-F. Scott Fitzgerald

The gospel of infinite prosperity is back in full bloom.  Echoing from the television talking heads and radio pundits preach that the economy is on the mend because we have spent our way into prosperity.  This recovery, as we are led to believe, is occurring even though jobs are being lost at the rate of 2.5 million a year and this is somehow good (or less bad in their words).  We are now led to believe that jobless recoveries are simply part of the new economic landscape.  This coming from a group of people that missed the largest recession since the Great Depression (maybe they should avoid predictions for a few years).  Since the recession started in December of 2007, a painful 20 months indeed, the U.S. economy has shed 6.9 million jobs.  That is the official number.  If we dig deeper, we have 26.3 million unemployed and underemployed workers in the economy.  For a recession that is the “worst since the Great Depression” we sure got out of it fast.

Getting out of it fast is what we are being led to believe.  Yet the public is being fed a bunch of nonsense from the gospel of infinite prosperity.  Much of this philosophy was also part of the Roaring 20s.  The near religious belief in the big business culture of the U.S.  Of course, much of this has influenced the way the crony capitalist have infected Wall Street with their cannibalistic method of destroying wealth for the country for short-term gain.  The notion that spending trillions of dollars and giving authority to those that have led us to financial Armageddon is perverse as it is backwards.  If anything, it simply demonstrates that Washington and Wall Street are wedded at the hip while ignoring the plight of the average American.

For a country that talks about the “small business owner” the reality is much different.  During this economic crisis it is the mighty who are receiving the biggest handouts.  You don’t see Jim’s local hardware shop getting a bailout.  But Bank of America, Wells Fargo, and JP Morgan all received their piece of the economic handout.  And look at all the bank failures.  In relative terms, the small are being allowed to implode.  In reality, they hold very little of the banking wealth.  The U.S. currently has 8,195 banking institutions according to the latest FDIC report.  116 institutions or slightly above 1 percent own and control 77 percent of all banking assets.

And wealth inequality is at record levels once again:

Source:  William Domhoff

81 percent of all financial wealth is concentrated with the top 10 percent.  If you are wondering about another time in history when so much wealth was concentrated in a few hands you can look to the Great Depression.  Even though the punditry proclaims to believe in the middle class the data paints a very different picture.

In today’s Lessons from the Great Depression series we are going to examine the Roaring 20s.  Much like our economic climate today, much of the “success” was confined to a small group.  Sure, many lived up the good times like during our HELOC housing bubble mania but once the tide went out, people learned a quick lesson between wealth and income.  Income can be taken away rather quickly as many people are now realizing.  Wealth on the other hand has longer sustainability and can impact control including favorable policies enacted by lobbyist to protect the unequally weighted status quo.

This is part XXVIII in our Lessons from the Great Depression series:

22.  The Infection of Consumerism and Living Fake Lives.

23.  The Worst Housing Crash in American History.

24.  Economic Crises Around the World in Synchronization.

25. Reconstruction Finance Corporation II

26. Pecora Commission Where Art Thou?

27. Current Net Worth Drop of $13.8 Trillion Equivalent to 21 Percent Drop.

I’ve studied the Great Depression in great detail.  Some of the best books on the topic include:

Only Yesterday by Frederick Lewis Allen

The Great Crash of 1929 by John Kenneth Galbraith

The World in Depression by Charles Kindleberger

Today I’ll be focusing on a few passages from The Year of the Great Crash 1929 by William Klingaman.  People think of the Roaring 20s with images from the privileged elite that may come from F. Scott Fitzgerald’s Gatsby like literature.  Yet the reality is very different.  What we find is a nation that shuns savings, spends on credit, cuts deep in to the working class, and ultimately leads the nation into financial Armageddon:

“Beneath all the sanctimonious probusiness rhetoric, the Coolidge boom was based upon the tremendous expansion in productive capacity of American factories in the 1920s, particularly in such basic industries as iron, steel, petroleum, chemicals, and light metals.  Because America’s fundamental transportation and manufacturing systems had been completed before 1914, and because the war had suddenly thrust the United States into an entirely unfamiliar role as a creditor nation possessing a record-breaking stock of European gold, businessmen were free to turn their attention toward refinements in the production and distribution processes.  Spurred by military demands during the war, and sustained by the adoption of scientific management techniques in the years immediately afterward, U.S. industrial production nearly doubled between 1919 and 1929.  Automobiles production skyrocketed; by 1929, Detroit was turning out nearly five million new cars a year.”

America is anything but a creditor nation.  We are a nation full of debt.  The green shoot argument was based on spending money we didn’t have.  The use of Keynesian philosophy in such a poorly managed way is disturbing.  It would be one thing if the bulk of the money was spent on average working Americans but the vast amount of bailout funds went to the top 10 percent while the middle class is seeing the American dream largely disappear.  If you want to see a current breakdown of the current bailouts, this is how it would look:

How the stimulus package can garner more heat when we have given the banking and financial sector nearly 20 times more in funds is amazing.  The crony capitalist have figured out a way to get the public to focus on smaller shiny things while ignoring the massive exploitation of fraud going on.
To think that suburban sprawl is only a thing from our current housing bubble is incorrect:

“Highway construction (funded primarily by state and local expenditures) provided thousands of new jobs; and as Americans enjoyed the benefits of increased mobility, sprawling networks of suburban development grew up virtually overnight, further fueling the building boom that also provided most of the nation’s cities with brand-new skylines, symbolized by the graceful, unadorned, and ultra-modern brick, cement, and stone skyscrapers that kept soaring higher and higher each year.  Utility companies expanded their grids throughout the countryside, bringing the blessings of inexpensive electric light and power to most of rural America for the first time; power consumption in the United States increased at the rate of 15 percent a year during the decade.”

