Tag Archives: credit crisis

Market Rally Taking Lambs to the Slaughter

I’m as ready as anybody to see the market rally that becomes the leading indicator of economic recovery… but this one isn’t it.  This is a fool’s rally that is going to take retail investors to the cleaners.

This rally began with Citibank’s statement that their core banking business was profitable in the last quarter if you discount write-downs of toxic assets, the fact that they are earning money on tens of billions of “free” dollars injected by the government, etc.  Retail investors have focused on “profitable” and ignored “if you discount”.

The government’s stress tests are still a month away from completion and when they wrap up they are going to show that core business profitability or not, several of the largest US banks, probably including Citi, are insolvent and will need to be nationalized in deed if not in name.  When the results of the stress tests re-assert reality, this boomlet is going to fall like a house of cards.

The real rally will not occur until the banks are fixed with no “if you discount”‘s.   That could be as soon as June or July if

  1. the results of the stress tests come back dire enough that
  2. the administration is forced to face reality, nationalize the zombie banks, and take over the damaged assets on their balance sheets and
  3. sell clean, chopped up, smaller banks back to the public
  4. with new regulations in place reinstating the firewalls between commercial banks, investment banks and insurance companies; forcing limits on the size of financial institutions, and putting concrete limits on the overuse of leverage anywhere and everywhere in the economy.

If these things do not happen, the real rally will be delayed months or years more until banks slowly work through the realization of their asset losses.

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Make These Changes This Week, Fix the Economy by Next Week

Paul Krugman recently wrote that what is at the heart of the economic meltdown is a surplus of savings beyond what businesses are willing to invest. These savings have been bouncing around the globe looking for a return for over a decade.

Everywhere these excess savings have landed, they have bid the price of assets up to unsustainable levels, bid down the returns on those assets to zero or negative amounts, and created havoc and dislocation. These savings fueled the dot.com boom in the late 1990s, funded sub-prime mortgages from 2001 to 2006, poured into commodity markets in 2007 and 2008 creating bubbles in crude oil, mined minerals and metals, corn, rice, and other grains and farm goods, etc. These savings have since flooded into United States Treasuries, driving yields to zero and, sometimes, even negative.

To me, this points squarely to the root cause of our economic problems (surplus savings only tells part of the story) as well as the solution. Many will tune out my assessment without making it to the end of the next paragraph. For those with a little more patience than that, hear me out then engage me in debate. I value your constructive thoughts about the substance of this, ways to implement it, and better ways to explain it. Ready for half our friends to tune out?

Too much wealth has gotten too concentrated in the hands of too few people. It needs to be “redistributed.”

Wow! Did you see them go? Anyway, now that they’re gone, lets discuss this, and lets use the words supply and demand a lot.

Business uses people’s savings to create the supply of goods and services that will meet demand. Supplying goods and services to meet demand is what business does, so if business is not willing to invest savings to increase supply, it can only be because it sees no demand for what it would produce.

We can be very confident that there are still needs and wants all over the world. I have many needs and wants myself, and I’m just one me. Demand only occurs when people have enough money to buy the goods and services that will satisfy their needs and wants.

People can escalate through three economic levels. At the most basic level, people spend whatever money they earn trying to meet their basic wants and needs. They are pure consumers. Every dollar they earn becomes demand for a good or service.

As people earn more, they cycle back and forth between increasing their level of consumption and securing their level of consumption against downturns, emergencies and retirement by saving some of their earnings. People at this level, lets call these people the “middle class”, decide how much to consume based on an inverse relationship with savings returns. If there is a great financial incentive to save, they will opt to consume less, while if there is little or no financial incentive to save, they will consume more. To the degree that these people opt for consumption, they generate demand for goods and services. To the degree they opt for savings, they generate the ability to supply goods and services. The relative supply and demand of goods and services in the economy changes the relative value of supply to demand, and changes this group’s behavior accordingly.

Some people earn enough that, while it may or may not be at an extravagant level, they max out their desire or even their ability to consume and they have more than enough wealth to secure their consumption forever. People at the highest level create as much demand for goods and services as they care to, and still have money left over that must be saved. These people generate supply in excess of their ability to create demand.

