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72 comments on Close, but no cigar

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SocraticGadfly on February 15, 2006 - 12:47am Permalink | Subthread | Parent | Comments top
Question: Can the rest of the world survive a major stumble in the U.S. economy without so serious of a lurch itself?

China obviously is directly connected to our economy and would take a big hit; and, if they redirected some of their dollar holdings to Euros, of course, our hit gets worse.

But that arguably would ease oil prices enough elsewhere that Japan, the Asian tigers, and Europe all might have relatively lesser recessions.

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Gets IT on February 15, 2006 - 6:16am Permalink | Subthread | Parent | Comments top
This is why I'm arriving at a most probable longer term scenario of a rocky road to high US interest rates (15-25% for awhile) with inflation (+ hyper???), US bubble pops, USD declines, general world economic decline for awhile including somewhat lower oil demands and a price renormalization in relation to non-USD currency basket price.  Continues with an eventual substitution of the now dominate US consumer market by growing China, India and Oilstan economies.  Then new equilibriums develop with US permanently down 3 or 4 notches, Europe -1 or -2.  Is that the lemming's roadmap?
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Don Sailorman on February 15, 2006 - 12:24pm Permalink | Subthread | Parent | Comments top
If I had to write a consistent and likely single scenario for the future, it goes like this:
  1. Recession, stagnation, unemployment, rising real energy prices force
  2. Federal Reserve system to choose between massive inflation through montetization of the debt and unemployment rising into the double digits (approximately a choice between 30% inflation vs. 30% unemployment. Numbers used for illustrative puroses only--not forecasts). Fed opts huge acceleration in the inflation rate as the lesser evil.
  3. Changing perceptions and expectations drive interest rates up to levels found in countries such as Brazil and Argentina in recent decades--in other words, the expected inflation rate plus a huge risk premium for increased uncertainty and expectation of total collapse.
  4. Stock market crashes, with DJIA going down lower than 1,000, NASDAQ maybe around 140.
  5. TSHTF
  6. TEOTWAWKI
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Stoneleigh on February 15, 2006 - 1:54pm Permalink | Subthread | Parent | Comments top
I realize that the Fed could theoretically monetize the debt, but I'm intrigued as to why you think this would work in practice considering the scale of the debt in question. Personally, I don't believe the Fed has the equivalent of a magic wand. I don't, in fact, think that they have a fraction of the power over the course of events that they, and others, think they do.

The Fed also has a strong anti-inflation bias. There seems to be an overwhelming consensus that it is inflation we should be concerned about. It seems to me that Bernanke mentioned dropping money from helicopters merely as a means of dismissing concerns over deflation out of hand, not because he did in fact have any intention of printing money. I suspect he believes, as you suggest, that deflation can be easily avoided. The implication is that he sees inflation as the real enemy, as did the power-that-be on the eve of the (deflationary) Great Depression.

I agree with you that changing perceptions and expectations would drive up interest rates, but I see this as compounding deflation (and increasing the chances of a liquidity crunch) rather than as a result of inflation. I agree with your forecasts for the the DJIA and the NASDAQ by the way, probably within ten years and likely within five.

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Don Sailorman on February 15, 2006 - 2:14pm Permalink | Subthread | Parent | Comments top
For the sake of brevity I left some premises hidden (implied) nor did I attempt an explanation of the Fed's actual powers--which are well-known inside the economics profession and not known or not understood outside it.

Premise: Congress created the Fed and Congress can destroy the Fed or take away its power.
Premise: All Fed members know and fully appreciate the above premise.
Premise: Because of political pressure, the fed will have no choice but to monetize the debt. (Note: This has happened before and will happen again. How else did we get from a 100 cent dollar in 1913 to approximately a 4 cent dollar today?)
Premise: To stave off a rerun of deflation and the Great Depression the Fed will not only use its Open Market Operations magic wand (with which they legally create bank reserves and hence [potentially] money but also its Ultimate Magic Wand (UMW, not to be confused with United Mine Workers;-) of lending however much they feel like to pretty much whomever they feel like. Through the use of these two Magic Wands, the Fed will not have to ask the Treasury to directly print money.

