Friday, 10 October 2014

We’re in an Economic Neverland - Part 2

Guest post by Bill Bonner, continued from yesterday (check out part one here).

Yesterday, Bill Bonner looked at some of the destructive effects of Zero or Negative Interest Rate Policy (ZIRP or NIRP), and the issuing of all that new debt . Today he continues …

Neverland - Part 2

"There can be nothing more unreal in
its pretensions than debt currency itself."
Charles Holt Carroll (1860)

Ex Nihilo Nihil Fit

I spent much of the spring at our ranch in Argentina. I was cut off from the flow of news and opinion. No telephone. No TV or radio. But I was still thinking… in a desultory way… about how you can get something from nothing.

“Out of nothing comes nothing,” is the expression. It expresses a deep truth, much like the law of conservation of matter and energy. You can’t get something from nothing. You can’t get rid of something once you’ve gotten it, either. That is, you can’t get nothing from something. As you know, the law of conservation of matter and energy tells us that you can just change the way it is expressed… where and how it shows up.

Getting something out of nothing violates the laws of the universe. It doesn’t seem possible. And of course, it’s not. Free money is oxymoronic. Like an “honest dollar” or a “reclusive film star,” it doesn’t exist.

So, if you think this free money coming from the Fed has no cost, you’re probably going to be surprised… and disappointed. The bill for it is out there somewhere. In the future. Debt is essentially a financial arrangement between the past and the future. And eventually, the future comes.

I was thinking about this when I was helping with the roundup at our ranch in Argentina. At the time, I couldn’t figure it out. How can you get something from nothing? Who gets the bill? How? When?

Then a 2,000-pound bull charged me.

It’s amazing how fast something like that concentrates your attention. I practically flew over a six-foot fence to get away from him. And I got a demonstration of the conservation of energy principle. The energy I used to scramble over the fence was more or less equal to the energy that the ground… and my head and shoulder… absorbed when I came down on the other side.

I think my head injury has helped me. I drool more often. But I understand the NIRP world better.

A Corrupt System

The traditional way we understand credit is as follows: A guy runs a surplus—that is, he earns more than he spends. He saves the money and lends it to someone else… just as a farmer might lend a neighbour some of his excess time… or his excess tomatoes.

This excess is real savings. It is what enables the borrower to make something… because he has something to work with. It is something real. If he is lent some seed corn, for example, he can plant it and pay back the loan out of the harvest. If he eats the seed corn, or throws it on barren rock, he will have no way of paying back the loan.

But with the new financial system that came into being in the late 1960s and early 1970s, the money changed… and so did the type of credit. Gradually, the world economy came to operate without savings… without real capital… and with credit that could be consumed, wasted and never paid back. So was the entire economy transformed in deep and abiding ways… which we are just now beginning to understand.

Before I get into the details of this new system, I want to emphasize that this is the system that we know… that has dominated our economy for most of our adult lives… and that we all take for granted as “the way things work.”

But it’s not the way things always work… and it can’t possibly continue indefinitely. Debt can’t grow forever. And Japan is about to prove it.

Lessons from Japan

Is there a single road, bridge or municipal building in Japan that is in need of repair? Probably not. Because for 24 years, the government has borrowed the nation’s savings and turned them into GDP-boosting public works projects.

Now, with more people retiring than entering the workforce… more people spending their savings than saving more… and more money leaving the country than coming in… the jig is almost up.

This insight is an important one. But it is also an investment trap. You see disaster coming. You take cover… and sit there while the stock market goes up 150%! But watch out. It’s an even bigger danger to assume that debt can expand forever.

Credit began expanding in the late 1940s… and it has been expanding ever since. My entire life has been spent in a credit expansion. I have never seen the other side of a credit cycle… at least not in the US. We all know in our minds it can’t go on indefinitely. But in our bones, we feel it will.

That’s why it’s so important to try to understand what is really going on… if for no other reason than to overcome the “momentum” bias of our own experience. This will be the most difficult financial period of our lives, because we have no experience of anything else.

But we are coming to understand this freaky thing more and more. We see that it can’t possibly last much longer… and that it will probably end in a catastrophic depression. Or worse, that it will mean the end of our civilization.

Former World Bank Economist Richard Duncan, who came to Baltimore to visit just a few weeks ago, points out that the Great Depression was, at least partially, responsible for World War II… a war that killed more people than all the wars before it put together. And that war began before people had nuclear weapons… and before people were so completely dependent on an elaborate, worldwide supply chain… and an ultra-sophisticated, and perhaps fragile, electronic money system… and on extremely vulnerable urban lifestyles.

In 1939, most of the world’s people still lived on farms. They were at least partially self-sufficient. They bought and sold things with physical money. And they didn’t depend on ATMs and central banks. They could survive a credit contraction.

Duncan has helped me understand this new economy. He studied the build-up of credit over the last 60 years. At first, the credit expansion was based on healthy economic growth… new family formation after World War II… and useful technological advances.

People took on more debt, but they were also earning more money. Then, for a variety of reasons, this healthy credit expansion was replaced by an unhealthy credit expansion. Incomes stopped growing. And the system began to look sickly.

Lots of things were going on. But one thing, and one thing only, made it possible for credit to continue growing even as the fundamentals weakened: The US federal government changed the money system. The US took gold out of the money system in two steps: the first in 1968, when President Johnson removed gold backing from the dollar; the second in 1971, when President Nixon unilaterally cancelled the direct convertibility of the dollar to gold.

