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Flow of Funds Q4 2008: Debt Deflation confirmation - Eric Janszen

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  • Flow of Funds Q4 2008: Debt Deflation confirmation - Eric Janszen

    Flow of Funds Q4 2008: Debt Deflation confirmation

    Buried in the details of yesterday’s quarterly Fed Flow of Funds report is the collapse of the private credit market in Q4 2008 and attempts by the Federal Reserve and Treasury Department to compensate for the loss with government credit as the world's largest lender of last resort.

    Debt growth levels declined in all sectors except US Federal. Household debt turned negative.


    Security credit liabilities collapsed.


    ASB assets extended a decline that started in Q1 2007.


    Agency and GSE securities assets collapsed.


    Treasury securities issuance made up part of the difference.


    The value of household mutual funds holdings collapsed.


    Pension fund reserves extended declines that started in 2005.


    Personal and corporate income taxes declined sharply in Feb 2009 from FY 2008 and FY 2007.
    Much attention is paid to the health of US banks, but a more pressing problem as the Flow of Funds reveals is that the magic securitized debt machine broke in the final quarters of 2008 that for decades fulfilled the endless demand for credit by households and businesses. Now that unemployment is rising, demand for credit is falling, and with the securitized debt machine broken, the supply of private credit has dried up, too. Where does that leave us?

    Questions:
    • Can the securitized debt market be restarted? How can the supply of private credit be restored to even close to previous levels without it? (The securitized debt market will not be restored to anywhere near its previous level. Private credit markets going forward will be a function of sound investment demand, not issuance creativity.)

    • Can confidence in the debt securitization model be restored in time to boost the credit supply before the economy contracts so much that credit demand falls to comatose levels?

    • How can household borrowing be restored when unemployment is rising? The US economy desperately needs organic job creation to raise incomes from salaries, and high interest rates to motivate saving. (Household borrowing will never reach previous levels relative to income.)

    • What will happen to GDP short term if credit supply and demand are not quickly restored? (GDP will decline precipitously. In the future a pool of savings more than credit will finance expansion.)

    • What will happen to sales, income, capital gains, and property tax receipts as sales revenues fall with a decline in consumer and capital spending, incomes fall with rising unemployment, capital gains fall with declining asset prices, and property taxes fall along with property valuations? (Tax receipts will fall dramatically.)

    • How can the federal government stimulate jobs creation with spending programs at the same time state governments are laying off employees in droves to meet budget restraints? (The government cannot "create" jobs, but can move them from one part of the economy to another, or from the future into the present when they are needed more. The net long term results is, however, negative. The only "solution" to the credit collapse problem is to not allow a credit bubble to develop in the first place.)

    • Won’t the federal government find itself needing to finance state and local budgets to achieve the politically desired net job creation, and won't that add substantially to federal budget liabilities? (Yes.)

    • How will the federal government stimulate demand by job and income growth at the same time household net worth is falling with asset prices, creating an undertow of negative wealth effects? Won’t the Federal government for political reasons need to step up the financing of public pensions, and even private ones to at least backstop those losses? (Yes, further increasing budget liabilities.)

    In sum, we see the risk that, much as in 2001 following the collapse of the technology stock bubble but driven by considerably more extreme circumtances, tax receipts in 2009 are vastly over-estimated while demands on the federal government to finance both fiscal stimulus and to act as a long term lender of last resort are vastly underestimated.

    Perfect Storm for a Balance of Payments Crisis?

    As argued in “Road to Ruin: Final stretch” the US is vulnerable to a balance of payments crisis. The cause of that crisis is the convergence of four main crisis events, and we are ready to say that these may occur within the next three quarters:
    1. Epiphany that tax receipts will be dramatically lower than current estimates and expectations, creating a fiscal deficit shock (Timing: Late April or early May?)
    2. Epiphany that demands on the Federal budget are higher than currently expected due to extension of lender of last resort operations to finance current credit market challenges and the inclusion of new rescue operations, such as to support credit card and insurance companies, and a series of funding crises, such as public pensions, and state and local government budget shortfalls. (Timing: Ongoing)
    3. Supply crash meets money supply boom, resulting in rising inflation. All across the supply chain, from raw to finished goods, supply is falling. Starting with raw materials, it is easy to forget that mining is a capital-intensive process, and without credit production has slowed dramatically. Without trade credit shipping and trade have slowed dramatically. In terms of finished goods, the retail trade industry is contracting quickly. Much as occurred starting in 1975, government efforts to reflate the economy by increasing the money supply ran head long into a collapse in goods supply. Looking at trends in goods supply and money supply, a rise in inflation starting with consumer prices may have already begun. (Timing: Q4 2009 or Q1 2010?)
    4. Epiphany that China will as its economy contracts not be able to afford to continue to purchase US Treasury bonds despite the virtually guaranteed result, a collapse in US export demand and value of dollar denominated reserve assets. The situation will be similar to that which the US and UK found themselves in 1930, unable to continue to make payments that maintained capital inflows that the German economy depended on to finance its fiscal and current account imbalances: the German economy collapsed in a Sudden Stop event in 1931. The timing of this event is very difficult because it is political; at what point does the cost of buying Treasuries outweigh the cost of not buying them? (See Economic M.A.D.) Long before the now common warnings from China are acted on, we should see some early signs [See: Headed for a Sudden Stop). One of those signs will be investors hiding out in dollar inflation hedges like commodities and precious metals, and we take the coincidence of falling Treasury yields and rising gold prices as a sign that some investors are preparing for a Sudden Stop event. (Timing: Q3 or Q4 2009?)

