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The
ability to wage war on credit gave the West an insurmountable advantage over
the East. The West’s credit, however, has now turned to debt and the
West has lost its advantage. But the return to parity will not be easy.
The three hundred
year economic expansion fueled by debt-based capital markets is coming to an
end and with it, the hegemony of the West over the East. During that period,
debt-based paper money propelled first England
then the US
to world dominion because of the ability to wage war on credit and to print
money ad infinitum.
That era is now
ending because the critical balance between credit-driven expansion and
debt-driven contraction has now shifted significantly in favor of the latter;
and in 2010, both East and West now find themselves on the edge of a growing
deflationary sinkhole created by the sequential collapse of two large US
bubbles, the dot.com and US real estate bubbles.
The US
caused the 1930s deflationary depression and is again cause of the current
contraction; and although similarities exist between the two, the differences
between them insure a far more consequential outcome today than in the 1930s.
Global demand is
again falling as credit contracts, a sign that debt-driven deflation is back
but, today, there is an additional danger as well. Since 1971, because of the
US
default on its gold obligations, money no longer possesses intrinsic value
and the consequences will soon become apparent. Deflationary depressions and
a collapse in the value of fiat money have happened before but never
simultaneously. Soon, they will.
We are in what
Stephen Roach, Chairman of Morgan Stanley Asia, calls the end-game, the
resolution of past monetary excesses and imbalances, excesses and imbalances
that reached never-before-seen heights in the last decade. The long awaited
day of reckoning has arrived.
THE PROBLEM
Capitalism cannot
function unless its constantly compounding debt is serviced and/or paid down.
Today, the US, the world’s largest debtor, can no longer pay what it
owes except by rolling its debt forward and borrowing more, what the late
economist Hyman Minsky called ponzi-financing, financing common in the
final stages of mature capital systems.
The amount of
outstanding US
debt has now reached levels that can never be paid off:
… the United
States government and its agencies have, by
far, the largest pile-up of interest-bearing debts ($15.6 trillion), the
largest accumulation of unsecured obligations (over $60 trillion), the
largest yearly deficit ($1.6 trillion), and the greatest indebtedness to the
rest of the world ($4.8 trillion).
Martin D. Weiss,
www.moneyandmarkets.com
The unpayable
levels of US debt are not
just the problem of the US.
Because the US dollar is the lynchpin of today’s fiat money system, US
debt is everyone’s problem. The US dollar is the world reserve currency
and a default by the US
will have far-reaching consequences, especially in China,
its largest creditor.
INFLATE, DEVALUE
AND TAX
Bill Gross,
co-founder of PIMCO, the world’s largest bond fund and an expert in
matters of debt, wrote in 2006, the way a reserve currency nation [such
as the US] gets out from under the burden of excessive liabilities is to
inflate, devalue, and tax.
Inflation
destroys the value/cost of liabilities by eroding the value of money. Debts
are paid back with inflated currencies, a process which benefits the debtor
and injures the creditor. This is why reserve currency nations usually
inflate their way out of debt by printing what they owe.
Devaluation is
another option afforded reserve currency nations. By devaluing the value of
their currency, the value of what they owe falls relative to other
currencies. Again, the benefit is to the debtor at the expense of the
creditor.
Taxation is
another option but is no longer available to the US, as its liabilities are
now too high. It would be like forcing the elderly and morbidly obese to
engage in strenuous exercise to regain youth. Of the three, inflating away
debt is by far the preferred option but it is one the US can no longer choose.
Managing Director
and Chief US Economist at Morgan Stanley, Richard Berner, recently discussed
the reasons in We Can’t Inflate Our Way Out, February 24, 2010. http://www.morganstanley.com/views/gef/index....8b-bbc960980e46
It's tempting to
think that the US can inflate its way out of its fiscal problems. A
faster, sustained increase in prices would erode the real value of past debt,
and higher future inflation would - other things equal - reduce the real
resources needed to service and pay back the promises we are making today.
However,
inflating away US debt won’t work because as Richard Berner points out nearly
half of federal outlays are [now] linked to inflation, meaning that
increments to debt would [also] rise with inflation.
Inducing monetary
inflation would also raise aggregate US debt resulting in a self-defeating
cycle of higher prices and higher debt. However, there is also another
more fundamental reason why inflating away US debt won’t work, to
wit: Inflation is almost impossible to induce during severe
deflationary contractions.
