Commentary on the FDIC Bank Failure Report (05 March 2010)

Apologies on not updating for the last two-plus weeks. We have a large project which we're in the throes of wrapping up, so quite a bit of other things fell off the table, FDIC reports being one of them.

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The last two weeks' closures were relatively unremarkable, except for their small-ish size - none were larger than $1 billion. Even the least recoverable bank, Rainier Community Bank, wasn't all that bad: it was 'only' 48.25 cents on the dollar. Below average, yes, but not a bell-ringer, as the tenth worst failure by recoverable value - Century Bank FSB - was 40.72 cents on the dollar. Rainier's board of directors needed to fritter away another 8 cents per asset dollar to make our prestigious Ten Nastiest Bank Closures.

Oh well, maybe next time.

It is presently fashionable to blame the U.S. for the ongoing Depression, and we are only too happy to join in: the U.S. banking system has, for the past decade, exported rot and decay to the rest of the world, in the form of securities and derivatives, passed off by the credit rating agencies as somehow AAA debt. In 2007 the domestic became so unutterably septic that even the U.S. banks couldn't handle it anymore, and so the system broke down. Left to its own devices, the banking system would have imploded, taken down the U.S. economy and Government, knocked the stuffing out of the world economy, and then that would have been that.

That obviously did not happen, and now that same rot and decay is not only still extant in the world economy, but the U.S. is attempted to restart the exportation of more, so as to stave off domestic economic collapse. Both issues have severe implications for the rest of the world: first, if said securities and derivatives are not expurgated from the economy, they will with age become even more poisonous than they are now; and second, if the U.S. managed to force-feed more toxic assets to the rest of the world, there will be just that much more poison in the system.

What that means for the person on the ground, trying to make his or her way through this Depression, is rather grim. The greatest Keynesian-Fisherian nightmare is mass liquidation; which is to say, everything must go. We posit that the Keynesians presently holding the purse-strings in the central banks of the world are only forestalling the inevitable, and thereby making the future situation worse, in exchange for papering over the present. When the papering-over fails, as we suspect it will, then more of the baby will be thrown out with the bathwater; or, more good assets (e.g. precious metals, tools, bicycles, et cetera) might collapse in value with those assets which have none to begin with (e.g. AAA rated debt, designer clothing, suburbia, et cetera). This facet will make investing one's financial resources very difficult; indeed, down not so much might become the new high return.

Since the ongoing Depression was fomented in the U.S., we suspect that the next big leg down will also come from the U.S. When - not if - this next drop occurs, we suspect that the FDIC will be caught flat-footed and flat broke. That situation might already be in place, and the economy is not crashing fast enough to reveal the tenuous position of the FDIC, but whatever the case, going into the future, having large and vital amounts of cash sitting on deposit at banks will become a riskier proposition. Put another way, a bank account will change from being an asset, to a liability, for the average person.

Some banks will be better off than other. Some might even be perfectly solvent and capable of performing adequately, and be able to defend their depositors' money. Tying back into our earlier comment, it is highly possible that these rare, healthy banks will be destroyed along with the bad banks, either by hapless Government intervention, or panicked bank runs, or both.

Punishment by Debt-Based Money

Debt-backed money evolved to facilitate economic growth in response to the braking effect of precious metal money and its inherently inelastic supply. Unfortunately during a depression, debt-backed money is destroyed as old loans are paid off or defaulted upon and new ones do not take their place, and thus can be even more restrictive to economic activity than precious metal money which is not destroyed. National Governments' and Central Banks' current furious pace of borrowing is an effort to replace private debts with public ones and keep the money supply from shrinking.

Will this public debt binge work? Only if the expanding public sector can engender sustainable growth. As we suggested in previous posts, there is a range of optimum government spending above which is too much, and below which is too little. Another factor is the quality of that spending. Government spending can be considered to be quality when it provides services that are actually useful (for example electric power) in contradistinction to wastes of resources (such as luggage inspection).

Yet another factor is whether any further consistent economic growth is possible at all. If it is not, and there are many reasons it may not be, then having debt-based money will be especially ruinous. Debt is a magnifier of both profits and losses. Now that humanity finds itself on the right-hand side of Peak Just-About-Everything, private debts are increasingly being realised to be more untenable than previously imagined, and servicing public debt will exact an increasingly heavy toll on an chronically shrinking economy. This toll will likely exceed the imagined benefit of maintaining the debt-based money supply.

Energy Independence the Hard Way, Part 2

Read Part 1 here.

