Cuts and Debts – why the bail out may already have failed.

I believe the bailout has failed. I think we are already ripped from stem to stern and it is just a matter of time.

Last week liquidity quite suddenly disappeared from the US stock market. In seconds an unstoppable disintegration swept away 800 points on the DOW, 10% of all value in Paris. In response the ECB was told to spend 750 Billion Euros to try to avoid a black hole of default that was threatening to swallow European banks and whole nations.

But the fix wasn’t enough. The high hasn’t lasted. You see we’re junkies and now we’re hurting.

The markets recovered less than half of what they had lost. The next day the markets merely hovered. Today the DOW fell – again – by 114 points despite last minute intervention to try to stop it. The buyers lifted it for a few minutes then it fell back like a stone. Why? 114 points isn’t so much. But only days after 750 billion euro fix? Not good.

Are some players getting the jitters that it’s now not just Goldman that is being investigated but Morgan as well?

Or was it the report that retailers haven’t actually seen the much hyped and expected recovery in spending? Retailers are just not making money, because – despite being told over and over again that they should spend, consumer’s are in fact NOT spending.

Or did the news, that Midwest Banc holdings, a 3.2 Billion dollar bank collapsed, remind people of the rising, sewage-filled water level of bank failures?

Or was it the fact that yesterday the US government revealed such a collapse in tax revenue and explosion in spending, that in April alone they had an 86 billion dollar deficit – four times the April 09 deficit.? Some recovery! Perhaps some people had figured out that this catastrophic collapse in tax take was twice what economists surveyed by Reuters had expected?

Or could it be that some people knew this figure was actually a fraction of the truth. As the indefatigable Karl Denninger pointed out over at Tickerforum the real deficit is actually double again the official figure at $176B (Mr Denninger always finds the figures they decided not to include).

One last possibility to offer up. The FED revealed this evening that it had lent 9.2 billion in dollar swaps to European Central banks. This will spook the US because it will make people fear that America is going to get sucked into bailing out Europe and its banks.

I only run through this list to give you a flavour of the wide variety of sign, that all is not exactly peachy.

But why do I say we are done, bar the actual drowning, and that the bail-out is already a failure? Surely not for any of the above reasons? No. The above stuff is to indicate the kind of debris that is starting to scatter and tumble about. You don’t want to be on a steep slope when little stones start to move and things begin to slide about under your feet. It nearly always begins something you do NOT want to be caught in when it moves as a body.

No, my reason is simpler.

The bail-outs so far have relied on flooding greater and greater amounts of ‘liquidity’ – bail out cash – into the markets. Borrowed or printed in has poured in, as an un-stoppable, biblical torrent. This money is debt- and because it is debt, it is literally inexhaustible. Debt can be conjured out of thin air for as long as people believe someone, somewhere will make good on it, at some point. Go beyond that point of belief, of course, and up becomes down, wealth becomes dust and the sun turns blood red in your sky.

With the European bail out I believe we have reached that point. For this simple reason.

So far we have been adding-in something elastically expandable – debt. But now we are trying to take out, something inelastic – cuts to spending. Cutting spending, unlike creating debt, is not elastic, it is finite. There is only so much to cut and to make matters worse you don’t know where the point of anger-ignition is.

We have arrived at the point where, to stop the debt turning to dust, we now have to cut. We have to cut otherwise the market itself will lose faith in the debt it is busy gorging itself on. If that debt turns to ash, the banks will instantly choke and die. So will the markets. This is a dangerous, perilous moment for the banks.

But unlike debt creation, the banks are not masters of this process. They cannot order infinitely expanding cuts the way they have ordered infinitely expanding debt. And THIS, I believe is beginning to dawn on them. You can keep creating debt. You cannot keep creating cuts. Cuts and debts are like particles and waves. Both are real but their qualities and behaviour are quite different.

What if there are not enough cuts? What if the cuts cannot be made. Bankers are not accustomed to resistance in their calculations. It is foreign to them.

While it was debt there was no limit. But now it is cuts. Cuts are part of a material reality the way debt is not. Reality may reassert itself. If it does we are done with this fantasy recovery.