Four really, really bad scenarios

That’s a question that James Rickards spends a lot of time pondering these days, as he sifts through the national security implications of the financial crisis facing the United States.

Rickards will lay out his worst case scenarios in a lecture sponsored by the Navy and the Office of the Secretary of Defense for Policy tonight. And his forecasts aren’t for the faint of heart.

Rickards calls it the “A to Z” problem: What are the threats that could make the U.S. economy look less like America and more like Zimbabwe? He sees them everywhere – in the Chinese ownership of vast amounts of American debt, in Russia’s increased centralization of its economy, in Al Qaeda’s long-established fascination with damaging the U.S. economy.

In many ways, Rickards is the ultimate bear. He’s not just thinking about whether the stock market will decline, but whether or not the stock market will survive.

All that puts Rickards decidedly outside mainstream economic and political thinking in America. But he does have an influential audience: the United States intelligence and defense communities.

Rickards is a regular adviser on financial issues to the director of national intelligence's office, and he lends his financial advice to the national security community.

His lecture comes as part of an annual “Rethinking Seminar” produced by the Johns Hopkins University Applied Physics Laboratory. Rickards argues that government is not doing nearly enough to prepare for the worst. “Here’s the policy problem for the United States,” he said in an interview. “We have experts in defense and intelligence, and huge depth in capital markets experience at the Fed and at Treasury. But they’re separated by the Potomac River. And they’re not talking to each other.”

Rickards came by his economic experience the hard way. He was the general counsel at Long Term Capital Management, the hedge fund that collapsed in spectacular fashion in the late 1990s and nearly took the global economy along with it. That near-economic death experience gave him a healthy appreciation for risk. Today, he’s the senior managing director for research at Omnis, an applied research firm.

Terrorists, and al Qaeda in particular, are fascinated with the idea of destroying the U.S. economy. Rickards worries that the economic meltdown in the United States could serve as bait of sorts for a terrorist attack, as plotters calculate that a strike now could have a “force multiplier” effect because of the already skittish U.S. stock market.

The Chinese own more than $500 billion worth of U.S. Treasury bonds, and billons more in the debt of other U.S. entities such as those held by Freddie Mac and Fannie Mae. And a general sense of mutually assured financial destruction keeps them from wielding that debt like a weapon: if the Chinese dumped U.S. debt on the global market, their own holdings of U.S. debt would decline in value, the U.S. economy would be damaged, ultimately harming the Chinese economy by reducing American ability to buy more Chinese goods.

They’d have to be crazy to try it. But Rickards points out that governments don’t always do the rational thing. And in the meantime, their holdings give the Chinese incredible power over American decision making.

“It gives the Chinese de facto veto power over certain U.S. interest rate and exchange rate decisions,” Rickards explained. “For example, there’s a limit to how much dollar depreciation the Chinese would tolerate.”

That potentially closes off one American economic strategy: allowing the dollar to decline in value in order to help boost U.S. exporters. And China’s leverage is only growing as each federal bailout adds to the U.S. deficit.

A pessimist by nature, Rickards believes that many economic forecasters are wrong, and the recession will get far worse than predicted.

He sees an epic disaster scenario in which the U.S. gross domestic product declines by a staggering 35 percent over the next six to seven years. Crippling deflation could take hold. Unemployment, he says, could approach 15 percent.

That’s a calamitous rate, but it would not be an all-time high: unemployment hit 25 percent during the Great Depression.

“The national security community needs to be conversant with this,” Rickards said. “In defense, intelligence, and national security, you earn your money by preparing for things that may be remote, but pose an existential threat if they come to pass.”

In this scenario, the possibilities for global unrest increase dramatically as a staggering United States retreats from foreign aid and global diplomacy and the list of dangerous failed states grows sharply.

“The Number One vulnerability is the dollar itself,” Rickards concluded. “We’re printing them and shoving them out the door, and the Fed is basically out of bullets. So why hasn’t the dollar collapsed? The short answer is, global investors don’t have any other choice.” That is, there simply aren’t enough Euro- or Yen-backed securities for investors to shift their money out of dollars and into some other currency.

But what if some kind of global coalition – say a trillion-dollar sovereign wealth fund allied with several countries around the world – banded together to create a gold-backed alternative to the dollar?

