End This Delusion Now!

The signs of a capitulating economy are percolating. The Occupy movement is restarting its protest occupation. Professor Paul Krugman, who has recently criticised Ben Bernanke for not doing more to reinvigorate the economy, has just come out with his new book "End This Depression Now!"

At last a figure of high regard in the economics profession now admits that we're about to enter a depression.  But Krugman himself still doesn't completely grasp the issue. With Bernanke still blind to the scary situation that's progressively unfolding, Krugman is the one-eyed man in the land of blind economists, meaning he gets only 50% right.

Krugman claims that Bernanke isn't aggresive enough while Bernanke counters that Krugman's inflation promoting suggestion is reckless. At the end of this civilised spat, both remain none the wiser simply because one is nebulous and the other clueless. At the root of the issue is the belief that there is a solution to the crisis. We had three Kondratieff Waves in the past, and their curtain calls were all marked by three depressions.

We might as well beseech God to put a stop to tsunami waves. When the calamity is inevitable, you don't attempt to find a solution; you adapt to the problem. If you knew when a tsunami would strike, you would have put the ships out to sea and moved the residents to higher grounds. Unfortunately, we have yet to discover the means for triggering advance warnings of tsunamis though we can roughly estimate their timing based on a 70- to 100-year cycle. This lack of tsunami early warning indicators is the main reason that many are always caught unprepared.

A Kondratieff Wave is different. We have all the past patterns needed to sense its timing. The symptoms are evident years before disaster strikes. The timing is almost perfectly regular. Now what should we be doing to minimise, mind you, not avert, the impact of the depression? First we need to identify the distinguishing features of an economic depression. Then we'll walk through the depression to see how it reaches its natural conclusion so that we can anticipate the succeeding moves. Our aim is to have minimal surprises. For this post, we'll focus on why the depression is unavoidable and why there's no solution, but only adaptation.

The problems of this depression are essentially two-fold: a drastic fall in money supply and a skewing of wealth distribution. These also happen to indirectly relate to the dual mandate of the Fed, that is, price stability and maximum employment. Contrary to received wisdom, the fall in money supply is merely a symptom, not a cause, of the depression. The true cause of the depression is however the maturing technology drivers of the Kondratieff Wave in which a few producers have cornered the productive capacity. Towards the end of the wave, wealth accumulation is highly skewed resulting in an extreme imbalance between creditors and debtors (see The Wall Street Journal chart above). Even if the first problem is resolved, it will recur as long as we are stuck in the same Kondratieff Wave.

In any case, the symptom must be addressed before all else in order to unfreeze the economy. Even this the policymakers can't even grasp. Tackling the symptom is easy, if only the policymakers had the authoritarian powers to bulldoze the corrective measures through. First they need to understand that the money supply has to fall. Any measures to prop it up will not last long, much like the Japanese sea-walls that were destroyed by the 13-metre sea waves. What we have now is the excess money created during the credit boom years trying to downsize itself so as to be commensurate with the size of the economy.

The intellectually bankrupt policymakers are preventing this fall by creating money in baby steps. With every step forward, they are taking two steps back. There are two solutions but both are unpalatable and therefore, without authoritarian powers, unimplementable. One is to quicken the pace of the money winding down by the forceful large scale write-off of debts. Those with financial savings will terribly suffer. The other is to increase the income level and asset prices superficially by unleashing inflation à outrance, not the 4% suggested by Krugman. With this the underwater loans will refloat and debts can be wiped out. Again the same group of people will suffer but the main beneficiaries in both cases will be the debtors. Without either of these two options, the suffering will be long and excruciating.

Both Bernanke's and Krugman's failing lies in their inability to apprehend the money supply. As money is 98%  credit, Bernanke cannot create money regardless of how much he prints. Bernanke only swaps one form of credit, deposits by the banks with the Fed, with another, treasury bonds and mortgage backed securities (MBS). Even if Bernanke were to print trillions worth of paper money for the banks and forbid them from placing it with the Fed, inflation would still be flat. Why? The banks will sit on the paper money and guard it with Fort Knox-like security. The cost is cheaper than losing money from lending in times of  low repayment prospects. No lending, so no new money, thus minimal inflation.

