Collision Course: The Perfect Financial Storm

By James J Puplava CFP, March 1, 2004

In the world of finance (besides guessing where the stock market will end up this year), a topic that dominates front page news is the issue of inflation or deflation. The financial world is divided over this issue with the deflationist dominating the debate.

The Deflation Argument

The deflationists cite the historical levels of debt overhanging the economy and the enormous asset bubbles in stocks, bonds, mortgages and real estate. In a levered economy and financial market any increase in interest rates would cause the whole debt bubble to implode. This would lead to a deflationary spiral as debts are liquidated contracting the supply of money.

In an economy and financial world, this leveraged rise in interest rates would devastate the financial markets and the economy leading us back into a recession. Rising interest rates would also usher in the next leg of the secular bear market which has yet to begin. Collapsing asset prices, debt defaults, and bankruptcies would surely contract the money supply and this would be deflationary.

Another argument made on the deflationary side of the debate is the world is awash in excess capacity. Global competition is keeping a lid on prices, so therefore we live in an environment whereby prices continue to decline. Here again the same mistake regarding prices as a symptom rather than a root cause obscures the deflation debate as it does the debate over inflation.

Defining Deflation

I refer to Webster's definition of deflation: a lessening of the amount of money in circulation, resulting in a relatively sharp and sudden rise in its value and a fall in prices. As mentioned in a previous essay, inflation and deflation are both sides of the same coin. They are both a monetary phenomenon. A rise or fall in price is more of a symptom than it is a cause. Once again we have confusion here regarding monetary terms with deflation usually thought to be synonymous with falling prices. Historical evidence points to falling prices as a consequence of productivity and economic progress that result from increasing production and the supply of goods and services which lead to lower prices.

If a given good or widget can be produced in greater quantity resulting in lower prices, this is a perfect example of economic progress and productivity that results in goods being manufactured at a lower cost. What needs to be distinguished here is that there are two primary drivers of lower prices. The first driver is an increase in production and the supply of goods that result in lower prices as a result of efficiencies achieved in manufacturing. This is economic progress not deflation. The other driver of lower prices is a decrease in the quantity of money and/or volume of spending in the economic system. The commonality that both drivers share is falling prices; one is economic progress, while the other is deflation.

If I can buy a widget or manufactured good today at a cheaper price than what I previously paid for that same item years ago, aren't I better off? That's progress not deflation. The computer I bought last week is cheaper than the computer I bought last year at this same time. In 1997 I bought my first DVD player for over $700. Last year I bought a replacement player for less than $200. As manufacturers are able to increase production and the supply of a good or widget, its cost comes down as a result.

What Brings Deflation?

What brings about deflation is a contraction in the money supply. This reduction in the amount of money in circulation or the volume of spending in the economic system causes prices to fall. With less money circulating within the economy there is less money that can be earned, and thus there is less money available for the repayment of debt. This leads to monetary contraction and is the only real form of deflation that exists. Falling prices by themselves aren't deflationary. As the supply of money contracts, falling prices become the cure. The drop in prices is what enables an economic system to be able to buy the same amount of goods and services as before the collapse in the supply of money. Therefore falling prices are always positive as they enable a reduced quantity of money and volume of spending to buy the same amount of goods as when the supply of money and spending was much larger. It is not the general level of prices that makes debt liquidation difficult, but the supply of money that is available to pay that debt.

There are a number of ways in which governments and their central banks can confront a collapsing money supply. The government can come in and monetize debts and take them over. Government spending can be substituted for consumer spending. There are other means which government can combat a shrinking money supply. Today's financial system has also become more sophisticated by offering numerous ways in which the supply of money and credit can enter the system. Government sponsored entities (GSEs), the securitization of debt and the expansion and of money market funds are just a few of the ways that money and credit can be expanded outside the purview of the Fed or the nation's banking system. The Euro-dollar market is another.

Deflationary Storm Front Closing In

Within the next 12-18 months I fully expect a deflationary storm front to hit the financial system and the economy. The debt overhang will begin to implode with rising interest rates causing financial asset prices and real estate prices to fall. This will be deflationary. What the Fed and the government will do to counteract this deflationary storm front will be to expand the supply of money and credit within the system and the amount of money spent within the economy. This will bring about inflationary forces that will counteract the prevailing deflationary headwinds of a collapsing financial system.

