Economic Observer 2011-10-01
I'm a mildly competitive guy. I still play soccer at a competitive level. While I have come to view losing as part of life and a chance to grow through the experience, I really don't like to "look bad" while I'm playing. In other words ...
It's OK for someone to beat me, but it's not OK for me to lose.
Now mind you, that passionate and competitive spirit only applies to certain games, like soccer. If the game were different - say the game of Wipeout (as seen on TV) - I could care less how I looked. For that matter, I would never play such a game because it is so silly and it is so easy to lose no matter how good you are.
Kick the Can
This is where America finds itself in the economic game of "Kick the Can" and I guess for our leaders it is important to look good in this game. Not to be outdone, the European Union is trying to show that they are the true masters of throwing money at lost causes - namely sovereign debt - in an effort to buy a few more months of time in office.
It all makes for great theater, but a lousy economic environment for the rest of us to endure.
The next several years will prove to be ultimately challenging for you unless you are willing to say, "I don't want to participate in this game at all. I accept that the game is rigged for players to lose (picture the bouncing mud balls in Wipeout) so I'll just stay home and laugh as some poor other sucker gets wiped out."
Quick Review
In the 2011-Q1 Economic Observer I suggested that America could gain credibility by using the next several months to seriously address the major underlying economic issues - most notably excessive leverage, a lack of transparency and a load of toxic debt in our financial sector as well as an anemic recovery that came about at a huge cost (to future generations) through massive fiscal liquidity efforts.
We still have the leverage. We still have the toxic debt and we still have the obfuscation. Nobody knows what anybody else in the financial sector is really doing. Ben Bernanke "fixed" the problem with QE2 which helped put more money in the Banksters' pockets and drove up commodity prices on the things the rest of us use every day. Beyond that, nothing else has been fixed.
In the 2011-Q2 Economic Observer, I noted that still nothing had changed and laid out a playbook for how to navigate the next several months or years. The only thing that has changed since then is that more people realize the game for what it is (rigged to fail) and we are much closer to an end game than I imagined we could be in so short a period of time.
Europe
This quarter's Observer starts in Europe because they are at the top of the "Kick the Can" leader board.
The Greek debt problem is a prime example of the "Kick the Can" game and the futility of trying to play it. Greek's problems first found public awareness in Spring of 2010. At the time it was estimated that if a Greek default were to happen, it would cost the European Union a lot of money (40 billion Euro or more) and would seriously impair the European banking system since most of that Greek debt was held by European banks.
Since that time, the European Union has thrown about 150 Billion Euro at various projects including buying up Greek sovereign bonds. The current round of bailout efforts will add close to another 150 Billion Euro to the cost - a cost that taxpayers in better-off countries like Germany will get to bear.
Greece is going to default, anyway. Today there is very little question of "if" that will happen. It is only a matter of "when" and how much money will go down the drain in that effort. The price tag could have been 40-50 Billion Euro. Instead it will be 300 Billion Euro (or more) - almost 10 times as much.
Commodities
Last time I said:
"As long as extra liquidity is sloshing around in the system, the price of something will be going up. That could be in the form of price inflation on everything (including wages) or just price inflation on certain assets."
QE2 ended in June and up until then the asset class that benefited from the excess liquidity was commodities - especially oil, food and gold. Interesting to note: now that QE2 is over and that excess liquidity is being absorbed by the system, the bull run in each of these assets has reversed. Prices will eventually stabilize, but that process will take some time.
The Next U.S. Recession
The latest news out of ECRI (who are probably better at this sort of thing than anybody) is that we are either IN a recession already or about to fall into one. What is interesting about this video report is how the ECRI spokesman frames the double-dip question.
"We have a bad economy [now] ... but we haven't seen anything yet. It's going to get a lot worse than what it feels like right now."
At first blush that may seem like a scary statement and for many, their worst fears will be realized. But while this IS a sobering concept to mull over, it doesn't mean the sky is falling on you. It just means that the next year or two are going to be more challenging than the past year or two. You can still survive and even thrive in this environment, but only by being well above average in your approach.
More Instability
As predicted in July, volatility both in investment markets as well as social dynamics has grown (and will continue to increase). The VIX volatility index is above 40 and at a point we haven't seen since the first quarter of 2009 (and before that not since a brief episode of volatility during the S&L crisis in August of 1998). Unfortunately, this is at the beginning of a recession with all the major issues still to be resolved. Expect volatility like we saw in the days of the Lehman collapse before this is all said and done.
Likewise, social instability is still brewing and will continue to increase as unemployment rates inch higher and people become more aware of (and disillusioned by) how ineffective government is at coming to their rescue. I fully expect to see far more visible social strife over the next 12-18 months.
