The Next Economic Crisis

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grondeau's picture
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The Next Economic Crisis

 It is becoming clear that the Europeans will not get it together to save the Euro and avoid a major debt crisis.  I guess we can hope that the next major crisis intervention meeting will produce results that prop things up for more than two days, but I'm not holding my breath.  The European approach has been characterized by draconian hard money policies and a demand for austerity, whether deserved (Greece) or not (Spain).  The result of these measures is the predictable Keynesian outcome of further depressed demand and higher unemployment. What was telling with this latest round of negotiations was the supposed capitulation by the banks to accept a 50% haircut on their Greek loans.  Merkel and Sarkozy gave them a take-it or accept-the-consequences deal; the fear of another Lehman event was greater than the pain of the losses, so they took the deal to avoid a "credit event" that would trigger action on the largely unknown quantity of credit default swaps (CDS) that could unhinge other financial institutions.  It seems that just about anything will be done to avoid the uncertainty associated with unmasking this unknown mountain of  CDS exposure.

One-Year Chart for Italy Govt Bonds 10 Year Gross Yield (GBTPGR10:IND)

Interest rates on Italian 10 Year bond

It appears that Italy is the next victim of the self fulfilling promise of austerity under the Euro.  Bond rates have been rising in Italy since early summer, but then in August, the European Central Bank (ECB) promised to buy enough Italian bonds to drive the prices back down.  But they have been inching back ever since, with fear that Italy would be the next victim after Greece was out of the way.  The big meeting with Merkel and Sarkozy was supposed to provide an answer that would calm the markets, as the ECB's debt purchases did in August, but this time it only took a day for the true implications of the deal to sink in -- that is was still too little, too late -- and rates are on the rise again.

Demand for more austerity seems guaranteed to cause deeper recession in the affected countries, less tax revenue, and less ability to repay loans in a timely manner, leading to higher bond rates, leading to more demands for austerity...  you see where this is going.

So what does all this mean for us in the US?  Although this mess is largely a European problem, as the Lehman event showed us, everything is connected these days.  Right now, the uncertainty in Europe is making US treasuries at 2% look like a good safe haven.  The danger is from the feared "credit event", when hedge funds and banks would be forced to reconcile their CDS bets.  There is a good possibility that a significant default event, from even a small county like Greece, could cause some major bank or hedge fund to become insolvent themselves, and subject to default on portions of their portfolio.  A sea of CDS bets could unravel in a tsunami of litigation and frozen credit.  With today's global financial institutions, there would be no escaping the consequences of the global generalized bank run that would develop.

This is the scenario that must not be allowed to happen, that scared the bankers to accept their 50% losses on Greek debt. Perhaps this will be the model for future banking negotiations -  capitulate or accept the MAD (Mutual Assured Destruction) consequences.  Maybe it will work.  After all, it kept us out of nuclear war for 60 years.

timeandtide's picture
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Next crisis

I could not disagree more with your comments. You obviously believe that if the European leaders and technocrats make the right decisions, then calamity can be avoided. I think that it is far too late for that. Governments, their advisors and corporate allies have been making the wrong decisions for so long now that it simply is not credible that they could pull the rabbit out of the hat at the last minute. You complain about the “draconian” German response. They still have memory of the last time the printing press ran amok. The recent deal cooked up by Merkel and Sarkozy, the so called 50% haircut, is nothing of the sort in reality. As was pointed out by Dan Denning of The Daily Reckoning last week – why buy government bonds if the insurance you buy to protect against default (CDSs) is unusable because of government chicanery? I will concede though that most CDS purchases are most likely purely speculative in motive and I won’t be shedding any tears when speculators get scorched. The use of Credit Default Swaps for insurance was shown to be a poor strategy in the last meltdown because of the counter-party risk.  Credit events are financial tsunamis and in the currently still over-leveraged financial world, a credit event will involve dozens of financial institutions. In the last meltdown, Goldman Sachs only got paid by AIG for the CDSs that AIG had issued to GS to cover mortgage defaults. They had made a huge business out of issuing CDSs but they had not bothered to set aside the collateral to cover payable events. Lloyd Blankfein strong-armed the former Goldman boss, Paulsen, who just happened to be the US Treasury secretary into paying them out with the taxpayer money that the government bailed AIG out with. This is just one of many examples of corporate power working hand in glove with state power. Goldman may well have failed without that “leg up” from a friend in government. Until the banks are forced to mark to market their sovereign debt “assets”, which has yet again been side-stepped because they have avoided a “credit event”, bankrupt businesses which should be allowed to fail will continue to operate and continue to misallocate capital.