    The near convergence of these events means they may occur either in sequence or more or less at the same time. For example, if clear evidence of inflation arises soon, that will cause Treasury prices to fall, and in fact may be causing them to do so already. The most likely trigger is a Tax Receipt Epiphany that leads to a Fiscal Deficit Shock and sudden loss of confidence in US sovereign credit quality.

    The result in the fabled “Poom” of iTulip’s 1999 Ka-Poom Theory, a theory of the final stage of the disinflation and reflation process of the asset price inflation cycles that began in the early 1980s, began to end in early 2008 with the onset of debt deflation.

    We explore the fiscal deficit shock idea in more detail in Flow of Funds in a Transformational Depression ($ubscription)

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    Last edited by FRED; 03-14-09, 12:09 AM.

  • #2
    Re: Flow of Funds Q4 2008: Debt Deflation confirmation

    I assume all of these questions are rhetorical, EJ. If the government is forced to finance states and pension funds combined with the Chinese withdrawing funds, then all of your predictions come to fruition at once and you can remove the "jump ball" from 2009. Is this what your book is moving towards?

    Comment


    • #3
      Re: Flow of Funds Q4 2008: Debt Deflation confirmation

      Possible worst case scenario -- could the government pull an Argentina and "nationalize" all pension funds?

      Comment


      • #4
        Re: Flow of Funds Q4 2008: Debt Deflation confirmation

        Not just pension funds but 401k's as well, why do you think I hold no money in either? For fear the govnt could take it at anytime.....

        Comment


        • #5
          Re: Flow of Funds Q4 2008: Debt Deflation confirmation

          Epiphany that tax receipts will be dramatically lower than current estimates and expectations, creating a fiscal deficit shock (Timing: Late April or early May?)
          This is happening: Feb FY09 Net Individual/Corp Income Taxes: $6.6 bn;
          Feb FY2008: $21.5 bn; Feb FY2007: $42.4 bn; and Feb FY2006: $37.6 bn.

          This year, no doubt, lots of early individual tax filers to get refunds, but it portends a collapse in March and April also, especially corporate income taxes, which may plunge to $100 bn in FY 2009, down from $304 bn FY 2008, $370 bn FY 2007 and $353 bn FY 2006 (September of all years).

          All data from Monthly Treasury Statements.

          Comment


          • #6
            Re: Flow of Funds Q4 2008: Debt Deflation confirmation

            Originally posted by kelton56 View Post
            This is happening: Feb FY09 Net Individual/Corp Income Taxes: $6.6 bn;
            Feb FY2008: $21.5 bn; Feb FY2007: $42.4 bn; and Feb FY2006: $37.6 bn.

            This year, no doubt, lots of early individual tax filers to get refunds, but it portends a collapse in March and April also, especially corporate income taxes, which may plunge to $100 bn in FY 2009, down from $304 bn FY 2008, $370 bn FY 2007 and $353 bn FY 2006 (September of all years).

            All data from Monthly Treasury Statements.
            Thanks. Double checked the data at the Treasury Dept. site and added a chart.
            Ed.

            Comment


            • #7
              Re: Flow of Funds Q4 2008: Debt Deflation confirmation

              In http://www.itulip.com/forums/showthr...1591#post81591 EJ wrote:

              The Treasury Department needs to stop taking trading our precious credit for securities of questionable value and instead issue Infrastructure Development Bonds. These bonds can use the accumulated savings within the FIRE sector to finance the reconstruction of a new, productive economy rather than pour money down a whole in a vain attempt to resurrect the FIRE Economy that has gotten us into the current troubles we are in. It will then be the duty of Americans who can afford to buy them to do so, to each according to his means. That is the American way out of a mess like this, with a fair sharing of the burdens of cost.
              Is this domestic accumulated savings pool remotely adequate to offset the balance of payments shortfalls? That's probably a wild question but if so, what will the ultimate rate of return have to be in order to get it flowing in the direction they need it to, all else considered?

