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Before the Stroke of Midnight

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  • Before the Stroke of Midnight

    Before the Stroke of Midnight

    Investors await their fate, again

    by Eric Janszen


    Vice chairman of Goldman Sachs Robert Hormats is the latest observer to look up at the US foreign and domestic debt clock and see the hands about to strike midnight.
    Goldman Sachs guru warns of war-debt failure: Is America becoming a global credit risk?
    July 23, 2007 (Paul Farrell - Marketwatch)

    Recently Robert Hormats, vice chairman of Goldman Sachs (International), appeared before the U.S. House Budget Committee to "discuss an issue of great economic, financial and national security importance to our country -- the growing dependence of the United States on foreign capital." Currently we import $1 trillion new debt annually, with no repayment plans. That's a historic break from over two centuries of American policy.

    Hormats was in Washington with warnings from his brilliant new book, "The Price of Liberty: Paying for America's Wars." He traces the history of American wartime financing from the Revolution through the War of 1812, the Civil War, the two World Wars and the Cold War to the present.

    Conclusion: "One central, constant theme emerges: sound national finances have proved to be indispensable to the country's military strength" and long-term national security.
    The argument is that domestic consumption fueled by foreign lending and household borrowing, versus domestic saving and investment, will eventually lead to inflation and recession, and wreck the economy.

    The first compelling warning that these debt limits were about to be breached that we are aware was authored by Lester Thurow, ex-Dean of MIT's Sloan School of Management, writing for New Perspectives Quarterly: "He is concerned that our current prosperity resulting from debt driven consumption, will come to an abrupt halt when foreigners stop lending us money." We've made a couple of tweaks, indicated by brackets, to keep it relevant, and leave us with a punch line.
    When the Lending Stops

    This problem of accelerating foreign indebtedness began in 1981 with economic policies that presumed the rest of the world didn't exist. We had 22% interest rates while the Germans and Japanese had 5% and 6% rates. That disparity attracted a massive inflow of money from their economies to ours. This drove up the value of the dollar and made American products noncompetitive on world markets.

    As a result, a huge trade deficit developed, which forced us to borrow money from abroad to cover the difference between what we produced for export and what we consumed.

    By 1986, foreigners lent us one out of every four dollars we borrowed. Of the $800 billion we borrowed, $200 billion came from foreigners. In other words, if foreigners had not lent us the money, one out of every four cars could not have been purchased, one out of every four homes could not have been financed, and one out of every four credit cards would have to be taken away This debt is essentially the cost of living beyond our means.

    If the money we were borrowing from abroad all went into factories and robots, we wouldn't have to worry because the debt would be self-liquidating It's the fact that we are using it entirely for consumption that makes it a serious problem.

    Inflation & Recession

    In the absence of cooperation, it is very likely we will end up with simultaneous inflation and recession.

    Inflation is... a path of least resistance because it would make the hundreds of billions we owe the rest of the world worthless. For policy makers who realize that the debt will keep growing until we restore competitiveness to the US economy, inflation is a far more attractive option than facing a steep drop in the American standard of living.

    Add to this the decision to cut our balance-of-payments problem by letting the value of the dollar fail. [Otherwise imports] ...will become too expensive and their exports will fall. If they don't rebuild their economies for domestic-led growth, they will slow dramatically because they can't rely on exports. If they fall into recession, then we are dragged along because there is no one to purchase our exports.

    The central short term issue, then, is whether we may slip into a recession without the capability to do anything about it. Who can play the role of economic locomotive for the world when the US is so overburdened with debt there is no room for Keynes?

    When the Lending Stops

    It's true that up until now, the rest of the world has been willing to continue lending us money, and so we maintain the appearance of prosperity. Eventually, though, foreigners have to stop lending to us. As we build up our trade deficit and our international debtor position, we have to pay more and more interest, and then interest on the interest. Before long, the compound interest will eat us alive. We will have to borrow more than the rest of the world has to lend us.

