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report

17th December 2009

This issue is dedicated to:


Phase II of the crisis – waiting for the
“Creditanstalt moment”
Martin Armstrong
It was the failure of Austria’s Creditanstalt bank in May
1931 which brought on the second phase of the Great
Depression. Capital flows led to the transmission of the
crisis in terms of cascading debt defaults from smaller,
weaker economies to the rest of the world, just when
many commentators thought the corner had been turned.

Fast forward to today and the Dubai news, together with


problems in Greece, Ireland, Spain and now Austria,
confirmed that the current debt crisis is alive and well and
spreading to sovereign nations. The European banking
Imprisoned for being the best
system (especially in Austria, Germany, Italy, France)
financial analyst of us all
is horribly over-exposed to nearly bankrupt nations on
Europe’s periphery. Despite this, there has been no change
to the normal modus operandi for generating consensus
expectations, i.e. extrapolating current conditions, trends,
hopes, etc, in a linear way into the future.

What has been missing so far is a “Creditanstalt moment”


and I would put more money on this being a “when”
rather than “if” event. It almost happened at the weekend
Contact/additions to distribution: with the failure of Austria’s (again!) Hypo Group Alpe
Adria (HGAA) bank. HGAA posed systemic risk and was
Paul Mylchreest nationalised just in time, but Austria is in a terrible mess.
paul@thunderroadreport.com Hungary, Romania and Ukraine are on IMF life support,
Greece and Ireland remain horribly vulnerable, while the UK and Spain are getting close to
the edge. How long can the obscene bailouts and deficits continue without government bond
markets raising the white flag? Yields are finally beginning to edge up.

Powerful inflationary and deflationary forces remain locked in combat – an incredibly dangerous
and volatile scenario and a result of policy makers attempting to defy economic gravity. I expect
the next phase of the crisis to be characterised by massive global capital flows as “hot money”
traverses the planet in response to “shocks”, moving from currency-to-currency and asset
class-to-asset class, looking for security and/or asset price inflation. The remonetisation of
gold continues to unfold and the recent acceleration in capital concentrating in the gold market
is, above all, a huge vote of no confidence in the economic stewardship of the major nations.

One of the enduring aspects of the financial markets for me is the existence of asymmetric information/
understanding and the need for its continual pursuit in order to gain that all-important “edge”. With the
proliferation of information these days, the search for new angles or ideas seems to take more sifting from
an ever widening number of sources, while my “physical” library gets ever bigger (a “neurosis” according
to my wife). It has also led to me to largely dispense with sources in the mainstream media, apart from
having “Financial Entertainment TV” (CNBC) on in the background.

Looking back 3-4 years, the crucial asymmetric information in the financial markets was an understanding
of credit bubbles, debt/GDP ratios, Kondratieff waves, the dysfunctional US mortgage market and (as
always) a good knowledge of financial history. That said, just because I saw it then doesn’t mean I’ve got
a handle on the key themes right now – but I hope you’d be disappointed if I didn’t have a go. Here are a
few in no particular order - the prolonged nature of debt crises, lessons from the cascading debt defaults of
1931-33, Martin Armstrong’s model, the wrecking ball of global capital flows, inflation and crack-up booms,
etc.

Talking of asymmetric information in general, it fascinates me how few people have been aware of the huge
debate regarding the end of the Mayan calendar on 21 December 2012. The Mayans were the “keepers of

time” and I’ll allude to this again later. Dan Brown referred to the end of the Mayan calendar in his latest
novel, “The Lost Symbol”, and the 2012 movie has recently premiered, so it should begin creeping into

© Thunder Road Report - 27 December 2009 2


people’s consciousness to a greater extent. I was chatting to one of London’s smartest fund managers and
he remarked how he’d love to be able to:

“Buy shares in 2012 awareness”!

So would I and would also add awareness of the works of Joseph Campbell and Carl Gustav Jung. Not
surprisingly, the 2012 movie takes an “apocalyptic” approach to 2012 in line with the common usage of the
word. However apocalypse can also mean an “unveiling” according to Dan Brown or, just as interestingly, a
“revelation”. I expect the financial markets will deliver a revelation, for these really are strange times when:

BB Grown men enthusiastically advocate quantitative easing and near zero interest rates on the part of
insolvent governments in the hope of a quick fix, little realising that they are literally just “papering”
over the cracks; and

BB Experienced financial professionals genuinely believe that we have “dodged the bullet” with regard to
the debt crisis and things will be okay going forward, even if the recovery is slower than normal, blah,
blah, blah.

John F. Kennedy said:

“Too often we enjoy the comfort of opinion without the discomfort of thought.”

While portfolio manager John Hussman nailed it in his article, “Reckless Myopia”, from two weeks ago:

“I should have assumed that Wall Street’s tendency toward reckless myopia - ingrained over the past
decade - would return at the first sign of even temporary stability. The eagerness of investors to chase
prevailing trends, and their unwillingness to concern themselves with predictable longer-term risks, drove
a successive series of speculative advances and crashes during the past decade - the dot-com bubble,
the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble…In part,
the market’s increasing propensity toward speculation reflects the increasing lack of fiscal and monetary
discipline from our leaders. Policy makers who seek quick fixes and could care less about long-term
consequences undoubtedly encourage investors to embrace the same value system.”

It’s truly staggering really when one of the biggest lessons of financial history, and very recent financial
history no less, is that prolonged periods of cheap money lead to asset bubbles and eventual disaster.
We’ve seen it time and time again, but the majority always fall into line with the reassurances of central
bankers and politicians – no matter how bad their track records.

In this vein, Doug Noland in his Credit Bubble Bulletin highlighted how the majority of commentators don’t
forsee the disastrous consequences of current US monetary policy:

“The sources of acute systemic fragility are generally not easily or commonly recognized during periods
of excess. The risks wrought from Fed-induced market distortions and mis-pricings during the mortgage
finance bubble were not apparent to most until it was much too late. The perception today is that our post-
bubble systemic backdrop is not vulnerable to either excesses or inflationary pressures. The bulls scoff at
the notion that there are domestic risks associated with sticking with ultra-easy monetary policy. The risks
are there but not so visible.”

There’s been a procession of Fed “big cheeses”, who didn’t see the debt/real estate bubble coming, reassuring
us that they aren’t creating another one now. According to Ben Bernanke

“It’s not obvious to me in any case that there’s any large misalignments currently in the U.S. financial
system.”

Oh yeah? How about a bubble in your currency even though its value is declining? That really is economics
turned on its head! But my favourite comment from the Federal Reserve recently was San Francisco Fed
President, Janet Yellen’s comment about identifying asset bubbles:

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“Further research into the connections among monetary policy, the banking and financial sectors, and
systemic risk is needed to help answer this question.”

You want to do MORE research, give me strength! You (the Fed) had 22,000 employees on the case in
2005-06 and couldn’t see the bubble developing. It seems that the Fed hires people who, in financial
analysis terms, couldn’t hit the back of a donkey with a banjo.

“Excuse me. Do you know anything about financial analysis?”

“Not really”

“Excellent.”

Repeat 22,000 times. I’ve always liked the way that the high-living, hard drinking, Dean Martin was
introduced as “Direct from the bar” in the Rat Pack’s Las Vegas shows. Well “Direct from his prison cell” in
Fort Dix New Jersey, here is the world’s greatest financial analyst, Martin Armstrong, who called the 1987
Crash TO THE DAY as well as the Japanese crash in 1989, the Russian crisis in 1998 and the current crisis
almost to the day in each case (talking of track records!):

“Ayn Rand would be buying a ticket to China about now to flee what appears to be on the horizon.”

On that note, it’s interesting that legendary investor, Jim Rogers, sold up in New York and moved with his
family to Singapore 2007. As he said:

“If you were smart in 1807 you moved to London, if you were smart in 1907 you moved to New York City,
and if you are smart in 2007 you move to Asia.”

It makes you think, doesn’t it? A traffic warden where I live is no longer called a traffic warden - he has a
badge saying “Civil Enforcement Officer”. How Orwellian is that? In the meantime, all we can do is trade
what is in front of us and identify the sectors where capital will concentrate next while the economic
policy (mis)managers do their thing. This has been the basis of my “Global End of Normal” thesis and the
“Badlands” pieces on the impending dollar crisis (and other currencies) in which I’ve argued that the best
asset classes are gold/silver, food/agriculture, energy and network infrastructure.