              I'm probably walking way out on a flimsy limb here but, what the heck else is left? Would this be the last resort source of funding, aside from printing?

              Comment


              • #8
                Re: Flow of Funds Q4 2008: Debt Deflation confirmation - Eric Janszen

                I feel privileged to read this commentary. Nowhere else on the internet would one find commentary so cogent and so succinct.

                Problem for me is: I've got a stash of dollars and I don't know what to do with it. Shouldn't I avoid buying ANY assets linked to the US? For e.g., an investment in USO runs the risk of being ruined by price controls. An investment in major resource companies runs similar risks especially if the companies have significant operations in America.

                So short of buying gold, sticking it under the ground and guarding it with a gun, what other alternatives are there really? I speak here as a resident of Blighty which is in far worse shape and that really boggles the mind.

                Comment


                • #9
                  Re: Flow of Funds Q4 2008: Debt Deflation confirmation - Eric Janszen

                  All of these scenarios are going to provide a conduit to introduce massive inflation. Right now deflation is happening much more fast than inflation due to the markets efficiency at deflating which is faster than the incompetent govenment can inflate. SUPPLY of commodities and stuff you need is being wiped out at the same time a tsunami of cash is about to hit the system. The American economic Alpha and the Omega (fed and treasury) will utilize their evil alliance to try and jump start an economy which is just a hollow shell at this point.


                  Purchasing power preservation is paramount. You have deflationary risks in assets and inflationary ones in staples. Stock up on as much staples as you can hold right now. Deflation or inflation will not affect a holding of staples on your person. Normally I would NEVER recommend this. I've lived through the seventies when they thought society was going to collapse but I thought they were whackos. The eighties we could have been nuked at any time, but I didn't build a bomb shelter because I thought that was a little too "tin foil hattish".

                  This economic crisis is different. I can feel it in my bones. Things need to be seriously re-structured and nature has a way of seriously re-structuring things irrespective of peoples desires.

                  Buy consumables all you can carry and store. Keep all your currency in an amount that doesn't exceed your fixed debt (in a deflation cash is king, if inflation hits pay off your fixed debt with the debased currency if both hit your still ok paying off your debt.) Store the rest of your money in gold which you need to get progressively closer to as this crises unwinds eg. GLD etf-unallocated bullion-allocated bullion-safe deposit box-personal possession to minimize storage problems,liquidity issues and safety.

                  Be prepared to move out of gold when the mania hits. Gold will be the last bubble to pop and when you see the ratio of gold to real estate and gold to oil and gold to equities get outlandish, then the partie's over for gold, and the healing can begin, probably with a currency that has a different name and definitely a different structure.


                  There is a free online book called "The Alpha Strategy" that is a little dated, but can give you some more ideas about preserving your wealth through these turbulent times.

                  On a positive note,in the future things will get better in an equal and opposite manner to how bad things are in the present.

                  Hope this helps.

                  Comment


                  • #10
                    Re: Flow of Funds Q4 2008: Debt Deflation confirmation - Eric Janszen

                    Originally posted by occdude View Post
                    All of these scenarios are going to provide a conduit to introduce massive inflation. Right now deflation is happening much more fast than inflation due to the markets efficiency at deflating which is faster than the incompetent govenment can inflate. SUPPLY of commodities and stuff you need is being wiped out at the same time a tsunami of cash is about to hit the system. The American economic Alpha and the Omega (fed and treasury) will utilize their evil alliance to try and jump start an economy which is just a hollow shell at this point.


                    Purchasing power preservation is paramount. You have deflationary risks in assets and inflationary ones in staples. Stock up on as much staples as you can hold right now. Deflation or inflation will not affect a holding of staples on your person. Normally I would NEVER recommend this. I've lived through the seventies when they thought society was going to collapse but I thought they were whackos. The eighties we could have been nuked at any time, but I didn't build a bomb shelter because I thought that was a little too "tin foil hattish".

                    This economic crisis is different. I can feel it in my bones. Things need to be seriously re-structured and nature has a way of seriously re-structuring things irrespective of peoples desires.

                    Buy consumables all you can carry and store. Keep all your currency in an amount that doesn't exceed your fixed debt (in a deflation cash is king, if inflation hits pay off your fixed debt with the debased currency if both hit your still ok paying off your debt.) Store the rest of your money in gold which you need to get progressively closer to as this crises unwinds eg. GLD etf-unallocated bullion-allocated bullion-safe deposit box-personal possession to minimize storage problems,liquidity issues and safety.

                    Be prepared to move out of gold when the mania hits. Gold will be the last bubble to pop and when you see the ratio of gold to real estate and gold to oil and gold to equities get outlandish, then the partie's over for gold, and the healing can begin, probably with a currency that has a different name and definitely a different structure.


