Shibboleths and self fulling prophecy, betting on the next financial crisis - Lets

Would it be good to know what’s going to happen in the future? Planning for retirement and investments would be easier if you could see the future.  Being editor of Let’ I am constantly looking at ways to take a bet on the future. Not an easy task by any means, because, that’s a bet you don’t want to lose. Especially if you are investing for retirement or family.

What to do? Long story short, with no employer pension and no prospect of having an employer to pay into a pension, who’s going to save me from this quandary? That’s that’s right no one! WAIT, no sorry, ME. Of course there’s financial advisers and other industry professionals, but by comparing bets, we surely stand a chance of winning more wealth.

Readers may want to use this post to frame thoughts about how to plan for a financial future-self. What does the future look like? Comfortable retirement, new house, it’s all in the realms of possibility.

Out of a fear of being on the wrong side of financial markets a question preoccupying my mind has been when will the next financial crisis hit, what is going to happen and what it means for the future. Many other people are asking similar questions.

Cutting to the chase, YES, another crisis is going to happen. Possibly in the next 24 months. But, why, how, and for how long.

To answer this question, readers may want to ask how deep does the rabbit hole go? After a bit of digging about this subject, the answer is unsurprisingly really deep. A better question is, if I where a rabbit, how deep would I want to scurry into the rabbit hole? Bearing in mind, ‘going all in’ with managing personal finances is a big bet (if you think about it): so it’s not going to be something you can scribble on the back of an envelope (except possibly the following words, dollar hegemony, shibboleth, self fulfilling prophecy, financial institution, cooperation, and gold).  Read on to find out what the hell we’re talking about.

In the words of Deutsche Bank emanating from their annual long-term asset return study “ we’re quite confident that there will be another financial crisis/shock pretty soon”. For the purposes of this post we’re going to roll with Deutsche Bank’s definition of crisis (all from October 2017 prices); a 15% drop in the equity market (or more), a 10% fall in government bonds, or double digit inflation”. Interesting, there no mention of deflation in this definition. Deflation is definitely a bogey man for mainstream economists and politicians. Deflation would be bad for Wall Street, The Square Mile and main street (the man on the street).

Having started in 2009 the current economic expansion (although it may not feel like that for some people) is the second longest period of expansion since WW2. May 2018 marks the date making it the longest period of economic expansion in recent times. Taking a simple look at previous cycles a crisis will probably be caused by a recession or abrupt slow down in economic activity. How is it going to play out?

To answer this question without help, as a layman, would be like pissing in the wind. Let’s face it, what do I, you, we, know about economics, and how is it going to be possible to predict what hasn’t happened yet? Understanding economics in a bit more detail is an essential ingredient of tackling this question.

We have assembled a team of experts to help in our quest. This post will focus on the macro economic view point and suggest ways to place financial bets moving forward. Reader’s will notice a big slant towards what’s going on in the USA. The USA is the global command economy and what happens there will ripple across the pond (both ponds). To take teaching from the Sage of Omaha (Warren Buffet CEO and Chairman of Berkshire Hathaway) “ don’t bet against America”. Wise words.

Who is going to help us see the wood for the trees?

Our A-team consists of two economists, a hedge fund manager, a lawyer, a historian and a physicist. All are commentators about current affairs and what’s happened in the past. An almost random selection of people to answer the question. You may have guessed it, this post is not going to be a short one, be prepared. Here’s our list of experts, not all to be used in the post directly but have been indispensable sources of information.

The economists
After stumbling upon a book called ‘The Accidental Theorist and other dispatches from the dismal science’, the Author Paul Krugman, is going to be the first economist to help. Krugman’s book is well written with short essays and witty criticism of other economic ideas. I also digested this book quickly as it’s easy to read and light on complex theory, equations and the like. Mr Krugman is a American economist (Professor of economics at Princeton University USA and a Nobel Prize winner). Published in 1999 during the Clinton administration (you know, I did not have sexual relations with that women!, and generally well received welfare reforms and economic policy), it is great because his criticisms of other economic ideas can be assessed using the test of time. Krugman specialises in recessions making him perfectly positioned to help.

Steve Keen is an Australian professor of economics and head of School of Economics, Politics and History at Kingston University London. Contributing to the subject by studying instability in financial markets. Influenced by Hyman Minsky (and others) he’s built mathematical models that help predict the future. Being a straight talker he’s unlikely to win the Nobel Prize, in my view making him a perfect fit for this task. His material includes books, and Youtube content – which is more detailed than output from Mr Krugman, which is more marketed towards the mainstream.

The hedge fund manager
Ray Dalio, billionaire hedge fund manager of Bridgewater Associates. Having built up the worlds largest hedge fund Mr Dalio has taken a more public profile, is writing books and doing interviews. Hedge funds have been a source of economic crisis in the past making Dalio a good selection. During the economic crisis of 2008 he made a group of wealthy people even more rich so he is popular with his clients amoung other people. As rich as Mr Dalio is, his books and commentary have not been produced out of necessity but from generosity, so he’s making the cut for our A-Team of advisers. His views are mainstream. His hedge fund is so big that it takes a command position in the markets and may also be contribute to future instability. Cynics may mumble that a multi billionaire hedge fund manager writing a book is a sure fire contrarian indicator suggesting something is about to change.
Great economists of yesteryear have described the economy has being a delicate machine, which is perhaps by Mr Dalio has released a video called “How the economic machine works”, which has helped me with a general understanding of economy. It’s simple but doesn’t make you feel like a simpleton, so it’s worth 30 minutes of your time. Here is the link. Bridgewater associates have made it available in multiple languages, they’re clever guys at Bridgewater Associates.