I think a current example of asymmetry is an understanding of inflation. The view propagated incessantly
by central bankers and many financial commentators is that the risk of inflation is low because of the
output gap. This is monumental disinformation in an environment of massive government deficit spending,
ludicrously low interest rates and money printing. But we had Bank of England governor, Mervyn King,
commenting recently on the recession:

“it has opened up a margin of spare capacity that will continue to bear down on inflation looking ahead.”

He’s in good company. Here is SocGen’s equity strategy team, which is normally very good on big picture
issues (although this looks like a “Parisian production” rather than a London one), in its “Outlook 2010”
report:

“inflation risks should remain low due to the size of the output gap. Even if the recovery proves stronger
than anticipated, it should still take a few years to close the gap and for inflation to materialise in the
economy.”

This sort of thinking is only true as long as the value of the currency doesn’t decline sharply. The people
of Iceland know this only too well - inflation there soared to over 14% last year - even if the head of the
Bank of England doesn’t. Does he really not know, or does he just not say? The Greek people might have
had an Icelandic inflationary experience already if Greece wasn’t part of the Eurozone. At the moment, it’s
like watching tracer bullets slamming into the Euro from almost every nation on the European periphery!
The question is whether one eventually proves fatal? It’s even making the US dollar look relatively good
for now.

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You may have heard the great comment from Marc Faber (MF) on the Financial Sense news hour a few
weeks back in response to a question from portfolio manager, Jim Puplava (JP):

JP: A deflationist would argue that because we have a weak economy, we will have deflation.

MF: Look, the deflationist will tell you, essentially, we have an output gap – it means that GDP is below its
full potential. Would you please ask the deflationists to call Mr Robert Mugabe in Zimbabwe and ask him
by how much his economy is below potential? It is below potential by at least 90% and where do we have
inflation?

Brilliant!

A point I’d make is that inflation takes time to incubate as it also requires people start to lose confidence in
the purchasing power of money. In the words of the Austrian (school) economist, Ludwig von Mises:

“The first stage of the inflationary process may last for many years. While it lasts, the prices of many goods
and services are not yet adjusted to the altered money relation. There are still people in the country who
have not yet become aware of the fact that they are confronted with a price revolution which will finally
result in a considerable rise in all prices…”

As I’ve said in previous Thunder Roads, we have both inflation and deflation – it just depends where you
look and how you define them. This is the result of the extreme inflationary measures (in the sense of
deficit expansion) being taken to counteract what would otherwise be a natural deflationary process (lower
consumer, commodity, equity and housing prices and credit contraction), whereby western economies
would purge themselves of excessive debt. Obviously, the needed (but painful) debt reduction is being
offset by the shift in the debt burden to governments. Central bankers believe that they can truly manifest
an economic “free lunch” while, in reality, it will be shown as nothing more than a time preference for
current comfort versus future discomfort.

Back in 2007, I argued that by circumventing the deflationary process, central bankers (and the Fed in
particular) would likely create the conditions for an inflationary “crack-up boom”. What I got wrong back
then was the length of time it would take for this to develop. I thought that if the western nations ramped
up deficits and printed money to the tune of trillions of dollars to bail out the doomed financial system
then confidence in the value of paper currencies would suffer. I have to acknowledge that my pre-crisis
expectation was too hasty compared with post-crisis events and that it takes considerably more time for
confidence in currencies to erode.

By the way, I found out recently that crack-up boom translates beautifully as “KATASTROPHEN HAUSSE”
in German. I can’t get rid of this image of the Federal Reserve building collapsing around Ben Bernanke’s
ears. Here is more of Ludwig von-Mises’ explanation of a crack-up boom:

“But then the masses finally wake up. They become suddenly aware that inflation is a deliberate policy and
will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his
money against ‘real’ goods, whether he needs them or not…Within a very short time…the things which were
used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give
away anything against them. It was this that happened with the Continental currency in America in 1781,
with the French mandates territoriaux in 1796, and with the German mark in 1923. It will happen again
whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion
must not believe that the quantity of this thing will increase beyond all bounds.”

Obviously a crack-up boom is an extreme inflationary event as Martin Armstrong has elucidated:

“We must understand that the hyper-inflation outcome involves the sheer collapse in public confidence.”

We are still a long way from that just now, but if the inflationary forces really start to prevail Doug Noland’s
(of the Credit Bubble Bulletin) comment that “Liquidity loves inflation” will be reminiscent of “Blue Horseshoe
loves Anacott Steel” from the Wall Street movie. There might also be a rush to buy Costantino Bresciani-

© Thunder Road Report - 27 December 2009 5


Turroni’s book on the Weimar period “The Economics of Inflation – A Study of Currency Depreciation in Post
War Germany”, which was first published in 1931.

It’s not exactly light reading and you really can judge this book by its cover. It amused me because I
was reading Marc Faber’s “Tomorrow’s Gold – Asia’s Age of Discovery” and I realized he’d beaten me to
Bresciani-Turroni’s book by two decades (note to self: try harder). This is the first sentence of Chapter 10
from Marc’s book:

“About 20 years ago, my friend Gilbert de Botton, who founded GAM, suggested I read the Economics of
Inflation, a 1931 book by Professor Costantino Bresciani-Turroni, an Italian economist and member of the
German Reparation Commission during the Weimar hyperinflation years. We highly recommend this book
to anyone interested in investing because it is the most comprehensive analysis of the causes and effects
of inflation…”

In addition to “real” assets, there have also been substantial capital flows into the stronger emerging
nations. Doug Noland articulated the difference between the current global reflation and previous ones
in his 4 November 2009 piece, “About a Half Paradigm”. I’ve quoted some of Doug’s key points at length
because I think they are so insightful. In addition, his thesis sounds every bit like a “crack-up boom”, but
without naming it as such:

“The Bernanke Fed has now locked itself into a policy course that will ignore global reflation dynamics and
instead fixate on specific US. economic indicators. Instead of adopting a more hawkish posture and laying
the market groundwork for withdrawing extraordinary monetary stimulus, the Fed flew even farther into
uncharted dovishness. This adds to a long series of (compounding) errors from our central bank.”

“So, from a macro perspective, a clearer view is coming into focus – a new paradigm is emerging. New
global reflationary dynamics have gained important momentum. Credit systems in China, India, Asia, Brazil
and the developing world – the “periphery” - are today significantly more robust than they are here at
home (the “core”). Powerful global financial flows to the inflating periphery (“monetary processes”) also
work to ensure market and economic outperformance. The rising periphery – with its billions of consumers
and rising demand for commodities – has realized a robust and self-reinforcing inflationary bias. Moreover,
secular dollar weakness has increased the investment and speculative merits of commodities and other
hard assets when contrasted to dollar securities. Dollar weakness begets global reflation that begets dollar
underperformance that begets a new paradigm.”

“I will humbly suggest that a momentous global economic transformation is at this point About Half a
Paradigm. Powerful global economic and inflationary forces have decisively shifted to the periphery…”

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What Doug Noland is describing is a key theme of Martin Armstrong’s work, i.e. global capital flows and the
concentration of that capital which leads to booms and busts. As Martin said:

“What makes one sector or nation rise is the concentration of capital…in a floating exchange rate system,
capital will be attracted on a dynamic basis…What became obvious was that capital will concentrate
even globally. After the 1987 Crash, the Japanese pulled back foreign investment…They started to invest
domestically. The Nikkei Index rose sharply into December 1989…The Bubble in Tokyo was caused by
capital concentration. When it burst, it moved to Southeast Asia, then it moved back to Europe for the birth
of the Euro.”

One could add that it then moved into the US technology sector, then US real estate, etc.

While there have been substantial capital flows into gold, commodities and the stock market in recent
months, the flows into several emerging nations, the “periphery” as Doug Noland calls it, are posing severe
problems for these nations as a result of US monetary largesse. Brazil and Taiwan have already taken
actions to limit inflows of “hot money” and the Indonesian central bank indicated that it was considering
limiting foreign investment in its short-term debt, although it has subsequently played this down.

