Can The Fed Save You From The Credit Crunch

Once credit contraction begins, there is very little the Fed can do to stop it — though that doesn't stop consumers from believing that the Fed has the power to steer our economy. In fact, "seventy years of nearly continuous inflation have made most people utterly confident of its permanence."

As you can see in the chart above, the Fed clearly follows the market; it does not dictate its direction. The September 2007 Elliott Wave Financial Forecast explains: "With respect to the timing of the Federal Reserve Board rate cuts, we need to reiterate one key point: The market, not the Fed, sets rates."

In fact, as Robert Prechter notes, "it is nearly impossible to find a treatise on macroeconomics today that does not assert or assume that the Federal Reserve Board has learned to control both our money and our economy." (Chpt. 13, CTC)

You see, most people think that deflation is impossible because the Fed can simply print money to stave it off. The problem is, that is not the Fed's primary function. In fact, for the past 89 years, the Fed has fostered the expansion of credit that is now beginning to contract. The Fed has done this by setting and influencing short-term interbank loan rates, including the "discount rate," and by keeping interest rates low — which simply encourages banks to borrow from each other and to loan credit to their customers.

This system works well during social mood uptrends when borrowers are confident participants in the process. But during monetary crises, the Fed's attempts to target interest rates don't appear to work, because the demands of creditors overwhelm the Fed.

For instance, as banks begin to lose money from bad loans, they will turn reluctant to give out loans. The only way for the Fed to induce banks to begin making loans again is by raising interest rates — ensuring the banks they won't lose money. But that will create problems too, as higher interest rates will drive away customers not willing to pay higher rates:

"A defensive credit market can scuttle the Fed's efforts to get lenders and borrowers to agree to transact at all, much less at some desired target rate. If people and corporations are unwilling to borrow or unable to finance debt, and if banks and investors are disinclined to lend, central banks cannot force them to do so." (Chpt. 13, CTC)

Even if the Fed did start printing banknotes to try and reinflate our economy, there would be problems. For example, if deflation is underway, a defensive emotional environment could cause investors to panic if they see the Fed printing more money. That could simply trigger investors to lose all confidence in the economy and banking system.

"Understand further that even the government's tools' of macroeconomic manipulation are hardly mechanical levers on a machine; they are subject to psychology" (Chpt. 13, CTC) — just like the people they are meant to manipulate.

You've read the headlines: "Fed Vigilance Urged on Credit Crunch," "Loan Drought May Deepen Housing Slide," "Rush to Pull Out Cash," "Regulators Warn Credit Problems to Take Time to Correct."

You've heard the stories about people losing their homes, subprime mortgage woes and hedge funds going bust.

You may not know it, but you have probably even experienced some of these issues firsthand. Take a look around your neighborhood. How many homes are for sell? How long have they been on the market? Were any of them foreclosures?

Unfortunately, this is only the beginning. So far, the average American has been relatively insulated from the burgeoning credit crunch, but as the headlines above hint, this won't be the case forever. However, the headlines above do not reflect the whole story. In early 2007, media reflected an everlasting optimism for housing and the credit markets. At that time and even today, they do not understand the potentially devastating scope of the credit crisis. They do not understand that the credit crisis will probably take years — not months — to remedy itself. And they do not understand just how bad it can get before it gets better, as evidenced by this September 2007 headline: "Credit Crunch and Market Turmoil Have Little Impact Beyond Real Estate."

Robert Prechter was virtually alone when he forecast the ticking time bomb that was the credit markets in his bestselling book "Conquer the Crash," in which he warned the average American could start feeling the pinch very soon.

Why? Because we've all been caught up in the "Great Asset Mania." As a society, we are overextended in credit, and the time for a contraction is now. In "Conquer the Crash," Elliott Wave International President Robert Prechter looks at how we got ourselves into this financial mess, what it means for the future and how you can protect yourself before it's too late.

This article looks closely at chapters 10 and 13 of "Conquer the Crash" and will give you an idea of why the credit crunch is taking its toll.