The Lawyer
James Richards was the lead lawyer for the bailout of Long Term Capital Management, which collapsed in 1998, and has given advice to US Government agencies. Mr Richards made the New York Bestseller list on a number of occasions. His geo-political insights make him stand out from the crowd as does his apocalyptic narrative of current economic affairs. He has said the US Federal Reserve is involved in what he calls “the greatest gamble in the history of finance”, making him a perfect source of information for Apparently Ray Dalio makes his trainees read Richards’ book, Currency Wars, when they start working for him. Richards is a good communicator and helps make complex geo-politcal interactions comprehensible for the uninitiated. One of his projects it to tinker with a predictive analytical systems that use techniques and methodology not used by the big banks.

The historian
Mary Beard professor of classics at the University of Cambridge, UK. Beard has written a number of books and presented history programmes on the UK’s BBC and brings us a classical historian’s view point. Her book SPQR A History of Ancient Rome provided me with a number of light bulb moments regarding elitism, taxing the rich and the formation of institutions at grass roots level. SPQR is the Romans’ own abbreviation for their state: Senatus Populus Que Romanus, ‘the Senate and People of Rome’. This book gets into nitty-gritty of early Roman Empire and readers will get a proper understanding of how historians ply their trade. An understanding of the rise and fall of empire will help with answering our question, if only to discount the chance of a catastrophic bear market. There is no better place to look than Ancient Rome.

The physicist
Michio Kaku is a Japanese American theoretical physicist and professor of theoretical physics at City College of New York. Physics and especially theoretical physics is a good base to help answer this question of what the future holds, because, theoretical physicists are trying to work out how everything works. If you really want to see the wood for the trees, then check out Mr Kaku’s futurologist views in this video. In Mr Kaku’s view we are a multicultural, scientific and cultural society moving into a type 1 economy (among other things).

Economics is a brainstorm of ideas given by clever people using complicated (for me anyway) mathematics, alluded to in Krugman’s book. He mentions the close connection between economics and politics. Adding politicians into this mix of ideas causes some economic ideas to gain traction more than others, and it doesn’t matter if they are patently wrong (in Krugman’s view). As the name of the book suggests. Economics becomes influenced and perhaps twisted by positive and negative attributes of human nature. Economics and politics are not mutually exclusive and can not be separated.

Two sections of Krugman’s book ‘jobs, jobs, jobs’ and ‘a good word for inflation’ are particularly useful for understanding our economy. Jobs help create a stable society thus they are important to economists. Key drivers of economy and job creation are interest rates and inflation (price inflation and money supply).

Krugman’s expertise stems from crisis economics. As the number of financial crises have increased over any given decade Keynesian economics is at the fore front of what’s happening now in the UK, USA, Europe, Japan etc and what will happen in the future. Quoting from Keynes at the start of the book it is evident that John Maynard Keynes is a major influence.  Reading this book in 1999 and by reading between the lines regarding Krugman’s subtle references to Keynes readers may have been able to predict what was to come 9 years after it was written (in the same year Long Term Capital Management collapsed).

Do you know what a shibboleth is? Nor me, or possibly you do, but Krugman’s book links shibboleth type behavior to when economics is used for political ends. It was said “ simplistic ideas in economics often become badges of identity for groups of like-minded people, who repeat certain phrases to each other, and eventually mistake repetition for self-evident truth”. I should rephrase what I said, I do know what a shibboleth is, it’s just that I didn’t know it was called a shibboleth. God! if you look hard enough you will find or could mistakenly find shibboleth behaviour everywhere!

Back to economics, the book goes on to say that public discussion at the time was dominated by people who want growth or people who want stable prices (they don’t want the costs of a new car to go up 20% per year and they want to be able to afford a pack of butter without it burning a whole in their trousers). Those wanting stable prices argued that growth (what they mean is economic growth of 4% per year which was the political discourse of the time) comes at too high a price, literally because it causes price inflation which can cause wage push price inflation which spirals out of control. Those in favour of stable prices are also deemed to be ill advised. Evidence for this assertion rested upon what happened in Canada at the time, which was a period of stable prices. In 1999 they had 10% unemployment. From 1992 to 1994 47 percent of collective bargaining agreements involved wage freezes. This inadequate wage flexibility resulted in unemployment. If you judge success in terms of employment (which most politicians do now) targeting price stability failed. Those with jobs may not have thought so, but, what about the other 10% of the working population?

Krugman advocates not sitting in either camp and goes on to explain a shibboleth free solution, which is very similar to what the USA, United Kingdom and Europe have been doing (in different ways) since the financial crisis of 2008. That is to target low but not no price inflation (as measured by the preferred metric of the time) between 3 – 4%. The mantra went some inflation is better than no inflation.

During times of crisis like a serious recession or a depression the response would be to follow Keynesian economics and manage the amount of aggregate demand or total spending in the economy. That is what has happened and what will happen in the future.

This is where central banks come in. Krugman explains what the Federal Reserve bank of America can do in order to optimise the economy. He uses a model described in his previous book called Peddling Prosperity. For anyone wanting to check it, it was called “ Monetary Theory and the Great Capitol Hill Baby-sitting Co-op Controversy.” A collection of young couples who mainly worked on Capital Hill wanted baby sitters for their children. This group got together and agreed to baby sit each other’s kids so that they could go out for dinner and such other entertaining things. Settling on a script system members where issued with coupons worth one hour of baby-sitting time. The coupons allowed them to pay each other to babysit. Eventually each couple did as much baby sitting as they got in return because they had to earn their coupons to pay for babysitting. A certain amount of coupon was required to keep the system going. When the system was tested by the vagaries of their social calendars it started to grind to a stand still. An impromptu recession occurred. Some couples had special occasions they wanted to attend as well as the odd night out causing them to hoard coupons to pay for babysitting for a number of consecutive nights. They became reluctant to go out on the odd night out because they where saving coupons for special events, thus, depriving other couples the opportunity to earn coupons. The problem? There where not enough coupons in the system. After adding more it started working again. Simple.