Bernanke doesn't want to print more money out of his misguided fear that this may lead to runaway inflation. And Krugman is accentuating the confusion by castigating Bernanke for being timid. The funny thing is that both believe high inflation will be the outcome of Krugman's suggestion. Are they teaching voodoo economics at Princeton?

Prices are indeed falling but most people don't notice them because the CPI doesn't include asset prices, but only goods and services. If you factor in all prices, we're already in deflation mode because money is fast drying up. The flow of money is akin to the water cycle. Water in the ocean is not water in the meaningful sense. Only when it circulates through the water cycle, does it benefit the ecosystem. Likewise, money placed with the Fed or stashed under the pillow is dead money and shouldn't be counted towards the money supply. So you can have lots of money yet having zero impact on the economy. Now what do you need to get this money cycle moving?

Again the water cycle analogy helps. First we need to understand why the Sahara which is a desert today used to be a green region with large lakes about 10,000 years ago. William Ruddiman's book, Plows, Plagues & Petroleum, has a fascinating account of the climatic shifts that led to the radical change in the Saharan environment. The root causes of these climatic shifts are the main drivers of global warming and cooling. Fossil fuel is only a recent and to boot a very minor contributor to global warming. In fact, we should be grateful to fossil fuel for without it we would now probably still be in the Little Ice Age, which began as early as 1250 and lasted until 1900, although some would consider 1550-1850 as the real interval. Regardless, it came to an end with the industrial era warming. The coming Fifth Kondratieff Wave, which will yield cheap energy, will see us struggling to get carbon into the atmosphere in order to prevent earth's cooling.

How big the impact of fossil fuel, it's the variation in the sun radiation that actually contributes far more to global warming and cooling. The radiation varies as a result of three astronomical rhythms: the 22,000-year precession cycle, the 41,000-year tilt cycle and the 100,000-year orbital cycle. Precession is the change in the tilt direction of the earth's spin axis. It's like a spinning top, changing the direction in which it leans, progressively until it traces out a complete circle. Note that precession doesn't change the angle of the tilt, only the direction. The tilt cycle is where the earth's tilt angle changes from a maximum of 24.5° to a minimum of 22.2°. The orbital cycle is the cycle in which earth's orbital path changes from elliptical to cyclical. During its elliptical orbit, the earth's distance from the sun is shorter by 5 million kilometres from its average distance of 155 million kilometres.

Over the last 3 million years, the impact of these cycles has gradually resulted in the earth trending towards a more refrigerated state. Only the very recent greenhouse warming has arrested this progress. But of far more interest is the precession cycle since it's the one that has greatly influenced the Saharan environment. This cycle controls the solar radiation at tropical latitudes, which in turn drives the summer monsoons. The maximum radiation arising from this cycle occurred about 10,000 years ago. It so happened that that was when the Sahara desert was green with grasslands and dotted with lakes. Right now, we're at the minimum radiation state.

It seems strange that minimal radiation is associated with desertification whereas maximal radiation with greenery. But you need a strong Sun to heat the land and the overlying air. When the heated air rises, the low pressure left behind by the rising air is filled by moisture-bearing air from the ocean. This air is in turn also heated but this time the moisture condenses as it reaches the upper atmosphere. Clouds are formed, followed by rains in the afternoons and evenings. If the Sun is not strong, the region is devoid of low pressure and the air is dry, hence the present Sahara desert environment.

The man-made fossil fuel global warming is having a relatively small impact and would be easily reversed in the Fifth Kondratieff Wave driven by advances in nanotechnology and biotechnology. Our attempts to do so prematurely during the present Fourth Kondratieff Wave are costly and wasteful of economic resources.

The same goes for our efforts to subvert the downward phase of the Kondratieff Wave. The Sun equivalent for the Kondratieff Wave consists of the capacity and communication technology drivers which in the present wave are computers and the internet. As we are past the halfway mark, these technology drivers are unleashing capacity instead of driving investments. So fewer people are increasingly needed to produce a given level of output.

So a fall in money supply is to be expected. Instead of allowing money to finds its natural level, policymakers are flogging a dead horse by creating more money through government deficits. This slowing down of money contraction coupled with Bernanke's induced low interest rate environment attracted new house buyers, who thought that house prices had hit bottom, towards the end of 2010. Now these buyers are under water, creating more problems instead of solutions that the original stimulus intended.

