One More Time...Let's Understand This Economy Now

Last post, titled What You Should Know About Today's Economy, I shared an email conversation with my daughter, Andrea (this was originally written in March 2008).  In it I referred to some of the problems in today’s economy, and posed the question if we are in 1977 all over again.  Every one of you for whom we have prepared a written Retirement, Tax, and Estate Plan during the past four years have read a section discussing our current “socio-economic environment.”  Within that section we made some generic observations about interest rates, the deficit, the falling dollar, international trade, each of the investment markets including real estate, and many other topics. But, throughout those four years we have included in every engagement the following observation:

Corporate and Personal borrowing is at an all-time high. This is the major chink in the armor of the economy. Rising interest rates may force defaults, causing a domino effect on defaults – on corporate debt and home mortgages….The severity of massive debt keeps the economy in a more precarious condition that it otherwise would be; more critically, it keeps families with debt more precarious, while families with minimal debt will be cushioned against economic volatility...” Do you remember reading this in your plan? It’s been there for four years.

We may not be able to change the economic problems of our nation, but we can do things to insulate ourselves against them.  I will say it again: the last time we saw these economic indicators was 1977-1979.  Do you remember 1979-1981?  Let me remind you: falling dollar (this is the one to watch), 13% inflation rate, 13% unemployment rate, 21% Prime, 18% money market funds, 17% mortgages, $850 gold, $50 silver (remember the Hunt brothers trying to corner the silver market?), skyrocketing deficits, skyrocketing oil and food prices, money supply growing far faster than the economy, plummeting stock market, plummeting real estate, zero building, “stagflation,” and on and on.

We ask ourselves why?  The discussion of indicators is too exhaustive to make meaningful mention here, except to say that the world has changed since then.  Some of the similar signs are the falling dollar, which has fallen almost 50% against the Euro during the past few years. That suggests a terrible 10-15% inflation rate; after all, inflation is ultimately defined as “the value of the dollar.”

Some might ask, “Why has America been able to spend and spend and run such large deficits without inflation?  Without a day of reckoning?”  I’ll just mention two reasons we’ve been spared: (1) Free trade has allowed us to buy goods and services while keeping our costs down and enjoy a higher standard of living (incidentally, free-trade is also the #1 foreign policy to prevent war—people don’t go to war with people with whom they trade), and (2) Foreigners have been willing to finance our government deficit, allowing us to spend and spend without a day of reckoning.  More on this in a moment.

Who can veto Congress?  Who can veto the President?  The Fed?  No. Who can veto the Fed?  Hint: Many are not even U.S. citizens. Those that are buying U.S. Government Bonds—China, Saudi Arabia, and Japan, in that order, because they are the one’s financing our budget deficit.  They are why we have not had a day of reckoning. People can hate them all they want, but they pay for our Medicare, entitlement programs, and wars.

Now, what’s the problem with all this?  The problem is that, with the falling dollar, U.S. interest rate must, I repeat must, rise!  Those nations will not continue to finance our deficits if they can’t get their money returned to them, adjusted for the currency exchange rate!  They’d rather go finance the deficits of Western Europe!  Are our friends in Western Europe financing our deficits? No! They’ve got their own deficits.  And will the U.S. Government pay the higher rates, even if it breaks the economy as it did in 1981? Or worse?  Of course, because who would finance America’s deficit if it defaulted on its debt?

The Fed can lower short-term rates, but it has no control over long-term rates. That’s determined by the free market.  Inflation is, and interest rates will, rise dramatically!  What does this do to a debt-ridden nation?  See 1979-1981. BUT, perhaps worse this time.  Far worse.

A very wise and astute businessman made some quiet but urgent observations about our economy.  Members of the predominate faith here in Utah refer to him as “the Prophet.” Whether you are of the faith or not, he was a mature adult at the time of the Great Depression, and he has managed the business of a large multinational organization. He passed away a couple months ago.  He commented, “the economy is a fragile thing…there is a portent of stormy weather ahead.” (Gordon B. Hinckley, CR, 10/1998)  Later he again stressed the importance of getting out of debt and the shocks our economy could see (CR, 10/2001). And again recently (CR, 4/2007). Why don’t we listen to those that have been down the path before?

Why far worse?  In 1991 then Governor Bangerter appointed me along with two others to serve as three members of the Utah Thrift Panel to arbitrate claims brought by depositors against five failed thrift institutions.  Do you remember the S&L debacle of the late 1980s? And how it broke the FSLIC, needing a congressional bail-out? And caused a real estate collapse of 50% in CA, AZ, and elsewhere?  Now the banks are into mortgages, and the FDIC is no stronger, and the problem is many, many times larger. Unlike then, today the consuming public have been cannibalizing their net worth under the stupidity of home equity loans, living high, going to Tahiti, on equity that sometimes took generations to grow. The growth of the 1990’s was phony growth, spurred by spending that we did not have, and which is exhausted now.

