Throughout 2017 the world ecomomy has been hanging on… by a thread… held loosely together by various politically-inspired money printing initiatives by central banks. In tandem with this there have been various “bubbles”, particularly in the USA and UK founded on little more than rampant speculation. This is the age of “bubble economics”.
But how much longer can this be sustained, with investors, speculators and traders seemingly burying their heads in the sands, deliberately ignoring the fundamentals.
We think not much longer. We think that 2018 may well be a watershed when certain realities come home to roost. Read on…
Firstly a little recent history…
In 1998 financial panic almost destroyed global capital markets. Starting in Thailand in 1997, it rapidly spread to Indonesia and Korea. By summer 1998 Russia had defaulted on its debt and its currency collapsed. The resulting liquidity crisis caused massive losses at US-based hedge fund LTCM.
The upshot was a bailout of many of the world’s biggest financial institutions including Goldman Sachs, JPMorgan, Citibank, Credit Agricole, UBS and many more. Eventually, almost $4 billion of new capital was obtained from Wall Street, the US Federal Reserve cut interest rates and the situation stabilized. However it was a close call, and something nobody ever wanted to recur.
Hedge funds became more regulated in the belief that this would prevent another crisis. Yet ten years later, when the panic of 2008 hit, there was surprise that problems were not in hedge funds but in something new — US sub-prime mortgages. The collapse of the US mortgage market rapidly spun out of control and once again brought global capital markets to the edge of collapse.
In September 2008, Lehman Brothers filed for bankruptcy.. With US$639 billion in assets and US$619 billion in debt, Lehman’s bankruptcy filing was the largest in history. At the time Lehman was the fourth largest US investment bank with 25,000 employees worldwide.
In the ensuing global financial crisis almost US$10 trillion in market capitalisation disappeared from global equity markets.
So once again regulators set out to regulate and made mortgage lending much safer. And once again they have totally ignored future potential problems.
At this point it might be useful to mention that the five biggest banks in the United States in 2008 are today even bigger, carrying a larger percentage of the assets of the banking system. They have much larger derivatives books and, due to their increasing complexity, the risk in capital markets is now many times greater. So there is a situation where the US and global economies in general are far from good, with the whole thing being propped up by money printing by the US Federal Reserve and other central banks. And the current tinkering with interest rates and “quantitative tightening” is doing little to diffuse the situation.
The coming economic crisis, which is all but enivitable, is going to be much worse than the 2008 crisis (the effects of which, in case you haven’t noticed, are still not over). And it will be bigger than the US Federal Reserve Bank itself. Not to mention other central banks around the world.
We keep referring to the US banking system and economy simply because they are still the largest in the world and the US dollar is still the world’s reserve currency. Thus any major financial problem in the USA will quickly be reflected around the world. More on these issues in a forthcoming article.
Returning to our consideration of the next financial collapse. It will not come from hedge funds or home mortgages but from somewhere different, and this time it is likely to be so big that the Fed and central banks will not be able to contain it. There is simply insufficient liquidity… indeed there is a strong argument for postulating that many central banks are technically insolvent.
At this time of year, it is seasonal to think of snow and snowflakes. And it only takes one additional flake of snow to trigger off an avalanche. And a huge amount of snow can accumulate before that one final snowflake arrives to start the chain reaction.
Unfortunately skiers and climbers never know which individual snowflake actually caused the avalanche, but it is helpful to know what to look out for. Whilst today there are many possibilities, according to James Rickards, an American lawyer, economist, and investment banker, the following five snowflakes do appear highly likely candidates.
Snowflake #1: A credit crisis in China: China is actually in more of a credit bubble than the United States. The United States has many problems, but China is actually much worse, without the experience in dealing with such bubbles. With extreme levels of debt financed construction projects, real estate finance, flight capital, and oligarchs syphoning off money, the Chinese credit bubble shows little sign of abating. And this populous country has no experience in dealing with such levels of systemic risk.
Snowflake #2: Failure to deliver gold: This is certainly on the horizon. So much of the gold market is “paper gold.” This paper gold market is so manipulated, we no longer have to speculate about it. It’s very well documented. But it all rests on a tiny base of physical gold. The market can be seen as an inverted pyramid with a small amount of real gold at the bottom and a huge amount of paper gold resting on top.
The available amount of physical gold is actually becoming smaller, a fact which surprises many people. The might say, “But there’s 2,000 tons of mining output per year, and the gold that exists doesn’t go anywhere, so why aren’t stocks getting bigger and not smaller?”
However in reality it is necessary to distinguish between the total supply and the “floating supply.” The total supply gets bigger every year by about 2,000 tons, and when for example gold bars are moved from a warehouse in London to a Chinese warehouse in Shanghai, the impact on the total supply is zero. However the “floating supply” actually shrinks. This floating supply may be defined as the physical gold that is genuinely available to back paper transactions.
When you take gold from a London warehouse and put it in Shanghai there’s no impact on the total supply. But the floating supply shrinks.
Due to increasing demand for gold, primarily resulting from the ongoing debasement of fiat currency, vaults in Switzerland are being built as fast as possible, even by hollowing out mountains in order to create storage facilities capable of withstanding nuclear attack. Nevertheless storage capacity is finite and it is running out.
The physical gold is actually coming from some very large banks and their customers and being handed over to logistics and storage companies . On the other hand bullion banks like UBS, take physical gold and sell it 10 times over. That means there are ten claims for every ounce of physical gold.
So how does this end?
Someday, probably sooner than later, somebody is going to turn up and say, “I want my gold, please,” and the custodian won’t be able to give it to them.
What if a major institution wants its gold but can’t get it?
That would result in a shock wave likely to set off panic-buying in gold, and inflation expectations, now somewhat subdued, could spiral out of control.
Snowflakes #3, #4 and #5 relate to potential geopolitical shocks.
When rogue North Korea builds a nuclear program capable of targeting the world’s only superpower, that’s a snowflake (#3).
When China asserts territorial dominion over the South China Sea that pits it against key United States allies, that’s another snowflake (#4).
When Saudi Arabia is embroiled in internal strife and seems on a collision course with Iran throughout the entire Middle East, that’s snowflake #5.
Here we are simply making the point that a single snowflake can cause an avalanche. But of course not every snowflake does. Most snowflakes fall harmlessly, except that they make the ultimate avalanche worse because they’re building up the snowpack. And when just one more hits, no matter how small, the situation can spin out of control bringing everything down.
The global economic system is becoming increasingly unstable, and it might not take much more to trigger the avalanche.