(This is Part 8 of a series. Go back to Part 7.)
There is a lively debate these days, among some financial analysts, as to whether or not the U.S. might be heading for a financial calamity, and if so, whether that calamity would take the form of an inflation or a depression.
Readers of this series are aware of my belief that there will indeed be a systemic financial calamity and that it will come sooner rather than later.
And as discussed earlier, I think that this calamity will take the form of a very serious stagflation, that is, a combination of both depression and serious inflation.
Let's look a little deeper now into this issue of depression vs inflation. Are we really going to get both?
To answer that question, let's look at depression first:
In my opinion, as discussed earlier, we will indeed shortly be heading into a recession and then into a depression. Why? Again, the basic reason is that we are sitting atop the largest financial bubble in history—larger than the bubble that collapsed into the depression of the 1930s—and it's about to implode.
The simplest reason that this gigantic financial bubble is about to implode is that all bubbles do. Research analysts have recently looked at every financial bubble in history —28 in all—and found that each of them had eventually returned to a point below where the bubble started.
This gigantic bubble of credit (and therefore debt) that exists now has been building for some 70 years or so. And this "mother" bubble of leveraged credit and debt has a number of "daughter' bubbles, such as the mortgage, housing, stock, bond and derivatives bubbles.
Consider: Last year the broadest measure of the money supply, M3, increased by $590 billion. Meanwhile, the U.S. economy last year added $2.7 trillion in new debt.
In the last four years consumer income has increased by $1.4 trillion. Meanwhile, consumer debt has increased by $3.2 trillion. See a pattern?
Try this: Since 1990 real median household income (that is, adjusted for inflation) has risen by 11%. In the same timeframe real household spending has expanded by 30% and real household debt has jumped by 80%.
Or this potpourri: Last year the United States added $20 of debt for each $1 of savings. Outstanding debt in the U.S. has risen by 38%—$10 trillion—over just the past four years. Two-thirds of all mortgage originations last year were for interest-only or adjustable-rate mortgages, highly vulnerable to interest-rate increases. The median house price in the U.S rose 15% in the last 12 months.
Structured credit derivatives, a fancy term for exotic financial debt instruments, have increased by $50 trillion since 1999. Since these are private contracts between companies, there's no way to know how much risk is there, but we do know this: The risk is untested and the instruments are highly leveraged.
In fact, the whole financial system is highly leveraged now—highly geared as the British like to say. In fact, more so than at any time in human financial history.
At this point it would be well to remember the first rule of leverage: That the very gearing that drives prices skyward on the way up—whether in housing, in the hedge fund "carry trade" or in structured derivatives—acts to unwind them more quickly on the way down.
The other salient characteristic of gigantic debt bubbles and their daughters is that they add tremendously to the fragility of the entire financial system, because the various parts of the system are so interconnected now. Structured derivatives affect emerging market debt which affects the yield curve which affects currency valuations and on and on—all connected.
What this means is that the financial system becomes increasingly prone to an "accident" of one kind or another which then triggers an implosion of the vast leveraged credit bubble—and with it, the economy. Hence the coming depression, which is virtually inevitable at this point. It's just a question of when.
The "accident" could be anything from the collapse of the dollar to the failure of a hedge fund to the bankruptcy of a multinational corporation. It could be almost anything. In a highly leveraged financial system, a failure in one place can trigger a series of falling dominos that can eventually affect every corner of the system.
This is the coming recession-leading-to-depression, which will indeed be accompanied by a deflation—in the prices of assets, such as stocks, bonds and real estate. These markets, which are now highly dependent on low interest rates and easy liquidity, will fall relentlessly for years.
In the meantime, we'll see prices in the real economy—where people and businesses buy gasoline and heating oil and rolled steel and apparel and so on—begin a relentless
increase. Why?
(This is the end of Part 8. Go to Part 9.)
—jim sloman, 5.24.05
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