Okay, here is my "Ode to Squeak" who has asked me to expand on a currency collapse regarding the USD and how to prepare for it and the events that will unfold thereafter.
Disclaimer 1: There is no road map or playbook for what I am going to discuss. No third world debt default can compare to what a default of US debt and/or the collapse of a major world currency such as the USD, Euro, or Yen.
Disclaimer 2: Due to unprecedented levels of government hubris, intervention, complete disregard for law, and manipulation, any assumptions I make could be just as easily discarded as they could be true. Since the rules of the game change every Sunday night, it is very difficult to play. This is not a caveat for being wrong (as I am not afraid to be wrong) rather a caveat that history, education, and research go out the window when rules can be made and broken at will.
Disclaimer 3: Any assumptions made are my own. I will not take the time to post links to every piece of factual research that I post as that will take too long but if someone wants that information please PM me and I will provide it. Pretty much 99% of the information that I use or cite are easily found government stats that can be Googled.
Where We Are Now:
There has been much debate in the media and in some of these threads regarding whether we will sooner see inflation or deflation. There are many camps that are discussing this matter and you have probably heard them all by now. Heck, we cannot even agree on how to define inflation and deflation. For practical use purposes though, it is more helpful (IMO) to define them as they relate to the money supply in circulation. It is economic theory that if you create a bunch of money in the system and pump it into people's wallets, they will go out and buy things. This increases demand. An increase in demand, without a corresponding increase in supply, will create an increase in prices of "stuff". Deflation would work the opposite way. If you take money from people, they cannot spend and therefore demand will decrease and without a corresponding decrease in supply, prices fall.
Now, NOTHING in economics can be viewed in a vaccum for the ONE simple fact that economics involves the behavior of IRRATIONAL beings. This fact cannot be stated loudly enough. This fact is also a reason that econometric comparisons to the Great Depression ought to viewed as nonsense. It is like saying if the Patriots played the Bears in the SuperBowl this year the Bears would win by 36 points since that is what happened in SuperBowl XX. We all can see clearly why that assumption is nonsensical. Different this, different that... but those differences make a huge difference in outcome.
Economics is the same. Please keep that in mind as we go through this.
The only thing that the US has produced in the last decade plus is financial engineering defined more technically as velocity of money. Mathematically put, the output of a country can be simply defined as the aggregate money supply multiplied by the times that money supply moves through the economy. "High powered money" is the theory that $1 moves through the economy and changes hands multiple times. As I get paid from work, I pay the landscaper, he pays his employees, they pay their bills, etc etc. Since 72% of our economy (at the most recent peak) is measured by how much we, as consumers, spend, you can see very quickly how the "velocity" of money creates a HUGE impact in the final tally of our output.
But, as some of you may be saying now, how is that really "output". "We have not created anything" you say. And you are right. This goes back to a fundamental issue with our country's monetary & fiscal behavior. We have a fiat currency and a fractional reserve monetary system. In English, that means we have a currency that is backed by nothing, can be created at will, and when deposited by members of the Federal Reserve Banking system, can be leveraged 10-1 (at least). This is how the "money mechanism" works. The Fed prints $1 and puts it into the bank of choice. The bank puts $.10 on "reserve" with the Fed and lends out $.90. The bank makes money on that loan called "interest" (this is the trouble with "usury". If the Fed prints all the money needed, then who creates the money to pay the "interest".... and on and on we go). The bank loaned that $.9 to me so that I could buy a car from my neighbor. My neighbor takes that $.9 and puts it into his bank. Guess what his bank does? His bank takes 10% of that money and puts it on "reserve" with the Fed and loans out the rest. And so on...... you don't even want to get into the leverage amounts that the government afforded to JP Morgan, Bank of America, Goldman Sachs, Morgan Stanley, B. Stearns, and L. Brothers. What shock, three of them don't exist anymore and the other three only exist because they were the "chosen ones" to be bailed out.
So, what have we done over the last decade? Well, we had a complete "productivity miracle" occur with the advent and application of the internet. I cannot say how much this system has revolutionized global business and changed economics. This was real and tangible. This was measurable and legit. What it allowed us to do however, was to again manipulate our system for the worse. What increases in productivity do is to keep a lid on what is called "unit labor costs" or wages and other inputs that go into the cost of goods. Lower cost goods means that "inflation" (that pesky inflation again...) AND THIS IS IMPORTANT, "as measured by the Consumer Price Index", stays low. Again, in English, this means that we can make computers now for $500 instead of $5,000. That, according to the CPI is a huge move down in inflation, or the "costs of goods and services". The government's response to a move down in the costs of goods and services is to keep the pedal to metal in terms of monetary and fiscal policy. No inflation? No hikes in interest rates. Money is cheap and stays that way according to them.
