Dan Denning

Let’s dispense with the usual recap of bad news today and go straight to more important matters, like the weather.

“Is that rain?” asked a co-worker the other day.

“No. It’s the sound of leaves blowing down the street,” we speculated.

And it was.

Huge drifts of leaves have accumulated on the footpaths in the past week, swirled around by the wind and piling up in banks along the street. All the leaves on the plane trees that line Melbourne’s streets seem to have died at once during last week’s heat wave. Normally, in the autumn, the leaves fall at a statelier pace. The days get cooler and the seasons change at a more natural rhythm.

But not this year. They fell all at once. The whole natural cycle was condensed into just a few days, thanks to the heat wave that scorched the trees last week. And alongside huge piles of dead leaves burnt brown you’ll find the occasional dead brown possum.

We stumbled on three the other day, walking up St. Kilda Road. It’s a veritable banquet of organic matter for the flies. The poor little possums lay on the ground, their prehensile tales curled up in a tidy little spiral. By the looks of things, dead possums do not bounce.

The plane trees are not native to Australia (they were imported from Britain to Victorianise the place). The possums ARE native. But neither one is suited to the kind of extraordinary heat that set upon the city last week.

Sure, there are hotter places in the world. But if something is designed to live in one environment and finds itself in another, it probably won’t last long if it’s not adaptable. Tomorrow is expected to be another 43-degree day in Melbourne. Which brings us to the economy.

Recessions are perfectly natural in the business cycle. Human beings take risks with borrowed money during a growth phase. Some risks pay off. Some don’t. A recession is a reckoning up of the risks. The bad investments are liquidated, asset values readjust, and the next cycle begins.

You can only get a depression when the government and the monetary authorities take unusual steps-driven by political motives-to prevent the natural process of recession. This is why today’s policy moves are setting us up for a Depression. And it’s not the first time.

It’s widely believed that the Great Depression had its origins in the slow response of the Fed to the banking collapse that followed the stock market crash. That failure, so the theory goes, was followed by too little fiscal innovation and government spending by then U.S. President Herbert Hoover.

But all of that claptrap is exactly wrong, we humbly suggest. The Depression was a foregone conclusion the minute the business cycle was hijacked by manipulation of the credit cycle. A recession is natural. A Depression is always man-made.

That’s right; the origin of the Depression is in the credit boom that preceded it. The credit boom of the 1920s made it inevitable that the natural rhythm of the business cycle would be amplified and made more severe. The boom was boomier. The bust was…worse than it had to be.

It was made worse by government policies that put America into debt, allocated capital in the most inefficient hands possible while crowding out business investment, and locked in wages and prices higher than they ought to have been, further delaying the vigorous rebound in employment and wages you usually get in a recovery.

To repeat, recessions are a natural and unavoidable part of the business cycle. Depressions are the bill you pay for trying to avoid recessions with even looser monetary policy and more government spending to stimulate consumption. What you need is a cleansing break. What you get is a money-induced fever of pointless economic activity, full of noisy cash registers, signifying nothing.

So here we are on a Friday, waiting for the Depression. How seen we get one depends, in some small part, on what Timothy Geithner comes up with next week and world stock markets receive it. Geithner unveils his plan to rescue America’s banks and get the credit crisis behind us on Monday. It had better be a good plan.

What can you expect? Well, for one, we’d be really surprised if there wasn’t a suspension-at least for a period-of mark-to-market accounting. This would prevent the banks from having to realise losses on securities they don’t intend to sell, but are currently held on the books at values well below market value.

Another element will be buying “toxic” assets from the bank. At what price? You’ll find out soon enough. It probably won’t be fair value. But it won’t be so far below fair value that it forces the banks to realise huge losses and require even larger infusions of taxpayer capital.

Not to be a stick in the mud, but do you get the feeling that the Feds are already one or two steps behind in the game of “prop up the falling asset values”? Bloomberg reports that, “Moody’s Investors Service is reviewing the ratings of $302.6 billion in commercial mortgage-backed securities as real-estate values drop and property owners fall behind on payments.”

