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    Default Road to Ruin: Final stretch - Eric Janszen

    Road to Ruin: Final stretch

    A bull market in chaos

    by Eric Janszen (February 23, 2009)
    The credit crunch may only be in its early stages and a bigger contraction in lending in coming months could have "serious implications" for the U.S. economy, Standard & Poor's Rating Services said Friday.

    While politicians and others have complained that banks aren't lending, the data on credit outstanding credit in the U.S. only tenuously supports this idea, the rating agency said.

    "What's behind the apparent difference between perception and reality?" Standard & Poor's credit analyst Tanya Azarchs said. "It may be that, while growth in overall credit was positive through at least third-quarter 2008, it has risen at a slower pace than at any time since 1945 -- far below the 8%-10% rate in most years."

    Banks are replacing loans as they mature, but there's little net new loan growth, she noted. "That could mean that the slowdown in lending is just an opening act, and a true credit crunch may yet take the stage," Azarchs warned. - Credit crunch may only have just begun, S&P warns, MarketWatch, February 21, 2009

    Renowned investor George Soros said on Friday the world financial system has effectively disintegrated, adding that there is yet no prospect of a near-term resolution to the crisis.

    Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union. - Soros sees no bottom for world financial collapse, Reuters, February 21, 2009

    "One year ago, we would have said things were tough in the United States, but the rest of the world was holding up," Volcker told a conference featuring Nobel laureates, economists and investors at Columbia University in New York. "The rest of the world has not held up."

    In fact, the 81-year-old former chairman of the Federal Reserve said, "I don't remember any time, maybe even the Great Depression, when things went down quite so fast."

    "It's broken down in the face of almost all expectation and prediction," he noted. - Volcker sees crisis leading to global regulation, AP, February 20, 2009
    The method to our madness -- negative on stocks since we opened in 1998 and positive on gold since 2001 -- becomes painfully apparent.

    The DJIA closed Friday at 7,367, a level first seen in May 1997 in nominal terms. Adjusted for inflation, 7,367 shares of the DOW today buys only that which 5,600 shares bought in 1997; in real terms, the stock market got kicked back to1996. As dreadful as those facts are, they could be worse - and current course and speed maintained -- they will.

    The Nikkei closed Friday at 7,416, off 81% from Japan's stock market bubble peak of 38,916 on December 29, 1989 -- nineteen years ago -- as Japan's credit, stock, and real estate bubbles ended and an era of debt deflation set in. Collapsing US credit, stock, and real estate bubbles confronted the US with a similar fate starting in 2007. Marking the top of the US stock market bubble at 14,165 on October 9, 2007, if the US debt deflation era goes as badly as Japan's -- is as badly managed -- we can look forward to the DOW closing at 2,700... in the year 2026.

    Imagine that.

    As iTulip readers who have been us from the start know, we do not believe that will happen. Instead, as we have said for ten years, the US will never pay down all the foreign debt taken on during the FIRE Economy era, from 1980 to 2006, at least not on full-value dollars. America 2008 is not Japan 1990.

    Since 1992 Japanese policy makers transferred debt from private to public account via bailouts and fiscal stimulus, siphoning off cash flow from households and businesses to repay the loans carried on the books of banks as assets on the side of the creditor-debtor balance sheet where the political power lives, collateralized by buildings, houses, and land, which prices were inflated by the very credit that created in the onerous debts that became ever more so as the Japanese economy shrank.

    Banks and other creditors convince government to pursue policies to deflate the debt against the incomes of households and productive businesses, reducing the debt the slow painful way, dragging the country deeper and deeper into a hole.

    The Obama administration's stimulus plan does not target spending on infrastructure projects that boost long term US economic growth and competitiveness as much as we had hoped; and it fails to confront the core problem, the need to restructure both private sector and public debt left over by the FIRE Economy.

    Debt Deflation Continuation Plan

    So far, one year into debt deflation, the US is executing a Japan credit bust style Debt Deflation Continuation Plan; as if the US, with its gross external debt of 95% of GDP, and current account deficit that grew from 5% to 7% of GDP in recent years, financed by nearly $4 billion dollars per day in capital imports, is in the same trade and savings position as Japan in 1991, without external debt and running a large current account surplus as the world's largest exporter of capital. The magical thinking that underpins US policies extends the core fantasy that formed the foundation of the FIRE Economy itself: an economy can grow continuously by taking on ever more debt.

    The US may be starting down the path of deflating debt against the incomes of its hard working citizens and non-financial business sectors, but the situation is temporary. After more than 30 years the US is in the final stretch on the road to ruin that stated in 1971 when the US left the international gold standard and developed into the FIRE Economy in the early 1980s.

    Long before 19 years pass as they have painfully for Japan, US creditors will address the heart of the matter, that as markets deflate asset prices in the US -- housing prices have only lost half their bubble era gains -- the debts taken out against them must deflate as much as well. So far, mortgage relief programs are not aimed at reducing principal but the size of interest payments on excessive debt. If principal on debts is not reduced by negotiated debt restructuring, the markets will eventually deflate the debt against the monetary unit of the debt, the US dollar.

