John Mauldin describes how he thinks we will get from the credit crisis he believes is coming in the next 12–18 months, to what he's terming the Great Reset

By John Mauldin*

Today we will summarize something I’ve been thinking about for a long time. Exactly how will we get from the credit crisis, which I think is coming in the next 12–18 months, to what I call the Great Reset, when the global debt will be “rationalized” via some form of nonpayment. Whatever you want to call it, I think a worldwide debt default is likely in the next 10–12 years.

I began this tale last week in Credit-Driven Train Crash, Part 1. Today is Part 2 of a yet-undetermined number of installments. We may break away for a week or two if other events intrude, but I will keep coming back to this. It has many threads to explore. I’m going to talk about my expectations given today’s reality, without the prophetically inconvenient practice of predicting actual dates.

Also, while I think this is the probable path, it’s not locked in stone. Later in this series, I’ll describe how we might avoid the rather difficult circumstances I foresee. While it is difficult now to imagine cooperation between the developed world’s various factions, it has happened before. There are countries like Switzerland that have avoided war and economic catastrophe. We’ll hope our better angels prevail while taking a somber look at the more probable.

The experts who investigate transport disasters, crimes, and terror incidents usually create a chronology of events. Reading them in hindsight can be haunting—you know what’s coming and you want to scream, “Don’t do that!” But of course, it’s too late.

We do something similar in economics when we look back at past recessions and market crashes. The causes seem obvious and we wonder why people didn’t see it at the time. In fact, some people usually did see it at the time, but excessive exuberance by the crowds and willful ignorance among the powerful drowned out their warnings. I’ve been in that position myself and it is quite frustrating.

As I outlined this, the steps seemed to fall in four stages. I’ve dubbed them:

  • The Beginning of Woes
  • Lending Drought
  • Political Backlash
  • The Great Reset

Again, the precise route and speed are uncertain, but the probable destination is not. Consider this a kind of “road map” to orient us for the journey. Now, let’s look at each stage.

The Beginning of Woes

Last week, I described how legendary railroad engineer Casey Jones was barreling along when an unexpected train appeared ahead. He saved his passengers at the cost of his own life. Today’s high-yield bond market has no such hero, and I think the crisis will begin there.

The problem will be what I mentioned last week: massive illiquidity. Trading can and will dry up in a heartbeat at the very time people want to sell. In late 2008, the high-yield bond benchmarks lost a third of their value within a few weeks, and many individual bond issues lost much more, in large part because buyers disappeared.

The same thing happened in the dot-com recession, though not quite as dramatically. There were still several whipsaws and a particularly terrible month in June 2002.

This time, I believe the collapse will go deeper and happen faster because Dodd-Frank has decimated market makers’ ability to cushion it. Likewise, the Fed will be reluctant to bail out ridiculously priced bonds like WeWork and its many covenant-lite, unsecured brethren. And rightly so, in my view.

But if it’s not high yield, something else will set off the fireworks. There’s always a train that shouldn’t be there, a dog that didn’t bark, always something. We may not even recognize it at the time. Remember, then-Fed Chair Ben Bernanke said in 2007 that the subprime debt problem was “contained.” Whatever starts the next credit crisis, authorities will assure us it is “contained.” (Spoiler: It won’t be.)

Last week, I read a powerful chapter by my friend William White, former chief economist for the Bank of International Settlements and now chairman for the OECD economic committee. I read everything from Bill that I can get my hands on. He is my favorite central banker in the world. This paragraph jumped out at me (emphasis mine):

… the trigger for a crisis could be anything if the system as a whole is unstable. Moreover, the size of the trigger event need not bear any relation to the systemic outcome. The lesson is that policymakers should be focused less on identifying potential triggers than on identifying signs of potential instability.

This implies that paying attention to macroeconomic “imbalances” may pay bigger dividends than trying to assess financial instability through highly disaggregated “risk maps” of the sort currently being encouraged by the G20 and the IMF. The latter are not only expensive to monitor, but potential rupture points in the financial fabric can change rapidly in real time.

