海角大神

For more than a year, the 鈥渞ecovery鈥� bounce in the stock market has refused to give up. The indexes have recovered more than 50% of what was lost. Technically, they look pretty good. What鈥檚 more, the S&P sells at more than 21 times normalized earnings, according to Robert Shiller鈥檚 latest tally. It seems like nothing can stop stocks now.

Then there鈥檚 the Treasury market. Overall, yields remain remarkably low. It is almost as if Treasury buyers are unaware that they are being asked to finance the biggest increase in sovereign debt ever. It doesn鈥檛 seem to matter either that many of the applicants for money will be incapable of repaying it. Several sovereign debtors, including the US, have already reached the 鈥減oint of no return,鈥� according to professors Rogoff and Reinhard.

Still, the financial press is optimistic. Economists are irrationally confident. Investors and advisors are overwhelmingly bullish. And the American public seems willing to add a trillion-dollar health-care program to its burdens 鈥� a sign of remarkable faith in the nation鈥檚 prospects.

So, let鈥檚 go back and reexamine our basic position. Is this really the 鈥淕reat Correction鈥� that we think it is?

If there is one lesson we鈥檝e learned over the years, it is that we need to be patient. Things that have to happen generally do, sooner or later. You just have to wait. And when they happen, they generally happen much faster than you expected. Even when you鈥檝e been expecting something for years, it can come and go before you realize what is going on.

You get used to being wrong鈥�or at least premature. You wait. You watch. You think the time has come鈥�and then: whoops鈥�not yet. Pretty soon, you are overcome by anticipation fatigue. Then when the real thing finally does start to happen you don鈥檛 believe it. You wait to be sure鈥�you hesitate鈥�and then it鈥檚 over!

Just what am I waiting for? I鈥檓 anticipating more evidence of this Great Correction, including another big swing down in the real price of stocks, bonds and commodities鈥�further deterioration in the real estate market鈥�a falloff in consumer spending鈥�and a higher savings rate.

I鈥檓 also expecting higher yields from government debt鈥�and a dangerous intensification of financial problems in both the private and public sectors. If I鈥檓 right, those things must happen eventually. So far, we鈥檙e still waiting.

But this week the long-awaited turnaround in the bond market may have begun. Rates are rising along the entire yield curve, especially at the long end. 鈥淭he bond market is now very close to saying, 鈥榃e鈥檝e had enough,鈥欌�� predicts the octogenarian stock market technician, Richard Russell. The 30-year T-bond鈥檚 recent decisive move above 4.80% marks the end of a 25-year bull market in bonds, says Russell. Rates will be moving higher from here.

Investors are starting to tune into how sovereign debt works. And they鈥檙e starting to realize that even governments can default. In fact, almost all of them do default eventually. Yes, even governments whose debts are denominated in their own currencies default. And even when they have the power to print the currency themselves.

How could that be? Well, it is very simple and worth spending a little time on. I want to make two points:

First, governments will usually choose to default on their debt rather than risk hyperinflation of their currencies. Second, when they reach a 鈥減oint of no return鈥� they have no choice. They cannot cut back spending. Because even the most drastic cutbacks will not do the job. That would simply result in lower tax receipts and an even bigger deficit. At a certain point, the multiplier effect becomes the divider effect.

I鈥檝e made the point many times that democracy seems hell-bent on self-destruction. America鈥檚 founding fathers noticed many years ago that when people realized that they could vote themselves money from the public treasury, democracy would be doomed.

Most people presume that if a politician offers benefits, 鈥渟omeone else鈥� will pay for it somehow, someday. In practice, the money doesn鈥檛 come from additional taxes. Taxes are already, at least theoretically, at their optimal level. Higher tax rates produce lower economic activity, which lowers tax receipts. So instead of raising taxes, governments borrow the money. Then sovereign debt loads become larger and larger until, as Greece has recently discovered, they are impossible to carry.

America also has public sector debt problems 鈥� of about equal measure to Europe 鈥� and she has huge private sector debt problems as well. For the moment, the skies over the American financial markets are clear. But out at sea a hurricane is spinning faster and faster. There is a huge wave of debt defaults/foreclosures in the private sector that will hit the markets soon. This wave, combined with record borrowing from the US government, is bound to push up bond yields鈥�making it harder than ever to get needed funding.

The situation with the US government is more complicated than it is with private borrowers 鈥� or even with Greece or California. The federal government can print money. But it, too, is ultimately at the mercy of the bond market. Last year Uncle Sam borrowed $2.1 trillion. This year it will borrow $2.4 trillion. Without this money, US government spending would have to come to a halt. The US counts on lenders. It needs lenders. Without them it would be forced to make cuts equal to about 10% of GDP. Think you鈥檝e got de-leveraging now? Just imagine what that would do.

Typically, of course, government bond buyers don鈥檛 cut off a lender altogether. They merely demand a higher rate of interest to offset what they see as an increased level of risk. The higher interest rate adds to the borrower鈥檚 cost 鈥� increasing his deficit and forcing him to borrow more.

This is where it gets interesting. You might say that a government can 鈥減rint its way out鈥� 鈥� it can just print the money it needs rather than borrowing it. But what would happen if the US chose to print $2 trillion this year? It would risk hyperinflation. Lenders would run for cover. Prices would shoot up. The damage to the economy would be severe鈥�so severe that only governments under extreme pressure 鈥� think Weimar Germany or Mugabe鈥檚 Zimbabwe 鈥� are willing to risk it. Instead, they try to muddle through, as Greece is doing now 鈥� promising budget cuts, making special financing deals and pushing up the rate of inflation a bit, but not so high as to cause panic in the bond market.

See, as long as the bond market permits it, debt levels continue to grow. But at some point 鈥� the point of no return 鈥� a government can no longer save itself from disaster. How does that work? Well, when deficit/debt levels are too high, the cuts necessary to bring the budget back in balance are so great that they squeeze the economy hard, reducing output and decreasing government鈥檚 tax revenues.

In this case, the government cannot escape. It has to print money. Or default. Most often, it will choose default, because it is the less painful solution. Either way, the government finds that it will be cut off from the bond market. Hyperinflation is merely an additional and unnecessary aggravation. (That said, I agree with Nassim Taleb, that hyperinflation remains an underestimated black swan risk.)

The underlying story of the economy has not changed. We are in a Great Correction. We don鈥檛 know exactly what it is correcting鈥�but it looks as though it will at least reduce some of the leverage that has been added to American and British households over the last 60 years.

So far, the process is tentative鈥�and unsure of itself. From a peak of 96% of household income in 2007 debt has fallen to鈥�94%! The drop is so small that it makes you wonder if it is a trend at all. But if it is, it has a long way to go. Ten years ago 鈥� at the peak of the dot-com bubble 鈥� household leverage was only 70% of income. At the present rate it will take another 24 years to get back to 1999 levels.

Albert Edwards of Societe General has examined the non-financial leverage in the system. There is excess leverage of about 60% of GDP, he says. He calculates it will take a decade of 鈥�Japan-like pain鈥� to eliminate it.

Either way, you鈥檙e talking about a long process of getting back to 鈥渘ormal.鈥�

The Great Correction is also what is keeping housing and unemployment down. When the banks aren鈥檛 adding to the nation鈥檚 credit, you just can鈥檛 expect many new jobs or many new house sales.

Nothing has changed in the last week 鈥� except we have moved one week closer to whatever crisis lies ahead.

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