There are going to be a lot of disappointed people out there who will be suffering terrible losses and real pain in daily life. Societies don’t do well when the public falls into the broad despair that is the opposite of hope. That’s when the long knives and the tribal animosities come out and things get smashed.

Within the context of conventional party politics – the kind that has been baseline “normal” in the USA for a long time – we see this playing out in two factions that are increasingly out-of-touch with reality.  The Obama government has made itself hostage to a toxic form of pretense and lying. In order to sustain the wish for “hope” – if not hope itself – the President and his White House advisors along with his cabinet appointments, are pretending that the historical forces of compressive contraction are not underway.  They’re flat-out lying about the employment figures issued in the government’s name. They’re willfully ignoring the comprehensive bankruptcy gripping government at all levels. They refuse to bring the law to bear against “the malefactors of great wealth.” They appear to not understand the epochal energy scarcity problem the whole world faces, or its implications for industrial economies. Most of all, they persist in promoting the lie that this economy can return to the prior state of reckless debt accumulation (a.k.a “consumerism”) that has made us so ridiculous and unhealthy.

The trouble with self-delusion, either in a person or a society, is that reality doesn’t care what anybody believes, or what story they put out.  Reality doesn’t “spin.” Reality does not have a self-image problem.  Reality does not yield its workings to self-esteem management. These days, Americans don’t like reality very much because it won’t let them push it around. Reality is an implacable force and the only question for human beings in the face of it is: what will you do?  In other words, it’s not really possible to manage reality, but you can certainly choose to manage your affairs within reality.  We won’t do that because it’s too difficult. This harsh situation leaves the public increasingly with little more than bad feelings of discouragement and persecution

Reality unfolds emergently, and this ought to interest us.  For instance, I have maintained for many years that we are approaching the twilight of the automobile age – and the implications of this for daily life in the USA are pretty large. For a long time, I had assumed that this change of circumstances would proceed from our problems with the oil supply.  But reality is sly.  It has thrown two new plot twists into the story lately. America’s romance with cars may not founder just on the fuel supply question.  It now appears that our problems with capital are so severe that far fewer people will be able to borrow money from banks to buy cars at the rate, and in the way, that the system has been organized to depend on.  Our problems with capital are also depriving us of the ability to pay to fix the hypercomplex system of county roads, interstate highways, and even city streets that make motoring possible. What will we do?

For now, a cashless government gives out cash-for-clunkers, which is basically a self-esteem building program designed to make the government feel better about itself because it is ostensibly taking 11-miles-per-gallon cars off the road and replacing them with 27-miles-per-gallon cars, thus forestalling scary problems with climate change. It’s dumb of course, but the failure of leadership is comprehensive. Even the elite environmentalists at the Aspen Institute are preoccupied with finding new “green” ways to keep all the cars running.  They put zero effort into the idea of walkable communities, or restoring the railroad system, which will be the reality-based remedies for the car-dependency problem.

The extreme right is, if anything, even more childishly delusional. For them it comes down to “drill, baby, drill.”  They know nothing about the geology of oil – they don’t even believe that the earth is more than six-thousand years old, meaning they don’t believe in geology, period – but they are inflamed with the faith of eight-year-old children that we must have a lot more oil in the ground because this is America and God loves us more than people in other parts of the planet so it must be there. As their disappointment mounts, their childish ideas will turn cruel and sadistic. They’ll seek to punish anybody who believes that the earth is more than six thousand years old. The catch is, if they get into power in the election cycles ahead, they’ll be impotent and ineffectual even at persecuting their enemies.

In the meantime, American life will just wind down, no matter what we believe.  It won’t wind down to a complete stop.  Its near-term destination is to lower levels of complexity and scale than what we’ve been used to for a long time.  People will be able to drive fewer cars fewer miles.  The roads will get worse.  They’ll be worse in some places than others. There will be fewer jobs to go to and fewer things sold. People who live in communities scaled to the energy and capital realities of the years ahead are liable to be more comfortable. We’re surely going to have trouble with money. Households will drown in debt and lose all their savings.  Money could be scarce or worthless. Credit will be scarcer.

Both factions of American political life indulge in the fiction of control. History is reality’s big brother.  It is taking us someplace that we don’t want to go, so it will probably have to drag us there kicking and screaming. For starters, both reality and history will probably take us out to some woodshed of the national soul and beat the crap out of us.  That could be a salutary thing, since the crap consists of all the lies we tell ourselves. Once we’re rid of all that, we may rediscover a few things left inside our collective identity that are worth regarding with real self-respect.

Regards,
James Howard Kunstler

November 11, 2009

Hypercomplex Systems Will Fail Due to Scarcity of Energy and Credit was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Stock market bulls aren’t concerned about the inevitable acceleration in bank failures — at least for now. Even though deposits will be insured against loss, the loss of local banks will still have a depressing effect on hundreds of small communities. These communities are going to lose their only access to business credit when their local zombie banks — loaded with toxic construction or commercial real estate loans — are liquidated or merged into other weak banks.

Meanwhile, the latest monthly figures show that commercial bank balance sheets are shrinking at a fairly rapid rate, due to a combination of several factors: loan charge-offs, older loans are being paid back at a faster rate than new loans are being made, and regulators pressuring banks to build larger capital buffers.

So credit-fueled growth in consumption or investment is not occurring. Combine this with stagnant or declining wages and corporate profit margins and it becomes hard to imagine how GDP will rebound on a sustainable basis. GDP is the stat that every money manager fixates upon — despite the fact that GDP does not accurately measure true economic progress; it’s like evaluating a stock purely on sales growth, without thinking about what’s driving sales, and whether these sales are sustainable or accretive to wealth.

Nominal GDP is calculated as “consumption + investment + government spending + exports – imports.” Then, government statisticians subtract a highly doctored CPI figure from annualized changes in the above variables to get “real GDP growth.”

Note that all the variables in the GDP equation can be pumped up by excessive credit growth. As I mentioned in the Sept. 4 alert, if GDP is growing at the expense of degraded balance sheets, the end results are never happy. Japan’s GDP stayed higher than it otherwise would have been in the 1990s despite the incredibly wasteful spending on bridges to nowhere. Its policymakers reacted to a huge misallocation of capital into real estate in the 1980s by misallocating capital into government projects and subsidies to favored industries.

U.S. policymakers are following this playbook even faster, only without acknowledging one crucial difference: Japan had a high household savings rate to finance its government deficits, while the U.S. does not. Plus, the U.S. has already “dollarized” the rest of the world, and there are signs international demand for dollars has reached its saturation point.

The gold and commodities markets are reacting to this unpleasant reality. These markets are starting to discount the fact that the Fed will be the aggressive buyer of last resort for all types of debt securities. We’ve likely only seen the beginning of growth in the Federal Reserve’s balance sheet. As long as it can get away with it, the Fed will keep creating new money out of thin air to finance the U.S. federal deficit. Plus, via its liquidity facilities, the Fed and the megabanks will keep swapping Treasuries for legacy toxic securities marked at fantasy levels.

A few wild cards could disrupt this benign “reflationary” environment we’ve been in since the March stock market bottom, resulting in the stock market taking another nasty leg down:

1. If the “audit the Fed” bill were to pass and result in more handcuffs on the Fed, it would help to slow the reckless debasement of the U.S. dollar. But if it put an end to the Fed’s exotic lending facilities, which would force the owners of toxic securities to retain and mark them down sooner, then we could see a return to the January-early March 2009 stock market environment — only most of the damage would be contained to the financial sector as equity of insolvent institutions gets wiped out or diluted.
2. Contraction in the real economy and state governments could easily overwhelm expansion in the “federal government economy.”
3. International holders of trillions in paper U.S. assets could accelerate the rate at which they diversify into real assets. That’s how we could see a spike in “money velocity” that the deflationist camp says is a necessary condition for the CPI to rise. Most of the price pressure will be felt in oil prices, especially later in 2010 and 2011, when today’s underinvestment in new oil projects leads to tight international supplies.