However, under (if I recall correctly) Civil War legislation the U.S. Treasury has the legal authority to print as much currency as it feels like doing. Us oldsters can remember "U.S. Treasury" $5 bills; you youngsters cannot.

Note that it will not only be Congress putting pressure on the Fed to inflate, it will also be the Treasury Department. How else will they be able to finance a deficit of three or four or five trillion dollars per year?

Final observation: The Supreme Court has no power to stop any of this, because the laws giving the Fed and the Treasury its powers have been tested in the courts and have stood up to every challenge.

Note that I make no predictions. I do not know what will happen.

Now here is a query: In the opinion of the readers of this column, does the new Fed chairman have steel balls? Volker did. Most Fed chairman have not had these. Greenspan? Brass balls.

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Stoneleigh on February 15, 2006 - 11:54pm Permalink | Subthread | Parent | Comments top
I am familiar with the Fed's magic wands, but I doubt very much if wielding them will work as planned. To use a contemporary (Harry Potter) metaphor, I suspect the spell will backfire and the Bernanke will end up vomiting slugs.

If I had to propose a potential course of events, I would suggest that Bernanke is likely to raise interest rates initially in order to establish his anti-inflationary credibility. With the housing market teetering on the brink, this could be enough to precipitate a housing market crash. Bernanke would already be trying to ride a tiger by this point, which could come relatively early in his tenure.

Bad debt could leave many financial institutions vulnerable, but attempting to bail them out would threaten the role of the dollar as global reserve currency and the continuing influx of foreign capital. International dumping of the dollar could proceed rapidly, although within the US the value of many assets classes could still fall relative to cash in the rush to cash out and cover debts.

I envisage a cascade of bank failures as defaults snowball and savers try, and fail, to reclaim their savings. A liquidity crunch could follow, severely limiting purchasing power and therefore energy consumption, among other things. I very much hope to be wrong, but the power of a positive feedback loop in action can be truly awesome. I have no faith in the ability of one institution to stand in the way of such a chain of events, magic wands notwithstanding.

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Drum Roll on February 16, 2006 - 3:49am Permalink | Subthread | Parent | Comments top
Stoneleigh,
 If I understand you correctly, you are suggesting that all of the Fed's efforts to inject liquidity into the system in order to prevent deflation and bank failures might be insufficient, or that while nominally sufficient, these measures might backfire by causing panic selling of US Treasury notes and a subsequent crash of the dollar relative to other major currencies. So Bernanke could choose inflation as a monetary tool and yet end up triggering deflation anyway.

One thing you said puzzled me though:

 "I envisage a cascade of bank failures as defaults snowball and savers try, and fail, to reclaim their savings."

So you are saying that the FDIC would not be able to honor its commitments, causing peoples' savings to just be wiped out? I would think that the Fed and Congress would act to prevent that at all costs because that's the type of thing that could result in a revolution. Think about millions of unemployed mortgageholders who then lose their homes because they can't make their mortgage payments using their savings. That situation would be very ugly.

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Stoneleigh on February 16, 2006 - 9:13am Permalink | Subthread | Parent | Comments top
Yes, I am saying that Bernanke could chose inflation and yet end up triggering a financial panic and deflation anyway, in fact that is what I would expect to happen. Panic can withdraw liquidity from the system more quickly than even the Fed can pump it in IMO.

I am also saying, as you point out, that deposit insurance is not likely to be worth the paper it's written on, as it was never designed to actually bail out a systemic banking crisis. It's existence has lulled savers into a false sense of security IMO. I would expect the Fed and Congress to find themselves overwhelmed by the monumental scale of bad debt in the system, and unable to prevent a liquidity crunch. As you say, the social and political consequences would be severe, especially considering that there may also be energy supply disruptions and price volatility simultaneously courtesy of peak oil and natural gas. Needless to say, I don't think we are looking at a slow squeeze here.

