Why Another Depression Is NOT Off the Table
by Thomas P. Au, CFA
June 28, 2010
Most people breathed a sigh of relief as the economic crisis of early 2009 came and went. Another Great Depression had been avoided, or so people thought. After they got over their initial, late 2008 shock, the U.S. Treasury Department and Federal Reserve Bank got the job done, albeit in the worst way, creating enough liquidity to prevent a financial “seizure,” at the cost of worsening the deficit.
That deficit is actually symbolic of America’s problems. Current income levels can only support a 1980s level of spending. We’ve been borrowing the difference, meaning that once the lending window is closed (as it was recently), there has to be a quarter century regression in the American standard of living (the original 1930s took America back to the 1910s). That was the true meaning of the 1930s Depression. Soup lines and 25% unemployment were merely the symptoms.
The current problem is also expressed in the housing bubble. Greedy and chicane banks convinced American home buyers to pay more for housing than their incomes could support, borrowing the difference in (often) adjustable rate mortgages. As long as home equity could be extracted from such houses, this process actually boosted consumer spending. But when the process stopped, due to interest rate resets, the result was that discretionary consumer spending has been crippled for a whole decade. Or if homeowners practice “strategic default” and the banks ending up eating the losses, bank balance sheets and lending will be crippled for a decade, which means getting to the same place in a slightly different way. And this problem will come to a head in the summer of 2010, as teaser rates on adjustable rate mortgages adjust upward again, while the $8000 a head housing “stimulus” comes to an end.
And if this weren’t bad enough, it is likely that our fate may not be in our own hands.
It is important to remember that the 1931 event that caused what was only a severe recession to morph into a decade-long Depression took place outside of the United States. This was the collapse of the CreditAnstalt Bank in Austria, which was Germany’s largest “offshore” bank. It brought about the unraveling of the German economy (then the world’s second largest, de facto, if not de jure).
There are plenty of problems in modern Europe, which could be the site of a second Credit Anstalt event. The continent is breathing a sigh of relief as Greece is pulling back from the edge of a cliff, with the assistance of European bailout funds, after having been led there by American banks like Goldman Sachs. But other countries like Spain have stepped into the dock, with similar problems. And if there is domino effect in other “PIGS” countries such as Italy and Portugal, the resources of the European union probably won’t be enough to stem all the problems.
And that might not be even where the biggest danger spot lies. Rather it is probably connected with China, and specifically “offshore” China, in Hong Kong or Taiwanese, or possibly Korean banks on which China depends, but cannot control. China has replaced Germany (from the 1930s) as the de facto world’s second largest economy, which is to say that the United States depends on the well-being of this economy, more than any other, for its own growth.
China (and America) would be in fine shape if America had taken advantage of this situation in moderation, thereby providing a boost to both economies. But as in the 1920s, America’s turn of the century party turned into an orgy. That is to say that the Americans bought more Chinese goods in the past decade than they can reasonably pay off, in order to fuel a steroidal, consumer driven, growth. Meaning that the Chinese were also induced to expand their productive capacity to a greater degree and at a faster rate than was healthy for them.
Global economic growth in the past decade and a half has been the result of a Faustian bargain between Chinese overproduction and American overconsumption. These two forces compensated for each other, while pulling the rest of the world along. As long as both processes remained healthy, the world was ok. But the attenuation of either one is problematic for world markets, of both spells serious trouble.
Americans are finally getting weary of consuming more than they can produce, and working ever harder to pay off the “finance charges” on things they have enjoyed in the past, but may not soon enjoy in the future. China, on the other hand, doesn’t yet have the means to manage the consumption of all that it produces, meaning that a lot of production is finding its way into the sump pit called real estate. This will be a temporary palliative until the underlying superstructure becomes too heavy, and topples over, from the paucity of cash flows relative to the so-called investment. This would expose the massive malinvestment (and underlying lack of investment opportunities), bringing down the rest of the Chinese and global economies.
In the final analysis, it was such a lack of investment opportunities that brought about the depression of the 1930s. This, in turn, stemmed from the overinvestment of the 1920. A similar pattern was exhibited in the past decade and half, based on a false belief in a “new economy.” Large investments were made in the past decade that will pay off only in our children’s time (the 2020s and 2030s), not today. This dampens investment between now and then. The 1930s exhibited a similar investment chasm relative to the 1940s and 1950s.
The other result of the past decade is that economically, China and the United States are now like Siamese twins (the original of which could not be separated without killing one or both of them). Only the working of the above U.S.-China bargain staved off the bad outcomes. If that bargain is coming to an end, the world may be in for the “mother of all depressions.”