What Can't Happen Economically?
Minyan NM Writes:
For almost 30 years, count them, for almost thirty years people like you have predicted that our economy will collapse and the end of the consumer. Throughout all of those years, it didn't happen. No matter how many logical arguments the "gloom and doom" crowd has made, it hasn't happened.
NM, I have only been on the deflation bandwagon for a few years, not 30. However, you are correct about one thing: Some notable people have indeed been calling for a collapse for nearly thirty years. However, does that mean an economic collapse can’t happen?
Chronology Of Things That Can't Happen
- One of the reasons the Fed was created was to manage the economy and prevent further depressions. Guess what? The biggest deflation in history, the Great Depression, happened 17 years later.
- At one time economists thought that inflation and recession could not happen at the same time. It happened anyway. A new term was coined for it: “Stagflation.”
Deflation supposedly couldn't happen in a fiat regime. Japan proved otherwise. - If you asked anyone in Japan if housing prices could fall for 18 straight years, they would have said "It can't happen." It did happen.
- For 30 years people have said US housing prices would never again decline on a national scale. They were wrong. It happened.
Because of the very nature of the market, it takes the convincing of nearly everyone to believe that something cannot happen to actually cause it to happen. Consider housing. Everyone became convinced that housing was a one way ticket north, that all housing was local, and housing would not decline nationally.
This mass belief in a faulty housing premise in spite of evidence to the contrary in Japan is what helped form the US housing top. Greater fools everywhere who came to believe that faulty theory eventually rushed in to speculate in housing. That made the top. Even the rating agencies got into the act.
Please consider Fitch Discloses Its Fatally Flawed Rating Model. As amazing as it might seem now, Fitch disclosed as recently as March 2007 that its model for rating CDOs assumed low to single digit home price appreciation forever into the future. It even admitted its model would break down if home prices were flat for an extended period of time. There is a shocking conference call discussed in the above link where Fitch described those fatally flawed assumptions.
Fitch placed so much faith in its models (as did Moody's and the S&P) that the biggest financial speculation in housing history took place. Greenspan and the Fed cheered the miracle of derivatives most of the way. Such foolishness has already cost Citigroup (C) and Merrill Lynch (MER) their CEOs. It may cost Citigroup its entire company. See More Writedowns Force Citigroup To Sell Assets.
Housing speculation is likely to cost both Ambac (ABK) and MBIA (MBI) their companies. See Buffett Signs Death Warrant For Ambac & MBIA for more on the demise of the guarantors.
It's Different Here
All of the above are casualties of the bursting of a housing bubble, a bubble that until last year people denied even existed. Instead of looking at Japan for what was about to happen, all we heard was "It's Different Here. The US is Not Japan." 
The above image is thanks to The Best of Five Things You Need to Know.
Housing prices rose three standard deviations above norm in relation rental prices and wages yet excuses were made as to "why it's different this time." Now, in spite of all the evidence to the contrary, most still insist that "Deflation Can't Happen Here." The entire argument rests on one or more of the following faulty premises.
Faulty Premises
- It's different here.
- It's different this time.
- The Fed won't let deflation happen.
Belief in the third point above goes well beyond amazing to the point of being nearly universal. Yes, there are a handful of us that see deflation coming, but, as Nimesh writes, "For almost thirty years people like you have predicted that our economy will collapse and it hasn't happened."
That is precisely the sentiment that it takes to make a top (or a bottom). Many predicted the demise too early and are now discredited. Those hopping on the bandwagon near the top are compared to the early visionaries. It becomes guilt by association even though there is no real association.
Mocking of the early visionaries is part of the topping process. Group think sets in and is reinforced over the years. Risk premiums drop as the long term trend reaches the peak. That takes time. Memories fade. Does anyone fear another Great Depression? Heck, does anyone even remember it, let alone fear it?
Where Prechter Went Wrong
Since everyone knows the early visionary we are talking about, we may as well openly discuss his name. Robert Prechter ignored and/or did not foresee many things that could keep the credit bubble expanding. Let's start with a flashback to conditions of the 70's and 80's.
Why The Credit Bubble Lasted For Decades
- Single household breadwinner became two household bread winners
- Interest rates were at 18% headed to 1%
- Internet revolution provided tremendous numbers of jobs
- Lending standards declined
- Housing boom provided jobs
- Rising asset prices supported consumption
Every one of those things allowed the credit bubble to keep expanding. Many of those factors took years to play out, decades in aggregate. The decline in interest rates alone made housing more affordable for quite some time, at least until things went extremely loony a few years back.
Sadly, people still give Greenspan credit for his role in keeping the economy expanding. Greenspan deserves absolutely no credit. All Greenspan really did was accelerate the existing trend. Furthermore, he did so in a way that was completely reckless. The only reason the economy did not collapse under Greenspan was the ability of consumers and businesses to take on credit had not yet peaked.
