Systemic Chaos Will Continue

"The unprecedented success of Keynesianism is due to the fact that it provides an apparent justification for the "deficit spending" policies of contemporary governments. It is the pseudo-philosophy of those who can think of nothing else than to dissipate the capital accumulated by previous generations.

Yet no effusions of authors however brilliant and sophisticated can alter the perennial economic laws. They are and work and take care of themselves. Notwithstanding all the passionate fulminations of the spokesmen of governments, the inevitable consequences of inflationism and expansionism as depicted by the "orthodox" economists are coming to pass. And then, very late indeed, even simple people will discover that Keynes did not teach us how to perform the "miracle ... of turning a stone into bread, but the not at all miraculous procedure of eating the seed corn..  

There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved" - Ludwig Von Mises.

I like to believe that there are always positives and negatives in every situation. So how do we fill up this balance sheet in the middle of our current historic economic crisis? Its good to end on a positive note so why not start with the negatives.

Sadly, you can not improve an unjust and deeply flawed system simply by reinforcing it, and so far this is all that has happened. The system has the same incentives it always had, except now they have now been increased as the downside for the banks is even more limited by explicit government backing. Incentives always trump regulations, so do not believe that there is any quid pro quo for the bailout. It may bring some temporary relief, but when the whole world economy has been held to ransom by a few blatantly greedy bankers, the system itself needs radical change, rather than support. This inevitably means that further chaos is guaranteed, until we can find a better system. 

The second key negative is that we should now expect a prolonged recession, which I suppose we should call a depression. For reasons described below we simply cannot avoid or delay this any more. While there are enormous attempts to pretend that this is not so or can somehow be fixed, this is highly unlikely. It would be much better if we just faced up to this, and once we have then we can adjust and see this as just part of the natural process, which actually has a beneficial side as well.

For so long I have had to play the part of the pessimist. This has been a thankless task, but no one is well served by false hopes, or unrealistic expectations. I will have to remain on the pessimistic side until the market and general perceptions reflect the reality we are confronted with, or even something worse. Gladly, I am beginning to see the possibility that we will get there within the foreseeable future. Then, at last, I can play the role of the out of concensus optimist.  

Fortunately, most Americans are beginning to see the system for what it is. The week of the Bail Out Bill was very revealing. Congressmen heard a clear message from their constituents. One congressman indicated that 50% of his voters said "No" to the Bail Out, and the other 50% said "Hell No". In the end the voters were ignored as congress found a way to buy enough votes with someone else's money, and even though Wall street had created the crisis they still got their $700 billion of someone else's money.

Most Americans may not fully understand all the details of the plan or the relationship between Wall Street, the Federal Reserve, and the government, but their instincts are telling them that something smells really bad, and this is the hope for the future. It will become increasingly apparent that too many people are being unfairly treated. This will lay the ground for change and a more equitable and healthy system, although it will take time.

Also, although a depression may sound depressing, once the initial adjustment has been made it should lead to much better behavior, conditions, and even contentment in much the same way that endless borrowing and spending failed to produce the health and happiness it seemed to promise.

Maybe or maybe not, but lets get back on track with facing up to our current conditions.

The Party Is Over

This is so much more than just a mere liquidity or credit crisis, the current financial storm represents the death throes of the old global economic order, and perhaps the birth pains of a new one. The sun is setting on the borrow and spend culture that has defined us for a generation. Our long ride on the global gravy train is finally coming to an end, and once it does nothing will be the same. The sooner we come to grips with this the better.

Despite the myriad of proposals and policy adjustments that are coming from Washington and other world capitals, we must understand that this crisis cannot be cured by governments. In the United States, credit is gone because savings are gone. Our shallow pool of savings has been depleted through bad loans, and we can no longer entice foreigners to lend us their available savings. Given that we are already too loaded up on existing debt we cannot realistically repay, who can blame them for not wanting to lend us more?

The result is that the free market is trying to put an end to our spending spree. Without savings or home equity to fall back on, Americans struggling with rising prices are finally being forced to cut back. This has terrified our leaders and is causing them to dismantle the remaining structure of our free enterprise-based economic system.

The intention of all these daily federal interventions is to keep the credit spigots open so Americans can go even deeper into debt to buy more stuff they can't actually afford. This should be clear enough to anyone who listens to what our leaders are actually saying. When speaking about the need for an even larger fiscal stimulus package, Barney Frank, chairman of the House Financial Services Committee, said, "We have to prop up consumption." He has it backwards. The government has been propping up consumption for far too long, and the best thing they can do now is remove the props so spending can be replaced by savings.

