Welcome to the updated Financial Sense! We hope you enjoy the new experience.

We have changed payment processors, so any existing renewals will need to be re-subscribed after expiration. You will receive an email when this happens. Also Subscriber Feeds for iTunes and RSS have changed. Visit your Subscriber Features to find updated information.

Watch this video for a quick overview or send us a message using the Contact page. Thank you!

The Eta-Recovery

Depression is Dead Ahead

Tue, Jul 6, 2010 - 12:59pm

Economic experts have used letters like U, V, W, etc. when speaking about the current recession. The letters should represent graphically the course of the recession. The U-shaped recession stands for a fall, some time at the bottom, and a steady recovery. In case of a V-shaped recession, the economy bottoms out quickly and then recovers just as quickly. The concept of using letters is sometimes applied to stock-market bottoms. A good example of a V-shaped crisis was the stock market collapse of 1989, which would not even be called a collapse, if you cut out 1989 and 1990 from the charts. Currently, many distinguished economic experts talk of a W-shaped recovery, sometimes referred to as a “double-dip” recession. This means hitting the bottom, then a modest recovery and then another bottom before the final recovery.

Which of these scenarios – U, V, or W – is the most likely? Unfortunately, none of these is likely. It rather looks like we are in for a ride on a Greek letter which no-one wants to know or talk about. To understand it, one needs to grasp the so-called “hidden flows” beneath economy. We usually read about many things in the newspapers, but most of the reality is completely different and hidden. However, secrets do sometimes come to the fore, like the current crisis in Greece. Now it is all over the newspapers. Still, a year or two ago, everyone knew how much money they had borrowed, but no one was talking about it.

To understand the recession and the recovery better, one need to look at what is actually not talked about at the moment. No-one talks about the fact that the current crisis differs from previous ones in that currently the whole world is consumed with it, possibly with the exception of some isolated and relatively independent countries like North Korea and Mongolia. No-one talks about the fact that when a crisis involves the whole world, the bubble is bigger than before, and when the bubble finally bursts, it would be more painful and louder than before.

The loudest sound heard by a naked human ear is supposedly the eruption of the Krakatau volcano in the 19th century, which could be heard thousands of kilometres away, all the way to Delhi. Like Krakatau, the burst of this financial and debt bubble is going to deafen all fund managers, banks, and other financial “experts”. The current financial system has created an historic debt bubble of unheard-of scale and proportions. Unfortunately, it is on its last legs.

The average person is, first and foremost, concerned with his or her mortgage loan, but it is much more serious than that. Mortgage loans are just the tip of the iceberg. To an average person, his employer probably also has taken a loan, probably many loans, whether the company is a bank, a hotel, or a retailer. Businesses are always looking for investors or lenders to raise more money, which they euphemistically call “capital”.

Right now, the widespread attitude of inability to run businesses without loans is considered “normal”. Everyone is borrowing money, and it seems to everyone that this is the way it is supposed to be. Finance textbooks consider a good chunk of debt “optimal” under certain appropriate conditions. Textbooks teach that if owners don’t borrow enough, then they are not smart enough to maximize their own returns. They make it sound like borrowing is the smart thing to do.

However, no one thinks about when the debts would be completely repaid and when the company would be able to continue to operate without a loan. Upon taking each loan, it is already factored in advance that the loan will be repaid by refinancing with yet another loan. If a natural person wants to spend his life paying off a bank’s loan with loans from other banks, then he will be considered a crook, and it probably won’t end well. This, of course is a pyramid scheme, and that’s exactly how Bernie Madoff ran his own business. Remarkably, when it comes to companies, this kind of attitude seems perfectly normal. Actually, this could be considered “normal” when an implicit assumption is taken for granted, an assumption that financial managers refuse to acknowledge explicitly – the assumption of debt refinancing. However, it could happen that the next new loan won’t be there to refinance the old one and the company should go bankrupt.

Business failure is the best regulator in the economy – it is the most natural, the most common, and the ultimate regulator in a market economy, as it always has been and indeed should be. Unfortunately, the biggest free-market fans get really nervous when they discover that they also have to be subject to the market discipline of business failure. Then they twist their song – harsh market discipline for everyone, but “too big to fail” for them with government bailouts and handouts. What a convenient free-market ideology!

It gets even better. There are many economic experts who confuse the meaning and influence on people of phrases like “the central banks ease the monetary policy” or “tighten the monetary policy”. In the most modern sense, these mean mainly lowering and raising interest rates. The first stimulates the economy, while the latter restrains it. However, stimulus means that the companies whose business plan would not work are tempted by the lower interest rates, are able to borrow, and able to proceed – this is the Austrian boom and the poorly invested capital turns into a “malinvestment”. Restraint means no new loans to refinance old ones, so there will be an extensive wave of bankruptcies, as companies who have built their businesses on bank loans begin to choke on them.

