Op-Ed: The Second Great Depression?

By Minyanville Staff  OCT 06, 2008 2:45 PM

Unnerving parallels between now and then.

 


Editor's Note:  James Quinn is a senior director of strategic planning for a major university. James has held high level financial positions with a retailer, homebuilder and a university in his 22-year career.

This country has been living in false prosperity since the early 1980s: The huge McMansions, luxury cars, high tech gadgets, granite kitchens, second homes and exotic vacations were all purchased with debt. These “assets” are depreciating rapidly, and consumers and companies are selling them desperately to pay down their suffocating debts.

The psychology of this country has begun to change from conspicuous consumption to forced liquidation and saving. The most recent flow of funds data shows that total credit market debt is $51 trillion; our GDP is $14.3 trillion. Debt as a percentage of GDP is now 356%; during the Great Depression, it was 260%. This massive buildup of leverage is just beginning to unwind; the pain will be tremendous when it gains momentum.

Coming Depression?

There's no consensus regarding the causes of the Great Depression, but some common themes are clear. I will try to evaluate today’s environment versus the conditions that existed in the 1920s.

1. Expansion of the money supply during the 1920s

According to the Austrian School of Economics, the Great Depression was mainly caused by the expansion of the money supply by the Federal Reserve in the 1920s, leading to an unsustainable credit driven boom. Both Friedrich Hayek and Ludwig von Mises predicted an economic collapse in early 1929. In the Austrian view, it was this inflation of the money supply that led to an unsustainable boom in both asset prices (stocks and bonds) and capital goods.

Alan Greenspan reduced interest rates to 1% for over a year in 2003. This act led to a speculative frenzy in real estate, $3 trillion of equity withdrawal by consumers and tremendous overconsumption built upon a foundation of debt. This speculative frenzy was exacerbated by the “Masters of the Universe” on Wall Street, with their CDOs, MBSs, and other magic potions that made bad loans appear good.

The Bush administration’s decision to not enforce any existing oversight of the banks also contributed greatly to the current situation. Realistically, the current conditions are worse than they were prior to the Great Depression, based on the speculation that has occurred in the last 8 years in stocks and real estate.

2. Excessive debt leading to false prosperity

By 1929, the richest 1% owned 40% of the nation’s wealth. The top 5% earned 33% of the income in the country, while the bottom 93% experienced a 4% drop in real disposable income between 1923 and 1929. The middle class comprised only 20% of all Americans.

Society was skewed heavily towards the haves but, by 1929, more than half of all Americans were living below a minimum subsistence level. Those with means were taking advantage of low interest rates by using margin to invest in stocks. The margin requirement was only 10%, so you could buy $10,000 worth of stock for $1,000 and borrow the rest.

There are some disturbing parallels between what was happening during the 1920s and what's been happening in America in the last 10 years. Today, the richest 1% own 21% of the nation’s wealth. The bottom 50% experienced a 4% drop in real disposable income over the last 8 years. During the dot-com boom, small investors used massive margins to speculate in companies with no earnings. When this bubble collapsed, a lesson should have been learned. Instead, Alan Greenspan lowered interest rates to 1% and encouraged everyone to take out an Adjustable Rate Mortgage. The speculation in real estate reached phenomenal heights by 2005; the downside of that speculation is now only half finished. Stabilization of housing prices is at least another year -- and another 20% to the downside -- away.

That would still leave prices high on a historical basis. Home prices did not fall on a national level during the Great Depression.

Excess speculation by a small group of wealthy investors

The administrations of Warren Harding and Calvin Coolidge are considered the most corrupt in American history. Coolidge declared that “the business of America [was] business,” and his was a laissez-faire, anti-regulation government.

The top tax rate was lowered to 25% in 1925, the lowest in any decade since. Exports boomed due to the low value of the dollar versus the British pound. Wall Street speculators were a ruling elite in a society in which only 1.5 million out of 120 million people invested in the stock market at all.

Ben Strong, attempting to help Britain, reduced rates in 1927. This ignited a speculative frenzy in 1928 and 1929. Margin loans increased from $3.5 billion in 1927 to $8.5 billion in 1929. Stock prices rose 40% between May 1928 and September 1929, while daily trading rose from 2 million shares to 5 million shares per day. The market reached a peak of 381, with a P/E ratio of 23 based on normalized earnings, on September 3, 1929.

Greenspan’s excessively low rates caused a speculative frenzy in stocks, then housing. The Bush administration’s belief that free markets can regulate themselves led financial institutions to take ridiculous risks and acquire massive amounts of debt. Despite 2 ongoing wars and growing budget deficits, the Bush administration decreased taxes on the wealthy.

The dollar declined dramatically over the last 8 years, resulting in increased exports. The PE ratio of the market reached an astronomical 38 in 2000, before crashing below 20 by 2003. Currently, the P/E ratio (25) exceeds that prior to the crash in 1929.



In the last few months, how many times have we heard Hank Paulson, John Thain, and other Wall Street cheerleaders tell us the banking system is safe and sound? Ben Bernanke has reduced interest rates dramatically, pumped money into the banking system, and taken bad assets onto the Fed balance sheet. So far, this doesn't appear to be working. The market has declined 30% from the peak, but is overvalued on a historical basis with profits about to plunge during the coming downturn. Tighter credit, higher taxes and higher tariffs

Ben Bernanke, a self-proclaimed expert on the Great Depression, concluded that missteps by the Fed in 1930 and 1931 caused the Depression. After the stock market crashed, speculators began selling dollars for gold in 1931. This caused the value of the dollar to plummet. The Fed raised rates and reduced the money supply by 30% to prop up the dollar. Investors began withdrawing their dollars from banks.

