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Unintended Consequences, Part 1: Easy Money = Overcapacity = Deflation

Somewhere back in the depths of time the world got the idea that easy money — that is, low interest rates and high levels of government spending — would produce sustainable growth with modest but positive inflation. And for a while it seemed to work.

But that was an illusion. What actually happened was textbook, long-term, surreally-vast misallocation of capital in which individuals, companies and governments were fooled into thinking that adding new factories, stores and infrastructure at a rate several times that of population growth would somehow work out for the best.

China, as with so many other things, was the epicenter of this delusion. In response to the 2008-2009 financial crisis it borrowed more money than any other country ever, and spent most of the proceeds on infrastructure and basic industry. It’s steel-making capacity, already huge by 2008, kept growing right through the Great Recession, and now dwarfs that of any other country.

China steel produciton

The result was indeed higher prices for iron ore and finished steel up front (that is, the inflation the architects of the easy money era expected and desired). But this was soon followed by falling prices as the rest of the world’s steel makers tried to stay in the game.

Steel price

It’s the same story pretty much everywhere. Miners that produced the raw materials for the infrastructure/industrial build-out started projects based on inflated price projections and now have no choice but to keep producing to cover variable costs and avoid bankruptcy. Prices of virtually every commodity have as a result plunged.

In the US, retailers built new stores at a pace that vastly exceeded population growth, apparently on the assumption that consumers would keep borrowing in order to buy ever-greater amounts of semi-useless stuff. And now bricks and mortar retailing is suffering a mass-die-off.

Retail space per capita

Even cheese, of all things, is in a potentially disastrous glut:

Let’s Brie Honest: The Entire World Is Awash in Cheese

(Wall Street Journal) – Yes, fattened cows, excess milk production and a strong dollar have helped U.S. stockpiles of cheese grow to unprecedented levels. But the great American cheese glut is also getting a boost from overseas.

Even as U.S. sales have fallen abroad due to a relatively strong dollar, a glut of production along with the weakening of currencies in dairy producing regions, has increased imports of cheese to the United States from Europe, New Zealand and Canada.

On a tonnage basis, annual U.S. cheese and curd exports were down 14% as of the end of February at 309,704 metric tons, while imports of cheese were up 23% at 209,402 tons, according to U.S. Census Bureau Trade Data.

Milk production from the top seven exporting regions continues to increase, albeit at a much slower pace compared to when the expansion first began in 2014, Gregg Tanner, chief executive of dairy giant Dean Foods said in a February earnings call. The European Union is the largest contributor as milk production there has increased by more than 5% year-over-year since the elimination of milk quotas the end of March last year.

The increase is significant as Europe’s dairy production is already one-and-a-half times larger than the U.S. and seven-and-a-half times larger than New Zealand and comes at a time when Russia is banning imports.
This adds up to good news for the cheese adventurous.

A typically hard-to-find exotic cheese from farflung New Zealand that normally sells for $8 a pound recently showed up across the street from Tom Bailey’s house, haphazardly packaged and selling for $5 a pound. He snatched it up.
“They’re just trying to clear this stuff,” said Mr. Bailey, a senior dairy analyst at Rabobank International in New York. “You might see some cheeses you haven’t seen before.”

What does this mean? Several things:

Cheap money sends a “borrow and spend me” signal to the markets, just as expensive money (i.e., high interest rates and government surpluses) says “save and invest me”. So when money is made artificially cheap by cluelessly expansionist governments, it leads people to overborrow and overbuild.

The resulting overcapacity leads to price cuts as marginal producers sell for whatever they can get just to keep the lights on. Falling prices for individual products in the aggregate create systemic deflation. In other words, we’re getting exactly what we should have expected from “inflationary” policies — which is deflation.

The next stage of this process will be either:

The mass failure of marginal players in virtually every basic field. Steel mills, cement factories, shopping malls, high-cost miners, dairy farms, etc., etc., will default on their debt, fire their workers and liquidate their assets, leading to a global depression in which deflation exceeds the 25% seen in the 1930s. Or…

Mass devaluation in which the world’s governments lower the value of their currencies to make their debts survivable. This will, of course, scream “borrow and spend me before I lose even more value” to the markets, thus increasing systemic leverage and producing an even bigger bust somewhere in the future.

