by Egon von Greyerz – Matterhorn Asset Management
When we look at the world economy today, wherever we turn wesee a wall of risk. And sadly this is an insurmountable wall with risksthat are totally unprecedented in history. There has never before beena potentially catastrophic combination of so many virtually bankruptmajor sovereign states (US, UK, Spain, Italy Greece, Japan and manymore) and a financial system which is bankrupt but is temporarily keptalive with phoney valuations and unlimited money printing. Butgovernments will soon realise that they are not alchemists who can turnprinted paper into gold. The consequences of the global financialcrisis are potentially catastrophic.
As the Austrian economist von Mises said: “There is no means ofavoiding the final collapse of a boom brought about by creditexpansion. The alternative is only whether the crisis should comesooner as the result of a voluntary abandonment of further creditexpansion or later as a final and total catastrophe of the currencyinvolved.”
In our view, governments like the US and the UK and many others willnot abandon further credit expansion. They are committed to printingincreasing amounts of worthless paper money in order to finance thegrowing deficits and the rotten financial system. Therefore there is no chance of Quantitative Easing ending but instead it will accelerate in 2010 and after.The consequence of this will be a hyperinflationary depression in manycountries due to many currencies becoming worthless. No economy in theworld, including China, will avoid this severe economic downturn whichis likely to have a major impact on the world economy for many, manyyears to come.
Investors are ignoring the risks
What makes the current situation in the world economy so intriguingis that most investment markets have not recognised the risk.Stockmarkets and bond markets rallied substantially in 2009, totallyoblivious of the risks. The housing market is down in the US and someEuropean countries like Spain and Ireland. But in many other countriesit is still near the bubble highs created by low interest rates andreckless lending.
The most important criterion, when taking investment decisions, isunderstanding the risks involved. Matterhorn Asset Management has inthe last few years warned investors about the risks in the financialsystem due to the massive worldwide credit expansion and moneyprinting. We have found it difficult to fathom so few people realisethat the world economy has become a time bomb waiting to explode ormore likely implode. All the so called experts have declared that it isimpossible to identify the problems in the financial system in advance.For example, Greenspan, Bernanke, Geithner, other central bankers andgovernment officials as well as Blankfein of Goldman Sachs and manybank heads have all stated that they couldn’t see it coming. Eitherthey are lying or they are stupid. Sadly, it is most likely the former.It is virtually impossible to find an honest politician. They have onemajor objective – Power. To attain power they have to buy votes. But tobuy votes they cannot tell the truth. No politician ever forecasts badnews because bad news does not buy votes. (Yes, there are exceptionslike Ron Paul in the US). And as regards the bankers, it is definitelynot in their interest to worry about risks to the financial system. Forevery year that they issue additional toxic debt and derivatives theyearn more in that single year than most normal people earn in alifetime.
Sovereign Defaults
The list of countries at risk of bankruptcy is increasing by theday. The acronym used to be PIGS (Portugal, Ireland, Greece and Spain).It is now PIIGSJUKUS and growing. The main contenders are currently: USA, UK, Japan, Spain, Italy, Greece, Ireland, France, Portugal, Baltic States, Eastern Europe and many more.On a proper accounting basis all of these countries are alreadybankrupt, but since many nations can either print money like the US andthe UK or increase their already high borrowings, like Greece or theBaltic States, they have technically avoided bankruptcy although inreality all the countries in the list above are basket cases with verylittle chance of a return to normality. Shown below is what we call theSovereign Time Bomb. The bomb consists of countries that have acombination of budget deficit and borrowings relative to GDP which putsthem into the category “Time Bomb” or high risk of default. Thesecountries have budget deficits from 6% (Italy) to 12.5% (UK, Greece) ofGDP and their Public Sector Debts are ranging from 60% (Spain) toalmost 200% (Japan) of GDP.
The Sovereign Time Bomb
The problem is not just the current debt levels of these nations,because the deficits in all the countries are rising. Tax revenues arecollapsing and with rapidly rising unemployment, the governments’expenses for social charges are soaring. In the US for example thefederal deficit in 2009 was $1.5 trillion (10.7% of GDP) and isforecast to stay around that level for many years. The plight of the USstates is just as bad. Out of 50 states only 4 are expected to have abalanced budget in 2010. Up to 40 states, including California, NewYork, Florida, Illinois, Michigan, Ohio, North Carolina and New Jersey,are virtually bankrupt.