By the end of 1932, 9,000 banks failed. People hid their cash under their mattresses. Bank deposits were uninsured, so when banks failed, people lost their life savings. Businesses failed; panic and fear gripped the nation. The remaining banks hoarded their cash, refusing to make loans to businesses.

Instead of stimulating the money supply, the government attempted to protect American businesses by passing the Smoot-Hawley Tariff in June 1930. This bill increased taxes on imports, which led to retaliation by other countries and contributed greatly to the worldwide downturn. World trade declined 67% by 1933. Herbert Hoover increased the top tax rate from 25% to 63% in 1932.

All these missteps led to a downward spiral in the economy. In 1930, the GNP declined 9.4%; unemployment rose from 3.2% to 8.7%. In 1931, the GNP declined a further 8.5% and unemployment surged to 15.9%. 1932 was the worst year of the Depression, with GNP down 13.4% and unemployment reaching 23.6%.

Thus far in the current crisis, no one can accuse the Fed of failing to provide liquidity or reduce interest rates. The discount rate has been reduced from 4.75% to 2% in the past year. In the last 9 months, the Fed increased their balance sheet by over $1 trillion. The government has committed in excess of $1.3 trillion of taxpayer money to keep the financial system from imploding.

The question that has yet to be answered is whether a severe recession or possible depression is inevitable regardless. The country has a national debt of $9.6 trillion, annual deficits of $600 billion, unfunded future liabilities of $53 trillion, a trade deficit of $600 billion, inflation of 6%, 2 wars costing $12 billion per month, and a weak currency. Therefore, we have entered an extremely dangerous period without strong economic fundamentals.

In the last few years, Congress has become much more protectionist. The sale of US ports to Abu Dhabi was blocked. The acquisition of a US oil company by China was also blocked. Worldwide trade negotiations recently broke down with no agreement reached. Free trade is being threatened.

In 4 weeks, the country will likely elect Barack Obama; Congress will be overwhelmingly in the hands of the Democratic Party. Mr. Obama has made it clear that he will increase taxes on corporation and those earning more than $250,000. His plans include health coverage for all Americans and major spending initiatives on education and infrastructure. With colossal deficits, a protectionist Congress, tax increases coming, and gigantic spending initiatives, the next 4 years will be exceptionally difficult for the US. economy.

The parallels to the early 1930s are eerie.

Morass of Uncertainty

The $820 billion bailout package won't fix what's wrong with this country. Hank Paulson will buy bad assets from any financial institution for some yet to be determined price.

Many smart people have concluded that the plan will not work. The banks need a direct infusion of capital to begin their recovery process. The American taxpayer will never see a dime of that $820 billion paid back. When was the last time a government program actually worked?

Corrupt politicians, Washington bureaucrats, Wall Street fat cats, and clueless commentators have failed to realize that the jig is up. Our entire financial system has been built upon deception, lies and debt. The only thing keeping the system afloat was blind faith in our government and financial leaders to do the right thing. That trust has been shattered into a billion pieces. There's currently a worldwide run on the banking system. Nowadays, bank runs can occur in seconds: Companies and wealthy people in the know are pressing buttons and transferring billions in cash out of shaky financial institutions. With leverage of 30 or 40 times their cash balances, banks are collapsing around the globe while the average American is kept in the dark by the all-powerful lords of finance.

Governments worldwide are desperately trying to stem the tide of defaults; Ben Bernanke and Hank Paulson are scrambling to provide enough liquidity to keep the system from imploding. A coordinated reduction in interest rates worldwide will soon occur as a last-ditch effort.

For the first time in many years, I saw something that shows promise for our country’s future: The American public was firmly against this bailout bill. I sense that the “Me Generation” is finally ready to accept the consequences of their selfishness, and the materialistic frenzy that's been the hallmark of the past 30 years is coming to an end.

It's being forced upon many, but will be the choice of many more. The worldwide deleveraging will lead to a new mantra of frugality and living within your means. People will turn inward and seek comfort in more simple pursuits. While this will ultimately be beneficial, the immediate effects will be wrenching.

The irony of our current economic system is this: If everyone lives within their means, the economy will collapse. Spending money we don't have is what's driven our country for the last 3 decades. But if banks won't lend, credit card companies won't offer credit, and auto makers stop financing cars, consumers will have no choice but to downsize. The government, by contrast, will continue (and likely accelerate) deficit spending.

By the time this crisis is finished, we're likely to be left with 5,000 banks or less (there are now 8,500). The official unemployment rate will easily surpass 7%, possibly reaching 8% by 2010. Based on the unemployment calculation used during the Great Depression, we already have unemployment of 15%. This could conceivably reach 20%. Market P/E is still above 20. Profits will plunge in 2009 and irrational pessimism could propel the Dow to its 2002 low of 7,200. That would be 28% below today’s levels and almost 50% below the all-time high of 14,000.

Even if we somehow avoid a true depression, the next few years will be extremely painful. The question is whether we come out stronger on the other side, or as a nation in decline.

The words of Congressman Ron Paul should be our rallying cry:

“The issue boils down to this: Do we care about freedom? Do we care about responsibility and accountability? Do we care that our government and media have been bought and paid for? Do we care that average Americans are being looted in order to subsidize the fattest of cats on Wall Street and in government? ...When the chips are down, will we stand up and fight? Times like these have a way of telling us what kind of a people we are, and what kind of country we shall be.”

It's time for our citizens to accept the bitter medicine of bad times, learn from our mistakes, and put this great nation back on course.
No positions in stocks mentioned.

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