Things fall apart

Well, there’s the bounce. The Dow up 181 points yesterday. Gold off $3.

The end will come – sooner or later – for the big bull market in US stocks and for the debt bubble. But it didn’t come yesterday. Will it come today or tomorrow?

Today, we explore the time that land forgot. That phrase doesn’t really make any sense, but we wanted to try it out anyway. We’re talking about the space on the calendar filled by ‘eventually’ and ‘sooner or later’ – that part of the future where things that can’t last forever finally stop.

Specifically, we wonder about when and how the biggest bubble in history blows up. Recall that Planet Debt added $30trn to its burdens in the last six years – a 40% increase. That can’t continue forever. But how does it end? Inflation, deflation, hyperinflation, hyperdeflation?

To make a long story short, a bubble can’t blow up without a lot of ‘lation’ of some kind. And with a bubble so big, it’s bound to be a humdinger. Most likely, we will see ‘flation’ in all its known forms. And maybe in forms we haven’t heard of yet.

You can argue about what effect quantitative easing (QE) has had on the economy, and what effect it will have when it is withdrawn. But there is no doubt that microscopic interest rates have done their job. People who could borrow at the Fed’s low rates, did so.

Governments borrowed more heavily than ever before – just to cover operating expenses. Corporations borrowed to expand, to buy new plant and equipment, to refinance old debts, and to buy back shares (raising share prices and, coincidentally of course, giving management bigger bonuses).

The most recent figures we have are from the third quarter of 2013. Those three months saw $123bn of buybacks – up 32% from the same period a year before. If that rate were to persist throughout 2014, it would mean nearly half a trillion dollars devoted to boosting corporate stock prices, coming from the corporations themselves.

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Is management stupid or just greedy? The sage advice “buy low, sell high”, does not seem to have reached them. At the bottom of the crash in ’08-’09, reports Grants’ Interest Rate Observer, hardly any US corporation availed itself of the opportunity to buy its own shares at a bargain price. Now, that prices are high again, almost all seem to want to buy.

Surely, that is something that must end too. Nor does it take a lot of imagination to foresee what will happen when it stops: stock prices collapse.

First, credit expands, and asset prices rise. Then, credit shrinks, and asset prices fall. Asset prices typically foreshadow consumer prices.

After so much inflation in credit, we’d expect to see a helluva deflation when the bubble bursts. All of a sudden, the ‘wealth effect’ would become the ‘poverty effect’, with people cutting back on expenses, investments, luxuries.

This would be normal, natural, and healthy. A debt deflation doesn’t create bad debts or bad investments, it just forces people to own up to their mistakes. Businesses go broke; they can no longer borrow nearly unlimited funds at nearly invisible yields. People can once again default, and they will have plenty of company. The $5trn that came into being – almost magically – as the stock market rose suddenly disappears whence it came.

There is no mystery about the credit cycle. Wealth created ‘on credit’ goes away when the credit is cut off. Then, you find out who’s made the most serious mistakes.

The open questions are: how big can this bubble get before it explodes? And how will central bank meddling affect the outcome?

The first question gets the obvious reply: who knows? Central banks are still at it – led by the US and Japan. The corporate and government sectors are still willing borrowers.

Corporations are still buying their shares. And asset prices, as near as we can tell, are still going up. It could go on for a while longer. No one knows how long.

Tomorrow, we take up the second question: when the end comes, what form will this new ‘flation’ take?

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