Financial Departure From Reality

“This Is The Largest Financial Departure From Reality In Human History”

Tyler Durden's picture

Submitted by Tyler Durden on 08/03/2015

Submitted by Nicole Foss via The Automatic Earth blog,

Our consistent theme here at the Automatic Earth since its inception has been that we are facing a very powerful deflationary depression, following on from the bursting of an epic financial bubble. What we have witnessed in our three decades of expansion and inflation is nothing short of a monetary supernova, and that period has been the just culmination of a much larger upward trend going back many decades at least. We have lived through a credit hyper-expansion for the record books, with an unprecedented generation of excess claims to underlying real wealth. In doing so we have created the largest financial departure from reality in human history. 

Bubbles are not new – humanity has experienced them periodically going all the way back to antiquity – but the novel aspect of this one, apart from its scale, is its occurrence at a point when we have reached or are reaching so many limits on a global scale. The retrenchment we are about to experience as this bubble bursts is also set to be unprecedented, given that the scale of a bust is predictably proportionate to the scale of the excesses during the boom that precedes it. We have built an incredibly complex economic system, but despite its robust appearance it is over-extended, brittle and fragile after decades of fuelling its continued expansion by feeding on its own substance.

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The Automatic Earth, December 2011The lessons of the past are sadly never learned. Each time the optimism is highly contagious. In the larger episodes, it crescendos into euphoria, leading societies into a period of collective madness where risk is embraced and caution is thrown to the wind. Sky-high valuations are readily rationalized – it’s different here, it’s different this time.


We come to believe that just this once there might be a free lunch, that we can have something for nothing. We throw ourselves into ponzi finance, chasing the mirage of speculative gains, often through highly questionable and outright fraudulent practices. Enron, Lehman Brothers, and recently MF Global, are but a few egregious examples of what has become an endemic phenomenon.


The increasing focus on chasing speculative profits parasitizes the real economy to a greater and greater extent over time. After all, why work hard for small profits in the real world, when profits on money chasing its own tail are so much greater for so little effort?


Who even notices the hollowing out of the real economy, or the conversion of large amounts of capital into waste, or the often pointless depletion of non-renewable resources, or the growing structural dependency trap, when there is so much short term material prosperity to pursue?


In such times, the expansionary impulse drives the development of multiple engines of credit expansion. The reserve requirements for fractional reserve banking (already a ponzi scheme) are whittled away to almost nothing. Since the reserve requirement effectively determines the money supply multiplier effect, that multiplier becomes almost infinite.


The extension of credit through the shadow banking system removes the semblance of central bank control over monetary expansion. Securitization and financial innovation also create putative wealth from thin air, using underlying collateral to derive layers of additional illusory value. In this way, excess claims to underlying real wealth are created. The connection between the rapidly expanding virtual worth of the derivative instruments and the real value of the underlying collateral becomes ever more tenuous.

Shadow Banking and Phantom Wealth

Since 2011, in our desperate attempt to avoid the consequences of an imploding bubble, we doubled down on the doomed strategy of ponzi credit expansion. In doing so, we have only succeeded in digging ourselves into a deeper hole, and have done so on a massive scale. While the aggregate balance sheet of the world’s central banks grew exponentially from $3 trillion to $22 trillion over the last 15 years, the expansion in the shadow banking sector has been even more dramatic, and its role in fostering the overall credit hyper-expansion has become increasingly clear:

Shadow banks are that exploding growth segment of global finance capital that share the following characteristics: they are largely unregulated, they invest primarily in financial asset securities of various kinds (i.e. stocks, government and corporate junk bonds, foreign exchange, derivatives, etc.) instead of real asset investment (plant, equipment, software, etc.), they target high risk-high return opportunities based on asset price appreciation and volatility to realize financial capital gains, their investments are highly leveraged and debt driven, their investment targets are highly liquid financial markets worldwide that enable a quick entry, price appreciation, and subsequent just as quick short term profit extraction.


Their client base is predominantly composed of the global finance capital elite – i.e. the roughly 200,000 worldwide ultra and very high net worth individuals with net annual additional income from investment flows of $20 million or more—for whom they invest individually as well as for themselves as shadow bank institutions.