I describe the world as still heavily over-leveraged. Some may argue with me on this because most data shows outstanding credit falling as the world deleverages. However, I would say that as long as financial institutions can get away without marking “assets” to market, we simply do not know the state of the balance sheets of many of the largest institutions operating today. In other words the levels of leverage may be approaching infinity if those institutions are, in reality, completely bankrupt as I believe many of them are.

You imply that Greece may not deserve austerity. A country whose citizens in the private sector simply do not pay their taxes and whose government hired Goldman Sachs to engineer their way through the small problem of disguising deficits and debt levels to gain entry to the EEC deserve all they get.

You also describe Italy as a victim. While it is true that Italy’s debt levels are much lower than most other European countries (private debt is 125% of GDP and government debt is 121% of GDP), the debt of the third largest euro economy is still $1.9 trillion. That is a huge problem because Italian sovereign debt is held by financial institutions all over Europe and they are very worried. The Greek haircut will have weakened the French banks even further. Banks have to raise money somewhere so they are selling Italian debt and so the yield rises.

It is simple arithmetic really. Debt is debt and it is a real call on the future. As long as the future comes round the outstanding debt will be there. It can be temporarily hidden, it can be obsfucated but when its time comes round it will still be there. Many people talk about debt relief. There is no such thing. Debt relief is a euphemism which simply means that the debt is passed onto someone else – usually the tax payer.  So while one entity may be relieved another is burdened. The idea that spreading it out over millions of taxpayers will somehow mitigate the effects of the extra burden is a nice idea but someone will be worse off and therefore economically handicapped. In fact millions will be worse off. My point is that the perpetrators of the various money frauds are the ones who should pay. If they don’t pay they or those who come after will do the same thing again. The only way the whole show is being kept going is by the continuance of debt creation out of thin air by banks at the behest of government. More credit money was issued during the GW Bush years than in the entire period from 1776. The size of the fraud is beyond comprehension. It cannot be rectified except by deflation and bankruptcy. Real assets – the old fashioned capital assets like infrastructure, buildings which have a real use such as dwellings and factories, warehouses and silos, the means of production, farmland, machinery, mines and so on will find a level of value that reflects real economic output. I suspect many office buildings will struggle to find any value because we will come to realise that the vast bureaucracies of paper shufflers (including those in financial services) are simply nether affordable or sustainable. There will be new relativities of value. Food will probably become more valuable and dwellings less so.

You state that uncertainty in Europe makes US Treasuries at 2% look like a good safe haven. As if there is not a similar level of uncertainty in the US! The reason that US Treasuries are at such low levels is because the world is awash in US dollar “money” because the US created more credit than anyone else. It is so valueless that the Chinese thought nothing of spending $170 a ton for iron ore until quite recently. That was a six fold increase in 5 years. There are millions and millions of tons of the stuff in Australia, Brazil and Africa. The wonder is the extraordinary expertise to raise the capital, design the mines, the huge machinery, the rail and shipping infrastructure to deliver 350 million tons a year from Australia alone. That is a real business, yet mining companies with a few exceptions (like BHP and Rio) are midgets compared to the titans of the financial world. As the world deflates, which it eventually must continue to do despite the respite since March 2009, vast amounts of financial “assets” will simply disappear – they already have but it has not been acknowledged on balance sheets. When it is, those balance sheets will be seen for the frauds they are. As the dollars disappear so will the value of the dollar rise. The same goes for the Euro so there will be a ratcheting back and forth of currency values as first one economic zone deflates faster than the other. There are more dollars and more assets denominated in dollars so I suspect the last man standing will be the US dollar. It will buy an awful lot more than it does now when the dust settles and the howls die down. I have no idea whether this process will take decades, like Japan, or just a few years. I suspect the latter because the US is not a country where people like to sit around. At some point a realization will be made and there will be a year or two of brutal reduction. A complete re-calibration. Companies, institutions, governments will be broken up and assets will pass from weak hands to strong. Those without debt will be the strong hands. New leaders will appear. The can will no longer be kicked down the road but will be crushed. Bring it on, I say.