To adapt to this depression, we need efforts on a collective scale to channel wealth from the well-off to the needy. That's where the consuming demand lies. We don't need more investment since we have more than enough capacity to meet the needs of the world. The spending from the consumption will flow back to the well-off and thus how the wealth cycle like the water cycle works. But as depression rears its ugly head, fear grips everyone's mind. Generosity takes a back seat to selfishness. And everyone will be the loser.

The misleading tool for the missing job

"All the business of war, and indeed all the business of life, is to endeavour to find out what you don't know by what you do; that's what I called 'guessing what was on the other side of the hill.'", reminded Field Marshall Arthur Wellesley, the first Duke of Wellington. To achieve the 'what-you-do-know', the Duke didn't guess; instead he employed spies in his war with Napoleon on the Iberian peninsula.

In the field of economics, we don't have to be as crafty as the Duke. It's enough to rely on just three easily available indicators to know the true state of the economy. Even our indicators should be as simple as possible. The more indicators and the more complex they are, the greater the possibility of us being lost in the mass and confusion of details. For example, most economists rely on the M1, M2 and M3 metrics to measure money and when they couldn't correlate those metrics with inflation, deflation or GDP, they tweak them by using moving averages that cover several months' metrics. If only they had used total credit, the trend would have been obvious from the start.

Not only in the economics profession but also in the business world, the increasing trend towards dependency on a multitude of charts and indicators is numbing most of our senses. Thankfully, there are still pockets of expertise in which human senses are still valued. A good test of a ship captain is whether he can navigate the vessel without the use of any instrument. His judgment of bearing, distance and speed must be sound. Similarly, a good manager can quickly sense the state of employee culture by simply observing the workplace environment or he can tell whether a factory is making money by just walking around the factory floor. If he were to wait for an employee survey or a production report to discover the answer, that would badly reflect on his competence.

We have already reviewed  two of our three important metrics: the total credit and the Case-Shiller 20-city composite home price index. The last metric in our list of indicators that matter is the Labour Force Participating Rate (LFPR). I only discovered the importance of this metric when searching for the cause of the protest movement in the US that emerged in the mid 1960s and lasted until the early 1970s (see 'The protests, 45 years on').

To understand this metric, we need the big picture on the labour force. A recent issue of The Wall Street Journal has an excellent graphic at left that puts the various civilian population components in their proper perspective.

The US population in this context includes all members of the population aged 16 and over. Unlike the LFPR in other countries which covers only the working age population, the US LFPR also includes those above 65. A major part of this population participates in the labour force, whether employed or unemployed, as depicted by the two green boxes. Unemployed here means they are in search of jobs in the four weeks prior to the labour force survey.

There is also a smaller category of people which by choice or circumstance does not form part of the labour force. These people are permanently not in regular or part-time employment. They also include those who have stopped searching for a job in the past four weeks prior to the labour force survey. These various categories are represented by the cream coloured (or pinkish hue) area.

Now the main issue here is why we should rely on the LFPR instead of the employment or unemployment numbers. Let's bring up the unemployment chart. This one from The Economist at left shows that there is no obvious pattern that can be discerned. Can you predict how it's going to unfold in the coming months or years? Almost impossible; there's an equal chance of it going up or down. However, one pattern that sticks out like a sore thumb is the long-term unemployment line graph which accelerated sharply since the start of the current recession in 2008. Although past unemployment rates had been higher than the current rates, the rise in past long-term unemployment was modest. That should've alerted us that this recession is atypical and that the unemployment now is not cyclical but structural.

Let's take the LFPR chart, from The Wall Street Journal, that covers the same period as the above unemployment chart. Note the obvious difference between this chart and the previous. With this chart, you'd have no problem predicting where the line is heading. Because the line graph in this chart cannot turn on a dime, you can figure out the turning point months ahead.

Now we can explain the movement in the labour force components shown in the first chart. The movement between employment and unemployment, i.e., the two green boxes, is pretty fluid. It can go either way depending on the state of the economy. But the shift between the green and the cream areas can only be unidirectional.

As a result of this one-way traffic, the unemployment rate can be showing improving metrics even though the job market is deteriorating. When the unemployed give up looking for jobs, i.e., become non-participating, both the numerator (the unemployed) and the denominator (the participating labour force) decrease. Thus the improvement. In the case of the LFPR, the same situation would reduce the numerator (the participating labour force) while keeping the denominator (the aged 16 and above population) unchanged. Thus the declining LFPR. Note that a lower figure is good news for the unemployment rate but negative for the LFPR.