I’d like to bring to your attention one more thing about today’s investing climate, because it’s being used so often lately in the media to justify today’s nosebleed stock valuations: the “money on the sidelines” fallacy. Growth or contraction in the current balance of $3.5 trillion in money market funds depends on how much companies look to borrow in the commercial paper market — not on the level of the stock market, as so many seem to believe.

Those who point to the $3.5 trillion in money market funds as if it’s a bucket that can be “poured” into the stock market bucket to keep the rally going do not understand that money does not go “into” or “out of” the market, but through the market. Trader A sells every share bought by Trader B. Once this transaction settles, cash goes one way and shares the other. The price at which the transaction takes place depends on how badly Trader B wants to own shares, not how many money market shares are in his account.

Also, money market fund balances represent very liquid short-term loans; they reflect an amount of money that’s already been spent in the economy and will be paid back over a very short time frame. John Hussman — one of the best mutual fund managers, in my view — refutes the “cash on the sidelines” fallacy best. It’s worth reading and remembering the next time you hear a talking head arguing that the rally can keep going because of liquidity.

Washington Federal Closes Offering; Now We Wait for Earnings

Yesterday, Washington Federal (WFSL) announced that its secondary stock offering would generate net proceeds of $333 million. This works out to a per share price of $13.79, including underwriting discounts and expenses and assuming full exercise of the underwriter’s overallotment. Here is an example of cash going “into” stocks, because these are newly issued, rather than existing, shares in the secondary market.

As I noted in Monday’s flash alert, I expect the offering will be necessary to absorb a mounting wave of net charge-offs in the future. It’s possible that this offering plan became a necessity after a friendly suggestion from regulators to raise more capital.

On Wednesday, WFSL stock rallied on high volume, but did not reflect organic demand for the stock. JP Morgan was the sole book-running manager for the Washington Federal offering. Knowing that it would likely receive a few million WFSL shares as a form of compensation in the underwriters’ overallotment, JPM’s trading desk probably established a short position that it plans to cover by delivering the shares it will receive upon the closing of the deal. This likely explains the bizarre trading moves in the stock this week: When institutions were more interested than expected, resulting in a higher offering price of $14.50, JPM likely covered some of their short position.

As for the analyst reaction to the offering, the two analyst notes I saw might as well be corporate press releases, because they expect this new capital to be deployed into an FDIC-assisted rollup of lots of zombie banks in the Pacific Northwest. Also, these analysts cite WFSL’s “strong” capital ratios without adjusting for future credit losses. One might suspect that these analysts have not even read the asset quality footnotes in Washington Federal’s SEC filings.

The big losses WFSL will take on construction loans are obvious, no matter how long management claims it will be able to sit on them. But what’s not obvious to the market — yet — is the rapid future loss formation in its $6.7 billion mortgage book. Management has set aside practically zero allowance for loan losses against its mortgage book. See the chart below for the allocation of WFSL’s allowance by loan type.

WFSL carries a mere $18.8 million loss allowance against its $6.7 billion book of mortgages — a ratio of just 0.28% of assets. The harsh reality of the mortgage crisis tells us that this $6.7 billion asset value is overstated, along with capital ratios (or equity); it should be marked down by far more than $18.8 million. Yet WFSL’s accounting translates as follows: Management does not expect more than $18.8 million in cumulative credit losses in mortgages (defaults, net of recoveries after foreclosure) through the rest of this credit cycle, despite the fact that the majority of these mortgages are now underwater and the job market remains weak.

As you can see in the chart, the ratio of loss allowance to nonperforming loans (by category) has shrunk dramatically. In December 2007, WFSL’s residential mortgage loss allowance was $13 million, and its nonperforming mortgages were also $13 million. As of June 30, this loss allowance had been built up to $18.8 million, but nonperforming mortgages had grown to $119 million (and will keep growing). This loss coverage ratio has shrunk from 100% to 16% over the past six quarters (as shown in the chart’s blue line) and needs to be built back up to a respectable level. And the only way for WFSL to build it up is to book large credit provision expenses in future income statements.

Washington Federal’s “strong” capital ratios are a function of hopeful accounting. I expect the market to come around to this view — not only for WFSL, but also for the entire banking sector. Ever since the loosening of mark-to-market accounting rules last April, the creators and users of financial statements have collectively chosen to deny reality and bury their head in the sand about the future direction of market values for collateral backing loans — and the value of the loans themselves.

Everyone is waiting and hoping for a miraculous rebound in housing prices and the labor market, when we have yet to see the bottom in either. When reality sets in, this will not end well for owners of bank stocks, REITs, and other financial stocks. These stocks are claims on assets that are marked to fantasy levels.

Mark-to-market suspension has slowed the rate at which losses are recognized, but this self-delusional accounting practice cannot make the losses disappear, and will likely make these cumulative, stretched-out losses even bigger in the future by rationing credit to the healthier parts of the economy.

Regards,
Dan Amoss

September 23, 2009

GDP’s Debt to Credit was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The U.S. Labor Department reported that around 467,000 Americans lost their jobs in June. This was unwelcome news. The data had been getting less bad every month since January. Then the June numbers rocked up, fell out, and took stocks down with them. This is causing everyone with a pulse (and most with a brain) to have second thoughts about just how good things are-or how much worse they might get.

The S&P and the Dow both fell nearly three percent. Oil and gold were down too. About the only things up were Treasury bonds and notes. Speaking of which, the U.S. will auction another $73 billion of those this week. Wednesday’s auction is for $19 billion in ten-year notes while $11 billion in 30-year bonds go on sale Thursday.

“You may have green shoots, whatever you want to call them, you may have temporary relief, but you are still in a world that’s breaking,” Black Swan author Nassim Taleb told CNBC’s Squawk Box. “Anything that’s fragile like the financial system will eventually crash, he said…We’re in the middle of a crash…So if I’m going to forecast something, it is that it’s going to get worse, not better.”

Taleb’s point is not a popular one. But it is a realistic one. The fiat money, leveraged finance Western financial system went global in the last twenty years, providing an epic rise in asset prices (and the debt used to purchase them). There’s no doubt that real goods and services have traded hands with world growth. But now we wonder how much of that is sustainable when you take the credit away.

Did we use phony money to build a world with completely unrealistic levels of growth? Were trillions of dollars of capital allocated based on final demand that was artificially pumped up by credit, currency manipulation (low U.S. interest rates and global dollar pegging), and government stimulation?

Yes we did!

Mind you, the crash of the financial system is not the end of the world. It is a massive calamity to be sure, wiping out the value of retirement assets many people were counting on to make it through their golden years. But as many readers have reminded us in the last few months, there is more to life than money.

Fair enough. But there is more to wealth than money too! Peace of mind, having your assets in forms that can’t be inflated away or won’t suffer from debt deflation…we would count these as “wealth” at a time like this.

That brings us back to the problem growing at the back of our mind yesterday. Can a massive deflating credit bubble nullify the liquidity measures by central bankers, which are puny in comparison to the nominal value of the assets at risk? “Yes you can!” comes the answer from some of the friends we put the question to.

“I’m tempted to disagree that expansion in government credit won’t reach the economy and therefore won’t be inflationary,” replied Money Morning editor Kris Sayce. “I’m not mistaken, the Fed is buying up these ‘assets’ in order to take them off the banks and also to help price them. If the Fed didn’t do this then the banks wouldn’t be able to lend extra money to customers as they would breach their lending limits.”