Hoarding coupons caused a liquidity problem. If a couple wanted to also buy a house with the coupons (if they where allowed to use coupons to buy a house), hoarding would have been even more of a problem. It is a special event and costs a lot of money. Consider house prices in the United Kingdom (circa 2017) and the sort of drag that must cause on the economy (especially for those who do not have the bank of mum and dad or do not want buy a new build house with Government subsidies).

A simple study to highlight one of the key take away points from this book and for indicating what has happened since. What can the Federal Reserve or the Bank of England do to maintain the inflation target? Following Keynesian economics they turned on the money taps to ease up the system and boost aggregate demand (demand side economics). There has been no problem with supply because we have just finished a long period of economic expansion where capacity on a global scale grew massively.

Krugman explained problems that Japan’s economy had experienced at the time and have been having since. His solution was for them to “PRINT LOTS OF MONEY”. Something they have recently started to do under the present political administration, coined Abonomics. So he got it spot on even it was 10 years before they did it.

The magic money tree

Central banks have dealt with each crisis by harvesting the money tree to increase aggregate demand in the economy. Here are some techniques central banks have for adding more money to the system.

Lowering interest rates. Lower interest rates increases demand for loans which banks are willing supply. Each time a loan is given to a person or some other legal entity money is created. Our fractional banking system allows banks to hold a small fraction of assets in reserve allowing them to lend out many times what they have in deposit accounts. Making the system unstable in time of liquidity crisis (when suddenly there is not enough money in the system / or in the right places).

When interest rates hit zero that’s when quantitative easing and other financial trickery is used which can come under the phrase money printing. That’s where we are now. Something that has not happened since the 1950’s after the second world war.  Experiments are being conduction with different ways of creating money to massage what is called the yield curve for the USA Treasury market.  The largest market for Government debt in the world.

One of the consequences of pumping money into the system is that it has inflated the stock market, and the bond market, the housing market, markets for art, classic cars and other collectables. This has caused the biggest wealth gap between the richest and poorest since the period of 1935 to 1940. When the wealth of the top 1% of the population was equal to the bottom 90%. People have coined it the everything bubble.  However, to the credit of the authorities prices for food, electronics and various other goods have not seen unreasonable inflation, so the people on the street have not be deprived their basic rights. One of the reasons touted for the rise of the Nazi party in Germany in the 1920s and 1930s was due to a population annoyed by price inflation and lack of basic necessities like food. Driving them to do crazy things which history is testament to.

Paul Krugman acknowledges the existence of economic cycles in his book and warns against drawing too many parallels with the past, possibly because the previous debt cycle ended up with World War 2. Ray Dalio’s video linked to previously goes into the existence of economic cycles in more depth, particularly the debt cycle. After a 30 year build up of credit how is this going to be worked off?

Beautiful deleveraging

After coming to the end of a long term debt cycle that culminated in 2008, debts are being work off. Ray Dalio explains what policy responses have been and what to expect in the future, here’s a video link, and the video linked to previously explains debt cycles. Shorter term business cycles are driven by the expansion and contraction of credit supplied by a financial network of companies.  Deleveraging has been beautiful so far because central banks have found a balance between policy that causes inflation (printing money) and policy that causes deflation (debt write downs; austerity; wealth transfer of west to east and rich to poor; and reductions in the Fed balance sheet).

Had the Fed, Bank of England and other central banks not done this we would have got a deflationary depression, similar to what happened in the 1930s USA.

Other key points from Ray Dalio

  • one man’s debt is another man’s asset, so effecting the value of that debt through policy responses has geo-political consequences (viz China, who holds a lot of US treasuries)
  • debt to income ratio needs to be reduced. The last time this happened in a big way was after WW2 in the UK and The Great Depression in the USA. Currently the ratio of debt repayments to income is gradually reducing.
  • positive growth in emerging markets will help ease this process: reductions in the value of the dollar help this because the dollar value (principle and interest payments) of emerging market debt goes down. This is good for the world economy and started happening circa 2017.
  • policy should be focused on export related growth.
  • in view of policy response from the USA and around the world Dalio expects inflation to be the biggest risk long term, with deflation being the risk short term.
  • complex systems have a tendency for extremes (various example of this exist, e.g The Weather, crazy and evil political parties like the Nazis).
  • policy response needs to be to get money into the hands of people who will spend it. Think of the UK help to buy scheme for house purchases and the car scrappage scheme. Both initiatives to channel money to spenders.

Looking at history the last two times when interest rates where zero was in 1937 and 1950. What are the similarities now?

Between 1929 to 1933 there was The Great Depression (amoung other things the 1930s brought the USA where Al Copone and prohibition of alcohol – crazy time indeed). It was a prolonged period of economic contraction, austerity and debt write downs. They printed money in the early 1930s. That’s what we’ve had since 2009. Interest rates were zero in 1937 and the stock market surged. Then a slight tightening of money policy at the time, similar to what is happening now, caused crisis. What happened next? WW2, driven by deep rooted and insidious core shibboleths helping a minority of people mentally destabilise a whole nation! Dalio’s (Bridgewater associates’) bets on the future are going to be affected in a large part by how conflict is managed politically.

Just a little more from Ray Dalio as he has been so generous with his insight and information. What are Ray’s recipes for success?

Ray punched his old boss in the face. He doesn’t mention if that is one of his principles, in any case not in the video. Hmmmm sounds like good advice to me!  Here’s the link.

Quick recap

We know the presiding economic theory behind what’s been going on is Keynesian. Steve Keen helps break this down, “Turn over of existing money in the economy plus money creation equals demand”. Paul Krugman indicated that it’s demand side economics that’s in fashion.

