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The US, and much of the world, faces an unavoidable reality. There must be a severe economic collapse before we can proceed with the next period of sustained economic growth. This scenario is based on fundamental economic theory and a long history of what happens when the current economic conditions persist and are worsening. This reality is of utmost importance to any investor except one with a very short-term investment horizon.

This unavoidable reality is clearly demonstrated by the fundamentally opposing policies of the American right and left. The right, represented by the Tea Party, has both the clearest policies and the least supportable views in terms of economic theory and the real history of the world. The Tea Party's economic plan is to lower taxes, primarily to the richest. To balance the budget, it plans to cut benefits, primarily to those most in need. This strategy will do severe damage to the pretense of a social safety network. A fundamental reason for cutting taxes to the rich is that they will invest and thereby enrich the whole community.

The Tea Party plan fails based on three critical parameters:

  1. Classic economic theory.
  2. Historical fact in similar circumstances.
  3. Common sense.

First, let´s discuss classical economic theory. GDP (Gross Domestic Product) is the measure of how an economy is doing. GDP is the measure of our total annual income. When GDP goes up, people naturally tend to invest. When it goes down, people naturally tend not to invest. GDP is the sum of all spending by the people (the private sector) plus all the spending of the government (government sector) plus net exports (the net balance between exports and imports). If exports are greater than imports, the net balance adds to the GDP. If imports exceed exports, the net balance decreases the GDP.

The Tea Party Plan will substantially lessen the government spending. First, it plans to bring deficit under control, apparently very quickly. Total US government income in 2012 is $2.5 trillion and expense is $3.8 trillion, meaning there is a 50% shortfall in income. (Any private business that spent $3 for every $2 of income would be out of business long ago!) However, any meaningful Tea Party cut in government spending will have enormous negative effects on the GDP.

Furthermore, there is the multiplier effect. The multiplier effect is the businesses that close because they lose the necessary income to stay in business. The multiplier effect is the reduction in spending by all classes except the richest because they have less to spend, particularly when many lose their job. In short, reducing government spending by one dollar will end up reducing GDP by much more than one dollar because of the multiplier effect. Classic economic theory is clear that reducing GDP is not the way to create growth and wealth in the US.

To see this empirically, we can look at the second measure of the Tea Party Plan, which is the historical fact in similar circumstances. First, let´s look at England today. England is a government that is taking a measured, middle of the road approach with some spending cuts, but with consideration for the social safety net. Actually, England's GDP is declining year after year, with great frustration for it´s government.

Then we can look at an out of control situation such as Greece. Each cut in government spending simply makes matters that much worse for the country. And finally, I strongly recommend Rogoff's and Reinhart's book, "This Time is Different" - which looks at hundreds of years of history and countries all over the world. When countries get to the position of the US, one of two things happen. The amount of indebtedness becomes so high, the world loses faith in the country to pay. The result is sky rocking interest rates and financial collapse. You can see this movie in real time looking at Greece and Spain at this moment.

Alternatively, the country tries to deal with the problem by cutting expenses, but brings on the problem sooner. The tendency of the US is to "kick the can down the road". It makes the US today to seem to be following Greece and Spain. But with respect to the Tea Party view, history shows you cannot cost cut your way to economic well-being after you reach a certain level of indebtedness. The problem is both an economic and social problem for the people affected, but it is also a problem where the indebtedness reaches proportions simply too big to manage back to reasonable levels.

Thirdly, let´s discuss common sense as the third measure where the Tea Party Plan fails to work. The allegation that lower taxes will produce the incentive to invest is simply not true. People invest because they believe they can make money. The cutting of government expenses will dramatically cut GDP with the multiplier effect. People invest in a growing economy and new opportunities. People do not invest in a shrinking economy without good opportunities. Investors invest to make money. If the economy is falling, no one will invest even if the tax rate is zero.

In short, the Tea Party Plan fails to make sense by three powerful criteria. The Tea Party Plan will fail, and bring on the economic collapse. Perhaps its only virtue is that it will bring on the economic collapse problem sooner than the Democratic approach, which ultimately tends to be more painful because the taxpayer ends up owing much more.

The Democratic position is best represented by Paul Krugman. He is an intelligent man who has held important positions. He is articulate and has written many books. Krugman's position comes down to Stimulus is the only remedy given where we are. He does not argue that it will go on forever, but simply long enough to get us out of the problem where the economy can then survive on its own.