“It’s not so much that the Fed is directly feeding the banks money which flows through to the economy, it’s more that the Fed is feeding the banks money which allows them to expand lending which they otherwise wouldn’t be able to do. Thus at the very least is preventing prices from falling, or from falling as much as they ordinarily would without the intervention. In effect there is more money flowing in than there otherwise would be. There already IS inflation.”

Another colleague in the States replied that, “I am leaning more and more to the idea that the credit-based stuff will deflate (real estate, stock prices) but the cash-based stuff could rise (like foodstuffs, energy). In a way, it’s not a debate about inflation or deflation, but which assets inflate and which deflate. There might be a strong dichotomy within the economy between the two.”

To the extent that you cannot eat a mortgage-backed security, we see the wisdom in this view. The world has a lot of people. They have a lot of real needs. Regardless of the value of derivatives and opaque financial assets, a certain level of economic activity for a certain kind of tangible good will still be there. The challenge for investors is to determine if you can profit from this in traditional ways (stocks and bonds) or if you have to venture into less traditional asset classes and forms of ownership (land, real commodities, precious metals).

And of course, the thesis could be incorrect. If credit is not money-or if the large lending and government guarantee programs don’t reignite a lending boom in the real economy-then you may simply see a lot of wealth disappear down the memory hole.

Finally, a mystery Aussie commentator who wishes to remain anonymous but whom you may hear from in the future in this space sent a philosophical yet practical reply.

“What is money? Currently, that’s what the Federal Reserve (and other central banks) put in the reserve accounts of their member banks. The banks then use this as a base to create their own money, or ‘like money’. I guess this is also known as credit. So yes, credit is not money.

“And this bank credit is now contracting as the natural force of the market tries to drive prices lower and correct the boom. The Fed is offsetting this process by swapping ‘money’ (fed funds) for the impaired assets. But the banks are sitting on the cash, and obviously do not have the risk appetite (or the demand) to lend it out.”

“So at this point additional base money is not being lent out as inflationary ‘like money’. I’m not sure the Fed has the mechanism to make out and out purchases of assets other than through lending facilities, unless they are Treasury or Agency purchases. As far as I’m aware, the Fed can only distribute its newly created money through the banking system, and no other way. The banks have always been the source of inflation, and they need to lend to create this. They will probably use their excess reserves to buy Treasury’s in the coming years, and then the Fed can but the Treasury’s back off them in time. This will be inflationary.”

“Where does gold come into it? Well, gold is real money….chosen independently by the people. As trust in the US dollar continues to evaporate, demand for gold will increase. At some point gold will again be referred to as money. Because the amount of credit (debt) in the world dwarfs the amount of gold, and because gold will be a legitimate extinguisher of the debt, gold will likely rise massively to have the capacity to extinguish the debt. This is a process unfolding over years though.

“A rising gold price is actually deflationary in that it represents a rise in the purchasing power of money. So I think deflation is the ultimate force that cures this massive credit bubble…outright deflation if long-term faith in the US dollar remains, or gold price induced deflation should the bottom fall out of US dollar trust. The quantity of US dollars may be rising at the moment but the real turning point will be when the perceived quality of the dollar declines.”

Hmm. Gold rising indicates the rising value of cash…because gold is money. But if money is not wealth…and gold is money…does this mean gold is not wealth? Now there is something to think about.

Regards,
Dan Denning
Daily Reckoning Australia

July 7, 2009

Money Isn’t Wealth was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

I could write a book on precious metals and mining — and energy and capital formation — which is something that Agora Financial publisher Addison Wiggin wants me to do. On that one, well… stand by. But as I await my inner Johannes Gutenberg to surface — and keep in mind that Gutenberg was a goldsmith as well as a printer — I’ll just continue to publish these weekly notes to keep you up-to-date on what’s going on.

Precious Metals on a Tear

So what’s going on? Gold had a heck of a month in May, rising about 9%. And silver did even better, moving upward by over 26%. It’s that silver slingshot effect, in which silver occasionally makes up for the time spent in the shadows of gold.

Gold and silver were on a tear last month, and that’s great. Can they do it again in June? You surely know that price of gold and silver can go down as well as up. Don’t be shocked at a pullback. But for the medium and long term? Precious metals look good.

The “Insurance” of Gold

I’ve often referred to owning gold and silver as a form of “insurance.” And now, guess what? According to a recent report from Bloomberg, Northwestern Mutual Life Insurance Co. — the third-largest U.S. life insurer by 2008 sales — has been buying gold. This is the first time in its 152-year history that Northwestern has purchased gold.

According to Northwestern CEO Edward Zore, “Gold just seems to make sense; it’s a store of value.” Then Mr. Zore added, “In the Depression, gold did very, very well.” (And I’ll discuss that same point below).

According to Bloomberg, Northwestern has accumulated about $400 million in gold. CEO Zore believes that the price of gold could double “or even rise fivefold” if the economy continues to weaken. “The downside risk is limited, but the upside is large,” Zore said. “We have stocks in our portfolio that lost 95%.” But gold “is not going down to $90.”

So here’s a large, sophisticated company like Northwestern Mutual putting gold where its money is. I guess it wants to be around for another 152 years.

You Can’t Cheat Hephaestus

Meanwhile, the central banks, money center banks and most politicians of the world (except Germany’s Angela Merkel) HATE monetized gold and silver. Why? Because precious metals require these worthies to suck it up. They have to live in an economy based on hard work, long-term investment and honest governance. Can’t have that, can we? So there are serious forces out there attempting to manipulate the precious metals back down. Expect it.

But you can’t cheat Hephaestus, god of the forge. So if the metals retreat and share prices pull back for mining companies, use the opportunity to acquire more metal and shares at a discount to the future price. And remember that my basic precious metals recommendation is that you should have 5-10% of your portfolio in physical metal — and TAKE DELIVERY!

I’ll be plenty happy if our six new precious metals plays move upward in the short term — say, over the next few months. But if we have to wait for the medium term, say, six-12 months, that’s OK too. And surely, over the long term, a year or more, these guys ought to shine (no pun).

In my view, the politicians are spending the country so deep in the hole that the nation will never be able to work and pay its way out. Thus, the monetary stars are aligning toward economic hard times and future inflation. And as we see with Northwestern Mutual above, one investment idea that has historically worked out during hard times and inflation (as well as deflation, I should add) is the precious metals angle.

The Homestake Story

Along those lines, let’s look at the share price of the old Homestake Mining Co. back in the 1920s and 1930s. (See the chart, below.) Homestake was among the world’s largest gold miners in its day, digging gold from the Black Hills of South Dakota. Due to a dearth of records, many historians use Homestake as a proxy for the entire gold-mining industry in that era.

Notice how between 1929-1935, the Homestake share price rose — along with a significant rise in both earnings AND the dividend. Homestake’s earnings per share (EPS) increased from $4.16 in 1929 to $32.43 in 1935. In other words, the gold miner showed annual compound EPS growth of 41%. Wow.

And notice how much of the rise took place in 1930, 1931 and 1932, before Franklin Roosevelt became U.S. president — and seized the nation’s gold, in April-May 1933! But even FDR’s gold seizure didn’t stop the upswing for Homestake. The stock, and its earnings and dividend, kept appreciating and held strong through most of the early years of the New Deal.

That is, the rest of the U.S. business economy suffered from declining earnings during essentially ALL phases of the Great Depression. The overall U.S. economy was awful, with national unemployment rates well over 25% at times. But through it all, the gold mining industry was a hot spot of economic vibrancy.

