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POSSIBLE U.S. ECONOMIC COLLAPSE
(Part II)
WARNING
Why These 4 Reasons Make the Economy Vulnerable

Imagine if a guy named John took on a bunch of debt above the level of income and potential income that would allow the debt to be paid off. John then tries to float the debt by taking on new debt to pay off old loans hoping eventually he would make enough income to pay off all of the debt - except his income continues to decline. Eventually creditors would not be willing to lend to him and he would default and need to start over.

This is the state of the U.S. government, except for one difference; the government's ability to print money to eventually pay off the debt at a diluted value. However, this makes the government's economic situation worse off than John, who would have defaulted. The below information more directly outlines the current U.S. situation.

  1. Because of the government's bailout philosophy and long-term policy plans, U.S. debt will continue to grow larger. Eventual rising interest rates will add to this debt load.
  2. The debt has to be paid off - If it is not paid off, we will default and collapse.
  3. Productivity and taxes normally pay off debt, but we are becoming less productive and tax revenues are declining rapidly. Also, dramatic tax increases to cover debt are counterproductive to the economy. Even a good case turnaround in productivity is not likely to be enough to service the rapid debt growth.
  4. We are resorting to printing money to pay off the debt, but this devalues the dollar, which hurts our creditors when they are paid back with money of less value than they lent out.
  5. Major creditors, such as China and Russia, are swiftly switching their policies to have less dependence on the U.S. dollar.

These factors alone can cause a flee from the U.S. dollar (i.e. a currency crisis), which would have a catastrophic effect on the economy. In the near term, it is not likely that a given country would make a bold move to run from the dollar as it would hurt their own economy to harm one of their most important customers (i.e. U.S. imports). However, much international tension has built during the crisis that makes the international community more likely to run away from the dollar in the case of an unknown event (e.g. another financial catastrophe, a natural catastrophe, a significant terrorist attack, another war, etc.)

On top of these factors and despite what the mass media is communicating about "green shoots" and economic recovery, the U.S. economic situation is not getting better. There are several economic factors existing and forming that could cause an exacerbation of the current situation to trigger a full breakdown of our economic system.

Status of the Banking System

At the core of our economic system is the banking system. Despite the mass media and government's claims, the banks are in bad shape with significant threats to their survival approaching in the near future:

1. The government's bank stress test results were not good, but still depicted U.S. banks as much healthier than they actually are.
a. The criteria used for the worst case economic scenario was about as bad as the current economic situation, and will most likely be surpassed within the year.
b. Recently changed accounting rules propped up the financial condition of the banks to favor better test results.
c. The banks argued aggressively with the government to release better than actual results so that shareholders and customers would not lose faith.
d. The tests were performed in a short period of time. Past bank stress tests have historically been quite inaccurate, and that is under testing processes performed over significantly longer time periods.
e. The tests focused on 19 banks making up about 70% of the banking industry. The other 30%, which are smaller more localized banks, face different kinds of current and approaching problems.
2. The banks need more capital to survive, hence the government bailouts and capital-raise requirements. The government estimates the banks will need about $600 billion to cover approaching losses. Given this total and the allotment to each loss category, it is highly likely that the estimate will miss the mark by hundreds of billions, if not trillions, of dollars. Several significant problems that have not yet hit the banks and were underrepresented in the stress tests are:
a. Residential Mortgages - estimated $1.1 trillion to $2.6 trillion in losses approaching from non-subprime Alt-A and Option ARM mortgages. Take a look at the below Credit Suisse graph to see the magnitude of resets approaching.

b. Commercial Real Estate - estimated $1 trillion+ losses starting in 2009 through 2013; 60% of commercial real estate lending comes from non-stress-test banks (smaller/regional banks)
c. Corporate loans and bonds - estimated $390 billion in losses to come
d. Credit card and auto loans - estimated $350+ billion in losses to come; most of the losses by 2010
e. Leveraged buyout (LBO) exposure - several hundred billion dollars in likely private equity leveraged buyout losses stemming from $1.4 trillion in deals made in 2006 and 2007
f. Interest rate swaps (IRS) - these derivatives add several trillion dollars of exposure in the event of volatile and/or rising interest rates.
Note: The TALF and other government programs are supposed to help stifle the blows from the coming residential and commercial real estate losses. However, so far the TALF has been extremely ineffective. Less than $20 billion out of $1 trillion has been activated because the associated underlying assets are not deemed as good investments. Additionally, most of the key approach through these programs is to support the asset-backed securities and to refinance risky loans. The ability to refinance is highly problematic with dramatically declining residential and commercial real estate values, let alone rising interest rates.

The diagram below depicts how the underlying problems are likely to play out within the banking sector, a current linchpin to the U.S. economy.