I thoroughly recommend reading Bill Bonner of The Daily Reckoning on this subject. He has been letting fly in his inimitable style just lately:  

No_Fiat's picture
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 It is unwise to make such

 It is unwise to make such predictions, because the powers that be will make a liar out of you every time. It is better to learn as much as you can about what is really going on and then do your best to circumvent it. Making predictions only gives them better ammo to work around us.

grondeau's picture
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Timeandtide,  Thanks for

Timeandtide,  Thanks for detailing your disagreement.  Here's my 2 cents on the basic problem with the "hard money" line that you are defending.  First, money has value as it is perceived by the people who use it.  Indeed, the quantity of money in circulation has some basis for its perceived value.  Presently, cash and credit are very nearly the same thing as far as investors are concerned because of the essentially zero interest rates. Despite the huge pools of money and cheap credit out there, still we have very low inflation.   The reason is a dramatic demand slump caused by 1) the self fulfilling action of debt deflation that erodes the value of working class consumers faster than the deflation rate - the process that started with the collapse of the housing bubble. 2) the large concentration of wealth at the top where there are few consumers effectively removes spending power from the majority.

As you point out, debt is a real obligation into the future.  However, there is a simple way to reduce that obligation and that is through inflation.  In this forum, inflation is usually preceded with the "hyper", but it need not be.  The Fed, (again universally reviled in these forums) showed that it could control run-away inflation under Volker by merely raising rates high enough.  Unlike the lower bound that the Fed is against now, there is no upper bound on interest rates, so the Fed has and can effectively prevent runaway inflation.  Targeting modest inflation would do the world a lot of good.  Real inflation implies BOTH rising prices and rising wages.  In a world where there is a 1% holding all of the assets and 99% that are the consumers and debtors, inflation is a very simple way to tax the rich - which is exactly why it is given such a bad rap!  An inflation target of 5% a year would steadily erase debt.  The holders of mortgage debt could finally spend money again!  Furthermore, as the world runs up against the limits of resource depletion and other limits to real growth, inflationary growth in nominal terms allows our current economic system to adjust to no-growth or de-growth without shocks.  

Please understand that I have no sympathy for the banks!  They need much tighter regulation, Tobin taxes, breaking up, etc.  There is plenty of corruption and money-power-government collusion that needs to be reigned in. 

At this point in time there is still some possibility of avoiding the destruction of a debt-deflation scenario, but we are quickly losing that opportunity.  The result of a chaotic default - which seems to be the direction we are headed - will not be as pleasant for the average Joe as the modest inflation solution...  The default scenario that I see has credit locked up for months as all of the interested parties play legal musical chairs to see who is left holding the bag and who isn't.  This could mean months of effective economic shut-down.  Jobs go away.  Oil tankers stop running.  Commerce freezes up.  The gold you have for this emergency isn't particularly useful because its hard to use it to by potatoes.   Despite all the money the Fed pumped out, cash is still king, because the money they printed went in the wrong place and we still can't get at it!

After the lawyers finally settle accounts, there will be winners and losers - far more losers - and the losers have nothing.  The result is indeed less money in the world - but still a very inequitable distribution of it. 

The idea of a fixed money supply, as simple and comforting as it sounds, simply removes one of the control variables available to maintain a stable economic system. 

You will not find a stable "natural" solution to what amounts to a positive feedback control problem.  

Economies are NOT naturally stable entities.  Prior to the Fed and central banking, FDIC, etc., the typical time between very large financial panics was only about a decade.  The solution is not to throw out the Fed and government intervention into the economy, it's to make sure that banks and individuals can't co-opt the system for personal profit.  This is a governance and political issue – not an economic one.

timeandtide's picture
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inflation is so seductive

 Hello Grondeau,


I will go through your points one by one.

Money has value as it is perceived…. True but I believe that most people and especially those like myself who are well past 50 years have great difficulty in attaching an “accurate” real value to it. Some things like real estate have inflated hugely and many other things such as manufactured goods out of China have fallen. Perception of value has been extremely hard because the price signals have been so messed up by the extraordinary inflation of the money supply.

Investors would be wrong to think of cash and credit as the same thing because credit always has to be paid back.

Of course the Fed could control inflation if it had a Paul Volker at the helm. My point is that it does not and it has no intention of deliberately reining in inflation by raising interest rates because it is terrified of what that would do to its own balance sheet, let alone the balance sheets of the other US banks which collectively own the Fed.

You believe that we have very low inflation – well the official figures might suggest that but they strip out energy and food which is not very helpful. Williams shadow statistics paint a somewhat different picture. Until 2006 property was inflating madly, until 2008 oil ran over a decade from $10 to $148, the share market ran hard from 1982 until 2000, took a fall into October 2002, ran pretty hard for another 5 years, fell very steeply into early 2009 and ran up again until early May this year. We are now sitting about 15% off the Oct 2007 top.  Gold has also run up very strongly over the decade and is just 7.5% off the top. Looked at from this point of view it is very hard to be conclusive about the inflation rate. The pure measure of inflation is really the money supply and that has been rampant but the only way money is really entering circulation is via government spending because the banks are just not lending, except to the Fed and the public are not borrowing. The financial community is speculating crazily while the general public are doing their best to pay off debt. So it is very complicated and nothing is quite as it may seem.

