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Anatomy of a Meltdown – Articulating the Fear of a Developed World Currency Collapse

by Garrett Fisher
May 25, 2013

There are rumblings amongst visionaries and seers that the dollar and other developed world currencies are due for a collapse in the near future. Those that make such predictions speak of the 2008 Great Recession as merely a pre-cursor of what is to come. These predictions state that excessive money-printing by central banks will no longer be tolerated by investment markets – and devastating consequences lurk with governments unable to step in and control the economic implosion. How real is such a fear? And what would the anatomy of such a meltdown look like?

First Analysis: Supercycles and The Lifecycle of Currencies

Supercycles are based on the Elliott Wave – which is a theory that nested economic supercycles exist in 70 year patterns – followed by implosive price declines and economic contraction. Notably, the Elliott Wave was first applied to retroactively establish, from the 1857 contraction, a contraction in 1928. History tells us that it hit in 1929 – and since then there has been retroactive analysis, debate and application of the Elliott Wave and a healthy dose of head scratching as to whether or not we are standing at the edge of an economic cliff – or if we slipped off of it some time from 1987 to 2008 – and we aren’t sure which one was the cliff. The thought that we have to look back and wonder if we fell off a cliff tells me that we have not.

Currency lifecycles are often quoted by people that recommend that you buy gold – and many of the subject matter experts have invested in it themselves or somehow to stand to gain by a continued increase in the price of gold. It is hard to distill a reasonable assumption amidst the hype and drama – so it is best to fall back on what we do know. Countries that excessively pile up debt and effectively default have two options to deal with the problem: a) a long and painful road to recovery and repayment – lasting longer than the political will to do so or b) devalue the currency (default), get the debt vanquished, and start over. It is true that countries going into the process are over leveraged, endure a period of pain and then many times start on a refreshed footing – as their devalued currency makes them internationally price competitive – and their lack of debt servicing allows the economy to flourish with the rebound of activity. A collective apology letter goes out to the bondholders holding the bag.

It is my disposition that Supercycles and national bankruptcies are linked events. Sometimes national bankruptcies may occur in periods shorter than Supercycles – and other times Supercycles themselves impose a national bankruptcy. I believe that both of these events have ramifications for the Anatomy of a Meltdown.

How Does a Supercycle work?

For someone to latch credibility to the theory of a Supercycle, they would need to know how it works. Why 70 years? Saeculum Theory implies that a certain sequence of generations effectively relearns the same lesson over and over. To an extent, this is very true – as the presence of natural disasters creates a distinct memory – and over time, people forget. The Great Earthquake of 1906 in San Francisco rings a bell – and sometime after that event and before the earthquake of 1989, a poorly constructed double-decker freeway was built in San Francisco that resulted in great loss of life. 83 years between disasters – and a curiously short memory about earthquakes. Generational mathematics, psychology and probability are the key to behavioral relevance. Too far away, too small a chance and people forget. When faced with the same short-term opportunities at the expense of long-term gain (cheaper bridge, poor fiscal management), people are wired to take the short-term route and disbelieve low probability events. A recent memory of a super disaster tells the psyche that the event isn’t low probability and people pay attention for a while.

Competition and impatient motivators for short-term gain result in predictable behavior: economic recklessness. Countries fear being left behind – and when facing other countries engaged in short-sighted competitive behavior, fear motivates participation in the same short-term behavior. Case in point: we know that greenhouse gas emissions are going to wreak immense havoc on our habitat with incredible costs, yet no country wants to be the first to blink and adopt economically expensive alternatives. Americans won’t quit fossil fuels because of the Chinese. The Chinese won’t because of the Indians and list goes on. Who will be the first to sacrifice their wallet for humanity – likely no one – until something so big and so bad happens that everyone gets scared enough to find collective value in a change.

Given the examples of such solvable, obvious issues that face intellectually capable humans, it is no surprise that introducing generations of time between catastrophic events would create an amnesia that is more powerful than fear and short-term gain. Market pricing is based on short-term events – and the requirement that each participant in a capitalist society look out for themselves guarantees a predictable pattern of economic behavior. Again – which citizen will empty his wallet for the good of mankind when the system is heading for collapse? Fear will guarantee he engage in self-preservation – which often accelerates the problem (in times of economic bubbles, participation worsens it. In times of depression, hoarding cash worsens it).

