August 18, 2014

The extent to which monetary stimulus weakens an economy’s foundations and gets in the way of real progress will be proportional to the aggressiveness of the stimulus. This is because the greater the monetary stimulus, the greater the part within the overall economy that will end up being played by ‘bubble activities’ (businesses, projects, investments and speculations that only seem viable due to artificially low interest rates and a constant, fast-flowing stream of new money). That’s why the unprecedented (at that time) monetary stimulus of 2001-2005 led to the most severe economic fallout in more than 50 years, and why the even more over-the-top monetary stimulus of 2008-2013 has paved the way for an economic downturn of even greater severity than that of 2007-2009.

I’ll be writing more about the coming economic bust (aka severe recession or depression) over the next several months, especially if signs appear that it will soon get underway. For now, here are a few preliminary thoughts:

1) The next economic bust is likely to be worse than, and different from, the one that occurred during 2007-2009. What I mean is that the next bust is unlikely to be an amplified version of what happened previously. The main reason is that almost everyone, including the monetary central planners, will be prepared for a repeat of 2007-2009. Of particular relevance, whereas the Fed didn’t start to pump money into the economy until almost 12 months after the start of the 2007-2009 financial crisis and economic recession (the Fed began to cut its targeted interest rate in September of 2007, but it didn’t begin to monetise assets in a way that boosted the monetary inflation rate until September of 2008), it’s likely that the next time around the Fed will be much quicker to ramp up the money supply.

2) Due to the much quicker application of monetary ‘accommodation’ to counteract future economic weakness, the next bust could be associated with sharply rising commodity prices. This would be due to commodity hoarding in reaction to the belief that money is being trashed.

3) In the lead-up to and during the next economic bust, gold will probably be the best investment because it is the most logical commodity for large investors to hoard. It is the most logical commodity-refuge due to its global liquidity, its globally recognised value, the fact that the amount of gold used in commercial/industrial applications is trivial compared to the amount of gold held for monetary/investment/speculative purposes, and the distinct possibility that a collapse of or an existential threat to the current monetary system would result in gold returning to its traditional role as money.

4) The next economic bust won’t be caused by a geopolitical event, such as the disintegration of Ukraine and/or Iraq, but it will likely be exacerbated by restrictions placed on international trade due to increasing geopolitical tension.

5) The timing of the next bust is currently unknown. Two years ago I thought that it would be well underway by now, but it’s clear that negative real interest rates have a remarkable ability to postpone the day of reckoning. My current guess is that it will begin in 2015.

6) Three things I expect to see shortly before the start of the next economic bust are: a) the S&P500 Index dropping well below its 200-day moving average; b) evidence across the financial markets of a general increase in risk aversion (e.g. widening credit spreads, strength in gold relative to most other commodities); and c) a decline in the US monetary inflation rate to below 7%.

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