Then the internet bubble bursts. Wealth is literally destroyed overnight. This is why an understanding of inflation and deflation is so important. When you remove the consumer's ability to buy, leverage, borrow = spend, you create a complete bottom out in demand. Our economy is built on debt, remember that is how money is created over and over again. If you remove that money, if you destroy that wealth, you handcuff the people's ability to spend.
Now, another key, CORE theme in economics is the theory of rate of change. Since economics is totally linked with behavior, the rate of change makes all the difference in the world. This can be most recently noted in either the default rate of mortgages or the US consumer savings rate (or if you want to get really scared look at the savings rate of change of Japan). A small uptick in the % of defaulted subprime mortgages caused massive waves through our system. Our savings rate went from negative to now at 6.5% in about 1.4 years. 6.5% for a savings rate is not high "by historical standards" but that does not matter AT ALL, it is the rate of change that matters.
So what we had was a complete drain of wealth from the bursting of the internet bubble. We entered a recession as defined by negative growth, or GDP. A contraction, if you will. What causes contractions in a society that is based on debt? Less debt. Less money. Less purchasing power. OR, and we will get into this in a minute.... a paradigm shift of consumers from spending to savings. A jump from a negative savings rate, to a positive one, has catastrophic impacts on corproate earnings and profits. If the savings rate gets high enough you experience what is called the Paradox of Thrift. This is now occuring. Because I save money on landscaping, my landscaper cannot pay the people to wash his cars, and those people then cannot go out to eat as much which takes money from the waitress who then cannot get her hair done every other week, and so on and so on.....
In times of economic contraction the government and The Fed, will become the "Lender of Last Resort". This goes back to GDP and the money mechanism. If people have been using their homes as ATM's, and their housing values plummet taking away their ability to spend, the government wants to step in and create a supply of money to abate the crisis. When the government can create money from thin air, why not? Well, here is why not....
To pull us out of the recession of 2002 (which was mild at worst) and the devestating effects of 9/11 (don't want to get into CT here), The Fed pumped massive amounts of money into the system and regulations were relaxed for Wall Street lending. We created another bubble to solve the problems of a bubble bursting. We also spent billions and billions on war, the most profitable business model our government has ever known. Since money and credit is like a virus, it landed and infected assets such as real estate.
We inflated the real estate market and all the ancillary markets (construction, retail, furniture, autos) that go with it. That is a bit misleading because there were not specific instructions to inflate the real estate market but regulations were sidestepped and new rules put in place which made real estate the spot where the lending landed/credit expanded.
So, let's go back to economics. We had a contracting GDP so we did what we always do (the only tricks we have) on the other side of the equation, we pumped massive amounts of cheap money into the system to increase the depleted money supply and then we did something of EPIC proportions, that we had never done before, we literally created "financial weapons of mass destruction", as Buffett calls them, which is the alphabet soup of credit "derivatives" that we all hear about. Here is how it went down....
The orders came from Washington to open up the printing presses and issue massive amounts of government debt. The government debt went to transfer payments but more importantly, that that time, to funding the wars on military spending. The Fed essentially created no cost money which meant that banks could take that money from The Fed and lend it out and make huge money on the "spread". But that "huge spread", or net interest margin, was not enough. Since interest rates were held so low, and there was a "global savings glut" which kept bond yields very, very low, savers were being punished due to the increases in prices from the increase in demand. Banks started the process of syndication in the name of risk mitigation. And here is where it gets really, really bad. Syndications allowed banks to play a virtual game of hot potato. Since borrowers (hedge funds, pensions, you name it) could go out and borrow money (there is a carry trade aspect here with the Japanese that I am leaving out for sake of simplicity) in the global arena very, very cheaply, you could borrow money at 1% and buy a package of "insert mortgage product here" which was "said" to pay 5%. These events created a velocity of money that was unparalleled before. Speed of light, one trillion times. It was awesome to see. Buy something today, sell it by lunch. Do it again tomorrow. All cheap, all profit. No money down, no doc, no anything.... just get it done. "Castles to the sky". Credit cards, cars, boats, houses... The profits were obvious, the money cheap, the underwriting free, the game rigged.....
Fiat currency in a fractional reserve system works until it doesn't. And here is when it doesn't. We built up capacity (think auto dealerships, malls, schools, movie theaters, gyms, restaurants, etc.) for consumer spending that was probably in the range of 75% GDP going to 80% GDP. Our entire system was based on debt. Unlike equity, debt has to be paid back, or losses taken. It doesn't just go away and worse, unlike equity, has immediate residual consequences that create a cascade affect in economics.