Gold Miners Versus Banks

While we’re looking at the history of gold in the Great Depression, let’s consider what was going on with the banks in the U.S. According to economist John Walter, writing in 2005 in the Economic Quarterly of the Federal Reserve Bank of Richmond, the U.S. went from over 31,000 banks in the mid-1920s to under 15,000 banks by 1934. That is, over HALF of all banks FAILED! In 1933 alone, over 4,000 banks failed — that’s about 80 per week, or 16 per business day.

And back then, a bank failure was almost always a total wipeout for depositors. There was no federal deposit insurance until late 1934, and the initial coverage was just $2,500. Most depositors in those 16,000 failed banks of the 1920s and early 1930s just plain lost everything. There was no relief at all. If you were a depositor, you went down with the ship.

Banks that didn’t fail paid depositors a paltry 1% (or less) in “earned interest” on their savings. Makes you wonder why people kept any money in banks at all. Risk losing it or get paid 1% interest. Not much choice, right? No wonder that a lot of Depression-era people spent the rest of their days saving money in coffee cans in their basement.

Gold Mine Shareholders Did Well

All the while, Homestake shareholders collected dividends in the range of 8-10%, plus capital appreciation. The Homestake dividend went from $7.00 in 1920 to an astonishing payout of $56 per share by 1935.

It’s interesting that “hard times” are somehow good for gold miners and gold mining stocks. One explanation I’ve heard is that the aftereffects of the 1929 stock market crash caused a sustained contraction of the money supply (thanks to the Federal Reserve), along with a reduction of bank credit.

The result of less credit was that lending just plain froze. (Sound familiar?) Many businesses, households and individuals simply could not obtain credit no matter what their story. And most of the early New Deal programs — “relief,” the Civilian Conservation Corps, the Works Progress Administration and the like — were just transfer payments to otherwise idle individuals. The New Deal may have institutionalized humanitarian government policy toward the unemployed, but it was NOT capital investment.

So with most private capital investment halted during the New Deal, there was a dearth of fundamental capital formation in the economy. The economy couldn’t get traction to move ahead.

Tight credit extended even to governments, and by extension to their fiat currencies. As world trade tightened due to protectionism, public credit evaporated as well. Eventually, investors fled from paper currencies (even U.S. Treasuries). The big players in international finance converted paper currency into the only “money” that was not someone else’s liability — and not subject to counterparty default: gold.

“Gold Has Worked for 2,000 Years.”

Let me sum up by quoting one of America’s legendary financial geniuses, Bernard Baruch (1870-1965). He said, “Gold has worked down from Alexander’s time… When something holds good for 2,000 years, I do not believe it can be so because of prejudice or mistaken theory.”

Until we meet again,
Byron King

June 9, 2009

Gold, Gold and More Gold was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

I maintain that there are countless constructive tasks waiting to occupy us on a long national “to do” list for rebuilding a national economy, but they are way different than the ones currently preoccupying government and the mainstream media. The Obama White House, Congress, and The New York Times are hung up on exercises in futility — “rescuing” banks and insurance companies that cannot be rescued (because they are hopelessly trapped in “black hole” credit default swaps contracts), and re-starting a “consumer” binge that was completely crazy in the first place, based, as it was, on a something-for-nothing standard-of-living.

Meanwhile, if the buzz on the blogosphere is a measure of anything — and I think it is — then a new consensus is forming out there about where to start doing things differently. Unfortunately after less than two months in office, President Obama finds himself awkwardly behind-the-curve on this. It begins with the understanding that a general bank rescue is hopeless and, going a step further, that the people who caused the train wreck of “innovative” securities have to be prosecuted. The public’s collective voice on this is muted but growing. It has been muted by the general air of blackmail that the banks have used to enthrall policy and opinion — the “too big to fail” idea — in effect holding the nation’s future for ransom.

Last week, New York State Attorney General Andrew Cuomo hauled Bank of America chief Ken Lewis into his office to explain who, exactly, received an aggregate several billion dollars in bonuses late in 2008 after the US Treasury forked over billions of dollars in TARP money to his bank. That was a good start. Mr. Lewis, being lawyered-up to the max, had the temerity to reply that answering the question would compromise his ability to keep talented people in his employ. For that impertinence alone, Mr. Lewis ought to be dragged over fifteen miles of broken chardonnay bottles behind a GMC Yukon — but that is not how we do things in American jurisprudence. To be more realistic, a simple indictment would be in order, and then Mr. Lewis can answer this question, and a few others, in the comfort of an air-conditioned courtroom. Ultimately, that might lead to Mr. Lewis becoming the wife of a bodybuilder in one of New York State’s houses of correction — a just outcome that would go far in rejiggering the nation’s expectations about how people in authority ought to behave. And such an outcome might lead to the conviction of many other brides-to-be from the Wall Street debutante pool.

Now it has come to light, just last week in the wake of AIG’s latest bail-out, that previous AIG bail-out money to the tune of $50 billion was distributed to a set of banks including Goldman Sachs (former employer of then Treasury Secretary Hank Paulson and then New York Federal Reserve Governor Tim Geithner), plus Morgan Stanley, Merrill Lynch, Mr. Lewis’s Bank of America, and a long list of European banks with operations in the USA. Since the transactions took place in New York State, the investigation of these irregularities alone could solve the unemployment problem here if NY Attorney General Cuomo were given a free hand in hiring staff to depose everyone involved — including the hiring of caterers to bring in coffee and meals for round-the-clock proceedings.

All of this raises another awkward question: where is United States Attorney General Eric Holder in this situation? Surely the federal statutes offer some grounds for inquiring about the misuse of Treasury funds — and many other issues arising from Wall Street’s stupendous orgy of misbehavior. What I’m hearing out in the blogosphere is a growing clamor to call people to account before we are really able to move on to the massive task-list that awaits us in rebuilding our economy.

The bigger question for now is whether any of these authorities will act effectively before the public simply goes apeshit and starts burning down Greenwich, Connecticut. The dangerous shift in public mood is liable to occur with shocking swiftness, in the manner of “phase change,” where one moment you see a bewildered bunch of flabby clown-citizens vacuously enraptured by “American Idol,” and the next moment they are transformed into a vicious mob hoisting flaming brands to the window treatments of a hedge funder’s McMansion. The moment of opportunity for avoiding that outcome is looking sickeningly slim right now.

Another thing that President Obama can set into motion anytime — and pull himself back to the head of the curve of leadership — is to either by executive order or by proposal to congress, shut down the credit default swap system for a period of time while procedures are drawn up to place all these dubious contracts in a “clearing” market, where the holders of them will have to come clean about what they’re sitting on. The lack of this procedure is allowing zombie banks to hold the United States hostage for never-ending bailout ransoms. None of these banks are going to survive another six months anyway, so the basic blackmail motif that the whole money system will collapse if ransoms are not paid is a bluff that has to be called sooner or later in any case. So Mr. Obama might as well get on with it.

Once these two matters are dealt with — an earnest start-up of prosecutions and disabling the credit default swap blackmail racket — then perhaps a stressed-out and impoverished public might be induced to not go apeshit and instead get on with the mighty task of rebuilding our nation along lines that have a plausible future.

Regards,
James Howard Kunstler

March 10, 2009

The Consumer Economy Isn’t Coming Back was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

My guess is that the disorder in agriculture will be pretty severe this year, especially since some of the world’s most productive places — California, northern China, Argentina, the Australian grain belt — are caught in extremes of drought on top of capital shortages. If the US government is going to try to make remedial policy for anything, it better start with agriculture, to promote local, smaller-scaled farming using methods that are much less dependent on oil byproducts and capital injections.
     