Perhaps more important, serious economic and financial crises can have their roots in imbalances outside the financial system.

As I will show in this letter and others, the system itself is unstable. Predicting the actual trigger in advance is difficult. I can imagine numerous possible “triggers” for the coming credit crisis.

As in the biblical book of Revelation, the initial credit crisis stemming from the fall of high-yield bonds will be merely the beginning of woes. Illiquidity will spread as lower-end corporate bonds fall to junk ratings. Legal and contractual constraints will then force institutions to sell, pressuring all except the highest-grade corporate and sovereign bonds. Treasury and prime-rated corporate bond yields will go down, not up (see 2008 for reference on this). The selling will spill over into stocks and trigger a real bear market—much worse than the hiccups we saw earlier this year.

I give the probability of the credit crisis in the high-yield junk bond market somewhere close to 95%. For the record, nothing is 100% certain, as we don’t know the future. But I think this is pretty much baked in the cake.

Lending Drought

Remember how Peter Boockvar describes the new cycle. Instead of recession pushing asset prices lower, lower asset prices trigger the recession. That will be the next stage as falling stock and bond prices hit borrowers. Rising defaults will force banks to reduce their lending exposure, drying up capital for previously creditworthy businesses. This will put pressure on earnings and reduce economic activity. A recession will follow.

This will not be just a US headache, either. It will surely spill over into Europe (and may even start there) and then into the rest of the world. The US and/or European recession will become a global recession, as happened in 2008.

Aside: Europe has its own set of economic woes and multiple potential triggers. It is quite possible Europe will be in recession before the ECB finishes this tightening cycle. With European rates already so low, and the ECB having already bought so much corporate debt, I wonder how else they will try to bring their economy out of recession? Everything is on the table.

As always, a US recession will spark higher federal spending and reduce tax revenue, so I expect the on-budget deficit to quickly reach $2 trillion or more. Within four years of the recession’s onset, total government debt will be at least $30 trillion, further constraining the private capital markets and likely raising tax burdens for everyone—not just the rich.

Political Backlash

Meanwhile back at the ranch, job automation will intensify with businesses desperate to cut costs. The effect we already see on labor markets will double or triple. Worse, it will start reaching deep into the service sector. The technology is improving fast.

Needless to say, the working-class population will not like this and it has the power to vote. “Safety net” programs and unemployment benefit expenditures will skyrocket. The chart below from Philippa Dunne of The Liscio Report shows the ratio of workers covered by unemployment insurance is at its lowest level in 45 years. What happens when millions of freelancers lose their incomes?


Source: The Liscio Report

The likely outcome is a populist backlash that installs a Democratic Congress and president. They will then raise taxes on the “rich” and roll back some of the corporate tax cuts and increase regulatory burdens. They may even adopt my preferred consumption-oriented Value Added Tax (VAT)… but without the “reduce income taxes and eliminate payroll taxes” part that I suggested in 2016.

 At a minimum, this will create a slowdown but more likely a second recession. Recall (if you’re old enough) the back-to-back recessions of 1980 and 1982. That was an ugly time for those of us who lived through it.

Of course, that presumes a recession before the 2020 election. It may not happen—I put the odds at about 60–70%. Also, it is possible the Democrats will fumble what for them will be a golden opportunity. I’m not sure Republicans should view that as a “win” because they will then have to deal with the eventual recession themselves instead of being in opposition. I think by the latter part of the 2020s, US total government debt will be at $40 trillion. You think Washington is paralyzed now? You’ve seen nothing yet.

My friend Neil Howe thinks we could see a socially conservative, fiscally liberal party gain power. (Some would argue one already did, given the current GOP’s spending binge.) But in any scenario, I see very little chance the federal government will shrink or reduce its impact on the economy. That is already a big problem and will only grow.

