According to the Mayan calendar, the Great Cycle will end on December 21, 2012, at which point the current Fourth World founded on August 11, 3114 BC will come to an end, leading us into a Fifth World of greater enlightenment. Economically, this is beginning to seem like a remarkably accurate prediction. There are a number of signs in today’s market that a world-changing crisis is approaching, after which our economic environment will never be the same.
The approach of a market apocalypse can be gauged by considering the relative valuations the market is currently putting on assets. Considered rationally, the most attractive asset today should be equity participations in the world’s fastest growing economy, China – yet Chinese equities are at 33-month lows, and many small Chinese companies are trading on earnings multiples not seen since the Great Depression. Considered rationally, among the least attractive assets today should be the long-term debt of two countries with unsustainable budget deficits and governments that have made very little effort to close them – yet British and U.S. government bonds are trading at yields close to all-time historic lows and far below the rates of inflation in their respective countries.
Extreme market irrationality of this kind is a pretty good warning signal of coming market collapse. Just as the Emperor’s Palace grounds being worth more than the state of California signaled the end of Japan’s real estate bubble in 1989, so current valuations of British and U.S. government debt signal that we are very close to a massive reversal, in which probably for several decades it becomes impossible for those governments to sell new debt except at very high cost. Bank balance sheets worldwide, which have loaded up on government debt because of the foolish Basel banking regulations and the attractiveness of “gapping” income between short-term and long-term rates, will collapse into insolvency. The early part of this collapse will be marked by a rapid reversal of “mark-to-market” regulations, so that banks are not forced to mark down their debt holdings to deflated market prices, but even if this accounting chicanery works in the short run, it will prove no solution in the long run, as short term rates rise above the meager long term yields on their government bond portfolios.
The First Pennsylvania Bank failed in 1980 through precisely this problem, at a time when there was thought to be no risk whatever of a U.S. government default or delay in payment. Adding the default possibility into the equation will simply make the problem all the more insoluble. Banks will attempt to hedge themselves through interest rate swaps and credit default swaps, but that will only cause a collapse in swap markets as well; the depth of those markets will prove completely inadequate to solve their problems. Naturally as in 2008 there will be a few sharp operators, like John Paulson and Goldman Sachs in that year, who make money out of the collapse, but their ability to do so will merely worsen the burden on the rest of the system and the costs of any attempted rescues.
There is thus considerable danger, probably in the latter half of 2012 as the Mayans predicted, of a banking system collapse dwarfing that of 2008. Value distortions such as those prevalent currently are necessarily of short duration. The eurozone problem seems certain either to find a solution or to cause a major upheaval in 2012, with the balance of probability being on the latter outcome. In the United States also, 2012 seems the period of maximum near-term danger for the budgetary problem; solutions are impossible in an election year and exacerbation of the problem by foolish handouts only too likely. Maybe the U.S. budget mess can avoid collapsing before 2013, but any market shock, for example from Europe, is likely to push it over the edge. Japan, too, is nearing the point at which its government debt to GDP ratio moves above the level at which it is unsustainable; again a market shock in 2012 could push it over the edge. To use a chemical analogy, the market solution is super-saturated, and any tiny crystal dropped into it will cause precipitation. A trivial event, such as a repetition of May 2010’s stock market “flash crash,” could be the trigger for a market collapse.
Given the extent to which banks have loaded up on “risk-free” government debt, a collapse of the government debt market will cause a collapse of the banking system. I have written before how the world economy would work rather better if government debt were not considered the universal risk-free investment, and were instead considered the doubtfully solid security it actually is. However there is no question that the transition, with the collapse of global government debt markets and banking systems, will be extremely painful. Since government debt market collapse will cause banking system collapse, there will be no rescue available.
Central banks worldwide will of course attempt to alleviate (or rather, postpone) the problem, by an endless array of gimcrack money-printing schemes. Since their credibility, already dented, will be at an all-time low as evidence of world systemic collapse emerges, they will doubtless attempt to devise money-printing schemes with a populist appeal. Thus Ben Bernanke, whose 2002 “thought experiment” of dropping $100 bills from helicopters was intended as a snobbish academic joke against the bourgeoisie, will end up doing just this. TV cameras will be lined up, the world’s financial bloggers will be prepared, and a Bernanke-bearing helicopter will appear hovering over some carefully chosen demographically balanced slum, dropping roll after roll of greenbacks to a Secret Service-prescreened crowd of adoring populace. Of course the real money will still zip by wire transfer to the vaults of the nation’s largest banks and embezzling government securities dealers, but the production values of a benign Bernanke rewarding a faithful underclass will be thought well worth creating.
It won’t work. Far from obeying Walter Bagehot’s famous advice for a financial crisis, of lending freely against top quality security at very high rates, Bernanke and his chums will as in 2008 throw money around like confetti, taking little account of the quality of the security nominally tendered, and lending it at rates that allow the banks to make yet more illicit billions by on-lending their subsidized finance. The European Central Bank’s handout last week, where it lent $600 billion of 3-year money to the banks at 1%, in the hope that they would re-lend it to tottering Eurozone governments at a spread of some 500-600 basis points, is typical of current central bank thinking.
Lend money to the banking system by all means, if you think there is a liquidity problem, and lend it for 3 years if you want to stabilize their financial position. However the money should be lent at a stiff interest rate of around 7%. At that rate, only those banks that really needed the money would have borrowed it, so the bailout would have been limited to $100 billion or so. The remainder of the rescue of banks’ balance sheets would have been achieved by them rushing to sell all their assets that yielded less than 7%. This would notably not include consumer loans and productive small-business loans, which generally yield considerably more than 7%, but it would include all the miscellaneous government junk with which the banks had been playing “gapping” games, hoping to borrow at short term rates and lend at long-term rates, capturing the spread between short-term and long-term interest rates. With their marginal funding cost 7% for 3 years, this would no longer be profitable.
Of course, many Eurozone banks, a simple lot, have not incorporated marginal pricing into their Treasury operations, so will happily borrow at 7% and lend through a different department at 3%, puzzling why their profits are less than they were. But frankly, a little Darwinian selection against stupidity in the European banking system would do no harm at all!
The chance of a system-destroying financial breakdown in 2012 is thus substantial, and December 21 is as good a day as any other on which it might occur. With government credit and banks both collapsing, the old financial world as we have known it since the Bank of England’s foundation in 1694 would indeed have ended. The good news is that this would not shove us back to 1694’s living standards. As for my Great-Aunt Nan, who put her savings in British government War Loan when she retired in 1947 and found inflation and interest rate rises eroded more than 90% of their value before she died in 1974, the disappearance of government bonds, bank stocks and many bank deposits from our assets would cause great hardship. However the central function of banks as a payment mechanism would not disappear and commercial, manufacturing and service-providing activity would continue.
The disruption would be huge, but human civilization would carry on, even the affluent Western civilization many of us have grown used to. It would not be necessary to invest our assets in gold, canned goods and a shotgun; those of us with our savings in non-financial sector stocks would find their long-term value would recover, after what would doubtless be the mother of all stock market crashes.
There would be a Fifth World for us as the Mayans predicted. In it we will finally have achieved enlightenment – about the folly of fiat money, over-powerful central banks and “risk-free” government paper. Achieving this enlightenment will be painful, but it will be worth it!
Happy New Year to all readers!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)