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2012 is shaping up to be the blockbuster main event of the ongoing
financial crisis. Massive amounts of new debt, vast quantities of additional digital
dollars and the spark of higher interest rates will set off version 2.0 of
the credit-driven financial implosion.
Why Was Financial Crisis 1.0 Only a First World Crisis?
The original 1.0 version had its origins in the
collapse of the US subprime mortgage derivative deck of cards in 2007 before
morphing into a broad-based financial crisis in the fall of 2008. It
gradually spread to most other first-world advanced economies, but did not
wreck havoc on emerging markets and second and third world nations. Most such
economies were insulated from the folly of first-world finance - credit,
borrowing, overwhelming debt and onerous interest payments – simply
because they did not qualify for the intoxicating elixir of credit.
Can the US Government Prevent
Another Financial Crisis?
A
plethora of fact and opinion has been offered to explain what went wrong -
Wall Street greed, crony capitalism, deficient and inadequately administered
regulations, a credit and debt engorged consumer-driven economy, imprudent
lending standards, negative real interest rates and nonexistent savings.
Invariably, all reasons rest on the overwhelming availability and excessive
abundance of cheap and easy credit and cash.
The
meagre measures that have been designed and implemented since the onset of
the Great Recession to mitigate financial risk, such as the Dodd Frank
Financial Reform legislation, have merely institutionalized the shortcomings
of the regulatory framework. Moreover, the ‘too big to fail’
private financial institutions which qualify for unlimited taxpayer bailouts
are even fewer and larger today. Indeed, the supposed solutions to the
problem exemplify what the problem really is – government!
Deficits are exploding rapidly leading inexorably to massive debt at
all levels of government from federal, to state and into local governments.
US sovereign/federal debt is now over $14 Trillion and is expanding in the
current fiscal year at over $1.65 Trillion – over three times greater
than just three years ago. Currently 37 percent of all federal spending comes
from borrowing, which means much more debt...and a veritable fairyland of
more magic money created by the FED to service the ballooning beast.
To this cauldron of crud one must add all the unfunded and underfunded
obligations of the social safety net represented by Social Security, Medicare
and Medicaid, all conveniently excluded from the federal government’s
annual operating budget. Depending on what assumptions are made for such
factors as future inflation, eligibility criteria, program utilization and
related issues, further unfunded liabilities of between $60 Trillion and $110
Trillion must be added to the US federal government’s debt tab.
State and local governments contribute a further $3.87 Trillion in
unfunded liabilities attributable to their employee pensions and health
insurance benefits. Recent state and municipal employee demonstrations
militating for retention of the unsustainable status quo have profiled what
clearly are bloated pension and health benefits.
Respected economists Carmen Reinhart and Kenneth Rogoff,
in their recent book entitled “This Time is Different” outlined
how a debt to GDP ratio of 90 percent is a nation’s tipping point.
Their conclusions are based on an analysis several hundred years of economic
history. The USA, United Kingdom, Japan and others are lined up to join
Greece, Ireland, Portugal among others staring at the looming financial
abyss.
Fundamentals are therefore in place for another financial collapse. This
time governments will join private financial institutions heading
toward the financial debt wall. Government won’t be able to perform
its previous role of bailing out ailing financial giants since government
itself is now in need of rescuing.
Indeed, the most
challenging questions today are how and who will bail out our failing governments? European nations in the EU and those who share the Euro currency
can’t help since many of them occupy an equally perilous perch on the
financial precipice. It seems all advanced nations not supported by a strong
natural resources sector (Canada, Australia) or high productivity
manufacturing (Germany) are facing financial catastrophe.
What Will Trigger Financial Crisis 2.0?
Rising interest rates are all that is necessary to
trigger the round two collapse of the ongoing financial crisis. It doesn’t take Mensa level
intelligence to notice that current interest rates are lower than they have
been since the early 1950’s. Real interest rates are also perilously
close to being negative, if not already. With rapidly growing price
inflation, interest rates will be forced northward.
Until this year foreign purchasers have been the largest buyers of US
Treasury debt, with China and Japan in the lead. Japan now has other
priorities following its recent highly destructive tsunami. China has already
substantially reduced its purchases citing lack of confidence in the
declining value of the United States dollar. They have also found that
spending their inventory of surplus US dollars by ensuring future supplies of
minerals and energy to be much more beneficial to the Chinese economy.
Moreover, bond purchasers find sixty year low interest rates on US Treasury
bonds, less than the rate of inflation, a very risky and unattractive
investment.
In the absence of enough foreign or private sector purchasers, the US
central bank, the Federal Reserve Board, has been ‘monetizing’
federal government debt through its purchases of Treasury bonds. The process dubbed Quantitative Easing, by which the
FED creates money out of thin air, allows the FED to become the purchaser of
last resort of government debt. At the present rate it is expected that the FED will purchase a full
50 percent of all new and maturing Treasury bonds in the current fiscal year.