Major Bubbles Fueled By Greenspan
Greenspan fueled an overall stock market bubble by bailing out banks exposed to Long Term Capital Management. For more on LTCM please see Genius Fails Again.
- Greenspan fueled a dotcom bubble in 1999-2000 out of irrational fear of a Y2K crash.
- Greenspan embraced the productivity miracle and was worried about the economy overheating just months before it imploded. The story is documented in FOMC minutes.
- Greenspan fueled an even bigger bubble between 2003-2006 by embracing ARMs and slashing interest rates to 1% to bail out his banking buddies caught up in bad loans to dotcom companies and bad loans to countries like Argentina.
In a sense, Greenspan was the luckiest Fed chair in history. He had a tailwind of productivity at his back that helped keep consumer prices low while he fueled bigger and bigger and bigger credit bubbles when each of several smaller bubbles popped.
Greenspan has now left an unsolvable mess for Bernanke to cleanup. This time, there is no bigger credit bubble to be blown.
What They Were Saying And When
- In 1999-2000 people were saying "The Nasdaq hasn't crashed yet so it's not going to."
- In 2006 Lereah wrote Why The Real Estate Boom Will Not Bust. Ironically, it already had.
- In 2007 many are writing me with reasons why the credit bubble will not bust. It already has. However, just like in 2006, the implications had not yet been fully felt.
The party is over once the ability and willingness of banks to lend, or ability and willingness of consumers and businesses to borrow is exhausted. Those signs in place today for all but ostriches.
One thing I want to be clear on is that I am not calling for another Great Depression. We could have one, but I am inclined (at least right now) to doubt it. Japan went through 18 years of deflation and the world did not end. The US will survive deflation as well.
However, we are likely to see something the US has not seen since the Great Depression: a falling standard of living and a declining middle class. Many things will be A Matter Of Choice but no one alive knows exactly what choices government will make.
One thing I am sure of is the more money the U.S. spends in policing Iraq and other nations, the worse off it will be.
Can The Fed Inflate Out Of This Mess?
There is enormous and unwarranted belief in the Fed's ability to "inflate out of this mess." It's all an illusion. Greenspan presided over an economy that added enormous numbers of Internet jobs followed by enormous numbers of housing-related jobs and enormous numbers of jobs related to the buildout of commercial real estate.
This was not "success." This was forestalling the day of reckoning by repetitively blowing bigger bubbles. Greenspan appeared successful only because the ability and willingness of consumers and businesses to take on more debt was not yet exhausted.
Bernanke, on the other hand has no dotcom boom to bail out the economy. Nor does Bernanke have a housing bubble to look forward to that will bail out bad bank lending practices and provide jobs to the economy.
Problems Bernanke Faces
- Falling real estate prices
- Subprime housing mess
- Alt-A mortgage mess
- Pay Option ARM mess
- Sharply rising unemployment
- Rising credit card defaults
- Commercial Real Estate implosion
- Global wage arbitrage
- Falling US dollar
- Overheating China
- Slowing global economy
- Tapped out consumers
- Implosion of $500 trln in derivatives
- Solvency issues at banks
- Forced unwind of massive Yen carry trade
- Boomer retirement
- Pension plan assumptions in an economy starving for yield
- Rising corporate defaults
Greenspan never had to deal with anything remotely close to that set of problems. It's a lethal combination of things given that solvency issues at banks that will restrict lending. It is also a lethal combination in the face of consumers and businesses that are unwilling to expand because consumers are tapped out. In addition, rising unemployment sure is not going to do anything about consumer’s willingness or ability to take on more credit.
Yet because of Greenspan's so called success, many came to believe in the magic of the Fed. The idea was further enhanced by one of the most ridiculous Fed speeches ever, Deflation: Making Sure "It" Doesn't Happen Here.
Trends Do Not Die Easily
With Bernanke's speech came the near universal belief that Bernanke would succeed in fending off deflation as well. However, near universal belief in a flawed idea is a necessary but insufficient condition for a primary trend exhaustion.
The housing boom morphed into merger mania, leveraged buyout speculation, buyout bingo and all sorts of other nonsense, including covenant "lite" deals, where debt was paid back not with interest but with more debt.
There were not really any more players because there was no one left to convince. Rather the players involved just got greedier and greedier. Even as housing died, credit expansion looniness continued for two more years.
Chuck Prince Dances At the Top
When everyone acts as if every risk, no matter how unsound, will go unpunished by the Fed and the market, it fosters the environment where the greedy participants (and even some innocent bystanders) are going to be tremendously punished.
It is fitting that Chuck Prince marked the top of the insanity in July of 2007 when he announced No End Soon To Buyout Boom. Chuck Prince resigned in disgrace four months later.
Unsound Beliefs Foster Unsound Actions
Few have stopped to consider that credit conditions only got as insane as they did because of the fundamentally unsound belief that the Fed cannot fail. Similar beliefs marked the top of the housing boom in the summer of 2005. Yet, in spite of the housing implosion, everyone acted (and most still do) as if there is no risk of deflation. Most still fail to see that it was unsustainable credit expansion that fueled not just housing but the economy in general.