The perma-growth model was in full force back then as well.  But I am certain that we protected the mom and pop shops back then right?  I mean that is the story of small business:

“In a never-ending quest for efficiency and greater control over every aspect of their operations, businessmen in the 1920s became obsessed with bigness.  Local utility companies merged into mammoth regional empires; nationwide chain stores such as A&P, Piggly-retail shops, and Woolworth’s squeezed out thousands of small, independent retail shops; big-city banks gobbled up defenseless competitors and turned them into branches of multitiered holding companies.”

Many things are large myths.  The Roaring 20s roared for a select few until it all imploded with the Great Depression.  Mega organizations ate and swallowed up small businesses like breakfast bars just like gigantic too big to fail banks are eating up smaller banks that are not too big to fail in the current recession.  Even in the 1920s, pushing an anti-saving mentality was easy to do in the United States:

“Unfortunately, there was no corresponding expansion of employment or wages to accompany this boom in industrial output – which was, after all, achieved largely by the substitution of machinery for manpower.  Without some powerful outside stimulus, production soon would have outpaced consumer capacity.  So, to encourage a wider distribution of the mushrooming supply of goods and services, advertising became a major industry in itself.  Saving was condemned as hopelessly out of fashion and almost unpatriotic; it was every American’s duty to provide himself with as many wristwatches, electric floor scrubbers, Frigidaires, Kriss-Kross razor blades, ultraviolet sun lamps, exercise machines, and canned peas as humanly possible.”

Does this sound familiar?  Just replace the Frigidaires with Sony plasma TVs and every other consumer good you can squeeze into your Visa card.  Only this time, we took it to another level with the home equity ATM because back in the 1920s homeownership was roughly 45 percent while this time we nearly took it to 70 percent.  The home became the personal stimulus machine sanction by the U.S. Treasury and Federal Reserve.  Once again spending does not equal wealth.  But for those at the top, they have to find ways to keep the consumer running on the treadmill faster and faster.  The birth of adverting was a good way to get this going:

“Advertising “makes new thoughts, new desires and new actions,” declared Coolidge approvingly in 1926.  “It is the most potent influence in adopting and changing the habits and modes of life, affecting what we eat, what we wear, and the work and play of the whole nation.”  In preaching the gospel of material abundance, advertisers received an incalculable boost from the invention and popularization of the radio; although the medium had been wholly unknown to most Americans before the war (only one American family in ten thousand owned a radio in 1920), the seemingly unlimited potential of radio captured everyone’s imagination during the twenties and revolutionize the nation’s communications and entertainment industries.  The advent of installment purchasing plans provided additional impetus to consumption; all one needed to buy a new washing machine or diamond necklace was a minimal down payment.  As the decade progressed, credit terms became even easier, with payment extended over longer and longer periods.”

Easy credit and media encouraging folks to buy things that are simply beyond their means.  Now those in advertising understand basic rules in human psychology.  People want to be loved, feel important, and take care of their family.  If you can make someone feel inadequate in any of these areas and promise them that your product will take care of the void, you have a good chance of selling it.

Speaking of making someone feel inadequate, remember this wonderful ad for real estate during the boom?

How many people bought a home because of a conversation like this?  I would wager that tens of thousands did because they wanted to avoid pain or be loved (both are bad reasons for making the biggest financial purchase of your life).

But the real underlying weakness could only be masked for so long:

“High-powered sales strategies only camouflaged the basic weaknesses in the American economy, however.  At one end of the scale there was too much idle capital; at the other end were too many idle workers.  Income and purchasing power were dangerously concentrated in the hands of a favored few: government statistics showed that 90 percent of the nation’s wealth was owned by 13 percent of the people.  While the number of truly rich Americans kept rising – a study by the Federal Reserve Bank of New York revealed that there were forty thousand millionaires in the United States at the end of 1928, where there had been only seven thousand in 1914 – millions of American families remained locked outside the charmed circle of prosperity.  Farm income declined steadily throughout the twenties, and unemployment kept climbing until it neared the four million mark by the end of 1928.  The coal and textile industries remained depressed for most of the decade, producing pockets of appalling poverty in the South and especially in Appalachia.  Federal surveys revealed that two-thirds of American families were struggling to survive on incomes below $2,500, the official minimum standard for a decent living.  Lured into exorbitant installment purchases, workers watched as a growing percentage of their wages was sacrificed every week to meet mounting interest payments.”

We find ourselves in a similar predicament.  All these cash for clunkers and tax credits for purchasing homes are simply a way to get people back into major debt.  How many people bought those cars with cash?  I would venture to say very few.  In fact, many now have 5 to 7 year auto loans that will commit a certain amount of their income to a depreciating asset.  Good move.  And those buying homes with the tax credit?  How many bought in areas where prices will continue to fall?  After all, a jobless recovery is in the books and it is hard to make a 30 year mortgage payment with no job.  This act of encouraging massive debt purchases in the midst of the deepest recession since the Great Depression is a page out of the Roaring 20s.  Wealth does not equal debt!  Those in the top 10 percent can tell you that but probably won’t.  Anyone that tells you spending more than you earn or can afford is a path to wealth is out of their mind or doesn’t understand the basics of finance.

One group that is on a quick way to financial wealth are those awesome Wall Street CEOs:

CEOs’ pay as a multiple of the average worker’s pay

If this is the reward they get for leading us into economic disaster, can you imagine the pay with green shoots involved?

At a certain point the gig is up:

“In the second half of the decade, as the struggle among producers for customers grew ever more vicious, it became clear that “prosperity” was the exclusive province of big corporations, as the mortality rate among smaller businesses increased inexorably.  “The business structure of the United States is undergoing a rigorous process of ‘rationalization,’” explained the managing director of the National Industrial Conference Board in early 1928, “in which many of the smaller companies find it increasingly difficult to compete with the high efficiency standards set by well-managed, large-scale enterprises.”  The New York World was less enthusiastic about the trend: “In the intensive competition which is now under way, and which shows no signs of immediate abatement, only the large organizations able to apply the best that science and skill have to offer are showing satisfactory earnings.  This goes far to explain what is sometimes called the ‘miracle’ of prosperity and falling prices.  When the nature of this prosperity is understood its miraculous features become less evident.”

