July 26, 2008
Chart: Courtesy Barry Bannister
The financial system will collapse before "zero-hour" actually occurs. I think we are seeing signs of it in the desperate measures being employed to nationalize companies which trade on market exchanges as private enterprises. There is simply no way to defend the SEC’s decision to selectively enforce the prohibition of naked short selling for 17 ‘fragile’ financial companies and to not enforce it for the over 5000 other companies which trade on US stock market exchanges. And plans to rescue Fannie Mae and Freddie Mac breathe of a sort of corporate nationalism. Over time this will deal a massive psychological blow to financial markets. They are currently rallying on the sense of relief that the efforts to prevent Fannie and Freddie from dragging US financial markets into the abyss have succeeded and the inevitable day of reckoning has been postponed once again.
But this time around market participants are beginning to smell blood and are beginning to consider that US dollar’s status as the world’s reserve currency is in jeopardy. It is now clear that the Bear Stearns bailout was not the bottom and that the bottom has not likely occurred. Many were betting that the market lows in March would hold and that the demise of Bear Stearns marked the nadir from which markets were sufficiently cleansed to begin their new ascent higher.
In the past such events did in fact mark the bottom. Going back to the 1987 market crash we have had a series of market crises, each one met by massive Federal Reserve liquidity injections, which ignited a new phase to the bull market rally. We saw similar effects after the Long Term Capital Management (LTCM) debacle in 1998 and the series of rate cuts that followed the collapse of the internet bubble and the 9/11 bombings.
Yes, not only are we are witnessing the asymptotic approach of the marginal effect of debt, but we are now seeing the dwindling market impact US Government market interventions are having. In a commentary just written by Ron Paul, titled "The Crisis is Upon Us," he writes, "There are reasons to believe this coming crisis is different and bigger than any the world has ever experienced." He is largely dismissed as a quack by the mainstream for being "Chicken-Little" and for not being as polished as our current crop of focus-group-driven politicians. He subscribes to an economic philosophy not taught in our American schools called Austrian economics. But after the final crisis plays itself out, the mantra "We are all Keynesians now," will be replaced by "We are all Austrians now." Referring to the chart below, also provided by Barry Bannister, we see the effects of 35 years of ultra-expansionary monetary policies:
Chart: Courtesy Barry Bannister
Congressman Paul makes two points in his commentary. One, each financial crisis over the past 35 years has not been actually been solved in a final, sustainable manner; rather, they have been papered over which have created the conditions for a bigger crisis that will have to be dealt with in the future. And, two, the crisis will be magnified because it is globalized in nature and "Instead of using globalism in a positive fashion, it’s been used to globalize all the mistakes of the politicians, bureaucrats, and central bankers."
If your eyes are glazing over all of these numbers then perhaps you might understand a reference to inflation in all of the Austin Powers movies. In the movies, the characters of Austin Powers and Dr. Evil, both played by Michael Myers, travel back and forth between the late 1960s and the late 1990s. In the first movie, not understanding the power of inflation, Dr. Evil, still caught in the 1990s, demands a ransom for threat of destroying the world in the amount of $100 billion for a world in the 1960s. The 1960s world leaders explain to him that $100 billion is more than all of the money in the world. Today, $100 billion would barely qualify as a bailout or stimulus package.
Now the lesson here is that the unthinkable has occurred. We have expanded the money supply (and commensurate debt) more than 1000-fold in less than 40 years, yet no one really thinks that we have expanded economic growth and real wealth to anything near that level.
Rather, the excess money has resulted in a series of rotating inflationary bubbles. Bubbles in commodities, consumer prices, and wages are seen as bad, while inflation in stock and real estate assets are seen as good. But both are symptomatic of an unsustainable system doomed to failure, as Congressman Paul explains:
Ironically, in the past 35 years, we have benefitted from this very flawed system. Because the world accepted dollars as if they were gold, we only had to counterfeit more dollars, spend them overseas…and enjoy our unearned prosperity. Those who took our dollars and gave us goods and services were only two anxious to loan those dollars back to us. This allowed us to export our inflation and delay the consequences we are now starting to see. But it was never destined to last, and we now have to pay the piper….Printing dollars over long periods of time may not immediately push prices up — yet in time it always does. Now we’re seeing catch-up for past inflating of the money supply. As bad as it is today with $4 a gallon gasoline, this is just the beginning.
The days of highly-leveraged, borrowed investment speculation (especially if you want to short a government-protected asset) and" living la vita leveraged" for consumers are over. The credit contraction and deleveraging process is going to at the very least serve as a torturous economic headwind as the effects of 35 years of irresponsible financial behavior are unwound.
While Treasury Secretary Paulson and most in Congress are desperately looking to employ measures that prevent a systemic collapse of world financial markets, such tools will only serve to feed the beast and make the day of reckoning that much more devastating. Another development which distinguishes this crisis from others in years past is the lack of support shown by some free marketer Congressional leaders. I side with them and believe that we should be trying to starve the beast. This is going to get a lot worse. Kill this beast now. In the film The Sixth Day, clones are created to bring people back to life so they never die, but each time they come back with a congenital mutation that causes the contraction of each successive life span before cloning is required again. Toward the end of the movie the wife of the character played by Robert Duvall begs to be left to rest and not be reincarnated as a clone of herself. Likewise, some of these financial monstrosities should just be left to die.
