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A Final And Total Catastrophe?
By Ron Hera October 18, 2012 ©2012 Hera Research, LLC Famed Austrian economist Ludwig von Mises wrote in his seminal work, Human Action (originally published by the Yale University Press in 1949), that “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” The collapse of a historic credit bubble occurred in 2008. However, despite years of further credit expansion, “a final and total catastrophe” of the U.S. dollar system has yet to occur. Prolonging the U.S. dollar system involves a combination of market interventions, direct government control over the economy and ongoing monetization by central banks. Of primary concern is the probability that the U.S. dollar will collapse versus the sustainability and long term effects of what might be described as a new economic paradigm. A stock market crash, economic recession or depression, sovereign default, widespread bank failures or a systemic collapse of the financial system are all logical, potential consequences of an artificial boom brought about by excessive credit expansion. Arguably, policymakers cannot prevent some form of “collapse” but they can, at least, prolong the process and shift the costs. Rather than a sudden, catastrophic collapse, the post 2008 period is defined by a policy based status quo. Instead of allowing banks to fail and sovereign nations to default, and surely suffering an economic depression, buying time has allowed policymakers a window of opportunity in which to develop longer term solutions. However, as the consequences of current policies, both intended and unintended, have mounted, longer term solutions have not emerged. Measures that began as emergency interventions have become routine and their consequences suggest an emerging new economic paradigm. Leading up to the 2008 financial crisis, excessive leverage and risk in the financial system, e.g., the housing bubble and unregulated over the counter (OTC) derivatives, resulted in bank insolvencies, a historic stock market crash and a near collapse of the global financial system. Despite, massive market interventions, bank bailouts and debt monetization, a deep, global recession ensued. The 2008 financial crisis, the recession, and the policies used to manage them, required sharp increases in government spending while tax revenues were in decline, bringing sovereign debt sharply into focus. As a result, Europe was engulfed in a sovereign debt crisis. In the U.S., the residential real estate collapse and stock market crash represented a direct loss of household wealth while bank bailouts represented a transfer of wealth from proverbial Main Street to literal Wall Street. Deficit spending, debt monetization and the Federal Reserve’s asset purchases expressed an inflationary monetary policy involving numerous risks and potential consequences. Although various monetary aggregates can have different effects, the overall increase in the supply of U.S. dollars is concerning.

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Despite the 2008 financial crisis, global recession and inflationary policies, confidence in the U.S. dollar, the U.S. stock market, the U.S. federal government and the U.S. economy remained largely intact. Inflationary policies reduced certain risks, such as the risk of a deflationary collapse, while increased liquidity from central bank monetization lifted financial markets. More recently, investor confidence has been supported in Europe by the European Central Bank’s (ECB) outright monetary transactions (OMT) program and in the U.S. by the Federal Reserve’s quantitative easing III (QE3) program. In Europe, the risks of sharply rising sovereign bond yields, sovereign defaults and the potential breakup of the euro have been muted by OMT while European leaders putatively move toward a fiscal union. Thanks in part to the Federal Reserve’s ongoing “operation twist,” U.S. Treasury yields remain near historic lows.

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On the surface, the fallout from the 2008 financial crisis has been effectively managed, but another financial crisis seems inevitable. Developing mechanisms to manage a crisis similar to that of 2008 and preventing another crisis are fundamentally different propositions. The basic causes of the 2008 financial crisis have not been fully addressed. The lines between depository institutions and securities firms, erased in the U.S. by the final repeal of the Glass-Steagall Act in 1999, have not been restored and the U.S. Financial Accounting Standards Board’s (FASB) mark-to-market rule has yet to be reinstated. Although bank capital ratios have improved, leverage remains excessive, balance sheet assets remain troubled and, arguably, risk levels are higher than in 2008 because economic conditions have deteriorated compared to the pre-crisis period. Banks deemed “too big to fail” in 2008 have since become bigger and the gross credit exposure associated with risky OTC derivatives is nearly as large as it was before the 2008 financial crisis. History has shown that OTC derivatives increase leverage and risk in the financial system. OTC derivatives are likely to result in bank or hedge fund failures and to contribute to another financial crisis. According to the International Swaps and Derivatives Association (ISDA), OTC derivatives risk is widely misunderstood because the net notional amounts of OTC derivatives, such as credit default swaps (CDS), total only about 10% of the gross notional amounts. In other words, gross notional amounts, totaling roughly $700 trillion, are not a direct measure of credit exposure. If the same percentages apply for all OTC derivatives, the net exposure of market participants, e.g., “too big to fail” banks, is less than $70 trillion. Although $70 trillion is approximately equal to the world’s total gross domestic product (GDP), it is unlikely that all counterparties would fail simultaneously or that all losses would be 100%. Nonetheless, the failure of major financial institutions in connection with OTC derivatives risk could lead to another financial crisis which would accelerate the disintegration of the U.S. dollar system. While increased liquidity makes a stock market crash less likely, it remains unclear where earnings growth will come from for many U.S. companies. Ongoing monetization has elevated U.S. stocks ahead of the economic recovery and economic data have been disappointing, making a correction logical. Additionally, by the end of 2013, the Federal Reserve’s balance sheet will have exceeded $3.4 trillion and the Federal Reserve’s intention to eventually unwind its positions could become less credible.