The 1%/99% figure you quote is a bit of an urban myth. According to Joseph Stiglitz the top 1% control around 40% of the wealth and take 25% of the income as compared to 25 years ago when the top 12% controlled 33% of the wealth. They mostly got there by creating inflation. They prospered from it because they (the financial institutions) massively expanded and encouraged the use of debt for real estate and other forms of speculation. Thus began a game of pass the real estate parcel. The music stopped several times but it stopped for good in 2005-06. I do not believe that this was some grand conspiracy – it was just the madness of crowds. Everyone was caught up in it but the facilitators, the bankers/ mortgage originators/insurers/RE agents etc were ticket clipping as well as taking direct stakes all the way through the mania. It was no wonder they made a fortune. Some of them lost their fortunes too. Still, if you have amassed a few hundred million you can afford to lose half and still be extraordinarily well off.

This is what rampant inflation does. It destroys market signals. It encourages speculation. It actively discourages thrift and it is from savings that the next proper economic uplift will come. It can only be financed from the surplus that is put aside like seedcorn. I really cannot agree with your idea that even a bout of modest inflation would do the world a lot of good.

If you could explain to me how this moderate dose of inflation is created if not by borrowing, I would be all ears. The Fed has been trying to inflate since early 2008 with quantitative easing which has quadrupled the balance sheet to $2.8 trillion with precious little effect on ordinary people’s lives, although it has made some speculators very rich and others poor. The employment rate is still around 10% but probably double that if the figures were not so manipulated. The world is awash in debt and that includes China. It will never be repaid but will have to be liquidated through bankruptcy.

It is true to say that in an inflationary period it is the correct strategy to borrow to buy assets because they tend to increase in value faster than the interest cost of the borrowed money. It is also true that a degree of inflation suits governments because generally inflation will allow them to pay back their borrowings with money that has less purchasing power than when they originally borrowed. They pay back with taxpayer revenue which tends to increase because the very same inflation drives wages and salaries into higher tax brackets. However, the debt still has to be paid back. Alan Greenspan may have believed in a “new economic paradigm” and economists may have talked blithely of the  “goldilocks economy” but they were wrong and the taxpayer revenue was unable to keep up with the outgoings. That is the story of the US and Europe and the dishonest belief in inflating away debt.

In the past, governments could and did set money aside to stimulate things when there was a downturn. They maybe even borrowed a modest amount. That is not the scenario today. In the early 2000s, the proportion of S&P500 earnings coming from financial firms was over 40% - that was indicative of the sort of gearing being employed. The government, in its way, was doing the same thing. It cut taxes and began the prosecution of the world’s most expensive war. This was another indication of the mania. An extraordinary confidence that it was affordable- that business would continue to produce enough profit which could be taxed at a lower rate and still produce enough revenue to cover a mounting deficit. What were they thinking? Equally, what were all those people with ordinary jobs earning ordinary wages thinking when they signed on for a $400,000 mortgage with no deposit? It was a collective madness and it now has to be paid for. There is not much point in pointing the finger at the bankers – they were just as stupid as Joe Sixpack. The only good reason for the Occupy Wall St movement is to prevent those who should have known better from passing off their losses onto the taxpayers without paying substantially themselves. That is why the bail outs must end. No matter which way you look at it, the ordinary people will suffer the most. They always have done and they always will but they should try their hardest to hold those most culpable to account while recognizing that they are not so innocent themselves. Those most culpable are clearly members of government and their unholy alliance with the Wall St elite.

You simply cannot inflate your way out of debt – that is what governments have been doing more or less since the Federal Reserve system of fractional reserve banking was set up in 1913. The value of a dollar today is less than 5 cents of a 1913 dollar. We are at the end of the line and debt has to be accounted for which means liquidation on a massive scale. That is deflation. The other point I would make is that as long as people do not want to borrow or banks want to lend, then deflation is pre-ordained. It is happening because the people know it has to happen. People are saving and banks are not lending. The mood of confidence is rapidly evaporating although I believe that change of mood from optimism to pessimism actually began in the late 90s and is now gathering strength . Most people seem to think that the falling sharemarkets of 2000-02 and 2007-09 created the pessimism. If that were true, why did the markets turn down in January 2000 and October 2007? Things were flying – if there is a feedback loop it should be positive as well as negative i.e. the feedback should have propelled the market onward. There is no feedback loop. If there was then the mood would be constantly reinforcing either up or down and would never change direction. Elliott Wave Theory holds that markets are moved by endogenous waves of confidence and pessimism. Since just about everything in the universe runs to a wave cycle, the theory makes complete sense to me and I believe it is probably crucial to our long term survival.

