Tuesday, February 15, 2011

A 5-Year Scenario: 2011-2016

In this scenario, the wheels fall off the debt-fueled global "recovery" and assets bottom in 2014.

Here is one possible scenario for the next five years. Why do I consider this somewhat more likely than other possible scenarios? Here some undercurrents which may be generally under-appreciated:

1. There is a difference between speculative and organic demand. The two are of course related, as industrial consumers of resources must hedge against rising prices using the same instruments as speculators--futures contracts, etc.

2. Follow the credit, not just the money. It's not just the U.S. economy which is dependent on cheap, abundant credit--the same can be said of China and the European Union to some degree.

Just because Chinese buyers put 50% down on their fourth flat doesn't mean they don't need credit for the other 50%. Chinese developers are heavily dependent on credit issued or backed by the Central Governments banks and proxies.

Credit is not cash, and creating credit is not the same as printing cash. Shoveling $1 trillion in zero-interest credit into the banking system does not necessarily mean that $1 trillion flows into the real economy--that can only happen if someone or some entity borrows the credit.

This is why some claim that hyperinflation has never occurred in a credit-based system; it can only arise in a monetary system in which cash itself is printed (i.e. Zimbabwe et al.)

I am not making any such broad claim, but to identify the two as identical seems to me to be a profound confusion.

This distinction plays out in a number of ways. If the Fed had actually printed $1 trillion in cash and dropped it from helicopters, then those collecting the cash on the ground might have spent it, creating more organic demand for goods and services.

If the Fed creates credit and loans it to banks at zero-interest rate, the credit only flows into the real economy if somebody borrows it.

Without borrowers, the "money" just sits in reserves, where it does not spark inflationary organic demand for resources, goods or services.

If someone borrows the "money" to refinance existing debt, the only money that flows into the real economy is the difference between their original debt servicing costs and their new debt servicing costs, presuming the new costs are lower than the original. (Not always the case if said borrower had an interest-only "teaser rate" mortgage that he/she is now rolling into a mortgage with principal payments and a market rate interest payment.)

Or a large speculator (trading desk, hedge fund, etc.) could borrow the credit-money to speculate in commodities, driving prices up on the widespread expectation of higher costs in the future. In this case, the credit-money does influence the real world economy by driving commodity prices above levels set by organic demand.

But speculative "hot money" is not organic demand; it flees or is lost if trends suddenly reverse.

Since commodities such as oil are priced on the margins, this matters. A sudden decline in oil from $86/barrel to $76/barrel would trigger an exodus from speculative long positions, reinforcing that decline in a positive feedback loop.

3. Hoarding is a special flavor of organic demand. Like speculative demand, it vanishes once the fear of ever-higher prices evaporates.

4. The global GDP is around $60 trillion; the Federal Reserve has "printed" $2 trillion in the past three years. Placed in the proper context, the Fed's printing and asset purchases are large enough to influence the U.S. stock and bond markets, but they simply aren't significant enough or focused enough to enslave the entire global markets in stocks, bonds, precious metals and commodities.

Other players are busy printing and issuing zero-interest credit, too, of course, but we should be wary of sweeping generalizations about the deterministic nature of these central bank campaigns.

As further context, consider that the Fed's vast interventions have distributed some $2 trillion into the financial sector; meanwhile, U.S. homeowners saw their net equity decline by some $6 trillion.

OK, on to the scenario which will get me in all sorts of trouble:

Here is the sequence of events I consider rather likely:

Q3/Q4 2011-2012: extend and pretend fails. The wheels fall off the global "recovery," the emerging market equity bubbles, oil, China's equities and its property bubble, and most if not all commodities. Gold and silver swoon as per late 2008 as raising cash become paramount. Oil retraces to the $40/barrel level, and then drops further as exporters ramp up their exports to generate desperately needed cash.

Interest rates rise sharply, risk assets tank, borrowing dries up, housing prices "slip" to new lows (the stick-slip phenomenon), and the hated/loathed U.S. dollar confounds almost everyone by breaking out of technical resistance levels.

Civil disorder spreads along with recession and lower energy prices, which devastate oil exporters' primary source of government revenues.

With better grain harvests stemming from improved weather, declining meat consumption in 2012 due to recession and the implosion of the market for corn ethanol, grain prices plummet, wiping out all the speculators who reckoned 2010 had set the trend for the decade.

All of this starts slowly in Q3 2011 but gathers momentum in 2012.

Unfortunately for central banks, all their printing and credit creation is analogous to insulin resistance: without borrowers and solvent banks and consumers, their frantic efforts to "stimulate" their economies with additional liquidity come to naught.

The Central State's other gambit, monumental fiscal "stimulus," runs into the brick wall of rapidly rising interest payments and a political revulsion triggered by the realization that only the financial and political Elites actually benefitted from the trillions squandered in the 2008-2011 orgy of Central State "stimulus" and backstops.

With asset prices collapsing in a phase shift, the equity needed to float new loans vanishes; with risks rising, the market for junk bonds and other risk-laden debt also disappears.

All those who clung on through the "recovery," hoping to made whole, are wiped out. Their bankruptcies trigger a new wave of selling and writedowns.

2013-2014: Re-set and reckoning. Widespread political and financial turmoil leads to a few central choices:

1. Repudiation of the Neoliberal Central State/Financial Oligarchy strategy of 2008-2011 which focused on preserving the insolvent (but politically dominant) banking and Wall Street financial sectors and transferring their private losses to public entities/taxpayers.

2. Replacement of incompetent, venal, exploitative dictatorships with some new flavor or autocracy, oligarchy, theocracy or dictatorship, most of which will prove to be equally incompetent, venal and exploitative--but shorter-lived.

3. Experimentation with new models of governance, "growth" and credit/debt. Some modest recognition of the profound failures in the "extend and pretend" status quo generates a sense that these catastrophically destructive policies have been recognized as such and corrected.

These years will see the near-term bottom in housing, equities, and other assets. Those few who preserved cash during the meltdown are in a position to snap up assets on the cheap. Those who depended on credit/debit find borrowing is now difficult and dear. Those who "bottom-fished" real estate in 2011 are wiped out, along with those who bet that commodities were heading straight to the moon.

2015-2016: false dawn. Things get better; prices stabilize, assets and commodities start rising in price and a sense of hope replaces widespread gloom and distemper.

The real crisis has been pushed forward to 2020-2022. Nonetheless, 2015-2016 will offer those with cash tremendous profit opportunities.

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