Hussman Weekly Market Comment: Little Dutch Boy

In the Mary Mapes Dodge book titled Hans Brinker, there is a fictional story within the story of a little Dutch boy who, on his way to school, notices a hole in the dyke. Having nothing else to fix the leak, he plugs the hole with his finger and stays there through the night until workers come to repair it. We are now into the fourth year of efforts to print trillions of little Dutch boys out of dollars and euros in order to stop a tide from crashing through a fundamentally damaged dyke. All of this has bought time, but no workers have arrived, and no real repairs have been done.

The holes seem only loosely related: non-performing mortgages, widespread unemployment, massive U.S. budget deficits, a “fiscal cliff” sideshow, inadequate European bank capital, European currency strains, a surge of non-performing loans in China, and unexpected economic softness in Asia and global trade more generally. All of this gives the impression that these problems can simply be addressed one-by-one. The truth is that they are all intimately related to a single central issue, which is the utter unwillingness of politicians around the globe to accept and proceed with the inevitable restructuring of bad debt, and their preference to defend the bondholders of a fundamentally rotted financial system.

But haven’t things improved? No doubt, bank balance sheets have been relieved of transparency through changes in accounting rules. Nonperforming loans have been easy to kick down the road thanks to an interminable “amend and pretend” process whereby a month or two of mortgage service is exchanged for extensions that tack delinquent payments onto the back of the loans. Meanwhile, banks have recouped some of their losses through wider interest spreads, by refusing to refinance higher interest mortgages, and by paying lower interest costs as a result of monetary policies that provide zero interest compensation to savers.

But aside from the appropriate equity wipeout, debt writedown, contract renegotiation and reissuance of General Motors, very little debt restructuring has occurred anywhere else in the economy – certainly not in financial or mortgage debt. Meanwhile, the European banking system faces major capital inadequacies, particularly in Spain, where delinquent loans have surged to record highs. The Federal Reserve just altered its annual stress tests for too-big-to-fail banks to now include the risk of a slowdown in Asia. The U.S. budget deficit remains near a peacetime high, with little prospect of substantial reduction even if the so-called “fiscal cliff" is resolved. The European economy is clearly in a fresh recession. We continue to infer that the U.S. also entered a recession during the third quarter. This will not be helpful to deficit reduction efforts.