The coming financial collapse and how to prepare for it

2012-10-15 22:18

This article has a few parts to it: First, a bit of shock, not only to keep you reading, but also because it could be true. Then some background where I throw around a few facts, partly to convince you that I know at least something of what I speak, but also some analysis to help make some sense of it all. Lastly, I hope to advise on what one might do about it, other than adopt the brace position.

Onto the shock... Those ancient Mayans and their long count calendar reckoned we would face a new age come December 2012. Some already call this the Age of Aquarius, the water bearer bringing a great levelling to the land. Wouldn’t it be nice if that levelling were to bring richer and poorer closer together? Well partly it is. Assuming we survive of course. When a financial system fails it hurts the rich more than most. Their equity profits are typically the first to go. Then they take a hit on their cash savings and retirement funds. However, the rich also have houses that are generally paid for whilst the poor get whacked with massive inflation and interest rate rises and the cost of debt spirals. Generally however, the poor have less to lose. The shocking part is how unprepared we are for a complete financial collapse and what the consequences could be.

Imagine the scenario... Banks around the country experience bank runs as all available cash is withdrawn. They become technically insolvent and can’t continue to finance working capital for corporates. Trucking companies can’t pay for their operations and fuel supplies are disrupted. In fact, never mind that. Refiners can’t get the cash to fund their oil purchases in the first place. Coal stops getting delivered to power stations. In a couple of weeks, the lights go out and the water and sewerage systems stop working. By this time most grocery stores have run out of food anyway. I don’t want to think about what happens then… I like my fellow human beings but does anyone recall the phrase, “survival of the fittest”? And by the way, you can’t eat or drink gold.

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I was born in the 70’s along with a little mathematical formula called Black & Scholes. The mathematicians behind the formula won a Nobel prize for it. They also ran a fund called Long Term Capital Management which imploded on the Russian debt crisis. The Black & Scholes formula is used to price options and since the 70’s financial institutions have been leveraging themselves to the hilt based on these and other forms of derivatives. The value of all the supposed money in the system created from leverage vastly outstrips the actual physical resources of our planet to ever pay it back. Isn’t money supposed to reflect an actual physical value of something? Not when it comes to betting on some future outcome apparently.

Going a little further back, since the end of the 2nd world war, many European countries started to spend more on social welfare systems than their tax bases would allow. As raising taxes is never a great election winning strategy, most governments simply elected to borrow money instead. They borrowed from banks and investors like you and me. Now the problem is that, once upon a time, banks that took in mine and your money and lent it out again in the form of mortgages (retail banks) were once separate from investment banks (that advise governments and corporates on all their borrowing and punt their money on future outcomes). The repealing of the Glass Steagall act allowed these two kids to play in the same building (albeit made of Chinese walls) which helped wreak havoc on leverage and the financial system in general.

Leverage can best be explained by that old story about a wealthy German traveller going to a hotel in a heavily indebted little Greek town. The traveller places a $100 bill on the table while he goes to inspect the rooms. The hotelier immediately goes to the butcher and settles his $100 bill. The butcher goes to the mechanic and settles his $100 bill and the mechanic goes to the local prostitute and settles his bill. She in turn runs to the hotel and settles her bill for renting rooms by the hour. The hotelier quickly places the $100 bill back on the counter and the German tourist comes back down, declares the rooms unsatisfactory and takes his $100 bill back. Leverage. Or how a bank can turn $100 of real money into $400 of some financial instrument linked to real money.

So first we had all these nasty bankers creating all these stupid leveraged products and then they had to be bailed out by the central banks and governments. Now we’ve shone the spotlight on the massive government debts that have been accumulating. Spain and Greece just happen to have collected less tax and taken more siestas and squandered more money than the hard working Germans. The Euro has helped to shine a light on that by making everything equal for comparison purposes. The madly efficient Germans are mighty annoyed that they might have to bail out the partying Greeks. I can imagine some Stein being spilt in anger this Oktoberfest.

As South Africans we can surely relate to the Greek experience. We might not have a Euro making things all uncomfortably transparent for us but we have insanely corrupt politicians on the take while the going is good, and a dwindling tax base. Unfortunately we don’t have a big German brother to bail us out. However, the Chinese like our minerals and we like their money, so long as it can find its way into our tax receipts.

