The deflationary depression upon which the world has embarked has two central themes: debt, and the inability of government and central banks to control multiple variables and consequently, outcomes. Viewed through these prisms, everything that has happened and will happen is readily comprehensible.
The received wisdom before last week’s US stock market plunge was that China’s economic and financial problems would remain local. After the plunge, the revised received wisdom is that it’s all China’s fault. Neither analysis is correct. China has entered a debt contraction after one of the greatest, if not the greatest, debt expansions in history. Its problems are exacerbated by its lack of freedom and its command and control government (they’re communists, after all), which stands revealed as unable to dictate economic outcomes. It has its fingers crossed that its inability does not cross over into the political realm, probably a vain hope.
The US has entered the same debt contraction phase as China—just a few months later—after a debt expansion that dates back to the 1960’s, when Presidents Johnson and Nixon opted for guns and butter on the installment plan. Nixon cut the last fiscal tether to reality in 1971 when he closed the gold window. The US’s problems will not be solved by the command and control ministrations and manipulations of its government and central bank, any more than China’s have been.
Governments and central banks are the problem, not the solution. The market-based solutions of debt contraction, asset repricing, insolvency, bankruptcy, reorganization, economic contraction, reduced consumption, and unemployment are not planks of a platform designed to win next year’s US election or quell Chinese unrest. They will, however, happen regardless of who’s running things in either nation. The one certainty is that the powers that be in both nations will make matters worse.
The incompetence of governments and central banks renders absurd the debate about whether the Federal Reserve will abandoned its hinted-at plan to raise the federal funds rate target next month. For SLL’s money, it will not raise the rate in the face of crashing economies and financial markets; we’ll probably see the next iteration of quantitative easing before year’s end. And for SLL’s money, it won’t make a bit of difference what the Fed does. At the first hint that the rate won’t be raised we’ll see one of those one- or two-day wonder rallies that crucify the shorts. In the long run, it will be an almost imperceptible upward squiggle on a stock chart that bears a striking resemblance to that of the last crisis (except this one will have a steeper negative slope and a more precipitous drop).
Governments around the world are racing to make things worse as debt unravels. Financial markets, no longer faithful lap poodles, are registering the carnage. Currencies are being competitively devalued in a less-than-zero-sum race to the bottom that will have no winners, but which will impoverish citizens of any nation that imports anything. Repayment by governments and corporations of foreign currency debt becomes increasingly problematic as economies shrink and domestic currencies depreciate.
Economic contraction is killing exports for raw materials and finished goods, outweighing the transitory benefits from currency depreciation. Local stock markets have tended to follow local currencies, so it’s turning into a rough year for emerging market investors. Widening credit default swap spreads and rising interest rates indicate that it’s also going to be a rough year for emerging market creditors (see “This Is Not A ‘Correction’……..It’s The Beginning Of The Global Bubble Unwind,” by Doug Noland, SLL, 8/22/15). Emerging market travails should occasion no smugness among more developed nations. The former’s problems are the leading edge to which the latter will catch up.
SLL readily confesses to two systemic errors. SLL has always underestimated the desperate lengths governments and central banks will go to sustain the unsustainable. During the last financial crisis, SLL would have taken the other side of bets that: the Fed’s balance sheet would expand by four times; the ECB would do “what ever it takes” to keep the European afloat, including allowing as collateral all sorts of garbage debt; central banks would promote negative interest rates; China would go on its massive debt binge, and Japan’s central bank would monetize everything, including equity ETFs.
Nevertheless, all these things happened, which brings up SLL’s second systemic mistake: underestimating the willingness of financial markets, speculators, and investors to play along with incompetent, counterproductive market manipulation and economic policy. Perhaps no chart is more telling in this regard than one tracking the closely correlated size of the Federal Reserve balance sheet and the S&P stock index, even as the economy experience its weakest “recovery” since WWII. SLL predicts that correlation will soon be broken, but there is no denying that it has persisted for over six years, or about three years longer than SLL thought it would.
The looming financial and economic debacle will put those mistakes in the rear-view mirror, although new SLL mistakes will undoubtedly be made further down the road. For the time being, there is no need to make things complicated. We are in a debt contraction and economic depression that will be marked by widespread deflation in assets prices of all stripes. Virtually everything governments and central banks do to forestall or prevent these inevitable outcomes will only make things worse.
For those who are prepared and who get it right intellectually, there will be comic, even hilarious, moments. For example: as markets and economies crash, a long overdue comeuppance is at hand for maladroit, corrupt, rapacious elites. Hard as it is to believe, those who maintain that the bad guys and gals never get what’s coming to them may be too cynical. Picture politicians, central bankers, lobbyists, crony capitalists, and other scum in the dock or the hoosegow. To borrow from Oscar Wilde, you would have to have a heart of stone to witness such “tragedies” without laughing. If nothing else, satire flourishes during hard times, so the coming years should be a Golden Age. In addition to commentary and analysis, SLL will try to supply some of the laughs.
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