It took almost 200 years for US Federal debt to reach $ 1 trillionwhich it did in 1981. In 2009 the debt increased by $ 1.9 trillion injust that year to $ 12.4 trillion. In the next ten years the US debt isforecast to reach $ 25 trillion. And this doubling of the debt does notinclude any funds to prop up a bankrupt financial system or thespending of tens or maybe hundreds of trillions of dollars on worthlessOTC derivatives. The forecast also assumes growth in GDP which isextremely unlikely especially for the next 2-5 years. Currently USFederal debt is six times what it collects in tax revenue every year.With debt exploding and tax revenues collapsing, there is no chancethat the debt can ever be repaid with normal money. Also, with debt outof control interest rates will rise substantially to 10-20% per annum.Applying a 15% interest rate to a $ 25 trillion debt would give anannual interest bill of $ 3.75 trillion which would be substantiallymore than tax revenues.
The chart below shows the US Federal Debt per person. In the last ten years it has gone from $ 20,000 to $ 40,000. TotalUS debt, including private and corporate debt as well as unfundedliabilities, comes to $430,000 per individual. It is an absolutecertainty that every man, woman and child in the US cannot pay offalmost half a million dollars with normal money. Only massive moneyprinting will take care of that.
With these levels of deficits for the next ten years on topof an already massive debt, there is no possibility whatsoever that theUS economy can avoid bankruptcy. No country has ever abolished debts ofthis magnitude by printing paper and the US will not be the first oneto succeed either.
Only Lose – Lose Options
Governments have two choices – continue to borrow and print money orreduce government spending. This is a lose – lose situation andwhatever choice they make it will end in disaster. Countries withinthe EMU like Greece or Spain are introducing austerity programmes thatforecast their deficits to come down to 3% of GDP which is the EUmaximum deficit limit. These are totally unrealistic targets that aremainly based on an improvement in the economy which is total fantasy.The dilemma is that not one single country within the EU is below the3% limit, not even Germany. And the effect of the austerity programmeswill lead to such a major contraction of the economies that taxrevenues will collapse, further exacerbating the plight of thesecountries.
The alternative is to print or borrow more money. Printing is not aluxury that individual EMU members have and for these insolventcountries to borrow money is becoming almost impossible or very costly.But the European Central Bank can print money and this is likely to bethe path they will initially choose to save Greece and possibly Spain.Countries like the US and the UK can still borrow and print money. Andthis is what they will continue to do. With rising deficits, risingunemployment and the problems in the financial system re-emerging theyhave no choice. Both the UK and the US are set upon a course ofself-destruction. We will see trillions of pounds and dollars printedin the next few years. But the only buyers of these governmentsecurities will be the US and UK governments. The rest of the worldwill dump their holdings which will result in both the dollar and thepound dropping precipitously and interest rates rising substantially.
Hyperinflation – Consequences
The effect of a collapsing currency will be a hyperinflationarydepression. This is the inevitable outcome for the UK and US and thereis sadly no action that the governments of these countries can take toalter this course. We discussed the consequences of this outcome in ourJuly 09 newsletter – “The Dark Years Are Here”. There will be extremepoverty. None of the social safety nets will function. So most of thesocial security payments that people in need have been used to willdisappear or be worthless due to hyperinflation. There will be severeshortages of food which will lead to famine and social unrest. Hungrypeople are restless people that will take the law into their own hands.This will lead to violent protests, lawlessness, theft and violentcrime. And there is unlikely to be a force of law that is paid andfunctional to deal with the problems. Already today, many US cities andstates are cutting down on the police force and their equipment. Thistrend will accelerate during 2010 due to budget cuts and lack of funds.
There will be massive cuts in education and many schools will closedue to lack of resources. Pensioners will be major sufferers. Manypension plans are unfunded but also the funded ones will be decimated.Pension funds are invested in three areas – equities, bonds and realestate. All three are likely to go down by at least 50% but probablymore like 75% at least, all in real terms.
