This article is taken from a September Special Report for subscribers to the Hat Trick Letter, a piece of the same name. Several paragraphs are deleted which appear for paid subscribers, while others are shortened to manage the length. The outlined content is the same though, so as to capture the meaning in a longer treatment than a mere synopsis or abstract. It might be important to step back from the silly news on DJIA hitting 11,800 mark, or European race cars which attain 60 mph in 3 seconds, or what opulence $5 million buys in a luxury home, or the failed deal with continental weakling GM & Nissan & Renault, or the back-dated executive stock option scandals (even to a dead person, see Cablevision), or the falsified research story and lawsuits in a Vioxx scandal, or the US Congressional cover-up sex scandal, or the sentencing of Fastow in the Enron scandal, or exoneration stories of insiders like Greenberg or Mack, or the engineered energy market decline for election purposes without publicity or scandal, or the electronic voting machine controversy involving Maryland deleted eligible voters without publicity or scandal, or the civil war in Iraq, or the total breakdown in Afghanistan. We have systemic breakdown under our noses, but the arrogant tilt renders recognition impossible. Housing is the lynchpin to the USEconomic risk of breakdown, and in my viewpoint, a bear market of historic proportions has begun in housing, noted by staggering momentum from many factors. Even USFed Chairman Bernanke admits a 1% drag on US GDP from a housing slowdown. Try triple that, at least!
The debate over whether inflation or deflation will prevail exposes the prevalent ignorance for the true problem, even among enlightened analysts, even within the gold community. We have had both inflation and deflation for several years. We will continue to have both inflation and deflation, as neither will overcome the other. In fact, both inflation and deflation will intensify, with each gathering more strength, but with some interchanged parts. The natural response within a system is for liquidation to be forced upon abusers and their flawed devices. The human response within that same system is to attempt monetary inflation. The central problem for the United States is that we generate lower finished product prices, lower wages, and higher costs, along with asset bubbles certain to eventually burst. Amazingly, the US generates more price deflation from monetary inflation, except with cost structures. Such is the nature of a financial hurricane, picking up assets and tossing them around. Financial assets and commodity prices inside the United States have increased, while at the same time wages and imported product prices have decreased as a direct effect of Chinese and Indian participation. Next, housing prices will decline, another certain deflationary impact. If a house can be picked up and tossed like a child's toy in a hurricane, then why not see it thrown onto the deflationary ledger column in a financial hurricane? A first year 5% housing decline would equate to at least $1 trillion in lost home equity, with a definite and guaranteed impact on a deflationary force. Some call it debt and asset deflation. The problem is that, using distorted economic statistics, the US Federal Reserve has chosen not to amplify its monetary rescue inflation, a gigantic money pump prime operation. It is not yet engaged, but it will be soon, but probably too late. My diatribe has consistently called them hacks, a much deserved label.
FLAT TREASURY YIELD CURVE
The Treasury Yield Curve reflects this trend of cost inflation, smothered wages, and a weak USDollar which can only worsen the rising cost situation. The falling long-term 10-year TNote yield (TNX) reflects failure in the USFed Reflation initiative. The presence of China has rendered pricing power as non-existent for both finished products and wages. Thus no "cost push" is possible, as in previous business cycles, or rather credit cycles. The Treasury Yield Curve reflects both the failed attempt to generate systemic inflation (shared by wages) and the capital liquidation in progress on a widespread basis. The most unreported aspect of the price inflation effect inflicted upon the USEconomy is that it appears on the COST SIDE almost exclusively. This suppresses activity, thus a continuing downtrend in long-term interest rates, which befuddles the gold community. Economic growth is weakening, and if you remove the distortion, is clearly in recession in my view. Many questions are answered if the phony 5% lift to GDP growth is removed, just like a 5% lift to the CPI is imposed. That is, if one chooses to live in the world of reality! The falling TNX, now under 4.6% amazingly, also reflects the monster cost inflation climate, absent wage gains.
A tough argument to make is any claimed success to the USFed Reflation initiative. We are not on a smooth course of USEconomic recovery, not if asset dependent (housing). We are not in a situation where the higher cost structure can be afforded, either by corporations from pricing power, nor by households from higher wages. If the USFed Reflation were successful, as in past cycles, the USTreasury Bond market would have recognized the rising price structure. It has not yet. The original objective was to "inflate debts away" but the opposite has occurred. Debts have gone ballistic. Now even more inflation is required in order to wash debts away? Such policy works into the hands of Weimar Policy, marred and marked by uncontrollable inflation. If that occurs, a more likely outcome is a step toward more USEconomic liquidation and threat of collapse.