When supply and demand get seriously out of balance, economics steps in with a heavy hand to pull them back together. If demand gets ahead of supply, inflation will occur. This reduces buying power, which reduces demand. If supply gets ahead of demand, unemployment will occur. When resources (be they land, savings, or labor) go unemployed, our capacity to create supply shrinks back in line with demand.

Lets revisit Krugman. What does it mean if there has been a glut of savings bouncing around the globe for over a decade? One thing it should mean, is that the return on invested savings should be zero and the middle class should be using as much of their wealth as possible to consume and create demand. They should be saving relatively little. Despite the middle class creating as much demand as it can, there is still so much extra supply that all these trillions of dollars of savings are still going… unemployed.

We like to think of markets as perfect. We assume that market prices reflect all known information and that they balance instantly. The existence of arbitrageurs proves to us that even tiny discrepancies in markets are balanced immediately.

Markets are not even close to perfect, however. Markets that are thinly traded often mis-price goods and services. There are seas of information that is legal to trade on that is not available to all market participants. If the employment market was perfect, wages would rise and fall daily, if not throughout the day, to account for the never ending fluctuation of the supply and demand of all the many talents and skills. Most workers, however, only see income adjustments once a year, if that, unless the disparity between what they are worth and what they are making becomes so egregiously great that they either quit or get laid off. The mega-trillion dollar market for unregulated bond insurance is so opaque no two players know the terms of any other players in the market at all. The mortgage backed securities market would require intimate knowledge of individual neighborhoods, houses, and families that just doesn’t exist to be able to accurately set prices.

Markets that are lacking in transparency, information, liquidity, etc. further become distorted by mass psychology. In lieu of useful information about what drives prices, people have a tendency to consider price changes themselves to be information and they, en mass, make erroneous decisions.

The inefficiency of our markets has made it appear, for the entire time that the real yield on savings was zero, that the yield was positive in many areas. The flood of money into mortgage backed securities fueled real-estate prices, which gave the false impression of returns on savings, which shifted the middle class erroneously from consumption to savings, created the illusion of demand where there was none, created the appearance of profits where there were none, etc. The unwinding of all of this distortion puts us in the confusing mess we are in today.

For all its complexity, however, ultimately, the real situation is fairly simple. There are people with huge amount of money who are incapable of creating demand because they are tapped out of goods and services they need or want. There are people with needs and wants who are incapable of creating demand because they have no money with which to purchase goods and services. Because demand for goods and services is so low, the demand for the wealthy people’s savings is so low, that yields on savings remain essentially zero. The excess of supply in the economy has now started a whirlpool in which labor, factories, land, vehicles, and all sorts of other resources are becoming unemployed alongside the excess savings and the cycle is building on itself.

The solution is to stimulate demand. Of course, this comes as no surprise… Congress recently enacted a nearly $800 billion program designed to do just that. But there are problems. The most serious problem is that supply is exceeding demand by trillions of dollars, not hundreds of billions of dollars. Government’s efforts to stimulate demand, while monumental, are tiny compared to what is needed. Another problem is that the stimulus program is a government program in the first place when it needn’t be.

Brief detour.

We can all debate what the proper size of government should be. My own opinion is that government can and does do a lot of great things for us and is not only necessary but wildly beneficial to us. It does many things that only a government can do. I think we often starve government of the resources it needs to do what we ask of it well, then we use its inability to do these things well as as excuse for not having it do them at all, or for further starving it. I think government should be bigger than it is today. Others disagree and that it fine. Ultimately, we should be making decisions about what we want government to do based on getting as close as we can get to a consensus of what things we want and how much we are willing to pay. Whether that is bigger or smaller is why we are a democracy. We should not be making government bigger or smaller because we need it to increase or decrease the demand for goods and services.

Back again.

Ultimately, what is needed are structural changes to the economy that will create disincentives to own wealth that is not stimulating demand. A portion of this excess wealth needs to be paid out, perhaps in as simple a form as a mandatory raise for all employees around the world, to the middle and lower classes that would have the ability to stimulate demand overnight if they only had money to spend! As people with needs and wants become able to stimulate demand, business will finally start to soak up the remainder of the savings in order to meet the new demand with new supply. This, finally, is the only way that the glut of savings can finally be eliminated so that the remaining savings that exist can actually generate returns sufficient to again place the middle class in its proper role of balancing supply and demand.

