Backward vs. Forward Looking Analysis: Economic Icebergs Ahead

Includes: SDS, SKF
by: James Wood

Most economic analysis is really backward looking. New reports that retail sales were up this month, employment was down slightly, Company X increased sales and profits, etc. are all forms of essentially looking backwards. One is trying to discover the future by seeing minor changes in the trends from the recent past. But this type of analysis always misses major turning points in economic history.

The reason the Titanic hit the iceberg and subsequently sank was that the Captain was so busy going fast that he did not see the iceberg ahead of him. There are economic icebergs out there that we are about to hit and that are not seen prominently in most economic minds.

Iceberg 1/ Major Turning Point 1. We experienced a historic asset bubble in real estate that hit a high in 2006. Most people hope that bubble has been contained at this time. However, there are alarming indicators that we are about to hit this iceberg for the second time. Even though we have essentially nationalized housing finance, Fannie Mae and Freddie Mac are broke, and probably are going to explode again. With these agencies owning 4 million repossessed homes, the fruitless efforts to sell off these repossessed homes, the growing need to keep putting money into these government agencies, the inability of many people to repay their housing loans and the growing tendency for home owners to give up on their mortgage payments means that almost certainly this issue will blow up in the next year or so.

When housing financing collapses again, there will be enormous deflation in the prices of not only housing, but also this deflation will spread to the general economy. Losses will explode in the banking system, putting it at much greater risk and there will be a follow up effect on the bonds and financial derivatives based on the housing market. Collectively, this will cause a major reduction in the money supply and lead to significant price deflation in the general economy, in addition to widespread bankruptcies in the private sector.

Iceberg 2 / Major Turning Point 2. The collapse of real estate prices starting in 2006 put in danger the solvency of the American banking system in 2008. The national government intervened massively to avoid the collapse of the banking system in 2008. In 2010, we realize there are substantial doubts as to the financial reliability of the nation, particularly with respect to the increase in debts in the coming years for new expenditures such as stimulus plus committed expenditures such as medical care and retirement payments.

These same problems are now also appearing in Japan, England, the European Common Market, although the causes may vary slightly. While these countries will not go bankrupt, the cost to fund their debts is likely to dramatically increase in the next year or two. Greece was of course the one that got the first headlines for it’s excessive spending. But less spoken of is that the US, Japan, UK and the European Union have the same problem. These countries also face a big increase in the cost of funding their indebtedness as the necessary cost to maintain the viability of selling their debt.

For an extraordinary article on Japan, see James Quinn´s When Japan Collapses. In this article, Quinn shows how Japan will push up its borrowing costs to non-sustainable levels by trying to raise yields on its pension investment portfolio and devalue the yen vs. major international currencies such as the dollar and Euro. When the cost of funding goes up in the US, Japan, the UK and the European Union, we will quickly be at an iceberg without solutions. At 3.5% interest, Japan will spend 100% of their income from taxation for paying the interest on the debt and with nothing the cover to costs of running the country. When the costs of funding the US debt go to 8 or 12% from an average of 2 to 3% now, we have similar situation in the US. The European Union is a political union and not economic union (i.e. they have a common money but not a common economic policy), and the southern countries will make an unsustainable burden by their excessive spending on the northern countries, particularly Germany. England has been the most upfront in saying there is a problem, which needs to be solved.

However, solving it is quite another situation. As interest rates go up, bondholders will experience enormous losses. All those investors now looking for yield in buying higher risk bonds will find they have gone from a bad situation to a worse one. In summary, there is a second iceberg of increasing the cost to pay the national debts of the leading countries (excluding such countries as China). These increased costs will make difficult for the countries to pay normally their existing debts much less spend heavily for new stimulus or other development programs. The major countries will simply not be able to buy their way out of the problem, forcing us to suffer through consequences of another worldwide depression.

The big issue is that most people simply do not examine these two critical issues. Correct prediction of the future requires focus on the priority issues of the future such as the probable collapse of the housing market and the funding that is related to the housing market. Likewise we must focus on the probable increase in funding costs of the major countries to fund their debt. Minor changes in the economy will prove to be irrelevant to these two major issues, which have the power to shape our economic future. Those who insist on looking backwards will say the hitting of the iceberg was not predictable.

However, it is completely predictable if we look at the relevant facts and do not get distracted by backward looking economic analysis that ignores the icebergs in front of us.

Disclosure: Short ESZ10, long SKF and SDS