The Economy Guy

Happy Memorial Day.  I hope you are all celebrating this special holiday and honoring the fallen soldiers who have brought the freedom that we enjoy today.  Without them, we could easily be speaking German or Japanese right now.

In the news over the weekend……

Spanish Debt Downgraded – by Fitch from AAA to AA+.  And this has shaken the markets again after they closed on Friday.  Spain was the area of Europe to create the most jobs two years ago, but now has one of the highest unemployment rates at 20%.  (And you think our 9.9% is bad??)  Spain is the slowest European country to emerge from the recent downturn.

3 Florida Banks Closed – by the FDIC, plus two more banks and this brings the total banks to fail this year to 76 banks.

Italy Strike – on June 26th by biggest unions to protest government budget cuts.  This will bring Italy squarely into the spotlight of a country with budget problems and should trouble the markets some more in a month.

More Dubai Debt – Dubai International Capital, an investment company controlled by Dubai’s ruler asked lenders for a three-month extension on repaying some of its debt. DIC did not provide details of the debt involved except to say the request involves “certain maturities.”  The company has a $1.25 billion loan coming due in June.  Just another instance of debt problems around the world.  Remember that the Dubai World default started this whole debt problem awareness.

Special Report……

I am taking this Memorial Weekend to write a very special report to all economyguy readers.  I will try to answer the most complex US economic question that has bothered me since our current crisis has taken hold.  The question is:

“Are we in a deflation or are we going into an inflation?”

Part of the question is fairly simple to answer.  We are in a deflation right now.  How do I know?

1. Housing prices continue to decline across the US in the majority of metropolitan areas with only a few upward price areas.
2. The Money Aggregate for M3 (even though it isn’t reported any longer) is currently going negative.   That means we are having less money in circulation in the US.
3. The Unemployment Rate remains stubbornly high at 9.9% – and the best economists predict it will remain high.
4. The world economy is not stable as demonstrated by the fact that Greece will NOT be able to repay its debt in the future.  Spain’s debt rating has been dropped, The US debt rating is threatened to be reduced.
5. European bond markets have spoken, and they have said “No more loans to bankrupt nations.”  That is what caused the European Central Bank to buy national debt (like Greek junk bonds) with a new $1 TRILLION bailout plan.  The healthy (?) European nations had to swallow hard to allow that to happen.
6. The FED and other central bankers have  used highly inflationary policies to counteract the deflation going on.
   

Remember that the real definition of inflation is an increase in the money supply, and deflation is just the opposite.  Money is going to money heaven as it did with all those toxic US Mortgage Securities (now held by the FED as collateral) and as it is today in the housing market.

Money Heaven – the best way to understand Money Heaven is to understand the opposite of Money Heaven, money creation out of no where.  If a stock price goes up, it is caused by having some buyers willing to pay more money for those shares.  However, ALL share holders benefit as the “market” value of their shares just went up.  And, that increased value is recognized as real money.  Money Heaven is the downward spiral of any asset class – for example stocks, bonds, real estate, antiques, stamp collections, aluminum, etc.

But what does the future hold????  Here is the heart of this special article.  I think I have seen a possible economic scenario that could be played out of the next few years.  Listen to this story, and reflect on whether of not you think this could happen.  First of all, the world’s central banks (and individuals) thought that we could live on debt forever, as we have for the past 50 years, and continue to grow the economy.  The world is now realizing that this strategy is unmanageable, and we can’t live that way any more.  Governments will continue this “Ponzi scheme” until it fails as the cost of the debt overwhelms the income to pay it off.

The BIG banks of the US are either bankrupt (my personal opinion as the mark-to-market rule has been lifted from their reserve asset calculations, or they are at least heavily leveraged according to their own reports.  The BIG banks have a reserve of 2 to 4% today.  I assert that it wouldn’t take much of a shock to create a situation where that 2 to 4% would be wiped out, and the bank would be bankrupt.   Let’s play a “what if” game and see if we can come up with some ideas how this might happen.

1. A key European bank fails, and the US bank is left holding the bag.  In other words, the US bank hold securities issued by the now failed European bank.
2. A key European nation fails (declares a default) on its debt payment, and a US bank is left holding the bag.
3. A small 3rd world nation declares a default, that brings down a European bank, etc.
4. Interest rates start to rise, and BIG banks cannot earn as much interest spread as they currently earn with FED Funds Rate os zero percent.  This weakens all BIG banks.
5. A war breaks out, and countries default on their debt.
6. others??
   

