After QE2, What’s Next?

In our last post about U.S. Quantitative Easing (QE) http://investmentsandbeyond.blogspot.com/2011/06/deadline-june-30th-end-of-quantitative.html, we discussed about the background and actual results of the QE program. We also mentioned about the possible outcomes that might emerge. As anticipated, the Federal Reserve is contemplating on injecting another bout of “money-pumping” program, as evident from Fed Chairman’s testimony to the Congress Financial Services Committee on July 13, “the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support”. Ironically, the same period coincides with crossing the full-limit of U.S. debt ceiling, which needs to be enhanced and pending repayments must be made by August 2.

We can surmise from careful reading of Ben Bernanke’s statement to the Congress that the Fed would somehow and someway (however they name it) come to the rescue of the flat economy with another trillion or so free dollar. The stalled debt talk would reach a synthetic conclusion at the 11^th hour, the U.S. debt would narrowly escape the default. Actually the US government and correspondingly the Fed have no alternative. As Bernanke himself testified before the Congress, “Any U.S. default would be a major crisis and would throw shockwaves through the entire global financial system”. The US economy is being cut by a double-edged sword, on one side, further indebtedness crushing the U.S. dollar further; on the other, the U.S. mandatorily has to borrow more (as the US default would permanently jeopardize the government’s credibility) to repay and to further expand the economy. This is imperative, as in the U.S., where consumer spending accounts for 70 percent of the GDP, without increased consumer spending, the economy would again be recession-bound. And the less people are out of work, the less they consume.

 So, we can fully expect another DILUTION of money. Through the haggling over “money”, by means of endless credit expansion, the government has put the “trust” in money (which acts as a legal tender provided by the state) in serious jeopardy.  Already the ratings agency Moody’s announced it is considering downgrading of U.S. debts. This would further increase the interest rates and the borrowing costs. The increased payment costs would just make the likelihood of pulling out of downward debt-spiral almost impossible.

Another aftershock of this attempt to crush the Dollar would be the fall of housing prices further. According to Gary Shilling, President of A. Gary Shilling and developer of S & P Case/Shiller  Housing Index, we can expect “another big leg-down in housing”, which might trigger serious problems for the economy in 2012. The Bottom Line is: Gary Shilling thinks house prices probably have another 20% to fall.  

The same story holds for European countries, where sovereign indebtedness for lot of countries has gone beyond their actual capacity (i.e. national economic output). For example, Italian Debt-GDP ratio is now 120%, for UK it is 77%. For Japan, it is the highest indebtedness rate of 225%! So, clearly we are heading for a global economic anarchy.

Thus we are witnessing the Dollar fall and inherent reciprocal rises of gold and oil. Bernanke, himself testified, “the rising prices of gold reflects global uncertainties…the reason that people hold gold is as a protection against what we call tail risks: really, really bad outcomes’. As the governments all over the world have become the source of systematic risks by abusing the powers they have been entrusted with: power to spend, borrow, tax and print money. We don’t see any possibility of respite from this vicious cycle in foreseeable future.  Amid these uncertainties, gold is poised to shoot further in price, with the value of $2000 knocking at the door.

Sovereign Debt Crisis: Where does it end?

The problem with debts is that once you open this Pandora’s Box, it becomes a vicious cycle. You take on more debts and so on. This spiral goes on, as if a powerful genie is pushing you through. If capitalism brings forth more freedom, sometimes this freedom becomes abusive. You create unlimited amount of debt capital for whatever purposes to satiate unending needs. The sovereign nations are victims of this vicious cycle and seem to be heading towards doom. They have gone extreme beyond their means.

European sovereign debt crisis nicknamed "the PIIGS" (after countries most affected like Portugal, Ireland, Italy, Greece and Spain) is worst hit.  At end of 2010, Portugal's public debt was 93% of its GDP; Ireland's  96%; Italy 119%; Greece 143%; Spain 60% (source:Wikipedia). Then comes the story of Japan, which crossed the national debt to GDP ratio of whooping 226%! The US indebtness is estimated at 93% of GDP. Economists Carmen Reinhart and Kenneth Rogoff have shown that a rise in government debt above 90% is associated with a decline in economic growth of roughly one percent point per year.

Prof. Reinhart warns, “These processes are not linear, you can increase debt for a while and nothing happens. Then you hit the wall, and—bang!—what seem to be minor shocks that the markets would shrug off in other circumstances suddenly become big.” That is the nature of debt bubbles; they keep expanding and expanding until the day that they inevitably burst. Governments around the world will issue somewhere in the neighborhood of $5 trillion more debt this year alone. Debt to GDP ratios all over the globe continue to rise at a frightening pace. Because the world is so interconnected today, the collapse of even one nation will devastate banks all over the planet. If even one domino is toppled, there is no telling where things may end.

We have seen the marathon round of bailouts being taken place in Europe. We have to keep in mind that all of these “bailouts” are just more loans. There is no way that the Greeks are ever going to be able to repay all of this money. But this is what happens when a nation lets debt get out of control. For years and years it can seem like all of that debt does not have any consequences, but then the day of reckoning comes and it is a complete and total nightmare.

So will these bailouts solve the problem?

No, giving Greece more loans is only going to kick the can down the road for a little while longer. The truth is that Greece is bankrupt. Unless huge amounts of Greek debt are forgiven, Greece is going to default sooner or later. When confidence in the finances of a nation is lost, borrowing costs can go up very quickly. Today, the yield on two year Greek bonds is up to 28.6%. When Lehman Brothers collapsed, it was leveraged 31 to 1. Today, German banks are leveraged 32 to 1. German banks are also holding a massive amount of Greek debt. That is why there is so much fear that the crisis in Greece could spread across the rest of Europe and start toppling dominoes. The severity of the crisis is evident.

The U.S. is rapidly approaching a day of reckoning like the one that Greece is going through. The U.S. government has piled up the biggest mountain of debt in the history of the world and faith in the U.S. dollar is dying. The whole world is watching the U.S. government run up record-setting budget deficits and they are watching the Federal Reserve print money like there is no tomorrow and they realize that the U.S. financial system is slowly imploding. Now President Obama is crying for a sustainable solution of budget deficit by reaching a deal as part of a trade-off in which Congress would agree to extend the nation’s debt limit (which has already crossed $14.3 trillion limit) by Aug. 2 to prevent a catastrophic government default on its bills. Right now, the Federal Reserve has been buying up most new U.S. government debt with dollars that it has created out of thin air. This is a giant Ponzi scheme, and it is a major contributing factor to the decline of faith in the U.S. dollar.

The world financial system is far more vulnerable today than it was back in 2008. Professor Sung Won Sohn at California State University warns that “The European debt crisis has the potential to have as big an impact as the subprime mortgage crisis did in the United States.” The next wave of the financial collapse is going to hit at some point, and when it does it is going to probably be even more painful than the last wave. The major risk involves is, this debt crisis destabilizes the very fabric of the society. It was evident from the wild protests that have been taking place in Greece. Today more and more Americans are losing their jobs and their houses, being forced to become outcasts. It portends sad unrest that may erupt elsewhere in the world also. So, are we heading to a complete financial collapse and pervasive civil unrest around the globe?