Tuesday, January 4, 2011

2011 Outlook: How We Got Here

Before August 1971 the world was on a gold standard. When a country ran a trade deficit, in order to pay their bills they were forced to sell their gold. When the gold was gone, the party was over, and they were forced to become a net exporting country through a focus on manufacturing.

This was occurring with the United States through the late 1960’s as our gold was rapidly leaving our vaults. The US was faced with an oncoming “default” which was how it was known at the time as foreign countries would only accept payments in gold.

In August 1971, the United States made a landmark decision when we decided we would no longer play by this rule. We left the “gold standard” and our currency, and every other currency in the world, was now backed by nothing. This is the first time in history every currency in the world had no gold backing.

This created a 37 year boom that allowed a country (the United States) to run endless deficits that could not exist under the previous gold standard.

This new form of deficit spending allowed the government and our central bank to “smooth over” any problems the economy faced.

In the 1980’s they created a boom through Reagan tax cuts that were financed with an explosion in our federal deficit.

In the 1990’s Alan Greenspan of the Federal Reserve cut interest rates creating an explosion in the money supply.

In the 2000’s we had a combination of both. George Bush cut taxes that were financed through massive deficit spending, and the Federal Reserve cut interest rates to record lows creating a massive explosion in the money supply.

This environment created a world of booms and busts, where the previous stimulus created the next boom and then the subsequent bust, which was followed by the next stimulus.

This process continues today. The financial crisis of 2008 was due to the massive stimulus provided after the stock market crash of 2000.

In order to face the 2008 crisis, our leaders have used the same prescription although the new strategy has been put on steroids.

President Obama took our record setting annual deficit from $460 billion up to $2 trillion in order to stimulate growth. We continue to run $1.5 trillion deficits annually as a means to fight the economic slowdown.

The Federal Reserve has taken interest rates down to zero, and has now embarked on what is known as Quantitative Easing where they print money to purchase various forms of debt in order to keep interest rates low.

This strategy put a bottom to the economic downturn in some ways in March of 2009, and since then parts of the economy have been in continuous slow growth.

Other parts of the economy such as real estate, employment, and consumer spending continue to stay in a depression which began in December 2009.

In the face of every economic downturn over the past 40 years of global fiat currencies, governments had the opportunity to cleanse the system of the excess by allowing banks, companies, and investments to fail.

They were faced with this decision during the financial crisis of 2008, and they decided not to take the medicine. Instead of allowing the losses on the banks balance sheet to be cleansed, they nationalised the banks and put the losses on the backs of their country’s tax payer.

When this decision became clear during the week of the AIG and TARP bail outs of over $1 trillion, which was echoed by various governments around the world with their subsequent bail outs, the next crisis became crystal clear.

The sovereign debt of governments around the world would not be able to support both the toxic balance sheets of the banks as well as the already bloated debt they were currently encumbered with.

There would be a day of reckoning when the countries were unable to pay, bringing the next global financial crisis. The only question at the time was: When?

During the financial crisis the first sign of trouble came in the form of a California subprime mortgage broker named New Century who shocked the world by shutting their doors due to surprising massive losses on their darling subprime loans.

This was the first domino in a chain that led to two massive Bear Stearns hedge funds failing, the credit shock waves during August 2007, Bear Stearns failure in February 2008, Indy Mac, Countrywide, Fannie Mae, and Freddie Mac failing in the summer of 2008, and Lehman brothers bankruptcy followed by the collapse of the financial system in the fall of 2008.

When New Century failed and the first domino fell, most analysts could not imagine, never mind predict, the contagion that would subsequently spread over the next 18 months.

Why is this important?

Because the same set of dominoes are currently falling in real time as we move through the next crisis in sovereign debt. Let’s discuss where we’ve come so far, and this will bring us to where we go from here.

In the fall of 2009, the city of Dubai shocked the world (sound familiar?) by announcing that they would be unable to pay their debts without support from near by governments.

They received the bail out package they needed, but their trouble set the stage for the coming sovereign debt storm.

Six months later in March of 2010, credit spreads began to blow out for the government of Greece as investors began to understand that it would be impossible for them to service their debts.

A bail out packaged was put together soon after to temporarily quell the nerves of investors and stave off a national bankruptcy.

Only a few months later Ireland found themselves in the same situation as investors began to “run” on their debt and interest rates began to skyrocket.

Their bail out package was announced a few weeks ago, and investors have once again found themselves in a state of complacency that the worst is behind us, and the sovereign debt crisis is contained we as move into 2011.

Let's take a look now where we go from here.....

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