Posts

Davos, Debt & Systemic Failure

Too Much Credit

Davos, Debt & Systemic Failure

When West Meets East

The preferred diet of most Davos attendees is a fusion inspired composition of individual, government, and corporate debt combined with a free-market frisee of lax regulatory oversight held together by a roux of central bank credit that dissolves instantly when paired with matching counter-party risk.

The January 2008 gathering in Davos, Switzerland at the World Economic Forum is similar to the 1957 meeting in Palermo, Sicily of American and Sicilian Cosa Nostra crime families who met to discuss mutual problems and opportunities. The notable difference being that those in the Cosa Nostra live outside the law; while those at the World Economic Forum in Davos make them.

Those in Davos, however, share with the Cosa Nostra a common problem—the success of both depends on inherently unstable systems. The Cosa Nostra model is based on violence and greed which is both its strength and weakness. Capitalism, the source of wealth for those in Davos, is based on greed and leveraged debt, a combination as powerful and effective as the system of the Cosa Nostra—and just as unstable.

WHEN SYSTEMS FAIL

Unstable systems can function for years without serious problems. But over time, unstable systems will always break down. We are witness to such a systemic failure today. Global credit markets are slowing and contracting. The capitalist system responsible for economic expansion and wealth is in disarray.

Debt, in capitalist systems, is a wondrous device. That is, until it can’t be paid back. Under capitalism, credit fuels expansion but it does so at a cost. As capitalism expands, credit becomes debt and the greater the expansion, the greater the debt.

EXPANSION BEGETS DEMISE

Capitalism’s fatal flaw is apparent only in its later stages. As capitalism matures, its inherent systemic instability manifests. The very expansion of capitalism sets in motion its demise. The Achilles heel of capitalism is its perpetual need to expand.

Only perpetual capital expansion can create sufficient capital flows to service and retire previously created debts, the amounts of which are always increasing because of the accruing compound interest being charged. While any slowdown is cause for worry, a contraction bodes far worse.

FEAR IN DAVOS
WHAT A DIFFERENCE A YEAR MAKES

One year ago, the mood at Davos was one of quiet, almost smug, confidence. The on-going economic expansion appeared to be endless, the profits of investment bankers skimmed off the top of productive enterprise was greater than ever. Private equity, the investment banker’s equivalent of flipping real estate, was the hottest game in town.

It is no longer. Today in Davos, the scent of Armani is now mixed with the acrid smell of anxiety produced by falling markets and uncertain futures. Concern has replaced confidence. The major pheromone in Davos today is fear.

WHEN WEST MEETS EAST

A year ago, the confidence of those gathered in Davos was based on the belief that if an economic slowdown occurred, it would be offset by (1) the expansion of Asian economies and (2) the ability of global markets to decouple from slowing American demand. Both assumptions have proved themselves wrong.

The recent expansion of Asia was made possible by the debt-based consumption of American consumers. Now that America’s consumers have run out of cash and credit, the economies of Asia—China, India, Japan, Korea, Taiwan, Malaysia, etc. will slow. When capital markets slow, you know what happens; and, if you don’t, you soon will.

WHEN CREDIT MEETS SAVINGS

As capitalism expanded from the west to the east, western bankers hoped their success would be repeated. They were wrong. Asians responded to the new paradigm and their new found wealth by saving, not spending.

Western bankers were dismayed by this unexpected reaction. If Asian economies continued to save instead of spend, it would slow the expanding juggernaut of capitalism; and if capital expansion slows, like bicycles, capitalism doesn’t do as well at slow speeds.

CHINA AND GOLD

As western bankers run out of markets to exploit, leaving behind tapped out and overextended borrowers, e.g. consumers, governments, corporations etc., it was hoped Asia would provide the new horizon needed for capital markets to expand.

Asia instead will be a conundrum to the west. Not the surrogate state, militarily and economically, that Japan is in danger of becoming, China will prove to be less amenable to the western bankers hoping to economically colonize the last great prize of imperialism’s global puzzle.

While Chinese spend, they also, as do most Asians, save. They are currently holding $1.2 trillion in foreign savings—and this ingrained tendency to save will not give western bankers the acceleration they need to keep capital markets expanding as western markets contract.

At Davos, Dominique Strauss-Kahn, the Managing Director of the IMF, urged emerging economies with sound balance sheets to run fiscal deficits in order to offset a slowdown by US consumers. Will Asian economies choose to encumber their balance sheets in order to save the west’s capital markets? It is not likely.

Asians, in times of fiscal stress, prefer the safety of gold to credit and debt; and, although gold is no longer viewed as a mainstream investment in the west, gold still retains its traditional appeal in the east:

In Caishikou Department Store, a popular physical gold dealer in Beijing, more than 100 people lined up to purchase bullion for the Lunar Year of the Mouse on Nov. 22, the first trading day of the products. More than 200 kilograms of the gold bars were sold within 1.5 hours. Moreover, the total subscription amounted to two tons.
Xinhua, January 19, 2008

Gold will be the choice of Chinese seeking safety and profit in the coming year. India, another large emerging Asian economy, values gold as much, if not more, than China. This does not bode well for bankers in the west.

Davos will not be the same next year. If you’re planning on going, be sure to take some air freshener.

Darryl Robert Schoon
www.survivethecrisis.com
www.drschoon.com

Creative Commons License photo credit: Andres Rueda

The Economy & The Fat Kid

Cash Economy

The Economy & The Fat Kid

Credit-based economies constantly need to expand in order to service constantly increasing levels of debt. Central banks adjust the flow of credit to maintain the balance between economic expansion and economic contraction.