Last week, Richard Fisher, head of the Dallas Federal Reserve Bank, "speaking solely in [his] own capacity," alerts us that "the unfunded liabilities from Medicare and Social Security…comes to $99.2 trillion over the infinite horizon. " Fisher goes on to warn:
This comes to $1.3 million per family of four – over 25 times the average household’s income….No combination of tax hikes and spending cuts, though, will change the total borne by current and future generations….We know from centuries of evidence in countless economies, from ancient Rome to today’s Zimbabwe, that running the printing press to pay off today’s bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid.
Congressman Paul is a Republican and Richard Fisher was appointed by a Democrat. But both appear to be drinking from the same Texas tap water, however regarding the nefarious and inevitable effects of money printing and inflation. Maybe one day they will be able to bottle it up and persuade others to drink it. It appears that Fisher could be auditioning to team up with former Comptroller, David Walker, another "economic Paul Revere", to serve on Pete Peterson’s team in an effort to save the Republic from economic disaster before it is too late.
A couple of weeks ago, William Poole, formerly of the St. Louis Fed warned that Fannie and Freddie were insolvent. These aren’t the warnings of bombastic flamethrowers. These are former respected and responsible government officials who courageously dare to speak the truth!
So things are bad, but how bad? Nouriel Roubini, Chairman of RGE Monitor and Professor of Economics at the NYU Stern School of Business, is now being recognized by the financial media for having correctly predicted many of the afflictions which currently ails our economy. He believes that:
This is not just a subprime mortgage crisis; this is the crisis of an entire subprime financial system: losses are spreading from subprime to near prime and prime mortgages; to commercial real estate; to unsecured consumer credit (credit cards, student loans, auto loans); to leveraged loans that financed reckless debt-laden LBOs; to muni bonds that will go bust as hundred of municipalities will go bust; to industrial and commercial loans; to corporate bonds whose default rate will jump from close to 0% to over 10%; to CDSs where $62 trillion of nominal protection sits on top an outstanding stock of only $6 trillion of bonds and where counterparty risk – and the collapse of many counterparties – will lead to a systemic collapse of this market.
This will be the most severe U.S. recession in decades with the U.S. consumer being on the ropes and faltering big time as soon as the temporary effect of the tax rebates will fade out by mid-summer (July). This U.S. consumer is shopped out, saving less, debt burdened and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation and rising oil and energy prices. This will be a long, ugly and nasty U-shaped recession lasting 12 to 18 months, not the mild 6 month V-shaped recession that the delusional consensus expects.
While I agree with the devastating effects due to the harmful complex inter-linkages in the world financial markets and the negative feedback loops between the financial world and the real economy that Roubini cites above, I believe that the our fate will be much worse than Roubini’s 12-18 months U-shaped recession, a prediction that already exceeds the most bearish forecast among the mainstream economists. As a Keynesian, Roubini believes that a deteriorating economy will lead to a large decrease in aggregate demand, resulting in much lower energy and other commodity prices. Keynesians do not place much weight in monetary supply concerns in their analysis. As an Austrian, I believe that much more commodity inflation has been baked into the cake, and rising commodity prices are more likely to have an effect on the length and intensity of the recession than the recession is likely to have an impact on commodity prices, at least initially. Furthermore, Keynesians believe that aggressive fiscal stimulus packages can be implemented in order to prevent any recession. And there’s the rub.
While I expect the Keynesians to win out and for us to receive the biggest fiscal expansion of government, coupled with continued loose monetary policy, in the history of the world in order to limit the fallout of the economic collapse Roubini outlines above, I expect it to blow the budget through the roof to crash the dollar. There will be no starving of any beasts. There will only be the creation of bigger wealth-sucking leviathan bureaucracies. Other governments will reject our paper, painful as it might be for them initially, and the US dollar will lose its status as the world’s reserve currency. Yields on US treasuries will soar. Other governments are inflating their currencies as well, so gold be the only real winner in this race to the bottom for fiat money.
Sadly, we will reject willfully accepting the consequences as paying the piper today in return for a road that will lead us down the path of unrecoverable ruin that will permanently harm our place in the world. The time to heed the warnings of Ron Paul is growing short:
I have for the past 35 years, expressed my grave concern for the future of America. The course we have taken over the past century has threatened our liberties, security, and prosperity. In spite of these long held concerns, I have days – growing more frequent all the time – when I’m convinced that time is now upon that some Big Events are about to occur. These fast approaching events will not go unnoticed. They will affect all of us. They will not be limited to just some areas of our country. The world economy and political system will share in the chaos about to be unleashed.
In order to position yourself for such an investment environment I refer you to my commentary.
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