    In reality, the lending will stop long before we get to that ultimate limit because foreign lenders fear they will be repaid in devalued dollars. In the first quarter... there was evidence that the private capital inflows from abroad began to stop. Most of the capital now comes from governments who have stepped in for fear of instigating a credit crunch that would set off bankruptcies and recession.

    When the foreign lending stops, all of our debts - our foreign debt, the federal budget deficit, the Latin debt, corporate and consumer debt - will be harder to roll over because the amount of credit will be constrained. As I pointed out earlier, one out of every four dollars we borrow now comes from foreigners. If that suddenly stops, a tremendous tussle will erupt in our society over who gets the other three dollars of credit.
    When did Thurow make this dire prediction?

    In 1987, months before the October 1987 stock market crash, the last truly major crash since 1929, when US markets declined 23% in a single day. His phrase "In the first quarter... there was evidence that the private capital inflows from abroad began to stop," referred to the first quarter of 1987, although that phrase applies to 2007, as well.

    But Thurow didn't predict a crash. He predicted recession, a crashing dollar, and rising inflation and interest rates. Why didn't this happen?

    One reason, really. Thurow warned of these negative outcomes in an "absence of cooperation" among central banks and economic policy makers. Since then, some trends he identified have actually intensified, such as Japan's export dependent growth. In fact, China, the largest export driven economy today, was not even on Thurow's radar in 1987, adding to not diminishing trade imbalance pressures. As it turns out, the area of cooperation that really mattered to forestall, although not in our view prevent, the predicted inflationary and recessionary outcome has been among the world's central banks. They discovered how to cooperate within the framework of the US Treasury dollar based system, and in the process helped to produce global asset bubbles. The resulting distortions have led to massive increases every area of imbalance that Thurow warned about 20 years ago. Each has grown so unimaginably large since 1987 that the numbers are hard to comprehend.

    The three major areas of imbalance are the trade deficit, domestic debt, and foreign debt.


    Around the time Thurow first sounded the alarm about the trade deficit, it reached an extreme of $40 billion in Q3 1987. Immediately following the stock market crash October 1987, the trade deficit declined more than 50% over four years, reaching $17 billion in the second quarter of 1991. Since then it has continued to increase, reaching an extreme of $219 billion in Q3 2006, more than eight times its previous peak. The trade deficit has declined to $201 billion in Q1 2007, but it's not clear what that means.


    When Thurow wrote his warning about government and household debt in 1987, domestic financial debt was around $2 trillion, household debt was also near $2 trillion, and total debt was approximately $7.5 trillion. Since then total debt has increased by almost four fold to over $28 trillion, household debt has more than tripled to almost $7 trillion, and financial debt has exploded nearly seven times to nearly $14 trillion. Meanwhile, real GDP has only doubled, from $6.5 trillion to $13 trillion.


    (Thanks Aaron Krowne for the chart)

    How has the dollar held up over the past 20 years since Thurow's warning?

    The dollar had peaked for the cycle by 1986 and was on its way down when Thurow wrote "When the Lending Stops," due to declining foreign demand for US financial assets. No one was sure what that meant, and that uncertainty was one of the causes of the crash of October 1987. The dollar bounced along from 1987 until 1995 when it started to rise, not coincidentally, in our opinion, with the start of the US-centric stock market bubble.

    Note that correlation between dollar depreciation and net foreign purchases of US securities is sometimes positive and at other times negative. We believe that the recent de-coupling of US equity markets from other global markets, and gold from equities, indicates that the correlation is about to reverse again, with unfortunate consequences for US markets on the order of October 1987.


    One future event that Thurow did not dream of back in 1987 was one where household balance sheets turn upside down. How could he? This had not occurred before, going back to 1946.

    In sum, what has happened since 1987? Every measure of imbalance that Thurow warned about has become so extreme that measures defy imagination.

    If no crisis has occurred in the 20 years since Thurow's warning, does this mean that imbalances don't matter?

