Whether we “like” it or not, or “disagree” or not doesn’t change what’s ahead, which is a complete unwinding of all the extremes and distortions in the American (and the world’s) economies. The rollercoaster ride is about to get “fun,” as in unpredictable, volatile, and unnerving for those normalized to extreme distortions “fixing” all things financial. In a word, the global economy is toast. All that’s left is the distribution of the burned bits.
BY CHARLES HUGH SMITH ON SUBSTACK
Humans have a knack for normalizing extremes. We quickly habituate to conditions that would have been intolerable before the extremes were normalized by habituation and recency bias. In no time at all, we’ve persuaded ourselves that living on reds, vitamin C and cocaine is not only normal, it’s healthy.
For 15 years, extreme policies have steadily dragged the economy and the wealthy higher. Now we’re finally at the top of the rollercoaster, so hang on, the ride gets “fun” from here to the bottom. Stripped of normalcy bias, the distortions of hyper-financialization and fraud finally caught up with the global financial system in 2008. The wealthy refused to accept any losses of their immense winnings at the rigged casino and so we’ve been living on debt and a Federal Reserve-engineered “wealth effect” that enriched the top 10% at the expense of the bottom 90% and systemic stability.
That’s the US economy stripped of artifice, propaganda and deception. Whether we “like” it or not, or “disagree” or not doesn’t change what’s ahead, which is a complete unwinding of all the extremes and distortions.
When an economy chooses to live off ever-rising debt and refuses to write off bad debt and book the losses, there are only two possible futures: Japan took the first path in 1989-90, when its credit-asset bubble popped and its wealthy class refused to accept any losses in their bubble-inflated phantom wealth. The net result has been 35 years of stagnation as the vitality has been bled out of Japan’s economy and society.
Japan survives off its soaring debts, zombie companies and immense holdings of foreign assets while its younger generations have given up on marriage, family and home ownership, as all are now unaffordable. If this pathway to national decay sounds like the way to go, take your blinders off and look around: we’re already well down that road.
The other pathway is high inflation which eats wage earners and savers alive. When you rely on debt to fund consumption and the spending of the wealthy (generated by the central bank-induced “wealth effect”), productivity stagnates and all that fresh debt-money pouring into the system pushes inflation into a dynamic of increasing instability.
The 1970s stock market reveals how inflation works its magic: stocks noodle up and down for years, and everyone is relieved when the market returns to its previous highs: yea, we’re whole again! Well, no. Adjusted for inflation, “buy and hold” investors lost 2/3 of their capital. (Gamblers lost, too, and eventually gave up on minting money trading stocks.)
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The third alternative is the debt-asset bubble pops despite everyone’s best efforts to normalize extremes, and the economy and market crash as all the debt is written off / unwound. Then the result is a classic reversal of the asset bubble, as valuations return to the pre-bubble starting point. This is a preview of what lies ahead:
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Let’s run through the extremes that will get unwound whether we “approve” of the unwinding or not. Here’s the Case-Shiller Housing index: housing is unaffordable to all but the wealthy, a massive distortion just begging to be unwound.
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Here’s total debt in the US As the dog in the burning cafe says, “this is fine:” normalization at work.
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Federal debt is soaring because we’re playing a game of transferring debt expansion from the private sector to the public sector to make things look nice. Sorry, vitamin C and cocaine are still not a healthy diet:
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Unfortunately, 15 years of gulping down Delusional had addled the minds of those who believe interest rates are heading back to near-zero and so everything will be “fixed.” The reality is it’s all been “fixed” for 15 years, and that’s why interest rates will move higher regardless of how much Delusional we’re swallowing.
Historically, a range of 5% to 7% is normal, but if we try to “fix” the problem by dropping rates back to 1%, we’ll get 9% to 12% rates at our banquet of consequences.
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Here’s what happens as rates normalize: all our money goes to pay interest. Once the credit card is maxed out, our borrow-and-spend consumption dries up: No more GDP “growth” funded by debt.
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Corporate profits “earned” by crapifying goods and services and cartel pricing will fall from the stratosphere. Even AI can’t save corporate profits when consumers run out of credit. No matter how many MBAs are fiddling with AI chatbots, they won’t be able to extract blood from stones.
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And just as a reminder of who won and who lost during the 15-year ascent to extreme distortions: the super-wealthy scooped the vast majority of the casino’s winnings:
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While the bottom 50% lost ground: hey, you never had it so good, right?
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The rollercoaster ride is about to get “fun,” as in unpredictable, volatile and unnerving for those normalized to extreme distortions “fixing” all things financial. Click “unlike” if you like, it won’t make any difference. Systems have their own dynamics, and human hubris and magical thinking have no influence.