What made the music stop? People. Behavior. Psyche. The system gets so bloated and overweight, that it collapses under its own weight. No one stands up on Capital Hill and waives a flag saying the game is over. You just wake up one day and the tone has changed. You "can" have events that do that... a comet, or drought, etc. But not in this case. The paradigm shift was underway. People smartened up and the scales tipped from those "getting in while the getting was good" to "getting out before it all crashes down".
It is that simple and resembles a snowflake at the top of a mountain that rolls into a snowball and then into an avalanche. Rates of change in a system built on debt where everything is connected.
We built up an empire of debt that has never before been seen in our nation's history. What's worse is that the same globalization that was borne in the wake of the productivity miracle of the 1990's made it so that no rock was left unturned. Credit infected every single aspect of our lives across the globe. People in Poland were issued mortgages that were priced in Swiss Francs but those people were paid in the local currency, the Zolty. When the Polish government became so overwhelemed as the credit stopped, the Zolty got hammered in the currency markets. The people that were paid in zolty's but paid their mortgage in Franc's saw their mortgage payments jump 40% overnight. Ouch. Everything is connected.... economics is pushing on a string.
Back to the US. When the weight of our system began to implode you had a rush to the exits. Owners became sellers overnight and buyers went away. From the end of the chain came the "no mas" signal. No more. The fund at the end buying everything was full. No more. All the way down the line to the bank that finally said, "No" to the mortgage applicant because the bank was now having trouble unloading the mortgages they currently had on their books.
See, what happens when you create all of this "stuff" with debt is that debt has to be paid back.... if you are creating increases in the prices of "things" faster than wages are increasing, you have a major issue coming. Relative to the price increases, wages were not moving an inch for the average person. And that average person was the couple buying the $500K house with the pool, the second home in FL, and filling the driveways with SUV's. The day that John Q. Public, or John Q. Speculator, called the bank and said, "I've got a problem paying this month"... the music stopped and stopped fast.
Velocity slowed, which means lending slowed, which means borrowing slowed, which means spending slowed, which decreases demand in a debt financed society, which collapses prices.... and the process starts again from the top until velocity crashes. Money, wealth, the ability to spend is stopped immediately. Prices crater and money/debt is evaporated into the thin air from which it was created...... deflation.
The Fed is powerless against deflation caused by a paradigm shift from consumerism to thift. The Fed can create all the money it wants, but if the public doesn't borrow it, velocity goes to zero and stays there. And this brings me to the collapse of the USD.....
If you go fishing in a swimming pool, you are not going to catch anything. You can have the best rod, the best lure, and 400 ft. of Spiderwire, but you are not going to catch a thing. You can cast and cast and cast, but nothing. Why? Because there are no fish....
There are no consumers in the US and the globe. The game of money from debt, that game created by the banks for the banks, only works if there is a consumer there to borrow. If people stop borrowing, it is very bad, if people start paying off their debt, it gets worse. A loan is an asset on the books of the banks. They do not want you to pay it off or else they face reloan risk and interest rate risk.
So what does the government do???!!!! Well, from the same playbook, they create a TON of money!! But just like our fisherman at the pool who let's out 100 ft of line, if there is no fish, you are going to end up with a big bird's nest of line on your reel.
The government's attempts to "stimulate" the economy includes pumping massive amounts of money into the banking system. What is so nuts though is that, for the first time in history I think, the Fed is paying banks interest on their deposits at the Fed. Talk about discouraging lending. Why lend money out to borrowers that may not pay it back when you can put it on reserve at the Fed and collect interest. Also, the borrowers just are not there. People do not want more debt. Who on earth needs another car or who on earth needs a new one? All of the buying and selling, for the next decade, was done in the last 3 years (prior to the crash). So now we are left with overcapacity and a shift to thrift. To bring it back to the inflation versus deflation debate, we have seen wealth destruction that far exceeds the amount of money being printed right now by the government. But what is more important than the money being printed is that there is ZERO willingness to borrow and spend which reduces that velocity to 0. Go back to rates of change and you will understand how dire it will get when you go from hypervelocity to nothing.... the Fed can print all it wants, but the money will just sit around, and here is how we get to the collapse of the USD.
The government is issuing massive amounts of debt to finance its spending and transfer payments. The US government is so far in debt that we now need to borrow $1.85 Trillion for 2009 and will need to borrow another $2 Trillion for 2010. This goes to pensions, wages, Medicaid, Medicare, SS, TARP, bailouts, wars, etc. All told, the global amount of government ONLY debt issuance for fiscal 2010 will be over $5 T. That does not count corporations, commerical mortgages, etc. Where will that money come from during a global deleveraging process? Well, the debt will be what is called "monetized". That is a not so fancy word for, inflated away. The government will sell bonds to itself and foreign central banks, the print the money needed to pay the interest. Rinse. Repeat.
