The Mother of All Bubbles

Though the massive increase in the narrowest measure of the money supply (the monetary base) would have created record inflation all by its lonesome, the real danger is long term interest rates, which can only be contained as long as society believe the USD is a viable currency.

This, however, is not the case in the view of the people (nations) that really matter. China, along with Brazil and few other Latin American countries, have decided to engage in international trade in remimbi, real (as seen through the small use of yuan swaps) etc.

This holds vast implications as it "unofficially" takes the world reserve currency status away from the USD. Even Russia! Yes, Russia has publicly voiced it worries concerning the massive money pumping the US has engaged in. It has also stated that it intends to sell some of their US debt. They have even announced selling U.S debt for IMF debt (they are both poor allocations of capital in my opinion). One needs only look at the 94% depreciation of the USD since the institution of the Fed in 1913.

What does this mean? This means large amounts of US dollars will flow back into the U.S (the majority of currency in circulation is held outside presently), exciting inflationary fears domestically, marking the beginning of an unprecedented inflationary era.

But what if the Fed realizes the potential consequences of its actions and decides to suck up excess reserves? Well this is unlikely to happen, at least to a meaningful degree as residential mortgages reset, thus causing the default rate to increase. Not to mention the commercial real estate bubble, which has managed to avoid massive defaults as they are far better capitalized the residential sector.

Now the bubble that will break us: Back in the late 70s, Paul Volcker needed a 19% prime rate to combat the easy money policies of his predecessors. We will undoubtedly experience far greater rates of inflation, but to be conservative let’s just assume inflation will reach the same level in the next 3-5 years. Bernanke, due to his ignorance regarding economics in general, may begin to raise rates to 2%, then 5%-8% between now and 2011.

In other words, even if he switched course towards tighter monetary policy, he could not drastically raise them as this would send us into an even deeper recession that what we are experiencing now.

To keep rates down/ prop up the banking system, the Fed is going to either monetize debt (no matter what they are saying now) , issue more debt to foreigners (but they are trying to sell it now) or keep doing Treasury auctions week after week after week. The ill effects will be extremely higher loan defaults, both residential and personal (as they are closely linked to the 10-year, which the yield has nearly doubled over the last 6 months).

This will likely lead to the current excess reserves in the system (900 billion), potentially turning into a maximum 8.1 trillion via fractional reserve banking (although the entire 8.1 trillion is unlikely, 4 or 5 trillion is in the realm of possibilities.

The other, even more devastating, effect will be a substantial rise in the 30 year Treasury yield (which like the 10 year, has nearly doubled from 2% in December to 3.93% presently). This means our creditors in December would be receiving annual interest payments on the debt (assuming 12 trillion, though it is likely higher) would be : %4* 12T= 480B.

But remember that is only for 2009, as long term rates will likely move between 8-10% in 2010 and 12-15% in 2011 or 2012 (I am not a market timer but rather just using some likely scenarios that will occur at some point in the near future). The Fed eventually will have to resort to monetizing the 30-year to subdue these high payments.

But free market forces are telling society to save, in opposition to what the Fed wants in attempts to spur economic growth. So eventually the yield on the 30-year Treasury can't be artificially suppressed. Assuming the free market's equilibrium interest rate (the loanable funds market) reverts to the aforementioned 20%, our interest payment would then be an astounding 1.92 trillion every year! In case my ramblings seem confusing, I wrote the following a few months back:

It is well known the Fed will be a big purchaser of Treasuries, those buying now will be positioned when the buying spree begins. if the Fed pays higher price in the future (to contract the money supply), traders can earn spectacular profits.

But realistically speaking, this demand for Treasuries is artificial as they are in the hands of speculators, not investors. In other words they are similar to house flippers. (People did not occupy these houses but flip them and sell to future buyers, but as these houses came back on the market , prices collapsed).

Like the housing bubble, the government issued massive amounts of debt to finance multi trillion annual deficits. So the Fed continually buys Treasuries to prevent a collapse as these speculators mentioned earlier unload their holdings. The has to print money to buy these bonds because we are broke adding to inflation.

