A Sea of Debt
By Tony Allison, May 14, 2007
Warren Buffett has famously quipped “it’s only when the tide goes out that you learn who’s been swimming naked.” Well, the great sea of liquidity currently swamping the global financial system will eventually ebb, and many, many people will be caught without a bathing suit.
Every new generation believes that it is special, and not subject to the lessons of history, or the laws of economics. Until things go terribly wrong of course. Then historical parallels are crystal clear, in hindsight.
Setting the Stage for the Roaring 20’s
While every era is different, the problems associated with excess liquidity ultimately make their way to center stage. In a book titled “Money Central Planning and the State,” author Richard Ebeling makes some interesting observations about the Federal Reserve from inception in 1913 through the 1920’s.
“In the first seven years after the Federal Reserve came into full operation in 1914, wholesale prices in the US rose more than 240%. How had this come about? Between 1914 and 1920, currency in circulation had increased 242.7%, checking deposits had gone up by 196.4%, and time deposits had increased by 240%.” As an aside, this followed a period of over 100 years of stable prices, except for times of war when the gold standard was suspended.
During this period the Fed began to replace gold certificates with the new Federal Reserve Notes. “Unlike gold certificates with 100% gold backing, Federal Reserve Notes only had a 40% gold reserve behind them,” said Ebeling. “This enabled a dramatic expansion of the currency.” By 1933, the gold backing of the currency disappeared into history.
A Warning for Future Generations
According to Ebeling, one of the few economists to question the Fed’s actions during the 1920’s was Benjamin Anderson, Senior Economist for Chase National Bank. In February 1929, Anderson pointed out that “excessive bank reserves generate bank expansion, and bank expansion running in excess of commercial needs will overflow into capital uses and speculative employments. Low interest rates and abundant credit will reflect themselves in rapidly rising capital values.” Anderson believed this pointed inevitably to a corrective downturn. Clearly Benjamin Anderson was not a popular guy during the Roaring 20’s. What a wet blanket!
Immediately following the crash of October, 1929, Anderson summed up the situation and left an explicit warning for future generations. “Basically, our present troubles grow out of the excessively cheap money and unlimited bank credit available for capital uses and speculation from early 1922 until 1928. There is no intoxicant more dangerous than cheap money and excessive credit.” (Emphasis added)
This Time Things are Different
Fast forward 78 years, and many things have changed, but not human nature. The Federal Reserve is supremely confident it could avert anything remotely like the depression of the 1930’s. The world financial system today is much more sophisticated. Any market “dislocations” can be handled with coordinated and savvy professionalism by the world’s central banks. This time things are different.
Actually, things are different. The US federal debt levels are vastly higher today ($8.8 trillion and climbing) than in 1930 (approximately $16 billion). We are no longer energy self-sufficient as we were in the 1930’s. Today, the US must import over 50% of its energy needs. The latest trade deficit numbers for March ($63.9 billion) reflect this. The deficit included $24.6 billion for imported oil and refined gasoline, over 38% of the total trade deficit. To offset our growing trade gap, the government must borrow $2.5 billion per day from foreign sources just to stay afloat. And lastly, according to the Bank of International Settlement data, the total notional value of global derivative positions, non-existent in 1930, is now estimated at $370 trillion (that’s 370 followed by 12 zeros), up nearly $300 trillion in less than 10 years. Yes, things are different this time.
Debt as a Tattoo
Outwardly, the global economy has never been stronger. Historically however, economic excesses are praised and welcomed as the bubbles expand. Everything is just wonderful until one day it isn’t. But then it is one day too late. The tipping point is unknowable of course, but when it arrives, the markets just might react too quickly for an investor to calmly ponder his or her next move. Debt of this magnitude is like a tattoo; fun to have at first, but one day you realize it’s all a huge mistake. And tattoo removal, while painful and expensive, may be much easier than eradicating a debt burden that is on an exponential growth curve.
A re-run of the great depression is probably not in the cards. However, with rapid currency growth now occurring on a global basis, a multi-national version of Argentine-style hyperinflation is certainly possible.
A Reversion to the Mean
These global and historic debt levels will eventually be rebalanced, as “unsustainable” trends finally can sustain no longer. The question remains if the reversion to the mean will be hard and fast, or more gradual. Either way, the laws of nature and economics aren’t likely to be repealed just for us. But as we should all know by now, imbalances and bubbles can extend far beyond the realm of common sense. The global credit bubble may continue for another five years, however unlikely that may seem today. But it will end.
As Prudent Bear credit analyst Doug Noland noted recently, “the longer current destabilizing flows are allowed to run roughshod- distorting prices, risk perceptions, and economic structures in the process- the more arduous the unavoidable adjustment period. That’s just the way it works.”
The Federal Reserve will continue to work hard at dampening inflationary expectations. This has proven successful in the past and may yet for a period of time. But ultimately the inflation visited daily upon the populace is likely to become too burdensome to ignore. People will not hold and save a currency indefinitely when it buys less and less at an increasing rate. As many other foreign currencies are now printed to excess, we could see competitive depreciation in currency values. Gold and silver are the obvious benefactors of this global debasement. Once inflationary expectations become part of the public consciousness, the genie is out of the bottle. Inflation will then be perceived as accelerating. The public perception may then be very difficult to change without significantly higher interest rates.
Prepare for the Ebbing Tide
The solution is not to go the ostrich route and ignore the problem, but to take prudent action while you go on about your life. The drill should be familiar. While Uncle Sam can’t get out of debt, the average citizen would be well advised to do so, or at least lower one’s debt profile. Next would be to invest in areas that will mitigate against rising inflationary trends, such as the natural resource sectors and other tangible assets. Thoughtful, ongoing preparation is the key. It’s somewhat analogous to getting punched in the mid-section. If you know its coming and prepare yourself, the punch may hurt a bit, but it’s manageable. If you are totally blind-sided, you end up writhing on the ground, gasping helplessly for oxygen. If you believe inflation will be a major issue in the years ahead, now is a good time to get started on protecting yourself.
Noting the aforementioned wisdom of Warren Buffett, when the great global tide of liquidity finally ebbs into reverse, make sure you are one of the forward-looking swimmers dressed for the occasion.
“No generation has a right to contract debts greater than can be paid off during the course of its own existence.” George Washington to James Madison, 1789.
U.S. NATIONAL DEBT CLOCK
The Outstanding Public Debt as of 14 May 2007 at 10:13:53 PM GMT is:
The estimated population of the United States is 301,880,797
so each citizen's share of this debt is $29,225.94.
The Dow Jones Industrial Average advanced 20.56, or 0.15 percent, to 13,346.78. Other stock indicators were down for the day. The Standard & Poor's 500 index declined 2.70, or 0.18 percent, to 1,503.15, and the Nasdaq composite index lost 15.78, or 0.62 percent, to 2,546.44.
Bonds fell slightly, as many investors stayed on the sidelines ahead of Tuesday's economic data, which will include the National Association of Home Builders' housing market index. The yield on the benchmark 10-year Treasury note edged up to 4.69 percent from 4.68 percent late Friday.
The dollar was mixed against other major currencies, while gold prices fell slightly.
Blue chip stocks managed a modest increase following DaimlerChrysler AG's announcement that it will sell 80.1 percent of money-losing Chrysler Group to Cerberus Capital Management LP, a private equity group, for $7.4 billion. The announcement, which helped provide a hefty lift for Ford and General Motors shares, undoes a 1998 merger aimed at creating a global auto giant. If there is any further proof needed about the excessive amount of private equity funding looking for a home, this deal may provide the evidence.
Wishing you a good evening,
© 2007 Tony Allsion