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Tuesday, 27 January 2009

Another Great Depression

I don’t like to start any new year on a gloomy note. I am by nature an optimist, but I am also a realist who readily faces facts. Right now those facts are not very pretty and suggest to me that the world has entered into another Great Depression. Here are some shockers about the US economy that are worth pondering.

The National Bureau of Economic Research reckons that the present recession began in December 2007. In only one month since then has the US economy not lost jobs, but worryingly, the job losses are occurring with increasing momentum suggesting that the economy is spiraling downward.

Last week the US government announced that the unemployment rate rose this past December to 7.2% from 6.8% the month before. The US economy lost 2.6 million jobs in 2008, of which 1.9 million were lost in the past four months. Of these, 524,000 were lost in December alone.

Importantly, there are clear indications that employment will drop further. Companies have been cutting back on hours worked, which reached a record low in December of 33.3 hours per week. This measure is a leading indicator because companies first cut back on hours worked before they cut jobs. Also, layoffs are growing. The Wall Street Journal reports: “The new year has brought no letup on layoffs, as employers have already announced more than 30,000 cuts.”

The monthly unemployment report is prepared by the Bureau of Labor Statistics . It reveals that the number of unemployed has climbed over the past year by 3.6 million to 11.1 million, but the real numbers are much worse when looking through the government sugar-coating in these reports. As The Wall Street Journal explains it: “While the official unemployment rate is 7.2%, a different figure that includes discouraged workers who have dropped out of the labor force and those working part-time because they can't find full-time work hit 13.5% in December. That was nearly a full percentage point higher than in the previous month and up from 8.7% at the end of 2007.”

While a 13.5% unemployment rate is shocking, the truth is even worse because the WSJ is still relying upon government reports. To get the unadorned picture, we need to turn to private economists, and I reply upon the work of John Williams of Shadow Government Statistics , who presents in his latest report the true picture of the dire unemployment situation: “During the Clinton Administration, ‘discouraged workers’ those had given up looking for a job because there were no jobs to be had were redefined so as to be counted only if they had been ‘discouraged’ for less than a year. This time qualification defined away the bulk of the discouraged workers. Adding them back into the total unemployed, actual unemployment, as estimated by the SGS-Alternate Unemployment Measure, rose to 17.5% in December from 16.6% in November.”

Unemployment is the key measure that signals whether or not a depression has begun, and by the SGS measures we are rapidly approaching the 25% unemployment rate usually mentioned as the most important signpost marking the depths of the Great Depression. That high rate of unemployment cut a wide-swath of misery through the American population.

Given the current 17.5% rate of unemployment, it would appear that I am not far off the mark to suggest that we have entered another Great Depression, and I am not alone in my thinking. Others who are more attuned to the economic situation see it the same way as I do.

For example, the following quote is from an OpEd piece by Nobel Laureate Paul Krugman that was published in The New York Times on January 5th: “The fact is that recent economic numbers have been terrifying, not just in the United States but around the world. Manufacturing, in particular, is plunging everywhere. Banks aren’t lending; businesses and consumers aren’t spending. Let’s not mince words: This looks an awful lot like the beginning of a second Great Depression.”

I agree, which is unusual because I don’t often agree with Mr. Krugman. But not only do I think his observation about another Great Depression is accurate, but I also agree with another key point of the analysis in his article.

Namely, Mr. Krugman observes: “In 2003, Robert Lucas of the University of Chicago, in his presidential address to the American Economic Association, declared that the central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. Milton Friedman, in particular, persuaded many economists that the Federal Reserve could have stopped the Depression in its tracks simply by providing banks with more liquidity, which would have prevented a sharp fall in the money supply...It turns out, however, that preventing depressions isn’t that easy after all.”

Not only is it not “easy”, it is impossible, and the reason is simple. Ludwig von Mises explained this phenomenon in 1912 in his seminal work, “The Theory of Money and Credit”.