Yesterday's post asserted that the United States will painfully achieve energy independence in the coming years, through economic collapse and demand destruction so pervasive and deep that it boggles our mind. Nevertheless, we see this eventuality as a certainty for the U.S. Today we give details.

The 2007 Depression, as we have said many times before, is lowering income; that is the nature of an economic depression. In the United States, one can expect to see income on par with the global average ($10,000 per person). This means an approximate loss of 78% of present United States average income ($45,800).

This destruction of income will come hand-in-hand with several other, global trends. The first is peak oil: the unstoppable decline in oil production, ever since production peaked in 2005. Oil exporters, like Saudi Arabia, are already beginning to divert more of their production for domestic use, and less for exports. Once the fall in global oil consumption, due to the Depression, is overtaken by the fall in oil supply, the price of oil will inexorably rise.

Additionally, the U.S. Dollar is rapidly facing its demise as the world's reserve currency. As the world savours one last economic violation at the hands of Bretton Woods, the call has gone out for Bretton Woods II, and a global central bank. This is the death knell for the privileged position the U.S. Dollar enjoys, and the end of inexpensive imports for the USA.

Putting these trends together, everyone will be poorer in the United States. Gasoline will be far more difficult for the average American to buy. Because of both these trends, personal vehicles as they are known today (i.e. gas-sucking commuter tanks) will no longer be affordable for all but a tiny minority. We posit mopeds will be the more attractive option, or motorcycles, if one feels affluent.

This change in income and transportation will necessarily bring a change in living space (see an earlier post). In 1950, the average American enjoyed 292 square feet; the McMansion binge makes today's number around 900 square feet per person. A 75% drop in today's average living space per person seems about right to us. This, taken together with improvements in energy efficiency, will greatly diminish the need for home heating, lighting and cooling. Commercial space, especially retail, can expect a equivalent slimming down.

In conclusion, we come back to President-elect Barack Obama's economic stimulus programme at change.gov. Billions of dollars, if not trillions, are going to be thrown at the "energy problem"... but we will bet good money it will have no lasting effects. The economic collapse we've outlined is an unstoppable force that has a programme of its own.

Smell that in the air? That's change.

What is Deflation?

There is, at present, a raging debate in the blogosphere and elsewhere as to whether the economy has entered a period of inflation or deflation. The conflict is not helped by the fact that there are no generally accepted definitions of these two concepts. We will attempt to create a definition that will provide a framework for analysis of various viewpoints.

First of all, the most useful definition of inflation and deflation would explain them as two sides of the same proverbial coin. A naive definition would call inflation, rising prices; and deflation, falling prices. Unfortunately in the real world, the prices for all sorts of things rise and fall continuously for a wide variety of reasons. Many analysts attempt to reduce their definitions to narrow, easily observed phenomena, i.e. official defined money supplies, or indices of consumer prices. Much of the contention arises over what is being observed.

Inflation and deflation could be said to be something that is hard to define but, like pornography, we know it when we see it. In that spirit, we define deflation as pervasive, structural falling of costs as measured by the currency across a broad range of economic activity; and inflation as its inverse.

By pervasive, we mean costs therefore do not just refer to retail prices, but also asset prices, wholesale prices, producer prices, and most critically wages and rents (including profits and interest). By structural, we mean that economic activity is inherently complex. Making money has many costs embedded within it, and what one pays out axiomatically ends up as many multiple others' income. This aggregation of costs, wages, interest, and so forth we call the structure.

Is deflation happening in the 2007 Depression? What costs have fallen so far? Obviously, the cost of many securities, houses, and commodities. Not so obviously, the cost of interest on national debts (with some notable exceptions, such as Iceland), and corporate profits. What about costs that are rising? The U.S. minimum wage went up in 2008 by 12 percent, and in 2009 will be going up a further 11 per cent; U.S. Postal first class stamps; and, as a personal example, our water and sewer utility service.

The picture is once again, conflicting trends. Over time, one of these trends will emerge the 'winner'. In the mean time, falling prices of certain things might be called 'deflationary', but that is very conjectural. For example, if the price of a commodity falls so much that it is unprofitable to produce it, the fall will simply be what is known as a price spike down. The price will then have to rise again, if people want to continue using the item. This is hardly deflationary.

Likewise, incomes will likely soon be shown to be falling, and some may call that evidence of deflation, but it might just be people becoming poorer. If what people want to buy does not also become more affordable, then there is no deflation.

It is our opinion that the 2007 Depression will probably not be deflationary. Two significant factors are at work to ensure that outcome. First, it is the stated objective of monetary authorities everywhere to prevent deflation. Second, many costs (such as minimum wages or social security benefits) are fixed by law, and even more costs, contractually over long periods of time.

