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Worse than the Great Depression
Dr. Krassimir Petrov
War
on You
Monday, Feb 2, 2009
The mainstream media and Wall Street have reached
the consensus that the current credit crisis is the worst since
the post-war period. George Soros’ statement that ”the world
faces the worst finance crisis since WWII” epitomizes the collective
wisdom. The crisis is currently the ultimate scapegoat for all
the economic evils that currently plague the global financial
system and the global economy – from collapsing stock markets
of the world to food shortages in third world counties. We are
repeatedly assured that the ultimate fault lies with the Credit
Crisis itself; if there were no Credit Crisis, all of these
terrible things would never have happened in the economy and
the financial markets.
The most extraordinary thing is that the mainstream
media has never attempted to compare the current economic environment
to the one preceding the Great Depression. In essence, it is
assumed outright that the Great Depression can never possibly
happen again, ever, thus obviating the need for such a comparison.
I actually believe that the macroeconomic fundamentals today
are much worse, so that we are in for a protracted period of
economic depression – a depression much worse than the Great
Depression, a depression that would likely be remembered in
history as “The Second Great Depression” or The Greater
Depression, as Doug Casey has called it so aptly. Here
is why I believe that this is the case.
Duplicating
Mistakes from the Great Depression
At its core, the environment of the 1990s, and
the response of the Fed to the tech-telecom bust has created
an economic environment that has encouraged the repetition of
the very same mistakes that led to the Great Depression. Here
is a concise summary of widely recognized mistakes of the 1920s,
without going into the details, with obvious parallels in the
current environment
(Article continues below)
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Asset Bubbles – first in
the stock market during the 1990s, then in real estate during
the 2000s, pretty much mirroring the stock and real estate
market bubbles of the 1920s.
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Securitization – although
not in the very “ultra-modernistic” form and shape of the
2000s, with slicing and dicing of pools and tranches of
seniority, it was widely recognized in the 1930s that securitization
during the 20s drove the domino effect in the U.S. financial
system during the Great Depression.
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Excessive Leverage – just
like in 2008 the topic du jour is “deleveraging”, so the
unwinding of leverage during the 1930s was the driver of
forced liquidations and financial pain. Of course, it was
very clear back then that the root of the problem was not
deleveraging per se, but the excessive leverage that took
place prior to the deleveraging process. “Investment Pools”
were then instrumental in both the securitization and excessive
leverage, just like the Hedge Funds of today.
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Corrupt Gatekeepers – we
know well that the Enrons and Worldcoms were aided and abetted
by the accounting firms – those same firms that were supposedly
the Gatekeepers of the financial community, yet handsomely
profited from the boom while neglecting their watchdog functions.
In the current financial crisis, we also know that the rating
agencies were also making hay during the boom. Very similar
were the issues during the 1920s that led to the establishment
of the SEC and other regulatory bodies to replace the malfunctioning
“gatekeepers” at the time.
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Financial Engineering –
we are led to believe that financial engineering is a rather
recent phenomenon that flourished during the New Age Finance
Era of the last 15 years, yet financial engineering was
prevalent in the 1920s with very clear goals: (1) to evade
restrictive regulations, (2) to increase leverage, and (3)
to remove liabilities from the books, all too familiar to
all of us today.
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Lagging Regulations – just
like the regulatory environment lagged the events of the
1920s and regulations were introduced only after the Great
Depression had obliterated the U.S. financial system, so
we are yet to see new regulations addressing the causes
of the current crisis. Understandably, regulations should
have foreseen today’s financial problems and should have
been introduced before the crisis.
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Market Ideology – back
in the 1920s, just like in the last two decades, the market
ideology of “laissez faire”, which Soros quite appropriately
described as “Market Fundamentalism”, has swept the financial
markets. Of course, the free market knows the best, but
the reality is that the money market is not really free
– when the Fed determines the cost of money (interest rates),
and can fix this cost for as long as it wants, then all
sorts of financial imbalances can be sustained without the
discipline imposed by the market. This can lead to all sorts
of problems that we actually have to face today.
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Non-Transparency – back
in the 1930s, it was widely recognized that businesses and
especially financial institutions lacked transparency, which
allowed for the accumulation of significant imbalances and
abuses. Today, financial markets and institutions have intentionally
compromised transparency in a number of ingenious, or better
disingenuous, accounting trickeries and financial gimmicks,
like off-balance-sheet entities (SIVs), hard-to-understand
derivatives, and opaque instruments with mind-boggling complexity.
Today CEOs and Chief Risk Officers of major financial institutions
cannot figure out their own risk exposures. Originally,
lack of transparency was designed to fool the markets; ironically,
modern-day financial executives have gotten to the point
of fooling themselves.
Worse
than the Great Depression
So, why Worse Than The Great Depression?