As this inflation diminishes the value of low yielding bonds, we embark then down a slippery slope. As the Fed the starts to prop up bond prices, the larger incentive to hit the Fed's bid.

THE RESULT WILL BE THAT ALL TREASURIES SOLD WILL BE PURCHASED BY THE FED. The outcome resulting from such actions coupled with inflation kicking into high gear, will necessarily cause all other type of debt (municipal, corporate, ect,) to fall through the floor thus PUSHING RATES TO THE MOON. The Fed will prevent these rates from going to high by purchasing the other types of debt previously mentioned. To avoid this scenario the Fed will have to pull out of the bond market before it is to late.

But this will cause exactly the thing the Fed is trying to prevent as default rates, would increase, 5, 10, 15 ,20 fold or more(no one can really know).

UNLIKE THE BURSTING OF THE REAL ESTATE BUBBLE, THE GOVERNMENT CAN NOT BAILOUT THE BOND MARKET BECAUSE IT WILL BE THE FED THAT NEEDS A BAILOUT.

Conclusion: So it comes down to a few basic concepts that will cause massive wealth destruction and a severe overall standard of living, more specifically the inordinate amount of increasing unfunded liabilities each year.

Here is a brief summary of the obstacles that will more likely than not bring the USD to its knees. Let’s go out to 2013-2014 to see what will be in store.

1. 14 trillion in public debt with at 12% 30 year Treasury = about 1.7 trillion
2. 1.3 trillion in healthcare liabilities, reaching 2 trillion a year by 2020
3. Defense spending plus other government programs ( 800 billion – 1 trillion)
4. These alone bring the total to nearly 4 trillion which will increase every year.
5. The means they will probably build more printing presses.

Do what you can to protect yourself, own REAL assets: precious metals, oil , agriculture, equities that will increase faster than inflation or international stocks. Hoarding cash is the worst thing to do.

Comments

[Steven Hansen:]

the issue is timing - not that the event will occur.

Jul 05 05:44 AM

[Steve in Gr...:]

Agree.

Not really much more to say, other than "thanks, Mr. Bernanke and Mr. Geithner".

Jul 05 07:01 AM

[valuepredictor:]

Was the lack of current local micro economic information a factor in the Housing Bubble? Has anyone looked into this? Or does free macro economic data rule?

Jul 05 07:52 AM

[DONE_SONZ:]

Fiats dont work.Hate the game not the player.

Jul 05 07:56 AM

[D. McHattie:]

The currency code for the united states dollar should change from USD to IOU.

Makes things a little clearer, you know, for the kids.

Jul 05 10:56 AM

[OldFordTruck:]

I don’t dispute the article above…as outlined before; it is the crash scenario of the USD. My biggest fear is not becoming poor as a result of hyper inflation, but of the breakdown of the rule of law and the tyranny of an oppressive government. If it comes to pass, I fear the US government will use the crisis to re-write laws (i.e. Chrysler bond holders for example) or simply impose martial law and confiscate personal property and liberties. Sure you can hold guns and gold, but if they are both outlawed what then? Do American’s today have the moxie of our Founding Fathers to reconstruct the country in their image?

Jul 05 11:43 AM

[EUARTE:]

The greatest problem will be civil unrest. This will not be avoided because Washington doesn't want to avoid it. Obama hates the previous Capitalist America. The only way he can get rid of it is more and more financial crisis in our economy.
You must note that he has spent only about 6% of the stimulous money. He is not interested in stimulating the economy. His Cap and Trade is another of his blows at the economy. Health "reform" is another effort to control the populous.
The only hope is the voters will massively catch on for the 2010 elections. I doubt it.

Jul 05 12:00 PM

[Ergo:]

Agreed that the issue is timing. And for individuals, employment uncertainty can prohibit you from being a long term investor. I miss buy-and-hold.

