Get ready for the Big Payback(ZT)

5.  The Big Payback

Get ready for the Big Payback. 

• Last week's credit crunch  (Wow, last week! Has it been so long already?)  has set off a worldwide rush for dollarsas banks and fund managers scramble to pay back loans used to buy riskymortgage securities, Bloomberg says.
• Aftera five-year decline that saw the U.S. currency reach its lowest levelin a decade, it has rallied 1.4% against the euro and 1.2% against thepound in the last three trading days, Bloomberg noted.
• Now,isn't the economy in the U.S., led by housing, slowing?  And aren't theFed, and central banks around the world, injecting liquidity?  Soshouldn't that pressure the dollar? 
• Get ready for what the late James Brown referred to as the Big Payback. 
• "I may not know karate, but I know KA-RAZY!!!  Yes we do," Brown stated.
• There are a some things to keep in mind about the dollar under these circumstances. 
• First,increased risk aversion (that is, after all, what we are seeing: banks,lenders becoming risk averse, refusing to lend money under previouscredit terms) actually creates incentivesto save and postpone spending if those who have been borrowing toleverage assets believe those assets will be lower and purchasing powergreater in the future.
• This pattern can be self-reinforcing, which is what the Fed fears the most. 
• A deflationary credit unwind worsens repayment burdens for borrowers, precisely for the reasons Bloomberg's article noted, because the burden of repaying debt increaseswith deflation, and the dollar - because borrowers who want to repaytheir debts must accumulate more of them in order to do so - moveshigher. 
• Debts remainfixed in dollar terms, if you borrow $3 billion, for example, you stillowe $3 billion, but the cost of that $3 billion in dollar terms is nowhigher.
• But can't the Fed cut rates?  Well that's the problem. 
• As former Federal Reserve Chairman Alan Greenspan explained in a 2002 speech,the lower bound on interest rates - the Fed can only cut rates to zero- means that even if debtors are able to refinance loans at a zeronominal interest rate, real rates will likely be still rising (afterall, that's exactly what happens when the dollar begins to appreciatedue to risk aversion and the big payback) and this can cause theirbalance sheets to actually deteriorate further even as they are trying to pay back debt.
• This cycle of risk aversion and decreased time preferences is already playing out in real time. 
• See, for example, Sallie Mae (SLM) facing the fact that investors have suddenly gotten cold feet about their $25.3 billion takeover.
• Risk aversion, decreased time preferences.