A very important truism was learned by me from the venerable Kurt Richebдcher during a 2003 visit in France. He said several times that the bond market eventually takes its cue and follows the dynamics within the real economy, not the asset markets puffed by bubbles. The most important industrial segment is car manufacturing and the transportation sector generally. Ours is dying except for trucks on interstate highways, hardly a testimony of efficiency or planning. The asset bubbles are fleeting, temporary, and aberrant. When they retreat, chaos results.
DISRUPTED BUSINESS CYCLE
The typical Business Cycle is more appropriately named the Credit cycle. Past patterns are not occurring like in past pretexts. Credit would be yanked hard to cause a recession by means of hiked interest rates, a time when the Ruling Elite would shift capital from stocks to bonds, then later to utilities, likely with tipoffs in policy shift. Later, after debt was reduced (e.g. via bankruptcies, writedowns, layoffs, plant closures) and cleansed to a sufficient degree, pent-up demand gathered as in a wondrous wellspring. A "call to arms" by the USFed official cut in interest rates, and the next game was on! Demand rose, the economic stirred, the system awakened once again, fresh demand was tapped. This time, however, the system is grinding its credit gears with exhausted demand. This time, monetary inflation has been exported to Asia, only to return dressed up pretty as cheaper products. We have been importing deflation for years, especially since China was invited to join the global trading village in 1999. We have been indirectly monetizing the bond market after our debts pass through the Asian trade surplus tunnel and through the Persian Gulf petro revenue tunnel. Wage increases are welcome news, too little too late though. They might be joined by installed price hikes in Chinese imports to the United States soon. China remains in control of price levers.
My biggest outward concern is that the USTreasury Bond rally will grow out of control. The nitwits in the USGovt actually enjoy lower long-term rates, for refunding recycling purposes of colossal debt. It reduces borrowing costs. The USTBond reinforces the USDollar support. At some point soon, the bond rally might come to an end. Its brick wall might be determined more than we know by the "BRIC" nations of Brazil, Russia, India, and China. The great expressed concern among macro-economists is the likely pullback in foreign investment in the United States if the housing market drags down the economy like a two-ton millstone.
CHINA INTERRUPTS REFLATION
China (mostly manufacturing) and India (most services) have emerged as economic embryonic powerhouses, the main effect of which is an "iron ceiling" on prices, both of products and wages. The Iraqi and Afghan Wars succeeded in jump starting the recovery in the USEconomy, but it has backfired both militarily and economically. Violence in Moslem lands is horribly under-reported in the United States, where the press & media are mere public relations appendages to the USGovt in power. See the covers of Newsweek on the four continents, as the US offers "puff pieces" while the rest of the world is warned of "Jihadistan" in lawless Afghan lands where warlords are trying to take back the heroin trade.
China was invited to the global table in 1999, a maneuver which has rendered USFed policy as more manager of the liquor supply, carnival barker to the stock & bond markets, maestro to the musical distraction, tinkerer to the press, and controller of water flow to the leaking swimming pool. China has quietly become a major credit master which has lately warned of no more additions to their FOREX horde. Expect infrastructure investments to buttress energy deals and foreign aid to rise. Can anyone dispute how debt makes a person (or nation) slave to its master? Case in point is how the US Congress backed off on trade tariffs against China. What happened? Did Beijing threaten to sell a few $10 billion tranches of USTBonds each week until the US imperialist dogs stood down with a whimper??? What private deal did Treasury Secy Paulson win? Will we ever know? Is the payoff to Goldman Sachs?
The first phase of the mega-storm saw prices rise for everything needed in our domestic supply chain. The bull market in commodities is broad, all these items being in hot demand in Asia. That bull will surely return and be resuscitated once the November elections conclude in the United States, like clockwork. In contrast, the Asian trade routes have brought to US shores cheaper finished products over a broad range, involving home electronics, housewares, appliances, and furniture, even as US-based factories were shuttered. Is that progress? The depreciated USDollar value spawned a supply cost increase with a correspond finished product price ceiling. Businesses have been squeezed unmercifully in the cost explosion. They have reacted by replacing workers with equipment, a surefire productivity enhancement, but also by outsourcing to Asia, a trusty low-cost solution. The tragedy lies in how the solutions impoverish the nation. Hence, US domestic wages did not increase, as they have in all past cycles. The next phase of the mega-storm will be more dangerous and treacherous.
SILENT MONETARY EXPLOSION
Central banks worldwide have grown the money supply in reckless fashion in the last year. The pace ranges from a seemingly modest 8.5% in European Union, a modest 7.5% in Australia, and roughly 9% in the United States. Check this! Money supply growth is up to 18.4% in China, 19.1% in India, and a whopping 23.2% in South Africa. While not "Weimar-like" numbers, for the modern era, these are staggering numbers. The next phase will be marred by the futility of more rapid money supply growth to kickstart economies, in conjunction with flat economic growth outside Asia. The more rapid money growth will render US energy costs as painfully high again, since the USDollar's crippled status will be recognized, acknowledged, debated, and confirmed. Without fanfare, Russia has increased its money supply by almost 45%, not so much inflationary as capitalization of energy deposits.
