The User's Guide to Fiscal Calamity

[BaronVonBigmeat]

(Taken from the December 2006 issue of International Speculator, at www.dougcasey.com)

The Users Guide to Fiscal Calamity
By Bud Conrad and the Editors of Casey Research


As even recent subscribers know, here at Casey Research we believe that the U.S.—and by extension the world—is heading inexorably toward a financial crisis on a scale to match or exceed the Great Depression that was announced by the 1929 stock market crash.

We’re not cheerleaders for hard times. We don’t invoke the Great Depression just to make our hearts beat faster. Instead we point to it as proof that from time to time truly extreme events happen. And when they do, most people get hurt while a few profit extraordinarily.

Even a little foresight can help you join the few. Of course, economic foresight is squinty at best; but if nothing else, it rewards you with a context for your portfolio decisions. So in this article, we are going to examine some of the features of the Great Depression and then discuss the differences that, this time around, argue for an inflationary crisis, with consumer prices doubling repeatedly, rather than a 1930s-style deflation, when consumer prices dropped by one-third.

What, Me Worry?

The Dow Jones Industrial Average recently reached a new high. Employment is ticking along at just 4.4%. How, then, could a major financial crisis be lurking just over the horizon?

What would you say if someone told you that just before the Great Depression, U.S. unemployment was at its lowest levels… ever?



And the stock market? As you can see from the chart below, heading into 1929 you’d be called a grouch if you weren’t optimistic. But optimism would have cost you dearly: those who bought stocks in the waning months of the 1929 rally had to wait almost 30 years just to break even. Those who bought real estate in the hot Florida and California markets had to wait even longer.



And Then There’s This…

Of course, while history shows repeating economic cycles, they never repeat exactly.

In the way of similarities, leading up to the 1929 crash was a string of fat years for speculative stocks—much like the dot-com boom leading up to 2000. But unlike the 1929 crash, the dot-com bust seems to have hurt only the participants, not the bystanders. In fact, many pundits see the sharp sell-off in equities in 2000 as akin to opening a safety valve. It reduced the stock market excesses built up over a 20-year bull market without causing a general economic meltdown.

Yet two important factors suggest that the 2000 correction was only a foreshock—and that it left the economy ready for the big quake.

A. Dividend Yields. Dividend yield is a widely followed indicator of stock market valuation. The lower a stock’s dividend yield--the income it throws off measured as a percentage of the stock’s price--the more richly the stock is being valued. By that indicator, stocks are just a tick off record highs… and are pricier today than just before the 1929 crash.



B. Correction, what correction? If you look at housing and stocks as a piece—together they now represent the bulk of household wealth—the “correction” of 2000 was merely a bump in the road. That’s because the Fed’s loose monetary policy did so much to bid up real estate prices. By contrast, in 1929 housing crumbled just before stocks and then was damaged further by the scramble for liquidity. They went down together as the deflation proceeded. But following the 2000 stock market peak, what stocks were taking away, the housing market was replacing. The next chart reveals a bubble intact… a bubble waiting for a pin.



Speaking of Housing

The wild stock market leading up to the fall of 1929 now serves screen writers as a period-piece cliché. But there was also a housing bubble of historic proportions in the 1920s. In 1925, housing investment in relation to the size of the whole economy was even bigger than it is today.



This Time It’s Different…

Overpriced stocks… a bubble in financial assets… a weakening housing market… it all sounds deflationary. So why are we expecting an inflationary crisis?

To answer that, we have to look at some of the key differences between then and now.

A. Now a fiat currency. From 1879 to 1934, the U.S. dollar was redeemable for gold, at $20.67 per ounce. Even until 1971, it was redeemable for gold by foreign central banks, at $35 per ounce. There were bouts of inflation from time to time, but with the dollar’s tie to gold, they were self-limiting and invariably were followed by periods of declining prices. (The deflation of the 1930s seemed unremarkable when it began--but later accelerated as the Fed ignored the sharp contraction of the money supply.)

The dollar’s grounding in gold ended in 1971, and the Fed gained unlimited power to expand the money supply. Today there is no brake on money creation except the Federal Reserve’s fear of price inflation—which tends to take a back seat to its fear of recession. During the Greenspan days, the Fed used its money creation power to make massive foreign purchases of U.S. government Treasuries. This pumped up prices of stocks and other financial assets and fed the bubble in the housing market. Foreigners have been complicit in the process by taking their trade surpluses and buying Treasuries, agencies, and corporate bonds, in the process providing a ready source of credit for creating mortgages to drive houses higher.

So, far from seeing the kind of credit collapse that occurred in the Great Depression, this time around we have seen a massive credit expansion.

B. Government entitlements. Back in the 1920s, there was relatively little in the way of a government “safety net” and certainly nothing like the politically entrenched entitlement programs of our modern welfare state. Social Security and Medicare alone have the government on the hook for $36 trillion.

And the piper won’t wait to be paid. As previously discussed, fully 78 million “baby boomers”—about 26% of the entire population—are now either in, or approaching, retirement age. But they are doing so with historic levels of debt and, on the average, woefully inadequate net worth (over 25% will have a net worth less than $50,000)… much of which is based on deflating home values. But every one of them has a mailbox that’s just right for receiving government checks.

The pressure on the government to continue handing out checks won’t ease; it will build. Faced with the option of defaulting on its obligations—political suicide—or inflating those obligations away, the government can be counted on to take the time-honored and far more politically acceptable path of inflation.

C. War. In the 1920s, people thought the war to end all wars had been fought, never to be repeated. Military spending was cut to the bone.

Today the U.S. and its few remaining allies are embroiled in a global war with Islam. The early cost estimate for Iraq alone is $1.3 trillion. As we see it, even with the recent swing towards the Demopublicans, the worst is still ahead. All our stomping around in the world’s messiest neighborhoods has helped recruit the next wave of dedicated jihadists, armed with a slew of new and battle-tested guerilla warfare methodologies… increasing the odds of another 9/11-scale attack against the U.S. And when it happens, the political parties will fall all over themselves trying to prove themselves the tougher cops, leading to yet more conflict. The “Forever War” means continued high military spending… even though the U.S. already spends more on “defense” than the rest of the world’s governments combined.

D. Energy Dependence. In the 1920s, the U.S. was energy independent. Today it is not. To keep the lights on, the U.S. must keep shipping money out of the country to energy producers, adding to the unprecedented trade deficits discussed below.



F. Derivatives. Derivatives are investment contracts tied to the price movements of underlying instruments, most commonly bonds and currencies. The market for them is huge, and they come in a rain forest of varieties. Financial institutions use them to hand off risk to other parties. Speculators use them to make bets. And hedge funds use them to create leveraged plays.

The numbers in the following chart are astounding; please note that the totals are trillions, not billions. The $370 trillion notional value of outstanding derivatives is staggering—28 times the $13 trillion annual output of the entire U.S. economy.




Admirers claim that the rapidly expanding use of derivatives helps to decrease overall economic risk by shifting particular risks toward the investors that can most easily bear them. It’s a nice idea. And it’s not really a bad idea. But it’s launched a very big ship that has never had a real shakedown cruise. Derivatives may give an appearance of decreasing risk on a case-by-case basis, but when taken together, the risks to the economic system are not decreased but made worse.

A typical participant in the derivatives market is busy buying with one hand and selling something slightly different with the other. Whatever risk he takes on, he tries to offset with a derivative from someone else. And that someone else is doing the same thing with another someone else. And so on. The simple fact is that no one knows where the long rows of dominoes begin or end, or just how much shaking it would take to knock over the least stable of them.

To take just one example: Credit Default Swaps (CDS) provide guarantees against a bond defaulting. They carry the rating of the party granting the guarantee, which is usually AA. But if such an issuer were forced to make good on a big default, its credit rating could drop, lowering the value of every other piece of paper it has guaranteed—many of which are wrapped up in derivatives sold by other issuers… many of which are wrapped up in derivatives sold by still other issuers. The chain reaction could run far beyond the initial default.

By mid-2006, CDS issues had grown to $16 trillion, a 100% increase over the year before.

The individuals who manage banks and dealers in the derivatives market don't want rules so confining that they can't do business. We suspect most of the derivative operations are sturdy enough to withstand anything that has happened in the lifetimes of the people who run them. But they're not ready for anything rougher than that. If "6 sigma" is their standard, 7 sigma has implicitly—but dangerously—been assigned a probability of zero.