Rickards says investors – many of whom already resent that they have no alternative to the dollar – would sell American currency in huge numbers to take advantage of the new opportunity. “If that happens, that’s the end of the dollar,” Rickards said. “You’d have high unemployment, deflation, and interest rates would go up. It would take what already looks like a strong recession and make it a Great Depression or worse.”

Still, even Rickards sees a silver lining to all this. He looks around the world to the problems facing other countries such as Russia, China, Iran, and those in the Middle East.

“There are vulnerabilities for the United States, but also opportunities,” he said. “I’d rather be the United States than any of these other countries.”

So far, Bernanke is following the BOJ playbook pretty closely... The central problem, IMO, is a loss of confidence by the consumer and investor

Bernanke and Krugman studied Japan in the late 90's. They came to the conclusion that simple re-inflation (that is, direct increase of the money supply) is not a solution, because the problem is not one of supply but of confidence... increasing the money supply does nothing when the money multiplier is exactly 1 (like it is right now).

They concluded that the most effective approach is for the Fed to (using Krugman's own words) "credibly promise to be irresponsible." In other words, the best way to get banks and the public to spend and lend is for the Fed to do things that convince the public that they are about to destroy the dollar. Needless to say, that is a path frought with peril, since it essentially requires the Fed to play chicken with Zimbabwean hyperinflation.

This sheds some light on why Bernanke would pursue policy he has already concluded will fail. He (and many others of various schools of thought) have admitted that ZIRP is not mathematically very effective because is cannot encourage lending (why get 0% nominal yield on a loan when you get 0% nomical yield on cash) and discourages some borrowing (what am I gonna do with borrowed money that is both safe and profitable). They've also concluded that quantitative easing is of limited effect because the Treasuries are only really monetized (that is, functionally equivalent to broad money) while their yields are 0%... that is, while the flight to safety keeps money supply non-inflationary.

Their only solution at this point is to put on dramatic press conferences and try to stoke up headlines with lots of exclamation points. Of course, it's kind of hard to fool the general public when the latest Nobel economist is posting the details of conspiracy on his NY Times blog.

I’m not so convinced that China is desperate enough to destroy its American golden goose. Status quo before Q308 had them growing at a much faster rate than the US, so they seem to have an approach of not upsetting the China-leaning apple cart... at least not in this generation. Of course, yes, it does limit our freedom of action when they own so much of our debt.

I’m more concerned about Russia and Iran. $40/b petroleum strangles both Russia and Iran, and they both have the means to create “economically favorable” (for them) “disturbances” to the world geopolitical balance, if you know what I mean. I think that’s the most probable next shoe to drop.

Al Qaeda? They must be drooling right now to do something. All they need to do is undermine confidence. That alone sends us into another downward economic tailspin. If they have the capacity, they will use it. If not, the open bok of history will treat Bush much better than the closed files required of ongoing policy.

This is actually a very good opportunity to break OPEC. With prices so low and such dramatic production cuts planned, a lot of the smaller OPEC countries are gonne cheat. If the US (and Canada) ramped up production now, internicine fighting within OPEC could unravel it, or at the least induce further cheating and help keep prices low. Tragically, I doubt it will happen. Now would be a good time to re-read the previous 2 paragraphs, and maybe think about a good price to get into USO. I’m thinking 30, although I may wait for 25-27.

I don’t know that actual conversion to a non-government gold-based currency would happen. Ignoring the question of inflation, the US Treasury and Fed prob have enough gold reserves to use as an implied (if only partial) backing for the dollar if worse comes to worst. Of course, that would require that gold increase to several multiples if its current price, but I’ve always held that a little GLD is a good portfolio hedge against both inflation and against a general flight from risk.

As far as just plain old boring economics... deflation and debt. The Fed is hamstrung. Japan did zero interest rates, quantitative easing and fiscal stimulus, and got nothing but zombie corporations and debt of 160% of GDP. We had 60% of GDP before we even started.

I realized you were smart.

Well, I'm not sure what I said to earn that compliment ...

where you think the economy is headed in 2009

... but with an opening like that, who could possibly resist responding with some sort of prediction?

Following the collapse of Lehman Brothers in September 2008, the financial industry (big banks, central banks, stock markets, hedge funds, insurance companies, and investors therein) took an Absolutely Monstrous hit in October of 2008. They were already in a weakened state after suffering through the collapse of the mortgage financing bubble for the previous year.

Such monstrous hits bleed through to other areas of the economy, usually with a few months delay.