Professor Keen 

Prof Keen’s work and contribution to the debate indicates that the severity of a recession or depression is proportionate to the amount of change in money creation (going back to the debt cycle). If money creation goes negative then you get a 20 – 50% correction in asset prices, which is what happened in 2008. In a depression almost all asset prices reset, known as a Minsky moment (more on that later).

Between 1945 to 2007 credit and debt creation remained positive. The level of private debt to GDP peaked one year after the crisis in 2009. We have been deleveraging since, which rimes with the opinion of Ray Dalio. Prof Keen criticises the establishment for ignoring private debt when looking at economic policy and points out the last time the system was forced to reduce private debt was WW2. No country has got out of this situation by increasing debt except possibly where there has been an export boom. E.g. Saudi Arabia, Norway and Germany.Norway and Saudi Arabia have both focused on energy exports. Circa 2017 USA is setting up for a gas export boom.

Courtesy of a recent presentation Prof Keen did for the Green Party fringe. Here are some interesting charts. Here is the video link.

This chart shows the level of UK private debt.  It fell during World War 2 and started to rise in part due to financial deregulation in the Thatcher era.  Private debt has been shown to be reducing since the financial crisis of 2008.

UK Private Debt

Prof Keen believes the build up in private debt since the wave of deregulation in the financial sector since Marguerite Thatcher was a mistake and that it should be reversed. He does not say how it should be reversed without tipping us into a more serious depression.

Other conclusions from from Prof Keen is that private debt becomes the main destabilising affect on the economy and to society as a whole. As Dalio points out one man’s debt is another man’s asset so not paying that debt back via various means will have various negative consequences.

What’s the Lawyer got to say about all this?

The size of each financial crisis is getting bigger. James Richards sees progression of crisis events as non linear and exponential. Here is some back ground from Richards. In 1998 Long Term Capital management collapses. A hedge fund that collapsed and caused global financial instability. Wall Street bailed them out. In 2009 wall street collapsed which reverberated around the world, and nation states bailed them out. Each time the amount of money involved increases and the frequency of these events has increased.

The Wall Street collapse was like a domino effect. Banks where bailed out by sovereign wealth funds in 2007. Bear Sterns went south in 2008. Fan and Freddy Mac, the US Government sponsored enterprises designed to expand the secondary market for mortgages, where bailed out by the US Government in June 2008. Lehman Brothers failed in September 2008. The US Government ended up footing most to the bill by having to do to QE.

What’s next? Next it will be a sovereign debt crisis. When a sovereign debt crisis hits it will be the International Monetary Fund that provides liquidity to the system via special drawing right (SDR). That’s a whole different post right there, and this post touches on how the new SDR may work. This time very large amounts of money will be involved. Personally I do not think we are at this point now and any crisis in the next 24 months is unlikely to come from this, because, further QE would be required in order to push things that far.  Conceptually the SDR is an excellent idea and helps spread the economic costs of QE and monetary creation around the globe and should buy enough time before alternatives are adopted.  In reality this transition may not go as smoothly as people hope.  SDRs are also explained in this video by the International Monetary Fund available here.

James Richards lays out the case for introducing a gold standard again as an alternative to the SDR and has run the calculations to see how it would be priced.  In order to price the gold standard relative to how much dollar currency is in circulation and to not cause any deflation or inflation one ounce of gold would be worth approx $10000.  Personally I disagree with the price, but, not the calculation for working it out.  Setting a price at that level is essentially sending a signal to certain people in the global community that the USA can do whatever they like.  If they want to create 4 trillion dollars of currency (a currency that lots of other countries have to use due to the system we have all adopted) out of nothing then that’s the way it is.  Unfortunately others do not agree: influenced by religious idealogues, world history, and idiosyncrasies of culture.

Setting the gold standard price is a political issue.  Previously when a gold standard has been reintroduced they have set the price level lower than that required to balance deflation and inflation.  As such, a deflationary shocks occurred previously and would do now.

Of the two options; SDR, or gold standard, the SDR is currently the preferred route by international institutions.   Furthermore, China is pushing for SDRs to be used as the world’s reserve currency. Watch this space.

Looking back to look forward

Japan is the closest we have now to being a working example of where these monetary policies can lead. They’ve mimicked what is currently happening at the Fed. Have a look at this chart.

bank of Japan balance sheet

A contributor at Capital and Conflict featured a tweet from someone who spotted something interesting. The BOJ also tried tightening monetary policy for a while and look at what happened to their balance sheet afterwards. Changes to the size of the US Fed’s balance sheet has been laid over that of the Bank of Japan (which has been brought forward 10 years).  Look similar don’t they.

Roman Civilisation shows a long history of debasing coinage by adding other metals into the mix in order to add to the money supply (as it creates more coins). This allowed government to increase the amount they could spend particularly on wars either to maintain or expand the empire, and, then to service the needs of a larger empire. A seminar given in 1984 on Money and Government by Joseph R. Peden available from the Mises Library gives the full picture of what happened at the end of the Empire in terms of economy.

Paul Krugman warned against drawing to many parallels with the past and possibly Roman history was partly what he was referring to. James Richards has been influenced by history going by some of his prognostications, however, Roman Civilisation lasted from 753 BC to 1453 AD during which time they expanded the money supply many times over and survived for hundreds of years, even after Diocletian’s reforms.

Diocletian 284-305 AD
Between 280BC and 518AD the silver content of the silver Denarius fell from around 80% to 0.75%. Size, weight and silver content all fell. During the 3rd century AD the chaos that ensued after succession of one emperor to the next was said to have bathed the Empire in blood.

