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Monday, February 23, 2015

Fundamentally Flawed - Outline, How the US, EU, UK, and Japan are Delaying the Inevitable Bankruptcy

By Chris Hamilton, February 2015
This book uses publicly available data from the Bureau of Labor Statistics, Census, Federal Reserve, US Energy Information Agency, Congressional Budget Office, etc. to show a much different reality than what is portrayed by the government, the Federal Reserve, Wall Street economists, and the consensus viewpoint.  From identical inputs, I will show stunningly different outputs than the consensus.  Throughout this book, I offer graphs and correlations to help put the numbers into perspective.  I do not claim to know all the answers nor claim this is an all-encompassing overview of the US or global economy.  I only know what the data shows about what led to the financial crisis of 2008 and its aftermath.  I also try to put the crisis into a broader context of economic and political developments from WWII ‘til present day.  I also make some educated guesses about what may be taking place behind the scenes.  Still, not all the pieces of data fit into a neat or tidy narrative…and that is the challenge of viewing reality and the global economy…it is shades of gray that require interpretation.  I undoubtedly will be wrong with some of my conclusions but I hope this effort spurs better questions and answers.
I believe that the general public wants to understand what is happening in our economic world and why. I hope those that challenge themselves to read this will gain context on the difficulties we face, have better ability to gauge the effectiveness and durability of the programs undertaken to deal with the crisis, and also have far more questions that require answers; not just of me but also of the federal government, Wall Street economists, the Federal Reserve, and ultimately of ourselves. 
  • Outline  Page 2
  • Chapter 1 – Advanced vs. Developing Economies  Page 13
  • Chapter 2 – US Dollar; Bretton Woods to “Petro Dollar”  Page 30
  • Chapter 3 – American Economic Scoreboard  Page 38
  • Chapter 4 – Demographics and Immigration  Page 70
  • Chapter 5 – Treasury Market  Page 79
  • Chapter 6 – Debt Ceiling Fiasco – July 2011  Page 85
  • Chapter 7 – The “Taper”  Page 89
  • Chapter 8 – 10k tons of Gold? Math says China could have done it!  Page 97
  • Chapter 9 – Oil  Page 105
  • Chapter 10 – Gold  Page 117
  • Chapter 11 – Resolutions and Solutions  Page 125
  • WWII claims some 50 million lives in the conflict and simultaneously produces a low birth rate during the war…this is followed by the WWII-Participant Nations’ baby boom over the subsequent decade, and then post-baby boom slowing birth rates across these nations.
  • As WWII draws to a close, the victorious nations arrange a new monetary system for the post-war period; the Bretton Woods agreement.  The dollar was anointed the world reserve currency and the dollar was to be backed by gold to avoid the US abusing the privilege as reserve currency.
  • The US ran a balanced budget for over a decade (from the War’s end until the late ‘50’s) and US had huge economic growth, wage increases, and stable inflation.  However by mid ’60’s, government debt began growing and “Great Society” programs were initiated.
  • Beginning with the ’69 budget, Johnson’s “Great Society” programs were unfunded in the change to a Unified Budget process.  The intent of the change was to co-mingle the Social Security and Medicare surplus’, meant to pay for future benefits, with the general federal budget receipts and outlays…all to pay for the Vietnam war without raising taxes…this was the kickoff of today’s massive unfunded liabilities and subsequent dollar proliferation.
  • In 1971 Nixon closed the gold window, no longer allowing the conversion of excess creditor nation dollars to gold.  This was in response to the US gold reserves having fallen nearly 60% in less than a decade (20+ k tons to 8,133.5 tons by 1971).  The US gold standard (and basis of the Bretton Woods agreement) was abandoned.  However, Nixon nearly simultaneously arranged the Petro dollar agreement that all Saudi and, subsequently, all OPEC oil (regardless the buying nation) must be paid for in US dollars and that all importing nations would need significant reserves of US dollars to facilitate this purchasing.  The US pledged military and regime support for those OPEC “allies” that honored the petro dollar agreement.  This arrangement allowed a conduit to export the massive dollar creation (US debt) globally without the potential hyperinflation in the US that would typically result from diluting a currency or the loss of the dollars purchasing power internationally.
