Prepare For Crisis

How bad could it get? What are prudent steps that you can take now to prepare for the next leg of the crisis

Bubbles Always Pop

The global economy has been on life support since 2008 thanks to trillions of dollars of  government spending and central bank printing of trillions more. Both strategies have boosted asset prices and given the illusion of economic growth.

It is difficult to know the extent that markets and the global economy have benefited from official policy stimulus; however, six years after the crash, economic growth and the labor recovery remain subpar. Strong growth should have been ignited by now.

Bubbles popMost economists still believe in the ‘official position’ that growth is edging higher and that interest rates will slowly rise to reflect it. They could be correct, but should it fail to unfold as expected, confidence in the efficacy of official policy will diminish and the social contract will break down further. Since markets require confidence, they will also react accordingly.

Some argue that economic benefits to stimulus have run its course, while the costs from looming unintended consequences have not yet been unleashed. Many believe (including us) that the risks and costs of current Fed policy outweigh the benefits.

The Fed’s asset purchase program (QE) and Zero Interest Rate Policy (ZIRP) are the foremost factors that have widened wealth inequalities. The richest few have benefited the most, simply because the 10 percent richest Americans own 80 percent of US stocks. The FOMC believe that its asset-price-inflation-trickle-down-policy leads to spending which ultimately leads to job creation, especially for the poor.

However, several FOMC members themselves have questioned Fed policies, citing that they have not worked as well as had been hoped, and pointing out that aggregate demand has been weak throughout the recovery. To his credit Fed Governor Jeremy Stein broached the subject of unintended consequences of Fed policies when he mentioned in his February paper, “A prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risk, or to employ additional financial leverage in an effort to ‘reach for yield’”.

Zero interest rates have incentivized corporations to issue debt in order to capitalize on the historically low interest rates; however, corporations have primarily used the money to pay greater dividends, buyback shares, or modernize plant and equipment. There is a strong case to be made that holding interest rates at zero for a prolonged period is actually counter-productive to the Fed’s efforts to achieve either of its dual mandates. This is because increasing productivity through modernization typically exposes redundancies: it allows firms to lay-off workers, while the improvement in competitiveness allows firms to drop prices.

An unintended consequence of ZIRP could be to lower household spending rather than raise it. There are some conservative savers who have a predetermined goal in mind for the minimum amount of savings they wish to accumulate over time. Those investors may refuse to move out the risk curve in search of higher yields (likely widening the wealth divide). To them, lower interest rates simply mean a slower rate of accumulation, which likely will jeopardize their minimum goal. The only recourse for this investor is to save more, which is the exact opposite intention of the Fed’s policy. For example, if interest rates fall from 4 percent to 3 percent, an investor would have to increase savings by more than 20 percent each year to reach the same goal over 30 years.”

Another negative result of ZIRP is that banks and other lenders are discouraged from lending due to puny return levels; and, therefore, the Fed’s desire to expand lending is compromised. Are lower (or negative) interest rates supposed to increase the incentive to lend money? That is an absurd assumption. Although somewhat counter-intuitive, if interest rates rose, then the supply of money willing to be lent would increase due to wider interest margins.

Current policies are so unprecedented and unproven that it is possible that the Fed itself has now become a source of financial instability. This could be the case either through the potential fueling of asset bubbles, through its compromised ability to conduct future monetary policy (due to it  unwieldy $4 trillion balance sheet), or due to “unknown unknowns.”

In a low to zero interest rate policy (ZIRP) environment, investors desperately search for yield. This frequently chases investors into assets to which they are ill-suited and to which they will miscalculate liquidity and downside potential. Under ZIRP paradigms, riskier assets become the best-performing. Credit spreads collapse and equities soar.

Massive monetary ‘printing’ by global central banks has not just emboldened investors, but these actions have collectively changed their behavior and psychology. There is evidence that policies have led to misallocation of resources. Investors are emboldened to take what many critics believe is inappropriate or reckless levels of risk. The motto, “Don’t fight the Fed” has taken on added meaning. Moral hazard and a deep-seated bullish psychology have become rampant.

