Crisis Progress Report (11): The Dark Side

The perpetually bullish yammer on, but recognition of two realties spreads. Recent financial market perturbations are more than just a “healthy correction,” or a “pause that refreshes,” to use two phrases beloved by media touts. Markets are catching on to the inchoate reversal of the largest and longest-lasting debt bubble in history. Crashing natural resources prices, increasing credit stress, imploding export-based economies, gluts of commodities and manufactured goods, and collapsing world trade have become too much to ignore.

And in what amounts to tentative repudiation of a widely and tenaciously held faith, the realization dawns that the biggest governmental debt spree in history, and unprecedented central bank monetization and interest rate suppression, have had no effect on the real economy. They have only served as addictive crack cocaine for debt and equity markets. Like crack, they have wreaked immense damage: mis-pricing interest rates, thus fueling malinvestment and overconsumption, and destroying the incentive to save, the foundation of true economic progress. Acknowledgement of governmental and central bank impotence is a sea change that will have to satisfy those of us who have been making that point for years. Down the road a chastened few of the acolytes may admit the immensely destructive consequences of their faith, but don’t hold your breath.

Although there have been some reluctant murmurings acknowledging past ineffectuality, paradoxically, the belief persists that more debt, monetization, and suppression will stop the “healthy correction” from becoming a rout. These whistlers past the graveyard, shielded from reality and consequences for so long, have—to borrow from Darth Vader—no idea of the power of the Dark Side of Debt. All the governments and central banks of the world, with all their “macroeconomic tools,” will be as effective as a Boy Scout troop with shovels and superglue would be trying to repair a gaping fissure in Hoover Dam.

The US has run perpetual trade deficits, which have been promoted by US economic policy. Government debt, and central bank debt monetization and interest rate suppression, have spurred consumption and investment, which draws in imports of consumption and capital goods. Normally a trade deficit will weaken a currency. Imports will become more expensive and exports less expensive, an automatic corrective. However, the US has the world’s reserve currency, provides much of its defense, and is the largest export market, so a flaccid dollar is in nobody’s interest. The rest of the world has soaked up the debt-based dollar flood with liquidity creation of its own, with much of the dollar accumulation invested in US assets. In effect, the US has exported its debt promotion policies.

The end of quantitative easing in the US and the drawn out drama of raising an overnight interest rate a mere twenty-five basis points may be tacit acknowledgment by Fed officials that the US and global economy are saturated in counterproductive debt. That’s probably giving them too much credit, but it is clear that even at low interest rates, the burden of debt service now outweighs any benefit from the consumption or investment it funds. It is also clear that low interest rates have promoted carry trade speculation that has driven bond and equity prices to bubble valuations untethered to the weakening real economy.

Global debt that can no longer expand will necessarily contract. Debt contraction first manifests itself in the most overly leveraged sectors of the global economy. In 2006, it was the US housing and mortgage finance sectors; this time it was natural resources (see “Oil Ushers in the New Depression,” and “The Shape of Things to Come,”). The natural resources boom got its impetus from the Chinese boom; both were fueled by super-abundant cheap debt. Debt contraction in China has closed followed contraction in the natural resources sector.

Debt contraction, with its attended economic contraction and falling asset prices, is leading to all sorts of untoward consequences, in China and elsewhere. Chinese economic policy has taken a bizarre turn, with the government visibly promoting a stock market bubble, discouraging some types of credit and encouraging others, and devaluing the yuan while simultaneously trying to maintain its value (to discourage capital flight) by selling its US assets, using its dollar reserves to buy yuan.

This puts downward pressure on US equity and bond prices. Further pressure is coming from the governments of oil exporting nations. They too are liquidating their US assets, built up over the years via petrodollar recycling, in order to maintain revenues cut by the fall in oil’s price.

With the end of quantitative easing and a rate hike in the offing, the dollar has strengthened. Foreign governments and companies that have borrowed in dollars, assuming the dollar would stay weak, are getting crucified, as they must pay their debt with more expensive dollars. As debt shrinks, so too does speculative liquidity; stock markets are faltering and credit spreads are widening, even for investment grade debt.

All this economic and financial stress and the credit contraction is still in its infancy! The descent is always much quicker than the ascent. Daisy chains of debt will topple like dominoes in a line. As the stress intensifies, look for a crash. SLL has noted, “much of the global economy is a mirage,” (“A Skyscraper of Cards”) based as it is on decades of debt growth that has far exceeded actual economic growth. The coming collapse will have epochal consequences. War, revolution, succession, changing political boundaries, anarchy, police states, rampant lawlessness, and widespread chaos are all possibilities. Recovery, if there is one, will be a long, arduous, and drawn-out affair, not one of those familiar—and phony—V-shaped, government- and central bank-engineered con jobs.

SLL has used the following quote before, in “A Skyscraper of Cards” last October, and it is appropriate here. Washington Irving wrote The Great Mississippi Bubble in 1820.

Every now and then the world is visited by one of these delusive seasons, when “the credit system,” as it is called, expands to full luxuriance, everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open; and men are tempted to dash forward boldly, from the facility of borrowing….Every one now talks in thousands; nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer….Speculation is the romance of trade, and casts contempt upon all its sober realities….a panic succeeds, and the whole superstructure, built upon credit and reared by speculation, crumbles to the ground, leaving scarce a wreck behind: ‘It is such stuff as dreams are made of.’

History does indeed repeat itself.