History doesn’t repeat but it does bring back stupid financial moves.  I know I know, this isn’t the Great Depression.  But what industry is going to lead us out of this deep funk?  Are we going back to selling houses to one another while Tetris experts sell mortgage backed securities on their Bloomberg terminals on Wall Street to other foreign countries?  Is that our idea of a booming economy?  Do we think that putting a granite countertop on every home is the idea of a healthy economy while people max out their credit cards?  If anything, during the 1920s we did produce and produced a lot.  We were a creditor nation and exporter.  Now we export debt and U.S. Treasuries while we spend to no end.  The fact that we used the $8,000 tax credit to encourage home buying is disturbing because excessive home buying is what led us into this Great Recession!

But don’t let this get in the way of the new gospel of prosperity.  Everything is fine.  Just go out there and spend the money that you don’t have and wealth will magically appear.  The financial elite of the country appreciate your service to their wealth building.

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I’ve been digging through research papers trying to find accurate measures of household balance sheets during the Great Depression to try to develop a reference point for our current bubble.  The trouble of course is that much of our new toxic instruments like Alt-A mortgages and massive amounts of commercial real estate debt really didn’t have a big impact during the Great Depression.  At the time, it is estimated that some 1 million Americans were invested in the stock market.  The homeownership rate was rather stable during the early half of the century:

This goes in stark contrast to our bubble peak when homeownership neared 70 percent while the majority of Americans are now involved in the stock market either directly or through a pension fund.  Yet looking at research conducted on the American balance sheet during the Great Depression, we find that this current bust has caused more wealth destruction.

This is part XXVII in our Lessons from the Great Depression series:

21.  The Big Change

22.  The Infection of Consumerism and Living Fake Lives.

23.  The Worst Housing Crash in American History.

24.  Economic Crises Around the World in Synchronization.

25. Reconstruction Finance Corporation II

26. Pecora Commission Where Art Thou?

It is hard to grasp such a large drop in net worth.  Let us chart this out:

*Click for sharper image

The growth in American household assets has been rather unrelenting since the 1950s.  We had a hiccup earlier in the decade with the tech bust but we were back on track in a very short time.  However, since the peak the asset side of the equation has imploded.  We also see on the chart above the increase in liabilities.  As in most busts including the Great Depression, assets adjusted quicker than liabilities.  While asset prices have come down $13.8 trillion the liability side of the equation has only decreased by $420 billion.  How is this disconnect remedied?  By massive amounts of defaults and foreclosures since the instrument that caused the bubble was real estate and the debt tied to it.

Now I know that during the Great Depression, the safety net was largely non-existent.  There was no FDIC.  No Social Security.  No large pension funds.  So for the most part, people were on their own.  It is no surprise then that the unemployment rate peaked at 25 percent with 14 million unemployed Americans.

It is hard to believe that we now have 14.7 million unemployed Americans with another 11.2 million either working part-time for economic reasons or some who have given up looking for work.  Yet the pain isn’t as visible as soup lines or men standing outside of manufacturing plants looking for work.  Unemployment benefits are done electronically through the internet and in some states, funds are disbursed through debit cards.  Yet on a percent basis, Americans have lost more household wealth in this crisis than in the Great Depression.  Let us look at the balance sheet from the Great Depression American household:

*Source:  Frederic Mishkin – The Journal of Economic History (Dec., 1978)

I struggled to find this data and even the author in the above work had difficulty constructing the data set.  Much of this is largely due to the poor record keeping done prior to the Great Depression.  As we can see from the above chart, the household net worth peaked in 1929 and didn’t hit a bottom until 1934.  From peak to trough, the amount loss was 11 percent.  Now why the lag?  For the most part, much of the wealth of the American household wasn’t in stocks contrary to popular belief.  Of course, the stock market rocked the economy and led to job losses which in turn hurt the balance sheet but many Americans did not have their money linked up in stocks.  The lag and hits came with many of the bank failures and subsequent foreclosures.  The most visible historical memory is the stock market crash with photos of anxious crowds gathering outside of Wall Street.

It is interesting to note that the patterns of bubbles are rather similar.  That is, liabilities keep on increasing even after the peak.  Let us look at the liability side of things:

Mortgages were not a gigantic part of the balance sheet.  Much of this had to do with mortgages being constructed with a 5 to 10 year term and a balloon payment at the end.  Let us take the peak year of 1929 for example.  While household net worth (in 1958 dollars – we are focused more on percent changes) was $844 billion mortgage debt was $29.6 billion, or 3.5 percent of net worth.  Let us look at our peak data.  Net worth peaked at $64.2 trillion and mortgage debt was $10.5 trillion, or 16.3 percent.  Now this would make sense since homeownership is much higher than during the Great Depression but it also shows how dependent we were to the housing industry.  In fact, that is why the government and Wall Street are so concerned about maintaining high home prices even though in many parts of the country they are still unaffordable.  We are approaching the bust in differing ways.  Take a look at a paper written in 1933 during the Great Depression addressing various government programs:

It is strange to see a government initiative during the bust seeking affordable housing.  How things have changed.  Most of the current legislation and programs seek to maintain high home prices (i.e., loan modifications, bailouts, etc).  Since much of the American balance sheet is tied to real estate when the housing industry busted, much of the bubble wealth also came crashing down.  At the peak real estate made up $24 trillion of the $64 trillion in household net worth.  That is a large portion.  It’ll be fascinating to look at the Q2 data since housing prices have been coming down but the stock market has rebounded.  Real Estate is still a larger segment so I would expect the net worth figure to decrease for the quarter.