Seven Headwinds of Inflation

As the financial markets begin to crater with an accompanying rise in bankruptcies and defaults, the government and the Federal Reserve will move with a use of force with every tool at its disposal. The result is that monetary and fiscal stimulus will accelerate. Listed below are seven inflationary headwinds that will confront a deflationary headwind in the financial markets and the economy.

1) Lax Monetary Policy

The first headwind is that monetary policy will remain lax. The Fed will keep interest rates low and may even drive rates lower if the economy doesn't improve or the employment picture weakens. There is simply too much debt in the system now for the Fed to tighten interest rates unless it is forced to do so by the currency markets. If rates rise, the Fed brings about the very deflationary forces it has been trying to combat. A sharp rise in rates would lead to a reversal of the "carry trade" which would cause the bank and hedge fund community to unwind their long bond positions causing rates to rise even further.

The last time the Fed attempted to raise rates was back in Q3 of 2000. The Fed raised interest rates and then quickly reversed themselves as our economy headed into recession and our financial markets collapsed.

The last major interest rate cycle was back in 1994 which led to a derivative debacle resulting in major losses for major corporations, the collapse of the Mexican peso, and the near bankruptcy of Orange County. The derivative market was around $16 trillion back then. The latest OCC reports indicates that derivates at our nations top seven banks now stands at $67 trillion, an increase of 325%.

The derivative market is a nuclear financial bomb hanging over the financial markets that would detonate with a sharp rise in interest rates. If rates were to rise sharply, the detonation of the derivative market would bring about Financial Armageddon. Central bankers' worst fears would be realized as the world's financial system would surely implode. The worldwide derivative market is estimated to be around $125-150 trillion. The sharp rise in derivatives means that central bankers will be forced to keep inflating and keeping interest rates low because there is simply too much debt in the system today. Combating inflation with a rise in interest rates as Volcker did in the late 70's and early 80's is simply not an option. We have gone well beyond the point of no return for that to happen again without the worst consequences possible from occurring.

2) Expanding Budget Deficits

3) Expanding Government Spending

Today the majority of the government's budget is made up of non-discretionary spending. Entitlements such as Social Security, Medicare, the Department of Health & Human Services, and interest on the debt make up the bulk of the government's budget aside from defense spending. We are a nation at war, so I don't expect the defense budget to decrease as I will show in just a moment. The point here is that the majority of the government's budget is untouchable. It will continue to rise at a rate faster than the economy and there are very few politicians in Washington who have the courage to tell voters that we are issuing checks that we don't have the means to pay for. In recent testimony on the budget last week, Alan Greenspan warned congressmen of the coming Social Security problem. One congressman responded honestly by stating that there wasn't a single congressman on the committee from either party who would attempt to cut any of today's popular entitlements. Entitlements are simply untouchable.

Shortly, in the year 2008, the first batch of baby boomers will enter into retirement. They will begin collecting Social Security benefits putting further strains on the government's budget. The problem for the government is there is no trust fund to use to pay these benefits. The money has all been spent. All that remains is IOUs in the form of zero coupon bonds that will need to be cashed to pay future benefits to an expanding Social Security benefit base as a result of aging boomers. These bonds, when they come due, will have to be paid for out of the government's general fund. This will only exacerbate an expanding budget deficit and make those deficits biblical in size. Even if you believe in the myth of a trust fund, we still get into trouble as shown in the three government graphs shown below:

2003 Financial Report of the United States Government (Net Cost Comparison), OMB, February 2004

Our government's unfunded liabilities have risen to over $44 trillion and are rising by over $2 trillion a year. There is simply no way out and the only option left is to inflate or die. Does anyone reading this really expect their local or national representative to level with the truth that we are broke and don't have the means to pay benefits? All I see and hear is politicians from both parties promising me more cookies and lollipops.

The mindset in Washington is that politicians must continue to spend money. It is the only reason for Washington's existence. Politicians love to hand out cookies and lollipops to the voters. The majority of congressmen are economically illiterate. There is always a well of money somewhere which politicians can tap in order to keep the flow of cookies and new lollipops to voters at election time. This year is no different with politicians in both parties promising more and even bigger entitlements to voters.

