Recession and Black Swan Events, by Don M.

Financial calamity can take many different forms.  The Brazilian saga of hyperinflation / depression / recovery from the 1980s leading to one of today’s most robust economies is a classic tale of overcoming adversity.  Argentina’s economic collapse in 2000-2001 followed by hyperinflation in 2002, debt repudiation and seizing foreign deposits is another story with a solid recovery afterwards.  The disastrous 20-year Japanese experiment with deflation and negative growth is at the other end of the spectrum.
Which will the US experience first?  And, how quickly will we feel the scorching fire of hyperinflation or the freezing blast of deflation?
The short answer is that today we should be preparing for a recession in the near future with actual deflation in certain sectors.  We also need to anticipate the possibility of a deflationary spiral into the “Great Correction.”

As the economy struggles through the next recession, we need to be alert for signals that the Federal Reserve has screwed up and overshot its goal of controlling deflation.  A big miss with too much monetary expansion and the US economy could lurch into hyperinflation with very little warning.
In JWR’s novel Patriots, our heroes experience an occupation force of primarily European UN troops.  Today, that seems unlikely but only because the European countries are determined to make a bigger mess of their economies even more quickly than the US.  After all, politicians in Europe have over-promised for even longer than politicians in the US.  The cost of providing the European welfare state has proven far more expensive than forecast, and the bill is now past due.

Almost everybody watching the Euro crisis has concluded that Europe is headed straight into a major recession – regardless whether or how the Euro crisis is solved.  The recently mighty Euro has been steadily losing value to the US dollar and is no longer a candidate for a replacement reserve currency.  In fact, Euro-denominated assets, especially the government bonds of Greece, Italy, and Spain, are almost toxic.

Updated Collapse Scenario

Does that mean that the disaster scenario in Patriots needs to be updated?  No way.  In fact, all that matters is that Patriots provides a realistic scenario that could easily lead to the rapid collapse of infrastructure especially in large cities.  The story line makes the point that rational people need to be prepared for the worst and that working together is much better than going it alone.  The take-away message is about being prepared and not about the details of which camouflage pattern or what brand of battle rifles.  If those details stick in your mind, that’s great, but the real lesson is to think ahead and start planning before Schumer comes knocking.
In the meantime, we have to get on with our life in today’s real world.  The characters in Patriots had to deal with their particular environment; we have ours.  Each of us gets to deal with our jobs, our family and friends, and “our” government.
Keep in mind that how you define a problem can artificially constrain how you think about the solution.  If you imagine that the most likely problem is hyperinflation and soon, that framework might justify spending critical savings to stockpile supplies before prices skyrocketed.
But if, as I predict, the US will deal with several years of recession first, the heavy spender might use up critical savings needed to deal with an unexpected problem like major illness or loss of a job.  Also keep in mind that the frugal saver who does reasonably well in a recession may overlook or ignore the warning signals for hyperinflation and see the value of his savings evaporate in a few months or even weeks.

Being an International Banker

My first job out of business school was trading foreign currencies in Beirut for one of the largest American banks and then as branch manager in another Middle Eastern country. After several more job moves including working as the international treasurer for a Fortune 500 company, I was recruited to head up global treasury management for the largest bank in the US.  Eventually, I left the financial sector and got a real job running a company that manufactured products in the US.

Like many people I read the news headlines and generally ignore the daily ups and downs of the stock market.  Most of my attention goes to more technical articles following trends in currency swaps, forward currency transactions or futures, inter-bank lending rates, national bond offerings, and changes in credit default insurance rates.  Not very sexy stuff, but these details paint a clearer picture of world events than the sound bites carried on television news.

As a banker, I was paid to make bets on major currency movements and the direction of national economies.  Sometimes, I was just plain wrong and lost money.  Occasionally, I had the right trend or direction but was way off in the timing.  That also counted as a loss.  Fortunately enough of the bets paid off, and I kept my job.

