Letter of Grave Import
The Looming Recession Circa End of this Decade.
Last update 10/24/05 

by Lorenzo Wang



Dear friends and family,

        As some of you know, I've recently been very concerned with the state of the economy and the decline of the U.S. dollar. As we all know, the state of the economy right now is not great. What I have learned is that it is not on track to get better, and will most likely get much worse. I am writing this long letter to share some of the research I have done to find the reason for this time of trouble, and what we can do to survive it. Through this letter, I will ask for your attention, and then your criticisms, comments, or questions. I hope the gravity of this letter causes you to become interested in researching for yourself. Your conclusions may be different, but your concerns should be just as serious.

        Not all of you are very financially savvy, and admittedly I am not either, so I will present my argument without too many numbers, graphs or formulas, and stick to common sense, logic, and example. But please don't misunderstand me, every statement I make comes from research and data that anyone can reproduce. This is meant to be a layman's guide. There is a lot of debate among investors, experts, scholars, and scientists about whether or not doomsday is a myth. My approach has been to find all the people who are right, and find where they all agree. I've condensed the result here, leaving out arguments that have been sufficiently disproven, and will present the essence of the issue. This means I ask for us all to take a step back and look at things outside the day-to-day good and bad news.

        The conclusion of this essay will be that the U.S. will soon enter a terrible recession, or perhaps even a depression, and it will be the worst economic disaster of our time, and perhaps in all of history. The U.S. dollar will fall terribly in value. The entire world will struggle to survive with the temporary loss of the U.S. as its engine for growth. I base these predictions on several sources (which I've listed some of at the end) that each look at our current state from a different, but connected perspective. The major concerns I will detail are monetary policy and trade, oil and industry, demographics, politics, and our natural cycle of rise and ruin in human civilization.



Monetary Policy

The first and most important thing to look at is monetary policy. Since the beginning of the modern economy, there has been three major systems:

- The Gold Standard (ancient-1914) = gold backs all value of all currency.

- Bretton Woods Agreement (1929-1973) = gold backs the dollar at about $35/oz, all other currencies are pegged to the dollar at a fixed rate.

- The Dollar Standard (1973-current) = the current system, where dollars form the bulk of the world's assets regardless of the amount of gold to back it up.


        I duly recognize the disadvantages of the gold standard; it was not an infallible system. It would have slowed both the global imbalance as well as the credit creation that led to the global growth we enjoy today. It was a double-edged sword. John Maynard Keynes, the father of macroeconomics, once condemned the gold standard as “that barbaric relic,” but following the economic chaos of WWII, conceded that there was a need for some sort of "commodity-reserve," and helped to create the Bretton Woods system as well as lay the foundation for the IMF SDR, a sort of universal currency.

        A quick history lesson. In 1914, WWI led nations to suspend the gold standard. After the war, repayments from Europe filled the U.S. coffers with gold, leading to a widespread credit creation. Production and investment soared exponentially. When overproduction outpaced the public's ability to consume, the result was the Great Depression. In 1944, the Bretton Woods System was formed, using the dollar as the only fully gold-convertible currency, and all other currencies fixed their values to the dollar accordingly. In 1973, the desire to spend led Nixon to kill off the the Bretton Woods system, leading to the current situation, where the dollar is so far removed from gold that it essentially became the new reserve currency. Today, everything is backed by dollars, not gold.

        Rather than lead this paper into an argument about which system is better, I will simply say that the gold system generally forces economies to remain in balance and outside of easy control, whereas the dollar system empowers the government to both stimulate growth as well as suppress recession. With that power comes responsibility, which has been abused. There is no free lunch, especially for things that sound to good to be true. Stimulating growth endlessly without suffering recession is too good to be true. Even on the gold system, trade imbalance can grow to dangerous levels, so there's no perfect solution.



The Dollar Standard

        The dollar has become the reserve currency of the world. This means worth is held in banks as dollars. When the U.S. prints more dollars, thereby increasing the supply of money, the only way for the dollar to back up a certain amount of worth is to decrease the value of the dollar. This money is then used to pay people. As the world's largest importer, we pay the rest of the world over $200 billion a year for stuff. But for that money to make interest, it must be reinvested in the U.S.

