How to prepare for the coming crisis

Part I: Something horrible this way comes

My apologies for a very long delay between posts. Me and our firm have lived through quite drastic changes during the spring, which are now slowly settling into place. As you noticed from my previous post, I will renew this newsletter to serve both forecasting and preparation, and I will start it with a series posts detailing how to prepare for the coming crisis.

Many are currently debating, how deep/shallow the recession will be and when the Fed will ‘pivot’. I find such discussions to be rather heavily detached from reality.

The world economy is quite simply too fragile and too indebted to be able to sustain the combination of rapid inflation, rising interest rates, withdrawing (artificial) central bank liquidity, and the possibly industry-crippling shortages. I will return to specifics of these in my posts later, and concentrate now on the expectionality of the approaching crisis.

Into a ‘perfect storm’

We are now facing a possibility of a multitude of crises hitting the world economy in a consecutive or even overlapping order. The “mother of all economic crises” is likely to include:

1. Inflation crisis (already here).

2. A financial crash.

3. Global banking crisis.

4. Sovereign debt crisis.

5. Corporate debt crisis.

6. Currency crisis.

Needless to say, that we have never, in all of known history, experienced such a ‘perfect storm’. I will briefly go through all the crises.

Inflation crisis

Inflation crises can have two meanings. It can either be used to describe a period of rapid and/or unsustainably rapid inflation, i.e., hyperinflation.

In each case, periods of very rapid increases in consumer prices usually result from the monetization of government deficits. During monetizations, fiscal agencies determine the real government budget deficit that the central bank must finance. Central banks cover this with seigniorage revenue by expanding the monetary base, and the rate of money growth determines in turn the equilibrium rate of inflation. This is especially true for periods of hyperinflation, when the monthly inflation rate exceeds 50 percent.

Currently, two of the main drivers of fast or even runaway inflation (hyperinflation) have emerged:

1. Excessive growth of money in circulation.

2. The possibility of a broad reduction in productive capacity

The balance sheets of central banks have swollen massively especially over the past year due to the QE -programs (see my previous post).

Production capacities may be hampered by forces that push companies into bankruptcy. One of the most historically common and pernicious is war, such as the Great War which contributed to the hyperinflation in the Weimar Republic between 1919-1924. Moreover, production capacities can also collapse due to the large-scale failure of zombified corporations. Thus, counterintuitively, rising interest rates, which are likely to push zombified corporations into bankruptcy leading to drop in production possibilities, may actually push us into a hyperinflation, although this scenario is a bit “theoretical”, at least for now.

Currency crisis

Generally, a currency crisis is an attack on the exchange value of the currency in the markets. If the exchange rate is fixed or pegged, such an attack will test the monetary authorities, that is, the central bank's commitment to the peg.

Market participants expect that the policy of monetary authorities will be inconsistent with the peg, and they will try to force authorities to abandon the peg thereby validating their expectations. What matters for speculators are the internal economic conditions relative to the external conditions set for the currency.

The foreign exchange rate of a currency can crash even if the rate is not pegged. During a currency crisis, the external value of a domestic currency decreases, which leads to an increase in the value of foreign debt, leading possibly to a corporate and/or a sovereign debt crisis.

The breakup of the Eurozone is probably the biggest currency crisis ‘tail-risk’, at the moment. A breakup of the common currency would mean that all sovereign debt would be subject to possible redenomination in new national currencies under the Lex Monetae, or the ‘Law of Money’. This specifies that a sovereign state has the right to regulate its currency under international law. Therefore, the creation and substitution of the national unit of payment is entitled to recognition by other countries including their courts and official bodies. This means that sovereign states can dictate the currency they use in debt repayments.

However, some national debt currently carries the Collective Action Clause, CAC, which means that they must remain in the euro.[1] If the euro is dismantled in totality, the redenomination will be decided by negotiations between the government and investors. In this case, it is impossible to predict in which currency principal and interest payments on the bond will eventually be made.

Sovereign debt crisis

Sovereign debt or fiscal crises consist of periods of severe deficits in public financing and/or periods during which the government fails to meet domestic or foreign obligations.

Gerling et al. (2017) identify a fiscal crisis by four criteria: credit event (foreign default), implicit domestic default (monetization, domestic arrears), loss of market access and exceptional official financing (IMF). In a credit event, the government of a country announces that it will not pay interest and/or the principal of some or all of its debt (bonds) that it owes to foreign creditors. This means that the government defaults on its foreign-held debt. This usually leads to loss of access to international money markets, which may also happen if the interest rates on sovereign debt rise so high that they become impossible for the government to service.

