A Tale of Two Credit Bubbles

By Neland Nobel

Rarely does history repeat, but as Mark Twain once quipped, it often rhymes.

The financial crisis of 2008 and 2009 was a rolling crisis, with some of the features of that crisis listed below.  A number of things clustered late summer 2008 that culminated in the housing crisis, the collapse of Lehman Brothers and the shot gun wedding of Bear Sterns.

It was followed by bailouts of money funds, the auto industry, nationalization of mortgage firms Fannie and Freddie, and the FED purchase of insurance giant AIG. Then there was the $700 billion dollar bailout, central bank coordination, zero interest rates, and TARP.

During the liquidity panic gold fell, reaching a low in late October 2008 and then subsequently tripling in price.  Stocks bottomed about 4 months after gold, in 2009.

Conditions are quite different today, but markets are concerned that the Covid-19 virus could spread, causing the economy to either slow significantly or actually tip into recession.  So, while there are significant differences today to 2008, what you have in both cases is a likely decelerating economy running into a debt bubble.  The bubbles may not be so much in real estate finance but have their counterpart in bloated emerging market debt, corporate debt, and financial leverage causing a significantly over valued stock market.

But there really are two issues:  will the virus spread, but more importantly, will people panic whether it spreads or not and thereby inflicting damage on the economy just the same?  Cowboys can be killed by stampeding cattle, whether the herd panics either for good or imagined reasons.

The economy and the stock market have both been in a bubble phase for quite a while. The economy has been held aloft, even when growing, by extraordinary loose monetary policy, active fiscal stimulus, and plunging interest rates.  We have government debts out of control, huge unfunded liabilities, and many state and local government pension programs underfunded. The economy can scarcely afford a significant slow down in the economy or the ugly under belly of credit excess will surface.

A credit crisis could surface first in the debt of marginal oil producers being crushed by the collapsing prices of crude, or by problems in China, which has been a debt bomb with a hissing fuse for some time.  A serious slump in China will spread to all the commodity producing countries that sell to China and endanger their tenuous debt.

One stark difference between then and now, is that the FED has largely fired all of its ammunition to maintain the current prosperity, saving little to fight off the invading deflationary hordes.

That means monetary policy will be limited in what it can do and politicians will reach for fiscal stimulus.  In plain language, that means big spending programs.  Jason Furman, former Chairman of the Council of Economic Advisers under Obama made precisely this argument in a recent editorial in the Wall Street Journal. https://www.wsj.com/articles/the-case-for-a-big-coronavirus-stimulus-11583448500

Republicans, seeking to hold on to their power, are unlikely to resist these calls for more spending and higher deficits.  They don’t want another Herbert Hoover.  And besides, even when they held both the White House and Congress, Republicans could not muster the nerve to curtail spending or reform entitlements.

Adding to the complications, is the fact that demographics will be driving spending higher as the biggest bulge in the Baby Boom is in the process of retirement. Recession plus demographics, added to debt and deficits that have been growing rapidly even without a crisis, will equal record fiscal deficits.  Look for mind boggling deficit numbers over the next few years.

What is interesting about the chart shown, is that the bulk of the gold price advance did not occur during the crisis itself.  It occurred as a result of all the steps taken by government to deal with the crisis and the residual affects lasted for about four years after the bottom of the stock market.

If history is any guide, THE GOLD PRICE ADVANCE IS JUST GETTING STARTED. This crisis will likely also have the same kind of rolling feature as government plays whack-a-mole dealing with emerging debt problems.

We do not know exactly how it will unfold.  What we do know is that printing money (credit creation) is the one thing governments know how to do and big deficits are about the only thing our political parties can agree on.

Chart courtesy of Stockcharts.com. Derived from sources believed reliable but investment results cannot be guaranteed.

–Neland D. Nobel is a retired money manager and Certified Financial Planner with 45 years’ experience in financial markets. With a Master’s Degree in Economic History he has been a long-time observer of gold and financial markets from both the practical and theoretical perspective.