4) A Falling Currency

As a result of America's twin deficits (trade deficit and budget deficit) the dollar will head lower, much lower. The loss of 28% of its value since 2001 has done very little to address the nation's trade imbalance which is structural. The recent trade deficit figures indicate that we continue to import more capital goods into this country, while our exports of capital goods continue to decline despite a falling dollar. We are also importing more oil and paying a higher price for that oil. The trade deficit is structural and will continue to climb until the dollar loses half of its present value. When that happens, Americans will no longer be able to afford to buy foreign cars and electronics. But we will still be importing capital goods that we no longer manufacturer here and we will still be dependent on foreign oil to run our economy. That dependence will only deepen during the twilight of the oil era.

A falling currency translates into higher prices for the things we import into this country. While higher prices may eventually weaken demand for foreign made goods, it will not get rid of our need for basic necessities. If we burn more oil and natural gas, we will simply have to pay what the market dictates. We are no longer in control of our energy future. In fact we are looking head on at another energy crisis or series of energy crises this decade. We also face issues regarding capital goods. If we need to buy a tractor to increase food output, if we need to import more fertilizers to realize higher crop yields, if we need to modernize plant and equipment to remain competitive and these goods are no longer made here, we will have to import them. If our currency continues to decline and depreciate, as it surely will with trade and budget deficits set to remain above $1 trillion each year, the dollar will only head lower and the price of things we need will only go higher.

The Twin Sisters with Their Cousin

5) War and an Expanding Military Budget

The next war has just begun. The era of peace and stability that we have come to know is over. We are entering an era in history, not of peaceful economic competition between nations, but a time of warfare between tribes, ethnic groups, religions, and economic systems. This war will be unlike other wars. There will be no major battlefields. Armies won't line up to face each other and do battle. The 21st century war will be taken to the cities and suburbs as well as the skies. It will be fought with car bombs, small explosives, light armaments, and surveillance. It will be a war of men killing each other at close quarters. Battles will be replaced by skirmishes, bombings, massacres and genocide. It will be fought by regular armies against small groups known as terrorists, guerrillas, bandits and robbers. For the first time in the West, war will become personal. It won't be watched from afar, but will be experienced first hand as immediate participants, victims or targets. In this new war, age and sex will be meaningless for many of its warriors will have little regard for life.

The Visible, Yet Invisible Face of Evil

This war will be bloody, brutal and cruel. Lives will be lost, villages and property destroyed, commerce disrupted, and governments toppled. In many ways, it will seem like medieval times. Military and economic functions will start to merge in an effort to wage war. Glory, profit and the spoils of war will be just as important as winning the war. In fact, they may become the objective of war itself. At other times it may seem that the war doesn't exist. Most of this war will be fought covertly. Battles, victories and skirmishes may not be reported or for that matter, even known. It will be a lot like a chess game, but with real players. It will be fought through intelligence as each side tries to determine what the other side is up to in order to predict what is unpredictable. It will be fought through action as well as words. It will be visible and at the same time, invisible.

The deeds of 19 terrorists on September 11^th were visible for all to see. Yet al Qaeda is visible only when it acts. It is not a nation. It has no boundaries. Its few thousand warriors are scattered throughout the world. It is both agile and highly mobile as it is invisible. It doesn't present an easy target for the generals. This will not be an easy war to win. It will be as long as it is uncertain. There will be no measurable yardsticks for the public to view its progress. An occasional firefight, a sudden explosion, or a downed jetliner will be the only recognition that this war even exists.

Defining The New War - Shifting Plates

To some this war will be about freedom, to others it will be about revenge. To the Islamic world, it is about social unrest as well as an assertion of cultural and national identity against a background and inability to modernize in a very modern world. This war will have many facets, some of which will be political while much of it will be economic with religion thrown in between the two. Like all wars, it will disrupt the flow of power and wealth. A great power shift is taking place. Like the natural world where volcanic eruptions and earthquakes signal powerful forces are at work, the tectonic plates are on the move again. Just as those volcanic eruptions and earthquakes throw the earth's crust up into mountains and down into basins, the same events are taking place in the world's political and economic systems. The world's present power structure and economic system are coming under severe strain. The economic eruptions that are now present in the financial and currency markets are the first signs that a Vesuvian eruption is about to be unleashed. As these political and economic plates shift under the pressure of war, a new political and economic order will emerge.[1]

