The Five Horsemen
Below is another Martenson Report from May of 2009, which I am now making available.
Nothing has been edited or changed.
- What can we expect next, and how will we recognize it?
- A series of sharp, interrupted shocks is more likely than a major sudden collapse.
- Five game-changing events, what I call The Five Horsemen, will indicate that the rules have changed and a new reality is about to take over:
- The First Horseman: New credit growth falls below interest payments
- The Second Horseman: The Fed monetizes debt
- The Third Horseman: Government deficit spending exceeds 10% of GDP
- The Fourth Horseman: The dollar goes down, while interest rates go up
- The Fifth (and final) Horseman: US debt becomes denominated in foreign currencies
Severe structural damage has already been inflicted on our economy. As I wrote two weeks ago (May 16, 2009) in It Has Hit the Fan:
If you have been waiting for further confirmation about the direction of the economy, or waiting for a sign that it's now time to get serious about preparing for a future filled with less, this report is written for you.
You are living in the midst of the collapse of western economies, which are moving from a more complicated state to a less complicated one. This is it. Keep a journal, because it's happening right now.
After the Great Depression, many people remarked that it was only obvious in retrospect. While it was unfolding, things steadily eroded. But 75% of the workforce remained employed, while hopeful signs of progress were constantly trotted out by various politicians, private economists, and official-sounding government agencies. It is often quite difficult to appreciate the true magnitude of sweeping change while it is occurring.
The most pressing question now is this: What can we expect next, and when?
In this report, I give you the precise combination of macro-events that will cause me to issue an alert and kick my thinking and actions into new orbits.
I do not expect a major sudden collapse to be the most likely path, although it is a possibility. Instead, I anticipate a series of sharp shocks, followed by periods of relative tranquility.
Here's how I described the various paths in May of 2008, in a report entitled Charting a Course Through the Recession:
While it is possible, I do not anticipate a one-way slide to the bottom, wherever and whenever that may be. I lean towards the ‘stair-step’ model, where a series of sequential shocks and relatively placid periods mark the path to the future. The three scenarios around which I tend to form my thinking (and actions) are:
- No change. The future looks just like today, only bigger, and no major upheavals, shocks, or recessions happen. The Fed and Congress are successful in fighting off the deleterious effects of the bursting of the housing bubble, and everybody carries on without any major changes or adjustments. This is not a very likely outcome. Probability: 1%.
- A series of short, sharp shocks. Moments of relative calm and seeming recovery are punctuated by rapid and unsettling market plunges and marked changes in social perspective. Think of the food scarcity and riots, and you know what this looks like. One day there was low awareness about food scarcity and the next day shortages and prices spikes were making the news. Soon enough, relative calm returns, prices fall, and order is restored, but prices somehow do not recover to their previous levels, leaving people primed and alert for the next leg of the process. I see this as the most likely path forward. Probability: 80%.
- A sudden major collapse. Under this scenario, some sort of a tipping point causes a light-speed reaction in the global economic system that requires shutting down cross-border capital flows. Banks would no longer be able to clear transfers and accounts, which would wreak all sorts of havoc upon our just-in-time society. Food and fuel distribution would be the most immediate concerns. There's enough of a chance of this scenario occurring, and the impacts are potentially so severe, that you should take actions to minimize the impacts to yourselves and your loved ones. Probability: ~20%.
Based on the odds, the most likely outcome that I see is a series of short, sharp shocks (#2, above) as being the most likely to define the path forward. So far this has been our exact pattern with the first shock occurring in 2007, the second between October 2008 to March 2009 and now a period of stability between March and June of 2009. I invite you to re-read the piece linked above as a means of assessing my information,gathering abilities, and my ability to connect the dots, and shine a light on the future.
In the grand sweep of the trajectory that will deliver the United States, and many other western countries, to a lower standard of living (although not necessarily a lower quality of life, but that's another story), there are several discrete elements that I think of as The Five Horsemen.
The Five Horsemen
I believe that a diminished standard of living is in the future for each of the major economies across the world especially those where the inhabitants have been living beyond their means.
Another belief I hold is that any period of living beyond one's means must certainly be followed by an equivalent trough of living below one's means. For example, if you produce 100 but consume 110, then at some point you will need to produce 100 but only consume 90.