What happens when unprecedented events make the markets even more volatile? No building can be made absolutely quakeproof.

Almost makes one long for the simpler days of the late 1920s…

 

[BaronVonBigmeat]

The Big Enchilada—Foreign Holdings Of U.S. Currency

Fiat money, expensive welfare obligations, a wandering war, energy dependence and an unmapped tangle of derivatives—each of them marks our current situation as different from the eve of the Great Depression. But their importance isn’t just the trouble they represent on their own; it’s the way they tie the hands of the U.S. government in dealing with the big enchilada—the unstable accumulation of dollar assets by foreigners.

Non-U.S. investors now hold 6 trillion U.S. dollars. The biggest owner is China, whose official holdings are closing in on $1 trillion. Central banks in Japan and Taiwan are similarly awash in dollars. Some of that money, especially the cash owned by individuals, is actual U.S. currency (there are more $100 bills outside the U.S. than inside). But most of it is U.S. Treasury bills and other dollar-denominated IOUs. It’s held, whether by individuals, companies or central banks, as a way to store value. It’s their secondary currency, a reserve.

Those reserves have been built up by foreigners selling more goods and services to people in the U.S. than they buy from the U.S. In fact, the growing mountain of foreign-held dollars is nothing more or less than our accumulated trade deficit staring back at us. It’s a big mountain, as you can see in the following chart. But it’s not an old mountain. It has grown up in just the last two decades, as the U.S. was becoming the world’s biggest debtor. And most of the mountain has been heaped up in just the last few years.

How did it happen? A trade deficit isn't something you can do on your own, like bad manners. Some group of foreigners must decide to ship goods to you in exchange for hundred-dollar bills, Treasury bills or other paper. In the present situation, it's not foreigners generally who've elected to be our trade-deficit enablers. And it’s not the Chinese or Japanese or Taiwanese generally. It's a handful of individuals in those three governments. Why have they done so? For a number of reasons, not the least of which is they are in bed with the people who own the export industries in their respective countries. Today the Chinese government spends trillions of yuan to buy up dollars and keep Chinese exporters happy.

So foreigners, chiefly foreign central banks, have fed our trade deficit by lending us the money to buy their exports. American consumers keep consuming more than they produce, and the U.S. government keeps spending more than it takes in, and both keep going deeper into debt. It’s been going on long enough that it seems natural. But it can only continue until rising concern over the outlook for the dollar—its reliability as a store of value—reaches a tipping point and spurs foreigners to action. And the bigger the mountain of foreign-held dollars gets, the jumpier its owners are going to become.

The sell-off probably won’t begin with foreign governments and central banks—though indications are abundant that they are already edging toward the door. It is likely to start with sophisticated financial institutions and well-connected, wealthy private individuals looking to front run the official sell-off. It will be slow to start, but once it does, it will quickly pick up speed. No one will want to be the last one through the exit. The eventual stampede will crush the dollar in foreign exchange markets, and the world will stumble into economic chaos as its de-facto reserve currency turns into 6 trillion Old Maid cards.

Can the U.S. government prevent this? In principle, yes. The formula would be to cut spending, balance the budget and declare a holiday on increases in the money supply. Interest rates would have to rise. But the need to make good on Social Security, finance the Forever War, pay for energy imports and dodge the falling derivative dominoes makes that a political impossibility. To the politicians, a dead dollar is preferable to 12% unemployment rates, unprovisioned soldiers and millions of angry retirees.



Among other things, you’ll note that the balance of trade was very positive before and during the Great Depression.

The consequence for the U.S. itself will be unprecedented price inflation. Most of the exported dollars will flow back to the U.S., where they will represent excess cash that the owners will try to spend quickly, which will bid up prices. Foreign dumping of T-bills will be met with Federal Reserve buying, paid for with newly printed dollars, which will further fuel price inflation.

While it is too early to say whether we will be forced to buy bread with basketfuls of dollars, as was the case in Germany under the Weimar Republic, it is worth contemplating that in that instance, it was only Germany and, to a lesser extent, a few of its neighbors, that were gravely affected by the country’s reckless monetary policy. Today, because the U.S. dollar is the world’s reserve currency, all the currencies of the world are at risk.

What This Means for Investors

The rapidly approaching dilemma for the Federal Reserve comes down to a choice between (1) engineering a standard sort of recovery from the next recession by speeding up monetary growth and reducing interest rates and (2) keeping the dollar afloat.

Choose the “solution” behind Door Number One and trigger a monetary crisis. Open Door Number Two and our heavily indebted economy is devastated by the higher interest rates needed to support the U.S. dollar. For all the reasons discussed above, and with the next presidential election season now kicking off, the odds heavily favor inflation.

In fact, Fed Chairman Ben Bernanke virtually gave the game away in a speech in Frankfurt on November 10, 2006.

“It would be fair to say that monetary and credit aggregates have not played a central role in the formulation of U.S. monetary policy.”

In other words, the total amount of money in the system—what we “print”—plays no serious role in current U.S. policy. That’s a politic way of admitting that the U.S. government is planning to paper over all its many obligations and accelerate a trend that has been in motion since the creation of the Fed in 1913.


Casualties

As the dollar loses purchasing power, interest rates eventually will rise—inevitably as lenders demand some compensation for inflation, and intermittently as the Fed attempts to slow the wholesale abandonment of the dollar by foreign holders. That will make bonds the worst investment and garden variety stocks the next worst.

That inflation should hurt bonds—with its double-whammy of rising interest rates and declining purchasing power—is obvious. But the damage that inflation does to stocks is nearly as bad, as a comparison of market action during the Great Depression with the sell-off during the inflationary 1970s makes clear.



As you can see, there are two noticeable spikes, in 1929 and in 2000. But most of the movement in stock prices is hidden by changes in the value of the dollar (deflation in the 1930s and inflation in the 1970s). Correct for a fluctuating dollar, as in the next chart, and you see a whole new picture.



A raging inflation—and we believe what’s coming will be much worse than that of the 1970s—can have the same devastating impact on stocks as a depression. It is also worth noting how long the peaks loom over the years that follow. If you buy at precisely the wrong time, it can take two decades or more just to break even.


Beneficiaries

The biggest beneficiary of the flight from the dollar will be commodities.

A preview of what’s to come can be seen in what has already occurred since the U.S. government gave the gold standard its last kiss goodbye in 1971. Fiscal restraint ended, the dollar became nothing more than a floating abstraction, and commodities took off.



While commodities in general will do well during the flight from the dollar, the biggest winners will be precious metals. Gold’s story is the simplest: the flight from the dollar will be a movement toward a reliable store of value.

And, just in case you are reluctant to eliminate all stocks from your portfolio (other than those in the resource sector), we believe that certain industries in the U.S. and certain areas will be helped by a cheap dollar. Export industries, e.g., agriculture, will be helped.

It might seem shrewd to try to leverage your profits from a declining dollar by borrowing dollars to finance investment purchases. But that’s a risky strategy. The flight from the dollar won’t be a straight-line process. It will go in fits and starts, and there will be temporary reversals that can cut the legs off a trader who’s playing with borrowed money—especially if it’s margin money or any other kind of credit with a floating interest rate.

We prefer to find leverage from a different source—the kind of selected junior resource stocks that we follow in International Speculator. Their prices tend to far outrun the prices of the underlying commodities… without the risk of margin calls.

The bottom line is that we are in the early stages of a serious monetary crisis, a crisis you can make your friend by steadily and cautiously building a portfolio of resource stocks, the kind of investments we bring to your attention each month in this letter.

 

[gonegolfin]

(Taken from the December 2006 issue of International Speculator, at www.dougcasey.com)



F. Derivatives.

The numbers in the following chart are astounding; please note that the totals are trillions, not billions. The $370 trillion notional value of outstanding derivatives is staggering—28 times the $13 trillion annual output of the entire U.S. economy.

Some comments ... Thanks for the post BaronVonBigmeat ...

I am in the camp that at some point (likely in the next decade) a hyperinflation followed sometime later by a corrective deflation will ultimately occur. I guess you could say that is my 75% -> 80% scenario. My reasoning is based on a lot of what Casey presents in his writeup. However, I am concerned that we *could* enter directly into a deflationary scenario (contraction of the money supply). There are several things that could cause this to happen. One of them is derivatives. Hence, while Casey makes the case for hyperinflation by using the astounding amount of outstanding derivatives as an example/contributing factor, he could have it backwards here. The astounding amount of outstanding derivatives could very well be the recipe for a massive deflation and ultimately a large scale deflationary depression (as opposed to a hyperinflationary depression - such as Weimar and France in the 1700's).

