The collapse of the commodity bubble beginning late this summer erased inflationary worries from the minds of many. Crude at $145/bbl, natural gas at $24/MMBtu, and gold at $1000/oz characterized the artificially inflated prices during the commodity boom, which began in 2002. This secular bull in commodities was caused by massive perceived demand in emerging markets, particularly the BRIC nations-- Brazil, Russia, India, and China, which were growing at unprecedented rates. As they became increasingly wealthy and industrialized, these economies represented growing new demand for energy, food, and production inputs. This great demand, coupled with the perception of quickly diminishing supply (most famously in crude oil), caused the strong price surge in commodities, and self-perpetuated the idea of emerging market demand growth. However, as a global recession sets in, the massive anticipated demand growth from emerging markets is slowly proving unfounded, causing the commodity bubble to collapse. Nevertheless, the decline in commodity prices does not eliminate the threat of inflation in the United States; if anything, it supports the thesis. The recent economic collapse can be traced to Alan Greenspan's extremely dovish interest rate policies in the 1990s, which led to artificially strong growth in America's economy. Greenspan's policies caused huge leveraged investment in artificially strong assets, particularly real estate and equities, since low interest rates prevent savings and encourage leveraging capital as credit is cheap. The growing excess liquidity, invested in diminishing opportunities, resulted in a classic speculative bubble. The housing bubble came crashing down in 2007, leaving Americans significantly less wealthy. Financing home, car, and other big purchases (through loans and credit cards) pervades American culture, and consequently, the housing correction affected Americans all the more, as their mortgages suddenly were significantly more expensive than the houses they were paying for. Lenders issued risky adjustable-rate loans to low-credit borrowers because of the cheap credit. As the Federal Reserve finally started raising interests in response to the bubble collapse, these high-risk borrowers suffered even more. Many were forced to default on their loans, which caused a liquidity crisis in mortgage lenders and also banks, who had accumulated large leveraged positions in mortgage-backed securities during the credit boom. This led to a credit crisis, as banks became unwilling to lend out of their depleted capital reserves. An equity market crash followed, which also had an immediate impact on Americans, who traditionally allocate their savings in mutual funds and pension funds. And this is all before the fall-out of the credit crisis sends businesses to bankruptcy, increases employment, and all of the other consequences affiliated with a deep recession. Alan Greenspan's artifically cheap credit policies caused an internal economic crisis, which coupled with President Bill Clinton's strong encouragement of globalization and foreign trade led to a dependence on debt that will deepen the current deflationary recession into an inflationary depression. Since the collapse of the Soviet Union in 1989, nations around the world have privatized and reformed their economies. These reforms are behind the emergence of China, India, and other growing economies, particularly through increased trade and foreign direct investment. Since the United States possesses the global reserve currency in its Dollar, it can safely run large trade deficits, causing it to represent huge demand for foreign exports. The nations exporting to America, whose growing GDPs indicated growing demand for commodities (which are priced in the global reserve currency, USD), represented great demand for U.S. Treasuries. This caused America to issue massive debt to these nations, but used this to finance further consumption rather than production or industry. This led to the formation of a debt bubble, as the United States entered a cycle of consuming foreign exports, issuing debt to its trade partners, and using the debt to consume more of their exports. Theoretically, the United States can continue to print more dollars as long as a demand for them exists abroad, which has as emerging markets grew sizably in recent times. However, the demand for U.S. debt has drastically fallen as the world's economy contracts as a result of the credit crisis in America and foreign nations attempt to finance domestic growth. On November 9, China announced a $586B domestic stimulus package, more than triple the size of America's 2008 package. Australia also announced a $10.4B package and Japan a $51B. Not only is there an immediate need for economic stimulus at home, there is decreased demand for exports abroad (particularly in the United States), so nations are focusing on domestic growth instead of externalizing it through foreign trade. This has a twofold effect on the United States-- it places a formidable burden on America's industry as the U.S. can't simply consume its way out of recession, and it prevents the U.S. from just issuing more debt to finance domestic stimulus. This has alarming consequences in the context of current recessionary conditions. Consumption accounts for over 2/3 of America's economy and its industry is weak. The United States has an external debt of $13T and now that foreign nations are forced to finance domestic