U.S. Leads Global Slowdown
For 2012, the International Monetary Fund (IMF) projects 2.2% growth in Japan and the United States and 3.5% growth globally. Based on the Baltic Dry Index (BDI), which reflects the price of moving major raw materials by sea, the global economy slowed significantly in 2012 and showed few signs of recovery. Nonetheless, there has been overall improvement in comparison to the depths of the global recession in 2009.

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The BDI is a leading indicator of economic activity because it reflects the demand of manufacturers for raw materials. A decline in the BDI signals falling global demand for manufactured goods. In the U.S., rail carloads also indicate falling demand.

Removing potentially optimistic projections, the U.S. Energy Information Administration’s (EIA) liquid fuels consumption data also suggest a U.S. slowdown.

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In the past few decades, U.S. corporations moved production offshore, destroying domestic jobs. Credit expansion masked the lost income of U.S. consumers but the process inexorably reached its logical conclusion in 2007. The shift of U.S. workers to lower paying service sector jobs was counterproductive because income flowed out of the U.S. following on the heels of jobs.

Although policymakers, including Federal Reserve Chairman Ben Bernanke, deny it, in fact, U.S. unemployment is a long term, structural problem linked to the outflow of U.S. consumer incomes.

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The current surplus of U.S. labor, abundant capital and somewhat less expensive energy are insufficient to stimulate a broad based economic recovery in the U.S. U.S. consumers remain burdened with high debt levels and, in a global slowdown, it remains unclear where customers would come from for new U.S. products and services even with a weaker U.S. dollar.

The true test of current policies is to be found in the resulting economic conditions. Although the financial system has continued to function due to massive infusions of liquidity, economic activity, with some exceptions, has not generally recovered or has continued to deteriorate, e.g., the shrinking number of people in the official U.S. workforce.

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U.S. GDP has been boosted by government deficit spending in excess of $1 trillion per year and, removing the temporary effects of extraordinary deficits, U.S. GDP remains negative.

Loose monetary policies, rather than spurring lending to consumers or small businesses, have created inflationary pressures and have lead to stagflation. Currency debasement, rather than putting Americans back to work, raises the specter of inflation.

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Based on U.S. Consumer Price Index (CPI), the official inflation rate in the U.S. is roughly 2%, but the CPI does not accurately measure the cost of maintaining a constant standard of living. Using the same methodology as in 1980, the CPI would be 9.3%.

Hyperinflation Risk
While an inflationary U.S. monetary policy has serious consequences, hyperinflation is not an immediate consequence. There are three general ways in which the U.S. dollar system could break down: (1) a domestic failure of confidence, (2) rejection of the U.S. dollar as the world reserve currency, or (3) as an eventual consequence of U.S. federal government insolvency. Of the three, the latter is the most serious because it would result in both of the former two.