Additional Thoughts


If all employees are given a mandatory raise of, say, 20%, won’t companies immediately need to raise prices by 20%, creating 20% inflation, and nullifying the effect of the raise? No. Labor is not the entire cost of goods and services. Technology, the cost of money (when it isn’t available for free), and raw materials also go into the cost of goods and services but would not see 20% increases. There might be 15% inflation, but that would still create an increase in demand beyond that which would be clawed back by inflation.

More on inflation

Just as unemployment is more harsh on some than others, so is inflation. Is it fair to charge so much of the economic recovery to savers? Our goal should be to have close to full employment of all resources with little inflation. Right now unemployment is ravaging some sectors of the economy. Later on inflation is going to ravage others. I submit that savers are already being ravaged by unemployment, though, because it is their very savings that are going unemployed along with the labor of others. While it is unfortunate that some of their savings will be lost to inflation, this is the only way for their remaining savings to once again start earning a positive return. This glut of savings has turned into an infection. While it is true that some people who have an infection may not want to see it lanced because, after all, it is their infection and they don’t want to lose it, it is the only way they can get healthy again.

If markets have set wages based on supply and demand, and now we’re going to increase them on a whim, aren’t we just adding a new distortion into the markets that will have to be worked out later down the road?

I don’t think so. First, I’ve already discussed the inefficiency inherent in accurately pricing labor. Second, in the decades since the Vietnam War, globalization has increased the labor pool so dramatically that the price of labor has been kept flat or nearly flat for many, many years. Globalization has also opened up new markets, so we would like to believe that the new supply of labor should be sopped up with the new demand for goods and services. This has not been the case though. For the very reason that the increased supply of labor has kept wages down, the increased supply of people with wants and needs has not translated sufficiently into an increase in the number of people capable of creating demand. This is one of the major factors, probably even bigger than US tax policy changes, behind the consolidation of wealth.

Only by increasing the ability of workers to convert needs and wants into demand can the global economy be brought back into balance.

A related factor is time. While it may be true that given enough time and enough cycles of unemployment and inflation that supply and demand will come naturally into balance, this process could will take decades. After all, not only do we need to account for dislocations that have built up over several decades since the advent of global trade, we need to account for the dislocations that haven’t even occurred yet because globalization is still in its infancy. All of the trends it has fostered are still being increasingly fostered today.

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Too Big to Fail is Too Big to Be

As we start nationalizing the most insolvent of the major banks we need to take a new look at our anti-trust laws.  In addition to putting teeth back into the idea that competition is a good thing, we need to realize that corporations, and banks in particular, that get “too big to fail” represent huge national security threats.

It is telling that the two attacks that have had the most devastating economic impact on American citizens have both come from our own bankers.  No military threat or action has ever been as damaging to the American people as the Great Depression in the 1930’s or Depression 2.0 that we are entering now.

We need to fully recognize that banking is an absolutely critical function of our way of life, and that anything that threatens our banks threatens us.  And we need to recognize that the most severe threats to our banks have historically come solelyfrom their own executive leadership.  We must nuetralize bank executives’ ability to put the banks that are so central to our public well-being in jeopardy.  The best way to do this is to divide and conquer.  Citibank and Bank of America have to, for the moment, be viewed as the enemy.  And since they are too big to take on head to head, we need to break them up into much smaller pieces, none of which has sufficient power to harm us.

We spend hundreds of billions of dollars a year on our military so that more than anything else, it can be a credible deterrant to attacks on us.  We need to have a similarly sophisticated and credible deterent capable of preventing attacks coming at us from our bankers.  In our nation’s brief lifetime, the most damaging threats to our well being come from inside, not outside.

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The Second Major Flaw in the NEW Bank Bailout

Immediately after Treasury Secretary Geithner announced the framework of the new bank bailout program the stock market sank hundreds of points, as I hope he expected it would do.  The plan fails to address the real banking problem and fails to fully acknowledge the real housing problem.

The plan includes a variety of programs and provisions that will help lower mortgage rates on new purchases, make it possible for many borrowers to refinance into mortgages with lower rates, and for some borrowers to be able to restructure their mortgages to avoid foreclosure.  Lowering home owners’ mortgage payments by lowering their interest rates will have a significant stimulative effect on the economy and will reduce the number of families forced into foreclosure by some marginal amount.  It will not solve the core problem and may actually make it worse.

