Spend, spend, spend, extend and pretend James Vinall 12th February 2011

Here are a couple of good quotes for you

Henry Morganthau Jr. was FDR's Treasury secretary and close friend through the Great Depression; in 1939 he said:

“Never in the history of the world has there been a situation so bad that the government can’t make it worse”.

Morganthau also said

"We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong … somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises. … I say after eight years of this Administration we have just as much unemployment as when we started. … And an enormous debt to boot."

The potential outcome of the current global government “spend, spend, spend, extend and pretend” is neatly covered in Charles Hugh Smith’s latest Of Two Minds blog.

A 5-Year Scenario: 2011-2016 February, 2011

In this scenario, the wheels fall off the debt-fuelled global "recovery" and assets bottom in 2014.

Here is one possible scenario for the next five years. Why do I consider this somewhat more likely than other possible scenarios? Here some undercurrents which may be generally under-appreciated:

1. There is a difference between speculative and organic demand. The two are of course related, as industrial consumers of resources must hedge against rising prices using the same instruments as speculators--futures contracts, etc.

2. Follow the credit, not just the money. It's not just the U.S. economy which is dependent on cheap, abundant credit--the same can be said of China and the European Union to some degree.

Just because Chinese buyers put 50% down on their fourth flat doesn't mean they don't need credit for the other 50%. Chinese developers are heavily dependent on credit issued or backed by the Central Governments banks and proxies.

Credit is not cash, and creating credit is not the same as printing cash. Shoveling $1 trillion in zero-interest credit into the banking system does not necessarily mean that $1 trillion flows into the real economy--that can only happen if someone or some entity borrows the credit.

This is why some claim that hyperinflation has never occurred in a credit-based system; it can only arise in a monetary system in which cash itself is printed (i.e. Zimbabwe et al.)

I am not making any such broad claim, but to identify the two as identical seems to me to be a profound confusion.

This distinction plays out in a number of ways. If the Fed had actually printed $1 trillion in cash and dropped it from helicopters, then those collecting the cash on the ground might have spent it, creating more organic demand for goods and services.

If the Fed creates credit and loans it to banks at zero-interest rate, the credit only flows into the real economy if somebody borrows it.

Without borrowers, the "money" just sits in reserves, where it does not spark inflationary organic demand for resources, goods or services.

If someone borrows the "money" to refinance existing debt, the only money that flows into the real economy is the difference between their original debt servicing costs and their new debt servicing costs, presuming the new costs are lower than the original. (Not always the case if said borrower had an interest-only "teaser rate" mortgage that he/she is now rolling into a mortgage with principal payments and a market rate interest payment.)

Or a large speculator (trading desk, hedge fund, etc.) could borrow the credit-money to speculate in commodities, driving prices up on the widespread expectation of higher costs in the future. In this case, the credit-money does influence the real world economy by driving commodity prices above levels set by organic demand.

But speculative "hot money" is not organic demand; it flees or is lost if trends suddenly reverse.

Since commodities such as oil are priced on the margins, this matters. A sudden decline in oil from $86/barrel to $76/barrel would trigger an exodus from speculative long positions, reinforcing that decline in a positive feedback loop.

3. Hoarding is a special flavor of organic demand. Like speculative demand, it vanishes once the fear of ever-higher prices evaporates.

4. The global GDP is around $60 trillion; the Federal Reserve has "printed" $2 trillion in the past three years. Placed in the proper context, the Fed's printing and asset purchases are large enough to influence the U.S. stock and bond markets, but they simply aren't significant enough or focused enough to enslave the entire global markets in stocks, bonds, precious metals and commodities.

Other players are busy printing and issuing zero-interest credit, too, of course, but we should be wary of sweeping generalizations about the deterministic nature of these central bank campaigns.

As further context, consider that the Fed's vast interventions have distributed some $2 trillion into the financial sector; meanwhile, U.S. homeowners saw their net equity decline by some $6 trillion.

OK, on to the scenario which will get me in all sorts of trouble:

Here is the sequence of events I consider rather likely:

Q3/Q4 2011-2012: extend and pretend fails. The wheels fall off the global "recovery," the emerging market equity bubbles, oil, China's equities and its property bubble, and most if not all commodities. Gold and silver swoon as per late

2008 as raising cash become paramount. Oil retraces to the $40/barrel level, and then drops further as exporters ramp up their exports to generate desperately needed cash.

Interest rates rise sharply, risk assets tank, borrowing dries up, housing prices "slip" to new lows (the stick-slip phenomenon), and the hated/loathed U.S. dollar confounds almost everyone by breaking out of technical resistance levels.

Civil disorder spreads along with recession and lower energy prices, which devastate oil exporters' primary source of government revenues.

With better grain harvests stemming from improved weather, declining meat consumption in 2012 due to recession and the implosion of the market for corn ethanol, grain prices plummet, wiping out all the speculators who reckoned 2010 had set the trend for the decade.

All of this starts slowly in Q3 2011 but gathers momentum in 2012.

Unfortunately for central banks, all their printing and credit creation is analogous to insulin resistance: without borrowers and solvent banks and consumers, their frantic efforts to "stimulate" their economies with additional liquidity come to naught.