Extended Fed promises of lower rates and a continuation of asset purchases even as the economy heals, are conspiring to propel prices ever-upward. Investing today has become mostly about seeking relative yield, rather than assessing value or determining if the investment’s return is sufficient compensation for the risk.

Simply stated, investors and speculators receive ever-lower returns for ever-higher levels of risks. Over time, the ability of an investor to assess an asset’s fundamental value becomes ever-increasingly impaired.

There have been persistent cycles of asset booms (bubbles) that eventually turned to ‘busts’. Very low or negative real rates always create economic distortions and the mispricing of risk, thereby creating asset bubbles. Each ‘boom’ had some differences, but the common factor has always been easy money which the Fed was too slow to withdraw. Providing liquidity is always easier than taking it away, which is one reason why the Fed has hit the “Zero Lower Bound” in the first place.

Eventually asset prices always return to their fundamental value, which is why bubbles always pop. The FOMC has backed itself into a corner. Current changes in policy are being designed around efforts to manage the unwind process seamlessly. Central bank micro-management appears based on a belief that they can exert an all-encompassing central control over markets and peoples’ lives. Those in power have come to believe that policies have a precise effect that can be defined and managed. This is highly unlikely.

In ‘normal’ times there is a more discernable connection between cause and effect. However, the usual relationships particularly break down during periods of over-indebtedness, unprecedented regulatory changes, and official rates reaching the zero lower bound. Today, the world is far from ‘normal’. It is not difficult to imagine the looming fallout from policies that have promoted asset price inflation, and which have materially compromised market liquidity.

In the long run, policies that punish savers at the expense of helping risk-takers and speculators are bad long-run policies for any country. It would be better to transform the country into net savers, rather than to continue to promote policies where growth is reliant on overly-leveraged consumers or speculators, and is micro-managed by attempts of central-control.

Death of Money

“The world is witnessing a climactic battle between deflation and inflation,” Jim Rickards writes in his excellent new book The Death of Money.
“It is just a matter of time” before this battle comes to a head.

inflation_vs_deflationAt some point, the U.S. economy will experience “an earthquake in the form of either a deeper depression [from deflation] or higher inflation, as one force rapidly and unexpected overwhelms the other.”

Which one will win? And what are the potential outcomes? Rickards goes over each of those in his book…

Inflation is the easy one to understand… For the most part, the government creates this one… by “printing” trillions of dollars.

Deflation is less easy to understand… For starters, we “have no living memory of it.” The last episode of persistent deflation was in the Great Depression. Rickards calls deflation “the Federal Reserve’s worst nightmare.” For one, deflation “increases the value of government debt, making it harder to repay.”

Because of fear of deflation, the Fed can’t stop its money printing. If it did stop, “deflation would quickly dominate the economy, with disastrous consequences for the national debt, government revenue, and the banking system.”

Which will win – inflation or deflation?

Rickards explains that “the most likely path of Federal Reserve policy in the years ahead is the continuation of massive money printing to fend off deflation.” The Fed assumes it can later deal with inflation that it might create.

I agree with him. Governments have proven for centuries that – while they might be pretty bad at most things – one thing they’re pretty good at is creating inflation through printing money.

The easy conclusion is that inflation will win… but many times, the easy conclusion isn’t necessarily the right one.

In his book, Rickards builds a strong case for how deflation could win as well.



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death of money

Whether inflation or deflation wins this battle, Rickards makes a strong case for a higher gold price.

If inflation wins, then it will take more paper dollars to buy an ounce of gold. And if deflation wins, then the price of gold will move higher to break that deflation…

The only way to break deflation is to declare by executive order that gold’s price is, say, $7,000 per ounce… the purpose would be not to enrich gold holders but to reset general price levels. Such moves may seem unlikely, but they would be effective… there is no other solution when printing money fails.

