This Isn’t 2007. It’s a Mess

Just as Germany approved the revamp of Europe’s dedicated bailout fund, the rumours began swirling. Are the Irish printing punts? Are the Germans creating Deutschmark?

Why the pessimism? Because it isn’t 2007. Back then, people with just a touch of cynicism and common sense could see something was wrong. It was straight forward to warn people of the impending stock market crash, the financial crisis and economic disaster. Markets and Money editors did it every day all around the world.

Today everyone can sense something is wrong – even the Federal Reserve. That makes life difficult for investors. Being ahead of the curve is very difficult when you don’t know which way the curve is moving. Inflation or deflation? Dollar rally or collapse? China boom or bust? Sovereign defaults or rescues?

Of course, without government intervention, things would be much clearer. But we don’t live in an ideal world. So our bet, as is often the case at the Markets and Money, is that we’ll have them all. Inflation and deflation. A dollar rally and then collapse. A China boom and then bust. Sovereign rescues and defaults. In other words, we’ll have chaos. The real question is how bad that chaos could get. And what to do about it. Dan Denning is answering the second question in his newsletter Australian Wealth Gameplan. That means we’ll have to stick with the first for the most part.

The chaos will be very bad.

It won’t end in a return to the Stone Age, but it may well be on the scale of the Great Depression. In many nations it already is if you allow for changes in technology, living standards and how things like poverty and unemployment are measured. For example, if you measure unemployment as it was measured in the 1930s, the US wasn’t far off the 1930 level just last year. Based on the calculations of, it is still trending up.

SGS Alternate Unemployment Rate
U.3 is the government’s official rate
U6 is a wider definition of unemployment
SGS is Shadow Government Statistics estimate

It’s quite likely that things could get worse than the Great Depression in many nations. That’s because debt magnifies risk. To the upside and to the downside. There are limits to the downside though – beyond which the story ends very badly, with default.

This holds true for the overleveraged private and public sectors around the world. In Australia, the public sector isn’t overleveraged, but we make up for that by relying on China, where all leverage is public sector in the end. More on that below.

Once debt growth slows and deleveraging begins, so slows the economy and a recession/depression begins.

Governments are struggling to keep the welfare state funded already. And we’re not even in a recession … according to their statistics. What happens when bond markets run dry or interest rates go up? What will happen if welfare cheques are paid for by the central bank creating new money?

It’s a pretty miserable scenario. But can it be avoided? Unlikely. Any sort of breakthrough technology that would allow economies to put on a growth spurt would be derided as job destruction by Keynesians. If someone invented the next internet, they would lament the loss of postal sector jobs. If someone invented tooth cleaning chewing gum, they would create a dentist lobby banning it.

That’s a bit of a detour though.

Back to the point of funding governments – the only economic entity willing to leverage up during economic downturns. The maths of public debt repayment and default are frightening. The debts of so many nations are too big to be repaid and a default will sink the banking system. The rock and the hard place leave only inflation. Zerohedge explains that ‘no government, political system or social regime in the history of mankind ever imploded due to hyperdeflation.’

But while inflation might be the endgame, a lot can happen in the meantime according to three bears. The first is Hugh Hendry, a Scottish fund manager at Eclectica Asset Management:

‘We’ve reached a very rare moment in economic history where the problem is greater than the ability of the politicians to respond. There is no policy prescription that they can offer that will redeem the situation. The redemption will come through the population of Greece and elsewhere throwing the politicians out…’

That solution still leaves a lot of debt to be dealt with though. Hendry’s solution? ‘Bankruptcy is a solution.’

Over at the BBC, Alessio Rastani who runs the Leading Trader blog, comes up with his medium-term forecast and some advice for listeners:

‘It’s gonna crash and it’s gonna fall pretty hard because markets are ruled right now by fear. Investors and the big money – the smart money – I’m talking about the big funds, the hedge funds, the institutions, they don’t buy this rescue plan. They basically know the market is toast. The stock market is finished. The Euro, as far as they are concerned, they don’t really care.

‘Listen, I would say this to everybody who is watching this: This economic crisis is like a cancer. If you just wait and wait, thinking this is going to go away, just like a cancer, it’s going to grow and it’s going to be too late. What I would say to everybody is ‘get prepared’. This is not a time right now to do wishful thinking that government is going to sort things out. The governments don’t rule the world, Goldman Sachs rules the world. Goldman Sachs does not care about this rescue package. Neither do the big funds.

‘The first thing people should do is protect their assets. Protect what they have. Because in less than 12 months, my prediction is, the savings of millions of people is going to vanish. And this is just the beginning. So, I would say, be prepared and act now. The biggest risk people can take right now is not acting.’

Last but not least, Marc Faber points out what might be the most important story, explaining why Australia won’t be spared the economic troubles this time around:

‘In my view, we don’t know yet for sure why stocks have been this weak over the last 3-4 months. I think the stock market is a discounting mechanism and particularly here in Asia the weakness in stocks … has to do with a forthcoming meaningful slowdown in the Chinese economy and disappointing news out of China. If we define a bubble as excessive credit growth and artificially low interest rates, then China has had a gigantic bubble… I think some sectors of the economy will collapse.’

Just remember though, central bankers are unlikely to let the above happen. They will intervene in ever more dangerous ways. That’s why the leading Austrian newspaper has the following on its front page: ‘Politiker Riskieren Hyperinflation.’ It probably doesn’t need translating. Over at the Bank of England, former Goldman Sachs banker Ben Broadbent reckons inflation should come second to job creation. Why he thinks inflation creates jobs is a mystery. Anyway, he is setting the scene for stagflation – a combination of high unemployment and high inflation.

How do you invest when expectations are for a complete mixture of inflation and deflation, defaults and booms? One clever option is a balanced portfolio that reweights. We don’t mean a portfolio of stocks, but asset classes. To find out which asset classes, click here.

Until next week,

Nickolai Hubble.
Markets and Money Weekend Edition

Nick Hubble
Nick Hubble is a feature editor of Markets and Money and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about Markets and Money, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails.

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