UK Economic Recession: Will We Survive a Crash?

A Daily Reckoning Special Report

By Bill Bonner

Winter is here. The little squirrels look to their hoard of nuts to see them through the cold times. But what’s this? The sorry squirrels of North America hunt around…where are the nuts? Uh oh…they forgot to put any away!

US consumers enter a recession in the worst shape ever. It’s a richer world than it was in the ‘30s. There’s no danger of starving. We don’t imagine that people will have to stand in line to get a bowl of soup. But when it comes to money… never have so many people owed so much to so many. And when the creditors try to collect – there’s going to be Hell to pay.

On Friday, the Dow fell another 59 points…ending a very depressing week for stock market investors.

“What is going on,” investors ask themselves. “Many investors will begin the week asking whether they need to add worries about an equity bear market to their fears of economic recession,” explains the International Herald Tribune.

Nobody knows anything… so let us help the clueless investor: Yes. Worry about a bear market. Because it is almost surely here.

The Russell 200 Index, a gauge of mainly smaller US companies, is already down more than 20%. The mid-cap FTSE 250 in Britain is down more than 20%. And the Japanese index – the Nikkei 225 – is down 24% since its high in July. The S&P 500 is only off 16% - but it’s catching up.

From California, we learn that the jobless rate has jumped to over 6%. Oh, those poor little squirrels. Nothing in the nut-bin. And now, the nuts on the ground seem to have disappeared.

UK Economic Recession: Boom is a Fraud

You’ll recall the argument we entertained a couple of years ago. “The boom is a fraud; it’s making people poorer,” said we. “No, it’s real…people are getting richer,” said our opponents. Something grand and barely comprehensible had happened, they claimed. People had gotten so smart that the old rules no longer applied. You no longer needed to save, for example, because modern information technology and sophisticated financial instruments could provide growth and protection without savings. Besides the Asians were saving more than enough for the whole world…and, as for a rainy day, what are credit cards for?

Well, now this New Era is being tested. Now we’re going to find out who was right.

But why pretend? We already know the answer. We were right; our opponents were wrong. New Eras don’t come along very often, not in economics. Bet against them and you are almost sure to win.

Why? Because the rules don’t change. It’s the circumstances that change – in ways the rules dictate. Which brings us back to the nuts and the squirrels.

The rules tell us that if you spend more than you earn you must get poorer. The difference between spendings and earnings is subtracted from your net worth. While the spending spree was going on, it didn’t seem to most Americans that they were really getting poorer. They thought they were getting richer, mainly because their houses were going up in price.

But there is nothing like a hanging to focus a man’s attention. Last year, house prices went down about 10%. Suddenly, the average homeowner finds himself dangling at the end of a rope…and the last five years flash before him with crushing clarity: he sees that he spent too much. He sees that he bought more house than he could afford. He sees that his earnings have actually gone down in real terms…while his cost of living has gone up. In short, he sees that he’s been had.

UK Economic Recession: Phony Consumption Boom

Even newspaper columnists are beginning to get the picture. Americans need to “get back to saving rather than leveraging assets in a phony consumption boom,” writes Roger Cohen in the International Herald Tribune.

Naturally, this insight is making its way onto the political stage. A few weeks ago, the war in Iraq was Americans’ number one concern. Now, ‘it’s the economy, stupid.’ The trouble is, the economy is something that neither the candidates, nor the man who currently lays his head on the White House pillow, know anything about President Bush is pushing a plan to give the country a “shot in the arm” – at a cost of $150 billion. If Congress would just get behind this thing, he says, we could have rebate cheques in the mail in just a few weeks.

Our president misses the point. He, like all the White House hopefuls, wants to keep the phoney boom alive – in the worst possible way, by providing more “stimulus” to consumers…that is, by helping them spend even more money they haven’t got on things they don’t really need. What this perverse economy really needs is not a shot in the arm, but a shot in the head.

Meanwhile, Mitt Romney is proposing a $20 billion bailout of Detroit – as if all that Motown, smack dab in the richest auto market in the world, needed all along was more money.

And Rudolph Giuliani asked in October whether he thought a recession might be coming, reminded listeners that he still believes in the promise of the New Era. What with America’s modern, sophisticated market – and the freedom to do any damned thing it wants – “the sky’s the limit.”