Dioclcletian decided on a set of reforms to bring the empire under control. Apart from political reforms his administration overhauled the monetary and fiscal system completely. For instance new coinage was brought in and the gold content of the gold Aureus was increased in an attempt to reduce inflation (by inflation they mean the expansion of coins in the system and price inflation of things like wheat and basic necessities). At the same time wage and price controls where instigated to reduce inflation. Under some estimates inflation was in excess of 10000% in the third centuary. It’s worth noting that there is a papyrus dated 335AD that shows that wheat prices where 6300% higher than when price freezes imposed by Diocletian came into affect. A clear signal that wage and price freezing do not work (something politicians in the UK may want to take note of). Other minor and major changes to the coinage where also carried out. During this whole period and up until now the buying power of gold has remained relatively stable. A gram of gold would buy the same amount of something like wheat during Roman civilisation as it would now. That’s why some people love gold.

Economists from yesteryear to listen to

Hyman Minsky is an economist who has given inspiration to many people.  A Minsky Moment could occur at some point. A Minsky Moment is a sudden major collapse of asset values which is part of the credit cycle or business cycle. Such moments occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money. Minsky hypothesised that stability itself is destabilising. In the case now it is central bank imposed stability.

What do I think?

Personally I don’t think a Minsky moment is due at least until central bank balance sheets of major economies around the world look like Japan’s, and that won’t happen until central banks in the USA, UK, Europe and China have done more QE.

I am going to use some arrows to give a quick synopsis of the run up to current times.

NICE 1997 to 2007

1997 to 2007 was like this. Known as a period of none inflationary continuous expansion.




financial repression

Since 2010 things have looked something like this.  Otherwise known as financial repression.  Actual inflation is probably higher due to the way agencies of government report the inflation figures.  There are multiple ways to measure price inflation.  The value of debt falls as monetary inflation continues upwards.  Everyone receives a pay cut in real terms.  All part of the cycle of deleveraging.  With this everyone helps with the process.  Personally it seems like the fairest way to do it, however, people with assets (property, stocks and shares, etc) have benefited so far from a larger inflation in asset prices.   Eventually wages will grow and that will increase the affordability of the debt load.  For this to happen there will be lots of political activity.  Productivity gains would also be a driver of wage growth.

If deleveraging remain beautiful private sector debt to income rations will continue to fall.  Governments ability to service the national debt will increase as tax receipts increase helping to erase high debt levels.

What is the fly in the ointment?

Have a look at the US National Debt clock. You might notice something about it. US Federal tax revenue is increasing a bit more slowly than US national debt. When I checked it took 14 seconds for income to go up by $100000, but, 11 seconds for US national debt to increase by the same amount. Even though private debt is reducing, national debt is going up.  In fact it’s going up more than tax revenue: about 27% faster or roughly $5.5 billion per week.

Central banks are committed to fighting deflation and there are many deflationary forces in the global economy.  In part due to large trading partners conducting currency wars (see Jim Richards’ book).  Due to a dogged determination to fight off deflation what we may end up with is even higher inflation coupled with low employment.

As central banks of the USA, UK, China, Japan and Europe all synchronise they will all gradually reduce the debt (some would say default on the debt) buy running high inflation.  Compared to the alternatives this seems like the most fair and least destabilising way of getting everyone to pay a little back for enjoying the good times.  Private debt to income ratios will really drop when wages rise.

Many things now stand us apart from ancient history in so far as we have not seen run away price inflation of goods and services. Why is this? Freely floating currencies that are valued relative to one another: that do not fluctuate to really extreme levels and productivity gains through the adoption of technology are probable causes.  Technology advancements have permeated all levels of human activity from food production, commodity resource extraction, and consumer electronics: and that’s just the tip of the ice burg and it’s not even touched upon the coming revolution of technological changes, viz, automation, electric vehicles, artificial intelligence, block chain use in finance, energy markets and other things, quantum computing, humans beings more active in the solar system, quantum science, energy development and transport systems.  Adopting some new technologies will require large scale infrastructure development, making it more likely more QE will be needed to pay for it.

What about human nature?

Something that can not be discounted is that even the most rational and economically literate of politicians, market participants and scholars may not escape shibboleth type interactions. Currently it is Keynesian style economic responses, the inexorable quest for economic growth and use of liquidity to increase demand that may itself end up being a shibboleth style situation. Taking history as a guide mainly from the late Roman Empire it’s clear that extreme monetary conditions can endure for a long time and longer than our lifetimes. Strong international institutions like the International Monetary Fund, forums like that held at DAVOS, and OECD meetings will be able to keep things going for a long time. Strong financial institutions have fostered cooperation between nations that has seldom been seen. The physicist, Michio Kaku makes comment about this in his video about futurology, see the link above top.

Regarding what is going to cause the next crisis in the next 24 months is more likely to result from self fulfilling prophecy. Another quirk of human nature that almost no one can escape completely.  October 2017 marked the start of the Federal Reserve reducing the size of it’s balance sheet. Selling securities into the open market is a non starter as it would cause massive in balances and negative affects in those markets (a large supply with not enough demand). Instead securities held on the Fed balance sheet can just be allowed to mature. Interest payments and principle from these maturing securities will no longer be reinvested in the market, thus reducing reserves held in the banking system.

The Crux

Bringing us to the crux of the question, what is going to happen in the next 24 months. Will the Fed’s actions be monetary easing or monetary tightening and cause inflation or deflation?  A serious amount of conjecture surrounds this point.  Ray Dalio mentions the Fed has done a good job, so far, of getting the balance right. If banks have repaired balance sheets sufficiently (after increasing their reserves and unwinding some financial commitments) by using the help they have received via the central bank they should be able to increase lending enough to make the net affect of balance sheet reductions zero. That’s a big IF.