    False Dawn

    But wait, you say, back up. Is there not a silver lining in the US economic contraction? Isn't the personal savings rate finally rising, laying the foundation for the next economic expansion?

    Sadly, no. Incomes fall during economic contractions generally as debt repayment rises, creating a statistical increase in saving because debt repayment is reported as saving. But in a post-bubble world it is not the kind of saving that winds up in bank accounts to be spent later in consumption. What we are seeing today that looks like saving for future consumption is in fact the debt left over from the FIRE Economy sucking the life out of the US economy.

    Similar policies, combined with the demographics of an aging population, led to a continuous decline in personal savings in Japan since 1992, two years after the end of the assets bubbles ended that started in 1985. Not coincidentally, the savings rate in Japan peaked at the same time. Why? During a period of asset price inflation, households stop saving and take on debt. After the asset price inflation ends the savings rate then increases for a year or so as debt is repaid.

    Asset price inflations and deflations exert a perverse effect and saving. First the pool of savings to be spent on future consumption shrinks during the period of asset inflation because households are fooled into believing that asset price inflation is wealth creation, that inflating stock and home prices are doing the saving for them. Income is spent on current consumption. After the bubble pops and the fake wealth is wiped out, briefly the savings rate rises as post bubble recession has not yet expressed itself as rising unemployment and incomes have not yet begun to decline. About a year later then the pool of savings starts to shrink again as unemployment rises, incomes decline, and a greater proportion of income is goes to paying off debts taken on during the boom.

    Savings declines.

    Collision Course

    The duplication by the current administration of Japan's misguided policy to use public and private funds to pay down debt taken on during a credit bubble era is self limiting in the US case in a way it was not for Japan; as long as the debt repayment versus restructuring is pursued, and the banking system is left in its current state of disrepair, the US economy will continue to rapidly decline. (See: How a government that is politically independent from its financial sector swiftly ends a banking crisis.)

    By our estimates, due to the combined impact of the crushing weight of debt burdens created by the FIRE Economy and maintained by the current Debt Deflation Continuation Plan and absent an immediate and effective, politically independent response to the banking crisis, leading to an intensification of the credit crisis as S&P predicts, real GDP will fall 4% in 2009 and 4% again in 2010. This despite the fiscal stimulus, estimated by Adam Posen of the Peterson Institute for International Economics at $1.5 trillion when TARP and other programs are taken into account. If federal government spending continues to increase outlays at the current rate of more than 10% of 2007 GDP per year, and federal government receipts continue decline at a 7.5% annual rate in 2009 and 2010 as in 2008, the fiscal deficit as a percent of real GDP will certainly exceed 10% in 2010, and the current account deficit on a balance of payments basis rise above 10% percent, even as imports fall as previously prodigious capital exporters in the Middle East and Asia suffer current account deficits of their own.

    If and when its fiscal deficit reaches third world levels, will the US -- with its massive current account deficit financed by the public sector and daily dependence on capital inflows to maintain a balance of payments - finally suffer a balance of payments crisis, rapid currency depreciation, rapidly rising cost-push inflation, and rising interest rates? What we at refer to as a "Poom" portion of a Ka-Poom Theory?

    It could happen this year. In fact, it may be happening now.

    When the Russian government found itself unable to pay the interest on its foreign debt in August 1998, nor able to borrow more money in the international financial markets, nor increase taxes on its imploding economy, nor locate private capital inside Russia willing to lend it money, it suffered a balance of payments crisis. The result was capital flight, a ruble crash, and a spike of cost-push inflation.

    In theory, this can't happen to the US, or so we are told. If the US experiences a balance of payments crisis capital has no place to flee to from the US.

    The US enjoys the world's least badly managed government.

    The US issues the world's reserve currency.

    The US is the model of political stability.

    The dollar has persisted for over a century without having ever been recalled, unlike any other currency in existence today.

    But these arguments ignore two facts.

    First, historically it is the very absence of previous experience with either a severe inflation or deflation that lulls policy makers into over-stepping the bounds of market tolerances. Japan, its currency and its people's savings once wiped out by hyperinflation pursues inflation phobic policies that leave the nation vulnerable to deflation while the US, once gripped by a deflation spiral in the 1930s, pursues reckless anti-deflation policies that expose the country to a horrific hyperinflationary outcome (See Hyperinflation case revisited - Part One: On the road to hyperinflation. Will we complete the trip?).

    Second, the dollar is not the only option for capital flight from economies doing even more poorly than the US as the collapsing FIRE Economy spreads economic hardship around the world. Money has been fleeing into hard assets the in the manner of capital flight by insiders from a third world country before a balance of payments induced currency crash (See US exchange rate and capital controls or bust?).

    Most observers do not see the recent rise in the price of gold (and silver as well) in this context because gold has been a cult for so long that even the gold cultists don't understand what has changed. They see the current price rise as a part of a bull market that started in 2001, but we side with Soros on this, and Volcker: we are witnessing a global systemic breakup, the end of the road we got onto in 1971. We passed the last exit in 2001, the last chance to adopt a strategy to shift to a production and savings based economy through a series of steps negotiated with trade partners. Instead we increased the debt further through a property bubble financed with fraudulent structure credit products. The road ends when the US cannot finance its debts. The end of the road is near.