We’re clearly opening door number two, so the volatility of the coming decade should put today’s uncertainties to shame.

One final, hopeful note: In both scenarios, real cash, i.e., gold, is king. In the Great Depression, things got cheaper, which made life easier and more fun for people with money. During times of currency devaluation, gold soars in local currency terms — and life gets easier and more fun for the metal’s owners. So either way, owning sound money (as opposed to euros, dollars, yen or yuan) is one part of a plan to survive what’s coming.

36 thoughts on "Unintended Consequences, Part 1: Easy Money = Overcapacity = Deflation"

  1. Gold as a hedge will only work for a short while as those who still nthink that owning the means of transaction is more important than owning the means of production, especially of food, fibre and pharmaceuticals. The problem with gold is that its value, in terms either of money in circulation or in goods and services has to be negotiated every time.

    If you have an ounce of gold and want 10kg of my pumpkins, is that a good deal for me or not? How do I know what the exchange rate against real goods is for any particular quantity of gold on any given day? I can look up the price of gold on one exchange and the price of pumpkins on the other, but then cash will do as well.

    And how will I know that the gold you are offering is as good as you say it is, that it has not been adulterated, alloyed, shaved etc?

    Money facilitates exchange when its value and fungibility can be guaranteed by the state, at some times gold has been used as money and, when economies are relatively static, its durability has acted as a store of value, but when TSHTF, don’t bring me your gold and expect me to sell you anything for it. You want my products, you can work for them, 4 hours of your labour will get you a meal and a bed.

    1. Hi Earl

      Currencies, in some form, will still be in place. Gold holders will still be able to exchange their gold for currency and barter will be avoided. If a barter system emerges it will only be in place for a short while until a new currency system is established. The exchange rate for gold into currency will be very favourable to gold holders, maybe not for ever, there will certainly be opportunities for those with gold.

      1. Well, you are an optimist I see. Frankly, the collapse of the monetary/financial ponzi will almost certainly take the state that depends on it with them in many cases and there is no way to know in advance which they will be.

        I’ll stick with my long term strategy
        1. No debt
        2. No financial “investments”
        3. Stay in cash or near cash (TD’s)
        4. At the right time, shift any surplus into hard goods
        5. Now is the right time.

        1. Hi Earl

          Not a bad set of strategies ! We’re not that far apart, actually. I also guess my optimism extends to believing there will be tremors before the crash, e.g. bank failures, pension defaults or sovereign default(s) which will be actual warnings for those willing to see. Like you I have things in place so I won’t be caught at the exit door, if you know what I mean.
          In terms of the evaporation of the “state” I can’t see that happening while they have the military/guns. The state might take a very different form, e.g. Military Junta, but I believe there will be a state and it is likely that order will be maintained at gunpoint, including the use of a (new ?) currency.
          While I believe in being prepared as things may happen suddenly I believe that the destruction of the worlds currencies and globalised economic system has years to play out as the “state” completely controls the game AND nearly every player.
          While I feel like we’re in an economic “Twight Zone” (TM) I think there are whole new levels of absurdity we are not yet even near in terms of bizarre economic experimentation.

          1. Of course your schema has a chance of being correct, however I am always aware of a discussion I had with a couple of young Germans a while back. They were adamant that their generation had accepted the existence of two Germanies and they wished the older generation would get over their absurd nostalgia for reunification.

            I believed them, I was in Germany at the time and could see absolutely no sign that they were not right. August 1989. In 4 months it was all over.

            One thing i know for certain is that complex systems do not degrade elegantly, they spend huge resources to maintain their status quo, then they fail suddenly and completely. The DDR was a perfect small-scale example of your claim about a system under perfect control. I’m betting that will scale nicely to the global as well, although anyone who claims to predict the timing is an idiot.

            However, we are as one that in the interim the system will scale new heights of absurdity in trying to prevent the inevitable. Staying out of THAT game is also a priority around my house.

            Good luck with your plan.