What becomes clear is that even though there is more overall prosperity in 2009 than in 1929, there has never been a time in history when so much wealth has been lost.  Even the Great Depression did not see such large wealth destruction.  We have more humane safety nets in 2009 but these are being strained.  Many unemployment insurance benefits are reaching their end even with extended dates.  What then for these people?  Even though the freefall in unemployment may have stopped, companies are still not hiring.  So what then?  Trade is still hurting:

The American household balance sheet will only begin to feel some relief when companies begin hiring again.  The balance sheet will only be helped when the liabilities side of the equation begins to reflect the real world value of the assets.  There are many lessons to learn from the Great Depression.  What those in Wall Street forget is that you have to create jobs to have a healthy economy.  Without that, this is going to be a long and drawn out recession.  Even Ben Bernanke had this to say:

“A lot of things happened, a lot came together, [and] created probably the worst financial crisis, certainly since the Great Depression and possibly even including the Great Depression,” Bernanke said at the start of a town-hall meeting in Kansas City.” – July 26, 2009

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Ferdinand Pecora was appointed Chief Counsel in the last months of the Hoover administration.  The banking edifice of the United States was crumbling and even the house of Morgan (read The Lord of Money Speaks) was no longer strong enough to support the economy.

This is what a March 1933 issue of TIME had to say about Mr. Pecora:

“Ferdinand Pecora, most brilliant lawyer of Italian extraction in the U. S., finished public schools at 12. At 18, after loping through his brother’s law books, he was managing clerk of a law firm. Even on the most complex cases (which he, tireless, likes best) he never needs notes, never forgets a word of testimony once it is on the record. One of his most famed convictions was that of former New York State Superintendent of Banks Frank H. Warder for his part in the failure of Manhattan’s City Trust Co. in 1929. At 47, his black eyes flash, his black hair bristles.

Last week, sitting always at Chairman Norbeck’s right, Mr. Pecora put on the show. His the right to question; Mr. Mitchell’s the duty to answer no more no less than suited Mr. Pecora-and Senator Brookhart darkly hinted that a jail cell was ready if the banker balked. Banker Mitchell proceeded to say enough to damn himself to the satisfaction of the Committee, Mr. Pecora and a large part of the U. S. people by the following admissions.”

This is part XXVI in our Lessons from the Great Depression series:

20.  The Four Horsemen of the Economic Apocalypse

21.  The Big Change

22.  The Infection of Consumerism and Living Fake Lives.

23.  The Worst Housing Crash in American History.

24.  Economic Crises Around the World in Synchronization.

25. Reconstruction Finance Corporation II

Mr. Pecora had an uncanny ability to put together complicated Wall Street jargon into a tangible and understandable argument.  Not only did he have this ability, but he understood what the public would be furious about.  We need to remember that at this time, it had already been over 3 years since the Crash of 1929.  If we want to put a date on our current crash, we can look at August of 2007.  If that is the start date, we are not even two years into this crash which is shocking to even think about.  So the public in 1933 had already had enough and was on the verge of populist anger.  The country ousted Herbert Hoover from office and brought in Franklin D. Roosevelt.  Roosevelt being savvy allowed Pecora more time to investigate the shenanigans of Wall Street.  So this was a bi-partisan fight.  Bill Moyers has an excellent talk which came out last week regarding the Pecora hearings:

The reason this is important is here we are approaching 2 years of being in this crisis and we have yet to see a modern version of a Pecora Commission.  Who is going after Wall Street?  And I’m not talking about a congressional  toungue lashing and then cutting them a check.  We’re talking about a deep investigation.  These are a few things uncovered by Pecora and his team:

“Pecora’s investigation unearthed evidence of irregular practices in the financial markets that benefited the rich at the expense of ordinary investors, including exposure of Morgan’s “preferred list” by which the bank’s influential friends, including Calvin Coolidge, the former president, and Owen J. Roberts, a justice of Supreme Court of the United States, participated in stock offerings at steeply discounted rates. He also revealed that National City sold off bad loans to Latin American countries by packing them into securities and selling them to unsuspecting investors, Wiggin had shorted Chase shares during the crash, profiting from falling prices and Mitchell and top officers at National City had helped themselves to $2.4 million in interest-free loans from the bank’s coffers.”

Just to show you that even in 1929, people saw the corruption of the crony capitalist:

“Mitchell is the ideal modern bank executive.”-Carlton A. Shively, Financial Editor of the New York Sun, May 1929.*

“Mitchell more than any 50 men is responsible for this stock crash.”-U. S. Senator Carter Glass, November 1929.”

That is Senator Glass from the Glass-Steagall Act which was passed in large part by the absurdity that was found during the investigations.  Of course, the Glass-Steagall Act was repealed in 1999 under President Clinton (D) which was largely rammed down the throat of the public by Senator Phil Gramm (R).  Can you believe Phil Gramm was the chairman U.S. Senate Committee on Banking, Housing, and Urban Affairs from 1995 to 2000?  Talk about having the fox guarding the henhouse.  Yet the point of this all is the de-regulation that setup the massive global debt bubble was supported by both parties.  And of course, back in the Pecora investigations the banking community was also vocal about bringing people to justice:

“There rested, over the weekend, the issue of banking morality and responsibility. With one other angle: bankers high & low throughout the land, while not condoning the acts of 1929, loudly proclaimed that last week the greater villains were U. S. Senators who would risk the credit of the U. S. by putting scandal into the headlines when Confidence had already received body-blows at St. Louis (TIME, Jan. 23), New Orleans (TIME, Feb. 13), Michigan (TIME, Feb. 20) and in many another state.

But the Senate Committee had succeeded in getting its man. On Monday morning at 9 a. m. Charles Edwin Mitchell, 66, resigned, and James Handasyd Perkins, 57, was promptly elected chairman of the nation’s second biggest bank. Few hours later the directors of National City Co. accepted the resignation of President Hugh Baker. Mr. Mitchell and Mr. Baker returned to Washington for further grilling.”

Talk about a different time.  Here we are 2 years into the crash and instead of looking for our own Pecora investigation, we are actually giving the 19 biggest banks unlimited access to taxpayer money via the Troubled Asset Relief Program (TARP) and also the flawed Public-Private Investment Program (PPIP).  In fact, even FDR was quick to bash the banks in his inaugural address!