    Bull market in chaos: Is a US balance of payments crisis imminent?
    Your sensible source for apocalyptic predictions

    March 15, 2006 (Metafilter) has returned. Back in the go-go days when Internet stocks ruled the world, iTulip was one of a very few voices warning about the NASDAQ bubble and the likely fallout. As bad as things got, the overall financial bubble never really popped, it just shifted into debt and real estate after furious slashing of interest rates and money-printing by the Fed. Financial manias are terrible; their unraveling has been compared with economic nuclear weapons. The only good solution to a bubble is not to have one in the first place.
    When we re-opened in March 2006, we observed in an article on Credit Risk Pollution in 2006 that structured credit was an accident waiting to happen to the global financial system, and the Frankenstein Economy - the result of a breakdown in accountability between borrower and creditor -- was an accident waiting to happen to the US banking industry. Now the greatest accident of all that has been waiting to happen, and is coming upon us with the same grim predictability as the other crises forecast here over the years but astonishing speed: US dependence on capital inflows to maintain its balance of payments, which inflows depend outflows by US creditors, which outflows depend on now rapidly shrinking output.

    Japan, for example, experienced its first ever trade deficits over the past five months as the yen-carry trade reversed, spiking the yen, and exports declined due to a collapse in US demand and a strengthening currency. China has been taking up the slack. When China can no longer cover US capital import needs, it's all over but the crying.

    The mother of all accidents waiting to happen

    Source: IMF

    The nearing of a US balance of payments crisis point is, in our view, why gold crossed the $1,000 mark again Friday to close at $994 while stocks closed at 12 year real lows.

    We edge ever closer to our 2:1 DOW/Gold ratio target of 5,000 for the DOW and $2,500 for gold. The DOW/Gold ratio declined from 15.34 in September 2008 to 7.65 on Friday, 50% in five months. The previous 50% drop took five years.

    Our positions in Treasury bonds and gold have served us well for over a decade. A buy-and-hold 85% position in 10 year Treasuries since 1998 combined with a15% gold position since 2001 has returned north of 7% a year. However, after ten years we are growing increasingly uneasy with our Treasury bond position.

    Our concern about Treasury bonds is not technical. Our long-term targets remain at $2,500 for gold and 5,000 for the DOW as they have for years. Our new concern is that we are not be taking the forecast far enough, fast enough.

    Think back three years to the time iTulip re-opened. We made correct calls on gold, stocks, and Treasury bonds, the collapse of structured credit and the credit-dependent financed-based economy, the decline in the Fed Funds rate to zero, the bailout Superfund (aka TARP), unemployment exceeding 10% in 2009, and later forecast infrastructure and energy related fiscal stimulus spending. But consider how much else has happened, and how much more quickly, than even our dire forecasts predicted?

    Think back to March 2006 and imagine we had also forecast the following:

    • Fannie Mae and Freddie Mac nationalized
    • Lehman Brothers and other major Wall Street investment banks bankrupt
    • US automakers facing bankruptcy
    • Major US banks facing nationalization
    • Collapse of Iceland's and Latvia's economies and governments
    • Japanese output declines more than 25% in five months

    If you look back over the dozens of articles and newsletters published by us years before this crisis, warning you about it, you will find that they describe events developing more slowly and less dire than the actual events that transpired with astonishing speed. In short, while we have been accused of making overly apocalyptic forecasts we were, in the event, overly optimistic. What if we still are?

    Extrapolate and recalibrate: Accelerating to the end of the road

    We are getting a 1930 to 1933 financial system and debt deflation collapse but in Internet time. The Internet that operated so efficiently for ultra efficient transmission of pricing information and execution of transactions is accelerating the financial and economic crisis process far more quickly than governments can respond to it. A 20th century international regulatory and trade institutional framework is no match for 21st century computer networked financial markets. No administration can correct 30 years of errors in a few months. Unfortunately, a few months is all we have because of the accelerated rate of change we are experiencing.

    History teaches us that adjustments to imbalances can be sudden and brutal, and we think it imprudent to bet that the mother of all international payments imbalances -- between the US and the rest of the world -- will be the exception.

    The rise of gold from $260 to $700 in six years followed by an increase from $700 to $1000 in two years may be quickly followed by a rise from $1,000 to $5,000 in just a few months.

    In other words, our forecast of gold at $2,500 and the DOW at 5,000 may be as prosaic as our other seemingly dire forecasts because our perception of the rate of change and extent of the financial system, economic, and political crisis has been too optimistic.

    Our primary concern at this stage is no longer our readers' portfolios but their ability to weather a US dollar crisis if one erupts. In response, we are increasing our gold allocation to 30% and moving all Treasury holdings to the very shortest maturities, to three month Treasury bills, until we see indications that conditions are stabilizing. We encourage you to engage with the community to actively discuss strategies that are appropriate for you.

    (Image top: Once prosperous Gary, Indiana. Video below: Paul Volcker.)

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    Last edited by FRED; 07-02-09 at 02:14 PM.

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