Are Bonds in a "Bubble"?

The latest widespread investment thesis is that bonds (fixed income) are in a bubble similar to the Nasdaq stock market in 2000 or commodities in 2007 i.e. an unsustainable price level that sooner or later will collapse.

First off, to lump all fixed income investments together as "bonds" is asinine and reveals an oversimplified bias among the pundits who hold this view. There are a large number of professional investors and amateurs actively shorting the U.S. Treasury market which *may* bias their viewpoint...

Different kinds of bonds

Bonds are delineated based on their level of risk. The "risk free" rate is defined as short-term U.S. Treasury bills (30,60,90 day) which are deemed essentially the closest electronic equivalent to cash (i.e. paper currency). Out from there, you have various maturities of Federal Government bonds up to 30 years. These bonds are deemed equally safe from a default standpoint, however, these carry duration risk also known as purchasing power risk - the risk that inflation (prices) will increase, causing the value of the bond to be reduced and inducing a capital loss. The longer the term of the bond, the more volatile the price, so 30 year bonds are much more volatile than 2 year bonds.

Meanwhile "spread product" are fixed income investments that are deemed to carry default risk, hence they typically have yields that are above Treasury yields of a similar duration hence they have a risk premium aka. "spread" over Treasuries. Spread products include Corporate bonds (both investment grade and junk bonds), Municipal bonds and Mortgage Backed Securities (MBS). To the extent that these risk spreads have been narrowing substantially over the past year, one could argue that "spread products" are in fact overvalued relative to their historic spreads over Treasuries.

This is all very academic, so far. So here is my take on things:

1) Most/all risk bonds (Corporates, Munis, MBS) ARE overvalued although I would not call it a speculative bubble, since investors are hardly frothing at the mouth when envisioning yields of 4% on their bond portfolios i.e. there is no comparison here to the Nasdaq in 2000. The reason, I believe, that these types of bonds are overvalued is because investors are shunning risk after a decade of losses from stocks, housing, commodities and therefore seeking return of capital vs. return on capital. Meanwhile, exacerbating the situation is that the average investor does not fully understand the risk apparent to these types of investments and/or may not have access to Treasury-only investments. Many company 401k (retirement) plans have very limited investment options and offer some sort of "fixed income" option that usually includes a blend of Treasuries, Corporates, Munis and MBSs. Based on my own anecdotal experience at several companies, I doubt the average retirement plan investor has access to a pure Treasury-only bond fund.

Worse yet, many retirement funds offer an enticingly safe "Money market" fund, which we have all been led to believe are cash-like investments. Here again, however, these are short-term funds that typically include a blend of Corporate and Treasury short-term bills. Back in 2008 there was a great panic over the fact that several of these "money market" funds lost money ("broke the buck") wherein the Net Asset Value (NAV) of the fund fell below the benchmark $1/share. The Federal Government stepped in to insure money market funds, to avoid panic withdrawals, however this program had limited funding and has now since expired.

To the extent that these Spread/Risk bonds are overvalued, I still think that these investments are much safer than stocks and commodities; however, in the type of deflationary collapse that I am envisioning, losses on a typical blended "fixed income" fund could exceed 50% depending on the blend of bonds in the portfolio (Treasuries v.s. risk bonds).

Are Treasuries in a Bubble?

When pundits pose the question are bonds in a bubble, they are usually referring specifically to Treasuries, which as we know have been skyrocketing in price of late (yields falling). The answer to this question is again subjective, and depends on whether or not one believes we are heading for pervasive economic/price deflation. During Japan's deflation of the past 20 years, Japanese Government 10-year bonds yields have dipped below 1% several times. By comparison, the U.S. 10-year bond currently yields 2.65% so there is potentially still a lot of room to fall. What about the massive U.S. fiscal deficit and Quantitative Easing (QE)? Here again, it's a question of timing and sequence of events. If Japanese Government bonds can yield less than 1% despite the Japanese debt being ~ 200% of GDP, then surely U.S. Government bonds could hit the same level given that U.S. public debt is "only" ~100% of GDP (depending on whose figures you use...). Meanwhile inflation is quiescent and trending down, despite QE round 1. In addition, in a flight to quality scenario we should expect the dollar to strengthen (as it did in 2008 and has been recently) and institutional investors to invest those dollar inflows into Treasuries.

Some (EWI and others) argue that it's better to invest in short-term Treasuries v.s. long-term due to price volatility inherent in the latter. I personally think a mix is appropriate, because similar to 2008, yields on short-term Treasuries are now approaching 0% and therefore those seeking refuge in the short end of the curve will soon have the distinct pleasure of paying the Government to borrow your money - i.e. rollover risk. This EWI notion that prices (inflation) will crater, the dollar will soar, but long-term Treasury yields will rise is totally speculative and ignores the direct causal connection between dollar inflows and Treasury prices. Contrary to some belief, taking $400 cash increments from an ATM machine is not an institutional option i.e. there is no other "low risk"/highly liquid option for someone moving billions of dollars around.

In addition, institutional investors who are paid based on performance tend not to invest in non-yielding/negative yielding investments...go figure.

Ultimately, whether or not one deems Treasuries to be a "safe haven" depends on your inflationary/deflationary outlook and also the risk of the U.S. Government outright defaulting on its debt in the near-term (2-3 year) time period. I think given the proven propensity for the Federal Reserve to outright buy Treasury debt (Quanititative Easing), then the chance of default is de minimis, as all of the debt is denominated in dollars and the Fed owns the printing press. More to the point, what is the alternative? Gold perhaps is an alternative, if you believe gold prices will hold up through extreme price deflation i.e. for gold to hold its value against dollars it would actually be gaining in value relative to other commodities/assets, since in deflation by definition, the dollar would be gaining in value. I am not betting on it, but that could happen, so some amount of gold is always advisable. Another option may be Swiss Francs, however that country's banks have huge exposure to loans made to Eastern European countries.