This will, of course, require a re-allocation of lands suitable for growing food. Our real estate market mechanisms could conceivably enable this to happen, but not without a coherent consensus that it is imperative to do so. If agri-business as currently practiced doesn’t founder on capital shortages, it will surely collapse on disruptions in the oil markets. President Obama at least made a start in the right direction by proposing to eliminate further subsidies to farmers above the $250,000 level. But the situation is really more acute. Surely the US Department of Agriculture already knows about it, but the public may not be interested until the shelves in the Piggly-Wiggly are bare — and then, of course, they’ll go apeshit.
    
The recent huge drop in oil prices has left the public once again convinced that the world is drowning in oil — if only the scoundrelly oil companies were forced to deliver it at reasonable prices. The public has been consistently deluded about this for decades. What’s missing so far is for the president of the US to lay out the reality of the situation in a dedicated TV address. I know a lot of you think that Jimmy Carter already tried this and failed to make an impression (and ruined his presidency in the process). I guarantee you that Mr. Obama will have to do this sometime in the next few years whether he likes or not, and he’d be well-advised to get it done sooner rather than later. And by this I don’t mean just vague allusions to “energy independence” or “renewables” in speeches devoted to many other issues. I mean telling the public the plain truth that we’ll never offset oil depletion and the intelligent response is to do everything possible to transition to walkable towns and public transit, not to sustain the unsustainable.
     
The alternatives — i.e. what we’re trying now — is to further delude ourselves into thinking that we can run WalMart and the suburbs by some other means than oil. Despite all our investments in these things, we won’t be able to run them by other means, and the news about this had better get out before enormous disappointment turns into titanic rage. If Americans think they’ve been grifted by Goldman Sachs and Bernie Madoff, wait until they find out what a swindle the so-called “American Dream” of suburban life turns out to be.
    
On this blizzardy Monday in the power centers of America, attention is fixed on the never-ending fiasco of AIG — a company whose main product turned out to be credit default swaps, and is now choking on them. Kibitzers on the sidelines of finance are forecasting a king-hell bear market suckers’ rally in the stock markets followed by a belly flop to Dow 4000 or lower. I myself called for Dow 4000 two years ago — and was obviously a bit off on my timing. All this is surely trouble enough. But while your attention is focused on Rick Santelli in the Chicago trader’s pit, or Larry Kudlow desperately seeking “mustard seeds” of new growth in financials, try to let one eye stray to the horizon where these other complex systems are working out their next moves. Farming. The oil markets. These are the coming theaters of alarm and distress.

Regards,
James Howard Kunstler

March 3, 2009

Peak Oil, Credit and the Collapse of Complex Systems: What Next? was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Those tuned into the media-waves were enchanted, in a related instance, by Rick Santelli’s grand moment of theater in the Chicago trader’s pit last week when he seemed to ignite the first spark of revolution by demonstrating that bail-out fatigue had morphed into high emotion — and that the emotion could be marshaled against public policy. The traders in the pit on-screen seemed to color up and buzz loudly, like ordinary grasshoppers turning into angry locusts preparing to ravage a waiting valley. “Are you listening, President Obama?” Mr. Santelli asked portentously.

In the broad blogging margins of the web that orbit the mainstream media like the rings of Saturn, an awful lot of reasonable people have begun to ask whether President Obama is a stooge of whatever remains of Wall Street, with Citigroup and Goldman Sachs’s puppeteer, Robert Rubin, pulling strings behind an arras in the Oval Office. Personally, I doubt it, but it is still a little hard to understand what the President is up to. For one thing, the stimulus package, so-called, looks more and more like national sub-prime mortgage itself, a bad bargain made under less-than-realistic terms, with future obligations fobbed onto whoever inhabits this corner of the world for the next seven hundred years — and all to pay for a bunch of granite counter-tops and flat-screen TVs.

I suppose Mr. Obama is burdened with the knowledge that the economic truth is so much worse than he imagined back in November that there is simply nothing to do at this point except pretend to serve up a “tasting menu” of rescue plans in the hope that markets and mechanisms might be conned back into compliance with our wish keep getting something-for-nothing forever. FDR already used the fear of fear itself trope, so Mr. O is left with little more than displaying pluck and confidence in the face of overwhelming bad news.

The sad truth is that banking has become a Chinese fire drill — a frantic act of futility — as insolvent companies persist in covering up their losses in order to avoid the counter-party hell of credit default swaps that would ring the world’s “game over” bell. This can only go on so long. All the chatter about “nationalizing” the banks really boils down to what kind of bankruptcy work-out will they be put through, how destructive will the process be, and how much of the pain can be shoved forward in time to people now in diapers and their descendants.

Among the questions that disturb the sleep of many casual observers is how come Mr. O doesn’t get that the conventional process of economic growth — based, as it was, on industrial expansion via revolving credit in a cheap-energy-resource era — is over, and why does he keep invoking it at the podium? Dear Mr. President, you are presiding over an epochal contraction, not a pause in the growth epic. Your assignment is to manage that contraction in a way that does not lead to world war, civil disorder or both. Among other things, contraction means that all the activities of everyday life need to be downscaled including standards of living, ranges of commerce, and levels of governance. “Consumerism” is dead. Revolving credit is dead — at least at the scale that became normal the last thirty years. The wealth of several future generations has already been spent and there is no equity left there to re-finance.

If contraction and downscaling are indeed the case, then the better question is: why don’t we get started on it right away instead of flogging rescue plans to restart something that is DOA? Downscaling the price of over-priced houses would be a good place to start. This gets to the heart of Rick Santelli’s crowd-stirring moment. Let the chumps and weasels who over-reached take their lumps and move into rentals. Let the bankers who parlayed these fraudulent mortgages into investment swindles lose their jobs, surrender their perqs, and maybe even go to jail (if attorney general Eric Holder can be induced to investigate their deeds). No good will come of propping up the false values of mis-priced things.

No good, in fact, will come of a campaign to sustain the unsustainable, which is exactly what the Obama program is starting to look like. In the folder marked “unsustainable” you can file most of the artifacts, usufructs, habits, and expectations of recent American life: suburban living, credit-card spending, Happy Motoring, vacations in Las Vegas, college education for the masses, and cheap food among them. All these things are over. The public may suspect as much, but they can’t admit it to themselves, and political leadership has so far declined to speak the truth about it for them — in short, to form a useful consensus that will allow us to move forward effectively. One of the sad paradoxes of politics is that democracies do not seem very good at disciplining their citizens’ behavior. The wish to please voters and the influence of campaign money overwhelm even leaders with mature instincts. In America’s case, this could lead to what I like to call corn-pone Naziism a few years down the road. Someone will design snazzy uniforms and get us all marching around to “God Bless America.” At the point of a gun.

It’s not too late for President Obama to start uttering these truths so that we can avoid a turn to fascism and get on with the real business of America’s next phase of history — living locally, working hard at things that matter, and preserving civilized culture. What a lot of us can see now staring out of the abyss is a new dark age. I don’t think it’s necessarily our destiny to end up that way, but these days we’re not doing much to avoid it.

Regards,
James Howard Kunstler

February 24, 2009

Sustaining the Unsustainable: The Abyss Stares Back was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

During a credit deflation, things get cheaper. Without lines of credit, people can’t bid things up and prices fall to their “cash on hand” level. Given a long enough time, things settle out and prices relative to wages actually become attractive. But it’s a long and bumpy ride from here to there. The trick is to maintain roughly the same level of income as others take wage cuts or lose their jobs entirely. Add this to the general lack of credit and you find that the cost of living drops dramatically. You might have felt poor a couple of years ago when you earned $50,000 per year, but if you can hold onto that income, why, in the next couple of years you could feel positively wealthy!

The holding on part is where it gets a little tricky.