  • ‘80’s and ‘90’s were all about credit, “financialization”, and leverage premised on unsustainable consumer and government debt, masking slowing US wage growth…and then the tech bubble, the housing bubble, and now the government debt bubble.  US manufacturing employment collapsed despite the US maintaining its place as a major manufacturer and then the “FIRE” (finance, insurance, real estate) economy tanks in ’08-’09.  Since, lower quality service sector job creation (primarily part-time and w/out benefits) replace higher quality full time jobs that are lost. 
  • The following four indented points on banking and derivatives are important but in no way fully formed or inclusive.  These are outside my expertise and beyond my scope…so I will mention them here but will not focus on these in my work as others have far better detailed these topics.

    1. A series of federal banking deregulations from 1980 forward give banks like S&L’s (Savings and Loans) many of the same capabilities of commercial banks but without the same regulations.  The late ‘80’s S&L crisis had resulted from among other things, a loophole in the Glass-Steagall act, which allowed “insolvent zombie” S&L’s to offer higher depositor yields paid for by S&L’s investing in riskier, higher yielding loans.  The ultimate Resolution Trust Corporation shut down over 700 banks at a cost of $160 billion by 1995.
    2. But by 1999, Congress repealed Glass-Steagall, the 1933 act meant to separate banks (with FDIC insurance) from riskier brokerage houses (without FDIC insurance).  This change allowed commercial banks to operate brokerage houses, putting depositor monies at risk as banks were not satisfied with typical “banking earnings”.    The “too big to fail” reality and the “heads big banks win, tails taxpayers lose” business model was fully formed.
    3. The Big 5 US banks (BofA, Citi, JP Morgan, Goldman, Wells) utilizing VaR (value at risk) models to tie up the least amount of capital / deposits for reserves, allow the greatest possible leverage to maximize their riskier wins, and hedge themselves with derivatives like those offered by AIG so they were “well capitalized” in any negative event.  As of Q3 2014, there is $239 trillion in notional derivatives in the US and 80% of that is focused in interest rate sensitive products.  95% of this derivative activities in the US is done by the big 5 banks.  Globally, as of June 2014 according to the BIS, there are nearly $700 trillion in notional derivatives contracts with a gross market value of $17.5 trillion…and 80%+ is interest rate swaps and options (i.e., if rates rise, who will have the reserves to pay off all these hedges???).
    4. Many of these derivatives were insurance like products…but so long as they weren’t called “insurance”, they were sold without the oversight of insurance regulators or the collateral regulations for potential losses.  Often two institutions pledged with one another that if the other lost a million or a billion or whatever, the cross institution would bail them out.   And vice versa.  But without a central clearing house or regulator to confirm the cross parties did indeed have the resources to pay the claims…well liars poker was in full flight.  Leverage to the “nth” degree allowed unbelievable profits but unbelievable risks.  The $185 billion bailouts to AIG, $45 billion (each) to Bank of America and Citi-Group and $25 billion to JP Morgan seemed to imply they were not well capitalized or well hedged.  I believe great risk still looms here with false reassurances that everyone is hedged…but my best guess is the hedges are no better now than in ’08.
  • In 2007, the US 25-54 year-old total population and employment among that working age core segment peaked and has been falling since; taking organic demand with it…and this was generally occurring over most WWII-Participant nations.  From 2007 through 2014, the US population grows by 18 million, but the growth of the 55+ population segment is responsible for 15 of the 18 million.  Only 3 million net new jobs are created in the US economy…and US full time employment declines by 1 million.  The net job gains are low quality, low paying, no benefit, part-time positions.  On a different metric, all the net job gains are in the 55+ population segment while the 25-54 yr/old segment employment declines by 4 million.  Plus, to top it off, median household incomes fall.
  • Nearly all future US (and advanced economy) population growth is premised on immigration and immigrants’ higher birth rates.  In the US, almost all immigration revolves around Hispanics coming in search of work; raising the US portion of Hispanics from 15% today to 30% by 2050…but the premise of low skill, low education Hispanics coming to the US is a mismatch now that the US is not creating adequate jobs for its native population, let alone immigrants.  And the new jobs that are created are primarily coming in high skill, high education sectors of the economy.  