                    There is a free online book called "The Alpha Strategy" that is a little dated, but can give you some more ideas about preserving your wealth through these turbulent times.

                    On a positive note,in the future things will get better in an equal and opposite manner to how bad things are in the present.

                    Hope this helps.
                    occdude, I just LOST a three paragraph post describing my 1970s experiences and what I've done to prepare for this. I'm just too tired and pis#!% -off right now to retype it.:mad:

                    Thank you for your thoughtful post. I agree with everything you said.
                    The only huge unknown (to me) is the timing.:confused:

                    Comment


                    • #11
                      Re: Flow of Funds Q4 2008: Debt Deflation confirmation - Eric Janszen

                      Originally posted by Raz View Post
                      occdude, I just LOST a three paragraph post describing my 1970s experiences and what I've done to prepare for this. I'm just too tired and pis#!% -off right now to retype it.:mad:
                      After losing and having to reconstruct many posts, I have taken to copying and pasting to a text editor (e.g. notepad) and then copying back.

                      The probability of losing a post will significantly decrease.

                      Comment


                      • #12
                        Re: Flow of Funds Q4 2008: Debt Deflation confirmation - Eric Janszen

                        Originally posted by occdude View Post
                        Be prepared to move out of gold when the mania hits. Gold will be the last bubble to pop and when you see the ratio of gold to real estate and gold to oil and gold to equities get outlandish, then the partie's over for gold, and the healing can begin, probably with a currency that has a different name and definitely a different structure.
                        Move out of gold . . . into WHAT ???

                        Will the new currency be established before the gold bubble pops??
                        raja
                        Boycott Big Banks Vote Out Incumbents

                        Comment


                        • #13
                          Re: Flow of Funds Q4 2008: Debt Deflation confirmation - Eric Janszen

                          Originally posted by raja View Post
                          Move out of gold . . . into WHAT ???

                          Will the new currency be established before the gold bubble pops??
                          Move into anything that has a historical relationship with gold that is skewed eg. Dow to one oz. or even 1/2 oz. of gold or one oz. of gold to 100 barrels of oil. Or one OZ. of gold to a new home. Trade your physical asset of gold for these other physical assets. In the mania your neighbor will be day trading gold futures.


                          I think the new currency will be based on gold again, or other tangible assets like real estate which is what they did in the Weimar republic that finally ended their hyperinflation. They pegged the old currency at a level to the new currency and stopped inflating it. The price of gold to this new currency will eventually stop rising as faith is restored.

                          Comment


                          • #14
                            Re: Flow of Funds Q4 2008: Debt Deflation confirmation - Eric Janszen

                            Originally posted by hayekvindicated View Post
                            I feel privileged to read this commentary. Nowhere else on the internet would one find commentary so cogent and so succinct.

                            Problem for me is: I've got a stash of dollars and I don't know what to do with it. Shouldn't I avoid buying ANY assets linked to the US? For e.g., an investment in USO runs the risk of being ruined by price controls. An investment in major resource companies runs similar risks especially if the companies have significant operations in America.

                            So short of buying gold, sticking it under the ground and guarding it with a gun, what other alternatives are there really? I speak here as a resident of Blighty which is in far worse shape and that really boggles the mind.
                            HayekV: Price controls will usually exacerbate the supply shortage, and drive up the international [external to the price control environment] price of whatever is being controlled. Ever since EJ's piece about the potential for capital controls in the USA, I have revised my view about the USA being a "safe jurisdiction" in which to hold assets, or companies that have assets predominantly in that jurisdiction. However companies that hold high quality assets in the price controlled commodity [e.g oil reserves, etc.] outside the USA should benefit greatly from US price controls as supply gets clobbered still further.

                            Comment


                            • #15
                              Re: Flow of Funds Q4 2008: Debt Deflation confirmation - Eric Janszen

                              Originally posted by GRG55 View Post
                              HayekV: Price controls will usually exacerbate the supply shortage, and drive up the international [external to the price control environment] price of whatever is being controlled. Ever since EJ's piece about the potential for capital controls in the USA, I have revised my view about the USA being a "safe jurisdiction" in which to hold assets, or companies that have assets predominantly in that jurisdiction. However companies that hold high quality assets in the price controlled commodity [e.g oil reserves, etc.] outside the USA should benefit greatly from US price controls as supply gets clobbered still further.
                              You Canadians are lucky. You've got commodity exchanges where you can play with the stuff and you don't have to worry about price controls because Canada is resource rich and is unlikely to go broke. except for the high taxes, you've got it perfect for this scenario.

                              Unfortunately for me, I think the UK will also institute price controls so playing the price spikes on commodity exchanges here is ruled out. Also, I do believe that Britain is not far away from bankruptcy and is likely to go bankrupt faster and sooner than the US.

                              Comment

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