My point is that something will undoubtedly come along to disrupt the heavenly rapture that banks find themselves in today.  It will come out of the blue (as the Greek problem apparently did) and cause real chaos in the financial markets.  The world is in a debt crisis today.  It isn’t just the US.  It is many nations in Europe – Greece, Spain, Portugal, Italy, Ireland, UK, France, Germany, etc. etc.  The US debt problem is worse than most European nations.  A debt problem of some sort will break the back of a BIG US bank sometime in the future.  That bank will be in the “too big to fail” category, and the FED will be stuck with the political reality that the US won’t have the political guts to bail them out.  One bank affects another bank, so one BIG bank going down can pull down its neighbors.  We came very close to this in 2008.

What did the FED do in 2008?  It printed (out of the blue) $2 TRILLION and gave it to the BIG banks – taking the toxic debt as security.  The FED had about $1 TRILLION on its books when it created the additional $2 TRILLION, so it now has $3 TRILLION on its books.

The next time around, it won’t work so easily.

Here is what I think will happen.

1. Interest Rates will start going up in the US starting sometime in the next 12 months.
2. The US economy will tank based on no one’s ability to pay increased interest rates.
3. Stock prices will tank to levels lower than the March 2009 crisis levels, as we are in a secular bear market.  (For example, the S&P should hit about 500 which represent book value of the S&P 500 companies.)
4. The US will continue down the road of a deflationary economy.
5. Then a few years out, a major crisis will bring down a BIG US bank.
6. The FED (in concert with all other major Central Banks) will respond with their “proven” method of saving the nation.  But, this time….
7. The FED will print about $50 TRILLION in new money and spread it around to save the banks and the financial system.
8. The FED crisis will take place in a 2 week period – in other words, it will happen very quickly.
9. The FED will coordinate with all major economies so all currencies are devalued about the same percentage at the same time.  This would be a “world” solution to our problems.
   

So, what this means is that our deflationary economy will become inflated overnight.  It will not be the “traditional” hyperinflation method we have seen in the Weimar economy or Zimbabwe. Nor will it look like the inflationary period created in the US by Volker that crept up week by week.  Inflation will not creep up on us by measuring it  with the CPI.  In other words, price inflation will not be a precursor to our massive inflation.  It will happen in a 2 week period.

Then, I would speculate that the FED would create a new currency to replace all those Dollars that are now worth 2% to 17%  of what they were worth the day before.  Did you get that calculation?    If there is $1 TRILLION in FED paper circulating in “good old normal times”, then when it jumps to $50 TRILLION, each Dollar is 1/50th in value.  Or, if you think our normal is $3 TRILLION, then the new value is 3/50 (or 17%).

Printing all that money, and issuing a new currency would eliminate a lot of headache for the government as all those old debts could be paid off with the new money (the $50 TRILLION) printed out of the blue.  Why $50 TRILLION?  Well, there isn’t anything magic about the amount, except that $50 TRILLION is about the amount we owe is debt and Fannie/Freddie and Social Security/Medicare/Medicaid.  Any other number would have a similar affect.

Here is what is VERY SCARY about this scenario:

1. YOU won’t have any advance notice that it is coming
2. If you are not positioned correctly before it happens, you will be wiped out.
3. For example, all cash deposits in banks will become worthless overnight.
   

I would appreciate anyone’s opinion on this Scenario.  I see it being so easy to achieve this end, and the FED has all the power it needs today to enact such a scheme.  In fact, the FED would be following its purpose in life by saving the US economy from the ravages of a meltdown that would stop commerce as we know it.

For you personally, you must get “outside” of the US credit and debit system because that is where the problem is.  Gold and real estate are probably good places to have your assets when this happens.  Having you money in cash or bonds will be the wrong place because cash and bonds will become fairly worthless overnight with this scenario.

The ongoing bull market in gold is being caused by a total lack of confidence in all currencies.  Gold is now a defacto currency.  It will go up and down, but the long term trend is up, and should go much higher than it is today.  At some point the gold bubble will burst, but as George Soros says (and who is investing in gold himself) “gold is the ultimate bubble.”  I interpret this to mean that gold will be the final bubble before the world rearranges itself and corrects it indebtedness.

Here are the last numbers for today:
Dow Jones 30 Industrial – 10,044 (down 23)
10 Year Treasury Bond – 3.16% (down 0.07%)
Euro – $1.2351
Gold – $1199 (up $5)
Oil – $69.96 (down $0.25)
Gasoline – $1.93  (down $0.04)