(This is Part 4 of a series. Go back to Part 3.)
However, there's another side to this rising money and credit creation. The vast and increasing amounts of debt that keep the system going also make it more and more fragile and susceptible to an implosion—literally, a bursting bubble. If the flow of liquidity begins to dry up, if parts of the system begin to decline or freeze up, as is now happening in the U.S. subprime mortgage markets and the U.S. buy-out credit markets, the potential is that such a cardiac event could rapidly spread to other areas of the financial system, since all of it is so leveraged.
In other words, with this historic amount of leverage everywhere, the danger is that a contagion of margin calls, debt defaults, distress selling and so on could build on itself, cascading down in a vast financial implosion as everyone sells things to lower their leverage.
The massive risk of this kind of leverage existing all throughout the financial system is supposedly okay since it is watched over by the latest risk-management programs designed by a horde of mathematical "quants" with Ph.Ds. Of course, the same thing was said about the brilliant "quants" at Long Term Capital Management just before their huge bets failed in 1998 and almost took down the financial system with them.
In this universe, as far as I can tell, all extremes contain the seeds of their own destruction. The financial world is no different.
For example, it now takes an average of $4 of new debt to create $1 of new economic activity. To put it succintly, that is an unsustainable economic model. The financial system has gone into such a degree of overshoot that it will have to go into undershoot, at least for awhile, in order to rectify the maladjustments and excesses that have built up from this vastly overextended credit-fueled global economy.
Imagine a forest where there has been no forest fire for many, many years. The longer it continues like that, the more the underbrush builds up and the more vulnerable the forest becomes to a fire. Not only does it become more vulnerable, but if a fire does begin it's likely to be much bigger than it would otherwise have been.
When in a state of undisturbed nature, forests have periodic fires which tend to be relatively small and over relatively quickly but which serve a purpose—to clear out the underbrush and prepare the forest for the next stage of growth. For a long time the U.S. Forest Service would quickly extinguish these natural periodic fires. But then they found that by quickly extinguishing these smaller, natural fires they were making it possible for much more massive fires to occur.
Now they tend to let natural forest fires occur. Such natural fires burn more frequently, yes, but also, because of less underbrush, they tend to be small and self-limiting. As said, if these smaller fires are quickly extinguished then even larger ones will eventually follow.
This same principle is playing out currently in the global financial world. We could say that, by stepping on the gas of money and credit creation, the financial system has prevented smaller fires of recession/depression from occurring but in the process has made it a great deal more likely that a much larger financial and economic tsunami will occur.
For example, in the 1987 stock market crash the market went down about 22%. Normally, this would have led to a recession. But the Fed poured enormous amounts of monetary reserves into the system and the recession was avoided. The same thing happened after the market drop from the top of the bubble in 2000 to the bottom in 2002: Normally, this would have led to a depression—because the financial bubble in 2000 was much larger than the one in 1987. But the Fed would not allow it. Once again it flooded the system with new fiat money and this time blew a huge housing bubble from 2002 to 2007. Other examples of this process could be given.
As a direct result of not accepting the recessions we should have had, or to the extent that we should have had them, the system has now become vulnerable to a much bigger crash. If the system begins an implosion, which it appears to be doing, it could rather quickly lead to a very deep crash and depression.
Will the Fed and other central banks allow the full downcycle this time? They will certainly try to quickly extinguish it by injecting even more fiat money into the system, a process which, as we've seen, ultimately leads to hyperinflation. Whether they will succeed this time in staving off the downcycle is an open question.
Once a crash of a huge financial bubble gains some momentum it becomes very difficult to stop. The Fed can increase monetary reserves, but ultimately, new money entering the system depends on new credit entering the system. If banks and other financial institutions become more leery of extending credit, as seems to be happening now, the system can freeze up and the exertions of the Fed and other central banks can become like pushing on a string. We'll see.
In the financial world, as with the forests, it's wiser to allow the natural rhythm of periodic small recessions to occur, since if these natural fires/recessions are staved off then the misalignments and excesses of the system build up further and the financial system becomes prone to a much deeper recession. And if such a deep recession is also staved off then the system becomes prone to a crash and deep depression.
Such a crash is unpalatable to both politicians and the public, so the financial bubble blowing will continue higher and higher until it ends, as virtually all examples in history have ended, in some extreme outcome—either a hyperinflation or a depression or both together. (Note that a hyperinflation is also a depression, though not of the classic kind. A hyperinflation becomes an economic depression after awhile because the value of money itself is being destroyed.)
As mentioned before, this financial bubble blowing used to happen in individual countries, such as France in the 1790s, the United States in the "Roaring 1920s" or Argentina in the 1990s. But now this process has been happening in every corner of the globe.
Therefore the resulting extreme outcome—either hyperinflation or depression—will also likely be global in nature when it arrives. It could even be both at once, as in the 1970s—when prices climbed even as the economy faltered—though, given the size of the current bubbles, this possibility would be much more severe this time.
To sum it up, this highly vulnerable and unstable financial system will resolve itself in one of two ways. Either the higher and higher bubbles will resolve into a runaway inflation, where the value of money—and the middle class—is systematically destroyed. Or, at some point before then, a classic crash/depression could ensue, where the debt is resolved through a series of failures and bankruptcies. As mentioned, it's even possible that both could occur, an inflationary depression.
Note, though, that however things go, the endgame of this process is a drastic fall in the standard of living. The U.S. and the world have gone into such tremendous overshoot in the financial arena that an extreme outcome has become almost inevitable. (Farther on, we'll look at this phenomenon of overshoot in other contexts.)
This extreme economic outcome will very likely be preceded by an extreme outcome in the world's stock markets. Yet this too could be one of two types: a classic crash, where the markets collapse and usher in a classic depression, or an inflation-adjusted crash, where stock markets go up in nominal terms while melting down in inflation-adjusted terms.
The latter is what occurred to Germany in the early 1920s: The stock market climbed to the sky in nominal terms but collapsed over 90% in inflation-adjusted terms. And of course the currency eventually became worthless. In this process the middle class lost its life's savings and became impoverished, which paved the way for Hitler. But that's a story for another day.
In the volatile financial and economic environment we're heading into, gold may give the best chance to preserve some purchasing power, whichever way things go. Gold has performed this function many times in history, and most likely will do so this time as well. A position can be taken through exchange-traded funds (ETFs). However, sooner or later, physical possession gold coins or bullion will likely be desirable.
If I were to make a bet as to which way it’s going, I would say that a crash seems to be impending. About ten hedge funds and other financial entities are publicly affected so far by the spreading credit crunch, including New Century Financial and American Home Mortgage, two big mortgage lenders which share the characteristic that they both recently went belly-up.
This story is almost certainly just getting started. And it could turn into the greatest financial/economic collapse in history. Of course, if that happens it will be blamed on some proximate event such as a large bank failure. But actually, such an event would arrive courtesy of the historic debt bubble that preceded it.
Conversely, central banks could pump in enough liquidity to take us on another round of bubble blowing. Sooner or later, though, the piper will have to be paid.
That's the big picture financially. Now let's look at global geopolitics . . .
(This is the end of Part 4. Go to Part 5.)
—jim sloman, 3.13.07
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