Shadow bank ‘forms’ include private equity firms, hedge funds, asset and wealth management companies, mutual funds, money market funds, investment banks, insurance companies, boutique banks, trust companies, real estate investment trusts – to note just a short list – as well as dozens of other forms and newly emerging initiatives like peer to peer lending networks, online investment funds, and the like.


Shadow banks have been estimated to have investable assets (i.e. relatively short term and liquid) of about $75 trillion globally as of year end 2014, a total that does not include revenue from ‘portfolio’ shadow-shadow banking. That is projected to exceed $100 trillion well before 2020.

The exponential growth of both central banks and shadow banking during the long global boom constitutes a gargantuan increase in the supply of money plus credit relative to available goods and services, which is inflation by definition. This huge supply of virtual wealth has acted to push up asset prices, creating a plethora of asset price bubbles and a cascade of malinvestment based on those price distortions. The explosive growth of shadow banking in particular, following the 2009 bottom, was accompanied by a return to extreme risk complacency and rock bottom interest rates, leading to a frantic search for investment returns in riskier and riskier places. 

Inherently risky emerging markets became a major focus during this time, and the search for outsized returns not only sought out risk, but actively increased it. Volatility provides the momentum that generates trading profits, but it also creates considerable instability. Given that finance is virtual, and that changes in the financial world therefore unfold far more quickly than the real economy can realistically adapt to, large influxes and exoduses of hot money looking for quick profits are very destablizing to target sectors of the real economy, and to entire countries. The phantom wealth generated by the shadow banking bonanza has both created and subsequently fed upon real world destruction:

What China, Argentina, Greece, Venezuela, and Ukraine all share in common is an ongoing struggle with global shadow bankers, who continue to destabilize their financial systems and drive their real economies, at different rates, toward recession and worse….


….Shadow banks and their finance capital elite clients make money when financial asset prices are volatile, i.e. when such prices rapidly rise or fall or both. It is thus in their direct interest to cause asset price volatility and instability—whether in provoking a rapid rise in government bonds rates (Greece), in contributing to the collapse in currencies (Venezuela, Argentina), or in IMF-enforced ‘firesales’ of companies (Ukraine).  Their strategy is to exacerbate, or even create, financial price inflation in the targeted market and financial instruments, be they stocks, junk bonds, real estate, foreign exchange, derivatives, etc. That same financial price instability, however, is what causes havoc with the real economies of countries—like those in southern Europe in recent years, in Asia in the late 1990s, Japan in early 1990s, and which led to the global financial crash of 2008-09 itself….


….Shadow banks generate profits from excess lending and debt creation, from financial speculation, and from creating financial asset bubbles that primarily benefit their wealthy investors….Shadow banks add little to the real economy or real economic growth.  And in the process of generating excess financial profits for themselves and their finance capital elite, they destabilize economies and can often lead to major financial asset collapses, general credit crunches and at times even credit crashes, that in turn lead to deep recessions and prolonged, difficult recoveries….


….Shadow banks are the preferred institutions of the global finance capital elite. They always work to the benefit of that elite, often at the direct expense of the real economy, including non-financial businesses, and always at the expense of working classes who never share in the capital gains but pay the price in slower economic growth and repeated financial-economic crashes.

Recovery? No, Endgame

Since 2009 we have collectively told ourselves that recovery was underway, and this became the mainstream received wisdom. Optimism made a substantial return, even though it was, for insiders, tinged with desperation, and was grounded in the catabolic consumption of peripheral economies. Fears of deflation, which had been widespread during 2008/2009, receded again, and once again deflationist commentators were ridiculed. Commentators returned to speaking of inflationary risks, as they always do after a long enough period of upward momentum, given humanity’s proclivity for extrapolating current trends forward, and relative inability to anticipate trend changes, however obvious they may be if one is paying attention.

The supposed recovery is a temporary fantasy – a smoke and mirrors game grounded in ponzi finance on steroids. The excess claims to underlying real wealth, created during the both the initial boom and the false recovery, are set to evaporate once the extent of our crisis of under-collateralization become evident, and that moment is rapidly approaching. The deflation which was always the obvious endgame of credit expansion, is now underway and picking up momentum. A gigantic pile of IOUs is set to be defaulted upon, and the resulting monetary contraction will slash demand for almost everything, not for lack of desire to purchase or consume, but for lack of ability to pay for the privilege. This will undercut price support for almost everything many years.