Ray Dalio and James Richards both indicate that risks to the market will come from monetary tightening which ends up being more than what the market expects. Richards mentioned balance sheet reduction is just another form of monetary tightening because it pulls money from banking system reserves which would reduce their ability to lend (depending on the health of the bank’s balance sheet on a case by case basis).  After digging a bit further and checking some figures let’s see what might happen.  Wall Street and major global banks where in full-on party mode for the years running up to 2008.  BANG! There’s a black hole in their balance sheets.  Where’s all that money gone?  Who knows.  Strippers, Champagne, gold platted Bugatti’s, and diamond encrusted dog collars. US authorities step in with $3.7 trillion dollars and save the day.  Other central banks around the world follow suit. This allowed the global banking system an opportunity to start an orderly reduction in lending (deleveraging of private debt).

Now the Fed is going to deal with the $3.7 trillion of securities sat on the balance sheet, which it shouldn’t have under normal operations.  As the securities on the Fed balance sheet mature they will not reinvest the funds they receive from payment of principle.  The principle payments will not being reinvested into the system (lending banks like those on Wall Street).  Consequently banking system reserves shrink and it permanently takes money out of the system.   Definitely a form of monetary tightening.  Manmohan Singh, a senior economist at the IMF, wrote an argument for FTAlphaVille for why balance sheet reductions could have an easing affect.  Reducing the reserves given by the Fed (which come with strings attached and restrictions) will free up bank capital that can be used more efficiently and for more economic purposes.  A reasonable proposition but, it would probably involve a good dose of pain before this takes affect.

Balance sheet reduction will be phased in and expected to reduce the balance sheet to below $3 Trillion by 2020.  Reductions will increase over the next 3 years until they hit a cap.  A intelligent and well considered solution to the problem.  Something that has changed since Roman times is that monetary policy and the creation of monetary architecture is the job of a group of well educated people: independent (depending on your definition of independent) from the political machine.  Something I bet Diocletian wished he’d thought of.

Disclosure, I am no expert on these matters, so, readers are welcome to set me straight if you know more.   As the level of balance sheet reduction starts to withdraw a significant amount of money out of the system a time will come when it starts to impede the operations of normal lending banks thus reducing their ability to lend money. Interest rates would need to rise so that banks can attract more deposits.  As Mr Singh noted in his article linked above “a leaner central bank balance sheet, if it doesn’t result in a tightening effect, could justify a much higher policy rate in this cycle than currently being anticipated”. As such, during the next 24 months the most likely trigger for a crisis or stock market correction will come from rising rates.

Problems may occur if trading partners and other onlookers around the globe take umbrage to the size of the USA’s magic money tree and the why in which this process of reducing the money in the system is managed.  If participants in the global monetary system lose confidence and no longer trust it, the USA would need to raise interest rates to restore faith in the dollar system.  When Deutsche Bank set the definition of crisis we are using in the post, the part about 10% drop in government bonds refers to this.  As interest rate rise, due to the USA winning back trust in the dollar, bond prices will have to drop for bond yield to increase.

The crisis becomes self fulfilling as it results from measures introduced by the central bank in order to help prevent the next crisis (Theory from the Austrian School of economics suggests as much).  But the next crisis is caused by the fed raising interest rates, the very solution used for stopping crisis in the future.

Rising rates would cause overpriced asset class valuations to reset thus triggering a chain reaction exacerbating vulnerabilities in the banking system such as lending based on inflated asset values and large derivative holdings.  Before this happens and triggers another big crisis similar to that in 2008 the Fed can, slow down or stop the speed at which it reduces the size of the balance sheet; and or stop increasing interest rates.

If a crisis ensues a stronger policy response will be required. Resulting in QE for the people.  Central banks may even preempt crisis by doing more QE. Giving people money to spend. Getting more money into the hands of people who have benefited the least from central bank policies. Prof Steve Keen suggests doing this by giving everyone shares in corporations. The proceeds from share sales would go to helping companies pay of their debt. Essentially a debt for equity swap with central banks supplying the funds. Alternatively more QE could come in the form of creating money to invest directly in infrastructure projects.

All this makes it increasing likely that the credit / money created will sit on central bank balance sheets indefinitely, storing up lots of inflationary pressures in the system.

Possible outcomes / causes for a crisis (chicken and egg)

Confucius advised against pissing in the wind, to be precise ” man who piss into wind get wet”.   But we are going to have a stab at some possible outcomes in view of what’s been covered in this post.

Probability / risk chart for a crisis before 2019 in either the UK or USA

risk chart for a crisis before 2019

  1. This is happening now.
  2. Assuming the Fed has got things about right with the calculations this is a more likely event.  Inflationary pressures are building in the UK and USA due to the currency price fluctuations with major trading partners.  The risk/probability is higher than scenario 3 because interest rates rising rapidly from very low levels would fundamentally affect treasury yields.  In turn changing the risk free rate, against which, all other investments are compared.
  3. Disinflationary recession is a 50:50 chance.
  4. Before 2019 this is a lower probability. After 2019 Stagflation would be more sensitive to political changes, especially in the UK.
  5. back to the 1930s, there’s no why central banks will let that happen again, as long as there isn’t another Pearl Harbour style event.

Scenario 2 and 3 are more likely to cause the next crisis.  Bearing in mind the preferred policy response of more QE asset prices would bounce back relatively quickly.  Disinflationary recession is shown as having less impact because it would likely result in more QE from central banks which would therefore cause a bigger bump to asset prices and the economy.  A disinflationary recession is more likely for a correction in share prices to turn into a bear market (when a 20% decline lasts for more than 60 days), especially if disinflation turns to deflation.

Here are some facts about stock market corrections.

