This website provides analysis of critical economic events and market trends, and in doing so it aims to provide a complete picture of the global financial landscape. This article serves as a brief summary of the current economic “big picture” and presents my view on how the next few years might look.
From debt fuelled economic boom to debt fuelled bust
The abolition of financial regulations such as the Banking Act of 1933, aka Glass–Steagall, coupled with double-digit year-over-year expansions of money supply and low interest rates, created an environment in which it paid to take on risk and increase leverage (debt) particularly for the banks.
This casino like environment fuelled a series of bubbles such as the technology bubble of the late 90’s, and the US housing bubble of the early to mid 2000’s – each of which burst triggering a recession. Rather than let these recessions run their natural course, governments and central bankers in the US and elsewhere responded by slashing interest rates and stimulating demand. This kept the credit bubble inflating and with it the price of almost all assets.
All of this came to a head in 2007 with the collapse of the US subprime mortgage market and the subsequent contagion to the global banking system. By the summer of 2008 the worlds financial system was teetering on the brink of systemic collapse and so the Federal Reserve (Fed), alone with other central banks including the Bank of England (BoE), began to step in and buy up the troubled firms and their toxic debts.
At this point the banking crisis became a sovereign debt crisis with governments socialising losses and instructing central banks to fulfil their role as lender of last resort.
Over the past couple of years, despite all the talk of austerity and reform, the sovereign debt crisis has gone from bad to worse. As GDP fell in many G20 nations they took on more debt in an attempt to stimulate spending and kick-start their ailing economies.
History has proven that once a country’s debt as a percentage of its GDP passes 100%, a dangerous downward spiral tends to develop. As debt continues to accumulate sooner or later is becomes apparent that it can no longer be adequately supported by the nation’s tax base. This impacts the debtor’s credibility and therefore their ability to access capital, and fear of a default triggers a sharp rise in interest rates.
The levels of indebtedness within many of the countries at the centre of the crisis are such that they are simply unable to continue to rollover their current debt. It is therefore impossible for them to continue funding their current (profligate) levels of spending. For the countries trapped inside the euro currency zone they are left with two choices: default or seek a bailout. The problem with bailouts however, is that they further weaken the countries that must stump up the cash. This course of action leads the whole eurozone closer to disorderly default and disintegration.
Where do we go from here?
As G20 governments instruct their central banks to print money (likely in a coordinated fashion) and find ways to push that money into the global economy they will continue to create asset bubbles, the largest of which is in the government bond market.
Bond yields in the US peaked in September 1981 at over 15% and have fallen ever since. At the end of May the yield on the benchmark US 10-year Treasury note fell to its lowest level in around 220 years, and because bond prices move in the opposite direction to yields, prices are at multi-decade highs.
In addition to creating new asset bubbles, it is my opinion that the actions of desperate governments will create a prolonged period of hyper-stagflation. In other words, a period of high unemployment, low (or no) economic growth and high inflation. I believe it’s possible, even likely, that we will see inflation rates as high as they were during the 1970’s. In the UK the annual inflation rate (RPI) peaked in August 1975 at 26.9%, while inflation in the US (CPI) peaked in March 1980 at 14.7%.
This bout of high inflation, brought about by rapid competitive currency debasement, will destroy a good portion of the wealth and savings of millions of people. This destruction of wealth will likely be the trigger for the final stage of the crisis, i.e. the loss of confidence in paper (fiat) money and with it the loss of confidence in the ability of governments to resolve the crisis.
In a period of high or even moderate inflation, the losers are those that have positioned their wealth in paper assets such as cash, bonds and bank CDs, while the winners are those holding debt, i.e. governments. The inflationary episode I see coming will be a deliberate attempt by governments to inflate away their debts, however it will also destroy a large part of the capital stock required to build a new sustainable economy based on investment and production.
The bottom line
Those who wish to take pre-emptive measures to protect themselves from this period of tremendous wealth destruction should begin accumulating physical gold. Gold won’t make you wealthy but it will keep you wealthy.
Other assets that are likely to appreciate in this environment include: silver, copper, prime residential property, farmland and precious metals mining stocks.