The Imminent Collapse of the Financial System

I’ve been doing a lot of reading about the state of the current financial system in the world today. And I’m getting this sinking feeling about the whole thing. I’m beginning to develop the view that the current system cannot go on for much longer. It is so tipsy that it is not a matter of ‘if’ it will collapse anymore. Instead, it is just a matter of ‘when’.

It would take a book by itself (and perhaps even more than one!) to explain the points in complete details. But I’ve decided to summarize the points for your benefits. I must forewarn you that this article is a bit longer and also more complex than the usual. It needs to be – we’re talking about the state of the current financial system here!

The imminent collapse of the U.S. Dollar

The Federal Reserve is printing money – over $1 trillion in 2009 alone. This money – conjured out of thin air – is to battle the rising deficit, credit crunch, subprime crisis, bailing out the ‘too-big-to-fail’ companies and other dragons.

So the plan appears to be, to allow the dollar to drift down (and if needs to, crash down) so that American goods remain cheap so that other countries can afford to buy them, and therefore send enough of their money to the U.S. to help address all these mega problems.

Throughout the last century, all the countries that were spending beyond its means had to pay the price when their currencies were devalued. Argentina, Mexico, Thailand and even big economies such as Germany, Britain and Japan – all paid the price. All except one – the U.S.

For a long time (too long in my opinion), other countries have been propping up the U.S. by supporting the dollar. Many central bankers are scared of the results should the dollar be allowed to find its own way. Chaos, disruptions to the status quo and perhaps the collapse of civilization as we know it. So, even though the U.S. is spending beyond its means, and with no way out in the near future, it is still moving along because the rest of the world is covering up for them. But the question remains – for how much longer?

The China connection

A lot will depend on what China – the largest foreign creditor to the U.S. – decides to do. Its international reserves have been shooting upwards since the mid-1990s – from $100 billion in 1995 to $2.3 trillion in 2009. Half of its GDP – $1.6 trillion – is held in U.S. dollars in some form – U.S. Treasury bonds, mortgages, corporate debts, etc., etc. And that figure will only grow in the coming days as it continues to record trade surpluses against the U.S. even on a monthly basis.

Currently, China is telling the rest of the world that any diversification of their reserves away from the dollar will be made gradually. But as the debt grows larger and larger, the day will come when even the Chinese government will be asking themselves: “How long can we continue to subsidize the high spending white men? How long must we continue to let them wear their big hats while we take care of their cattle? How much longer?”

Lack of viable investment alternatives

The same money that used to go to stocks may not go there for much longer. The stock market faces massive obstacles because (1) the consumer-driven economy in the U.S. has weakened; (2) the probable withdrawal of money by the retiring baby boomers; (3) it is unlikely that companies will be able to maintain the current high earnings into the future. And as the days for large profits for the companies may be over, the prospect for higher stocks prices and generous dividends for the investor may also be over.

Ditto for bonds (yields are at multi-decade lows) and even real estate. The major and prolonged real estate boom (lasting over 20 years) – financed by easy credit – was good while it lasted. But this makes the chances of it going higher very unlikely.

So in short, the prospects for these investments are getting dimmer as their risks gets higher, which makes them unattractive for investors.

Their money has to go somewhere. And that somewhere is gold.

Worldwide physical supply and demand for gold

The demand for newly mined gold has consistently exceeded the supply in the last few years. And by the looks of things, this situation can only continue, and will probably get bigger, in the coming days.

Firstly, the demand has grown because of the introduction of new investment vehicles such as ETFs and increase in demand from Asia, particularly from India and China.

Next, the major central bankers are not selling as much gold as they used to. In fact, a few central bankers such as India, China and Russia actually bought gold recently.

Yet, despite all these activities, the supply has pretty much remained static. Firstly, the total supply of newly mined gold has been falling continuously since 2001. In fact, the production in South Africa, which used to be the world’s largest producer of gold, has been falling for over three decades! Even the rising supply from China and Latin America has not been able to make up for the shortfall.

Distrust in the financial system

If you believe that everything is rosy with the current banking system, that the monetary authorities are doing a fine job and that derivatives are the best things since the invention of money, then you are wasting your time with gold. Since the financial system is fine, it means that prices should be rising while gold, being the anti-matter as far as the system is concerned, should be going nowhere.

However, that consensus appears to be wearing thin even as I write these words. While we still do believe in the current system, a lot of people – including economists, central bankers and even governments – are beginning to have second thoughts. They have seen the chaos: the subprime crisis, the real estate bubble, the fall of financial giants and the collapse of ‘too-big-to-fail companies’. All a result of the excesses in the current financial system.

The worse is may yet to come. A few financial instruments in the market today did not even exist 30 years ago. One example is derivatives: financial instruments that are so complex that you cannot talk about them and not use the word ‘complex’ in the same sentence! Few people understand them and even fewer know how to measure their risks. So they are potential time bombs. There has been only one live test so far, the fall of Long Term Capital Management (LTCM) in 1998, and that nearly floored the whole banking system! And in case you didn’t know, LTCM was founded and ran by Nobel Prize winning economists! What is really scary about it is that the value of the derivatives contracts when this happened was less than $70 trillion. The market have exploded since then so the same contracts were valued at over $415 trillion in 2008, more than six times larger than the global GDP! So any sudden jerks and certainly failures in that market will bring much pain – perhaps even a global collapse of the financial system as we know it.

The U.S. government is an aging star

For the last 100 years, there is a phenomena that everybody knows but do not want to admit. And this is that phenomena: what will happen is what the U.S. government wants to happen. And generally speaking, what the U.S. government wants, the U.S. government gets. So if they want to price of gold to rise, the price of gold will rise. And vice versa.

As an example here, the price of gold remained at $35 per ounce from 1935 to 1971 – a period of 36 years that included World War II, the Korean War, the Vietnam War and numerous other conflicts. Why? Because the U.S. government needed to price to stay at that level to save their crumbling economy during the Great Depression and later on to allow the U.S. dollar to usurp the coveted role of being the world’s reserve currency from gold. The rest of the world did not like it but that was what happened.

However, that may not be the case for much longer. The U.S. government is like an aging star – everyone still respects her because of what she has done and because she still wields a little bit of power. But everyone also knows that she is getting old. And the power is slowly slipping away as new stars rises.

Further, the situation may be even out of their control. Their debt is monstrous, their trade deficit is growing every day, their population is aging, their financial system is on a ledge and there is growing distrust from the rest of the world.

Author: Azizi Ali