Editor's Note: The Credit Crunch is the second in a series of articles on the world economy, published on Axis of Logic. This series is based on Ian Gordon's interpretation of the Kondratieff Cycle as applied to the current world economy. This series was originally published on The Long Wave Analyst Special Edition for August - November, 2007. You may want to read Ian Gordon's first article in this series, THIS IS IT! before proceeding to the article below.

The Kondratief cycle* was first described by Nicholai Kondratief, a Russian Economist early in the 20th century. He discovered a 50-60 year cycle in economic data series of the economies of the United States and other Western industrial nations. He used it to explain the underlying patterns of rises and falls in these economies.

"And important underlying feature of the cycle is a build-up in debt during the up-phase of the cycle, and a destruction of that debt as the economy collapses, in the crash phase at the end of the period, normally considered to be 50-60 years."

THE CREDIT CRUNCH

�The turmoil in global banking hit the streets of Britain yesterday as thousands of Northern Rock customers queued up to withdraw their savings from the UK mortgage lender after it was rescued by the bank of England.�

Financial Times
September 15th, 2007

It was rumoured that customers had withdrawn $2 billion U.S. from Britain�s fifth biggest mortgage lender. This was the first bank run in England since 1866.

The Bank of England has now injected almost 8 billion pounds into the floundering mortgage lender. In order to try and reassure the depositors, the British Government has guaranteed all the money on deposit at not only Northern Rock, but also at any British bank that experiences trouble.

In Germany, the IKB bank was saved from collapse when the value of its speculation in US sub-prime mortgage bonds and derivatives plummeted. Other German banks, encouraged by Peer Steinbruck, Germany�s Finance Minister, guaranteed almost $US 11 Billion worth of its debts and loans. Axel Weber, president of Germany�s Bundesbank called this �an isolated, institution specific incident.� But soon afterwards, Sachsen LB, a publicly owned Landesbank, or state bank also had to be rescued. The German banking crisis prompted Alexander Stuhlmann, chief executive of WestLB, another Landesbank to say that the situation was �not uncritical.� �We sense a reluctance on the part of foreign partners to extend credit to German banks.� (Financial Times)

Jochen Sanio, Germany�s Financial Regulator, compared the evolving crisis to the banking crisis that developed in 1931, following the failure of the Credit Anstalt bank in Austria. This is an interesting comparison, coming as it did in the last Kondratieff winter. The failure of this relatively unimportant bank was instrumental in destroying the world monetary system after Britain abandoned the gold standard in 1931, and followed by the collapse of the entire US banking system after Roosevelt declared a banking holiday in March, 1933.

The trouble is that no one knows the value of the collateral that banks pledge against their inter-bank borrowing. It takes one back to 1932, when the great steel magnate, Charles M. Schwab, said,

�I�m afraid, every man is afraid. I don�t know, we don�t know, whether values we have are going to be real next month or not.�

- The Lords of Creation. P.418

Altogether, Central Banks added $320 billion, during the week ending August 11th 2007, to offset the emerging credit crunch. �Central banks can ultimately fix a liquidity crunch by shipping in boatloads of cash and they are effectively doing that,� said Alan Ruskin of RBS Greenwich Capital. �There is very little doubt that they will come through in the end.� (The Financial Times. August 11th/ August 12th, 2007).

There is hope that Federal Reserve Chairman, Ben Bernanke will right the ship, just as his predecessor had done on numerous occasions. He is injecting money into the overnight lending market and has cut the Federal Funds rate by 0.5%. Today (September 18th, 2007), he reduced the Discount rate by 0.5%. Typically, the stock market responded in joyous fashion. The DJIA jumped 345 points.

Similarly, John Johnson interviewed on BNN (Business News Network) on September 11th, 2007, replied to one question submitted by the interviewer, �we�ve been here before and we�ve always gotten through it.� But the truth is that we have only been here before in 1837, 1873 and 1929; all climaxes to their respective Kondratieff autumns. It is true that we did get through each of those times, but only after a debilitating deflationary depression had destroyed the wealth of many people.

That so many people trust in the power of their leaders to offset the natural progression from boom to bust in the economy is incredible. It can be demonstrated time and time again that leaders have always failed in their quest to arrest economic and financial decline. In fact, the more that these leaders believed in their power to maintain the status quo, the greater the ultimate damage and the greater the suffering endured by the people who had blindly placed their trust in them.

�There seems to a general conviction, cultivated not just by Mr. Greenspan, that the US economy has become virtually immune to recession. It is widely seen just as a bursting of strength due to ingrained �flexibility� and �dynamism�. In addition, of course there is unbound faith in the virtuosity of the Fed to avoid a serious recession.�

Dr. Kurt Richebacher
The Daily Reckoning
3rd August 2003

Of course, we should expect the Federal Reserve to respond in exactly the same fashion as it always has. After all, while reflation failed to work between 1929 and 1933, it has worked every time since then, particularly under Alan Greenspan�s watch. But Alan Greenspan never faced the bursting of a credit bubble. He only knew how to manufacture them. In fact, no Federal Reserve chairman has been challenged with a financial problem of this magnitude since the 1930s. Indeed, the problems confronting the Federal Reserve after the stock market crash in 1929 were rather miner when compared to what not only faces the Federal Reserve Board, but, also all Central Banks today.

It is one thing for the Federal Reserve to inject cash into the banking system, but another to lower administered interest rates. In that regard, the Federal Reserve is caught between a rock and a hard place. In 1929, America was the world�s largest creditor nation. Today she is the largest debtor. Managing administered interest rates in 1929 had no effect on her creditors, because America owed nothing outside the country. Today, she owes foreigners about half of her $9 trillion total debt. Under these circumstances if the Federal Reserve acts to lower administered interest rates, market interest rates are, in fact, likely to rise when the US dollar slides and foreigners demand higher rates of interest to compensate for the risk of holding US dollar debt. Anyway, lowering administered interest rates at this point is unlikely to have the desired impact. Banks must want to lend, and borrowers must want to borrow. But both lenders and borrowers have been badly burnt and neither is likely to engage at this point; particularly the banks. They are already beginning to feel a capital strain from the evolving crisis.

As the debt bubble unwinds and the world enters its Kondratieff winter depression, creditor nations will be forced to sell their US dollar debt to bring the money home in order to shore up their ailing economies and aid their failing banks. Under these circumstances, the effect on the US dollar and US interest rates in general, will be devastating.

These speculative manias only occur once in a lifetime and that is during the Kondratieff autumn. As noted above, these speculations are always initiated by a huge  expansion in the supply of fiat money. As the great bull market progresses, it draws everyone into its embrace. It becomes the centre of attention; the talk on the cocktail circuit and in the factory lunchrooms. Everyone follows its progress on television and in the newspapers. In this milieu, a cadre of experts come to the fore and the investor herd leans on their every word.

First article in this series:

THIS IS IT!
Ian Gordon, Economic Forecaster and Interpreter of Kondratieff Cycle
The LongWave Analyst; Bolder Investment Partners

*THE KONDRATIEFF CYCLE