Robert Prechter and his theory of Socionomics and Elliott Wave Theory  are well worth reading for his brilliant insights into cause and effect.

I quite agree with you that a fixed money supply is not the answer, even if it were actually possible. However, I do think that money supply has to be taken out of the hands of the bankers or governments or countries (I am thinking of the abuse of the US dollar as the reserve currency here).

 I disagree with you over this because you are advocating that we do not throw out Fed or government intervention. Your viewpoint surprises me given the extraordinary mess the actions of the Fed and the government have made of the basic need to more or less balance the books at least every decade.

 There is a reason for this. After the 1929 meltdown, the government hauled in the banks with the Banking Act of 1933 (Glass-Steagall) to separate deposit taking institutions from trading and investment banking. If you were to follow Elluiott Wave Theory, you would see that from the worst lows of 1938, the equity market began moving up right through the war and took off in the 50s, set back from about 1966 to 1982 and then rolled into the greatest bull market of all. The confidence was so great that by the mid 90s all the protections had been removed and Citicorp (a deposit taking institution) had taken over Travelers Insurance and Smith Barney and Saloman Bros (both brokers). This did not happen because of a few evil bankers. It happened because it was politically possible – because the market had been running hot for a dozen years and people were just full of themselves. The general public were not complaining. The Clinton government was wanting to free up credit so everyone could own a house and everyone believed it possible.  And that was way before the LTCB bust where Nobel prize winners with algorhythms and egos to match were running amok  and the dot com boom and real estate rampage were still to come.

 All basically a re-run of the Dutch tulip boom, the South Sea Bubble and the 1929 crash.  Such manias are not about fundamentals or supply and demand but simple human cycles of optimism leading to delusion followed by dreadful realization and destructive  pessimism. I am not sure that there is anything to be done about it except to try to prevent the delusion running away on such a massive scale as we have allowed over the last two decades. Surely it would be less destructive to have a panic every decade rather than a worldwide meltdown after 30 years?

timeandtide's picture
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The powers that be?

Hi,  No_Fiat

 I am not a conspiracy theorist believing in a bunch of people sitting round a table plotting the futiure of the world which presumably includes the enrichment of the plotters and the enslavement of the masses.

That seems to happen all by ityself as it has done since time immemorial. Todays enslavement, though, tends to be voluntary. No one holds a gun to the head of the person taking out a large mortgage with a tiny ( or even a zero) deposit. Millions did this but many, because of the extraordinary system of non-recourse lending in the US, were able to walk away. What did they lose? If anyone was stupid, it was the bankers and other Wall streeters. How could I possibly imagine that these same geniuses could have the nouse to "work around us" ?

This is not about one bunch of human beings putting it over another bunch. Thius was about the whole world going bonkers for a decade. It has happened before and it will most likely happen again. Humans are brilliant until they believe it, then they go mad until regret and sense put them back on the path again.

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More Fun!

 Hi Time&tide,

If you are willing to put in the time, so am I, so let’s see if we can fine some common ground.  I don’t really think we are as far apart as it may seem.  At one time or another, I’ve had similar concerns to yours, but over the last few years I’ve done my best to try and understand the spectrum of thought on the monetary system and economics in general.  There was a real good test of the two views about what was likely to happen soon after the 2007-2008 crisis.  There was a very strong split between Peter Schiff’s and Paul Krugman’s idea of what was coming along.  In response to that crisis – Krugman has been spot-on while Schiff has had to “weak dollar, inflation will kill us” can down the road.  The main difference between these two thinkers is that Schiff has a simple model where monetary supply is inversely proportional to dollar value, and Krugman has the IS-LM simple macro model that say there is a problem of “liquidity preference” once interest rates hit zero.  This is crucial – since the fed’s primary tool for regulating the economy is the setting of short term rates at their discount window – which just became useless when it was most needed. 

I think it is a misconception that the Fed has all that much power.  They really deal with relatively small amounts of money compared to the private markets.  It’s never possible for the Fed to be completely contrary to the general market trends.  I looked at this issue when I asked myself – what sets the “natural” rate of interest, and how are the Fed’s actions related to that.  Inflation and the “risk free” interest rate, has a couple of nice graphs, and this process helped me to understand how the Fed actually makes policy happen.  If you look at the Fed’s decisions in context of the economic milieu at the time, it’s difficult to pick an instance when you could say they were knowingly making an error.  They do have there “dual mandate” after all.   

