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“Anatomy Of A Bubble – How the Federal Reserve and the U.S. Congress Have Created a Debt Crisis of Historic Proportion”

Thursday, March 26, 2015 11:09

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“Anatomy Of A Bubble – How the Federal Reserve and the

U.S. Congress Have Created a Debt Crisis of Historic Proportion”

By Sannleikur Komist

“To understand where the stock market is going we first need to understand from where it has come.

Let’s start by comparing the currently in vogue macro economic philosophy, Keynesianism, to a much older and wiser philosophy known as the Austrian School.

Keynesians believe consumers must perpetually be coaxed into borrowing and spending in order to maintain growth in an economic system, whereas the Austrian School does not believe the economy can be controlled and that any attempts to that end only lead to mal-investment and credit bubbles of potentially catastrophic proportion.

Producing and saving is the only true path to prosperity. Perpetual credit (debt) promotion only leads to bubbles in the economy. With that in mind, I will talk about the nature and character of bubbles, show you some examples of past bubbles and make an argument for why I believe we are in the throes of the greatest credit bubble in modern history.

I will start by reminding you of the words of one of the founders of the Austrian School, Ludwig von Mises: “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as the final and total catastrophe of the currency involved.”

In other words, bubbles occur naturally in the economic business cycle and will naturally collapse themselves if left alone to do so. However, attempts to perpetuate the euphoric boom times through monetary manipulation and credit (debt) expansion, will only create even larger bubbles which will inevitably burst with even larger consequences. Before we can understand this phenomenon we need to know what a bubble actually is, what it looks like and how it works.

Anatomy of a Bubble: Bubbles are a fascinating phenomenon wholly and totally created by human emotions.

While the Keynesians consider bubbles to be the failure of fiscal and monetary policy to maintain control over economic conditions, the Austrian School’s Theory of the Business Trade Cycle considers them as naturally occurring phases of the business cycle designed to weed out mal-investment and greed. While often painful when they occur, bubbles are necessary medicine which may taste bad at the time but ultimately cures the patient of the afflicting malady.

Refusal to take the medicine only prolongs the illness and makes it even worse. In the worst case, catastrophe, the patient can die.

In the generic analysis above you can see what a bubble looks like. As it begins to form in the Stealth phase, no one recognizes what is happening except the smart money. As the bubble progresses into the Awareness phase, institutions (hedge and mutual funds, etc.) begin to become aware that something is starting to take place and they jump on the bandwagon.

In the Mania phase, the media and the public finally begin to realize what is happening and buy into the bubble with abandon. But it is too late. It is the mania phase that Alan Greenspan described in 1997 as “irrational exuberance”.

When the bubble begins the Blows off Phase, no one wants to believe the good times are over. You can see that the first move downward is met with denial, ‘this can’t be over!” When the market bounces back up there is always a false sense that normalcy is returning.

Eventually, however, reality sets in. The final collapse into fear (anger), capitulation (bargaining) and despair (depression) occurs quickly but painfully. Then the cycle begins all over again as everyone finally realizes (acceptance) it’s time to move on and begin the difficult task of dealing with the aftermath.

I want you to notice several characteristics of a bubble because they are important for later recognizing where we are currently in our economic bubble here in the U.S. The first thing I want you to notice is the overall shape of a bubble.

It begins almost flat, rising slowly for as much as two thirds of the length of the cycle pretty much paralleling the mean line until it begins to capture the attention of an exuberant media and public. But during the manic phase the rise becomes parabolic, rocketing upward in the final stage, almost straight up at the peak.

This parabolic curve shape is typical of every bubble.

The manic phase of a bubble does not form slowly. It always rockets upward fueled by greed and delusion as depicted above.

As the bubble rolls over into collapse, no one believes (or wants to believe) the rocket can actually be heading back down. Indeed, the first bounce back upward is broadly met with the faith and confidence that things are returning to normal and the uplifting ride is about to continue.

Unfortunately, this “bear market rally” only serves to suck more naïve and gullible money into the bubble. While those ignorant of the character of bubbles refuse to get out of the market and even buy back into it during this phase, the smart money is selling into the rally as fast as they possibly can, unloading their equity burdens at a frenetic pace.

When the final leg of the collapse begins its downward plunge, only the public and poorly managed funds will remain in the markets. None of them will want to buy anything. All of them will be frantically trying to sell their rapidly collapsing assets for whatever they can get. “Just get me out” is the mantra during the capitulation stage of a final collapse.

But there will be no buyers until the bottom is reached and the smart money returns to pick over the dead and dying carcasses that remain, purchasing them at bargain basement prices from the depressed and crestfallen sellers who have no idea things are on the verge of turning around for the better – just as they had no idea the market was beginning to collapse when it rolled over at the top.

Notice the gray dashed mean line traveling gradually upward from left to right. This line is important because all bubbles eventually come back to it. More over, in the final collapse of a bubble, the mean line is generally overshot before conditions eventually revert to it.

The worst, most depressing stage of the final collapse happens here. For those that understand bubble theory, however, it is also during this time that fortunes can be made for those savvy enough to have protected their wealth and alert enough to recognize that the worst of the collapse is all but over.

A Quick Look at Some Famous Historical Bubbles: Two of the most famous bubbles happened in the 17th and 18th centuries, the Gouda Tulip Bulb bubble and the South Sea Company bubble. You can Google them if you are interested in more detail.