What makes me believe that the current depression will be worse
than the Great Depression? I present six of the most important
fundamentals that are “baked in the cake” and that suggest of
a Greater Depression.
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Overvalued Real Estate.
The real estate market has been driven by a number of innovations
in real estate finance. Overvaluation in real estate implies
overvaluation in real estate financial instruments; an implosion
of real estate prices implies an implosion in those instruments.
It is widely recognized by economists that the Case-Shiller
Index is a good proxy for the prices of real estate. A widely-recognized
chart from 1890 to 2007 tells the story. The chart makes
it crystal clear that the current overvaluation of real
estate in real terms grossly exceeds the one during the
1920s. The coming correction in real estate will be protracted
and gut-wrenching, with an expected cumulative effect that
is much worse than the Great Depression.
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Total U.S. Credit. Credit
makes leverage: the more credit in the financial system,
the more leveraged it is. Today’s total U.S. credit relative
to GDP has surpassed significantly the levels preceding
the Great Depression. Back then, the total amount of credit
in the financial system almost reached an astonishing 250%
of GDP. Using the same metric today, the debt level in the
U.S. financial system surpassed 350% in 2008, while the
level in 1982 was “only” 130%. As Charles Dumas from Lombard
Street Research put it quite aptly, “we’ve had
a 30-year leveraging up of America, ending in an unchecked
orgy.”
The chart below shows a dramatic buildup
of debt (leverage) in the 1920s and a deleveraging from
1930 to 1945 (or 1952). Then it shows a consistent buildup
of debt afterwards, with a dramatic rise since the 1990s,
and surpassing in 2000 the previous peak in 1929. The
chart shows the level of 299% at the end of 2005, but
the level has already reached 350% by 2008.
Of course, leveraging, as already indicated
above, must necessarily be followed by deleveraging.
The best way to think about leverage is
to compare it with using drugs, while deleveraging is
like detox. The problem is not that the detox is killing
the patient who has abused drugs for years; what is really
killing the patient is the drug abuse itself. However,
one thing is clear – the patient must either go through
a painful detox or die; the same applies for the financial
system – it must either deleverage or implode.
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Explosion of Derivatives.
Derivatives have been likened by Warren Buffet to “financial
weapons of mass destruction”. The notional amount of total
derivatives, as well as “Value at Risk” (VaR), has skyrocketed
in recent years with the potential to destabilize the financial
system for decades. To put it more allegorically, derivatives
hang like a sword of Damocles over the financial system.
A comparison with the 1920s is difficult
to make. mostly Derivatives back then were extensively
used, although not widely understood. Given that I am
not aware of any statistics of derivatives for the period
of the 1920s, a meaningful comparison based on hard data
is admittedly impossible. Nevertheless, I would venture
to make an intelligent guess that the size of modern-day
derivatives is hundreds or even thousands of times larger
relative to the size of the economy in comparison to the
1920s. Some of the latest reports indicate that the total
notional value of derivatives outstanding surpasses one
quadrillion dollars. To put this into perspective, this
amounts to almost 100 times the GDP of the U.S. economy.
The chart below shows the explosion of derivatives
in the U.S. banking system. You can see that in 1991 the
notional value of the derivatives was about the size of
the U.S. GDP. By 2006 the size has grown to about 10 times
the GDP, vastly outgrowing the real economy.
The chart below shows an even more telling
picture. It shows world GDP and world’s notional value
of derivatives. Again, while there is no direct comparison
with the 1920s, it is clear that the overall level of
derivatives has skyrocketed during the last two decades
and presents risks that were simply not present at the
onset of the Great Depression. The unwinding of these
derivatives could only be compared with a nuclear explosion
in the financial system.
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Dow-Gold Ratio. The Dow-Gold
ratio represents the most important ratio between the relative
prices of financial assets and real assets. The Dow component
represents the valuation of financial assets; the gold component
– of real assets. When leverage in the financial system
increases significantly, so does this ratio. A very high
ratio is interpreted as an imbalance between financial and
real assets – financial assets are grossly overvalued, while
real assets are grossly undervalued. It also implies that
a correction eventually will be necessary – either through
deflation, which implies deleveraging and a collapsing stock
market, or through inflation, which implies stagnant stock
market for many years and steadily rising prices of real
assets, commodities, and gold, usually associated with stagnant
economy and typically resulting in stagflation. The first
case—deflation—occurred during the 1930s, while the second
case—stagflation—occurred during the 1970s.
The graph below illustrates the above concepts.
The very high Dow-Gold Ratio in 1929 was followed by the
Great Depression, while the higher level in 1966 was followed
by the stagflationary 70s. It is evident from the chart
the peak in 2000 surpassed the previous two peaks in 1929
and 1966, so this provides a reasonable expectation that
the forthcoming return to “normalcy” will be more painful
than the Great Depression, at least in terms of cumulative
pain over the next 10-15 years.