There are two foreclosure crises going on right now.  The first crisis is hitting speculators, many of whom look like very normal people, like you and me, and who would not consider themselves speculators.  But they were.  Any family that used an adjustable rate mortgage or any of the other specialized tools to buy more house than they could afford with a traditional 30 year fixed mortgage was speculating that the price of their house would continue to increase and that they would be able to sell for a profit before their rates started increasing.  When the housing market peaked, these people found themselves unable to sell and they are the ones who have been getting picked off by the adjustable rate mortgages in droves.  To a degree this phenomenon has happened all over the country, but it has only happened in crisis proportions in a few places.  California and Florida had the most upside speculation and have had the worst downside losses.  Nevada’s and Arizona’s populations have soared as people have retreated from the untenable California housing market, which created mini-boomlets in these communities, which now have also collapsed.

For every one of the families that has taken a loss on a speculative real estate investment, remember that another family took a profit earlier.  In fact, very often the families that were able to parlay a series of houses into bigger and better houses through market forces rather than the sweat of their brow, are the same families that are now being forced into the reality of what their money should have been buying them all along.  We should have minimal sympathy for people who took profits on the way up but are now screwed on the way down.

The second foreclosure crisis is a result of the recession created by the credit crisis that sprang from the first foreclosure crisis.  Michigan and Ohio have been hit particularly hard by this crisis as unemployment has soared.  With the deepening recession and spiraling job losses, there will be more of these foreclosures and they will be distributed more evenly around the country.  While they don’t feel any better or worse for it, these are the “innocent bystanders” of this mess.  These are the people who mostly bought homes they could afford, financed with jobs they had every right to expect they could keep, and who have been caught in a crossfire that never should have happened.

Here’s the problem.  These two foreclosure crises are qualitatively different but the solutions on the table only apply to one of them and may aggravate the other.

The main thrust of the mortgage relief program is a variety of ways to lower mortgage interest rates.  When rates are lower, payments are lower, and the line between keeping your house and losing it moves so that a marginal number of people get to stay in their homes who otherwise wouldn’t have.  When rates are lower, houses also become comparatively better investments.  They may not be as good an investment as they were several years ago, and they may even just be a less bad investment than they were last year, but either way, since their competitive position improves compared to other investments, their prices will either go up a little or, at the very least, fall less.  This will have a dramatic impact in California, Florida, and other markets where the primary cause of the foreclosures is the real estate bubble.

Around the rest of the country, where foreclosures are happening because of job losses, no amount of restructuring or changing interest rates is going to make up for a catastrophic loss of income.  The only solution in these parts of the country is getting everybody back to work.  In fact, the prospect of increased housing demand in parts of the country where demand is only depressed because of a poor economy will, what?  That’s right… it will create an artificial increase in housing prices which will likely lead to a whole new batch of dislocations further down the road.

The answer?  If we are so screwed that we have to accept that we have no choice but to make speculators whole for their bad investments… we should limit that to those markets where the most speculation occurred.  Around the rest of the country, we should take whatever funding is going to go into lowering tens of millions of home owners interest payments and put it toward economic stimulus that will benefit the entire economy, including renters.

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The First Major Flaw in the NEW Bank Bailout

Immediately after Treasury Secretary Geithner announced the framework of the new bank bailout program the stock market sank hundreds of points, as I hope he expected it would do.  The plan fails to address the real banking problem and fails to fully acknowledge the real housing problem.

The real banking problem is that the asset bases of hundreds of banks including the very largest among them have collapsed in value.  Banks typically lend about $12 for every $1 in assets they have.  Because the value of their assets have crashed, without moving a muscle many of them have become devastatingly over-leveraged with loan to asset ratios of 30 to 1.  We have known since time immemorial, although we willfully ignore it every time we think we have found free money, that bank leverage ratios at this level lead only to one place… dead banks.

This is why when the first $350 billion of the TARP funds were distributed to the banks they didn’t suddenly start lending.  Those funds rescued them from the brink of collapse but did not reduce their loan to asset ratios to any sort of level that would have made it responsible for them to lend more money out.  If prudent ratios are 12:1, the banks ended up at 30:1, we rescued them by bringing them back to, say, 20:1… they still are going to need a lot more money before they can start resp0nsibly lending again.