The Great Reset

Unemployment may approach the high teens by the end of the decade and GDP growth will be minimal at best. What do you call that condition? Certainly not business as usual. Long before that happens, the Federal Reserve will have engaged in massive quantitative easing. There’s a lot of misunderstanding about QE, so let me clarify something important.

Quantitative easing is not about “printing money.” It is buying debt with excess bank reserves and keeping that debt on the Fed’s balance sheet as an asset. The Bank of Japan is an example. They did not put currency (yen) into the market. That’s how Japan still flirts with deflation and its currency has gotten stronger. QE is the opposite of printing money, though there is a relationship. That’s one reason central bankers like it.

As this recession unfolds, we will see the Fed and other developed world central banks abandon their plans to reverse QE programs. I think the Federal Reserve’s balance sheet assets could approach $20 trillion later in the next decade. Not a typo—I really mean $20 trillion, roughly quintuple what they did after 2008. They won’t need to worry about the deflation that usually accompanies such deep recessions (dare we say depression?) because the Treasury will be injecting lots of high-powered money into the economy via deficit spending. But since we have never been in this territory before, I must say this is only my guess.

If that’s what they do, will it work? No. The world simply has too much debt, much of it (perhaps most) unpayable. At some point, the major central banks of the world and their governments will do the unthinkable and agree to “reset” the debt. How? It doesn’t matter how, they just will. They’ll make the debt disappear via something like an Old Testament Jubilee.

I know that’s stunning, but it’s really the only possible solution to the global debt problem. Pundits and economists will insist “it can’t be done” right up to the moment it happens—probably planned in secret and announced suddenly. Jaws will drop, and net lenders will lose.

While all that is brewing, technology will keep killing jobs. Many mainstream commentators and serious analysts like Karen Harris (see The Great Jobs Collision) are projecting that 20–40 million jobs will be lost in the US alone and hundreds of millions across the developed world.

As we get into the 2020s, the presidency and Congress will again be whipsawed, and we will begin to discuss Bernie Sanders’ “crazy” universal basic employment idea, or others like it. By then, the idea will not be considered crazy, but the only feasible choice. Even conservative politicians can see the light when they feel the heat.

All of this is going to lead to the most tumultuous decade in US history, even if we somehow (hopefully) avoid throwing a war into the mix, as is typical of the end of a Fourth Turning. Typically, the end of a Fourth Turning (which started in 2007, according to Neil Howe), has been accompanied by wars. This one could, too, though I think we will more likely see multiple low-grade skirmishes.

If we somehow get through all that, and particularly the Great Reset, the 2030s should be pretty good. In fact, think incredible boom and future. No one in 2039 will want to go back to the good old days of 2019. Our kids will think it was the Stone Age. But we have to get there first.

Wrong Track

I keep coming back to this train-wreck metaphor because it fits so well. I said Casey Jones plowed into a train that wasn’t supposed to be there. The full story is a little more complicated.

Railroads in 1900 knew the danger of collisions. They took extensive precautions to make sure it didn’t happen. The stopped train in front of Casey Jones had pulled off onto a siding like it was supposed to. The error was that its last four cars were stuck on the main line because an air hose had broken, locking their brakes.

This is a good analogy for our financial system. We know bad things can happen. We have systems to prevent them and limit their damage. Those systems are only as good as the people who manage them… and even then, surprises happen, and the safeguards fail.

What broken air hose will push the financial system close to collapse and bring on the Great Reset? I don’t know, nor do I know when it will break. But I’m quite sure it will happen. Now is the time to get ready. There’s no Casey Jones to save us.

Winston Churchill said America always does the right thing—after we try everything else. Maybe we can find that middle and “work it out” before the crisis. America has shifted before. Maybe that’s only a dream, but it’s one we better hope comes true.

In later letters, we will talk about how to protect your portfolios and trade through the coming crises. You don’t have to go gently into that good night. You can get off the train. There is plenty of time, but you need to start planning now.