Ironically, it is the unvarnished arrogance by Bernanke, in conjunction with greater fools who believe in his untested academic wizardry, that fostered the very extreme risk taking attitudes towards credit that makes deflation inevitable.
Things that "can't" happen are about to.
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In a bullet in this article you brought up something I've begun to view as a huge risk for '08, and that's the Pension issue. After the dot com bubble burst, many companies were forced to sell assets and raise capital otherwise in order to fund pensions that had lost large amounts when the bubble burst. GM selling Hughes (ie DirecTV and PanAmSat) is one example. There are still a ton of CDOs unaccounted for and the other MBS asset classes yet to fall (Alt-A, etc) are in huge circulation. Some of them will never see the light of day as asian governments sweep them under the rug, but my guess is that pensions are holding a lot of these assets. If Florida teachers were investing their cash in SIVs, is it hard to think that pensions all over the country (and world) are heavily invested in these other structured assets? With asset values declining and virtually no credit available, how are the sponsors of these pensions going to fund them?
1) Print more money- Check
2) Allow the Fed to take more risky assets for collateral at the discount window- Check
3) Change the length of loans at the Discount Window- Check
4) Allow the discount window to loan to banks that usually fall outside of having the ability to go to the DW- Check
So according to Sir Alan's paper we still have the following tools available to fight the deflation:
1) Cap treasury bond prices and yields
2) Buy foreign government debt to effect the exchange rate
3) Fed acquires private assets
So essentially, the FED has admitted by taking four of the steps above that it IS fighting deflation right now.
It is a very interesting paper and I appreciate the link very much.
Even thought I don't necessarily get what capping bond prices and yields will do, I think that Government investment ("If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.") in private industry will be the last tool the government uses. The MBIAs and CFCs of the world will need something and I highly doubt that foreign government investment funds are ready to take on that kind of risk.
Minyan James (my first post)
A boy goes to buy an ice cream cone in 2007 in the same neighborhood. It now costs 5 dollars. His father makes 120,000 a year. His mother works too and makes a bit more than his dad 125,000. They are rarely home. The house now costs 900,000 dollars. The family has a floating interest rate on the loan and there is a danger of a big bump up in the next two years. The family puts little money away for a rainy day. Still the boy never works for his neighbors because he doesn't really know any of them and his parents won't let him. Anyways he is loaded up with soccer and homework. Also his parents are not getting along and they are thinking of splitting up. The kid knows it so he goes to get an ice cream cone just about every day. He weighs about 20 pounds more than the kid in 1967.
Which life sounds better? The one where his dad made 13,000 a year or now when his parents make 145,000 a year? Also which family can withstand a recession or some other kind of calamity? The house appears to have increased 25 times its 1967 value. The family brings in 22 times what they did in 1967. Clothes are more plentiful as are the cars. Wives are more independent.
But kids have less in that they often are not allowed to work for themselves. They do not have the big neighborhoods of kids where they learn about human nature. They just study numbers and subjects and go to soccer practice and eat too much ice cream. His mom is not home when he gets out of school.
When a recession hits which family, neighborhood will withstand its effects better? Thus are all recessions alike over time or do they change with the values in the lives? How can deflation or inflation ruin the second scenario whereas it cannot ruin the first?
This is something not calculated by our financial gurus for what is of value here are hidden aspects of life. The first ice cream cone was simply a sign of security for the kid, the family, and the neighborhood. Now it is a sign of insecurity, a distraction from an empty home, an overloaded homework schedule, and a never ending soccer season just kicking a ball up and down the field, leading nowhere of interest except a 'successful future'.
Makes you sort of hate financial progress doesn't it......
-- Attributed to the French author, Alexis de Tocqueville
that: The FED would become the lender "of last resort," and provide "whatever liquidity was neccessary."
That was when the S&P was at 330 (aprox) and declined 30%
before recovering. That puts today's S&P (no pun intended)
in at 990.
And then what?
In the name of "progress," watch for cries for:
1. the nationalization of all large corporations and trusts;
2. profit-sharing in all major industries;
3. government take over of all large dept stores (read: Wal-Mart)
4. guaranteed jobs;
5. "abolition of income UN-earned by work." (That's US, Minyans)
Sound like any present-day Presidential candidates?
Pretty close! Almost too close! Points 1-5 are in fact, the planks
of the facist Nazi Party platform, BEFORE Hitler joined up.
(Google it)
(Facism was dubbed "Right Wing" only because it was to the
right of the Bolshevicks. ..it's high time we set the record straight.)
We're all Minyans here. We all know this is a bubble, with half
all stocks trading below their 50 dma ( as reported elsewhere
herein) ...and it means trouble.
Which partly explains why the Republican Party is in such a
frazzle, ...where to go?
It also explains why I'm short the S&P.
I hope I'm wrong about it all.