  2. The problem isn’t just in the false demand signal which encourages over capacity. Because of the falling rate of interest, new capacity has a continually lower cost of capital, destroying the viability of existing capacity. This means that newly emitted low-cost credit displaces previous savings, effectively destroying (the value of) capital and supplanting equity by debt.

  3. Why do you people keep saying the Feds will confiscate gold? They will tax the hell out of it when you sell it but they are not going to steal it. We are long off the gold standard. The 1930s are over. The Feds want your dollars, not your gold.

  4. It’s my view that governments across the globe will never allow Gold to supplant the currencies of the day worthless though they may be. Private ownership of Gold coins, bars, etc. will be banned in the event of such an upheaval.

    1. Could very well be….so it is incumbent upon us all to ensure the government(s) do not know you have it.

        1. Not true, at least in sunny Florida, USA. Getting it online or through the mail, yes, but you can buy from a local dealer and they won’t even ask your name. You get a handwritten receipt (and least from where I’ve bought) on the dealer’s letterhead that specifies only what you bought and the price. Only if you buy more than $10,000 worth at one time do they have to report that, but unless you’ve got hundreds of thousands to convert, just dollar cost average a few gold coins at a time (per day, week, month, etc.) Same for silver.

          However, taxing the sale of PMs is very possible, but I suggest you buy PMs only with money that is long-term savings so you won’t have to sell soon, or when you don’t want to. Some cash currency is bound to be useful to even if the SHTF because that’s what “most” people will have.

  5. As with so many smart people that understand the problems, and misunderstood the reaction of stocks and gold to QE, you have gotten wrong the markets reaction to the coming collapse you correctly highlight.

    Gold will be protection against govt going amuck, provided govt doesn’t confiscate it again, which no one can guarantee wont happen. More importantly to understand is that gold will rise due to the collapse of confidence in govt, which is just getting started, and also means the bubble in govt debt will also pop – starting in Europe and Japan. So, where do you think all that capital that is parked in govt debt is going to go? There is only one market that’s big enough to absorb the flows, and it aint PM’s.

    Everything you say is correct, except one critical item – the US Dollar will not decline with the rest of the world’s currencies, at least not in the beginning stages, which could take a couple of years and wipe out everyone on the wrong side of the trade. In order for the dollar-based debt bubble to wipeout everyone, the dollar and rates have to rise, which the Fed will once again ignorantly accomodate.

    I’m not saying one should not get their money out of the system through the purchase of physical gold and silver, but understanding the drivers of global capital may save you some grief, and increase your returns so you have more money to park in gold, bullets, and the aid provided to friends and family.

    1. I agree with except for one issue. I believe the government WILL confiscate all the gold and silver and not allow it to be a hedge against the coming collapse. Now what do you do????

      1. It may go to SDRs first or some kind of basket of gold and currencies. Russia, China, Germany, and the US will be the ones at the table negotiating.

      2. Cash is good, if you don’t want to short the coming scare in stocks. When stocks bottom, which will occur with the breakout of the dollar, breakdown of the euro (below 105), buy blue chips in your name (not street name), and run away from anyone telling you to buy ETF’s and govt bonds. You could also look to short govt bonds and go long the dollar. As it breaks the pegs in HK, the ME, and blows up the balance sheets of all entities that issued many trillions of dollar-based debts, look for another Bretton Woods that will replace the dollar as the reserve currency with an SDR-like weighted hybrid.

        Move away from big cities, and states that have a Constitutional obligation to fund pensions, as property taxes will skyrocket and property values will tank.

        Learn to be as self-sufficient as possible and keep as much money as practical out of the banks as we move into 2017. Be mentally prepared to have your world turned upside down, as the govt so many trusted to take care of them from cradle to grave turns aggressively against the people to save themselves.

        Fight for short term limits at every opportunity. The fundamental change that is required will never occur until the career politician is made extinct.

        1. Scot…I really just can’t leave it at an upvote……Dude….you really have your chit together….that was one well written comment. I agree 10000000000000000%

        2. Do you think the stock market’s will even be around after this? When the 1.2 QUADRILLION Dollar derivatives bubble bursts banks will fail and the gov’s won’t be able to bail them out. Therefore when the losers can’t pay the winners the winners also become losers.