The World Bank reported that 2008 global GDP was $60 T. This will be far less in 2009 and less in 2010. That means that global government debt issuance will be 10-11% of global GDP. That is a huge problem and here is why.
Governments are used to borrowing at very low rates. Uncle Sam pays us 3.5% to use our money for 10 years. In a time like this, a deflationary period of falling prices, that "real return", or adjusted for inflation, is large because inflation, as measured by price increases, is negative. But 2.5%? When I could take that money and payoff my credit card which charges me 20%...! What will happen is what is called the "crowding out effect". The cost of borrowing, or the interest rate paid, goes up to compete. Would you buy a GE bond paying the same rate as a government bond (default theories aside)? Of course not. So GE's cost of capital needs to go up to compete with all the government debt being issued. Bad for corporations, bad for workers, bad all around. This also works on a global level as governments must compete for dwindling capital. Japan's interest rates are going to skyrocket since they need to issue massive debt ( I could do a whole other post on this mess) and compete with the US for capital.
We will print money. Japan will print money. The Eurozone will print money. We will all lower interest rates but again, remember how this plays out in economics. It doesn't happen in a vaccum. All nations rely on exports and imports, buying and selling... it's commerce, right? Well, if one currency loses value because of monetary policy, it becomes more competetive in the export game against another currency that is stronger. You have a "race to devalue" all of a sudden. The feedback loop is vicious.
The US will print and print and print. And issue debt and issue debt and issue debt. Solving a massive leverage problem, with more leverage = not the answer. The real killer in this will be when the interest rates increase (this is why the US government has been buying so much of its own debt). If you are used to borrowing at 3.5%, and the rates jump to 4%, that may not seem like a lot at 50 bps, but the rate of change is large and the corresponding increase in interest cost is staggering! Think of Japan. They issue debt at 1%. What happens if that goes to a paltry 2%?
The feedback loops are enormous and will end when the race to devalue ends at 0. This is why you hear that the cost of everything we NEED will go UP but the price of everything we HAVE will go DOWN. The worst of both worlds. The value of my house, down. The value of my stocks, down. The price of milk, up. The price of gas, up.
How does that occur. Currency. The devaluation of currencies will be the reason that products we want will go up, and that which we have will go down. We, in the US, have enjoyed the ace in the hole because our currency is accepted world-wide as the "reserve currency" which means it is necessary for global trade. But that is changing, rapidly. US debt is now at 375% of GDP which is a post 1870 record. We leveraged more during a deleveraging process. That makes us clearly prone to deflation and complete stagnant growth. We are a debtor nation which removes any comparisons to Japan in the 1990's or the Great Depression.
We are in much worse shape now than ever. EVER. We may see temporary increases in GDP but GDP per capita, as the population grows, will decline and that will be reflected in the lower standard of living. We will see deflation take hold and run its course driving asset prices into the ground and creating massive losses for banks and lending institutions. Falling prices, unless spurred through increases in productivity, are death for corporations and therefore workers. Deflation is nasty, very nasty.
In an effort to be the lender of last resort world governments are issuing trillions in debt and printing trillions in new money. But it all falls on deaf wallets. When it does that it has the effect of our fisherman friend letting line out to catch a fish that isn't there.... a huge bird's nest. Our currency will become worthless as foreign countries get sick of being paid back with fiat currency that is being devalued by the day. Again, the only ace we have right now is that our currency is the "reserve currency". The IMF prices their loans in the USD. It should now be obvious as to why China wants more of a voice at the table and why we always push for more loans from the IMF to other nations. Everytime the IMF issues a loan to Poland or Iceland or Argentina, we have an immediate buyer of the USD.... Why do you think we invaded Iraq? Saddam would not price his oil in the USD.
The game will shift to one of resources. China is buying commodities is because they understand that at some point in the very near future, money will not mean a thing, but copper will, gold will, oil will. The game is about resources now. That is why we will not drill in ANWR. Why use our oil when we can invade a country, take its massive oil and natural gas supplies, and price it in our currency, and exploit it? We will use our oil when we need to.
The question of "how to prepare" should be an obvious one. As our currency falls in value, and confidence wanes in our currency, commodities will rise in price regardless of demand. Food especially. Europe is in even worse fiscal shape then the US and Japan is worse than that.
It is ugly. Really ugly. Contrary to our "microwave" way of thinking, this will not play out over the course of 1 minute. This will be a slow painful death for world banks and currencies but one that is almost impossible to reverse.
Prepare by coverting your paper wealth into tangible wealth. That is my advice and that is how I am preparing.
I am sure that I have missed themes but I tried to hit on the highlights of what shapes my thinking. I am certain that parts of my diatribe was remedial for some, but others may learn something new. I hope that you found it interesting and helpful and please remember that I am not saying that I am correct with my future assumptions since there is no playbook for where we are heading.