To make matters worse, the banks are not teetering on the edge of insolvency.  According to a number of prominant economists including Nobel Laureate Paul Krugman, the big banks are already insolvent and have been for many months now.  The only way these banks have been able to continue functioning in remotely bank-like ways is by everyone agreeing not to realistically value their mortgage backed assets.  By looking the other way and pretending that they are worth more than they are, the banks have continued to borrow money from the Federal Reserve to pay off their own lenders but, in reality, the gig is up.  The banks have collapsed, even if they haven’t fallen down yet.

When banks collapse three groups of people get hurt.

  1. Bank investors lose their investment in the bank.  The value of their stock goes to $0.  This is bad for them, but no worse than when any of their other investments go bankrupt, and they get compensated for this risk through the return they demand on their investment.
  2. Bank bond holders lose their investment in the bank.  The value of their bonds goes to $0.  This is bad for them too but, again, no worse than when any of their other investments go bankrupt and, like stockholders, they get compensated for this risk through the interest they demand on their loans.
  3. Bank customers are the big losers.  There are no mechanisms like interest or dividends that compensate them for the risk that their uninsured deposits and day-to-day operating funds will vanish overnight in a puff of Wall Street smoke.  They lose everything, and the economic ripples start here as businesses, suppliers, employees, and customers all end up eating a share of a loss for which they never received compensation.

The fact that bank customers lose without compensation is the one and only factor that differentiates an insolvent bank from any other insolvent business.  FDIC insurance, to the extent that it covers deposits, was created to ensure that bank collapses would not leave savers penniless.  It does not, however, provide for continued short term operating loans.  So it helps, but it doesn’t help enough to avoid economic shock waves, closures, Main Street bankruptcies, and unemployment.

Protecting these vulnerable, uncompensated bank customers from the effects of bank collapses should be the government’s one and only banking related concern right now.  But that is not what we are seeing in any of the bailout proposals that have come along so far.  All of the bailout proposals and actions have maintained at least some mechanism that maintains at least some value for bank stockholders and bondholders.  That is reason number one why Wall Street crashed dove today.  Making people whole for losses they have already been made whole for does nothing at all to solve the problem and is just patently, blatently, disastrously, unfair.

The second reason Wall Street doesn’t like the new bailout proposal is that it insists that banks lend out the money the government gives them!  This seems logical on the surface, but remember the problem in the first place is that the banks are insolvent!  They already have loan to asset ratios of 30:1.  If we add to their assets and then insist that they lend those assets out, it does very, very little to reduce the lending to asset ratio to a responsible, sustainable level.  We may be able to defer some problems this way, and we may be able to soften the economic blow to the customers this way, but it is massively inefficient and doesn’t ultimately solve the problem.  The banks are insolvent and the only real solutions are going to have to have that as their starting point.

What this means is that the stockholders and bondholders have to be wiped out.  In order to keep the banks functioning without impact to their customers, the government will have to assume their operations and provide them with new assets at a sufficient level so that their loan to asset ratios are sustainable.   Once the government does this, it can go about selling them back to a public that will be as eager to invest in clean, healthy financial institution as they were before this mess.  It is a trade.  The government puts in the money that the old investors lost, and then new investors put their money in so the government can get its money back out.  Bank customers, in the meantime, experience a seamless transition as if nothing had happened.

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Why are gas prices so low now?

I was asked this question today and found that the more reasons I gave, the more reasons I thought of.  I think this speaks to the perfect storm elements that have put us where we are.

Traditional Supply and Demand

  1. Two million American jobs have been lost so far this year.  I saw an estimate that 10 million people are under-employed, which the government defines as working part-time when they want to be working full time, rather than the more logical problem of working as a bartender when you have proven ability to run the joint.  If 2 million have actually lost jobs, there have to be a hundred million at this point who are nervous that they might.  These folks drive less and use less gas.  That reduces demand, which makes the price go down.  Some.
  2. They also buy less, which means fewer trucks are needed to move goods around the country.  More fuel savings.
  3. Whatever fuel and energy went into supporting these 2 million jobs gets reduced.  Factories have been shut down, machines idled, and office buildings emptied out. Air conditioning and heating of these facilities is gone.  Fed-ex shipments have been reduced, restaurant food deliveries have been reduced, office supplies have been reduced.  All of this reduces demand, which lowers the price.
  4. Oil is still being pumped out of the ground pretty quickly.  OPEC has voted to reduce supply, but to some degree the reduced price is encouraging member countries to cheat, sell more, and recoup some of the revenue they’ve lost.  It turns out OPEC can’t usually just turn off the spigot over night.  So supply hasn’t fallen as quickly as demand, tanks and tankers are filling up, and the oil companies have no choice but to lower price to stimulate demand so they don’t end up having to drink it.