I believe what Casey is driving at is the notion that the Central Banks will forestall a deflationary crisis by staying out ahead of the problems. This includes, but is not limited to, mounting US debt, mounting US trade deficits, the housing bubble where $2 trillion of adjustable mortgage debt is scheduled to reset this year, and the reliance on the consumer to go into more debt to support the economy (current savings rate is negative). But more liquidity has the potential to cause even more problems if the world continues to increasingly turn away from the US Dollar. We could easily have a stagflationary scenario. But what if the Federal Reserve and other key Central Banks are unable to stay out ahead of the problems, despite their intentions and best efforts to do so? What I am driving at here is the inability for the Central Banks of the World to handle a nearly $400 trillion derivatives monster that could cause a liquidity crisis in the blink of an eye. Monetary scientists are the most arrogant and egotistical humans on earth ... until they are faced with a crisis they have never seen and the monetary system experiences a meltdown. The derivatives monster is new and it is unclear if, when, and how a derivatives crisis might unfold. With the amount of leverage we are talking about and the potential rapid unwinding of the dominoes/dependencies, we could be in a liquidity crisis before the Central Bankers even respond. And even after responding, they may not be able to run the "printing presses" fast enough to provide the liquidity required to curb the contraction.

My other concern is that for some reason (I can think of a few possibilities) the US Central Bank and/or some others may want to initiate a massive credit contraction and therefore a deflation that could lead to a depression. It happened before (Great Depression) under very different circumstances. The Federal Reserve in the late 1920's had a goal in mind and they achieved it via a contraction of the money supply. The innocent bystanders were deemed simply as unfortunate "casualties of war". In this case, the war between the National and the Non-national banks.

Some other things to note in Casey's article ...

#1
Unemployment is only 4.4% using today's formulas (U-3) ... formulas that have changed several times since the Clinton administration with the goal of delivering better numbers. Less-than-a-year discouraged workers totaled 504,000 in 2004. These unemployed former workers have been purged from the formula. Adding these back in takes the unemployment rate up to about 12.5%. Demographic sampling has also changed and arguably produced deflated numbers.

#2
China does not hold $1 trillion in US Dollar reserves. They hold about $1 trillion total in foreign reserves. But the amount of US Dollar reserves held by China is unsettling. Especially when you consider that the Chinese are making progress developing their economic base and infrastructure. As time passes, they will need the US consumer less and less. And they will hold the economic equivalent of a nuclear bomb.

#3
Casey briefly addresses the current stock market as at an all-time high and uses it as an example why folks would be incredulous to the idea that a crisis could be looming. But I know Casey does not believe that the markets are truly doing well as I have read some of his past material. What is often left unsaid is how the stock market is doing in real terms (purchasing power), instead of in terms of the US Dollar (which has been declining at an annual double digit clip). In other words, the US Dollar is a very poor measuring stick these days. This is something that is lost on so many people. The Wall Street media continually touts the stock market making new index highs. But what is really happening in terms of its value (purchasing power)? It has been a decidedly negative story, both in the last decade and since the commencement of the last "bull" run when the stock market bottomed (2002). With the money supply increasing at an annual rate of 11% and price inflation running at over a 10% clip, the US Dollar is declining at a nice clip. If the stock market gains 10 -> 11%, you are merely treading water. Unless you had to pay taxes on those phantom gains (gains only due to inflation). In which case you need a considerably higher return than 10 -> 11% just to break even in terms of the value of your savings/investments.

Brian

 

[gonegolfin]

Actually, I see that it was Bud Conrad that wrote the piece, along with some others from Casey research.

 

[BaronVonBigmeat]

One thing I don't quite follow: I hear Casey and others talking about China sitting on a mountain of dollars, and how if they sell them it would cause a "stampede for the exits" amongst other central banks (Japan, Taiwan, etc) that hold dollars, thus hyperinflation.

I assume they are talking figuratively (in the same way that we say "the fed is printing money" to simplify what they do, even though it does not involve a literal printing press). China holds treasury bills, not literal dollars, which pay a fixed amount at a fixed date, yes?

Okay so if that's true, I hear people on other boards saying that it doesn't matter if China floods the market with treasuries. Their logic (I think) is that treasuries aren't dollars, and China's hypothetical dumping would not change the payout amount, or the due date, so why worry?

The answer to this--if I understand correctly--is something like this:

A) A glut of treasuries pushes the current selling price down. So now if the government wants to continue borrowing, any new treasuries it sells must offer exhorbitant interest rates to attract new buyers, and high interest rates strangle the economy (?)

B) Without much higher interest rates, the government would not be able to sell it's debt and finance it's deficits; and thus would have to stop borrowing and running deficits--by slashing spending, or raising taxes. Not likely, since this would be up to congress, and neither is politically popular.

C) The Fed could buy treasuries with freshly printed dollars, basically a stealthy quasi-default. Welcome to Weimar Germany.

Am I even understanding this correctly? I don't recall any smoking gun type evidence or quotes from Bernake that the Fed would purchase treasuries in such a scenario. So they're basically assuming that the Fed will buy treasuries, given it's history and priorities...but such an action is not written in stone, it's just assumed because of the factors that Mr. Casey lists.

?

 

[gonegolfin]

One thing I don't quite follow: I hear Casey and others talking about China sitting on a mountain of dollars, and how if they sell them it would cause a "stampede for the exits" amongst other central banks (Japan, Taiwan, etc) that hold dollars, thus hyperinflation.

I assume they are talking figuratively (in the same way that we say "the fed is printing money" to simplify what they do, even though it does not involve a literal printing press). China holds treasury bills, not literal dollars, which pay a fixed amount at a fixed date, yes?

Correct. Although, I think other large savvy investment houses would smell it coming and would begin to diversify out of dollar based investments before some of those Central Banks realized what was happening.

Okay so if that's true, I hear people on other boards saying that it doesn't matter if China floods the market with treasuries. Their logic (I think) is that treasuries aren't dollars, and China's hypothetical dumping would not change the payout amount, or the due date, so why worry?

To say that I do not agree with this is an understatement.

The answer to this--if I understand correctly--is something like this:

A) A glut of treasuries pushes the current selling price down. So now if the government wants to continue borrowing, any new treasuries it sells must offer exhorbitant interest rates to attract new buyers, and high interest rates strangle the economy (?)

They have a couple of options here of which I am aware, assuming they do not get spending in line and raise the requisite treasury revenues. One is exactly what you describe above. That is, more supply to the debt markets resulting in lower prices and higher yields. The second is monetization of the debt. This involves the Fed creating more dollars out of thin air to purchase this debt. Of course this debases the currency further (increased money supply) and will eventually result in more price inflation. Once investors realize what is happening, they will demand more interest for their debt investments.

This monetization of debt is something I believe the Fed has utilized recently to hold long term interest rates in check (and even lower them resulting in an inverted yield curve). The general thinking of late is that with $2 trillion worth of adjustable mortgage debt set to reset in the next year, long term rates must be held low for a period of time such that a certain portion of these debtors can qualify to refinance to a fixed mortgage. Else, the housing market really gets hammered as does the economy. But even worse, a significant portion of the derivative based mortgage backed securities in existence would default. Fannie Mae and Freddie Mac would make Enron and Worldcom look like dropped change on the sidewalk. Many banks and pension funds, of which a significant portion of their investments are held in mortgage backed securities and other credit derivatives, would have their portfolios collapse. I am sure you know who steps in to bail out these organizations ... resulting in even more debasement of the Dollar. And as I discussed in the previous posting, a massive deflation could seemingly ensue if enough of these credit derivatives are called in during a rush for the exits (a type of domino effect). If the Fed and other Central Banks could not stay out in front of this, liquidity would dry up and we would enter a serious deflationary depression.

B) Without much higher interest rates, the government would not be able to sell it's debt and finance it's deficits; and thus would have to stop borrowing and running deficits--by slashing spending, or raising taxes. Not likely, since this would be up to congress, and neither is politically popular.

Yes ... or monetize its own debt, which eventually results in higher interest rates. Just not immediately.

C) The Fed could buy treasuries with freshly printed dollars, basically a stealthy quasi-default. Welcome to Weimar Germany.

