Straight Talk With Bob Prechter, Part VI | Elliott Wave International

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Straight Talk With Bob Prechter, Part VI
A series of Q&As with EWI founder and president

By Editorial Staff
Wed, 06 Oct 2010 11:30:00 ET

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This is Part VI of our multi-part series of questions and answers with Robert Prechter, the world's foremost authority on Elliott wave analysis. (Excerpted from an hour-long June 19, 2010, interview with Jim Puplava's Financial Sense Newshour.)

We are posting a new part every business day, so come back to elliottwave.com tomorrow for more. (Here are Part I, Part II, Part III, Part IV and Part V.)

...Jim Puplava: I want to take two well-known investors who would take the opposing view of a declining market. One is Dr. Marc Faber, who believes the S&P low of 666 will stand and that the government will simply inflate, because its debt is denominated in its own currency, unlike let’s say what we saw in Mexico where Mexico experienced some problems as a result of devaluation, they saw an increase in their stock market from the lows in nominal terms. So Marc believes because the U.S. debt is denominated in its own currency, the government will simply print, print, print. To add to Marc's views I want to take famed investor Felix Zulauf. In a recent interview in Barron's he also said one day the world's financial system will reach a financial reckoning day where the Fed's balance sheet will expand not by just a trillion or two, but by multiples of that, five, six, seven trillion, which would negate the deflation scenario. How would you argue against Faber and Zulauf's views?

Robert Prechter: I don't think I have to. These are political predictions that may or may not come true. In other words, why does it have to go that way? Someone else could say just as easily, “Well, it's also possible that the voters will all become Tea Partiers, they'll throw all these people out, and they'll elect conservative guys who will balance the budget and eliminate the Fed.” How would you argue against that? You can't. It's just a scenario. It's not an argument, just a possible scenario. Still, I don't think it's likely because of what I already said.

I think the change in social mood towards the negative is already showing results. Here we are in a positive rebound, yet you’re still seeing Tea Parties and you're still seeing incumbents pushed out of office. I think by the time the trend really turns down again and breaks those 2009 lows, you're going to see the public so angry at their representatives that they're going to start forcing a difference in behavior. Congress is not going to be spending like it was before. They'll probably be drawn and quartered if they try to bail out another giant bank or certainly if they try to bail out the European banks as they did in the AIG disaster. All of this spendthrift behavior people are cluing into, and it's spreading on the Internet, and it's spreading through word of mouth.

You have this scenario that politicians are just going to monetize and they're going to go crazy. But it’s not a given. It requires that politicians are somehow untouchable by politics. But in a democracy, they're very subject to politics. Even in Greece, the leaders of that country wanted nothing more than to keep spending and borrowing and spending and borrowing. The creditors finally came in and said, “Enough. You can't continue or you're going to be literally out of power and bankrupt tomorrow.” So they agreed to some austerity programs, some creditors came to the door; some European governments, for example, came to the door. It's always the creditors who are in control -- these bond vigilantes. Even Clinton was upset when he found out they existed.

The U.S. government depends on these people for all of its borrowings. The Fed hardly has any U.S. Treasury bonds anymore; its portfolio is full of mortgages and all sorts of junk. The private market and other governments have sopped up all these Treasury bonds. The government could decide to “print, print, print,” but the only thing it can print are bonds. It can't print Fed notes; it can only print bonds. If the creditors shut down and say we're not taking any more of Treasury bonds, there's going to be a real disaster. They're going to have to raise interest rates to double digits, maybe 80 percent or 100 percent or some crazy amount. That's going to suck money from every other corner of the earth, and the economy is going to crash one way or another.

A crashing economy is going to be deflationary, because it means the debt that exists won't be paid off. It's the collapse in existing debt that's the problem. Now the Fed and the Treasury are trying to shore up some of this debt. The Treasury said, “Look, we're going to guarantee Fannie Mae and Freddie Mac,” and the Fed gave money to help bail out Greece. The IMF did the same thing, which is mostly funded through the American taxpayer. But relative to the amount of outstanding credit, these are actually small moves, even though they're unprecedentedly large. That's because the amount of credit that has been building up for 70 years dwarfs the amount of money that we have in circulation.

I think the problem is too big for them to solve. It's too late. The only thing they have to offer is more credit, more credit, more credit. So far, they really haven't offered much more money. Credit is the problem, so printing more bonds in my view is not going to solve the problem. The government has already been borrowing at a mad pace. Wouldn't you agree that the last year or two has seen the greatest government borrowing ever? And yet you certainly don't have runaway inflation according to the commodity indexes. What is it going to take to create inflation? It's going to require that they create something like 100 trillion dollars worth of new money, and I don't think Congress is going to be able to stand up to the people and do that.

These scenarios are matters of social analysis, political analysis and opinion. What I’m saying is, let's look at present conditions in the U.S. We can also look at Japan, which had quantitative easing like crazy, and they still ended up deflating: Stock prices are down, and real estate prices are way down in Japan. And the same thing is going to happen here. And that's the best scenario. The Japanese economy kept going because the rest of the world was still expanding. Now the whole world is basically on the edge of depression. Nobody's going to be able to bail out the world, because we're the only people in it.

I think it's a one way road to the nearly complete collapse of outstanding credit. And if you count all the derivatives, all the domestic and foreign debt that exists, you've got about a quadrillion dollars worth of IOUs out there and already written. I just don't think central banks can or will replace all of that debt with money. It would mean their own self-destruction. And not only that, there's this thing called moral hazard. As I said in a recent issue, the Fed is not a moral institution; it does not care about morality. But if it were to announce that it was literally going to monetize all the bad debt that anybody can create, the first thing that would happen is everybody would be out there creating new debt as best as they possibly could and selling it to the Fed.

The scenario is not realistic. It comes from people who think the Fed and the government are machines. They don't realize that they're run by people who are going to have to survive politically. I don't think they're going to be allowed to do it. But time will tell.

[Part VII is now posted. Topic: Junk, municipal and corporate bonds in deflation]

Come back tomorrow for another part of the "Straight Talk With Bob Prechter" series. Or, you can read the rest of it now, free, inside Club EWI. All you need is a free Club EWI password.

P.S. For Prechter's very latest insights, consider a risk-free subscription to his monthly Elliott Wave Theorist. Here's what you'll find in the latest issue.

Tags: Robert Prechter, social mood, U.S. Treasuries, Treasury bonds, Fannie Mae, inflation, derivatives

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