Domestic Confidence in the U.S. Dollar
Within the United States, outside of Wall Street and Washington D.C., the overall economic environment in the broad U.S. economy remains deflationary. Bank lending to consumers and small businesses remains depressed while debt service represents steady deflationary pressure. In other words, private sector debt levels remain high and money is relatively scarce in the ‘real economy’. Reported increases in consumer credit are significantly the result of increased student loans, which are linked to unemployment and poor job prospects for young people. A scarcity of physical notes or a race to shed currency in favor of hard assets seems unlikely to originate within the U.S. unless there is first a conspicuous scarcity of goods. Virtually unlimited support for banks by the U.S. federal government and by the Federal Reserve has thus far proven sufficient to prevent a panic. U.S. households do not generally have cash and often rely on electronic conveniences, such as automated payroll deposits, electronic bill payment and on credit and debit cards. Additionally, unlike countries that have suffered hyperinflation in recent history, U.S. citizens have no practical alternative currency. In the absence of runaway inflation, the impetus to flee the banking system or to rush out of the U.S. dollar is unlikely to originate in a domestic collapse of confidence regardless of U.S. monetary policy. An outlying but nontrivial risk related to hyperinflation is the risk of a breakdown of confidence in the U.S. financial system related to its perceived legitimacy. Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement pose a serious threat to confidence in the U.S. financial system. Before the 2008 financial crisis, confidence in the U.S. financial system was shaken by fraudulent sub-prime mortgage lending and securitization practices. In 2010, the so-called “Flash Crash” reopened questions about the stability of U.S. financial markets and, in 2011 “robo-signing” and other foreclosure frauds were reminiscent of sub-prime lending. In late 2011 and 2012 perception of the U.S. financial system suffered a staccato of blows, including the failure of MF Global Holdings Ltd., with the loss of $1.6 billion in customer funds; JPMorgan Chase & Co.’s $6.2 billion “London Whale” OTC derivatives trading loss; the failure of Peregrine Financial Group Inc. (PFGBest), with the loss of over $200 million in customer funds; money laundering by HSBC for drug cartels, including Mexico’s most violent criminal organization, Los Zetas, and for states that sponsor terrorism; Knight Capital Group Inc.’s high-frequency trading (HFT) loss of $440 million; as well as a growing number of civil and criminal cases linked to mortgage, foreclosure and securities fraud. Scandals elsewhere in the world, such as the rigging of the London Interbank Offered Rate (LIBOR) by Barclays, in cooperation with other banks, including JPMorgan Chase & Co. and Citigroup, Inc., have further undermined confidence.

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World Reserve Currency Status
A growing challenge to the U.S. dollar system relates to its waning status as the world reserve currency. The BRIC countries (Brazil, Russia, India and China), along with South Africa, no longer use the U.S. dollar for trade settlement amongst one another. The Chinese have internationalized the renminbi (RMB), which is now used in trade settlement with the other BRIC countries, as well as with Australia, Japan, the United Arab Emirates (UAE), Iran and various South American and African countries under bilateral agreements. Iran, which is the world’s 4th largest oil exporter, has refused to accept U.S. dollars in exchange for crude oil since 2009. While European countries utilize the euro, South American countries have instituted a local currency payment system, the Sistema de Pagamentos em Moeda Local or SML. At the same time, the IMF stands ready to settle international trade using Special Drawing Rights (SDRs). However, local settlement at the regional level is largely irrelevant. At the global level, the implicit crude oil backing of the U.S. dollar by the Organization of the Petroleum Exporting Countries (OPEC) remains in place and the U.S. military remains dominant. As long as OPEC backs the U.S. dollar, and as long as there is no viable challenger, the U.S. dollar is unlikely to be deposed. The euro, for example, is a troubled currency and its future is questionable. China’s economic ascent is likely to continue and the RMB can be redeemed for Chinese-manufactured goods. However, the Chinese economy is currently in a recession, the RMB is not a fully international currency and China’s military is not ready to take on the role of a global superpower. At present, no national currency stands as a viable challenger for the position held by the U.S. dollar and there is no consensus regarding its eventual replacement. However, discussion of the gold standard has moved from the fringes of the financial world into the mainstream. The price of gold has risen in response to widespread currency debasement, i.e., as a hedge against inflation.

OPEC and many other countries could, potentially, fall back to gold if the U.S. dollar were no longer viable, i.e., if the prices of global commodities, and especially the price of gold, were to rise at an accelerating rate measured in U.S. dollars. China and Russia, for example, are significant buyers of gold

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and crude oil can be purchased with gold instead of U.S. dollars pursuant to bilateral agreements, if not on world markets generally. An eventual return to the gold standard is possible but seems unlikely in the near term. Governments, banks and corporations around the world hold trillions of U.S. dollars along with U.S. dollar denominated financial assets, such as U.S. stocks and U.S. Treasury bonds. Even countries hostile to the United States cannot benefit by refusing U.S. dollar transactions or by dumping U.S. Treasury bond holdings in the market. Ignoring the fact that the Federal Reserve and its Primary Dealers, together with other Western central banks, stand ready to intervene as needed to support the U.S. dollar, retaining the majority of the value of U.S. dollar holdings is always a superior alternative in the short run, particularly if the alternatives are economic sanctions, war, or, in the case of the U.S. dollar’s collapse, a 100% loss. In other words, the tolerance of the world financial system and of the global economy for the U.S. zero percent interest rate policy (ZIRP), ongoing U.S. Treasury bond market interventions, i.e., Operation Twist, and quantitative easing is far greater than is commonly believed. The U.S. dollar certainly will be replaced as the world reserve currency at some point in the future, but claims that the U.S. dollar is in danger of imminent collapse as a result of international rejection are exaggerated.