As we wrote in 2011:

In the process of credit expansion, we borrow from the future through the creation of debt. Our focus on virtual wealth has very significant real world effects, as it distorts our decision-making in ways that guarantee bust will follow boom. We bring forward tomorrow’s demand to over-consume today, frantically building out productive capacity in order to satisfy that seemingly insatiable demand.


As money supply increase leads the development of productive capacity during this manic phase, increasing purchasing power chases limited supply and consumer prices rise. Increasing virtual wealth also drives up asset prices across the board, strengthening speculative feedback loops that inevitably strain the fabric of our societies, all too easily to the breaking point….


….Decades of inflation lie behind us. It is deflation – the contraction of the supply of money plus credit relative to available goods and services – that lies ahead….When a credit expansion reaches the point where the debt created can no longer be serviced by a hollowed-out real economy, and the marginal productivity of debt becomes negative, continued growth is no longer possible….


….The process of monetary contraction following a ponzi expansion is implosive because it involves the destruction of virtual value – the fairly abrupt realization that the emperor has no clothes….It is an economic seizure, and its effect is devastating. Credit in its myriad forms represents the vast majority of the money supply, and it is about to lose its money equivalency. This will leave only cash, and that cash will be extremely scarce.Aggravating the effect of crashing the money supply will be a substantial fall in the velocity of money, meaning that money will largely cease to circulate in the economy as people hang on to every penny they can get their hands on….


….Nothing moves in an economic depression. This is the polar opposite of the frenetic activity of the inflationary boom years. Instead of the orgy of consumption to which we have become accustomed, we will experience austerity on a scale we cannot yet imagine.

This is exactly what we are currently seeing places like Greece and Cyprus – the canaries in the coal mine. As much trouble as such places are currently in, however, this is still the thin edge of the wedge even for them. And for places as yet unaffected, the storm is rapidly approaching. Departures from reality can persist only so long as the illusions they are based on retaincredibility:

Self-evidently, we are now in the cliff-diving phase, but unlike the bounce after the September 2008 financial crisis, there will be no rebound this time around. That is owing to two reasons. First, most of the world is at “peak debt”. That is, the ratio of total credit market debt to current national income ranges between 350% and 500% in every major economy; and that is the limit of what can be serviced even at today’s aberrantly low interest rates. As Milton Friedman famously observed, markets are ultimately not fooled by the money illusion. In this case, the illusion is that today’s sub-economic interest rates will last forever and that debt carrying capacity has been elevated accordingly. Not true.


Short-term interest rates may be temporarily and artificially pegged at the zero bound by central bankers, but at the end of the day debt carrying capacity is tethered by real economics and normalized costs of money and debt. Accordingly, the central banks are now pushing on a string.  The credit channel of monetary transmission is over and done. The only remaining effect of the residual level of money printing still underway is that ZIRP enables carry trade gamblers to drive financial asset prices ever higher, thereby setting up another thundering collapse of the financial bubbles being generated for the third time this century by the world’s central banks.

We are already witnessing the next phase of financial crisis, and the fear-based contagion is already spreading. However, as John Stuart Mill said in 1867, “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.” A vast quantity of capital has been so betrayed during the era of monetary profligacy, mispricing and malinvestment that is now coming to an end, and the coming financial reckoning will reveal the extent of that destruction.

After the Commodity Blow-Off…

The monetary supernova sparked an orgy of consumption, fuelling an explosion of demand for commodities of all kinds and a frantic scramble to supply that demand. In the process, huge distortions were created from which considerable consequences will flow now that the blow-off phase is over:

The worldwide economic and industrial boom since the early 1990s was not indicative of sublime human progress or the break-out of a newly energetic market capitalism on a global basis. Instead, the approximate $50 trillion gain in the reported global GDP over the past two decades was an unhealthy and unsustainable economic deformation financed by a vast outpouring of fiat credit and false prices in the capital markets.