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Drum Roll on February 16, 2006 - 1:38pm Permalink | Subthread | Parent | Comments top
Thanks for the followup, Stoneleigh.

That is indeed a grim picture. Considering your disagreement with "conventional" wisdom (specifically the efficability of the Fed) about how such a financial would unfold, how do you think the holders gold and silver bullion would fare?

I had an uncle, since passed away, who was a "gold bug" and believed the U.S. financial system would eventually melt down. It seems to me that although bullion holder would fare better than the hapless depositors jilted by the FDIC (the bugs still have their store of value), the practical aspects of using that bullion might be problematic. In other words, a clerk in a grocery store would not be able to accept anything that wasn't legal tender. So using it in retail stores for necessities doesn't seem feasible. So you have identify people who have what you want and find out if they will accept gold. Hopefully these are people you already know and trust, otherwise you might just end up trading gold or silver for lead, so to speak.

Interesting times indeed.

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Stoneleigh on February 16, 2006 - 3:39pm Permalink | Subthread | Parent | Comments top
I think owning gold is likely to prove to be impractical at best and dangerous at worst for most people. It isn't something that can easily be traded for something else one might need, especially if private gold ownership is outlawed again as it was in the Great Depression. Owning it may also make you or your family a target as Don has pointed put. It may make sense as a capital preservation strategy for those favoured few with sufficient resources to deposit a pile of gold in a vault in Switzerland, but not for the vast majority of people. Silver would be a better bet in my view for those who really want to hold something of value (in a concentrated, but not too concentrated form), but even that is likely to pose difficulties. I'd rather have firewood, solar panels, batteries in my basement, a good vegetable garden, knowledge about self-sufficient lifestyles, good friends/neighbours with a similar outlook etc.

Personally, I would look first to getting out of debt, then to hedging your bets with some basic self-sufficiency measures (as economic disruption can lead to inconsistent availability of necessities) and finally to holding some form of liquidity (although this is easier said than done in a liquidity crunch as you might imagine). If you can't afford a house without a mortgage (unless it's a very small one), then I'd rent and let someone else take the house price risk. The equity you extract could serve you well if you can manage to hold on to it. I see money as the lubricant for the economy. Without it, the economy seizes up like a car engine run with the oil light on. That's why a liquidity crunch is so disruptive.

Beware of governments trying to separate you from what wealth you may have managed to preserve. In Russia the government got all the money out from under the beds of the nation by reissuing the currency and then making it very difficult for many people to exchange their old rubles for new ones in time. Many lost their life savings. In Argentina, the government converted dollar savings accounts into Argentine currency then allowed that to devalue drastically as the currency peg fell (debts remained denominated in dollars). They also converted short-term government debt into long-term and then later defaulted on it. There are no risk-free answers.

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unplanner on March 1, 2006 - 3:44am Permalink | Subthread | Parent | Comments top
Personally, I would look first to getting out of debt, then to hedging your bets with some basic self-sufficiency measures (as economic disruption can lead to inconsistent availability of necessities) and finally to holding some form of liquidity (although this is easier said than done in a liquidity crunch as you might imagine). If you can't afford a house without a mortgage (unless it's a very small one), then I'd rent and let someone else take the house price risk. The equity you extract could serve you well if you can manage to hold on to it. I see money as the lubricant for the economy. Without it, the economy seizes up like a car engine run with the oil light on. That's why a liquidity crunch is so disruptive.
I don't know about you but wouldnt having a mortgage held by some faceless corporation far away facing financial collapse easier to deal with than the landlord that is more than likely local? In a complete financial meltdown, who will be doing the evicting. Wouldnt a more prudent strategy be take out a mortgage that is well underwhat you can pay and try and hang on longer than 95% of your fellow mortgage holders?
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Agric on February 15, 2006 - 6:45pm Permalink | Subthread | Parent | Comments top
The Fed SAYS it has an anti-inflation bias, I don't think the evidence of the last 20 years supports that claim. Rather like the 'strong dollar' policy. The only real anti-inflation activity I've noticed in the last decade has been a fiddling down of the official inflation statistics.

