Laws of Finance

Below is an email response I wrote as part of a chain of emails. It may be interesting reading to some of you. In many ways I have gone to the darkside in thinking the whole system is going to collapse or have to be dramatically altered over the next decade. How it plays out is anyone's guess.

Email

Now, why I have gone to the dark side. There are laws of finance just like there are laws of nature. Most of the laws of nature can be overcome through the right force, the right combination of other natural elements. Rocket boosters can overcome gravity. A natural force that cannot be overtaken is death. Similar to the concept of entropy. One can delay the process but one (so far) cannot reverse death. In finance, there are many laws also. Supply and demand, diminishing returns, etc. etc. For finance, that law that cannot be overcome is leverage. Centuries upon centuries of financial history is littered with economic failure because of to much debt. Not once has financial failure because of debt been reversed by adding more debt. To prevent an economic entity from leverage collapse, there is only one solution and only one solution. Deleverage!!

Let's look at the last twenty years of economic history in the U.S. Late 80s into the early 90s we had a commercial real estate and residential downturn. We had the culmination of the S&L crises and a general economic recession. We addressed it as a country head on, allowed a form of cleansing to take place and continued on. Economy got overheated and to much financial leverage got in the wrong hands and we had LTCM in 1998. What happened? We should have gone into a recession at that point. Instead the government bought the recession and it didn't occur and off to the races in a full blown equity bubble. We bought 3 years. At that point it got to overheated. We should have gone into a severe recession. The government bought the severe recession away and only entered a recession. We still not did not cleanse. We bought 3 more years (2004 to 2007). At that point we still did not cleanse and instead spread the bubble somewhere else. This time we should have gone into a depression. The government stepped in and purchased a severe recession. We still have not cleansed. In fact, despite all the money spent, we are more insolvent, more indebted, in an overall weaker state!! We are not using the only solution that works, deleveraging. Each step the economy was unbalanced and needed a natural capitalism rebalancing. Each step we did not allow a reblancing to occur and the next iteration was even a more imbalanced system. Imagine a see saw where it is off center and keeps getting more and more off center.

There is one fundamental difference between each iteration. Until the last twelve months, the risk was confined to the private sector. At this point, all risk has been transferred to the public sector. What this means is that mom and pop restaurant in po dunk Texas is bearing the risk of the of the entire financial system. The risk that was confined to Citigroup has been transferred to the government and hence transferred to mom and pop restaurant. Did they want to take this risk? No, the government decided to place this risk upon them.

Since all risk has been essentially been transferred to the public sector, the next downturn will probably cause the public sector to fail which will cause the meltdown of the entire private sector. This would cause the failure of those who have been conservative and did not take the risk that others driven by greed took.

Now the U.S. government has bought time. Possibly multiple years but the municipal crises, Europe, or Japan I think are the 3 most likely trigger mechanisms. (since we have not fixed anything, it really could come from anyway). The municipal crises I have already touched on. I have a report that details all of it if anyone is interested. Europe is ****show. I could write for hours on the problems in Spain, Greece, Italy, and Eastern Europe. Because of the way these countries are all tied together with the Euro, a collapse (think Iceland) in one or more of these countries (which I consider a very high probability event in the next five years) has at least a coin flip probability of causing the entire Euro structure to collapse. Is Germans going to suffer massive economic pain because the economy run by Spaniards collapsed? Japan may be the darkhorse. Kyle Bass has been all over this story buying up the cds (betting essentially they will default). Government debt to GDP is approaching 200%. In the next year the interest expense will be more than all government revenues. The yield on government debt has been extremely low. If the 10 year yield goes above 2%. Watch out. The shakeout globally from that occurring could be sharp and very very painful.

One other comment. China. What is going on there is unfathomable and is setting up for its own collapse regardless of everything else. They are spending $900 billion to prop up a 4.3 trillion economy!! That is unheard of by multiples of like 10. To make matters worse, 48% of GDP is going into fixed investment!!! What does that mean? That means they are building **** that has no use currently and is simply adding to capacity. This is great in the short term but considering the world already has to much capacity this is setting up for a collapse a few years down the road. Consider this. China consumer more cement than the rest of the world at 1.4 billion tons per year. Yet they have been adding to capacity at a break neck pace now having an estimated 340 million tons in excess capacity. To put that into perspective, that is more cement that the U.S. India, and Japan use combined. China's collapse would probably naturally occur years down the road. It will probably happen much quicker because of other things mentioned.

I slightly disagree with you when you said "we only come together in times of peace and optimism, not times of despair." That is normally true unless the despair is severe. It is usually then end of the process. United Nations after WWII. So you have a collapse of the system, massive human suffering, and at the end (5 years into it) a new system is introduced. A world currency may or may not come. I don't know. I just know that the odds are increasing because the world reserve currency (the U.S. dollar) won't be able to hold that status in the next two decades.