U.S. Federal Government Debt and Unfunded Liabilities
Setting aside domestic confidence in the U.S. dollar and its world reserve currency status, the most critical threat to the U.S. dollar, lies in the risk of U.S. federal government insolvency. Before the 2008 financial crisis, the U.S. federal government had reached a point where no combination of economic growth, tax increases or government budget cuts will allow it to pay back its public debt and also meet its unfunded liabilities.

As a percentage of GDP, total U.S. federal government debt is larger than that of Spain and nearly as large as that of Portugal and Ireland.

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The U.S. federal government’s budget deficit, which stands at approximately 8.7% of U.S. GDP, is as high as that of Greece and higher than those of Spain, Portugal and Italy.

Total U.S. government spending at all levels is approximately 40% of GDP and, unless economic conditions improve, will increase further. Unfunded liabilities of the U.S. federal government total $61.6 trillion ($534,000 per household). The liabilities include federal debt ($9.4 trillion) and obligations for Medicare ($24.8 trillion), Social Security ($21.4 trillion), military retirement and disability benefits ($3.6 trillion), federal employee retirement benefits ($2 trillion) as well as state and local government obligations ($5.2 trillion). Based on Generally Accepted Accounting Principles (GAAP), economist John Williams has projected U.S. federal government insolvency and, as a result, hyperinflation, as soon as 2014. Mr. Williams’ projections do not include the fact that numerous U.S. states, counties and cities are insolvent or at risk for bankruptcy.

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The insolvency of a sovereign nation becomes inevitable once new borrowing is required to service existing debt, but the Minsky moment only arrives when (1) further borrowing becomes impossible and also when (2) monetization results in rejection of the currency. The more unworkable U.S. federal government finances become, the more likely a hyperinflationary collapse of the U.S. dollar will become. Increases in the money supply and in debt levels suggest that the probability of a hyperinflationary collapse of the U.S. dollar is increasing at an accelerating rate.

An inevitable outcome is not necessarily an immediate one and U.S. policymakers are masters of “kicking the can down the road.” Another financial crisis or a further economic decline in the U.S. could accelerate the financial breakdown of the U.S. federal government, but a robust U.S. economic recovery, technological breakthroughs and other decelerating factors could delay it. Despite the fact that Mr. Williams’ Hyperinflation Special Report 2012 is required reading, the timing of the predicted outcome assumes a low international tolerance for the monetization of U.S. federal government debt. Mr. Williams implicitly assumes that the market for U.S. treasuries is a free market and that, therefore, either U.S. Treasury bond yields will skyrocket or that willingness to lend to the U.S. will collapse, but that may not be the case. Together with other central banks, the Federal Reserve could continue to manipulate U.S. Treasury bond yields and the value of the U.S. dollar for an indefinite period of time. On one hand, according to Herbert Stein’s Law, “If something cannot go on forever, it will stop.” On the other hand, the U.S. dollar remains ‘the worst currency in the world, except for all the rest.’ Since the start of the Federal Reserve System, the U.S. dollar has passed one apparent ‘point of no return’ after another and with each one, e.g., the start of QE3, critics have argued that the collapse of the U.S. dollar is imminent. The roots of the arguments generally date back to 1971 when Nixon closed the gold window. Severing the link to gold was a crucial point of no return, but, more than forty years later, a hyperinflationary collapse of the U.S. dollar has yet to occur. If history is any guide, additional points of no return lie ahead for the U.S. dollar.

