Golden words

The Great Depression is a topic taught in many economic courses - one which holds many lessons that professors hope leaders of the present and future will heed. Alas, history is beginning to repeat itself, not even a century later. The Great Depression is a thing of the past; the Greatest Depression is a thing of the future.

Let's look at some of the trends and similiarities that exist between our economy now and the economy just before the Depression. To understand the story, take yourself back to the early twenties...

WWI had just finished. Men were returning home, women were sex-deprived, and all the war bonds people had purchased during the war were being turned in for cash. For those who don't know what war bonds are: during the war, factories were sanctioned with respect to what they could or couldn't produce. There was no need for leather sofas, if there weren't enough bullets being made. So all these factories were converted to assist the war effort, and citizens led a meagre life with the basic necessities and a corresponding savings. What to do with all this money? Well the government needed to finance their wars and so they started selling war bonds - an effective way to force saving, harness the liquidity of their citizens, and keep people working. When the war ended, factories reverted to producing consumers goods and people were cashing in their war bonds. A lot of money flowed into the economy with an increase in the production of consumer goods. Life was good.

The roaring 20's were characterized by lavish spending, increase in large purchases (homes, appliances, and cars), lower interest rates, and a greater income inequality. While the regular folk were cashing in bonds and spending, factory owners were making money hand over fist.

Lets compare this to the 1990s. The Cold War ended when the Berlin Wall crumbled (in 1989 I believe). America was victorious, the need for billions in defense ceased, and so with stability came investment and peace. A time for prosperity. Innovation grew, mainly with technology and sophisticated in financial markets. People became richer and richer, the advances in financial markets allowed for more credit and thus borrowing increased as well. The spending potential of the average consumer increased exponentially. Life was good. But it closely mirrored the behaviour of the early-to-mid 1920s.

Many economists have theories as to why the depression happened. Keynes has noted that the government didn't step in to aid the economy when it was flailing (hence governments now run deficits during recessions to maintain balance). Friedman stated that the FED didn't inject enough cash into the system. Hundreds of other theories exist as well. None of them really matter because we find ourselves in a simliar position today.

A lot of factors contributed to the economic meltdown in 1929. What happened was actually quite simple. It was easy to get credit. Banks had propped up all over the USA. Many were a single branches who lent credit to locals and was occasionally supported by the big city banks. Money was cheap, times were good, and so credit was doled out it like was nobody's business. But it was. It was somebody's business to keep the all important risk/return in check. With the increased demand in cash (everyone was borrowing and spending money) came an increase in the price of cash, or the interest rate. As rates edged upwards more and more people started defaulting on their loans. The bigger city banks were able to withstand these pressures, but small-town, single branch banks became unstable. They were unable to maintain liquidity with the increase in defaults. Initially the city banks helped their little cousins out with short-term interbank loans. Eventually the tap ran dry and all hell broke loose. Banks went belly-up, consumer confidence plummeted and the all-important spending dropped. So two things happened: the small banks went bankrupt, people had available credit lines dry up and so were unable to pay their bills and maintain their lifestyles, bigger banks had their loans lost (since the little banks went bankrupt), business started to suffer since everyone stopped buying goods, larger corporations experienced debt service problems and they began to default as well. The economy was in a free fall. Keep in mind this story is EXTREMELY simplified and occured over half a decade. There were mini peaks and troughs in this story but at the end of the day the economy tanked.

Fast forward to the late 1990's. Tech stocks were pushing wealth to never-before-seen levels. All of a sudden, however, consumer confidence dipped and tech stocks burst. Hence the year 2000 popping of the bubble. Since then the economy has rebounded, just as it did in the early 30s, but real estate (a leading indicator of future economic health) has reduced (as it did in the early 30s). With people buying less homes, the positive outlook turns sour. Less appliances are bought and all other associated items with a new home purchase. The mood has soured. We currently exist in the most highly leveraged, consumer-driven, unequal level that society has EVER been in.

US currency has fallen to 15 year lows. Foreign investors are beginning to fret. Why invest in North America if they can get higher relative returns in Europe? The Republican will tell you that financial markets are sophisticated now. Credit and debt has been revised to withhold large levels of default. In the 20's when a bank lent you money, they kept the debt on their books and if you defaulted they were the sole losers. Nowadays, banks package their debt and sell it off to other banks in bits and pieces. It is as if you lent $20 bucks to a friend and then borrowed ten from another and told that guy that the first borrower would pay him from the 20 he owes you. So now if one of us dies, I'm only out $10 bucks since I borrowed the other $10 and I share the loss with my second friend. Voila. This arrangement saved the economy many times, throughout the years, but how robust is the system really? How many defaults or interest hikes are we away from another meltdown?

The Chinese currently buy American debt like its going out of style. When you that the US consumer is spending more money, you have to wonder where they're getting this money from. In one word - China. China makes products that it cannot possibly sell at home, so it has to sell abroad (US). If the Americans don't have the money to buy their goods then China gets fucked. So what does China do? Lend the US money to buy Chinese stuff. Its a beautiful relationship until two things happen: 1. The avg Chinese is able to start spending money and buying up goods made in China, so the American market becomes unneeded, or 2. Interest rates go up, Americans can't support their monthly payments and begin defaulting.

Next year, Americans will pay more in debt service to foreigners than they will in taxes to their government!! Can you imagine that? The country is paying more to outsiders than they are to themselves? Note the shift in power. If foreigners are receiving more money from Americans they are going to have more power over US citizens than their own government. A shift in interest can turn the whole country into turmoil.

Another issue: settlement defaults. Bank A owes Bank B who owes Bank C who owes Bank D who owes Bank A. At the end of a business day, everyone pays everyone and all accounts are settled. Ofcourse there are more than four banks in the world and so think of how complex the system is. When this systems fails or their is a cross default where all accounts aren't settled, then we risk a meltdown. This failure is happening more and more and the system is becoming more complex and burdened. On 9/11, the system effectively failed. One account couldn't get settled by another and so a domino effect happened. Settlements were short by $1.4 trillion dollars. If left unheeded, we would have plunged into a depression. The FED stepped in and pumped $1.4 trillion into the economy to jumpstart it back to life. Since then, the system has failed four times, each time the US FED stepping into to bring it back to life.

Conclusion? Don't expose yourself to the system entirely. The notion of losing everything you have isn't impossible. Pay down your debt, have cash in the bank, invest in gold, and own your home as soon as possible. This was true back in the 20's and it is just as true now. I wish I could listen to my own advice...