There are two ways that we might expect this period of adjustment to unfold economically. I laid out the basic elements in Crash Course: Chapter 12 - Debt. When too many claims (debts) are laid upon the future the only question is whether those debts will be defaulted upon or paid back (with "inflated away" being a form of default). If all those claims are destroyed by default, then the reduction in future living standard falls to the holder of the debt(s). If the debts are paid back, then the debtor must accept that they will have less money to spend on consumption. Either way, somebody has less coming to them in the future than they either expect or currently enjoy.
Stretched across an entire nation, too much debt becomes an unsolvable problem, a predicament, due to the fact that no benefit accrues from shifting the burden of bearing the impact of default from one sector to another. Shifting a promissory note from one pocket to the other does not change the net worth of the individual and this tactic is equally ineffective for an entire country.
Thus the fact that the US government is assuming massive piles of bad debt from stricken financial corporations does nothing to solve the underlying problem, which sprouts from a nation that has overconsumed for decades. But this is exactly what the government is doing, and the goal seems to be to preserve the status quo at all costs.
Assuming this view is correct, there are signs we can read along the way to confirm if our fiscal and monetary authorities have selected the right path or the wrong path. This report details the signposts that will tell us when certain thresholds have been crossed that will mark that the current strategy is failing and that a new leg of the journey has begun.
The problem and the mindset of the economic elites are neatly revealed in this quote:
May 30 (Bloomberg) -- World Bank President Robert Zoellick warned policy makers that fiscal-stimulus plans are insufficient to turn around the “real economy” and rising joblessness threatens to set off political unrest across the globe.
“While the stimulus has given an impulse, it’s like a sugar high unless you eventually get the credit system working,” Zoellick said in an interview yesterday
I like this quote because it distinguishes between the "real economy" and the economy resulting from excessive government borrowing and spending. Stimulus money is almost by definition wasted money because the probability of it resulting in proper investment is so low. The gains from stimulus money run out the very second the juice is turned off.
But it is the second part of the quote that is revealing - "...unless you eventually get the credit system working..." - apparently those in charge find it unthinkable that an economy could be built on anything other than credit.
An alternative quote expressing a more fundamental view would read, "While the stimulus has given an impulse, it’s like a sugar high, unless it is followed by growth in wage-based income".
The difference between the real quote and the one I provided is like night and day. The Zoellick quote assumes that our past period of living beyond our means is recoverable and extensible, and mine does not. Mine assumes a long-term relationship exists between what people earn and what they can spend. In order for us to service our past debts, we need to grow our incomes, not our access to easy credit.
There is a mathematical limit to this "game," at which point it cannot be carried on any longer. I think we have reached the outer limits of our debt-fueled fantasy, although I recognize that the extreme efforts to carry it on a bit longer may well produce short-term results.
The most obvious and mathematically-defendable end of a credit economy comes when interest payments exceed all income. However, things rarely progress that far, as the trouble becomes painfully obvious far earlier and creditors withdraw their continued support.
How will I know that the participants in this game have finally caught on to the fact that it's over? Here are the five game-changing events that will indicate that the rules have changed and a new reality is about to take over. As I mentioned, I have been tracking these for years and, unfortunately, been watching them unfold one by one.
The First Horseman: New credit growth falls below interest payments
Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist.
~Kenneth Boulding, economist
In our debt-based monetary and economic system, it is imperative that new credit growth at least equal the interest payments on past debt. If this does not happen, then the entire financial edifice, levered up as it is, immediately begins to wobble and crumble. Of course this imposes an exponential growth "requirement" on our entire debt/money system rendering it a long-term impossibility.
Total credit market debt (chart below) stood at over $52 trillion at the end of 2008 and has fit an exponential curve nearly perfectly over the past 5 decades.
The "getting the credit system working again" quote by Mr. Zoellick refers to keeping the curve of this chart sweeping upwards in an uninterrupted fashion, as nothing less will get us back to "how things were."
Where this chart required ~$1 trillion of new yearly credit growth in 1995, the remorseless math of the exponential function turned that into $2 trillion per year by 2000, $3 trillion by 2005, and more than $4 trillion by 2008.
While the government's $1.8 trillion of deficit spending for 2009 is certainly heroic, it needs to be complemented by more than twice that amount from the private sectors in order to keep this chart on a smooth path. That, I am confident to say, will not be happening this year.