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*This is an article from Thoughts from the Frontline, John Mauldin's free weekly investment and economic newsletter. This article first appeared here and is used by interest.co.nz with permission.

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39 Comments

Depressing to read but seemingly obvious.

I think the great reset will ultimately hurt the rich most but the middle class will also cop it big time. Imagine being told your investment no longer counts for anything.

Gifting an out for the those greatly indebted doesnt exactly set a great example through consequence of actions, but I have to agree that a great reset is extremely feasible given the mess we have created.

Is the article implying that the debt forgiveness would be for private debt? It could be that the reset would apply to government debt, corporate debt, but that joe blogs will still be left saddled.

He seems to think the Dodd Frank Act provides an insufficient cushion. Well if that Act is repealed there won't be any cushion.

Perhaps even the Great Reset won't resolve the fundamental problems. A debt jubilee by privilledged states and organisations may resolve their debts (Lenders will lose and Joe Bloggs and dafaulters deemed not too big to fail will be punished). States and large organisations love avoiding responsibilities. The real issues will probably be the last to be addressed - if at all- and with inefficient economies the borrowing could soon begin to build up again.

I'm looking forward to the advice on how to see my way through this!!!!
I can't imagine what areas will be immune.
Please don't give me the "diversity" crap.

I imagine the advice might be to reduce your own exposure to a liquidity crisis. Ie, don't be trapped with huge amounts of debt and be forced to sell stuff while everyone else is also trying to sell stuff.

Yet with the GFC the best thing you could have done is take on as much debt as possible and buy property (assuming you kept your job).

Jimbojones, if you already have masses of debt when the crisis occurs, you can't get access to more debt, that is the problem, the liquidity problem. Getting debt is not simply about keeping your job. When there is a crisis, lending criteria tighten and lenders become much more picky.
After the GFC when house prices crashed and the credit crunch occurred (not so significant in NZ) but yes if you could get your hands on debt to buy a house, you did very well, because there was very little competition to buy but huge amounts of people trying to sell (again not so much in NZ). However, those who already had masses of debt were often stuck. There are bargains to be had in a financial crisis, whether it be houses, stocks etc.If you are tanked up to your eyeballs in debt, you are often illiquid, maybe even struggling to refinance the debt you already had.

This is still a problem in the UK, for instance, referred to as "mortgage prisoners". Where credit conditions have tightened and lenders will not offer them good deals because they are not attractive borrowers in the tightened credit conditions, so they are trapped at higher interest rates.

http://www.bbc.com/news/business-44001514

Yes good point. Although I think the people who ended up worst off were the ones who sat on their cash as some form of safety net. Could be different next time I guess.

Well people who just sit on their cash always ultimately lose out in someway over the economic cycle eventually, because their cash devalues. I've known plenty of risk averse people waste some utterly spectacular opportunities but then none of them have been sunk either. If a huge crisis comes, and you are neck deep in debt, you stand to lose everything, in addition to having lost the opportunity to move during the crisis. So the ones who end up being the absolutely worst off, are the ones who didn't fix the roof while the sun was shining.
If the economy is booming, there is job security and pay rises on the horizon, you can perhaps more safely take the risk on bigger debt but how many currently have massive debt, no sign of pay rises on the horizon and little job security in a crisis?

I disagree, JimboJones is correct.

What happened if you had lots of property debt in 2017/2018 was that your repayments went WAY down.

The OCR went from 8.75% to 2.5% over night and Interest rates crashed too. So as soon as your fixed period ended, your mortgage repayments halved or what have you. If the lending was on rental properties, then ching ching, your net income just doubled.

And then the idea would have been (in hindsight of course) to load yourself up the eyeballs and beyond with property debt in Auckland, then sell it all about 6 months ago. You would have made millions.

And as JJ points out, if you sat on cash, you just watched it lose value in comparison to all other assets.

