Possible U.S. Economic Collapse

(Final Part)

July 13, 2009

Scenarios for the U.S. economy:

The conditions described to this point are enough to cause a severe economic catastrophe. However, the recent crisis combined with the current monetary policy direction, add extra elements to the equation that make catastrophe more likely.

Scenarios #1 and #2 below both stem from the Fed's plan to inflate (increase the money supply to cover the output gap) its way out of the crisis and eventually pull back the money supply once the economy begins to grow. The Fed knows it must rein in the money supply once growth begins, because if they do not, inflation will become uncontrollable. It is important to note that this has never worked in the past without experiencing heavy economic pain. However, the main problem with the Fed's current situation (unlike past crises and inflationary periods) is that they have virtually no ability to pull back. The Fed cannot effectively sell its balance sheet assets to rein in the money supply because:

  1. The political nature of the assets they have purchased and are propping up
  2. The long-term nature of the assets they have purchased
  3. The political nature of forcing interest rates up to appropriate levels

Even if they could sell off significant enough levels of balance sheet assets and increase interest rates to rein in money, an economic breakdown would follow because of the newly removed support of the latest grown asset bubbles within the economy.

Here are possible scenarios for the U.S. economy:

Scenario #1: Hyperinflation

Hyperinflation is the dramatic devaluing of the currency in the case of a mishandled money supply increases by the central bank. This has happened many times in many countries in recent and distant history, and is most likely when a country has a fiat money system (currency backed by no assets), a lack of confidence in the government, and significant national debt that the country cannot manage to service. To understand the conditions that lead to hyperinflation and the results that stem from it take a look at the hyperinflation periods experienced by Zimbabwe, Argentina, Brazil, Germany, and others. Once hyperinflation begins, government tools used to fight it may stop the process, but deep economic pain is not avoided. As outlined at the beginning of this section, the Fed has put itself in a unique situation in which these tools are unlikely to be effective.

Scenario #2: Deflationary spiral

As the Fed continues to put trash onto its balance sheet (which it has continually done during this crisis) and prices rise from inflation, there can come a point where the collapsing asset prices of the Fed's purchases will cause a panic for lenders (people and countries) to sell those assets at the highest possible price - getting their dollars back before the asset prices fall. As the economy prior to this scenario will be in pain from higher prices, there will be no production to replace the perceived value of the Fed balance sheet. The Fed will not be able to meet this elevated demand. Dollars would be quickly sucked out of the market causing them to spike in value (the opposite of inflation). Global currencies in turn collapse with the increase of the dollar and exports are halted. Locally, as the dollar rises dramatically, prices collapse and borrowing is stopped making the economy motionless. [Arbitrary Vote came aware of this particular deflationary scenario through an article by Karl Denninger of the Market Ticker blog]

Scenario #3: Long term stagnation and economic deterioration

The government's bailout and money printing policies distort pricing, hinder economic calculation, perpetually increase interest rates, cause fascist corruption, and leave no ability for genuine economic productivity to increase as entrepreneurs and businesses are discouraged from participating in the economy. Ultimately this is likely to create an environment that makes one of the above collapse scenarios more likely, but stagnation and slow decline can last for many years if not decades.

Scenario #4: Another economic boom and more dramatic bust

In the unlikely event that the Federal Reserve succeeds at credit expansion to turn the economy back to significant growth, the new growth will be based on the same artificial fundamentals as our recent two bubbles - the dot com bubble and the housing bubble. A new bubble would be larger and more far reaching than ever and would burst harder than ever, sure to break what should have been allowed to break during the last two bursts, but with added problems from the most recent government remedies.

Scenario #5: War

The worst case scenario, and hopefully the least likely, is war. Throughout history times of economic stress have spurred on wars for various reasons (protectionism, government breakdown and disorder, desperation, the belief that it is an economic net positive, etc).

Scenario #6: Sudden revolutionary breakthrough to avoid collapse

All of the above scenarios are doom and gloom scenarios. Unfortunately that is the reality of the situation. However, there is a reason for hope no matter how unlikely this scenario may be to transpire. A revolutionary breakthrough, similar in economic magnitude to the industrial revolution or the information revolution, could ignite powerful, genuine growth that would allow the U.S. to grow its way out of its dire circumstances. We have no way of knowing if this will take place, but a couple possibilities might be an artificial intelligence revolution or a breakthrough in a ubiquitous energy source, such as cold fusion.

Warning Signs and Triggers to Monitor to Foresee a Collapse Before it Happens

One event or a combination of several events can signal or trigger an economic collapse. Below are several events to keep an eye on to gauge the likelihood of a collapse:

An strong increase of treasury yields/interest rates - 10-year bonds are used to set mortgage rates. The Fed has tried to suppress these rates through expanding the Fed balance sheet and quantitative easing. Rates dropped shortly after announcing their plans, but have risen against their will since. A strong move above 4 or 5% on the 10-year yield could signal the abandonment of faith in U.S. Treasurys, or the ability for the U.S. to pay back the loans with money of held value. A spike in this rate can trigger a run on treasuries and a stifling of the economy. Additionally, the 1-month T-bill spiking above the current 0-.25% level could have a harmful effect.