God Bless.
Disclaimer 1: There is no road map or playbook for what I am going to discuss. No third world debt default can compare to what a default of US debt and/or the collapse of a major world currency such as the USD, Euro, or Yen.
Disclaimer 2: Due to unprecedented levels of government hubris, intervention, complete disregard for law, and manipulation, any assumptions I make could be just as easily discarded as they could be true. Since the rules of the game change every Sunday night, it is very difficult to play. This is not a caveat for being wrong (as I am not afraid to be wrong) rather a caveat that history, education, and research go out the window when rules can be made and broken at will.
Disclaimer 3: Any assumptions made are my own. I will not take the time to post links to every piece of factual research that I post as that will take too long but if someone wants that information please PM me and I will provide it. Pretty much 99% of the information that I use or cite are easily found government stats that can be Googled.
Where We Are Now:
There has been much debate in the media and in some of these threads regarding whether we will sooner see inflation or deflation. There are many camps that are discussing this matter and you have probably heard them all by now. Heck, we cannot even agree on how to define inflation and deflation. For practical use purposes though, it is more helpful (IMO) to define them as they relate to the money supply in circulation. It is economic theory that if you create a bunch of money in the system and pump it into people's wallets, they will go out and buy things. This increases demand. An increase in demand, without a corresponding increase in supply, will create an increase in prices of "stuff". Deflation would work the opposite way. If you take money from people, they cannot spend and therefore demand will decrease and without a corresponding decrease in supply, prices fall.
Now, NOTHING in economics can be viewed in a vaccum for the ONE simple fact that economics involves the behavior of IRRATIONAL beings. This fact cannot be stated loudly enough. This fact is also a reason that econometric comparisons to the Great Depression ought to viewed as nonsense. It is like saying if the Patriots played the Bears in the SuperBowl this year the Bears would win by 36 points since that is what happened in SuperBowl XX. We all can see clearly why that assumption is nonsensical. Different this, different that... but those differences make a huge difference in outcome.
Economics is the same. Please keep that in mind as we go through this.
The only thing that the US has produced in the last decade plus is financial engineering defined more technically as velocity of money. Mathematically put, the output of a country can be simply defined as the aggregate money supply multiplied by the times that money supply moves through the economy. "High powered money" is the theory that $1 moves through the economy and changes hands multiple times. As I get paid from work, I pay the landscaper, he pays his employees, they pay their bills, etc etc. Since 72% of our economy (at the most recent peak) is measured by how much we, as consumers, spend, you can see very quickly how the "velocity" of money creates a HUGE impact in the final tally of our output.
But, as some of you may be saying now, how is that really "output". "We have not created anything" you say. And you are right. This goes back to a fundamental issue with our country's monetary & fiscal behavior. We have a fiat currency and a fractional reserve monetary system. In English, that means we have a currency that is backed by nothing, can be created at will, and when deposited by members of the Federal Reserve Banking system, can be leveraged 10-1 (at least). This is how the "money mechanism" works. The Fed prints $1 and puts it into the bank of choice. The bank puts $.10 on "reserve" with the Fed and lends out $.90. The bank makes money on that loan called "interest" (this is the trouble with "usury". If the Fed prints all the money needed, then who creates the money to pay the "interest".... and on and on we go). The bank loaned that $.9 to me so that I could buy a car from my neighbor. My neighbor takes that $.9 and puts it into his bank. Guess what his bank does? His bank takes 10% of that money and puts it on "reserve" with the Fed and loans out the rest. And so on...... you don't even want to get into the leverage amounts that the government afforded to JP Morgan, Bank of America, Goldman Sachs, Morgan Stanley, B. Stearns, and L. Brothers. What shock, three of them don't exist anymore and the other three only exist because they were the "chosen ones" to be bailed out.
So, what have we done over the last decade? Well, we had a complete "productivity miracle" occur with the advent and application of the internet. I cannot say how much this system has revolutionized global business and changed economics. This was real and tangible. This was measurable and legit. What it allowed us to do however, was to again manipulate our system for the worse. What increases in productivity do is to keep a lid on what is called "unit labor costs" or wages and other inputs that go into the cost of goods. Lower cost goods means that "inflation" (that pesky inflation again...) AND THIS IS IMPORTANT, "as measured by the Consumer Price Index", stays low. Again, in English, this means that we can make computers now for $500 instead of $5,000. That, according to the CPI is a huge move down in inflation, or the "costs of goods and services". The government's response to a move down in the costs of goods and services is to keep the pedal to metal in terms of monetary and fiscal policy. No inflation? No hikes in interest rates. Money is cheap and stays that way according to them.