  • In 2009, on a GAAP (generally accepted accounting principles) basis, the US went bankrupt and economic activity begins declining; led by falling mortgage debt and falling energy consumption while debt, QE, and interest rate suppression have been the governmental response to declining quantity and quality of consumer demand...all in an attempt to disguise this bankruptcy.
  • The term “deflation” is brought into the financial lexicon as the new “boogeyman” to be feared.  However, this is to disguise what is truly falling advanced-economy populations of working age citizens, falling advanced-economy real wages, and their waning demand for more credit and debt.  These factors, in conjunction with the greatest innovative advancements in human history (replacing costly labor in every manner imaginable with higher productivity), meant the quantity and quality of jobs available would and will continue to shrink.  This word “deflation” is meant to obscure that falling prices are, at times, inevitable and only via central bank intrusions can the natural course of deflation be synthetically turned to inflation (rewarding a minority group of asset holders at the non-asset holder majority’s expense).
  • Despite US federal debt ramping, in the July 2011 Debt Ceiling fiasco the US congress declines to enact any serious “austerity” and instead maintains massive trade and budget deficits and debt accumulation…indefinitely.  The US is determined to abuse its status as global reserve currency and refuses to live within its means, refuses to raise taxes (particularly on corporations) or cut spending.
  • China’s reaction was immediate…in July 2011 China begins selling off Treasury’s & almost surely began buying gold in massive quantities alongside Russia and other developing nations…and gold / silver prices collapse on a huge increase in demand for physical gold while “paper” gold or digital gold / silver are liquidated and shorted to move the price down?!?  And despite China’s selling of Treasury’s, yields collapse and prices rise on demand from entirely unforeseen buyers.
  • Markets are premised on the notion that they are meant to reward good behavior and punish bad behavior (corporate or governmental).  Given the bad advanced economies and advanced governance (particularly poor US governance), the Federal Reserve and advanced economy central banks determined that “markets” should essentially be overridden by the Federal Reserve’s QE (Quantitative Easing), ECB (European Central Bank) LTRO (long term refinancing operations), BOJ’s (Bank of Japan) and Japan’s prime ministers “arrows” and likely many other known and unknown programs…and US Treasuries were primarily bought by the Federal Reserve, Belgium, Cayman Islands, Luxembourg, Ireland, and Japan (the same Japan that suffered the 4th largest quake in recorded history in March 2011, shut down all its nuclear plants and ran huge budget and trade deficits to purchase all their imported energy and keep the nation functioning post-quake / tsunami).  None of these nations generally have the dollar reserves or trade surplus to make these purchases but, mysteriously, these buyers emerge on cue wanting ever-more US debt at ever-lower yields (while relative bond returns vs. equities or real estate are pathetic)…and the likely collusion of US / UK price suppression of gold / silver prices seem to indicate some sort of agreement may have been made between the US and China to maintain China’s manufacturing economy, maintain the inflow of cheap goods into the US, collapse US (and advanced economy) interest rates, and allow China to accumulate something of value (gold) with their ongoing record dollar reserve accumulation…avoiding a monetary panic while this plays out.
  • US oil production peaked in 1970 (with the advent of the petro dollar) and falls for nearly 4 decades…but US / Canadian oil production begins ramping in 2009/10 and creates nearly all net new oil supply to the global market since 2005.  The US / Canada is the only region in the world to significantly increase production on the five times price increase (and present fall) of oil over the previous decade (in truth…Russia is the only other producer to take advantage with a modest production increase).  The lack of oil production increases outside the US/Canada while the price of oil skyrocketed perhaps pointed to peaking production and/or a concerted effort by producers to be paid more for their asset in a rapidly diluting petro dollar...and perhaps the US/Canadian surge in rigs and production was a government supported effort to force prices down and avoid the global oil producers de-facto taxation of US consumers via high oil prices?  Certainly the low productivity of US / Canadian wells divided by total US/Canadian production (and significantly lower than every other region) calls into question the economic durability of US production gains.
  • From ’11 ‘til present, China runs record trade surpluses with the US but does not follow its previous decade-long pattern of recycling nearly 50% of its US dollar trade surplus into Treasuries…instead, with record quantities of dollars incoming, China continues selling Treasuries and almost surely accumulating gold.