It’s tricky because when credit evaporates, less goods and services can be bought. A lot of jobs providing those goods and services become unnecessary. Layoffs become all the rage. You wind up with a lot of formerly employed people with no jobs and no money and no attractive prospects. Doesn’t seem fair, but that’s what happens when hopes and livelihoods get propped up on the shifting sand of credit expansion.

When credit vanishes, actual cash becomes king. Promises to pay take a back seat to actual ability to pay. Exactly what are we calling “cash”, though? God and the free markets like gold and silver because they’re relatively rare, easily divisible, and it’s very difficult to control their supply, and hence they’re innately honest. Governments prefer colorful bits of paper that they issue precisely because they can print up as many as they need.

While credit isn’t wealth, neither is money. Money is just a commodity we use to represent and exchange wealth. It’s rather vital to have a measuring tool that resists stretching and deformation or else you get into all sorts of trouble. Gold and silver tend to resist stretching; paper money begs for it.

During the last really big credit bust in this country cash was very strictly tied to gold and silver. The exchange rates were fixed; you got one ounce of gold for a twenty-dollar bill (plus 67 pennies). Fifty-four cents got you an ounce of silver. So when the credit bubble popped and prices slumped, they did so in terms of a dollar that was a reliable proxy for gold and silver. How things have changed!

First FDR devalued the dollar and a little later Nixon killed it. The currency we have today is a hoax wrapped in a lie. It isn’t tied to anything. The old dollar was a certificate that could be exchanged for a very specific amount of gold. The one we’ve had since 1971 is a promise from the U.S. government…and little paper promises from governments have a dismal history.

You might have noticed that during our recent gargantuan credit bust people again ran to the dollar. They expressed a very strong preference for greenbacks over…well, just about everything else in the wide world. But running to the dollar for shelter these days is like seeking protection from the man who is shooting at you…or running from the doorway of a burning building to the second floor.

During the last depression, the dollar’s tie to gold limited the ability of our communist dictator to goose the money supply. Roosevelt had to coerce the citizenry to give him their gold under pain of imprisonment so he could allow for some easing of the dollar’s value. This time around, FDR II can just have central banks conjure up as much cash as deemed necessary out of nothingness because the dollar isn’t tied to gold anymore.

Inflation is a slow burn on its default setting, which governments enjoy so much. It’s why they insist on monopolizing currency in the first place. But let inflation go on long enough and the currency becomes worthless. Sometimes events conspire to accelerate the race to worthlessness. Wars, laughably unpayable national debt, financial panics…that sort of thing.

The government would prefer an endless boom, even though such a thing—like individual biological immortality or perpetual motion — just isn’t possible. The central bank gets things started by expanding credit. Good times ensue. Everyone is employed and everyone lives beyond their means and bids up the prices of assets with money they don’t really have. This can’t go on forever (and never does!), but governments hate to see the ravages of the inevitable contraction after their artificially-induced boom. States love for their citizens to be blissfully distracted with fantasy, especially the really unsustainable sort.

So what is a government to do when it wants people to spend and they just refuse? When the rubes refuse to play ball and insist on hanging on to their savings, all you have to do is make saving less attractive than spending. Increase the money supply…make the money people hold less valuable…encourage them to get rid of it. Set the currency ablaze and ferret the consumers out.

Around these parts, we subscribe to the view that savings are essential for capital investment, but politicians side with Keynes on this and believe savings are for suckers; debt is where it’s at. And if private debt has brought the population to its knees, then the obvious answer is a dollop of public debt to kill their currency and finish them off!

It’s not just the amount of dollars that the central bank produces, however; it’s the amount that actually gets circulated and the speed at which it moves through the economy. When the general populace senses that the dollars they’re holding are losing value (because the central bank is accelerating the increase in supply), they try very hard to get rid of them as quickly as possible. They trade them for things that will hold their value.

The real trouble with hyperinflation isn’t that it devalues the currency, however; it’s that it devalues souls. It leads people astray. It removes the moral stops. It changes all sense of proportion. Like a sadistic, juvenile prankster, government spikes the punch with a little quantitative easing and before you know it all bets are off. People drunkenly succumb to the baser instincts they normally keep in check. The thin layer of restraint provided by the neo-cortex is broken and all sorts of reptilian longings are indulged…and consequences be damned.

Trying to invest and plan for the future under a fiat currency regime is like trying to be witty and convincing while drunk. Inevitably the wrong things are said and done because perception and judgment are hopelessly warped.

During a hyperinflation, the majority of the population who counted on the scrip they were forced to deal with and save can only feel angry desperation as all their savings turn to ashes practically overnight. The reward for personal thrift coupled with trust in the largest institution around—the state—is loss and future uncertainty. Under such conditions, societies tend to come apart fairly rapidly. Crime rises as savings and incomes disappear. Ethnic tensions may mount. There is a bull market in internal strife and personal misery.

People generally rather consume than produce or delay gratification. This is why the masses can be lied to with paper. But the universe is a weighing machine, not a voting booth. Wishes don’t trump reality. And disaster must befall those who expect something for nothing. We here in the Whiskey Room like to point the finger at governments, but we also have to acknowledge that thing in human nature that allows governments to exist in the first place and to flourish.

For the past decade in the U.S. easy credit — pretend money — led people to put their houses up as collateral on debts that could only be paid back if real estate prices kept getting propped up by more easy credit. Then they used this debt to finance vacations and trips to big retails chains to buy things that would not be used to produce or store wealth. And this was just an expansion of credit!

When the actual money supply expands in order to ease debt repayments…well, all sorts of screwy things happen. That’s what generally spurs the vulgar expansion of the money supply: the political desire to ease massive debt repayment, both public and private…that and war. When you see a nation living beyond its means, watch out; its currency will be thrown under the bus when the bill comes due.

Destroying the currency, however, means that the debts really weren’t repaid…because they were paid back with dollars that aren’t worth the value of those that were initially borrowed. It’s a big swindle and everyone involved knows it. But it goes on anyway with all the nasty consequences you’d expect from such massive debauchery, delusion and theft.

The list of countries that have suffered the ravages of paper money hyperinflation is pretty darned long…and ironically it starts with the very first country to give paper money a try, long, long ago. China’s Yuan Dynasty’s little experiment with paper money ended badly. In fact, it helped end the Yuan Dynasty.

For the first time in history, currencies everywhere are merely paper…including the world’s reserve currency. The potential…the inevitability…of a worldwide bonfire of these little paper vanities staggers the imagination. The conflagration will be mesmerizing in its size and intensity. You may even find yourself enjoying the view…if you make it a point to be standing far enough away not to be consumed.

Regards,
Gary Gibson
Managing Editor, Whiskey & Gunpowder

February 17, 2009

The Joys of Hyperinflation was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

For at least a year several story-lines have been slugging it out inconclusively for supremacy of the Web-waves. The main event has been the Deflationists versus the Inflationists. The first group basically says that so much “money” is being welshed out of existence that it dwarfs the new “money” being shoveled into existence in the form of bail-outs, tarps, and office re-decoration stipends. The Deflationists see the tattered remnants of the consumer credit economy auguring ever deeper into a hole until it is buried so far down that all the back-hoes ever sold will not be able to dig it out. The competing Inflationists say that the massive truckloads of shoveled-in “money” will soon overtake vanishing “wealth” and, in the process, make the US dollar worthless.

Some of us see both outcomes in sequence: the deflationary “work out” of bad debt currently underway — of loans that will will never be paid back, of acronymic paper securities revealed as frauds, of “non-performing” contracts entering the swamps of foreclosure, of banks pretending to still exist, of hallucinated “wealth” rushing into the cosmic worm-hole of oblivion — can only go for so long before everyone who can go broke will go broke. Then, just as we find ourselves a nation of empty pockets, the tsunami of shoveled-in “money” designed to “reboot the consumer” (created not from productive activity but just printed recklessly), will start churning through the “economy,” chasing products and commodities that became scarce during the deflationary phase — and the result is hyper-inflation, the eraser of debt, destroyer of fortunes, and suicide pill of feckless governments.