7% change from FY 04 to FY 05

Although I wrote these words over two years ago they are just as relevant today. We are a nation at war and our military budget reflects this war. The military budget will expand by 7% next year to $401.7 billion. It has risen from $$297 billion in 2001 to this years $375 billion. As shown in the table below, outlays for military spending will rise to $487.7 billion by the end of the decade. These outlays do not include emergency and non-emergency spending for the War in Iraq which will added another $72 billion to the military budget for 2003 and will add another $66 billion to the military budget this year.

Department of Defense - Military (In millions of dollars)	Actual		Estimate
	2001	2003	2004	2005
Spending
Discretionary Budget Authority:
Military Personnel	76,373	93,932	97,932	104,812
Operation and Maintenance	107,450	125,290	127,626	140,636
Procurement	61,672	74,677	75,321	74,904
Research, Development, Test, and Evaluation	41,109	57,337	64,331	68,942
Military Construction	5,405	6,505	5,452	5,288
Family Housing	3,622	4,179	3,805	4,173
Revolving Funds and Other (with rescissions and transfers)	1,169	3,340	792	2,962
Subtotal	296,800	365,260	375,259	401,717
Emergency and Non-emergency Supplementals 1, 2	10,009	72,235	66,109
Total, Discretionary budget authority 3	306,809	437,495	441,368	401,717
Discretionary Outlays	287,222	339,270	377,711	403,453
Emergency and Non-emergency Supplementals 2	4,527	48,831	56,396	25,477
Total, Discretionary outlays	291,749	388,101	434,107	428,930

¹ 2003 supplemental funding does not reflect all transfers to other agencies.
² 2004 includes CPA administrative costs.
³ For comparability, the 2001 data reflect transfers related to the creation of the Department of Homeland Security
Source: FY 2005 Defense Budget

Wars are inflationary. Why? The government spends more money which therefore does not contribute to productivity or expansion of the supply of goods and services within the economy. Wars also consume resources which means the price of tangible goods keep going up and will rise even further.

6) Soaring Oil and Commodity Prices

We are entering an era of energy scarcity, a time when the price of energy will rise relentlessly. There will be times or brief periods when the price of energy will recede, but only for brief moments of time. The western world whose economies run on oil will experience rising energy prices throughout this and the next decade as major oil fields go into decline globally. Falling oil discovery rates will result in further industry consolidation as companies rely more on new technology to harvest oil from existing fields. The energy markets will be characterized by the fact that we will be finding less and consuming more. The result will be even higher prices for the energy we consume. Western economies run on oil. We use it as fertilizer to grow our crops and power the tractors that plow the fields. We use it as a source of heat and to cool our homes as temperatures change. We use oil in all forms of transportation from the ships that carry crude across the oceans, to the trucks that transport goods to factories and stores, and a means of transportation to and from work or a leisurely drive in the country. Oil is used as fuel to carry passengers in planes around the world. Our modern world runs on oil.

The simple fact is that we are running out of cheap oil and there are no remedies to immediately replace it. All present projections for increasing demand assume that that increase in demand will be met by growing surpluses coming out of OPEC. Specifically, when the world refers to OPEC they really mean Saudi Arabia. Saudi oil has become the plug factor that makes up for supply deficits in the rest of the world. However, the assumptions of abundant Saudi oil have not been verified for a long, long time. Experts now believe that the kingdom's oil fields are now in decline. Outsiders have not had access to detailed production data for more than two decades. The Department of Energy estimates that Saudi Arabia will need to expand production to 13.6 million a barrels a day by 2010 and to 19.5 million barrels a day by 2020. That is a lot of oil and there are many experts in the energy field who now question that capability. The majority of Saudi Arabia's output comes from one large field: Ghawar. According to these experts, decline rates in the kingdom's mature energy fields is averaging 8% a year.