So here we are, with a handful of winners declaring the system is working great and high-fiving each other, too busy congratulating themselves to see the tsunami of karma racing toward shore.
It’s a toss-up which is wider: the widening gap between the top 10% and the bottom 60%, or the gap between the complacency of the top 10% and the reckoning that’s overdue. Call it karma, just desserts or the wheel of history, the unfairness and inequality of a rigged system generates blowback, and the longer it is suppressed, the greater the eventual swing of the pendulum to the opposite extreme.
But really, who cares about the bottom 60% being left in the dust by a system rigged to benefit the top 10% because hey, the S&P 500 is going to 6,000–yippee! More free money for everyone who bought assets years or decades ago before the Federal Reserve decided the best way to “boost growth” was to inflate assets to generate “the wealth effect” among those who already owned the assets being inflated.
And once the fortunate few were awarded the vast majority of the Fed’s unearned largesse–the top 10% own 93% of stocks–they have the wiggle room to ignore inflation. The bottom 60% living on wages–well, not so much.
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Readers remind me that many of Americans’ financial ills are self-inflicted: poor money management, instant gratification over making sacrifices for long-term gains, getting into credit card debt with 22% interest rates, buying vehicles they can’t afford, paying $100 for an oil change instead of learning how to change the oil themselves, and so on–all of which indeed make modest financial circumstances much more difficult.
Having been in the bottom 60% in terms of earnings most of life, I constantly preach the virtues of frugality and anti-consumerism, learning how to do things for ourselves so we don’t have to pay for them, and building networks of reciprocity–I help you, you help me–that make all the difference between financial security and insecurity. These are the fundamentals of Self-Reliance.
But better money management doesn’t erase the rigged system that has sluiced the lion’s share of the nation’s gains to the top 10% and left the bottom 60% in the dust. If the rising tide raises all ships, then how is it the bottom 50% own a rounding-error share of the nation’s financial wealth– 2.6%:
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The bottom 50% own 11% of the nation’s real estate value–a mere fourth of the 44% owned by the top 10%.
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The top 10% excel at a few things they rarely receive full credit for: one is choosing their parents wisely, another is believing that since they’re doing great, everyone is doing great— a self-serving delusion that doesn’t reflect reality: those who don’t own a share of the $45 trillion in stock market wealth weren’t issued rose-colored glasses:
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The 10% below the top 10% reckon they’re “middle class,” but how can the top 20% be “middle class”? The reality that the “middle class” has eroded into the top 20% haves and the top layer of the have-nots who still harbor illusions is conveniently obscured by economic cheerleaders lumping the fantastic gains reaped by the top 10% in with the bottom 90% and declaring the entire population is reaping splendid gains. But statistical trickery can’t obscure the systemic unfairness of a rigged game.
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While many finger the abandonment of the gold standard as the Original Sin, this ignores an economic change of equal consequence: the collapse of all societal values other than increasing shareholder value, which optimized hyper-financialization (stripmining the real economy to enrich financiers and corporations) and hyper-globalization, which stripmined the nation to enrich the top 10% who own 93% of all corporate shares.
These forces drastically eroded the purchasing power of wages to the benefit of the owners of assets, who skimmed the vast majority of the immense financial gains of hyper-financialization and hyper-globalization. Those who depend on wages lost out, those who owned assets enjoyed ten-baggers not from genius but from mere luck.
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So here we are, with a handful of winners declaring the system is working great and high-fiving each other, too busy congratulating themselves to see the tsunami of karma racing toward shore.
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Those of us who did nothing more than buy a house and invest in index funds–the same common-sense steps taken by previous generations to earn modest returns–and who through no special effort reaped enormous gains thanks to the Fed’s “wealth effect”–might benefit from a bit of humility by admitting our gains are the result of a system rigged to benefit all who bought assets before “the wealth effect” rocket-launched the value of our assets. The word few dare utter is “unearned.”
In the end, it won’t matter what we think, like, believe, or hope, for reversal is the movement of Tao. Put colloquially, the pendulum of inequality driven by a rigged system will swing to the other extreme, and claiming that payback is somehow “unfair” won’t change the trajectory or the volatility.
Confidence / complacency doesn’t map the real world, in which liquidity dries up and markets go bidless.
When Alan Greenspan issued his mea culpa in late 2013 about missing the subprime mortgage implosion and the resulting Global Financial Meltdown (Why I Didn’t See the Crisis Coming Foreign Affairs), he started by noting the complete and utter failure of everyone’s sophisticated models to predict the collapse of confidence.
The core failure, he suggested, lay in the models’ reliance on the notion that humans make decisions rationally as Homo economicus, when the reality is we are extremely prone to irrational exuberance (a.k.a. running with the greed-enchanted herd) and panic (running off the cliff with the herd). He invoked Keynes famous “animal spirits” as the missing variable in economic models.