The dysfunctional nature of the global financial system and, critically, its vulnerability to the movement
in massive “hot money” flows, is becoming ever more apparent. The head of the Hong Kong Monetary
Authority, Norman Chan, commented several days back that:

“With interest rates exceptionally low and with abundant liquidity around the world, Hong Kong faces the
potential risk next year that asset prices may go up sharply and become increasingly disconnected from
economic fundamentals,”

According to Reuters:

“Hong Kong attracted a record HK$567.5 billion (US$73 billion) in fund inflows between Oct. 1 2008 and
Nov. 13, 2009, according to the HKMA. That has helped Hong Kong stock prices soar 57 percent this year
and property prices surge nearly 30 percent.”

In the interview with Chan, he went on to explain the Catch-22:

“‘In theory, these economies could of course raise interest rates to contain inflation and increases in asset
prices. But the fear is that once interest rates are raised the carry trade will become even more active,
attracting even more fund inflows. Asian economies are therefore facing a dilemma.”

The flow of hot money into emerging markets is also raising concern in Russia as the WSJ highlighted:

“Russian authorities escalated their campaign to discourage speculative investments, which have been
flooding the country and risk driving up the value of the ruble and destabilizing the economy.  The Russian
central bank… said it would to boost its intervention in the currency markets, increasing ruble sales in a
recently tightened trading range.” 

Then there’s the even bigger issue of China. Here is Dan Norcini on Jim Sinclair’s jsmineset.com website
on 19 November 2009:

“For the Chinese to go out of their way to formally rebuke the US ruling elites and monetary officials about
the commodity bubble that is occurring courtesy of the collapsing US dollar, is quite remarkable given their
penchant for etiquette and tact. One can easily discern just how irritated not only China, but all of Asia is
with the US. At some point, this tension is going to erupt in a much larger way. Heaven help us all when
it does because it will be marked by a period of soaring interest rates as a buyer’s strike occurs in the US
Treasury market.”

Here’s a VERY telling anecdote about a meeting with the Chinese in the aftermath of the Asia crisis from
Martin Armstrong:

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“When I sat down with the Central Bank of China, I was completely stunned. It was like sitting down with
a bunch of traders. These were not academics nor bureaucrats (unlike our lot, Paul). The people I met with
were real. They then explained that to qualify to work at the central bank, they had to work on trading
desks in the West at major banks. These were people who had hands-on experience. I was so impressed for
we got right to the heart of the problem – CAPITAL FLOWS. They understood what I was writing at that time
and how capital was shifting to Asia and starting to move back from 1994 toward Europe in anticipation of
the coming Euro. That is why they called upon me. They had understood my explanations of how the world
had changed and that the key was now a new way of analyzing trends – CAPITAL FLOW ANALYSIS.”

And wait for this…

“China also gave me a tour of a most interesting installation. I was taken to a building surrounded by major
huge (sic) satellite (dishes) pointed at the sky and guarded by tanks and troops. I was taken inside and saw
a room with several hundred people who were surfing the internet gathering knowledge. I was then taken
to a meeting room where every piece I had ever written was stacked in piles on the table…I was shown that
they were monitoring every price in China on everything.”

Do they read Thunder Road??? And this:

“China was doing what I had always hoped would be done in the West. Just for once let us look, observe,
and learn, instead of the constant effort to manipulate and change the economy forcing one’s will and
desires even if they are insane…China understands there was (sic) a cycle and that they could not prevent
the change. Instead, they have gone with the flow. While this is not a complete step yet, it is a step in the
right direction that could make China the new center of the world economy – the new Rome.”

Sticking with the China theme, there was an interview with Jim Rickards on CNBC. Rickards is a lawyer
turned investment adviser and was the senior negotiator in the rescue of Long Term Capital Management
back in 1998. He argued that with the US consumer “flat on his back”, weak business investment and
unsustainable government spending, the only hope for US GDP is to increase exports, which will require an
even weaker dollar. This is where the asymmetric interests of US and Chinese national interests rear their
ugly head in relation to the Yuan/US dollar exchange rate. Rickards explained:

“Here’s the Catch-22, China has got the same problem in reverse. Their exports are down 20% in the last
year. They are not economic players they are political players. They’re communists and they’re worried
about political stability and the perpetuation of the regime. They’ve got ten million people a year walking
into cities saying ‘Give me a job’. They’ve got to provide those jobs. So here’s the Catch-22. China’s saying
in effect ‘We’ll revalue the Yuan when we see exports pick up and a little action in the US economy. The US
is saying ‘You’re not going to see those things unless you revalue the Yuan. Bernanke’s trying to break the
Bank of China. This reminds me of Soros and the Bank of England in 1992 where they were trying to defend
Sterling. Soros said ‘I’m selling Sterling, selling Sterling’. The Bank of England bought it until they finally
broke. Bernanke’s saying ‘We’re just going to keep selling dollars, run the printing presses 24/7 and China’s
sitting there buying all the dollars. The difference is, in order for the Bank of England to defend Sterling,
they had to sell dollars and they had a finite supply of dollars. So Soros just said ‘I can short Sterling
longer than you can provide dollars so I’ll break you’ and he did. (For) China, what’s the short when you
are buying dollars? It’s the Yuan. They can print it and they can force it on their own people. So they have
an unlimited supply, an unlimited capacity to go short. So this is basically a game of chicken between the
two biggest economies in the world. The irony is that each country is shorting its own currency. Bernanke’s
selling dollars, China’s selling Yuan. I don’t want to be in that trade. I’d rather just buy gold and let these
guys fight it out.”

A severe warning is implicit in Martin Armstrong’s “Economic Confidence Model”. A bit of background in
case you haven’t heard of him, Martin is the imprisoned financial genius and former Chairman of Princeton
Economics who has predicted numerous turning points in financial markets often years before they
happened. Curiously, the charges against him for comingling investment funds occurred shortly after he

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refused to give the US government exclusive access to his work. He spent 7 years in jail, WITHOUT TRIAL,
for contempt of court, before “pleading guilty” in 2007 when he was sentenced to a further five years.

In my opinion, Martin’s work is a huge example of asymmetric information existing in financial markets.
As I’ve said several times in Thunder Road, his report, “It’s Just Time”, which he typed from prison on an
old-fashioned typewriter is probably the best piece of financial analysis I’ve ever read (see here). I asked
a portfolio manager who’d just sent me a piece written by Martin:

“Can I ask whether you are aware if many brokers are following/talking about Martin Armstrong’s work?
Or is it just people like us???”

His reply was:

“to tell you the truth most of them care only about making “fast” money and “advancing “ their careers...
and not to know/read people like Armstrong.”

To my knowledge, Martin’s Economic Confidence Model has NEVER been wrong on a major trend and the
major trend implied by his model remains down for another year and a half. The consensus view is that the
economic outlook is slowly improving, but as Jim Sinclair said:

“I have learned not to argue with Armstrong on cycle timing.”

While I also believe that economic conditions will be considerably worse than expected, what I think or
other commentators think is not the point. In my opinion anyway, Martin’s track record necessitates that
all financial professionals, and investors in general, digest his work.

The chart below shows how Martin Armstrong’s model implies that we will remain in a downturn until the
turning point in 2011.45, i.e. the 13th June 2011 - and note how key turning points in the global economy,
including the crisis which began in early 1997, were all predicted back in 1997!

The proponents of near zero interest rates and money printing (QE) believe that their implementation can
mitigate the impact of a downturn, essentially implying some degree of “free lunch”. I tend to take a more
“proportionate” view of the impact of the downturn compared with the bubble that preceded it. Reading
over Martin Armstrong’s work recently, I thought he captured this idea perfectly in discussing the genesis
of his own cycle work:

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“it is the motion of pendulums that fascinated me because I saw the economy and markets as a pendulum
swinging between the two most extreme points of highs and lows. I saw the markets were propelled by
these movements that often the further extremes in one direction caused a massive swing with an equal
and opposite energy taking it in the other direction; the boom & bust cycle.”

One of the messages from Martin’s work is that bear markets take time to play out. As he says:

“Perhaps it is like frying an egg. It just takes a certain amount of time to cook.”