It is also our opinion that the 2007 Depression will probably be, overall, strongly inflationary, if not even hyperinflationary. We believe that the overhang of money, and money-like securities (bonds, CDs, money market funds, etc.) from the bubble years combined with central bank efforts to prevent deflation will create a surplus of currency chasing a quantity of goods and services which is declining due to contracting production. In other words, when more money chases fewer goods, the outcome is inflation, not deflation.

Preventing Deflation Won't Stop the Depression

The world's monetary authorities are, at present, desperately trying to stop "deflation." Deflation is a complex and controversial topic, but suffice it to say deflation is the perception of falling prices. The theory behind central bank actions is that when prices are perceived to be falling, one becomes reluctant to invest or even spend on consumables, when just waiting will get one a better deal.

Obviously, stock and commodity prices have fallen dramatically in the last few months. Most real estate has been falling for a couple years now. Consumer prices are beginning to fall as well. Can this process be stopped? Actually, yes. Central banks can ensure that the money supply rises fast enough to devalue the money in one's pocket, making assets, goods and services again an attractive use of that money.

Can arresting deflation stop the 2008 Depression? No, it cannot. Depressions are a self-reinforcing process of declining income. Wages have been falling in purchasing power for decades. Households responded at first by sending more of the population into the workforce to support the household. Families with a single 'breadwinner' are now quite rare. Lately, workers have taken to eliminating savings, borrowing against the value of their homes, as well as taking on increasing amounts of consumer credit in an attempt to fund their spending. This is, of course, not sustainable. In fact, defaulting consumer debt will be a serious drag on the world economy for quite some time. A further drag is rising unemployment, and over all personal income in decline.

At this point, the economy will not recover until several things happen: the losses from bad investments are recognised; failing undertakings have been liquidated; savings rates return to healthy levels; employment and the purchasing power of wages begins to rise. Current government policies are not promoting any of these conditions. If anything, the policies are working against the first two conditions.

It is possible that we are witnessing an effort to 're-inflate the bubble.' Perhaps if the public sees that their houses and investments have stopped falling in value, they will pull out their metaphorical charge cards and dig themselves even deeper into debt. Leaving that central banker fantasy aside, we believe that conventional economic theory is incorrect. The current decline in prices is a symptom of economic contraction, a destruction of purchasing power. Alleviating the symptom will not cure the disease. Denominating prices in a debased currency will do nothing to help the current situation, and even risks igniting an economy-destroying hyperinflation.

Two Macro Trends of the 2008 Depression

We have been careful to avoid detailed or specific predictions of what is going to happen during the 2008 Depression. Certain symptoms, like the housing price and tax receipt collapses, are 'baked into the cake.' In this post, we will look at some macro-scaled trends of this Depression, and what shapes they may take in coming years.

The first trend is a monetary crisis. This Depression, like every other, involves economic contraction. This was brought about by too many people and organisations assuming more debt than they could feasibly service. As these debtors inevitably began to default, the world economy began to contract. This process will continue until all untenable debt world-wide has defaulted or been renegotiated.

This unstoppable contraction is putting considerable pressure on all monetary systems. The world-wide paper money experiment is unable to cope in its present form with this force, and is in a state of crisis. Central bankers are aligning their respective policies to inflate the money supply in an attempt to combat the economic contraction. They may succeed in creating consumer price inflation, but they will not be successful in arresting the ongoing contraction.

This phase of the 2008 Depression does not necessarily spell the end of the paper money experiment, but it guarantees at least one large and unpredictable shift in policy. Whether this will cause rising consumer prices or falling consumer prices is unimportant to the macro trend. Suffice it to say that money as it is known today will be rapidly changing in the near future.

The second trend, which will serve to reinforce the contraction of the world economy, is that of increasing energy scarcity. Peak oil, long considered a crackpot theory, is indeed a reality: production of light sweet crude oil, the most potent and versatile natural energy source, peaked in 2004 and has begun an irreversible decline. There is no way to reverse this trend... but we will save more detailed discussion for a later post.

As energy becomes increasingly scarce, the world economy will increasingly contract. What energy is available will be increasingly diverted towards high-value-added processes. The world economy has hit the wall of falling energy availability, and will be forced to adapt to the new energy reality.

These two macro trends -- monetary crisis and energy scarcity -- are ones to be very aware of in the coming years. The 2008 Depression will make working against these trends ruinous. It would be wise to avoid institutions and investments which ignore these trends, or simply assume these trends will be managed without ill effect. If one recognises these trends are not temporary, one can plan more effectively for the future.