The Second Global Depression

THE COMING FINANCIAL ARMAGEDDON

"The American Republic will endure until the day Congress discovers that it can bribe the public with the public's money."
                                                                   -de Tocqueville

 For the better part of a year I have held that the global financial system is on the brink of a calamity that will make the financial crisis of 2008 look like a Sunday School picnic; one that may very probably eclipse the Great Depression of the 1930’s. My reasons for believing this are grounded in my analysis of the world’s current economic fundamentals- particularly in the Western Hemisphere. I began to question the mainstream narrative of global recovery when I started my career as a financial trader. My work brought me into contact with economic data that seemed -in my eyes- to contradict what politicians and the media were preaching. Digging deeper, I was overwhelmed to realize that not only was the mainstream narrative not correct; it was the complete opposite of what was actually going on. Those of us warning of an imminent financial collapse have been relegated to the ranks of religious doomsday prophets. How could we possibly talk of a global financial holocaust when everybody knows that economies are picking up? When the world’s equity markets are carving out new highs every other day? These are the same questions that were asked when a handful of economists and investors predicted a crash in the real estate market during the peak of the housing bubble: a time when real estate was believed to be immune to the laws of supply and demand.

It is indeed true that stocks are doing exceptionally well today. Unemployment appears to be falling across the board and GDP figures from the major economies- though not nearly as spectacular as the prevailing stock and bond rallies- are not lamentable either. But are asset prices a reliable proxy for overall economic health? Before we answer this question, let’s put the clock back to the decade of the 1970’s to see where and how it all began.

Since 1944, the world had been on the Bretton Woods monetary system. The system pegged the currencies of the world’s major industrial states to the U.S. dollar, which was in turn pegged to Gold at a fixed exchange rate of $35 an ounce. But the Bretton Woods system carried the seeds of its own destruction. In the 1960’s, inflation and colossal balance of payments deficits in the U.S.A. made the dollar’s convertibility to gold at $35 an ounce dubious, and foreign governments- realizing that the dollar was highly overvalued in terms of gold- began to redeem their dollars for gold. Facing a run on its dwindling gold reserves, the U.S. eventually closed the Gold Window in 1971. The U.S. dollar was now completely decoupled from Gold; as was every other currency.

Flawed and doomed to failure though the Bretton Woods system had been, it had one crucial strength: it reined in the power of governments to expand money supply at will. Now, with nothing standing in their way, governments were free to print money to the extent that they could get away with it. And print they did. Between 1971 and 2006, the U.S. Federal Reserve increased money supply (M3) from roughly $800 billion to $10.2 trillion- erasing 82% of the dollar’s purchasing power within this time.

The consequences of profligate credit expansion go beyond the attendant inflation. In the post-Bretton Woods era, governments across the developed world- from the U.S.A. to Japan- turned on the monetary spigots to full stretch; ostensibly to stimulate domestic demand and fight economic recessions. In the late eighties, the Bank of Japan took interest rates to new lows to stimulate domestic consumer demand and check the appreciation of the yen against the dollar. The result was a property and equity bubble that unleashed unparalleled carnage when it burst toward 1990. Japan’s calamitous monetary experiment did not stop the U.S. from taking the same route in the decade that followed. Through the decade of the 1990’s, the U.S. Federal Reserve kept interest rates too low, driving capital to stocks in search of high yields. As in Japan, when interest rates started rising, the stock market went belly up. But the government would not allow the ensuing recession to run its course; so what did they do? They took interest rates back down and inflated another bubble….a bigger one. This was the Real Estate Bubble that burst in 2007/2008. Still, the U.S. government would not allow the necessary adjustments to take place. Allowing a recession to run its course is of course politically suicidal. In the wake of the Sub-prime crisis, both Presidents Bush and Obama- under the auspices of the monetary sorcerer Ben Bernanke- continued with the same policy of credit expansion that had augmented the crisis in the first place. Under Obama, the Fed raised the stakes yet again, deploying a clandestine monetary policy known as ‘Quantitative easing’: this is merely an important-sounding euphemism for money printing. Beginning in 2009, the Federal Reserve has been adding $85 billion worth of government bonds and mortgage-backed securities to its balance sheet on a monthly basis. In other words, it has been creating $85 billion out of thin air every month. It was not only the United States that took up quantitative easing: Britain and the Eurozone have also been monetizing debt in a vain attempt to jumpstart their economies. Japan is perhaps the first country to have carried out QE. Thirteen years after QE began in Japan, not only has the economy remained in dire straits, the country has rolled up more debt than the human mind can probably conceive.

