Dodd-Frank reforms not exactly a boost to recovery

With the US economy showing signs of slowing down again as the first stimulus package wears off, commentators are beginning to talk about a second package. One thing is for sure, the Dodd-Frank financial sector reform bill passed into law last week is not a stimulus.

It is of course sensible to restrain the excesses of the US financial system. If only it had been done before the crisis and not after it. Stopping deposit taking banks gambling with their capital is a good thing, so in theory is keeping a better eye on the credit ball.

Negative for growth

But in the bigger picture any restaint on the banking sector comes at a cost in terms of lower credit flow. What else can it mean? And that is not good for growth prospects.

After all what was it that kept the US economy expanding in the 2000s when there should have been a major recession following the dot-com bubble? It was only the flow of credit, and far too much of a good thing as it turned out.

Now turn off those spiggots and where is the growth going to come from? China? You cannot have it both ways and keep the banks under tighter supervision and expect to see the credit flow again to produce another boom anytime soon.

The Federal Reserve knows that and the minutes of the latest Beige Book show it contemplating five to six years as the time required to recover from the recession. The Fed does not say so but that period may well also include a double dip recession with a second period of negative growth.

It is not that bank credit has stopped entirely. That was the nightmare scenario of the financial crisis. But lending is not what it was, and in fact the M3 money supply is already contracting. In the past an M3 contraction predicts a recession with about a six month time delay.

Money supply contracting

Perhaps it will be different this time but the latest manufacturing and confidence data suggests that M3 will be as accurate as ever yet again in predicting a downturn. Prices have also fallen in the US for three months in a row for the first time since the Great Depression.

The investment implications are severe. Global stock markets have moved largely sideways over the past six months with some heady volatility along the way. In mid-May a downward movement began and who knows where or when the bottom will be hit.

All major asset classes except bonds and cash will be dragged down in a major deflation of global asset values. Bubbles like China will burst as its stock market has actually been predicting for over a year. The same thing happened in Dubai in 2006 with the stock market crashing long before the real estate boom imploded.

For investors who want to be brave while others are fearful this will be a lifetime buying opportunity.