Simit Patel

As we enter 2009, many if not most agree that the US economy is struggling, and that these struggles will continue. An increasing number have been making comparisons to the Great Depression. With that in mind, let's compare and contrast the situations:

Similarities

1. Both were preceded by an extensive period of credit-fueled bubbles. Before there was the Great Depression there was the Roaring '20s; likewise, before Depression 2.0 were the Greenspan NASDAQ and housing bubbles. Consistent with Austrian business cycle theory, the end result of a credit-fueled bubble will be a corrective recession that purges out the malinvestments resulting from an excessive expansion of the money supply.

2. Both were marked by government interventionist policies designed to prevent falling asset prices. For instance, bans on short selling occurred in 2008 and at the beginning of the Great Depression. Likewise, stimulus packages were the prescribed remedy at the onset of the Great Depression, and are in vogue once again now. It's worth noting they were unsuccessful back then, and don't appear to be succeeding now.

Differences

1. There is a lack of a gold standard, which serves as a restriction to how much the money supply can be expanded. The dollar was devalued relative to gold during the Great Depression, so there were attempts to circumvent restrictions on the money supply, but ultimately the gold standard was not fully abolished until 1971, and so the Federal Reserve was a bit more restricted in how much money it could create. This restriction does not exist today.

2. America was not as debt-ridden during the Great Depression as it is today. Credit cards are a rather new creation, and the national debt and deficit spending were significantly lower.

3. America's debt is owned largely by foreigners. This introduces the possibility of economic warfare; foreign debt owners can devalue the dollar by selling Treasury bonds as well dollar reserves.

4. All major currencies are fiat currencies, and the US dollar is the world's reserve currency. This helps the United States in a way, as central banks have been inflating their money supply along with the US dollar to maintain parity of sorts. In this way, the US gets to export its inflation.

Conclusions

1. Because of the similarities, it is reasonable to expect asset prices to continue falling in real value. It is easiest to define "real value" as the price in gold; in other words, assets will fall relative to the price of gold.

2. Because of the differences, currency devaluation is much more likely. Iceland and Argentina, which I've previously written about (here and here), is much more likely. Those who argue for deflation and a scenario similar to Japan are not considering that the Federal Reserve under Bernanke is willing to use unorthodox measures to inflate; Japan was more cautious, and did not heed the recommendation of economists like Paul Krugman, who had called for the Bank of Japan to fully monetize Japan's budget deficit by simply creating more money. As there are no restrictions on the Federal Reserve to expand the money supply as it pleases, currency devaluation is more feasible. Moreover, unlike Japan and like Argentina and Iceland, the US is a debtor nation -- not a lender. This increases the likelihood of a run on the currency, which will result in significant currency devaluation.

3. Because of the US dollar's role as world reserve currency, other economies may try to devalue their currency along with the US dollar to avoid the pain and chaos of decoupling. This would result in the value of all fiat currencies falling.

4. Depressions that are purely deflationary, like Japan and the Great Depression, last significantly longer and can be characterized by reversals that last for years. Roger Nusbaum noted this in his 2009 forecast, in which he expects a rally -- offering a comparison to the significant rallies that occurred during the '30s during the US' Great Depression. Inflationary depressions, though, have a much sharper and harder fall, and thus do not have genuine rallies until currency stability is restored.

5. While zero percent interest rates and quantitative easing are the tools currently being utilized, should currency devaluation begin to be an issue, raising interest rates will be the most likely and most effective way of preserving the US dollar's value. Paul Volcker's policies during the late '70s and early '80s are a historical precedent in this matter, and interestingly enough, Volcker has returned as an economic advisor. Should interest rates rise, this would likely send stocks falling.

6. Should foreign currencies devalue along side with the US dollar, gold and silver should rise. Should foreign currencies decouple, the US dollar may fall relative to them.

Disclosure: Long gold and silver.

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uahmed

Dear Simit,

Once again you deliver with a great article!! Keep up the great work!!!

Ali

Unregistered

Well said, well said.

I agree completely, however there is also one important difference that you missed out. At the time of the Great Depression, America's industrial base was the economy's driver (contributing about 25% of GDP). Today that number is 12% and falling. The two biggest contributors to GDP today are government spending, and consumer spending.

Now if one takes the Austrian view of money; ie that it is a medium of exchange that represents something of value that has been produced, America was much better positioned to recover from the depression.

Put another way, economists today (*cough* Krugman *cough*) seem to think that money is just a quantity that must be increased or decreased depending on economic conditions, and that making more money can somehow produce wealth. Of course this is nonsense, since money is not an indicator of wealth, more money means higher prices, less means lower prices, however true wealth can only be measured by the amount of goods and services of value that are produced by the country.

America is where it is today because of decades of unproductive consumption. It has produced less and less each year and consumed more and more, as compared to the 20's where the amount that America produced increased greatly in that decade and the ones preceding it. It is for this reason that this current crisis could be worse than the Great Depression; as the facade of credit-financed growth is peeled back by deleveraging, the true state of the American economy will be revealed, and it aint pretty. That is why those in power will do anything to try and prevent this from happening.

Simit Patel

@ ali: glad you found it useful

@ unregistered: excellent point regarding GDP, thanks for adding it. Many economists (Keynesians) view America's consumption as the driving engine of the global economy, though in reality I think it is more like a cost that the rest of the world is bearing -- especially now when foreign countries loan money to the US government via Treasury bonds, and the money is then used to bailout industries, so that individuals can purchase products made by the foreign countries loaning the money. The good news is that while the transition out of this system is likely to be quite painful, I think it will ultimately increase efficiency overall for the global economy.

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Unregistered

The current situation is certainly unnerving - we are a society and a nation that has been consuming for far too long with much of the economic growth of the past 10 years being artificial - meaning malinvestment and consumption activity driven by mounting debt (started with the Reagan years). We are now over-leveraged at both the individual and government level (not to mention some corporations, hedge funds etc), the federal goverment in its pursuit of saving the economy is driving us much further into debt, the dollar continues to lose its status (on an accelerating basis now) which should logically trigger a run on the currency which will drive interest rates higher which will put additional strains on the economy, the debt markets, the consumer, the equity markets and will further hamper growth. I don't see how anything but a significant de-leveraging process with its own reverse multiplier effect as being possible. It seems to me the government is only slowing what is an inevitable outcome. It is hard to see anything but a very painful and long ending to this.

That having been said, I am always interested in hearing counter arguments. I am at a loss though as to what logical counter argument there may be for a sustainable turnaround that is not just a rest on the trip downward. I feel like we are the boat that has gone past the point of no return and are about to get swept over the falls and there is nothing we can do about it.

I am curious as to your thoughts on a counter argument and what foundation that counter argument rests on that is long term and sustainable.

Simit Patel

@unregistered: apologies for the late response. I think the US economy is out of ways it can keep the game going, but its fate is in the hands of foreigners. If foreigners are willing to continue buying US treasuries, then the US economy may be able to keep going without a significant reversal of sorts. Likewise, if foreign central banks are willing to devalue their currency while the US devalues its currency, that could avoid pain.

Of course, by "avoid pain" I really mean export -- as the buyers of Treasuries that cannot be repaid and the willful devaluation of currency only hurts the foreign nations.

Another way to think of it would be to imagine the US as an individual person who is living entirely off credit card spending. If the individual can continue to find more credit cards, and if prices do not really rise, then it may not be a problem. Of course, in such a scenario, the individual's consumption is being financed by everyone else; he/she is essentially getting a free ride.

Personally, I think the market is not going to be able to prop up the US for much longer, and a correction of sorts is going to occur.

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kkpatel1924

There is so much talk about the $ being devalued that there has to be a way to take a position against the dollar to protect our entire set of assets (taxable, IRA, 401k, home etc) with a hedging tool. Of course, the Eur/$, Yen/$ and other vehicles gives us that option via ETFs and FXCM, but:

1. Are we protecting it completely and correctly?
2. Is Gold/Silver ETFs and Bullion also a good choice?
3. How do we allocate this to hold onto it for the long term, since it might take all of 2009 and part of 2010 for the devaluation to occur?
4. Finally, as we are holding these, there may be cycles within it that we might have to trade. Can we discuss the timing of these cycles.

We have 'so many' threads created on this topic that I am having a hard time following 2-3 that lead to some really extensive discussion on security selection, positions, timing etc.

Any thoughts Simit, Dave and others?

Thanks.

KKP

Simit Patel

Here's my take regarding your questions:

1. Only one way to find out. Though I agree with the Peter Schiff/Jim Rogers view that there is a boom coming in Asia, and hence Asian currencies, bonds, perhaps some equities (particularly those in the commodities niche), and precious metals are a great way to preserve and even gain value.

2. I don't recommend precious metal ETFs as there is a greater chance of the metals not actually being there and the ETF collapsing in value. Bullion and physical deliver I do like and am acting accordingly. Here is my take on preferred bullion merchants, as well as my take on my preferred physical dealer.

3. Personally, I have a little under 20% of my precious metals in my physical possession. The rest is in vaults. Your allocation will depend on your risk assessment. Some people are comfortable with ETFs and trading and thus may prefer having a higher percentage with them. I know some people that want to take delivery and don't trust vaults.

4. That's where technical analysis comes in. I expect the forex market to continue to be volatile. Precious metals will likely be volatile as well, although I am taking a buy and hold stance with them. With currencies, I look for opportunities to trade dollar weakness; this strategy has been working well for me thus far. I trade primarily off the daily chart and typically exit losers quickly (within a week) while holding on to winners for a few weeks or a month.

Of course that's just what I'm doing. So far I feel as it's been working well for me in terms of preserving and cautiously growing capital. We'll see if 2009 requires a re-adjustment of sorts.

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Unregistered

this could just be a well thought out plan for a communist takeover