A failed treasury auction - Throughout the year, the Fed holds auctions to sell Treasurys so that it may borrow money to fund the budget deficit. There can come a time when the supply of those Treasurys is so high and demand for them so low that not all treasuries offered are sold. This is a failed auction. We have already had a few auctions this year that did not fail, but interest rates on the treasuries had to be raised to entice people to participate, which sends signals that U.S. debt is not very attractive. If an auction were to fail, the consequences could be a run on the U.S. dollar.

A U.S. debt rating downgrade - The credit ratings agencies (Moody's, S&P, Fitch) rate U.S. treasurys just as they would any loan. The U.S. has long held a AAA rating on its debt. A downgrade of the U.S. credit rating would send a loss of confidence to its creditors and potential creditors which could cause rates to rise and an abandonment of the dollar.

A strong drop in the U.S. dollar index - A declining value of the U.S. dollar is a sign that inflation (the increase in the supply of money) is increasing and confidence is being lost in the currency. A strong dip in value could cause an abandonment of the dollar.

A bank holiday - Although unlikely given the potential for bank nationalization, a bank holiday could be ordered if the government believes the public has lost confidence in the banks and fears a run on the bank deposits. Bank business would be halted for a day or so to allow the government to absorb or prepare for potential losses.

Bank nationalization - Given the high probability of U.S. banks experiencing losses beyond existing losses and those projected through the stress tests, the government has put in place triggers to convert bank debt to equity. This is the technical way of saying that the government is taking increased ownership in the banks under the premise that it will instill confidence and health in the banking system. This process will be accompanied with the announcement that the ownership will only be temporary, but the magnitude of the situation makes this highly unlikely. As Diagram 1 above depicts, nationalization does not solve the underlying problems and can lead to a worsened economic situation.

Another economic boom - If a collapse does not happen first, eventually the Fed's massive money printing and credit expansion could artificially boost economic indicators and GDP. Given the likelihood that this would reach all parts of the economy (i.e. rather than just housing or a given sector) the size of the unjustified over-investment could lead to a much more powerful and deep economic bust.

Other economic signs and triggers - In conjunction and in addition to the signs and triggers outlined above, significant stress in the following economic areas could contribute to or trigger an economic collapse:

  • Commercial real estate defaults
  • Alt-A and Option ARM residential mortgage defaults
  • Credit cards and auto loan default increases
  • Life insurance company struggles from falling stock market
  • Private equity problems from past leveraged buyouts
  • Retail struggles
  • Oil prices rising
  • Food shortages from recent record droughts around the world
  • Default on commodities futures contracts
  • Interest rate swap defaults from rising interest rates
  • Pension collapse
  • Corporate bond defaults
  • Municipal bond defaults
  • State fiscal collapses
  • Collapse of Eastern European countries or other countries to spur contagion

Unknown disaster - Other events that could trigger economic turmoil in the economy's vulnerable state are:

  1. Natural disaster (hurricane, earthquake, flooding, pandemic, etc)
  2. Unnatural disaster (terrorist attack, escalation of international tensions such as Afghanistan, North Korea, Iran, etc)

What Can Result From an Economic Collapse?

Imagine if the money you have in your savings account, checking account, or U.S. treasurys, which you thought were all safe places save your hard-earned money, lost half or even 90% of their value overnight. This is exactly what can happen in our current situation. This can have a catastrophic effect on the economy and social well-being.

Further economic deterioration leads to rising unemployment. Unemployment benefits eventually run out. The government has added an extension to unemployment benefits, but hundreds of thousands of people are passing the time limit of the extension. People will have devalued dollars and in many cases no income or hope of income at all.

Historically this type of financial stress on a mass basis often leads to civil unrest. In an extreme economic crisis, unrest is possible in the U.S. because of:

  1. General desperation from extreme financial hardship
  2. Racial tensions because Obama ratings may drop and blame could be placed – Various races may attempt to place blame on one another.
  3. Class tension because of a large percentage of the population receiving entitlements and bailouts (handouts) while producing nothing. Entitlement and bailout outlays are increasing while ability to produce/create is decreasing.
  4. Class tension because handouts will eventually have to be cut back which will cause more stress and anger
  5. Class tension because of the mass perception of corporate and executive greed

Ideas for Preparation

With so many possibilities of how the U.S. economic situation can play out, it is difficult to know exactly how to prepare. Below are some ideas that may be helpful as you evaluate your own personal situation.

