America is headed for a depression


The worst is yet to come.  After spending about a year following this I found out pretty quickly that economists are like politicians in the sense that they have different schools of thought.  Each different school has its own interpretations of things.  The Austrian school, the realm of hard core free market libertarians like Ron Paul, offers the most compelling diagnosis of the fiscal nightmare unfolding around the world.  They believe we are headed for some very difficult times and I believe them.

Why?

A) They predicted our situation far better than any one else.

Check out this debate between Peter Schiff and Art Laffer on CNBC in 2006.

B) The credit crunch is a symptom of a much deeper problem : too much debt.

Let me illustrate the American financial situation by scaling it down.  Imagine the fictional town of Bellview.  Bellview has 100 families and one bank.

If Bellview’s premier home builder, Bellview Homes constructs 10 new homes and 11 families want a house then people will bid up the price on those homes.  If 20 families want new homes then the price would be even higher.  Conversely if only 5 families want a new home the price will be low.

Normally the interest rate on a home mortgage is 5% at Bellview Savings and Loan.  The normal price of a home is $100 000.  At that rate only 10 families a year in Bellview could afford a new home so prices remained relatively stable.

When the bank decides to lower interest rates to 3% five more families decide they want a new home. Now there are 15 people looking for a new home and home prices rise.  When the Bellview bank drops interest rates to 2% and starts giving out loans to people who have no business getting a loan and almost anyone can afford to buy a house then the prices skyrocket.  The price of a new home shoots up to $200 000.  Bellview Homes watches the boom and borrows lots of money to buy new tools and hire new workers to keep up with the demand.   The new low interest rates allows them to invest more money they normally would.  The growth in construction creates new jobs and everyone seems to be very happy.

When Bellview Savings and Loan raises their interest rate back up to 5% far fewer people can afford to buy a home. The demand for homes is reduced and the prices come down.  The people who borrowed money at 2% can’t afford the higher payment so they default on the mortgages.  The bank forecloses on the mortgage and sells the home increasing the supply.  Home prices come down to an average of $175 000.  The bank is now losing money because the house they just foreclosed on sold for much less than the money they loaned to someone to buy it.  They are out thousands of dollars on each home they foreclose.

Lots of people in Bellview can afford to make the higher payments but it means they are spending less elsewhere.  The hardware store and the grocery store have to lay off of some of their employees because less business is coming through the door.

To ease off the pressure the bank lowers interest rates again so less people lose their homes.

Things start to get complicated for the bank.  Bellview Savings and Loan didn’t just loan out the money they have deposited in the bank.  Most of the money they lent out was borrowed from banks in other towns.  They in turn borrowed it from other banks and a lot of that money came from other countries.

Eventually the other banks lose confidence in Bellview Savings and Loan because they can’t be sure how financially stable the bank is.  The bank loaned out all this money to people who can’t afford to pay it back.  If they keep interest rates where they are they are just going to add more bad mortgages to the pile.  If they raise interest rates many more families will lose their homes creating a huge glut of supply and the prices will come crashing down.  Most likely the average price would drop to below the starting point of $100 000.  Why?  Because there are way more homes on the market than there are people who can truly afford them.

The bank will own a lot of homes that will lose value sitting empty.  Those people who can barely make their payments will spend less in the town causing business activity to slow and more people will lose their jobs.  If more people will lose their jobs more people will default on their loans.  This course of action would result in bankruptcy.

They are also starting to feel very nervous because another town down the road followed the same path and lost the confidence of their depositors.  When half the town pulled their money out of the bank the bank had to shutdown because it had no money to work with.

So the bank comes to the town and says we need some help.  They told town council “We can’t borrow any more money so we won’t be able to give out any credit.  There will be no student loans, no credit cards, no personal loans, no car loans, no business loans and no mortgages.  Will you buy out all these bad mortgages off of us so that other banks will trust us again?”  The town reluctantly agrees because they are afraid of the alternative.  The bank goes bankrupt.  All credit ends and all new investment that doesn’t stem from real savings in the town will stop, there will be a massive amount of foreclosures, many people will lose their jobs.   Those who keep their jobs will watch their income drop but their loan payment will stay the same.  The town’s economy folds like poorly built house.  The only thing left will be the hard assets, the solid foundation that had holds real value.

The town saved the bank in the short term but the root problem still exists.  There are too many people in the town that borrowed more many than they should have.  The homes are still over valued.  There are still people living in homes spending far too much of their income making loan payments.  When interest rates come back up there will be a whole new round of foreclosures.  The situation will not rectify itself until all the bad loans, all the dubious assets, all the poor investments are purged from the system.  When that happens the market will accurately price everything and the town can start to rebuild again from a sure foundation.

This analogy illustrates the philosophy of the two main schools of thought debating the media.  The Monetarists like Ben Bernanke of the federal reserve fear “debt deflation”.  Irving Fisher put forth his debt-deflation theory on the Great Depression while in the midst of it.  A simple version of his theory would be the following:

  • Something new in the economy (like really low interest rates from a central bank) lead to a great volume of indebtedness.
  • When people go bankrupt all the assets used as collateral are liquidated
  • The volume of these assets creates and oversupply and distressed selling leading to falling prices and increased value of the dollar
  • The liquidation of assets fails to give the lender their money back, they lose money and are less able to pay back their debts, the depression gets worse

This pulls so much money out of the economy everything grinds to a halt.  When people lose more confidence in the economy that would be normally justified growth becomes very very difficult.  Irving Fisher, who is more famous for his ridiculous prediction that the stock market reached a permanently high plateau in 1929, advised that the central bank must use reflation, or increase the money supply to unseize the credit markets and build confidence back up. 

