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Current
Economic Crisis Worse than the Great Depression
By Dr Krassimir Petrov
OCT 03 2008
The
mainstream media and Wall Street have reached the consensus
that the current credit crisis is the worst since the
post-war period. George Soros' statement that ”the
world faces the worst finance crisis since WWII”
epitomizes the collective wisdom. The crisis is currently
the ultimate scapegoat for all the economic evils that
currently plague the global financial system and the global
economy – from collapsing stock markets of the world
to food shortages in third world counties. We are repeatedly
assured that the ultimate fault lies with the Credit Crisis
itself; if there were no Credit Crisis, all of these terrible
things would never have happened in the economy and the
financial markets.
The
most extraordinary thing is that the mainstream media
has never attempted to compare the current economic environment
to the one preceding the Great Depression. In essence,
it is assumed outright that the Great Depression can never
possibly happen again, ever, thus obviating the need for
such a comparison. I actually believe that the macroeconomic
fundamentals today are much worse, so that we are in for
a protracted period of economic depression – a depression
much worse than the Great Depression, a depression that
would likely be remembered in history as “The Second
Great Depression” or The Greater Depression , as
Doug Casey has called it so aptly. Here is why I believe
that this is the case.
Duplicating
Mistakes from the Great Depression
At its core,
the environment of the 1990s, and the response of the
Fed to the tech-telecom bust has created an economic environment
that has encouraged the repetition of the very same mistakes
that led to the Great Depression. Here is a concise summary
of widely recognized mistakes of the 1920s, without going
into the details, with obvious parallels in the current
environment:
*
Asset Bubbles – first
in the stock market during the 1990s, then in real estate
during the 2000s, pretty much mirroring the stock and
real estate market bubbles of the 1920s.
* Securitization –
although not in the very “ultra-modernistic”
form and shape of the 2000s, with slicing and dicing of
pools and tranches of seniority, it was widely recognized
in the 1930s that securitization during the 20s drove
the domino effect in the U.S. financial system during
the Great Depression.
* Excessive Leverage –
just like in 2008 the topic du jour is “deleveraging”,
so the unwinding of leverage during the 1930s was the
driver of forced liquidations and financial pain. Of course,
it was very clear back then that the root of the problem
was not deleveraging per se, but the excessive leverage
that took place prior to the deleveraging process. “Investment
Pools” were then instrumental in both the securitization
and excessive leverage, just like the Hedge Funds of today.
* Corrupt Gatekeepers –
we know well that the Enrons and Worldcoms were aided
and abetted by the accounting firms – those same
firms that were supposedly the Gatekeepers of the financial
community, yet handsomely profited from the boom while
neglecting their watchdog functions. In the current financial
crisis, we also know that the rating agencies were also
making hay during the boom. Very similar were the issues
during the 1920s that led to the establishment of the
SEC and other regulatory bodies to replace the malfunctioning
“gatekeepers” at the time.
* Financial Engineering –
we are led to believe that financial engineering is a
rather recent phenomenon that flourished during the
New Age Finance Era of the last 15 years, yet financial
engineering was prevalent in the 1920s with very clear
goals: (1) to evade restrictive regulations, (2) to increase
leverage, and (3) to remove liabilities from the books,
all too familiar to all of us today.
* Lagging Regulations –
just like the regulatory environment lagged the events
of the 1920s and regulations were introduced only after
the Great Depression had obliterated the U.S. financial
system, so we are yet to see new regulations addressing
the causes of the current crisis. Understandably, regulations
should have foreseen today's financial problems and should
have been introduced before the crisis.
* Market Ideology –
back in the 1920s, just like in the last two decades,
the market ideology of “laissez faire”, which
Soros quite appropriately described as “Market Fundamentalism”,
has swept the financial markets. Of course, the free market
knows the best, but the reality is that the money market
is not really free – when the Fed determines the
cost of money (interest rates), and can fix this cost
for as long as it wants, then all sorts of financial imbalances
can be sustained without the discipline imposed by the
market. This can lead to all sorts of problems that we
actually have to face today.
* Non-Transparency –
back in the 1930s, it was widely recognized that businesses
and especially financial institutions lacked transparency,
which allowed for the accumulation of significant imbalances
and abuses. Today, financial markets and institutions
have intentionally compromised transparency in a number
of ingenious, or better disingenuous, accounting trickeries
and financial gimmicks, like off-balance-sheet entities
(SIVs), hard-to-understand derivatives, and opaque instruments
with mind-boggling complexity. Today CEOs and Chief Risk
Officers of major financial institutions cannot figure
out their own risk exposures. Originally, lack of transparency
was designed to fool the markets; ironically, modern-day
financial executives have gotten to the point of fooling
themselves.
Worse
than the Great Depression
So,
why Worse Than The Great Depression ? What makes me believe
that the current depression will be worse than the Great
Depression? I present six of the most important fundamentals
that are “baked in the cake” and that suggest
of a Greater Depression .
