Monday, August 20, 2007

Quadruple Whammy Meltdown

Let's review the past two Great Bear Markets for clues about the one which lies just ahead.

The Great Depression, 1929 - 1946. If we cut to the chase, we find the Great Depression was essentially a credit/debt/leverage bubble of epic proportions which finally blew up. Various other factors (raising tariffs to choke off international trade, for instance) undoubtedly made a bad situation worse, but the Depression was caused by an unprecedented explosion in credit, leverage and risk which eventually led, as it always does, to a credit contraction and "renormalizing" of risk.

Hmm, does this sound familiar?

The Stagflation-Oil Crisis Bear Market, 1967 - 1982
. Oil shoots up in price, roiling the global economy, a free-spending "guns and butter" Federal deficit boosts money supply, Federal agencies mask inflation with phony statistics (launching "core" inflation to obscure "real" inflation), and structural weaknesses in the U.S. economy (declining product quality, tepid productivity, etc.) combine to create "the misery index" of high unemployment and inflation, a.k.a. stagflation.

Let's start by noting oil has risen from $10 in 1999 to $71 today. The Standard Line is our economy is much less dependent on oil for production of goods and services, so this seven-fold increase is no big deal. Perhaps--or has the effect simply been obscured by deflationary imports from China and Asia, and a little agency "tweaking" of the consumer price index?

As for structural problems with the U.S. economy--the list is long indeed. Sagging productivity, rising local taxes, a dollar which has lost 1/3 of its value in 5 years, stagnant real wages, most of the jobs created since 2000 have been in housing or financial services, both of which are speeding off a cliff, labor/benefits costs which are increasing far faster than official inflation, Medicare and entitlement spending rising far faster than the economy or tax receipts, a hugely expensive, hugely unpopular overseas war is grinding through thousands of young Americans and hundreds of billions of (borrowed) dollars--hmm, let's just start with that short list, shall we?

Notice any parallels? How about an economy whose decay has been masked by a speculative frenzy in financial services and lending/leverage based on real estate? How about decaying wages and rising real costs? How about stagnant productivity and employment? How about a draining unpopular war? How about structural Federal deficits without end?

What this means is the coming Recession will be a Double-Whammy, combining the debt/leverage excesses of the 20s with the skyrocketing costs of energy, stagnant productivity and wages and hidden inflation of the 70s.

But wait--there's more! The oil spikes of the 70s were artificially induced: the Saudis expressed their displeasure in 1973 with an oil embargo against the U.S., and the Iranian Revolution in 1980 provided a political headlock on oil markets.

Now we have something completely different: a true imbalance between total supply and demand. This is the core of Peak Oil: there is more global demand for oil than there is global supply. We are teetering on the balance beam right now at 84 million barrels a day in both supply and demand; but as China's demand rises by 15% every six months, that will soon tip into an imbalance which cannot be rectified by the Saudis pumping another million barrels a day (if they even can increase production by that amount, which is doubtful).

So we have a Triple-Whammy on our hands. No, make that a quadruple-Whammy, because never before in history has the bedrock of American middle-class wealth--housing--been exploited in a stupendous speculative bubble. Sure, those "regular people" who had speculated in stocks (leveraged 10 to 1 via margin) were hurt when the market crashed in 1929, and when banks folded, many lost their life savings.

But now everyone who owns real estate--the 70% of the citizenry who isn't poor--is going to get hurt as the speculative bubble collapses. That too is unprecedented. And as interest rates rise and the stock market enters a decade-long decline/malaise, everyone with a pension or IRA invested in standard bond and stock funds will see their savings decimated.

The risks inherent in globalization might well be a fifth vulnerability which will exacerbate the depth and pain of the coming recession. Globalization has been around for several thousand years. The Romans imported vast quantities of wheat from North Africa, and Arab traders made fortunes bringing goods from Indonesia and India to Mediterranean Europe. But we now relie on global trade to an unprecedented degree for goods and financial liquidity.

The uninterrupted flow of cheap energy is the essential ingredient in global trade, and that commodity is widely seen by experts as shooting to $100 per barrel or more in the near future. So much for cheap energy.

