The Credit Depression

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Here they come. At the end of 2008, all the social and personal signs of a real depression were absent. They are making themselves present now. The suicides, the frauds, the job losses…they’re all on the front pages of the papers now. If 2008 was the year of the financial crisis, 2009 will be the year it got personal.

We will borrow a term from a reader on the message board which seems apt. It is the credit depression. This amounts to a depression in the belief that tomorrow will be better than today. More on what this means economically in just a moment. But first, to the dictionary!

In Latin, a creditum is a loan or thing entrusted to another. The Latin for “to entrust” or “to believe” is “credere.” The word “creed” also has similar origins, as you can see.

So a credit depression is a period when belief or trust in a set of ideas falls to new lows. The basic creed itself (for example, the idea of fiat money) might even be, ahem, discredited.

We’d suggest that 2009 will be the year when a lot of previously and thoughtless held beliefs are discredited. Just ask Ramalinga Raju, the previous head of Satyam Computer Services. Satyam is India’s fourth-largest software export services firm.

Raju is the former head of Satyam because he quit last night after telling investors the company’s profits had been falsely inflated for years. The stock price fell by nearly 80% after the lie was disclosed. He said about $1 billion of the company’s so-called cash-or 94% of the total on the books-was a complete fabrication (from the Latin Fabricare, to fashion or to build).

Now we are finding out how much of modern commerce and economic activity has been built on a lie. That is why etymologies are so useful. The names of things and what we actually call them tell us something about their nature (if they are aptly named). In these days of 24/7 news and digital media, we drift away from the origin of things and have little time to question where they came from.

Thank goodness we can take time out to reckon daily!

In any event, the credit depression is upon us. Raju, Madoff, Adolf Merckle…these are just the poster boys for the crisis. The collapse in real asset values and real wealth is going to cost a lot of people a lot more. But then you’ve heard that before from us, so we won’t dwell on it.

In Australia you won’t find a lot of obvious signs that the credit depression is upon us. After all, the National Australia Bank used the Rudd government’s guarantee of bank debt to raise $3.5 billion from U.S. investors yesterday. ANZ has managed to borrow $3.7 billion as well. In fact, according to Eric Johnston in today’s Age, Aussie banks have used the guarantee to secure over $37 billion funding.

But what does this really mean? “Secure funding” is just another way of saying “borrow money.” To the extent that the money is raised overseas, it’s both good and bad. It’s good if you believe it shows that foreign lenders trust the Aussie government guarantee and loan the banks money.

It’s bad, however, in that Australia banks are importing capital from foreign lenders. Capital is an increasingly scarce resource these days. And though the banks have been able to borrow, it’s been at higher rates than this time last year. How much of the foreign-sourced capital is going to make it back to Australian borrowers (both business and household?) Hmm.

And what about the retail economy? November retail sales figures were better than expected. But according to Steve Scott in today’s Financial Review, once you strip out food sales from the figures, it was actually the worst November on record for retail sales. Ouch.

“How bad do you think it will get,” asked a friend in an e-mail yesterday. Our friend has a Master’s Degree in Classics (Latin and Greek). We know that when he starts wondering what’s going on in the economy there are probably a lot of other people starting to sit up and question their basic economic beliefs too. Here, partly for the benefit of those who are new to the Daily Reckoning, is what we told him.

“First, our long national love affair with debt is over. When you first fall in love, you’re happy to ignore all the little blemishes, faults, and habits that later drive you insane. The dependence on revolving credit, home equity lines of credit, and zero percent financing didn’t seem like a bad thing as long as people had steady incomes and could pay the interest.

“But now, asset values are falling…but the principal on the debt remains. People will shake themselves vigorously and wake up to the credit depression we live in. They will learn to live within, or even below, their means. Wherever that level is, it’s a lot lower than today. The upside is that it’s probably more natural and relaxing and less stressful. Stress kills the brain. So people may be poorer and hungrier. But some of them may actually be happier. Not all, mind you.”

“Second, as people dial back their spending and consumption habits, it sends ripples throughout the economy. For example, tomorrow’s jobs figure in the U.S. will likely be the worst in sixty years. Over 700,000 Americans will have lost their jobs in December. This is on top of 400,000 in November.

