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Whirlpools of Wealth Destruction

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Panic gripped the world's financial markets last week. Oil fell to $26 per barrel, 10-year US government bond yields dropped to 1.52%, the MSCI World Equity Index fell into a bear market down 20% from its peak and bank shares in Europe and the US crashed as investors began to question the banking industry's solvency in a negative interest rate world.

Just days before the latest plunge in asset prices began, Citi's strategy team published a report stating the global economy was trapped in a "Death Spiral" caused by the strength of the US Dollar. They described this Strong Dollar Death Spiral as follows: Weak global growth spurs demand for the Dollar. A strong Dollar pushes down commodity prices. Low commodity prices hurt the Emerging Market economies. Weak Emerging Markets reduce global growth. Weak global growth spurs demand for the Dollar; and so on, in a downward reinforcing spiral.

Citi's analysis is correct, but incomplete. It strikes me that there is not just a single Death Spiral, but, instead, a number of overlapping and mutually reinforcing Death Spirals now dragging the global economy down toward depression. Here, I will describe three others:

The China Hard Landing Death Spiral.

China's growth slows. So, China imports less. Therefore, commodity prices fall. Lower commodity prices hurt the Emerging Market economies, so they import less. Less demand from the Emerging Markets causes China to export less. So China's growth slows further. In response, China devalues its currency. That causes commodity prices to fall further; and the downward spiral continues.

The Deflating Asset Price Bubble Death Spiral.

When Quantitative Easing ended, US stock prices stopped inflating and then began to deflate (since they can't be sustained at the current inflated levels without more QE). Falling stock prices cause US Wealth to contract. So consumption falls, the US economy weakens and the Unites States imports less. Consequently, commodity prices fall. As a result, the rest of the world exports less and falls into recession. Profits fall and debt defaults increase in the Emerging Markets and among corporations in commodity-related businesses (such as metals and mining, oil and gas and commodities trading). Stocks fall further; and the cycle spirals down further.

The Credit Death Spiral.

US credit grows by less than 2% (adjusted for inflation), causing the United States economy to move back toward recession. The US imports less, so commodity prices fall. The rest of the world exports less and, so, goes into recession. Debt defaults rise in the United States and around the world, especially in the commodity-producing Emerging Markets. Banks suffer losses, so they extend less credit. Consequently, the US economy falls deeper into recession. And, around and around, downward the spiral goes.

As you can see, our global economic raft is being sucked down in a whirlpool of overlapping and mutually reinforcing Death Spirals. All four share a common cause: Aggregate Demand is inadequate to absorb existing Supply. That means the global economy and asset prices are likely to keep sinking until a new source of aggregate demand is found.

As I see it, there are only three ways out of this Death Spiral Crisis:

  1. Death (followed by Hell)
  2. QE 4 on a very large scale, or
  3. Fiscal stimulus on a very large scale.

I suspect that, eventually, large-scale fiscal stimulus will be used to revive global economic growth, but I'm not certain how the money will be spent - or how soon it will be spent. How soon the stimulus occurs will determine how long the global economic crisis continues to intensify. How the stimulus money is spent will determine whether the crisis is permanently resolved or only temporarily ameliorated.

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Original publish date: February 15, 2016

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