  • The Federal Reserve announces the “taper” in Dec ’13.  Since the economic crisis, the Fed had been the primary buyer of the vast majority of all mid and long term US Treasury debt but this was to be decreased and then ceased over the course of the taper.  Over this process, interest rates collapse to new lows as mysterious buying in Belgium, the Cayman Islands, Luxembourg, Japan and other odd locations suddenly buy unheard of quantities of US Treasury debt yielding record low rates.  And simultaneously stock markets hit daily record highs despite record low cash positions among investors.  Stocks and bonds both find record (though contradictory) demand.  Given the underfunding of pensions and boomers retiree plans and likewise the massive debts to be serviced…it’s fair to say record low bond yields and record high equities are likely national security issues and any unannounced actions taken to bolster these could be justified within the government.
  • Likewise, OPEC nations continued running huge dollar surpluses but not recycling much into Treasuries (about a $40 billion total increase since ’11, from $245 to $286 billion)…while interestingly OPEC has been decreasing net oil exports since ’05.  As the US created massive new debt, OPEC nations were paid significantly higher quantity in dollar terms for their oil despite the falling quality of those dollars purchasing power…until US and Canadian production increases beginning in ’09 eventually undercut their pricing…this diluted dollar combined with collapsed oil prices is likely putting the Petro Dollar agreement in real peril…and the dollar’s place as the global reserve currency in question. 
  • And now the Dollar is “strengthening” on perceived Federal Reserve tightening (formal QE terminated) and anticipation of interest rate hikes.  After an increase in the US monetary base of 375% or $3.3 trillion from ’08 until peaking in Sept ’14 @ $4.15 trillion…the subsequent fall in the monetary base of $200 billion (5% decline) has sent the dollar soaring since September of ’14…and oil prices collapsing.  Clearly this is placing the US and Canadian shale and tar sands producers in true peril of a trillion dollar later day subprime-like collapse (and bailout?)…and the oil price collapse double whammy is the likely impending undoing a large portion of the US job gains since ’09, which came in the energy sector.
  • China and others are presently accumulating gold at breakneck speed and arranging non-dollar trading arrangements…as if the dollar would not be the reserve currency.  The US and advanced economy nations’ central banks and their agents are accumulating all the US, EU, UK, and Japanese government debt possible.  This is collapsing the interest rates and making the debt serviceable (the trend among advanced nation government bonds yields to zero interest rates is clear).  Commodities are collapsing in price (some on record demand) and “dollar strength”.  And advanced economies’ 25-64 year old populations will be shrinking for a decade while their 65+ year-old needy populations will spike over the same period…and global population growth in Africa or other poor developing nations does not replace the falling demand among the advanced nations.  The pre-supposed population driver to advanced nations of immigration is quite dubious and an obvious mismatch of low skill workers into high-skill economies, creating insufficient jobs even for their native populations, let alone immigrants.  The only perceived answer the US, EU, UK, and Japan have to mask collapsing organic demand from falling working age populations is more and faster debt creation…but will that debt be accepted and for how long?  What will be the impact on the dollar given the necessity of further debt creation but potentially absent a functioning petro dollar arrangement (and declining need for dollar reserves globally) to accept the excess dollars?  Gold’s role in this near future environment isn’t entirely clear but its importance is obvious.
  • However, global total debt to GDP (government, consumer, financial, corporate) continues to ramp…up from 246% in 2000, 269% in 2007, to 286% at years end 2014.  Globally, debt continues growing faster than the economic activity it spurs.  But, it should be noted that debt growth in advanced economies is coming almost exclusively via government debt…while developing nation’s debt is rising but primarily via consumer, corporate, and financial debt.  China alone has quadrupled its total debt from 2007 to present ($7 trillion to $28 trillion primarily via corporate, financial, and household debt and over 50% of all this is funding real estate loans…that’s how you do a bubble!).  Net-net, deleveraging simply isn’t happening as the $57 trillion rise (40% increase from $142 trillion to $199 trillion) in total global debt since ’07 or 230% since ’00 ($87 trillion to $199 trillion) should make eminently clear.
