The Day the Markets Crashed

(To fully understand this story, refer to 2012:The Other Prediction , where I explained why the US dollar would crash on 21 December 2012)

It was the morning of Friday, 21 December 2012, and the bell at the New York Stock Exchange was about to ring. Gloom and a sense of foreboding hung over the trading floor. Outside, there were hundreds of ‘Occupy Wall Street’ protesters rallying against the abuses of the 1%.

It was not only ‘triple witching’ day (the day when all kinds of option contracts expire), but also only three full days before the trading year ends; and many traders were still holding more US stocks than they wanted. The Dow Jones stocks that they still held no longer seem to be safe anymore, and they had to have ‘safe’ stocks in their portfolio by year-end. Thus, many traders were set to sell off the rest of their Dow Jones stock holdings that day.

2012 had been a disastrous year. Till February, the Dow Jones was above 12000 points, but by March the tide had turned and prices drifted downward the rest of the year. Nothing could cheer people enough to take prices higher. The reelection of Obama and the Democratic sweep of Congress had not helped. On the contrary, Wall Street was depressed after the elections. There are now bills pending in Congress that will force an increase of taxes on Chinese goods come the New Year. And this will surely cause a Chinese reaction and a trade war at the worst possible time. And to make things worse, oil prices had drifted upwards all year – Brent was now at $150/barrel (and WTI at $130).

Today, the Dow Jones was just above 10,000 points. For the first time in history, foreign traders have dumped their US stocks in their year-end ‘window dressing’ operations. Apparently, they no longer considered Dow Jones stocks as ‘good’ stocks to hold.

After the Bell
Right after the opening bell, share prices plummeted. Within the first hour, stock trading had to stop for 15 minutes because the Dow fell more than 10% below the average of the previous quarter (the trading curb, at approximately a 1000 points drop), triggering the automatic stop.  After trading resumed, the Dow reached 9000 points, and a whole series of stop-loss orders to sell stocks hit the exchange.  In contrast to previous crashes, investors were no longer rushing into Treasuries. They were in fact dumping US Treasuries almost as fast as they were dumping stocks. This meant that the effective interest rates on US debt rose from 3% to 5% in a couple of hours.

The US dollar suffered accordingly. It was at $1.60: 1 Euro by 1 pm. At 2 pm, there was concerted action by a number of Central Banks (most of them were limited in their response because their home markets were already closed by this time), which buoyed the dollar to $1.55: 1 Euro. It was the middle of the night in Asia, and the Fed was mainly alone in intervening to save the dollar.

The market dipped even lower by the close of trading, as a whole swath of put options were exercised (which involved the sale of a lot of stocks and currency); the Dow closed at ‘only’ 8500 points (it had gone below 8000 points during the day), and with the exchange rate at $1.60: 1 Euro. It was terrible, but everyone was sure that concerted Central Bank action scheduled for Monday will calm the markets.

It was not to be. Middle Eastern markets were opened on the 22nd and 23rd (Saturday and Sunday), and stocks and the US dollar continued their slide, reaching $1.70:1 Euro at the end of Sunday trading. In the morning of Monday, the Bank of Japan  intervened heavily to support the dollar; but by midday, it stopped. At the same time, the Peoples Bank of China started dumping dollars. This was followed by Russia, and then a host of Third World countries.

The ECB, the Bank of England, the US Fed and the Central Banks of Canada and Switzerland furiously bought dollars all day. Together they bought more than a trillion dollars on that day alone. It did not help. Middle Eastern, other Third World sovereign funds and many Third World Central Banks dumped their US$ bonds and stocks all day. The Euro remained at $1.70:1 Euro all day.

It was a gloomy Christmas in most US households, who saw their 401k balances evaporating, and who realized that the prices of goods will go up a lot in January.  On the 26th, ordinary Americans dumped their holdings in Dow Jones stocks, and bought Japanese and European mutual funds. Oil (WTI crude) hit $200/barrel, and gasoline rose to $6/gallon.  The US government announced that it was monitoring to see that no gas station will sell gasoline above that level. The government warned against price gouging by retailers, and issued an order that prices were to remain at the present levels for the meantime, unless explicit permission was given to raise an item. But this set off a stampede of people buying what they can while the prices were relatively cheap. By the end of the year, grocery stores reported that their stocks of food had been all sold out; panicky people were stocking up.

By the first trading days of the new year, the US dollar had gone to $1.90: 1 Euro, and it was steadily deteriorating. Interest rates on US treasuries hit 7%, and kept climbing. By 15 January, the US government formally called on the IMF for help. The US government could no longer finance its debt, with the interest rate on Treasuries at 9% and climbing. The IMF put together a rescue package of about 1 trillion SDRs. But this would only be given if the US reduces its deficit from $1.3 trillion yearly to only $100 billion in 2012. Obama then forwarded a budget proposal which specified: a 50% cut of defense spending, a tax on luxury houses, cars and yachts, a national Value Added Tax of 15% (and abolition of state sales taxes), etc.

The IMF declared that it was making the SDR the new international reserve currency, and that it would exchange dollars held by Central Banks at $2: 1 SDR. This provided a floor for the value of the US dollar, and stabilized the currency markets. For cash, people used the Euro or the Yen.  After the IMF action, the US dollar was removed as the reference currency for oil (which changed from dollars/barrel to Euros/hectoliter), gold (to Euros/gram) and other commodities.