Before those changes, the money supply was limited by the availability of gold. The supply of savings was limited by the supply of money. The supply of credit was limited by the availability of savings. And the amount of debt was limited by the supply of credit. After those changes, the limits were removed.

This is a new world. A new economy. New money. With many elements that never existed before. Nobody knows how something like this unwinds. I was just on the verge of figuring out the essential secret to it when the bull interrupted my thoughts. So, for now, I can only pass along a partial understanding of it…

It’s Just Paper…

Let’s stick with the new money for a moment. The post-1968 dollar is an unusual kind of money. It’s not like the old money. It doesn’t have anything behind it: neither gold nor goods or services. It is nothing. And it came from nothing.

Banks conjure up credit out of thin air. You think banks are lending out deposits or reserves. But it’s not true. The Fed lowered the reserve requirements so that, after World War II, banks had about 18 cents cash on hand—real money, backed by gold—for every dollar they loaned out. Today, they have about 2 cents… and it’s just paper, backed by nothing.

When a guy borrows, the bank gives him credit. The credit is buying power that comes from nowhere. Then it enters the economy, where it is indistinguishable from real money. It cost nearly nothing to produce. No one earned it or saved it.

Since the 1970s, the US economy has created about $33 trillion worth of cars, houses, pancake breakfasts, lawnmowers, movie tickets—you name it—all bought with this “money from nothing.”

Unlimited credit changed everything. It’s money that you don’t have to work for… or save. Like winning the lottery. Or like Spain in the 16th century. Spanish explorers had conquered the Aztec and Inca civilizations and shipped boatloads of gold and silver back to Spain. The Iberian Peninsula was soon swamped with new money.

As a result, the Spanish—with so much money on their hands—found it easier to buy products from the British, the Dutch and the French rather than make them in Spain. As a result, prices rose. When the mines of the New World were emptied, it sent Spain on a course to becoming one of the poorest countries in Europe for the next three centuries.

The Fuse Is Lit

So, here is an economy where—over a 30-year period—credit expansion has risen above trend by about $33 trillion. (Note that this credit was provided far in excess of available savings, which declined over the period from about 10% of GDP to near zero. Also note that the typical spender had less real spending power at the end of 2010 than he had at the beginning of 1980.) In other words, people were spending money they didn’t have… they never earned… and which didn’t exist.

And when, in 2008, the crisis threatened to undermine asset prices… and send the value of these accumulated credits back where they belonged… the feds (including the central bank) offered a backstop of an amount of credit that was almost unlimited. An amount of liquid capital that not only did not exist, it also could not exist.

All of this was puzzling to me. Here was an entire economy that, in sickness and in health, ran on ethereal money. It looked as though we really had gotten something for nothing.

Here’s another oddity: When money is free and unlimited, who benefits the most? The weakest borrowers. Credit spreads narrow—because, as long as the money flows, companies with weak balance sheets are not much more likely to default than those with strong balance sheets. The weaker companies gain the most. They can borrow at relatively lower rates.

Junk-rated borrowers issued a record $380 billion of bonds last year, according to Bloomberg. The newsgroup further reports that junk bonds are the top performers this year… up 94% since the end of 2011.

And yet—and this is in some ways the strangest thing of all—implied stock market volatility is remarkably low. No one is worried. More debt? Who cares? It may be crazy. But no one thinks it will come to an end any time soon.

Here’s what I make of it…

Yes, the Fed and Washington have distorted the economy. And yes, there is some strange stuff going on. And the longer it goes on, the worse the eventual blow up is going to be. The lack of volatility is the calm before the storm. Here is my friend Nassim Taleb, writing in Foreign Affairs magazine in 2011:

Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks.
Such environments eventually experience massive blow-ups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blow-up to occur, the worse the resulting harm in both economic and political systems.

And here’s a prediction: You will never make any durable returns in Neverland public markets. If the economy improves, interest rates will rise and the NIRP world will disappear. If the economy doesn’t improve, interest rates will sink further… investors will panic… and asset prices will fall.

When either of these scenarios will happen, I don’t know. But Duncan says volatility will increase in the second half of this year, as the Fed continues to reduce its QE program. It is also possible that the US stock market will fall hard… and the Fed will come back with more QE.

Duncan believes the Fed could succeed in holding off the day of reckoning for many years. It is also possible that investors will lose confidence… that more QE won’t work… and the entire credit-based edifice begins to give way.

We don’t know what the future will bring. But we know that, in the present, you and your family face a serious threat. Free money is a gift… but there’s a fuse attached. And it’s lit. This is why we remain cautiously hedged.

Bill Bonner is an American author of books and articles on economic and financial subjects, the founder and president of Agora Publishing, co-founder and regular contributor to The Daily Reckoning, and author of a daily financial column,Diary of a Rogue Economist.

He is author and co-author of Financial Reckoning Day: Surviving The Soft Depression of The 21st Century, Empire of Debt and Mobs, Messiahs and Markets.

Click here to order Bill Bonner’s forthcoming book: Hormegeddon: How Too Much of a Good Thing Leads to Disaster.

This excerpt first appeared at the Casey Daily Despatch.


  1. I remember reading in one of my many subscription mails a very good summary of this:

    For 30 years the US (and by extension the west) have been buying goods made of sweat with dollars made of air. At some point the world is going to figure this out, and it is going to be ugly.

  2. Were Keynes alive today, he would have shaken his head, backed away and apologised.

  3. So true Shane (and good to see you online) - he is one of the most misquoted people in modern history; hopefully one day the average Keynesian will actually read Keynes' books haha!


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