I do not agree that stimulus can fix the problem. Stimulus, like cocaine, is addictive. Fundamentally, we have been doing stimulus since Alan Greenspan became head of the Fed in the 1987, with particular emphasis on stimulus from autumn 2001 and thereafter. We have now ballooned the deficits to a place where there is no way to go back without the horrific economic adjustment. In essence, the fundamental question from the Democratic side is whether Stimulus will work as a solution to the problem without causing an economic collapse due to excessive debt.

Here is a quote from a 2010 article of mine on stimulus called Heading Down the Path of Correction to Depression.

Does stimulus work?

Now, however, we have to ask the question "Does economic stimulus work?" Since this is the principal downturn fighting tool currently being used by major governments, the question and its answer is very relevant. One of our brightest academics is Paul Krugman who in his recent book The Return of Depression Economics and the Crisis of 2008 analyzed whether stimulus works. He comes to the surprising conclusion that sometimes it works and sometimes it does not work. But he doesn't know why. I do know why it sometimes works and other times do not work.

I have mentioned in several of my articles over the last year and half the explanation why stimulus sometimes works and sometimes does not work. I call this concept the 'Limitation to Stimulus'. The concept is quite simple. Stimulus works in the beginning and middle of economic cycles but does not work at the end of the economic cycle. At the beginning and middle of the economic cycle, there are useful areas to invest stimulus money. At the end of the economic cycle, there are no useful areas to invest in and the money goes to worthless investments that ultimately go broke. In short, much of the money invested in stimulus at the end of a major economic cycle simply defers the moment of truth and builds a larger bubble to blow up a little further down the road. Much of the money now being invested in stimulus will ultimately be lost and make it infinitely worse for the citizens who will inherit staggering losses of their government and have to pay ultimately much higher taxes.

Let's summarize the position on Stimulus. It will fail this time because we are at the end of a historical bubble where there are very few worthwhile investment opportunities. The multiplier effect on stimulus money has been reduced to near zero for lack of a favorable investment environment. The collapse of Solyndra is typical; the government financed solar panel company that collapsed with hundreds of millions of dollars of government money. It is not a matter of fraud: it is a matter of competing with the Chinese and a declining market for lack of government subsidies. Bad investment. Wasted stimulus. In short, stimulus will fail because of inadequate places to profitably invest the money.

Let´s look at some of the indirect consequences of the Stimulus that have made our world more risky and contribute importantly to the probability of the coming economic collapse. The four points below illustrate the complexity of Stimulus. I point out how our world has become more dangerous and this is directly attributable to unintended consequences of Stimulus.

1. The safety of US Government Debt.

For most of us, this is sacred. Yet, behind the scenes of the stimulus, lies the disguised reduction of interest rates as a major strategy to keep the US debt sales viable in international markets. While debt has increased by 90% in the last six years (from $8.4 trillion to $16 trillion), the cost of the funding this debt is essentially the same at $400 billion. The average interest rate paid is down from 5% p.a. 6 years ago to 2.7% p.a. today.

The Fed has driven the short, medium and long-term interest rates to the lowest level in history as part of the Stimulus program. Interest rates exceeded 12% when Fed Chairman Paul Volker dealt with the last big bubble in the early 80s. US government interest costs have averaged about 6% during the last 50 years. Interest costs of 16% p.a. would mean the entire tax revenues of the US government would go to pay the debt and there would not be any money to pay for any US government costs, including Social Security, Medicare and defense.

Since interest rates hit near 12% the last time we had to fix the debt problem with Fed Chairmen Volker, we must see the high probability that the cost of US interest will increase dramatically at some time in the future. Reinhart and Rogoff estimate that the relation of debt to GDP over 90% is generally an indicator of a country with a structural debt problem that is likely to end in collapse.

This year, the United States passed the 100% mark for debt to GDP. Furthermore, debt is growing over a trillion dollars per year. The stage is set for a catastrophe, where the cost of interest on the US debt can soar, making it obvious to creditors of the inability of the US to pay its debt obligations. While we do not know the date this catastrophe will happen, it will become inevitable assuming the present trend continues. See Greece and Spain for what they are: the present day reality for them is what the US will experience later with the current deficit trend.

2. The safety of the derivatives market.

There is approximately a $600 trillion notional value market in derivatives. The derivative market is designed to fundamentally be a means of eliminating risk. If you have a variable cost loan, you can buy interest rate swap that permits you to lock in you cost. If you are concerned that your loans to Italy are at risk, you can buy a derivative to protect you. So in theory, this is a market of large numbers, but in theory should have very little risk.