The current economic paradigm does not accept this simple, but fundamental idea. The “no-capital, no-business” culture won’t die until the current system has died a violent and painful death. And that death will necessarily come because borrowing doesn’t end at the company level. The higher structures, i.e. of towns, of cities, of local governments, of states, and of countries, also are all deep in debt. Thus, the intelligent reader would naturally ask: if everyone is so deep in debt, then who lends all the money? The correct answer is rather surprising and absurd – no one. What really happens is that the banks create money “out of thin air” at the moment of lending, i.e., banks create debt out of nothing thanks to our unstable and unsustainable system of fractional reserve banking

Recently, and even today, as big companies frequently acquire small companies, the acquiring companies don’t really save a big chunk of money to pay for the acquisition. Instead, the acquiring company goes to an investment banker, presents its balance sheet, and borrows to pay. Thus, it leveraged its balance sheet and jeopardized its financial stability. It could happen that its CEO would even get the title of “The Businessman of the Year”. The most “successful” would be considered the one, who would get the most loans from banks to acquire the largest number of companies, like Tyco’s Dennis Kozlowski, not the businessman who actually built the business on the basis of financial stability with his own capital.

Currently, the whole world has created a giant Debt Bubble, with no theoretical possibility to pay back that debt in real terms. The only thing policymakers try to do is “kick the can down the road” by refinancing with even more debt. That is done, for example, by most lenders whose mortgages are in default – they just reschedule or renegotiate the loans and keep them current. This is done even at the global level by countries like Dubai and Greece. This, however, is only the beginning. Iceland is bust. People now talk about the PIGS, Japan, and the U.K. However, there is no point in even talking about the US debt burden. By some calculations, all U.S. wealth and its earning power is not enough to pay back these (funded and unfunded) obligations, so repayment in real terms is not even theoretically possible. Then the only thing left is to print and inflate, which ends up in hyperinflation.

It is important to note that this sort of mess has happened many times before, even though on a smaller scale. In those cases, the answer was a radical change of the monetary system, usually by destroying it first via hyperinflation. The most commonly cited example is Weimar Germany, but recently also Russia, Ukraine, Belarus, and Zimbabwe. Months ago Vietnam also took that road and “revalued” its dong (they actually devalued it). The recommended cure is always “austerity” and devaluation. Economists claim that currency devaluation boosts exports, but in reality it means impoverishing the country’s citizens relative to the rest of the world and a collapse in their standard of living. Right now we are similarly expecting currency depreciations and devaluations, but the devaluation must occur relative to some other currency. All currencies can’t be devalued at the same time, but they can be depreciated all at the same time against gold! Currency devaluation leads to rising prices. Currently, there is talk of deflation, instead of inflation, but this will soon change. With current policies, extreme price inflation becomes inevitable. Indeed, we are on the road to hyperinflation – it is only a matter of time.

The current recession is far from over. We haven’t hit the true bottom yet. We will eventually reach the bottom only when there is a fundamental, systemic, and revolutionary transformation in the current economic and financial system. Unfortunately, every system is designed to protect its own structure until its ultimate destruction. Unfortunately, there won’t be a peaceful “restructuring” - it will most likely be dramatic, radical, and violent.

So far, none of fundamental causes of the crisis has been resolved – all the causes are still with us. Extraordinary debt burdens are still considered “normal” and rising; it is still incorrectly believed that governments will save us from the crisis. The banks continue to create money “out of thin air” and lend it to the government, regardless of the fact that even Cicero insisted that an honest monetary system must be based on precious metals or other tangible assets. Banks still keep their profits, while the public bears their losses. Right now, no-one in the world has enough money to pay the debts of Greece or Spain. Nothing has been fixed.

So, we finally arrive to the shape of the current recovery. The current economic recession will have the shape of the Greek letter Eta. It will look like this – ɥ. First there was the initial fall. Then came the governments’ rescue, with governments borrowing and spending money that they didn’t have and creating a phony recovery. We then come to the final stage – a longer and deeper collapse. In the worst-case scenario, which is also likely to happen, this will be similar to the fall of the Roman Empire.

However, most people still believe that the current system will never fail. Just like the primeval period, slavery period, and feudalism, so will the current Western “free-market” system soon come to an end. (Whether it is truly free is a topic for a much bigger and much more controversial discussion.) Oswald Spengler, who studied 7 historic civilisations, brought out the common characteristics of their falls – growth of urbanism, decline of country life, establishment of geometric cities, prosperity of the “everything is all right legally” system, rising suicides and sexual deviancy, etc. The underlying problems of the West are neither financial, nor economic; instead, they are moral, cultural, and civilizational.

The main question is clear – “How long will the fall last, before a new social system emerges, which restores values like intellectual development and spiritual harmony, which restores balance between humans and environment, and which rejects accumulation of property, wealth, and power. The recession will be long and protracted, much longer than expected, and all necessary changes may take even generations. This, however, is another topic. Until then we will continue in the shape of ɥ.

About the Authors

Associate Professor in Finance
Krassimir_Petrov [at] hotmail [dot] com ()

Founder and Chairman
Supervisory Board of the TAVEX Group
alar [at] tavid [dot] ee ()