The vast majority of ALL other types of financial assets regardless of which country, pose EXTREME LEVELS of counter-party default risk in a deflationary depression.

The other day, Jeremy Siegel, Professor of Finance at Wharton was on CNBC debating this "Are Bonds in a Bubble" issue with Tony Crescenzi of Pimco. At one point, Siegel said the dumbest and most astounding thing I have heard anyone say in the longest time, let alone a Professor of Finance. He said that investors who buy bond funds (v.s. individual bonds) in a rising interest rate environment lock in their losses permanently, because the bond fund is constantly rolling over its maturing investments i.e. the reason you buy a bond fund in the first place. Uh, repeat that please? Professor of what? The sins of stupidity here are many: First off, he didn't bother to mention that the bond fund would be rolling over at ever-higher rates of return which is what you would presumably want to do with your money as interest rates rise. Secondly, he never mentioned that ALL financial assets tend to do poorly in a high inflation environment (to wit stocks in the 1970s). Thirdly, as Tony Crescenzi all too meakly pointed out, these are mark to market investments that trade every day i.e. no one is forcing you to hold these investments forever. If you believe that interest rates are rising, then SELL NOW (i.e. reduce your duration)! His greatest failure however, especially as a Professor of Finance, was to not factor in purchasing power and opportunity cost risk, because while it's technically true that an investor who holds individual bonds (as an alternative to a bond fund) through maturity never has to realize a capital loss, so what? Garnering a 2% return for 30 years straight implies huge loss of purchasing power when the market return is 20% and inflation is running at 18%.

For those who want to protect their assets via Treasuries, the easiest way is to buy a Treasury bond mutual fund or buy the Treasury ETFs in a brokerage account. If your 401k retirement account does not offer a Treasury bond fund, then you may be able to use a "self-directed" account to buy the Treasury ETFs below. If none of these options is available, then you are still better off parked in a Money Market fund and pray Uncle Sam reinstates the insurance plan from 2008, when the shit hits the fan.

The Treasury ETFs:

SHY: 1-3 year maturities
IEI: 3-7 year (probably the best compromise between long and short-term)
IEF: 7-10 year
TLT: 20+ year (most volatile/speculative, but most upside if yields fall)

Deflation...Redux

The specter of deflation is creeping back into the collective consciousness. I just noticed three separate articles on Yahoo discussing the various impacts of deflation on the economy. This is all right on time, because similar to 2008 pre-Lehman, the stock market has come off a retracement high, shuffled sideways for the past 3 months and should now be ready to fall off the next cliff. So, this renewed preoccupation with deflation evidences a psychological shift in mentality from reflation back to contraction, indicating we are fast approaching the next point of recognition, as it finally dawns on everyone that we are headed for a "double dip" of historic magnitude.

Price Deflation
The concept of (price) deflation is not as simple or complex as most people seem to think it is. The fact is that few of us (except my 93 year-old grandmother and others her age) have ever experienced a sustained price deflation. In order to have a sustained price deflation across ALL asset categories at the same time, requires a decrease in the supply of money. Likewise, in order to have a sustained price inflation across the board requires an increase in the supply of money. By contrast, when the price of oil goes up because the Saudis have embargoed oil exports as occurred in 1974, that in itself is not a cause of inflation (assuming no change to money supply), because the extra money used to purchase oil draws down demand from other sectors of the economy and hence lowers prices elsewhere.

Fanatical Libertarians tell us that there is nothing wrong with deflation and that all of the media hype around deflation is simply scare-mongering. Well, unfortunately these Libertarians are fantasizing about supply-side deflation resulting from a fixed money supply and increasing production efficiencies. Whereas, the type of deflation we are about to experience is a demand-side deflation wherein the price of everything drops simultaneously because there is no demand (aka. purchasing power), and where businesses go bankrupt en masse because they can't meet their fixed costs. This leads to mass unemployment and personal bankruptcy as jobs are lost, asset (home prices) crater, all the while debts (mortgages etc.) remain contractually fixed in value i.e. payments stay the same.

Credit deflation
As indicated above, credit deflation axiomatically leads to demand-side price deflation simply because there are too few dollars chasing too many goods. And despite all of the yammering and hand wringing over hyper-inflation, the Fed's unprecedented monetization of debt (~$3 trillion) has failed to yield economic reflation let alone price inflation. Credit deflation is all but inevitable now because there still exist record levels of debt (~ 4x GDP) and the renewed slowing of the economy will bring about a chain reaction of delinquencies and bankruptcies.

Just this week, the Fed announced that it is considering another round of quantitive easing (buying of debt) as a mechanism for further easing credit markets. This is an act of desperation, since the first round of debt monetization did not work, so what makes them believe this time will be different? As long as borrowers are insolvent and unable to borrow and lenders are ever-more cautious, then adding more cheap money to the pile of existing cheap money means banks will just buy up more financial assets (stocks, bonds etc.) sending yields even lower and making the inevitable market crash that much worse.

More to the point, as I explained previously here the money supply, which consists primarily of credit (loans) and to a much lesser extent currency (cash), is a giant Ponzi Scheme all of its own. And when it inevitably unwinds, it will collapse like a cheap tent at a rate that even Fed monetizing couldn't possibly offset, as there is over $50 trillion in credit outstanding (not to say that it will ALL go into default, but the largest part eventually will in my opinion).

Then there are those who believe that all of this debt is not an issue because it's largely money "we owe to ourselves" i.e. American lenders. Despite the trillions in U.S. debt owned by foreigners, it's actually true that most is held here in the U.S., to which I say "so what?" This "owe it to ourselves" argument is illustrative of the type of disinformation now commonplace in the Idiocracy. Simple reasoning shows why...

