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US and European Economies Heading for Depression 2.0

Economics / Economic Depression Feb 01, 2008 - 12:17 AM GMT

By: Christopher_Laird

Economics

Best Financial Markets Analysis ArticleDepression 1.0 started about 1929 and ended around 1940 with the entry of the US into WW2. Even then, many economists say that, had the US not entered WW2, the depression would have continued for years in the US, and the rest of the world.

Now, since WW2, the US and West entered a period of unparalleled post war prosperity. This resulted in an incredible rise in the standard of living in the US and West. People don't realize, but much of the US didn't even have electricity in the 1920's!


The combination of a post war prosperity boom, cheap energy, and also a huge credit boom resulted in incredible economic growth. (Oil was new, guys, the world used coal and steam and wood prior to the 1900's, how far we have come in a few decades, no?) 

Where Are We Now

Modern big investors are saying that what we are witnessing right now is not merely another recession. It is the end of a 60 year post World War 2 prosperity and credit boom. It drove the whole world economy, and the US led the show. The USD was used as a world reserve currency during WW2 when the war in Europe threatened to collapse the European currencies and the Pound. I don't know if people know that is why the USD became the world reserve currency in the first place, in the Breton Woods agreement during WW2 to stabilize currencies.

The US gold stockpile (we had accumulated most of the world's gold in WW1 and WW2 backing our allies) was used in Breton Woods to act as a reserve for the USD. That was broken when Nixon went off the gold standard in the 1970's. But that is another story.

Getting back to what we are looking at now, a very similar unwinding of a credit bubble, similar to what developed in the US and West in the 1920's (Roaring 20's). But, this time, the amount of leverage out there, and money out there, in financial and asset markets such as real estate is nothing less than astounding.

And we are also seeing the damage that financial derivatives are doing when they go bad. These are leveraged bets and contracts that have 30 to 50 to 1 leverage. Try that in a stock exchange.

Well, of course they did try that in stock exchanges with mortgage backed securities, MBS, and we all know that is what started the unraveling of our world credit bubble – with Bear Stearns and their CDO mess and the other MBS messes that started to show themselves around Spring of last year. Then the mess multiplied in Summer, and finally detonated in August of 07, leading to our present collapsing and paralyzed credit markets today, Jan 31 08.

We are about to witness the onset of Depression 2.0

George Soros said that what we are seeing is not just another recession but the unwinding of the huge credit bubble that began after WW2. Fund manager Jim Rogers said we are going to see something much worse than a normal recession, and that the severity of the onset is surprising him.

Well, surprises to the downside appear to be the norm these days. I think the Central banks, the Fed and ECB, are nothing less than horrified, a bit panicked, and realize their normal major weapons to combat this Depression 2.0 are not working much at all. If this is a credit crisis, offering more credit does not work, people cannot pay what they already have borrowed. We already are seeing cases where banks are freezing their balance sheets (not lending new loans) to try and stem the bleeding. I saw one commentator (Mike Shedlock) say the US banks have lost their entire net capital so far! Financial institutions are literally shell shocked at how fast this happened. (Witness financial mass destruction ala W. Buffett thanks to derivatives.)

In fact, I am seeing comments from financial media that big investors are beginning to realize just what I said above, that the Central Banks have lost control of the situation.

Gold is rallying in this whole mess. In fact, if you look at gold's big rises in the last year, it correlates well with the onset of the credit crisis after Aug, September.

Gold seems to think we are in stagflation. Gold rose dramatically in the stagflation of the 1970s. We see many of the same trends today. The credit bust has caused central banks to flood out money, and growth is stalling. Inflation remains a problem, tying central bank's hands, and since we are in negative real rates (inflation is higher than US interest rates, hence negative) gold reacts by rising dramatically. Gold rises big in negative inflation environments.

As central banks combat Depression 2.0 and try to stave of deflation which wants to emerge, and markets contract and spending contracts, gold will rise during the stagflationary stage, which we are in now.

At some point, deflation might actually come into the picture, and gold steady if the US and ECB don't panic and just flood out $trillions and trillions to try and stop the deflation from emerging.

But, in any case, unless things change the direction they are going, and if the credit bubbles continue to be paralyzed and deleveraging, and central banks keep flooding out money and lowering interest rates, gold will rise well over $1000 in 08 and stay there.

We have been saying to subscribers that they should get gold while it is still below $1000. Of course gold right now may correct significantly, since it has risen so much in recent months. But, longer term, gold will soon be over $1000 an ounce, and people will be sorry for having to pay over $1000 when they could have had it for mere hundreds.

And there is always the possibility that the world stock markets will let go big and gold correct. I had a subscriber ask me (paraphrased) ‘I want to get some more gold but I might want to wait for a correction then get it. I have some now, but want to get more. But gold keeps going up, so I'm not sure?'

My reply was that I personally consider gold a buy below $1000 for reasons I just outlined here. I told him of course gold can and does correct significantly when the financial markets sell off. And that can happen. I personally buy gold when it's at these lower than $1000 levels. Gold has shown itself to recover rapidly after sell offs for liquidity in financial sell offs, when big investors need to cover margins so as not to be forced to sell on down markets. I said these exact comments when gold was at $635 in 06, even as it was dropping, I bought ounces. One reader back then asked me why in the heck I said I was buying at $635, when it was falling then. Well look at the price now, over $900….in only a year roughly.

General Commodities Different

This does not apply to the general commodity complex in my opinion. Gold will stay up overall because it's money, and a central bank reserve asset. Something like copper is not. And copper is super sensitive to any economic slowing, as we see now. Also, China just indicated they expect a tough 08, and a slowing in economic growth. That is something we have been discussing for over a year, that China is an overestimated factor. Sure, they can grow tremendously, but many people don't seem to realize that they have had an incredible industrial and financial boom, and it's time for them to also have an economic correction, and that will definitely hit general commodities hard in 08 I believe.

By Christopher Laird
PrudentSquirrel.com

Copyright © 2008 Christopher Laird

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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