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The long and the short of it
Friday, 20 February 2009
Hugo Salinas Price

Several years ago – I don't remember the date – I read an interesting comment: “The great boom that the world is enjoying, is in effect an enormous shorting of cash and going long on debt. Eventually, there will be a short squeeze on cash which will have to be covered by going long on cash and shorting debt.”

This appears to be a succinct description of events we are now seeing. A tenet of the Austrian School of Economics holds that all human action involves choosing. I am indebted to Professor Antal E. Fekete for the insight that choice involves going long what we choose and giving up – shorting – what we give in exchange.

The US consumer has been shorting cash for decades. The very low, sometimes negative savings rate has shown that Americans have not wanted to accumulate cash. Americans did not want to go long on cash, they wanted to short it. They went long on houses to live in, houses to speculate with, boats to have fun with, new cars, extra cars, ocean cruises. They also went long on stocks – now selling for 50% of their value in October 2007.

US businesses went in for “Cash Management” – which was supposed to minimize cash balances – short cash – and go long on purchasing short-term or overnight debt from banks to meet coming maturities. Holding plain cash or checking account balances was old fashioned.

Worse, businesses also wanted to expand at all costs. Extend more credit – short your merchandise and go long on accounts receivable – in order to increase sales. Car manufacturers had their own financial arm, to enable them to short their own excess production of autos, and to go long on debts due from customers up to six, seven year's out.

The long position in debt held by US banks is enormous. The debt (bank assets) whose market value is known is classified as “Tier 1”. The debt whose market value can be assumed by comparison with the market value of similar debt is classified as “Tier 2”. The debt whose value is strictly an assumption on the part of the bank is classified as “Tier 3”. Then there are the highly dubious assets that some of the big banks are allowed to keep off their balance sheets, as “it would not be practical” to put them on the Balance Sheet, where accountants know they belong. The banking system of the US went hog wild shorting cash, throwing it around the world in exchange for anything with a signature on it: shorting cash and going long on trash debt instruments.

The squeeze on those who shorted cash is now tremendous. The figures on outlandish leverage in US banks and the figures on household debt illustrate the situation. The Fed and the ECB are trying to meet and overcome the short squeeze by providing enormous amounts of money, available at the banks, in an effort to provide funds to those who are trying to cover their shorts on cash by going long – obtaining cash – to cover their long positions on debts owed.

The enormous increases in cash available at the banks are insignificant in comparison with the prevailing enormous shorts on cash and long positions in debt. The squeeze is implacable.

In effect, everyone on God's green earth is trying to obtain cash - going long on cash - in order to cover their long positions on debt.

“If consumers and businesses refuse to spend and instead pay back debts…” This is saying in effect, “consumers and businesses are now attempting to go long cash and cover their long positions on (i.e., short) debt”. High time they did so. News today is that US businesses face $200 billion in debt coming due in the next three years. They are going to be terribly squeezed for cash. Maybe lots of businesses will simply declare bankruptcy.

“Cash is being hoarded by banks and consumers alike” means “Banks are going long cash and shorting debt (trying to reduce their leverage) and consumers are saving cash (going long on cash) and shorting spending.”

Deflation and Depression are actually a manifestation of a massive short squeeze on cash in an attempt to reduce a gross and unsustainable long position on debt.

The Deflation and Depression will continue until the long position on debt is reduced. The long position on debt in the world is so massive, that it will only be reduced by equally massive defaults.

Only until these defaults reduce the long position to a tolerable figure will the squeeze on cash terminate. At that point, banks and consumers will once again be willing to short cash and go long on debt: the banks will once again be willing to lend and consumers will be once again willing and able to take on debt and spend, or reduce their rate of saving and become buyers once more.

Delaying the inevitable will only drag out the agony of Deflation and Depression for many years. Bringing all the massive liabilities of the banking system onto the Treasury's indebtedness – while the corresponding assets are worth far, far less than these liabilities – will solve nothing.

Debt must be reduced by defaults and bankruptcies. There is no other solution!

The driving force behind the rise in the price of gold at this time is not the fear of inflation but rather the fear of placing cash where there is a possibility of default. Only physical gold in possession is free of this risk.

I may add that even national treasuries do default on their bond obligations (Nouriel Roubini just confirmed this) and can and do default partially by devaluing their currencies. The world is gradually realizing this and this is propelling investors into gold.

Could it be there is Method in the government's Madness? Perhaps the unspoken idea is to save some critical institutions by bailouts at all costs and then – the Treasury defaults later on this year?