When the economy is not at a standstill, and there is the ability to invest in a project and expect a positive return, what matters for businesses is cash flow.  Growth is predicated upon building more infrastructure to enable more production for more profits.  In this case, cash and a 0% loan really are the same.  With money that is used for investment, it is expected to yield a net positive return.  The decision to invest will be made based upon the expected return on investment versus the cost of money.   If you are a business with cash on hand, your choice is to put it in the bank at 0% rates, or to invest it in some new business expansion.  These decisions are very similar with similar financial outcomes.  There is always the liquidity preference for cash.   So if you are going to tie up funds in an investment, then there is further incentive to take the 0% loan, since you will still have your cash to handle emergencies. 

As far as the various components of inflation go… Two points:  1)  When it comes to the largest asset that most Americans own, housing has gotten lots cheaper.  So asset-weighted we have had some deflation.  2)  The problem of scarcity is not the same as of general monetary inflation.  We should expect oil prices to rise compared to other prices as peak oil makes itself felt.  The result needs to be demand destruction, which with oil as inelastic as it is, results in large price spikes.  The various government agencies keep tabulating this stuff.  They have found that usually they can make better decisions if they consider the less volatile components.  This has been proven true often enough.  For example, about a year ago it looked like prices were on the rise – mostly because of fuel costs associated with the loss of Libyan oil.  That’s worked through the system, and the prices abated.  The core inflation indexes remained subdued despite surges and retreats of the headline numbers.  But it is the headline numbers that make the headlines, usually when they are going up. 

I agree with you entirely about the numbers on wealth.  I was jumping on the 99% bandwagon.  But I don’t agree with you on the idea that inflation got the rich where they are.  In fact I think that is just backwards.

 I look at capitalism as big profit making pump.  In takes raw materials – transforms them into waste and goods that eventually turn to waste and generates profits in the process.  It need raw materials.  Oil was great, so are forests and fisheries, and agricultural land and all of these resources have now been exploited to the max.  As the world gets fully exploited by the big companies, the rate of growth slows down because it gets harder and harder to make a profit when every niche is already used up or under production.  This is why “developing markets” are all the buzz – there is still something to exploit.  In our country, growth began to get a lot harder after US peak oil in 1975.  The last great untapped source of wealth was the vast sea of cash that was the middle class.  When you expect the economy to be growing year-in and year-out at 3% the source of the growth went unquestioned, as Regan era deregulation, banking “innovation”, and a general “me first” attitude deadened us to the implications of what was going on.  But bubbles are like that.  If I pick and era to put some blame on the Fed, it would be Greenspan’s insistence that the bubble was not a bubble during those years.  Investors had a problem too.  Where to put their money when there was little that could guaranty at good return.  The debt problem is also a “too much money to invest” problem.  Every transaction has two sides, after all.  So you gradually get to the point where most of the disposable wealth is concentrate with the very few, and the broad middle class has to start reducing their consumption to make their mortgage payments.  All well and good until jobs start going away and the mortgage doesn’t get paid. 

The solution to the present great recession is not with the Fed, it’s with additional federal spending – and yes, borrowing.  But remember – to make our money back on any venture, all we have to do is not lose money when credit is at 0%.  So put to work the unemployed.  Easiest way to really get things moving is to give states $ so they can rehire the teachers they have had to let go.  We are already spending $ on unemployment insurance, so anything that reduces those numbers, and brings in more taxes helps as well.  etc., etc. 

Your concern obviously is inflation.  So the question is can the Fed keep things under control as the economy starts to heat up.  This is a fair question.  But as I see it, the Fed is reactive to changing market conditions.  Once interest rates naturally become positive, the Fed can begin to let its treasuries expire and not buy them back, etc.  And if things start to get out of hand, the Fed can effectively cut off short term money by raising rates higher than the market for short term funds can bear – another Volker moment.

But the real question to ponder today are who the winners and losers are if we have modest inflation or deflation in the years ahead.  Debt is the problem and it has two sides.  The rentier class – the 1% holds a lot the paper.  Lots of mortgage holders hold a lot of the debt.  There really is a class difference between debtor and creditor.  Inflation helps out the debtor by allowing him to repay the loan with less valuable dollars.  The creditor sees inflation as big tax on their assets.  Is it surprising the business media is obsessed with inflation??  In a world where we need more progressive taxation – inflation is one of the easiest way to impose a progressive tax without doing a thing other than targeting 5% inflation for a few years.  (at the rate we are going we are still probably 3-5 years away from having a nonzero interest rate, however, so don’t hold your breath for this nice solution to present itself.)  Deflation will leave the wealthy with more valuable $, as long as the source of those $ doesn’t default on their loan.  If they do, the wealthy still have something and the poor homeowner has nothing and is out on the street.  Result is MORE inequality with deflation.