For that reason, the radical swings in commodity prices during the last two decades mark the path of a central bank generated macro-economic bubble, not merely the unique local supply and demand factors which pertain to crude oil, copper, iron ore, or the rest….What really happened is that the central bank instigated global macro-economic bubble ripped commodity pricing cycles out of their historical moorings, resulting in a one time eruption of price levels that had no relationship to sustainable supply and demand factors in the mines and petroleum patch. What materialized, instead, was an unprecedented one-time mismatch of commodity production and use that caused pricing abnormalities of gargantuan proportions.

The erstwhile prolonged frenzy of consumption has created the sense that demand for commodities would be eternally insatiable, but that perception is now being profoundly shaken. It has long been clear that commodity demand would fall enormously during the coming period of deflation and depression, but the illusion of perpetual expansion has been slow to release its grip.

In the summer of 2011 we wrote that commodities were peaking and offered a bearish prognosis in Et tu, Commodities?. At the time this was seen as being quite heretical, as contrarian forecasts at peaks always are. Fear of shortages was rampant, but fear causes market participants to bid up the price in advance of what the fundamentals would justify, opening the door to a major price readjustment, as we saw in 2008. At the time, we explained the nature of commodity tops and what inevitably follows:

As an expansion develops, one can generally expect increasing upward pressure on commodity prices, thanks to both demand stimulation and latterly the perception that prices can only continue to increase. The resulting crescendo of fear – of impending shortages –  is accompanied by the parabolic price rise typical of speculative bubbles, as momentum chasing creates a self-fulfilling prophecy. At the point where almost everyone with the capacity to do so has jumped on the bandwagon, and all agree that the upward trend is set in stone, a trend change is typically imminent.


We find ourselves still near the peak of the largest credit bubble in history. As faith in many of the more spurious ‘asset’ classes devised by ‘financial innovation’ has been shaken, faith in the ever increasing value of commodities has strengthened. However, commodities are not immune to the effects of a shift from credit expansion to credit contraction, despite justifications for endless price rises, such as the apparently bottomly demand from China and the other BRIC countries.


Every bubble is accompanied by the story that it is different this time, that this time prices are justified by fundamentals which can only propel prices ever upwards. It is never different this time, no matter what rationalizations exist for speculative fervour. BRIC demand only appears to be insatiable if we make our predictions solely by extrapolating past trends, but that approach leaves us blind to trend changes and therefore vulnerable to running off a cliff. Insatiable demand results from seemingly endless cheap credit, given that demand is not what one wants, but what one can pay for. When credit collapses, so will demand, and with it the justification for higher prices.


While credit expansion (inflation) is a powerful driver of increasing prices, credit contraction (deflation) is a far more powerful driver of decreasing prices. Credit, having no substance, is subject to abrupt fear-driven disappearance. Confidence and liquidity are synonymous….As contraction picks up momentum, the loss of credit will rapidly lead to liquidity crunch, drastically undermining price support for almost everything. With purchasing power in sharp retreat, however, lower prices will not lead to greater affordability. Purchasing power typically falls faster than price under such circumstances, so that almost everything becomes less affordable even as prices fall.

At the time we called it a peak that would stand for a very long time.

There were commodity peaks across the board in 2011, and despite the supposed on-going recovery from that time, price declines have continued.









Notice that there was a virtually simultaneous price peak in every case. In some instances it was a secondary peak, following a top in 2008, and in others prices had gone beyond the 2008 levels. Only gold lagged in time, and not by much. This illustrates an important point that we have made before, the prices are not determined by the fundamentals of these industries, but by the ebb and flow of liquidity. Once a sector of the real economy has been thoroughly financialized, it is subject to the boom and bust dynamics of finance, and is no longer driven by it’s own fundamentals. Price swings of huge amplitude are possible in very short timeframes, as in 2008.

Tops in different asset classes can be remarkably co-incident. See for instance this graphic that we have shown before (thanks to, demonstrating the ‘All the Same Market” phenomenon with co-incident tops on the same day:


Of course the commodity narrative is also a story of movements in the US dollar. We have always maintained that the dollar was going to see a major rise in a deflationary environment, both as a result of demand for dollars torepay dollar denominated debt, and on a flight to safety into the reserve currency. This position was also contrarian and heretical. US dollar sentiment was extremely bearish in 2011, with the majority seeing only the previous trend and full expecting it to continue. Commentators were calling the dollar toilet paper. That is exactly what one would expect at a bottom.