Banking Issues
Internationally, banks are under a lot of pressure. Much of this comes from the toxic debt of soon-to-fail countries that they hold. In the U.S., the biggest banks still have massive amounts of bad debt on their books left over from the sub-prime crisis (and that was three years ago) in addition to their exposure to European sovereign debt.
To date, the United States Federal Reserve and various other government agencies have thrown trillions of dollars with the hopes of papering over the issue, but we have done nothing to address the toxic debt plaguing bank balance sheets. In Europe, they are hell bent to do us one better in the "Kick the Can" game, but the result will be the same for them.
Until we can go through some kind of resolution process (the tried and true method of restructuring is bankruptcy), toxic debt will continue to fester and ooze through our financial system, slowly clogging all the arteries until the system completely fails. Either we clear out the bad debt or the capital markets as we know them will stop functioning.
Clearing the debt will still create pain, however. It will make today's financial storms look like a lovely spring shower. My point here (and below) is that in the long run we'll be better off if we address the issues today.
Interest Rates
As far as interest rates are concerned, it is important to understand that not everybody will be affected at the same time. Already 10-year Greek debt costs 20+% per year in interest costs. Italian 10-year debt is at 5.4% and rising (rapidly). Spain is at 5.2% and Portugal is at 11.1%. All of these were below 2.0% 18 months ago.
Thanks to Federal Reserve manipulation of their balance sheet, interest rates in the U.S. are at record lows. This is great for people who want to borrow money and are good risks (so someone will actually lend them money), but that is an unfortunately small percentage of Americans. It is, however good news for the U.S. government who owes everybody a lot of money and can borrow all the money it wants at a cheap rate - at least for now.
It is not good news for banks or older people on fixed incomes because savings yields are next to zero so people are being forced to reach for riskier assets in search of some kind of income. Price inflation in commodities is also punishing these same people (fixed income seniors) as well as our nation's poor - the folks who can least afford it.
For now, the U.S. is the safe haven for cash - not because it pays anything (it doesn't) but because compared to all the other currencies, ours looks good. We are the best looking horse in the glue factory.
Solutions
The past six months, I have had comments from readers, friends and listeners to my radio appearances that I need to offer more solutions to these issues rather than just spouting off about all the problems that we are going to face. While I believe there is great value in simply having someone tell you that you are sailing your ship into a severe storm - it's better than not knowing it's coming. I will, however, add a few suggestions as to how you might want to make your financial vessel more secure and prepared for what's in store:
--- Watch Cash Flow - If there was ever a time to trim some fat from your expenses, this would be it. You may find you need that extra money to cope with short-term challenges.
--- Build Cash Reserves - We never refer to them as Emergency Funds because doing so invites an emergency in which to use them. Try to have at least six months of ongoing expenses in completely liquid (cash) form.
--- Take Risk Off the Table - Risky assets (like stocks) drop on average 40% during the first parts of a recession. The markets are off about 20% so far. We're half way there.
--- Pay Attention - This is not a good time to "set it and forget it." Don't put the boat on autopilot and go take a nap. You will want to be at the till.
--- Value Beats Price - Prices are determined through mutual agreement by a buyer and seller. No agreement, no sale. In volatile times, prices can and do move around a lot as it becomes harder for both parties to agree on the "right" price. Prices can be manipulated. Value on the other hand is completely within your own control. Focus on spending money on the things that are of greatest value to you rather than things where the price is the lowest.
Avoiding the Unavoidable
We have come to a point where I believe we must accept reality.
We can no longer afford to play this very expensive game of "Kick the Can." Paying 10 times as much for the same result (as with Greek default) is ... well frankly ... stupid. The "storm" is out there and getting stronger every day. Eventually, we're going to have to sail into it. Spending a lot of money to decorate the boat with beautiful new deck chairs is an expensive distraction and a waste of money.
Back in 2008 I had wishfully called the financial mess we were going through, "The Great Reset" - a great opportunity to hit the reset button, flush the system, take the pain and then move forward from there. Instead, we threw trillions of dollars here in America in an attempt to turn it into a Great Recession - something that could easily become the Greater Depression if we don't address the situation soon.
I have also repeated a concept from Minyanville.com's Todd Harrison - We have a choice between a Car Crash and Cancer. Both are going to be painful. When the Car Crash is over, we'll start healing. With the Cancer, we'll be fighting it for years with no guarantee that it will ever go away.
We've been fighting the toxic debt cancer since 2007. We've spent trillions of dollars on the treatment. We are still sick. Had we taken the Great Reset (car crash) option back in 2008 ... we'd be in a recovery now and very likely in a lot better shape than where we are today.
It's time we take the hit, clear the system and stop trying to play a game where we are guaranteed to lose and look silly in the process.
John