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Thursday, 11 June 2020

Hope for the best, plan for the worst (2)

A friend called part 1 of this blog a "bite-sized dose of bitter realism". Both of us expect that the worst can happen but that it will not. The stakes are just too high. Nevertheless, his (and my) question is: how long can this situation of "irrational exuberance" last? Moreover, what would happen when this asset bubble bursts?

When this asset bubble would burst then no asset (class) is safe; not even cash. Planning for the worst would then imply having a self-sustainable agricultural and/or livestock farm. Just imagine an economy without money. Bartering will - again - replace worthless money. Bartering implies trading goods and/or services for goods and/or services, without any money changing hands.

The burst of any bubble will trigger fire sales, initially of related asset classes. Fire sales imply losses. Losses imply bankruptcies, redundancies and unemployment. Fire sales will then spread to all asset classes. Initially, the new mantra will be: cash is king.

However, when assets are deflating, creditors will start worrying. Their debt collection will only increase the losses on already deflating assets. Hence, expect many bankruptcies.

Cash is stored at financial institutions (eg, banks). Only some of these will be safe. Banks will face a double whammy of (1) asset losses (eg, loans, real estate), (2a) cancelling of wholesale funding (ie, by other banks), and (2b) cancelling of retail funding (ie, bank run) as deposit holders will try to save their savings. Hence, expect bank failures.

Quite possibly, governments will order a transfer of commercial and private savings deposits to central banks following these commercial bank failures (eg, VK-2020).

However, the balance sheets of the ECB and Fed will show ginormous losses because financial assets were bought at inflated prices in order to (i) decrease interest levels (ie, quantitative easing 2008-2019) and (ii) subsequently to avert a coronavirus related recession (2020-onwards).

These losses of central banks will be borne by respective governments. These governments will want to recover those losses. A transfer of savings deposits to central banks will enable governments to apply a discount (or: haircut) on these savings. An alternative would be hyperinflation.

To some extent, the above happened in Suriname in 2019-2020. Commercial banks were forced to transfer about US$ 100 million of their foreign exchange to the Central Bank of Suriname. The Suriname government "used" that money to pay its bills (eg, Daily HeraldNRC).

The above is only the beginning of the end.

The End (1967) by The Doors


Note: all markings (bolditalicunderlining) by LO unless stated otherwise.

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