The dollar is now receiving additional upward propulsion from the Federal Reserve’s stated goal to raise interest rates, but this is almost certainly less of a factor than a flight to safety, which would occur even at lower rates if driven by sufficient fear. Since interest rates are a risk premium, low rates are a good indication that the asset in question is perceived to be a safe haven. As a flight to safety gets underway in earnest, we should see a flood of money into the USD in a climate of falling interest rates, perhaps even to the point of being marginally negative in nominal terms, at least temporarily. In a climate of extreme fear, investors will pay for the privilege of capital preservation, for so long as the illusion of it lasts. 

Emerging markets, which have collectively borrowed $4.5 trillion USD are going to experience a tremendous squeeze, aggravating the consequences of their bust phase.


Notice that the US dollar began its rise at the same time as commodities, denominated in dollars began to fall. The dollar is part of the all-the-same-markets phenomenon, in that is trend changes coincide with trend changes in other asset classes, but its movements occur in the opposite direction. There are many commentators who therefore regard falling commodity prices purely as a function of a rising dollar, but the situation is not so simple. Correlation is not causation. All values fluctuate relative to one another, and none is a fixed value against which all else can be measured. The dollar is trading on its relatively safe haven status and is therefore increasing, but the commodity decline is by no means simply a dollar story. It is a story of the realization that we have grossly over-built productive and extractive capacity, but that realization is only just beginning to dawn four years after the peak:

Had stockmarkets fallen more than 40% from their peak, the national news bulletins and the mainstream papers would be full of headlines about collapse and calamity….But this is one of the great bear markets. It may seem less important because few people are directly invested in commodities. But in terms of people’s daily lives, commodity prices are very important indeed. The Arab spring started as a response to soaring food prices in North Africa. Rising and falling prices act as a tax rise/cut for western consumers. For commodity producing nations, falling prices mean loss export earnings, lost jobs and currency crises.

Declining Fortunes

Emerging markets and commodity companies are caught in a global economic downdraft, following on from their years of extraordinary boom and consequent over-investment. That misallocation of capital, compounded by the leverage involved, has created an enormous overhang of productive capacity. The sunk costs create an incentive to continue producing and generate at least some revenue, even as a supply glut is already causing prices to collapse. This is a toxic dynamic for a highly leveraged sector, leading to downward spiral of excess inventory and a pancaking debt pyramid:

In the case of the global mining industries, CapEx by the top 40 miners amounted to $18 billion in 2001. During the original boom cycle it soared to $42 billion by 2008, and then after a temporary pause during the financial crisis, reaccelerated once again, reaching a peak of $130 billion in 2013. Owing to the collapse of commodity prices as shown above, new projects and greenfield investments have pretty much ground to a halt in iron ore, met coal, copper and the other principal industrial materials, but there is a catch.


Namely, that big projects which were in the pipeline when commodity prices and profit margins began to roll-over in 2012, are being carried to completion owing to the sunk cost syndrome. This means that available, on-line capacity continues to soar. The poster child for that is the world’s largest iron ore complex at Port Hedland, Australia. The latter set another shipment record in June owing to still rising output in the vast network of iron mines it services——-a record notwithstanding the plunge of iron ore prices from a peak of $190 per ton in 2011 to $47 per ton a present.

In such a climate, commodity company valuations are very vulnerable.They have already fallen substantially, but considering the negative circumstances they face are far closer to their beginning than to their end, it seems highly unlikely that the decline will end any time soon. Talk of capitulation is extremely premature:

Sprott Asset Management’s Rick Rule is one of the smartest guys in the resource investing world — and one of the most reasonable — which has made his interviews of the past few years a little disconcerting. Along with the obligatory positive thoughts on the long-term value of gold and silver and the resulting bright future for the best precious metals miners, he always points out that the sector hasn’t yet endured a capitulation, where everyone just gives up and sells at any price, tanking prices and setting the stage for the next bull market.


