The problem with a deflationary collapse of a credit bubble is that everything that worked for you on the way up works against you on the way down. It’s sort of like Judo gone wrong.

Where rising levels of credit masked poor business decisions and models, shrinking credit will expose them.

Where credit led to more credit, defaults will lead to more defaults.

Where optimism fueled the ride up, pessimism will drag it back down.

The difficulty for the Federal Reserve and the Treasury Department (and soon, Obama) is that all the big solutions with the big numbers being thrown at the big problems are insufficient. The stimulus is not reaching the right places – it’s getting stuck in the big institutions.

So even as prodigious amounts of money are being created and applied to “the problem,” the evidence suggests that their efforts are not working down on Main Street.

The reason for this is very simple – it is not possible to solve a crisis of solvency with liquidity. It is not possible to fix a crisis of malinvestment with the purchase of bad debts.

Here’s one example. Take retail store space. On the ride up, malls were developed at a furious pace. By every definition or comparison, the US overbuilt capacity in this sector by a very large amount. Given this, what’s going to happen next when this malinvestment is exposed? Well, we don’t have to wait to find out the opening notes of this symphony.



Retailers Will Face Darwinian Fight as Losses Mount

Dec. 18 (Bloomberg) — U.S. retailers will face a Darwinian fight for survival next year as they run out of cash as early as January and competition forces thousands of store closings, according to private-equity buyers and restructuring experts. Probably 50,000 stores could close without any effect on consumer choice, Gregory Segall, a managing partner at buyout firm Versa Capital Management Inc., said yesterday during a panel discussion held at Bloomberg LP’s New York offices. “The United States is massively over-stored in all categories,” Segall said. He said his firm is in “a wait mode” and he expects banks to squeeze retailers after Jan. 1.

The answer is that retail companies will go out of business, stores will become vacant, and the Federal Reserve will find themselves buying up a lot of the failed mortgage notes and exotic derivatives built out of commercial real estate debt, if they haven’t already.

But how does this help? The debts are going bad because they represent a bad business decision, undertaken because of false price information, flashed by the mega-credit bubble, spawned by the meddling activities of the Federal Reserve.

The stores are going out of business because the vaunted consumer has left the store and isn’t buying anything. The ripple starts there and spreads throughout the system, knocking debt pillars out at every step of the way.

As consumers cut back, inventories pile up, and then the production gets cut at the factories. In turn, their suppliers feel the burn and have to cut back.

The fear for the Fed is that once this dynamic takes hold, it can develop a life of its own that is extremely difficult to control. Here are two examples of this dynamicat play:

The Consumer Electronics Inventory Glut

Automakers aren’t the only ones halting production as inventories pile up. The consumer electronics industry is also coming to grips with rising stockpiles of unsold goods that are likely to result in price pressure and falling profit. Recent evidence of growing inventories came Dec. 15, when SanDisk (SNDK), a maker of memory cards and storage drives, said it will temporarily stop production at two Japanese plants for two weeks through Jan. 12. After that, the factories will resume work at 70% capacity. SanDisk hopes the cutbacks will help it whittle away at the piles of unsold devices in warehouses and on retailers’ shelves.

Bracing for the Global Downturn

Last Friday, the world came to a standstill in Sindelfingen, a town located near Stuttgart. On normal days, about 1,500 trucks and 52 rail cars arrive at the Mercedes plant in Sindelfingen, carrying steel and glass, tires and dashboards, headlights and seats. More than 36,000 employees pass through the factory gates every day to develop new models and assemble the current ones — the Mercedes C, E and S classes. On normal days, at least 1,500 cars roll off the assembly lines at the plant. But what is normal nowadays, with new reports on the recession coming in each day? Now the Mercedes plant is closed — until Jan. 11. Production facilities worth billions have been shut down. Everything, from the paint shop to the welding and production robots to the assembly line itself, has stopped moving.

The worry here is that the economy will hit stall speed, at which point its downward momentum just feeds on itself ruining banks, companies, lives, and even countries.

The whole chain comes to a halt and then morphs into a vicious cycle, where cutbacks lead to job losses, which lead to reduced economic activity, which lead to cutbacks, and so on, down and down, until some sort of a bottom is reached.

Typing “Production Halt Slowdown” into Google and constraining the results to the past month yields 150,000 results from all over the world.

We’ve recently seen headlines about 20%+ export declines for Japan and a shipping index that does not even cover the cost of the fuel and the crews, let alone debt service and insurance. We’ve heard about Rio Tinto, the mining giant, laying off 14,000 workers. We’ve seen the record declines in spending and capital investment.

Taken together, we have many more signs that the game is being lost by the world’s central banks than signs of progress.

Whether this can be fixed with another few hundred billion, or even a few more trillion, tossed in the general direction of a few well-connected Wall Street banks is highly questionably at this point.

Given that neither the Fed nor the Treasury has displayed any real understanding about the roots of this problem, it would be wise to prepare for a protracted slowdown and a possible hard landing.

We are very close to stall speed.