          This is the most dangerous time in history for capital, as such I personally would think you would want to be completely out of the financial system. Physical gold, silver, bitcoin, cash.

          Just my 2 cents. This collapse is going to be a wild ride… 🙂

          1. I worry that the government will confiscate gold and silver and outlaw owning any of them. that is my fear with this idea.

          2. Banksters will be bailed out by depositors (bail-in), and to prevent depositors from getting out of the system, look for strong push to eliminate cash. After all, we have to stop the money laundering by dru cartels and terrorist that the banksters already profit from and the govt supports. The EU propaganda machine is way ahead of US.

            We are transitioning from public to private. Companies have actual intrinsic value, versus just fraudulent promises backing govt debt. By stock in your name, not street name, which is the default for brokerage firms, and you will the remove the 3rd parties between you and your money.

          3. Eliminating cash isn’t practically possible either. First of all, about 65% of US dollars are overseas. Secondly, there are so many miscellaneous uses for cash that politically it won’t work. Large denomination bills maybe, but that’s about it.

        3. Great advice Thanks. I have created a self sufficient self sustaining farm property 50 miles outside of Chicago in Indiana. I hope that is far enough. Set it up as a Foundation 501C4 to try and deal with the property tax issue. I really have no gold or silver at present as I worry that these will be confiscated. I am going to look into your other ideas thanks for the information.

          1. Even in the 30’s gold wasn’t “confiscated” physically. Instead people were asked to voluntarily sell it back to the banks. Yes, if you were caught with it you could have had problems but if you just stored it and waited for the re-valuation you’d be fine.

            Think people would voluntarily do that again? I don’t.

      3. Not worth the trouble (i.e., political cost and practical logistics.) First of all there is about 185,000 tonnes of refined gold in the world and the jewelry industry and jewelry itself accounts for about 60% of that. “Investors” account for about 15% and central banks account for about 15% too. Besides that, Americans own just about the least on a per capita basis than the rest of the world. It’s just not doable.

    2. “So where do you think all that capital that is parked in govt. debt going to go?”

      That is actually backwards. Capital isn’t in debt. A bond holder has LOANED capital to the borrower (e.g., govt.) and has spent it. When the borrower can’t repay the principal the debt-owner/bond-holder loses. In the case of most govts. however they can always “print” the currency to repay the principal, but that’s a ploy that won’t work for long.

      1. My point was when the bonds are sold, where will the proceeds go? The big money does not simply put under their mattress. Who wants to have it in a bank or in govt bonds? Since one can’t just jump on a plane anymore with a suitcase full of gold or cash, the only way to move large sums of money is through blue chip stocks.

        1. And what I’m saying is that when the bonds are attempted to be sold there may be no bid (or at very low levels) and for the reason you say: Why would anyone who is liquid buy the bonds (vs stocks or PMs, etc.) Unless “you” are the first to get out just about everyone will be thinking the same way.

          1. Exactly. And since the debt is created in the banking system by a double entry, when the loan is unpayable, the other side of the entry has to be written off. Any valuations of the business that relies on the assets and income to be generated by unpayable loans will then have to be adjusted to reflect that failure to pay back.

            Margin buys of the stock of the banks will then be called in and, since there will be no funds to make good on those, the process accelerates and spreads.

            This is what started to happen in 2007/8 and the governments and central banks staved off the reckoning by flooding the system with even more, even cheaper debt. But since the original debts were unpayable, the new debt is already defined as unpayable and the only thing we are waiting for is the point where the system finally concedes that most of its “money” has ceased to exist. Those with all their “money” in digits will be bailed in to restore what they can of their banks’ balance sheets, physical cash will be replaced with “new” cash at a rate defined by the banking state to drag in everything from under the mattresses and gold? Gold will be left to rot because there will be nothing reliable left against which to measure its value.

            Its happened before, at the end of the Roman Empire, money ceased to circulate because the empire that guaranteed its bona fides had failed and the trade that made it useful stopped. It CAN happen again, but this time with a difference.

            Every time this has happened before, the saving grace has been that the energy and material resources available to rebuild the fabric of societies and economies has always been greater than that which has been consumed. Not any more.

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