- Overvalued
Real Estate.
The real estate market has been driven by a number of
innovations in real estate finance. Overvaluation in real
estate implies overvaluation in real estate financial
instruments; an implosion of real estate prices implies
an implosion in those instruments. It is widely recognized
by economists that the Case-Shiller Index is a good proxy
for the prices of real estate. A widely-recognized chart
from 1890 to 2007 tells the story. The chart makes it
crystal clear that the current overvaluation of real estate
in real terms grossly exceeds the one during the 1920s.
The coming correction in real estate will be protracted
and gut-wrenching, with an expected cumulative effect
that is much worse than the Great Depression.
- Total
U.S. Credit.
Credit makes leverage: the
more credit in the financial system, the more leveraged
it is. Today's total U.S. credit relative to GDP has surpassed
significantly the levels preceding the Great Depression.
Back then, the total amount of credit in the financial
system almost reached an astonishing 250% of GDP. Using
the same metric today, the debt level in the U.S. financial
system surpassed 350% in 2008, while the level in 1982
was “only” 130%. As Charles Dumas from Lombard
Street Research put it quite aptly, "we've had a
30-year leveraging up of America, ending in an unchecked
orgy."
The chart below shows a dramatic buildup of debt (leverage)
in the 1920s and a deleveraging from 1930 to 1945 (or
1952). Then it shows a consistent buildup of debt afterwards,
with a dramatic rise since the 1990s, and surpassing
in 2000 the previous peak in 1929. The chart shows the
level of 299% at the end of 2005, but the level has
already reached 350% by 2008.
Of course, leveraging, as already indicated above, must
necessarily be followed by deleveraging.
The best
way to think about leverage is to compare it with using
drugs, while deleveraging is like detox. The problem
is not that the detox is killing the patient who has
abused drugs for years; what is really killing the patient
is the drug abuse itself. However, one thing is clear
– the patient must either go through a painful
detox or die; the same applies for the financial system
– it must either deleverage or implode
- Explosion
of Derivatives.
Derivatives have been likened by Warren Buffet to “financial
weapons of mass destruction”. The notional amount
of total derivatives, as well as “Value at Risk”
(VaR), has skyrocketed in recent years with the potential
to destabilize the financial system for decades. To put
it more allegorically, derivatives hang like a sword of
Damocles over the financial system.
A comparison with the 1920s is difficult to make. mostly
Derivatives back then were extensively used, although
not widely understood. Given that I am not aware of
any statistics of derivatives for the period of the
1920s, a meaningful comparison based on hard data is
admittedly impossible. Nevertheless, I would venture
to make an intelligent guess that the size of modern-day
derivatives is hundreds or even thousands of times larger
relative to the size of the economy in comparison to
the 1920s. Some of the latest reports indicate that
the total notional value of derivatives outstanding
surpasses one quadrillion dollars. To put this into
perspective, this amounts to almost 100 times the GDP
of the U.S. economy.
The chart
below shows the explosion of derivatives in the U.S.
banking system. You can see that in 1991 the notional
value of the derivatives was about the size of the U.S.
GDP. By 2006 the size has grown to about 10 times the
GDP, vastly outgrowing the real economy.
The chart below shows an even more telling picture.
It shows world GDP and world's notional value of derivatives.
Again, while there is no direct comparison with the
1920s, it is clear that the overall level of derivatives
has skyrocketed during the last two decades and presents
risks that were simply not present at the onset of the
Great Depression. The unwinding of these derivatives
could only be compared with a nuclear explosion in the
financial system.
-
Dow-Gold
Ratio.
The Dow-Gold ratio represents the most important ratio
between the relative prices of financial assets and
real assets. The Dow component represents the valuation
of financial assets; the gold component – of real
assets. When leverage in the financial system increases
significantly, so does this ratio. A very high ratio
is interpreted as an imbalance between financial and
real assets – financial assets are grossly overvalued,
while real assets are grossly undervalued. It also implies
that a correction eventually will be necessary –
either through deflation, which implies deleveraging
and a collapsing stock market, or through inflation,
which implies stagnant stock market for many years and
steadily rising prices of real assets, commodities,
and gold, usually associated with stagnant economy and
typically resulting in stagflation. The first case—deflation—occurred
during the 1930s, while the second case—stagflation—occurred
during the 1970s.
The graph
below illustrates the above concepts. The very high
Dow-Gold Ratio in 1929 was followed by the Great Depression,
while the higher level in 1966 was followed by the stagflationary
70s. It is evident from the chart the peak in 2000 surpassed
the previous two peaks in 1929 and 1966, so this provides
a reasonable expectation that the forthcoming return
to “normalcy” will be more painful than
the Great Depression, at least in terms of cumulative
pain over the next 10-15 years.
- Global
Bubbles.