        So the world takes that money and puts it back into the U.S., owning stocks, stuffed in banks, equity, etc. The U.S. then looks at the money washing back, and creates more money based on it. Just as a bank does not hold all the money it owes, neither does the U.S. It simply needs to be able to pay the people who want to cash out, which they don't do as much as they invest because they want to earn interest. In this way, credit begets more credit. As long as we don't have too many people cash out at the same time, we'll be fine.

        Essentially, this is no different than when Beavis & Butthead kept paying each other with the same dollar bill, buying up an entire bag of candies. While every candy bar was paid for by a dollar, what happens to the person whom they owe money to? The accounting is not right. But as long as this dollar is being passed back and forth, the economy is growing because people will work hard when they are told they will get paid. The U.S. cuts the dollar into more pieces and declares each piece worth a candy bar, and this helps spending go more efficiently. The debt between Beavis and Butthead balances out, but what about the guy they got the candies from in the first place? What happens when they need to pay him? Promise to sell more candy bars, like us?

        At some point, the amount of debt will be so tremendous that the dollar will no longer be considered credit-worthy. Uninhibited, the debt would exceed the worth of the entire country's GDP. With our country's GDP at $11-13 trillion and our total debt to the world at $8.4 trillion, it is clear that with debt rising as fast as it is, it won't be long before the dollar is completely not credit-worthy. This means the the dollar will no longer be the reserve currency of choice, which means investors will look elsewhere for a creditworthy currency, perhaps the Euro, or even the yuan.



Asia's Miracle Bubble


        The Asian bubble is a good example of what monetary manipulation has done. Tremendous amounts of export to the U.S. caused large surpluses. Large surpluses led to credit creation. Credit creation drove more development and powered the real estate equities. With real estate speculation rampant, people used their equity as buying power, and consumed. There was so much equity that people invested heavily back into stocks and that led even more development, which led to even more surplus.

        The end result was that the Asian bubble popped. From Japan to Thailand, the real estate boom reached a point where more houses were developed than the people needed, at prices more than they could afford. Thailand, after its crash, has nearly 30% of all residencies vacant to this day. At one point, the value of all land in Japan was nominally worth more than the entire U.S., and the gardens of the Imperial Palace were worth more than all of California. That is how overboard it went. Deflation happens when there is more capacity to produce than the people have to consume. But let's keep this simple, and look at one of the worst economic crashes in recent memory.

        In 1989, Japan, the world's largest lender, began its descent into a recession so devastating that even today experts predict at least 5 more years of hard times. How was this possible when interest rates were being slashed repeatedly to stimulate growth? Cheaper borrowing encourages more borrowing normally. However, in a global economy, investors need to place their money someplace safe, someplace that earns interest. As the interest falls, the Japanese yen becomes less desirable, and the dollar more desirable. This means that less people invest in Japanese banks, which means banks must lend out less money. Eventually, lending is too low, growth stops, consumption dies, profitability goes down, and the economy collapses.

        Clearly then the U.S. dollar (and hence our economy) grew strong at the expense of the Japanese. As the dollar strengthens, our ability to lend increases, which means we can print more and more money not backed by gold. Here is the timeline of what took place:

-1981 Reagan administration opened the way to paying trade deficits with treasury securities, and also invited open trade. The result was a flood of Japanese imports, and the dollar grew strong. Our deficit soared.

-1985 In desperate need to keep production in the U.S., the Plaza Accord was met to artificially devalue the dollar against the yen. The dollar fell in half against the yen over the next 3 years. Investors panicked, and in late 1987 the U.S. stock market crashed as growth halted.

-1987 While stocks crashed here, Japan faced a rising yen. Manufacturers left for cheaper places, like Taiwan. As Japan continued to print more yen, and refused to allow cheap imports (or else lose more manufacturers), domestic spending had only one place to go: stock markets and real estate.

-1995 The dollar began to drop against the yen again as people started to feel the U.S. was in control of our trade deficit. The Japanese panicked, printing even more yen than ever to deface its value, as well as slashing interest rates to nearly zero.

-1996 As the dollar continued to strengthen, exporters who had taken over for Japan suddenly saw their own profitability fall, just like Japan before. Worse, their currency was pegged to the rising dollar, and the Asian miracle bubble burst as people scrambled to escape their own equity speculation.

-1998 Completely oblivious, Japan continued to deface the yen until both Japanese and U.S. governments both panicked. An attempt was made to halt the rising dollar. Two years later, faced with a plateau-ing dollar, U.S. stocks took a huge tumble.

