By Julian D W Phillips

As with so many crises in history, says Julian Phillips of the Gold Forecaster, the consequences of certain situations now playing out were not foreseen, or if they had been foreseen, they were downplayed to either inaction or insufficient action.

So it has been with the sub prime crisis that is now a full blown liquidity crisis that is spreading like a gangrene into other aspects of the credit market. You may still wonder why this crisis is causing such a threat to the entire financial system so as to cause the Fed to 'throw money from helicopters'? The problem is essentially due to the functioning of collateral.

Banks have to keep a relatively small percentage of their capital as a base for all their lending activities. Firms that raise finance in the fixed interest market have to ensure that their assets cover such loans or top up these if their values fall below the required levels. With the value of many of these previously 'sound' mortgage related assets falling like a stone, such collateral became inadequate to meet the legal requirements so forcing institutions to provide capital as a top up. Then their own debt related securities dropped in values making it more difficult to effect such top ups.

As the 'spreads' on such borrowing rose the borrowing became more and more difficult until anything to do with either a mortgage related security or the institutions that issued them or used them as collateral became unacceptable as collateral.

Effectively then, the capital that such securities represented 'disappeared' to the extent that prices had dropped leading to some bankruptcies and to a contagious effect that the disappearance of further value caused as other institutions holding these companies now distressed debt, suffered the same fate. As the credit cancer spreads so the crisis grows. A look at the Weimar republic's hyperinflationary beginnings point to a similar situation. (Subsribers to the Gold Forecaster should contact us for a copy of our article on the subject...)

Tragically, the longer short term expedient measures are put into place the 'contagion' will continue to spread. And each step of the spread of the disease the more likely it is to effect more and more parts of the financial system. Clearly the solution, deemed as unacceptable still, is to restore value to such securities in such a way as to convince all that the mortgage market is healthy again and likely to resume growth again

If interest rates fall to the extent that the housing market recovers, foreclosures cease on those who hold mortgage bonds, whose rates are set to climb, are moved to a healthy zone the market will recover its confidence.

Last year when we first talked about the crisis we used an illustration of a firm retrenching one worker. The confidence lost in such actions can only be restored by the employment of two workers. Such is the case in the credit markets now. For the Fed to accept mortgage backed collateral for 28 day loans does not do it. It simply tells the market that they are providing short term bridges for the industry, but not rectifying matters.

This can only be done if interest rates fall to the point where the fear of mortgage foreclosure on the more than 1 million potential victims is halted and those mortgages regarded as sound enough to be used as solid collateral. This is not happening and such a solution goes against the grain for lenders. As such, the only likelihood of an effective solution will come up when the crisis is likely to cause systemic failure!

If the Fed does not accept such collateral as solid security for loans and be seen to be doing so the crisis will spread. This will mean a situation such as is seen in Japan, where interest rates are not far from zero. Until then it doesn't matter what the state of the economy is, 'disappearing money' will have the same effect as raising interest rates, issuing bonds by government and any move intended to drain liquidity out of the system, such as rising oil prices and trade deficits.

Doing nothing or not enough will cause the contagion to spread. The process of pumping money, not only into the US monetary system, but the globe's, has to continue and grow until the crisis stops, with the Fed holding all those dubious securities.

The money has to come not just from the Fed or the European banks but from trade surpluses, oil producers reinvesting back into the US, and Chinese and other Asian surpluses being invested back into the US, too. If this capital does not return it disappears from the US economy and gives a whole new dimension to the liquidity crisis , with foreigners taking a proportion of ownership of the US it may well not be ready for.

Add to this gangrenous problem the bleeding trade deficit and you have a suppurating wound infecting the US with a recession and unless properly handled with the transfusion of huge more amounts of additional liquidity, will lead to a depression. It is too late for academic discussions on whether it is a recession or not. It is time for action time to stop the bleeding! A healthy US economy can be one where prices are forced to keep stable, but a relatively sound economy in a considerably depressed condition is disaster.

The fact that Bernanke felt obliged to ask the banks to increase lending is clear evidence that the banks have not increased credit to the degree the Fed would like them to. Effectively, the Fed can influence the cost of credit by changes in interest rates and other tools, but it cannot directly influence the supply of credit. If banks continue to be reluctant to increase the supply of credit, the financial markets will come under considerably more strain, vastly increasing the attractiveness of all hard assets, including gold.

Rumors of the potential collapse of a large financial institution, which turned out to focus on Bear Stearns in the first instance but which have yet to subside after its sale to J.P.Morgan have further exacerbated the situation, despite the injection of a further $200 billion by the Fed.

To quote, there is a de leveraging spiral of credit removal, asset price destruction, capital debasement...ad infinitum that is occurring.

But the most disturbing facet of this is that the liquidity crisis is accelerating. An rapidly accelerating inflation will counter this causing the monetary systems and currencies to embark on their own destructive dramas. This is not a gradual decay, it is one that is hampering most traditional methods of spurring growth and has to receive emergency room treatment or it will become a crisis that could take a decade or so to repair.

And what are we seeing to make us say this? The Dollar is dropping like a stone, the oil price is irrepressible, Asian growth is ensuring commodity prices, metals and food (supported by speculation) will stay high and higher for as far as we can see ahead. The defensive measures that are being taken, so far, are Central Banks protecting national interests through exchange rate management to retain international competitiveness with key trading blocs.

Sadly this removes all obstacles to tsunami like movements of capital flowing across the globe creating systemic damage of its own. These can only to be stopped by Capital Controls and Exchange Controls. It will be easier to stop such capital flows than impose trade barriers, harming those prevented from free trade but also those imposing them until local production replaces imports.

Such protectionism will fragment the global economy. And moves against speculation may precede such moves.

Can the world cooperate sufficiently to ensure the global economy in its present state does not fragment? Only hyperinflation in isolated areas and an environment where the control of money moves into the political arena lies ahead unless the crisis is properly tackled now.

In conclusion, we are moving to a level of decay that sits in an inflationary environment, which could move to unforeseen and eventually exponential levels as it did in the past in Germany, but this time moving into connected nations. Such an environment will see a plethora of national tariffs, exchange and capital controls across the globe, trying to prevent this infection.

How can Gold and silver not rise far higher in such a climate?

JULIAN PHILLIPS one half of the highly respected team at GoldForecaster.com began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the Dollar Premium . On moving to South Africa, Julian was appointed a macro economist for the Electricity Supply Commission guiding currency decisions on the multi billion foreign Loan Portfolio before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

By arrangement with: www.bullionvault.com

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