Why far worse?  Maybe this is the clincher: Derivatives. Ever heard of them? Originally Fed Chairman Greenspan was against regulating them because they were a means to “reduce risk.” Derivatives are basically “bets” that some risk will or will not happen. Derivatives do not “reduce risk,” they “transfer risk,” in a zero-sum manner. What’s the problem?  Greedy bankers figured they could get rich off trading derivatives.  And they could do this without regulation, without reporting it to their shareholders on their financial statements, and by being highly leveraged, based on the bank’s credit rating.  Maybe they only had to put-up $1 for every $20 dollar bet, thus leveraging themselves 20 to 1, and as much as 100 to 1.

Get this.  Every major financial collapse in the past 20 years has been the result of derivatives, starting with Black Monday in 1987. Then the S&Ls. Remember the 223-year-old British Barings Bank brought down by a reckless hotshot 27-year-old trader?  Remember Orange County going bankrupt due to $1.5B loss in derivatives? Remember the collapse of the Asian markets in 1997?  Remember Enron getting caught in the squeeze, too leveraged to hide any longer? The collapse of Argentina? Remember the LTCM hedge fund collapse when the Fed organized a $3.5B bailout? And now the collapse of Bear-Stearns.  Why?  Derivatives on their mortgage portfolio multiplying the impact of the basic problem (sub-prime loans) many-fold.  It isn’t the sub-prime loans—it’s the derivatives.

How does all this happen?  And how does it affect you?  This happens when the bet is made, and a financially strong institution only has to put up, say, 2¢ on the dollar as collateral. But, if their financial rating gets downgraded, as happened to Ford & GM a while back, those holding the contract have to increase their collateral to double or triple. What assets do they sell to cover their bet?  Their bad assets? The derivatives?  No. They have to sell their good assets, their stocks. This puts selling pressure on the market, things worsen, and downward spiral begins. So, this isn’t just about derivatives.  It is about the banking industry, the stock market, and real estate. (Bonds would likely increase in value, which is the major asset backing the insurance industry.)

Two weeks ago, for the first time in history, the Fed pumped money into the ailing securities markets to save the investment bankers and brokerage houses from collapse, to the tune of $200 billion.  Now the Fed says they want to regulate not only banking, but also the securities industry, and virtually replace the SEC.  Will it happen?  Of course it will. “Them that’s got the money make the rules.”  The Fed’s got to “protect their investment.” And the Fed can buy/dictate anything because it’s got the printing press (at the cost of our inflation). 

How big is this phantom economy where no real goods or services are produced?  The U.S. economy is almost $14 Trillion in total output.  The world economy is about $50 Trillion in total output. Current derivative “bets” out there total $516 Trillion dollars—that’s 10 times the size of the entire global economy!  And 37 times the size of the entire U.S. economy!  And one-third of it is held by three banks: JP Morgan Chase, Bank of America, and Citigroup ($158T as of 3Q07, John Pugsley, Sovereign Individual, 3/08).  “J.P. Morgan Chase’s dabbling in derivatives makes it too big for even the Federal Reserve to bail out.” (John Crudele, New York Post.)

“Derivatives the new ‘ticking bomb’ … Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen.” (Market Watch, 3/10/08)  As Warren Buffett said at his last Berkshire Hathaway annual meeting: “A world where huge amounts of leverage have been brought into the system is a dangerous world.”

Banks and securities/brokerage firms are into derivatives, hence the $100 billion and $200 billion bail-outs, respectively, two weeks ago. This isn’t pocket change. We will all pay for it in a higher inflation-tax.  Same with the mortgage industry.  The only financial industry that has stayed away from derivatives is the insurance industry, which primarily holds 90%+ in bonds to back its obligations.

I am not a doomsayer.  I simply say that we live in a precarious economy with unknown risks. I suggest we go conservative by staying/getting out of debt, and putting our dollars into safe vehicles that will weather most any financial storm.  I suggest that if we prepare right, we have nothing to fear. I believe the prices of wheat and other commodities will continue to rise, so get your year-supply of food.  And there is a whole list of other actions someone can take to protect their families against days of increasing commotion and volatility ahead.  I am not saying anyone needs to panic and run out and live off nature, or sell everything and buy gold.  I am suggesting that we be forewarned, forearmed, prepared, and informed about what’s going on in the world about us.

If you are already a client, we invite you to call for a periodic review. If you are not already a client, we invite you to talk with us. You can start by attending one of our public workshops.  If not us, then talk with somebody that understands more than just a few annuity products, but also a little bit about tax strategies, and the world economy.   My sincerest best wishes to you. 

Hank Brock is president of Brock and Associates, LLC, a financial planning firm specializing in retirement, estate, and tax planning.  Hank Brock can be reached at 435-673-9599.