It's Not A Real Financial Crisis Until Credit Cracks

I was hoping to relax after my visit to Rome, but the equity markets are currently in freefall during the Sunday night futures sessions. At the time of writing, the main U.S. equity markets are down 15% or so over three trading days (including Sunday). Although this is certainly an eye-opener, this is not yet a financial crisis. (We are in an economic crisis thanks the White House brain trust, of course.)

Equity markets are almost entirely secondary market trading — owners of existing shares flip them back and forth amongst themselves. Very little capital is directly raise in the equity market — in fact, stock buybacks mean that equity markets largely consume capital. Instead, capitalism is financed by debt.

As long as firms can issue new debt to roll over existing debt, the game of capitalism goes merrily along. However, if debt cannot be rolled over, activity will rapidly seize up. Although I was too busy checking out artworks (and avoiding being run over) to have a firm feel of the pulse of the markets, I have not yet seen indications that the credit markets have seized up.

If credit market conditions remain orderly, we will get a very rapid divergence between equity commentators — and the White House — and the Fed. The Fed is looking at a hefty price level shock coming, and so is not going to be too happy cutting rates in an environment where hard data is still based on “Pre-Liberation Day” dynamics. This would be a tricky political situation, but it is not clear that credit will be able to avoid contagion from the ongoing equity market collapse.

Although the White House is largely insulated from economic reality, a credit market seizure might be enough to catch everyone’s interest. Lower Treasury bond yields does not help the private sector if nobody is willing to lend to the private sector, and the yelping that would create might finally penetrate the policy fog.