In reality, this is the biggest casino in the world for a small part of the total players. Principally, the risk is concentrated in those selling the coverage, not those buying the coverage. Yet it takes only one important player a la AIG (American International Group of insurance companies) to bring the system down. The US government had to put in $150 billion to save AIG in 2008. If the US had not done so, it would probably have brought down Goldman Sachs and many others in addition to AIG.

Jaime Dimon is generally considered the smartest US banker we have, and yet he let a rogue trader incur just last month a $2 billion loss or more for the account of JPMorgan Chase (JPM). One big player that defaults puts the whole system in risk of default as one bank collapse brings on another bank collapse. It would take a 3 % loss in the derivatives market to wipe out the worldwide capital of the banking system in the world. The probability that numerous of the world's major banks will fail in the coming years due to derivatives is extremely high, putting at risk the solvency of the worldwide banking system.

3. Making the US Banking System Safer.

We talk a lot about making the US banking system safer, but in fact the commercial banking system has more risk today because Stimulus has driven down long-term lending rates. Commercial banking depends on lending at a significant margin over the cost of funds; for example make a housing loan at 7% interest and fund it with no or very low costs deposits of a short time frame.

Stimulus has lowered the long-term cost of funds to be very similar to the short-term cost of funds. Therefore, traditional banking has very little ability to make money the old-fashioned way as most of the profit has disappeared from its traditional form of making money because Stimulus has pushed long and short rates down so far.

The US banking system is being driven to take higher risk bets because its traditional profit structure has been harmed by Stimulus. Most of the higher risk items are closer to betting at the casino than traditional banking. There is a high probability that many of the world's major banks fail in the coming years, primarily because of lower gross margins on lending, bad credit or high risks on derivatives. This week, Spain's largest bank, Bankia, failed due to bad real estate loans and has to be bailed out with $125 billion of government funds. The financial cost for bailouts will begin to soar shortly, first in Europe and later in the US.

4. The safety of the US residential and commercial real estate markets.

While the perception exists that the real estate market may be on the mend, the fact is average prices are down over 19% on average since 2007. Untold losses still exist there, but most people could not take another 20% to 30% drop in prices. If any one of the three issues above explodes, it will inevitably lead to another round of declining prices in real estate - which affects not only the individual homeowners, but the viability of the banking system and the enormous bond and derivative market associated with the underlying real estate loans.

The above explains why stimulus cannot work at this time and the negative unintended consequences for large parts of our financial system coming from the well meaning Stimulus by the Fed.

Furthermore, we must now add in the polarization of the political process between the Tea Party on the right and the Democratic left. The traditional US government is effectively paralyzed due to the inability of the parties to find common ground. This is largely, but not exclusively due to Tea party intransigence. The political process is effectively paralyzed and cannot take essential decisions to solve the problem.

Furthermore, it is my belief that the polarization of the political parties is not the cause of the problem, but a consequence of the problem. Witness this week's spectacle of a male member of the Greek parliament slapping a female member in parliament. Polarization and a breakdown of communal efforts is almost always accompanies political and/or economic collapse of societies throughout history.

In January 2011, I wrote an article "A Possible Market Timeline to 2015". This article made a number of predictions about how this market would develop in the coming years. This article predicted the Southern European countries banks would fall and this would invariably lead to contagion in Europe that would then follow to the US. These scenarios seem to be playing out very much as described in this article of 18 months ago. This article in some ways complements the views expressed here, although it focused more on the coming events than the underlying causes for why they will happen.

Summarizing:

  1. The Tea Party position is shown to be not practical by three critical measures: economic theory, historical fact in similar circumstances, and common sense.
  2. The Democratic position supports Stimulus as the solution. But stimulus will only defer the problem; it is not capable of solving the problem at this stage of the economic cycle. We are at the end of a historical bubble where there is no real place to profitably make new investments that will have a positive multiplier effect on the economy, an essential condition to making stimulus work.
  3. The inevitable consequence is that shortly (possibly months or a couple of years), the US and most of the developed world will enter into a several year-long major economic decline causing terrible consequences. Nearly all people will be affected negatively, including billions of the world's inhabitants that will experience truly terrible economic upheaval. An extremely small minority will see and understand the coming collapse and be able to actually improve their economic position. I hope to be among them.
  4. As always with economic and business cycles, the downturn will end after several years and the world will begin a major new cycle of economic renewal and growth.
Source: The Unavoidable U.S. Reality: The Upcoming Economic Collapse

Additional disclosure: When the market is in decline, I hold SKF and FAZ.