OK, you got it. The monetization of debt I am describing is your C) above. And as I said, it is being done today. And we are experiencing double digit inflation (I expect it to get much worse) ... and have been for several years.

Of course, what happens if this course of action continues over a long enough period of time. Interest rates rise (investors demanding more interest for their devalued dollar debt investments). This could begin a negative chain of events in the credit derivatives market (which constitutes a large portion of the $400 trillion figure I alluded to in the previous post). The government (or its front men - the major investment banks and brokerages) would also need to get out of those long credit derivative positions they are in, further exacerbating the situation. Which again, could lead strangely enough to a liquidity crisis. Hence, we could have hyperinflation followed by deflation (Weimar) or mild inflation followed by deflation (more like the Great Depression). I still think the hyperinflation -> deflation scenario is most likely. But I am hedged for the deflation scenario as well.

Am I even understanding this correctly? I don't recall any smoking gun type evidence or quotes from Bernake that the Fed would purchase treasuries in such a scenario. So they're basically assuming that the Fed will buy treasuries, given it's history and priorities...but such an action is not written in stone, it's just assumed because of the factors that Mr. Casey lists.

I have seen comments from both Greenspan and Bernanke that allude to such an implementation. Also, similar comments from heads of foreign central banks. I guess you could say it is part of the multi-faceted plunge protection team (PPT). Every once in a while, this stuff leaks into the press.

It does help explain why our M3 money supply has been expanding despite the continued increase in short term interest rates.

Brian

 

[gonegolfin]

This monetization of debt is something I believe the Fed has utilized recently to hold long term interest rates in check (and even lower them resulting in an inverted yield curve). The general thinking of late is that with $2 trillion worth of adjustable mortgage debt set to reset in the next year, long term rates must be held low for a period of time such that a certain portion of these debtors can qualify to refinance to a fixed mortgage. Else, the housing market really gets hammered as does the economy. But even worse, a significant portion of the derivative based mortgage backed securities in existence would default. Fannie Mae and Freddie Mac would make Enron and Worldcom look like dropped change on the sidewalk. Many banks and pension funds, of which a significant portion of their investments are held in mortgage backed securities and other credit derivatives, would have their portfolios collapse. I am sure you know who steps in to bail out these organizations ... resulting in even more debasement of the Dollar. And as I discussed in the previous posting, a massive deflation could seemingly ensue if enough of these credit derivatives are called in during a rush for the exits (a type of domino effect). If the Fed and other Central Banks could not stay out in front of this, liquidity would dry up and we would enter a serious deflationary depression.

And look what made the news today ... surprise, surprise. Not just HSBC, but the smaller outfits are having problems.

http://www.businessweek.com/ap/financialnews/D8N5NNDG1.htm

This is one of the things that happens when you allow bankers complete autonomy of the monetary system. You get an unprecedented credit bubble due to insane lending practices. Which then drives an insane housing market. The bubble has just started to pop. How will the Federal Reserve choose to address the problem ... ?

Door #1 - Continue to inject liquidity into the system, increasing the money supply at an even greater rate and driving down long term rates via debt monetization? (Significantly more inflation)

Door #2 - Do nothing and allow deflationary forces to build and risk plunging the economy into a serious recession/depression?

... or as I alluded to ... the Fed might not be able to get out in front of the credit derivatives problem ($400 trillion) and we suffer a serious deflation.

Door #1 is usually the one that is chosen and is the most politically expedient. In that case, I do not want to be holding Dollar denominated assets.

Brian

 

[Delbert]

Thanks for the great insight guys. You wont hear that kind of
stuff on the CBS evening news.
Newbie here, but been reading here for a couple months.
I dont know much about economics, but have been trying
to learn. The one thing that has always bothered me was the
over spending of the federal govt. Ive always felt it would be a big
problem, and possibly our downfall.
My question for you guys is this...... how would one best protect
ones family if any of those situations arose. For instance,
If someone believes hyper-inflation will hit, what things should he/she do or
invest in. Same question for recession/depression or deflation.
Is silver/gold the answer? Is personal debt good or bad in those situations?
Thanks again for the info
Bertman

 

[gonegolfin]

Thanks for the great insight guys. You wont hear that kind of
stuff on the CBS evening news.

You are certainly right about that. You can throw Bubblevision (CNBC) in there as well. Bloomberg on the radio has better coverage (not nearly as biased), but still has its fair share of permabulls. But you will not hear the above posts/talk on Bloomberg either.

Newbie here, but been reading here for a couple months.
I dont know much about economics, but have been trying
to learn.

If you are going to start, Von Mises is the way to go (IMHO). Human Action and the Theory of Money and Credit are works of genius. If you want to learn about money, monetary policy, the Federal Reserve, and very interesting world history as it applies to the financial elite and banking systems, I highly recommend G. Edward Griffin's - The Creature from Jekyll Island.

The one thing that has always bothered me was the
over spending of the federal govt. Ive always felt it would be a big
problem, and possibly our downfall.

Indeed. Debtor nations have not fared well in the annals of history. But one problem that we have is the absurdity of our monetary system. Our currency is simply liabilities of the banks. Every checkbook dollar and every physical dollar in your wallet/purse is someone else's liability. If all public and private debts were extinguished, there would be absolutely no money in circulation. Chew on that for a moment.

You are correct in that the accumulated deficit as well as current account deficit (mostly the trade deficit) is in scary territory. Where is the ledge? Nobody knows for sure. But historically, countries have gotten into serious trouble when their trade deficits approached 5% of GDP. I think since then, monetary science and financial instruments have obviously gotten immensely more sophisticated (look at the derivatives bubble as an example - especially credit default swaps). Monetary scientists find new ways to squeeze liquidity into the system and keep the status quo going before a meltdown. So, maybe we have a little more room to go. But I am not taking the chance.

My question for you guys is this...... how would one best protect
ones family if any of those situations arose. For instance,
If someone believes hyper-inflation will hit, what things should he/she do or
invest in. Same question for recession/depression or deflation.
Is silver/gold the answer? Is personal debt good or bad in those situations?
Thanks again for the info
Bertman

I will give you my opinion, I am sure Baron has some good ideas as well ...

This is something I have been thinking about for several years now. I have implemented a plan and continue to invest towards that plan. Protection of your family is the primary goal.

Let's talk about inflation ... inflation is good for debtors and bad for creditors. This is why most governments have perpetual inflation. This is probably the way our government will try to get us out of the unfunded liability mess we have with SS and Medicare. Folks that have personal debt will see the value of their debt diminish as they can repay in depreciating dollars. Silver and Gold are an excellent choice to hold during inflation. But be careful not to buy paper Gold and Silver. Buy the physical metals. I do not trust the ETFs, save maybe the Silver ETF (the jury is still out on it). I am wary that these are used as manipulation vehicles by the banks (and real silver or gold is not standing behind the funds, just paper promises). In much the same way as the futures market is used to manipulate the price of gold and silver (and other commodities) by the big banks and Fed. If you buy the physical, they cannot whipsaw you out of your positions. I am a fan of Goldmoney.com and Bullionvault.com. Here you can purchase and store physical gold and silver (just Gold w/BullionVault) offshore. Audits are performed and available to ensure that the physical metal is in the safe. I think energy is also a good play here and obviously precious metals mining companies (I keep a nice portfolio of these stocks). I also keep some money in base metals through an ETF. I keep nothing in your traditional equities (Dow, S&P 500, Nasdaq 1000), save stock options and stock from my employer. Again, the above is true except for energy and mining companies. For example, I think Chevron is a decent play in this environment.

Now, hyperinflation always ends. And it ends badly. It ends in deflation. This results in what is called a hyperinflationary depression (Weimar, France 18th Century, Argentina '90). At this point, the fiat currency begins to strengthen. But by then a new one is usually issued anyway. The point being is that you would want to begin reducing your positions in precious metals and other commodities once deflation kicks in. Always keep core positions in these metals (their value or purchasing power remain relatively constant, just their value in terms of the fiat currency changes). But you would begin to move into some cash positions.

Deflation will result after a hyperinflation, but you do not need a hyperinflation to transition into deflation. Deflation is simply the contraction of the money supply. This happened in the Great Depression when the Fed contracted money and credit to kill off the non-national banks. The result was a deflationary depression.