Let's say I borrow $20,000 from you - thanks buddy ! Then a year from now I've lost my job, declared bankruptcy, and unfortunately you lose the entire loan because I spent every last dime. What happens? According to the "we owe it to ourselves" morons, nothing happens - case closed. Umm, except, here is what happens in the real world: First off, I am bankrupt, so I am shut out of the credit markets - can't get a loan/credit card and my spending drops to nil. Second, the $20k of your money I spent last year was a one shot deal, so GDP was boosted by $20k last year but this year drops by that amount (think of this in the aggregate). Meanwhile, I liquidated your savings, so you too are piss broke, won't/can't spend (due to the reverse wealth effect), have lost confidence in the credit markets and are now hiding what is left of your money in the safest place possible i.e. buried in the forest. That in a nutshell is credit deflation.

The more you think about it, the more you realize it would actually be better to have all of U.S. debt owned by foreigners so that we could leave them holding the bag and not experience the adverse impacts of the reverse wealth effect. Yes, the U.S. dollar would fall relative to other currencies (although all nations will be doing their best to debase their currencies as well), but a lower U.S. dollar would: (1) improve the trade deficit (2) put China out of business (3) put WalMart out of business...i.e. the trifecta !!!

Monetary Policy No Longer Working
As I have said before, monetary policy is no longer working. Fiddle fucking with the price of money only causes the misallocation of capital and does not lead to a long term increase in economic production. It creates perpetual boom and bust cycles, and these latest grand attempts by Greenspan and Bernanke to "smoothe" the economic cycle by side-stepping recessions with ever more monetary "stimulus" just means this bust cycle will be the Mother of All Clusterfucks.

What Now?
The fact that the Fed is once again considering quantitative easing (debt monetization) emboldens my willingness to own Treasury debt of various maturities as I described here , because it's always nice to know that the Federal Reserve is the buyer of last resort for your primary assets.

In addition, until foreigners find an alternative safe haven for their trillions in assets, the dollar and hence Treasuries will continue to be the safe haven of choice and everyone can pretend for a little while longer that we are not borrowing to pay interest on prior borrowing (aka. ponzi borrowing). When we get through this deflation cycle, that will be a different story. As I've said, when you start getting a pack of crisp new $100s in the mail from the U.S. government each and every month (e.g. "Stimulus v6.0" or something like that) , then it's time to worry about inflation....

The Rich Karlgaard Collapse

I hereby dub this next leg of the ongoing economic collapse as the "Rich Karlgaard collapse". I didn't even know who this guy was until I read about him on Barry Ritholtz's blog. Apparently Rich is an editor at Forbes.

Recently, he (Rich) went on this diatribe against Robert Prechter and all of us so-called "perma-bears". As is typical of most Lamestream media articles these days it was a vacuous piece that focused on a select few data points while totally ignoring the much broader picture and the much more salient facts such as overall debt levels, failed policy response etc. So, just for fun I dissected his piece to show how ludicrous and denialistic the consensus opinion is at this juncture.

So, according to Karlgaard, Prechter is wrong because:

1) He (Prechter) wants to be like Roubini...

Yes, apparently we all want to be constantly derided University Professors wearing Hush Puppies and speaking in foreign accents while Joe ("the troglodyte") Kernan laughs at us...

2) "Americans love debt"...

I couldn't come up with a suitable rejoinder for a statement this stupid

3) I, Karlgaard, predicted Dow 18,000...

Yet the stock market has gone nowhere for 12 years and Treasury Bills (let alone bonds) have outperformed stocks. Dow today? 10,200.

4) "I've given up on formulas and models"...

Right, we get that Rich, now you rely on "interviewing" (on the golf course, no doubt), data mining recent historical trends, and plain old fashioned wishful thinking...good strategy.

5) Interviewing is the way to go. I have interviewed a thousand other Baby Boomers and despite the fact that things are not great now, they are bound to get better any minute now. That's the way it's always been since 1968 and the Democratic Convention...Whoa, sorry, flashback !

Since Rich tells us he is a student of history (his version at least), here's an overwhelming historical fact: no country in the history of the planet has borrowed its way to prosperity......and guess what, the U.S. will not be the first.

6) We are like Japan...

Except different in every way i.e. the rest of the world cannot bail us out while we are going through the death throes of deflation...We (the U.S.) are not a primarily export-based nation, like Japan, duh !!! and the rest of the world relies (25%) on our consumption...

7) I, Karlgaard, like Barry Ritholtz and Doug Kass because they think like me and therefore reinforce my overwhelming need to believe that the future will be just like the past. I also would like some Google links into their sites, which I just got.

I was going to call this the Kass collapse for that other smug disinformer, but thanks to his timely article Karlgaard got the honour.

The basic overall theme here is that 'ol Rich can't look into the abyss because it's "too scary". I hear this all the time, that the economy can't get worse because that would be really bad. Ralph Acampora just said the exact same thing in the NY Times Article here:

“I don’t want to agree with him, because if he’s right, we’ve basically got to go to the mountains with a gun and some soup cans, because it’s all over.”

So, let's get to the heart of the denialism movement, 50,000 plus children worldwide die every day because we can't come up with a few dollars worth of food and medicine, but the Baby Boomer generation can't face life without Sauvignon Blanc.

Sorry folks, largely owing to the likes of Rich Karlgaard and his comfort-seeking brethren, we are going down again (much) sooner than one would like to think. Those who do not acknowledge or comprehend the overwhelmingly deflationary forces that are gathering at this point in time, do not understand the credit-based monetary system, economics, or even basic math, which unfortunately describes the vast majority of economic commentators at this juncture. Until you get a package of hundred dollar bills in the mail from Helicopter Ben Bernanke, any fears of inflation and indeed fantasies around reflation, are totally unfounded.

