THE BEAR'S
LAIR The
end is nigh By Martin
Hutchinson
According to the Mayan
calendar, the Great Cycle will end on December 21,
2012, at which point the current Fourth World,
founded on August 11, 3114 BC, will come to an
end, leading us into a Fifth World of greater
enlightenment.
Economically, this is
beginning to seem like a remarkably accurate
prediction. There are a number of signs in today's
market that a world-changing crisis is
approaching, after which our economic environment
will never be the same.
The approach of a
market apocalypse can be gauged by considering the
relative valuations the market is currently
putting on assets. Considered rationally, the most
attractive asset today should be equity
participations in the world's fastest growing
economy, China - yet Chinese
equities are at 33-month lows, and many small
Chinese companies are trading on earnings
multiples not seen since the Great Depression.
Considered rationally, among the least
attractive assets today should be the long-term
debt of two countries with unsustainable budget
deficits and governments that have made very
little effort to close them - yet British and US
government bonds are trading at yields close to
all-time historic lows and far below the rates of
inflation in their respective countries.
Extreme market irrationality of this kind
is a pretty good warning signal of coming market
collapse. Just as the Emperor's Palace grounds in
Tokyo being worth more than the state of
California signaled the end of Japan's real estate
bubble in 1989, so current valuations of British
and US government debt signal that we are very
close to a massive reversal, in which probably for
several decades it becomes impossible for those
governments to sell new debt except at very high
cost.
Bank balance sheets worldwide, which
have loaded up on government debt because of the
foolish Basel banking regulations and the
attractiveness of "gapping" income between
short-term and long-term rates, will collapse into
insolvency.
The early part of this
collapse will be marked by a rapid reversal of
"mark-to-market" regulations, so that banks are
not forced to mark down their debt holdings to
deflated market prices, but even if this
accounting chicanery works in the short run, it
will prove no solution in the long run, as
short-term rates rise above the meager long -term
yields on their government bond portfolios.
The First Pennsylvania Bank failed in 1980
through precisely this problem, at a time when
there was thought to be no risk whatever of a US
government default or delay in payment. Adding the
default possibility into the equation will simply
make the problem all the more insoluble.
Banks will attempt to hedge themselves
through interest rate swaps and credit default
swaps, but that will only cause a collapse in swap
markets as well; the depth of those markets will
prove completely inadequate to solve their
problems.
Naturally, as in 2008, there
will be a few sharp operators, like John Paulson
and Goldman Sachs in that year, who make money out
of the collapse, but their ability to do so will
merely worsen the burden on the rest of the system
and the costs of any attempted rescues.
There is thus considerable danger,
probably in the latter half of 2012 as the Mayans
predicted, of a banking system collapse dwarfing
that of 2008. Value distortions such as those
prevalent currently are necessarily of short
duration.
The eurozone problem seems
certain either to find a solution or to cause a
major upheaval in 2012, with the balance of
probability being on the latter outcome. In the
United States also, 2012 seems the period of
maximum near-term danger for the budgetary
problem; solutions are impossible in an election
year and exacerbation of the problem by foolish
handouts only too likely.
Maybe the US
budget mess can avoid collapsing before 2013, but
any market shock, for example from Europe, is
likely to push it over the edge. Japan, too, is
nearing the point at which its government debt to
GDP (gross domestic product) ratio moves above the
level at which it is unsustainable; again a market
shock in 2012 could push it over the edge.
To use a chemical analogy, the market
solution is super-saturated, and any tiny crystal
dropped into it will cause precipitation. A
trivial event, such as a repetition of May 2010's
stock market "flash crash", could be the trigger
for a market collapse.
Given the extent to
which banks have loaded up on "risk-free"
government debt, a collapse of the government debt
market will cause a collapse of the banking
system. I have written before how the world
economy would work rather better if government
debt were not considered the universal risk-free
investment, and were instead considered the
doubtfully solid security it actually is.
However there is no question that the
transition, with the collapse of global government
debt markets and banking systems, will be
extremely painful. Since government debt market
collapse will cause banking system collapse, there
will be no rescue available. Central banks
worldwide will of course attempt to alleviate (or
rather, postpone) the problem, by an endless array
of gimcrack money-printing schemes. Since their
credibility, already dented, will be at an
all-time low as evidence of world systemic
collapse emerges, they will doubtless attempt to
devise money-printing schemes with a populist
appeal.