He goes on to point out that from the intra-day high of 386.1 on 3 September 1929 to the intra-day low of
8 July 1932 of 40.6 took 33 months. For the Nikkei, the time from the peak closing high in December 1989
to the July 1992 low was 31 months. Martin acknowledges, however, that the July 1992 low was penetrated
in the wake of the LTCM crisis in 1998 which led to a further downward move with the market eventually
bottoming in January 2003. For the NASDAQ, the time from the peak in March 2000 to the trough in
October 2002 was 31 months. He argues:

“Look at major collapses from all bubble tops and this is what you will find. The minimum amount of time to
complete the fall and decline is this 31-34 month time period except in the waterfall events (i.e. complete
and utter collapse, Paul)”

This brings us to an intriguing possibility. If history repeats itself in this regard, we could be approaching
another major leg down in world financial markets, at least several of them anyway. The Economic
Confidence Model predicted the high in the current cycle almost to the day - 2007.15 or 24 February
2007 - when the sub-prime problems first came to light in the US (with HSBC’s announcement) and when
the BKX Index of US banking stocks peaked. Moving forward by 31-34 months from 2007.15 takes us to
September-December 2009, i.e. now. If we look at the recent performance of the BKX, it certainly seems
to be treading water at this point:

BKX Index of UK Banking stocks (2 years)

Source: Yahoo finance

In addition, the problems in Dubai, Greece, Ireland and Austria have obviously come to the fore in the last
few weeks.

Alternatively, if we take the 2007.15 peak and add “Pi” in years, i.e. 3.14159 takes us to 2010.29 or 16
April 2010. While pi figures in equations of the motions of pendulums, it also figures in the structure of
Martin Armstrong’s model. For instance, 8.615 years is equal to 3,144 days, i.e. almost identical to Pi x
1,000 = 3,142 days. Martin has highlighted 2010.29 or 16 April 2010 as potentially significant in his work,
commenting that:

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“The more pronounced lows would be due on a timing basis between December 2009 and April 2010.”

But does April 2010 only relate to economic events? I’m just going to go off on a tangent here, because
what follows freaked me out slightly, so please bear with me. If you are studying Martin Armstrong’s work
in depth, or if you are studying the Mayan calendar and the 2012 phenomenon, you are, to an extent,
studying the nature and geometry of time itself (And no I haven’t gone mad!).

Now if you go back from his 2007.15 peak to the peak of Martin’s previous 8.6 year cycle you arrive at
1998.55. Adding 3.14159 years takes you too 2001.692, i.e. 10 September 2001, which was just one day
before 9/11. Martin has highlighted this, but from delving into his model, more “coincidences” seem to
pop up. For example, if we go backwards in time to the next peak in Martin’s 8.6 year cycle, we arrive at
1989.945 or 11 December 1989. Adding 3.14159 years takes you to 1993.077, i.e. 28 January 1993. This
was less than a month before the first World Trade Center bombing.

Another genius, in my opinion, is Gerald Celente of Trends Research, both in what he says and how he
says it (e.g. “the two-headed, one party system”). He had this to say a few days back about what will be
amongst his top trends for 2010:

“We are very concerned because one of them is going to be ‘Terror 2010’ and people better be prepared
for it, because the last time terror struck in the United States they closed down Wall Street. Next time it
comes, with economic conditions being so fragile, they may close down the banks. So this is a time to really
prepare for the worst, (we) could always move back from that point if the worst doesn’t happen, but if you
make no plans at all, there’s no escape plan at all.”

Celente was quoted in USA Today in December 2000 predicting terrorist attacks against US citizens in 2001.
I find all of this makes me feel uneasy and I want to mention one more thing. I’ve spent quite a lot of time
working through and trying to understand the different layers of Martin Armstrong’s model. In the Thunder
Road of 8 April 2009, I mentioned the interim high of 2009.3, i.e. 20 April 2009. I wrote:

“there just might be more to this period in late April 2009 than initially meets the eye...However, I wonder
if he (Martin) is holding things back...In fact, from my deeper study of Armstrong’s work, the period 15-30
April 2009 could be quite significant – and disturbance in financial markets may only be part of it”

Remember what happened? This is from Wikipedia:

“In late April (2009), Margaret Chan, the World Health Organization’s director-general, declared a ‘public
health emergency of international concern’ under the rules of the WHO’s new International Health Regulations
when the first two cases of the H1N1 virus were reported in the United States, followed by hundreds of
cases in Mexico.”

I bet you’re not convinced, so back to the story:

Martin Armstrong has pointed out that the concentration of capital, which led to the current crisis, was in
the debt and real estate markets and not in the stock market. This is potentially very significant for global
capital flows going forward. It was only fitting, therefore, that the recovery in so many asset prices this
year was interrupted by the potential default by Nakheel subsidiary of the state-owned Dubai World – an
overly indebted property company. Stock markets fell sharply, with the Footise down 3.2%, China down
3.6%, crude oil down 2.4%, etc. The US was closed for Thanksgiving but fell 1.7% in the shortened session
on the Friday.

One of my themes is that while most commentators either see inflation or deflation, I would assert that
we are experiencing both simultaneously. Furthermore, the inflationary and deflationary forces are likely
to remain locked in combat for an extended period. Before the Dubai news, the inflation scenario had been
more ascendant as global capital flows moved into commodities, equities and some emerging markets and
out of the US dollar. To an extent, what was happening to the US equity market in the last couple of months
was the classic “Paradox of Value” to use Martin Armstrong’s term, i.e. the rise in the equity market was
largely compensating for the decline in the value of the US dollar.

© Thunder Road Report - 27 December 2009 11


In spite of this, it seems that rising stock markets were giving great cause for optimism about the global
economic outlook in general – misguided in my opinion. But that’s the markets for you! Two people watch
the same events unfolding but they “see” completely different things. Have you heard Lady Gaga’s recent
single, “Bad Romance”? It’s really good and right up there with “Poker Face” in my opinion. More importantly,
have you seen the video for “Bad Romance”on MTV or youtube? To most people, the video probably seems
like some whacky, futuristic *rgy of musical surrealism. In contrast, if you’re reasonably well read in the
esoteric field, it’s immediately and strikingly obvious that the video is absolutely dripping with all manner
of occult(i.e. hidden knowledge) symbolism. I’m not saying that there is any sinister intent, but you know
it when you see it.

For example, notice in the main body of the video Miss Gaga’s sequence of costume changes - from black
to white to red - in that order. Carl Jung would have spotted it - nigredo, albedo, rubedo - in an instant. So
should any Hollywood screenwriter worth his salt these days as they’ve moved on from Joseph Campbell’s
work, so ably used by George Lucas in Star Wars, to Carl Jung’s work (right Dave V. – equity trader and
screenplay writer!). And all that focus on Miss Gaga’s spinal column, can anyone say KUNDALINI? There’s
a lot more in the video but, in essence, the plot symbolizes an alchemical transformation. C.S. Lewis’s
“Chronicles of Narnia” are also laden with occult symbolism, but how many realize that? And they’re
supposed to be for children!

When the events in Dubai occurred, four things were immediately apparent:

BB The news confirmed that the global debt crisis is still very much alive and well and that the battle
between inflationary and deflationary forces is ongoing and on a knife-edge;

BB With Dubai World being state-owned, the debt crisis has now got to a level where it is beginning to
impact sovereign nations;

BB There was a sudden, albeit brief, movement of hot money flows out of equities, commodities and
emerging markets back into US Treasuries and the dollar, i.e. the deflationary trade briefly returned. This
was the paradox of value once again, with a brief resurgence in the value of money vis-à-vis other asset
classes (not gold which is “real” money).

BB The major western banks remain vulnerable to a second phase in the debt crisis. In the case of Dubai,
it is mainly UK banks with HSBC, Standard Chartered, Barclays and RBS having combined exposure of
some US$50bn. The RBS share price, for example, fell 7.8% after the Dubai announcement.

What’s interesting to me about Dubai is the timing of the announcement on 25 November 2009. The
property company, Nakheel, was just over two weeks away from having to repay a US$3.5bn bond. Sheikh
Mohammed had said this as recently as 8 September 2009:

“I assure you we are alright, the UAE is alright, and we are not worried,”
This comment resulted in the price of the Nakheel December 2009 bonds jumping 8.2% afterwards. Can
you sue a Sheikh? My questions are twofold.

BB Given human nature, how many other struggling corporations are leaving it to the last minute to
acknowledge insolvency in the hope that “something turns up”. A lot of those LBOs from 2004-07 come
to mind?

BB How many weak corporations are going to find it difficult to roll over loans coming due because they are
crowded out by a combination stronger borrowers and banks in retrenchment mode?