The sad reality is that we borrowed and spent our way into this crisis, and we are not going to borrow and spend our way out of it. Legitimate credit can only be supplied if there are genuine savings to finance it. Savings can't be magically concocted into existence by a printing press, but can only be created by consumers who spend less than they earn. Efforts to fool the market will not work and will ultimately lead to a monetary disaster and runaway inflation.

Were the government to allow market forces to work, Americans would now have to pay cash for their consumption. That would mean no instant credit for new cars, plasma TVs, appliances, consumer electronics, clothing, furniture, etc. Unless buyers actually had the cash in their checking accounts these purchases would have to be deferred. From an economic perspective this is precisely what the doctor ordered. But for an economy based 72 percent on consumer spending, the medicine would go down hard.

It is probable that now the majority of Americans are close to bankruptcy, the savings rate will have to rise from around zero, to around 15%. Without a rise in wages, this is how far spending might have to fall for several years in order to restore personal balance sheets.

Ultimately, a serious reduction in consumer and mortgage credit, combined with an increase in personal savings, would again provide a pool of needed capital for businesses to produce products and provide employment opportunities. However, the danger is that this potential credit could be completely crowded out by massive borrowing by the Federal Government. In addition, if the government keeps creating inflation to artificially sustain consumer borrowing and spending, there will be no savings left to fund anything and prices will be so high that there will be few goods that Americans could actually afford to buy.

It's Called A Depression

Tragically, a rapid and dramatic drop in spending is coinciding with a massive deterioration in the budget deficit. As the government tries to offset the collapse in private spending in a dramatic final attempt to keep the status quo alive, the budget deficit is hit on both sides. Revenues are falling, but spending explodes. Very quickly the options available, even to the government, start to close.

There are numerous attempts to deny what is actually happening.  While most economists continue to argue whether the US has entered a recession, this argument is based around deeply distorted government statistics. A previous note touched on this issue and the arguments are too long and detailed to explain in this short note. Suffice it to say that nominal growth has been below true money supply growth for some time already, and a great deal of balance sheet repair remains a necessity at a time when there is very little savings available. With this enormous readjustment now a necessity, there is little prospect of any real growth for some time. This is called a depression.

Government intervention will just make it worse in the long term, although it will decide the extent to which we have either falling prices or hyperinflation. Usually, governments, or more importantly the bankers, far prefer inflation, as it makes their collateral more valuable relative to their loans.

But I am becoming an optimist

We need to face up to how unnatural and damaging our economic system has become. Leveraging ourselves to the limit with our credit cards, and mortgages, while saving nothing. Allowing our banking system to become leveraged beyond belief, with minimal risk control. Allowing our government to explode both our current debt and future liabilities, without a signature from the government accountant approving our annual accounts. Did you really think that this could last? 

It is time to return to sanity before we do any more damage. It can only improve our behavior and ultimately our happiness, and the sooner it happens the better even if it is a painful adjustment. The longer we leave it the worse will be the ultimate adjustment. Thrift and saving have been abandoned, and what has it done for us? Simply it has weakened us financially to the point that we now have very limited options. It may sound like tough medicine but it should be welcomed as a return to natural and sustainable values and behavior.

It is always remarkable how quickly adjustment can be to new realities, once they are understood. Admittedly there is always an initial shock but markets and perceptions adjust very quickly. Equity valuations have improved dramatically across the globe, and while many of the developed banking dominated countries face a severe retracement, there are many Asian and Emerging Market economies that now have strong balance sheets and enormous growth opportunities ahead. The world has a way of righting itself through any crisis. We may not have yet seen to lows in all markets yet, but for longer term investors there are already enormous opportunities. Crisis is simply a way for a necessary rebalancing to take place.

Overall there are many reasons why we should welcome the current crisis.

Notice

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. Chris Belchamber (the author) may or may not have investments or positions in any assets or derivatives cited above.

Communications from the author are intended solely for informational purposes. Statements made by various authors, advertisers, sponsors, and other contributors do not necessarily reflect the opinions of the author, and should not be construed as an endorsement by the author, either expressed or implied. The author is not responsible for typographic errors or other inaccuracies in the content. We believe the information contained herein to be accurate and reliable. However, errors may occasionally occur. Therefore, all information and materials are provided "AS IS" without any warranty of any kind. Past results are not indicative of future results.