Thus Federal Reserve chairman Ben
Bernanke, whose 2002 "thought experiment" of
dropping $100 bills from helicopters was intended
as a snobbish academic joke against the
bourgeoisie, will end up doing just this. TV
cameras will be lined up, the world's financial
bloggers will be prepared, and a Bernanke-bearing
helicopter will appear hovering over some
carefully chosen demographically balanced slum,
dropping roll after roll of greenbacks to a Secret
Service-prescreened crowd of adoring populace.
Of course, the real money will still zip
by wire transfer to the vaults of the nation's
largest banks and embezzling government securities
dealers, but the production values of a benign
Bernanke rewarding a faithful underclass will be
thought well worth creating.
It won't
work. Far from obeying Walter Bagehot's famous
advice for a financial crisis, of lending freely
against top quality security at very high rates,
Bernanke and his chums will, as in 2008, throw
money around like confetti, taking little account
of the quality of the security nominally tendered,
and lending it at rates that allow the banks to
make yet more illicit billions by on-lending their
subsidized finance.
The European Central
Bank's handout at the end of December, where it
lent US$600 billion of three-year money to the
banks at 1%, in the hope they would re-lend it to
tottering eurozone governments at a spread of some
500-600 basis points, is typical of current
central bank thinking.
Lend money to the
banking system by all means, if you think there is
a liquidity problem, and lend it for three years
if you want to stabilize their financial position.
However the money should be lent at a stiff
interest rate of around 7%. At that rate, only
those banks that really needed the money would
have borrowed it, so the bailout would have been
limited to $100 billion or so. The remainder of
the rescue of banks' balance sheets would have
been achieved by them rushing to sell all their
assets that yielded less than 7%.
This
would notably not include consumer loans and
productive small-business loans, which generally
yield considerably more than 7%, but it would
include all the miscellaneous government junk with
which the banks had been playing "gapping" games,
hoping to borrow at short-term rates and lend at
long-term rates, capturing the spread between
short-term and long-term interest rates. With
their marginal funding cost 7% for three years,
this would no longer be profitable.
Of
course, many eurozone banks, a simple lot, have
not incorporated marginal pricing into their
Treasury operations, so will happily borrow at 7%
and lend through a different department at 3%,
puzzling why their profits are less than they
were. But frankly, a little Darwinian selection
against stupidity in the European banking system
would do no harm at all!
The chance of a
system-destroying financial breakdown in 2012 is
thus substantial, and December 21 is as good a day
as any other on which it might occur. With
government credit and banks both collapsing, the
old financial world as we have known it since the
Bank of England's foundation in 1694 would indeed
have ended.
The good news is that this
would not shove us back to 1694's living
standards. As for my Great-Aunt Nan, who put her
savings in British government War Loan when she
retired in 1947 and found inflation and interest
rate rises eroded more than 90% of their value
before she died in 1974, the disappearance of
government bonds, bank stocks and many bank
deposits from our assets would cause great
hardship. However the central function of banks as
a payment mechanism would not disappear and
commercial, manufacturing and service-providing
activity would continue.
The disruption
would be huge, but human civilization would carry
on, even the affluent Western civilization many of
us have grown used to. It would not be necessary
to invest our assets in gold, canned goods and a
shotgun; those of us with our savings in
non-financial sector stocks would find their
long-term value would recover, after what would
doubtless be the mother of all stock market
crashes.
There would be a Fifth World for
us as the Mayans predicted. In it, we will finally
have achieved enlightenment - about the folly of
fiat money, over-powerful central banks and
"risk-free" government paper. Achieving this
enlightenment will be painful, but it will be
worth it!
Martin Hutchinson is
the author of Great Conservatives
(Academica Press, 2005) - details can be found on
the website www.greatconservatives.com - and
co-author with Professor Kevin Dowd of
Alchemists of Loss (Wiley, 2010). Both are
now available on Amazon.com, Great
Conservatives only in a Kindle edition,
Alchemists of Loss in both Kindle and print
editions.
(Republished with permission
from PrudentBear.com.
Copyright 2005-12 David W Tice &
Associates.)
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