The modern 1930s are the logical consequence of the "New Economy" of the past decade, just as the original was a logical consequence of the "Roaring Twenties." In each case, technology and leverage combined to create a potent but ultimately poisonous brew of wildly inflated asset prices. In essence, greedy CEOs (and investment managers) said, "we brought you the new economy, please cash us out now." And a gullible American public affirmed this by bidding up prices to insane levels, expecting to share, rather than subsidize, the wealth of the selling shareholders. First the tech companies, then the financial intermediaries were then caught in traps of their own making, and escaped as sorely crippled entities, if they survived at all. But by this time, the more privileged players had "taken their money and run."

Probably without meaning to, the Los Angeles Times aptly summed things up with an article headlined "A New Great Depression? It's Different This Time." The aptness is if you interpret the headline as "The Depression is Different This Time" as opposed to "Things Are Different This Time." The details will naturally differ from those of the 1930s, but the substance will remain the same. But the paper dismisses the popping of asset bubbles in housing and stocks as merely "disturbing parallels." Working together, the Fed (and the modern J.P. Morgan) "saved" Bear Stearns, the modern Bank of the United States, thereby preventing a collapse of the banking system. International trade remains robust, at least for now. So things don't seem to bad, at least to the Times.

But are things really that different almost 80 years later? For instance, the popping of major asset bubbles almost defines a recession by itself. And one can argue that the 1930s collapse of the banking system is the consequence, or reflection of the real economy, rather than its cause. So saving one insolvent institution isn't going to prevent the unraveling of the rest of the system early in the new century. And yes, the international situation is okay, but that's just because America is the cause, rather than the recipient, of global economic problems this time around; falling stock prices abroad are saying that foreign GDP growth will soon collapse as a result of America's troubles.

In deciding whether or not we are headed toward depression, one needs to look at the substance of economic events, as opposed to the form. Some examples of the substance: 1) A post-war record level of home foreclosures headed to 1930s levels fueled by a similarly record collapse of home prices. 2) Several major "runs on banks" as investors begin to wake up to the fact that a lot of what passes for collateral is in fact worth very little. 3) A panicked Fed trying to head off a financial panic by simultaneously lowering interest rates and injecting money into the system.

And what's worse, we are only in the early stages of the crisis. Last year, 2007, was the year that the mortgage market unwound. This year, 2008, will feature the collapse of major financial institutions, starting, but not ending, with Bear Stearns. Next year, 2009, will be the year when the problems make their way to the rest of the U.S. economy, including the still-buoyant industrial sector. By 2010, the recession (or worse) will be global.

Some take comfort in the fact that we haven't yet seen soup lines, or 25% unemployment. But soup lines are merely an unnecessary (and hopefully unrepeated) appendage of the above. And anecdotal evidence suggests that many welfare agencies are now stretched to the absolute limit, meaning that new soup lines will appear if the system is tested just a bit more. And unemployment hasn't risen because companies have so far chosen to cut health care and pension contributions rather than lay off workers. One can easily get to the 1930s 25% unemployment with a 0% headline unemployment rate - by assuming that half the work force will be "temps" working half time without fringe benefits.

But perhaps one of the better definitions of the modern 1930s was given in a previous article on this site - a two decade pullback in the American standard of living to the 1980s (the original took American consumption back to the 1910s). Such a pullback seems inevitable from the deleveraging and loss of wealth that is now taking place. Moreover, such a retreat would last for an extended period of time. That's because we had the best of all possible worlds (relative to the true state of the global economy) for most of the past decade and half. The next decade and half will probably see the worst of all such worlds.

Regards,

Tom Au
The Daily Reckoning Australia

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The inflation that most American economists remember best (from the 1960s and later) is wage inflation, otherwise known as demand-pull inflation. Workers observe rising prices and demand compensation in the form of higher wages, which creates a vicious cycle of more inflation and more wage demands. This has not been happening until recently in the United States, due to the absence of labor unions, and to what Karl Marx called the "reserve army of the unemployed" in "offshore" markets. This appears to be the form of inflation that the Fed and other U.S. government authorities are focusing on, and it has indeed been benign up to now.

A less common, but more volatile form of inflation is commodity inflation, better known as cost-push inflation. We can see it today in commodity prices such as energy and metals. Energy and food price changes are excluded from "core" inflation because of their period-to-period volatility. But over time, oil price rises have averaged 6% a year, higher than other forms of inflation, and assuming that they don’t cause inflation is really assuming away the problem. Other commodities such as timber rise at 3% a year "real" (above the rate of calculated inflation).

That’s largely because such rises are (wrongly) excluded from the calculation. Another form of commodity inflation that is excluded from the official statistics has been the parabolic rise in housing prices. (The government instead uses a calculation of "owner equivalent rents," which are basically tied to the benign wage numbers.) Commodity inflation is the most obvious form of inflation today (after having been quiescent in the 1990s), as reflected in higher food, gasoline and gas bills, but is severely understated.

Monetary inflation was most famously seen in Weimar Germany during the 1920s, when the German government went crazy with the printing presses to the point where it took billions of marks to equal one dollar. This wiped out the savings of the middle class, most members of which were compensated with (worthless) "million mark" notes, and eventually led to the rise of Hitler. Nothing of this sort has happened in the western world since, but it is a worry when the United States has a chairman of the Federal Reserve who has talked (hopefully facetiously) of dropping money out of helicopters.

Fiscal inflation is due to excess government spending, for which the budget deficit is a reasonably good proxy. It originated in the "guns and butter" spending of President Lyndon Baines Johnson in the 1960s, and similar spending of today’s President George W. Bush. We have war spending without a "war economy" e.g. rationing or wage and price controls, and if the 1960s are any guide, we will be paying the price later this decade and in the 2010s.

The last type of inflation, foreign exchange inflation, is particularly scary to me, someone who lived in Mexico before and during the peso crisis in 1994. This happens when the local currency (pesos in this case) falls dramatically against other world currencies, thereby sharply raising the price of imported goods, and hence the overall price level.

This is a real worry for the United States when the latest annual trade deficit is somewhere over $760 billion. I’m not looking for anything like the two-thirds fall of the Mexican peso in 1994-95 as a result, but even a 20% across the board drop of the U.S. dollar against the Euro, yen and yuan (the Chinese currency was unpegged from the dollar only in 2005) would be a severe shock stateside.

Regards,

Tom Au
for The Daily Reckoning Australia

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Who would have thought it would come to this? For three decades after World War II, the average American worker's income grew by 2-3% a year after inflation, and stateside consumer spending grew apace. But after the mid-1970s, these income gains slowed to a crawl, while spending growth continued at the same pace. But Baby Boomers felt that the 2%-3% average annual real income growth enjoyed by their parents was their birthright. And when they didn't get it, they settled for "the next best thing," 2%-3% average annual spending growth financed by artificial means. The result is that the average American is now spending at a level not sustainable by income, but only by asset values, specifically in real estate. And when those asset values collapse, and they're doing so as we speak, so will U.S. consumer spending and overall economic growth.

But that can't be so, some might say. The country is much wealthier today than in the 1970s, which would support much higher consumer spending. That much may be true for the country as a whole, but it's not for the whole country by any means. The reason is that while (President) John F. Kennedy's "rising tide lifted all boats" through the 1960s, most of the gains since then have accrued to the top 20% of the population. For instance, as late as 1980, the average CEO made only about 40 times as much as the average worker, now it's more like 400 times. On the other hand, antipoverty programs and removal of lingering discrimination have greatly reduced the number of the truly poor. So the person in top decile (90th percentile and higher) of the economic ladder, is decidedly better off than the equivalent thirty years ago, and someone in the bottom decile (10th  percentile and lower) is somewhat better off. But the average person (the one at the 50th percentile, and 30 percentiles on either side) is the one who has gained very little real income in the past three decades. Nevertheless, it has been in the interest of U.S. economic policy to pacify this person by allowing him/her to maintain spending growth at historical (post World War II) levels, even though income growth hadn't been keeping up.

The housing bubble was a good a tool as any for this purpose. At first the gap was plugged by reduced savings. But as savings rates plummeted in the 1980s, this fuel could not last for long. So credit card debt took up the slack. But that soon played out, especially when the deduction for credit card interest (but not mortgage interest) was removed in the 1986 tax reform. The ray of hope was the fact that interest rates were falling through the 1980s, and periodic refinancings meant that homeowners could save money by capturing progressively lower rates on their mortgages, and using the difference for spending. What's more, interest on this mortgage-related spending could qualify for the tax deduction denied credit card interest.

But if falling interest rates meant that constant mortgages required progressively lower monthly payments, they also meant that a homeowner could choose to "invest" by maintaining constant payments, taking out larger mortgages, and buying more house. And if a synchronized housing boom was underway, or at least could be orchestrated, many might be persuaded to do so. And so it was done, which is why housing values doubled in real terms between 1996-2006, an unprecedented rise in American history. Now the consumer had a house (or two) that could also double as an ATM, i.e., the best of both worlds (a framework that could serve as both a place to live, and a source of "income" for other consumer spending).  Using this twisted logic, going over one's head (taking out a mortgage that consumed 50% or more of income) was a smart thing to do because it meant a more valuable asset and more spendable income down the line.

Thus housing became the nation's latest Ponzi scheme, one that could work only if more and more people were sucked into it. But even if the housing market was on fire, as it was in the past decade, it needed firewood to burn. And if there was a growing shortage of "firewood," to feed this boom, there was always "kindling" (soft materials such as leaves and hay that burn for only a short period of time), in the form of such monstrosities as interest only and negative amortization loans to subprime borrowers. From a financial point of view, however, such borrowers were placed in the position analogous to "tearing down their (financial) house for firewood" (pun intended), i.e. being forced create a problem of less house for tomorrow because today's problem of freezing to death was so severe.

The collapse of the housing bubble is bringing about an end to this game, and will soon face average American consumers with the fact that their consumption standards of the mid-2000s, were way out of whack with income levels that had reached only a mid-1980s trendline (given perhaps ten, not thirty, iterations of 2%-3% growth off the mid-1970s base). To bring income and consumption back into balance, average Americans will have to fall back two decades in terms of standard of living, which would still put them back at Western European levels of today. But such a pullback would represent "the modern 1930s."

That's because the original 1930s took American consumption back to 1910s levels, which then represented "prosperity" by prevailing global standards. But that was a big comedown for an American public that had just experienced the 1920s, which gave a glimpse of a prosperity that would be experienced in the 1950s by their children, but not by themselves.

Likewise, the Internet Boom of the 1990s gave adult Americans of the time a glimpse of the world that their children will inherit for their middle age - in the 2020s - as the Boomers get ready to shuffle off this mortal coil. Like the peers of Moses, who saw the Promised Land but never got to enter it, Americans will wander the desert for two generations until their children are ready to take the big step. (And yes, I believe that those children will fight the modern "battle of Jericho" to get there.) But getting from here to there will not be a pleasant experience.

Regards,

Tom Au, CFA
for The Daily Reckoning Australia

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