I guess the basic difference is that the hardcore Deflationists seem to think that their process can go on forever. The society just gets poorer and poorer until we’re back at something like a scene out of Pieter Bruegel the Elder. The Inflationists see a fork in the road leading to more overt destruction, especially political turmoil as a lot of negative emotion joins the work-out orgy and overwhelms government.

But in this moment, the week after a new president’s inauguration, the deadly fog has rolled in and absolutely everyone dreads what lurks on the other side of it, without being able to discern the path through it. For example, the “bail-out fatigue” being reported suggests that congress may just call a halt to money-shoveling. Where would that leave Mr. Obama’s urgent call for “stimulus?” Not to mention further TARP injections for redecorating bank offices.

I’ve been skeptical of the “stimulus” as sketched out so far, aimed at refurbishing the infrastructure of Happy Motoring. To me, this is the epitome of a campaign to sustain the unsustainable — since car-dependency is absolutely the last thing we need to shore up and promote. I haven’t heard any talk so far about promoting walkable communities, or any meaningful plan to get serious about fixing passenger rail and integral public transit. Has Mr. Obama’s circle lost sight of the fact that we import more than two-thirds of the oil we use, even during the current price hiatus? Or have they forgotten how vulnerable this leaves us to the slightest geopolitical spasm in such stable oil-exporting nations as Nigeria, Mexico, Venezuela, Libya, Algeria, Columbia, Iran, and the Middle East states? And we’re going to rescue ourselves by driving cars?

I know it is difficult for Americans at every level to imagine a different way-of-life, but we’d better start tuning up our imaginations, because endless motoring is not our destiny anymore. The message has not moved from the grassroots up, and so at this perilous stage the message had better come from the top down. Mr. Obama needs to go on TV and tell the American public that we’re done cruisin’ for burgers. He could do that by drastically reviving his stimulus proposal as it currently stands.

Putting aside whether this “stimulus” represents reckless money-printing in an insolvent society, let’s just take it at face-value and ask where the “money” might be better directed:

– We have to rehabilitate thousands of downtowns all over the nation to accommodate the new re-scaled edition of local and regional trade that will follow the death of national chain-store retail of the WalMart ilk. Reactivated town centers and Main Streets are indispensable features of walkable communities. The Congress for the New Urbanism (CNU.org) ought to be consulted on the procedures for accomplishing this and for rehabilitating the traditional neighborhoods connected to our Main Streets.

– We have to reform food production (a.k.a. “farming”). Petro-dependent agri-biz will go the same way as the chain stores. Its equations will fail, especially in a credit-strapped society. That piece of the picture is so dire right now, as we prepare for the planting season, that many crops may not be put in for lack of front-money. This portends, at least, much higher food prices at the end of the year, if not outright scarcities and shortages. And the new government wants to gold-plate highway off-ramps instead? Earth to Rahm Emanuel: screw your head back on.

– As mentioned above, we have to get passenger rail going again because the airlines are going to die the next time there is an uptick in oil prices, or a spot shortage of oil. Let’s not be too grandiose and attempt to build expensive high-speed or mag-lev networks — certainly not right now — because they require entirely new track systems. Let’s fix those regular tracks already out there, rusting in the rain, or temporarily replaced by bike trails.

Those are three biggies for the moment and enough to keep this society busy for a couple of years. But more to the point of this blog, observers of all stripes are having trouble imagining any way out of our multiple predicaments. All the possible actions tried so far have seemed absurd. Why even try to prop up inflated house values when the single most crucial need in this sector is for house prices to return to parity with incomes so the shrinking pool of ordinary people still employed can begin to think about buying one? Well, the obvious explanation is that politicians can’t bear the pain of watching mass foreclosures and the ruination of families. This is pretty understandable, and it is tragic indeed. Frankly, I don’t know of any political narcotic that can mitigate the pain that results from having made poor choices in life — even if those choices were promoted and reinforced by the mighty ideology of “American Dreaming.” Anyway, the foreclosures are well underway now, and perhaps the salient question is how long will the public’s fury remain constrained while they hear about Wall Street executives buying $80,000 area rugs? Surely there is a tipping point of collective distress that is not too far from where we’re at now.

In the realm of TARPS and other continued bail-outs aimed at the banks, the car-makers, and a host of other corporate special pleaders, I wonder if we have already reached the saturation point. But opinion on the Web is starkly divided and a prime manifestation is the debate over whether it was a terrible blunder or the right thing to let Lehman Brothers sink into bankruptcy. Both sides make valid arguments, but virtually all the other super-banks right now have lurched to death’s door and we have no clear guidance on what we should do about them. Each one is touted as “too big to fail,” as well as being interlocked with the others on credit default swaps that would bring them all crashing down if one counter party truly failed. It seems to me that this is what lies at the heart of the present situation. Nobody I’ve encountered in the sphere of opinion-and-comment thinks that these banks will survive, and this outcome beats a short path to the conclusion that the entire banking system is fatally ill — leading directly to a super-major crisis of political economy in which the whole reeking, leaking system just crashes. I think this is what lies behind Mr. Obama’s appeals for very urgent action.

But then we’re back to square one: nobody, including Mr. O himself, has really proposed a set of actions that have not already been tried in the way of money-shoveling. So this will be a week in which, perhaps, some wise and intrepid figures — perhaps even the president — will articulate something we haven’t heard before, perhaps even something like bearing our hardships bravely. It’ll be a very interesting week, I’m sure.

Regards,
Jim Howard Kunstler

January 29, 2009

State of Cringe was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Prices communicate information. The NYMEX February oil contract fell over 5% today in New York trading to $34.40. This suggests oil is falling in value, at least in the short term. And maybe that’s not totally a lie.

After all, the current oil price results from two factors. First, the absence of leverage from the oil futures market leaves prices reflecting immediate supply and demand. With inventories full, the market seems well supplied (so much so that OPEC is cutting production). Second, the reality that oil demand will be flat or slightly fall this year because of the worldwide financial pandemic.

Adequate supply plus stagnant demand equals $35 oil. So why is the December 2010 oil contract trading nearly 80% higher at $61.80? What could possibly happen between now and December 2010 that would cause oil to go up 80%?

Well, for one thing you might be in the early stages of an economic recovery by then. Demand would have recovered. Shares could be higher. Everything could be fine.

But we can think of at least three reasons why the current oil price is headed much higher this year (not in 2010). First, the lower oil price is actually going to lead to lower oil production later this year and next. Oil production is declining to begin with. But the crash in prices has put the kibosh on exploration and production.

Second, as Diggers and Drillers contributor Mike Graham explains in a January article on the subject, the clear trend within the oil market is that historical exporters are exporting less oil. There are several reasons for this, which Mike gets into in his story.

One is that oil exporters are hoarding it now and waiting for higher prices later. Another is that oil exporters are consuming more of their own production, leaving less for export. And still a third reason is that the world’s largest oil exporters face declining production trends thanks to…you guessed it…Peak Oil.

Yes. Peak Oil has not gone away. It’s been sent to the corner while the Credit Depression hogs the stage. But Goldman Sachs oil analyst Jeffrey Currie issued a report yesterday predicting a, “swift and violent rise” in oil prices in the second half of 2009.

Currie told a conference in London that, “”Thirty dollar oil reflects the same imbalances that got us to $147 oil. The problems haven’t gone away. We still believe the day of reckoning is to come.” What problems?

