Why Another Crisis is Inevitable

The seemingly non-stop melt-up in the S&P500 stopped last week.  The S&P dipped 0.2%, but on strong volume which continues to signal that the equity markets are vulnerable to a stronger selloff.  The VIX index also jumped up almost 14%.  This supports the idea that the market is jittery and could retreat violently because many stockholders may not be as hedged as they were a year ago.  So for these folks, if prices fall some more, the fastest way to minimize damage would be to sell.

The macro data was mostly weak.  US trade figures came in worse than expected.  This multi-decade imbalance–where we import much more than we export–has yet to be corrected.  Consumer prices, both headline and core, were muted, implying that there’s very little inflation at the end-user level.  Retail sales were better than expected, but as many economic analysts pointed out, this was in part due to the spare cash available to millions of homeowners who’ve stopped making their mortgage payments.  Initial claims spiked to 484,000–much higher than the consensus estimates; continuing claims (with emergency and extended figures included) are hovering near record highs–10 million.  Housing starts were better than expected, but only because apartment starts jumped; starts for single family homes actually fell.  Consumer sentiment fell sharply, when it was forecast to rise.

The technicals are still screaming overbought, on both the daily and weekly charts.  The week ended with a sharp sell off; if this continues next week, the overbought levels could be further corrected.

At the George Soros sponsored Institute of New Economic Thinking, the former chief economist at the Bank of International Settlements, William White, presented some insightful thoughts on how policy makers around the world–and especially in the US–attacked the most recent recession, and why this approached is doomed to fail.

At root, White pointed out that economists pulled out cyclical tools to fix a secular problem.  The secular problem is the massive accumulation of total debt over the last 3o years.  And this debt load was built up across multiple business cycles.

But when our current balance sheet recession hit, our leaders applied cyclical tools–fiscal and monetary stimulus–but did NOTHING to address the underlying structural problem, the massive debt load. In fact, they made it even worse, by pumping up government debt.

The chart below highlights the limits of the cyclical tools.  As debts rise (as a percentage of GDP) and as the Fed pushes down short-term interest rates, we rapidly approach a terminal state where there is no more room to push debt loads up and rates down.  The Fed cannot lower rates below zero, making it impossible for the economy to take on more debt (at ever lower rates) without incurring the risk of default. 

So monetary policy is becoming ineffective.  And the private and public sectors will be forced to deleverage. 

The problem is that broad deleveraging is easier said than done.  Ideally, it’s done gradually to reduce the negative impact of lower incomes, which lowers GDP and lowers the ability to pay down debt in the first place. 

And history suggests that deleveraging rarely follows the ideal path.  Instead, public and private sectors typically de-lever most effectively by defaulting.  And defaults typically lead to bankruptcies and sovereign debt crises. 

This is why another crisis is inevitable.

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