Most of us may not recognize the reality, but today everyone in the United States is making a daily bet in the world’s foreign currency markets.  We are all international economic forecasters.  What happens in Greece or China or Japan has a direct impact on the US dollar, the US stock market, the rates on US savings accounts, the price we pay for bread, or the cost to fill up our Toyota, Hyundai, or Chevrolet.

Major Bets

You say, “Wait, I don’t even own stocks.  I’m sitting tight hoping that everything blows over.” My friend, that is a bet – a very big one.  You are betting on the status quo.  In fact, you are putting your livelihood and your savings on the line placing a number of bets at the casino every day.  By doing nothing, you are actually making the following very specific bets, for example:
a.)            The Euro-zone remains intact;
b.)            None of the European Club Med countries default;
c.)            Crude oil stays between $80 and $120/barrel, and the Middle East stays peaceful;
d.)            The Federal Reserve can and will keep interest rates between zero and 2% for at least two more years;
e.)            The Fed’s interventionist policies will keep the US from a recession in the next two years or at least until the presidential election is over;
f.)            The Muni bond crisis in the US will be postponed at least a year;
g.)            Obama will win his second term as President; and
h.)            Majority Leader Harry Reid and Speaker John Boehner will continue their ineffectual sparring with neither party making much ground in the 2012 elections.
The list could go on, but I think you see the point.  Taking no action is a gigantic sucker bet.
By the way, you also made the bet (correctly) that Obama would keep his word and that troop withdrawals from Iraq would proceed according to plan.  After all, everyone knows that Iraq and Afghanistan have been completely pacified and are capable of responsible self-rule without any assistance from the Evil Empire.  Further, there is absolutely nothing that could disrupt the steady supply of Middle Eastern oil to Europe and Asia – not even the Ayatollahs of Iran and the Straits of Hormuz.
When you placed those wagers, you were making the exact same bet that Federal Reserve Chairman Ben Bernanke is making, namely an ever-increasing federal deficit can be financed indefinitely by an ever-expanding supply of cheap credit.
Further, this surplus of credit, according to Keynes and all his disciples, will lead only to moderate but not excessive growth which will allow the US to solve all of its economic problems by the end of the second Obama administration. 

Bernanke is too old to have such faith in the Tooth Fairy, and so are you.

The European Mess

Each week for the last several months, the press has alternated with good news that the Euro crisis has been fixed once and for all with the following week’s announcement that some new catastrophe has derailed last week’s bailout plan or solution or new treaty or whatever.  My personal bet is that at least one of Club Med countries will default on its bonds in the next six months.  Frankly, it doesn’t matter whether the first to go is Greece, Italy or Spain.

The most likely consequence of any major national default is that this will be the final trigger point for a long-term recession in Europe with repercussions in the US economy and the rest of the world.  Even without a specific trigger, Europe will slide inevitably into recession generally considered to be two consecutive quarters of declining GDP.
How likely is it that a major recession in Europe will lead to another recession here?  Most economists and central bankers think it will happen quickly once the house of cards called the European Union starts to tumble.  In fact, many of the most common measures used by the National Bureau of Economic Research already point to an extended decline here in the US in real income, actual vs. reported unemployment, retail sales, and industrial production as well as other key measures.
Bernanke and Treasury Secretary Timothy Geithner believe in the linkage, and the Federal Reserve has already taken extraordinary steps to delay the inevitable collapse in Europe just to postpone the recession here.

