Sunday, December 21, 2008


I'm back for one more post. Recent developments are just too significant to be ignored.

Take this Bernie Madoff scandal as an example. Old Bernie has been credited with creating the largest Ponzi scheme in history. Are you kidding me? How can you compare Bernie's puny $50 billion dollar pyramid scheme to the U.S. Government's pyramid scheme involving trillions of dollars?

Since I stopped blogging a few months ago, the total tally for U.S. government bailout funds has gone from roughly $500 billion to over $7 trillion !!!. Essentially the U.S. government has been using its own balance sheet to buy up all of the irresponsible loans from banks and lenders. Add that $7 trillion sum to the existing roughly $10 trillion in Federal government debt and untold trillions of Corporate and Consumer debt and the total debt figure easily climbs north of $50 trillion. Once you add in another $50 trillion for those unfunded liabilities known as Social Security and Medicare and that sum is up to a cool $100 trillion !

The All Important Question
The critical question in all of this, and one that only a few observers seem to be asking themselves, is what will come of all of this debt and how/will it ever be repaid?

The clear and obvious answer of course is that it will never be repaid, simply because the economic fundamentals of the economy are inherently unsound and therefore provide no basis for repayment via normal means (i.e. taxation).

So, that brings up the question of how will the U.S. government eventually get out of repaying all of this money? And to that question, there are only 3 possible answers:

1) Outright default - this means that the U.S. government repudiates its debts and then overnight essentially becomes a third world banana republic. This scenario is highly unlikely however the because the debt is denominated in U.S. dollars, which gives the Fed the option to print our way out of this mess, whereas other banana republics don't usually have that option (e.g. Latin American debts are usually priced in U.S. dollars).

2) Debt monetization (Printing Money) - So far the Federal Reserve has been "sterilizing" all of its bailout operations to prevent outright printing of new currency; however, should the Fed get really desperate, then they could simply credit the U.S. government account with fresh money that could be used to buy back Treasury bonds, hence "printing money".

3) Inflation - This is the most pernicious of mechanisms that can be used to get out of debt. Instead of an overt repudiation of debt, inflation is instead an indirect way of essentially devaluing the dollar such that the debt gets partially repaid but with significantly devalued dollars.

Since option (1) would be politically unthinkable, that leaves options (2) and (3) on the table, and with deflation now spreading inexorably, I believe that the Fed will eventually need to use both options in tandem to relieve the collective debt burden. Monetizing the debt will be the mechanism by which the U.S. government gets itself out of debt. It will also allow Helicoper Ben to make good on his promise of distributing "free" (devalued) money to the masses, which will ultimately generate inflation, hence relieving the consumer debt burden.

How Now Deflation?
So given this recent massive increase in the "money supply", how is it that we could still be heading towards deflation and not inflation? This is the key fundamental question, and one that seems to elude most economists and bloggers. The answer is two-fold. First, as I mentioned above, to date, the Fed has not been printing currency, they have been expanding credit and also sterilizing these operations to prevent outright inflation. The second part of the answer is that contrary to most belief, credit is not "money", credit is debt and whereas in a normally functioning economy the expansion of credit is inflationary, in an asset-impaired economy the expansion of credit has no impact i.e. lenders won't lend and borrowers won't borrow - out of lack of confidence, lack of collateral etc.

Bear in mind that Bernanke is a dedicated Monetarist. He believes in a credit (debt) based economy. He also thinks that he has learned the lessons from the Great Depression and can take steps to avoid the same deflationary spiral. Bernanke and other Monetarists believe that the Fed of the 1930s caused the Depression by allowing the money supply to contract (i.e. as banks failed). However, comparisons between then and now are completely specious, because at that time the U.S. was on the gold standard. That means that the Fed was physically limited to the extent that it could increase the money supply by the amount of gold reserves. So while yes, the Fed did less to expand credit after-the-fact in the 1930s, keep in mind that the money over-supply going into the Great Depression was likewise much more constrained than what we are facing now, due to the disciplines imposed by a Gold standard. Therefore despite Bernanke's interventions, there is no reason to believe that economic fallout from the catastrophe that we are now facing won't be as great or greater than what was faced during the Great Depression.

Careful what you wish for
And of course the Misian pollyannas are out in full force telling us that deflation is not something to be feared but something to be embraced.

Unfortunately, there are actually two types of deflation. There is the "cinderella deflation" that the Noveau Misians speak about, as characterized by responsible fiscal and monetary policy, a fixed money supply (based on the gold standard) and ever-increasing productivity.

Then, there is what I call "Frankenstein" deflation which is precipitated by 30 years' of reckless fiscal/monetary policy leading to out of control debt accumulation; characterized by widespread asset price destruction and precipitating a rapid uncontrolled economic collapse the likes of which not even an Ivory Tower Misian hiding behind 20 foot walls could embrace i.e. "are those the neighbour's kids eating out of my garbage can?".