Back At the Precipice

Like groundhog day, the U.S. and other Western economies are once again at the edge of the economic precipice. The nascent economic recovery is stalling out only 9 months since Bernanke declared the "end of the recession". Of course, for those 10% officially unemployed (17% when you include people who have given up on finding employment), the recession never ended. Wall Street as usual is in total denial, because the average expansion since WWII has lasted 40 months, so the piggies are not yet ready to leave the trough this early in the cycle when the consensus is that "there must be" more of that free money left in the Bernanke monetary punch bowl. Won't they be surprised.

Bear in mind that this depressionary relapse is occurring despite policy-makers having applied unprecedented levels of stimulus, both fiscal and monetary. The Federal deficit this year is 10% of GDP (~$1.5 trillion), which means that the Federal government has to borrow 30 cents for every dollar it spends just to propagate the illusion of recovery !!! That is a staggering fact: 10% unemployment despite a 10% of GDP deficit. And yet there are two moronic camps that keep arguing one on the side for more fiscal stimulus and the other on the side for fiscal austerity. These are like two fat bald men fighting over a comb on the deck of the Titanic. The mere fact that the economy is stalling out, despite a 10% GDP deficit means that fiscal stimulus at the margin is no longer working, because it has been overused. This chart below shows the marginal growth effect on GDP from an additional $1 of debt - it's now less than $.20 on the dollar ! Game over, man !

On the other hand, contrary to the tax-fearing "Tea Baggers", none of this money is EVER going to be repaid anyway, since basic math indicates we would need to grow the economy by 30% (assuming no changes to tax rates) just to eliminate the deficit, to say nothing of paying down the additional trillions in debt that will accumulate in the meantime.

So, despite and because of the Federal Reserve giving out free money at 0% and the Federal Government borrowing a third of its annual budget, policy-makers are now completely out of ammo. Even as fresh signs of renewed downturn abound, in the recent horrendous housing numbers, pathetic employment figures, and leading economic indicators , which are all pointing down.

But you don't need fancy data to tell you the economy is slowing. Just today, the yield on the 10-year Treasury bond reached 3.11%, a level it has only touched twice since 1962 ! i.e. bond markets which are usually concerned with inflation are signaling that fear of inflation has left the building. In line with that sentiment, Bill Gross from Pimco (world's largest fixed income management firm) speaking on CNBC admonished the Fed to state that they will keep interest rates exceptionally low for an "exceptionally long" period of time i.e. keep the free money flowing and love me long time Sugar Daddy. No conflict of interest there at PimpCo.

Meanwhile, those few economists lucid enough to even consider a "double dip" recession are just rearranging deck chairs on the fat man's Titanic. Sure, unlike the rest of their irretrievably clueless brethren, they at least have a latent sense of impending downturn, and yet these few are still too conventional in their thinking to realize that the economic ship is already keeled over at 90 degrees and getting set to sink inexorably to the bottom.

And that is the state of the U.S. economy. Hard to imagine that Europe is as bad or worse. Several well known European countries are on the verge of sovereign debt default and one does not have to be a genius to figure out that it will only take one default to fell the others like dominoes. All of these countries (as does the U.S.) rely on well-functioning credit markets to rollover their debts on an ongoing basis. Once risk aversion sets in and interest rates rise beyond a certain point, then default becomes inevitable as the deficit/debt service burden becomes too large and unmanageable. As stated before, it's only because the U.S. dollar is the world's reserve currency and hence the only viable safe haven from a liquidity standpoint, that allows the U.S. government to pursue the profligate path versus the austerity path being forced on Europe. Of course at some point, the U.S. government debt ponzi will collapse as well, when investors repudiate U.S. debt and the dollar, but that will likely be *some time* down the road closer to the end of the deflationary cycle that is still just getting underway.

For those looking to protect their assets through the deflationary cycle, here is what I recommend. And yes, TLT (long-dated Treasuries) are still outperforming well. Even Pimco recently got back onboard the Treasury wagon.

[FYI, for more insight on deflation, Robert Prechter (EWI) recently gave an excellent interview for the web site "The Daily Crux" which you can read for free here]

Drill, Drill, Drill

Owing to this horrifying BP oil spill, it is now blatantly obvious to all but the thickest observers that America's addiction to oil is the greatest threat facing this country now and in the future. America has sold its soul to the oil industry and the end-game is now unfolding. What was once a secure source of energy that enabled economic growth and progress has now become a massive ball and chain that will severely inhibit all economies rigidly tied to fossil fuel infrastructure.

The threats are overwhelming, with clear linkages between the environment, the economy and national security, three areas that one would think are high priorities to policy-makers. And yet, like the 800 pound gorilla in the room, policy-makers of all stripes still walk on egg shells around the slimy oil industry, even as it sponsors global warming disinformation and fights tooth and nail for more drilling rights in the gulf, not withstanding the current environmental fiasco. Obama now looks like a total fool for having opened new areas to offshore drilling just 3 weeks before this catastrophe started, no doubt alienating a big part of his political base. Meanwhile industry tools Bobby Jindal (Governor of Louisiana) and Louisiana Congressman Charles Boustany are bent hard over opposing Obama's 6-month drilling ban which was intended to give time to investigate the root cause of the oil spill and take corrective action. It's mind boggling that these shills can't see taking 6 months to figure out what happened and how to prevent the same in the future, even as their state's fishing and tourism industries are in the process of being wiped out.

This gulf oil spill disaster is just the latest reminder that the industry as a whole is taking on greater and greater risks in its quest for oil. Rigs are operating at extreme depths using unproven methods without adequate safeguards. All appropriate regulations have been bypassed, as the necessary regulatory agencies were greased up front, assuring swift approval without adequate (any) environmental review. Speaking to an environmental attorney this past weekend, he told me that all of these deep sea rigs were approved on the premise that they posed de minimis environmental risks ! i.e. the lowest level of environmental review was required, basically a rubber stamp.

