For years the US Economy has been propped up on a lie. This well precedes President Obama, who inherited a mess that was created at the end of World War II. Many like to blame Clinton and/or Bush but that would be wrong. The mess within which we find ourselves today was not created by either Bush or Clinton. The “Nixon Shock,” moving from gold to fiat currency valuations, was not the cause either. Each President has dealt with long term structural deficiencies with short term, politically expedient solutions. Consequently, the reason our economy is a house of cards is far more simplistic. We did not make tough choices after World War II.
The bottom line: we were handed a dominant economic hand and we squandered it. Our country emerged as the only viable economy capable of providing a global currency and we failed to do that which was needed to maintain its dominant status. Now those decisions are about to hit back extremely hard.
A crash is coming.
Warning: some content may not be suitable for all audiences; reader discretion is advised
Before I begin, I must warn the reader that this is a very complex piece.
I apologize to those of you who are used to quick two page “solutions” from Conservative and Libertarian authors. This is DEFINITELY not it. But neither are our economic woes. If you have neither the intellectual fortitude nor stamina for complex thought, please leave. This post is not for you. If you really want to dig deep into a series of essays designed to inform, please stay. We need your informed help to fix this problem.
Most collectivists or leftists are ill-equipped to follow economics as a concept. The hard math realities of “feel good” policies do not mesh with their preconceived notions of right and wrong… should and should not. Economics is really not a leftist’s “thing.” Paul Krugman, for instance, often the voice of leftist economic policies, speaks out of both sides of his mouth. On the one hand, George W. Bush’s deficits were ‘bad,’ on the other hand, Obama’s deficits were ‘good.’ For Krugman, the nature of deficits, not the deficit itself, determines its moral value. He, like his colleagues, has a hard time grasping quantitative reality. Structural deficits are simply not good – period. There is no nuanced way to approach our current state. We are mathematically screwed.
Moral hazard is very challenging for the heart, but its logic is sound. If you are right of center, you are probably intuitive enough to follow this essay with little guidance. However, I warn you, it can get quite wonky, but it’s important because it lays out the foundation of an entire argument of just how bad things are with the US economy. I must be blunt. Things are really bad!
Let’s get started… if you think you are up to it.
Today – A Cheap Dollar Bubble
Over the past five years, global equities markets have been soaring, largely as a result of returns garnered in the Chinese and East Asian stock markets which translated into gains in the US equities markets. This occurred during a time of otherwise tepid, but consistent, US economic recovery. The reason for that growth in those markets has much to do with the availability of cheap US dollars and arbitrage opportunities in higher yielding emerging market bonds and equities. That shell game can only last so long. The cheap dollar bubble is collapsing.
The US dollar is roaring back, possibly uncontrollably, for an important reason: the lack of a viable alternative global currency. This risk of deflationary pressure is very real and it threatens the structural integrity of the world’s second largest economy’s equity markets (China). It also risks taking down credit heavy, cash dependent larger corporation with big debt ratios. That scare is more pronounced by a very real American made issue: the post-collapse enormity of American banks.
In the post-2008 environment we entered a return to a bygone era. “Too big to fail” is not new. Rather, it is a return to an older model of banking, grounded in the assumption that really big banks can withstand the storms of monetary and liquidity crises better than smaller banks. This underlying assumption was pushed largely by Tim Geithner, the first Treasury Secretary of the Obama Administration. To be fair, his concept received support from American conservatives as well. However, like most technocrats, he missed a gaping hole in his own assumptions. In a diverse, fluid global market place within which there exists multiple market places to invest cash with minimal American regulatory oversight, large corporations are not necessarily designed to withstand storms; they are designed to start them.