The key to the Supercycle is that we are doing it to ourselves. As prices in a marketplace begin to bottom, people are compelled to spend their money on goods and services at an excellent price. As they do so, businesses perform better. Such businesses desire to expand – and they turn to banks to finance their expansion. Banks willingly grant credit based on increased performance. This, in turn, increases the business’ capacity, which results in more earnings, and more credit potential. For public companies, share price is effectively a multiple of earnings times a forward number of years. So, in a short time, suddenly an increase in one year’s profits for a business results in a spigot of credit, expansion and instant increase in company value due to forward expectations. This drives an increase in pricing – which eventually drives a decrease in volume. Banks pull credit. Stock prices fall. The process repeats itself. Elliott propounded that these waves exist on a daily micro scale – all the way up to nested multi-decade time periods. We do this to ourselves based on how markets are driven.

So Why Hasn’t the Supercycle shown up yet?

We are late for our visit with the Elliott Wave. Some question if it already happened. Some wonder if it is coming. And others wonder if Elliott got it all wrong. A theory is only valid if the assumptions it is based on remain consistent. If the existential equilibrium around the theory changes, then the theory itself must adapt. When Elliott developed the theory, the concept of government involvement in the economy was lower. Computers did not exist as they do now – and up-to-the-minute economic monitoring did not exist. We have information and central banking willing to apply healthy doses of Keynesian economics that did not exist before (during the Great Depression, stimulus took 4 years to commence and even then, the government was experimenting in uncharted waters). That change has upset the equilibrium around the theory – so it is reasonable to expect some variation in outcome.

Case in point: When 1929 struck, the existing administration felt that it was caused by recklessness and excessive lending and actually contracted credit. When administrations changed in 1932, the economy had bottomed and the government started spending to pick up activity. In 1937, the government felt that the economy was fine and withheld spending to let it “stand on its own.” The economy collapsed again. Government spending kicked up – and World War II saved the economy. No one knows how long it would have lasted had WWII not come.

Contrast to the 2008 Great Recession. As a statement of free market principles, the government allowed Lehman Brothers to fail. Hindsight tells us that this event caused markets and credit to implode and economists contend it was a mistake. The government reacted – and poured money into the banking system and economy (economists state this was a wise reaction to the fact that they forced themselves into it with the Lehman collapse). In fact, the extent of the recession was misunderstood – and economists would have called for more stimulus had they known how bad it was. Both events (1929 and 2008) were similar – left to their own devices, the economy would have utterly collapsed – and probably ended in war or revolution. High rates of government intervention in 2008 prevented a Great Depression. High rates of government reaction in the Great Depression prevented a revolution.

The reason that 2008 government intervention was possible was due to lessons learned from the Great Depression and near real-time economic data available. The government could act with speed in ways it could not before. The Elliott Wave was propounded at a time when such technology and political will did not exist – and therefore to expect the Elliott Wave theory to perform as originally proposed is inaccurate.

What’s the point? I contend that the manifestation of the Elliott Wave is delayed. The can is kicked down the road. Instead of the economy facing terrible times and imploding, debt loads have increased massively – and the problem is sitting on a national balance sheet – with everyone hoping that it can amortize over a long enough time to not be a problem. If Mr. Elliott is correct, then another wave down is in store – and the question remains – what path will the situation take to resolve it? Much like our national bankruptcy analogy – either the economy painfully implodes and gets it over with or there is an ongoing, painful restructuring. A third option that may have materialized in recent years as exemplified with Japan. They have not bankrupted, nor have they gotten their debt in order. They have continued to add money into the situation – and the result has been a long-term malaise with a progressively leveraging balance sheet. In effect, the Depression was blunted while the problems were neither solved through default nor long-term repayment. They wait – and we don’t know how it will end exactly.

The question remains if the United States and Europe are on similar paths – effectively punting the restructuring down the road – perfecting a 20th/21st century “third option” to national bankruptcy. Given that the experiment is unfolding, the question remains what will happen. Will time go by at low growth rates to effectively spread the pain over decades? Will the leveraging get so bad that it will force a default in and of itself (albeit infinitely worse than facing it in the first place)? Will it keep going on while developing countries continue to outcompete developed malaise?