Now why do I say that there must be financial collapse to come? Simply because at 2% global growth you cannot hope to pay off these excessive global debts that have built up. War is a good way to cancel debt i.e. “to the victor the spoils” and the cancelled debt benefits. Ask the US and the UK after World War Two. However, one cannot of course condone war as a solution. So the alternative is what central banks are trying to do at the moment. Fight fires as they appear and try and keep interest rates as low as possible to allow economies the room to grow. They’re hoping that the value of created stuff from growing and more productive economies will approach the levels of debt and leveraged paper money that exists in the system. Not a chance. We’ve only had 4 years of austerity (2008-2012) to combat all that leverage since the 70’s. Ok, it’s really only been since the 90’s of which that Gordon Gecko “greed is good” speech summed it up.

Of course however, we are stuck in a growth trap where no-one is risking spending anything to grow. The thing with money is that it can be printed. But the more you print, the more each unit of that money loses value. Ask Bob next door. He printed so much of it that the Zimbabwe dollar became totally worthless. One might wonder where all the money from all these rescue funds and quantitative easing schemes is going. It’s simply going into corporates and households and money-related instruments such as equities and allowing us to repay our debts whilst governments are becoming more and more indebted.

The Americans are being quite clever. They’re not exactly printing money, rather issuing treasury bonds and rolling the maturity out on those bonds to some future date that hopefully will never come. However, the money received from their quantitative easing is also flowing into the economy. Ever wonder why the equity markets are doing so well lately? Everyone is expecting inflation because of all this money that’s supposedly been created. But the money has not been printed yet. Only the instruments for that money have been created and those instruments have been increasing rapidly in value, mainly in stock market returns and the amount of bonds out there. Oh yes, inflation will come. But for now we are still ‘deleveraging’. And when it comes then the stock market and bond markets will collapse like a bear falling out of a window.

When the money is printed the Chinese are going to be mighty annoyed. After all, they hold most of the American treasury bonds and foreign currency reserves. As the Dollar loses value aka Zimbabwe style then the value of Chinese holdings will get smacked as well. But Ben Bernanke is playing a very clever game. All he needs to do is hold American interest rates lower than everyone else for longer than everyone else, to try and keep the value of the US Dollar at least stable relative to other major currencies. After all, everything is relative. He of all people really doesn’t want the only other major currency, the Euro, to collapse. And he would really love the Chinese to float their currency freely, instead of pegging it to the Dollar. Do you really think the Chinese will fall for that?

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So what does all this mean for you? Here’s what I think will play out. Interest rates are going to start increasing around the world, perhaps even sooner in South African thanks to our striking workers. The world economy will not have fully recovered by then and will still be chugging along in neutral, trying to deleverage. This is typically called stagflation i.e. low growth, high inflation. It’s not pretty. It’s Japan in the 90’s. Hey, remember how everyone had to learn Japanese in the 80’s and now we all should learn Mandarin. The Chinese kleptocracy is about to fail just as spectacularly but that’s another story entirely.

Stagflation means that both rich and poor get squeezed. But the ones getting squeezed the most will be governments as they struggle to raise enough money (or confidence) to cover their debts. This will become a proverbial game of passing the hot potato and the ones to default on their debts first will be the lucky ones. The one left holding the can last is going to have to take the largest whack. Thankfully South Africa will largely be excluded from this process. There will be massive calls on retail banks to come to the aid of governments but depositors will make a run on their bank, wanting to draw down their cash before it gets handed over to governments. Governments could step in and prevent cash withdrawals but that would risk anarchy prematurely. Ultimately both governments and banks will fail. Corporates will end up with some cash but no-one will come to work anymore as they will be too busy surviving.

The rich will have their mansions but they won’t have food or petrol to put in their expensive toys. Just like everyone else. So what can you do? Keep a tank full of petrol somewhere safe and get as far away from a big city as possible when you see stock markets collapsing. Preferably somewhere with fresh water and food that you know how to grow yourself. We really need to learn how to be human again. We’ve really cocked things up financially and morally this time. Is there a special place in hell reserved for bankers?

P.S. Don't give up your day job, just in case I'm totally wrong about all this.

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