This is necessary simply because there are not enough foreign or domestic,
private sector or government buyers to be found at current rates of interest
and levels of risk.
The most telling and perhaps scary portent occurred recently when
PIMCO, the largest private bond fund, sold its entire US Treasury bond
holdings, thereby demonstrating its concern about federal government debt.
Reasons cited for the sale by PIMCO head Bill Gross are risks associated with
near negative interest rates and the declining value of the US dollar
stemming from excessive money creation.
Knowing that institutional money managers representing pension funds
and insurance company investment pools frequently follow industry leaders, we
can confidently predict that many more Billions and Trillions of Treasury
bonds will soon be dumped into the sickly bond
market. When this process plays out, FED money creation and debt monetization
will go into overdrive, since price inflation will take off as the dollar
devalues.
Why America’s Political Process Virtually Guarantees Financial
Crisis 2.0?
How can we be so certain that another and more serious financial
crisis is on the horizon? Salient factors include:
1. the magnitude and momentum of expanding government
deficits, debt and unfunded liabilities,
2. the monetization of Treasury debt by the Federal
Reserve Board using manufactured money acquired through the somewhat mystical
process labelled ‘Quantitative Easing’,
3. the strong prospect of higher interest rates
necessitated by an inflating and devaluing currency followed inevitably by
increasing price inflation.
The political process virtually guarantees that no tough, but
essential, measures of consequence will be undertaken by political decision
makers to stabilize the financial system. Witness the recent embarrassing
public tussle between the two parties in Congress over a mere $33 Billion of
pocket change in budget reductions when the total shortfall is $1.65
Trillion.
To suggest that strong leadership at this time of looming financial
crisis is needed is to state the obvious. However, politicians are like most
other people in that they are ambitious careerists who worked hard to secure
the jobs they so treasure. Ditto for government bureaucrats who want to
preserve their careers and the associated benefits, including the cushiness
of defined benefit and inflation protected pensions as well as gilded health
insurance. Preservation of the status quo is understandably their top
priority.
Voters expect their elected representatives to be active and to ‘do
something’ when a crisis strikes them between their eyes. However,
there is absolutely no incentive to scan the horizon and to implement tough
measures designed to head off a mounting crisis.
Politicians of across the partisan spectrum and range of ideologies
have learned, indeed they have thoroughly inculcated, the reality that the
voting public does not want to hear about emerging or imminent problems. They
want reassurance, not anxiety, but when a crisis blindsides them, they want
immediate action from their government.
Until the crisis arrives, politicians who assume leadership roles as
educators and disseminators of serious policy options are frequently branded
as bad news bears and messengers of mayhem for calling for belt tightening
and sacrifice. Instead, voters reflexively point to government waste and to
the ‘rich people’ for austerity and additional revenue.
Politicians of vision are invariably chastised by losing their jobs at
the next election. Candidates who ignore the storm clouds and who promise
good times ahead are most frequently rewarded with the endorsement of a vote.
Political will wilts in this kind of hostile electoral environment. Is it any
wonder the voting public hears what it wants and gets what it deserves?
Presidential election years are traditionally awash with positive
investment environments. Politicians in power know that the public can be
bribed with their own money...actually borrowed money. Voters enjoy their
apparent prosperity and the general feeling of financial wellbeing. Incumbent
Presidents, legislators all, do well in such circumstances.
We will see this scenario play out again in 2012...but only if the
persons in power can engineer it yet again. But can they? Will record low
interest rates continue? Will the large institutional Treasury bond
purchasers such as pension funds and insurance companies follow PIMCO’S
Bill Gross out of the Treasuries market? Will the dollar plummet with the
excess of FED money printing? Will emerging price inflation in food and
energy make for a grouchy voter? Can the government keep the lid on or will
the financial pressure cooker explode?
Conclusion: 2012 Will Be the Year of the Perfect Financial Storm...
Buying time by creating ever more magic money, which inevitably
results in price inflation, overheated stock and commodities markets and
which devalues the currency - will work until it doesn’t.
This analyst sees the perfect storm of converging criteria almost
perfectly timed and aligned with the 2012 election cycle. When the moment
arrives, the financial earthquake will rapidly demolish the existing highly
precarious financial system. Government will stand by helpless, unable to
shield itself, much less its vulnerable citizens or private financial
institutions from the tsunami of debt and currency destruction.
If starting tomorrow morning our politicians were to act like adults,
willing to lead in a pragmatic and focused fashion, free from the concerns of
partisan advantage, rancour and rigid ideology, financial collapse could be
delayed...perhaps avoided. Unfortunately the challenge seems insurmountable
and the political will too feeble.
Get ready for Financial Crisis 2.0 in 2012 –
It’s inevitable!
Arnold Bock
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