Davo36
1. Maudlin is not talking about NZ property investment. Not even a little bit. So his next article and advise is not going to be specific to the NZ obsession with property investment either
2. Regardless of how much your debt repayments go down, if you have negative equity or very little equity you are unlikely to be able to access future borrowing.
3. Your scenario applies only to those people who would have had mortgages that suddenly went down after the GFC but had substantial equity so that the banks did not consider them high risk. These were exactly the sort of people who did benefit from the GFC because they had liquidity and could move to cheaper mortgage deals and borrow more to buy well priced 2nd, 3rd etc homes. However, the stats are different now. Interest rates can't drop as dramatically as they did and NZers are heavily indebted at historical low rates. Should markets crash globally, presenting a once in a decade (or even generation) buying opportunity in stocks, bonds, property or whatever those who are heavily indebted (especially if that debt in in a house losing value) will not be as liquid as someone with cash. If they chose not to spend that cash then more fool them.
4. If it turns out that somehow it is good advise to NOT pay down debt as aggressively as you can while interest rates are at historic lows, when every asset market globally is at record highs, when global debt is at record highs and when the economic cycle is considered to be "mature" then honestly I'll eat my hat.

I imagine if a big financial crisis happened tonight, the effect would be a lot different for NZ. For a start interest rates can't really go much lower. They may even go higher this time. We have low government debt again which should help out, but we also have a very overheated housing market that will almost surely crash (although to be fair the likes of Bernard thought our housing market was overheated back then!).
I think gingerninja is right that having low debt would be the best approach, then buy as much as you can when its flogged off cheap.

I foresee a scenario where lots of bullshit jobs in finance and property disappear. Key societal roles like teaching will reassert their position. As will people who make and sell 'real' things

I foresee a scenario where lots of bullshit jobs in finance and property disappear. Key societal roles like teaching will reassert their position. As will people who make and sell 'real' things

My guess will be diversity by way of Gold, Cash and recession growth industries

Interesting read....

https://www.investopedia.com/articles/stocks/08/industries-thrive-on-rec...

Repairing toasters could be the go!

Cash in the bank? Nope: OBR+ covered bonds......
Or do you mean cash as in wads of it?

Uninterested,(I still think you mean disinterested),

I am very wary of those who say with absolute certainty that they know how to navigate these very uncertain waters. i have around 55% of my assets(not including my home) in predominantly NZ equities,20% in a rental,12% in short-term deposits,6% in Fixed-interest securities and some other investments such as Harmoney loans. I have no debt. Would you call this 'diversity crap'?
Over the past 2 years,I have doubled my cash. If and when,we see a major stockmarket correction,then I am well placed to take advantage of it on a staged basis.
have I got it right? I hope so.

Some currency diversification would also be useful :)

Chessmaster, earlier on you strategically trolled me seeking a timeframe for when the music might stop. I suggest you read not only the first part of the "approaching train wreck" series here; https://www.interest.co.nz/opinion/93763/john-mauldin-begins-delve-what-...

then this one above. I sincerely hope this helps release you from your apparent confusion and form an investment strategy that works ;-)

Thanks RP. But this writer is saying 12 to 18 months. That's so long in today's terms. I found a whole heap of articles and threads by mistake about a economic and house price collapse from 2015 and 2016. None of this has come through yet. The timing of all this is clearly guess work. I read another article today saying immigration is down last month but still 67,000 people coming in instead of 72,000. That's still a lot, don't you think into a small country like us and probably majority settling into Auckland. Even the govt can't build for under $650,000 for a basic dwelling so how is this big adjustment in prices going to happen. Maybe they should drop the Kiwi build and wait for prices to cone down too. At the end of the day, shelter is a basic need and we still have a major under-supply.

Haven't various economists been predicting this 'train wreck' or a similar one for 10 or so years now? They always seem to know for sure that it will happen this year - until it doesn't happen. Of course it might happen this year - but I wouldn't listen to anyone that claims to be able to predict it.

Standard economist joke.. he's a good economist, he's predicted 9 of the last 5 recessions.