International Monetary “Easing”

On November 30, 2011, the Federal Reserve issued a press release announcing greater availability and lower pricing for “temporary U.S. dollar liquidity swap arrangements.”  What really happened is that Bernanke, without the approval of Congress, agreed to make the Federal Reserve a lender of last resort to the rapidly failing commercial banks in Europe.  These banks have enormous exposures to various European national bonds, and the Fed is effectively taking on that liability.  You read it correctly – the commercial banks.  The US taxpayer is now backstopping the shareholders of foreign banks.
A press release announcing a done deal means that there were weeks or months of intense, behind-the-scenes negotiations as well as position papers and PowerPoint presentations detailing the consequences of opening up that credit window.  These documents have not been and probably never will be released.  Where is Wikileaks when you really need it?
Will these new credit facilities change the outcome?  Not really.  Utilization of the credit facilities may slightly delay the starting date for the European recession, but the sad truth is that the US government and the US taxpayer is now much more exposed to a commercial banking collapse in Europe.
We thought that the Mother of All Bailouts (MOAB) had occurred here in 2008 and 2009 to avoid the bankruptcy of Bear Stearns and the collapse of the US banking system and AIG.  Not satisfied, Bernanke is now offering bail-out money to Europe’s banks.

The Euro Summit and the “New Treaty”

Clearly the 27 Euro-zone leaders believed that a major recession would be the best outcome they could expect from the spreading Euro crisis unless they took extraordinary action.  The 27 heads of state participated in an all-nighter in Brussels on December 8 and 9.  The result is that member states have been asked (blackmailed?) to ratify an amendment to the European Union treaty setting new mandatory economic guidelines.
The most important requirement is that each country must take active measures to reduce “structural” deficits to no more than 3% per year.  This means drastically reducing the maximum amount by which any country can outspend its net tax revenues.  This was the non-negotiable demand that German Chancellor Merkel imposed on all the member countries at the Euro Summit.
What the Germans wanted and got was agreement that member countries would reduce their deficits by immediately cutting government spending and simultaneously raising tax revenues.  “Cutting government spending” is Euro-speak for firing a significant number of government workers and reducing funding for government programs.

In addition to cutting public sector employment, these measures will lead to a further loss of jobs in the private sector.  The obvious consequence all across Europe is greater unemployment, a further loss of consumer confidence, a continuing reduction in consumer spending, and a corresponding decrease in capital expenditures by businesses.  To that recipe for economic disaster, stir in the simultaneous requirement to raise tax revenues.

Tie Your Hands

With this toxic combination how can the EU member countries avoid an outright recession?  Not possible.  This was the reality that every head of state knew in advance of the Brussels summit and had already accepted. Even more amazing is that all of these government leaders also agreed to keep from using the conventional Keynesian tools for fending off or turning around a recession including reducing taxes or increasing government spending.  They have tied their hands behind their backs even before the fight started.  You have to ask was this  the epitome of stupid politics, or were these leaders even more afraid of the inevitable economic catastrophe from a collapse of the Euro? How long before this new treaty is effective – if ever?  According to a Reuters article, French President Sarkozy admitted that the earliest expected ratification was June, 2012.  Obviously, the “big rescue” is not a “quick rescue.”  In the meantime both Moody’s and Standard & Poor’s have placed almost all European countries on credit watch, often the first step before a down-grade in credit rating and a major increase in borrowing costs.

Too Little and Too Late

Many commentators have opined that the simmering Euro crisis will boil over long before the new treaty can be approved.  The summit got great press coverage, and the Euro leaders got to pat themselves on the back.  But, an honest assessment has to be too little real substance and way too late to do any good.
Put the pieces together.  Europe’s leaders have basically given up and are reconciled to a large and extended recession beginning no later than the first half of 2012 along with a big jump in public and private sector unemployment plus major increases in national borrowing costs.  By accepting Germany’s terms, the members of the EU have also agreed in advance to a very slow recovery from the inevitable recession.  No reason for optimism here.

The Toilet Bowl Spiral

First, what is the practical definition of deflation?  Second, why is it such a big deal?
The official definition of deflation is a decrease in the general price level of goods and services typically measured by a decline in the Consumer Price Index.  In other words, real inflation drops below zero measured against the prices of a consumer basket of goods and services.  The major concern is that deflation can get out of hand and lead to a deflationary spiral.
In this type of downward spiral, the vicious circle starts as businesses try to maintain or increase demand by lowering prices (think Christmas sales).  If lower prices fail to stimulate demand, businesses have no choice except to lower production or reduce retail inventory depending on where they are in the delivery chain.  Manufacturers fire excess workers and cancel any plans to increase plant capacity.  Retailers place smaller than normal orders and leave empty shelf space.