And if you think this BP gulf spill is bad, clearly this is just business as usual for the oil industry pigs who have left their greasy hoof print in every corner of the globe.

Hurricane Body Blow

Those cruel gods of reality have found a most direct way of punishing the U.S. for its oil addiction. It's a hard fact that the average hurricane is now 50% stronger than it was 40 years ago, and worse yet the occurrence of deadly category 4 and category 5 hurricanes has also increased proportionally. Although, oil industry apologists and everyday morons still deny the linkage between burning fossil fuels and environmental catastrophe, these are the types of people who will deny anything that is not in their own immediate self-interest. They are like a a 400 lb fat man who can't get out of his own way and needs every ounce of energy just to get back into the buffet line.

As for the legitimate scientific community, there is now overwhelming scientific agreement on anthropogenic (manmade) climate change. Even the American Association of Petroleum Geologists has recently shifted stance to a new "non-committal" statement, although also (finally) admitting:

"Climate change is peripheral at best to our science…. AAPG does not have credibility in that field…….and as a group we have no particular knowledge of global atmospheric geophysics".

Oh right, now they tell us, I wouldn't trust these corrupt house boys to tell me the time of day.

Back to the key point, this season NOAA expects 8-14 major hurricanes, which would make it one of the deadliest seasons ever recorded. It's not hard to predict that the growing ubiquity of these deadly hurricanes is going to eventually decimate a majority of gulf coast and Atlantic seaboard communities, causing widespread economic dislocation.

Between oil spills, rising sea levels, deforestation, desertification, droughts and recurring Katrina's, the credibility of the oil industry and its copious disinformers will eventually be lower than Wall Street's. Unfortunately that day will likely come at a time when it will be far too late to do anything of consequence about the problem. Suffice to say that by the time there is political consensus on global warming and the need for immediate action, there will be a lot of bodies buried.

The other blood-stained aspect of this oil soaked faustian bargain we have entered into, is this oil-for-souls economic/military "strategy" that has grown out of control in the Middle East. Apparently squandering hundreds of billions in oil payments to the Saudis, Iranians, Kuwaitis and other corrupt Middle Eastern regimes has not been a great idea. Come to find out, some of the hundreds of billions we gave them, was not just used to prop up puppet governments and corrupt potentates, but it also found its way into the hands of dozens if not hundreds of terrorist groups. Using armed coercion to keep these same terrorist malcontents at bay in the region hasn't been working out great either. These costly, never-ending wars in Afghanistan and Iraq have simply further hollowed out, destroyed, and otherwise destabilized those failed states which will no doubt become renewed hot beds for terrorist activism when the U.S. inevitably pulls out. That will leave the region with two very unstable and hostile nuclear armed regimes in Iran and Pakistan, augmented by two or more totally failed and anarchic states (Iraq, Afghanistan, Yemen etc.) that can be used as training bases. Essentially, it will be a nuclear-armed insane asylum, having a major axe to grind with the West and the U.S. in particular. Meanwhile, from an economic perspective, along with outsourcing, this entire oil import strategy has contributed to the total depletion of the economy and left the U.S. imminently dependent upon the generosity of foreigners for day-to-day funding and rollover of debt.

And yet, for all that, the U.S. is the only major developed nation that still does not have a basic consumption tax on oil, therefore we are essentially subsidizing the entire oil industry with all of its environmental "side-effects" on top of subsidizing the entire Middle Eastern terrorist complex.

Idiocracy Realized

Ayn Rand would be proud. These past 50 years have been an unprecedented orgy of consumption and self-interest that would make even her blush. Granted, the economy has devolved into a Frankenstein's monster of crony capitalism with a dash of pseudo-socialism. Unfortunately the system of "pure capitalism" that she envisioned currently only exists in Milton Friedman's text books and in those parts of Latin America where it wiped out entire economies and impoverished millions. Here in America, we will get there, but these things take a bit of time.

She would be pleased to see Wall Street firms back at work, following a (very) brief hiatus, busily securitizing and liquidating the country. She would nod approvingly at a growing gap between rich and poor now back to historic levels last seen in the 1920s - further proof that altruism is indeed dead and long buried. She would note the 3 billion plus people across the globe living on less than $1/day and the 50k+ children dying each day for want of a few dollars of food and medicine. She would give a nod to our fortitude to allow these indolents to suffer the inevitable consequences of their laziness and inefficiencies.

She would highly approve of the populist tea party movement enthusiastically railing against its own interests and the "profligacy" of the current Administration, not withstanding the 30 previous years of squandered resources and deficits. Talk about closing the barn door after the horses are out. I cannot fathom the average individual taking to the street to oppose the extension of health care benefits to the unemployed, yet implicitly supporting tax cuts for the ultra wealthy, copious handouts for the Beltway bandits, troops in 140 countries, 18 aircraft carrier groups and 2 totally pointless wars. Go figure.

I also can't reconcile those who seemingly profess a belief in Judeo-Christian values while enthusiastically embracing Ayn Rand's decadent ideology of "rational self-interest". After all, Ayn Rand considered altruism to be immoral, thereby not only bastardizing the term "moral", but also taking a diametrically opposite view to that other well known Jewish philosopher.

All sarcasm aside, I don't think even Ayn Rand could get her demented mind around this current fiasco we call the economy. The fact remains that any economic system that is systematically dismembered by special interest groups will fail, be that Capitalism, Socialism, Communism or any other system we conjure up. Political operators believe that the status quo is sustainable and even desirable - this endless oscillation between one political ideology and then another, each allowing its constituent crony special interests to feast at the public trough. Yet just an ounce of honesty and decency reveals that to be a false and self-serving belief. We could completely swap out and replace the entire current batch of jokers on Capitol Hill with a completely new crew and yet obtain the same deleterious outcome, as long as special interest groups have unfettered access to public money and power.

