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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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