Posted simultaneously with this article is an article by Lindsay David, via wolfstreet.com, “Australia’s Bad Bet on China.” Mr. David toots his own horn a bit, but he’s got reason to toot. In early 2014, he predicted that iron ore, then trading at $120 per metric ton, would trade below $20 per metric ton by the end of 2017. Iron ore is currently around $50 per metric ton; not yet at $20, but it’s only 2015. In May of 2014, he attended “Australia in China’s Century Conference,” a generally bullish conclave on the interlinked fates of the Chinese and Australian economies. Mr. David dared to ask Andrew “Twiggy” Forrest, non-executive Chairman of Fortescue, an iron ore producer: “What if Australia made a bad bet on China?” Mr. Forrest was not amused. An Australian newspaper reported he “angrily slapped down the suggestion,” as the audience applauded. Mr. David said his question made him “the most unpopular attendee at the conference.”
There are two reasons why the unpopular Mr. David merits attention. The first is his analytical bent, apparent from the title of his most recent book, Print: The Central Bankers Bubble. The study of modern economics is the study of serial central-bank created bubbles inflated from asset class to asset class. Those in the profitable middle of such bubbles, like Mr. Forrest, seldom realize it until they bust. Central banks create bubbles not, as the title of Mr. David’s book implies, by printing currency, but rather by monetizing debt—buying debt, often sovereign but not always, and in exchange crediting the seller’s account with the central bank.
No lasting value is created from the out-of-thin-air increase in the seller’s account; if it was that easy we’d all be billionaires. However, modern experience teaches that while such increases may, under some circumstances, promote temporary bumps in economic activity, they almost always raise various asset prices—the bubble effect. Indubitably, central bank asset monetization increases total debt, since its purchases drive down the prevailing interest rate and encourage both private and public debt formation. Debt, like any factor of production, realizes diminishing economic and financial returns until debt service costs overwhelm such returns and additional debt actually retards growth. Financial returns will, over time, tend to mirror actual growth.
Bubble analysis has worked well since the turn of the century. The bubbles have been easy to spot—technology in 2000, housing in 2007—and their source was not hard to trace. The Federal Reserve had promoted debt, expanding its balance sheet and suppressing interest rates; all that liquidity was going to find its way into speculative assets. The only analytic difficulty was determining when the bubble would pop. It is impossible, almost by definition, to pinpoint exactly when mass irrationality will end, but end it does.
The second reason Mr. David merits attention is because his story illustrates what happens to an economist, analyst, or speculator who gets it right. Irrational manias are manifestations of crowd psychology. Mr. David’s experience is common among the few who stand apart from the herd and beforehand, try to warn it, or afterward, are known to have profited from the mass delusion. There is safety in numbers, even when the numerous are wrong, and vitriolic hatred against the solitary, especially when the solitary are right. Presumably the solitary derive some consolation from their profits, if any.
Now the third bubble of this century has been inflated. It is larger than the prior two, consequently, its bursting will be more spectacularly destructive. The inflatable assets of choice have been sovereign debt and equity markets, and this time the inflating is being done not by one, but all the world’s major central banks. They have driven the interest rates on sovereign debt to absurd lows, in many cases below zero. They have driven equity market valuations to absurd highs, even as actual economic performance has been anemically mediocre (the last time real US GDP annual growth exceeded 3 percent was 2005). Microscopic interest rates have driven the expected return on investment close to zero, and the mounting debt load zaps economic performance as debt service takes an ever greater share of actual production.
This morning the government’s first estimate of first quarter GDP growth came in at .2 percent. Back out a massive inventory build, in and of itself a bad sign (businesses are involuntarily stocking, rather than selling, what they’ve ordered), and according to Zero Hedge, the GDP would have been -2.6 percent (“Biggest Inventory Build In History Prevents Total Collapse Of The US Economy,” 4/29/15, zerohedge.com). Bad economic numbers have often been greeted with joy in financial markets, in the hope that they would prompt more central bank debt monetization and even lower interest rates. At some point, the crowd will realize that diminished or contracting production is inadequate to support the financial claims against it.
As SLL predicted in “Oil Ushers in the Depression,” SLL, 12/1/14, oil will not be an isolated case; it is proving to be a harbinger. The US fracking “revolution” was funded by an abundance of cheap debt, but the underlying production only made economic sense at an oil price far higher than what currently prevails. There have been defaults and there will be more. That debt is somebody else’s impaired asset, so those holders realize losses, The industry is cutting back, reducing employment and capital spending, which ripples across a host of industries and geographic areas (including, as Mr. David notes, iron ore mining and usage in Australia and China). The contraction in oil is widening, not just because oil is an important industry, but because it is acting as a financial and economic margin call across the entire debt-saturated global economy. The largest bubble in history may have met its pin.
If it has, then sovereign debt and equities are not the assets of choice. Cash is a nice place to hang out, but as a couple of recent SLL posts have warned, governments don’t like the anonymity of cash (“‘The War on Cash’ Migrates to Switzerland,” and “The ‘War on Cash’ in 10 Spine-Chilling Quotes,” SLL, both 4/26/15), and cash may one day disappear. Cash is anonymous, which recommends it to the liberty-minded, and unlike a lot of instruments issued by governments, is not requiring payment of negative interest rates. However, while holding some cash is recommended, it is still paper issued by governments, with no intrinsic value.
Gold and silver have intrinsic value, are not issued by governments, and have historically been stores of value and either mediums of exchange or the foundations of mediums of exchange, primarily convertible-on-demand bank notes. Gold is also anonymous. However, if you plan to preserve at least some of your hard-earned wealth in physical gold, do so sooner rather than later. Governments and the intelligentsia are starting to wage war on cash, laying the psychological groundwork for the “cashless” society. The US government has outlawed the private ownership or possession of gold in the past (1932), and it would be no surprise if it did so again. Any kind of long campaign, however, kicked off with “random” trial balloons, will send a lot of gold into hiding. Expect a sneak attack: the government makes the announcement one day and takes immediate steps to enforce it. So buy your gold, anonymously if possible, tell no one, and keep it well-hidden.
When the crash finally comes, there a few almost surefire predictions that can be made. The small, obscure cottage industry of analysts, alternative media figures, and bloggers who have been warning about the unsustainable debt build up and the consequences of its implosion will labor on, still obscure. Plenty of Wall Street and government “economists,” and mainstream media talking heads who saw nothing but blue skies right up to the crash will continue in their well-paid positions. None of them will revise whatever passes for their theoretical models, although those models will, once again, have failed to predict a huge financial and economic crash. Most of them will maintain that nobody could have seen the crash coming. Finally, for those speculators fortunate enough to successfully time and speculate on it (a very small group after six years of “buy the dips”), their enormous profits will probably be subject to a confiscatory Windfall Speculation Tax, they will be called before hostile Congressional committees, pilloried in the popular press, and subject to legal and regulatory sanctions.
HOW DID THE ECONOMY FUNCTION WITHOUT A CENTRAL BANK?