The developed world would be in enough trouble if it only had to contend with the consequences of expansionist monetary policy. But they face a far more colossal problem: debt. Today, sovereign debt is almost synonymous with the PIIGS (Portugal, Ireland, Italy, Greece, and Spain). But in truth, debt problems imbue most of the West and Japan. Japan is special on this score- as on many others- with national debt standing at over a quadrillion yen (more than 200% of GDP). A quarter of Japan’s public spending goes on servicing the debt. This is staggering, but even more so when you take account of the low interest they pay on their debt: 0.6% on ten-year bonds and 0.2% on five-year bonds. If interest rates in Japan rose to historic norms, they would need to use up their entire annual output to service just a fraction of the debt. Through the course of the last century, politicians promised too many things to too many people. This had the consequence of piling unsustainable obligations onto governments, which did not matter to said politicians since they would be gone (maybe even dead) by the time the chickens came home to roost.

For a long time, Europe was hailed as the prodigy of social democracy; a halfway house between socialism and capitalism; a third way. The lofty European Welfare state was the sacred cow of many on the left. Europe had proved, at last, that capitalism and socialism could exist side by side within a single economic unit. The mistake that was made in coming to this conclusion was one that Milton Friedman warned about all-too-often: judging policies by their intentions rather than the incentives they created- and therefore the consequences they were likely to produce. Because noble as the goals of the European Welfare state sounded, the results it produced weren’t nearly as noble. Far from creating a sustainable safety net, the welfare state engendered massive rent-seeking, corruption, high tax rates, swelling bureaucracies, runaway public spending, and debt. Currently, spending on Social services accounts for 58% of all public spending in the European Monetary Union. A good deal of social spending in the E.U. is financed by borrowing- a situation that has left the region carrying national debts cumulatively surpassing €11 trillion: equivalent to about 85% of the E.U.’s G.D.P. It needs to be said that these numbers do not figure in unfunded obligations such as pensions and medical cover promised to retirees. When you figure in these liabilities, Europe now owes more than €100 trillion. Margaret Thatcher famously said that the problem with socialism is that you “eventually run out of other people’s money”. For a long time this was just another of her loathed quotations: today it is- for most of Europe- an implacable reality.

On top of the impending insolvency of its entitlement systems, Europe is beset by a rapidly aging population: a serious problem for the U.S.A. and Japan as well. But it should be noted that an aging population is in itself not a financial liability. It is only a liability in a system of pay-as-you-go transfers, such as exist in the U.S.A., Japan, and most of Europe. In Chile, for example, citizens make contributions into private pension funds. Although the government still guarantees the pension funds (creating a moral hazard on the part of the funds), such a system is less- if at all- prone to problems arising from a change in demographics. Moreover, a capital funded system benefits the economy since the funds contributed are invested, as opposed to a pay-as-you-go scheme which- in the manner of a Ponzi Scheme- simply takes money from one person and gives to another.

The Dutch King recently announced plans for the transformation of the Dutch welfare system to what he termed a ‘participation society’. The Dutch Welfare state has been particularly generous, with pensions of as much as 80% of pre-retirement earnings. Other countries in Europe have likewise taken steps to scale down their public spending. But almost without exception, these steps have only been token measures that are not going to turn Europe’s dire financial circumstances around. Mending Europe’s financial situation mandates such radical measures as could never survive the political process.