The moral hazard of bailouts taught American banks that they could take risks and there would eventually come American Government intervention. The American taxpayer will always cover their bad bets because the alternative is far worse. Now, in the return to the era of “too big to fail,” the banks have more cash with which to play than ever before. Since regulatory agencies like the FDIC and the Office of the Comptroller of the Currency (OCC) are designed to test regulatory adherence and fundamental accounting principles of US banks, all looks good. The big boys seem to be playing by the rules. But one area has escaped oversight: legal loans to overseas investment corporations, especially Chinese companies, made by American-based global banks like Citi Group and JP Morgan Chase. If things go wrong with those loans, the US will have very little insight into the construct of their collapse. Furthermore, a bailout will not help this time because the cash that is exposed has no collateral to reclaim. Meanwhile, American taxpayers no longer have the means to bailout the banks. We, as a nation, are broke. If one thing goes wrong overseas – within the constructs of those investments – the whole deck of cards collapses.
Things have gone wrong…
In a quest to make higher gains, American bond and equity traders sought overseas markets to earn greater returns than the low yielding American bonds or American-oriented corporate stocks. American banks lent dollars to those traders who in turn lent that money to Chinese equity and bond buyers. They bought both and in order to increase their capital, they created a quasi-mutual fund type product. Unlike a mutual fund, which pays gains as equity holdings within its portfolio rise or fall, the new Chinese products offered fixed returns. This is the stuff of Bernie Madoff legend, multiplied by trillions.
Chinese and global investors seeking fixed returns enjoy the stability seemingly offered by the product, thus the individual Chinese investor, and in some cases foreign investors including Americans, invested in these products. Chinese managers then used the cash that was provided by both the banks and investors, to make investments with higher yields (i.e., typically riskier) often in less regulated markets (e.g., African or Latin American equities and bonds). The goal for the Chinese was to earn as much money as possible to cover the interest on loans, meet their fixed return obligations, and pocket the difference. Essentially, Chinese equity managers and their American partners took US dollars and bought higher yielding equities in a race to ensure all bills were paid and a profit can be made.
Think of it this way: imagine if you take a home-equity loan because you are struggling to pay your bills (gas, electric, etc). Your total bills are $5,000 and you take out $5,000 from your home, plus you go to another bank and you take out an additional $5,000 against your personal credit. You now have $10,000, but really, you are $15,000 in the hole because you will eventually have to pay the loans back and you still owe $5,000 to the utility companies for whom you initially borrowed the funds. However, rather than pay off your bills, you decide to go to a casino and gamble all $10,000 hoping to make $6,000 in “profit,” so that you can pay everyone off and keep $1,000 for yourself.
That actually has and is happening right now.
For a while, this has worked well. As a result, US banks have made a lot of money and keep doubling down at the craps table. But with each doubling down, the cumulative debt of these entities grows as they wait for the next cycle of “winnings” to occur. The biggest challenge is that all chips are on the table. One bad roll of the dice and the entire lot is lost – by both the US banks and the Chinese equity firms. Meanwhile, both the Federal Reserve Bank (the Fed) and the Chinese Government know this happening and are nervously watching for a collapse. In some ways, they are like nervous table wardens, fixing the dice through continued policy maneuvers (e.g., Quantitative Easing, Beijing opening of reserves/injection of liquidity) and hoping the die does not allow the players to crap-out before someone smartens up and stops the game.
Too late! Greece happened before anyone could do anything about it.
The Germans, keenly aware of that which the Americans and Chinese are doing, as well as its potential monumentally disastrous impact on the global economy, continue to prop up Greece and the Euro with German taxpayer funds praying that someone will stop the craps game. But no one can. These investment vehicles are far too deep and way too big to make a controlled landing possible.
With each devaluation of the Euro (the only plausible replacement currency) relative to the US Dollar, commodities prices drop because commodities are dollar denominated, but many economies are currency diverse. In other words, every time the US dollar rises, the price of oil drops AND the value of the alternative currencies, like the Euro, also drop. This kills a fledgling economy like those found in oil or commodities dependent Africa. With each drop in the price of oil (or other product), the commodities dependent, third market economies lose their overall growth and consequently, become riskier bets as it pertains to repay their long term debts (bonds).