-2002 Having not learned its lesson, Japan starts a new round of aggressive yen defacement. The results are yet to be seen.


        At this point, you are probably asking what it means for Japan to print so much yen. Simply, it causes the dollar to rise or stay strong, which is what is responsible for the inflation of American stocks and bonds. Chih Kwan Chen predicts that if things continue the way they are, with U.S. deficit and economy soaring simultaneously, by 2023 Americans will be the most indebted country in the world but everyone will be driving BMWs and dining in fine restaurants. Everyone in Japan, then “richest” country considering how much of its reserves will be held in the strong dollar debt here, will be riding bikes and living in shacks. If you don't believe that is possible, then things must change.



China

        Is China as powerful as it seems? China has grown incredibly in the last few years. It's easy to attribute the success of this growth to a billion hard-working, inexpensive laborers and improvements in education, as well as lighter governmental controls over more capitalistic practices. The reality is that China borrows heavily- domestic debt is soaring. Additionally, China's income comes primarily from the U.S. as our biggest trade partner. When the U.S. loses the ability to consume, China will suffer unless they can find new buyers, or change what they sell. But at the moment, they have built tremendous surpluses betting on our consumption, and that's how they create the credit to drive more growth. Unless China has a backup plan, the U.S. will pull China down with it.

        Worse, China's export is dependent on staying as the manufacturing middleman. Their equipment and expertise come from foreign investments, and these are used to produce foreign brands. Essentially, they are at the mercy of non-Chinese innovations and designs. Unless a political change happens, they will be as vulnerable as a Japan that does not have its brands. If the U.S. feels threatened and hold trade sanctions, China will have to deface the yuan. If their economy isn't willing to stop slow growth, Japan will happen all over again.



Oil

        Economic growth in modern industry is completely dependent on oil. The looming oil shortages will begin the downward spiral. Oil, no matter what people have tried to argue, is undeniably running out. To make matters worse, OPEC encourages members to exaggerate how much actual oil they have by dividing quotas based on those largely unverifiable numbers.

        Experts say that the oil shortage isn't real, that since 1910 we've found more oil every time we predicted a shortage. What they ignore is that oil prospecting technology has gotten better since then, exponentially so. And consumption has soared. Oil companies are not the evil barons we think they are. Our country has just become too oil thirsty too fast. So even if we manipulate money to continue to stimulate our economy, within 25-30 years there will simply be no more oil at our present rate, even if refinement weren't a problem. Which it is, a huge problem. Even if hydrogen was perfected in the next 15 years, the world would still be too addicted to oil to be saved.



What is the World Thinking?

        Why haven't investors already bailed out and moved their money into something safer? Isn't it obvious the dollar loses reliability non-stop? Truth is, investors do hedge their investments. For example, the second richest man in America, Warren Buffet, the self-made stock market genius, bought hundreds of millions in Euro for the first time in 2002 despite long misgivings about currency and an overall upbeat outlook towards the U.S. Investors know that the depression will probably not happen overnight. The people who will suffer the most will be folks about to retire who blindly throw their money into a 401k or IRA buying domestic stocks or index.

        Why haven't policymakers put a stop to such an obvious oncoming disaster? Why hasn't the Federal Reserve (the Fed) and its chairman Alan Greenspan foreseen the crisis, and made steps to remedy it? The quick answer is that he has seen it (the Fed themselves ordered the research confirming troubled times), but he can't stop it. He has frequently denied it, in fact, until finally admitting recently that all was not well. By trying to prevent it, we only worsen what will happen. Interest rates were slashed repeatedly to stimulate the economy, but interest rates cannot go below zero. While they have risen in recent years, they are nowhere near where they should be.

        This crisis was not a year in the making, it was 30 years in the making, perhaps longer since the rapid growth we had before 1973 is what drove us to abandon the Bretton Woods system. Could Nixon have stopped it by not abandoning the Bretton Woods system? Probably not, and if he did he would be blamed for bottlenecking economic growth.

        Who's to blame? Everyone, from politicians to you and me. A recession is a natural correction of the system; politicians are going to do everything in their power to avoid a recession during their terms, even if it means a worse recession later. You and me? We are huge consumers, helping to drive the need for growth and the surplus of foreign trade partners. Most of all, normal people don't want a recession at all, which is why when it happens it will be so devastating.

