Are you ready for the aftershock?

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Print this page by David Wiedemer and Cindy Spitzer

Have you heard the good news?  With unemployment still in double digits and the U.S. up to its eyeballs in debt, many cheerful analysts now say that the faltering economy has turned a corner, and the recession is all but dead.  Too bad it isn’t true.

As David Wiedemer predicted in our first book, “America’s Bubble Economy” (Wiley, 2006), the seemingly prosperous U.S. economy is being stalled by five co-linked economic bubbles that, while on the rise, helped lift the economy in a virtuous upward spiral. Now on their way down, though, they put the economy at increasing risk. These bubbles include real estate, stock, private debt, dollar, and government debt bubbles. 

Now that the first three bubbles have begun to pop, we predict that the final two will fall as the dollar and massive government debt come under increasing pressure over the next few years.  While tremendous wealth will disappear and most businesses and investors will take a beating, those who face facts early and make correct moves can be on the receiving end of the biggest transfer of wealth in history. They key will be protecting their wealth until prices of assets such as stocks and real estate are at levels that are well below their long-term values. These investors can then take advantage of the enormous bargains available. 

How can we be so sure that the worst is ahead when so many “experts” say the recession is over?  We know the dollar and government debt bubbles will pop for two indisputable reasons:  the U.S. Federal Reserve is printing too much money (in the form of quantitative easing) and the U.S. government is borrowing too much money (mostly from foreign investors) for the party to continue indefinitely. 

When will these pops happen?  The answer depends on another question.  What is the credit limit of the United States?  America’s credit limit is determined just as every other credit limit: by its lenders.  Typically, lenders look at a borrower’s ability to pay off debt as a measure of a loan’s riskiness.  If we use the same debt-to-income ratio that banks use to assess risk, we find that our $12 trillion debt is about six times greater than our FY 2009 income of $2.1 trillion.  By such a measure, our debt is highly toxic.  There is simply no realistic way for the U.S. to pay it back based on income, and frankly, the government has shown little interest in doing so. 

As we saw in the mortgage-backed securities debacle, debts that once were rated AAA can become XXX surprisingly quickly when investor confidence significantly falls. What will change?  This first factor is obvious:  The U.S.  is rapidly increasing its total debt, now at $12 trillion and projected to increase by at least $1.5 trillion per year for the next four years. Clearly, that will make lenders increasingly nervous.

The second factor is less obvious:  The U. S. is the largest holder of adjustable rate debt in the world.  Not technically, of course, but effectively, because about 36 percent of its debt has a maturity of less than one year, and the average maturity of the entire debt is only 4.3 years.  That means we have to keep refinancing our debt at the current interest rate. 
Just like an adjustable rate mortgage, as interest rates rise, our interest payments on the government debt will go up, too.  If interest rates rise modestly, our debt interest payments could easily reach $700 billion annually within five years.  If interest rates rise to levels we saw in the early 1980s, our interest payments could balloon to almost $2 trillion per year — about equal to our annual tax revenues.  That would seriously erode investors’ confidence, especially for foreign investors, pushing us closer to our credit limit. 

What could possibly push interest rates higher?  Say hello to the vulnerable dollar bubble.  Like all commodities, the value of the dollar depends on supply and demand.  The combination of a sluggish economy, a lackluster stock market for 10 years and fear of inflation could reduce investor confidence and demand for dollars.  As the government demands more and more capital, it is putting an enormous supply of new dollar-denominated investments into the market.  Rising supply and decreasing demand mean lower prices for the dollar.  This has already begun. 

Last spring, modest demand for dollar-denominated debt and a huge increase in government spending forced the Federal Reserve to begin its quantitative easing program that will soon result in the purchase (with essentially printed money) of almost $1.5 trillion in Fannie, Freddie and Treasury bonds.  To put that in perspective, our money supply, M1, is about $1.6 trillion. That means we have almost doubled our money supply by buying these bonds. 

Investors still view the dollar as a safe haven in times of financial crisis. Plus, there has been substantial support for the dollar from key central banks around the world.  But how long can this good will last as we continue to print and borrow money like there is no tomorrow?  In time, massively increasing our money supply will create serious inflation, especially if, instead of reversing the purchases of bonds, the government is forced to continue such practices, as we predict they will, given the massive deficits the country will likely face due to reduced tax revenues and increased spending. 
Rising inflation will cause rising interest rates, which will increase the government’s interest payments on the debt. Higher interest rates also will significantly hurt the economy, with negative impacts on commercial and residential real estate, business growth, employment, and the stock market. 

All this will further erode investors’ confidence, and the vicious downward spiral of America’s falling bubble economy will accelerate.  Eventually, investor confidence will become investor fear, the government’s credit limit will be reached, and all our previously economy-busting bubbles will pop.

So, people would be well served to remember the lessons of last year’s crash:  No matter how previously profitable your business or investment strategies, they are only as good as the macroeconomic view upon which they are based.  The correct macro view is absolutely essential for protecting yourself and profiting in the aftershock ahead. 

Editor’s note: John David Wiedemer is a Herndon-based economist with The Foresight Group and author of two books on America’s bubble economy.  “Aftershock — Protect Yourself and Profit in the Next Global Financial Meltdown” was released in November.

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