Catastrophic Default

Assuming things take the route of a delayed Depression – what does such a scenario look like? The debate that I have had personally – and I see economists question as well – is whether or not a collapse would take the form of a deflationary depression or hyperinflation. Both are catastrophic – yet they have different results altogether. To answer the question, we need to look at a confluence of social factors and money supply.

When a currency is fresh and competitive, money supply is usually well balanced. Traditionalists would begin howling that “we should go back to the gold standard!” While finite supplies of gold create a limit on money supply, there are problems with the theory. First, there is not enough gold to support the current money supply, so to pull off the change, a painful adjustment would have to take place. Secondly, a well balanced money supply is not a finite number. Gold mining ebbs and flows – and supply of gold may increase or decrease based on scientific and technological accomplishments of mining industries – not exactly experts in the money supply field. Third, there is the natural attrition of the physical money supply through wear (finger oils and friction due to physical cash exchange). For an excellent example of how complex this becomes, I suggest reading 1493 by Charles Mann. A lengthy section is devoted to China’s money supply issues centuries ago, silver and the Spanish galleon trade. Silver was no panacea to money supply. Fourth, money supply should match the potential of an economy – measured by productivity and population. If population grows and money does not, then money supply would unhealthily restrain activity. (For those that contend that the gold standard requires connecting paper bills to a defined, physical quantity of gold – thereby eliminating physical transfer issues of gold coins – I remind you that the price of gold is a function of its availability – which is still in the hands of gold miners).

Money supply needs to be almost perfectly balanced for money to function properly as a tool of exchange to allow for the population to most efficiently get their needs and wants met. The moment money supply is inappropriately constrained or excessively supplied, the very mechanism of need satisfaction becomes untrustworthy – and a host of volatility and complex problems get introduced.

Fear motivates competition. Competition, in turn, motivates messing with money supply. For example, lets a assume an economy is functioning pleasantly on a defined, balanced standard. Things are fine until two things happen – either outside competitive influences or political forces. Outside competitive influences (i.e., other countries) come up with something new that undermines the economic volume of the previously stable country. Or, a politician that means well or that means to garner political advancement spearheads an effort to increase economic activity. In either case, the first tool that the government will turn to is money supply increases. Opening the flow of capital – either via intentional government spending – or through the banking system – results in the ability for businesses to invest. Investment allows competitive forces to flow faster – introducing the theory of productivity advancements. Assuming things work by the textbook, all is well. However, the introduction of additional money supply (lending in and of itself creates money) puts upward pressure on capital asset, labor and commodity prices – and inflation absorbs the power of the increase in money supply. The currency and money supply is now imbalanced.

Over the course of time, increased money supply calls for more increases in money supply. Financial instruments get interesting and complex. Prices continuously increase – and the illusion of halcyon economic times create the appearance that the system is working. Bubbles result. In the course of the oscillation of money supply and associated instruments, the concept of money as being an effective means for ordinary citizens to get their needs met becomes more and more occluded. In the process, the divide between the rich and poor widens – as the knowledge required to increase wealth in such a complex system evades the common person.

Economic purists would take issue with things such as the Elliott Wave – raising a number of objections including that the mere discovery of the mathematics behind the Wave would result in efficient marketplaces neutralizing it. While the system is adjusted due to increases in economic data and government response, let us remember one fundamental about money. People spend money. What motivates people motivates what they spend their money on. So, money as a whole is an expression of human motivation. Humans are inherently short-term motivated and they have predictable human needs. So there is an intertwining of social issues with economic ones. While many choose to separate them, are not economic crises a crisis of needs and wants getting met? The average citizen is incapable of evaluating the Elliott Wave and deciding to upend his employment, housing, and other economic relationships to take advantage of newfound knowledge of the Wave. The collective mass of humanity is like an agitated ocean – restlessly ebbing and flowing – trying to continuously get needs met by acting in short-term ways. The average citizen is not powerful enough to change the Elliott Wave merely by knowing it exists.