Deflation and Inflation
Most economists and financial analysts disagree with thehyperinflationary scenario and believe that the deleveraging of debtwill lead to a deflationary downturn. That scenario would be morelikely if countries like the US and UK were not printing endlessamounts of fiat money. As we have explained above the printing presseswill not slow down but they will accelerate in coming years. The UK’sannouncement that they will cease Quantitative Easing is just atemporary measure that won’t last. Governments detest deflationbecause they know that deflation after uncontrolled credit growth wouldlead to an implosion of the financial system and the economy. Virtuallyall bank loans and OTC derivatives have been issued against inflatedand unsustainable asset values. In a deflationary economy with fallingasset values, falling wages, falling corporate profits and fallinggovernment revenues, there is no possibility that the massive amount ofbank credit outstanding can be serviced or repaid. Therefore thebanking system would not survive due to their massively inflatedbalance sheets and low equity. This is why governments are petrified ofdeflation after a sustained period of asset and credit bubbles. Sotheir only option is to print whatever money is required to stave offdeflation. And this is what they will do. There is absolutely no doubtabout it. But they are doing this in total ignorance of theconsequences.
Governments created the financial crisis
The current financial crisis was not created by the banks. It wascreated by governments’ irresponsible policies of buying votes bymanipulating the financial system through constant money printing,especially since the creation of the Fed in 1913 and the abolition ofthe gold standard in 1971. In addition they have used interest policyas a popularity contest thereby creating a totally artificial marketwhich distorts the normal laws of supply and demand. It is clearlyludicrous to artificially keep interest rates at 0% and print massiveamounts of money. Neither governments, nor banks should be allowed tocreate money out of thin air or interfere with market forces byartificially setting interest rates. It is this corrupt manipulation ofthe financial system and the economy that has totally destroyed thevalue of money in the last 100 years. Measured against gold, the dollarand the pound have declined by 99% since 1913. This would not havehappened if governments had not been allowed to use the financialsystem as a voting machine. But sadly this will continue at anaccelerated pace in the next few years. Governments seemtotally incapable of comprehending that they cannot solve the world’sgreatest financial crisis by applying more of the same toxic medicinethat created the problem in the first place.
The prosperity illusion
When you live in the midst of history you don’t realise that you arepart of making extraordinary history. Therefore most people don’tunderstand that the last 100 years has been an extraordinary period inhistory and even more so the last 20-30 years. The perceived prosperityand increase in living standards have been achieved primarily throughmassive increases in borrowing, both by governments and by individuals.Take away the enormous debt that has been created during this periodand the world would be a lot poorer. Alternatively, apply a market rateof interest on the debt. If governments had not manipulated interestrates and set them at artificially low levels, the normal forces ofsupply and demand would have forced rates considerably higher, mostprobably in double digits. The higher rates would have reduced demandfor credit and thereby prevented the credit and asset bubbles that havecaused the worldwide financial crisis. In recent years, Greenspanreduced rates from 6% to 1% between the end of 2000 and 2003. AndBernanke again applied the only remedy that central bankers know, inaddition to printing money, when he reduced rates from 5% to 0% between2007 and 2008. These people seem incapable of understanding thatsimple laws of supply and demand would have repaired the economyautomatically without their incompetent and desperate interventions. Byleaving monetary policy to market forces we would have normalrecessions and minor booms that would be totally self-regulating. Whatthe central bankers instead have created is the most enormous bubble inworld history. And sadly like all bubbles, this one can only end in adisaster of a magnitude that will affect the world for a very, verylong time.
So the last 100 years will be seen in history as anextraordinary period when governments thought that they had invented anew economic miracle based on unlimited credit and money printing. Butsadly this miracle will be seen by future historians as another faileddelusional economic theory dreamed up by politicians.
Risk of systemic failure of the financial system
The current financial crisis started due to the uncontrolled,worldwide debt and asset bubbles. The subprime defaults were just thefirst symptom of the lethal concoction of credit and OTC derivativesthat the bankers had constructed for their own personal gain with nounderstanding of the risks or the consequences. Governments and centralbanks worldwide injected or guaranteed around $20 trillion just to savethe financial system. But the only people who have benefited from thisare the people who caused it. Very little of these enormous sums wentinto the real economy. In addition to this enormous liquidity for thebenefit of the banking system, governments have allowed banks to valuetheir assets at totally false prices not based on market values but onthe hope that they will achieve full value at maturity. To furtherassist the banks governments worldwide have reduced interest rates tozero percent. So with trillions in fresh liquidity, zero interest ratesand valuing assets at fantasy prices, many banks have produced recordprofits and paid record bonuses.
Money supply in the US as measured by M3 is collapsing. The chartbelow shows how M3 has declined almost 6% year on year. This particularindicator has been very accurate in forecasting the major economicdownturns in the last 40 years and is now at the same level as beforethe 1970s recession.
