Volume X, No. VII

"Don't sweat the small stuff." It's one of those trite exhortations that actually make some sense – that is, unless you've been living or working in the City of New York during July. As it turns out, this could be the hottest July on record. The concept of "not sweating" has been out of the question – at least for the time being.

That's why when we found out that China just passed the U.S. as the world's #1 user of energy, we just couldn't get worked up. Sure, there's a story there, but frankly it'll have to wait for some other time, ideally when it's cooler and drier. Besides, we've got to finish up what we started last month.

If you remember, we were using Carmen M. Reinhart & Kenneth S. Rogoff's book This Time Is Different to get a grasp on what's going on with the crisis that started in 2007. We liked the fact that, as opposed to most of the commentary out there, these authors had sifted through 800 years of available data about these sorts of crises.

They broke our current crisis into five stages:

1. Banking crisis
2. Domestic sovereign debt defaults
3. Foreign debt defaults
4. Currency crashes
5. Inflation outbursts

Where are we now? – Somewhere between 2 and 3, heading into 4.

But wait a minute! Before we get started, we just noticed something. Has there really been a "domestic sovereign debt default" here in the U.S.? Based on Reinhardt and Rogoff's research, it would seem there should have been, or should soon be some sort of U.S. debt default.

Not so fast. We don't have time to get into details this month, but the dollar has a special status – and has since the end of World War II – that helps keep it "un-defaulted" in the face of virtually anything either the Fed or the U.S. government does to shake it up.

Question: Will that continue in the future? We're going to find out.

While Europe continues to struggle through its debt crisis, (remember all the noise about the PIGS and how the Euro was collapsing?), U.S. debt (the dollar, treasuries), haven't done all that badly. Default? Didn't the dollar rally after the crisis? Haven't the interest rates on treasuries gone down? – And that in spite of the predictions of almost every expert out there?

Well, the fact is, if the U.S. was an emerging market country, its exchange rate would have plummeted and its interest rates soared; access to capital markets would be lost. Yet the year following the crisis, the opposite happened: the dollar appreciated and interest rates fell as investors saw other countries as even more risky.

Now, if you're thinking the U.S. dodged a bullet, Dagong Global Credit Rating – based in China - just downgraded U.S. Treasuries from AAA to AA...with a negative outlook. You might think, "Ah, but they're Chinese; it's just the Chinese trying to undermine our economy." But it turns out that, on an objective basis, the criteria used by Dagong Global were more comprehensive and convincing than those used by credit rating agencies like Moody's and S&P.

(You remember Moody's and S&P, don't you? They're the credit agencies that rated sub-prime debt AAA right up until all the defaults starting raining down on us and kicked off the whole crisis to begin with. Oh, and they're still rating U.S. debt as AAA.)

Besides, while China may indeed be looking to become the world's #1 economy (they're already #2, in case you didn't notice), it's still in their interest to see the U.S. economy remain healthy. They've got lots of stuff they still want to sell to us.

On the other hand, while a rating downgrade isn't quite a default, it may well be the first step down a slippery slope. Reinhardt and Rogoff, with their academic style, might say: over the long run US exchange rate and interest rates could well revert to form, i.e., falling value, rising interest rates.

We'll just have to wait and see.

China, on the other hand, doesn't seem to be waiting. After Dagong downgraded U.S. debt, China sold off a bunch of their U.S. treasury holdings: not enough to shake things up too much – yet – but certainly a signal that we won't be going back to the good old days when China scooped up all the treasuries they could get their hands on.

And that's really the key point here: things aren't going back to "normal."

Rather than "sweat the small stuff," let's cut right to what makes this crisis the worst one since the Great Depression: It's the first global economic and financial crisis since World War II. We've had local and regional crises before this, but not a global crisis. That's why it's so severe and why it will be with us for the foreseeable future.

How exactly will this crisis affect us? Put another way, why does this matter to us?

Let's get specific now. (Remember, we're talking here about averages from previous severe crises.)

Housing:

Declines in housing prices average 35 percent over six years. (So far, the U.S. housing decline has averaged around 30 percent.)

GDP: Output falls (peak to trough) around 9 percent over two years. (The decline in GDP tends to be shorter than the declines in other areas.)

Unemployment:

On average, it rises 7 percent, lasting around 4 years. (Ours hovers over 9%, pressing on 10%. Count in all the "underemployed" and those who've "given up looking for a job" and we're around 17%.)

Government Debt:

The value of government debt explodes during a crisis. On average, it rises 86 percent post-WWII. Buildup of government debt has been a defining characteristic of the aftermath of banking crises for over a century. What causes it? The main cause is collapse in tax revenues. (Think: unemployed people pay less or no taxes; falling house values means lower real estate taxes…you get the picture.)

Equities: Let's not forget stocks. They average a fall of 56 percent.

Why Global Financial Crises Can Be
So Much More Dangerous Than Local or Regional Crises

So much for the averages of severe post-WWII crises. Let's get back to our current global crisis.