Fed Chairman Ben
Bernanke understands this difficulty quite well. Bernanke’s late
mentor, Milton Friedman, theorized the Great Depression could have been
prevented by sufficient monetary stimulus and so in 2008, faced with the
possibility of another deflationary depression, Bernanke put Friedman’s
theory to the test. It
failed.
http://jutiagroup.com/2010/01/27/looking-over-into-the-abyss/
Unfortunately,
when tested, Friedman’s theory didn’t work. Despite
Bernanke’s massive monetary expansion, global credit is still
contracting and lending is drying up.
The Telegraph UK
reported on February 17, 2010: lending has fallen by over $100bn
(£63.8bn) since January, plummeting at an annual rate of 16%.
"Since the credit crisis began, $740bn of bank credit has evaporated.
This is a record 10% decline,” he [analyst David Rosenberg of
Gluskin Sheff] said. The article continues: The M3 broad money
supply – watched by monetarists as a leading indicator of trouble a
year ahead – has been contracting at a rate of 5.6% over the last three
months. http://www.telegraph.co.uk/finance/economi...in-history.html
Inflating away debt is virtually impossible in the presence of deflation, but
if US monetary expansion is sufficiently large, it could result in the
hyperinflation of the US money supply, which would destroy both US debt and
the US economy as well.
DEVALUING THE US
DOLLAR
Devaluation is
the US’ only remaining option. But, on February 25th,
Comstock Partners’ special report, The Cycle of Deflation,
Impediments to Debt Relief, pointed out the major impediment to a US
devaluation to reduce debt—China.
…there
is a stumbling block to the normal competitive devaluations that typically
take place. In the past, a country that incurred too much debt just did what
they could to devalue their currency in order to export their way out of the
dilemma by exporting their goods and services to their trading partners. ..[But]The
Chinese have linked their currency to ours, so as we debase our currency, one
of our major trading partner's currency is also declining and China becomes
the major beneficiary of the debasement of our dollar.
http://www.comstockfunds.com
The China peg to
the US dollar thus prevents the US from altering its trade deficit by
currency devaluation, but it does not prevent the US from devaluing the
dollar for other reasons. If the US does devalue the dollar, it will not
be to reduce debt—it will be to maintain its advantage over the
world in general and China in particular.
YESTERDAY JAPAN
TODAY CHINA
In 1985, when
Japan was challenging the US for economic dominance the Japanese economy was
in danger of overheating and Japan signaled the US its intent to raise
interest rates.
The US responded
by threatening Japan with trade sanctions, cutting off Japan from US markets.
During the 1980s, the US badly needed Japanese savings to fuel Reagan’s
multi-trillion dollar debt-based military buildup; and if Japanese rates were
raised, Japanese savings would stay at home.
Threats of US
trade sanctions forced Japan to keep interest rates low but at a perhaps
fatal cost to Japan. Low interest rates combined with inflows of burgeoning
trade profits ignited a speculative frenzy in stocks causing the then largest
stock market bubble in history; and when the bubble collapsed in 1990, Japan
fell into a deflationary trap from which it has never fully emerged.
Today, US
dominance is again being challenged, this time by China. While it is not
possible to know what the US will do, it is naïve to believe the US will
do nothing; but whatever happens, US debt and the US dollar will be affected.
China has now
significantly reduced its buying of US debt leaving the US with growing
deficits and a virtual boycott by China of new US IOUs. This will impact
future US/China relations.
The tentative but
mutual benefits of the past are being replaced by self-interest as US
spending and consequent debt is increasingly perceived as being out of
control by China. That perception is correct. Since the 1980s,
America’s focus has been on borrowing more, not spending less and the
implications are clear.
U.S. government
borrowing, percentage of outstanding U.S. Treasuries owned by China
(2002-2009) – Sources: US Treasury, Haver Analytics, New York Times
With China moving
away from increasingly risky US debt, the US is now far more likely to treat
China as a challenger than as a needed creditor; and, while devaluing the US
dollar would have minimal impact on overall US debt, it would have a
significant impact on China.
In December 2009,
total foreign holdings of US government debt equaled $3.29 trillion. With
total US obligations now close to $100 trillion, a 30 % devaluation of the US
dollar would impact only that debt held by foreigners—but the losses to
China would significant
China currently
owns at least $1.7 billion in US dollar denominated securities; and, if the
US devalued the dollar by 30 %, China’s losses on its investments would
be in excess of $500 million.
As stated
earlier, it is not possible to know what the US will do. But since WWII
geopolitical considerations have always outweighed economic factors in US
policy decisions and there is little reason to expect this to
change—even as the end-game approaches.
THE END GAME AND
SOVEREIGN DEFAULT
The US is
trapped. Caught between rising expenditures and the need to borrow more,
outstanding US debt is incapable of ever being repaid and should the credit
rating of the US ever reflect its actual state, sovereign default, not
devaluation would be the result.