Protect your finances

A major challenge will be to protect your finances, especially since the normal safe-havens of treasurys, money markets, and cash are no longer safe. Verify what has been written within this webpage with other sources and evaluate your own situation accordingly. Arbitrary Vote is not offering investment advice, but here are a few ideas to help you think about such an unfamiliar situation:

  • Don't play the stock market unless you are intimately familiar with the economic situation and investing. There will be continued extreme volatility in the markets and a lot of known and unknown triggers for industries to collapse, while very few winners will emerge. PE ratios are still quite high. The stock market will rise if there is inflation, but the business and currency values won't. For example, Zimbabwe had the greatest performing stock market in the world during their hyperinflation, yet their economy was in complete collapse.
  • Diversify your investments. Precious metals such as gold and silver are strong with uncertainties in inflation, government, and currencies. Have at least a little gold and silver in your house as a safety fund. Also various other commodities do well in economic crises. Food/agriculture commodities could be a nice idea as they usually do quite well in inflationary environments, and food shortages are likely to be prevalent in the near future as recent major droughts and population growth are effecting food supply and demand.
  • Minimize your fixed income investment exposure, such as money markets, CD's, savings accounts, or U.S. Treasurys. The amount of money you have in cash should be minimal and as liquid as possible so that you can move money to safer places in anticipation of a crisis. Note that you want to try to figure out where to put your money before the crisis happens, as once it happens, it will be too late as your money will have already lost its value.
  • If you have significant debt, there are two sides to the payoff argument. One side says pay off debt as quickly as possible so that you don't run the risk of it becoming more expensive in a deflationary environment or with rising interest rates. The other side says don't feel the need to pay off quickly as debt becomes cheaper for you as inflation kicks in; plus the government's policy moves are likely to eventually give your debt relief anyway. Evaluate your unique personal situation and come to the best conclusion for yourself.
  • If relevant, get pension dollars as quickly as possible, or at least a strong understanding of your pension's status and funding source. Pensions are extremely pained and may not be reliable sources of income.
  • If relevant, accelerate receiving social security payments. Social security is extremely pained and a run can be made on it. Additionally, the government is likely to decrease payment amount and extend the point at which benefits may be claimed. Aside from the payment amount decreasing, the value of the dollar amount will decrease because of inflation.
  • Thinking of buying a house? Housing prices may still have a long way to go down for the following reasons:
    1. Foreclosures are still rising.
    2. Another heavy wave of defaults is on the way from non-subprime Option ARM and Alt-A mortgages.
    3. In many cases where the Option ARM and Alt-A problems don't cause foreclosure, they will cause early sales that will add to inventory and/or push prices down further.
    4. Many are leaving major residential real-estate states such as California, Florida, Michigan, New York, etc adding to inventory and/or hurting prices in those areas.
    5. Layoffs are continuing.
    6. Interest/mortgage rates are rising.
    7. Loans are harder to get considering interest rates and bank reluctance.
    8. The government's activity is artificially propping up housing prices (even though prices are still declining).
    9. The banks will eventually have to start moving foreclosed assets off of their books at lower prices or they will face bankruptcy/nationalization. Both scenarios are not good for housing prices.

This means lowered demand and excess and increasing supply. This translates to falling prices that will take a long time to bottom with a slow turnaround after the bottom. Keep in mind that after Japan's housing bubble and bust in the 80's, housing prices are still about 80% lower than they were at their peak.

This does not mean there aren't still a few decent buys out there. Be sure people are moving to and not away from the area where you are buying, and viewing the purchase as a long-term living investment (as opposed to a 2 or 3 year flip) will likely be your best bet. After all, houses are real and valuable assets that act as shelter and will still be standing even if the surrounding economy takes an unprecedented dive.

Other preparation measures to think through

  • Protect yourself and your family
  • Be aware of increasing crime
  • Self-defense skills could be valuable
  • Owning a gun may be valuable
  • A stock of extra preservable food
  • Communication plans and meeting plans with your family in case of emergency
  • Evaluate your city or region and its demographics, government, and economic situation. An accessible second home or family/friend home as a retreat may be valuable depending on where you live. Additionally, it may make sense to begin evaluating your country in a similar manner. Aside from the potential future safety issues in the U.S., you may be surprised to hear that the country ranks 6th on The Heritage Foundation & Wall Street Journal's Index of Economic Freedom and 36th on the Reporters Without Borders' 2008 Press Freedom Index.
  • Educate yourself - Understanding the situation and the potential outcomes is a major step toward proper preparation. Don't take this website's word for it. Compare mainstream and non-mainstream media and information sources and look at the facts yourself. Investigate economics, political, and financial books, blogs, and websites. A few suggestions are: Meltdown by Tom Woods, Peter Schiff books and blogs, Jim Rogers books and blogs, Ron Paul books and blogs, Mises.org, etc.

Some of these measures may sound extreme. All of it may not be necessary. However, in this environment, being mentally and physically prepared for the worst case scenario is a wise strategy as anything less, but potentially still harmful, will be easier to deal with.

If you have any questions, thoughts, opinions, ideas, or helpful information, feel free to post or discuss them within the forum. Updates based on new information and the evolving situation will be posted at the bottom of this webpage.

Note: All of the graphs within this report are cited. In the interest of time, much of the other statistics are not. Arbitrary Vote is happy to provide citations and background information on any of this information at your request.

India and the U.S. trump Italy as top gold jewelry exporters.