    Returning briefly to the present and Goldman Sachs' Robert Hormats, he goes on to say:
    America's new faith-based guns-and-butter policy is hurting both guns and butter. The war is costing us $12 billion a month. Hormats examined the Congressional Budget Office's projections for domestic costs: "In 2006, spending on Social Security, Medicare, Medicaid and interest on the federal debt amounted to just under 60% of government revenues" and "if they continue on their current path, they will account for two-thirds by 2015."

    * Social security from $550 billion to $960 billion
    * Medicare from $372 billion to over $900 billion
    * Medicaid from $181 billion to $390 billion

    Worse yet, these commitments will continue skyrocketing in later decades. The CBO projects the federal debt rising from 40% of GDP to 100% in the next 25 years: "Continuing on this unsustainable path will gradually erode, if not suddenly damage, our economy, our standard of living, and ultimately our national security."
    In our view, Thurow's warning is more relevant today than 20 years ago, and Hormats brings it up to date and into focus.

    What does it mean? Given the extremes of imbalance that have developed since 1987, we'll state the risks simply: the market event we are due, when it occurs, will make the October 1987 crash seem benign by comparison. The trigger, as Hormats implies but does not say, will likely be related to the Iraq War.

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    Last edited by FRED; 07-26-07, 01:17 PM.

  • #2
    Re: Before the Stroke of Midnight

    EJ, i always wonder about "They"...............You know, the people in back ground, un seen but proping up the $. I wonder if "They" decide that frankly they asset stripped America of everything they can, and before decamping to China......Why not arrange for the Market etc to Crash!

    Look what a Hedge fund did to the bank of England (ERM)........If "They" go for it it will be soon say Sept ish.

    Perth Mint here i come!
    Mega

    Comment


    • #3
      Re: Before the Stroke of Midnight

      in a similar vein, jeremy grantham's latest has just been posted at gmo.com [free registration required]. grantham last quarterly letter said the bubble was global and in all assets. in this one he says it's time to start constructing a portfolio to benefit from the disaster ahead, after first cashing in the last of the risk assets he's recommended holding- emerging markets.

      To conclude, I have been trying to come up
      with a simple statement that would capture how serious the
      situation is for the overstretched, overleveraged financial
      system, and this is it: In 5 years I expect that at least one
      major “bank” (broadly defined) will have failed and that
      up to half the hedge funds and a substantial percentage of
      the private equity fi rms in existence today will have simply
      ceased to exist.

      I have often been too bearish about the U.S. equity markets
      in the last 12 years (although bullish on emerging equity
      markets), but I think it is fair to say that my language has
      almost never been this dire. The feeling I have today is
      that of watching a very slow motion train wreck.

      Comment


      • #4
        Re: Before the Stroke of Midnight

        Thought-provoking as always. I'm always interested to see warnings from some period of history compared to contemporary concerns.

        Originally posted by EJ View Post
        When did Thurow make this dire prediction?

        In 1987, months before the stock market crash.

        But he didn't predict a crash. He predicted recession, a crashing dollar, and rising inflation. Why didn't this happen?

        One reason, really. Central banks discovered how to cooperate to produce global asset bubbles. As a result, every aspect of imbalance that Thurow warned about 20 years ago has grown so unimaginably large that the numbers are hard to comprehend.
        Just to play the devils advocate, what assures us this cannot go on for another 20 years? Sure the numbers are all bigger but... other than perhaps the compelling reversal in the Household Cash Less Liabilities chart, what is fundamentally different now?

        Comment


        • #5
          Re: Before the Stroke of Midnight

          >> what assures us this cannot go on for another 20 years?

          EDIT: what you wrote is actually the standard " iTulip 101" thesis - the current bubble will begin to burst and it will be re-inflated away

          (2nd edit I've written exactly this before, several times. I'm still wondering about the parallels to the early-90s crop of doomer books (Batra, Rees-Mogg, couple of others. I also wonder if the NY centre banks are really in danger if 99% of their derivatives bets match up counterparties, and therefore net to zero. Aaron and Bart AFAICT are critical of this latter view.