growth internally, they have slowed their U.S. debt purchases and will slowly stop buying American treasuries altogether. This will essentially force America to repay its debts abroad, which it obviously cannot do at the start of a deep recession without an enormous budget surplus, but we have a massive deficit. The recently-passed Troubled Assets Relief Program (TARP) allocates $700B to liquifying troubled banks, which are overleveraged and undercapitalized, and other troubled companies, the next of which may be automotives. Add that to the $53T owed by the U.S. government for unfunded Social Security, Medicare, Medicaid, veterans' pensions, and other similar programs, and the prospect of the United States paying off its debt appears slim. The economic conditions will only worsen this deficit, as more and more Americans will be uninsured (as unemployment skyrockets) and forced to retire primarily on Social Security (as pension funds lose value). The government will be forced to socialize further, financing it through more issued debt; this as foreign demand for U.S. debt dwindles. So, as external debt worsens, public debt follows suit, leaving no way to finance debt payments. The Federal Reserve will undoubtedly respond by printing more and more money, but without treasury demand abroad, this will lead to rampant inflation. Currently, as global equity markets collapse, investors are liquidating and deleveraging, fleeing to the traditional safe haven currency, the U.S. Dollar. This is a temporary response, and is behind the strong selling pressure in gold and partly behind the commodity decline. Recessions of this nature almost always lead to a period of deflation, as aggregate demand diminishes and banks are reluctant to lend. However, this crisis will not remain deflationary. When the United States debt bubble finally collapses, the U.S. will be forced to default on its debt and devalue its Dollar, as the Fed pumps more and more liquidity into the system. The CDS price for 10 year U.S. Treasury bonds has already increased by 2500% over the past year, and with more deficit spending ahead, the U.S. Dollar's perceived stability will diminish, as will its demand. Increased supply and decreased demand-- characterizing rampant inflation. What is left to do? Liquidate all mutual and pension funds into gold and/or Swiss Francs. Unlike other commodities, the demand for gold and other precious metals doesn't lie in its utility in production, but rather in its store of value. This makes gold a great inflationary investment, as it preserves purchasing power. Gold under $900 is a bargain, and I see it above $2000 by 2010 and above $3500 by 2011. The Swiss Franc is 20% backed by gold and boasts a 0.6% inflation rate, and its demand is only going to rise, as the United State's dominance in foreign currency reserves diminishes and foreign nations and wealthy investors seek a safe haven currency. What will end of America? I see the Dow Jones going all the way down to around 3300. However, the United States has leverage aside from its currency reserve status and economic dominance. It is the sole nation in the world that can be self-sustainable if need be, having substantial energy, food, and industrial commodity supplies. In addition, it has the ultimate leverage of all-- the largest and most powerful defense system in the world. At the end of all of this, whether or not after war, demagogy, or whatever doomsday scenarios can be conceived of, I believe the United States will come out as the reigning superpower in the world and through forced domestic investment and industrial development (particularly in alternative energy), will develop even further into the strongest economic powerhouse in the world. Before any of this optimistic speculation influences your opinion, however, I insist you look at the economic collapse that will precede any such positive event. I will leave you with this, a chart of the America's real total credit market debt-to-GDP, which is higher now than it has ever been, including during the Great Depression and World War II. This clearly shows our debt bubble, which is still inflating and will keep inflating until the U.S. Dollar defaults... http://static.zooomr.com/images/5432423_f504f6dca8_o.png Long recommendations: GLD, TBT, UDN, SDS, DXD, QID, Swiss Franc (CHF) Short recommendations: US Dollar (USD)
Great piece naufal - I agree with nearly all of your points. Gazing into my crystall ball, you'll probably get responses that argue for both an inflationary contraction and also a deflationary contraction. The differences in the arguments will most likely be around the definitions of "inflation" and "deflation". Deflationists will point to (nominal and real) declining economic growth, reduced availability of debt, declining (real) house prices. Inflationists will point to money printing as a means of paying off the US Govt's debt burden. You listed the following as your long picks: GLD (I agree) TBT (20 year bond yield) UDN (increases when USD decreases) SDS (ultrashort S&P) DXD (ultrashort DOW) QID (ultrashort Naz) If we experience significant inflation / hyperinflation, then it is possible for the stockmarket indices to gain in nominal terms (therefore SDS, DXD and QID would fall) but underperform gold. Furthermore if other countries join the "high inflation to pay debt and encourage nominal economic growth" regime, then it is possible for the US Dollar to appreciate against other paper currencies.