The Dubai news is likely to have sent a further tremor through the banking system, making banks even
more cautious on lending policies. Is another Catch-22 developing? The banks won’t lend because they
are technically insolvent at this point, i.e. if they marked-to-market. However, if they restrict credit too
severely, economic growth will be restrained, more of their borrowers will be bankrupted, and it will all
come back and bite them!

© Thunder Road Report - 27 December 2009 12


I remain of the view that the banking system remains extremely vulnerable and that a good deal of the
supposed improvement in its outlook is a mirage. Look at what’s happening in US commercial real estate,
for example. It was obvious that the US$3.0trn commercial real estate (CRE) is a huge problem for US
banks when the FDIC issued “Guidance on Prudent Commercial Real Estate Loan Workouts” on 30 October
2009. Basically, it avoided the need for write downs even if the value of the underlying collateral had
declined as long as interest payments are still being made. “Extend and pretend” as someone described
it recently. A spanner in the works, however, is that defaults on CRE mortgages keep rising. According to
Bain & Co.:

“The current long-term average default rate is 4.5%; as recently as 2007, it was just under 1%. These
failures are not limited to small or marginal firms; they are happening at large companies with at least
$100 million in assets…”

Donald Trump was on CNBC last week explaining the stand-off position of the banks in CRE:

“I can tell you if you have an IBM lease or if you have a prime tenant lease and take that lease to the bank,
the bank still won’t loan you money. So all of the money the government gave the various banks, they are
not putting out money at all…I see they come out and they say we’ve loaned money. They’re not loaning
money no matter how prime you are, no matter how rich you are, no matter how good your development...
Frankly, this economy can never come back until the banks are forced to loan money and it’s really the
money they were given by the government.”

If banks won’t even lend to prime borrowers, they can’t be that healthy. What are the banks doing if they
aren’t lending. My suspicion is they are going to the central bank trough and borrowing money at almost
zero percent and buying a heck of a lot of government bonds, especially US Treasuries, to take advantage
of the interest rate differential. If it’s not the banks buying them, then who is? It will be ironic if the banks
get killed on the value of those government bonds too, when sovereign yields rise down the road.

What about UBS’s big investor day on 17 November 2009? Analysts came away discussing the management’s
“bold target” for medium term (3-5 years) EPS, as though the crisis is over and done. The analysts seem
to have already factored in a steady global economic recovery during these 3-5 years – a giant leap of
faith after the popping of a bubble which, in debt/GDP terms, was even bigger than the one which ended
in 1929. Both UBS’s management and the analysts will both ultimately be at fault in my opinion. A false
sense of security seems to have developed, notwithstanding Dubai.

My suspicion is that financial stocks will be hit badly in the next correction in the stock market. It would
also be poetic justice after Goldman CEO Blankfein claimed that he is doing “God’s work”. I liked Gerald
Celente’s response:

“Can anybody imagine the arrogance of this guy, Lloyd Blankfein, the CEO of Goldman Sachs, telling us that
he’s doing, quote, God’s work? If he’s doing God’s work, we’re all going to h*ll.”

The consensus view is that we can look forward to a steady, albeit slowish, recovery and that the systemic
risk is now behind us. I think this is too optimistic and there is a lot further to go in order to work through
this debt crisis. This is clearly the message from the problems in Dubai, Greece, Ireland and now Austria,
etc. The sub-prime problems became apparent in February 2007 although it took until October that year
for the stock market to peak and until March 2008 before people really woke up with the collapse of Bear
Stearns. At the time, it was reminiscent of the writer George Gurdjieff’s assertion that most people spend
their lives in a kind of hypnotic waking sleep.

Maybe it’s me who’s half a sleep this time, but I think that the next phase of the debt crisis will draw in
sovereign nations in a major way and the banking system (again) – especially the European banking system
at first. If I’m correct, it will be the catalyst for massive flows of “hot money” traversing the globe, from
currency-to-currency and asset class-to-asset class, looking for security/price inflation. As the economists,
Milton Friedman and Anna Schwartz, noted:

© Thunder Road Report - 27 December 2009 13


“financial panic is no respecter of national frontiers.”

The initial realisation that “Houston, we (still) have a problem” will likely lead to a correction in equity
markets, but the medium-term direction will then depend on the response of the monetary authorities.
However, and this is critical, I would still expect any renewed strengthening of deflationary pressures
to trigger a reflexive response of even greater spending and monetary accommodation on the part of
desperate governments and central banks - it’s what they do. It doesn’t have to happen, but as Martin
Armstrong argued:

“In order for the deflationary spiral to unfold, as was the case in the crash of 1929, the currency must be
of a steady quantity and perceived to be a preservation of capital.”

I don’t see that and, as far as I can tell at the moment, the “beast” of debt/credit expansion will continue to
be fed until it literally falls over. The majority of students of Hindu scriptures characterise the current world
age as the Kali Yuga – the “dark” or “iron” age – symbolised by a bull standing precariously on one leg. To
the Hindus, this bull, or “dharma”, is representative of morality on the earth. Morality was also linked to
money by Ayn Rand:

“If you want to know when a society is set to vanish, watch the money. Whenever destroyers appear among
men, they start by destroying money, for money is men’s protection and the base of moral existence.”

And let’s not forget Greenspan’s comment all the way back in 1967, before he changed tack:

“Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious
process. It is the protector of property rights.”

So if the response is more bailouts and money printing, there is a risk of triggering a crack-up boom. Gold
remains the go-to asset because it outperforms in both inflation and deflation – what it hates is benign
economic conditions, but I still don’t see that. If the end-game really is a crack-up boom, then equities
should also rise as capital flows into “real assets” and shuns paper assets like currencies and bonds.

In light of these comments, I want to look back to the period of 1931-33 during the Great Depression. My
recent study of the years was prompted by Martin Armstrong’s comment that:

“what is not looked at closely was the glaring fact that all of Europe went into default…”

A key point back then was how the second phase of the Great Depression emerged in one of the smaller
and weaker European economies, i.e. Austria. Ultimately, it spread to the larger economies and even the
US which, back then, was the world’s largest creditor, and far from the sorry, insolvent state it finds itself
in now.

The ability of “hot money” to flow on a global basis, or at least an intercontinental basis, i.e. between the
US and UK/Continental Europe - was already well-established 80 years ago. Fast forward to today and the
capital flows are potentially even more powerful now that China, India, the Arab nations, Russia, Japan and
the Pacific Rim nations will all be involved in the fray.

As we know, current Fed Chairman, Ben Bernanke, is hailed as one of the world’s experts on the Great
Depression. In his book, “Essays on the Great Depression” (thanks Ben F. in Boston) he comments:

“By late 1930, the downturn, although serious, was still comparable in magnitude to the recession of 1920-
22; as the decline slowed, it would have been reasonable to expect a brisk recovery.”

The recovery never came as the next phase of the downturn unfolded in the wake of the Creditanstalt
failure in May 1931. Victor Aguilar at Axiomatic Economics put it in perspective:

“This more than any other event, extended the depression throughout Europe.”

© Thunder Road Report - 27 December 2009 14


And then back to the US.

It would just be too cute if history repeats, but the collapse of Creditanstalt in May 1931 coincided with the
completion of what was back then the world’s tallest building, the Empire State Building. The ribbon was
cut to open the building on May 1, 1931.

Here is Wikipedia on the new pretender to the crown of world’s tallest building:

“Burj Dubai (“Dubai Tower”) is a supertall skyscraper nder construction in Dubai, United Arab Emirates,
and is the tallest man-made structure ever built, at 818 m (2,684 ft). Construction began on 21 September
2004, and the tower is expected to be completed and ready for occupancy on 4 January 2010.”

In the run-up to Creditanstalt’s collapse, foreign capital had moved into Austria to take advantage of high
interest rates. The discount rate set by the Austrian National Bank was 10% compared with more like 5-6%
in other major financial centres. As former British Ambassador to Germany and France, Sir Eric Phipps,
argued:

“extensive short-term credits given to Vienna banks by lenders in London, Paris, Amsterdam, New York and
elsewhere…really formed the economic lifeblood of this country.”

Since the money was then typically lent out on a long-term basis, there was a maturity mismatch across
the Austrian financial system which was not perceived in early 1931. In the third volume of his history of
“The City of London”, David Kynaston quotes from a report on Creditanstalt published by the merchant
bank, Lazards, for the Westminster Bank on 7 January 1931:

“The leading bank in Austria and most important bank in Central Europe, perfectly good for its engagements.”