Consider that money supply increases (what starts the cycle decades in the past) are usually supported politically. Each citizen wants the chance to excel – and each citizen wants economic advancement – hence they want money supply increases. When it is evident on the backside of an economic implosion to the populace that the money supply was messed with, the masses get angry, blame government and banking and demand that it not happen again. Once it is fixed, the populace will years later demand increases in the money supply again. Short-term motivators and social needs mix.

The Wealth Transfer

So why do economies crash on an ongoing basis? What is accomplished by it (after all, it is accomplished nothing, why would we keep doing it)? Wealth transfer. Notice that we previously identified that the short-term actions that begin to undermine an economy result in a widening of the wealthy and poor. As this widening takes place (amidst prosperity many times), the bulk of the populace is required to work very hard to get their needs met – and seemingly does not advance despite the high amounts of effort required. Wealth imbalances ensure this condition – and short-term motivation comes in to play. People simply don’t want to work that hard for so little of a reward. While average people sometimes benefit during bubbles, they lose the most out of any class when the bubble ends. We are talking about averaged assumptions over time with the divide of economic classes.

The next part of the explanation is a bit fuzzy and skips some steps. We know, on one hand, that people are unhappy in a destabilizing economy. We know that their decisions are motivated by how they think – and when aggregated – they become a powerful force. We also know that on the other side of an economic implosion, the playing field is leveled and things start over. So, connecting the dots, I am postulating that human needs and demands made before a depression – and the resulting equalization afterward – tell us that the situation is linked. How people think and spend their money creates the tipping point and drives the economy to the balance desired by the masses.

So how does wealth transfer occur? In both cases, the masses take a grenade, strap it to themselves and light it off economically. Everyone goes down together and starts over. In the case of hyperinflation, those that hold liquid assets transfer wealth to fixed-rate debtors. The wealthy lose. Banks lose. Fixed-rate debtors gain. There are exceptions – when the wealthy put their investments into capital assets that nominally increase with inflation (although not increasing in real dollars). The wealthy that do that retain their position.

In the case of deflation, debtors get pressured so hard that they default. They effectively transfer wealth from banks to themselves – by passing now lower value assets back to banks in exchange for a debt write-off. Those that own operating businesses watch volume implode – such that the businesses are no longer viable to operate. If debt was involved, the business is crushed. Banks stop lending. The cycle spirals. Crushing deflation is the process of watching an economy stop altogether. Usually everyone loses – including the wealthiest once it gets bad enough.

An interesting combination that basically occurs in every significant recession is deflationary price pressures coupled with increases in the money supply. In an ideal world, increased money supply abates the recession and prices and economic activity stabilize. In the future situation, some economists propound that the first thing that will happen in an implosion is a deflationary collapse followed by hyperinflation. Effectively, the economy will implode because it cannot be sustained – and money supply increases will not work to stimulate activity – they will stimulate stagflation – price increases with recessionary characteristics. Weimar Germany in the 1920s is an extreme example (as Germany intentionally ran the money-printing press to pay of WWI). The United States in the 1970s is another example.

So what’s the outcome?

I cannot state for certain which option in the national bankruptcy scheme will happen. Long and painful, long malaised and leveraged, or catastrophic. What I do know is what recessions accomplish. They effect a social balance of wealth transfer (in a very destructive way) and they also force the economy to learn new ways to function. Inefficient industries die out – and innovative methods are invented. Consider that the real estate bubble was illogical and stupid – the US built more houses than it would need for a tremendous period at uninhabitable pricing. It took the Great Recession to stop the behavior and bring things down to earth. Also consider that many of today’s giant companies were started in recessions.

What we do know is that poor economic habits and social imbalances will collide in a severe contraction – and the way out will take place when the economy as a whole figures out how to function on a balanced level. Unfortunately for all of us, short-term motivation will be waiting on the other side and the cycle will pick up again. Nobody has lived long enough to watch this happen enough times to have the light bulb go off and cause it to quit.