Basically, banks make too many loans creating a ‘boom’ that is built upon an unsustainable and shaky foundation of credit. Eventually, the bankers and their borrowers realize that these extensions of credit and the mountain of borrowing that resulted from it was imprudent, and they then seek to improve the dire state of their overleveraged balance sheets. The ‘bust’ occurs because the loans made during good times inevitably lead to bad investment decisions that appear sound only within the illusory prosperity of the boom.

In short, prosperity comes from hard work and savings, not borrowed money and consumption. Unfortunately, hard work and savings have been in short supply, and economies around the world are now feeling the consequences.

For decades the global economy in general and the US economy in particular have enjoyed the boom. They are now in the throws of the bust, and this where Mr. Krugman and I part company. He believes that this current bust can be avoided by more of the same – government spending.

He says: “Friedman’s claim that monetary policy could have prevented the Great Depression was an attempt to refute the analysis of John Maynard Keynes, who argued that monetary policy is ineffective under depression conditions and that fiscal policy – large-scale deficit spending by the government – is needed to fight mass unemployment. The failure of monetary policy in the current crisis shows that Keynes had it right the first time. And Keynesian thinking lies behind Mr. Obama’s plans to rescue the economy.”

This wrong-headed thinking is what put the US economy – and indeed, the global economy – in this mess in the first place. Therefore, the cure cannot possibly come from government spending, all of which is going to come from debt – some $2 trillion of it that is estimated the government will borrow this current fiscal year.

If Mr. Obama follows this advice – and he has clearly indicated that he will – the US government will have gone ‘to the well’ once too often. It is foolhardy to think that the federal government’s resources and borrowing capacity are unlimited. They are not, and more to the point, they have already been exceeded. It’s just that too few people today recognize this reality, which is what always happens in bubbles. People accept certain conventional wisdoms without question or even any cursory analysis. For example, consider the following.

1. Circa 2000 – It doesn’t matter that Internet stocks are trading at multiples of revenue because ‘these companies are going to change the way we do business’.
2. Circa 2005 – It doesn’t matter that people are borrowing 125% of the home purchase price because ‘the price of homes always goes up’.
3. Circa 2009 – US government ‘T-bills and T-bonds are risk free’, so the federal government can borrow unlimited amounts of money. This example of bubble-mentality thinking not only ignores the defaults by countless governments, it also ignores the history of US sovereign defaults (gold in 1933 and silver in 1967) as well as the continuing debasement of the sorry US dollar from inflation.

It is questionable whether Keynesian dogma ever worked, but regardless, one thing is clear. Increased borrowing and spending by an overleveraged government in an overleveraged country that is already the world’s largest debtor will not make the economy strong or lead to an economic revival. It will lead to a collapse of the currency, just like it has done in dozens of countries throughout the world. By pursuing defunct Keynesian dogma the new administration is ringing the bell that signals the death knell of the dollar.

In short, the biggest bubble of them all – that the US dollar is ‘money’ – is about to pop. The US dollar is on the path to the fiat currency graveyard, and will soon get there.

Not only does the US have problems, but like the 1930s, they are global. While it had been hoped that China would be the shock-absorber of the world, both its exports and imports are falling from year-ago levels as its manufacturing activity stalls. Germany is also faltering, as is much of Europe. There is another similarity to the 1930s.

Most people mark the beginning of the Great Depression with the stock market crash in October 1929. I think it actually began over a year later with the collapse of the Bank of the United States in December 1930, a commercial bank based in New York City. Its failure turned an economic downturn into a full-fledged panic that rocked the American banking system to its core, which in turn sent ripple effects throughout the world, just like the collapse of Lehman has done.

Is there some good news for 2009? There are two things that should bring some cheer.

First, the plummeting price of crude oil to $40 a barrel has put some $200 billion back into the pockets of Americans. That may help economic activity somewhat or at the very least, help repair household balance sheets.

Second, gold is likely to have another good year as the world increasingly wakes up to today’s realities. As they do, they will also come to understand that gold is money, which is a good thing to hold any time, but particularly during economic and monetary turmoil.

by James Turk

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