Wednesday, January 13, 2010


Looks like the boyz on Wall Street got paid after all. So while the lucky few count their million dollar '09 bonuses compliments of the 2008 tax payer bailout, let us reflect on the year ahead.

One thing that I am continuously amazed by is the general widespread ignorance of history or insight that predominates current thinking about the economy and the ongoing crisis. This is true of the Mainstream Media, the Government and even to much extent the "alternative" (blogosphere) media that seems to have absolutely no consensus on how we got here or what is likely to happen next. As I have stated before, part of the reason for the conflicting viewpoints is purely due to greed and the never-ending desire to find some way to profitably "trade through" this fiasco - be it in gold, stocks, emerging markets etc. Another key reason seems to be that people extrapolate from their own past into the future which precludes them from envisioning any type of economic paradigm shift occurring in their lifetime, regardless of overwhelming facts and data all pointing in that direction. As an example, even Nouriel Roubini who is constantly being derided as "too bearish" and "Dr. Doom" is really not that bearish in the grand scheme of things. He is by no means predicting a deflationary depression or an event that would put in question the Western economic system as we know it. Compared to EWI, Roubini's predictions are outright tame yet both parties often reference the exact same data. Clearly, someone has to be wrong in this equation, and my money for being wrong is on those pseudo-bears (Roubini, Ritholtz, Shedlock etc.) who somehow conclude that one plus one can equal three.

Therefore, in an effort to maintain my own sanity and to prove that the rules of cause and effect have not been permanently suspended, I will elucidate what I believe at this juncture are the plainly evident and immutable facts which will lead to the inevitable if not imminent economic meltdown:

Fact #1: Monetary Policy is a latent catastrophe that has reached its predictable bad ending
The use of Monetary policy to stimulate the economy by encouraging debt accumulation was a stupid fucking idea in the first place and doomed to fail from the very beginning. Thanks to this officially sanctioned Ponzi Scheme, all Western nations are now saddled with enormous debts by all constituents: households, corporations, governments. Still, as evidenced by widespread and increasing foreclosures and bankruptcies, the marginal ability to stimulate the economy by tempting households to take on still more debt has reached its physical limit. The Zero Interest Rate Policy (ZIRP) used between 2001-2003 led to the housing bubble, subprime meltdown and the financial collapse of 2008. Now we witness a renewed preponderance of leveraged speculation, carry-trades and narrowed risk spreads evidencing that the current ZIRP policy will lead to a similar meltdown, only likely much sooner and of MUCH GREATER MAGNITUDE. Moreover, all of the debt-related jobs that were created during the Bush years (construction, mortgage finance) have evaporated, yet the debts accumulated during that period still remain. So, this time around the Bernanke Fed has all it can do to stimulate the economy in the short-term let alone pretending to create a sustainable economy in the longer-term.

Careful what you ask for: The reason why the Monetary Policy Ponzi Scheme was able to become the largest Ponzi Scheme in world history, is because the U.S. dollar is the reserve currency. It's every central banker's and politician's dream to control a reserve currency, because then they can collect seigniorage which is a fancy term meaning revenue derived by printing money. Government is the primary beneficiary of seigniorage, because it takes time for prices to adjust to the new level of money supply i.e. those parties closest to the printing press benefit while the majority at large suffer the effects of inflation. And while seigniorage seemed like a good idea at the time, maintaining the U.S. dollar as reserve currency allowed U.S. policy-makers to ignore the growing fiscal, monetary and trade imbalances to the point that they have grown to totally uncontrollable and lethal proportions, where they are right now. In other nations this could never happen. In Canada during the early 1990s, that government was forced to adopt austerity measures to defend the C$ which was losing substantial value due to concerns over the sovereign debt load. By contrast in the U.S., China and Japan have been more than willing to finance the trade imbalances and inevitable debt build-up to keep the dollar relatively stable and thereby give U.S. policy-makers the cover they needed to bankrupt their nation. What did China and Japan get in return for their inevitably worthless US dollar reserves? They got the majority of the U.S. manufacturing base and all of the related R&D and intellectual capital that goes along with it.

Fact #2: Fiscal (Keynesian) policy has been overused and is no longer effective
In Econ 101 we learned that Fiscal policy (government deficit spending) is intended to provide a source of counter-cyclical demand to mitigate reduced private sector demand during a recession, thereby reducing unemployment and keeping businesses solvent. No, it was not intended as a funding source for wars of misadventure nor to buy votes during elections. In addition, common-sense dictates that a nation must run surpluses during expansions to offset the deficits accumulated during recessions and thereby keep debt levels manageable. However, since Reagan took office with his gang of Neocons and Supply-side Fucktards, the U.S. has run deficits non-stop throughout recessions and expansions (except for a few of the Clinton years). Not surprisingly, now that the U.S. really needs a fiscal stimulus, the marginal impact of fiscal stimulus is substantially muted by the continuous deficits which have become baselined into GDP i.e. the 3% drop in GDP experienced in 2009 occurred despite Bush's $400 billion war deficit which was carried forward from 2008!!! So the Obama Administration was left to dig a hole within a hole in order to keep the economy out of depression in 2009. This is how $2 trillion dollar deficits occur. In addition, the accumulated debt and debt service costs are another source of permanent drag on the economy as money spent on debt service does not boost the economy. Of course there are all sorts of disinformers out there now saying that Fiscal (Keynesian) policy does not work at all (and never did), which is a lot like taking antibiotics for 30 years straight and then declaring that they don't work.