In 2008, Kenneth
Rogoff and Carmen Reinhart in This Time Is Different: A Panoramic View of
Eight Centuries of Financial Crisis reviewed the history of sovereign
defaults concluding the then dearth of defaults was in actuality a warning of
more to come. They were right.
Then, Rogoff and
Reinhart mistakenly described the US as a “default virgin”,
belonging to a small group of nations that had never defaulted. But on
February 26th Rogoff said that the US had, in fact, defaulted
during the Great Depression by changing the price of gold from $20 to $35 per
ounce.
While technically
a default, the US action was actually a currency devaluation. The real
default occurred in 1973 when the US officially reneged on its gold
obligations under Bretton-Woods, leaving other nations holding US paper
dollars that could no longer be converted to gold.
Professor Antal
Fekete noted the significance of that default when he wrote in 2008, Thirty-five
years ago gold, symbol of permanence, was chased out from the Monetary Garden
of Eden, replaced by the floating irredeemable dollar as the pillar of the
international monetary system. That’s right: a floating pillar. The
gold demonetization exercise was a farce. It was designed as a fig leaf
to cover up the ugly default of the U.S. government on its gold-redeemable
sight obligations to foreigners. The word ‘default’ itself was
put under taboo even though it punctured big holes in the balance sheet of
every central bank of the world, as its dollar-denominated assets sank in
value in terms of anything but the dollar itself.
As the end-game
progresses it is impossible to know what the US will do. It is likely the US
doesn’t know itself. What the US does know is that it is now trapped by
increasing levels of mounting debt from which there is no easy exit.
NO EXIT
What if –
to put it simply – you couldn’t get out of a debt crisis by
creating more debt?
Bill Gross,
PIMCO, March 2010
The question, What
if you couldn’t get out of a debt crisis by creating more debt?
will, in fact, be answered in some way by Mr. Gross himself. As Managing
Director of PIMCO, the world’s largest bond fund, Mr. Gross is in the
business of buying debt and betting on the outcome, an avocation that
increasingly resembles Russian roulette.
Spreads on
sovereign debt are rising and credit default swaps reflect the higher
premiums being charged to protect against default. Investors such as Mr.
Gross compare risk to reward in regards to debt and when the reward is
believed to compensate for the risk, the bond is bought and the bet is placed.
As we enter the
end-game, the odds, as in Russian roulette, exponentially increase making
previous yield curves irrelevant. The trigger event may be Greece, Spain, the
UK, the US, Latvia, Japan or some other nation. But, one thing is certain,
when someone takes a bullet, all bets will be off. No one can cover what
can’t be covered.
THE END GAME AND
HUNGARY
Professor Antal
E. Fekete grew up in Hungary during the most virulent period of
hyperinflation in the world. Perhaps the experience made the good
professor more sensitive than most about the possibility of its reoccurrence
in America but he is not alone in believing so.
The possibility
of a US hyperinflation was raised by Professor Laurance Kotlikoff in the
July/August 2006 Review, published by the St. Louis Federal Reserve
Bank: …The United States has experienced high rates of inflation in
the past and appears to be running the same type of fiscal policies that
engendered hyperinflations in 20 countries over the past century.
Since Professor
Kotlikoff wrote those words, US monetary expansion has far exceeded what
preceded it; and, what follows may be more predictable than we want to know.
From March 25-29,
in Szombathely, Hungary, Professor Fekete will present a seminar on the
unfolding financial crisis. Mr. Sandeep Jaitly, along with Professor Fekete
will discuss how the basis can be used to predict movements in the price of
gold and silver.
Mr. Jaitly is the
publisher of The ‘Gold Basis Service’ a monthly
subscription newsletter that describes movements in the basis and co-basis
along with predictions for the coming month for gold and silver, proceeds
will benefit the Gold Standard Institute. For details, see http://bullionbasis.com/index.php?p=1_3_Gold-Basis-Service.
I will also be in
attendance and will speak on capitalism’s journey to the East and its mixed
reception. The end-game is in progress and I have found few more
knowledgeable about its origins and progress than Professor Fekete.
To enroll,
contact GSUL@t-online.hu.
Those who attend will receive a complementary 6 month subscription to Moving
Through The Maelstrom with my monthly commentary and daily news updates,
see http://www.drschoon.com/members/join/view_membership_options.asp.
I have always
believed the financial crisis to be part of a far greater shift involving
more than money and power, although both will be affected. Yin and yang, the
universal polarities, are rebalancing.
The return to
parity will not be easy.
Buy gold, buy
silver, have faith.
Darryl Robert
Schoon
www.survivethecrisis.com
www.drschoon.com
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