China And The New World Disorder, by Raúl Ilargi Meijer and Nicole Foss

The title is somewhat misleading. This is an article about the global economics of debt, deflation, and depression. SLL could have written it, and if you put all of SLL’s articles about the 3 Ds in one place, it would look a lot like this. Importantly, the authors understand the diminishing and eventually negative returns from debt growth, and the deflationary consequences when debt growth becomes debt contraction. Like SLL, the Automatic Earth has been warning of impending doom for years. Those in that camp have no need to apologize. The world has inflated its largest debt bubble in history. It’s been going on for decades, and any economic analyst worth his or her salt should have seen this inevitable bust coming years before it happens. The apologies will be owed by those analysts who are either surprised by the bust or who go back to their own archives and cite vague statements, rather than the quite clear warnings of the bust-is-coming camp, to “prove” they knew it all along. This article by Raúl Ilargi Meijer and Nicole Foss is very long, but it’s a great compendium of the inter-workings of debt, deflation, and depression and has some revelatory charts. Even if you don’t read it all, bookmark it for future reference. From Meijer and Foss, at automaticearth.com:

Nicole Foss: Our consistent theme here at the Automatic Earth since its inception has been that we are facing a very powerful deflationary depression, following on from the bursting of an epic financial bubble. What we have witnessed in our three decades of expansion and inflation is nothing short of a monetary supernova, and that period has been the just culmination of a much larger upward trend going back many decades at least. We have lived through a credit hyper-expansion for the record books, with an unprecedented generation of excess claims to underlying real wealth. In doing so we have created the largest financial departure from reality in human history.

Bubbles are not new – humanity has experienced them periodically going all the way back to antiquity – but the novel aspect of this one, apart from its scale, is its occurrence at a point when we have reached or are reaching so many limits on a global scale. The retrenchment we are about to experience as this bubble bursts is also set to be unprecedented, given that the scale of a bust is predictably proportionate to the scale of the excesses during the boom that precedes it. We have built an incredibly complex economic system, but despite its robust appearance it is over-extended, brittle and fragile after decades of fuelling its continued expansion by feeding on its own substance.

The Automatic Earth, December 2011: The lessons of the past are sadly never learned. Each time the optimism is highly contagious. In the larger episodes, it crescendos into euphoria, leading societies into a period of collective madness where risk is embraced and caution is thrown to the wind. Sky-high valuations are readily rationalized – it’s different here, it’s different this time.

We come to believe that just this once there might be a free lunch, that we can have something for nothing. We throw ourselves into ponzi finance, chasing the mirage of speculative gains, often through highly questionable and outright fraudulent practices. Enron, Lehman Brothers, and recently MF Global, are but a few egregious examples of what has become an endemic phenomenon.

The increasing focus on chasing speculative profits parasitizes the real economy to a greater and greater extent over time. After all, why work hard for small profits in the real world, when profits on money chasing its own tail are so much greater for so little effort?

Who even notices the hollowing out of the real economy, or the conversion of large amounts of capital into waste, or the often pointless depletion of non-renewable resources, or the growing structural dependency trap, when there is so much short term material prosperity to pursue?

In such times, the expansionary impulse drives the development of multiple engines of credit expansion. The reserve requirements for fractional reserve banking (already a ponzi scheme) are whittled away to almost nothing. Since the reserve requirement effectively determines the money supply multiplier effect, that multiplier becomes almost infinite.

The extension of credit through the shadow banking system removes the semblance of central bank control over monetary expansion. Securitization and financial innovation also create putative wealth from thin air, using underlying collateral to derive layers of additional illusory value. In this way, excess claims to underlying real wealth are created. The connection between the rapidly expanding virtual worth of the derivative instruments and the real value of the underlying collateral becomes ever more tenuous.

Shadow Banking and Phantom Wealth

Since 2011, in our desperate attempt to avoid the consequences of an imploding bubble, we doubled down on the doomed strategy of ponzi credit expansion. In doing so, we have only succeeded in digging ourselves into a deeper hole, and have done so on a massive scale. While the aggregate balance sheet of the world’s central banks grew exponentially from $3 trillion to $22 trillion over the last 15 years, the expansion in the shadow banking sector has been even more dramatic, and its role in fostering the overall credit hyper-expansion has become increasingly clear:

Shadow banks are that exploding growth segment of global finance capital that share the following characteristics: they are largely unregulated, they invest primarily in financial asset securities of various kinds (i.e. stocks, government and corporate junk bonds, foreign exchange, derivatives, etc.) instead of real asset investment (plant, equipment, software, etc.), they target high risk-high return opportunities based on asset price appreciation and volatility to realize financial capital gains, their investments are highly leveraged and debt driven, their investment targets are highly liquid financial markets worldwide that enable a quick entry, price appreciation, and subsequent just as quick short term profit extraction.

Their client base is predominantly composed of the global finance capital elite – i.e. the roughly 200,000 worldwide ultra and very high net worth individuals with net annual additional income from investment flows of $20 million or more—for whom they invest individually as well as for themselves as shadow bank institutions.

Shadow bank ‘forms’ include private equity firms, hedge funds, asset and wealth management companies, mutual funds, money market funds, investment banks, insurance companies, boutique banks, trust companies, real estate investment trusts – to note just a short list – as well as dozens of other forms and newly emerging initiatives like peer to peer lending networks, online investment funds, and the like.

Shadow banks have been estimated to have investable assets (i.e. relatively short term and liquid) of about $75 trillion globally as of year end 2014, a total that does not include revenue from ‘portfolio’ shadow-shadow banking. That is projected to exceed $100 trillion well before 2020.

The exponential growth of both central banks and shadow banking during the long global boom constitutes a gargantuan increase in the supply of money plus credit relative to available goods and services, which is inflation by definition. This huge supply of virtual wealth has acted to push up asset prices, creating a plethora of asset price bubbles and a cascade of malinvestment based on those price distortions. The explosive growth of shadow banking in particular, following the 2009 bottom, was accompanied by a return to extreme risk complacency and rock bottom interest rates, leading to a frantic search for investment returns in riskier and riskier places.

To continue reading: China And The New World Disorder

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