Friday, July 13, 2007

1893, 1929, 1973, 2007: Echoes of Rolling Thunder

Let's start a re-cap of the week's theme--the Great Unraveling--with a brief look at The Panic of 1893:

"The Panic was the worst economic crisis to hit the nation in its history to that point. The National Cordage Company (the most actively traded stock at the time) went into receivership as a result of its bankers calling their loans in response to rumors regarding the NCC's financial distress.

A series of bank failures followed, and the price of silver fell. The Northern Pacific Railway, the Union Pacific Railroad and the Atchison, Topeka & Santa Fe Railroad all failed. This was followed by the bankruptcy of many other companies; in total over 15,000 companies and 500 banks failed (many in the west). About 20%-25% of the workforce was unemployed at the Panic's peak."

Hmm, calling in loans, 1893, calling in busted CDOs, 2007... and did you notice the 40-year cycle of recession/depression? 1890, 1930, 1970, 2010.

Let's look at the similarities between then and now:

1. 1893: Massive debt-fueled speculation. Railroads and other speculative ventures (yes, they overbuilt railroads in the late 1800s, just like they overbuilt the Internet in 2000) were all financed with debt-- heavily leveraged debt. No money down, no assets, just paper and promises. Sound familiar?

2. 1929: Massively leveraged speculation. In the Roaring 20s, you could buy $1,000 worth of stock with only $100--a 10% margin requirement. Now, CDOs and other derivatives are leveraged 10 times or even 20 times. A drop of only 5% in the underlying security/mortgage/bond thus spells ruin for the 20X leveraged derivative.

3. 1970: Rising energy costs, deficits and inflation, war, stagflation. The "guns and butter" policies of the late 60s and 70s (paying for a horrendously expensive foreign war and a global Cold War, while lavishing massive Federal entitlements on millions of citizens) created unprecedented deficits and inflation which despite various manipulations (the Feds started the bogus practice of "core inflation") began to run away from policy makers and consumers alike until interest rates were ratcheted up to 16% in 1981.

The oil shocks of 1973 and 1980 sent energy costs to multiples of previous costs--just as oil has risen from $10/barrel in 1998 to $74/barrel today. This combination of inflation, spiraling energy costs and business cycle slowdown created a decade of malaise and stagflation.

4. 1970s: Nowhere to hide for investors. The 1970s were a decade of decline for both stocks and bonds, especially when adjusted for inflation. Real estate faired better, as did gold, as "tangibles" were viewed as hedges against a sinking dollar. However, with the World's Greatest real estate bubble now deflating, real estate is not the "undiscovered hedge" it was in the 70s.

Now let's look at what's different:

1. Peak oil. The supergiant fields which supply most of our oil are in permanent decline. The "deep ecologists" and oil geologists who forsaw the Peak of U.S. production (Hubbert's Peak) in 1969 were roundly mocked as the last of the planet's large fields were discovered in the late 60s: The North Sea, Alaska, Nigeria and West Africa. Since then, no supergiant fields have been discovered, despite billions spent in exploration.

I had to chuckle (wryly) a year or so ago when the stock market leaped on the news that a 100-million barrel field had been discovered in the Gulf of Mexico. Nice, but that's only five days' worth of this nation's oil useage. At 21 million barrels a day, even a billion-barrel field is only 16 months of oil. And it takes a decade to drill and pump the field.

Now as the North Sea, Saudi Arabia and Mexico decline despite all technological fixes, we're facing a global Hubbert's Peak. Resource analyst and correspondent U. Doran has kept us well-informed on this development; please glance at the links in these previous entries for more:

Peak Oil: Denial Won't Fill Your Tank (April 12, 2007)

The Future Shortage of Energy (May 22, 2007)

2. Unprecedented trade deficits. As Yahoo News reported, despite a modest drop from last year's record high, the nation's trade deficit remains a staggering $700 billion:: Trade Deficit Up Significantly (July 12, 2007)

The deficit for May rose to $60.04 billion. The deficit with China rose to $20.02 billion, the biggest imbalance in four months. So far this year, the deficit with China is running 17.2 percent ahead of the pace set last year when the overall deficit soared to an all-time high of $233 billion.

So far this year, the overall deficit is running at an annual rate of $709 billion, down 6.5 percent from last year's $758.5 billion, which marked the fifth consecutive year that the deficit set a record.
Nice, but the year is still far from over. Many observers have noted over the past five years that no economy has sustained trade deficits of 5% of GDP or more for long--yet the U.S. continues to run current account deficits well north of 5%. Will the chickens of imbalance and debt ever come home to roost?

For one view on the way the trade deficit, the dollar and bonds are interconnected, please see Inflation/Deflation V: Bonds and the Dollar (January 12, 2007)

3. A sinking dollar. As I write, the Dollar Index is poised at 80.65, just a whisker above the drop-dead technical support level of 80, having dropped from 83 just a week ago. As the book The Dollar Crisis: Causes, Consequences, Cures explains, any huge, structural trade imbalance as we have today eventually gets resolved by a sharp devaluation in the currency. This rather common-sense analysis leads many to predict that the dollar will have to fall to 60 or so--a 25% devaluation from its current value--to begin correcting the yawning imbalance between imports and exports.

And lest you fall for the hype about rising exports: let's do some simple math. The U.S. imports about $1.7 trillion, and exports about $1 trillion annually. The Commerce Department reported both imports and exports rose by 2%. That means imports rose by $34 billion, and exports rose by $20 billion--meaning the trade deficit just widened by $14 billion. Just to stay even, exports have to rise about twice as fast as imports. Reality: 1, cheerleeaders: 0--again.

4. Generational war. As yesterday's entry outlined, retirees (defined as those old enough to qualify for Social Security and Medicare entitlements) are about to begin a war of attrition with taxpayers (many are both, of course, but if your entitlements far outstrip your tax bill, you're going to vote your bennies.)

Either the taxpaying generations quietly swallow huge tax increases to fund the Baby Boomers' vast entitlements (see yesterday's entry) or they rebel, forcing some reduction in entitlement spending. My own view is on record for over two years: Boomers, Prepare to Fall on Your Swords (June 2005)

Unfortunately, taxpayers will be fighting a two-front war, as hundreds of thousands of public employees have been promised retirement benefits and medical care coverage which is simply unaffordable without gargantuan tax increases and the slashing of other local government spending. As the public unions prepare to defend their entitlements with strikes, the public can only fight back by "throwing the rascals out" who try to raise taxes, and by refusing to cave in to the blackmail of public-union strikes.

To see chart, please visit

5. Unprecedented bubbles in all asset classes. Stocks, bonds, derivatives, real estate, art--you name it, it's in a bubble. Interestingly, the best returns of the stagflation years were made in precious metals (a hedge against inflation and a dropping dollar) and plain old cash, which was eventually earning 15% per annum in money market accounts.

The root cause of all financial panics and depressions is of course runaway borrowing/skyrocketing debt, risk and leverage. Is the U.S. economy heading for a Great Unraveling? This chart suggests there is no other possible outcome for a debt/leverage/risk expansion which now far outstrips the stupendous imbalances of 1929.

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