Tuesday, August 11, 2015

Fast Collapse or Slow? I Think Fast

Back in 2008, in the aftermath of a mortgage security meltdown there were so much distrust among banks that letters of credit and "eurodollars"liquidity -- the entire basis of payment for international trade, were refused for a month or so. International trade came to a halt. Yes, governments stepped in to backstop banks (sometimes whether they wanted it or not). Eventually, that situation eased.

But a similar, but more lasting ‘sudden stop’ might happen again and the drastic disruption to global trade and world supply chains (including food supplies) could be a basis for a rapid and prolonged collapse of the world economy.

I've written before that the collapse of commodity and oil prices along with high levels of debt might put the global economy at risk of collapse.

One problem is that we've reached "peak-cheap-oil." This means that the marginal cost of oil is so high now that when additional barrels of oil are demanded -- as is the case when the economy grows -- oil prices rise so quickly that it hurts consumer incomes and puts the economy in recession. That happened in 2008 when oil prices hit $140 per barrel. Consumers found their budgets so pinched that many stopped paying their mortgages. Mortgage debt stress morphed into a financial crisis and deep recession. Oil prices hit $108 in 2014 and it's causing a slower economy in 2015 as health care insurance and rents rise while wages are stagnant or falling. Slower growth is why oil prices (and all other commodity prices) are now dropping. Note the oil price that causes consumer retrenchment is dropping. $70 dollar oil in 2016 may be a limit.

Today, we literally can't afford high oil costs. If the economy can no longer afford high oil prices, then the economy can't grow! (because growth causes high prices!)

Low and falling oil and commodity prices are hurting all of the commodity producing countries putting them in recession and lowering their demand for our products. Sure enough, US exports are declining which means lower GDP. Chinese exports are declining. World trade is declining. High levels of debt in commodity producing countries may face defaults. Entire countries are facing default including Venezuela, Russia, Egypt and Ukraine. Some energy companies will likely face defaults.

And low oil prices hurt employment in the US oil and gas industry which lowers aggregate consumer income. US oil and gas was one of the few industries in this country providing strong employment growth and high wages. Now, that's gone. All of this is the stuff of recession.

Furthermore, the world has reached "peak debt." This means that we've basically reached the end of debt's marginal utility, meaning the amount of growth per unit of debt has declined to nearly nothing. I call it "debt saturation." It's true here and even true in China now, as their debt levels have skyrocketed since 2008. See my blog "More Debt Won't Work; Charts to Prove It."

China's economy has dramatically slowed it's debt spending as debt levels have reached historically unsustainable levels normally associated with financial crises. They "saved" the world economy in 2008 with massive projects funded by debt.  But now, the utility of debt has collapsed there too. The slowing Chinese economy is also causing all world commodity prices to collapse. Peak debt has come to China too.

And we've also reached the end of falling interest rates. Ever since 1982,  we've enjoyed a 33 year period of ever lower interest rates which has put the "wind at the back" of the economy for all that time. Now we're at zero. Most of the world is at zero. They can't go lower. Not only are rates not dropping, they might be rising. Some commodity producing countries are raising rates to defend their currencies. And the US Federal Reserve is determined to raise rates this year. But note that even steady interest rates are a problem.

Also, we've even learned that money printing, or QE, no longer works. At first it worked, but now it doesn't. The Federal Reserve stopped doing it because it wasn't really working, except to boost assets that wealthy people own. And it's distortions are known to outweigh it's benefit.

If we've reached the end of affordable energy, the end of debt's marginal utility (here and in China), no further interest rate decreases, falling commodity prices, falling consumer income and no more QE, then we've reached the "end" of world GDP growth.

And if GDP growth is ending, then the debt accumulated to pay for that growth may will prove to be unsustainable. After all, debt is predicated on rising incomes (growth) that enable future payments that include interest payments. If the economy stagnates or shrinks, then the debt with interest can't be serviced. You're seeing that in Greece and now Puerto Rico. You're seeing that in commodity producing countries and commodity producing companies. There will likely be significant defaults in energy and certain sovereign debts. These defaults will slow the economy further. More slowing causes more defaults, and on and on. This is called a depression.

What that means is that the debt crisis in 2008 was likely a prelude to more debt trouble -- even massive defaults -- in the years ahead. It might even be a prolonged economic Depression. Why prolonged? Because we no tools that works to counter it!!

So, when debt defaults create another financial crisis, it may be the "blow-ups" of the huge derivatives market that become the new crisis. An "accident" in derivatives related to commodities or the debt of commodity-producing or other countries may become the problem. It wouldn't take much to put bank's solvency in question, especially in Europe. Banks there (still) have low levels of capital. The sheer size in dollar terms of these derivatives and the size of losses may dwarf what governments might be able to do to reassure markets. In other words, a panic may not be halted. The safety of banks may again be questioned and another sudden halt of trade of all types (loss of faith in letters of credit like 2008) could happen. This time, the sudden stop of international trade and a failure of global supply chains might be prolonged as government's won't be able to cover bank losses. This scenario represents a fast collapse. This is just one scenario that could result from credit distress.

During the next recession, every central bank in the world would resort to "printing money" and buy up distressed debts, broken derivatives and fund government spending even when tax revenues crash. I could see the US running a $3 trillion annual deficit monetized by the central bank (the CB buys that debt). But maintaining government and government beneficiary spending while the global supply chain is compromised might create a rapid inflation when the supply of goods is curtailed.  If goods aren't available due to lack of credit to fund trade, and people find themselves with money the government sends them, then prices could rise rapidly. Money could become "funny money"as what it can purchase declines. This is called hyperinflation. You have this situation today in Venezuela.

If I'm right, we're facing falling world trade, recession, defaults, crisis, depression, wild money printing, hyperinflation and finally collapse (in that order). Get ready for nationalization of banks, more gov’t control and totalitarian methods employed to prolong a new but much lower level of normal that could last decades. No wonder all the movies set in the future feature dystopia. Does art imitate life? Or does life imitate art?

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