Unemployment goes up, real income goes down, real estate prices continue to plummet, tax revenues at all levels go down, and the deficit gets even bigger.  City, state, and federal governments – especially since they have already borrowed too much money – are finally forced to cut non-essential services and begin reducing essential services such as fire and police.
And, the municipal bond market takes a big hit as several major cities and one or more states default on interest payments and fail to pay vendors.
Then, even more government entities are forced to cut more public employees but usually not near the top where it would help.  Unemployment goes up again; aggregate income goes down even further; consumer borrowing drops more; consumer demand drops faster and further; and prices drop yet again to chase decreasing demand.

The Spiral Continues

Businesses create no new jobs.  There are no new housing starts.  New automobile production gets cut again.  As the spiral continues, businesses have to reduce their payroll even more by firing the most recently hired, by eliminating all entry-level jobs, and by firing the most expensive hourly workers – usually the oldest ones.  They even start firing middle management.  Just for the record, the last thing they cut is executive compensation.
There are two really important reasons for understanding why deflation is such a big deal – especially right now.  The first is that once this vicious cycle gets a good start, it is really hard to stop until it bottoms out like it did in the Great Depression.  Second, and maybe even more important today is the realization that deflation is at the current intersection of a massive academic ego and partisan politics.

Bernanke’s Ego and Obama’s Political Ambitions

Assuming that the Republican Party can eventually nominate any plausible candidate, even Waffle House Romney, Obama knows that the most important issue in his re-election campaign will be the economy.  Unlike Europe’s leaders, Obama cannot afford to give up and accept the inevitable recession unless he is also willing to be a one-term president.  He will do everything he can and support any idea no matter how far-fetched that has the slimmest hope of injecting good news into the gloomy economic picture. But Bernanke’s motivation is even more dangerous.  Ben Bernanke graduated from Harvard College and earned his Ph.D. from MIT.  He taught at Stanford Business School and NYU before becoming a tenured professor at Princeton.  His entire academic career focused on the policy decisions leading to the Great Depression.  In numerous papers and articles, he has expounded his theory that uncontrolled deflation triggered the Great Depression and delayed recovery.

While at Princeton, he was appointed a Member of the Board of Governors of the Federal Reserve in 2002.  He became Chairman of President Bush’s Council of Economic Advisors in 2005.  Bush nominated him as Chairman of the Federal Reserve in 2006, and he was reappointed to that position by Obama in 2009.  He is now able to treat the US economy as one giant laboratory in which to test his academic theories.
Nine years ago, then-Fed Governor Bernanke gave a speech called “Deflation: Making Sure “It” Doesn’t Happen Here.”  Read Bernanke’s words and weep:

“Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it.  If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”

The Magic Printing Presses
In fact, Bernanke has been pushing and pulling the economic policy levers in an unprecedented way since he became Fed Chairman under Bush.  Even with access through the Freedom of Information Act, the public may never know who really said what to whom as the federal government struggled with the bankruptcy of Lehman Brothers, the almost bankruptcy of Bear Stearns, the catastrophic melt-down of the sub-prime mortgage market, and the bailout of the banks that were “too big to fail.” What is clear is that the US tumbled into a recession, and the Fed under Bernanke’s direction did everything possible to contain it.  Some economists argue that it would have been better to allow capitalism to run its course, let the failures occur, and set the stage for a real recovery. The recession that started in 2008 continued in 2009, and true to his fervently held beliefs Bernanke injected massive amounts of money into the US economy, especially after Obama became President.  We can debate whether the bailouts were necessary or even beneficial, but for right now, that issue is irrelevant.  The world learned a crucial lesson about the way that Bernanke and Obama will handle any major economic crisis.

