We’ve been exploring how the credit bubble resolves itself. Inflation? Deflation? Are we locked in to a long, long period of stagnation, slump and economic sclerosis?
Yesterday, we shared our research department’s forecast for the short term: Based on simple regression-to-the-mean logic, it suggests that the ‘most likely’ course for US stocks over the next three months is a loss of more than 6%.
Today, we give you our long-term forecast.
Little by little or one savage blow
‘This is the most negative ever,’ says our chief number cruncher Stephen Jones. It shows a loss of 9.8% every year for the next 10 years. In other words, our mean-regressing-, debt– and demography-adapted model also seems to be pointing to a long depression.
But an average loss of 9.8% per year over 10 years can happen in a number of different ways. Little by little. Or in one savage blow.
A foreshadow of the long depression crossed the planet like a total eclipse of the sun twice in the last 100 years.
The first time was America’s Great Depression. You know that story. Stocks crashed. Businesses went broke. People lost their jobs. Banks failed. Events were following the typical depression script, which probably would have bottomed out and recovered within a couple of years — as happened in the Depression of 1921.
But then, the federal government stepped in. It froze prices, including the price of labour. It cut off trade. It blocked liquidations. It arrested the progress of the correction.
Murray Rothbard analysed the policies of the Hoover and Roosevelt administrations in his 1963 classic, America’s Great Depression. He showed how government, trying to stop the Depression, actually prevented it from doing its work.
The short, quick deflationary shock — which should have slashed bad debt, bad businesses and bad investments — turned into a long, agonising slump. The Depression, which should have been over by 1933, continued until the 1940s and was only ended then by the biggest public works spending program in history — World War II.
This, by the way, did not actually make people better off economically, but it ‘put people to work’ and largely disguised the drop in living standards which that war and the Depression had caused.
The second long depression was in Japan, following the crash of its stock market in 1990. It has now been a quarter of a century since that crash. Japanese GDP has scarcely advanced, as you can see in the following chart:
And the Japanese stock market?
From a high of nearly 40,000 in 1990, the Nikkei index now trades at around 20,000. It’s taken 25 years to claw itself back to a 50% loss!
Japan is running out of time and money
The blame for the long-ness of the depression can be placed squarely on the government. To this day, it continues to meddle in the economy — essentially forestalling a genuine clean-up of bad debt.
Instead of allowing the bad debt to be written off and reduced, policymakers have added more and more debt over the entire 25-year period so that today, Japan’s government is the most indebted in the world.
And now Japan is running out of time and money. Its aging population is no longer saving for retirement; now retirees expect to spend those savings. This means that the government can no longer count on financing from Japan’s savers. Now it must return their money.
But how? It has no money to give them. Like the US, it has been running budget deficits for years.
Japan’s economy is in a crisis. It’s been two years since the Shinzo Abe government began its stimulus program. But wages are actually lower today than they were when it began. And this is happening against a backdrop of falling labour supply; the labour pool is expected to shrink by 20% over the next 25 years. The main goal of the stimulus program was to raise Japan’s inflation rate. But you could multiply the last 12 months of price increases by nine and still not reach the government’s 2% target.
In the US, too, inflation has been disappearing as fast as good manners. In the last 12-month period, consumer prices were approximately flat. And that is despite a 400% increase in the Fed’s assets — the nation’s money foundation — over the last six years.
If that kind of money printing doesn’t cause an increase in the CPI, what would? We’ll come back to that question in a minute.
Cheap credit keeps the wheels turning
If inflation can’t be counted on to reduce the world’s debts, what about deflation?
The feds fear it, loathe it and try to prevent it every way they can. But deflation works. It knocks down sales, prices and employment, forcing borrowers into bankruptcy. Then, their debts are worthless.
Alas, in a zero-rate world, the banana peels disappear from the sidewalks. It is almost impossible to go broke, default or fall on your face.
Grant’s Interest Rate Observer told the story of one company: Radio Shack. The company lost the plot back in 2007, says Grant’s. The Onion satirised its chief executive, Julian Day, putting the following words in his mouth:
There must be some business model that enables this company to make money, but I’ll be damned if I know what it is.
But Radio Shack stayed in business — borrowing ever more money as its credit rating declined from BB- to D (or ‘junk’) over the following eight years. Finally, it bit the dust in February of this year.
There’s nothing like unlimited cheap credit to keep the wheels turning — slowly. In 2009, a grim year for American business, 60,837 firms declared bankruptcy. In 2014, there were 26,983 bankruptcies.
What is surprising is not that there were so few, but that there were so many. When you can borrow for nothing…or close to nothing…why does anyone ever default?
Of course, not all firms have equal access to the free money. The little guys go broke. The big guys stay in business. The economy stays alive, but on life support.
The big limitation of this system is that as the slump worsens, prices fall and real interest rates actually go up. That is, the feds may lend at zero, but if prices are falling, the effective, real borrowing rate may rise.
The authorities would be “zero bound,” unable to take nominal rates below zero and unable to keep the real price of money at nothing.
A War on Cash
Until recently, it had been presumed that rates could not sink below zero. People would not pay for the privilege of holding cash in a bank or a bond; they would just take the cash and hoard it.
But all over the world, central governments have begun a ‘war on cash’ designed to force people to use credit, rather than cash. The feds can monitor, tax and control credit. They can even force you to pay for the privilege of having it.