In short, unless you are an end times Militia freak living in a bunker in Montana surrounded by crates full of M16s and 5.56mm, I don't think it's going to be a fun time...

The Deflationary C(r)ash economy
John Maynard Keynes called it "The Paradox of Thrift". If one person saves his money, he makes himself wealthy. If everyone saves their money, the economy collapses. That paradox which is occurring as we speak, combined with the deflation in the credit markets and the corresponding unwillingness to borrow and lend fully explains why we are heading towards extreme deflation and eventually a cash-based economy. Imagine a cash based economy, where individuals hoard physical cash, because they can't trust their banks and where they are unwilling to borrow to buy consumer durables such as cars, homes, appliances etc. In other words, in a cash economy, economic activity falls drastically and the circulation of money (liquidity) falls correspondingly. That gets us back to options (2) and (3) above, wherein the Fed will get desperate and unleash hyperinflation to get the economy moving again and at the same time de facto wipe out all prior debts (think Weimar Republic, circa 1923). As I indicated above Bernanke won't give up on the credit markets overnight, but once he eventually capitulates and reaches for the nuclear option (printing currency), then all financial assets (stocks, bonds etc.) will be destroyed and the 40 year Class Warfare of Monetary policy will come to its predictable end.

What of this nascent stock market rally?
As I predicted this past August, the stock market had another major leg lower. Despite the fact that I am still extremely bearish in the longer-term, one must bear in mind that markets, being discounting mechanisms, do not fall or rise in a straight line. As I have pointed out here, I believe this market decline is markedly similar in shape and form to the crash of the 1930s. So if in fact we are following a script similar to that of the early 1930s, then we are currently in the retracement rally that started in late 1929 which should see the market lurch unevenly higher back towards the downtrend line at which point it will again rollover and head inexorably down towards oblivion. If you haven't sold your stocks yet, but are looking for a chance to do so, I think you will get the opportunity in the coming weeks/months, however, be realistic about your price target (i.e. S&P 500 between 1000-1050 seems to be a reasonable target)...

And yes, as I predicted several times, volatility did eventually explode to unprecedented levels with this last stock market decline and by all accounts those hedge funds that were net sellers of volatility were in fact decimated. Ironically in this economy, it's going to be hard for these guys to just get their old jobs back at Starbucks...

Despite the fact that gold (@ ~$840) has been holding up better than most markets, it is still lower than the peak of $1000 hit last spring. As I have said many times before, gold will be the ultimate asset to own when attempting to hide from the inevitable hyperinflation, but until we get to that point, and especially as we transition through the "cash economy" phase described above (brief though it may be), then gold will not be a good place to hide. I can't predict exactly what price gold will become a "buy" but I imagine it will be closer to $200 than to $800 where gold resides currently. So, as I see it currently 2-3 year treasuries (e.g. via SHY ETF) are the only safe haven in the short-term, with a longer term eye towards migrating towards gold with a "dollar cost averaging" strategy using wide "scales" (i.e. allowing for a large decline in gold).

The Economy
What of the economy? The eight year Bush Fantasy economy is gone and it's never coming back. The reason I am not optimistic about the future is because we can't solve a problem if policy-makers can't acknowledge the root cause of it. Most economists seem to think that if we bail out the banks, give out some free stimulus checks, change some regulations and wait a few months then we will get back to normal again. Unfortunately, what everyone seems to be overlooking is that this past 30 years hasn't just been a colossal financial disaster, much more importantly it has been a phenomenal economic/industrial disaster as well. As I have pointed out, this country has (in a relatively very brief period of time), outsourced its entire manufacturing, R&D, and engineering base, and all of the associated intellectual capital that goes along with it, to foreign countries. Those millions of manufacturing jobs that went overseas took with them hundreds of years worth of accumulated industrial intellectual capital, turning this country into a front office marketing and finance agency. Once the sound and fury from all of the credit crisis starts to quiet down, then it will finally dawn on everyone that the country's industrial seed corn has been eaten. There is no long-term engine for job creation, as the temporary jobs from the Bush era (mortgage finance, construction, bar tending) will have all long evaporated. In short, decades of greed-motivated industrial arbitrage (aka. outsourcing) has permanently hollowed out and impoverished what once was (and no longer will be) the middle class.

This entire era has been a grand failed experiment in the so-called "Anglo-American" economic model, premised on wide open markets as prescribed by the Ricardian model of comparative advantage and the modern day reincarnation of Supply Side ("Let them eat cake") Economics. Apparently Ricardo didn't envision what would happen when an open trade based nation like the U.S. goes up against dedicated export mercantilists such as Japan and China; however, I am sure he was smart enough to guess the inevitable outcome...