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The Post Collapse World
Arguably, the U.S. dollar system failed in 2008 and, therefore, is not precisely in danger of collapse. Thus, after the 2008 crisis, the proper subject of analysis became the eventual consequences of market interventions, direct government control over the economy and ongoing monetization by central banks. The emerging new economic paradigm reflects a transition from a market based status quo to a policy based status quo. Interventions that subvert market forces stand in evidence in virtually all Western countries, as well as in Japan and China. Countries in the European periphery, e.g., Greece, are excellent examples. In the case of Greece, the natural market outcome would have been a Greek default and an exit from the European Monetary Union (EMU) accompanied by losses for European banks and probably a number of bank failures along with a systemic impact caused by OTC derivatives. To prevent losses and bank failures, however, market forces were subverted and policies replaced markets. In a sense, the world has become more predictable as a result. Insolvent “too big to fail banks” will not fail. Bankrupt sovereign states will not default on their obligations no matter how unworkable their finances become. Currency exchange rates were openly managed before the 2008 financial crisis and in the post collapse world sovereign bond yields are also openly managed. Instead of deflation following a boom brought about by credit expansion, inflation stands in evidence. Whether market interventions, direct government control over the economy and ongoing monetization by central banks can produce significant or self sustaining economic growth is a crucial question. Inflationary policies, for example, support governments and banks but liquidity resulting from central bank monetization flows unpredictably and has destabilizing effects, such as fueling speculation commodities, asset price bubbles or currency wars. Central bank monetization alters the distribution of money, thus of purchasing power and redistributes wealth while inflation erodes the value of savings. The process replaces capital distributed throughout the economy with credit concentrated in banks. In the U.S., one of the Federal Reserve’s policy assumptions is that small businesses rely on bank credit, which is true for operations and expansion, but it is savings, not credit, that is the engine of small business creation. Most U.S. jobs are in small businesses, thus QE3 will ultimately destroy jobs by stifling small business creation. The combination of reduced business creation, continuing high unemployment and inflationary pressures exactly define stagflation.

Countdown to Crisis
As long as bank failures and sovereign defaults continue to be prevented, mainly through monetization by central banks, overall economic conditions in Western countries can be expected to deteriorate further. The debasement of major currencies will reduce the real values of debts but currency debasement cannot create a genuine economic recovery as long as both the banking system and government finances remain impaired. At the same time, without robust economic growth both the banking system and the finances of Western governments certainly will remain impaired. In the mean time, the new economic paradigm based on market interventions, direct government control over the economy and ongoing monetization by central banks is set to continue in the foreseeable future. ###

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Hera Research, LLC, provides deeply researched analysis to help investors profit from changing economic and market conditions. Hera Research focuses on relationships between macroeconomics,

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government, banking, and financial markets in order to identify and analyze investment opportunities with extraordinary upside potential. Hera Research is currently researching mining and metals including precious metals, oil and energy including green energy, agriculture, and other natural resources. Hera Research covers key economic data, trends and analysis including reviews of companies with extraordinary value and upside potential. ###
Articles by Ron Hera, the Hera Research web site and the Hera Research Newsletter ("Hera Research publications") are published by Hera Research, LLC. Information contained in Hera Research publications is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The information contained in Hera Research publications is not intended to constitute individual investment advice and is not designed to meet individual financial situations. The opinions expressed in Hera Research publications are those of the publisher and are subject to change without notice. The information in such publications may become outdated and Hera Research, LLC has no obligation to update any such information. Ron Hera, Hera Research, LLC, and other entities in which Ron Hera has an interest, along with employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in these publications or web site. The policies of Hera Research, LLC attempt to avoid potential conflicts of interest and to resolve conflicts of interest should any arise in a timely fashion. Unless otherwise specified, Hera Research publications including the Hera Research web site and its content and images, as well as all copyright, trademark and other rights therein, are owned by Hera Research, LLC. No portion of Hera Research publications or web site may be extracted or reproduced without permission of Hera Research, LLC. Nothing contained herein shall be construed as conferring any license or right under any copyright, trademark or other right of Hera Research, LLC. Unauthorized use, reproduction or rebroadcast of any content of Hera Research publications or web site, including communicating investment recommendations in such publication or web site to non-subscribers in any manner, is prohibited and shall be considered an infringement and/or misappropriation of the proprietary rights of Hera Research, LLC. Hera Research, LLC reserves the right to cancel any subscription at any time, and if it does so it will promptly refund to the subscriber the amount of the subscription payment previously received relating to the remaining subscription period. Cancellation of a subscription may result from any unauthorized use or reproduction or rebroadcast of Hera Research publications or website, any infringement or misappropriation of Hera Research, LLC's proprietary rights, or any other reason determined in the sole discretion of Hera Research, LLC. ©2009-2012 Hera Research, LLC.

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