"Can China Keep the Lights On?
Fortune Magazine, February 23, 2004

In fact the majority of the world's oil comes from 14 fields that have been pumping crude for over 60 years. New oil discoveries ended in the late 60's and early 70's. Shut-in spare capacity is small or nonexistent, while inventory levels remain at multi-decade lows here in the U.S. and "just in time" elsewhere around the globe. What separates us from crisis is a 1-3% increase in demand or a 1-3% reduction in supply. When it comes to energy, we have very few alternatives as demand continues to accelerate as a result of an expanding world economy, especially China. Demand for oil in China was up 30% last year. China now imports close to 60% of its oil from the Middle East. Last year China guzzled 5.4 million barrels of oil a day. China's government estimates by the year 2010 oil consumption in the country will rise to 7 million barrels day as per capita income rise above the $1,000 level and demand for passenger cars grows even stronger. Last year passenger car sales jumped 55%. Like the U.S. China's demand for energy has become insatiable.

While oil demand accelerates, the discovery and production of oil has fallen even further behind demand. U.S. and Canadian natural gas and oil production have peaked. Exploration companies in North America have been unable to grow oil and gas production despite a major increase in capex spending. Most western oil fields went into declines decades ago. The simple fact is that all of the assumptions about increasing oil demand assume that this demand can be met by cheap Saudi oil. Many experts such as Mathew Simmons of Simmons-International now question that assumption. If Simmons is correct and the reserves aren't there, the world has no backup plan. [See The Saudi Arabia Oil Miracle]

The simple truth is that we are at a key pivotal point that will swing the world away from oil as its primary fuel. This transition will be forced upon us reluctantly by higher prices as a result of peaking oil production. This will ultimately add even more inflationary pressures on the economy. While Wall Street experts continue to forecast $24 oil (a forecast that has been wrong for the last three years), we are more likely to encounter $100 by the end of this decade. Crude oil prices hit $36.86 in Nymex trading today. The CRB hit another new record at 278.61. The price of just about every major commodity is hitting a new record from copper, silver, platinum, soybeans, to corn and crude oil. We are now in an era of war and expanding government budgets. This is inflationary.

Source: www.ino.com

Just as war led this country out of the last depression, war will also be seen as a policy stimulus for an economy that hangs by a thread and is only a few steps from entering into depression. The major difference this time is that the U.S. economy is no longer a self sufficient economy as it was during the 1930s. The United States is no longer self sufficient in energy, manufacturing or in capital. During the 1930s we had an abundance of everything from energy to capital and made just about everything we consumed. We were the world's leading industrial power and enjoyed a competitive edge in manufacturing. Today about the only thing we manufacture is credit and cheap dollars. Our manufacturing base has been gutted and exported overseas. We ran out of abundant oil in 1971 and have steadily relied on imports ever since. Regarding capital, we now import over $500 billion of capital each year to fund our trade deficits and must borrow $5 for every $1 in economic growth.

The U.S. is a different country today than it was in 1930. Debt-based economies that are dependent on foreign goods and foreign energy and capital have a different depressionary outcome than those that are self reliant and self sufficient. Debt-based economies have a tendency to debase their currencies and inflate their way out of crisis. This is the road on which we now travel and that road is inflation.

7) Protectionism

As each nation struggles to keep its economy afloat, its politicians are adopting protectionist's measures to gain an up-leg on its competitors. Not only are protectionist's drums beating loudly in the halls of government, but also on the campaign trail. Calls for tariffs are being put into action here in the U.S. and overseas. Today the European Union imposed trade sanctions on U.S. exports in a dispute over export tax breaks. The European Union will impose a 5% duty on selected goods such as jewelry. The 5% duty will rise by 1% a month to reach $315 million by the end of this year.

Last year President Bush imposed tariffs on steel. On the campaign trail this year all of the candidates are talking about trade sanctions. Protectionism is back in vogue. Politicians aren't just talking about it--they are acting. Tariffs, trade sanctions or currency debasements are being enacted or carried out as official policy with governments around the globe. Each nation is resorting to a "beggar thy neighbor policy" reminiscent of the trade wars of the 1930s. The European statesman Fredrick Bastiat once remarked, "when goods don't cross borders, armies do."

Trade wars, currency debasement, tariffs and protectionists measures are inflationary. That seems to be the direction the world is heading. Like the 1930s, these trade conflicts will lead to general conflicts, which left unresolved will lead to war. War by its very nature is inflationary.