        What about the rest of the world? Well, their leaders have a clear choice. Either continue to receive our dollars as payment and invest with them, or invest with their own currency. As we've seen, the latter would cause their currency to rise in value, hurting profitability, and stifling growth domestically. The result would be something their leaders do not want to be responsible for either. Putting the weight of debt repayment on the U.S. is an easier choice than causing domestic stagnation.



Danger Signs

        If you watch the news today, everywhere you will see indicators that the above analysis is true. As industry overcapacity passes consumers' ability to spend, corporate profitability drops. Bankruptcy filings have more than quadrupled since 1980. Enron, WorldCom, Kmart, Texaco, the increased SEC investigations, CEO corruption, these are symptoms of that profitability evaporating. John Bogle, founder of Vanguard, sadly notes that CEOs and investors alike have little loyalty to their companies- today we are “renting” stocks, not buying them. Unemployment, housing prices defeating income, and a losing fight against inflation is one of the fates that await us. Growth stagnation and deflation is the other fate. As Richard Duncan says, “the only question is, will it be death by fire- hyperinflation- or death by ice- deflation? Fortunes will be made and lost , depending on the answer to that question.”

        Hyperinflation is not likely, despite rising oil prices. Hyperinflation happens when money is printed excessively with no debt offset, that is no public debt to soak it up. That is not the case in the U.S. What we are actually seeing is most likely a reflation (inflation of prices up to the value they should be at) which will be followed by deflation, i.e. with Japan and our own Great Depression. Why deflation happens is outside the scope of this letter, but that it will happen is important to us. Suffice to say, it comes from a loss of faith in spenders and plummeting consumerism relative to industry overcapacity. Deflation Map (click this link)

        So the most pivotal aspect of this question is... when? Telling the future is, for practical intents and purposes, impossible. There are many factors driving the global economy up and down. Our approach then should be to look at when the majority of these factors will coincide on the valleys. Since this is speculative talk, I think everyone should do their own research and make their own decisions on this. However, my best guess is a recession that will happen between 2008 and 2012, no later than 2020, and that it will last about ten years. My reasons are personal and subjective, but I'll offer them anyways.

        2008 will bring a new election, and with it, market instability. With the growing need for a recession here, if Democrats oust the Republicans (which is very likely), they will be given the opportunity to let the dip occur, and will be able to use the current administration as a scapegoat. At the same time, Greenspan will be replaced and his successor will be tested. Throughout the rest of America, the last baby boomer generation will be entering retirement, reducing productivity and straining our budget. Finally, consumption will begin peaking as inflation haunts domestic spending and many major industries hit the market saturation they want (i.e. cell phones, PC, broadband, and other technology). The housing boom will also peak. Oil prices soar so that growth stops. Our debt will only be stressed more, especially if Iran, Korea, or natural disasters continue to demand attention.



Recommendations

        Where, then, is our money safe? The real answer is nowhere. However, some places will be safer than others. In short, the less dependent a country is on export to the U.S., the less it will be affected by our crash. Right now, China, Mexico, Germany, and much of Asia have positive trade balances with the U.S., and large ones too. The Europeans (besides Germany) however are relatively independent and will be affected less. Australia and New Zealand also will take less damage. The Middle East is questionable- while they are dependent on oil exports with us, oil dependency is not exclusive to the U.S. And while they have large dollar denominated reserves, they also have large amounts of gold, Euro, and other reserves.

        My tentative recommendations would be in the Euro (if Europeans can get their act together), Australian/New Zealand 1-yr CDs (which incidentally earn up to 5.4%!), and commodities like gold or silver or uranium. For domestic stocks, properly hedged bets would be good. Warren Buffet's own Berkshire Hathaway is ready for inflation or deflation. Also good are companies that stand to benefit a falling dollar (for example, our big exporters who currently can't fight foreign competition). Retail, real estate, and similar areas are extremely risky in the next 10 years. In the short run, government bonds and energy are worth looking into.



Conclusion

        Let's summarize everything. The world has done its best to prop up our dollar in order to lead businesses their way, and their own currency must decline to make it more attractive. The U.S. consumes what they sell, acting as an engine for their growth. Because dollars have replaced gold, dollars are reinvested here, which we use as justification to print more. With no restrictions on how much dollar we can print, we must fight inflation with debt instruments. Eventually, our debt will exceed our "income" by too much, and confidence in our unbacked dollar will fall. The result will be a disaster as the world struggles to find a reserve currency they can have faith in. This will happen when we cannot consume anymore, which will hurt profits, kill jobs, and deflate investments drastically.