We can use the analogy of reverse osmosis (RO) to explain why the flow is one way. In RO, two factors cause movement from one side to the other: pressure and concentration. Right now in the green area, the pressure, to cut costs through retrenchment, is so strong that the movement is mostly from green to cream. Businesses are relying on technology to cut headcount while maintaining production at the same or even higher level. At the same time, a high concentration of baby boomers (those born in 1946-1964) has started to retire (see left chart from The Economist). So over the next 18 years, the baby boomers will migrate in a big wave to the non-participating section.

But the interesting bit about the declining LFPR is the cohort that is disproportionately hit is the one in the 16-24 age bracket (see lower panel of the LFPR graphic above). What most of those in this group have done is to take up additional study loans to further their studies hoping that by the time they graduate, the job market will have improved. How they're going to be utterly disappointed. They'll soon realise that they're jumping from the frying pan into the fire. The job market will still be moribund but worse, the loans that they've burdened upon themselves will take years to repay.

However there are others who, faced with this inextricable situation, plead disabled in order to claim disability benefits. In fact, disability claims have increased significantly during this recession, up by 22% since December 2007. There are also instances of those committing petty crimes in order to get free food and medical in jail. Funny that the losers in the monopoly board game also would find much relief when they get sent to jail. At least, in jail, you get sheltered from the economic horrors of the real world.

This final chart at left from dshort.com is presented just to prove that any indicators that include employment or unemployment as its numerator or denominator can be safely ignored. The blue graph is the employment-population ratio while the red is the unemployment rate. Since employment and unemployment are two sides of the same coin, the two line graphs are just mirror images of one another.

So with indicators as with anything else, less is more. The simpler, the better. The quicker you can grasp the pattern, the greater your ability to predict future trends. Least of all, you don't want to appear silly like Donald Rumsfeld with his known unknowns and unknown unknowns.

Grossly Distorted Picture

Continuing our review on the indicators that matter, we'll revisit our second most important economic indicator, that is, the Case-Shiller 20-city composite home price index. This index is a 3-month moving average of house prices lagged two months. So the recently published index for January 2012 is in fact an average of November, December 2011 and January 2012 home prices. The Case-Shiller may be a laggard but it compensates for the delay with accuracy.

This index at left confirms that home prices are still setting new rock bottom records despite the spate of favourable economic news on other fronts. In a depression, house prices can collapse by at least 50% from their peaks, last reached in the US in April 2006. The country with the worst performing state of real property is now Ireland where prices have gone down by 57%. In the US, the drop is a whisker short of 34%. That means prices have another 16% to fall from their peaks, or about 25% if based on current prices.

To be sure, Ireland had a mad building frenzy. The US also had a similar craze but of a refinancing variety. Going by the slow pace of property price drop, thanks to Obama's massive deficits, the prices will only hit bottom by the end of 2017. There's still a long way to go before we can see a real normal. Of course, reality will arise much sooner since the US government does not have that much stamina for sustained massive deficits.

With a new wave of foreclosures that is expected to set a more rapid pace than those of the past four years, house prices will be more depressed in 2012. Unlike in the past in which the subprime mortgages were the prime target, this time it's the ordinary mortgages that will be hit. In the fourth quarter of 2011, more than one in four homeowners were under water. Moreover, last year was the year in which proceedings were initiated and this year will be one in which settlement has been reached, allowing the banks to begin foreclosures. Sales of foreclosed homes will increase to 1.25 million this year from 1.0 million last year.

Because of the way it is calculated, the Case-Shiller index provides a pattern that is not distorted by short-term fickleness. Compare this with the US GDP growth for the fourth quarter of 2011 which registered a healthy quarterly annualised growth of 3%. Some commentators have stupidly claimed that recovery is in the pipeline. Although the GDP itself is saddled with quirky ways of computation, these are nothing compared to the ridiculous massaging of the annualised number.

