Economic Uncertainty Continues in 2010 and 2011

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Economic Uncertainty Continues in 2010 and 2011

As Brian Wesbury of First Trust Advisors pointed out at the beginning of this crisis, we are not experiencing a conventional recession.  This recession stems from a financial crisis in which financial institutions simply ceased to function in the normal manner, because the liquidity disappeared from the system.  That shrank the velocity of money which essentially stalled the economy — almost overnight.

Speaking at a conference in late April, John Mauldin of accurately described the U.S. money supply as consisting of $2 trillion in cash and $50 trillion in credit.  Most of the time, this imbalance works fine.  We treat the entire $50 trillion as the real money supply and use it as the means of exchange.  However, when everyone tries to settle their debts all at once, assets are suddenly devalued.  That's what happens in a panic situation like we had in October 2008.  It's at those times that we suddenly become aware of the reality of our economy:  This system can't be paid off and we must simply continue along on this "imaginary" basis. 

While the "extreme liquidity crisis" passed, as an economy we are still collectively attempting to deleverage our debt.  That has resulted in enormous losses and a devaluation of asset prices. 

Why?  Because deleveraging such a system means that trillions of dollars in "claims on assets" that were being used for transactions simply vanish as people are no longer willing to pretend that those claims are actual "cash."   This is happening across the globe, because other nations are similarly leveraged.

What deleveraging involves is a vast number of individuals and businesses clamoring for their share of the $2 trillion in "real cash."  Over time, as this process progresses, the entire economy gets reset to some lower ratio of debt-to-cash. 

One of the factors that led to the high ratio of debt-to-cash was the practice of withdrawing equity from homes that had increased in price.  That debt was rarely used to finance things that would create value, like business equipment, research, or education; instead, it paid for consumption and simply deferred the cost to some future date. 

During 2001 and 2002, those mortgage equity withdrawals were driving GDP.  Without them, there would have been negative GDP growth for two years running, which is to say, we would have been in a recession.  Home equity, along with the Bush tax cuts, kept the economy on its upward trajectory from 2001 to 2005.  Without those forces, GDP growth would have been below one percent for four straight years...

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