Then the internet bubble bursts. Wealth is literally destroyed overnight. This is why an understanding of inflation and deflation is so important. When you remove the consumer's ability to buy, leverage, borrow = spend, you create a complete bottom out in demand. Our economy is built on debt, remember that is how money is created over and over again. If you remove that money, if you destroy that wealth, you handcuff the people's ability to spend.
Now, another key, CORE theme in economics is the theory of rate of change. Since economics is totally linked with behavior, the rate of change makes all the difference in the world. This can be most recently noted in either the default rate of mortgages or the US consumer savings rate (or if you want to get really scared look at the savings rate of change of Japan). A small uptick in the % of defaulted subprime mortgages caused massive waves through our system. Our savings rate went from negative to now at 6.5% in about 1.4 years. 6.5% for a savings rate is not high "by historical standards" but that does not matter AT ALL, it is the rate of change that matters.
So what we had was a complete drain of wealth from the bursting of the internet bubble. We entered a recession as defined by negative growth, or GDP. A contraction, if you will. What causes contractions in a society that is based on debt? Less debt. Less money. Less purchasing power. OR, and we will get into this in a minute.... a paradigm shift of consumers from spending to savings. A jump from a negative savings rate, to a positive one, has catastrophic impacts on corproate earnings and profits. If the savings rate gets high enough you experience what is called the Paradox of Thrift. This is now occuring. Because I save money on landscaping, my landscaper cannot pay the people to wash his cars, and those people then cannot go out to eat as much which takes money from the waitress who then cannot get her hair done every other week, and so on and so on.....
In times of economic contraction the government and The Fed, will become the "Lender of Last Resort". This goes back to GDP and the money mechanism. If people have been using their homes as ATM's, and their housing values plummet taking away their ability to spend, the government wants to step in and create a supply of money to abate the crisis. When the government can create money from thin air, why not? Well, here is why not....
To pull us out of the recession of 2002 (which was mild at worst) and the devestating effects of 9/11 (don't want to get into CT here), The Fed pumped massive amounts of money into the system and regulations were relaxed for Wall Street lending. We created another bubble to solve the problems of a bubble bursting. We also spent billions and billions on war, the most profitable business model our government has ever known. Since money and credit is like a virus, it landed and infected assets such as real estate.
We inflated the real estate market and all the ancillary markets (construction, retail, furniture, autos) that go with it. That is a bit misleading because there were not specific instructions to inflate the real estate market but regulations were sidestepped and new rules put in place which made real estate the spot where the lending landed/credit expanded.
So, let's go back to economics. We had a contracting GDP so we did what we always do (the only tricks we have) on the other side of the equation, we pumped massive amounts of cheap money into the system to increase the depleted money supply and then we did something of EPIC proportions, that we had never done before, we literally created "financial weapons of mass destruction", as Buffett calls them, which is the alphabet soup of credit "derivatives" that we all hear about. Here is how it went down....
The orders came from Washington to open up the printing presses and issue massive amounts of government debt. The government debt went to transfer payments but more importantly, that that time, to funding the wars on military spending. The Fed essentially created no cost money which meant that banks could take that money from The Fed and lend it out and make huge money on the "spread". But that "huge spread", or net interest margin, was not enough. Since interest rates were held so low, and there was a "global savings glut" which kept bond yields very, very low, savers were being punished due to the increases in prices from the increase in demand. Banks started the process of syndication in the name of risk mitigation. And here is where it gets really, really bad. Syndications allowed banks to play a virtual game of hot potato. Since borrowers (hedge funds, pensions, you name it) could go out and borrow money (there is a carry trade aspect here with the Japanese that I am leaving out for sake of simplicity) in the global arena very, very cheaply, you could borrow money at 1% and buy a package of "insert mortgage product here" which was "said" to pay 5%. These events created a velocity of money that was unparalleled before. Speed of light, one trillion times. It was awesome to see. Buy something today, sell it by lunch. Do it again tomorrow. All cheap, all profit. No money down, no doc, no anything.... just get it done. "Castles to the sky". Credit cards, cars, boats, houses... The profits were obvious, the money cheap, the underwriting free, the game rigged.....
Fiat currency in a fractional reserve system works until it doesn't. And here is when it doesn't. We built up capacity (think auto dealerships, malls, schools, movie theaters, gyms, restaurants, etc.) for consumer spending that was probably in the range of 75% GDP going to 80% GDP. Our entire system was based on debt. Unlike equity, debt has to be paid back, or losses taken. It doesn't just go away and worse, unlike equity, has immediate residual consequences that create a cascade affect in economics.
What made the music stop? People. Behavior. Psyche. The system gets so bloated and overweight, that it collapses under its own weight. No one stands up on Capital Hill and waives a flag saying the game is over. You just wake up one day and the tone has changed. You "can" have events that do that... a comet, or drought, etc. But not in this case. The paradigm shift was underway. People smartened up and the scales tipped from those "getting in while the getting was good" to "getting out before it all crashes down".
