The Coming Credit Collapse
By James Cook
October 23, 2001

Let’s set aside for a moment the impact on our economy from the recent attack. For sure it will have an effect, but whatever’s going to happen to the economy would have happened anyway. And what’s most likely going to happen to the economy is a credit collapse of a magnitude and dimension that shakes the U.S. to its very foundation. What we have done to ourselves will vastly exceed what our enemies can ever do.

The incredible array of economic sins and imbalances in the U.S. economy are without precedent. For one thing, no country has ever experienced a sharp economic downturn against the backdrop of exploding credit demand. Never have consumers borrowed so madly to fend off a reduced lifestyle, nor have businesses borrowed so aggressively to keep their doors open.

In the 1930s corporations had $2.00 in cash for every dollar of debt. Today they have a dime. By borrowing extensively to buy back their stock or running down their precious cash reserves to boost their stock prices, many companies have painted themselves into a financial corner.
Meanwhile the consumer set a borrowing record in the second quarter to pay bills and keep on consuming. But, look at these five overpowering reasons for consumers to pull in their horns:
1. Loss of the wealth effect and a reversal from capital gains to capital losses.
2. Low savings or no savings.
3. Debt rising to record levels.
4. Falling income growth.
5. Growing numbers of layoffs.
In spite of gross deterioration in the financial system, the credit party continues. Champagne-drinking optimists refuse to notice the sober realities of the enveloping hangover.

An unprecedented systemic problem with the U.S. economy means a severe crisis ahead. We’re not making a bunch of facts up here. We’re not standing diametrically opposite the mainstream economic forecasts and Wall Street propaganda because of wishful thinking. The facts are horrible to contemplate. The severe strains in the system won’t go away if and when the business cycle turns up. In fact, these intractable problems insist that the business cycle will turn down further and stay depressed for a long time. How depressed is the crucial question.

Profits are the main engine of a growing economy. Profits fuel spending on products and services. Profits translate into capital spending on plants and equipment. Without profits this important spending can’t take place. An economy without profits is like a human body without enough calories. Robust activity diminishes. The profits decline in the second quarter was the greatest in 21 years. Despite a record nine interest rate cuts by the Fed, this profits malaise shows no sign of improvement. Something far worse than an inventory glut, the suspected culprit, must be at work.

What is it that turned down profits and plunged all important business investment into a funk? Here’s the list. You tell me how many of these profit depressants are going to go away quickly.
1. The Trade Deficit. Money going out of the country doesn’t buy anything inside the country. It’s the biggest negative to profits.
2. Misguided profit strategies. Downsizing and restructuring on a large scale hurt all businesses. Mergers and acquisitions take the place of all-important investment spending.
3. Financial leveraging. Borrowing money for stock buybacks and speculation leads to weak balance sheets, inflated asset values, soaring interest obligations, record debt and shrinking cash flows.
4. Savings on the uptick. Apparently most of the recent tax cut was saved. A 4% savings rate (supposedly the current rate) removes $300 billion from spending and GDP. Fears and concerns among consumers translate into greater savings and become an import profit depressant, a la Japan.

Despite what you’ve heard from Wall Street, information technology and the new economy failed to bring home the bacon for the U.S. These new technologies were overrated. Our so-called economic miracle pales in comparison to the auto industry of the 1920s with its intensive capital spending that created jobs, profits and wealth. Basically today’s new economy was propelled by Wall Street euphoria, runaway money and credit expansion and the worst examples of stock speculation and overvaluation in history. This was a bubble that has now burst with a vengeance. Wall Streeters recklessly continue to advocate more of the same but which of them has been right about anything for the past 18 months? What they have engineered and continue to promote amounts to the loss of five trillion dollars. The wealth of America is evaporating before our eyes. Attempts to reinflate the bubble with additional money and credit are now offset by corporations and the public who wish to hold on to their money and restore cash balances.

We all see that bankruptcies and defaults are on the rise. It’s my view that sooner or later cascading defaults will snowball into a credit collapse as one business failure brings down another. When a critical mass of consumers who are out of work or facing income reductions are forced to postpone their credit card payments or omit their mortgage obligations, the credit implosion will spiral out of control. Then we have the worst of all economic worlds. Our outrageously exorbitant money and credit expansion has fed into the willingness of too many people to overload on debt. When all the excesses and imbalances in the economy are taken together, I don’t think any country has ever been in a worse pickle.

Today’s continued optimism in the face of the facts I have related makes a person wonder if we are on a different planet from the money managers and economic experts. But I would argue that every economist who ever existed on this earth up to and including John Maynard Keynes would agree with me when I express these grave concerns. I hope you take my argument with more than a grain of salt and don’t let the assets you have accumulated wither away. Look at what’s happened so far. Use that as a roadmap to the future. There are good times and bad times, booms and busts, lush periods and droughts, peaks and valleys, pleasure and pain, joy and sadness. We have lived through a golden age and now we are likely to see its opposite. If all the excesses of the bubble period are liquidated, it will be a financial holocaust. If you’re not apprehensive, you should be.

All Rights Reserved © 2001 Investment Rarities, Inc.