Irrational “animal spirits” generate “tail risk,” events that supposedly happen only rarely but when they do happen, they trigger outsized consequences, and the Fed’s models failed to accurately account for “tail risk” because they happen more often than statistical models predict.
All this boils down to liquidity and illiquidity: When “animal spirits” are confident in future increases in asset valuations, participants place a constant bid under the market because prices will keep going up so I’ll make more money in the future. This constant bid is called liquidity: cash is flowing into the asset class, be it stocks or housing or cryptocurrencies or commodities.
When “animal spirits” turn to panic, sellers rush to sell as buyers vanish as they fear that prices will keep going down so I’ll lose more money in the future. Buying into a downtrend is known as “catching the falling knife”: the initial “buy the dip” players have their head handed to them on a platter, and those on the sidelines decide not to try to catch the falling knife.
This is an illiquid market: when sellers dump assets on the market and buyers vanish, the bid keeps dropping until buyers are willing to gamble that “this is the bottom.” But should asset prices continue sliding after an initial euphoric pop higher–“the bottom is in, buy!”–then those who held back find their caution reinforced: that wasn’t the bottom after all, and everyone who jumped in lost money.
As every surge of “buy the dip” players has their head handed to them on a platter, the market goes bidless–everyone who wanted to play “catch the falling knife” has been burned, and those who have lost the “animal spirits” to gamble stay out. The market goes bidless, and asset prices crash to levels no one in the greed-euphoria stage could imagine were even remotely possible.
Those who follow liquidity assume that the more cash sloshing around the system, the more money will flow into assets. But this assumes participants–and therefore markets–are rational. When caution–and then panic–take hold of the herd, no matter how much cash is sloshing around, none of it will be gambled on a losing bet.
Take a look at this chart of the Nasdaq dot-com bubble, and note the bubble symmetry: what shot up soon plummeted back to pre-bubble levels. Stocks that had reached $60 per share were recommended as “buys” at $45–a rational play perhaps, but wildly off the mark, as the stock eventually bottomed at $4.
When sellers desperate to sell swamp buyers, prices decline. If buying dries up, prices crash.
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It’s worth pondering the psychological reality that losses make a much bigger impression on us than gains. This is the foundation of risk aversion: once burned, twice shy. Everyone’s surprised when “animal spirits” reverse polarity, but the confidence that any asset has reached “a permanently high plateau” is misplaced. Every manic greed-inflated bubble pops and cascades back to Earth. Here is a preview of the Everything Bubble popping:
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Greenspan’s models–and everyone else’s–projected a rational market in which buyers continued to buy assets even as they lost money on previous attempts to “catch the falling knife.” In other words, the markets will always be liquid.
The Pavlovian “buy the dip” reflex that was so profitable on the way up now becomes the road to ruin as every pop higher gets sold. Those playing “buy the dip” are eventually wiped out, leaving only those burned and wary. Eventually people tire of losing and they give up. After losing 40%, a 4% return on a Treasury bond–brushed off in the glorious ascent as foolishly cautious–now looks pretty good.
Confidence / complacency doesn’t map the real world, in which liquidity dries up and markets go bidless. In the real world, humans panic and eventually decide to never again buy stocks or real estate, as the sting of their losses lingers far longer than their memories of glorious gains earned by riding the bubble higher.
The global economy is toast. All that’s left is the distribution of the burned bits.
The six one-offs that drove growth and pulled the global economy out of bubble-bust recessions for the past 30 years have all reversed or dissipated. Absent these one-off drivers, the global economy is stumbling off the cliff into a deep recession without any replacement drivers. Colloquially speaking, the global economy is toast.
Here are the six one-offs that won’t be coming back:
1) China’s industrialization.
2) Growth-positive demographics.
3) Low interest rates.
4) Low debt levels.
5) Low inflation.
6) Tech productivity boom.
Cutting to the chase, China bailed the world out of the last three recessions triggered by credit-asset bubbles popping: the Asian Contagion of 1997-98, the dot-com bubble and pop of 2000-02, and the Global Financial Crisis of 2008-09. In each case, China’s high growth and massive issuance of stimulus and credit (a.k.a. China’s Credit Impulse) acted as catalysts to restart global expansion.
The boost phase of picking low-hanging fruit via rapid industrialization boosting mercantilist exports and building tens of millions of housing units is over. Even in 2000 when I first visited China, there were signs of overproduction / demand saturation: TV production in China in 2000 had overwhelmed global and domestic demand: everyone in China already had a TV, so what to do with the millions of TVs still being churned out?