It is that simple and resembles a snowflake at the top of a mountain that rolls into a snowball and then into an avalanche. Rates of change in a system built on debt where everything is connected.
We built up an empire of debt that has never before been seen in our nation's history. What's worse is that the same globalization that was borne in the wake of the productivity miracle of the 1990's made it so that no rock was left unturned. Credit infected every single aspect of our lives across the globe. People in Poland were issued mortgages that were priced in Swiss Francs but those people were paid in the local currency, the Zolty. When the Polish government became so overwhelemed as the credit stopped, the Zolty got hammered in the currency markets. The people that were paid in zolty's but paid their mortgage in Franc's saw their mortgage payments jump 40% overnight. Ouch. Everything is connected.... economics is pushing on a string.
Back to the US. When the weight of our system began to implode you had a rush to the exits. Owners became sellers overnight and buyers went away. From the end of the chain came the "no mas" signal. No more. The fund at the end buying everything was full. No more. All the way down the line to the bank that finally said, "No" to the mortgage applicant because the bank was now having trouble unloading the mortgages they currently had on their books.
See, what happens when you create all of this "stuff" with debt is that debt has to be paid back.... if you are creating increases in the prices of "things" faster than wages are increasing, you have a major issue coming. Relative to the price increases, wages were not moving an inch for the average person. And that average person was the couple buying the $500K house with the pool, the second home in FL, and filling the driveways with SUV's. The day that John Q. Public, or John Q. Speculator, called the bank and said, "I've got a problem paying this month"... the music stopped and stopped fast.
Velocity slowed, which means lending slowed, which means borrowing slowed, which means spending slowed, which decreases demand in a debt financed society, which collapses prices.... and the process starts again from the top until velocity crashes. Money, wealth, the ability to spend is stopped immediately. Prices crater and money/debt is evaporated into the thin air from which it was created...... deflation.
The Fed is powerless against deflation caused by a paradigm shift from consumerism to thift. The Fed can create all the money it wants, but if the public doesn't borrow it, velocity goes to zero and stays there. And this brings me to the collapse of the USD.....
If you go fishing in a swimming pool, you are not going to catch anything. You can have the best rod, the best lure, and 400 ft. of Spiderwire, but you are not going to catch a thing. You can cast and cast and cast, but nothing. Why? Because there are no fish....
There are no consumers in the US and the globe. The game of money from debt, that game created by the banks for the banks, only works if there is a consumer there to borrow. If people stop borrowing, it is very bad, if people start paying off their debt, it gets worse. A loan is an asset on the books of the banks. They do not want you to pay it off or else they face reloan risk and interest rate risk.
So what does the government do???!!!! Well, from the same playbook, they create a TON of money!! But just like our fisherman at the pool who let's out 100 ft of line, if there is no fish, you are going to end up with a big bird's nest of line on your reel.
The government's attempts to "stimulate" the economy includes pumping massive amounts of money into the banking system. What is so nuts though is that, for the first time in history I think, the Fed is paying banks interest on their deposits at the Fed. Talk about discouraging lending. Why lend money out to borrowers that may not pay it back when you can put it on reserve at the Fed and collect interest. Also, the borrowers just are not there. People do not want more debt. Who on earth needs another car or who on earth needs a new one? All of the buying and selling, for the next decade, was done in the last 3 years (prior to the crash). So now we are left with overcapacity and a shift to thrift. To bring it back to the inflation versus deflation debate, we have seen wealth destruction that far exceeds the amount of money being printed right now by the government. But what is more important than the money being printed is that there is ZERO willingness to borrow and spend which reduces that velocity to 0. Go back to rates of change and you will understand how dire it will get when you go from hypervelocity to nothing.... the Fed can print all it wants, but the money will just sit around, and here is how we get to the collapse of the USD.
The government is issuing massive amounts of debt to finance its spending and transfer payments. The US government is so far in debt that we now need to borrow $1.85 Trillion for 2009 and will need to borrow another $2 Trillion for 2010. This goes to pensions, wages, Medicaid, Medicare, SS, TARP, bailouts, wars, etc. All told, the global amount of government ONLY debt issuance for fiscal 2010 will be over $5 T. That does not count corporations, commerical mortgages, etc. Where will that money come from during a global deleveraging process? Well, the debt will be what is called "monetized". That is a not so fancy word for, inflated away. The government will sell bonds to itself and foreign central banks, the print the money needed to pay the interest. Rinse. Repeat.
The World Bank reported that 2008 global GDP was $60 T. This will be far less in 2009 and less in 2010. That means that global government debt issuance will be 10-11% of global GDP. That is a huge problem and here is why.