          (2nd edit (they have admitted some of the problems, of course - remember the artilce iTulip linked to that wrote about the 2nd or 3rd in command at the NY FED running a skunkworks to figure out what to do in case of a derivatives meltdown. Problem is, that's known by almost no-one, while the FED governor speeches are broadcast all the time to everyone).

          ORIGINAL:
          If they don't admit to a problem, how can they do anything about it?

          And they're not admitting it - the decision makers (with the notable exception of Mr. Walker) are wedded (at least in public statements) to these ideas -

          1. nothing bad is happening -
          2. derivatives are good
          3. nothing bad will happen -
          4. money printing will cure all ills
          5. doctoring numbers can cure all ills that money printing creates (inflation) (OK, OK, they don't admit to this, although their endless repetition of their mantra "core, core, core, core" serves as an admission to me ...)
          6. if "it" ever happens they can clean up afterward - after all, that's what they did with the Internet bubble

          Originally posted by zoog View Post
          Thought-provoking as always. I'm always interested to see warnings from some period of history compared to contemporary concerns.


          Just to play the devils advocate, what assures us this cannot go on for another 20 years? Sure the numbers are all bigger but... other than perhaps the compelling reversal in the Household Cash Less Liabilities chart, what is fundamentally different now?
          Last edited by Spartacus; 07-26-07, 11:39 AM.

          Comment


          • #6
            Re: Before the Stroke of Midnight

            Fascinating thread. I feel disembodied, like an apprentice mortician at an orientation class, suddenly realising he will be a piece of the cadaver at the main event ...

            Comment


            • #7
              Re: Before the Stroke of Midnight

              Originally posted by jk View Post
              in a similar vein, jeremy grantham's latest has just been posted at gmo.com [free registration required]. grantham last quarterly letter said the bubble was global and in all assets. in this one he says it's time to start constructing a portfolio to benefit from the disaster ahead, after first cashing in the last of the risk assets he's recommended holding- emerging markets.
              For the moment, jk, a very timely post.
              Jim 69 y/o

              "...Texans...the lowest form of white man there is." Robert Duvall, as Al Sieber, in "Geronimo." (see "Location" for examples.)

              Dedicated to the idea that all people deserve a chance for a healthy productive life. B&M Gates Fdn.

              Good judgement comes from experience; experience comes from bad judgement. Unknown.

              Comment


              • #8
                Re: Before the Stroke of Midnight

                Originally posted by Spartacus View Post
                EDIT: what you wrote is actually the standard " iTulip 101" thesis - the current bubble will begin to burst and it will be re-inflated away
                True.

                ORIGINAL:
                If they don't admit to a problem, how can they do anything about it?
                ...
                6. if "it" ever happens they can clean up afterward - after all, that's what they did with the Internet bubble
                (2nd edit (they have admitted some of the problems, of course - remember the artilce iTulip linked to that wrote about the 2nd or 3rd in command at the NY FED running a skunkworks to figure out what to do in case of a derivatives meltdown. Problem is, that's known by almost no-one, while the FED governor speeches are broadcast all the time to everyone).
                It should be no surprise to us that, at least publicly, they never admit there is a problem; or if pressed, try to suggest that it's a minor problem. Then when things start to crash, they step in and set up another bubble to take its place.

                As this has repeatedly worked in the past, they probably believe they will be able to continue with this routine indefinitely. Perhaps they can!

                The little doomsdayer on my other shoulder though wonders if a time will come when they have exhausted all the methods available to re-bubble. There are many articles and forum posts out there arguing that we will reach this point soon... say in the next five years or so. Predictions of dollar collapse, hyperinflationary depressions, deflationary recessions, degradation back to the stone age... pick your avenue and severity of doom, someone is preaching it. I am just wondering if this "game over" point is so far out into the future it's not worth worrying about. Focus on the current bubble implosion and possibilities for the next bubble (here at iTulip, the prevailing theory is alternative energy), and leave it at that.