Investment Options

So the question becomes – is there a safe option in the event of a catastrophic implosion? Following our theory that painful deflation will first strike – the objective is capital preservation. Deflation deals a death blow to the banking system – refusing to allow the wealthy with significant capital sums to wait it out while the rest of the economic system suffers pricing collapse. Bank failures drag the wealthy into it. While we have the FDIC now – it is limited to balances per account holder – and we don’t know if the credit availability of the federal government will be sufficient even if balances are spread across multiple banks. We see an example with Cyprus – that the EU was willing to let the banks fail – thereby upending any theory that “the government won’t let that (bank failures) happen.” Bailout fatigue – whether by political will or economic reality is very real. So, again, capital preservation is key.

In a contracting, deflationary environment, the goal is twofold: first, find assets that preserve value and second, avoid institutional failures. To the extent that the implosion is not epic and that brokerage houses remain in business, contra funds and short-selling stocks is a way to increase capital. If the catastrophe is so bad that the financial system is at risk, physical gold definitely holds value. The question is what your entry price was – and also logistics around keeping gold secure. Gold would be very volatile in this kind of scenario. Another option is diversification amongst currencies – placing deposits and investments in well-managed developed jurisdictions with capital extremely diversified. Both gold and international currency diversification would protect against total currency failure.

After weathering the deflationary portion of the disaster, the next part is to handle the inevitable hyper inflation. If the deflation is bad enough and is not stopped, it will end in some form of civil unrest or revolutionary activity – if not through violence, definitely through shocking swings of political will. Hence, the only remaining tool in a defaulted environment devoid of credit for a government is to literally print money. This stops the catastrophic deflation – and brings on another problem – stagflation. The economy doesn’t do very well and yet inflation rages. It is an economist’s nightmare – as the solution is to crank up interest rates so high that it imperils the economy to stop the runaway inflation freight train. Nevertheless, governments may have no choice. In stagflatious environments, stocks are malaised at best. While the nominal value should increase, economy stupor creates a counter current. The stock market will underperform. Gold and currencies are a gamble – as it remains to be seen just what will happen. The key in inflationary environments is to hold capital assets that are needed no matter what. In this case, I recommend real estate.

Real estate would suffer during the deflationary cycle. Rents would fall – and terminal value of rental properties would fall as well (the “income method” to valuation). Costs of material, commodities and labor would fall – hence, properties would devalue under the “cost method.” The “market method” would certainly take a beating – as who would have spare capital to invest when it is drying up? Further, the de-leveraging of mortgage debt would accelerate otherwise “normal” downward pressure. You will notice that I have approached each of the 3 appraisal methods of real estate.

However, after the deflationary cycle, inflation will change things. Real property, since it is badly needed and of a finite amount, will increase nominally whereas it will struggle in real terms. In other words, factoring inflation, properties won’t increase much, at all. Without subtracting inflation – and dealing in cold, hard numbers of the face value of the property – it will rise (think 1970s USA). Effectively, it is a medium for capital preservation. Rents would eventually rise with inflation – allowing net annual returns as represented by rent to remain in positive territory. Real estate would be a good buy after mortgage defaults and foreclosures peak and credit-based borrowers have been pushed out of the market.

For those inclined to behave with some risk, if credit is available – obtaining fixed rate mortgages and leveraging would allow for transferring wealth from the banking system into your hands. As inflation rages, the investor would be repaying the bank with diluted currency while the bank had lent strong currency. This option works very well if inflation strikes as predicted. If deflation continues, the outcome is poor. Note that this is typical of any leveraged situation – income and loss possibilities magnify.

The Bottom Line

The reality is that money can be made in any situation. Studies have shown that rarely do the hyper rich end up poor – and rarely do the poor end up hyper rich. We effectively do not migrate far from the economic class of our birth. While our “starting point” financially is a part of the situation, the reality is that the bigger portion of wealth is a way of thinking. Successful individuals with an enterprising mindset that understand capitalism, opportunity and risk can make money in any market. Those that wish to transfer responsibility to someone or something else lie at the mercy of the marketplace and get trampled. In a catastrophic situation, wisdom and resilience enable ingenuity and marketplace creation. Remember that money is a transfer mechanism to allow needs and wants to get met. Those needs and wants may change some on the part of the population, yet they will still be there – even after the Elliott Wave shows up again. The economy will find a way to reset – whether it be through some modest adjustment, currency reset, national bankruptcy or civil unrest. Time has proven that the dust settles – and the cycle starts again. At least the beginning of the Elliott Wave is much more fun than the end.