People holding debt get killed in a deflation (whether that deflation was intended and put into play by the government or if it happens despite the government's intentions). The currency strengthens in a deflation and thus makes repaying debt onerous. A serious deflation would cripple the economy. All asset prices would be hit. Gold and Silver would likely drop in nominal value, but I think they would either stay flat or rise somewhat in purchasing value. They would still be considered a safe haven and a certain amount of money would seek cover here. But I would be keeping much more cash here. But be careful exactly where you keep it. I would not play the commercial money market (commercial paper, short term corporate credit obligations, swaps, and some short term treasuries) via money market funds (this comprises most money market funds). I would take a little less yield and invest solely in short term US Treasuries (currently about 4.75%). There are money market funds that invest solely in these securities. FDIC insurance is a scam in that the fund could not withstand more than a single big bank bailout. All it means is that the government would refund your holdings with newly created dollars (inflationary) that are worth less. FDIC for banks is a prime example of moral hazard if there ever was one.

As you probably saw in the previous posts, I am in the camp that we will see a hyperinflationary event, followed at some point by deflation (hyperinflationary depression). But I think that some of this is outside the control and influence of the Central Banks and do think there is a chance that we could wake up one day with bank failures and a deflationary event. Which is why I keep about 25% of my portfolio in cash type instruments (mostly short term US Treasuries). Knowing full well that if what happens is what I think happens (hyperinflation, or at least a healthy inflation), I can essentially kiss that cash goodbye as it would be worthless. But I would be secure with the other part of my portfolio.

Does that answer your question(s)?

I will close with one of my favorite quotes from Thomas Jefferson ...

"If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered."

Brian

 

[BaronVonBigmeat]

Actually I am an investing newbie. I have been reading mises.org since about 2003, and it was only like "oh...well, that's interesting, I guess". What really got my attention was when I got a job with a 401k for the first time. Yeah, put in X% and you'll have Y% when you're 70 years old. Yawn. Then in 2005 or whenever gold spiked upwards, I looked at my quarterly statement and saw that one of my funds had jumped up something like 30 percent.

Yeah, that got my attention.

I looked up the list of companies in that fund, and it seems that a lot of them are natural resources, mining and oil. So then I started getting interested in why, and will this trend keep going.

I lived with a relative during most of 2003~2004 to save up money for a 20% downpayment on a house close to work. I just stuck the money in a savings account. After moving in early 2005, I realized that I could have bought gold and just about doubled my money (and outperformed the stock market by a comfortable margin). Yeah, that realization was pretty stomach churning. If I'd bought a number of Casey's recomendations (or Rhodium, heh), I could very well have enough money to pay my house off, and then some. Doh! Well, now I can start investing at least. Oh wait, no I can't. I'm spending all my money on this @#$% house.

Anyway...GG, could you explain how the deflation part works? That's one thing I've never really understood. I understand more or less how money is created, and how bubbles happen. But I don't understand the part where they talk about the deflationary action after the bubble. How does money just disappear, (unless the fed sells it's debt holdings, soaking up dollars)? I hear the austrians talk about banks "calling in their loans"--err, what? Aren't loans for fixed terms? My reading comprehension may not be so good.

Furthermore, in your inflation/deflation scenario...a lot of your success would depend on timing. Switch back to dollars too soon or too late and you lose out. What signals would you look for? Reading a lot of the so-called gold-bugs' columns, and they reveal that they are only gold advocates for the moment, and will not be at some point. But they're generally vague in this regard. As Casey says, "But getting back to the question of how you’ll know when the top has come… One sure indicator is that you’ll hear people discussing gold and mining stocks at cocktail parties and around the water cooler. You’ll hear the Money Honeys yapping about it. Most important, you’ll have friends who know you were early to the sector and hence knowledgeable start asking you what stocks to buy. Finally, a major magazine, such as Slime or Newspeak, will run a cover story showing a golden bear tearing apart the New York Stock Exchange.

At the point you should hit the bid, indiscriminately, of every share you own. What should you do with your profits, which should be staggering? I don’t have a clue at the moment. But rest assured there will be some market, somewhere, that will look like the resource stocks did in 2000. But unlike most people, you’ll have the liquid capital to take advantage of it."

Anything more specific?


edit: In terms of holding plain old gold, not companies, I think I would be inclined to do as GG said and put money into a reputable online gold account--if for no other reason than convenience and safety. No risk of having your gold stolen, and you can sell without driving to a coin dealer.

However, if I were to buy and take possession of actual gold coins...I think I'd be tempted to buy some antique coins from amergold. For example:

http://www.amergold.com/vault/20FrancGoldAngels.php
http://www.amergold.com/vault/Dutch_Gold_10_Guilders.shtml
http://www.amergold.com/vault/britishgoldsovereignkings.php

If you buy a new american eagle or buffalo, the price right now (2/11/2007) is $704.95 for 1 oz. These historic coins are as low as $752.76 per oz. That's not even a 7% premium. I saw a chart somewhere showing the price difference for numismatic (antique) coins vs. new coins, and for now, it's very low. At other times, the price spread is quite high. So in other words, you'd have the upside of gold, combined with the potential upside of the numismatic market.

Plus, they have the advantage of being smaller weights. .18 oz, .24 oz. etc. instead of 1 oz. It's like the difference between carrying a $100 bill and a $500 bill. If you're in the market for smaller new coins, keep in mind that you'd pay more per oz. than the $704.95. For example, a new 1/4 oz. eagle is $190.44, or...$761.76 per oz. That's more than an antique British sovereign.

Just make sure you don't keep them in a safety deposit box in a bank. Remember that bank vaults can be sealed by regulators during emergencies--gold has been seized before and in a big panic, it probably will be again. You need a scapegoat in a depression, and gold "speculators" would certainly fit the bill.

 

[gonegolfin]

Anyway...GG, could you explain how the deflation part works? That's one thing I've never really understood. I understand more or less how money is created, and how bubbles happen.

For the benefit of others, it is important to understand that new money can only be created by borrowing it into existence (in our current fiat currency scheme). There are several ways that money can be created (increasing the money supply - inflationary) and extinguished (decreasing the money supply - deflationary).

1. Adjusting reserve ratios (bank reserves are alarmingly low today - less than 1% of funds on deposit)
2. Use of the Discount Window (and setting the Discount rate)
3. Fed participation in the Open Market (purchase and sale of debt securities)
4. Use of the "Acceptance Window" (purchase and sale of Banker's Acceptances)

#3 (Fed participation in the Open Market) is the most common method used to manipulate the money supply. Note that the Monetary Control Act of 1980 now gives the Fed the power to monetize virtually any debt instrument, including foreign bonds.

In the past, the Fed has used Banker's acceptances (#4) to increase the money supply when banks and/or individuals were unwilling to borrow. It does this by pledging to buy all of the BA's that were offered at a below market discount rate. Easy profit for the banks and a Fed desired increase in the money supply.

But I don't understand the part where they talk about the deflationary action after the bubble. How does money just disappear, (unless the fed sells it's debt holdings, soaking up dollars)? I hear the austrians talk about banks "calling in their loans"--err, what? Aren't loans for fixed terms? My reading comprehension may not be so good.

Since money is borrowed into existence (inflationary), there must be a similar opposite action that causes money to be extinguished (deflationary). This happens, for example, when bonds or any other debt instrument held by the Fed as "reserves" matures. Upon maturity, the principal payment flows back to the Fed where it is extinguished (money supply is reduced). Although, in this case of government debt, the debt is typically rolled over into new debt. Keep in mind that this is an example of the Fed monetizing debt. Borrowing from foreigners is a bit different as a foreign entity holds the debt instrument.

It is interesting to note that our purchase of bonds from other governments (referred to above) also increases the money supply. When that debt matures (or is sold by the Fed), the principal flows back to the Fed and is extinguished. Thus, our money supply is also based on the debt of foreigners.

And yes, as you point out, the Fed selling its debt holdings (soaking up dollars) results in a contraction of the money supply as money is again being extinguished. This is the Fed participation in the Open Market I refer to in #3 above.

Consumers paying off loans extinguishes money.

During a liquidity crisis, which is deflationary, (such as the potential derivatives debacle to which I referred earlier in this thread) , investors are attempting to close their positions (some of them highly leveraged via derivatives). In doing so, there is a scramble for available cash. In many cases you will have defaults (deflationary). The banks calling in their loans is no different. The banks realize that their loans are at serious risk of default (borrowers attempting to repay debt with appreciating dollars - i.e. dollars that are now harder to earn and come by). As such, callable loans (not all loans are callable - think of more than just mortgage loans) would be "called in" by the lenders in an attempt to secure cash, likely for the purposes of settling other positions. This is highly deflationary since money is being extinguished. It becomes a nasty spiral as it is a complex tangled web of dependency.