Supply and Demand That’s Less in Our Faces

There have been huge, gigantic, almost unfathomable tidal waves of money sloshing around the globe and bouncing off markets for over a year now.  These waves of money turn entire markets into competing products that have their own supply and demand.  This isn’t new, but the size and drivers of the money movements, to a degree, are new.

  1. Zillions of dollars, apparently, had found a happy home in all the mortgaged backed securities we keep hearing about.  As the risks of those securities became known, they outweighed the returns they offered.  Investors sold these securities en masse.  That money that had been parked in mortgaged backed securities had to go somewhere.  Some of it, over the last 18 months or so, went into equities or stocks.  The infusion of money into the stock market pushed it to record highs.  But with stock prices so high, yields were relatively low and those who could see the storm clouds on the horizon saw greater risks there than those low yields warranted.  So a lot of money got “parked” in commodities.  Which bid up the price of commodities in a way that had nothing to do with actual production and consumption of commodities and everything to do with the supply and demand of commodity based financial instruments.  The distortion this caused made commodities “hot”, which created a brand new speculative boom as giant investors started gambling on commodity futures.  This is a lot of what caused the enormous spike in oil prices and the spike in corn and rice prices that threw several developing nations onto the brink of mass starvation.  It wasn’t that people were suddenly eating too much rice or had stopped making enough of it.  The problem was that too many people wanted to own the rice for its investment potential instead of its food potential.  But now.the economy has been in recession, technically, since last December.  As per the traditional supply and demand issues above, consumption has been reduced which has, finally, popped the latest bubble that had driven up commodity prices.  So where is that money going now?  I’m glad you asked.  Debt is seen as too risky, the equity markets have been killed and remain extremely volatile, commodities are crashing… what’s left?  Investors are basically down to two options.  Mattresses and US Government Treasury bills and bonds.  The demand for US Treasuries has gotten so intense, as these untold billions of dollars smash around the world looking for a safe place to land, has pushed yields on them so low that at times they have actually gone negative.  That means that some investors have been willing to pay the US Government to hold onto their money for them in exchange for the gaurantee that only the US Government can make that their losses will be limited to only a small amount.
  2. The giant hedge funds and many other investors had been taking advantage of the debt and equity markets by leveraging their investments many times beyond what was safe.  When it got harder to borrow money, they had to start “de-leveraging.”  So, say a hedge fund had $1 billion of investor dollars in it, but had used that as collateral to get $30 billion in loans, which is what it actually invested in the markets.  If now they can only borrow $20 billion, they have to sell $10 billion of various financial instruments.  This dynamic is largely what was behind the stock market crash in October.  To some degree investors were predicting lower profits due to recession, but to a large degree, the crash had nothing to do with the “real” economy and everything to do with investors refusing to lend money to these hedge funds and, instead, putting their money into Treasuries.
  3. The hedge funds also have lost a lot of their luster to the giant investors because they did not provide the degree of protection against market risk that they were supposed to be able to do.  They got swamped instead and to a degree became a failed experiment.  So investors have been pulling their investments out and the expectation has been that much, much, much money will be pulled out of them by the end of this year.  If that hedge fund knows that it is going to have to fork over $250 million of its $1 billion in investment capital, it A) has to raise that cash, and B) means that it can no longer support the $30 billion it had borrowed.  So it has to liquidate investments, which means, it has to sell stocks.  Hedge funds haven’t wanted to get to December 31st and suddenly all of them sell trillions of dollars of equities and commodities at once, so they have been dumping stocks since about August or September. Most people seem to believe that they are done now, which, all else being equal, means that we are less likely to see catastrophic stock market crashes again, for now.
  4. All of this has led to huge deflationary pressures, which have further reduced prices of things and increased the value of cash… see the next post for some thoughts on this.

So… that’s why gas prices are lower.

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