There really is no other option than attempt a controlled inflation given the current situation, and that is what the Fed will try to do. I don't honestly know how that will play out, though it will take a decade or more if successful. Unfortunately it may get out of control and often runaway inflationary periods end with a nasty bout of deflation.

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The Swede on February 15, 2006 - 4:19pm Permalink | Subthread | Parent | Comments top
Don, what is TEOTWAWKI?
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The Swede on February 15, 2006 - 4:21pm Permalink | Subthread | Parent | Comments top
Don't worry Don I just got it. TEOTWAWKI. I'm afraid to say it by I agree
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cwilbur2000 on February 15, 2006 - 6:16pm Permalink | Subthread | Parent | Comments top
Could the Fed allow hyperinflation?  Wouldn't that immediately preclude further purchases of our debt by foreigners?  Is that even a thinkable option at this point?
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Don Sailorman on February 16, 2006 - 12:21am Permalink | Subthread | Parent | Comments top
At this point hyperinflation is unthinkable--sort of the way gay sex between cowboys was a few months ago;-) After TSHTF, the choice is fairly simple
  1. Another Great Depression, with falling price, bank failures and all the rest or
  2. Hyperinflation to wipe out intolerable debt burdens.

Keynes pointed out the superior political influence of the debtor class.

Politics rules.

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Southsider1 on February 16, 2006 - 1:24am Permalink | Subthread | Parent | Comments top
Yes, Don, but as a number of folks, including me, have pointed out before, how will the Treasury be able to sell any more bonds once the Fed resorts to inflation to vaporize past debts? Burned bondholders will shun them. Of all the things that are nearly certain in this world, the need for the U.S. government to continue selling bonds is one of them. Or are you assuming that once the Fed inflates all the debt away Congress will have the discipline to balance the federal budget?
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Stuart Staniford on February 16, 2006 - 2:42am Permalink | Subthread | Parent | Comments top
One of the things I've been thinking about in the context of a post-peak world which includes a very indebted and fiscally challenged United States: we have a sizeable fraction (over a quarter) of the world's coal reserves, plus most of it's oil shale (if anyone can figure out how to exploit that resource). To the extent that biofuels in fact prove useful, we have a big fraction of the world's agricultural potential, especially relative to population. In a post-peak world, energy is going to be much more valuable and expensive than it has been in the past. Thus I can see us being obliged to develop our remaining energy reserves and export a significant fraction of them in order to bring our debt back in line. It's kind of an amusing prospect - we will be exporting our natural resources in order to continue to get the products we need from the industrialized world (industrial production will almost entirely be in Asia by then).
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jkissing on February 16, 2006 - 2:52am Permalink | Subthread | Parent | Comments top
Exporting raw materials and food is the traditional way for those who cannot compete with the industrialized world.
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SocraticGadfly on February 16, 2006 - 10:26pm Permalink | Subthread | Parent | Comments top
I can't see the Fed choosing monetizing debt over increasing unemployment. Given the shift of our money to an investor class (see Paul Kennedy, "The Rise and Fall of the Great Powers," for how this undermined the Netherlands way back when, and arguably was one of the things that chewed away at the UK in the 20th century), a GOP with an anti-labor labor policy and a Democratic Party with no labor policy, as long as massive unemployment wrecks investments less than high inflation, the Fed and the government won't care.
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Gets IT on February 16, 2006 - 2:42am Permalink | Subthread | Parent | Comments top
Thanks 2 all.
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