Europe’s insoluble debt crisis has caused some to see the United States as a safer investment destination. American bonds and stocks have continued to rally in spite of the poor economic fundamentals. The Dow Jones has surpassed 16,000 points and the S&P 500 is also at all-time highs. The bond market is pretty robust as well: yields on ten-year bonds are still below 3%. But far from being a sign of brighter days ahead, these asset booms should be a cause for concern. The appreciation of asset prices has been fuelled solely by the Fed’s loose monetary policy. By keeping short-term interest rates at essentially zero, the Fed has sent investors looking for higher yields in stocks, bonds, and in the world’s emerging markets. Why would you put your money in a traditional savings account for a rate of return lower than annual inflation when you could get 14% from a Stock Index fund? Zero interest rates are also a magnet for carry traders, who can borrow at essentially no cost in the U.S. (or Japan) and invest in higher-yield instruments elsewhere.

As the United States Government continues to parrot the narrative of a recovery, we have to look at the actual numbers, and how consistent they are with this narrative. We would expect in a recovery to observe such metrics as rising real wages, greater factory output, higher rates of saving, and falling unemployment. In the United States today, real median household income is falling, as is the domestic savings rate. Factory output remains depressed. Even more startling, the U.S. now has a record number of people on food assistance. The claim of falling unemployment becomes ever more dubious when you look at labor participation rates, which have taken a nosedive since the recession. This means it is very likely that the unemployment rate is falling, not because people are finding jobs, but because they are leaving the labor market altogether. Labor participation has fallen by 5 percentage points from the pre-recession peak of 67%. Bond and house prices have certainly been buoyed by the Fed’s monthly purchases of government and mortgage-backed securities. The rise in consumer demand since 2009 is nothing to write home about either. With real wages falling, you don’t need to be an actuary to work out where the credit to fund this additional consumption is coming from. American consumers are obscenely leveraged, and this will become a problem when interest rates are forced to rise. In short, the supposed recovery is fiction. It is as real as Godzilla.

As public debt now heads for the $18 trillion mark (not including unfunded liabilities estimated at $100 trillion), American indebtedness has crossed the point of no return. Obama likes to say that “America always pays its bills”. But like many things the man says, this is complete nonsense: America never pays its bills. When its bonds come due, America simply gets a bunch of stupid governments and investors to buy new bonds and pay off the old ones. When these new bonds then come due, it gets a bunch of even more stupid bond buyers to pay them off. In other words, the U.S. bond market is a ponzi scheme in the most serious sense of the term. The only thing keeping the whole thing afloat is the gullibility of investors who do not look beyond the AAA rating. When they wise up- and they are beginning to- the pyramid scheme will fall like an oak. China (which has serious debt and bubble problems of its own) has already begun to reduce its holdings of U.S. treasuries. Some believe China’s Gold holdings are a lot bigger than reported.

Last month, China dumped $48 billion worth of U.S. treasury bonds. When the world wakes up and stops buying U.S. bonds, they will have to hyper-inflate the dollar or let interest rates rise. Whichever course they choose will unleash pure carnage. A debasement will depose the dollar as World’s Reserve currency and touch off ravaging inflation; a rapid rise in interest rates will deflate the countless bubbles and plunge the country into a recession- possibly a depression.

I said last year as the government shutdown debacle unfolded that fighting over Obamacare was akin to fighting over the arrangement of chairs on the deck of the Titanic. What not just Americans but the whole world should be doing is trying as best as they can to salvage their wealth. We are living through the mother of all bubbles. The entire global economy is being driven by speculative malinvestment. From Australia to Singapore, from Canada to China and the Philippines, stimulus programs and easy credit have inflated commodity and asset bubbles that have created the illusion that the global economy is on the mend. But in truth, it is sicker than it was in 2007/2008, and only a painful correction could begin to set things right. That the global financial system is going to collapse is a moral certainty. The real question is: when?

Kennedy Karuga is a self-taught financial trader and market analyst.

He lives in Nairobi, Kenya.