Fact #3: Reported GDP has been massively inflated
All of the approximately $50 trillion of actual debt that has been accumulated by households, corporations and government AND the money raided from social security and medicare has massively inflated recent years' GDP to an overall tune of around $100 trillion in total liabilities. With annual GDP of around $13 trillion, that gives an idea of the extent to which all of the debt and borrowing from the future has inflated past years' GDP. Clearly the "gap" between the GDP we have become accustomed to and long-term sustainable GDP is enormous. More to the point, once the credit deleveraging cycle goes into high gear, that gap is going to get closed rapidly, causing severe economic "dislocations". Many people underestimate the impact of raiding Social Security and Medicare, but its a lot like losing your job, taking a part time job, and then raiding your 401k retirement plan to prop up your lifestyle. It seems like a good idea at the time...

Fact #4: The U.S. outsourced its manufacturing base and ate its seed corn
One of the dislocations that will be caused by the GDP gap getting closed, will be the need to rebuild the economy from the ground up and to create new industries and real jobs that last longer than one election cycle. Unfortunately much of the U.S. manufacturing sector and its associated managerial skill base, R&D capability, engineering mind-share, and intellectual property has been outsourced or retired. This is the biggest tragedy of the past 30 years - that one generation could literally sell-off an entire nation's collective intellectual and manufacturing capital that took hundreds of years and tremendous amounts of hard work and determination to build. This fire sale was an inevitable consequence of a nation too lazy and greedy to confront its declining global competitiveness and a declining standard of living. In fact, most Americans did face reality through their stagnant wages, foreclosed homes and recurring job losses; however, the 20% or so of Americans who own and run the U.S. opted to trade the entire manufacturing sector for a 30 year consumption binge that in the final accounting will leave nothing left to show for it.

Suffice to say, the days of the multinational reaping massive profits by building toys in Asia for $2 and selling them in the U.S. for $30 are soon-to-be-over. This entire strategy was supported by a global vendor-take-back financing scheme in which the Chinese were willing to recycle their profits back to U.S. consumers to borrow to buy more junk.

Fact #5: Likelihood of inflation extremely remote if not impossible
Those who are betting on inflation, apparently do not understand how money is created under the current system. Money is created when the Federal Reserve lends money to the banks who in turn lend to consumers and businesses. However, at this juncture most banks are in survival mode, using operating profits to offset relentless loan losses that are bleeding their balance sheets. So the banks as a whole cannot take any additional loan losses and therefore are in capital preservation mode. On the other side of the coin, most borrowers are already underwater on their mortgages and consumer loans and/or have impaired credit ratings, so the demand for new loans is extremely low, except by those who have impaired credit ratings and can't get approved anyway. All indicators show that reserves at banks are piling up instead of being lent, so the likelihood of expanding the money supply is extremely remote, making the prospect for sustained inflation likewise remote. Back in the 1970s when inflation took off, overall debt levels were low and the U.S. labour market was relatively rigid - prior to the advent of widespread outsourcing. Today, circumstances are the exact opposite, debt levels are at a historic extreme and labour markets are wide open. Domestic labour is under constant deflationary pressures from outsourcing and foreign import competitors.

Ironically, we have already been through 100 years of inflation and the dollar has lost 95% of its value since 1913, so those holding out for hyperinflation remind me of a man in the middle of the ocean looking for water. Considering that price inflation is dependent upon further credit expansion, the bet now is whether the credit bubble will keep growing or burst. I am clearly in the ready-to-burst camp and we all know that when a bubble bursts it does not get bigger it gets a whole lot smaller.

Fact #6: Hyper-Deflation is likely imminent
A final bursting of the credit bubble is likely imminent at this point, as the system is very fragile and the Fed can only keep so many balls in the air at one time. The collapse will be precipitated by a sudden loss of confidence in the financial markets and a stampede away from risky assets. As I have mentioned before, there are many potential catalysts for a near-term panic, but the largest one is the threat of sovereign debt default and an associated currency crisis which would start in one corner of the globe and quickly spread worldwide. Once that happens, credit will be withdrawn from the markets, risky financial assets will fall, demand will collapse, prices will deflate, profits will deflate, unemployment will rise, loan defaults will rise, more credit will be withdrawn - i.e. it will be an inexorable downward spiral. And prices won't be cheaper as in "hey, let's go buy a new computer" cheaper. Prices will cheaper be as in "hey, I don't have a job and can barely afford to eat" cheaper. At that point, it will become painfully clear just how far ALL prices for all goods, services and assets have been overinflated by the Monetary Ponzi scheme, as there will be way too little money chasing way too many goods.

This deflationary collapse will usher in the era of the cash-only economy in which everyone will trust only physical cash even though it still won't be backed by anything tangible such as gold. It's not clear how long this next phase will last as there will be many cross-currents and severe geopolitical dislocations to occupy policy-makers. Also, expect that the Federal Reserve's role and powers will be modified if not curtailed entirely which will only greatly exacerbate the crisis. As always, human beings will do the exact wrong things at the wrong time in over-reacting to the crisis, which will only make the crisis a lot worse.

In summary, all talk of economic recovery and the end of the recession is totally premature and unfounded. That the "best" and "brightest" minds of the day have all been fooled into thinking that the worst part of the crisis has passed is beyond staggering. When one considers the basic facts I laid out above, along with the key fact that we are now applying the same monetary and fiscal "fix" that actually created the problems in the first place then the truth is self-evident. As they say, you can't patch a dam with water, yet here we are trying to solve a debt problem by encouraging more borrowing. How many times do we have to see this movie before we remember the ending? Even in the just the past 10 years, we had the Nasdaq/dotcom bubble and crash, the housing bubble/crash, the commodity bubble/crash (remember oil at $150?), the 2008 subprime/Lehman clusterfuck/crash and now here we go again thinking this time it will be different. One can only conclude that we are due for one hell of a hard lesson that won't soon be forgotten.

Yes, you should hope that I am wrong about all of this.....but don't count on it.