  • My best guess (certainly unprovable) is that the US gold window (following the thousands of year-old system of gold transfer to balance trade surpluses / deficits among nations) was perhaps never truly closed by Nixon or subsequent to the ’08-’09 economic crisis perhaps was quietly re-opened.  This may have been necessary to entice foreign Treasury buyers to buy record Treasury issuance with a sweetener (gold) as Treasury’s yields soured and US debt became rampant.  But after the combination of G7 allowance in March 2011 for Japanese currency manipulation (to China’s detriment) and the July 2011 debt ceiling debacle, perhaps the US government closed this arrangement as China and other net dollar surplus nations were replaced by Fed and advanced economy central bank “shadow QE” and/or the US ran out of gold and foreigner creditors were no longer were interested in worthless pieces of US paper.  Foreign trade surplus nations no longer recycled dollars as they had for the previous decade and strangely new nations began incredible (unbelievable) accumulations, seemingly acting as false fronts to maintain bond bids for ever more debt at ever lower interest rates.  These buyers seemed unconcerned about returns or underperformance among their peers?!?  No way to know, but July 2011 looks like it was the end of one monetary regime and perhaps the start of another or perhaps we are in limbo waiting for the new systems formal rollout and revelation.
  • To tie it all up…Once upon a time, business would recognize unmet demand and by taking credit (debt) would fill that need and from this effort intended to pay back the debt (principal & the interest) and still make a profit.  The government’s role was primarily that of a referee (of course there were bribing scandals large and small along the way…but generally government set rules and allowed business to operate within those rules).  However, about 1970 the government believed its role was no longer just a referee but also a player in the game.  The Government and Fed determined they knew appropriate demand and decided to provide cheap money and deficit spending (debt) to create demand that would not have otherwise been there…but the government no longer intended to repay the principal (ever) and debt servicing would be managed via the Fed’s 4+ decades of declining interest rate policies.  And the debt ballooned and interest costs did not.  Government debt and false interest rates created real demand that created real supply…It’s so important to realize the Fed’s abuse of low (and now zero) interest rate policy induced massive US credit (debt), pulling forward demand, perhaps 5% to 10% annually over the last 5 decades.  This credit was spent like money and created real demand met by real supply increases the world over.  And the Fed’s consistently lower rates induced corporations to play the same game…taking on massive debt with no intention of repaying the principal, only rolling existing debt to consistently lower servicing costs.  And eventually homeowners were brought into the game with refinancing and HELOC’s to enjoy the good life.  However, now advanced economy consumers are unwilling or unable to take on more debt.  Absent the desired demand, the overcapacity of everything is now laid bare…and the only means to temporarily mask this is by further collapsing rates and more deficit spending?!?  What we are viewing is collapsing demand highlighting the massive oversupply of nearly every sort of manufacturing, shipping, mining, oil production, retail, etc. etc. above and beyond what organic demand (i.e., wages, savings) can pay for.  Of course financial assets from real estate to equities to bonds are no different, in massive overcapacity and overvaluation.  Without even lower rates (NIRP?) and far greater debt (particularly given the shrinking core populations), there will not be adequate demand for all the overbuilt industries of the world, let alone much of anything new.  That is a classic set up for one hell of a depression…all because the Fed thought it knew better and could avoid the cleansing effect of recessions maintaining demand by interest rate trickery…so now a depression, magnitudes greater than the recessions we should have had, is the only means to cull all the overcapacity and debt.  This will ultimately return consumers, business, and government alike to solid traditional footing of honest balance sheets and simple supply and demand curves…but the pain will be acute and widespread.  And the greatest fear of all is the Fed will try to fully monetize this solvency crisis…as this is the only play in their playbook…and that is the greatest risk of all to the dollar’s continued existence.  Individually, you must choose from the few options available and safeguard your money and assets best as possible; but in truth there isn’t likely a low risk option to hide from this maelstrom.  The solutions are not individual investment options but collective political choices that will decide if America’s best days are behind or ahead of us.

1 comment:

  1. Excellent analysis and presentation. When the gold window was closed, Nixon mentioned in his speech that gold would be made available under certain conditions. Perhaps only to the Saudi royals for instructing opec to only accept dollars for oil. 300 tonnes per year royalty was the 1950's agreement. I don't believe any other country could force the USA to provide them with gold, so perhaps the US does still have all its gold. I hope so.


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