(this is a depressing story, but it will actually end up well. In another blog, Two Years After the Fall    I show what would happen two years after the crash.)

Euro Zone Austerity is Correct

US and UK economists are quite vehement in opposing the Eurozone’s stress on austerity. They say that this would jeopardize economic growth, which is important for increasing employment and maintaining welfare. But they are just expressing conclusions which stem from the dominant Keynesian view of economics. We will see that this view needs to be amended or replaced.

Addicted to Growth
American economists are addicted to growth. Keynesian economics teaches that governments should use fiscal and monetary policy to maintain growth at all times. Now, at its extreme, the US Fed is the one mainly holding up the US economy by using monetary policy alone. This obsession with growth has led to the Fed and the Bank of England (BoE) to print money (aka ‘quantitative easing’) in order to stimulate growth. People in these two countries have been led to believe that this is a good thing. That the economy will be alright, if only people continued shopping.

Non-economists may find such a policy of ‘printing money and encouraging shopping’ problematic; but then they would be faced by Keynesian economists assuring them that it is right. What the Keynesians fail to realize is that the world  is in the middle of an international tug-of-war for resources. Printing money and shopping are, in effect, asserting the US’ position as ‘consumer of last resort’ at a time when other countries would rather use resources elsewhere. And that is the weakness of the policy: third world booming economies are  increasingly reluctant to prop up the US economy if this means that they would be deprived of resources they need for their own development. The US economy, instead of benefiting the world with its consumption, is more becoming an impediment to growth of other countries.

In this light, the Euro countries’ call for governments to live within their means is a good policy. This means, concretely, that governments should no longer stimulate their economies through excessive government spending (fiscal policy). And combined with the EU’s thrust to lessen its carbon dioxide emissions; it means that Europe’s resource footprint will grow slowly, if at all. It will also mean that Europe will be producing goods and services in an increasingly efficient and competitive manner.

Building Efficient Economies
Government austerity forces economies to be more efficient, and to utilize all their resources properly. Austerity could mean cutting hidden subsidies on fossil fuel, taxes on waste, more efficient production or promoting recycling. While a natural problem with austerity programs is that they may also reduce vital services like the social safety net or public transportation, this will be corrected in the course of the political process as other parties would restore these.

Efficiency includes the concept of a good social safety net, because when workers who are displaced by rapid market changes are well taken cared of, they would more readily accept those changes. Societies should avoid, most of all, the destruction of human capital in the form of forced idleness and de-skilling.

There are also specific policies which skew a particular country’s utilization of resources. Among these are: differences in retirement age (e.g. Greece used to allow retirement at 52 years); low corporate tax (Ireland); or, tax-exemption for mortgage interest payments (Netherlands). Different rules for the Value Added Tax, for social security contributions and benefits; rules for buying and building houses; and, specific taxes on oil, ‘sin’ products etc distort economic and fiscal balances between countries.

Bank of Last Resort?
The idea that the ECB should step in and buy hoards of Italian bonds is wrong. The problem of Italy is that the ‘market’ thinks that its bonds are risky, and thus asks for a higher interest rates for them. While this perception is particularly problematic now, but if the problem does not get out of hand in the medium term, it will eventually solve itself. Investors would eventually settle on buying Italian bonds that have only slightly higher interest rates than German Bunds.

Higher interest rates are important for keeping governments more disciplined when it comes to making their budgets. Making interest rates uniform now (by instituting ‘Eurobonds’ for example) would effectively reward those countries who are misbehaving.

Time is on the side of the EU and the Euro. The Eurozone has a trade and payments surplus. This is quite different from the US, which has budget, trade and payments deficits.  Eventually bond buyers will need to park their money somewhere, and where better than the EFSF and the ESM (which are less than 1 trillion Euros in total, and are as solid as German Bunds)? It will eventually turn out not to be a good idea to park their billions of (petro)dollars in US Treasuries – whose supply increases by at least $1.6 trillion/year.

No Theory Yet
This is not to say that the Eurozone leaders are following a coherent plan, based on a well thought-out theory. Euro leaders are mostly improvising on the run, after being pushed by market conditions to take certain steps; while at the same time also hindered by those same forces from solving the problems quickly.

Economists heckle the policy of austerity because of the Keynesian prediction of an economic downturn if governments cut spending. But austerity is a move that is forced on countries by the market – the market is in effect demanding lower budget deficits, and will punish any government that now does deficit spending. But saying that governments are forced to undertake austerity does not mean that austerity is bad either. Governments are now implementing austerity , which it never would have done without market pressures.

The EU’s decreasing carbon footprint is an independent development, but one which fits neatly into the new EU economic ‘model’. So are the social welfare systems in EU countries, which are only marginally affected by the crisis. Now, the EU is confronted with the need for austerity, together with lessening its carbon footprint and maintaining its social welfare systems.

The present high pressure atmosphere within the Euro zone is clearing out many economic cobwebs. Technocratic governments in Italy and Greece will now work within the parameters, and try to both economize and grow. This means among others: that corruption be lessened, tax compliance improved, and protected professions opened to competition.

A new economic theory will eventually emerge that will affirm the correctness of austerity and reducing the resource footprint under conditions of resource scarcity.