“Yet our distress comes from no failure of substance. We are stricken by no plague of locusts. Compared with the perils which our forefathers conquered because they believed and were not afraid, we have still much to be thankful for. Nature still offers her bounty and human efforts have multiplied it. Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply. Primarily this is because the rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence, have admitted their failure, and abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.

True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They know only the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish.”

I don’t like the false analogy of, “well if your neighbor’s home was on fire, you wouldn’t wait to find out what happened before putting it out right?”  Essentially what they are saying is keep throwing $100 bills while you watch Benjamin Franklin disintegrate in the flames.  If that doesn’t stop the flames, go buy some of the most expensive wine and start pouring it on the flames until the fire goes out.  This is their reasoning.  We need someone right now like Ferdinand Pecora who can say, “stop throwing expensive stuff to put out a flame when we can put it out with freaking water!”  Is it important to keep current management?  No.  Is it important to maintain bonuses.  Absolutely not.  But hey, your banker neighbor’s 20,000 French Chateaux is on fire so let us use your money to put that flame out.  We can ask questions later.

As I have pointed out countless times, the majority of Americans are getting pummeled and fleeced while Wall Street and banks make away like bandits.  I should also clarify here.  We are talking about the investment firms and the top 19 banks.  There are hundreds of regional banks that actually operated prudently and have stayed away from toxic assets.  Yet these 19 banks make up two-thirds of the entire banking system in the U.S.  These banks grew into behemoths thanks to de-regulation which allowed them to be everything and anything.  Instead of packaging loans and selling them off to Latin America like some folks did in the Great Depression, people packaged mortgage backed securities and sold them off to anyone and everyone around the world.  The banking oligarchy is dictating the economic policy of this country.  One simple first step we should take is to start breaking up these gigantic banks and bring back modern regulation that will make banking more like a utility.  The riskier side of the business model can be spun off.

Yet who right now is pursuing this avenue?  Mr. Pecora was able to do this because he had experience breaking up bucket shops and understood the corrupt structure that had infiltrated Wall Street.  He managed to scour the books and present the information to the public in a manner that simply solidified the corruption on Wall Street.  Right now, all we get is a high tax rate on bonuses to AIG executives.  GM’s CEO has been ousted and the U.S. government is taking a hard stance against the beleguered automaker.  What of Bank of America or Citigroup?  What of Goldman Sachs?  How exactly are they turning a profit in this market?  Instead of a hard stance we give them more money!

And if you think Wall Street will allow regulation to come without a fight, this is what Mr. Pecora had to say in his memoir:

“Bitterly hostile was Wall Street to the enactment of the regulatory legislation.” As to disclosure rules, he stated that “Had there been full disclosure of what was being done in furtherance of these schemes, they could not long have survived the fierce light of publicity and criticism. Legal chicanery and pitch darkness were the banker’s stoutest allies.”

I must say that New York Attorney General Andrew Cuomo has put out a strong letter regarding Bank of America’s acquisition of Merrill Lynch.  Not only does this put the CEO of one of the country’s biggest banks on the hot seat, but it also puts a big question mark on former U.S. Treasury Secretary Hank Paulson.  Ben Bernanke comes up but only as a ghost because the U.S. Treasury and Federal Reserve do everything in the dark.  What is clear from the letter is this:

(a)     Ken Lewis thought he was going to make out like he found a Picasso at a swap meet by buying Merrill Lynch during those epic distressing weekends.

(b)   The deal was arranged.  However, after carefully reviewing the books, it turns out Merrill would have deeper losses.

(c)    Lewis wants out.  Lewis goes back to Paulson who basically tells Lewis, “Merrill was sold as is buddy!”

(d)   Ken Lewis tries to bluff and the U.S. Treasury and Fed pretty much convey to Lewis he and his buddies will be kicked out on the street if they try to break the deal.

(e)    Lewis is told to stay quite.

(f)    Merrill later records a ridiculous loss but the Treasury kicks Lewis down for his troubles.  By the way, the Treasury is taxpayer money.

(g)   All is well in crony world!

After reading the letter you will understand that the corruption runs deep here.  Is it any wonder that Americans have so little confidence in their banking system?  Enough of this.  We have plenty of proof and now it is time for investigations.  Ferdinand Pecora, where art thou?

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One good thing about the new information age is there is no lack of ideas on how to go about solving our current economic crisis.  Yet I am a bit dismayed how some people have suddenly found economic religion yet sat by when the Federal Reserve expanded powers to unprecedented levels and cheered on the first cut of the $350 billion in TARP funds.  It is a sort of reverse version of eat the rich where we eat the poor for the ills of our market.  Some people are latching on to an idea with iron claws that poor people (aka subprime borrowers) somehow caused this entire global collapse.  What is disturbing about this argument is the lack of math and analysis behind it.  The amount of subprime loans pales in comparison to the amount of overall mortgage debt, corporate debt, consumer debt, credit default swaps, and other more exotic forms of financial engineered credit products.  But some people love a good rallying cry and saying “subprime borrowers caused this problem” is an easy target since most subprime borrowers don’t have access to a public podium.

The argument during the bubble, if you can remember the mania, was that subprime was a tiny niche of the overall mortgage market so there was no need to worry about any market contagion.  Subprime was contained and if any problems did occur, it was such a small portion of overall mortgage debt that it was isolated on an economic deserted island.  Ironically, most of these people are now arguing that subprime caused all or the vast majority of the market problems.  Keep in mind that $7 trillion has been wiped off from the S&P 500 and the United States real estate market has seen $8 trillion wiped away from the peak.  Just with the S&P 500 and the U.S. residential market we have seen $15 trillion in wealth evaporate.  You mean to tell me that roughly $1 trillion in subprime loans has caused $15 trillion in wealth to disappear?  Is it any wonder why so many in our population don’t even understand the basics of Algebra but know who the last American Idol is?