Right now Ben Bernanke and the federal reserve are trying to increase the supply of credit so ease the deflationary pressure on housing.  Lots of really smart people think they are doing the right thing.  They have been doing it for so long that we’ve reached unparalleled heights of debt.

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This massive increase in credit created a massive increase in home values.

There is a big difference between introducing credit to jump start a completely seized economy and using credit to prop up a bubble. 

The Austrian school says that true growth cannot happen until all bad loans and the bad investments get purged from the system.  The bad mortgages need to be written off.  All the bad investments need to be cleared off.   Adding more credit just means more bad loans and more bad investments will have to be cleaned up and accounted for in the future.  In their view the current situation is like the human body with cancerous tumours.  In order to return to health it is necessary to cleanse the body of the cancer.  In order to do you have to that you must diligently cut it all out. 

I find the Austrian school’s diagnosis much more compelling but their prescription seems very harsh.  They are laiseez-faire, the exact moniker the opposition leaders tried to pin on Harper in the debate.  They want to let the market do its thing.  I think they are right about adding more debt to a debt problem is just fuelling the fire in the long term.

They say the crash has to happen so we can start over from building form the solid bedrock of the real economy hidden under all this debt driven insanity.  Right now the US housing market is probably over valued by 75%.

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There is one aspect to my analogy that doesn’t fit America’s current situation.  Unlike the town which had money to buy all these mortgages the US Government does not have any money and neither does the Federal Reserve.  The countries that have been propping up the credit bubble (China, South Korea, Japan, etc…) will not lend it to them.  In order to for the government to buy all these bad mortgages they may to have “print” the money to do it devaluing the US dollar.  The purposed “Bail out” treats the symptom and not the disease.  If you won’t treat the disease the symptoms will just return.

This bailout strategy combined with some other major negative event like a terrorist attack or oil shortage could tip the scales on the world’s confidence in the US dollar.  Already central banks are looking to dump US dollars for gold. Commodities will be traded in other currencies and the American dollar will have a fraction of the spending power it once had. A very bad situation for American consumers who will find all those imported goods much more expensive.  It will be a bad situation for the countries that supply America with goods and services. 

What this all means

It means the housing market and the stock market have a long way to drop yet.  Whether we see massive debt-deflation or massive inflation depends largely on the US Central Bank’s willingness to turn on the printing press.  We will see a prolonged period of economic under performance which will be exacerbated by the impact of Peak Oil and climate change.  While I cannot speak with absolute certainty I’m expecting the US to enter a major depression and Canada will likely follow.  I agree with our Prime Minister when he says  the fundamentals of our economy are strong but when your largest trading partner goes in to cardiac arrest there really is no way of avoiding joining the downward spiral.  A tight credit market and a receding housing market have already begun to impact parts of Canada.

It took three years before the economy hit bottom during the Great Depression.  The great stock market crash in 1929 only wiped out a third of the market.  In 1932 the value of the market hit bottom around 80% lower than the peak.    We are likely going to see trouble coming in waves as the dominoes fall.

  1. #1 by Frank Miller on October 5, 2008 - 9:25 am

    Now, the big banks are fighting each other in a break neck race to consolidate which is being done for business survival rather than business gain. Sadly, the bailout will not help them much. They are hurting and when they hurt, we all suffer. Everyone should start looking for ways to protect their money. This basically comes down to either taking your money out of the market and cutting discretionary spending or diversifying and investing some overseas. I personally use offshore bank accounts and they have helped me with diversification and asset protection. If you want to read more on why offshore investing is smarter, feel free to visit my website.

    Best,
    Frank Miller
    http://www.theoffshorebankaccount.com

  2. #2 by Marc on October 18, 2008 - 8:16 pm

    So what’s the average citizen, with few investments, if any, and an average mortgage to do? Sit and wait? Ride it out? Pull savings and investments (that certainly wouldn’t be helpful on a global scale)?

  3. #3 by Leighton Tebay on October 18, 2008 - 11:32 pm

    It is hard to tell. Some strategies work well in some scenarios and some not so well. The best investment is usually paying down debt because your “return” is guaranteed.

    Another good investment is to upgrade the efficiency of your home or vehicle. Anything to drop your gasoline, water/sewer, electricity and natural gas bill. With all the grants available for home rennos it becomes a no brainer.

    Slow discretionary spending and build up some cash reserves. If I was an American I’d buy gold because the US government is printing money to pay debt and that will eventually cause some major inflation.

    What to do with a mortgage? It all depends on how the central banks react. Will there be deflation or inflation? With deflation it would be best to keep things variable because interest rates will be very low. With high inflation it would be best to go fixed and lock it in for a long time (before the interest rates jump to kill the inflation). It is hard to know what is going to happen in Canada because we don’t have the same banking, debt, deficit and trade deficit issues the Americans have. Quite the opposite on all those fronts. We just happen sell 80% of our stuff to the US. If they go bankrupt we are going to feel it. This is probably one reasons Harper is talking to the EU about expanded trade to Europe.

    I’d start a garden and keep the pantry well stocked. I don’t expect we’d go hungry living in a place like Saskatchewan but keep a good buffer going. Our just-in-time shipping systems aren’t terribly resilient.

    I think the best option is to be a generous and sacrificial friend. In hard times no one or no family is an island. People will need each other. People may need places to stay.

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