INFLATE AMIDST LIQUIDATION
The mega-storm will develop and grow more destructive in the next phase. The contrast of greater high pressure against greater low pressure will add to the storm differential. Its power will increase, just like a hurricane. Higher pressure will come from human monetary inflation, otherwise known as liquidity infusions, credit growth, and further leveraged speculation, ongoing carry trade activity, as officials will fight the good fight, urged on by bankers, politicians, corporate chieftains, and influential individuals. Lower pressure will come from the shrinking value of the housing sector, from the diminished credit lines off flat home equity, and from eventual cutbacks in household spending. The reckless drain of home equity is soon to end. The mega-storm will worsen as the USFed next executes its response to the worsening real estate crisis. They will be slow on the uptake, however. New stimulation will eventually accomplish the same effect as the last few years, more cost stress. The stock market loves the new liquidity guarantees and steady influx of easy money, at least initially. The true havoc will come when the mortgage backed securities (MBS) writedowns occur. Their trading is not in the forefront of financial media screens, but rather in the banking world background, in the banking balance sheets and portfolio management.
Europeans describe the American practice of spending home equity as "burning their furniture to heat their homes" whereas mine is more "actively dissolving their home foundations while continuing to live in them." A new class of poverty is soon to arrive on the scene: the bankrupt homeowner. Reports of negative home equity are rampant and growing, without the mindful alarm.
A more pertinent, fitting, and applicable description is one offered by Antal Fekete. Without reference, only to cite his thoughtful assessment, his depiction is more frightening at the same time. He claims the United States lies in the midst of a grand liquidation of capital. My assessed explanation claims it is in direct response to the brutal effects of globalization. This liquidation is being utilized to pay for the rising costs, to finance our pathetic profligate lifestyle, to fund our reckless rampant consumption. Legitimate income has vanished from a gigantic central backbone in the US manufacturing sector long ago dispatched to Asia, where labor has an absolute advantage and will continue to have that upper hand forever. Foreign nations somehow feel motivated or obliged or compelled or coerced to support the USEconomy and its capital needs.
What will stop this trend? TRADE WAR, then wider MILITARY WAR, and growing geopolitical conflict, not just baseline strain. Trade quotas, motivated by protection from the damaging onslaught, will soon be sold to the US public, if not this November 2006 election season, then undoubtedly in Nov 2008 during presidential elections. The destructive message sells well to the public full of angst, as it repeats the songs sung before the Great Depression over 70 years ago. Politicians will choose to paint China as evil, rather than to make difficult choices.
CONSUMER BURNOUT AND/OR FOREIGN ABANDONMENT
The natural course is for huge imbalances to be resolved, for big gaps to narrow, for overdue dependence to be relieved, for deficits to be reduced. The primary reason why we move to the next phase in the mega-storm crisis is that all imbalances are worsening over time. We are moving in the wrong direction, and have been doing so ever since Alan Greenspan warned of "irrational exuberance" but then fed the debt and speculative addiction.
We will not have the good fortune of a rosy scenario, wherein the housing market has a Soft Landing, the USDollar finds an equilibrium peacefully, and the stock markets avoid the next bear market. These are fairy tales, chapters in silly economic mythology which sells well despite its constantly disproven validity. Not only are the financial imbalances and capital dependence at historically unprecedented levels, AND WORSENING, but the geopolitical climate grows more agitated and hostile with each passing month.
The risk of the US consumer suffering a bigtime noteworthy exhaustion is acute, greater than (for a while) the risk of foreign USTBond flight from the US and abandoning us. The ultimate risk is for the consumer to burn out AND THEN to see foreigners pull the plug and deliver a punishing blow to the USEconomy. Again, housing is the lynchpin to the pulled plug. In recent past history, the victim of foreign flight has been debt-ridden nations like Argentina and Thailand. Well, guess what? The United States looks every bit as crippled and hardly creditworthy. The USDollar might be supported by our military more than we realize. The United States has a gigantic unresolvable debt abroad and an unmanageable compromised budget process domestically. If not for a strong overwhelming military, and formidable financial weapons, an oversized consumer market, and multi-national corporate outreach, would our increasingly alienated partners continue to hand off over $2 billion in savings each and every day? Methinks NOT. They will respond to our housing bear market by gradual abandonment.
We are such silly creatures to expect foreigners will to turn slapped cheeks, to take insults on the geopolitical stage, to succumb to our heavy handed directives, to accept incredibly deadly banking coercion, to blink when viewing naval destroyers and warplanes. We expect them to continue to trade their finished products for our corrosive IOU's, and to endorse our asset-based economy. Our power plant is inflation. Theirs is work.
Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 24 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com.