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    Default FIRE Economy D-Day

    FIRE Economy D-Day: Greenspan's Black Swan

    Here we are. The day we have been warning you about since we re-opened iTulip April 2006 at the "peak of complacency" has arrived.

    The circuit breakers installed after the 1987 crash will prevent a repeat. Don't worry about that. Maybe the DOW goes down 300 to 600 points today but not lower than 800.

    Yet the comfortable fiction that governments – represented by global central banks – control markets will be put to the test. In truth, governments merely influence markets. At times that influence is effectual and at others not.

    Today, not.

    A quick review of how we got here and where we're going.

    Where we've been
    Turbulence in markets unnerves Bank and Fed officials
    June 13, 2006 (Times Online)

    CONCERN is growing over the present instability of financial markets among senior officials at the Bank of England and the US Federal Reserve.

    Giant Margin Call on Real Estate Begins
    July 30, 2006 (iTulip)

    What's the federal government going to give us this time? More tax cuts? More deficit spending? Seems like those bullets have been spent. What happens when you cut interest rates when oil is trading at $75 versus $20 as in 2001? Fasten your seat belts. It's going to be a weird ride.

    A Financial Market Crash is a Process, Not an Event
    Aug. 16, 2007 (iTulip)

    A financial crash is not sudden, singular event. The way the Crash of 1929 is commonly misunderstood, the market crashed on Monday, October 31, 1929 and soup lines formed Tuesday. Not so. A financial crash is a process lasting as long as a year, punctuated by a few notable grip-and-grin market events that make it into the history books. Underlying the process is the dissolution of a fallacious belief system that developed over a period of many years. Fallacies floated on an ocean of cheap credit. As the credit dries up, facts are revealed under the harsh light of reality.

    Collapsing Global Credit Bubble Churns up Financial "Whales"
    Sept. 17, 2007 (iTulip)

    As the Whales Hit the Beach, Don't Forget Where they Came From

    Mortgage Market Off the Rails, Economy to Follow
    Dec. 8, 2007 (iTulip)

    Whip Asset Price Deflation Now?

    Dehydrated Banks: Just Add Water
    Feb, 22, 2008 (iTulip)

    Can insolvent lenders be floated by the U.S. government? Should they?

    The American Bond Crisis
    March 10, 2008 (iTulip)

    The credit crisis that started June 2007 with obscure financially engineered debt products such as CDOs has now evolved to include bonds presumably backed by the US government. Guess what’s next after Agency debt? You guessed it!

    Debt Deflation, American Style: Yamaichi Securities Company 1997 vs Bear Stearns 2008
    March 18, 2008 (iTulip)

    In the summer 2007, nearly 20 years after Japan's post credit bubble collapse and debt deflation began, the US started its own journey down credit crunch and bankruptcy lane. The demise in 1997 of Yamaichi Securities Company, the fourth largest brokerage firm in Japan, and the intervention by the Bank of Japan (BoJ) has eerie parallels to the Bear Stearns collapse and Fed intervention more than ten years later. But the differences between the two events are even more telling.

    Buy Financials! Catch a falling knife!
    June 6, 2008 (iTulip)

    Don't buy financial stocks.

    That dreaded phrase: ''The system is fundamentally sound'
    July 20, 2008 (iTulip)

    The system is fundamentally unsound.
    Where we're going

    To put today's events in perspective we have to go all the way back to November 1998 when iTulip was first launched and we first made the case that we have stuck to consistently ever since, while always looking for evidence to contradict it:
    The lesson of the 1920s may be that markets grow to outstrip the capacity of central banks and other institutions to manage them, that markets naturally evolve to operate outside the control of monetary authorities. As a result, these institutions are always fighting the last war.

    Perhaps the crash of 1987 and the correction of 1998, which did not have a serious impact on the real economy thanks to quick Fed intervention, represent a phase in a longer term dynamic. Maybe these corrections and the subsequent post Fed bailouts set the stage for a bigger and less manageable market event in the future.

    The second thesis relates to the medium term outcome of a crash should the Fed be not much better at mitigating the effects of the collapse of this bubble better than in the 1930s, or at least no better than the Japanese have been in the past ten years since their market bubble collapsed in 1989.

    More than 40% of the sovereign debt of the US is held outside the US. History is completely consistent on this: in the event of a sustained drop in liquidity and economic growth of an indebted nation, foreigner borrowers demand to be repaid before other creditors. The dollar is likely to fall like a rock as foreign held US paper is sold. The domestic impact is inflationary. So unlike the US in the 1930s or Japan in the 1990s where deflation accompanied a period of economic contraction, the US is likely to experience a period of inflation in addition to recession.

    - iTulip, Nov. 1998
    Following this economic and financial market crisis, the cycle of global recession will not have the same impact on the US in 2008 as it did in the previous case in 1930. The US in 1930 was a net creditor but is today a net debtor, with its dual trade and fiscal deficits funded by massive daily capital flows from foreign private investors and central banks – mostly the latter.

    Historical Precedent

    The precedent is not US 1930 or Japan 1990. Both countries were net creditors with large pools of national savings and industrial capacity to tap to use to develop export trade to earn their way back out of an economic hole. A closer analogy is 1930 Germany.

    The sequence of Germany's pre-WWII economic crisis is commonly misremembered as follows:
    1. Hyperinflation
    2. Depression
    3. Hitler elected by angry masses
    4. WWII

    Not so. Here's what really happened.

    1.

    1921 to 1923: German hyperinflation

    1924: Dawes Plan to restructure debt, Rentenmark replaces the Papiermark

    1924: Rentenmark backed by land and industrial goods, hyperinflation ends

    1924 to 1929: US and British financing pours into Germany, economy recovers

    1925: Germany joins the League of Nations

    1929: US market crash (FIRE Economy V1.0), US and British investment in Germany ends

    1930: German economy collapses

    Then:

    2. Depression
    3. Hitler
    4. War
    So far US creditors have held their ground, but as the US recession and financial crisis deepen and the US transmits demand destruction to its creditors, that ground may give way. After the crash of FIRE Economy V2.0 in 2008 China, Japan, and the BRIC lenders may have to cut off funds to the US just as the US and the UK cut off funding to Germany in 1930 following the crash of FIRE Economy V1.0.
    China Cuts 1-Year Lending Rate; Reduces Lending Curb
    Sept. 15, 2008 (Bloomberg)

    China cut interest rates for the first time in six years and reduced the amount of cash that some banks are required to set aside after economic growth slowed and amid tumult on Wall Street.

    The People's Bank of China cut the one-year lending rate to 7.20 percent from 7.47 percent, effective tomorrow, and lowered the reserve ratio by 1 percentage point at some banks. The changes were in a statement on the central bank's Web site today.
    Watch for signs of recession among major US trade partners. When they are no longer able to ship their so-called "excess savings" to the US to fund America's twin deficits, the FIRE Economy will be no more, and the US will have to find a way to run its economy the old fashion way – by working, saving, and investing.

    See also:
    Fed Funds spread signals crash
    Sept. 15, 2008 (iTulip)

    The last time the Fed Funds target rate got this out of line with the effective rate was in 1987, and from a base of over 6% not 2%. On a percentage basis, at three times the target rate the spread is unprecedented. It happened today. more...
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    Last edited by FRED; 09-15-08 at 02:34 PM.

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