“A million people axed in two months. Job losses result in fewer incomes, and incomes are the source of business profits. As jobs and incomes fall, so do business profits, and thus business hiring. A feedback loop.”

” Plus, in these kinds of times, people save more and spend less. In an economy based on consumption (not production) lower levels of spending are bad for stocks and jobs. The government will try to fix this by giving people more money to spend. But the problem isn’t with people. It’s with the model. An economy structurally oriented to consumption is not one that produces real wealth or long-term capital assets. It just produces people who have debts they cannot pay, albeit in a house with a nice TV and great digital programming.”

“As household and business consumption (spending) fall, the government, under the banner of Keynes, will take to the field en masse. The armies of Fed money will be deployed, street by street, to patrol the economy in little platoons of stimulation. The ammunition for these armies will come from either Japanese or Chinese savers (via bond purchases) or from nowhere (the Fed creating more money).”

“Either way, the result seems unambiguously bad. If borrowed, the stimulus money must be repaid, and presumably at increasingly higher rates of interest the more rapidly America’s fiscal position erodes. Either way, with interest expense already nearly 10% of the Federal budget, you can expect it to rise when the U.S. government has to pay interest on a trillion dollars of new borrowing.”

“To meet these interest payments, the government is going to have to raise taxes or cut spending. Of course that’s hard to do when you’re deliberately spending more to begin with. If spending is going to be cut, it’d have to be from Defense, or Social Security and Medicare/Medicaid benefits (raising the retirement age, means testing benefits).”

“But even with more borrowing and higher taxes, it’s likely the Fed is going to have to simply print new money to conduct its unconventional monetary policy. Money supply will grow. And what does that really mean? Inflation. Much higher inflation. Rising prices for everyday goods like food and fuel and clothes.”

“Inflation is also a huge tax on savers and those who live on a fixed income. You know, the prudent people who saved for their own retirement. Inflation accelerates the depletion rate of their accumulated savings by steadily reducing purchasing power. $10,000 saved in 1970 ain’t what it used to be. This should be good for gold, however.”

“As inflation punishes those living on a fixed income, it will also push them closer to needing some sort of government aid. This in turn raises the percentage of federal spending going to Social Security and Medicare and Medicaid. It’s a transfer of old age and pension provisions from the private sector to the public sector.”

“But can America really afford it? Clearly not, which more than sucks for people who’ve lived their whole adult lives believing they’d be able to retire comfortably through a combination of a diversified portfolio and a supplementary check from the Social Security Administration.

“It’s looking more and more like the entire project of spending a quarter of your adult productive life idle and living off the income generated from your assets (houses, stocks, savings) is…well…dead. It simply ain’t gonna happen for most people. And by most, we’re talking 99%. People will work longer, harder, and leave leaner and meaner than they ever thought they’d have to.”

“The rest of the world will not be ready to continue funding America’s desire to live beyond its means. Why would Chinese and Japanese savers continue to invest in U.S. bonds and notes (effectively keeping U.S. interest rates low AND loaning Uncle Sam the money he needs to keep the promises he’s made?)

“In a world where investors are focused only on annual rates of return on their capital, you could argue that global savers would pour money into the U.S. govt bond market now and until the cows come home. It’s the safest bet in the world.”

“But that’s not the world we live in anymore. In the world we live inthe one with a credit depressioncapital (accumulated savings…or surplus income from your hard work) is a scarce and jealously guarded asset. You have to reckon people will be more worried about the return OF their capital than the return ON their capital.”

“All of which means America’s days of borrowing at low rates of interest from the rest of the world in order to build an economy based on buying things…are over. So you should find a job with a real skill that people are willing to pay for. Get your money out of stocks (though they’ll bounce in the next few months probably). Look for a home you can really live in and want to own (and aren’t trying to flip). But generally, your greatest assets will probably be your real skills that can be traded for goods or services (and not financial instruments you hold in a portfolio). It’ll be hard for people to live off income generated from financial assets…mostly because those assets are going to keep falling in real terms for quite a while.”