Avoid deflation at all costs!  Roll the presses!

The US Treasury has the national mints, but the Federal Reserve has printing presses.  Some of the presses are real intaglio printers used to print currency, and they are churning out new Federal Reserve funny money in larger denominations and greater quantities 24/7.  But the really dangerous ones are the virtual presses that put digital money on balance sheets without any intervening creation of goods or services.
One obvious example is “Quantitative Easing.”  This term deliberately obscures the real meaning.  Translated it means that the Federal Reserve purchases US government bonds from private holders (e.g., commercial banks) and pays for them by simply making digital entries in the selling bank’s account at the Fed.  No new goods or services.  No Congressional approval.  More money in the system.
Let’s admit that the whole world – China, Europe, the oil producing countries, and the US – face recession and possibly deflation.  We know for sure that Bernanke is self-righteous in his view that with enough money he will reverse deflation and avoid the deflationary spiral.  And, Bernanke believes that history will lavish great praise on the economist turned super-hero who saves the world.

Near-Term Forecast

Europe, will continue the inevitable slide into recession despite the best efforts of the European Central Bank (with no printing presses and no authority to manufacture money) and the Federal Reserve (with all printing presses working overtime).
On a slightly slower timetable, the US will slide back into recession as well.  Bleating like a lost little lamb, Obama will “encourage” the Democrats to create jobs, to tax the rich, to save the unions, to preserve jobs for public employees, to keep their pensions intact, and to preserve at all costs every single entitlement program, such as Social Security.
The Republicans will continue the full range of political brinkmanship.  Compromise is unlikely.  Nothing significant will happen to create jobs, reduce spending, or actually change the debt level for at least a decade.  In other words, same old stuff except that the government will officially acknowledge what we already knew in our pocketbooks.  The US is in another recession less than two years after the federal government declared a victory over the last one.

With the prospect that a back to back recession could easily lead to deflation and the dreaded spiral, Super-Hero Bernanke without any congressional oversight will be busy doing his magic.  The money supply will increase.  Interest rates will stay down.  Even so, commercial and consumer borrowing will drop.  Real estate will drop even further.  Frustrated because the story-book ending is not working out, Bernanke will pour even more money into the system.  After all, Ben runs the risk of losing his super-hero cape.
In summary, until this phase of Bernanke’s grand experiment with the American people runs its course in 24 to 36 months, you can count on three things:
1.)            Recession with a 30% or more chance of significant deflation.
2.)            Overcast conditions with no glimmer of sunshine from a grid-locked Congress.
3.)            Heavy precipitation in the form of money and credit raining down from the Federal Reserve.

This is the good news, and I fervently hope that we get a two-year run!

Black Swan Theory

The bad news is that the economic environment could go from recession to much worse very quickly if any one of several unexpected events occurred.  The “Black Swan Theory” holds that highly unpredictable events with low probability have a major impact often because we have overlooked such events and have ignored the huge impact of these supposedly rare occurrences.
For example, we can see that the list of possible disasters might include a spike in energy prices, another major terrorist attack on US soil, North Korea flexing its nuclear arsenal, the bankruptcy of the US Postal Service, or another major conflict in the Middle East.
Precisely because these events seem possible or even likely, they are not Black Swans.  But, if we think outside the box, we can speculate on events that might change everything – at least in their immediate sphere.  For example:
1.)            President Obama decides not to run for a second term, and Hillary Clinton becomes the 45th President.
2.)            North Korea offers to reunite with South Korea, and South Korea destroys its own economy in the process.  This leads to a collapse of the Asian “Tigers” in a mirror of the Euro crisis.
3.)            Iranian Hezbollah agents from Lebanon set off a small-scale nuclear device in Tel Aviv.  Israel retaliates against Syria and Iran.
4.)            The housing bubble in China explodes leading to full scale riots in six to ten cities that are quelled only with massive military force.  Chinese exports decline; imports, especially of raw materials, stop almost completely.
5.)            The national referendums on the new EU treaty trigger bloody rioting in Greece followed by popular uprisings in Spain and Portugal reminiscent of the Arab Spring in Egypt and Libya.  The Euro dies a painful death bringing down major commercial banks and private sector companies.
6.)            King Abdullah is assassinated, the Allegiance Council of the House of Saud is unable to name a successor, warring factions take over the Ministry of Defense and the Ministry of the Interior, and oil shipments stop.
These ugly events almost qualify as Black Swans, but the fact that we can conceive of them and have some idea of their impact might take them out of the category.  You have to imagine something even more unpredictable and more capable of sweeping change.  You will know it when you see it.