The danger ahead is that resource depletion is naturally recessionary (deflation) leading to higher inequality. 

Longwave theories, etc.  The real problem I have with this is that it’s too hard to separate any real science from the noise.  There is a type of noise we electrical engineers run into called 1/f noise.  This is found in everything, and it says that the amplitude of events is inversely proportional to the frequency.  Is the long wave just 1/f noise, and how would we know one way or another?  I’ve never felt the data was convincing.  You can go a long way just making reasonable statements about human behavior, which is what lots of “technical analysis” comes down to in some sense.  If we knew better, someone would make money off of it, and then the system would correct so that no more money could be made any longer because we all knew the secret…

There are always feedback loops!   It’s the definition of capitalism.   Capital => production => profit => Capital     For a good discussion of dynamic systems – there are many – but let’s go back to one of the first.  “Limits to Growth” by Dennis Meadows.  These days Ugo Bardi over at The Oil Drum has some good things to say on this subject and invokes these old gems.

I’m sure we both agree that the corruption of the system is a large part of the problem.  I believe less in overt conspiracies, and more that it’s often easier to believe something when your livelihood depends upon it.  However, I do think that there is very deliberate misinformation out there on a lot of this stuff.  Designed to confuse and distract attention from important issues.   

Whew… better stop!

timeandtide's picture
Status: Bronze Member (Offline)
Joined: Apr 3 2010
Posts: 65
crowd control is an illusion

 Hi Grondeau,

I actually think we are further apart than you think – essentially because I have little faith in economics which I see as an exercise in post event rationalization which has roughly zero predictive value. I note also that economists generally are in agreement, particularly at market highs and lows, which suggests that they herd as much as anyone else. As a result of my poor opinion of the dismal science, I also have little faith in the idea that an economy can be directed by a small group “controlling” the levers e.g. The Federal Reserve. The Fed may like to think that it controls interest rates but it follows the 3 month Treasury bill as does the Reserve bank of Australia. (I have charts showing this but I do not know how to insert a graphic from my computer into this reply and I do not have the URLs for these charts).

I have no idea if there is a natural rate of interest but if I was to imagine one, I would take my cue from nature where over time it is slightly above replacement rate. Of course, in nature we see periods of well above replacement growth followed by collapses due to drought or other cause. As an aside, most economists would advocate perhaps 3.5% as a long term healthy growth rate. Applying that rate over the same period as the longest human dynasty, the Egyptian dynasty which lasted 3000 years, brings you to 10 to the power 57. The universe is estimated to have 10 to the 24 stars. It seems most economists do not really grasp the exponential potential although they often discuss compounding. My point is that it is pure hubris to think we can escape the much lower but long term sustainable growth rate. I believe that we are entering a period where the “normal” expectations are going to be severely jolted.

As for risk free interest rates or risk free anything  – only those who believe in pulling the levers and adjusting settings would believe in such a concept. It is similar to the fine distinction many like to make between speculation and investment. For me, there is only speculation and probability – anything else is delusional.

I used to follow Peter Schifff until he debated Robert Prechter on King News. Although Prechter was almost unable to get in a word edgeways against the boorish and aggressive Schiff, he clearly made more sense than Schiff. I have never been a fan of a Keynesian like Krugman who cannot seem to see any course beyond spending up big.

Cash and a 0% loan really are not the same. Why do you think that rates are at 0%? At 0%, the environment for speculating is extremely high risk so the demand for money is very low – hence the low rate. Taking your point of view – there is still an economy as long as there are people. So why would a speculator not feel comfortable to start a business or expand one when money is at 0% ? Well, in the present case, the sheer amount of friction in the economy, the still very high cost of land and labour and materials – all brought about by poor market signals from artificially low interest rates for far too long is not conducive to economic expansion. In Austrian school of thought terms, the economy needs to contract because real savings have to be built up again, insolvent business need to be liquidated, assets need to pass from weak hands into stronger hands , that is from highly leveraged “ownership” to unleveraged real ownership. Most people, quite understandably, think of this process of deflation as bad because it will cause immense pain. So we have government, the media, business and , in fact, everyone including yourself condemning deflation. I would argue that it is a good process because it is the natural result of the excess that has gone before. The famous Roosevelt saying “Nothing to fear but fear itself” is true but you cannot stop it until it runs its course because it is a natural phenomenon. People are subject to mood cycles. It is what drives growth. Roughly speaking, that is 2 steps forward and one step back or in Elliott Wave terms it is 5 waves with 3 forward and 2 back (all Fibonacci numbers). It has been going on since the big bang – the  Fibonacci progression. It is in our spiraling galaxy, the Milky Way, it is in all nature’s growth patterns from pineapples to pinecones and snails to the transmission of nerve impulses.