The Central State's other gambit, monumental fiscal "stimulus," runs into the brick wall of rapidly rising interest payments and a political revulsion triggered by the realization that only the financial and political Elites actually benefitted from the trillions squandered in the 2008-2011 orgy of Central State "stimulus" and backstops.

With asset prices collapsing in a phase shift, the equity needed to float new loans vanishes; with risks rising, the market for junk bonds and other risk-laden debt also disappears.

All those who clung on through the "recovery," hoping to made whole, are wiped out. Their bankruptcies trigger a new wave of selling and writedowns.

2013-2014: Re-set and reckoning. Widespread political and financial turmoil leads to a few central choices:

1. Repudiation of the Neoliberal Central State/Financial Oligarchy strategy of 2008-2011 which focused on preserving the insolvent (but politically dominant) banking and Wall Street financial sectors and transferring their private losses to public entities/taxpayers.

2. Replacement of incompetent, venal, exploitative dictatorships with some new flavor or autocracy, oligarchy, theocracy or dictatorship, most of which will prove to be equally incompetent, venal and exploitative--but shorter-lived.

3. Experimentation with new models of governance, "growth" and credit/debt. Some modest recognition of the profound failures in the "extend and pretend" status quo generates a sense that these catastrophically destructive policies have been recognized as such and corrected.

These years will see the near-term bottom in housing, equities, and other assets. Those few who preserved cash during the meltdown are in a position to snap up assets on the cheap. Those who depended on credit/debit find borrowing is now difficult and dear. Those who "bottom-fished" real estate in 2011 are wiped out, along with those who bet that commodities were heading straight to the moon.

2015-2016: false dawn. Things get better; prices stabilize, assets and commodities start rising in price and a sense of hope replaces widespread gloom and distemper.

The real crisis has been pushed forward to 2020-2022. Nonetheless, 2015-2016 will offer those with cash tremendous profit opportunities.

Charles Hugh Smith - www.oftwominds.com

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So is everyone printing money?

 Source, The St. Louis Fed   Source: The BoE  

Source: The ECB Source: The BoJ

Source: The People’s Bank of China Source: Reserve Bank of India

It is interesting to compare the M2 Money Supply with the GDP and public debt figures below.

2011 UKThe 17 Eurozone

CountriesUSA Japan China

GDP $ 2,194,868,854,200 10,986,706,473,876 14,827,718,395,610 5,479,343,852,956 5,714,977,690,800GDP per Capita $ 35,269 33,379 47,866 43,219 4,266Public Debt $ 1,698,828,493,151 9,229,210,684,930 9,474,912,054,795 10,821,704,109,589 1,000,121,095,890Public Debt per Capita $ 27,291 28,040 30,588 85,358 747Population 62,232,876 329,146,025 309,777,534 126,780,273 1,339,627,397Public Debt as a % of GDP 77% 84% 64% 197.50% 18%Yearly rate of Change 10% -4% 20% 8.30% 19%

Source – The Economist

The USA has M2 Money Supply of US$8.867 trillion which is 60% of GDP. China has M2 Money Supply of RMB72.585 trillion (US$10.912 trillion) which is nearly double their GDP, showing just how much local money has been printed to keep the currency low and stimulate the recovery.

The chart of the price of gold (from Kitco on the right) reveals the deliberate start of the devaluation of the US$ to fund economic expansion by Alan Greenspan and George W Bush in March 2001.  Barrack Obama and Ben Bernanke have markedly increased Quantitative Easing stimulus since 2008. This left the UK, Europe, Japan and China no choice but to follow suit with a seemingly never ending round of “beggar thy neighbour” competitive currency devaluations.

Here is a chart of 6 major equity market crashes caused by overburdening debt, starting 6 years before the ultimate market peak and the aftermath.  In 1931, the DJI bottomed out at 10% of its peak value as there was no meaningful stimulus package and it took 25 years to make a new high.  The NASDAQ bottomed at 23% of its peak value in 2003 and remains under 60% of its ultimate.  Japan saw massive stimulus in 1992 supporting the market at 40% of its ultimate, but when that stimulus ran out 8years later the markets fell to 20%.  The Chinese since 2007, seem the be following the Japanese path of smoothing a decline.

Japan has found out the perils of a long term zero interest rate policy means the banks have no incentive to assume credit risk and lend to each other or anyone else, so they trade their own book.  The performance of the FTSE 100 and S&P500 suggest the true extent of the banks continuing to use cheap government money to trade bonds and equities.   Japan knows what happens when the “extend and pretend” gravy train stops rolling.

Equities should continue to rise while government stimulus money can find no other home. This is why politicians are irked at bankers bonuses, because they wouldn’t be making fat profits without cheap government money raised at the expense of the tax payers.  All tangible assets, commodities (metals, energy, agricultural) and rare artefacts are likely continue rising until growth is undermined.  The threat of rampant inflation and civil unrest will eventually cause the US, UK, Eurozone, Japan and China to rethink stimulus packages.

Some say this mess is a deliberately evil Machiavellian conspiracy to control us all, but it is most likely the unintended consequences of a very long chain of global borrow and spend policies designed to raise standards of living while getting governments re-elected (it certainly worked for Bush and Blair).

We are in bubble caused by politicians across the world trying to spend their way out of debt.  It hasn’t worked before and it won’t work this time either.

The problem is we do not know when the bubble will burst.

James