There are still major infrastructure bottlenecks in the global oil network. Currie says that despite the big fall off in demand, “This is not 1982-1983 all over again. The supply picture’s radically different…the demand picture’s radically different. The key difference is that today there are no large-scale next generation projects that are going to save the world. Commodity demand is exponentially higher than it was.”

This brings us to the third reason oil prices should rise later this year: the oil trade is back on. Sure, credit may still be a scarce commodity. But if you judge traders by their actions, you can see the market is setting up for a big oil back draft. As evidence, Bloomberg reports that, “Morgan Stanley hired a super tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from higher prices later in the year, two shipbrokers said.”

Our friend Dan Amoss back in America calls this the oil arbitrage trade, where supply is stockpiled offshore, and thus withheld from refiners, allowing existing gasoline inventories to be worked down. Then in six to twelve months time, when crude prices have moved higher, you simply park your ship at the terminal and cash in on the difference between what you paid six months ago (today) and the new market price.

It is normal for the oil futures to be in contango, where spot prices are lower than futures prices. What’s less normal is the amount of oil being stockpiled offshore. “Frontline Ltd., the world’s biggest owner of supertankers, said Jan. 14 about 80 million barrels of crude oil are being stored in tankers, the most in 20 years,” Bloomberg ads.

We also suspect that oil as an inflation hedge will come back into vogue later this year, which might be adding to the appeal of buying today at bargain basement prices. What’s more, you can never discount (although you can never fully quantify) the geopolitical aspect of oil prices. A good general rule of thumb is the more war there is in the Middle East, the more likely oil is to go higher.

Next is a massive topic we are reluctant to introduce today. But we have to. There is no other way around it. It begins with a question: how much air is left in the credit bubble?

Actually, the question comes via Howard Ruff and Steve Hochberg. Let’s start with Hochberg.

He’s the lead analyst at Elliot Wave International. Bob Prechter’s folks have been forecasting for years that the collapse of the credit bubble would lead to a general and massive deflation, including much lower gold prices. In his latest analysis, courtesy of a DR Reader, Hochberg explains:

“The systemic build up of total market credit is so large, currently about $52 trillion, that its implosion will swamp the Fed’s attempts to inflate. And as Conquer the Crash discusses, the remaining dollars that are not extinguished through bankruptcy, restructuring and write-offs, will increase in value. The thirst for cash will be insatiable relative to all other assets.

“Initially, the Fed’s attempt to inflate was akin to using a garden hose to refill Lake Mead after the Hoover Dam collapsed. Over the past five months the chart shows that the Fed has graduated to a fire hose. But creating just over $2 trillion in the face of a contracting pool of $52 trillion in total credit market debt is just not going to get the job done, and the only thing getting hosed right now is us.”

“Eventually credit will contract to the point whereby the income generated from economic production will be able to sustain it and at that point, yes, the U.S. dollar should indeed collapse of the weight of all the Fed’s machinations and gold should soar. But before the market arrives at that point, deflation must run its course. In our opinion, there is still a long way to go.”

But how far? A lot depends on the composition of that $52 trillion in credit. It can’t all just vanish can it? But how much of it is securitised by relatively stable assets? And how much of it could potentially melt away under the intense heat of deflation?

This is not an easy question to answer. But it begins with knowing what you’re dealing with. Specifically, you have to know who owes how much, and who owns how much. Those are two different questions. Let’s deal with the first one. And we promise we’ll make this as painless as possible. If you want to review this data yourself, by the way, you can find it here.

Keep in mind this data deals just with the U.S. And keep in mind it is government data. But the general question is this: how much deflation is left in the credit bubble and who stands the most to lose from it?

The Fed breaks up the total credit market debt outstanding into three categories: Domestic Nonfinancial Sectors (households, farms, nonfinancial corporations, state and local governments, and the Federal government), Financial Sectors (commercial banking, REITs, broker dealers, savings institutions, Government sponsored enterprise, Agency and GSE pools, and issuers of asset backed securities), and finally, the rest of the world.

What we find is that $32.9 trillion in credit market debt outstanding, as of the third quarter in 2008, was owed by the domestic non-financial sector. That’s 63% of the $52 trillion total. Households are on the hook for most of that, with $13.9 trillion owed (or 26% of all credit market debt outstanding). That would mostly be home mortgages we reckon.

Next within the financial sector are non-financial corporate businesses with $7 trillion, non-farm corporate businesses at $3.7 trillion, state and local governments at $2.2 trillion, and the United States Federal government at $5.5 trillion.

So what does it tell us? Well it tells us that if U.S. house prices continue to fall, there is a lot of room left to deflate in the credit bubble, at least several trillion dollars. It’s not hard to see this happening, given the rise in foreclosures, the prospect of even less federal funding for refinancing of mortgages, and the sudden collapse of America’s banking model.

But the lack of credit for refinancing and the looming wave of Alt-A recasts this year and next is, in some sense, already old news. What also keeps us up at night is the $16 trillion in credit owed by the financial sectors. How much of that is at risk to further deflation?

You can get an idea by looking at the L2 table on page 59 of the Flow of Funds report. There is $6 trillion in corporate bonds outstanding. Nearly $5 trillion in Agency and GSE-backed securitised mortgage pools are on the books, and another $3.1 trillion in GSE debt itself. This does not include $1 trillion in “other loans and advances” which may or may not include home equity lines of credit.

We’re sure you get the picture by now. There is still at least $8 trillion housing related assets owed by the financial sector. That might be kind of tough to pay off, given the falling value of the assets which securitise that debt. So who stands the most to lose if households can’t pay their mortgages, corporations default on their bonds, and housing-related assets held by financial corporations continue to fall?

The financial sector combined holds $37 trillion in credit market “assets.” It owns $37 trillion in other people’s promises to pay. Those promises, all $37 trillion of them, are on the books at face value. What’s more, U.S.-chartered commercial banks (Citibank, Bank of America for example) own $8.2 trillion in credit market “assets.” Life insurance companies own another $2.9 trillion. Money market mutual funds own $2.1 trillion in credit market assets, while mutual funds own $2.3 trillion.

Do you see what we’re getting at? The institutions that have the most to lose from a fall in the value of their credit market “assets” also have large obligations to shareholders and pensioners. Those institutions are counting on those assets to meet their own future liabilities (which do not fluctuate in value). And households are relying on those assets to retire, or in some cases, to live month-to-month on a fixed income.

Someone is going to lose, somehow. Or everyone will.

Households win if the value of the credit they owe (their mortgage) is written down or managed lower by some new law. But investors counting on that asset (often the household itself through a pension or life insurance) don’t win if the amount they are owed is arbitrarily reduced.

Either way, Prechter’s group is probably right. There is more deflation ahead. A lot of it. And not just in housing.

The corporate bond market would be another place to look. Corporate defaults haven’t begun to rise noticeably yet. But faced with a much slower economy and much higher borrowing costs, it’s going to be tough for highly indebted firms to roll over their debt, much less take on anything new. Dividends are already being slashed here in Australia.

And where does the deflation of the $52 trillion credit bubble leave us? Well Howard Ruff reckons we get a period of serious deflation, punctuated by a period of hyperinflation. Over at Kitco, he writes that, “First, we will continue to plunge into a major deflation period which will be characterized as a ‘recession,’ and later in the year as a ‘depression.’ Deflation and inflation are always monetary phenomena.”

“Second, deflation will evolve into a run-away-hyper-inflationary depression because of what government will do to try to prevent deflation, which is synonymous with depression and has overtones of the 1930s.”
How will government accomplish that? Stay tuned…

Regards,
Dan Denning

January 26, 2009

The Swift and Violent Rise of Oil was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.