  • Of the previous 44 declines of at least 10%, 19 became bear markets (20%+ declines). Roughly 50 / 50. A bear market is more likely if it coincides with the end of the business cycle evidenced by an inverted long term US treasury term yield curve; the 30 year treasury note vs the 10 year treasury note. The yield curve has not inverted yet. So if there is no serious recession they’ll be no bear market.
  • Bear markets tend to need the following ingredients; a recession, high unemployment and high inflation (of financial asset prices, and consumer prices).
  • This is entirely in the hands of the Fed as to whether they cause too much monetary tightening.
  • A 10 – 20% correction will normally bottom after two weeks.
  • About 20 stock market funds do 80% of the trading. These include Goldman Sachs, JP Morgan Chase and no doubt Ray Dalio’s Bridgewater Associates funds. Computer algorithms are used to fire trades into the system and super fast speeds, and may even be reading my posts! Who knows what parameters are set to trigger a correction (ha ha) but it’s the big guys that control market direction and momentum of the market.

A picture is worth a thousand words

global financial systemTo the left is my interpretation of the global financial system.  The networked part of the illustration at the bottom is courtesy of  They reported on computer scientists that noticed similarities between complex networks and how Google ranks wesbites using algorithms. The internet is awash with millions of websites which form a network of interconnections.

What is shown is the network created by the results of national football teams playing each other revealing the World’s All-Time Top Soccer Team. Teams are ranked highly if they have beaten other highly ranked teams. As the author writes, teams (or in our case banks/financial institutions) form nodes and the links between exist if they have played against each other.

Trading in the financial system is a competitive activity.  The network image produced roughly relates to the financial network between different countries. Circle size represents the amount of trade a country does, or equates to the amount of assets sitting on bank balance sheets. Strength and polarity of this link depends on how much business they carry out or the amount of money running to and fro.

A jumbled up collection of intersecting relationships result. Peripheral banks and financial institutions reside at the periphery. Money enters the system from the magic money tree at the top controlled by central banks, and, via international development banks. At the very top the IMF is there to keep the money tree alive. Proposals of how to keep the money tree growing are in flux, but, are headed in the direction that the Physicist Michio Kaku alludes to in his ‘Big Think’, available from the link at the top of the post. Trust and co-operation is what holds the system together. Money enters the system and permeates out through the network and has not caused inflation yet.

To finish 

  • Yes there will be a crisis, but, in the next 24 months the outcomes in order of likelihood are as follows, no crisis carrying on how we are now, getting more growth but more inflation causing rates to rise quickly causing crisis, disinflationary recession, stagflation where inflation is a a lot higher than growth, and last deflationary depression – all causing crisis.  In our view the most likely outcome does not result in a crisis in the next 24 months.  Some other event will cause a stock market correction that will not be a severe as a crisis and markets will trade sideways or increase in short order.  That event will be due to tensions in the international community.  20% chance of crisis and 80% chance of no crisis.
  • Any crisis that does happen probably be short lived and result in a bounce in asset values due to central bank policy, assuming World War 3 doesn’t break out!!
  • Inflation is the bigger risk longer term in view of Keynesian demand side pump priming of the economy.
  • ‘To big to fail’ theory of financial institutions has moved to sovereign states. In turn it’ll be the system itself that becomes too big to fail (which it already is, but, it’s not an issue currently).
  • Money is created and permanently added to the system. Normally if all those dollars where to stay in the USA they would have hyperinflation but if you take a look at the global economy you can see it’s very interconnected. The dollars permeate through the system which could be why there has been no high inflation (yet).

Where to place your bets

Investment strategy needs to discount that extreme markets reactions are possible albeit with less probability, and use some assets that are traditionally not correlated to the stock market. Disaster insurance would include holding  land, gold and hard assets.

Cash is a good alternative and provides options to the cash holder. During a crises it has been shown that all assets classes tend to become correlated. They all go down at once. Some assets are supposed to be non correlated but it doesn’t work out like that. By holding cash you can avoid a Minsky Moment. The amount of cash held in a portfolio should be proportionate to the persons opinion of the size and severity of the next crisis.

Holding hard assets or investing in mining companies could be a solution to diversify risk.  Copper, which is used heavily in wind turbines and in electric vehicles, is a commodity with a strong narrative.  The share price of gold mining companies have been shown to perform well in times of crisis, here is some analysis on this.

Carefully selected investments in emerging markets are a good home for some of a portfolio to cover against the risk that there isn’t a big crisis.

Further reading

In relation to long term outcomes for the system and how participants in the system might be affected readers may want to find out more about the concept of Gambler’s ruin.

Our team of experts all have a range of books or Youtube contents that is well worth checking out.

What’s Peter Schiff got to say about reported price inflation? Check his video.  Interestingly based on Mr Schiff’s estimate of inflation (which is similar to what it could be in the UK) the USA and UK could be well on the way to stagflation.  However, because the big banks referred to previously don’t recognise this as high price inflation assets like gold have not increased significantly in price.  Risk and impact of stagflation, in our view, is primarily political leading to 1970s still policies.

Who else should have made the A Team?

Ron Paul the founder of the Ron Paul institute should have been added.  Another person very generous with their content, amoung other things Ron Paul does the Ron Paul Liberty Report (see Youtube).  Interestingly his content would fall into the ‘alternative media’ category.  Mr Paul was a US congressman.  He is a libertarian and believes in US non interventionist foreign policies, and has done for a long time by all accounts.  Another reason this has been added after originally going to screen (the digital version of going to press) is because events in November 2017 regarding Ron Paul’s son, an acting US Congressman, ties in nicely with this post and a previous post about geopolitics.  Rand Paul has just been seriously physically assaulted by his neighbor who he hasn’t even spoken to in 8 years.  Rand Paul’s neighbour moved-in around the time of the Dot Com bubble crash in year 2000.  This incident got my attention faster than you can say Robert Ludlum (or dare I say it ….. conspiracy theory!).  Anyone who would like to get up to speed may like to watch this.