While good for the average American consumer, lower oil prices place all of those risky bets at risk. In order to keep the stock market propped up, oil needs to be kept high to cover risky bets on third world economies. In other words, the American consumer needs to feel pain in order for Wall Street to continue to make money. The President for his part has done everything possible to ensure that Wall Street remain the priority over the American consumer. Granted, he is also attempting to pay down the US debt, half of which is his, through dollar devaluation. But that is a long term strategy with which I will get into latter. For now, the priority is Wall Street.
Obama may not want to prioritize Wall Street over Main Street, but that is what he has to do at this stage to avert a massive collapse. Consequently, multiple attempts to devalue the currency through Quantitative Easing and low interest policies have led to record high stock valuations while American workers make their lowest wages since the Great Depression. Eventually, real earnings either have to rise or stocks propped up on slight of hand must fall. The latter is coming.
Bad Bets & Bonds
Now it appears the multiple steps taken by the current Administration to suppress the dollar and keep oil prices artificially higher is failing. It is collapsing inward as the weight of real market forces force the manufactured conditions to eventually pay the price of poor policy and government sanctioned risky behavior – especially in bond markets. Now that oil or other commodities are not earning what they should, because the Obama Administration cannot force the dollar any lower than it already has gotten, developing economies must offer more attractive bonds to entice foreign investors to maintain their spending levels. This increase in risk in emerging market bonds requires any third world country to offer a higher interest rate to attract new “investors” so that they can borrow more money. By offering higher interest yields, older bonds become worthless. After all, who wants to own a bond that pays 5% upon maturity when they can buy a bond that earns 7%… 8%… 10%… etc?
This places the holdings of those Chinese equity vehicles at risk because, when liquidity is required, they cannot achieve that aim. They will not have willing buyers to purchase the bonds and equities they hold to meet the demands of the loans, which were provided by American banks or their individual investors. If a run were to occur, such as a market scare, the rug will be pulled out from them.
This is the craps player who now owes the home equity loan, the personal loan, and the utility bills all coming at once.
The craps player, ie the Chinese investment firms, just lost because the world knows what should have been obvious: some countries were not cut out to be full EU members. The long term viability of the Euro in its present state requires nations to convert Euro denominated assets into US dollars. In such a buying frenzy, the dollar continues to rise, even while the Fed continues to attempt to suppress its value. Now there will be a race: can Germany sustain the Euro long enough for the Chinese investment firms to secure capital from the Chinese Government holding large cash reserves, BEFORE the US dollar rises to an unsustainable level that demands repayment on loans that will now seem higher due to deflationary pressure OR BEFORE the average Chinese and foreign investor withdraws his earnings OR BEFORE the commodity driven economies, with which Chinese investment managers used American dollars to invest, collapse?
The Perfect Storm
What if all three happened at once? That is the perfect storm. It has happened.
The Euro is dropping regardless of German moves to sustain it. Other Euro denominated countries are not doing their part to help Berlin. The dollar continues to rise because the US economy looks better than everyone else and it is considered a safe harbor. As US dollars strengthen in a dollar-favored environment, commodity prices drop. Commodity dependent economies are feeling a cash crunch of enormous levels (witnessed most recently by the ever stable Saudis) which is placing stress on the bond positions of the Chinese. Add to this financial mess a growing geopolitically volatile environment, marked with Russian incursions into its neighbors and extremely proficient alternative state terror groups, and you get a disaster.
A crash is coming!
However, unlike previous crashes, this one will be prolonged and brutal. It will hurt the world and especially the United States. Why? Because we are ill-prepared to weather this kind of storm. You can blame the political classes of Washington, D.C., both Republican and Democrat.
A crash is coming.
In the next part I will dissect the fundamental reasons we are no longer in a financially viable position to sustain a tempest of this enormity.