Wish I could say that social unrest is unlikely. But living in a big city, I see whole areas that are entirely dependent on gov't money, where crime and drug use is a big problem. And our society is secular now, without a true moral code being taught. I'd hate to throw a match into that.

Jul 05 12:15 PM

[Northstar10000:]

Cash/Silver\SDS your investment portfolio.

Jul 05 04:43 PM

[thelongolian:]

KA-BOOM!

Jul 05 05:16 PM

[Frugal Joe:]

Good breakdown of the financial difficulty we are facing. The problem is that if the Fed restricts (or pulls back) on dumping money into the system we will have even more severe unemployment as you describe.

They have no choice but to keep the system lubricated. Sadly, most of the first (Bush-Paulson) bailout and the second (Geitner-Obama) bailout money went to Wall Street executives as Bonuses and to banks as reserves.

If they pup in another Trillion, which I think they must, we will begin to see serious inflation next year...2010 Q2 or Q3.

Jul 05 07:22 PM

[Gary K:]

If this could be brought out to the open market, it would blow the lid off Oil prices ! Gasoline can be safely converted into a Vapor that's 100 parts of Air to 1 part of Fuel.With this, even the largest SUV could easily get 50+ MPG, & emit a fraction of the Emissions of an EPA mandated 14.7/1 Air/Fuel Ratio.Do a search on Tom Ogle,& energy21.freeservers.c... & check out near the bottom of the Page, just before the update.But, when a Vehicle Emissions Test is done,Oxygen [O2] Exhaust Sensors must detect combustion that indicates 14.7/1.That's the Law.Thus, it is entirely possible to fail an Emissions Inspection for not generating enough pollution!My Photo is of a Vaporizer, ignited to prove that it works.Big Oil & Big Government have outlawed it,and President Obama can't change it.If we are ever to get away from Oil, this has got to change! Then, the price will plummet !

Jul 05 10:25 PM

[Moon Kil Woong:]

It seems very clear that the Obama and other administrations will not be given a second chance at the massive budget deficit we are creating this year. The bond market will not support it. That does not preclude both politicians and the Fed from being stupid though. The Fed's blowing up of its balance sheet I feel is the #1 cause of the destabilization of US Long Term bonds so far.

What's to stop them from continuing. According to them they are not answerable to anyone. They only need to report to congress to get slaps on the wrist and spin silly lies like green shoots quarterly.

Jul 05 11:36 PM

[semperpax:]

We've got no one to blame but ourselves. We elected Obama and the criminals and idiots in Congress.

Jul 06 09:44 AM

[JeffDB:]

On Jul 05 12:15 PM Ergo wrote:

> Wish I could say that social unrest is unlikely. But living in a
> big city, I see whole areas that are entirely dependent on gov't
> money, where crime and drug use is a big problem. And our society
> is secular now, without a true moral code being taught. I'd hate
> to throw a match into that.

I think that at its foundation, our economic crisis is really the result of a moral breakdown in our country, as much as a fever is a result of a virus. Hopefully that moral virus is a little easier to beat than ebola.

When I've read of the struggles in "3rd world countries" I've often lamented the corruption that seems to cause so much pain to the people, and now it seems that corruption has integrated itself into our own beloved country. That view is not only my own, but that of former IMF chief economist, Simon Johnson who penned the following excerpt in his article in The Atlantic, "The Quiet Coup":

www.theatlantic.com/do...

"The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time."

It sounds like Matt Taibbi thinks the folks at Goldman Sachs fit the above description given his piece in Rolling Stone excerpted on their site here: www.rollingstone.com/p...

or available in full albeit in imperfect form in pdf format here: www.box.net/shared/lls...

Jul 06 05:16 PM

[Andy1234:]

well....only a percentage of the population voted him in....everyone else has to live with the others decision.

furthermore....people are just voting for money....which is the end of this republic.


On Jul 06 09:44 AM semperpax wrote:

> We've got no one to blame but ourselves. We elected Obama and the
> criminals and idiots in Congress.

Sep 25 10:06 AM