Our money is on inflation winning the battle – ultimately – but we think it could take a few years for the clear winner to emerge. In the meantime, we are likely to see short terms swings between deflation and inflation.

 

Why Things are FALLING APART

To understand the reasons why our financial system, our economy and our present policies are unsustainable, we need to come to grips with two simple truths.

  1. First, the economy and government are an interconnected system. As such the party attempting to steer it does not have controlling power over it.
  2. The second fact is that “faster, better, cheaper” always wins, replacing the inefficient and unsustainable. This is the reality within which the system operates.

The present foundation of our economy, is financialization. This is not by design but rather by evolution. It has unfortunately, become the basic engine of growth through its’ leveraging of credit and debt into phantom assets, such as derivatives and bubble asset valuations. The limitation of this system is that ever-increasing debt and leverage is unsustainable once private sector assets and incomes stop rising.

Uncontrolled financialization and unsound money, without historic exception, consistently leads to:

  1. Malinvestment in the private sector – cheap money will naturally flow into high-risk, low-return investments. For example, “McMansions” in the middle of nowhere;
  2. Crony capitalism in the Public sector – In the public sector, crony capitalism secures low risk, high-return investments. This leads to “Bridges to Nowhere.”

The system in its present form has become too complex and fragile. It is unsustainable. The unsustainable will collapse and be replaced by the sustainable. Creative destruction (a basic tenant of real capitalism) and “faster, better, cheaper” is the only sustainable system. The alternative is to cling to failed models until the system collapses.

“Any intelligent fool can make things bigger and more complex… It takes a touch of genius and a lot of courage to move in the opposite direction.”

(Albert Einstein)

Additionally, our economy and state are unsustainable for converging and disruptive systemic reasons, that go beyond the financial:

  1. Demographics-our aging populace and the impossible to pay entitlement promises made;
  2. Decline of paid work. Automation and the Web are destroying more jobs than they create;
  3. Diminishing returns of centralization. The more power the State grabs, the more broken the system becomes;
  4. EROEI (energy returned on energy invested): energy may be abundant but it is expensive;
  5. Healthcare in crisis. Our health declines as we spend 2 times more per capita than our other nations;
  6. The end of consumer spending growth. If debt and income aren’t growing, neither can consumption;
  7. Globalization. The genii cannot be put back in the bottle.

Roadblocks to Recovery in America

The number one problem in this country is excessive debt, debt at all levels – consumer, business, financial and government.

The bottom line, and despite all the plausible arguments to the contrary, we have too much public and private debt relative to the nation’s gross domestic product (GDP). Worse yet, an increasing portion of this debt is unproductive or even counter-productive.

In simple terms, the purpose of taking on debt is to generate future income. Part of that future income is productive, part of it is used to service and, presumably, pay down the debt. But the debt incurred today, especially at the government level, is taken on solely for the purpose of “propping up” the status quo. It is unlikely we will be able to generate the future income necessary to service this debt.

RoadblockIt is already affecting us. In the last fifteen years, debt-to-GDP ratio has risen from roughly 250 percent to more than one hundred points higher, 360 percent today, and our standard of living is no higher. I define “standard of living” in this case as median household income. We’ve taken on the debt, it’s bought modest gains in GDP, but it has not improved the welfare of the majority of our people.

This isn’t the first time the United States has been here before. We’ve seen three periods of excessive government debt:

In the 1820s and 1830s

Again in the 1860s

The early part of the 20th century

We survived those situations which probably seemed quite impossible at the time. This is really the fourth episode of extreme indebtedness to face our nation. These periods have occurred at very long, irregular intervals. That’s one of the difficulties, people weren’t alive at the time of the prior ones.

The first period of government indebtedness occurred in the 1820s and the 1830s, when we were building our early transportation infrastructure – canals, turnpikes and steamship lines. Initially, there was good value derived from the debt. But then the infrastructure was overbuilt and the credit available was used to finance living beyond our means.

