The Folly Of A Depression Thesis
As I spend more and more time pondering the actions of our Treasury and Fed, along with the last Depression and the actual steps taken by various administrations (most specifically Hoover and FDR), I come to the conclusion that those who claim to know so much about it, and how to prevent it, are in fact either talking out their ass – or worse.
Yes, this means you Ben.
See, the common rhetoric is that we had a Depression because credit tightened and liquidity dried up – the government took a “you made a mess, you burn in it” attitude.
This, however, is simply not true, and worse, it ignores the fact that The Fed created the bubble in the 1920s that led to the Depression, just as The Fed created this bubble that is now bursting!
In fact, one wonders – if Ben was chosen for his expertise on The Depression, was (and is) his intent to cause the second one?
You could hardly pick a better matching set of conditions.
- In the 1920s The Fed’s (newly minted at that from The Federal Reserve Act of 1913) “liquidity machine” was on overdrive, and regulation non-existent. There was a huge property bubble created filling in swampland in Florida, stock market speculation was rampant, and even ordinary shoe-shine boys were running on 10:1 leverage on margin accounts. People were becoming rich by the hour, to the point that we called the entire decade “The Roaring 20s”. Likewise, this time around The Fed pumped liquidity into the markets after the 2000 Tech Stock disaster, The SEC removed leverage limits on investment banks, regulators willfully ignored the fact that entities under their regulatory umbrellas were sporting 20:1, 30:1, 40:1 or even 80:1 (in the case of Fannie and Freddie) leverage and the CDS marketplace made a mockery of any sort of leverage limit at all. People became rich by the hour speculating in real estate.
- When the bubble burst in the Florida Property market in ’27 and then in the stock market in ’29, there were some who argued for a “liquidationist” position – that is let the idiots who made the bad bets fail. Among them was Andrew Mellon, Secretary of the Treasury. Herbert Hoover had always been an interventionist and in fact promoted that stance as Secretary of Commerce under Harding and Coolidge. From his nomination speech onward, he maintained a strong interventionist stance, and refused to allow the debtors and creditors who were overextended to meet their just desserts in the marketplace, instead intervening to prop both up. Today it is George W. Bush’s administration, headed by Treasury Secretary Paulson, who is taking the exact same interventionist steps that led us into a Depression the last time, with Ben Bernanke cheering all the way!
- There were tremendous attempts to hide the truth in the 1930s in terms of which banks were solvent and which were not. As a consequence bank runs swept the nation, taking them down institution by institution, until FDR was finally forced to declare a bank holiday, go into every bank and inspect its books, and decide which ones were safe to re-open and which were not. Today, we have the same game being played, with mark-to-market rules being removed first here in the United States, over the weekend in Canada, and now a wire announcement just came across that the EU is permitting the same thing. This should not surprise, given that many European banks are levered to as high as sixty to one! And people wonder why there is no trust between banks?
It is commonly thought that FDR “got us out of the Depression”. This is abjectly false. In fact, it was not until World War II that we exited The Depression, and no meaningful recovery in economic activity occurred prior to that time. Roosevelt’s interventionist actions in the economy made the problem considerably worse, compounding errors by imposing wage and price controls among other things. The “New Deal” was in fact responsible for deepening the economic malaise and prolonging the misery, as it refused to acknowledge and force into the open the investment that had caused the collapse in the first place.
There were positive things that came out of FDR, one of them being the HOLC. But the HOLC was a vehicle brought about by the insanity of the 1920 property boom, where short-term (typically 5 year interest-only balloon loans) were being used to purchase property and when refinancing became impossible, mass defaults ensued (does this sound familiar?) In fact, the HOLC put in place the structure for what was, up until the 1990s, sound mortgage finance – 20-30 year term loans with a fixed interest rate and stringent debt-to-income ratios.
Current attempts to extend FHA, Fannie and Freddie refinancing are radically misapplying the lessons of the HOLC, as DTI ratios in the 50% range are still being permitted and zero-equity positions, or close to them (e.g. 3% down payments and down-payment “assistance” remain available.) This has resulted from a different approach to that taken in The Depression; at that time property price “resets” to levels affordable by the average income family were considered inevitable and reasonable, where today every effort is being made to avoid that.
There are even more striking parallels in the 2000s and the 1920s. Like, for instance, the fact that Fannie and Freddie “arranged” a stealth lobbying campaign to kill legislation that would have trimmed back their leverage – and prevented the collapse:
“If effective regulatory reform legislation … is not enacted this year, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system and the economy as a whole,” the senators wrote in a letter that proved prescient.
Unknown to the senators, DCI was undermining support for the bill in a campaign targeting 17 Republican senators in 13 states, according to documents obtained by The Associated Press. The states and the senators targeted changed over time, but always stayed on the Republican side.”
This, after both firms were caught cooking the books in a massive accounting scandal.