Haven't various economists been predicting this 'train wreck' or a similar one for 10 or so years now?

Most economists who work within the "status quo" are not likely to forecast negative implications. That is like cutting their own lunch. Think Tony Alexander for example, who has finally received some advice on how to communicate without a smarmy persona.

Only economists or commentators like Maudlin, who don't rely on the status quo for a crust can paint such dire scenarios can get away with this.

Meh, just another branding exercise. He hasn't taken a vow of poverty https://www.mauldineconomics.com/about-us/john-mauldin/speaking-info

I agree.
The man himself is a charlatan.

That doesn't mean he (his advisors) isn't correct about certain things.

Agree. There is something a bit charlatanish about him. A giveaway is the old credibility promoting 'my friend so and so in so and so high place'.
There's a few well used butt covering techniques in his writing, too.
But as you say, there might still be validity in some things he says

Who is suggesting he should take a vow of poverty? Not sure where you come up with this rubbish.

The inference is that he can talk the truth because he isn't beholding to an employer. He's self employed so needs a point of difference to make money. Being extreme doom and gloom is his war cry. You could argue he's more conflicted than a salaried employee in being honest e.g. what happens if he changes his mind? Did BH ever change his tune?

BTW: If he is right, then own physical assets. The establishment is always going to protect the asset owners.

He hasn't taken a vow of poverty

I expect not.

The man himself is a charlatan.

No more than anyone else who makes predictions. Even if the outcomes materialize, it might be for different reasons. Mind you, I think he is likely to be cognizant of that.

Agreed. But something will happen given that the worlds finances are getting progressively more I-owe-you...
And pension fund payouts (incl Kiwisaver) may not end up being very, ummm high.

What I struggle with is the fact everyone owes more than they are owed.

Methinks you'll find that's a result of a wee practice called fractional reserve banking

"What I struggle with is the fact everyone owes more than they are owed."

Its called borrowing from the FUTURE. Hes the mug thats underwritten the debt (wealth).
That is why boomers have ripped the following generations ... their wealth and their related consumption is a (debt) illusion based on tomorrows energy stocks.
They started the ponzi.

A pretty good summary of whats coming .. but it isnt then logical to conclude
"If we somehow get through all that... the 2030s should be pretty good.."

The debt represents (unpayable) promises... promises that have been stretched ever further into the future to appear viable. Debt allows a non viable system to keep trading particularly when it is used for one off consumption (rather than to enable greater future consumption)
The debt build up has the added advantage in that it allowed increased complexity and reach in supply chains... so we can maximise our hammering of natural resources.

Any forgiveness then ALSO comes with the following kickers
- it writes off wealth claims (think pensions)
- reduces demand (therefore future incomes & viability of existing businesses)
- disrupts the complexity of supply chains
- it permanently lowers living standards & commodity prices

The underlying problem is we lack ever greater natural resources to underwrite the servicing of debt (ie incomes are stuck). Debt forgiveness does nothing for resource issues ... a problem compounded by the fact we have used debt as a proxy for real resources.

The only real conclusion is a scrap over a shrinking pie ... so the rules will have well and truely changed before the 2030s

What's the forecast on recession predictions proving wrong at this point? Everyone and their dog seem to have had a go at it over the last few years, why is this time different?

Squishy, as has been said above, economists have predicted 9 out of the last 5 recessions ;-)

However, if we put forecasting to one side, what this article also comments on is... what signs we might look at for the next recession, what the particular risks are to the global financial system peculiar to this economic cycle and in future articles, how to prepare for that.

It would be just as stupid, if not more so, to say that there will never be another recession or financial crisis. It is always wise to study the global economy, be as informed as you can be, listen to as many opinions and perspectives as you can and adapt as well as you can to the changes as they occur. If you have skin in the game, you position yourself accordingly. I try to process the information from as many places as possible, rather than become a devotee of a particular economist who fits my preferred narrative.

"The real nightmare is not just the crash but being unable to ever come back from it."

Indeed.