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October 13, 2008

Financial History in the Making
by Mary Anne and Pamela Aden

So much has happened this month, where to begin? It's been a month to end all months with one monumental crisis following another. At times, events were moving so quickly it was hard to keep up. Many analysts we know stayed up all night, several times, as developments and markets spiraled out of control in what's being called a financial tsunami.

What lies ahead is unknown because massive changes are still taking place as the worst financial crisis since the Great Depression unfolds. We do know that this is clearly the end of an era and the beginning of a new one, and we'll all be affected in one way or another.

LENDER OF LAST RESORT

For now, opinions are running rampant and although we can make some valid assumptions, no one actually knows how this will all end up. Here's why...

As you all know, the bailouts this month were massive and truly mind boggling, but the big spending actually started before. First, there was the $150 billion in stimulus checks, booming money supply, super low interest rates and the Bear Stearns bust.

Then came the takeover of Fannie Mae and Freddie Mac, which made the government responsible for about half of the mortgages in the U.S., totaling about $5 trillion. This amounted to the biggest bailout ever, costing $200 billion. But if just 10% of those loans have to be covered, it would mean another $500 billion and this alone equals the size of the entire annual defense budget... Then things really intensified.

A HOUSE OF CARDS

Lehman Brothers went bankrupt, Merrill Lynch agreed to be bought and the foundation of the financial system took a serious blow. Wall Street started to panic and the Federal Reserve, along with the world's largest central banks, poured unprecedented amounts of money into the banking system to provide ever more liquidity as stocks fell sharply and the banking situation grew more serious.

The government then took over AIG, to avoid the worst collapse in history of the U.S.'s largest insurer. Money market funds, which have always been considered safe, came under pressure. Worried investors started pulling out of these to preserve their savings, resulting in the Fed also having to lend banks about $400 billion in guarantees to meet these withdrawal demands. The bottom line was that in just one week, the Fed spent over $1 trillion to keep things going.

Next, Washington Mutual failed, which was the biggest bank failure in U.S. history. While all this was happening, the bailout package was a top priority. Bernanke and Paulson were desperate to get it passed, and fast. The President pushed for it too as they all warned that the alternative would be far worse.

PANIC SET IN

But the House rejected it and this shocked the markets. The Dow plunged in its biggest one day loss ever, dropping $1.3 trillion, which was way more than the $700 billion requested in the bailout.

Seeing the market's reaction, the package then passed quickly but stocks continued falling sharply anyway. The general feeling was that the $700 billion won't be enough and the plan is insufficient. Some feel this could be like the initial low estimates for the Iraq war and the final bailout tally could be $2 to $5 trillion, or more.

REALITY HITS MAIN STREET

Meanwhile, folks on Main Street were generally against the package. They simply didn't trust it or the politicians. Once they saw the stock market's reaction to the no vote, however, many people changed their minds as it became more obvious hat this wasn't simply a plan to bailout the mistakes made by greedy Wall Street big shots. People saw the writing on the wall and realized that this would affect everyone, resulting in a worsening economy, more job losses and no credit. And since U.S. retirement assets are already down $2 trillion in the past 15 months, dropping 401 and real estate values, bank failures and insecurity are also taking their toll.

The economy is the number one concern for most people and they're irritated at the mud slinging direction the election has taken while the priority issues take a back seat. So it'll be interesting to see how the election unfolds too.

DELICATE GLOBAL FINANCIAL SYSTEM

There's no question these are dangerous times and the financial world is in uncharted waters. The global financial system is on very thin ice, teetering on collapse. Yesterday's coordinated interest rate drop by seven central banks clearly illustrates this because it was the first time ever that so many central banks lowered rates together and by half a percent. They're literally pulling out all the stops to revive lending and the world economy.

Will these efforts work? Will they be enough? Those are the most important unanswered questions of the day and only time will tell, but we should know much more in the critical month or so ahead. Why?

HYPER-INFLATION OR DEFLATION?

The Fed is spending money at an astronomical rate. It's creating this money out of thin air by monetizing bad debts and whatever else it has to. Remember, this is on top of all the other ongoing government expenses and it's extremely inflationary.

Normally, there is a lag of about a year or so between money creation and inflation but eventually, what's recently happened will result in massive inflation, a much lower U.S. dollar and a soaring gold price. This is inevitable but as our dear friend Chris Weber points out... not necessarily.

The bottom line is this, if the banks start to lend again, then the economy will be on the road to recovery and inflation. But we know the banks are scared and they're being extremely cautious, for good reason. So if the banks decide not to lend and instead just sit on their cash, then the inflation process will freeze.

In other words, the risk of deflation has greatly increased. Inflation is not a given and much will depend on what the banks do, or don't do in the period just ahead. The Fed is providing the ammunition but the banks have to use it. If they don't, the outcome could be much different than what most analysts feel is a done deal.

WHAT TO DO

At this point, it's best to be prepared for either outcome. That means gold for inflation and cash for deflation, at least until we see how things unfold.

For now, important changes are taking place but that also means challenges and opportunities. This may all end up differently than what we initially thought, but we'll adapt and keep an open mind. Whatever lies ahead, the current challenge is getting safely from here to there relatively unscathed and we'll do our best.

Mary Anne and Pamela Aden
Aden Forecast.com

Mary Anne and Pamela Aden are internationally known analysts and editors of The Aden Forecast, a market newsletter providing specific forecasts on gold, gold shares and the other major markets.

Copyright © 2003-2009 Mary Anne & Pamela Aden

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