                Comment


                • #9
                  Re: Before the Stroke of Midnight

                  Originally posted by Spartacus View Post

                  ...

                  ORIGINAL:
                  If they don't admit to a problem, how can they do anything about it?

                  And they're not admitting it - the decision makers (with the notable exception of Mr. Walker) are wedded (at least in public statements) to these ideas -

                  1. nothing bad is happening -
                  2. derivatives are good
                  3. nothing bad will happen -
                  4. money printing will cure all ills
                  5. doctoring numbers can cure all ills that money printing creates (inflation) (OK, OK, they don't admit to this, although their endless repetition of their mantra "core, core, core, core" serves as an admission to me ...)
                  6. if "it" ever happens they can clean up afterward - after all, that's what they did with the Internet bubble

                  My biggest point here is that just because they don't admit to it with big neon signs does not mean that they're unaware of the various issues, or not doing things about it behind the scenes.
                  There was, for example, that sudden appearance of $1.2 trillion last week in the H8 report under "Securitized real estate loans".

                  Keep in mind that Bernanke is actually publicly worrying about inflation in the FOMC minutes and in various speeches.


                  Also keep in mind things like the data in the FOMC minutes from March 22, 1994:


                  "So the question is, having very consciously and purposely tried to break the bubble and upset the markets in order to sort of break the cocoon of capital gains speculation, we are now in a position—having done that and in a sense succeeded perhaps more than we had intended—to try to restore some degree of confidence in the System."
                  -- Alan Greenspan, Chairman of the Federal Reserve
                  (emphasis mine)
                  http://www.NowAndTheFuture.com

                  Comment


                  • #10
                    Re: Before the Stroke of Midnight

                    Originally posted by bart View Post
                    My biggest point here is that just because they don't admit to it with big neon signs does not mean that they're unaware of the various issues, or not doing things about it behind the scenes.
                    There was, for example, that sudden appearance of $1.2 trillion last week in the H8 report under "Securitized real estate loans".

                    Keep in mind that Bernanke is actually publicly worrying about inflation in the FOMC minutes and in various speeches.

                    Also keep in mind things like the data in the FOMC minutes from March 22, 1994:
                    incredibly, only itulip dug that one up. it's a beauty. google this phrase and you'll see what i mean...

                    having very consciously and purposely tried to break the bubble

                    personally, i like the point that martin mayer makes that ej quotes in that piece from 2003:

                    "Having won supervisory control over the entire financial services industry, the Fed must bring into the light where the markets can see them continuously the now hidden maneuverings of the private banking empires, the derivatives dealing, the over-leveraging that accompanies over-reliance on diversification and probability. And the Fed has never believed in sunshine as a disinfectant. The tragedy for all of us would be if the Fed's and the Treasury's and the Congress's reverence for people who make a lot of money left us unprotected against some sudden revelation of the truth that becomes obvious only in hindsight, that a lot of them don't know what they're doing."

                    http://www.itulip.com/forums/showthread.php?t=360

                    Comment


                    • #11
                      Re: Before the Stroke of Midnight

                      Originally posted by metalman View Post
                      incredibly, only itulip dug that one up. it's a beauty. google this phrase and you'll see what i mean...

                      having very consciously and purposely tried to break the bubble

                      personally, i like the point that martin mayer makes that ej quotes in that piece from 2003:

                      "Having won supervisory control over the entire financial services industry, the Fed must bring into the light where the markets can see them continuously the now hidden maneuverings of the private banking empires, the derivatives dealing, the over-leveraging that accompanies over-reliance on diversification and probability. And the Fed has never believed in sunshine as a disinfectant. The tragedy for all of us would be if the Fed's and the Treasury's and the Congress's reverence for people who make a lot of money left us unprotected against some sudden revelation of the truth that becomes obvious only in hindsight, that a lot of them don't know what they're doing."

                      http://www.itulip.com/forums/showthread.php?t=360

                      It's also, as you saw on Google, on my M3 & TIO page... and it has been on my false data page for longer than that - and Google doesn't show it in the list for some reason, perhaps due to it being an html table.


