My Two Cents - "Anatomy of a Disaster - The Next Stop"

10/24/2008

These past few weeks we have laid the groundwork for the upcoming economic and financial mess. Lacking a textbook definition of a depression and outright refusal by the media and government to even admit we’re in a recession, I will use the unscientific and arbitrary term ‘mess’ to describe both the current and upcoming realities. After all, ‘mess’ is a scalable term.

We are currently in the eye of the hurricane. While it certainly doesn’t seem like it, this is the best things are going to be for quite some time. With job losses leading the way, the US economy slides into the clutches of irrelevance with those in charge unwilling to acknowledge the magnitude of the situation. We’ve hit the iceberg, bulkheads 1,4,7, and 11 are flooded, and our leaders are on the Promenade handing out free water. Where do we go from here?

RIP US Consumer

One month a trend does not make, but given all that is going on, it seems increasingly likely that August’s decrease in consumer credit outstanding is not an aberration. In August, consumers actually began to repay debts faster than they accumulated new ones. It is about time. Of course, this reality has led to political spin, particularly from Condoleeza Rice about how we need to be ‘leaders in the world economy’. Worried about consumption? You ought to be. The dirty secret is that without debt accumulation, there is no growth. Period. The second dirty secret is that without the abandonment of credit standards and pedal to the metal monetary policy, this day of reckoning for consumers would have come back in 2001. By the Fed’s count, that was $1.6 trillion ago in outstanding consumer debt. The pump was housing and now the pump is irreparably broken. This reality leaves our leaders frantically trying to figure out how to maintain debt growth in the absence of a handy asset bubble. Maybe they will start allowing banks to lend to people against the ‘equity’ in their retirement account next? I bite my tongue. Contrary to the politicalspeak, consumers overall did the right thing in August. Keep doing it. Pay your bills. Trim your budgetary excesses and streamline. When your next stimulus check arrives in the mail, pay down your debt some more. Money is the least of the government’s problems; the Fed is really good at creating it from nothing and the Treasury is the 21st century version of Daddy Warbucks on steroids. No, money isn’t the problem. Creating endless amounts of it while trying to keep the public convinced that it is actually worth something is the problem.

Avalanche of Obligations

Somewhere in all the turmoil the fact that we have a demographic tsunami headed for the Federal balance sheet has been forgotten. True, with a stock market crash, dizzying losses in almost all asset classes, bailouts, and bank failures, it is hard to remember everything. None of what has happened though in the past 6 months changes the fact that both Social Security and Medicare are heading for outright insolvency. A recession (or worse) will cause inflows to these programs to drop even more, thereby exacerbating the problem. Baby boomers headed towards retirement have seen the value of their savings chopped by a third or more. This will cause them rely even more on Social Security and seriously hamper their ability to spend. These programs will need trillions moving forward. At this time those trillions don’t exist. We have an immovable object and an irresistible force. Either we’re going to have to create the money or else we’re going to have to cut the benefits. To this point there has been no talk of cutting benefits. An interesting observation to make here is that a year ago, bailing out Social Security with printed funny money would have seemed far-fetched to the average person. Not so anymore. The bailout mentality is firmly in place, and in fact, the scope of monetary magnitude has been lost. We used to say millions and it was a lot of money. Then it was billions. Now we discuss trillions of dollars like it is pocket change. This is a hyperinflationary mindset. Get used to it.

The Battle of the Backstop

More than ever, it will be necssary to be able to discern between nominal and real. Our website has dozens of articles, and the focus of a good many of them has been to differentiate between nominal and real. It’s not the numbers of dollars, it’s what they buy. It will be critical for individuals to understand what your money buys. If you fully grasp this, you will know when the tide changes. You will not need the Sunday paper. Right now we are focused on falling asset prices, and in the case of energy, consumer prices. While falling consumer prices are a welcome breath of relief, do not get too used to it. Enjoy it while it lasts and watch for signs that the trend is reversing. The biggest problem is the scale of the monetary creation to date that the Fed is willing to admit. Monetary inflation leads to consumer price inflation and when those spinning wheels hit the road and get traction, look out. Things will change quickly. It is imperative to be up on the wheel here so to speak.

Make no mistake, your wealth is in harm’s way unlike any other time in history. While the assault has been ongoing since we decoupled from the backing of real money, for a time, our money was backed by some degree of common sense. However, common sense dictates that you do not create trillions upon trillions of dollars to rescue the financial economy while leaving the foundations of the real economy to reap the whirlwind. Common sense dictates that your money supply growth should not exceed the growth of your underlying producing economy. Common sense should tell you that you don’t allow financial institutions to leverage their portfolios at 100:1. Common sense should tell you that you don’t allow a bank to lend out $10 for every $1 in deposits. Common sense tells you that FDIC is insolvent. It also tells you that California and New York are going to need a bailout. It might even suggest that many of the remaining 48 will require one at some point in the near future along with every pension fund and entitlement program currently in force. The magnitude of the final quantity of money that must be created is astronomical. From the standpoint of the authorities, it would be best if we continued to go into neverending debt. This way money could be multiplied through the banking system in an ‘orderly’ fashion. The next choices are handouts (think ‘stimulus’ packages), and direct monetization of debt (think outright purchase of new Treasury issues). The multiplier method leads to a ‘slow burn’ inflation such as what we’ve experienced to this point. However, there is an actual moment in time when the population cannot continue to accumulate debt at a level that will perpetuate the fiat system. Then we move to the latter two options which have a much greater likelihood of creating hyperinflation and the eventual end of the paper currency.

We have now reached the tipping point where debt accumulation on a meaningful scale cannot continue. Therefore, we are left to watch the remains of the current liquidation of assets then reap the whirlwind of rampant, undisciplined monetary creation.

Graham Mehl is a pseudonym. He is not an ‘insider’. He is required to use a pseudonym by the policies of his firm when releasing written work for public consumption. Although not an insider, he is astonishingly bright, having received an MBA with highest honors from the Wharton Business School at the University of Pennsylvania. He has also worked as an analyst for hedge funds and one G7 level central bank.

Andy Sutton is a research and freelance Economist. He received international honors for his work in economics at the graduate level and currently teaches high school business. Among his current research work is identifying the line in the sand where economies crumble due to extraneous debt through the use of economic modelling. His focus is also educating young people about the science of Economics using an evidence-based approach.