Stretched rubber bands break

Let's look at Iceland for a minute:

As a result of the global deflationary debt unwind, Iceland's three biggest banks, Kaupthing Bank, Landsbanki Island and Glitnir Bank have collapsed under the weight of about $61 billion in debts, and its stock market fell has fallen 81% so far this year. Meanwhile, employment has also plummeted as the collapse of the financial sector and large layoffs since October have resulted in a complete standstill in the construction industry. Most importantly, the deflationary collapse has caused the Krona, Iceland's currency, to crash which leading to hoarding of goods at supermarkets and an inflation of 16%.

The Iceland example shows how a nation can experience deflation (crashing stock, bond, and real estate markets) while also experiencing high inflation due to a currency collapse (soon to be hyperinflation when it allows its currency to float again).

At one point not long ago (as recent as 2007) Iceland had one of the highest GDP's per capita and was above the US (and at one point in the recent past was at #6). But it turned out it was all a sham. What do the Icelanders produce anyway? Turns out they were producing BS. Now they are screwed, big time.

Their economic engine threw a rod. It is broken. If they think that all they need is a major tune-up (by way of stimulus packages and bailouts) then they are deluding themselves. The engine has been destroyed. And they are unlikely to be able to rebuild it using the same design. They need a new design for their economic engine in the future.

Will the US follow in Iceland's footsteps? Unknown at this time but that's for a future post.There are some observations that should be discussed though.

The US economic engine based on consumerism (fueled by debt) is another engine that has thrown a rod too. It is broken. It is a bad design. Trying to tune up the engine isn't going to make much difference. We need a new design. The US needs to start producing something again, instead of outsourcing production, providing "services," and "creating" wealth with debt vehicles (credit cards, loans, printing money, etc.).

The US needs to learn how to take care of things again, produce and purchase high-quality, built-to-last items that can be repaired for a fraction of a new one - and people need to learn how to take care of and repair their own stuff. We need to stop being a throw-away society. (I'll address these in a future post too.)

Government spending and entitlement programs are out of control and will destroy the country by themselves if changes aren't made. Medicaid/Medicare costs are increasing at 6% per year and is unsustainable. Many other programs are in the same boat. Other countries are in the same pickle too. At some point people and the governments will have to face up to the fact that everyone is NOT entitled to a job, a college education, top-quality healthcare, a house, more food than they can eat, a TV, a Wii, a car, etc.

Deflation is going to happen. Bailout is a good term for what is happening to "prevent deflation." We see the banks and automakers and others getting "bailouts" but it's like a large boat with a square foot hole in the bottom and people using a small cup to bail out the water. It's a losing battle. The hole is too big!

This collapse occurred after a few decades of rubber band stretching. I believe the destruction of wealth, and deflation, is going to be much worse than most "experts" expect. The creative financing was producing leverage levels of over 100 to 1. There is huge over-capacity of most everything - houses, cars, clothing, strip malls, real estate agents, banks, restaurants, PC's, even milk. Asset inflation of most everything was enormous - just look at housing. The stock market was horribly inflated.

Deflation is going to be huge - and the $1 trillion "stimulus" isn't going to stimulate much of anything. I foresee well over $50 trillion of wealth destroyed over the next several years - these $1 trillion stimulus and bailout packages are going to be just a few drops in the bucket.

So what is the purpose of these stimulus programs and bailouts? My thought is that it has little to do with the economy as such, these are being done to prevent a revolution. If too many people lose their jobs, get thrown out of their houses, go broke, etc., the government could collapse altogether - riots in the streets, cities burning, crime rampant, local governments overthrown - enough people could reach a point where they felt they had nothing left to lose. This is what I believe is scaring the politicians.

Remember that Treasury Secretary Paulson warned Congress that there would be a need for martial law if the first $700 bailout bill didn't pass - maybe he was right. So the question for our "leaders" in the Government becomes, "what is needed to keep the masses at bay?"

The government bails out the Big 3 so that they can continue to produce cars that nobody wants to buy. The government buys milk powder that nobody wants to buy and puts it in giant warehouses. The government gives the banks money so that they can continue to keep people employed to do "financial engineering" and other useless activities.

This becomes a slippery slope. How far can the government get away with paying people to do worthless activities (inside and outside the government) and keep the dollar (and the country) from completely collapsing? Will the government pay people to watch TV too? (Answer: yes - that is essentially what welfare and extended unemployment insurance does.) It seems that the collapse of the dollar is a matter of when, not if, and we will see if the country can survive.

Why isn't Reykjavik burning? It's getting hotter there . . .

The anger expressed by ordinary citizens has been limited, so far. More and more people gather each Saturday in front of the parliament in Reykjavik.

Some of the 6,000 protesters at a demonstration on Saturday threw rolls of toilet paper at the building where a few months earlier the premier had declared that the Icelandic banks were robust and the country's finances were healthy.