If you listen to bankers and politicians, what we really need right now if for banks to start lending again. Then, all the problems we now see; house prices falling, stock market panics, mass currency movements, will sort themselves out. It might not happen right away, but, they assure us, it will happen. They are wrong, and here's why.



The last few years have seen a commodities boom; indeed, many say we have just seen the first stage in a long-term commodity super-cycle boom that still has 5-10 years to run. The result is that right now everyone is focussed on price inflation, as the cost of food, fuel and raw materials have pushed up the prices we pay in shops.

Yet move away from the headline inflation figures for a moment, and look at asset prices. Shares, bonds, house prices, all of them have been declining in value recently. This makes sense, because when raw material prices rise, companies must charge more for their goods, and so generally sell less, and make less profit.

Yet, as bad as things look, they may get a whole lot worse, all because of de-leveraging. For the past decade, and especially since 2001, easy access to credit has allowed hedge funds, investment banks and property tycoons to buy up huge amount of the world assets with borrowed money, all the while bidding up those assets prices.

As long as money stayed cheap, people could buy more assets, as long as people were still buying assets, prices kept going up and as long as prices kept going up, banks were willing to lend as they could always sell the asset themselves if the borrower failed to pay. It was in fact a giant pyramid scheme that depended on new players coming in and buying the assets from the owners with even more borrowed money.

Now however, the game is over. When house prices stopped rising it was a signal that the scheme had run out of new willing players, and so everyone who owned houses or any of the many bonds or stocks that depended on them, could no longer find someone to sell them to. The resulting crash was predictable, but the real problem was just how dependant banks had become on always being able to find new buyers for their asset-backed bonds.

Now, banks have closed the door on new lending, not just for house buyers, but to hedge funds and other investment vehicles. As a result, there is no-one able to pay the market price for their shares, bonds and other assets. This wouldn't be so much of a problem, but hedge funds must sell assets to meet the now far greater interest payments on their loans, and to return money to investors.

The results of this forced selling have been seen in the recent huge falls of world markets. This isn't individual investors or pension funds selling up, it's over-leveraged mutual funds, hedge funds and investment banks having to sell assets to pay the bills. It's the same for shares, bonds, commodities and even gold. The owners need the cash, so the assets get sold, regardless of fundamentals or price. And it's only going to get worse, as a result of the vicious circle where a fall in asset prices means more cash is needed, leading to more forced selling.

For the small individual investor, things aren't nearly so bad. Eventually asset prices will recover, and assuming you don't trade on margin, no-one can force you to sell at today's low prices. Unless you need to sell in the next few years, now is the time to hang on tight, and get ready to buy once the forced selling abates.