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The rest of this entry is a time capsule for the future, as a testament against the burgeoning if not fully realized Idiocracy. Following is a list of *some* of the more egregious widespread ideas and practices that years from now the survivors (if any) of the impending Dark Ages will not believe are commonly accepted both here in the U.S. and across much of the developed world:

1) Running fiscal and trade deficits for 30 years straight
(Except for a couple of years during the Clinton Administration when tax receipts from the tech bubble caused a temporary fiscal surplus )

2) Using cheap loans and low interest rates to "grow" the pseudo-economy via over-consumption and misallocation of capital, conveniently sidestepping each financial crisis by adding yet more monetary stimulus, until the entire system finally collapses in a deflationary credit collapse on a scale unprecedented in history

3) Spending Social Security and Medicare tax receipts as general revenues, thereby bankrupting the system and leaving future generations (and the Boomers) with no social safety net

4) Outsourcing an entire manufacturing base to foreign countries along with all of the accompanying managerial and engineering skills and intellectual capital, replacing these industries with Starbucks baristas, mortgage brokers, and bar tenders

5) Using homes like ATM machines

6) Paying Wall Street twenty-somethings millions of dollars to day-trade pieces of paper back and forth in a zero sum game while the real economy and real jobs are outsourced to foreigners

7) Injecting 80 million barrels of oil per day into the atmosphere and then ignoring the advice of the overwhelming number of climate scientists; preferring instead to follow the hack advice of infotainment talk show hosts, oil industry owned pseudo-scientists or Billy Bob next door who has been faithfully assimilating the Op/Ed section of the Wall Street Journal on his way to the Sports section:

- Despite hurricanes growing in force by 50% over 40 years
- Polar ice caps melting at unprecedented rates
- Acceleration in temperatures and growth in atmospheric carbon occurring at fastest rate in all of Earth's history
- Mass extinction of species occurring at fastest rate in Earth's history

8) Funding terrorist enemies in the Middle East via their wealthy oil sponsors who pretend to be our so-called allies in the war on terror, while we pretend not to notice...

9) Fighting two endless and pointless wars in the same region.
(Small hint for policy-makers: The war on terror can't be won; terrorism is a method of warfare, not a specific instance of war, uh duh!)

10) Electing a drug-addled, alcoholic, 'C' student, draft dodging dilettante and Alzheimer-ridden B-actor to the most powerful political office on the planet. More generally, electing smooth talking salesmen with no history of accomplishment who spend half their time campaigning and the other half of the time making fancy speeches promising the impossible.

11) Pumping our children full of factory junk food toxic waste while obesity and diabetes rates skyrocket amongst the young, all in the name of "consumer choice" i.e. the trojan horse for selling more corporate crap

12) Vastly overpaying country club CEOs tens and hundreds of millions of dollar to layoff millions of workers, outsource the most productive part of the economy, and otherwise drive the country into depression. Meanwhile, minimum wage is a measly $7.25, lower than it was in 1974 adjusted for inflation (i.e. 1974 equivalent is ~$10).

13) Producing an overwhelming preponderance of ESPN-addled boy-men too preoccupied with sports games and Xbox to notice the world disintegrating around them.

14) Using 5x as much resources as the average person on the planet and believing this to be a sustainable and scalable way of life, even when confronted with $147/barrel oil

Tsunami Alert

This week was a harbinger for the near future. The financial crisis and riots in Greece are just the canary in the coal mine for the impending global credit panic and ensuing anarchy that will make 2008 seem like a picnic. Just as the collapse of New Century financial and two Bear Stearns hedge funds was the harbinger of the subprime crisis (totally ignored by Wall Street and the media) so too, Greece is advance warning of this next much deadlier stage of the unrelenting credit crisis. It will likely only take one sovereign default to trigger an avalanche of defaults among all countries that have borrowed heavily and rely on accommodating credit markets to rollover their debt e.g. Spain, Portugal, Italy, Ireland, UK, Japan and a host of Eastern European countries.

The Elliot Waves now show that we are at the forefront of the biggest market decline in U.S. history, aka "Primary 3" (P3). Primary 1 was the market decline that started in 2007 and ended in March 2009 wiping out over 55% of market value. Primary 2 was this past year's countertrend rally. P3 will reassert the downtrend and take the markets far below the P1 low, potentially erasing the past 40 years of stock market gains, according to EWI. Before you dismiss these folks and Elliot Wave Theory itself out of hand as "financial astrology", bear in mind that while their timing was early, they called for a major top in 2007, they precisely called the low in 2009 (to the week), and now have been early (as have I) for calling a top here in 2010. If they are right now again, then that would prove the overwhelming majority of financial forecasters to be drastically wrong once again, and the early timing of the call will be rendered wholly irrelevant by the sheer magnitude of the decline.

Initially here the markets *may* stair-step their way down, as investors continue to "buy the dip", however, the inevitable flight from risky assets will likely cause a cascading panic crash. Yesterday was a small taste of just such a crash, as the market lost ~7% in about 10 minutes and then quickly recovered. We were told that this was a "trading glitch", except there is still no proof of any erroneous trade. The fact is there was no glitch, the mini-crash was simply a function of sellers overwhelming buyers. It was a one-sided market to the downside, which is exactly what we should expect after a year long Fed sponsored liquidity-driven rally intended to prop up Wall Street and propagate the illusion of recovery. Computer trading programs further contributed the problem as up to 70% of market trading volume is now controlled by automated trading programs. Many of these programs use technical (price) indicators to determine the current direction of the market and then drive momentum in the direction of the prevailing trend. Now that the trend has turned down, these programs are clearly exacerbating downside momentum.

Contributing to the inevitable panic will be the realization that the Fed and Governments are powerless to do anything, since they already squandered their resources in 2008 bailing out the investor/speculator class at the expense of the Middle Class. This time there will be no bailouts, not only because they will be politically unobtainable, but also because the scale of the market collapse will dwarf government/Fed resources.