Status of the first horseman: Arrived.
The Second Horseman: The Fed monetizes debt
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
~Ludwig Von Mises
My second sign occurs when the Federal Reserve directly "monetizes debt," which is a fancy way of saying "prints money out of thin air and exchanges it for private and/or government debt." This started in 2007 with the first set of rescues, although at the time the Fed took great pains to stress that it wasn't really monetization because they planned to reverse their actions soon. Of course, that has not happened yet. Some of their activity was cleverly concealed with complexity, such as when the Federal Home Loan Board (FHLB) bought up $160 billion in mortgages from failing originators such as Countrywide and then quietly passed them to the Federal Reserve for cash. Minus the FHLB complexity, this represented nothing less than the Fed printing up some fresh electronic cash and handing it over to Countrywide for some failing mortgage products.
The beginning of the end for nearly every debt-ridden country has always been the attempt to pay for past expenditures with newly-minted money. It always starts innocently enough and seems like the right thing to do, but soon the programs grow and grow, and eventually the currency of the country is destroyed.
Now the Fed is openly and actively buying dodgy debt from the government as well as from the private sector. I covered this in a recent "In Session" posting, where I charted the amount of US Treasury debt that was being purchased by the Federal Reserve on a daily basis.
This chart reflects only the Treasury purchases. When we add in agency debt, mortgage-backed securities, and various other corporate debt programs, we find that the Federal Reserve is printing up roughly $15 to $30 billion dollars a day just to keep things limping along.
As for the opening quote by Mises, which I think most accurately reflects how things will turn out, I think it is safe to say this: Any country that is printing up to $30 billion a day just to keep things moving along is not voluntarily abandoning credit expansion.
This means that we are risking a final catastrophe of the currency system involved. Unfortunately, the currency in question also happens to be the world's reserve currency, so this has enormous, far-reaching implications.
Status of the second horseman: Arrived.
The Third Horseman: Government deficit spending exceeds 10% of GDP
I did not expect to see this one arrive for the US this early in the game and I am quite stumped by the apparent acquiescence by the rest of the world's financial authorities to the US running a fiscal deficit of over more than 13% of GDP. I would have expected some resistance on their part, such as a refusal to continue buying US Treasury debt, more than a third of which (this year) has been bought by foreign central banks.
I am convinced that this stimulus money, as historical and enormous as it is, will fail to provide any lasting benefit, in part because so little of it is being spent on investments in the future. Promising to cover the losses for bad debts only protects those who financed past malinvestments. At most, a few measly percent of the total cost of this bailout and stimulus is going towards investments such as beefing up our energy independence or modernizing our transportation infrastructure. If, instead, 95% was going towards investments, and Wall Street had to fight over the remaining scraps, I would be singing a different tune.
The inertia of government spending programs assures that these record deficits will recede slowly only under the best of circumstances and will actually grow larger under normal or worsening conditions. I also want you to recall here that government deficit spending has the strongest correlation with future inflation handily beating out the impact of bank monetary reserves, a common red herring argument trotted out most recently by Paul Krugman who wrote in the NYT:
Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices.
Again, inflation correlates most highly with government deficit spending and I remain at a loss as to why this clean, clear fact eludes so many who should, truth be told, know better.
Status of the third horseman: Arrived.
The Fourth Horseman: The dollar goes down, while interest rates go up
As long-time readers know, it is this fourth horseman that I watch on a daily basis. The combination of a failing dollar and a rapidly rising interest rate on US Treasury obligations will signal to me that the "limitless borrowing spree" of the US government is over.
Currently, more than $7 trillion in US Treasury debt is "held by the public." (The other $4 trillion is owed by the government to the government, so it is not on the open market.) Treasury debt is bought and sold in vast quantities on a daily basis. More than half of it is held by foreigners. If foreigners sold this debt, rates would rise. If they then took the dollar proceeds from these sales and exchanged them in preference for some other currency, the dollar would fall.
The combination of rising interest rates and a falling dollar will signal (to me) that a final loss of confidence in the US dollar as an international store of value has occurred. When (not if) this happens, all manner of financial ills will stalk the globe. Everything priced in dollars will go up in price - in dollars. That includes basically all commodities. All holders of US dollars and US debts will be desperate to get out of their holdings, and you can expect wild plunges and gyrations in most markets. Interest-rate derivatives, which are mainly denominated in dollars and linked to US interest rates, will become toxic destroyers.