                      The false data page also contains some others like:

                      Former Federal Reserve governor, Robert Heller, had this to say in the Wall Street Journal on October 27, 1989:
                      "The stock market is certainly not too big for the Fed to handle. The foreign exchange and government securities markets are vastly larger. Daily trading volume in the New York foreign exchange market is $130 billion. The daily volume for Treasury Securities is about $110 billion. The combined value of daily equity trading on the New York Exchange, the American Stock Exchange and the NASDAQ over-the-counter market ranges between $7 billion and $10 billion."
                      ...
                      "An appropriate institution should be charged with the job of preventing chaos in the market: the Federal Reserve....The Fed already buys and sells foreign exchange to prevent disorderly conditions in foreign exchange markets. The Fed has assumed a similar responsibility in the market for government securities. The stock market is the only major market without a marketmaker of unchallenged liquidity or a buyer of last resort." ... "The Fed could support the stock market directly by buying market averages in the futures market, thus stabilizing the market as a whole."



                      “Owing to persistent advances in information and computing technologies, the structure of our financial institutions is continuously changing, I trust for the better. But that evolution in financial structure has also meant that supervision and regulation must be continually changing in order to respond adequately to these developments. In today's markets, for example, there is an increased reliance on private counterparty surveillance as the primary means of financial control. Governments supplement private surveillance when they judge that market imperfections could lead to sub-optimal economic performance.”
                      -- Alan Greenspan speech in 2002

                      "...the Federal Reserve has the capacity to operate in domestic money markets to maintain interest rates at a level consistent with our economic goals”
                      -- Ben Bernanke, Fed Chairman, March 26th 2007 to the Senate Banking Committee.
                      http://www.NowAndTheFuture.com

                      Comment


                      • #12
                        Re: Before the Stroke of Midnight

                        jk, thanks for the heads up on Grantham's article.

                        Comment


                        • #13
                          Re: Before the Stroke of Midnight

                          This reminds me of some graffiti that I saw on a building in Berlin in the early nineties (not too long after the fall of the wall): "Sozialismus ist tod und Kapitalismus ist nicht weit hinten."

                          Translation: "Socialism is dead and Capitalism isn't far behind."

                          Comment


                          • #14
                            Re: Before the Stroke of Midnight

                            Originally posted by Thallid View Post
                            This reminds me of some graffiti that I saw on a building in Berlin in the early nineties (not too long after the fall of the wall): "Sozialismus ist tod und Kapitalismus ist nicht weit hinten."

                            Translation: "Socialism is dead and Capitalism isn't far behind."
                            quite prescient. see...

                            "Under Mr Putin, Russia is sliding into fascism, with state control of the economy, media, politics and society becoming increasingly heavy-handed. And Nashi, along with other similar youth movements, such as 'Young Guard', and 'Young Russia', is in the forefront of the charge."

                            http://www.dailymail.co.uk/pages/liv...n_page_id=1770

                            reading jim rogers and michael hudson here, looks like the chickens are coming home to roost. a comment on this story from over at reddit where I found it...

                            "Too bad that the West blew it in 1990s. Now "real democracy" in minds of Russians is associated with rapacious Western companies stripping Russian natural resources, naive ideas about justice and law enforcement in case of greedy oligarchs and widespread misery and poverty. In 2000s, the "New American Century" neocons didn't help much either."

                            Comment


                            • #15
                              Re: Before the Stroke of Midnight

                              Originally posted by metalman View Post
                              quite prescient. see...

                              "Under Mr Putin, Russia is sliding into fascism, with state control of the economy, media, politics and society becoming increasingly heavy-handed. And Nashi, along with other similar youth movements, such as 'Young Guard', and 'Young Russia', is in the forefront of the charge."

                              http://www.dailymail.co.uk/pages/liv...n_page_id=1770
                              The sensationalist beginning was somewhat bemusing, but the rest of that article was indeed troubling. Interesting read, thanks.

                              Comment

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