As expected, U.S. Government Treasuries were a safe haven and long-dated Treasuries massively outperformed even beyond my expectations. Already Nassim Taleb's "no brainer" strategy of shorting Treasuries has turned out instead to be a "no brain" strategy. I can't imagine recommending shorting an asset that has proven to be a safe haven throughout the past weeks' turmoil. That is a boneheaded move, even by Ph.D standards. Yes, Gold held up well also, but as I have explained before, I don't see gold being a liquid safe haven during extreme deflation, as the amount of dollars in circulation will collapse, causing the prices of all things dollar denominated to fall. Further to the point, the U.S. dollar screamed higher against all other major currencies (except JPY), which caused further turmoil in the markets, as Wall Street's hot money (hedge funds etc.) are still clearly positioned for the "reflation" trade (short dollar, long commodities, cyclicals, emerging markets).

In short, if you have not already stocked up on food and ammunition, now would be a good time to do so, post haste.

Ayn Rand Gone Wild

This Goldman Sachs inquiry is beyond sickening. The usual Ayn Rand/Gordon Gecko-like apologists are out in force telling us that what they did was just business as usual and standard operating procedure for the financial markets. Just this week, "The Economist" (4/24, page 13) is saying that Goldman was greedy, but not guilty. That may be technically correct, but this is not just a legal issue, this is a fundamental moral issue, and anyone who does not think that what these pigs did was unconditionally wrong is morally bankrupt. "The Economist" argument is that various market participants go to market for various reasons and seller views of an asset by definition are opposite of buyer views. That is all well and good in a secondary market between parties of relatively equal information. However, these securities were sold in the primary market in which Goldman was the originator of a product certified to be high quality (AAA rated). To not make a distinction between Goldman's role as a market maker v.s. its role as an underwriter is amateur reporting. The underwriter role conveys a fiduciary duty that was clearly abrogated.

The Big Short (if you haven't read it, I highly recommend it)
By creating synthetic CDOs, Goldman essentially created a casino which allowed speculators (including themselves) to place billion dollar bets against the U.S. housing market. It wasn't enough to create plain vanilla CDOs which were layered packages of real mortgages and therefore had a modicum of investment purpose however foolish and ill-fated, no these "synthetic" CDOs were for pure speculation, a hand picked set of reference mortgages known to be particularly toxic and hence prone to failure. Bear in mind that the entire motivation for buying CDOs was to provide diversification by pooling a random set of mortgages from across the country of varying degrees of risk. Goldman did the exact opposite, they handpicked a pool of the most highly correlated, lowest quality mortgages they could find to guarantee the CDOs would fail. As soon as they sold these CDOs, they then bought insurance against them so they could profit from the inevitable failure. Moreover, by creating synthetic CDOs Goldman inflated a secondary (derivative) market that actually dwarfed the underlying mortgage market, thereby putting the entire system at risk when the whole pyramid inevitably collapsed. In all of this of course there were two main patsies, one of which was the overseas investors who were told these pieces of garbage were "AAA" rated securities which is how Goldman represented them to investors (thanks to the rubber stamp of the corrupt Ratings agencies). The other patsy of course was AIG who actually sold insurance guaranteeing these CDOs would not fail, much of which was not bought by investors to hedge their exposure, but by speculators hoping they would fail. The ultimate patsy however was the American taxpayer who ended up having to bail out AIG to the tune of $180 billion for the most part to pay off the speculators who had been betting against the U.S. middle class. What sick irony that the U.S. middle class tax payer was forced to bail out the scum bags who were betting that ordinary people would lose their homes. Were it not for the bailout of AIG, most of the speculators against the CDO market would have lost their bets and Goldman Sachs might not even exist right now. The fact remains that in the fall of 2008 there was a run on all of the investment banks - not just Lehman Brothers. Goldman Sachs was just a little further up the chain and rescued by the massive Bernanke/Paulson give-away.

So what did Goldman get for all this? In addition to getting $13 billion of the taxpayer AIG bailout money, for the bets they made against the very products they had created, they also "earned" roughly $3.7 billion in fees to originate these "crap products" (their own words from an email); products which had an average shelf life of about 18 months before self destructing and hence jeopardizing the entire financial system. Bear in mind, these were not trades in the secondary market. These were not junk bonds after-the-fact, trading for cents on the dollar, these were junk bonds at the point of origination that were marketed as high quality/high price (low yielding) securities. I submit, in what other industry can a company manufacture what is by their own admission a shit product, take out insurance against its failure and then still be in business two years later making record profits and paying out record bonuses? The analogy would be like Ford manufacturing fire-prone Pintos in the 1970s AND taking out life insurance on the buyers !!!

That there are still cheerleaders in the press and on Wall Street defending this type of destructive rent seeking and greed addled behaviour is a sign of the times and shows that the age of nihilism has reached a new all time low.

Slow...Motion...DISASTER

According to EWI, the top in the stock market occurred on January 19th. I believe they are correct. If so, then we have also seen tops in oil, gold and "risk" currencies. The safe currencies are therefore now the US dollar and Swiss Franc. The Japanese Yen perhaps as well, but I wouldn't bet that way due to that country's enormous debt load, which on a relative-to-GDP basis makes the U.S. debt look puny by comparison.

Humpty Dumpty
Therefore, the long anticipated 3rd wave meltdown is (very likely) underway. This next leg down in the ongoing financial crisis is starting as a slow motion train wreck, but will soon accelerate as the point of recognition occurs and panic spreads. Panic is inevitable, because everyone will come to realize that the government authorities are completely powerless to stop the meltdown. All of the stimulus, liquidity, credit and facilities put in place in 2008 will fail catastrophically. In the end, the only thing the 2008 bailout will have done is leverage up Wall Street one last time, and give the Greedbots one more bag of easy bonus money just before the house of cards collapses and stays collapsed.