So much hinges on the US dollar retaining its role as the reserve currency of the world that thinking through this scenario would require a report all its own. Suffice it to say, that you cannot overestimate the impact of a rapid decline in the value of the dollar coupled to rising US Treasury interest rates.
Because of this, I am quite perplexed that the other central banks continue to play along and buy US debt, while the Fed monetizes like crazy and the US government sports a 13% of GDP fiscal deficit.
Here's the latest data. We certainly are seeing a bit of a decline in the dollar and a bit of a rise in interest rates especially since mid-March when the Fed announced its intention to buy massive quantities of US Treasury debt.
However, these moves are not not yet strong enough to cause me to issue an alert or take personal actions. They definitely have a big portion of my attention, but are not yet at the top of my list of immediate concerns.
What would make me sit up and take notice? Right now that would involve the dollar slipping into the low 70's, while the $TNX (ten year bond yield) vaulted up by some massive amount which, for me, would be 50 basis points in a day (which is one half of a percent).
At that point, I would be putting out an alert that it's time for any fence-sitters to hurry up and grab some dollar-decline protection.
Status of the fourth horseman: Maybe it's here. Maybe. But not yet in full swing.
The Fifth (and Final) Horseman: US debt becomes denominated in foreign currencies
For whatever reason, some people still trust the debt-rating agencies, and one of the more farcical practices is that these agencies routinely "rate" the US for credit-worthiness. The good news is that Moody's recently reaffirmed that the US still has a "AAA" rating, which is the highest possible rating. Or is this good news?
The reason this is a farce is captured in a post that I wrote in an "In Session" forum thread on this matter:
This is a bit of a non-issue. For a country that has 100% of its debt denominated in its own currency there can be no other rating besides AAA.
The idea behind the rating is to answer the question, "What is the probability that this entity can pay off this debt?"
Well, that probability is 100%, when the entity has a printing press.
The only thing that would change this would be if/when that entity has debt denominated in something other than its own currency.
So while we can all be relieved that Moody's has such a high opinion of the US, this is useless information for the purpose of deciding if one wants to hold the debt of that country. An alternative measure would be, "What's the chance that this country will resort to printing to relieve itself of its debt burden, thereby eroding the claims of the current bondholders?"
Let's call this new rating the "M system." One M means, "Sort of likely," two Ms means, "Probably will do it," and three Ms means, "No doubt, they will print." By this system, I rate US government debt as quadruple M, or MMMM.
Off the charts, in other words.
However, the absolute game-changer would be if the US had to pay off borrowed money in a currency other than its own. Yen, for example. In order to pay off that loan, we'd have to get Yen from somewhere, with the usual source being a positive trade balance.
If the US could not get the Yen through legitimate trade, then it could always print up dollars and buy Yen off the open market. But this would serve to drive up the value of Yen and drive down the value of the dollar, so this scheme would rapidly unravel in a currency crisis. If this sounds familiar, it should. This is how most developing nations get in trouble and experience severe currency and debt crises.
Having your debt denominated in your own currency is an enormous privilege. Should that luxury go away, it would become immediately apparent how much the US depends on the kindness of strangers to continue living beyond its means.
So far, only Japan has made some low-level noises about denominating their loans to the US in Yen instead of dollars, but you can be sure other countries are quietly considering it as well.
Status of the fifth horseman: Not here yet.
Three out of the five "horsemen," which indicate where we are in the trajectory of our downfall, have already arrived. A fourth is possibly here; perhaps not quite yet. And the final one will mark an inevitable date with a vastly lower standard of living for US citizens and all countries that are the accidental holders of too many US dollars and debts.
I urge you to begin keeping a close eye on these five horsemen:
- New credit growth falls below interest payments
- The Fed monetizes debt
- Government deficit spending exceeds 10% of GDP
- The dollar goes down while interest rates go up
- US debt becomes denominated in foreign currencies
The current presence of three, or possibly four, of these signs has me thinking very carefully about my assets, my family's needs, and how we will manage the changes ahead. When the fifth horseman arrives, it will bring a new reality for all of us, and I intend to be as ready as possible.