muses of the moment

April 16, 2011

Mr. Smith’s latest post

Great post over at from Charles Hugh Smith. Mr. Smith is a deflationist, but we seem to agree on most everything else. click here.

His latest post is an excellent take on possible US Bond market manipulation. I completely agree with Mr. Smith’s assessment of what could happen to interest rates on US bonds in the next 2 years or what he refers to as a con. (In fact this could be the place that “hot money” will run to in Martin Armstrong’s Economic Confidence Cycle. We will have to wait and see.)

The Con:

  • Only buyer, Fed, stops buying US bonds.
  • Rates rise, big banks buy bonds at higher rate return and ride the hot money market up.
  • Rates crash with calls for austerity as economy ceases to function with such high rates.
  • By this time, big banks are out and the herd is left holding the bag.

Then Mr. Smith loses me. He makes a blanket statement as a conclusion for why this will happen the way it will:

What the true believers of hyperinflation and the destruction of the dollar cannot accept is that debt is an asset to the owner of that debt. In focusing solely on the advantages of inflation to borrowers, they ignore the critical fact that inflation quickly destroys the value of the asset that debt represents to the owner. And debt is a primary asset to pension funds, insurance companies, banks, and indeed the entire financial sector.

First of all, deflation destroys the value of an asset, too. And second of all, debt is ONLY an asset to the owner of the debt as long as the asset can service at least the interest on the debt.

If debt was always an asset to the owner of the debt, Fannie and Freddie would be the best performing stocks on the market.

Side musing: there are investment cycles when debt is an asset to the owner, they are called the spring and autumn cycles. The summer and winter cycles are not kind to debt, the winter being the worst. We are in the middle of a K-wave winter cycle right now.

The first wave of the debt collapse:

That is the problem we are facing with the global debt contraction right now. Debt is contracting in every market right now because the underlying asset can not be sold for its perceived value.

So debt, unable to be sold, must then at least be able to create enough cashflow (or in the case of government-ownership, print enough cashflow) to service the underlying debt.

The second wave of the debt collapse:

Soon, we will come to the next wave of the global debt contraction, the inability to service the interest on all the debt, even if you try to print it. Now you don’t just have the inability to sell for the book price, you have a major cashflow/liquidity/no capital creation problem. You are also in the catch-22 position of being unable to sell the underlying asset at any price, even at a loss.

Why would an investor buy an asset with debt attached that can not be serviced now or in the future? They wouldn’t at any price. That is the waterfall, point of no return, jig is up, global crash, fiat currency now seen as unsustainable debt vehicle. Yes, at some point, even the dollar will have no buyers, because fiat currency is DEBT.

This contraction in global debt….the inability to service current debt will happen in a deflationary phase or a hyperinflationary phase. It doesn’t matter.

During a deflationary phase, investors take a cut on the price of the underlying asset and accept less return on the debt issue. In a hyperinflationary phase, more money is created to service the debt, but that return is less valuable (purchases less) because it is priced in an inflated currency. The result is the same, but the “price” in the fiat currency may be different. Knowing the true value of an asset is much more important than price in this current investing cycle. It is not the same as it was just a few years ago.

In a global debt contraction, there will eventually be no market for any asset with debt attached to it. And there will be a huge market for any asset without debt attached to it.

The Housing Market

This is why groovygirl is constantly saying, it doesn’t matter how high or low the price of real estate is…if no one can get a mortgage, service current debt or get new debt: there is no housing market. A new system for buying and selling homes, one not so reliant on the system of debt, will need to be created before growth can resume. The same will happen to all other investments (including fiat currencies) currently backed by an unsustainable, ever-expanding debt system.

I think the key problem here is that groovygirl’s definition of inflation is not the “good kind” of inflation that is produced when economies have real growth based on higher production and more job creation. The inflation we have today is created by printing money and creating more debt to service previous debt just to keep things from collapsing. It is not growth in real capital from real production. This type of high inflation shows up in the “real things” created or natural resources, not necessarily the assets that were created by debt.

Let’s continue to keep an eye on the US bond market. I think that portion of Mr. Smith’s assessment is very plausible. But the temporary rise in US Bond rate return would be a temporary flight of capital or a hot money market, not necessarily a direct result of a deflationary or hyper-inflationary phase or the final resting place of global capital. Why? Because US bonds are DEBT, and all debt will contract.

The Crash Course

Chris Martenson has come out with a book. It is an expanded and updated version of the information in his 20-hour video series he has created called The Crash Course.

Groovygirl HIGHLY recommends the video series (free, click here) and the book (at Amazon, here).

Both of these references are must-reads/watch for anyone to understand what is happening right now and will happen from 2010-2020. Chris does a wonderful job explaining the end of growth in the United States and the global community. The rules have changed and the next 20 years will be completely unlike the last 20 years for the economy, energy, and the environment. How it will affect you and your family and what to do about it.

Recently, Chris was interviewed about his new book over at Two Beers with Steve, click here.

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