China’s model of economic development that worked so brilliantly in the boost phase, when all the low-hanging fruit could be so easily picked, no longer works at the top of the S-Curve.
Having reached the saturation-decline phase of the S-Curve, these policies have led to an extreme concentration of household wealth in real estate. Those who favored investing in China’s stock market have suffered major losses. (see chart below)
This is the problem with overproduction as a model of endless growth: it eventually overwhelms demand and the income needed to pay for it.
Where China’s workforce was growing during the boost phase, now the demographic picture has darkened: China’s workforce is shrinking, the population of elderly retirees is soaring, and so the cost burdens of supporting a burgeoning cohort of retirees will have to be funded by a shrinking workforce who will have less to spend / invest as a result.
This is a global phenomenon, and there are no quick and easy solutions. Skilled labor will become increasingly scarce and able to demand higher wages regardless of any other factors, and that will be a long-term source of inflation. Governments will have to borrow more–and probably raise taxes as well–to fund soaring pension and healthcare costs for retirees. This will bleed off other social spending and investment.
The era of zero-interest rates and unlimited government borrowing has ended. As Japan has shown, even at ludicrously low rates of 1%, interest payments on skyrocketing government debt eventually consume virtually all tax revenues. Higher rates will accelerate this dynamic, pushing government finances to the wall as interest on sovereign debt crowds out all other spending. As taxes rise, households are left with less disposable income to spend on consumption, leading to stagnation.
At the start of the cycle, global debt levels (government and private-sector) were low. Now they are high. The boost phase of debt expansion and debt-funded spending is over, and we’re in the stagnation-decline phase where adding debt generates diminishing returns.
The era of low inflation has also ended for multiple reasons. Exporting nations’ wages have risen sharply, pushing their costs higher, and as noted, skilled labor in developed economies can demand higher wages as this labor cannot be automated or offshored. Offshoring is reversing to onshoring, raising production costs and diverting investment from asset bubbles to the real world.
Higher costs of resource extraction, transport and refining will push inflation higher. So will rampant money-printing to “boost consumption.”
The tech productivity boom was also a one-off. Economists were puzzled in the early 1990s by the stagnation of productivity despite the tremendous investments made in personal and corporate computers, a boom launched in the mid-1980s with Apple’s Macintosh and desktop publishing, and Microsoft’s Mac-clone Windows operating system.
By the mid-1990s, productivity was finally rising and the emergence of the Internet as “the vital 4%” triggered the adoption of the 20% which then led to 80% getting online combined with distributed computing to generate a true revolution in sharing, connectivity and economic potential.
The buzz around AI holds that an equivalent boom is now starting that will generate a glorious “Roaring 20s” of trillions booked in new profits and skyrocketing productivity as white-collar work and jobs are automated into oblivion.
There are two problems with this story:
1) The projections are based more on wishful thinking than real-world dynamics.
2) If the projections come true and tens of millions of white-collar jobs disappear forever, there is no replacement sector to employ the tens of millions of unemployed workers.
In the previous cycles of industrialization and post-industrialization, agricultural workers shifted to factory work, and then factory workers shifted to services and office work. There is no equivalent place to shift tens of millions of unemployed office workers, as AI is a dragon that eats its own tail: AI can perform many programming tasks so it won’t need millions of human coders.
As for profits, as I explained in There’s Just One Problem: AI Isn’t Intelligent, and That’s a Systemic Risk, everyone will have the same AI tools and so whatever those tools generate will be overproduced and therefore of little value: there is no pricing power when the world is awash in AI-generated content, bots, etc., other than the pricing power offered by monopoly, addiction and fraud–all extreme negatives for humanity and the global economy.
Either way it goes–AI is a money-pit of grandiose expectations that will generate marginal returns, or it wipes out much of the middle class while generating little profit–AI will not be the miraculous source of millions of new high-paying jobs and astounding profits.
What we now have is a hyper-centralized, hyper-connected (i.e. tightly bound), hyper-globalized and hyper-financialized global economy of extreme fragility, over-indebted and hollowed out by speculation, fraud, corruption, leverage, sclerosis and by an unbreakable addiction to doing more of what’s failed spectacularly.
The downside slide into recession and polycrisis-collapse is not as fun as the boost phase.
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Concentrating assets, capital, control, debt and leverage also concentrates risk, which eventually leaks through the illusion of resilience and melts down the entire economy:
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In a word, the global economy is toast. All that’s left is the distribution of the burned bits. Those who end up with collapsing currencies experience hyper-inflation, and those who manage to wallow in deflation experience stagnation as the best-case scenario. In all cases, the pool of creaky policies from the 1930s that will actually work has dried up: all the “fixes” that were solutions in the past are now accelerating the slide into a post-bubble recession with no visible exit.