Then one day, a fat kid shows up at the playground. While everyone knows it’s a private playground and admittance is strictly controlled, no one knows where the fat kid came from or how he got in. Nonetheless, the fat kid’s there.

Then the fat kid walks over to the teeter-totter and sits down. The fat kid’s end of the teeter-totter slams to the ground as the other end skyrockets up; tossing all those on the high end off. The name of the fat kid is risk.

DON’T BLAME THE FAT KID
THE ROLE OF RISK IN FREE MARKETS

When the dot.com bubble burst in 2000, it was the largest collapse of a speculative bubble since the Nikkei, Japan’s stock market, crashed in 1990. The Nikkei had plummeted from its high of 38,957 down to 7,607, dropping 80% over thirteen years and setting in motion deflationary forces still in effect today.

It was the unexpected return of deflation that spooked Alan Greenspan and US central bank kreditmeisters to open up the floodgates of credit in 2002. After the Great Depression receded, central bankers had come to believe that unlimited fiat credit had forever banished deflation. But Japan proved them wrong.

When Japan’s economy continued to succumb to deflation during the 1990s, Japan’s central bank desperately slashed its interest rates to zero in 1999. But even this radical infusion of cheap credit couldn’t reverse the cancer-like deflation eroding the Japanese economy. US monetary authorities, however, believed Japan had done too little too late.

In 2002, the US Federal Reserve Board of Governors wrote:
We conclude that Japan’s sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities’ failure to provide sufficient stimulus to maintain growth and positive inflation… we draw the general lesson from Japan’s experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus-both monetary and fiscal-should go beyond the levels conventionally implied by forecasts of future inflation and economic activity.”

Ten years after the Nikkei collapsed, the US dot.com bubble also collapsed and Alan Greenspan and the US Federal Reserve were to get their own turn at the wheel of fortune. Perhaps they were right, perhaps Japan had waited too long, perhaps stimulus–both monetary and fiscal–beyond the levels conventionally implied by forecasts of future inflation and economic activity would produce better results.

In 2002 as the US economy contracted in the wake of the dot.com collapse and slid into recession, Alan Greenspan and the Federal Reserve Board moved decisively and quickly, slashing US interest rates to 1 %; and the crisis of deflation feared by Greenspan and the US kreditmeisters did not materialize–but another crisis did

ALAN’S GARGANTUAN BLUNDER

Although 1 % credit from the US Federal Reserve staved off a potentially lethal wave of global deflation in 2002, monetary and fiscal stimulus beyond the levels conventionally implied by forecasts of future inflation and economic activity caused a collapse of credit markets that is today threatening the underpinnings of credit-based finance and global capital markets; and, it did so by inadvertently banning market risk for five years.

Between 2002 and 2007, risk went into hiding as central banks flooded the markets with cheap money; allowing capital flows to mask losses while boosting asset values to record levels. Billions of dollars of central bank credit translated into trillions of dollars of leveraged bets creating bubbles in all asset classes–real estate, stocks, commodities, and bonds.

But global market risks, temporarily hidden by cheap credit, have now reasserted themselves with a vengeance. With many AAA rated bonds now suddenly worthless, buyers of Wall Street’s now suspect wares have deserted the credit markets in droves.

The rush for returns has been replaced by a rush to safety, reflecting the sentiment penned by the 19th century humorist Mark Twain: I am more concerned about the return of my money than the return on my money.

Risk is back and no matter how often the playground supervisor tries to reassure us, we know the playground is no longer safe. Even the big kids are getting hurt. The fat kid’s back and so is the whiff of deflation.

RISK IS IN THE HOUSE

LIBOR’s getting high
As central bankers try
To calm the markets down
But risk is back in town

Risk is in the house YO!
Risk is in the house

Credit lines are drawn
Where’s the money gone
Spreads are growing fast
Markets sucking gas

Risk is in the house YO!
Risk is in the house

Triple A means squat
Commercial paper rots
Monolines are down
‘Cause risk is back in town

Risk is in the house YO!
Risk is in the house

Risk is going ’round
Can you hear the sound
As tranches hit the ground
‘Cause risk is back in town

The bubble bloated assets of the kreditmeisters, e.g. real estate, stocks, and bonds, are now about to disappear into the maw of the bankers’ resurgent balrog. Deflation, an increasing cycle of decreasing demand, is now again waiting in the wings.

In the coming months and years, safety will command the market’s highest premiums. Traditionally cash and government securities, these havens will prove to be wanting in the troubled times ahead.

…the US Treasury’s 10-year Note lost 20% of its value compared to an ounce of gold since August 20 [sic 6 months]
Gary Dorsch, Global Money Trends Magazine, January 2, 2008

Fiat credit, fiat money, fiat government IOUs will offer but temporary shelter in wealth’s flight to safety; and, as deflation follows in recession’s wake, the Kreditmeisters’ stimulus– monetary and fiscal–beyond the levels conventionally implied by forecasts of future inflation and economic might well deliver us into even more dire circumstances.

In these times, playing with money is the same as playing with fire. The leverage of debt-based fiat money has yielded multiple returns in the past. In the future, the dangers of doing so will be obvious. The precious metals–gold and silver–the very antithesis of fiat money will offer both the greatest leverage and the greatest safety in the days ahead.

Darryl Robert Schoon
www.survivethecrisis.com
www.drschoon.com
Creative Commons License photo credit: psyberartist