I note that you accept that the housing market is undergoing deflation. However, you then try to make a fine distinction between scarcity and general monetary inflation. The problem is that you are making certain assumptions about scarcity. Peak oil for one. Human population for another. Things are only scarce relative to demand and supply. In the case of oil, I accept that it is becoming scarce in terms of energy input to extract the oil. Over the last century the cost of oil energy extraction has gone from 100 to 1 down to 10 to 1. However, there appear to be vast quantities of gas and as Paul Krugman pointed out this week, solar is gaining cost ground. The world population has reached 7 billion and is confidently predicted to reach 9 billion plus over the next 40 years. There is no expectation of a collapse. There are plenty of scenarios in which we could envisage a collapse with climate being the most probable pre-cursor to a collapse in food supply.  Not forgetting the other three horsemen.

I more or less agree with you about capitalism, except that it is a long time since capitalism has had the unfettered environment which it needs to thrive.  Your description of capitalism – turning raw materials into goods still goes on but if you take the car making industry, I doubt that a real profit has been made for at least half a century anywhere in the world when you take the whole industry into consideration and its infrastructure (which is crumbling) and include all the externalities. You mention “developing markets”. China comes to mind. We will know soon enough but it would appear that there has been a mis-allocation of resources on a monumental scale – empty towns, unused railways, dams silting up, polluted rivers, soil erosion etc – that has taken place in less than three decades to emulate what the US and Europe did over several centuries. Corporatism and Statism have replaced Capitalism.

My concern is not inflation – not for now anyway. The question is not “can the  Fed keep things under control” – they never have and they never will because they are followers. That is, they herd just like everyone else.  How do you think interest rates will become positive again? There is only one way – that is by deflation. Some Treasury paper will no doubt hold its value or is short dated enough not to be a substantial risk. But there is so much paper - mortgage bonds, municipal bonds, corporate bonds – which will go to zero. As bonds prices drop so their yields rise.  The rentier class will see huge nominal losses too but the relativities between rich and poor will remain but at a lesser level. I don’t believe that inflation can be maintained but even if it could, the result would just build inflate equity, commodity and real estate assets to even more unsustainable levels leading to a bigger eventual bust.  Inflation can only be created by creating “money” out of thin air. We do not need any more money. We need real wealth which can only  be created from real capital. Real capital is essentially our environment . The raw materials that we can extract at a cost that is less than the utillity that we can gain from those transformed raw materials using the energy which we also extract at a cost that does not exceed the energy output. Simple arithmetic but modern accounting is anything but.

We do not need progressive taxation because that also introduces distortions. If you want to tax the wealthy fairly, the simplest way is probably a Georgist land tax (following the ideas of Henry George) which would prevent land banking and level the playing field with regard to access to resources. That is another whole area and something that I hope will be up for serious consideration after the deluge.

Yes, there are always feedback loops. However, there are fundamentally different feedback loops governing speculative markets and economies governed by utility. Speculative markets are characterized by  increased participation as they near a top i.e. there are more buyers at higher prices and more sellers at lower prices as markets reach bottoms. That is why so few people actually make any money from speculation. However, in markets governed by utility, prices tend to reach an equilibrium after an innovation. Innovators who come up with a desired product tend to attract high prices until others come into the market with refinements or economies of scale lower prices which attract more buyers until the price cannot drop any further without a loss on the producer’s part. In other words, high prices will discourage buyers and low prices will attract them. This is the complete opposite of financial markets which are governed more by the fight or flight instinct rather than rational thought. In these markets uncertainty rules at all times in reality but rising markets tend to convince participants that things are certain. Of course, there is no time when things are truly more certain but when the herd is travelling upwards for a while it convinces itself that things are certain. The extraordinary thing is that the herd cannot convince itself that things are equally certain when the markets have been travelling downwards for any length of time!

I have never heard of Dennis Meadows or Ugo Bardi but I will look them up. I agree that there is a lot of confusing information. I am not so sure how deliberate it is. I think humans tend to believe what they want to believe and as Bill Bonner of The Daily Reckoning often says, they come to believe it when they need to!


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