        Benoit Mandlebrot, father of chaos theory and fractals, observes that as unpredictable as the world is, certain patterns do emerge. However, patterns don't stay the same- they change, grow, shrink, or in the case of the world's economy, soar. However, a pattern still exists, even the the scale of it changes. The more we grow, the greater we risk. The greater the potential to rise, the greater the potential to fall. This is natural. Perfect balance, however, does not meet the thresholds for growth, critical mass so to speak, so not only is this cyclic rise and fall natural, it's essential to progress. With every rise, we retain some of what we learn. It's in evolution, the environment, electromagnetic forces, emotion, and economies- it's in everything.

        No matter what happens, it's always prudent to be prepared for the worst. In 2002, people discovered that the too-good-to-be-true rule of “just buy index and diversify” doesn't work all the time. Yes, the U.S. will grow stronger and stronger, but along the way it will stumble. It is important that we don't retire when it stumbles thinking we are taken care of. Over 40 million Americans today expect their pension plans to keep them alive, when pensions have never disappeared faster than now. People lost retirement fortunes in unforeseen disasters like Enron's 401k. We should ask where wealth comes from, and why it costs what it does. Warren Buffett says “price is what you pay, value is what you get.” Are we paying the right price?

        Mandelbrot argues that the Efficient Market hypothesis is bunk. I agree. To say that the market already accounts for every bit of information and people are already making the best decisions they can is bunk. Investors are human, and are greedy, gullible, uneducated, and emotional. They rely on tips, hunches, misinformation, and misunderstanding to make decisions, and it's no wonder the market feels like gambling. In our arrogance, we think that our ability to analyze makes the markets too complex to understand. If our retirement pension was paid out based on how the bottom half of society rated the world as a whole, you can bet half of the corruption in the world would evaporate. But global stability just doesn't pay. What goes up, must come down.


> Thanks to Steve, Christine, and Bob for being so patient and giving me much needed feedback!


My Primary Sources (in rough order of importance):

The Dollar Crisis: Revised and Updated by Richard Duncan
An excellent book that offers the most damning explanation for the crisis looming. His explanation of Japan is lacking, but the explanation of the Asian bubble as a whole is fascinating. The only weakness in this book is the solution he offers to avoid future crises, a solution (global minimum wage) that would be rather unrealistic to implement.

The (Mis)behavior of Markets by Benoit Mandelbrot
Understanding the whys of the economy requires us to step as far back from it as possible. Mandelbrot, father of chaos theory and fractals, offers no answers, but asks all the right questions about why things happen. This book is important for more than just economical insight, but changes our perspective of all human behaviour. Is economics really a black box because of self-awareness? Mandelbrot argues that it isn't, and proceeds to attack the flaws of existing theories.

www.forcastglobaleconomy.com
An excellent, albeit dry collection of articles that thoroughly examine the pitfalls in Japanese and American monetary policy that led the world to its current state.

The Economist
– Various articles

Financial Times – Various articles

The Oil Factor by Stephen and Donna Leeb
While this book places a lot of faith in the Oil Indicator, using oil prices to gauge economy, it is otherwise a great read on the effect that oil has on growth, and the effect growth has on the economy. Take its faith in China with a grain of salt.

The Coming Generational Storm by Laurence J. Kotlikoff and Scott Burns
Very persuasive look at demographics and the inability of America to support the next generations. Also includes some decent investment advice even if it's way too positive on China. Main topics include Social Security, Medicare, ways our government debt has been obscured, and politician cowardice in telling us how deeply in trouble we are.

International Monetary Fund
Keep in mind the IMF analyses for the monetary policies of countries (and the central bank reports of those countries) are not completely honest. The IMF in particular ignores much of the problems in the U.S.

The Next Great Bubble Boom
by Harvey S. Dent
This book has terrible investing advice. The author has a track record of being wrong on many issues, and his own mutual fund went under. I mention this book still because he has some interesting information, particularly about demographics and population booms, technology cycles, things like that. Although he may be right about the coming bubble burst, he has many of the wrong reasons.
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All original material Copyright Lawrence Lorenzo Wang, 2002-2005, unless otherwise noted.