An Economic Historian's Explanation Why You Should Move To Cash

Includes: FAZ, JPM, SKF, SPY
by: James Wood

This article presents an economic historian's explanation why we are on the verge of a major economic collapse, based on simple to understand, hard to refute and very logical explanations of history.

When World War II ended, the United States was the only major world economy that was left intact by the war. Not one bomb fell in the mainland US. The manufacturing capacity of virtually every other major power was seriously damaged if not destroyed. This reality provided the US for several decades of easy growth that permitted a high school graduate to work in a car factory and be a member of the middle class in economic terms.

By the 1990´s, the world recovered much of their manufacturing capacity and had state-of-the-art plants with much lower cost salaries for their employees in the factory than the US. Recently, salaries in the US could be 6 times higher than Asian salaries for the same manufacturing position. (However, the gap is now narrowing some due to high inflation in Asia.) Manufacturing in the US has declined from a peak in June 1977 of 22% of non farm payrolls to 9% in March 2012. This is a 60% decline. Furthermore, manufacturing has a high multiplier effect for other jobs in the economy.

The ensuing economic decline in the last 15 years was caused by this increasing lack of competitiveness. This is simply the way competition works. It is not that we had bad government, unfair competitors or other excuses. When you have a 60% decline in the single most important driver for employment, you are going to have problems with your national income and debt levels. The US did not have competition in the 1950's through 1970´s. Today the US has competition everywhere.

As we became less competitive, we used more stimulus to try to deal with the lack of our fundamental competitiveness and resulting economic activity. I believe Alan Greenspan will go down in history as an unintentional bad guy, as it was he who first started extensive and more or less non-stop use of stimulus. Greenspan started the economic bubble that now haunts us. History will consider the stimulus from 2000 through 2007 coupled with the creation of financial instruments such as Collateralized Debt Obligations and the reunification of commercial and investment banking through the Citibank deal as a period of profound errors by the Fed and US government policy.

Stimulus is an effective short-term policy to deal with temporary economic imbalances, particularly at the beginning and middle of an economic cycle. Used continually, it simply creates a monetary bubble which history shows will always explode at a certain point of high indebtedness. Our current financial bubble is a direct result of the policies of Alan Greenspan.

The Greenspan 1999 reunification of investment and commercial banking introduced enormous risks into the financial system. (We split investment banking and commercial banking in 1933 through the Glass Steagall Act. Now we are proving we cannot learn from history ending Glass Steagall in 1999. The replacement of Glass Steagall, the Volker Rule, has been made essentially inoperative.) This week's JP Morgan (JPM) financial statements show clearly how earnings have shifted away from low risk commercial banking to high-risk investment banking, particularly where it becomes nearly a casino investing in derivatives. Most profits in recent years came from the JPMorgan Treasury Office investments in derivatives that we now know to have high-risk elements as opposed to commercial banking that is much less risky in this financial structure. The inevitable loss this year from the JPMorgan Treasury investment in derivatives wiped out the gains from commercial banking providing a loss for the first 6 months of this year.

In short, much of what we read in the newspapers simply does not deal with the major consideration: the inevitable loss of competitiveness by the US vs. other nations recovering from World War II during the last 60 years. When we became less competitive and the economy was growing inadequately, we resorted to stimulus and other policies that artificially promoted economic growth which created a large unsustainable financial bubble.

The US debt to GDP now exceeds the 90% level where debt levels historically become uncontrollable and end in collapse. This is best explained in Rogoff's and Reinhardt´s book, This Time is Different. The current annual deficit is $1 trillion dollars per year and growing, increasing every year the debt ratio to GDP.

The US economy will have to reset. This means major losses when the current financial bubble collapses either by inadvertent "popping the bubble" or being deflated purposely. The financial bubble "pops" when lenders lose faith in the US government to pay its debt and interest rates soar, leading to economic problems. Alternatively, the bubble is deflated by the US purposely deciding to raise taxes, cut the deficit and deal with the problem. Either way, there will be a dramatic reset of the economy: losses on real estate loans, derivatives, and interbank loans such as those to Europe. The financial losses inevitably lead to losses in jobs, business values, stock market indexes such as the S&P 500 (SPY) and increased interest rates for those businesses that survive the downturn. Deflation, not inflation, is the problem we will have to deal with. Deflation is caused by multi trillion dollar write-offs in the financial system of loans that cannot be repaid. These write-offs in financial loans decrease the total money supply and cause the deflation. One number illustrates this type of problem. A ½ of 1 % loss of the $600 trillion derivatives outstanding will cause the loss of an amount equal to 100% of the capital of the banks worldwide. The process of "resetting" will begin shortly.

What does this suggest for your portfolio? The simplest action is move to cash in banks with US government guaranteed deposits. Larger investors will go to short-term US Treasury Bills. Avoid long-term bonds, because interest rates will rise and bond values will fall. The stock market will fall across the board, but financial stocks will be the most affected, given the expectation of many banks going broke or being nationalized for being to big to fail. If you are more adventurous, you can buy leveraged short reverse ETF´s such as (FAZ) and (SKF). Real estate will also be falling in price and will not represent a safe hedge.

In a few years, the "reset" will be complete and economic growth will start again but with a new balance of the US vs. the rest of the world. Manufacturing will continue to be a low percentage of total employment. Natural US strengths will grow in banking, high technology, manufacturing automation to regain manufacturing competitiveness. Probably farming and natural gas will play important roles in the "reset" US. Natural Gas could dramatically reduce the US trade imbalances and at the same time strengthen the dollar against world currencies. For the middle class and wealthy, the US will continue to be one of the most desirable places to be. For people with low skills and education levels, the US will be a hard place to live with employment providing low salaries compared to the cost of living. Investors will find it is best to be out of the markets or short during the coming downturn, but then return to the markets in a few years when growth starts again. Investors will have the buying opportunity of the century when growth starts again.

Disclosure: I am long FAZ, SKF.