The picture on the left depicts two versions of the quarterly GDP, and both are correct. You can guess which is the more suitable measure simply by looking at the shape of the two curves. The blue line is the quarterly GDP computed year-on-year (YoY), that is, Quarter 4, 2011 over Quarter 4, 2010. The quarterly GDP for this is 1.6%. The recently announced GDP for the same quarter at 3.0% is based on the growth of Quarter 4, 2011 over Quarter 3, 2011 (QoQ). This yields a 0.7% growth which then is compounded four times to annualise it. This method of computation generates a highly distorted trend, totally unfit for uncovering pattern. In statistics, you must smooth highly distorted measurements through the use of a longer time span or you can compute a moving average like the Case-Shiller index. With the red line, the pattern is uncertain but not so with the blue line.

Since almost 71% of the US GDP is made up of personal consumption, house prices do play a significant role in influencing GDP growth. Homeowners with substantial home equity as a result of the housing boom, used that equity to take on more debt loads. Now the process has reversed itself with homeowners paying back for the sins of their over indebted past. With home prices still struggling to pick up, it's little wonder that the household sector is not contributing to any growth. As for corporations, they are sitting on a large pile of cash, not rushing to invest in an environment with plenty of capacity to spare.

Obama, relishing on seemingly improving indicators, seems more confident of his reelection prospects. But lots of surprises are around the corner waiting to pounce on him in the coming months. Foremost of all is his deficit spending. If you want to know the real cause of the movements since 2009 in the Case-Shiller house price index and the quarterly GDP, the YoY version, that is, just watch the federal government deficit growth (chart above). The two metrics lag the federal debt growth by one year. The deficit spending growth is slowing and the CS house index has moved accordingly. You can guess how the soon to-be-announced GDP number for Quarter 1, 2012 will turn out.

Already, corporate profits are forecast to grow at the slowest pace since the third quarter of 2009. With the federal debt as the main driver of growth since the beginning of the depression, the stock indices (see that of the S&P 500 from Bloomberg at left) have also charted a too well predictable pattern. April appears to be the pivotal month in which all indices turn on their heads.

It's the nature of compound growth that it thrives on ever bigger numbers in subsequent periods. So for Obama to perk up the GDP, his deficit spending must keep on escalating. Many obstacles lie ahead at the end of 2012: expiry of Bush tax cuts, the $1.2 trillion automatic spending cuts and the end of the payroll tax cuts. All these will lead to a substantially reduced deficit.

Finally, if you want to crystal-gaze into the future, the following three charts (from The Economist) using decadal averages from the 1930s to the 2000s afford indisputable long-term trends. Of course, you may argue that the 2000s is the turning point after which all measures will pick up. But remember, this depression will turn out worse than the 1930s Great Depression, and the indicators so far have yet to plumb depths deeper than those of the 1930s. As the indicators start notching new record lows, prepare for a new reality that will upend politics and economics.

Bloating treasuries, shrinking banks

The 2011 economic indicators that matter are now out. We only need to rely on the three crucial ones: the total debt or credit, the Case-Shiller house index and the labour force participating ratio (LFPR).

The most important indicator of the three, of course, is total credit. This indicator can be examined from several perspectives: its annual growth as well as that of its individual components, and lastly its ratio to GDP by debt component.

On the left is the first chart, depicting the total credit growth which is still flagging. It's still susceptible to falling into negative territory given that throughout 2011, the breakout from credit contraction lacked momentum, all the while hovering around the 1% mark.

Let's see which debt sector was driving the flaccid debt growth in 2011. For this, the sectoral growth is shown in the left chart. This time we can see two contradicting trends, one of growth and the other of decline and ambivalence.

The growth part involves only two sectors, government and non-financial businesses. Without the growth in government borrowings, the situation would have been much worse with all the other sectors showing worsening declines instead. Contrary to the Republicans' claim, it's Obama's deficits that have been holding up the economy. But not for long.

As for the decliners, to wit, the financials and GSEs (Fannie Mae, Freddie Mac, and Ginnie Mae), they are still shrinking although the pace has slowed down. The US and also the whole world's financial sectors are shrivelling as banks, in a process known as deleveraging, are ridding themselves of debts on the liability side of their balance sheet, which in turn means that they need to cut down on their loan books on the asset side. This whittling down of the financial sector will continue until the total credit has reached a point that can be sustained by the economy. This undoubtedly is a long process as the US total credit which stood at 386% of GDP as at first quarter 2009, only decreased to 353% by the end of 2011. Even if the GSE debts are excluded to eliminate double counting, that still leaves a high 304%. If we look at the chart above of more than 130 years of US debt history, a level of 150%-200% would have been a sustainable number over the long-term. That means current US debt load would need to be shaved by at least one third.