The European Central Bank and the Swiss National Bank already require depositors to pay for storing money. And beginning this week, JPMorgan Chase began charging depositors a ‘utilisation fee’ to hold their money.
Meanwhile, economists are advocating taxing cash or even, like Harvard economics professor Ken Rogoff, making it illegal. France has already made it illegal to pay bills of more than €1,000 with cash. And the US requires financial industry workers — such as bank tellers — to rat out customers by filing ‘suspicious activity reports’ on anyone who comes in with what they consider an inappropriately large amount of cash.
Why the ‘war on cash’?
Partly to control you. And partly to control the economy. If they can create a NIRP world — with negative nominal interest rates — they may be able to keep the credit flowing to cronies and zombies, maintaining the economy in a coma for many years.
Businesses that should go broke will have access to credit. Speculators will still make money. Governments will continue to print money and borrow it from themselves. The zombies will throw rocks and bottles every once in a while, but they will still get their cash and the system will survive.
Long, drawn-out depressions are caused by governments.
The politicians respond to today’s capital interests, not tomorrow’s. Today’s retirees vote. Today’s stockholders give campaign contributions. Today’s cronies control the power and money of today’s society.
And all of them fear one thing more than any other: the future.
They all know they will die, and that the process of capitalism is creative destruction — today’s wealth owners must be stripped of their money and power so that tomorrow’s generations can take over. And that’s why government’s essential role is to look into the future and prevent it from happening.
This is just another way of saying that governments will always try to stop depressions, because depressions are creative destruction in action.
Capitalism chops down today’s trees so that tomorrow’s saplings can get some air and light.
But trying to stop creative destruction does not stop the future. It just changes it. Instead of a dynamic, honest and growing economy, we get stagnation, economic gangrene and financial rigor mortis. Long depressions, in other words.
The tipping point approaches
As we have seen, Japan has already had a 25-year slump. The US is now in Year 8 of its slump, with fragile growth at only half the rate of the last century. They could get better…or worse.
Negative rates could keep the cronies in business. The slump itself — combined with peak debt and 500 million Chinese labourers — could keep inflation in check.
But the point comes when investors see that the risk of loss (because something can always go wrong) is greater than the hope of gain. That moment must be approaching in the US stock market. Prices are near record highs, even as the economy flirts with recession.
One day, perhaps soon, we will see stocks falling — as much as 1000 points in 24 hours.
Jacking up the stock market has been the Fed’s singular success. Activism has been its creed. Interventionism is its modus operandi. It will not sit tight as the market falls apart and the economy goes into recession.
Instead, it will announce QE 4. It will try to enforce negative interest rates. And it will move — as will the Japanese — to ‘direct monetary funding’ of government deficits. That is, it will dispense with the fiction of ‘borrowing’ from its own central bank. It will simply print the money it needs.
The US Fed of 1930 was not nearly as ambitious and assertive as the Fed of 2015. In the 30s, it watched as the economy chilled into a Great Depression. As Ben Bernanke told Milton Friedman, ‘We won’t do that again.’
It couldn’t if it wanted to. Back in the 30s, consumer debt had barely been invented. Most people still lived on or near farms, where they could take care of themselves even if the economy was in a depression. Few people had credit. Instead, they had savings. There were no food stamps. No disability. No rent assistance. No zombie industries. No student debt. No auto debt. No cash-back mortgages. And cash was real money, backed by gold.
Bogus rehab and claptrap therapy
Today, a long depression in the US would be unbearable. The public couldn’t stand it. Six out of ten households live paycheck to paycheck. Can you imagine what would happen if those paychecks ceased?
Supposedly, the US economy is still growing…with the stock market near record highs. Yet, one out of every five households in America has not a single wage-earner. Among inner-city black men aged 20-24 only 4 out of 10 have jobs. Half the households in the US count on government money to make ends meet. And 50 million get food stamps. What would happen to the cities — and the suburbs — in a real depression?
What would Janet Yellen do? Would she rehash the words of Andrew Mellon in 1929 to ‘liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people?’
Mellon was just suggesting that creative destruction be allowed to do its job. He was the last Treasury secretary to make such a forthright and honest comment. Thenceforth, Treasury secretaries and central bank governors could no longer accept the tough love of a free enterprise economy. They had to offer bogus rehab and claptrap therapy. They had to stop creative destruction. They had to ‘tell it like it wasn’t’ because that’s the way people wanted it. They had to pretend to make a better world by improving the market economy.
Today, a central banker or Treasury secretary who let deflation purge the rottenness from the system would be dismissed before sundown. Too much wealth, too many reputations, too much power and status depend on the continuation of the credit expansion. Instead of a Mellon, we will have a Greenspan, a Bernanke or a Yellen. And we will soon find out whether Mr. Bernanke spoke the truth in 2002 when he said:
‘We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.’
Threatened with deflation, the authorities will want to turn the tide in the worst possible way. What’s the worst way to stop deflation? With hyperinflation.
Yes, we may suffer a year or two more of sluggish growth…or even deflation. Stocks will crash and people will be desperate for paper dollars. But sooner or later, the feds will find their feet and lose their heads.
Most likely, the credit-drenched world of 2015 will end…not in a whimper of deflation, but in a bang. Hyperinflation will bring the long depression to a dramatic close long before a quarter of a century has passed.
for the Markets and Money Australia