How quickly things changed!

According to Aurel Schubert in his definitive work, “The Credit-Anstalt crisis of 1931”:

“Insolvency, not illiquidity, was the initial problem of the bank”

Ben Bernanke again:

“The insolvency of the Creditanstalt, finally revealed when a director refused to sign an ‘optimistic’ financial
statement in May 1931, sparked the most intense phase of the European crisis.”

© Thunder Road Report - 27 December 2009 15


In Aurel Schubert’s book, there is an anecdote which is eerily reminiscent of the “mark-to-model/myth”
being employed by banks in their financial statements today. He recounts a director of Creditanstalt saying
that:

“it was best to buy shares of firms that were not quoted on the stock exchange, as one did not then have
to lower the book values according to their quoted values.”

Creditanstalt’s insolvency was due to both bad debts and losses on its large securities portfolio. Once these
problems became known, there was a run on the bank as deposits were withdrawn. The Governor of the
Bank of England, Montagu Norman, warned the new head of the Fed, George Harrison, that:

“a monetary breakdown in Austria might quickly produce a similar result in several countries.”

As an aside, what makes me laugh is that Norman made the cover of Time magazine in August 1929 and
we all know what happened two months later. Guess who was just named Time’s “Person of the Year” for
2009. Oh wouldn’t the irony be something to behold!

Back to the story and Norman established a creditors committee and proposed a loan to the Austrian
central bank in order to precipitate withdrawals. About forty international banks gathered on 29 May 1931
in London, but it was to no avail. Indeed, a really interesting point about the Creditanstalt failure is how it
could have been averted as The Economist explained:

“It was clear from the beginning... that such an institution (as the Creditanstalt) could not collapse without
the most serious consequences, but the fire might have been localized if the fire brigade had arrived quickly
enough on the scene. It was the delay of several weeks in rendering effective international assistance to
the Credit Anstalt which allowed the fire to spread so widely.”

(At least the Austrian government acted quickly in the case of Hypo Alba last weekend – see below)

Then politics got in the way. According to Brad DeLong, the former Deputy Assistant Secretary of the US
Treasury during the Clinton Administration:

“The substantial loan to Austria was not made because French internal politics entered the picture. At the
beginning of his political career French Premier Pierre Laval had styled himself a politician of the left: the
Clarence Darrow of France. But by the early 1930s he was shifting to the position of a strong nationalist.
He blocked the proposed international support package for Austria, insisting that if France was to contribute
France had to get something out of it. The price that Laval demanded was made up of a series of diplomatic
concessions, most important of which was the renunciation of a prospective customs union with Germany

© Thunder Road Report - 27 December 2009 16


(by Austria, Paul). To Laval, playing the nationalist card in French politics, nothing that benefited Germany
could be allowed by France…In the long run France lost too: what might have been a chance to moderate
the Great Depression was lost. The ultimate consequences for France were dire. The rise of Adolf Hitler in
Germany is inconceivable in the absence of the Great Depression. Nine years after the Credit-Anstalt crisis
the French government surrendered to the Nazis.”

The run on Creditanstalt was followed by runs on other Austrian banks. However with support from
the Austrian central bank and deposits transferred from Creditanstalt, the situation stabilised briefly.
Unfortunately, it was quickly overwhelmed by a currency crisis for the Austrian schilling. In his book, Aurel
Schubert quotes an article by N. Kandor in 1932:

“It is clear that the state and the national bank have thus involved themselves in obligations from which…
inflation can be the only way out.”

Foreigners, and even the Austrian public remembering the hyperinflation of the early 1920s, quickly moved
out of Austria. The Creditanstalt failure was the first in a line of dominoes in central Europe and then, very
significantly, Germany. Quoting from David Kynaston’s book:

“financial instability in Austria spread rapidly to Hungary and Germany. The latter, owing to London’s
particularly high exposure there, was crucial… crisis erupted in July with a run of foreign withdrawals from
German banks.”

As with Austria, the problem was the rapidity with which capital suddenly exited the German economy
which was already weighed down by reparations from World War I. As the Japan-based entrepreneur and
writer, Bill Totten, explains:

“For many of Germany’s banks, including the fourth-largest, Darmstadter und Nationalbank Kommandit-
Gesellschaft (Danat), dependence on short-term New York and London capital borrowings had become
substantial, and at punitively high interest rates. The Weimar hyperinflation had largely destroyed the
capital and reserves of major German banks during the early part of the decade. Thus the expansion of
German bank lending during the late 1920s was by banks with a precariously small capital base in the event
of loan default or other crises. Germany stood unique among major European industrial countries by the
time of the 1929-30 New York stock market collapse. She owed international bank creditors an estimated
sixteen billion Reichsmarks in such short-term debts. This unsound banking structure required only a small
push to topple it in its entirety.”

As London’s clearing banks and merchant banks established a joint committee to represent their German
interests, crisis was also brewing outside Europe as Kynaston explains:

“India, to Norman’s considerable anxiety, appeared to be on the brink of insolvency; the situation in Chile
was critical; and to Brazil, following its upheaval the previous Autumn, a trusted lieutenant was sent in
order to seek to impose financial stability.”

With part of the British banking system’s capital frozen in Germany and the Dutch banks, which were also
heavily exposed to Germany, withdrawing capital from London, the focus of the crisis shifted to sterling.
Compounding these difficulties, Britain had a severe balance of payments problem and the publication of
the Macmillan Report showed that London was a net short-term debtor of some £254m (US$1.2bn at the
time).

On 20 September 1931, the British government announced that it would suspend the Gold Standard Act of
1925, and no longer meet its debt obligations in gold. In the worlds of “His Majesty’s Government”:

“Undoubtedly the bulk of withdrawals has been for foreign accounts…during the last few days international
markets have become demoralized and have been liquidating their sterling assets regardless of their
intrinsic worth.”

© Thunder Road Report - 27 December 2009 17


It turned out that the speculators made a smart move since sterling’s value immediately fell by more than
20% versus the US dollar. Webster Tarpley, in a thought provoking view of the 1929 crash and the Great
Depression, argues that Britain’s default was a deliberate policy on the part of Montagu Norman. Britain
had “trapped” its creditors who would be repaid in devalued pounds. The position of the US and the dollar
today springs to mind! This view is supported by France’s financial attaché at its London embassy at the
time, Jacques Rueff, who later (as President de Gaulle’s economic advisor) became the man who broke the
dollar by smashing the London Gold Pool in 1968:

“…(the) Bank of England defaulted intentionally in order to damage the creditor central banks, the Bank of
France in particular.”

After Britain defaulted and quit the gold standard, it was quickly followed by Canada, India, Sweden,
Denmark, Norway, Egypt, Austria, Portugal, Finland, Bolivia, Japan, Greece, Chile, Peru and others during
the next few months.

Less than a week after Sterling’s default, the Economist commented:

“The sterling bill enters so deeply into the whole mechanism of world trade and so many foreign banks,
including central banks, have been accustomed to keep a large portion of their reserves in the form of
sterling balances in London, that the shock caused by the depreciation of sterling to some 80 per cent of
its value has necessarily been profound…the depreciation of the pound means that the currency reserves
of many countries which are kept in the form of sterling balances have been seriously impaired, and the
pre-existing strain on the banking system of many centres is bound temporarily at least to be aggravated
by the universal shock which confidence has suffered.”

Sterling losses exported deflation to other parts of the world and the imposition of import duties on foreign
goods by Britain and British Empire countries further exacerbated the collapse in world trade – already hit
hard in the first phase of the Great Depression and US import duties with the passing of the Smoot-Hawley
Tariff Act in 1930. Between 1929 and 1933, US exports fell 61% while unemployment surged to 25%.

Despite being the world’s largest creditor nation, the US was still clinging to the gold standard. A combination
of fear that the US would be the next country to devalue and to cover losses on sterling, many countries
began to convert their dollar holdings into gold. According to Milton Friedman and Anna Schwartz:

“Anticipating similar action on the part of the United States, central banks and private holders in a number
of countries—notably France, Belgium, Switzerland, Sweden, and the Netherlands—converted substantial
amounts of their dollar assets in the New York money market to gold between September 16 and October
28.”

Within six weeks of the British default, the US had been drained of US$700m of gold.