It is impossible to make direct comparison with the 1920s,
but today the global economy is rife with bubbles. Back
then in the 1920s, the U.S. had its stock and real estate
bubbles, while the European economies were struggling
to rebuild from the devastations of WW1 that ended in
1919. I am personally not aware of any other bubbles during
this period, although I welcome reader feedback on this
topic.
Today the picture is very different. The U.S. economy
had a stock market and real estate bubble that has surpassed
its own during the 1920s. Colossal US current account
deficits have fuelled extraordinary growth in global
monetary reserves. As a result, Europe has real estate
bubbles across the board, from the U.K. and Ireland,
throughout the Mediterranean (Spain, France, Italy and
Greece), to the entire Baltic region (Latvia, Lithuania,
and Estonia) and the Balkans (Romaina and Bulgaria).
Even worse, many Asian countries (China, Korea, etc.)
also have their own stock and property bubbles, only
with the exception of Japan, which is still in the process
of recovering from its own during the 1980s. Thus, during
the 1920s only the U.S. suffered from gross financial
imbalances, while today the imbalances have engulfed
the whole world – both developed and developing.
It stands to reason that the unwinding of those global
imbalances is likely to be more painful today than it
was during the Great Depression due to both size and
scope.
- Collapsing
Bretton Woods II. The
global monetary system was on a quasi-gold standard during
the 1920s. Back then dollars and pounds were convertible
to gold, while all other currencies were convertible to
dollars and pounds. An appropriate way to think about
it is that of a precursor to the Bretton Woods from 1945-1971.
What is important to understand is that while the system
was fiat in nature, gold imposed significant limitations
to credit expansion and leveraging.
Somewhat similar was the role of Bretton Woods that
lasted from 1945 to 1971. The dollar was tied to gold,
while all other fiat currencies were tied to the dollar.
Just like the interwar period, gold imposed some limitations
on credit and financial imbalances.
We now live in what has been termed Bretton Woods II.
Essentially, this is a pure fiat dollar standard, where
all currencies are convertible to dollars, either at
fixed or floating exchange rates, while the dollar itself
is convertible to “nothing”. Thus, the dollar
has no limitations imposed to it by gold, so without
the discipline of gold, the current global monetary
system has accumulated significantly more imbalances
than ever before in modern capitalism. These imbalances
show up in the international monetary system as unsustainable
trade deficits (and surpluses), skyrocketing official
dollar reserves in some European and many Asian central
banks, and the proliferation of Sovereign Wealth Funds;
more generally, these imbalances result in a myriad
of bubbles, overleveraging, and other maladjustments
already discussed above.
Today Bretton Woods II is in the process of disintegration.
The world is slowly but steadily losing its confidence
in the dollar as the world reserve currency. A flight
from the dollar is in progress and the collapse of the
global monetary system is imminent. As Bretton Woods
II disintegrates and a new system replaces it, the process
of readjustment will be necessarily more painful than
the respective process during the Great Depression.
A caution on terminology is necessary here. While the
literature over the last 10-20 years has widely recognized
the term “Bretton Woods II”, in September-October
of 2008 the term was widely used by the media to describe
a proposed international summit with the goal of reconstructing
a new international monetary system designed from scratch,
just like “Bretton Woods”. Instantly dubbed
by the media “Bretton Woods II”, this term
could be potentially very confusing as it could mean
very different things to different people. The interested
reader should consult Wikipedia's Bretton
Woods II where both meanings are explained in detail.
Conclusion
Since August
of 2007 we have witnessed the relentless escalation
of the credit crisis: a steady constriction of credit
markets, starting with subprime mortgage-backed securities,
spreading to commercial paper, then to interbank credit,
and then to CDOs, CLOs, jumbo mortgages, home equity
lines of credit, LBOs and private equity markets, and
then generally to the bond and securities markets.
While the
media describes the problem as one of illiquidity and
confidence, a more serious analysis indicates that boom-time
credit has been employed unproductively and so losses
must be incurred. In other words, scarce capital has
been misallocated, poorly invested, and effectively
wasted. No amount of monetary or fiscal policy can fix
the errors of the past, just like no modern treatment
can quickly restore to health a drug addict debilitated
from a decade-long drug abuse.
Based on
indicators like - (1) global real estate overvaluation,
(2) indebtedness, (3) leverage, (4) outstanding derivatives,
(5) global bubbles, and (6) the precariousness of the
global monetary system, I would argue that the accumulated
imbalances in the current period surpass significantly
those preceding the Great Depression. I therefore conclude
that the coming U.S. (and possibly) global depression
will be of greater magnitude than the Great Depression
of the 1930s. It likely suggests that we are entering
a historic period that will likely be known as The Greater
Depression .
Investor
beware! Only gold can protect you from the ravages of
another Depression!
Krassimir Petrov ( Krassimir_Petrov@hotmail.com ) has
received his Ph. D. in economics from the Ohio State
University and currently teaches Macroeconomics, International
Finance, and Econometrics at the American University
in Bulgaria. He is looking for a career in Dubai or
the U. A. E.
Source: http://www.marketoracle.co.uk
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