I agree with deflationists that prices are declining and there is less debt available, but that is precisely why I think ultimately we will hit inflation. The United States has to finance its nominal GDP growth through external debt-- it has no industry and much too big of a public debt to even consider domestic financing. Bernanke has said before that he will print as much money as is needed to prevent a deflationary spiral. However, like deflationists say, there is less debt available. Foreign nations have much reduced demand for US treasuries. Printing more money indefinitely only works when there is a sustainable demand for US currency, but there just isn't anymore. Deflationists say so themselves. This will lead to a money supply increase that will put even more pressure on the US Dollar because inflationary conditions will even further reduce demand for US treasuries abroad, to the point of USD devaluation when the US is forced to default. There are two main incentives to purchase US treasuries: 1. It allows for the purchase of commodities and other inputs, since the USD is the global reserve currency and commodities are priced in it. 2. It is a safe-haven investment, as America has historically paid back its debts and the USD is historically stable. Incentive (1) is already starting to diminish, as a global contraction sharply reduces demand for commodities and production inputs, thus reducing demand for the USD. The global equity collapse has caused a lot of investors to deleverage and liquidate into a safe haven currency, like the USD, which is actually buoying the USD short-term. This is incentive (2). But as America's external debt increases further and it finances its public debt with more debt issuance, incentive (2) will fall sharply. Like I said, the credit default swap for a 10 year US treasury is up over 2500% over the past year. That shows the lack of investor confidence in the United States, which is unprecedented. The global contraction is going to worsen, even further diminishing incentive (1) and causing more U.S. deficit financing through debt, greatly diminishing incentive (2). It is a positive feedback system that will lead to the collapse of the USD.
Again, I'm in nearly 100% agreement. The key word in your question "What type of economic contraction will we eventually be in?" is 'eventually'. Right now we're in a deflationary contraction, however once additional extreme measures are taken to repay US Government debt, this may lead to very high inflation.
m22au Furthermore if other countries join the "high inflation to pay debt and encourage nominal economic growth" regime, then it is possible for the US Dollar to appreciate against other paper currencies. ............................................................................... If all the developed , developing countries move in unison in either direction....the change becomes relative...to be kicked out as a constant..... The real question also...is how much change in terms of the major manufacturing components...ie labor....all inputs... advantages via education costs ...other costs.... China is the overall lower cost producer.....the question being ......what other countries can match the production inputs...etc....will mark who is the best value in terms of comparables.... Inflation, deflation .....if evenly distributed......both cause havoc with regards to legal agreements about prices......The assets owners just get re-labeled at above normal rates....The other question being impacts on innovation....etc...
I highly doubt there will be a unified capitalist bloc that will agree to use inflationary prices as real prices to prevent an usurpation of global economic dominance by emerging markets like China.
The recent economic collapse can be traced to Alan Greenspan's extremely dovish interest rate policies in the 1990s, which led to artificially strong growth in America's economy. Greenspan's policies caused huge leveraged investment in artificially strong assets, particularly real estate and equities, since low interest rates prevent savings and encourage leveraging capital as credit is cheap. The growing excess liquidity, invested in diminishing opportunities, resulted in a classic speculative bubble. --------------------------------------------- I beg to differ. Greenspans interest rate policies were reactionary to what was billed as the "New Economy". The "artificially" strong growth was in technology and internet productivity, hardly artificial. The increase in liquidity was in response/preparedness to fears of Y2k which never materialized. Congress desired lower interest rates to achvieve their political homwownership goals (a la community reinvestment act).
Sadly, when a group of people become sufficiently deluded into believing they are entitled (deserve) more than they can produce, then the outcome is entirely predictable ... it is just a matter of when and who or what will be the triggers. Once the mess is cleaned up then the road show can roll along again on a sane basis. If people do not have the courage to address the mess, then the mess will continue but wearing a new set of Emperor's clothes. regards f9
No, plain wrong. It is traced to Greenspan and late 1990s, but not the fed funds rate, which is only one of the tools, actually one of the less significant ones. The fact is that it can really be traced to the inception of Federal Reserve and even the international bankers which have roots thousands of years back. The actual current crisis is due to deregulation allowing investment banks & commercial banks operating as one and the recognition of Credit Derivatives as a viable financial instrument (L3 asset) by the Fed. Banks & even hedge funds could place those on the books and trade them as assets. The scheme is nothing new. It's very similiar as the Tech bubble where you had companies with absurd valuations and market caps when the reality is that they were worth nothing. The same goes for the credit derivatives, they were worth nothing & were defunct while being valued at arbitrary numbers. All this has been planned for & executed with relative accuracy. Oh, and Greenspan/Bernanke/any Fed Chair are just spokespeople. They have no real power, in fact, they have almost no power. Nor do they claim to do so, nor does it state anywhere that they do have any power. Just representatives, like your local corporation's Public Relations VP.