Governments are used to borrowing at very low rates. Uncle Sam pays us 3.5% to use our money for 10 years. In a time like this, a deflationary period of falling prices, that "real return", or adjusted for inflation, is large because inflation, as measured by price increases, is negative. But 2.5%? When I could take that money and payoff my credit card which charges me 20%...! What will happen is what is called the "crowding out effect". The cost of borrowing, or the interest rate paid, goes up to compete. Would you buy a GE bond paying the same rate as a government bond (default theories aside)? Of course not. So GE's cost of capital needs to go up to compete with all the government debt being issued. Bad for corporations, bad for workers, bad all around. This also works on a global level as governments must compete for dwindling capital. Japan's interest rates are going to skyrocket since they need to issue massive debt ( I could do a whole other post on this mess) and compete with the US for capital.
We will print money. Japan will print money. The Eurozone will print money. We will all lower interest rates but again, remember how this plays out in economics. It doesn't happen in a vaccum. All nations rely on exports and imports, buying and selling... it's commerce, right? Well, if one currency loses value because of monetary policy, it becomes more competetive in the export game against another currency that is stronger. You have a "race to devalue" all of a sudden. The feedback loop is vicious.
The US will print and print and print. And issue debt and issue debt and issue debt. Solving a massive leverage problem, with more leverage = not the answer. The real killer in this will be when the interest rates increase (this is why the US government has been buying so much of its own debt). If you are used to borrowing at 3.5%, and the rates jump to 4%, that may not seem like a lot at 50 bps, but the rate of change is large and the corresponding increase in interest cost is staggering! Think of Japan. They issue debt at 1%. What happens if that goes to a paltry 2%?
The feedback loops are enormous and will end when the race to devalue ends at 0. This is why you hear that the cost of everything we NEED will go UP but the price of everything we HAVE will go DOWN. The worst of both worlds. The value of my house, down. The value of my stocks, down. The price of milk, up. The price of gas, up.
How does that occur. Currency. The devaluation of currencies will be the reason that products we want will go up, and that which we have will go down. We, in the US, have enjoyed the ace in the hole because our currency is accepted world-wide as the "reserve currency" which means it is necessary for global trade. But that is changing, rapidly. US debt is now at 375% of GDP which is a post 1870 record. We leveraged more during a deleveraging process. That makes us clearly prone to deflation and complete stagnant growth. We are a debtor nation which removes any comparisons to Japan in the 1990's or the Great Depression.
We are in much worse shape now than ever. EVER. We may see temporary increases in GDP but GDP per capita, as the population grows, will decline and that will be reflected in the lower standard of living. We will see deflation take hold and run its course driving asset prices into the ground and creating massive losses for banks and lending institutions. Falling prices, unless spurred through increases in productivity, are death for corporations and therefore workers. Deflation is nasty, very nasty.
In an effort to be the lender of last resort world governments are issuing trillions in debt and printing trillions in new money. But it all falls on deaf wallets. When it does that it has the effect of our fisherman friend letting line out to catch a fish that isn't there.... a huge bird's nest. Our currency will become worthless as foreign countries get sick of being paid back with fiat currency that is being devalued by the day. Again, the only ace we have right now is that our currency is the "reserve currency". The IMF prices their loans in the USD. It should now be obvious as to why China wants more of a voice at the table and why we always push for more loans from the IMF to other nations. Everytime the IMF issues a loan to Poland or Iceland or Argentina, we have an immediate buyer of the USD.... Why do you think we invaded Iraq? Saddam would not price his oil in the USD.
The game will shift to one of resources. China is buying commodities is because they understand that at some point in the very near future, money will not mean a thing, but copper will, gold will, oil will. The game is about resources now. That is why we will not drill in ANWR. Why use our oil when we can invade a country, take its massive oil and natural gas supplies, and price it in our currency, and exploit it? We will use our oil when we need to.
The question of "how to prepare" should be an obvious one. As our currency falls in value, and confidence wanes in our currency, commodities will rise in price regardless of demand. Food especially. Europe is in even worse fiscal shape then the US and Japan is worse than that.
It is ugly. Really ugly. Contrary to our "microwave" way of thinking, this will not play out over the course of 1 minute. This will be a slow painful death for world banks and currencies but one that is almost impossible to reverse.
Prepare by coverting your paper wealth into tangible wealth. That is my advice and that is how I am preparing.
I am sure that I have missed themes but I tried to hit on the highlights of what shapes my thinking. I am certain that parts of my diatribe was remedial for some, but others may learn something new. I hope that you found it interesting and helpful and please remember that I am not saying that I am correct with my future assumptions since there is no playbook for where we are heading.
God Bless.