Yes. It all feels a bit like the chart below. It’s the dreaded “Black Swan Formation.” We have asked Swarm Trader Gabriel to take a look at it and will let you know next week what he has to say.

Black Swan Pattern

Finally, we have been dodging the question of how you deal the infinite growth in a system with finite resources. We’ve been dodging it mostly because it’s such an abstract and theoretical subject that we fear we will bore you to death, and it is not good to kill your present or future customers. But since we are fundamentally optimistic about the answer, let’s push on!

The answer is in the architecture of the system you’re talking about and the energy inputs it requires. We have a global economy that’s developed a great deal of complexity thanks, in part, to an abundance of credit. It’s a system of systems built on two key inputs: credit and energy.

The more important input to the current world order is cheap energy. It began when Colonel Edwin Drake drilled his first oil well at Titusville, Pennsylvania in the spring of 1858. The world has never been the same.

With the huge amounts of energy available from petroleum came the Industrial Revolution, the acceleration of the division of labour with mechanisation, dramatic increases in agricultural yields (allowing for a major structural shift in employment as fewer people were engaged in growing food and more in making things), the growth of large urban population centers (and later the exodus to the suburbs and the housing boom as the cities went bad), and all the many capital investments and institutions that are somehow related to the fact that energy has been cheep and abundant for the last one hundred fifty years.

So is all that really collapsing now because of the fundamental physical limits on the amount of energy we can get from oil? Can an economy that’s evolved around oil as the chief energy input survive when its rate of growth has been so artificially accelerated by easy credit and fractional reserve banking? See. We told you. It’s a pretty ambitious question.

John Robb posts an answer over at his Global Guerillas blog. Robb quotes from Joseph Tainter’s book, The Collapse of Complex Societies. “The method of collapse favored by Tainter as a tipping point is defined by a fundamental change (assumption level) in the underlying costs of running the society. He maintains that every great society is driven to the heights of its organizational potential by leveraging a ‘free’ (for all intents and purposes) energy input.

“Unlimited access to this energy resource allows them essentially ‘free’ problem solving and rapid recovery from mistakes. However, once that ‘free’ energy becomes erratically available or expensive, the cost/benefit equations of many (if not most) of that social system’s evolved solutions turn decidedly negative. Collapse, at that point, is inevitable. In our case, this ‘free’ energy input would be fossil fuels (the negligible cost of which underwrites all social solutions).”

In a closed system, the amount of energy available to you is finite. In an open system, it is not. The Earth is an open system. Energy rains down on the planet everyday in the form of solar radiation. We do not, however, have a global economy that’s scaled to live and produce off this kind of energy.

Your editor’s guess is that we are headed to a fundamental reorganisation of the world’s economy that will be driven by how we get and use energy. The current system of production is based on cheap energy for the production of goods which are consumed with the help of cheap credit.

A graph of the growth of Wal-Mart stores across the U.S. from 1965 to today (where Wal-Mart became the largest private employer in America) reminds us of that scene in War Games with Matthew Broderick.

Only in the Wal-Mart example you have little nuclear explosions of consumerism. They should probably be red though, instead of green, those “store strikes”. America bombing itself to debt by cheap Chinese goods imported on container ships (efficient transportation) and distributed via Wal-Mart’s warehouse network (cheap energy and good logistics).

Add to this whole system the historically cheap cost of labour inputs (mostly in the Far East), and you have a global system buckling under its own excess and complexity after an enormous but abnormal rate of growth and innovation. As Bill points out below, creative destruction is a normal part of the business cycle. It’s essential, in fact.

And while the Austrian theory of the credit cycle is becoming vogue now for its successful prediction that a boom in credit leads to a later bust, a lot of Austrian theory is also focused on entrepreneurship and human action and wealth creation. If you spend some time in that part of the Austrian textbook, you might actually be encouraged about the future. Why?

Entrepreneurs love recessions. Not only is it a chance for investors to buy assets at a discounted price, it’s a time of reorganisation of economic life. People still have everyday wants and needs. And in a recession, there is much less competition. Most people are inclined to be conservative and take fewer risks with their capital.