Furthermore, in your inflation/deflation scenario...a lot of your success would depend on timing. Switch back to dollars too soon or too late and you lose out.

Some of your success would depend on timing. But you are not trying to pinpoint the top of the market (or bottom). You are trying mostly to preserve what you have. You can do this without accurate timing. I would err on the side of keeping your precious metals until you know deflation (whatever the degree) has now kicked in. Precious metals will still hold their value in a deflation (may even increase in value), even though they would likely decline in terms of nominal currency. Even after deflation has kicked in, you still want to keep core positions for the next bout of inflation the government will attempt in order to extricate ourselves from the deflationary/recessionary mess. Meanwhile, you can deploy some of your capital into areas of the financial markets where the excesses have been corrected (strong companies with healthy balance sheets that have been beaten down during the bout of deflation/recession). I am a firm believer in always keeping "real money" regardless of the investing and monetary policy climate. However, the allocated portion of my portfolio for real money will change according to this climate.

Now, if you are referring to a hyperinflationary collapse, it is even more important to stay in precious metals until it is obvious that deflation has set in. At some point (hyperinflation reaches a certain level), the currency in question fails to be transactable. That is, the real purchasing power of the currency has dropped to the point where nobody is willing to exchange goods and services for the currency. It is at this point where economic demand drops off the cliff because there is no purchasing power. You then have a seemingly endless cycle of falling demand and wages which then leads to a depression. Since the currency is no longer functional (transactable), a new currency is ushered in. This new currency is then exchanged for old currency at a rate that essentially unwinds (deflationary) all of the previous excesses (inflationary). This is the point where you trade in some of your precious metals for "cash" and begin looking for investment opportunities (as stated in the previous paragraph). Maybe real estate would look good again after the corrections.

What signals would you look for? Reading a lot of the so-called gold-bugs' columns, and they reveal that they are only gold advocates for the moment, and will not be at some point. But they're generally vague in this regard. As Casey says, "But getting back to the question of how you’ll know when the top has come… One sure indicator is that you’ll hear people discussing gold and mining stocks at cocktail parties and around the water cooler. You’ll hear the Money Honeys yapping about it. Most important, you’ll have friends who know you were early to the sector and hence knowledgeable start asking you what stocks to buy. Finally, a major magazine, such as Slime or Newspeak, will run a cover story showing a golden bear tearing apart the New York Stock Exchange.

I have seen this stated many times and I am not convinced this would ever be the case (or at least the primary indicator). I think that if Gold ever became that popular, it would be due to a monetary crisis. As such, there would be many more indicators/signals than simply the above. You would see the currency in a free fall. I think we would need to be in or near a hyperinflationary state to have Gold attain such popularity. I think that M3 would be exploding.

At the point you should hit the bid, indiscriminately, of every share you own. What should you do with your profits, which should be staggering? I don’t have a clue at the moment. But rest assured there will be some market, somewhere, that will look like the resource stocks did in 2000. But unlike most people, you’ll have the liquid capital to take advantage of it."

Anything more specific?

If referring to gold bullion, you would have profits in the sense of the underlying currency. But your purchasing power would remain the same as before. Except for the additional purchasing power that was attained because you initially purchased that Gold cheaper than you should have due to the massive Central Bank dumping and artificial price suppression over the years.

But yes, after the smoke has cleared (in the case of a hyperinflation - after the ushering in of the new currency), there will certainly be investment opportunities. Opportunities to deploy some of that Gold/Silver you had amassed in exchange for real estate, healthy corporations, good credit quality debt investments, etc..

edit: In terms of holding plain old gold, not companies, I think I would be inclined to do as GG said and put money into a reputable online gold account--if for no other reason than convenience and safety. No risk of having your gold stolen, and you can sell without driving to a coin dealer.

Yes, but not all of it. I do recommend holding some actual metal. Pre-1965 Silver coins are a good start. These once served as currency and are well recognized. These coins are 90% Silver.

As far as an online reputable account is concerned, make sure it is allocated storage. Audits should be available confirming the amount of gold in storage. And you should be paying a reasonable fee for that storage. If you are not, this is a serious red flag. Unallocated stored Gold is an asset of the bank (not the depositor) and you are simply a creditor should the bank fail. Additionally, unallocated gold can be loaned out (sold short) by the banks. Goldman Sachs and others do this to aid in the price suppression of precious metals.

However, if I were to buy and take possession of actual gold coins...I think I'd be tempted to buy some antique coins from amergold. For example:

http://www.amergold.com/vault/20FrancGoldAngels.php
http://www.amergold.com/vault/Dutch_Gold_10_Guilders.shtml
http://www.amergold.com/vault/britishgoldsovereignkings.php

A certain amount of these are good to have as they may provide some protection in the event of another gold confiscation by our government (this is an entirely different subject of discussion). However, these coins are in abundance and typically only fetch the spot price of Gold when you sell (many dealers also attempt to fetch exorbitant premiums for these coins (as much as 10% over spot)). So do not get ripped off. If you cannot purchase these coins for less than 3% over spot, it is not a good deal. It is only recently that these coins have been able to fetch just over spot when you go to sell (and this is restricted to the very best dealers). Dealers love to lead new customers with these coins because they get them so cheaply (less than spot). It should be noted that these coins would not be as good in a crisis since they are not well recognized in the states. For example, how many people know that these coins contain .1867 oz. of gold? Try telling that to someone in a barter arrangement. I will say that the coins are beautiful. But do not overpay and only make them a portion of your coin investment.

In my opinion, Gold Eagles/Buffalos and Silver Eagles are the way to go. Yes, they sell for a premium over spot. But you can also unload them for more than spot as well.

If you buy a new american eagle or buffalo, the price right now (2/11/2007) is $704.95 for 1 oz. These historic coins are as low as $752.76 per oz. That's not even a 7% premium. I saw a chart somewhere showing the price difference for numismatic (antique) coins vs. new coins, and for now, it's very low. At other times, the price spread is quite high. So in other words, you'd have the upside of gold, combined with the potential upside of the numismatic market.

I have been a Gold and Silver investor for a little while now. There is absolutely no numismatic value in the old European Gold coins that you mention.

I would take a look at apmex.com. The prices you list (2/11) are quite high. Spot Gold closed Friday (NYMEX) at $668.20. You can buy a single Gold Eagle for $689.20. 20 or more go for $686.20. The European coins go for $127.07 to 129.57 per coin ($680.61 to $694/oz.) depending on order size and particular coin. $752.76/oz. for the European coins is nothing short of highway robbery. You can typically buy the European coins for less than the Gold Eagles if you shop well. You also fetch less for them than the Gold Eagles.

Plus, they have the advantage of being smaller weights. .18 oz, .24 oz. etc. instead of 1 oz.

The non-standard weights and the fact that they do not stamp the weight of gold on the coin is actually a disadvantage.

Just make sure you don't keep them in a safety deposit box in a bank. Remember that bank vaults can be sealed by regulators during emergencies--gold has been seized before and in a big panic, it probably will be again. You need a scapegoat in a depression, and gold "speculators" would certainly fit the bill.

Indeed.

Brian

 

[Delbert]

thanks gg for your explanations, and taking the time! bvbm also.

I have been investing in pm's for a couple years also.
I go for the 90% silver, SAE's and GAE's.
I hold physical only. I protect it myself. hehehe!

-----------------------------------------------

Monetary scientists find new ways to squeeze liquidity into the system and keep the status quo going before a meltdown. So, maybe we have a little more room to go. But I am not taking the chance.


Lets say your hyper-inflation/then deflation takes place, how do you see the
timing of such an event? I know this is just speculation, but when do you
see it happening, how long will it take to play out?

------------------------------------------------

Yo gg, can you also comment on the real estate market.
Do you think prices will continue down for a while?
Will forclosures continue to increase?
What do you think is on the horizon?

thanks again

 

[gonegolfin]

thanks gg for your explanations, and taking the time! bvbm also.

I have been investing in pm's for a couple years also.
I go for the 90% silver, SAE's and GAE's.
I hold physical only. I protect it myself. hehehe!

Yes, I invest in Glock as well ... several of them.

Lets say your hyper-inflation/then deflation takes place, how do you see the
timing of such an event? I know this is just speculation, but when do you
see it happening, how long will it take to play out?