The concept of monetization was explained above. The government can also default on debt held by its citizens and domestic institutions. In this case, the government defaults on domestically-held debt. This may have serious repercussions for the banking sector of a country, which usually holds domestic sovereign bonds as collateral possibly leading to a banking crisis (see more, e.g., Malinen and Ropponen 2022; free older version).

IMF programs were originally constructed to help countries during balance-of-payment crises. In time, and especially after the fall of the Soviet Union, the IMF was forced to change its role quite drastically and diversify its portfolio of lending. Countries apply to IMF programs mostly because they provide emergency funding, technical and financial assistance and enforce unpopular but often necessary economic reforms during crises.

The key drawback to an IMF program are the conditionalities attached to them. These include removal of price controls from state economic enterprises (SEEs) and removal of subsidies. During the onset of the program, there are almost always agreements regarding ceilings for fiscal deficits and domestic credit. These lead to austerity. In addition, public and private debts are often rescheduled, and the nominal exchange rate regime is changed (see more, e.g., Malinen and Ropponen 2022; free older version).

Corporate debt crisis

A corporate debt crisis does not have a clear definition in the academic literature, but it can be considered as a situation where a large group of corporations are unable to make ends meet, implying that they will default on their debts. This will usually translate into a banking crisis, as banks tend to hold large quantities of loans to corporations.

And should corporations default on their debt, banks will suffer crippling losses. This is a major risk now, as the global economy is likely to be infested by hordes of ‘zombified’ corporations surviving on cheap (and plentifully available) funding alone, which is now disappearing. A corporate debt crisis usually turns into a fiscal and unemployment crisis as the ability of corporations to pay taxes and salaries declines.

The coexistence of crises

Economic crises have a tendency to coexist. For example, inflation crises sometimes cause a recession leading the economy to a stagflation, where prices rise rapidly but economic activity declines. Higher input costs and declining demand will lead to corporate losses, which will in turn lead to bank losses. Rising interest rates may further hasten this development crushing corporate and household sectors. The end-result is a corporate debt crisis and a banking crisis. 

Currency crises can also lead to bank losses and high inflation through devaluation and further to a debt crisis, as the principal and interests of a foreign-currency-denominated loans will increase (see, e.g. Malinen and Ropponen 2022). Banks may have contracts (e.g., loans, bond holdings) in foreign currency; a devaluation of the external value of the currency will cause the cost of these contracts to become more burdensome. This would have a highly detrimental effect on corporations holding large amounts of foreign currency denominated debt. If a country is highly dependent on foreign commodities, devaluation may increase their prices, causing inflation to peak.

A withdrawal of monetary support (quantitative tightening and/or interest rate hikes) in an extremely-levered market environment, like now, is likely to lead to crash in the asset and credit markets. This, on the other hand, may lead to both a banking and corporate debt crisis, as losses from the crash mount in banks and the price of corporate debt increases heavily. Financial markets crash can led to a currency crisis, as foreign investors leave the counrty, and even further to a sovereign debt crisis, when an over-indebted government succumbs to the rising yields and the combined effects of the crisis.

It is thus plausible not to prepare just for a recession, but to an outright economic collapse. This creates a swathe of challenges for preparation, on which we will start to seek solutions shortly.

However, before that, I will first publish my first monthly forecasting outlook.

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[1] In the midst of the euro-area crisis, the 24-25 March 2011 European Council meeting decided to Include CACs in all new euro-area sovereign bonds with a maturity of more than one year, from July 2013 on. The CACs would be identical and standardised for all euro-area Member States; furthermore, they would be based on the CACs that are commonly used in the US and the UK Markets and are governed by the two countries' respective laws.

These CACs were developed and agreed by the EFC in November 2011 and were subsequently included in the ESM Treaty (Article 12(3)). This 'euro area model CAC 2012' relies on a 'two-limb' voting structure. Specifically, a minimum threshold of support must be reached both in each bond Series (66⅔ % of the outstanding principal) and across all series subject to the restructuring (75 % of the outstanding principal).

In the opinion of Sami Miettinen, an investment banker familiar with bondholder restructurings, a 75% voting group acting in cooperation with the issuing nation can also change the redenomination of the bonds from the euro to some newly created domestic currency.