None of the problems that caused the banking crisis in 2007-8 havebeen solved. They have just been swept under the carpet. In the US 140banks failed in 2009 against 25 in 2008 and only 11 banks in the fivepreceding years. So far in 2010 a total of 15 banks have failed andbeen taken over by the FDIC (Federal Deposit Insurance Corporation).Virtually all the banks that fail show losses that are far greater thanthe balance sheet valuations. Of the circa 6,000 US banks, a majorpercentage will fail in the next few years due to rapidly decliningasset values. This will also be the case for many of the majorinternational banks. If their assets, and in particular their OTCderivatives were valued at market, very few banks would be solventtoday. In addition, resets of mortgage loans, commercial real estateloans, credit card loans, private equity loans etc are all problemareas that could bring major banks down.
The risk of terrorism
Terrorism is an imponderable and it is therefore impossible toforecast where or when it could happen. With 700 US bases in 120countries and with the US, UK and other countries’ involvement in Iraqand Afghanistan, the alienation that this creates especially in theMuslim world, poses a major threat of terrorist attacks especially inthe US and UK. The terrorists are almost always ahead of theintelligence agencies and security services. Therefore it is impossibleto forecast how, where or when the next attack will happen. It could beplanes, it could be shopping centres, or it could be a cyber waragainst major international computer networks. The more troops that theUK and US send to Afghanistan the higher the risks of terrorist actsagainst them. The greatest likelihood of preventing or reducingterrorism would be for the US and the UK to close all foreign militarybases and to withdraw all troops. Sadly, that is a very remotepossibility.
Markets
In January 2009 we forecast that stockmarkets were likely to correctup to 50% of the down move before continuing the bear market. The DowJones corrected just over 50% but it took a bit longer than weexpected. The correction is now finished and the primary trend of allstockmarkets is now resuming its downtrend. We are expecting verysubstantial falls during 2010. This will not be a year to be investedin general equities. We expect precious metal shares to do very welleven though initially they will come down with the market.
Bonds
One year ago we predicted that US long bond rates would rise. Thisis exactly what happened and the 30 year Treasury Bond yield went from2.5% to 4.6% during the year. We expect US and UK bond rates tocontinue to rise in 2010. This will be as a result of foreign holdersselling their holdings of these bonds due to the dire economicsituation in the US and UK and the currencies weakening. Internationalinvestors are not prepared to finance bankrupt sovereign states withoutgetting ample reward for the risk.
Currencies
Most people judge currencies on a relative basis. This is a verypoor measure of the value of a currency since it doesn’t take intoaccount the total destruction of paper money in the last 100 years. Weshowed in our December report (“Gold is not going up – Paper Money isgoing down”) that most major currencies including the dollar, pound,Dmark/Euro and Yen have all declined 99% against real money – gold –since the creation of the Fed in 1913. Thus, all currencies are weakand they will continue to be attacked one at a time. Fundamentally thedollar is the weakest currency and we would expect the next leg down tostart relatively soon.
The Euro also has its problems and is suffering from the problems ofits weakest members – Greece, Spain, Portugal, Italy, and Ireland. Likeall artificial currencies the Euro was doomed to have a relativelyshort life in its original form. We predicted this long before itsbirth in Maastricht in 1992. Short term the European Central Bank willsupport Greece and all other EU nations that need support. Longer term,once too much worthless money has been printed by the ECB withoutsolving the problems, the European Monetary Union is likely to break up.
But the current fear over Euroland and the weakness of theEuro relative to the dollar is overdone. The Euro zone budget deficitto GDP is 6.7% and debt to GDP is 88% whilst the US deficit is 10.7%and debt 92%. So on this basis it is extremely unwise to shift fundsout of the Euro and into US dollars especially since the underlyingfundamental problems are much greater in the US.
All the countries of the major trading currencies – the Dollar,Euro, Pound and Yen – have major economic problems that can only beresolved by massive money printing. This is why it is a futile game totry to predict which currency will be the weakest out of the abovefour. They will all weaken substantially but not at the same time.Therefore, we will have incredible volatility in currency markets inthe next few years whilst speculators lose their shirts jumping fromone currency to the next. There will be very few winners in that game.
So are there any currencies that are better? Yes, relatively, theNorwegian kroner, the Canadian dollar and possibly the Swiss Franc andAustralian dollar will do better. The Renminbi will also do well but isdifficult to invest in.
