Breathtaking...

cf. November 20, 2009

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Live! Tonight! The Depressions feat. D.J. Demand Destruction

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Dear Dad,

The recent developments in the global economy are terrifying. The risk to the economy now is entirely political-- trust in politicians worldwide is low, and by the look of recent events, I fear this is morphing into something new all together. In America, Europe, and the Middle East, it's no longer just people hating their politicians-- it's people questioning the very nature of government's authority, right to exist, and place in society. Society has become, I'd say, significantly less civil in the past eight weeks. You see this in the riots in London, you see this in the riots in Greece, you see this in the downright dangerous political language being bandied about in the US.

Gov. Rick Perry of Texas, candidate for President of the United States, stated yesterday at a fundraiser that Ben Bernanke's actions were equivalent to treason and by extension that Federal Reserve should be abolished. That this is possible right now... that that could even be possible given our country's obvious problems, and the tremendous body of literature showing how bad it was back in the day. (c.f. "Fifty Years in Wall Street" Clews, 1908) and the practical steps one could take fiscally... in conjunction with a little bit of swagger, charisma and monetary policy. Insane. Rick Perry is insane and unfit to be president. (Not that bashing the Fed is without historical precedent) As a result, the Europeans woke up to an America that looks way more dangerous than they anticipated. More and more, we feel the same about them. Repeat, Rick Perry should be shot for treason.

This feels really, really bad to me. This is not the same situation as when we spoke 5 weeks ago and I advised you to do nothing because the debt ceiling debate was a foregone conclusion. Indeed I was right, but many horrible things have happened since. For one, in the most recent GDP report, the final numbers for quarter 1 & 2 came in and they were horrible. Not something like 3.5% & 1.5% as previously reported, but something like 1.5% & 0.5%. Furthermore the Q4 decline in 2008 was newly revised down in light of more complete data, from -4% to -9% with similar adjustments to Q1 of 2009. And S&P downgrade of America. America is like, whatever, we just approved a bunch more NRSROs and we're gonna sue your ass for the "sub-prime crisis." Remember that the sub-prime crisis? Ben Stein's simple 200 billion dollar problem. God... those were the days. So much easier back in summer 2007 when I thought everything was going to turn into a combination of the the Great Depression and 1970s stagflation overnight or at least definitely by Christmas. Remember? I had just started dating Sadie Stein and I called you after our first date and told you I wanted to marry her? Its funny, I never told you this cause you'd would have been furious but that summer I stole a copy of Bernanke's textbook on the Great Depression from the Border's Books in between the NYSE and the American Stock Exchange. Sort of a performance-art piece. Actually that piece is getting more poignant all the time. Wow... Oops. Remember the ASE? Such a pretty building. I was there, walking by, freaking out about paper money and gold's potential potential, the day they announced its closing. Heard about it from a trader smoking a cigarette. January 2008. So sad.

We were freaking out back then too... alongside long suffering Mr. Greg Robb: Fed Watchers at a Loss: 01/27/08

And all of this feels really especially bad.. because all of these things taken together are ancillary, just colorful background to the slow motion banking collapse ripping through European Union as we speak.

[Insert current ten year DB chart as well as ten year soc gen, ubs, west lb, bank of america, j.p. morgan, kbe and XLF and the european equivilent, vix, the euribor-ois, dollar basis swaps, euro, gold, gold:spx, & maybe the ted spread though i don't know if there's action there yet.]

[And also my unrequited dream chart of the moment, GLD price v. GLD tonnage.]

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I believe that the amazing recovery of corporate profits has masked a cancerous deterioration of the broader economy over the past 2.5 years. These profits are due to permanent efficiency and productivity gains realized by the corporations. Gains that have elevated unemployment structurally and to lasting effect. Maximum employment, thought in the 1970s to be 3-4% is now very likely to be 6.5 - 7.5% at best over the next decade. This is bad.