Another interesting thing is occurring and this is more in the social trends department.  I’ve talked about a few radio shows here in Southern California that pumped up the real estate market like a used car salesman.  These shows normally occurred during the weekend.  Well for the last couple of weeks, this regular programming has been replaced with Beyonce and Ludacris.  Not sure if this is temporary but many that listened to the show realize how wrong these people were.  They not only were wrong they were major cheerleaders for the real estate market for years.  They were the real estate carnival promoters.  Radio is in it for the money.  And I am certain that many in Southern California got sick of hearing people so wrong about the market and probably tuned out.

What I want to discuss in today’s article is the Reconstruction Finance Corporation and panic moves during the Great Depression.  During the Great Depression, President Hoover recommended the formation of a big governmental credit agency that would then lend money to banks, railroads, and insurance companies.  This might sound very familiar but it would seem that people have forgotten many of the lessons from the Great Depression. It is important that we focus on what worked and what didn’t instead of demonizing one side or the other.  This is high stakes poker here and decisions that we make today will last for years.  The Reconstructions Finance Corporation (RFC) was chartered in 1932 during the last year of the Hoover administration.  The RFC was disbanded in 1954.

This is part XXV in our Lessons from the Great Depression series:

19.  The Silent Economic Depression

20.  The Four Horsemen of the Economic Apocalypse

21.  The Big Change

22.  The Infection of Consumerism and Living Fake Lives.

23.  The Worst Housing Crash in American History.

24.  Economic Crises Around the World in Synchronization.

So why did the RFC come to be?  I’ll refer to Frederick Lewis Allen here:

“Again Hoover acted, and again his action was financial. Something must be done to save the American banking system, and the bankers were not doing it; the spirit of the day was sauve qui peut. Hoover called fifteen of the overlords of the banking world to a secret evening meeting with him and his financial aides at Secretary Mellon’s apartment in Washington, and proposed to them that the strong banks of the country form a credit pool to help the weak ones. When it became clear that this would not suffice-for the strong banks were taking no chances and this pool, the National Credit Corporation, lent almost no money at all-Hoover recommended the formation of a big governmental credit agency, the Reconstruction Finance Corporation, with two billion dollars to lend to banks, railroads, insurance companies.”

It would seem that we are following similar patterns here.  Yet the problem in our situation is that the big banks don’t even have any capital to lend – in fact, we are injecting capital into them.  Last week we broke below the November market lows since two of the nation’s largest banks were pummeled under fears of nationalization.  This is another fascinating part about consumer behavior.  We already own Fannie Mae and Freddie Mac, two institutions that guarantee or own $5 trillion in mortgage debt yet people fear temporary nationalization?  We own AIG, an institution with over $1 trillion in assets yet people still don’t think the government is involved?  We are massively involved already.  And the problem that we now confront is do we keep lending money to zombie banks or do we nationalize a select few on a temporary basis, clean them up, and set them back to the private market.  Heck, even Alan Greenspan has recommended this course!

These fears of nationalization are nothing new:

“Already the pressure of events had pushed the apostle of rugged individualism much further toward state socialism than any previous president had gone in time of peace.  Hoover’s Reconstruction Finance Corporation had put the government deeply into business.  But it was state socialism of a very limited and special sort.  What was happening may perhaps be summed up in this was:

Hoover had tried to keep hands off the economic machinery of the country, to permit a supposedly flexible system to make its own adjustments of supply and demand.  At two points he had intervened, to be sure: he had tried to hold up the price of wheat and cotton, unsuccessfully, and he had tried to hold up wage-rates, with partial and temporary success; but otherwise he had mainly stood aside to let prices and profits and wages follow their natural course.  But no natural adjustment could be reached unless the burdens of debt could also be naturally reduced through bankruptcies.

And in America, as in other parts of the world, the economic system had now become so complex and interdependent that the possible consequences of widespread bankruptcy-to the banks, the insurance companies, the great holding-company systems, and the multitudes of people dependent upon them-had become too appalling to contemplate. The theoretically necessary adjustment became a practically unbearable adjustment. Therefore Hoover was driven to the point of intervening to protect the debt structure-first by easing temporarily the pressure of international debts without canceling them, and second by buttressing the banks and big corporations with Federal funds.”

It is a curious coincidence that under two of the most supposedly free market administrations have we seen two of the most direct market interventionist emerge.  Take a look at Henry Paulson and his $700 billion TARP plan and weekend bank parties with Bear Stearns, Lehman Brothers, and Merrill Lynch.  I think what we have witnessed is strict ideologues inflexible to common sense notions.  It is great to say the free market knows best but what use is it saying that if you can’t live by those ideals when times are tough?  Now I’m not a strict believer in quick taglines because I realize some people are greedy and economically lustful and many will spend more than they should if they can get away with it.  And that is what happened.  It is sensible to have some common checks and balances to prevent outright orgies in financial markets but we flew to the other side of the equation.

And that is why with the RFC, Hoover had to suck it up and do what he totally believed against.  That is, charter an entity that would do the lending that the free market could not.  That is, socialize lending.  Now during the first year in 1932, the RFC dispersed $1.5 billion and $1.8 billion in 1933.  Another $1.8 billion in 1934.  It is hard to simply lay these numbers out with no context.  For that, let us look at GNP from the Great Depression:

The first stunning thing you will notice is that GNP fell from $103 billion in 1929 to $55 billion in 1933, a near 50% fall.  To put that in today’s numbers, this would mean losing $7 trillion in GDP in the next few years.  So let us run some numbers here:

1933 GNP:     $55 billion

RFC 1933:     $1.8 billion

3.2% of GNP

2008 GDP:     $14 trillion

3.2% of current GDP:                      $448 billion

So already we know that we are spending much more than what was spent during the Great Depression.  First, we have allocated $700 billion through the TARP program.  Next, we have passed nearly $800 billion in a fiscal stimulus program.  Next, we nationalized the major mortgage lenders Fannie Mae and Freddie Mac and also one of the countries largest insurers through AIG.

