Curtain Call for Inflationary Run
The collapse of 2008 occurred because the US was clearly on an unsustainable path of excessive consumption and speculation, financed by credit. Debts are IOU's with repayment terms, which means debtors must pay interest to creditors; borrowers therefore are on the hook for the principle as well as the interest, and the whole system falls apart when debtors are unable to pay because they 1) don't produce anything, or 2) are denied new credit that becomes scarce when booms turn to bust.
Borrowing to consume is debt that is of the non self-liquidating type, an issue we have regularly written about. As it turns out, this type of borrowing was not limited to the know-nothing consumer and his get-rich-quick schemes this past decade, but government and corporations as well, who, one might think, should know better. The US economy is largely dependent on debt and smooth running credit markets. In the years leading-up to the collapse of 2008, large US corporations -- many not in the 'finance' business but rather industrial type companies -- greedily created finance arms to get a cut of the huge profits being generated by shuffling paper within the ballooning debt bubble.
In fact, with a large portion of corporate activity today centered around finance rather than production, it is easy to see how so many companies ended up getting into trouble; much of this debt bubble was based on mortgage loan origination -- loans based on home values that were too high and headed for collapse, held by consumers who couldn't afford to make mortgage payments at the first sign of trouble.
Non self-liquidating debt, in the tens of trillions it turned out, was everywhere, and is the reason the entire financial system of the US is at risk of collapse. The repeal of Glass-Steagall in 1999 allowed financial institutions to get so large that any suggestion of failure meant systemic risk, threatening the financial system of the entire world. The US government understood this all too well in late 2008, when it bailed out this "too big to fail" system. It borrowed even more money and handed it over to distressed institutions, guaranteeing some of the bad paper to boot. The Federal Reserve, as well as central banks around the world, also got involved in swapping government paper for toxic assets (albeit paper that is expected to be returned to their owners, eventually), as well as monetizing some of the new treasury issues.
It worked, and bought the system some time.
But as we sit here a year later, with stock markets rallying for months in the face of horrendous unemployment, it is hard to avoid coming to the realization that these gains have all been one big illusion. Not that the gains aren't real -- they most certainly are for those who actually sell and realize those profits. But rather, they are simply speculative gains derived from the liquidity governments have created in the past year: a liquidity rally within a deflationary collapse.
With no strings or conditions attached, Wall Street once again created silk purses out of sows' ears, shamelessly shuffling the trillions, courtesy of taxpayer bailouts, into enormous profits, and paying itself billions in bonuses in the process. Meanwhile, those who saved it from itself continue to suffer; in a sense, the gains of 2009 belong to the people whose currency has been sacrificed as a result of this emergency. In France not so long ago, this artful plundering of the people -- by both Wall Street and Washington -- meant the guillotine for the plunderers.
But sooner or later, most probably sooner, the jig will be up. This is because, in our estimation, 2009 will go down as a major inflection point in this country in that citizens are finally rising up and marching in the streets. Psychology has clearly changed in 2009. We saw Ben Bernanke go on 60 Minutes, in a feeble attempt to portray his institution as "one of us." In 2009, Members of Congress from both sides of the aisle are demanding an audit of the Fed. We think the government and Fed have hit a wall, and the people will no longer accept more of the same plundering. Their voices are getting louder by the day.
In the weeks and months ahead, it will become clear the US economy is not improving, while the unemployment problem in this country continues to get worse. The government and the Fed will have failed in their futile efforts to re-inflate the credit bubble. At that time, the stock markets will collapse once more, in a continuation of the deflationary collapse and a replay of October 2008-March 2009. That will be the day of reckoning, as far as the government and Fed are concerned.
To date, the Fed's monetization and balance sheet growth has clearly not been large enough to cause the US bond market to collapse. The Fed has been quite careful in that respect, since it knows the bond market is watching its every move. The Fed will not try anything funny. That is, it will not print funny money and take the country towards hyperinflation. Far from it.
Some half-brained scheme might be designed to reduce the burden of debt service, but the Fed will not willingly destroy itself. The Fed did not devise a meticulous program of stealing the purchasing power of US citizens, at crawl speed, for the last 90+ years, enriching itself and its powerful backers in the process, only to see it all go up in smoke, in a gallop, via the printing press.
Throughout history, inflations that were caused by credit bubbles ended in deflationary collapses. One of the most well known is John Law's scheme in France in 1720. Monetary chaos was no stranger to France in the seventeenth and early eighteenth centuries, especially the years 1681-1725. Louis XIV's palaces and wars had cost a lot of money, and the French government had amassed enormous debts. The currency was debased through this time, which caused great economic hardships for France.
Law's Mississippi scheme was supposed to help reduce France's debt burden. Law rose in prominence to chief banker, and put in place a fiat money system based on easy credit, tied to shares of his Mississippi Company, which was awarded France's exclusive trade routes to the New World. A boom ensued. Law made it easy for the masses to buy shares on credit, with little money down. Speculation ran rampant. Paris was booming, with luxury goods selling out as soon as they hit the shelves. An impromptu stock exchange was set up near Law's offices. Real estate values and rents soared.
Then it all fell apart. A few smart observers realized it was all a game of smoke and mirrors, and started cashing in their chips. Many more followed, and the shares in the Mississippi Company -- the entire boom -- collapsed. John Law fled France. The clean up of Law's mess, and economic and political crisis that followed led to the "great monetary reform and consolidations" of 1726, which brought in an era of stability lasting over fifty years.
That is, the economic collapse during Law's time led to a massive debt deflation, which brought down asset values indiscriminately across the board - a staple of deflationary collapses. Rather than meeting the collapse head on with "money printing" to inflate away those debts, it was decided that a return to sound money was necessary, along with the necessary action of defaulting on the country's debt which left creditors bankrupt, but the flipside was that France, as the debtor, was the net gainer, in a perverse sort of way.
In other words, the nature and size of the collapse changed the country's psychology, allowing for a return to sound money. An alcoholic may finally choose to go sober AFTER his ailing liver almost kills him. He doesn't go sober BEFORE he is rushed into the emergency room. France going back to sound money didn't cause the deflation, they went back to sound money as a result of the deflation.
In a modern financial system based largely on credit, it is simply not practical for large, complex transactions to be conducted in cash. Therefore, paper money, i.e., the dollar bills in our wallets, makes up only a small part of today's credit based monetary system. With the credit market running into the tens of trillions, if not hundreds, it is clear that these debts are too enormous to be paid back -- particularly with a paltry one or two trillion in all of US currency and bank reserves. Since credit deflations follow credit inflations, it is only after collapses occur that governments are confronted with hard choices. Currency inflation, i.e., "money printing" as in Weimar Germany, is but one of the choices.
The only thing governments know how to do is react to disasters (and they don't even do that very well). They are almost never ahead of the curve in efforts to avert disaster. We had the crash of 2008, and followed that up with more of the same debt gorging that got us into the mess to begin with. But we believe the change in the country's psychology this year will put an end to such practices sooner rather than later, and requires that we move out of the liquidity driven inflationary camp as a result. We don't make this decision lightly, but we don't believe the US will resort to currency inflation, either, for reasons stated above.
The reprieve in the markets since March has provided investors with an incredible opportunity to sell into strength, and get out of the way of an even greater decline dead ahead. But for some gold, which is and will always be real money, we advise readers to do the same.