As noted here and elsewhere ad nauseum, China has enabled the U.S. debt frenzy by sinking $1.3 trillion of its foreign reserves into U.S. Treasuries and other bonds. As China and other nations pursue a strategy of broadening their ownership of U.S. assets into stocks, red flags are suddenly shooting aloft, as long-time correspondent Albert T. noted in recommending this article from the Council on Foreign Relations:

The Next Globalization Backlash:

The next globalization battle lurks over the horizon, but you can already guess its contours. It will be shaped by two revolutions in finance and business: the growth of vast government-controlled investment funds abroad and the muddled progress toward shareholder democracy in this country. Taken together, these changes will give foreign governments a say in how corporate America is run. Lou Dobbs is going to love this one.

The rise of government investment funds suddenly preoccupies financiers. Treasury officials who never before gave a thought to these outfits now want them on their speed dials. Five years ago, governments were sitting on $1.9 trillion in foreign currency reserves, which was roughly what they needed to stave off financial crises. Now they have $5.4 trillion, way beyond their prudential needs and more than triple the amount in the world’s hedge funds. Increasingly, this cash is being moved into “sovereign wealth funds,” which have come from obscurity to manage assets worth an additional $1.6 trillion

Frequent contributor John B. recommended this essay on the same subject:


Every game has two players, of course, as China reminded the world when it raised the spectre of its "Nuclear Option," e.g. dumping its holdings of dollars and U.S. bonds on the market. Our formidable Treasury Secretary Paulson was quick to dismiss this talk, but the Chinese have their own self-interests to protect--as does every nation--so their threat should not be dismissed as idle chatter.

Given the risks inherent in such a global trade in goods, bonds and currencies, perhaps we should add this unprecedented complex of unstable risks as a fifth factor, making the current situation a Quintuple-Whammy. I will be poking around the theme of "What Lies Ahead" this week, with plenty of reader input as always.

Speaking of which: we have fascinating new essays from frequent contributor Protagoras and longtime author (and new correspondent) J. Joss, the lead paragraphs of which I tantalizingly reproduce below:

The Economic Significance of Unlimited Derivative Works in the Software Business:

You are all probably reading this on either Windows or Mac OS. There is a phenomenon at work in Linux and Open Source which may make the business model of both Microsoft and Apple obsolete and unsustainable in fairly few years. How probable it is that this will happen I am not sure. But that it is possible, I am certain.

The phenomenon is the power of a business model in which there are unlimited derivative works. (more)

Protagoras also submitted a very practical essay on an entirely different topic, In praise of the Santoku knife:

Everyone who has cooked seriously has a memory of various early accidents with cutting implements.

Published author John Joss submitted two essays. The first is a highly amusing memoir of A Transcontinental Journey:

It is ~700 miles from Houston to Tampico, through south Texas and across the border at Brownsville to Matamoros, world capital of flies. Half way between Matamoros and Ciudad Victoria, in the middle of a desolate Mexican highway, the Ford stopped abruptly. In retrospect I suspect a broken camshaft.

John also contributed a detailed, excellent essay on the travails of being an author, KISSING FROGS: THE GREATEST RISK:

Career choices remain, for most of us, the highest life risk. Bad decisions, early, may spell doom. The rot may set in while we are still in our teens, picking poor study specialties that become dead ends. Though we will each have ten or more separate jobs during our working life, it’s better to work into areas with genuine career potential. Buggy whips are no longer made in quantity. Repairing typewriters is not a growth trade.

The most significant risk I ever took was trying to become a writer. To be accepted as a writer is to offer one’s most intimate self——the mind and heart——for public appraisal. If this leads to authentication, so much the better. If not . . .

I have updated Readers Journal so please enjoy these four diverse essays and this week's readers' comments on Presidential Race Musings.

I end with a very appropriate Haiku from frequent contributor Jed H.:

Banks and Markets Flail
Sharks Smell Blood in the Water
The Grim Reaper Grins

Thank you, John B. ($21.12), for your generous and most interestingly numbered donation to this humble site. I am greatly honored by your support and readership. All contributors are listed below in acknowledgement of my gratitude.

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