Of the tulip bubble, Scottish journalist Charles Mackay wrote in his 1847 book “Extraordinary Popular Delusions and the Madness of Crowds”, “People were purchasing bulbs at higher and higher prices, intending to re-sell them for a profit.

However, such a scheme could not last unless someone was ultimately willing to pay such high prices and take possession of the bulbs.

In February 1637, tulip traders could no longer find new buyers willing to pay increasingly inflated prices for their bulbs. As this realization set in, the demand for tulips collapsed, and prices plummeted—the speculative bubble burst.”

The South Sea Company was a British joint-stock company that traded in South America during the 18th century. The company was granted a monopoly to trade in Spain’s South American colonies as part of a treaty during the War of Spanish Succession.

In exchange for the monopoly, the South Sea Company agreed to assume all of the national debt of England, a considerable debt which the nation had incurred during the war with Spain. Speculation in the company’s stock led to the greatest economic bubble of that era now known as the South Sea Bubble.

In 1720 the bubble burst causing devastating financial losses for a great many investors all over Europe, including names like Sir Isaac Newton.

These next two examples are the 1929 Dow Jones Industrial Average stock market crash which precipitated the Great Depression and the decade long Numismatic News Coin Index fund of the late 80s and early 90s that was eventually discontinued when it failed to recover from its speculative collapse.

And finally, a more recent and familiar bubble in which most of us participated, the epic failure of the government sponsored enterprise, Fannie Mae, when the housing bubble burst in 2006.

Fannie Mae is the Federal National Mortgage Association. It was formed after the Great Depression as part of the New Deal. Its expressed purpose was to expand the secondary mortgage market creating more lenders and increasing competition in the mortgage market.

It’s real purpose was to free up money for the major lenders by allowing them to sell their riskier mortgages to the government transferring the risk of failure to the U. S. taxpayer. As this chart shows, the latter is exactly what happened. Fannie Mae will eventually be dismantled and abandoned and tax payers will pick up the tab.

The thing to note about all of the above charts is the manic and blow off phases of the bubbles. They all conform to the bubble characteristics that I described above. Of particular note, the (irrational) euphoric rise always has a parabolic shape and the bottom of the bubble always ends below the mean and below the start of the bubble.

Now that you have a pretty good idea what a bubble looks like, what do you see when you look at this chart?

Click image for larger size.

The magnitude of this credit (debt) bubble is staggering, over forty-nine (49) times larger than the 1929 stock market crash. Look at the 1929 crash way off to the left there. It’s almost minuscule. Some things to note about the chart…

I have included the Kubler-Ross stages of grief. We are still in denial in terms of social mood. Everyone knows something just isn’t right with the economy, but no one is yet willing to admit we are in the clutches of catastrophe.

But as the markets begin to collapse, anger will set in and the public will go looking for heads to roll. Someone will be held accountable. Civil unrest of major proportion will accompany the collapse of this bubble, the largest in modern history, perhaps the largest of all time.

The red line is my own speculation of time and price based on the characteristics of bubbles as well as other indicators. Bubbles burst swiftly and violently and most often painfully. There are no soft landings for bubbles this big. Interestingly, global wars break out after bubbles bottom. The beginning of the next decade will probably be a rocky and tumultuous one. Perhaps I’ll write more about that in a future article.

One last chart. In Part 3 of my Inflation vs. Deflation series, I talked about the sub-prime housing bubble and showed this chart of the Case/Shiller Home Prices Index. Without an understanding of bubble characteristics, it may not have made much sense why I was projecting a further decline in the housing market, a decline rivaling that of the Great Depression. Perhaps it makes more sense now.

For those who have studied historical bubbles it is impossible to anticipate a positive outcome from the massive credit bubble enveloping us today.

The major investment institutions, like Goldman Sachs and JP Morgan, Citi Bank and Bank of America, whose intentional leveraging of the markets helped create and perpetuate this bubble, certainly understand the above charts.

The complicit congressional members who are profiting from the bubble, like the Chris Dodds and Barney Franks who have a history of legislation that encouraged and supported the bubble, certainly understand it.

The owners of the Federal Reserve and its governing members whose actions have perpetuated and continue to exacerbate the bubble as they profit from it, certainly understand it. And foreign beneficiaries like the European Central Bank, the World bank and the International Monetary Fund certainly understand it.

The only people who don’t understand the charts above are the lay public who are being criminally deceived into believing that the system is salvageable and are continuously told that there are financial institutions that must be saved at all cost because they are “too big to fail”. Shortly, the public will again be asked to bail out the failing banking and corporate institutions, to sacrifice their Social Security, Medicare and Medicaid benefits and to pay more in taxes. And, if the Cyprus model is any indication of the future, their personal savings accounts will be robbed “for the good of the nation…” until they have nothing left to contribute.

Like any game of hot potato or musical chairs, those left holding the potatoes or with no place to sit will be ejected from the game. It has never been any different.

The rich have always taken advantage of the poor. But the magnitude of this bubble is so much larger than any other in modern history.

You can see from the chart above how the current bubble dwarfs the crash that preceded the Great Depression of the 1930s. And you will notice that we are only going back to where we were in the mid-70s or early 80s in terms of market valuations, but the meteoric rise since then has been so steep and the wealth effect so great, that the fall is going to devastate huge segments of the global population.

It will be decades before the residual effects of this collapse are eventually overcome.

The world is about to become a very different place than it is today.”

- http://www.globaldeflationnews.com/

Source: http://coyoteprime-runningcauseicantfly.blogspot.com/2015/03/anatomy-of-bubble-how-federal-reserve.html

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