Well, yes…the sky’s the limit. Whether you are building something up…or blowing it up.

*** There is much disagreement among analysts and commentators: will there be a recession…how bad will it be? But one thing all agree on is that “inherent US vitality remains enormous,” and that the US economy will “bounce back.”

Oh yeah?

When everyone thinks the same thing, no one is thinking at all. And everyone now seems to think that whatever is ailing the US, it will pass. We disagree.

The rules don’t change. Instead, the rules determine how circumstances change. And circumstances can change for a very, very long time.

The Athenians have been waiting 2,300 years for their empire to “bounce back.” The Egyptians have been waiting even longer. And the Seleucids? The Mongols? The Incas? The Romans? Rome is a nice city but the Rome of Romano Prodi is hardly the Rome of Augustus. The city never bounced back. And the list of empires that never bounced back is as long as the list of empires. Once they are history, they are history.

UK Economic Recession: Americans are getting poorer

When you spend more than you can afford, you get poorer. That’s the rule. So, it should come as no surprise that Americans are getting poorer…though they are just beginning to realise it. Now, when they need money…they have to turn to foreigners…to their imperial competitors.

In the last couple of weeks, some of America’s biggest financial firms have turned to Asians for multi-billion-dollar infusions. The Asians – who’ve been following the rules –working…saving – now have trillions to put to work. The Gulf States, too, have trillions in oil revenues. In the Gulf, they’re building new cities. In Asia, they’re building new industries.

And in America?

The foreigners are putting their money to work – buying up key industries.

“For much of the world, the US is now on sale at discount prices,” says the International Herald Tribune. “Last year, foreign investors poured a record $414 billion into securing stakes in US companies, factories and other properties through private deals and purchases of publicly traded stock.”

We hasten to add that we’re not agin’ it. Politicians will rant and rave about the “loss of US capital and industries.” But it’s a little late for complaining. The loss has been going on for a long, long time. As Americans spent more than they had, the foreigners built up credits. Now, they’re cashing them in. What else can they do? And what would you expect? The falling dollar has reduced Americans’ earnings…and it has cut prices on their assets, too. Now, people with money are taking advantage of the situation.

If you have a factory or a business…you might consider selling to the top bidder – probably a foreigner. If you have no business to sell, well, maybe you can shine the foreigners’ shoes.

There’s no denying what it all means…America’s edge in the world is slipping away. Americans are getting poorer – relative to others. This is an adjustment that probably won’t stop anytime soon. The US will probably never bounce back to the heights it enjoyed in the ‘80s and ‘90s.

*** And here’s something else to worry about. Bill Gross, head of PIMCO, the world’s biggest bond fund, calls it the “shadow banking system.” He’s referring to the way money and credit fly around the globe, courtesy of the very same “sophisticated” and “free” institutions that created such prosperity for so many people in the financial industry.

Banks recognise that not all their loans will be repaid. They operate on margins of safety, with reserves set aside for when things go wrong. But in the worlds of swaps, hedge funds and derivatives…slick operators can invest billions with no margins of safety…and no reserves. The result, Gross says, could be catastrophic:

"But today’s banking system, as pointed out in recent Investment Outlooks, has morphed into something entirely different and inherently more risky. Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party’s accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant 'black swan' run that might break them.”

"According to the Bank for International Settlements (BIS), CDS totalling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks."

By Bill Bonner

First published on Mon 14 Jan, 2008

We encourage you to sign up for the free, Daily Reckoning E-Letter, which has the most innovative way of weaving valuable information about investing and living into a format that is not only educational but also entertaining. Learn what you can expect from today's markets -- and how to prosper in the face of uncertainty. You won't find more thought provoking writing anywhere on the Internet.

P.S If you enjoy The Daily Reckoning and found this article useful then I recommend you start reading The Fleet Street Letter. This independent, straight-talking newsletter has a history of predicting the very latest, hot investments. With unique forecasts of new trends, in-depth insights and decades of experience - since 1938 - it has successfully helped many investors achieve financial independence and security. Their latest research has uncovered three simple investments they believe will do very well indeed as the new generation of British nuclear power begins. Don’t miss out, start receiving The Fleet Street Letter today.