Now, here's where global crises become more dangerous than regional crises:

Countries that used to rely on exports to carry them through previous crises can't rely on exports anymore. Exports no longer form a cushion for growth.

For example, the comparatively open, historically fast-growing economies of Asia survived the initial shock of 2007 fairly well. Then, in 2008, they were hit hard. Their economies are more export-driven. Also, their exports are mostly manufactured goods. And their customers were primarily the countries whose economies began to sink in 2007.

So, if everything we listed above hits at once, to some degree, in basically all countries, the old reliance on exports – which may have carried these exporting countries through a crisis in the past – just doesn't work anymore.

A country trying to pull out of a post-crisis slump will find it far more difficult when the rest of the world is similarly affected than when, in the past, exports provided some stimulus.

Where Our Current Crisis Is Headed:
Common Patterns from the Past

So here's the sequence of events we're working through as we speak:

Banking Crises Come First...

Ours started in 2007 with the sub-prime crisis. Things really hit the fan big time because Wall Street turned junk mortgages created by banks engaging in risky lending into even junkier securities products (which they then sold to their clients, making them a fortune)…at which point central banks (like the Fed) decided they had to extend credit to the shaky banks loaded with junk mortgages and other institutions (like AIG) loaded with junk securities (part of that whole "bail-out" process).

Followed by Domestic and Sovereign Debt Defaults...

As the central banks step in as "lender of last resort" to save banks, thereby propping up their country's currency, the currency nevertheless wobbles.

Leading to Currency Crashes...

We've seen the re-valuation and devaluation of some currencies relative to others: Iceland and Ireland come to mind. This exacerbates the problem of banks who invest in assets denominated in those shaky, re-valued, de-valued and (in the case of Iceland) collapsed currencies.

Simply put, banks now hold an unknown quantity and quality of assets – a kind of messy stew – that central banks keep tinkering with in the hope that somehow, some way, some day, it will all add up to a fine dining experience. We'll stick with the Caesar salad and glass of red wine, thank you.

And, while we're at it, let's not forget the general depreciation of all currencies relative to gold. If you haven't followed the price of gold carefully before, we recommend you start doing that now. It's one of the key indicators of the nature of the currency crises we'll experience. As the price of gold rises relative to all other currencies (which it's been doing pretty consistently for at least a year), expect more currency crises.

Culminating in Inflation Outbursts...

The current buzz is all about deflation. Indeed, so many indicators point to deflation, it's hard to even talk about inflation these days. But if Reinhardt and Rogoff's research holds true, inflation will come. It's a matter of when and just how severe it will be. You'd better have some plan to cope with it before it arrives. Once it gets here, it will be too late.

That, in a nutshell is what's happening now, and what we can expect in the months and years ahead.

In their book, Reinhardt and Rogoff conclude that so far, by all measures, the trauma resulting from this contraction, the first global financial crisis of the 21st century has been extraordinarily severe. Even so, we're fortunate that – so far – it's only been the most severe global recession since WWII and not something worse.

Well, the sweat's pouring down onto our keyboard at this point, so enough of the crisis for now. The point of all this has been to provide some context, some framework, to help us judge what we need to do in order to be prepared for some dramatic and dangerous times to come. I hope we've succeeded in doing that.

But before signing off for the month, this being a letter about money and all that, we thought you might be interested in this...

Do You Want To Be Rich?

I just saw a terrific production of "Fiddler on the Roof" a wonderful American musical. You may know the play. If you aren't familiar with it, see it sometime if you get the chance.

At one point, the main character, Tevye, sings a song that's now pretty famous: "If I Were a Rich Man." He's the head of a Jewish family living in the early 20th century in Ukraine (when it was part of the Russian Empire), father of four daughters, struggling to make a living. He sings about what life would be like if he were rich.

(Click here for a video of the original Broadway star, Zero Mostel, performing the song brilliantly.)

Tevye may be Jewish, but there's much in the song for all of us. While we live a lot better here in America than Tevye and his family lived in the play, times are difficult right now. And things aren't so great for a lot of us. So maybe it would be nice, after all, if you could be rich, eh?

At the end of the song, Tevye asks God:

Have you ever felt this way? I have - at times. I have to remind myself that I can (thank God) provide a modest security and sufficiency for my family - even in these difficult times. I have to remind myself, too, that my family - for the most part - really isn't worried about things as much as I am sometimes. We've managed so far. As the kids have gotten older and have started moving out, they can support themselves. Our health is pretty good. I mean, there's really not much to complain about, when I think about it.

And, when you get right down to it – speaking from personal and professional experience – it's not like money buys happiness or anything that's really all that important in the greater scheme of things.

Still, I must say there are times when Tevye's question does pop up in my thoughts. I wonder what could it hurt if...well, never mind.

(If you're in the mood for a good chuckle, try this version of "If I were a rich man" in Japanese!)

Stay cool!

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com