In his book "The Great Wave", historian David Hackett Fischer concluded that the world was living in the late stages of a very long price-revolution. The author felt we had now arrived at a critical stage, a time when these processes accelerate becoming part of a global process. Hackett acknowledges that in time a free market will correct all price distortions. But in between this time, historical equilibriums are more common. Throughout the passages of history, equilibrium has been the exception rather than the rule. As Hackett puts it

"A free market restores equilibrium only to break it down again, and set into motion a new sequence of imbalances and instabilities with all of the troubles that follow in their train. In the full span of modern history, most free markets have been in profound disequilibrium most of the time-often dangerous and destructive disequilibrium" In our complex and highly integrated modern economies, there are no truly free markets any more. The free market in the twentieth century is an economic fiction, much like the state of nature in political theory of the eighteenth century. Markets today are highly regulated and actively manipulated by both public and private instruments "It is an axiom of military history that generals are trained to fight the last war. In economic history, planners and managers are taught to prevent the last crisis from happening again. The next one is always different."[2]

Fischer's Great Wave is about to play out to conclusion. As in all past price revolutions in history, we are now seeing the same sequence play out right before our eyes. We are seeing rapid rises in the price of food and energy, which habitually get excluded from inflation price indexes. As in past price inflations, energy prices are rising more rapidly than general manufactured goods. The reason manufactured goods are rising less rapidly is because of economic progress. The supply of manufactured goods can be expanded more rapidly to meet rising demand from a growing world population. The rising price of commodity goods is further exacerbated by monetary factors, which are becoming self-reinforcing. The quantity of money is expanding globally as governments and their central bankers try to meet the growing demands of their constituents. Government deficits are also soaring. What the government can’traise in taxes, they make up for by printing more money.

The result is that prices continue to rise on all the things you need, while manufactured goods prices remain moderate due to increasing worldwide production. More people are living closer to the margin as the cost of all basic necessities rise as reflected in the chart of the CRB index. Rising prices are leading wealth inequality as those least able to afford it are hit the hardest by the rising costs of life's basic needs of food, energy, and shelter. As prices rise, so does the crime rate and societal tensions. These conflicts and price increases will continue until they lead to a culminating crisis, either a war, an environmental catastrophe, an economic depression, or some new plague concocted from the vials of some terrorist's lab. History is repeating itself once again... maybe not in the same way, but in a familiar rhythm.

Today's Markets

It was a good day for the markets--very reminiscent of last year when all asset classes rose. Stocks closed sharply higher with the Dow adding close to 100 points. The tech sector looked like it was hoping for recovery. Today's gains were triggered by the Institute of Supply Management's February Index, which fell from a 20-year high of 63.6 to 61.4. The missed numbers were cited as being positive since the index has remained above the 60 percent mark for four consecutive months, something that has happened only nine times in the last two decades.

Bonds held firm with only slight losses with the 10-year Treasury note remaining below 4% at 3.939.

Commodity prices were hitting new records as the price of just about everything rose to new records. Copper prices hit a new eight and half year high at a price of $1.3985. Silver prices soared jumping $.23 to close out the day at $6.95. Oil prices jumped $.70 to finish out the session at $36.86. Platinum prices leaped $20 to $957.50. The result of all of these commodity price spikes was that the CRB Index hit a new multi-year high at 278.61.

The price of everything you need went up today as did the price of things you don't need such as stocks. These are inflationary times where the price of assets--both intangible and tangible--is rising at the same time.

On the NYSE volume levels hit 1.455 billion. Advancing stocks outdid losing stocks by a 24-7 margin on the NYSE and by 2-1 on the Nasdaq.

[1] Powershift-Oil, Money& War, Feb. 22^nd 2002, Perspective Series FSO
[2] The Great Wave, by David Hackett Fischer, p.252-253
Other References
FY 2005 Defense Budget (pdf) OMB/Dept of Defense
Budget of the United States - Fiscal Year 2005
"Budget Deficit May Surpass $450 billion" The Washington Post, July 15, 2003
2003 Financial Report of the United States Government (Net Cost Comparison), OMB, February 2004
OCC Bank Derivative Report for Third Quarter 2003 (pdf)

James Puplava

© 2004 James Puplava

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James J. Puplava CFP
PFS Group
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