As banks dwindle in size, the credit or money supply will likewise contract putting more pressure on prices of equities, commodities and real estate. It is a truism that banking thrives on continuing loan growth. As loans grow, asset prices riding on the back of loans, rise as well to the benefit of both borrowers and bankers. Unfortunately, when the process reverses, bank failure is the natural outcome. During the 1930s Great Depression, a similar situation prevailed to the extent that nobody wanted to work in banking.

Now the next chart shows which debt sector will dominate the rest. Throughout the current recession, the annual federal deficit has exceeded $1 trillion four years in a row. It's very obvious that government debt which has just overtaken all other debts will keep on growing. With Fannie Mae's and Freddie Mac's losses now totalling $183 billion, the GSE debt will in time fall in the lap of the government making the government debt much more higher. Although from 2012-13 onwards, the deficit is projected to progressively decrease, don't bet on this happening. Any sitting president has no control on the economy. It's the economy, or more specifically, the bond market that decides how much the deficit will be.

Even the Republican presidential contenders who are pressing for a balanced budget would surely change their stripes once they are in office. When Roosevelt campaigned for president in 1932, he criticised Hoover for deficit spending. Ditto for Obama. But once they became president, they broke all budget records because if they hadn't, the bond market would see to it that they be impeached. Undeterred, Roosevelt reattempted budget balancing at the beginning of his second term. The economy soon relapsed into a recession worse than that of 1929, forcing him to backtrack. In a depression, you don't meddle with King Bond; just let it grow.

In February 1993, James Carville, Bill Clinton's political advisor, presciently remarked, "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody." Then, the bond vigilantes sold off bonds upon hearing that Clinton would embark on deficit spending. Clinton was only saved by the massive borrowings undertaken by the financial sector and the households that allowed him to balance his budget. Now it's not the bond vigilantes but King Bond itself that decides who'd stay in power.

Although lately, economic trends have been pointing towards a recovery, we should treat this as merely blips in a secular downtrend. We've been through this false hope many times. Even in the 1930s depression, there were seven such instances that subsequently left many in a worse state of despair.

To see the true pattern, we can refer to a chart tracking the 10-year treasury yield since 1900 that The Economist has just published. The bond yield has only recently touched the 2% mark, repeating the pattern last seen in the 1930s depression. Then, the yield was down in the dumps for more than 10 years. Self-proclaimed pundits have been advising bondholders to exit bonds in the expectation that a recovering economy would push yield higher and thus bring down bond prices. Don't worry, Bernanke will see to it that the yield would remain depressed until at least 2020.

Would humongous government debt lead to  the downfall of any government? Actually, no. The strength of any modern government depends on the level of the country's new technology acquisition, and it's not just any technology but technology that meets the Kondratieff Wave criteria of capacity and communication. Because of this, the East Asian countries aren't likely to dislodge the US from its preeminent position, not now and never in the future.

However the Fourth and the Fifth Kondratieff Waves are stuffed with technologies that empower the small at the expense of the big. This is the root cause that will precipitate the decline of the US as a superpower. The symptoms of downfall that afflicted past empires will unfold for the US in the coming years. We will witness how hard-pressed the US will be to contain its debt load as the technologies that are in ascendant now and in the future will instead favour the breaking up of large nations.

In the bondage of bonds

Will interest rates go up or down? This is the $64 million dollar question. Supposedly, interest rates will remain in the low single digits because of central banks' quantitative easing (QE). The economy is expected to pick up as everybody will start to borrow to take advantage of the low rates. Is reality unfolding according to script, that is, the Investment Clock script (see left picture, one of many investment clock images widely available on the web)? Let's dissect recent events to uncover the truth behind the general trend.

The investment clock provides us with a  pattern that explains a complete boom-to-bust-to-boom economic cycle. However, as with most man-made patterns, we cannot take it at face value as the original author(s) might not have correctly observed the events over several economic boom-to-bust cycles. You not only need a very keen sense of observation but also a prolonged observation to ensure that your pattern can stand the test of time. As we now possess the hindsight benefit of recent developments in the global economy, we can test the investment clock pattern in this light.