It is too difficult to predict. Especially considering how sophisticated monetary science and the financial markets have become. Not sophisticated in the sense that fiscal problems that have harmed countries in the past have ceased to be a problem in the present. But sophisticated in the sense that monetary engineers are devising new techniques to hide problems and delay the day of reckoning. Which increases the pain when this mess finally does unwind. But I would be surprised if we do not see a significant problem with the Dollar in the next decade. Even the next couple of years is a possibility. The precious metals will tell you, despite the manipulation. But keep an eye on M3 as well. M3 is increasing at a very unhealthy rate of 11%. Other major currencies have similar money supply growth problems, save the Swiss Franc. But we are not quite at an all-time high yet ... but getting there. We have been increasing the money supply at a brisk clip for some time.

Yo gg, can you also comment on the real estate market.
Do you think prices will continue down for a while?
Will forclosures continue to increase?
What do you think is on the horizon?

thanks again

The current Real Estate market is a product of irresponsible mortgage lending and insane lending policies instigated by massive liquidity. Prices have been driven into the stratosphere because there is a lot of artificial demand in the market (and still is). People that either have no business owning a home or no business purchasing the amount of home they have purchased have created this artificial demand. First, I blame the Federal Reserve and general fiscal policy in this country. They knew that the only thing that would save this country from a heavy recession was continued massive liquidity injection. So they delayed the day of reckoning and it created an asset bubble in housing (from the stock market to real estate). So, instead of an economy with -5% GDP, we have an economy with -1.5% GDP (The numbers issued by the government are a fraud). Meanwhile, inflation is running at an 11% clip and price inflation is just north of 10%.

Second, I blame a bunch of plain dumb consumers. Basic knowledge concerning finances and money seems to be at an all-time low. In other cases it is simply the lack of fiscal discipline. And in some cases, all of the above. What happened to the days when you wanted to buy something, you had to have the money to make the purchase? Third, I blame the banking (always at the epicenter of fiscal problems) and lending industry. Many (not all) mortgage lenders and brokers should be ashamed of themselves. Many of them do not have a clue about the credit markets and monetary policy. Meanwhile, some of them resemble slick car salesman in luring people into not only bad loans, but into loans that are over the heads of consumers. A common line I have heard from lenders during this bubble is ... "Go ahead and borrow more. I can qualify you for more than that." This is another example of luring the ducks out of the pond with the feed corn, where they then become duck dinner.

It is not surprising that we are seeing many failures of these outfits. I believe 21 mortgage lenders have failed in the last month. All due to them getting in over their heads with subprime mortgages. HSBC provided a jolt to the financial markets this week when they announced that they will post larger than anticipated losses in its mortgage lending unit due to subprimes. I do not think they will be the only big bank with a similar story before this is done. Subprimes are just the beginning. The foreclosures will proceed up the food chain as more pressure is placed on housing prices nationally and consumers go into more debt to pay higher mortgages that have adjusted.

Yes, I think housing prices will continue to decline. How much depends on how long and how far the Federal Reserve can/will manipulate long term interest rates down by creating money out of thin air (inflation) and buying their own debt on the long end of the yield curve. Of course, our Dollar will continue to fall while this takes place. $2 trillion of adjustable mortgage debt was scheduled to reset over the next 18 months beginning in the middle of '06. At least half of that will adjust upwards in '07. This will put more pressure on prices as the foreclosures will increase. Despite what the Wall Street cheerleaders tout on CNBC, this market has not bottomed. Remember, these were the same people that said a year ago that there was no housing decline on the horizon.

A couple of interesting stats to leave with you ... #1 For sale inventory is 25% higher than it was at this time in '06. Do you think the supply of buyers is even the same as it was this time last year? This does not even include homes that were listed, but were taken off of the market because they did not sell. #2 The number of vacant homes (some of them listed for sale, some taken off of the market) are nearly 50% higher than at any time in our history.

Brian

 

[Delbert]

Thanks for your thoughts.

 

[BaronVonBigmeat]

More from Doug Casey...
==================================================

U.S. Housing and Interest Rates—Proverbial Rock and Hard Place

As in 1970, 1974, 1980, 1987 and 2000, the economy is at a turning point. But this time there is no good direction for it to go. The gentlest we can expect is a monetary crisis as bad as any in living memory.

This approaching crisis has fueled our gains in resource stocks over the last few years. But make no mistake, this show is just getting started, and the best profits are yet to come. (See “How High Will Your Gold Shares Go?” in the December 2005 issue of this newsletter for a picture of what happens when junior resource stocks really take off. For more analysis of the coming currency crisis, see “The Coming Currency Crisis” in the June 2006 issue, “Can the Fed Save the U.S. Economy?” in the October 2006 issue and most recently “The Users Guide to Fiscal Calamity” in the December 2006 issue.)

It will begin slowly, just a little trouble in the markets. Then, when foreign holders of U.S. dollars—including the central banks now using the greenback as their main reserve asset—start sending their Federal Reserve notes back by the plane load, the crisis will smash into the global economy like a tsunami.

In fact, the warning signs are here, with officials from nation after nation signaling their intent to diversify central bank reserves into other assets.

Diversification won’t just mean buying, say, euros, or moving away from the dollar in favor of a basket of currencies. It will also mean trading dollars for tangible assets. China, for example, recently announced plans to build a 150-million-barrel oil reserve. At $50 per barrel, that lets them unload $7.5 billion. A drop in the bucket, perhaps, but a sign of what’s building. Chinese and other monetary agencies may accumulate other tangibles. But every central banker’s easy and obvious two-asset solution will be to buy gold and silver. And when that buying begins in earnest, gold and silver prices will do a moon shot.

Ordinarily a country threatened with currency collapse would lean toward tight money, perhaps contracting its domestic money supply. That would push interest rates upward and compensate foreigners for holding on to the currency despite the depreciation risk. And it would soften that risk.

But this time things aren’t ordinary… there is a difference that turns what might otherwise be a disturbance into the makings of disaster: the U.S. economy’s inability to endure high interest rates. As we’ll discuss here, because of the grossly distorted U.S. housing market, raising interest rates to protect the dollar would prove as calamitous as not raising interest rates.

That’s why the coming crisis is so predictable: there’s no way to avoid it.

Home Is Where the Debt Is…

Because it is so sensitive to interest rates, housing provides the starkest picture of the economy’s predicament. This has been especially so in recent years, during which consumer spending, driven in large part by housing-related activity, has been a major driver of GDP growth.



As you can see in Chart A, housing prices rose steeply during the 1970s, on the back of rising inflation rates. After a slowdown in the early 1980s, as inflation began to moderate, the steep climb was revived and extended by a series of tax law changes that eliminated many alternative sources of deductions but enhanced the tax advantages of homeownership. Then, in 1999, in anticipation of the Y2K crisis that never was, the Federal Reserve flooded the system with liquidity, which held interest rates down and kept housing’s steep rise going. And most recently, to soften the recession that began in 2001, the Fed pushed interest rates down to levels that made short-term credit essentially free for prime borrowers.

At each turn, the easy availability of cheap credit led people who would not otherwise have been able to afford a house to buy one. And easy credit plus enhanced tax incentives brought a wave of “trading up,” with people taking on the bigger mortgages that low interest rates seemed to make affordable. The same forces fed a robust new market in second homes, many bought as pure speculations with little or no money down. Real estate prices rose to new and bubble-like highs.

The housing bubble also fueled a blockbuster business in home equity loans. Homeowners drew down their equity to splurge on consumer goods, including shiploads of imports. Billions in net value was stripped out of U.S. houses and traded for plastic lawn furniture, ATVs and bass boats.

The relative attractiveness of U.S. financial instruments kept the game going into overtime. The foreigners who received all those U.S. dollars put them into U.S. Treasuries bills and other dollar-denominated instruments, thereby underwriting low interest rates for all U.S. borrowers.



The net result? Foreigners funded our housing boom, as you can see in Chart B. The amount of mortgage growth annually matches the amount of trade deficit, which foreigners dutifully invested back into the U.S. Artificially low rates, increasing tax advantages and, most recently, enabling by foreign investors have kept the borrowing and spending going for better than a quarter century. It has made people feel more prosperous than they really are—much as someone might feel after pumping up their standard of living by borrowing a million dollars with thoughtless confidence that low rates, a rising income and future investment profits would carry the debt. But when rates rise, income stalls and asset prices fall, repaying such debt is going to mean a very real drop in standards of living.