The panic occurred in 1838. The bubble burst and speculative real estate prices collapsed. The economy experienced a difficult time all the way to the American Civil War. But we eventually saved, paid down the debt, and recovered.

The next major episode was in the 1860s – building the railroads. Initially the debt accumulation served a good purpose. Frist, we built what was known as the central route. Then we built northern and southern routes, and a whole host of feeder lines. A host of abuses followed – real-estate and stock market speculation, lavish consumption and living beyond our means. All of the railroads failed except one, and it was the one that was not financed by the government. Government involvement was significant in developing the rail system. Government created the incentives, but the private sector bet on the incentives. Government-manipulated incentives drove over-investment. Government incentives drove over-consumption and speculation.

The most infamous debt related crash occurred in the 1920s. Again, the incentive for the over-speculation was excessive liquidity created by the Federal Reserve. The Federal Reserve was newly established at that time, it had just come into existence in 1913. Interestingly, there were some Federal Reserve officials that were aware that the problem was out of control, but they were drowned out, because everybody was having too much of a good time. The Great Depression followed. The US economy didn’t recover until we entered World War II.

The forced austerity of World War II pushed the saving rate up to 25 percent. We repaid the debt, and this laid the foundation for the post-World War II boom.

The fourth episode has occurred in the last 20 years. Again, the incentives came from the government sector, mainly the Federal Reserve. The federal government also played its hand through two government-sponsored corporations – Fanny Mae and Freddy Mac. The perceived safety these agencies provided in the mortgage business allowed the bundling and “slicing and dicing” of mortgages. This created the façade that the mortgage was safe and secure regardless of how poor the fundamental characteristics of any individual loan were. Of course, that was a false notion, and so we have now had another very difficult time period and we are certainly not getting a normal recovery. The standard of living is continuing to fall, in spite of gains in GDP. We have a much more dramatic monetary and fiscal response, but therein lies the problem. We are not achieving a rise in the saving rate, the austerity that’s needed.

An Argument for Gold

Why gold? Consider the following:

  1. Worldwide money printing continues unabated.
  2. In just ten years $120 trillion dollars have been printed. U.S. total credit outstanding stands at nearly $60 trillion. Global debt just passed the $100 trillion mark. This is real government and private sector debt that has to be paid back or inflated away. It does not include unfunded obligations.
  3. From 2001 to 2011 global GDP has risen from $32 trillion to $70 trillion in lockstep with the growth of credit (debt).
    United States economic growth has become dependent on the creation of new credit. Four percent credit growth (about $2.4 trillion on debt of $60 trillion) is necessary to produce modest two percent annual growth ($320 billion on GDP of $16 trillion).
  4. The marginal return on printed money is negative in real terms. The world is living in an illusion of paper that people believe is money. Much of this illusionary paper wealth will eventually implode. The initial trigger may be the collapse of the world’s reserve currency – the US dollar. Russia and China may very well be the catalysts behind this collapse as they seek to destabilize the U.S. Watch any Russian/Chinese trade agreements closely.
  5. The dollar is backed by $120 trillion of US government debt (and unfunded obligations) and unknown gold reserves.
    All fiat currencies will continue their race to the bottom and lose 100 percent in real terms compared to gold. This will create a worldwide hyperinflationary depression.
  6. All assets financed by the credit bubble will lose value in real terms (gold). This includes stocks, bonds, real estate and paper currency.
  7. The global financial system is unlikely to survive in its present form.
  8. The banking system, including derivatives, has total liabilities of $700 trillion to $1.2 quadrillion – no one knows for sure. The derivatives market is almost completely unregulated and opaque.
    Derivative Notionals - April 2010
  9. With global GDP of $70 trillion, the world is too small to save a financial system which is 17 times larger. There will be unlimited money printing and perhaps hyperinflation as governments desperately attempt to rescue the global economy.
  10. The only asset that will maintain its purchasing power is gold.
  11. Gold has been money for 5,000 years and will continue to be money regardless of what happens to fiat currencies.