Knowing that this kind of existential crisis is still out there has taken the fun out of buying ever-cheaper mining stocks, which of course has been Rule’s point. Just because something is cheap doesn’t mean it can’t get a lot cheaper before its bear market is done….


….Both metals are now below the production cost of most miners, whose shares are cratering on the prospect of some truly horrendous operating results in the coming year. Which sounds a lot like what Rule is describing.

Commodities priced below the cost of production for most producers is exactly what one would expect in a deflation, as a combination of supply glut and lack of purchasing power drastically undercut price support. Our long term forecast at TAE is for an undershoot proportionate to the scale of the preceding overshoot, meaning a price collapse at least down to the cost of the lowest cost producer. Under such circumstances, there would be no investment in the sector for many years – a long period of under-investment proportionate to the previous over-investment. The attempt toavoid the day of reckoning is only adding to the eventual pain:

And that’s where central bank enabled zombie finance comes in. Production cuts and capacity liquidations in virtually every materials sector are being drastically delayed by the continuing availability of cheap finance. So what “extend and pretend” really means is that prices and margins will be driven even lower than would otherwise be the case in the face of excess capacity. Stated differently, the correlate of zombie finance is flattened profits for an unusually prolonged period of time.


Here’s the thing. During the central bank driven doubled-pumped boom, profits margins rose to historically unprecedented levels because scarcity rents were being captured by producers during most of the past 15 years. Now comes the era of gluts and unrents. The casino is most definitely priced as if scarcity rents were a permanent fixture of economic life——when they were actually a freakish consequence of the central bankers’ reign of bubble finance.

Vulnerable Commodity Exporters

Commodity exporting nations, which were insulated from the effects of the 2008 financial crisis by virtue of their ability to export into a huge commodity boom, are indeed feeling the impact of the trend change in commodity prices. All are uniquely vulnerable now. Not only are their export earnings falling and their currencies weakening substantially, but they and their industries had typically invested heavily in their own productive capacity, often with borrowed money. These leveraged investments now represent a substantial risk during this next phase of financial crisis. Canada, Australia, New Zealand, are all experiencing difficulties:

Known as the Kiwi, Aussie, and Loonie, respectively, all three have tumbled to six-year lows in recent sessions, with year-to-date losses of 10-15%. “Despite the fact that they have already fallen a long way, we expect them to weaken further,” said Capital Economists in a recent note. The three nations are large producers of commodities: energy is Canada’s top export, iron ore for Australia and dairy for New Zealand. Prices for all three commodities have declined significantly over the past year, worsening each country’s terms of trade and causing major currency adjustments.

South Africa and Brazil are similarly affected:

Brazil’s real plummeted to a 12-year low of 3.34 to the dollar, reflecting the country’s heavy reliance on exports of iron ore and other raw materials to China. The devaluation tightens the noose on Brazilian companies saddled with $188bn in dollar debt taken out during the glory days of the commodity boom.

Complacency has been rife in these ‘lucky countries’ which have tended to perceive natural limits as someone else’s problem and to regard themselves as impervious to systemic shocks:

This colossal collapse in wealth is symptomatic of the wider economic problem now facing Australia, which for years has been known as the lucky country due to its preponderance in natural resources such as iron ore, coal and gold. During the boom years of the so-called commodities “super cycle” when China couldn’t buy enough of everything that Australia dug out of the ground, the country’s economy resembled oil-rich Saudi Arabia….


….While the rest of the world suffered from the aftermath of the global financial crisis, Australia’s economy – closely tied to China – appeared impervious, with full employment and a healthy trade surplus. However, a collapse in iron ore and coal prices coupled with the impact of large international mining companies slashing investment has exposed Australia’s true vulnerability. Just like Saudi Arabia, which is now burning its foreign reserves to compensate for falling oil prices, Australia faces a collapse in export revenue.

The greater the extent to which an exporting economy has placed all its eggs in one basket, the greater the vulnerability of its economy:

Australia’s export base has narrowed to levels approaching that of a “banana republic,” a former government adviser says, raising the specter of the country’s economic nadir almost 30 years ago.The concentration of shipments abroad is at the highest level in more than 50 years, according to Andrew Charlton, who counselled former Prime Minister Kevin Rudd on economic policy. The nation’s budget is “hostage” to global iron ore prices, with a $10 drop taking up to A$10 billion from forecast revenue, he said. The global iron ore price has dropped more than $12 in the past month, further exposing Australia’s lack of export alternatives….