Open questions

When will velocity of money return to the USA?  Could it be tax cuts and US companies re-shoring their cash hoard and spending to invest?  Will re-structuring international trade agreements lead to outsourcing being reversed whereby people will be offered higher wage increases? Will the process of countries not using the dollar for trade (especially oil trade) gather speed?  If the size of the US Military machine (including the number of nation destroying Ohio class submarines, drones, scramjets, hardware fitted with atomic navigation)  grows in line with amount of dollars in circulation should investors just relax and let compound interest do the hard work?

If the dominant world reserve currency changes from Dollar to SDR how would this affect the size of the US military and it’s ability to operate military bases around the world?  This would be a very contentious point especially if gold is being used in order to calculate the value of the SDR as the federal reserve would be required to sell gold in order to spend SDRs.

Answers to open questions

Research on this topic has taken a look at history to try and figure out what’s going to happen next.  A academic visitor from Harvard University’s History Department, Paul Schmelzing, does a good job at presenting his and various research regarding how the present sits with what’s happened in the past with an interesting analogy giving us a possible glimpse into the future.  His work covers a larger data set over a longer period of time than Ray Dalio’s.

I suspect that most research will find consensus on one point; change will require some sort of trigger or turning point.

For those who don’t have enough time to read all of Mr Schmelzing’s post I have summarised some points that fit with the context of answering the question posed here.

  • Real interest rates (the difference between the inflation rate and the nominal rate of interest) have been in downward trend since 1400s Italy.
  • Within the longer term trend there have been shorter term cycles of real rate depression.  The author investigated what are accepted as being the last 8 cycles. Each one has needed a catalyst or trigger which can be financial, demographic, geopolitical or a mixture. Most cyclical rate depressions in history have been followed by inflation outperformances, but no always.
  • Some cycles where accompanied by specific economic circumstances, for instance, high savings and subdued inflation.

According to this research the closest historical analogy to today’s real rate depression is that of the 1880’s and 1890’s.

The author uses the following points as analogous to today using research available to him.

Following years of global infrastruture investment (think rail roads) global capacity peaked in the mid 1860s. A financial panic in 1873 ushered in two decades of deflationary price dynamics, and, a rise in global populism and protection.  Arguments remain about whether the period showed productivity growth but the period sowed the seeds of aggregate output growth in the late 19th centuary with the emergence of iron and steel industries and development in transport.

During this period of 1870 to the early 1890’s labour productivity shrunk significantly. Deflation at this time was caused by over supply and technological advances in the transport of good and services (supply side deflation).

The discovery of gold at the Klondike helped to increase the money supply which helped end this period of financial stagnation.  Gold supplies and therefore money grew at 4% per year.

Wage inflation started to outstrip productivity increases during 1885 which caused a recovery in general inflation. This is where I think we are at in the current cycle.

What we will see next are structural changes to help encourage more wage inflation and more QE to help increase economic growth to be more like 4% per year.  Price inflation targeted by central banks will really  be more like 4%. The difference with this example is that the stock market was at 15 lows in 1896 which is when William McKinley (a republican pro-business protectionist was elected).  After the turning point real interest rates normally snap back relatively quickly.

The author concludes that the last secular stagnation cycle started to fade naturally after a key financial shock not requiring the aid of decisive fiscal or monetary stimulus.  Mr Schmelzing also notes that rationale for the current system can be not found using history as a guide in it’s entirety.


To finish again

Using this period as an analogy there could be some time to go before wages increase sufficiently to pull us out of a period of secular stagnation to cause a turning point.

How the current turning point plays out is up to our politicians, the strucuture of global networks of the powerful and wealthy, as well as high ranking members of the worlds theocratic societies.

Apologies for the cynical under current of this final part. Human beings inherent bias towards self fulling prophecy and the events of the past my cause us to re-hash the past or possibly blaze a new trail which won’t involve
the pointless suffering of millions of people (that will require technological advancement). I would hypothise that as humans have evolved the death toll of the next turning point will follow a similar trend to that of the long term real rate of interest. If the current turning point remains part of a beautiful deleveraging it will require structural reform (protectionist reform) that doesn’t annoy other members of the global community too much.


September 2018

Interesting to re-read what’s been written here. Also it’s been good too see that some people have responded to some of the questions raised (thank you). Various parts of this analysis are playing out now. Stock market sectors, bond markets, and stock markets as a whole have adjusted to increasing interest rates.

Regarding the section ‘answers to open questions’ and the comments regarding Mr Schmelzing’s work. Mr Schmelzing notes in his work that change to the system as a whole will require a trigger. Steve Keen mentioned recently that he thinks environmental changes could be an eventual trigger, not necessarily to change the system as a whole but to cause big changes. Mr Keen has interesting views about how a global reserve currency should be
managed. In simple terms, interpreted by me, he thinks that digging shiney metals out of the ground and creating incentives for the use of fossil fuels should not be a factor in determining the backing of a global reserve currency. This would provide disincentives for people to hoard certain assets primarily the people that Ray Dalio refers to being in the top 1% of the global population. With these assets come power (which is how it’s always been). Personally I believe Steve Keen is well before his time on this one, which makes his work well worth following and contributing too. I think the contribution of nation states to technological advancement should be given more weight in constructing a global reserve currency; in fact based on James Rickards’
analysis of how the SDR is being constructed this is what they are already doing. The USA plays the largest roll, Europe is in there, the UK and Japan. It will be interesting to see how global economies and governments manage the transition of Asian economies. That’s a whole different story, will it all just break down into them and us or will the majority get on board with the changes proposed.

Something different

Some readers may be thinking, I don’t have any money invested in assets and I don’t have a lot of money to start doing this. I would be surprised if you’d got this far, but, there is another way to benefit from all the money sloshing around the economy.  Check out the profit accumulator review to find out more.

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