This panicked holders of US bank deposits who began to withdraw cash from the banking system. Between
August and the end of 1931, a total of 1,860 banks closed down. The banking crisis was still continued in
the run up to the Hoover/Roosevelt US election of November 1932. In “Once in Golconda: A True Drama
of Wall Street 1920-1938”, John Brooks noted:

“The public started to withdraw money from banks and beginning in October 1932, some states, like
Nevada, Michigan, Maryland, etc, were declaring bank holidays.”

Roosevelt won the election in a landslide based on his “New Deal”, together with the campaign song, “Happy
Days Are Here Again”, but things got even worse before he was inaugurated on 4 March 1933. John Brooks:

“A conviction that Roosevelt would devalue the dollar led currency speculators and firms with international
interests to exchange United States currency in large quantities for gold and foreign money, causing the
Treasury to lose gold at a frightful rate…In February 1933, it got completely out of control with almost one
sixth of all money in circulation being withdrawn from the banking system.”

© Thunder Road Report - 27 December 2009 18


Talking of cycles (since it would not be out of place today), here is a bit of what Roosevelt said in his
inauguration speech:

“Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by
the hearts and minds of men. . . . The money changers have fled from their high seats in the temple of our
civilization.”

Roosevelt sat down in the Oval Office and immediately shut every bank in the US for eight days. He
reorganised the banking system and by the end of the year, 4,000 small banks had either been shut or
merged with larger competitors. Depositors in failed banks received 86 cents on the dollar. Government
employees were hit with pay cuts, prohibition was repealed and the US left the gold standard. John Brooks
again:

“The stock market leaped in wild trading. That was logical enough; if the dollar was going to be cheaper –
and leaving the gold standard could mean nothing else – then it made sense to transfer one’s assets out
of dollars and into stocks.”

Dollar down, stock market up – sounds kind of familiar! As well all know, Roosevelt also famously confiscated
gold from US citizens at US$20.67/oz and subsequently devalued the US dollar to US$35/oz – a blatant
example of theft from his own citizens.

One final point I’d like to make about this period, which is also relevant to today (just substitute the dollar
for sterling), is how the situation was complicated by sterling being in the death-throes of its use as the
world’s reserve currency. At the same time, the dollar was still not ready to take over the mantle. Brad
DeLong explains:

“Before World War I the international gold standard was kept on track because there was a single, obvious,
dominant power in the world economy: Britain. Everybody knew that Britain was the ‘hegemon’, and so
everyone adjusted their behavior to conform with the rules of the game and the expectations of behavior
laid down in London. Similarly, after World War II the ‘hegemon’ for more than a full generation was the
United States. And once again, the existence of a dominant power in international finance--a power that
had the capability to take effective action to shape the pattern of international finance all by itself if it
wished--led to a relatively stable and well-functioning system.

But during the interwar period there was no hegemon: no power could shape the international economic
environment through its own actions alone. Britain tried, attempting to restore confidence in the gold
standard by the restoration of sterling, and failed. America might have succeeded had it tried--but successful
policy requires that the hegemon recognize its leading position, which the interwar US did not do. Thus
“resolute, coordinated” action to expand demand and halt the depression did not emerge from the leading
industrial power. And it was very unlikely to be generated by any committee operating via consensus.”

If you look at the situation today and try to decide what could be the falling domino that marks the
beginning of the next phase of the current debt crisis, it is hard not to feel spoiled for choice. If it’s not
Dubai, the nations of Central and Eastern Europe are looking particularly vulnerable at this moment, with
high profile problems in the likes of Hungary, Romania, Bulgaria and the Baltic states of Estonia, Latvia and
Lithuania. These nations all showed up in Moody’s External Vulnerability Indicator, albeit the most recent
one I’ve been able to find is for end-2008. The External Vulnerability Indicator attempts to measure a
country’s vulnerability to foreigners suddenly withdrawing capital by taking account of short-term external
debt, currently maturing long-term external debt and non-residents deposits, etc.

© Thunder Road Report - 27 December 2009 19


Source: Moody’s

If we look at the current situation in some of the larger ones, they are essentially on external life support:

BB Hungary is being supported by a loan from the IMF/EU/World Bank. Hungary’s GDP is expected to
decline by around 7% this year and see a further modest fall in 2010.

BB The Ukraine, which has already borrowed US$11bn from the IMF, is demanding a further US$2bn in an
emergency loan to meet external obligations. The IMF withdrew a US$3.8bn loan two months ago after
the country failed to implement budget cuts. Ukraine’s economy is likely to contract by about 15% this
year and the political situation is in flux with an election next month.

BB Romania was granted a Eur20bn loan from the IMF/EU/World Bank earlier this year, but Eur1.5bn was
withheld last month until budget cuts are agreed. The country is now in turmoil after a narrow election
victory for incumbent President, Traian Basescu, contradicted exit polls. GDP is expected to decline by
7-8% this year.

The most recent data from the Bank for International Settlements for end-June 2009 showed that foreign
banks have US$1.4trn of exposure to CEE:

Foreign claims on Emerging Europe (end-June 2009)

Country Claims (US$bn)


Poland 269
Russia 216
Czech Republic 178
Turkey 157
Hungary 152
Romania 119
Croatia 83
Bulgaria 44
Ukraine 41
Lithuania 40
Latvia 34
Total (incl. other nations) 1,417

Source: BIS

© Thunder Road Report - 27 December 2009 20


European banks have almost all of it, i.e. a massive US$1.3trn, with Austria, Germany, France and Italy
particularly vulnerable.

Foreign claims on Emerging Europe by nationality of reporting banks (end-June 2009)

Country Claims (US$bn)


Austria 224
Germany 196
Italy 179
France 160
Belgium 112
Sweden 100
Netherlands 95
Switzerland 44
UK 36
European banks total 1,284
US 56
Total (incl. other nations) 1,417

Source: BIS

Looking at the table above, the irony of ironies is that the next phase of the current crisis could emerge
from Austria, just like in 1931. The BIS data shows that Austrian banks have loans of US$223.7bn to
the emerging nations of Central and Eastern Europe (CEE), equivalent to 54% of its GDP. This lending is
significantly higher than loans made by other much larger countries such as Germany with US$196.2bn
and Italy with US$179.2bn.

Breaking down the Austrian banks’ lending by country, about US$90bn is to potential basket cases like
Romania, Hungary and Ukraine. Fortunately, they have minimal exposure to Estonia, Latvia and Lithuania.

Austrian banks exposure to Emerging Europe (end-June 2009)

Country Claims (US$bn)


Czech Republic 56
Romania 43
Hungary 37
Croatia 25
Russia 18
Poland 14
Ukraine 10
Total (incl. other nations) 224

Source: BIS

If Austria’s exposure to CEE causes it problems, foreign banks had US$331.4bn of exposure to Austria in
mid-2009, of which two thirds was accounted for by Germany and Italy.

© Thunder Road Report - 27 December 2009 21


Foreign claims on Austria by nationality of reporting banks (end-June 2009)

Country Claims (US$bn)


Italy 117
Germany 104
France 26
Switzerland 11
Netherlands 9
Belgium 9
UK 8
European banks total 300
US 9
Total (incl. other nations) 331

Source: BIS

Only this Monday, the Austrian bank, Hypo Group Alpe Adria, had to be rescued due to losses on its leasing
business in Croatia, Bulgaria and Ukraine. The bank was 67% owned by the German state of Bavaria, via
the Bayerische Landesbank. Back on 1 December 2009, the FT reported:

“Horst Seehofer, state premier in Bavaria, said last week that Hypo “is a system-relevant bank in Austria,
not in Germany” and the responsibility to rescue it lay in Vienna. However, Josef Pröll, Austrian finance
minister, repeated this weekend that he did not intend to make Austrian taxpayers pitch in.”

Despite Proll’s comment, he was forced to eat his words and Austria nationalised the bank with Bayerische
Landesbank contributing an additional Eur825m of capital. Reuters reported Proll as saying:

“The risk situation of this bank has created an enormous threat to Austria in the past days

And the head of the Austrian central bank, Ewald Nowotny, argued that the rescue had avoided:

“a massive risk to the entire Austrian economy at a critical point,”

So much so, apparently, that even the President of the ECB, Jean-Claude Trichet, was involved in the
negotiations. I am not surprised because it represented a systemic risk not just to Austria but the rest of
Europe, although I don’t think this was widely appreciated. I even bought the Financial Times to see how
much coverage it was given – nothing on the front page, nothing in Lex – you had to turn to page 5 in the
second section.