Most businesses, governments, industries, nations, funds (retirement, endowment, investment, hedge, ...), and markets will stumble along for another month or three, somewhat amazed to still be seemingly alive, before grinding hard down for a few months, as they realize the extent of the damage, the losses to their investments and revenue (whether from taxes or sales) and profits, and come face to face with the reality that its either deep cuts to survive, or die.

Federal government debt, programs, spending and regulations and Washington, D.C. employment, will be about the only things on the rise.

No one in a position of power today was an adult during the Great Depression, and times have been pretty good since then. So this one will take a while to sink in and for us to adapt to it. The Fed, in conjunction with the Treasury and the lead banks (JPMorgan and others) are trying to get another bubble going, this one in Treasuries. The centralization of financial power and socialization of political power will be major boom industries.

When a new leader comes in, he first airs the dark side, to show how bad things were left for him, and to justify whatever changes he has in mind. So the news will get gloomy for a while in the first half of 2009. Unfortunately the underlying reality will justify that gloom.

Unemployment will rise above 20%, bottoming out in either 2009 or 2010. The stock markets will have another major down draft between April and November 2009. Housing prices will continue downward. Commercial and retail real estate will crash. Social order in a few places will break down as it did in New Orleans after Katrina. This disorder will lead the evening news. Most communities will remain orderly, though depressed.

Serious inflation and/or major wars are likely, but I suspect won't happen for another one to five years.

Money invested in 401K's that provide a meager five or ten look-alike stock index fund options will continue to be crushed before your very eyes, if you can get up the courage to read the quarterly statement. If the Fed succeeds in stoking the fires of a good sized Treasury bubble (they're already off to a good start) then interest rates for prime debt will be reasonable, interest rates on Treasuries will remain very low, interest spreads and the rates on low quality debt will remain high, wages will be frozen (if you keep your job), and prices of goods, services and real estate will bottom out sometime in 2009. I will never see another stock market boom in my lifetime like we saw between 1980 and 2000. I'm guessing we've fallen about half the way we're going to fall in the stock market and real estate. But I'm not investing any money on that guess. It's possible that the stunning, massive, reflation efforts by the Treasury and Fed these last three months will have more affect, sooner, than I would have anticipated three months ago. Perhaps key prices have already put in their major bottoms.

A year ago, I sold all my stock and all my California real estate. In the last month, I've moved a little money back in the stock market, trying to time what seems to be a modest bear market rally. But I'm a nervous investor, with a quick trigger finger on the Sell button. I'm building up a position in gold over time, as convenient, in anticipation of future inflation and/or major currency upheavals. I've cut back my standard of living to where I could live on half my Social Security check if I had to, and preparing to return to work and work up into my 80's, if that's what's called for. That's one reason I am choosing economics for my next career. It seems to be a job that even very old men can accomplish. I find myself being a little more attentive to the Wal*Mart greeter than I used to be, for someday that might be me.

Some foreign countries, like some U.S. domestic urban areas, will be in deep trouble, bankrupt with social unrest. California and another few states will be bailed out. The automobile companies will be reorganized under Chapter 11, shrinking, closing plants, and sharply cutting back some retiree benefits. Overseas operations and big ticket weapon systems expenditures of the military will take a big hit. Health care will be socialized quite a bit further. I anticipate serious threats to the availability of the alternative health and nutrition options that I prefer, and I anticipate avoiding main stream medicine for any chronic disease (cancer or cardiovascular) treatment like the plague ... literally like the plague. Speaking of threats, I also worry that I will lose access to Limbaugh, Levin and the Free Republic. National Socialized government is here with a vengeance.

The nations mood will grow dark and bitter. Avoid being blamed as one of the Captains of Finance or Industry or Government who caused this mess. Those so blamed will be tarred and feathered and run out of town on a rail. Congressional hearings, regulations, spending and posturing will run amuck.

The job of President of the United States during seriously hard times is not that bad a job, if you have a silver tongue and a fawning press. Just ask FDR. Obama will continue to be well thought of by most people, and Bush will continue to be vilified by most, as he lacked both the tongue and the press.

But more important than the above, I predict unpredictable volatility. Stay light on your financial feet. Almost any investment of your savings or career is at risk of being wiped out if you leave it sit "for the long term." Keep your expenses low, avoid debt, stay friends with your neighbors, and cultivate your good health. Be prepared to make major shifts in investments, including being prepared to lose all your investments.

... there ... hope you got your money's worth ;).

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