Furthermore the return to healthy corporate profits has masked a truly disturbing fissure in wealth distribution, one which has occurred almost silently over the course of the past 2.5 years of economic recovery. There are now only three classes of people: those without retirement savings, those with retirement savings, and the rich. The return to healthy profits has torn a massive rift between the approx. 50% of the population with and the 50% without. This is bad for stability and probably has contributed to the decline in civility amongst our politicians.

You know what this adds up to once the stock market figures this out? Bad. To reduce all of the above to an equation: too little Demand + too much industrial capacity = ^ odds of Depression

And this overcapacity is a worldwide phenomenon right now. Keep in mind that things were not scarce during the Great Depression. There was a ton of nice things, new exciting inventions and technology, at amazingly cheap prices, with eventually --by corporate necessity-- ample financing, just no one had any money to buy or desire to finance anything. Sound familiar? Indeed, perhaps the brilliant promise of globalization has temporarily (i.e. for the past 4 years and for the next 10 or so) overheated. To put it another way, we are a victim of our own success, because we did not recognize and correct the tremendous global imbalances while they were building. I don't know how you feel but I blame, Alan Greenspan, Dick Cheney and the Chinese first and foremost.

The worst part of everything is that the Fed is probably going to announce a certain brilliant technocratic innovation/experiment at their meeting next week, one which they've been hinting at recently. As far as I can tell from watching and reading a lot of CNBC and NY Times, WSJ, etc. the market has no idea this move is coming and is not going to understand it one bit. It's confusing and scary sounding to the lay man, and involves the Fed imposing a negative interest rate on the deposits Banks have placed on reserve with the Fed. Its insanely complicated actually, and indeed, actually takes economics about as far towards metaphysics as... I can't even start to get into this, it a long lecture... but basically, its an attempt to force the weird/ethereal money created during QE1 and 2 into the real economy. I have no idea if it will work, but it fucking brilliant and definitely on the cutting edge of the current research coming out of academia. People are either gonna love it, or hate it. Its definitely the right thing to do, but people might fucking panic. I don't know.

If you agree that the latest developments politically worldwide are scary and that this could go terribly terribly wrong... I have a plan which, had I been more knowledgeable in 2007 before all this started, could have saved us a lot of aggravation over the years. Here is what I would like you to do. Agree to wager up to 5% of your retirement savings on a truly catastrophic decline occurring in the stock market by December 2013. If shit gets really bad, you will probably suffer only half the loss you would otherwise take on your portfolio. If the economy recovers, the most you could lose is that 5%.

You would get Justin to purchase a contract from the stock exchange. This particular type of contract is widely utilized and called a "put option." It states, for instance, that if the S&P is below 900 at any time before December 2013 you are entitled to redeem your contract for the difference in between the two prices. For instance, if the S&P is goes to 700, your contract is worth $200. Now because the market is currently at 1120 and the lowest it hit in 2009 was 666, the price for you to buy that contract is likely to be pretty low, perhaps a few dollars or so. If you take 5% of your portfolio and agree to risk it on this contract, you are likely to insure a good proportion of your savings in the outcome of a true disaster. If the economy just muddles through or recovers and takes off, the maximum you can lose is that 5% you used to buy the contract. Pretty slick. That's why the options market exists. To provide insurance. It started to help farmers manage their commitments. Interesting, no?

What you would be doing is a very routine operation employed by every CFO on the planet, everyday, to manage macro-economic uncertainty. Justin is definitely well versed how to execute this strategy, its a qualification for his license.

If this sounds plausible, send me the go ahead. I'll explain the concept to Mom and if she agrees with our assessment, she can call Justin. I know i've fucked this stuff up in the past, but I've had 3 years to study up since the last time. If I could quantify the risk, I would be less alarmed. But because the risk is entirely political, and because humans have been bad at politics domestically and abroad for their entire history, I am fucking' terrified.

FYI, I know you're performing eyeball surgery in the Namibian bush, but if you have the time, these articles from ftaphaville.ft.com lay out the outline of what the Fed is going to announce at Jackson Hole next week:

The High Powered Money Problem

The Fed's Secret QE3 Equivalent

The Fed's 1.6 Million "Somethings"

Love,

Matthew