….”Even some low-income countries like Nepal, Kenya, and Tanzania have greater export diversity than Australia.” His analysis again raises the question of what Australia will fall back on as the resources tide recedes. Exports have gone backwards as a proportion of the economy over the last 15 years in almost every non-resources industry, and services are now too small to offset mining.

Australia’s national business model has for a long time been ‘dig it up and sell it to China as quickly as possible’, but the success of the mining sector in its heyday caused a large appreciation of the currency (the Dutch Disease), which in turn damaged the international competitiveness of the country’s manufacturing base. Manufacturing was increasingly off-shored, hence the inability to revive it now that the currency is falling. Add to that the fact the global trade takes a major hit in times of economic depression, and it is obvious that alternative exports will struggle to pick up pace. In addition, so much of the focus of the domestic economy has come to centre around real estate during the development of its gigantic property bubble, that interest in out-sized profits from property speculation have easily outweighed interest in the normal profits one could expect from re-establishing manufacturing:

“Australian governments have been operating on the assumption that, once the mining boom passed, low interest rates and a falling dollar would be enough to bring the non-resource sectors dancing out of their graves,” Charlton, now director of consultancy AlphaBeta, said in a research report. “Unfortunately, no such resurrection is occurring.” “Australia watched idly as the rust-belt manufacturing suburbs around Sydney and Melbourne were transformed from red-brick factories into red-hot real estate,” he said.

Even erstwhile ‘rock-star economies’ are feeling the pressure to cut interest rates, in the vain hope that beggar-thy-neighbour currency devaluations will be beneficial:

Yesterday, the Reserve Bank of New Zealand slashed borrowing costs for the second time in six weeks even as housing prices continue to skyrocket. A day earlier, its counterpart across the Tasman Sea (already wrestling with an even bigger property bubble of its own) said a third cut this year is “on the table.”


Just one year ago, it seemed unthinkable that officials in Wellington and Sydney, more typically known for their hawkishness and stubborn independence, would join the global race toward zero. But with commodity prices sliding, China slowing and governments reluctant to adopt bold reforms, jittery markets are demanding ever-bigger gestures from central banks. Even those presiding over stable growth feel the need to placate hedge funds, lest asset markets falter. When this dynamic overtakes countries such as New Zealand (growing 2.6%) and Australia (2.3%), it’s hard not to conclude that ultra-low rates will be the global norm for a long, long time.

Contagious instability is spreading from the periphery towards the centre, threatening to convulse the financial world again, with considerable knock-on consequences in the real world:

Less than a decade after a housing/derivatives bubble nearly wiped out the global financial system, a new and much bigger commodities/derivatives bubble is threatening to finish the job. Raw materials are tanking as capital pours out of the most heavily-impacted countries and into anything that looks like a reasonable hiding place. So the dollar is up, Swiss and German bond yields are negative, and fine art is through the roof.


Now emerging market turmoil is spreading to the developed world and the conventional wisdom is shifting from a future of gradual interest rate normalization amid a return to steady growth, to zero or negative rates as far as the eye can see….Indeed, the major monetary powers that are easing — Europe, Japan, Australia and New Zealand — have all suggested rates may stay low almost indefinitely. Those angling to return to normalcy, meanwhile — the Federal Reserve and Bank of England — are pledging to move very slowly. Even nations with rising inflation problems, like India, are hinting at more stimulus….


….So…the central banks will panic. Again. Countries that retain some control over their monetary systems will see their interest rates fall to zero and beyond, while those that don’t will be thrown into some kind of new age hyperinflationary depression. Not 2008 all over again; this is something much stranger.