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Global Bubbles. It is impossible
to make direct comparison with the 1920s, but today the
global economy is rife with bubbles. Back then in the 1920s,
the U.S. had its stock and real estate bubbles, while the
European economies were struggling to rebuild from the devastations
of WW1 that ended in 1919. I am personally not aware of
any other bubbles during this period, although I welcome
reader feedback on this topic.
Today the picture is very different. The
U.S. economy had a stock market and real estate bubble
that has surpassed its own during the 1920s. Colossal
US current account deficits have fuelled extraordinary
growth in global monetary reserves. As a result, Europe
has real estate bubbles across the board, from the U.K.
and Ireland, throughout the Mediterranean (Spain, France,
Italy and Greece), to the entire Baltic region (Latvia,
Lithuania, and Estonia) and the Balkans (Romaina and Bulgaria).
Even worse, many Asian countries (China, Korea, etc.)
also have their own stock and property bubbles, only with
the exception of Japan, which is still in the process
of recovering from its own during the 1980s. Thus, during
the 1920s only the U.S. suffered from gross financial
imbalances, while today the imbalances have engulfed the
whole world – both developed and developing. It stands
to reason that the unwinding of those global
imbalances is likely to be more painful today than it
was during the Great Depression due to both size and scope.
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Collapsing Bretton Woods II. The
global monetary system was on a quasi-gold standard during
the 1920s. Back then dollars and pounds were convertible
to gold, while all other currencies were convertible to
dollars and pounds. An appropriate way to think about it
is that of a precursor to the Bretton Woods from 1945-1971.
What is important to understand is that while the system
was fiat in nature, gold imposed significant limitations
to credit expansion and leveraging.
Somewhat similar was the role of Bretton
Woods that lasted from 1945 to 1971. The dollar was tied
to gold, while all other fiat currencies were tied to
the dollar. Just like the interwar period, gold imposed
some limitations on credit and financial imbalances.
We now live in what has been termed Bretton
Woods II. Essentially, this is a pure fiat dollar standard,
where all currencies are convertible to dollars, either
at fixed or floating exchange rates, while the dollar
itself is convertible to “nothing”. Thus, the dollar has
no limitations imposed to it by gold, so without the discipline
of gold, the current global monetary system has accumulated
significantly more imbalances than ever before in modern
capitalism. These imbalances show up in the international
monetary system as unsustainable trade deficits (and surpluses),
skyrocketing official dollar reserves in some European
and many Asian central banks, and the proliferation of
Sovereign Wealth Funds; more generally, these imbalances
result in a myriad of bubbles, overleveraging, and other
maladjustments already discussed above.
Today Bretton Woods II is in the process
of disintegration. The world is slowly but steadily losing
its confidence in the dollar as the world reserve currency.
A flight from the dollar is in progress and the collapse
of the global monetary system is imminent. As Bretton
Woods II disintegrates and a new system replaces it, the
process of readjustment will be necessarily more painful
than the respective process during the Great Depression.
A caution on terminology is necessary here.
While the literature over the last 10-20 years has widely
recognized the term “Bretton Woods II”, in September-October
of 2008 the term was widely used by the media to describe
a proposed international summit with the goal of reconstructing
a new international monetary system designed from scratch,
just like “Bretton Woods”. Instantly dubbed by the media
“Bretton Woods II”, this term could be potentially very
confusing as it could mean very different things to different
people. The interested reader should consult Wikipedia’s
Bretton
Woods II where both meanings are explained in detail.
Conclusion
Since August of 2007 we have witnessed the relentless
escalation of the credit crisis: a steady constriction of credit
markets, starting with subprime mortgage-backed securities,
spreading to commercial paper, then to interbank credit, and
then to CDOs, CLOs, jumbo mortgages, home equity lines of credit,
LBOs and private equity markets, and then generally to the bond
and securities markets.
While the media describes the problem as one of
illiquidity and confidence, a more serious analysis indicates
that boom-time credit has been employed unproductively and so
losses must be incurred. In other words, scarce capital has
been misallocated, poorly invested, and effectively wasted.
No amount of monetary or fiscal policy can fix the errors of
the past, just like no modern treatment can quickly restore
to health a drug addict debilitated from a decade-long drug
abuse.
Based on indicators like (1) global real estate
overvaluation, (2) indebtedness, (3) leverage, (4) outstanding
derivatives, (5) global bubbles, and (6) the precariousness
of the global monetary system, I would argue that the accumulated
imbalances in the current period surpass significantly those
preceding the Great Depression. I therefore conclude that the
coming U.S. (and possibly) global depression will be of greater
magnitude than the Great Depression of the 1930s. It likely
suggests that we are entering a historic period that will likely
be known as The Greater Depression.
Investor beware!
Only gold can protect you from the ravages of another Depression!
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INFOWARS:
BECAUSE THERE'S A WAR ON FOR YOUR MIND
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