We are much more active than during the Great Depression yet things still are deteriorating at a quick pace.  What gives?  As I highlighted above, we are stunting the market process of finding a true bottom by propping up home prices or trying to save select banks.  All this will do is prolong the shaking out and will certainly give us a lost decade similar to Japan.  As things play out, I am more convinced we will face something similar to Japan.  Unless we temporarily nationalize banks and clean them out, this is going to be an extremely long crisis.  I don’t think any of us likes the options presented to us but we must choose the best course forward.  Otherwise, we will keep sinking billions into banks that are already insolvent.

The RFC in a way was like the good bank idea that was being proposed.  Create an entity that will loan to the market burden free of toxic loans.  Yet how can we with a good conscience now create another institution with $448 billion to loan out to small businesses and the public?  It is incredible how much money is being put at risk now.  I understand the frustration of many and don’t kid yourself, we are going to be dealing with the fall out for years no matter what course we take.  The RFC which was going to be temporary lasted over 20 years and morphed into all sorts of things.  Take a look at some of the lending numbers:

For a time the RFC merged with the FDIC.  RFC lending increased dramatically during World War II.  So to think that any programs established will be fast is nonsense.  Think of the first $350 billion in TARP injections.  That is taxpayer loans to the banks.  Want to take a wild guess when we’ll be paid back?

I also find it interesting how some people don’t even know what we have done.  For example, part of the recent housing plan comes straight from money allocated from the TARP and of our nationalization of Fannie Mae and Freddie Mac.  That is, we have already committed this money!  I almost fell off my chair when I saw some moronic Congress person hoping that Fannie Mae and Freddie Mac collapses.  We now own these agencies!  It would behoove us if we make smart and prudent moves with them.  We are now shareholders whether we like it or not.  If anything, the recent plan although painful for most prudent borrowers to stomach, could have been a lot worse.  One thing I like is that most option ARM folks in California and Florida are not going to get one cent.  I like that.  The fact that it is capped at 105% rules out many of the bubble states.  That was my main concern.  Frankly, if you can get someone in a $150,000 home to pay $200 less a month by increasing the term of their mortgage and dropping the rate by 1 percent, I find this more reasonable than injecting $350 billion into irresponsible banks and praying they do the right thing.

I understand the frustration that most feel.  It is absurd.  But keep in mind we have already committed this damn money and the time for anger was years and months ago when the bills passed or bad ideas germinated.  Frankly, this is probably the best they could do.  My fear was that we were going to get a plan that allocated funds to bailing out California or Florida home speculators that jumped into option ARMs.  That would have lit a fire under me.  It doesn’t look like that has happened and we better hope it does not because that would be a tragedy to our economy.  Here is an interesting take on the RFC:

“In addition to the empirical evidence indicating that in general the RFC loan guaranty program has exerted a destabilizing force upon the economy, there are a priori reasons why one would expect this to be true in the future as in the past.  A loan guaranty system operating with fixed rules such as eligibility requirements and a constant rate of interest would be expected to result in an excess demand for funds during periods of price rises and increasing marginal efficiency of capital.  Since the quantity of funds demanded at the fixed rate of interest would increase during inflation, this would create the impression that the “shortage” of private funds was increasing.”

This is from a paper written in 1952 and some of the same conditions work in today’s market.  For example, much of the bubble was caused by artificially low rates that actually did not factor in the true underlying risk of the credit products.  Now, we have outside forces trying to stabilize prices while the market is actually trying to increase rates because we are now understanding the true risk of the products that were sold.  The longer we blunt this price discovery, the deeper the recession will be.  That is why those calling for suspending mark to market are delusional crony capitalist that are basically saying, “let us suspend reality until we can sell out our crap at bubble prices we paid.”  Artificial price bottoms do not work.  They never have and never will.

It is difficult to say how much the RFC helped but it did have an impact with the numerous programs pushed by the government during the Great Depression:

Without a doubt, there was an impact by the fiscal spending done by the government.  Take a look at the above chart.  It is interesting to note that our current true unemployment rate is now at 13.9% which puts us in line with the 1935 unemployment rate which counts emergency government workers.  That is, our current unemployment rate is now at Great Depression levels.  People will argue otherwise because they focus on the headline 7.6% rate but does it really feel like that?  Of course not because it isn’t true.  You mean to tell me that having 7 out of 100 workers unemployed is causing all these problems?  Of course not.  Currently we have 11.6 million people unemployed in the U.S.  At the height of the Great Depression we had 12.8 million people unemployed.  I know that we have to factor in the fact that we now have 3 times the population but just take a look at those humbling statistics and you’ll understand why we are doing such historical moves to solve the current crisis.

I’m not exactly sure how to solve the current crisis.  Yet I do know what won’t work:

(a)  Price floors: Trying to put any price bottom on home prices will only prolong the misery.  It is hard to even come up with any good examples of artificial market floors working.

(b)  Capital injections into banks: The first $350 billion in TARP did nothing.  In fact, we are now below the November market lows.  Most of this money was never lent to the public.  Why are we suppose to inject more money to institutions who were the root cause of this problem?  If we want to lend the money let us do it ourselves through a good bank model.

(c)  Avoiding foreclosure: Fortunately in the U.S. we have a healthy rental market.  People can rent a home if they can’t afford their current home.  Is this all that bad?  We should actually be encouraging these kinds of programs.  In fact, there are many investors and lenders willing to buy homes and to rent them out at fair market rates.  Yet few will buy if there are artificial floors being put in place.  The notion that everyone should own a home is absurd.  You should own a home if you are prudent and can afford it.  That is why the 20 percent down payment made sense for many years.  It showed that you had the financial discipline to own a home.

(d)  Trusting Wall Street: I still don’t get why we haven’t seen any high profiled people go to prison.  We need to see a fleet of FBI agents stroll into Wall Street and take away many of the engineers of this crisis.  Many homeowners have paid for gambling.  They have lost their homes.  Many Wall Street executives have received bonuses for their part in crushing the global financial system for a quick gain.