Tallest Midget in the Circus
As expected, the dollar has been rallying for weeks now, especially vis-a-vis the Euro, because the Eurozone (Greece, Spain, Portugal, Italy, Eastern Europe) is likely the next source of financial chaos. So, for likely the last time, the unloved U.S. dollar will once again be the safe haven of choice during the ensuing panic. This will no doubt come as a great surprise to many people, especially the "tea baggers" and the Peter Schiff acolytes, but as EWI have carefully explained, a dollar shortage is exactly what we should expect in a credit deflation, as the supply of dollar-based credit collapses. I say for the LAST TIME, because this will likely be the dollar's last and greatest hurrah, as we eventually transition through deflation to the great printing of paper dollars that will undoubtedly lie somewhere down the road...

From an investment standpoint, EWI/Prechter has long advocated moving the majority of one's assets to short-term Treasuries, and I have advocated the same position on this blog. However, just this week, the self-anointed god of Finance and Economics, Nassim Taleb, recently told Blooomberg that it is a "no brainer" to short (sell) U.S. Treasuries. You may recall, that Taleb is most famous for his "Black Swan" theory, which postulates that rare and unpredictable events cause most Wall Street investment strategies to fail over the longer-term (I paraphrase). Obviously from an outcome standpoint, he has been proven correct, however, I disagree that the turmoil in the financial markets is at all rare or unpredictable i.e. these are more white swan events than black swan events. If anything, extreme volatility has become much more common in the past decade(s) and the inherent short-term/highly leveraged nature of Wall Street strategies makes the inevitable catastrophic outcomes very predictable. The reality is that most Wall Street trading strategies (hedge funds etc.) are like call options - heads I win and take home a massive bonus - tails I walk away and leave the investors, tax payers and system at large holding the bag. Taleb is very naive to think that Wall Street bankers are unaware of the underlying risks they take, considering the short-term incentives that are in place to take huge risks with other people's money i.e. they don't care. Therefore not withstanding Taleb's penchant for profound insight, I was not fazed when he made the "no-brainer" comment, because to believe Treasury interest rates will rise, is an implicit belief in reflation, which as I stated recently, is extremely improbable, if not impossible. If we have learned only one thing in the past 10 years it should be that any time a Ph.D tells us that an investment strategy is a "no brainer", you should run the other way, quickly, before a Black Swan swoops out of nowhere and shits on your head. Yet, magnanimous as always, I will agree to call Taleb's a "no brain" strategy.

Back to investing, the reason for advocating a long Treasury position is the same reason for being long the dollar - as a safe haven during deflation. When money flows out of risk assets and carry trades it will come back to dollars (the funding currency) and it has to be "parked" somewhere. It won't be parked in risky assets such as stocks or "spread products" (corporate bonds, municipals) etc. so that leaves Treasuries. Yes, the national debt and deficit are large, but relative to other countries (e.g. Japan) the debt load is still manageable (short-term) and in addition, the U.S. has options that the Euro countries do not have (e.g. monetizing the debt), explained in more detail below.

There are 3 major types of risks related to owning Treasuries:

1) Default Risk: Risk that the borrower (U.S. Government in this case) will simply not repay bonds at face value. I see Default Risk for Treasuries as being ZERO. The U.S. government's debt is all dollar denominated, which gives it the option to monetize its debt by having the U.S. Fed buy Treasury debt directly. If you think this can't happen, you are wrong, because it already happened last year to the tune of $300 billion under the aegis of "Quantitative Easing".

Keep in mind that if there is default risk, then it should be the same for all maturities of debt i.e. if the U.S. government decides not to repay its bonds, then logic dictates that all bonds will be affected not just select maturities. If anything, short-term bonds "could" be more at risk, since they need to be "rolled over" (re-paid) far more often than long-term debt.

2) Purchasing Power Risk: aka. inflation risk. The risk that market yields will rise, causing bond prices to fall. In a deflationary environment, inflation risk will be ZERO and if anything, nominal interest rates could be negative and still provide a positive real return. Imagine a scenario where GDP is down -20% year over year and prices decline by the same amount -20%. In that case, a market yield of -15%, would still net the holder 5% adjusted for "inflation" (deflation).

3) Rollover Risk: Rollover risk is the opposite of inflation risk, it's actually deflation risk. As indicated under the hyper-deflationary scenario above (-20% inflation) it's very possible that yields would go negative across the entire yield curve (all maturities). At that point you would be PAYING the U.S. government to borrow your money !!! At one point during the Lehman crisis in 2008 T-bills went briefly negative, so this is more than a hypothetical scenario. Now, would short-term yields go 15% (annualized) negative? That seems unlikely, but who wants to pay the Government to borrow their money? Fortunately, there is an easy way to protect against rollover risk, by simply buying longer dated maturities that do not roll over as often. Also, longer dated bonds will actually increase in value (potentially substantially) as yields fall, and you don't have to hold longer-dated bonds through to maturity (nor would you want to), you can sell them at any time i.e. they are highly liquid...

In summary, though I have long "advocated" the EWI party line of owning only short-term Treasury debt only during the deflation phase, I personally also own longer dated maturities to guard against Rollover Risk and provide some upside in the event of an anticipated major move down in yields. Given that Default Risk is assumed to be zero and/or at least the same for all maturities, Inflation Risk is zero (assuming deflation), and Rollover Risk favours long-dated, maturities, I cannot explain EWI's preference for short-dated Treasuries.

That said, the easiest way to own Treasury debt of all maturities is through the iShare ETFs which trade like stocks:

SHY: 1-3 year maturities
IEI: 3-7 year (probably the best compromise between long and short-term)
IEF: 7-10 year
TLT: 20+ year (most volatile/speculative, but most upside if yields fall)

Good luck !

MELTDOWN is INEVITABLE

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.