Treating the Disease, Not Just the Symptoms

Recently, I talked about trouble in the sub-prime lending sector in the U.S., which got to be this way after lending money to just about anyone who came knocking at the door. Caution and risk analysis be darned — credit was cheap and the bandwagon was roomy!

Yet, in recent weeks, about 20 sub-prime lenders went under; while industry experts estimate that about 100 more will be snuffed out by the end of this year. Sure, for investors not involved at arm’s length with those poor schmucks, trouble in lending paradise was an opportunity to profit in the short term. However, we would still be talking about symptoms of the disease, not its cause.

At the heart of the problem is global liquidity, which is really all the money that has hit the markets worldwide and has an enormous impact on worldwide investments. You see, with abundant money supply, risk tolerance increases as well. As risk tolerance increases, barriers for borrowers become more lax. The end result? Well, in two words or less — cheap credit!

Western economists have identified Japan as the main culprit for why the global money supply has been on a steep upward curve since 2001. Fashioned similarly to other western central banks, the Bank of Japan controls monetary policy by increasing or decreasing interest rates, which, on a macroeconomic level, are nothing more than cost of money to the economy.

Japan has been actively dealing with deflation from 2001 to 2006. The problem was addressed by increasing the money supply to Japanese economy, which required heavy buying of securities issued by the Japanese government. The idea was to give a boost to the country’s core Consumer Price Index (CPI). And it worked! Five years later, Japan posted three consecutive months of strong CPI growth.

But, Japan was hardly the only economy slashing its interest rates, which also means it was hardly the only massive supplier of money. During that same period, the U.S. cut its interest rates from 6.5% to one percent (!), and maintained that level for almost a year. The EU Central Bank cut their rates from 4.75% to two percent. Canada joined the bandwagon much later and for a shorter period of time, but it has joined it nonetheless. Obviously, Japan could not have been the only one pumping huge amounts of money into world marketplaces.

It seems that, last year, all of these economies finally came to their senses and started increasing interest rates, albeit very, very slowly. This is why we are still feeling the consequences of excess liquidity; restoring the money supply and demand equilibrium takes time.

But, what is the point of this short history/macroeconomic lesson to readers of Profit Confidential? Well, favorable interest rates and excess money supply usually create very narrow risk spreads and low market volatility. Typically, falling real estate prices are the next victim, as already evidenced in the U.S. And, as global markets’ infrastructures experience more and more negative pressure, a global financial crisis could be just around the corner. Now, financial crises are a fact of life and they happen from time to time in spite of our best efforts. All I’m saying is that smart investors should acknowledge the change in circumstances and adjust their game accordingly.