2018: The Year of Living Dangerously
I’m calling 2018 “The Year of Living Dangerously.”
That description might seem odd to lot of observers. Major U.S. stock indexes keep hitting new all-time highs. 2017 went down as the first calendar year in which the Dow Jones industrial average was up for all 12 months.
Even in strong bull market years there are usually one or two down months as stocks take a breather on the way higher. Not last year. There’s been no rest for the bull; it’s up, up and away.
Inflation is tame, even too tame for the Fed’s liking. The unemployment rate is at a 17-year low. U.S. growth was over 3% in the second and third quarters of 2017, much closer to long-term trend growth than the tepid 2% growth we’ve seen since the end of the last recession in June 2009.
The U.S. is not alone. For the first time since 2007, we’re seeing strong synchronized growth in the U.S., Europe, China, Japan (the “big four”) as well as other developed and emerging markets.
Growth breeds growth as consumers in one country create demand for goods and services provided by another. This is what economists mean by “self-sustaining” growth instead of force-fed growth from easy money and government spending.
Technology rules the day. The pace of innovation is unprecedented in world history. Our daily needs are being fulfilled better, faster and cheaper by the likes of Amazon, Google, Netflix and Apple. We can share the good news on Facebook.
Best of all, the U.S. Congress and White House got around to cutting our taxes in late December!
In short, all’s right with the world.
Or not.
To understand why 2018 may unfold catastrophically, we can begin with a simple metaphor. Imagine a magnificent mansion built with the finest materials and craftsmanship and furnished with the most expensive couches and carpets and decorated with fine art.
Now imagine this mansion is built on quicksand. It will have a brief shining moment and then sink slowly before finally collapsing under its own weight.
That’s a metaphor. How about hard analysis? Here it is:
Start with debt. Much of the good news described above was achieved not with real productivity but with mountains of debt including central bank liabilities.
In a recent article, Yale scholar Stephen Roach points out that between 2008 and 2017 the combined balance sheets of the central banks of the U.S., Japan and the eurozone expanded by $8.3 trillion, while nominal GDP in those same economies expanded $2.1 trillion.
What happens when you print $8.3 trillion in money and only get $2.1 trillion of growth? What happened to the extra $6.2 trillion of printed money?
The answer is that it went into assets. Stocks, bonds, emerging-market debt and real estate have all been pumped up by central bank money printing.
What makes 2018 different from the prior 10 years? The answer is that this is the year the central banks stop printing and take away the punch bowl.
The Fed is already destroying money (they do this by not rolling over maturing bonds). By the end of 2018, the annual pace of money destruction will be $600 billion.
The European Central Bank and Bank of Japan are not yet at the point of reducing money supply, but they have stopped expanding it and plan to reduce money supply later this year.
In economics, everything happens at the margin. When something is expanding and then stops expanding, the marginal impact is the same as shrinking.
Apart from money supply, all of the major central banks are planning rate hikes, and some, such as those in the U.S. and U.K., are actually implementing them.
Reducing money supply and raising interest rates might be the right policy if price inflation were out of control. But prices are actually falling.
The “inflation” is not in consumer prices; it’s in asset prices. The impact of money supply reduction and higher rates will be falling asset prices in stocks, bonds and real estate — the asset bubble in reverse.
The problem with asset prices is that they do not move in a smooth, linear way. Asset prices are prone to bubbles on the upside and panics on the downside. Small moves can cascade out of control (the technical name for this is “hypersynchronous”) and lead to a global liquidity crisis worse than 2008.
This will not be a soft landing. The central banks — especially the U.S. Fed, first under Ben Bernanke and later under Janet Yellen — repeated Alan Greenspan’s blunder from 2005–06.
Greenspan left rates too low for too long and got a monstrous bubble in residential real estate that led the financial world to the brink of total collapse in 2008.
Bernanke and Yellen also left rates too low for too long. They should have started rate and balance sheet normalization in 2010 at the early stages of the current expansion when the economy could have borne it (albeit without Dow 25,000). They didn’t.
Bernanke and Yellen did not get a residential real estate bubble. Instead, they got an “everything bubble.” In the fullness of time, this will be viewed as the greatest blunder in the history of central banking.
Not only that, but Greenspan left Bernanke some dry powder in 2007 because the Fed’s balance sheet was only $800 billion. The Fed had policy space to respond to the panic of 2008 with rate cuts and QE1.
Today the Fed’s balance sheet is $4 trillion. If a panic started tomorrow, the Fed’s capacity to cut rates is only 1.25% and its capacity to expand the balance sheet is nil, because the Fed would be pushing the outer limits of an invisible confidence boundary.
This conundrum of how central banks unwind easy money without causing a recession (or worse) is just one small part of a risky mosaic. I’ll be writing about the other pieces of the puzzle in future commentaries.
Here’s a sneak preview:
- Student loan debt is over $1.4 trillion, and default rates are over 20%. Most of these defaults have not yet hit the federal budget deficit. They will soon. Resulting bad credit ratings are standing in the way of jobs and household formation for an entire generation of millennials.
- The new U.S. tax bill is the greatest hoax since Orson Welles’ 1938 radio broadcast, “War of the Worlds,” about an invasion of Earth by Mars. Orson Welles caused a panic in the New Jersey/New York listening area, with people fleeing their homes and jamming the roads. The tax bill damage will be less visible but far more damaging.
Biggest winners: corporations and billionaires. Biggest loser: the U.S. economy. I’ll have a lot more to say about this in the weeks ahead. What is certain is the tax bill will add $2 trillion or more to the deficit, something the U.S. can ill afford.
- A catastrophic wave of emerging-market defaults is coming, with enormous spillover effects likely in developed economies. This will be worse than the Latin American defaults of the 1980s and the Asian-Russia defaults of the late 1990s. It will emerge from Turkey and Venezuela but won’t stop there
- A war is coming between the U.S. and North Korea, probably by this summer. The best case is that the U.S. wins but at a very high cost in lives and money. The worst case is World War III when China, Russia and Japan are drawn in due to the inevitable unforeseen consequences of war.
There’s more to come over the weeks ahead. For now, think of 2018 as the year of living dangerously.
Regards,
Comments: