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Traders Workshop

Economic Depression, Deflation and Your Financial Survival

Economics / Recession 2008 - 2010 Dec 09, 2008 - 12:33 PM GMT

By: Money_and_Markets

Economics Diamond Rated - Best Financial Markets Analysis ArticleMartin Weiss writes: If you're still skeptical that we're sinking into America's Second Great Depression, you don't have to believe Alan Greenspan, who says we're already experiencing the worst financial crisis in a hundred years. Nor need you heed the news that the economy just lost a half-million more jobs or that retail sales have just suffered their worst plunge in 35 years. All you have to do is get up from your chair, open the door and take a walk outside.


Nearly everything you see and hear will clue you in to the true plight of our time — one out of 10 households delinquent or foreclosed on their mortgage, one out of 10 using food stamps, four out of 10 upside down on their home equity, eight out of 10 fearful of the future, and rightfully so.

What will a depression be like? From the manuscripts and reports Dad has left behind, here's his answer:

Irving Weiss

“Some people of my generation have fond memories of the family fellowship and sacrifice of the Great Depression, and I do too. But I also cannot forget the numbers or the suffering they implied. In just three short years between the peak of the stock market boom in 1929 and the bottom in 1932, it felt like the entire world was falling apart. The financial bubble burst. Big companies failed. America lost 13 million jobs. Unemployment surged to 25%. American industry cut its production nearly in half. Home construction plunged by more than four-fifths. Deflation — falling prices — drove the value of almost everything into the gutter. Over 5,000 banks failed and ultimately disappeared.

“And yet, despite it all, there was one all-important investment that not only survived, but actually thrived: The United States dollar. Because of deflation, prices fell on virtually everything — commodities, farm land, homes, automobiles, consumer goods, even labor. And because of fear, investors shunned risk, seeking the safety of cash. Result: The dollar's purchasing power and value surged.”

Now, here we are once again, witnessing with our own eyes in our own generation how financial bubbles are bursting all around us. We see America's largest companies — Merrill Lynch, General Motors, AIG, Fannie Mae and Citigroup — bankrupt, bailed out or bought out. We have bursting bubbles in housing, commercial real estate, stock markets and commodities. We see busted booms throughout the Americas, Europe and Asia.

Even economies thought to be immune, like China or Australia, are impacted. Even investments said to be safe, like corporate bonds, municipal bonds, certain money markets and large government-sponsored companies, are sinking.

Our leaders themselves are sounding the alarm. Unless they act swiftly, they say, the world as we know it today will fall apart. Thus, to avert what they fear could be the ultimate disaster, the governments of the richest countries have embarked on the most expensive financial rescue operations of all time. The U.S. government alone has spent, lent, committed or guaranteed $7.8 trillion, fourteen times its biggest-ever federal deficit. European governments have jumped in with another $2 trillion; China, $586 billion.

They're bailing out bankrupt banks, broken brokerage firms, insolvent insurers and any company they deem essential to the economy. They're pumping resources into mortgage markets, consumer credit markets and stock markets. They're prodding lenders to lend, consumers to consume and investors to invest. They're doing everything in their power to prevent a Second Great Depression.

Martin and Irving Weiss

But will they succeed in this endeavor?

A not-so-long time ago, while Dad and I reviewed the historical charts and data, here's the answer he gave me to a similar question.

“In the 1930s, I was tracking the numbers as they were being released — to figure out what might happen next. I was an analyst and that was my job. That's why I remember them well.

“Years later, economists like Milton Friedman and my young friend Alan Greenspan looked back at those days to decipher what went wrong. They concluded that it was mostly the government's fault, especially the Federal Reserve's. They developed the theory that the next time we're on the brink of a depression, the government has got to step in and nip it in the bud.

“Bah! Those guys weren't there back then. When I first went to Wall Street, Friedman was in junior high and Greenspan was in diapers.

“I saw exactly what the Fed was doing in the 1930s: They did everything in their power to stop the panic. They coddled the banks. They pumped in billions of dollars. But it was no use. They eventually figured out they were just throwing good money after bad.

“The real roots of the 1930s bust were in the 1920s boom. That's when the Fed gave cheap money to the banks like there was no tomorrow. That's why the banks loaned the money to the brokers, the brokers loaned it to speculators, and the speculation created the stock market bubble. That was the true cause of the Crash and the Depression! Not the government's ‘inaction' in the 1930s!

“In 1929, our economy was a house of cards. It didn't matter which cards we propped up or which ones we let fall. We obviously couldn't save them all. So no matter what we did, it was going to come down anyway. The longer we denied that reality and tried to fight it, the worse it was for everyone. The sooner we accepted it, the sooner we could get started on a real recovery.”

Today, however, it seems the governments of the world have yet to learn the lesson Dad had learned from real experience. They're still trying to bail out nearly every major institution and market on the planet. Again, the big question: Will they succeed?

The quick answer: Yes, for a while, perhaps. They can kick the can down the road. They can buy time and postpone the day of reckoning. They can stimulate stock market rallies and even flurries of economic recovery. But that's not the same as assuming responsibility for our future. It doesn't resolve the next crisis and the one after that. It does little for you and me; even less for our children or theirs.

The better answer is contained in the white paper Mike Larson and I submitted to the U.S. Congress on September 25: The government bailouts are too little, too late to end the debt crisis; too much, too soon for those who will have to foot the bill.

Even as the government sweeps piles of bad debts under the carpet, mountains of new debts go bad — another flood of mortgages that can't be paid, a new raft of credit cards falling behind, a new line-up of big companies on the verge of bankruptcy.

Even as the government commits new billions to be spent on financial rescues, trillions in wealth are wiped out in sinking real estate, stocks, bonds and commodities.

Even as the government promises prosperity around the corner, we see more factories closing, more jobs lost.

The primary reason is simple and quite obvious: Our society is addicted to debt.

As long as government could keep the credit flowing — and as long as borrowers could get their regular debt fix — everyone continued to spend to their heart's content. But now that credit has stopped flowing, the American economy is sinking rapidly into depression.

The Threshold of the Absurd

We saw the first telltale warning of America's Second Great Depression when a credit crunch hit in full force in August 2007. Banks all over the world announced multibillion losses in subprime (high-risk) mortgages. Investors recoiled in horror. And it looked like the world's financial markets were about to collapse.

They didn't, but only because the U.S. Federal Reserve and European central banks intervened. They injected unprecedented amounts of cash into the world's largest banks; the credit crunch subsided; and everyone breathed a great sigh of relief. But in early 2008, the crunch struck anew — this time in a more virulent and violent form, this time impacting a much wider range of players.

Now, the big question was no longer: Which big Wall Street firm will post the worst losses? It was: Which big firm will be the first to go bankrupt? The answer: Bear Stearns, one of the largest investment banks in the world.

Again, the folks at the Fed intervened. Not only did they finance a giant buyout for Bear Stearns, but for the first time in history, they also decided to lend hundreds of billions to any other major Wall Street firm that needed the money. Again, the crisis subsided temporarily. Again, Wall Street cheered and the authorities won their battle.

But the war continued. Despite all the Fed's special lending operations, another Wall Street firm — almost three times larger than Bear Stearns — was going down. Its name: Lehman Brothers.

Over a single weekend in mid-September 2008, the Fed Chairman, the Treasury Secretary and other high officials huddled at the New York Fed's offices in downtown Manhattan. They seriously considered bailing out Lehman, but they ran into two serious hurdles: First, Lehman's assets were too sick — so diseased, in fact, even the federal government didn't want to touch them with a ten-foot pole. Second, there was a new sentiment on Wall Street that was previously unheard of. A small, but vocal minority was getting sick and tired of bailouts. “Let them fail,” they said. “Teach those bastards a lesson!” was the new rallying cry.

For the Fed Chairman and Treasury Secretary, it was the long-dreaded day of reckoning. It was the fateful moment in history that demanded a life-or-death decision regarding one of the biggest financial institutions in the world — bigger than General Motors, Ford and Chrysler put together. Should they save it? Or should they let it fail? Their decision: To do something they had never done before. They let Lehman fail.

“Here's what you're going to do,” was the basic message from the federal authorities to Lehman's highest officials. “Tomorrow morning, you're going to take a trip down to the U.S. Bankruptcy Court at One Bowling Green. You're going to file for Chapter 11. Then you're going to fire your staff. And before the end of the day, you're going to pack up your own boxes and clear out.”

It was the financial earthquake that changed the financial world.

Until that day, nearly everyone assumed that giant firms like Lehman were “too big to fail,” that the government would always step in to save them. That myth was shattered on the late summer weekend when the U.S. government decided to abandon its long tradition of largesse and let Lehman go under.

All over the world, bank lending froze. Borrowing costs went through the roof. Global stock markets collapsed. Corporate bonds tanked. The entire global banking system seemed like it was coming unglued.

“I guess we goofed!” were, in essence, the words of admission heard at the Fed and Treasury. “Now, instead of just a bailout for Lehman, what we're really going to need is the Mother of All Bailouts — for the entire financial system.” The U.S. government immediately complied, delivering precisely what they asked for — a $700 billion Troubled Asset Relief Program (TARP), rushed through Congress and signed into law by the president in record time.

In addition, the U.S. government has loaned, invested or committed $200 billion to nationalize the world's two largest mortgage companies, Fannie Mae and Freddie Mac … $25 billion for the Big Three auto manufacturers … $29 billion for Bear Stearns, $150 billion for AIG and $350 billion for Citigroup … $300 billion for the Federal Housing Administration Rescue Bill to refinance bad mortgages … $87 billion to pay back JPMorgan Chase for bad Lehman Brothers trades … $200 billion in loans to banks under the Fed's Reserve Term Auction Facility (TAF) … $50 billion to support short-term corporate IOUs held by money market mutual funds … $500 billion to rescue various credit markets … $620 billion for industrial nations, including the Bank of Canada, Bank of England, Bank of Japan, National Bank of Denmark, European Central Bank, Bank of Norway, Reserve Bank of Australia, Bank of Sweden and the Swiss National Bank … $120 billion in aid for emerging markets, including the central banks of Brazil, Mexico, South Korea and Singapore … trillions to guarantee the FDIC's new, expanded bank deposit insurance coverage from $100,000 to $250,000 … plus trillions more for other sweeping guarantees.

Grand total: $7.8 trillion and counting, eleven times more than the hotly debated and widely opposed $700 billion bailout package passed just 66 days ago. And that excludes a new bailout for Detroit in the works, a new $500 billion stimulus package expected early next year, plus hundreds of billions for at least 19 states running out of money for unemployment benefits.

Washington says it's all for a good cause — to save the world from depression. But it is obviously reaching a level that's beyond the threshold of the absurd.

Here's why it will fail …

Reason #1 - Too Much Debt

By mid-year 2008, there were $52 trillion in interest-bearing debts in the United States, including mortgage loans, credit cards, corporate debt, municipal debt and federal debt; the federal government needed about $50 trillion for Social Security, Medicare and other commitments kicking in at a quickening pace; and U.S. commercial banks held another $182.1 trillion in side bets called “derivatives.” Grand total in the U.S. alone: $282 trillion.

The numbers are not directly comparable, but just to give you a sense of the magnitude of the problem, that's 402 times more than the $700 billion bailout package.

If, along with their big debts, Americans at least had plenty of cash, it would not be such a problem. But, alas, nothing could be further from the truth. Americans have saved less than ever before in history and less than their counterparts in almost every other industrial country on Earth.

Reason #2 - Nobody Wants to Pick Up the Tab

In the rush to spend the trillions of dollars, no one has bothered to seriously consider this simple question: “Who's going to pay for it all? Where are we going to get all that money?”

With the economy already weak, it certainly isn't going to come through higher taxes. And with unemployment and welfare expenses surging, cutting the budget wasn't going to yield very much either. The government had only one choice: To borrow the money.

More big debts!

Sure enough, last month, the U.S. Treasury Department announced that it would have to borrow $550 billion in the fourth quarter, more than the total budget deficit for the entire year. At the same time, Goldman Sachs estimated that the upcoming borrowing needs of the U.S. Treasury would be a shocking $2 trillion — to pay for the bailouts, to finance the existing deficit and to refund debts coming due. That was about four times the size of the entire yearly deficit. This meant that, to raise the money, the government will have shove aside consumers, businesses and other borrowers; hog most of the available credit for itself; and then, to add insult injury, bid up interest rates for everyone. As Mike Larson explained Friday, it's the biggest bubble of all .

Some people hoped the government's resources, by some feat of magic, might be unlimited. But the reality is that there is no free lunch, someone has to raise the money and pick up the tab. And as soon as they try to do that, the pain will strike swiftly — in the form of steeper mortgage rates, higher credit card rates or, worse, virtually no credit at all.

Reason #3 - Sinking Confidence

Like in the 1930s, money alone, no matter how lavishly dished out, cannot restore public confidence . While it may buy some reprieve for large banks, it does little to help thousands of smaller banks. While it helps some percentage of consumers some of the time, it cannot help the majority most of the time. That's why consumer confidence has plunged to the lowest level in recorded history, consumer spending collapsed and Corporate America is responding with huge cutbacks. This story Dad told me about 1930 shows some interesting similarities:

“After the Crash, President Hoover was worried about the sinking U.S. economy. So he called the leaders of major U.S. corporations down to Washington — auto executives from Detroit, steel executives from Pittsburgh, banking executives from New York. He said, in effect:

“‘Gentlemen, when you go back home to your factories and your offices, here's what I want you to do. I want you to keep all your workers. Don't lay any off! I want you to keep your factories going. Don't shut any down! I want you to invest more, spend more, even borrow more if you have to. Just don't do any cutting. It's for a good cause — so we can keep this economy going.'

“That may have sounded like a good idea at first. But then the executives went back to their factories and offices and said to their associates: ‘If the president himself had to call us down to Washington to lecture us on how to run our business, then the economy must be in even worse shape than we thought it was.'

“They promptly proceeded to do precisely the opposite of what Hoover had asked: They laid off workers by the thousands. They shut down factories. They slashed spending to the bone. They cut back.”

Now, history is repeating itself, albeit on a much grander scale with a more ambitious government. As before, each new government bailout is initially greeted with some enthusiasm on Wall Street. But as the crowd of wannabe bailout candidates swells, and as people recognize the desperation of authorities to satisfy them all, confidence sinks even further.

Washington tries to encourage consumers and businesses to borrow more, spend more and save less, but they do precisely the opposite.

Washington prods bankers to dish out more credit, but the Fed's own surveys show that banks all over the country do precisely the opposite, sharply tightening their lending standards.

Government officials give frequent pep talks to inspire investors to take the risk of investing more, but most investors would prefer to slash their risk — or even their wrists.

In each case, folks realize that it was too much borrowing, too much spending and too much risk-taking that got them into so much trouble in the first place. So they just do what comes naturally: They cut back.

Reason #4 - The Vicious Cycle of Debt and Deflation

Debt alone is usually tolerable. People can pile up debts year after year, and as long as borrowers have the income — or as long as they can borrow from Peter to pay Paul — they continue making their payments. Life goes on.

Deflation — falling prices and income — is also not all bad. It makes homes more affordable, college education more achievable, a tank of gas easier to fill.

It's when the debts and deflation come together that the wheels are set into motion down the path to depression. That's what happened in the 1930s; and that's what began to happen this time as well.

In the housing market, Americans abandon their homes or are forced into foreclosure. The foreclosures precipitate distress selling. The distress selling causes price declines. And the price declines, in turn, prompt more people to abandon their homes or let them slide into foreclosure.

On Wall Street, we have a similar cycle: Big companies and banks run out of capital, cannot pay their debts and go bankrupt. The bankruptcies — and the fear of more to come — drive investors to sell their shares, forcing stock prices lower. With lower stock prices, corporations and banks cannot raise capital, and more go bankrupt.

Consumers, small and medium-sized businesses, city and state governments, hospitals and schools, even entire countries are caught up in a similar downward spiral — slashing their spending, laying off workers, dumping assets, losing revenues, and slashing their spending still more.

These vicious cycles are in full motion and gaining momentum. It's too late for any government to stop them. Now that the speculative bubbles have burst, all the king's men cannot put them back together again.

The government's rescue efforts will fail. America's Second Great Depression will strike swiftly and take no prisoners. You must be ready.

Time to Sell

The government-inspired rally on Wall Street is your signal. It's now time to sell ALL vulnerable assets that you do not need or you cannot hedge against. That includes …

  • Second homes, rental properties and commercial real estate;
  • Common and preferred shares, regardless of your profit or loss;
  • Corporate and municipal debt of all maturities, regardless of their rating;
  • Long-term Treasury bonds and government-guaranteed bonds (including Ginnie Mae, Fannie Mae and Freddie Mac); and …
  • Collectibles, including art, antiques, rare coins and stamps.

But do not sell the U.S. dollar! Quite the contrary, the U.S. dollar, stashed in short-term Treasury securities, is now your single best safe haven for most of your money.

Due to deflation, the dollar's purchasing power is improving rapidly with each day that passes. Due to a global flight to quality, the dollar's exchange rate is rising sharply against nearly every currency in the world. And due to the massive deflation and capital flight still ahead, this massive bull market in the dollar is just beginning!

Indeed, for the long-term future of our country, it is the one, outstanding silver lining of this crisis.

Be Bold AND Prudent

You need not sell your shares indiscriminately regardless of market conditions. Thanks to the government-inspired rally in the stock market, you have a short time window to get out with relatively normal market conditions.

You also need not dump your real estate properties on the market at crazy fire-sale prices. To set your price, just be sure to check prices of actual sales (not bids) that are truly recent (within the last 30 or 60 days) and that are really comparable. Then offer the very best possible discount you can ( at least 10%, possibly more) right from the very first day.

But you must not delay. Act boldly and prudently.

If you work with a money manager, before liquidating assets, ask if they have programs specifically designed to hedge and profit in a depression. If not, move your money to one who does. If your realtor or broker is unwilling to help you sell, find one who is. If you find that you or your family are still uncertain, consider Dad's recommendations:

“One of the greatest blunders people made in the 1930s was to blindly assume that prices were already so low, they couldn't possibly go any lower. In reality, the value of their real estate, stocks, commodities and virtually every other asset didn't stop going down at some particular level that appeared to be ‘cheap.' Nor did it stop falling just because it matched some historical price that was considered low. The end of the price declines came only when buyers, investors and lenders capitulated; when most of the bad debts were liquidated; and when the powerful vicious cycles were exhausted. Until then, huge losses were still possible and you needed to sell. Only AFTER we saw those climactic conditions was it time to buy or hold.”

In America's Second Great Depression, the same will be true, with one key addition: The most aggressive buyer, investor and lender of all is Uncle Sam; the decline cannot truly end until he abandons his efforts to stop it.

Good luck and God bless!

Martin

P.S. To profit handsomely from the surging U.S. dollar, click here .

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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