“So that’s how bad it could be. But human beings are hardy and resourceful. We’ll find a way to put food on the table. Speaking of which, it’s lunch time! Gotta go!”

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. The crystal ball would be handy.
    I am retired (as is my wife), and her retirement funds are in an Income Stream of investments, which have suffered a fall and now total $42,000 (thereabouts). We have seriously considered withdrawing these funds and putting them into Bank Term Deposits.
    But the question we face is the timing.
    Will the stocks go up again (or is that a pipe dream), and if so for how long?
    As I said I am retired – but at 73 returned to 3 days a week work (Accounting), and am now amost 76. I told them in December that I was quitting, but they have persuaded me to return on a 1 day a week basis. Unfortunately I am one of the highest tax payers, as I lose 40% pension for most of the dollars I earn, am too old for Super payments, and as a casual I receive no sick or holiday pay, although I have not missed a day through sickness.
    Without the crystal ball, can you give your concept of what we should do about the Income Steam – before it dries up!

    Don Galloway
    January 8, 2009
    Reply
  2. Excellent article, I really enjoyed reading that Dan (I don’t enjoy the suffering of others, it was just well written)

    Reply
  3. Don maybe you could look at it this way, think about taking in the hole picture of life, this article could help http://www.dailyreckoning.com.au/benefit-from-being-a-baby-boomer/2009/01/08/

    Reply
  4. Is it just me, or are they going about fixing this all backwards?!

    Take my situation. 12 months ago I changed jobs and went to a significantly higher paying position. That was just before the crisis really hit.

    At my old position I was able to save about 10% of my income after expenses and buying useless “stuff” from China, treating myself to the pub once a week and a movie a couple of times a month with the wife.

    Fast forward to now. I’m earning more than ever and spending every cent on simply living. Gone are the savings deposits, the pub, the movies and the useless stuff from China. Rent has skyrocketed and the cost of essentials has too. I’ve had to cut back on everything. I’ve even moved an hour out of the city to reduce our rent.

    This, in my mind, is because of uncurbed inflation – the ripples from the boom in lending over the past 10 years and the credit bubble.

    Therefore, instead of lowering interest rates (which does nothing for me because I’m a renter and a saver) and throwing more money into the system to maintain artificially high prices brought about by the credit bubble, they need to fix inflation: Jack up the interest rates to reflect the true level of risk of credit and let the mess sort itself out.

    It may be just me, but the problem is certainly not a shortage of spending.

    Reply
  5. Don. I assume that you are located in Australia. Seek out a several professional opinions (many preliminary consultations are free) and do your own research as well. Everyone should be mindful that some financial planners focus on commissions earned by shifting portfolios but most are ethical. As you are in the accounting trade, you may have some colleagues who can recommend some ethical sources of advice.

    I’m not working as a financial planner – but anyone who is will have current information on the rules relating to superannuation contributions by (or on behalf) of older workers. Your employer sounds a tad mean in some respects but there are probably worse (eg. those who won’t interview anyone over 45 …. let alone 73).

    Concerning your wife’s “income stream of investments” fund, you need to consider whar the underlying investments are(along with information on exit and entry costs (for alternatives). Don’t just put the money into term deposits without professional advice because there can be tax and pension penalties involved.

    I dont have a crystal ball either but, there are significant risks associated with long term cash positions at the moment. My posts in response to Marc Faber’s latest comments on Bloomberg refer. Sounds like you will pass 100 mark so a medium to long term investment horizon may indeed be appropriate.

    Pete: I’m glad the ALK tip worked for you.

    Coffee Addict
    January 9, 2009
    Reply
  6. Don. So what you are saying is that all these govt stimulus packages are a waste of time/harmful, and the pollies need the balls to stare the electorate in the face and talk about belt tightening? Thats not what they do. They know the messinger will get shot.

    Paul Tredgett
    January 9, 2009
    Reply
  7. Dear Don, hi, I reckon that you should read these 2 books: Rich Dads prophecy- why the biggest stock market crash in history is still coming, and how you can prepare for it and profit from it, by Robert Kiyosaki, and the roaring 2000’s by Harry S Dent. After you read these 2 books, a lot of your questions will be answered.

    Reply

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