BEST OF JIM COOK

November 15, 2005

CAPITAL DESTRUCTION

The greatest financial collapse in history lies somewhere around the corner. It will be far worse than 1930. No history book about America written over the next thousand years will fail to mention this great collapse. No future book that studies the economics of our time will fail to censure the monetary policies that caused the greatest financial crisis and panic ever known.

Up until a few decades ago, the world’s economists, past and present, agreed on important economic laws. Not the least of these was the need for savings. Savings and postponement of gratification were necessary for economic advancement. Savings provided the capital for investment in production facilities. Without savings, a nation could not progress. Today the U.S. has a savings rate close to zero. The old time economist would argue that we are ruining our economy.

Economists would also be shocked by the record levels of debt and credit in America. Most would argue that borrowing for the sake of speculation and consumption as we do (rather than for production) is the prescription for the destruction of a nation’s economy. If only that was all that was wrong. It’s not the half of it. There are so many imbalances and excesses in the U.S. economy that, at some point, financial disaster is all but certain.

Professor T.H. Watkins wrote a recent article for the New York Times entitled "All Booms Go Bust." He warned, "Most of us grew up with the memory of the worst bust of all, the Great Depression, firmly fixed in our family consciousness; even I, born in 1936, have floating in my mind shadowy images of destitute men, women and children traveling along Route 66, near where my family lived in California, and my mother and father carried the Depression’s scars all their lives.

"They used their experience as a cautionary tale, and it is as real to me as the nightly news, sometimes more so.

"Yet I find myself reluctant to play the Cassandra to a generation that seems not to know, or want to know, the reality written in my family bones; that there once was a time very like theirs in which, as Frederick Lewis Allen put it in ‘Only Yesterday,’ ‘the prosperity bandwagon…rolled down Main Street,’ but that the era ended abruptly and catastrophically, particularly for people of precisely their age and glimmering hopes.

"They cannot imagine that grown men and women, people just like themselves, once were driven to begging in the streets and fighting like junkyard dogs over scraps buried in garbage heaps, or that we still do not know precisely how many people were killed in the longest and bloodiest period of class warfare in our history.

"Above all, they cannot conceive that it could happen again – that to one degree or another, it will happen again, and maybe to them."

Nobody expected or believed it possible that the 1929 crash would occur. Nobody thinks it’s possible today. Publisher Bill Bonner explains the current sentiment. "Modern economists say you don’t need savings of any sort. They say the economy is now so stable, so solid and so well diversified that you no longer need to keep an inventory of ready cash. Money will always be there when you need it: from ATM machines, payrolls, investments, and lenders (including credit cards)…It is a new era, they say. You no longer need to stock firewood, or food, or money; it will all be there for you when you need it at prices you can afford."

That’s what they believe at the Federal Reserve. The newly appointment chairman has alluded to the treasury’s printing presses and the extreme inflationary measures that would be attempted in a deflation. However, the monumental levels of debt in America have a first call on the Fed’s vaunted liquidity. That liquidity is a mirage. In reality, liquidity can disappear in a flash of fear, or vanish if too many loans are called. Contemplate what your financial situation would be if your assets declined and liquidity dried up. At some point, before a runaway inflation occurs, this has to happen. You need to take some time and think about this possibility and how you would be impacted and what you can do to have your own pool of liquidity.

America has the greatest credit expansion in the world. Debt grows at an ever-increasing pace in relationship to economic activity. As we’ve mentioned, the corollary to the credit explosion is a savings collapse. Consequently, capital investment is ailing. Furthermore, consumer inflation has recently taken off, while real wages have fallen. The trade deficit is destroying manufacturing, and asset prices teeter at the brink.

Here’s the most important economic factor about America that you must understand. The central bank encourages a vast money and credit explosion which drives up the price of assets. These inflated asset prices facilitate fresh borrowing against this additional collateral. This new money goes exclusively into consumption, rather than investment in production. It goes overseas to buy consumer goods, and that amount is subtracted from U.S. spending and incomes. It kills U.S. manufacturing, and that’s why three million manufacturing jobs have been lost in four years. It boosts consumption at the expense of production. We are a nation that consumes more than we produce. How long do you think this process, which is financed by debt can last? How long can a nation survive by eating its seed corn? Whether an individual squanders his resources or a nation, the outcome will always be painful. We are violating the economic laws that lead to prosperity and replacing them with economic policies that lead to financial ruin.

If you can get your mind around these trillions of debts and deficits for only a moment, you can see clearly how far we can fall. It really takes your breath away. To forestall this horrible comeuppance, we can only hope that Mr. Bernanke at the Fed, will be able to keep all his inflationary bubbles in the air with a new round of credit expansion. Normally, a recession that cleans out the excesses of the boom period would be a healthy event. However, the extent of the leverage, speculation and debt in our economy, means the liquidation would be devastating. Richard Russell summed up nicely the current scenario. "The US is up to its eyeballs in debts and deficits. This places the US in the worst possible position to withstand a recession or even a slowdown. The Fed is fearful of even the possibility of deflation. The Fed stands ready to open the money spigots in the face of any kind of trouble. I think this is the key thesis in investing today."

It’s also the key enigma. What will the future hold? Wall Street, Washington and the media see nothing amiss that would disturb the recovery or the stock market. One inflationist replaces another at the Federal Reserve and all is well with the world. Nobody’s worried or concerned. Sometimes I wonder if I’m on a different planet. Is everybody blind to the enormity of our economic sins? Just about everyone was in 1929 and our monetary sins are much worse today. There’s no possibility of escaping bitter repercussion from the debasement of our currency. Unfortunately, the longer we hold off the crisis with more inflating, the worse it will be when it comes.