This is why the entrepreneur is the hero of Joseph Schumpeter’s capitalism. The capitalist provides surplus capital. But real business innovation and risk-taking comes from the entrepreneur. During a recession, he can form a long-lasting relationship with his customers. But what does that have to do with the current situation?

For the better part of one hundred years global trade has expanded, bringing more and more people into the world trade system. We suspect now that it must contract and eventually reorganise itself into smaller, more scalable systems. These smaller systems will produce and use energy more efficiently because they have to.

Of course no one is sure what it will look like yet. But it’s likely to be a lot different than what we’re used to. It will have to be, if we’re going to successfully adapt. We have an idea of what the characteristics of these smaller systems will be and will tell you about them next week.

But from an investment perspective, your Permanent Portfolio ought to maintain some small allocation of capital for aggressive growth stocks, especially in the energy space. They will be key to the success of any system which evolves out of the disintegration of the present one.

So yes. In a closed system without new energy inputs, there are inescapable limits on growth. We reckon the rate of growth is about to slow down dramatically (contract) as the complex systems and institutions supported by cheap credit and cheap energy collapse. But this does not mean we plan on finding a cave to hide in so we can curl up and die.

Far from it. There is only one way through a time like this. You have to have a plan. You have to use your own brain. And you have to have some idea of what’s coming so you can put yourself in a position to avoid the calamity and profit from the opportunity.

All easier said than done. But what else are you going to do? Wait for your government check? More on “The Plan” next week. And in the meantime, keep an eye on the efforts of the people who have the most at stake in the current system-the banksters and the Feds-to keep it alive. We reckon there is only one logical way for them to go, and we’ll tell you about it next week too.

Regards,
Dan Denning
Daily Reckoning Australia

February 6, 2009

Dan Denning

Dan Denning is the author of 2005's best-selling The Bull Hunter. A specialist in small-cap stocks, Dan draws on his network of global contacts from his base in Melbourne, Australia, and is a frequent contributor to The Daily Reckoning Australia.

  • MatthewM

    Good article. I had to chuckle at your black swan graph.

  • Tiki

    Too bad war, shortages of resources needed to exploit solar radiation, the fact that we also need petrochemicals for mass manufacturing, the lag time needed to retool manufacturing so that we can use other forms of energy, population increase, the desire of more people on earth to live a middle class existence, epidemics, and many other “minor” inconveniences have to get in the way.

  • Pingback: Trackback

Recent Articles

Addison Wiggin
A Manifesto, of Sorts

Addison Wiggin

More than a decade ago, Addison Wiggin helped co-found the Daily Reckoning with Bill Bonner. Today, he recalls this life-changing experience, and explains how - despite being rooted in the world of finance - it is and will always be about much more than money. Read on...


4 DIY Halloween Costumes You Can Make in 10 Minutes or Less

Peter Coyne

Halloween is tonight! And just in case you waited until the last second to think about what you're going to wear, here are four costume ideas you can easily put together in about 10 minutes or less. With these costumes you'll be the hit of your friend's party - provided you're friends with a bunch of economists. (Downloadable masks included...) Happy Halloween!


Bill Bonner
4 Basic Truths to Help You Navigate the Financial News

Bill Bonner

The financial news is full of misinformation - reported by unreliable pundits and taken at face value by an easily swayed public that doesn't really no better. That's why today, Bill Bonner relays the four basic truths he's discovered during his 30 year career in the financial industry to help you make sense of it all. Read on...


Extra!
How YOU Can Help Pass the Swiss Gold Referendum

Grant Williams

For those who doubt the effectiveness of the Swiss Gold Initiative, Grant Williams has a few startling charts to show you. Today, he relays just how popular this movement is, and how you can actually influence the outcome... no matter where in the world you call home. Read on...


How Small Cap Stocks Saved the Market

Greg Guenthner

For most of the year, no one wanted small cap stocks in their portfolios. But over the last three weeks, few sectors of the market have performed better than small caps. Greg Guenthner explains how to use this to your advantage... and what to expect for the rest of 2014. Read on...