The current poster child for potential sovereign bankruptcy is obviously Greece. Having been warned of
possible debt downgrade on 7 December 2009 by Standard & Poors, Fitch actually cut Greece to BBB+ the
following day. Every day, it seems, someone insists that Greece isn’t bankrupt, which is kind of reminiscent
of US officials assuring everybody that the sub-prime crisis would be contained. It’s usually the Prime
Minister, Georges Papandreou, but Angela Merkel and Jean Claude Juncker, the chairman of the Euro-zone
finance ministers, have pitched in too. This is in spite of the EU refusing to come to Greece’s aid unless it
sorts out its public finances.

The 2009 budget deficit is expected to be about 12.7% of GDP and is forecast to fall by about 4% in 2010.
What makes the outlook potentially even worse is the growing civil unrest. There have been strikes by
public sector employees and there were two days of civil unrest on the anniversary of the police shooting
of a 15-year old boy.

Looking at the BIS data on foreign bank exposure to Greece, we see that France, Switzerland and Germany
are most exposed.

© Thunder Road Report - 27 December 2009 22


Foreign claims on Greece by nationality of reporting banks (end-June 2009)

Country Claims (US$bn)


France 73
Switzerland 59
Germany 39
UK 13
Netherlands 11
Portugal 9
Ireland 8
European banks total 235
US 14
Total (incl. other nations) 281

Source: BIS

Then there’s Ireland. After last week’s budget cuts, we are led to believe that Ireland’s deficit problems are
behind it. Even with Eur4.0bn (US$5.9bn) of savings on government expenditure, the budget deficit will
only be reduced to an estimated 11.6% of GDP in 2010 from just over 12% in the current year. They are
the government’s estimates anyway. And by 2014, it will allegedly be 2.9%, conveniently bringing it back
to a whisker within the EU target. In the words of Finance Minister, Brian Lenihan, Ireland is:

“now on the road to economic recovery”

And it’s all been sorted in time for Christmas.

Despite cuts in public sector salaries by at least 5%, Mr Lenihan raised his forecast for Irish GDP in 2010.
The bad news is that he still expects a decline of 1.25% (compared with about 7.5% in 2009) with growth
not returning until the second half of next year. So a “jam tomorrow” story in my opinion and we shouldn’t
forget that Ireland had already cut government spending by Eur8.0bn during the crisis without a corner
being turned in its deficit problem. Maybe this time will be different, but with trade unions threatening
strike action, it’s far from certain.

The BIS data shows that UK and German banks are running neck and neck in terms of exposure to Ireland,
with Belgium a distant third.

Foreign claims on Ireland by nationality of reporting banks (end-June 2009)

Country Claims (US$bn)


UK 184
Germany 184
Belgium 72
France 71
Netherlands 33
European banks total 654
US 59
Japan 29
Total (incl. other nations) 887

Source: BIS

If we total up foreign banks’ exposure to Central and Eastern Europe, Austria, Greece and Ireland, we get
the following (n.b. this obviously excludes the Austrian banks’ domestic exposure).

© Thunder Road Report - 27 December 2009 23


Foreign claims on CEE, Austria, Greece & Ireland by nationality of reporting banks (end-June
2009)

Country Claims (US$bn)


Germany 522
France 330
Italy 327
UK 260
Austria 235
Belgium 199
Netherlands 148
Switzerland 129
Sweden 108
Total (incl. other nations) 2,917

Source: BIS

It does make me very concerned about the European banking sector in general and Austria, Germany and
Italy in particular. Another potential worry for the banking sector is rollover risk as shown in this IMF chart
on banks’ bond debt maturity structure in June 2009 versus June 2007:

Source: IMF

According to the IMF:

“Banks that issued record volumes of debt during the credit bubble lost the capacity during the crisis to
manage their maturity profiles. As a result, rollover volumes now peak around two to three years ahead
(versus a much flatter profile prior to the crisis) with an unprecedented $1.5 trillion of bank debt due to
mature in the euro area, the United Kingdom and the United States by 2012.”

But it’s not just the banks, governments face increasing rollover risk as well – especially the 800lb debt-
ridden gorilla which is the US government – in 2010. Here is a great chart from SocGen’s recent piece on
Greece:

© Thunder Road Report - 27 December 2009 24


Sovereign rollover risk in 2010

Source: SocGen

The old saying is that if something seems to good to be true, then it probably is! The continuing very low
levels of government bond yields in the face of obscene deficits and money printing fit into this category.
The last couple of weeks have been very interesting with confidence in government bond markets taking a
hit almost across the board. While the focus has been on a sharp rise in yields on Greek bonds, with 10-year
government bond yields rising from 4.99% to 5.30% last week, the UK 10-year gilt yield also rose 25bp
last week During the last two weeks, US 10-year yields rose by 35bp from 3.20% to 3.55%. If government
bond yields, especially in highly leveraged economies, including the US and UK, continue to rise, it will
obviously be:

“Game over”

Last words from Doug Noland:

“Meanwhile, the Federal Reserve still retains remarkable dominance over global market yields. I believe we
are in a transition period, with the Fed’s power over global yields waning over time (or perhaps abruptly
in a future crisis backdrop). In the meantime, however, global yields are mismatched to the reflationary
backdrop. This predicament implies ongoing market distortions, a rather extraordinary global mispricing
of the cost of finance, along with all the myriad financial and economic costs associated with unrelenting
“Monetary Disorder” (i.e. assets bubbles, imbalances, mal- and over-investment, financial and economic
fragilities, etc.).”

“Each month, the US credit system and economy become only more vulnerable to a rise in yields (mortgage
and Treasury borrowing costs, in particular). Imagine the U.S. housing market in an environment of much
higher mortgage rates and then ponder the scope of the Fannie/Freddie/FHLB/FHA bailouts in the event of
a spike in yields. Picture the dilemma faced by Treasury if its borrowing costs jump significantly. How about
the fiscal position of state and local governments? Could our frail banking system handle a surprise rise in
rates?  And imagine the corner policymakers would find themselves boxed into when the Fed loses control
over market yields.”

But a final thought for Martin Armstrong:

“And for each unharmful, gentle soul misplaced inside a jail,

We gazed upon the chimes of freedom flashing”

© Thunder Road Report - 27 December 2009 25


Lyrics by Bob Dylan (although the best version is by Springsteen)

Read Martin’s stuff at www.martinarmstrong.org, I can’t recommend it highly enough

Brief message to Martin: this goes to 4,000 people (mainly buy-side institutional investors) and I hope it
highlights awareness of your plight, as well as the genius of your work.

From the Princeton Economics website:

UPDATE December 1st 2009...thanks to all (especially the organizer of this protest - Kris over at Scribd.
com) who sent emails, phoned, faxed etc. to help Martin and stop him from being transferred to a rough
prison where he feared he could lose his life. The prison authorities backed down on their attempted
violation of US law after the bright light of public scrutiny was pointed at them…

Mr. Armstrong says, the court told him they knew he did not steal money and he says the government
know’s that Republic Bank employees did illegal trading in his Princeton Economic accounts but apparently
the government cannot admit to being wrong so Armstrong remains in prison going on 10 years now! What
gives these bureaucrats the right to ruin a man’s life!

© Thunder Road Report - 27 December 2009 26


Author: I started work the month before the stock market crash in 1987. I’ve worked mainly as an analyst
covering the Metals & Mining, Oil & Gas and Chemicals industries for a number of brokers and banks
including S.G. Warburg (now UBS), Credit Lyonnais, JP Morgan Chase, Schroders (became Citibank) and,
latterly, at the soon to be mighty Redburn Partners.

Charts: Thanks to barchart.com, LME, timingcharts.com, kitco.com, kitcometals.com, Sony Pictures, ebay

Disclaimer: The views expressed in this report are my own and are for information only. It is not intended
as an offer, invitation, or solicitation to buy or sell any of the securities or assets described herein. I do not
accept any liability whatsoever for any direct or consequential loss arising from the use of this document or
its contents. Please consult a qualified financial advisor before making investments. The information in this
report is believed to be reliable , but I do not make any representations as to its accuracy or completeness.
I may have long or short positions in companies mentioned in this report.

© Thunder Road Report - 27 December 2009 27