Near-Term Conclusions

Increased self-reliance is the best plan to get you and your family through the next two to three years.  For that short period, the US dollar will be the safe haven currency – not gold or silver.  Individuals, corporations, and governments around the world will decide to hold greenbacks and not local currencies or hard assets.
In fact, one possible explanation for the huge drop in gold in the last several months despite the Euro-crisis on the front pages is that major gold investors have already concluded that recession is the near-term problem not hyperinflation.

Study the SurvivalBlog “List of Lists,” and plan your expenditures carefully.  Look for sales and discounts.  Smart retailers have already figured out that consumers have become deal conscious and realize that retail prices have to drop to get customers in the door.
If at all possible, avoid taking on more debt other than student loans (just the opposite advice if hyperinflation were on the immediate horizon).

Given any reasonable opportunity, get out of an urban or suburban mortgage.  Even on an after-tax basis, renting makes more sense than owning.  Commercial and residential real estate will take another big drop in the next two years.
Before signing any contract extending more than 60 to 90 days, make sure that you are protected against wild price swings and unusual government delays of any sort.
Be prepared to dump digital cash and digital assets, i.e., bank deposits and brokerage accounts, on very short notice.
Have you been putting off a decision about relocation?  If you already live in a major urban area in the West like Denver, Phoenix, or Cheyenne, you are much better off than if your job keeps you in Cleveland or Harrisburg.  Use this window to visit some of the best candidates on your list.
If you decide to purchase silver dimes and take possession, don’t be surprised to see silver drop even lower before gold and silver surge past their previous highs.
Now is the time to develop additional skills that might be marketable in tough times and to look for financially secure employers.  Plan ahead for the consequences if one of the major bread winners in your family were to lose their job.
Even in the middle of the recession, keep a vigilant eye on the early symptoms of hyperinflation.  Anticipate a Black Swan event.  Be prepared to implement Plan B instantly.

Make a Plan B

Let’s assume that my conclusion regarding the near future is a good working forecast and that the next two years are bad but not ugly.  Even so, each of us has to be prepared to change our direction and actions on the spot.  In my experience, the best way to do this is to have a genuine contingency plan or “Plan B” worked out in advance.
Start with the assumption that some aspects of your plan will not work or will be just plain wrong.  Once you have developed a plan and worked out the implementation, changing that plan to fit the circumstances that unfold is much easier and quicker than doing a Plan B from scratch.  Unless you need to plan only for yourself, the other great benefit is that family or friends or members of your prep group are all on the same page.  Do the discussion before the crisis.
Although it may not be a part of your action steps, I recommend that your Plan B specifically address possible trigger points and that you get buy-in to take action as soon as certain trigger points are reached.  Even during the next two years of recession, an abrupt turn to hyperinflation is a real possibility.

  • Be alert to the early warning signs of hyperinflation.
  • Have your money out of the banks before the lines of angry depositors form.
  • Buy gas or diesel and storage containers before prices take off.
  • Practice packing and know how long it will take and what you really can carry.
  • Get home or bring family home while airlines are still flying.
  • Be prepared to leave Dodge City near the front of the convoy.

 

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