Is the U.S. Economy Headed for a “Sudden Stop” Event?

October 2nd, 2009

Must read.

(Full text below.)

Via: Reuters:

October 2nd, 2009

Why gold if deflation is the threat?

Posted by: Rolfe Winkler

Alice Schroeder wrote a great column for Bloomberg yesterday that I’m just getting to. The best stuff comes at the end, where she describes why some people are buying gold even though inflation doesn’t seem to be a big risk. (Apologies in advance for block-quoting lots of stuff in this post, but I think it’s worth it…)

[Gold bugs] aren’t just betting on inflation, as is the conventional wisdom. Gold has a wicked history of being an unreliable inflation hedge. It has, though, at times been a haven against sudden currency depreciation.

In all the talk of inflation because the Treasury is printing so much money versus deflation because it may not print enough, there is one type of inflation that is rarely discussed. This is the mega-inflation caused by a sudden currency devaluation. Currency is like any financial innovation, an obligation secured by assets. When the obligation is perceived to have increased far beyond the level justifiable by the assets, which in this case make up a country’s economy, a bubble has formed.

Schroeder is describing, in much simpler terms, what economist William Buiter has called a “sudden stop” event. (I’m having trouble logging on to FT to find the right link, but the guys at Baseline Scenario have a good one here.) Let’s take a quick detour to Buiter then, writing early this year:

But as the recession deepens, and as discretionary fiscal measures in the US produce 12% to 14% of GDP general government financial deficits – figures associated historically not even with most emerging markets, but just with the basket cases among them, and with banana republics – I expect that US sovereign bond yields will begin to reflect expected inflation premia (if the markets believe that the Fed will be forced to inflate the sovereign’s way out of an unsustainable debt burden) or default risk premia….

The US is helped by the absence of ‘original sin’ – its ability to borrow abroad in securities denominated in its own currency – and the closely related status of the US dollar as the world’s leading reserve currency.  But this elastic cannot be stretched indefinitely….

The only element of a classical emerging market crisis that is missing from the US and UK experiences since August 2007 is the ’sudden stop’ – the cessation of capital inflows to both the private and public sectors. . . . But that should not be taken for granted, even for the US with its extra protection layer from the status of the US dollar as the world’s leading reserve currency.  A large fiscal stimulus from a government without fiscal credibility could be the trigger for a ’sudden stop’.

Most economists, using their conventional models, are looking at things like “output gaps” to rationalize additional borrowing to stimulate the economy. So long as people and capital are unemployed, cost-push inflation isn’t seen as a threat so stimulus is believed to be cost-free. The risk, of course, is that we can’t borrow to infinity. At a certain point — tough to say when — we’ll tap out the national credit line. Where economists get in trouble, IMHO, is they envision this nebulous period in the “medium term” when the economy will be growing again and debt can be paid back. As I argued in my column yesterday, this ignores the fact that growth, which is to say growth in spending, is no longer possible without incremental borrowing. We’ve gotten ourselves into a cycle of perpetual borrowing to, in Schroeder’s words, “pump the economy back to a high-water mark that was phony to begin with.”

To Schroeder’s conclusion:

As in any bubble, those who recognize this need to act well in advance. Historically, governments have taken action to prevent currency flight when the owners of a severely overvalued medium of exchange start selling so much that it adds to the pressure on its price. They make private purchases of gold illegal, or tax the exchange of currency.

Right now, the American economy is worth less than the value implied by the market value of its obligations. How much less, no one knows. But gold bugs will tell you, privately, that this is why they are buyers. Might as well stock up, they say, before gold becomes a controlled substance.

The bolded section is why I haven’t touched stocks in two years and don’t plan to for some time: The U.S. economy is underwater. The value of our obligations is greater than the value of our assets, which is to say the equity value of the economy is negative. The best proxy for that is the stock market.

Stocks aren’t going to zero. They have option value. But a 90% fall from the peak is what I see happening eventually. Over what time frame, I haven’t a clue.

But that’s what happened during the Depression. Today we’re far more leveraged

Posted in Economy | Top Of Page

3 Responses to “Is the U.S. Economy Headed for a “Sudden Stop” Event?”

  1. tochigi says:

    excellent analysis from Mr. Winkler.

    i especially like this bit:
    “Where economists get in trouble, IMHO, is they envision this nebulous period in the “medium term” when the economy will be growing again and debt can be paid back.”

    thanks, Kevin, for the links.

  2. soothing hex says:

    The disconnection between money and reality is now so fundamental that one may suggest it will only take the trick of a hat to maintain anxiety and avoid major social unrest at the same time and for ages to come.

  3. shoe2one says:

    I’ve been hearing about the dollar re-valuation for awhile now, any day now, soon there’s going to be a bank holiday, it’ll be in two weeks major bank holiday, by mid-march, late june, early sept, mid october, 2nd week of nov, etc…

    If gold is a measure of inflation then we have been deflating for awhile. I’m still not even with the price of gold, getting close to what I purchased it at but not their yet. When it gets there I’m dumping all of it and good F’in riddance.

    To me this is a sign of what people do when they don’t have enough information and they feel like the world’s about to end. They start making shit up.

    This is the first major economic crash I’ve experienced, but my dad, uncle, and a number of other not-stupid people I know have experience a number of them before. My dad says even though this one is worse he still isn’t divesting of his dollars. He says people have been saying the dollar is going to crash for years. He lost more money listening to them.

    Me? I haven’t a clue, I don’t think the FED guys are idiots but what do I know. They’ve gotten us in and out of so many things it’s hard to think they are just making stuff up as they go along.

    I sense/think/feel that China is going to get the shit end of this economic stick. The dollar is going to rise in value. Gold/Silver is going to drop like a stone as is oil and other commodities (The Ticker Guy and Elliott Wave Guy). Is that 1000 Trillion or is it 700 Trillion dollar in derivatives debt considered real money? If so then we got a long way to go before even normal inflation would become a problem.

    Sometime in the not to distant future you’ll be able to buy back that $1001.90 per once gold for 600 to 700 dollars. I may buy some but I’ll probably by some land with a house and water rights, a tractor, some solar panels, and a better 5.1 surround sound receiver.

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