused by excessive fears of counter party risk having slowed credit growth and was averted by the actions of the US Fed whilst rescuing Bear Sterns. Poor quality securitised mortgages were exchanged for higher quality Government bonds. It seems to have worked in restoring confidence for now. The US Fed seems to have suggested an end to cuts in interest rates.

The sensex fell on all five days of trading last week, losing 862 points to end at 16737. Of the 30 stocks, only two, viz Tata Steel (which contributed 35 points) and HUL (1) were in the black. Major contributors to the decline were RIL (156), L&T (117) and ICICI (99). The Nifty lost 245 points to close at 4982.

It is possible that there could be another rally to take the sensex back to 17,500 levels. If and when that happens, remember the title of this column.

But against this background of staggering losses by the big banks, only five small banks have failed in the last 12 months. These are…

1. Metropolitan Savings in Pittsburgh
2. Douglass National Bank in Kansas City, Missouri
3. Miami Valley Bank in Lakeview, Ohio
4. NetBank in Alpharetta, Georgia
5. Hume Bank in Hume, Missouri

It Only SEEMS like the Banking System is Relatively Sound

In truth, that number is deceptively low compared to crises of the past. In fact, the list of possible problem banks remains at historically low levels. There are only 76 institutions on the FDIC’s “watch list.” In 1990, as the S&L crisis unfolded, there were close to 1,500 banks on the list, and 800 failed between 1990 and 1992.

However, while it might seem that the banking system is sound, federal banking regulators are gearing up for potential problems. The FDIC announced that it plans to hire at least 140 new employees to deal with a possible increase in bank failures over the next year.

You Have to Treat the Disease – Not the Symptoms

Dealing with economic problems is like treating a disease. Treating your symptoms without finding the cause of the symptoms can lead to disaster.

You could treat a mild headache with aspirin. But if an undetected brain tumor is causing your headache, then failure to identify and treat the cause will be fatal.

What is the cause of the recent failures of both large and small banks? Simply put, it is the monetary policies of central banks, the very entities that now are struggling to solve the crisis. Unfortunately, they are prescribing exactly the same medicine to cure the problems that caused the problems in the first place.

Central Bankers Are Passing Out Placebos to Cure This Crisis

This past week Mervyn King, Governor of the Bank of England, announced that the bank was prepared to swap £50 billion (US$100 billion) in government bonds for securities backed by mortgages and credit card debt. On this side of the Atlantic, Ben Bernanke has loaned triple that amount, US$360 billion, to troubled banks again, against collateral made up of securities backed by sub-prime IOUs.

The Federal Reserve was the first central bank to begin discounting the sub-prime securities that triggered the widespread banking problems of the past months. But now, other central banks are following suit as the ripples of the crisis spread in ever-widening circles around the world. Some observers suggest that these loans secured by sub-prime debts will rise above US$1 trillion. That could be just the beginning.

So what caused this credit crisis disease? It’s simple. But to fully understand it, you have to step back and view the evolution of the U.S. dollar over the past 200 years.

The Evolution of the Falling Dollar…
That Led Us to This Mess

In the 19th century, the dollar was defined as 1/20th of an ounce of gold. At the time, banks simply took deposits in gold and issued their own private IOUs in the form of banknotes redeemable in gold on demand. This process naturally restricted credit expansion, because you had to have tangible gold to back your dollars.

Then Congress created the Federal Reserve in 1913. Congress gave the Fed a monopoly on printing U.S. dollars. Also, initially, the Fed held reserves of gold to back its issues of Federal Reserve Notes.

However, eventually, the U.S. government wanted to break free of the restrictions on credit expansion. So they gave the Fed the authority to “discount” commercial paper from banks. In other words, the Fed could buy IOUs and pay for them with newly printed dollars.

Eager for profits, banks made loans, then sold the IOUs to the Fed, and then made more loans. The federal government financed its expenditures for World War I through borrowing from banks. Banks sold enough of those federal IOUs to the Fed to keep the credit supply growing.

The banks also loaned to businesses, investors and speculators, ultimately financing the asset frenzy called the Roaring Twenties.

As loan demand grew, the amount of notes rose against the fixed amount of gold the Fed held in reserve. Eventually, the speculative frenzy drove stock and real estate prices to unsustainable levels, and the bubble popped in 1929.

A credit contraction ensued as borrowers began to default on debts they shouldn’t have held in the first place. This should have turned into a short-lived economic correction that purged bad loans and punished those that made them. But the government stepped in to stop this healthy correction and wound up seeding the Great Depression.

So Similar it’s Scary

Today’s credit crisis is essentially identical to the 1930s. It’s a consequence of failed monetary policies. Just like the Roaring Twenties, those in power refuse to allow the bad loans to be purged from the system. The federal government allows central banks to buy these loans for newly printed money.

And meanwhile, Mervyn the Magician and Helicopter Ben ensure that their currencies will drop in value and the economy will suffer.
As mentioned, a century ago the dollar would buy 1/20th of an ounce of gold. Today it will buy only 1/950th of an ounce. In truth, it should buy less than half of that. Gold is underpriced. This is clear when we recognize that the dollar has lost far more purchasing power in terms of other goods.

The dollar today will buy what a nickel would buy at the turn of the last century. If you factor in productivity growth from advances in technology, then today’s dollar is worth less than 1% of what it was then. This is all the consequence of 10 decades of relentless credit expansion.