Stranger indeed, and a far more powerful contractionary impulse than in 2008. While ultra-low rates are characteristic of the current stage, as we stand on the brink, they are not likely to persist into the coming strongly deflationary environment rife with risk. While perceived low risk states may be able to maintain low rates for a while, others will not be so lucky as credit spreads blow out to form self-fulfilling prophecies. In any case, rates may appear low only in nominal terms. In a contractionary environment, where the real rate is the nominal rate minus negative inflation, real interest rates will be high and rising. This will compound the burden imposed by decades of over-leverage, for both companies and countries, to an enormous extent. Indebted ‘lucky countries’ are not going to look so lucky in a few years time.

China – Not Just Another BRIC in the Wall

More than anything, the story of both the phantom recovery and the blow-off phase of the commodity boom, has been a story of China. The Chinese boom has quite simply been an unprecedented blow-out the like of which the world has never seen before:

China has, for years now, become the engine of global growth. Its building sprees have kept afloat thousands of mines, its consumers have poured billions into the pockets of car manufacturers around the world, and its flush state-owned enterprises (SOEs) have become de facto bankers for energy, agricultural and other development in just about every country. China holds more U.S. Treasuries than any other nation outside the U.S. itself. It uses 46% of the world’s steel and 47% of the world’s copper. By 2010, its import- and export-oriented banks had surpassed the World Bank in lending to developed countries. In 2013, Chinese companies made $90-billion (U.S.) in non-financial overseas investments.


If China catches a cold, the rest of the world won’t be sneezing – it will be headed for the emergency room.

To put China’s construction bonanza in perspective, the country used more cement in 3 years than the USA used in the entire 20th century:


To get a feel for the pace of the development, look at Shanghai’s financial district in 1987 and again in 2013:

The setting is Shanghai’s financial district of Pudong, dominated by the Oriental Pearl Tower at left, and the new 125-story Shanghai Tower, China’s tallest building and the world’s second tallest skyscraper, at 632 meters (2,073 ft) high, scheduled to finish by the end of 2014. Shanghai, the largest city by population in the world, has been growing at a rate of about 10% a year the past 20 years, and now is home to 23.5 million people — nearly double what it was back in 1987.

Photos: Reuters/Stringer, Carlos Barria

Or look into China’s ghost cities, fully equipped with everything, except people:


China’s infrastructure build-out has to be seen to be believed. Fuelled by an exceptional level of corruption in the state-owned enterprise sector, a lack of feedback as to what is and is not a productive investment, perverse incentives for local government to push development and a huge expansion of credit and debt, the boom has created a society of extreme inequality and increasing social pressures:

The richest 70 members of China’s legislature added more to their wealth last year than the combined net worth of all 535 members of the U.S. Congress, the president and his Cabinet, and the nine Supreme Court justices. The net worth of the 70 richest delegates in China’s National People’s Congress, which opens its annual session on March 5, rose to 565.8 billion yuan ($89.8 billion) in 2011, a gain of $11.5 billion from 2010, according to figures from the Hurun Report, which tracks the country’s wealthy. That compares to the $7.5 billion net worth of all 660 top officials in the three branches of the U.S. government.


The income gain by NPC members reflects the imbalances in economic growth in China, where per capita annual income in 2010 was $2,425, less than in Belarus and a fraction of the $37,527 in the U.S. The disparity points to the challenges that China’s new generation of leaders, to be named this year, faces in countering a rise in social unrest fuelled by illegal land grabs and corruption. “It is extraordinary to see this degree of a marriage of wealth and politics,” said Kenneth Lieberthal, director of the John L. Thornton China Center at Washington’s Brookings Institution. “It certainly lends vivid texture to the widespread complaints in China about an extreme inequality of wealth in the country now.”….


….Rupert Hoogewerf, chairman and chief researcher for the Hurun Report, estimates that for every Chinese billionaire the company discovers for its list, there is another one it misses, meaning the gap between the wealth of China’s NPC and the U.S. Congress may be greater still. “The prevalence of billionaires in the NPC shows the cozy relationship between the wealthy and the Communist Party,” said Bruce Jacobs, a professor of Asian languages and studies at Monash University in Melbourne, Australia. “In all levels of the system there seem to be local officials in cahoots with entrepreneurs, enriching themselves, and this has led to a lot of the demonstrations.”

China built like there was no tomorrow, thereby guaranteeing that there will not be for the country in its current form. The raw materials demand was simply staggering:<


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