Jay Currie

Bear Stearns was bailed out on Friday. Very much a temporary fix and very much part of an ongoing process of financial musical chairs in which, when the music stops, there is no chair left.

People like Jim Kunstler can barely contain their glee. After all, the potential collapse of the American financial system just proved that George Bush, the suburbs, greedy Wall Streeters and sleazy mortgage merchants are just as bad as Kunstler has been saying they are. Throw in the rising price of oil and the falling dollar and the end of economic life as we know it – at least in America – is just around the corner.

Now, as it happens, I don’t live in America and from where I am sitting the “marking to market” of the sub-prime mortgage market, assorted bundled credit card debt and mounds of leveraged buyout corporate paper seems both necessary and manageable. The decline of the American dollar – given the US trade deficit and ongoing budget deficit – is also necessary and can be controlled to a degree. A decade and a half of capital export has to be paid for and that payment will take the form of a significant reduction in Americans standards of living.

How big a reduction and how it is distributed is, at the moment, unknown. However, to take a simple example, if the American dollar continues to decline the price of oil in dollars will continue to rise (although there is an awful lot of speculative froth in the oil market). Gas will go to $5.00 a gallon and this will take a chunk out of people’s disposable income. Similarly, consumer goods made overseas will rise in price.

On the other hand, things like houses and rent are likely to fall and fall fast. Not good if you own a house with a big mortgage, but encouraging if you are renting and hoping to buy.

The real question is how quickly this all happens. If it occurs over a few years the dislocations will be painful but possible. However, if it occurs in a matter of months the foundations of the American economy will be threatened.

At this point the Federal Reserve is pumping money into the system to try and extend the adjustment period. The worry is that that extension may be purchased with bad decisions and that those decisions will further erode the currency:

Paper dollars are technically Federal Reserve Notes, which means they are liabilities of the Fed. When it puts newly minted notes into circulation it does so by buying assets, usually U.S. treasuries, which it then holds on its balance sheet to offset that liability. By swapping treasuries for mortgages, the Fed effectively alters the compilation of its balance sheet and the backing of its notes.

However, backing paper money with mortgages is nothing new. The French tried it in the late 18th Century, and it lead to hyperinflation. Assignats, which were first issued in 1790 to help finance the French revolution, were backed by mortgages on confiscated church properties. Although the stolen underlying collateral did have some value, the revolutionaries saw no reason to limit how many Assignats were printed, which resulted in massive depreciation. Within three years, price controls were introduced and failure to accept Assignats, initially an offence subject to six years in prison, was made a capital crime. By 1799 the currency was completely worthless. 321gold.com

Central bankers know this stuff. To a degree the Fed is willing to run the risk of holding potentially worthless collateral in order to preserve the overall system. As a “one off” the Bear Stearns loan is not completely idiotic; however, as a pattern such loans could sink the value of the dollar in a matter of months.

Canada is in an odd position in all this. Our banks, while they took on some sub-prime exposure, have not been lending recklessly. Our governments, federal and some provincial, have a decade and a half of zero deficits and, in many cases budget surpluses. We have relatively low inflation. We have a huge endowment of ever more valuable oil and gas.

While we are, of course, exposed to the economy of our largest trading partner, our economy has been decoupling from the American economy for years. Which can be seen in our dollar’s strength relative to the USD. There is no reason to believe that the pain in the US will cross the border.

The US is undergoing a reality check. It’s political and financial systems have to re-align themselves so that budget and trade deficits are first reduced and then eliminated. Lending into bubbles will cause trillions of dollars to simply be flushed from the system. However, at the end of this process America will still have a huge economy and a vast capacity to invent, manufacture, design, distribute and market high value goods and services. If America can get its financial and political house in order there is every reason to believe it can beat the bears and emerge as an economic, scientific and cultural powerhouse.

With intelligent, realistic, decisions the contraction and re-emergence could take a couple of unpleasant years. With the wrong decisions, or, worse, no decisions or panic, a decade could be wasted.

Update: blazingcatfur notes that JP Morgan has just bought Bear Stearns for $2.00 per share. It closed Friday at $30.00 per share. Marked to market indeed.

Update:

JPMorgan today agreed to buy Bear Stearns, the second- biggest underwriter of U.S. mortgage securities, for $240 million, less than a 10th of its value last week. In order to strike a deal before the opening of Tokyo trading, the Fed agreed to help JPMorgan finance up to $30 billion of Bear Stearns ``less liquid assets.’’ bloomberg