How it started

During the bull market of the 1990s, and even into the new millennium, financial institutions everywhere were enamored with credit. Banks, businesses, even the government, fostered easy credit

And consumers were happy to take them up on it. From risky mortgages to home equity loans, millions were looking for a way to free up a bit more cash by leveraging their future in the form of IOUs. Optimism reigned, and everyone believed that credit would continue expanding forever.

It was the hallmark of a flagging bull market. Social psychology, or what EWI calls "social mood," was trending upward, but there was little real strength in the economy. All of our financial growth was based around the expansion of credit, as chapter 10 of "Conquer the Crash" notes:

"IOUs can be issued indefinitely, but they have value only as long as their debtors can live up to the demand only to the extent that people believe they will." (Chpt. 10, CTC)

Once social psychology begins to turn from optimism towards pessimism — and bear market mentality — the belief in that credit quickly changes, and debts begin to get called in.

Yet few thought of that while social mood trended upward. During the 1990s and onward, financial institutions began to take risks with credit. In other words, lenders were so optimistic that they began making loans to customers with poor credit records and even those with no credit records. "Easy financing" was the term of the day

On the flip side, customers were so optimistic that they began to assume more debt, accepting risky interest-only and adjustable-rate mortgages — loans that they would not have pursued (and would not have been available) if social mood had not been at such an apex.

It was only setting the stage for what is occurring now.

What is deflation?

As the Elliott Wave Principle states, social mood affects everything we do and guides the worldwide economy. So, what happens when social mood finally turns down?

Quite simply, optimism turns to pessimism.

Instead of seeing opportunities to make money, bank officers see only risk. At the same time, customers begin equating loans with risk, instead of opportunity. When that occurs, the expansion of credit turns into contraction:

"The expansion of credit ends when the desire or ability to sustain the trend can no longer be maintained. As confidence and productivity decrease, the supply of credit contracts." (Chpt. 10, CTC)

As credit begins to contract, you not only see banks foreclosing on houses, you also see potential buyers rethink the housing market. Instead of seeing real estate as an investment, all parties — buyers, builders, bankers and brokers — begin to see it as a risk. This type of thinking permeates bull market moods and can lead to a downward spiral. It is already occurring in housing, but it could soon spread to other financial markets, which could trigger deflation.

Deflation is defined as, "a contraction in the volume of money and credit relative to available goods." Quite simply, when deflation occurs, real money rises in value, and the volume of credit falls. But don't mistake deflation for falling prices:

"The most common misunderstanding about inflation and deflation is the idea that inflation is rising prices and deflation is falling prices. General price changes, though, are simply effects."

"Deflation requires a precondition: a major societal buildup in the extension of credit (and its flip side, the assumption of debt). When the burden becomes too great for the economy to support and the trend reverses, reductions in lending, spending and production cause debtors to earn less money with which to pay off their debts, so defaults rise. Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward spiral begins."
(Chpt. 10, CTC)

Does that sound familiar? Debtors can't pay the banks, so lenders are forced to foreclose and raise interest rates on their remaining debtors in order to ease their losses. This in turn causes previously secure debtors to fall further into debt. In turn, they will not be able to pay off their mortgages and will fall victim to foreclosures. Eventually, this cycle will envelop millions of debtors and spread to other markets throughout the world — as we have just begun to witness.

As you can see, this is a very dangerous and slippery slope that we are looking down. And yet most people think that should deflation occur, the government — in the form of the Federal Reserve bank — will simply step in and reinflate U.S. currency.

That is a dangerous assumption.

What you can do to protect yourself

There are several steps you can take to protect yourself and your assets from the spiral of the credit crunch. The most obvious is to get out of debt. If you don't owe anything to the bank, they can't take anything away from you.

You also need to find a safe place to put your money — including a safe bank (i.e. a bank that does not have your deposits tied up in bad loans, which it will not be able to recoup). You cannot rely on the Federal Deposit Insurance Corp. to insure your money when member banks have lost it all in risky investments.

These are just two of several actions you must take in order to ensure your safety during the coming financial crisis.

Robert Prechter's "Conquer the Crash" serves up several more, including a list of safe banks and powerful evidence that you can only rely on yourself and careful planning to survive and prosper during a truly historic credit crisis.