So where are we now on the clock face? It seems that we have passed 5 o'clock. The succeeding events are supposed to move according to the following script:
  6 o'clock - Falling real estate values? Check. Still going downhill.
  7 o'clock - Falling interest rates? Check. Bernanke and co. have buried them for good.
  8 o'clock - Rising share prices? Check. The Dow has recently touched 13,000.
  9 o'clock - Rising commodity prices? Check. Oil is back to above $100 per barrel.
  10 o'clock - Rising overseas reserves? Hmmm. The East Asians and the Germans have always been accumulating but have slowed down lately. As for the US, it cannot have forex reserves, otherwise the whole world will collapse.
  11 o'clock - Easier money? Oops, we shouldn't be here. Quick, back up to 5 o'clock.

Something has gone badly wrong. We've jumped the gun. Money is still tight. Even though it's cheap, the banks are not lending. They are worried not about the return on their money but the return of their money. They know that borrowers, be they businesses or households, are not going to earn enough income to pay back their loans. Simply put, Bernanke's cheap money is ineffective.

What should be the next move? Should we hang on to the Fed's cheap interest rate while waiting for the depression to clear itself out? Actually, there's nothing that we can do. The Fed itself has fallen into the trap that it helped set up. It cannot move. Neither can everybody else. The debt deflation is not going out with a whimper. To appease the debt monster, the Fed continues to feed it, storing trouble for its future handler.

Now, the investment clock's error is that it's meant for an inflation-induced recession whereas we're in a deflation-induced depression. The former is a short acute pain while the latter is a long-lasting chronic one. So to grasp the latter, you should view it as consisting of many repeating cycles of 2 o'clock to 6 o'clock, with short occasional breaks to the 7 o'clock and 9 o'clock range. Every time it breaks out, it comes back with a vengeance. The process iterates until the debt has been reduced to a level sustainable by the economy. Politicians and policymakers can only delay, not prevent, this natural sizing down of the debt monster.

In an inflation-induced recession, demand or consumption is ever present. Only the supply or capacity is tight. This results in prices rising across the board. You need to bring demand down through high interest rates so that it is in balance with supply. Once demand has fallen, interest rates will follow suit. Prices of shares and commodities will then rise as everybody will get back to their old spending ways.

The opposite is the case with a deflation-induced recession. Money is also tight at the deep end of the recession. In this case tight money is not characterised by highly priced money associated with high interest rates but by zero availability no matter how expensive you want to pay for it. In fact, a paradox happens: money is tantalisingly cheap but you can't even touch it. So near yet so far.

Although money seems cheap, its real cost will be high. Recall that money is credit. The unsustainable level of credit is a major symptom of the depression, the root cause being the skewed wealth accumulation. But the first step in getting out of the depression is to wring out credit. In the process, prices of everything including gold, will collapse. This makes money expensive even at zero interest rate because money increases in value relative to other assets. Everybody wants to retain money rather than lend it out. And nobody wants to borrow unless he/she has no intention of repaying.

Of course, technically, taking the debt to GDP ratio as the basis, we can also increase the denominator (GDP) instead of squeezing the numerator (debt) to bring back the ratio to a sustainable level. However, bear in mind that we're in the Fourth Kondratieff Wave. If you refer to the Elliott Wave chart (reproduced on the left) in the The Five Generations of Warfare, the fourth impulse wave (the green line denoted by the letter 'a') moves downwards, as does the fifth wave (green line 'c'). Henceforth, don't expect the GDP to grow significantly. Sure, we have unprecedented power to produce but we don't have the power to consume. Without consuming power, there's no necessity to produce.

The other alternative is to tolerate high inflation. Inflation will enlarge the nominal GDP while the debt remains fixed. The debt to GDP ratio then will decrease to a more sustainable level. But this option is no longer available as the central bankers have trapped the whole world into decades of low interest regime with their QE bazooka. In the last 20 years, only the Bank of Japan (BOJ) had embarked on QE prior to Ben Bernanke's. Now other central banks, such as the Bank of England and the ECB, though in a roundabout manner with its LTRO, have started to follow suit.

Bill Gross of PIMCO has warned us of the danger of extremely low interest rates. Japan is clear evidence why low rates can trap an economy in gridlock. The chart below (taken from The Wall Street Journal website in October 2010) shows that since April 1995, BOJ's overnight call rate has never risen above 1%. The Fed funds rate has similarly been stuck below 1% since December 2008.