Debt is now at unprecedented levels… and closing in on the point at which available income can barely service it. The message is clear in Chart C: low interest rates encouraged U.S. households to take on rising levels of debt.



Chart D shows indebtedness, which supported the recent housing bubble, increasing in comparison to income and GDP.



In recent years homeowners have been able to pay their mortgages only because of very low interest rates and the unsustainable “good times” those low rates engendered. Any significant increase in rates will turn many U.S. homeowners into distress sellers. Such distress selling would clobber housing prices and push legions of adjustable-rate borrowers into bankruptcy—and take some of their lenders with them.

 

[BaronVonBigmeat]

Equity, What Equity?

But hasn’t the appreciation in housing made people wealthier? Sadly, for many of them, no. Certainly not the people who borrowed against their homes and spent the money. And certainly not the people who bought a house (often with little or no down payment) in the last year or so and watched prices slip. Equity, as a percentage of value, is now at an all-time low, as shown in Chart E.



And people have also stopped saving. See Chart F. Higher prices for real estate (and also for stocks) made them feel richer. So why save, especially when interest rates are low? Borrowing is more fun—and a house is better than a savings account, right?



The chart shows a nation blithely squandering its rainy-day funds. Most Americans have little to fall back on except their house. Letting housing prices drop would devastate the average American’s most substantial remaining asset—which is why the government can’t afford to appear to stand by while housing prices drop.

A Glance at What’s Coming

Rates on adjustable rate mortgages have gone back up over the last two years along with the Fed funds rate. The effect has been a foretaste of the trouble to come if interest rates go much higher, as shown in Chart G.



The chart shows that as rates rose after 2004, fewer new ARMS have been issued. In other words, the ARM party is over, meaning fewer people buying houses. Less demand means more supply means lower prices.

But for a glimpse of how bad things could get should interest rates rise, look at the sub-prime market—lending to people who already have credit problems. These are borrowers who, absent loose lending policies, would be unable to buy a house. They also are borrowers who can hold on to a house only for as long as the economy keeps running smoothly and only so long as interest rates don’t rise. In recent years, however, “Bad Credit, No Problem!” has been the mantra of lenders who believed they had perfected a mortgage pricing model for lending to poor-credit borrowers. What they actually perfected was a way for lenders and their borrowers to get into trouble together.

Sub-prime lending is no mere sideshow. It’s big business. In 2005 it accounted for 25% of all new mortgages—about $600 billion of high-risk paper, most of it with adjustable interest rates. That big business is now a troubled business, with large and small participants closing their doors: According to MortgageImplode.com, over the past two months alone, 27 sub-prime lenders have either gone out of business or closed their doors to new loans. Freddie Mac announced that it will all but close down acceptance of sub-prime pools as of September 1. The destruction of lending in this segment is nothing short of a crash.

This sudden collapse raises the question of whether the illness will spread to other mortgage sectors. There are anecdotal stories of loan underwriters looking for excuses to turn down loans, and underwriters are using any small nuance as an excuse to claim violation of an agreement and send a loan back to the originator. The process has gone from gaming the system to push weak loans through, to the system gaming itself to keep them from getting through.

Most recently, both HSBC and New Century announced unexpected losses at their sub-prime lending units—more than $10 billion in “loan impairments” for HSBC alone. But the real danger is far broader than a couple of high-profile lenders. HSBC isn’t in jeopardy: for them, sub-prime lending is only a sideline. The real problem is that tens of billions of dollars of sub-prime mortgages have been securitized and sold off to banks and other financial institutions that rely on them to satisfy net worth requirements.

The big commercial homebuilders have experienced problems as well and have had to cut back. Centex said it will record land valuation adjustments of about $300 million because of the declining housing market. KB Home said that it will take an inventory impairment charge of $255 million and an $88 million charge from the abandonment of land option contracts. Lennar announced $500 million in losses from abandoned land options. Job losses from the construction sector are inevitable.

Meanwhile, mortgage delinquencies have risen to the highest level since 2001. In 2006, foreclosures almost doubled from the previous year. As interest rates rise, the inventory of unsold homes rises. A broad slowdown in housing has begun, as seen in Chart H, which will lead to more delinquencies.



A Vicious Cycle

A weak housing market hits the economy in two ways. First and obviously, builders and their entire supply chain (lumber mills, construction workers, etc.) and all the housing tag-alongs, such as furniture manufacturers and mortgage brokers, get hurt. But less obvious and even more important is the “wealth effect.” A slowing or reversal of home price appreciation for whatever reason would leave debt-ridden households poorer and force them to cut spending on consumer goods.

This second effect has never been tested as hard as it will be in this cycle. The only real estate boom that compares to the recent one was the Roaring ‘20s, just before the Great Depression.

The wealth effect of rising house prices kept homeowners borrowing, banks loaning, and spending growing. Chart I shows just how big the extraction of money in the form of loans against housing had become, and how it has fallen back. This guarantees slowing consumer spending.



Chart J shows that as permits for housing starts slow, the economy slows about 9 months later. The current slowing of permits indicates that we will see a slowing of the economy ahead.



Even if rates simply remain where they are, we can expect continued pressure on home pricing. But if interest rates were to be driven higher by a falling dollar and a corresponding need to provide incentives to foreigners to continue holding their unprecedented $6 trillion worth of U.S. dollar assets—then the downturn in housing prices would quickly accelerate… driving the economy into a recession.

Faced with historic levels of debt, falling housing prices, and weaker economy, the pressure on housing would gain momentum as desperate homeowners either hand their keys back to the banks, or simply hit the bid on the best (low) offer they can get.

A vicious cycle would set in, threatening to shove the economy into uncharted and unpredictable waters.

There are other reasons the government will do anything it can to avoid the trauma to the economy of rising interest rates.

For one thing, at the point that falling prices leave homeowners with mortgages exceeding the value of their homes, default rates will soar. This, in turn, will put lenders that hold large amounts of mortgage debt at risk, and possibly jeopardize the solvency of Fannie Mae and Freddie Mac, since they guarantee much of this debt. If these mortgage giants faced collapse—and they are already in well-documented trouble—a government bailout involving hundreds of billions of dollars would be a likely next step.

Chart K, of San Diego defaults shown as trust deeds, should scare anyone who imagines that we don’t yet have a problem:



Derivatives Thicken the Plot

And there is another overlay of risk unique to today’s markets: the massive growth in derivatives. Chart L doesn’t describe what all the derivatives are or how they are used to move risk around (that would take a whole book), but it does show the sheer size of these thoroughly modern instruments on the balance sheet of banks. When added to a similar amount not held by banks, you’ve got some truly frightening numbers. Given that the annual GDP of the U.S. economy is just $13 trillion, the $250 trillion in derivatives can only be seen as an accident waiting to happen. The less the boat is rocked, the better. And rising interest rates would definitely rock the boat.



It is, therefore, our expectation that the Fed will err on the side of trying to keep interest rates low, leading to inflation and higher prices for tangibles such as precious metals, but likely all commodities… even if that means accepting a weaker dollar. If interest rates were forced higher by inflation, we would expect to see both slowing and inflation.


The Hard Place

Of course, as discussed, lowering rates, or even leaving them where they are in the face of continued record trade deficits—2006’s $764 billion trade deficit shattered previous records—will, in time, slow foreign investment and destroy the dollar. The expected result is a government-supported inflationary cycle, like the 1970s, in which oil prices will rise and the dollar will lose its purchasing power.

Gold was a better investment than housing from 1970 to 1980. From 1980 to 2000, housing was the better investment. But since 2001, gold has again become a better investment than housing. The set of conditions now is a lot like the 1970s after the Vietnam War, a period when gold was king. This time, however, the economy is in much, much worse shape… from all perspectives.

Interest rates will, in time, rise… but not before the U.S. government is forced to it by the very real threat of a monetary crisis. At that point, however, it will be too late. The rock and the hard place will meet, with the average individual crushed in between.

The impending calamity—mass housing foreclosures, failing banks, Fannie Mae and Freddie Mac in ashes, millions of personal bankruptcies—is so dire… most people can’t even conceive of it. And indeed it may not hit us this year, or next, but the market always corrects itself, and this time will be no exception—sooner or later.

We have said before, and we repeat again: Rig for stormy weather.

 

[JeffWartman]

Note to BaronVonBigmeat: Don't try to appeal to redstatesrule or any partisans econmomic intelligence...the partisans dont have any...lol