Where were the cops? Sleeping, apparently. The SEC certainly had jurisdiction, as these were publicly traded companies. Was anything done? Nope.
Nor was Congress about to crap on their gravy train. No surprise there, right?
And while John McCain has railed about Fannie and Freddie being malfeasors, he’s not quite so coy about his campaign manager and where he gets his funds:
“McCain’s campaign manager, Rick Davis, or his lobbying firm has taken more than $2 million from Fannie Mae and Freddie Mac dating to 2000. In December, Freddie Mac contributed $250,000 to last month’s GOP convention.”
I guess talk is cheap eh John? Now to be fair, Obama has taken more direct money – $120,349 .vs. $21,550. But over $2 million, and then $250,000 to fund the GOP convention? $120,000 makes you look like a piker compared to a $2 million payday, doesn’t it?
DCI’s web page touts “Expertise. Execution. Impact.”
Sure looks like they delivered what they promised, and now the entirety of the United States is getting it – getting violated, that is.
In the “Roaring 20s” there were similar naysayers warning about the excesses of leverage and bubbles in both stock and property prices, but once again nobody listened, and as has happened this time, once the bubbles burst every attempt was made to keep those who had made the bad bets from being forced to recognize their losses.
We have several things working against us this time around, and few things working for us, compared to the 1930s. Here’s a short list:
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In the 1930s we were resource-independent. Today we are near-absolutely dependent on foreign oil. We import about 2/3rds of our consumption, and while Canada’s supply is probably assured irrespective of our economic condition, the same is not true for the net creditors to the United States, particularly Arab nations. They both can and might cut us off, and so may Venezuela.
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In the 1930s we had debt owned by foreigners, but nothing like today. Today we require about $2 billion in foreign capital per day to remain solvent as a nation at the government level. This has been almost-entirely financed through the purchase of cheap foreign goods from China and oil from the Middle East. If either of those sources of foreign capital flows are disrupted, things get very bad very fast. There is no reason to believe that either of these blocks of nations will continue to provide this funding as our consumption of their goods decreases and thus their need to recycle dollars disappears.
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In the 1930s we had heavy industry out the wazoo in America. Today we have very little. Yes, we produce more now here than ever before – but as a proportion of what we consume, it is at all-time lows. What this means for us is that as those trade imbalances disappear prices are going to go up as the “recycling” trade goes away and production is forcibly repatriated here to the United States. (The alternative, a refusal to repatriate that production, is far worse, as that will result in a currency dislocation that will produce the same sort of price increases but no wage improvement for Americans. Down that road lies really serious trouble for us.)
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On the good side, we have technology we didn’t have then. This means we may be able to find efficiencies that were the stuff of fancy 50 or 100 years ago. The counter-balance to this is that the really big efficiency gains are likely behind us, having been gained in the 80s, 90s and the first part of the 00s.
In short we are setting up for what looks like an even Greater Depression, perhaps something similar to the 1873 panic. While the causes would be very different in practice, in principle they seem to be the same – malinvestment caused by “easy money” that, when business conditions turn, becomes “protected” by government – leading to Depression instead of an ordinary business recession and bankruptcy of those who overextended themselves. Now, as then, we have companies that have spent incredible amounts of money to buy influence – it was recently disclosed that AIG, for example, continues to pay lobbyists in an attempt to loosen regulation even though they are now surviving on money borrowed from The Fed!
Be prepared, get out of debt and position yourself so you can survive without the use of consumer or business credit of any sort.
If you have liquid cash, you will be in a great position to pick off property and other goods that people are forced to abandon as the situation worsens. There are many people who became fabulously wealthy as a consequence of The Depression, and all of them had one thing in common – they had cash when things got really bad, and were able to pick off assets cheaply in forced sales.
The TARP has now been proven a failure; even Secretary Paulson has abandoned his original plan, but what he hasn’t done is come back to Congress (or the American People) and apologized for the idiocy of his original proposal, nor has he taken responsibility for the equity market crash that this bout of insanity precipitated. Not that this is surprising in the least – expecting anyone in government to have the smallest bit of integrity and admit that they screwed the pooch and hosed Americans is asking too much, isn’t it?
After all its not his retirement that got shredded – its yours.
Bet on the economy worsening, especially with Obama nearly assured election, and Nancy Pelosi and others already talking about further massive government intervention. They just can’t resist revisiting the misery of the 1930s, and you can be assured that with people in Washington DC such as Paulson, Bernanke, Pelosi and Reid you’re going to get it – in spades.
As for the stock market, my target within the next 12-24 months is now S&P 500 – yes, trading at 500. This target may not be achieved in full, but I am rapidly losing confidence that the 2003 Bear Market lows will hold, and if they do not, that is the next area of chart support, a full loss of the entire original bull market level going back to the early 1990s.
When adjusted for inflation the damage will, of course, be far worse than the nominal numbers indicate. In fact, for many investors, especially those who try to “buy the dips” here, they will be catastrophic.
Beware.
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