Diagram 1: Likely Progression of the U.S. Banking Sector and its Economic Impact

Below is further explanation of the above diagram:

  1. Given the banks current conditions and coming wave of losses (residential real estate, commercial real estate, LBOs, etc) described above the diagram, the banks will likely need to be nationalized as the government will not allow them to collapse.
  2. This will be done by converting bank debt to equity and diluting non-government shareholders.
  3. This does not remove the underlying asset and capitalization problems. Instead, the government will print money and take on more debt to cover the losses.
  4. The money printing and increased debt supply will cause a natural rise in interest rates (i.e. to drive demand to buy U.S. debt) and decline of the dollar. If higher interest rates stifle the ensuing inflation, they will also further hurt the economy (e.g. causes more defaults, harder for lending, etc). If inflation continues despite higher interest rates, hyper-inflation is likely to ensue causing an economic collapse.

Other Noteworthy Factors

  1. California (13% of U.S. GDP), New York, Massachusetts, New Jersey, and other states are having multi-billion dollar budget deficit problems because of rapidly declining tax revenue and over-spending. If this doesn't lead to further bailouts (and therefore more money printing and/or debt), their infrastructures and economies will further breakdown before a leaner spending structure can emerge.
  2. The Pension Benefit Guaranty Corporation has a $33.5 billion dollar deficit (tripled in the last six months). They also estimate that the auto sector has $77 billion in underfunded liabilities, with $42 billion not funded at all. Pension breakdown is likely to continue to rise with state pension stress rising and as the auto sector triggers additional pension cancellation in other sectors.
  3. Obviously rising unemployment, expiring unemployment benefits, prematurely rising interest rates, rising oil prices, and a weakening stock market will only exacerbate and add to the banking and broader economic problems outlined.

The banking and economic conditions, combined with the U.S. debt situation and money-printing practices, can lead to economic breakdown or more money printing to stave off the economic breakdown. The latter is the more likely case given the government's economic philosophy and direction during the crisis. However, this strategy only delays the inevitable as the underlying problems still exist. The resulting catch-22 of inflation and rising interest rates are what can cause catastrophe.

The economic dangers of inflation were touched on in an earlier section, but there are also several significant economic dangers of spiking interest rates:

  1. Loans (personal and business) based on adjustable rates are more likely to default or become more difficult to service.
  2. People and businesses are less likely to borrow or be able to borrow, which can actually be a good thing, but slows the economy in the short-term.
  3. The interest on budget deficits and the national debt increases, adding significantly to the country's debt load.
  4. Interest rate swaps (i.e. hundreds of trillions of dollars in derivatives) run risk of default.

The U.S. interest rate and inflation conundrum is unavoidable as debt is too large, productivity is too low, and money printing is our way of remedying the situation. The U.S. is vulnerable to an economic collapse through spiking interest rates, extremely high inflation (i.e. hyperinflation), or both spiking interest rates and extremely high inflation. The below diagram depicts the dangerous spiral.

Diagram 2: Inflationary Spiral Toward Collapse

Unprecedented Situation

Because of America's great history and foundations of patriotism, many have said that we've been through this before, the country is resilient, we've always figured it out, and we will again. Positive thinking can certainly work wonders, but it is also important to not let it cloud the logic behind the critical nature of the current U.S. situation. The U.S. has been a great country, but history shows that even great countries can fail.

As the first several graphs on this page depict, the U.S. is in a situation of unprecedented debt, deficits, and money printing. Additionally, the recent economic crisis has triggered problems in several sectors, and there are new, large problems on the horizon. All of this while policy direction shows little sign of an ability to fuel significant economic growth that might solve U.S. debt problems and cushion the coming economic blows.

The comparison has been made of our current situation to Japan's "lost decade" or the U.S. Great Depression with the assumption that this crisis likely can't exceed the pain of those periods. However, there are many differences in today's U.S. economic situation that remove much of the relevance of a comparison. Aside from these differences, key underlying factors that spared Japan and the U.S. from a severe economic collapse were:

  1. Japan had high savings rates and high demand for their exports (core to their economy) from healthy countries elsewhere. Although Japan did not experience a severe collapse, 20 years later their stock market is still around 80% lower than its peak before their crisis and they are experiencing continued economic stagnation.
  2. In the Great Depression and different from today's status, the U.S. had:
    1. High savings rates
    2. Excellent productivity increases to fuel the move out of the depression
    3. Countries with the wherewithal to purchase a strong base of exports from a key producer
    4. No weighty entitlement programs hanging over to add gargantuan debt levels to large preexisting debt
    5. High proportion of high character citizens that were not reliant on entitlement programs and better knew the value of hard work

July 8, 2009

(Part III will be posted in a few days)

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