It's not that the Fed hasn't been through this before. In 2003 the Fed funds rate even dropped to 1% because of the need to reinvigorate the economy after the 2001 dotcom bust. The low rates drove real estate prices up. Bond prices on the other hand move inversely with movements in interest rates. So as the interest rates gradually increased from 2004 to 2006, the bond holders incurred losses but these were more than made up by profits on the surging real estate prices. Banks also reaped huge profits on the soaring demand for mortgage loans.

A much longer precedent arose in the 1930s when rates remained in the doldrums for more than 10 years. As the Fed funds rates had not yet been introduced then, the annual average for the 3-month Treasuries rates, used as a proxy measure, fell below 1% from 1932 to 1947. That was a similar depressionary situation to that prevailing now. Hence we can expect our low rates to last till 2020.

How did they get out of the low rates in the 1940s? They had the benefit of electricity, the main driver of the Third Kondratieff Wave. Because of WW2, economic growth from electricity, in the form of factory mechanisation and higher female labour participation, was delayed and even spilled over into the early part of the Fourth Kondratieff Wave. The 1950s and 1960s period was the American century, in which euphoric feeling, as currently experienced by China, prevailed. Also much reconstruction work had to carried out to rebuild Europe after the devastation of WW2. Demand was growing to meet the expanding production. So even though the bonds lost value, growth in other areas more than compensated for the bond losses.

It should also be noted that the biggest chunk of the debt during the peak of the 1930s depression was non-financial corporate debt (see left chart from Forbes) which could be easily struck out with corporate bankruptcies. When WW2 came along, the depression was mitigated by the surge in government debt spending. But this debt surge was contained by the exceptional economic growth in the 1950s and 1960s, and inflation in the 1970s, putting a lid on the debt/GDP ratio. However the low inflation from the 1980s onwards has accentuated the rise of the debt/GDP ratio.

Now with real estate prices going downhill since April 2006, and commodities vacillating in an unclear direction, Bernanke's suppressing of interest rates has pushed bond prices up. Their yields have fallen so low that any slight uptick in yields can result in substantial falls in prices. For example, take the 10-year T-bonds. Its current yield is around 2%. If its yield goes up by 1%, the bond price will fall by 8.5%. And if it rises to 6%, the fall in value would reach almost 30%.

The Fed has become addicted to lowering the yield that Bernanke has hinted that he might buy the 30-year Treasuries, which currently has a yield of slightly over 3%. To fund the buying he'd be issuing short-term repos (repurchase contracts) to the banks. This has no impact at all on the money supply, only the long-term bond yield may go down. By doing this, he'd be tightening the grip that the bond market has on the economy. He can no longer countenance any rise in interest rates unless he wants to wreck the bond holders who are sitting on a large pile of bonds. The T-bonds alone now amount to $10.5 trillion, of which $5 trillion are held by foreigners and $1.65 trillion by US financial institutions.

We can look at Japan's total credit market (left chart from The Economist) to see how its government bonds have transformed into a godzilla. The legend at the top is incorrect. The bottom band is financial, followed by government, non-financial businesses and finally, topmost is households. Seeing how big the government debt has grown, it's not surprising that Japan is suffering from revolving door leadership; the bond is the de facto leader, the shogun behind the premiership. Japan has no other option. Push up inflation and the bond holders will scream while the financial system will be crippled. Stay status quo and the godzilla keeps getting bigger as other asset prices continue deflating.

Let's see how the US total debt market is stacking up. The left chart from The Economist also has the same erroneous legend as the Japanese chart. The chart which plots up to the first quarter 2011 still shows households (top band) as the biggest debtor. However the latest report from the Fed as of end 2011 indicates that the government debt has dethroned household debt from the top spot. And the government debt will be getting relatively much bigger as other debts will shrivel through debt write-offs. The trouble with government debt is that it can't be cancelled through bankruptcies or debt restructuring. As this debt progressively balloons, the effective future president of the US will be President Bond. Like Japan's, the nominal presidents will be lucky to last even one term.

How do we get out of this quagmire? Only strong economic growth would do as the debt has grown too large to be rooted out by inflation alone. Probably equities may rise in the Fifith Kondratieff Wave. But we know the Fifth Kondratieff Wave will be weaker than the Fourth which in turn is weaker than the Third. If the US can't get out of this hellhole, then the whole world will face an utterly bleak future.