So as we go along with this crisis, we can expect stronger oversight on Wall Street.  This is a long battle.  We haven’t even started tackling the dark world of the hedge fund industry which you can rest assured will come up.  If it isn’t apparent already, no one has a clean answer to this crisis.  Yet we can at least avoid making the obvious mistakes from the past.  The California housing market is off 50% and guess what?  Home sales are increasing.  We should avoid trying to make errors from the past that we already know will not work.  That is one thing that we should at least strive for.

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There are many deeper problems still swimming in the sewer that is our global banking system.  The paper presented at the AEA meeting focuses on historical banking crises instead of minor recessions.  It is safe to say that we are battling with a different kind of economic beast at the moment.  The data presented in the paper is startling and has research from across the world.  I understand that people initially are reluctant to use parallels with the Great Depression.  Yet I believe this aversion to discussing the Great Depression earlier say in 2005, 2006, or even 2007 has caused us to stack this house of cards only higher and higher and the downfall will now be much more widely felt.

It is rather apparent that exploring Ben Bernanke’s view of the Great Depression is deeply rooted in neoclassical economics.  This view that all ills can be solved by monetary policy and central banking is simply a misguided notion in such a complicated and global network of economies.  The problem with Bernanke’s view of the world is that economic systems have some kind of inherent equilibrium.  Yet I think this notion is false.  That in the end, the market will balance everything out and that there is some ideal level for economies.  That is to say that there is an ideal level of unemployment, an ideal level of inflation, an ideal price for most assets.  Yet economic systems rely on humans who are inherently chaotic and do not follow orderly systems.  Need we point to the current global battles going on to show that we do not always get along or follow nicely paved roads?

Going back to the paper presented earlier this month, it looks at banking crises and pulls data looking at housing and unemployment during the economic downturn.  What this shows us is that this crisis can run deeper and has the potential of snow balling into something more pervasive if it isn’t handled properly.  The unfortunate actions taken by our central bank and U.S. Treasury leave us wanting.  It also leaves us with a bitter taste in our mouth and a blatant disregard to what history has taught us.

This is part XXXIV in our Lessons from the Great Depression series:

18.  Charity for Financial Deviants.

19.  The Silent Economic Depression

20.  The Four Horsemen of the Economic Apocalypse

21.  The Big Change

22.  The Infection of Consumerism and Living Fake Lives.

23.  The Worst Housing Crash in American History.

Where is the Bottom?

As we approach 2009 with a solemn humility that markets can be chaotic, it is important to first assess the damage to the global equity markets:

*Click for larger image

Virtually every major equity market in the world is down from its 2007 or 2008 peak by 40 percent.  Many are down by 50 percent and some are down 60 percent.  Make no mistake, this is a global crash.  Yet looking at historical data this seems to be on par with many banking crises in our past.  What the paper found is equity prices fall on average 55 percent over a downturn of roughly three and a half years.  So assuming this crisis is like those in the past, the above declines seem about right.  Yet we are talking about averages.  Given the persisting problems, this would assume our crisis is closer to the end than the beginning.

It was interesting to hear a poll on MSNBC that 57 percent of Americans believe this crisis will last 1 to 3 years.  So much for the notion going around regarding a second half recovery in 2009.  Most people are already bracing for a longer economic downturn.  Let us look at some data presented in the paper:

Incredibly, this housing crisis is already worse than that of the Great Depression.  It is also the case that during the start of the Great Depression homeownership in the country was slightly over 40 percent while at the peak of our recent real estate bubble, homeownership nearly touched 70 percent (we are now back down from that level).  The research found that on average, real estate housing price declines average 35.5 percent and last 6 years.  Let us look at the most recent Case-Shiller data:

First, the peak was only reached in July of 2006 which means we still have until 2012 for this thing to run its course if we are to follow the historical average.  In addition, we have 12 percent more to go in terms of price drops.  Yet by any standard and measure this has been the biggest coordinated real estate bubble the world has ever seen so merely reaching the historical average would be fortunate.  My estimate is that we will fall much lower on the downside.  If you look on the chart above, Hong Kong fell over 50 percent which is something resembling the state of California which is already down 46 percent.  I still believe California will not see a bottom until 2011 and this recent budget hot air blowing simply shows how bad conditions are getting.

I think it would be useful to put this into context from a passage from Kindleberger’s book:

“Samuelson’s emphasis on the fortuitous character of the depression is not entirely satisfactory.  Financial crises have occurred with great regularity, or at least they did in the nineteenth century and prior to the end of the Second World War:  1816, 1825, 1836, 1847, 1875, 1866, 1873, 1890, 1907, 1929, 1937.  A number of these turned into great depressions.  The great depression of 1873 to 1896, sometimes regarded by economic historians as the great depression, was perhaps different in origin, characteristics, and effects, so that on these scores one can regard the period from 1929 to 1939 as unique.  Going further back, however, produces the uniformities that the social scientist searches for.  Like the First World War, the Napoleonic Wars were followed by a short, sharp deflation in 1816, comparable to that of 1920-21, and a period of monetary adjustment culminating in the restoration of the pound to par in 1819 and 1821.  Then came a spurt of foreign lending from 1821 to 1825, followed by a stock market crash in 1826 and a depression.  If one subtracts 100 plus three to five years from the major economic events of the 1920s and 1930s, interesting parallels emerge.  The 1826 depression was not perhaps as deep or widespread as that of 1929 or as those of 1837 and 1848 that followed it.  But the timing is disconcertingly similar.”

The point of course is that economic shocks occur quite frequently.  If we look at history after the 1929 – 1939 Great Depression, it would look rather tame in comparison.  Yet I think that is where the mistake is being made.  Let us look at a chart showing United States’ recessions dating back to 1854:

First, the Great Depression lasted 43 months officially on its first stint (1929 – 1933), then fell back in 1937 and 1938 for another 13 months.  However, if you look at the earlier Great Depression usually referred to as the Long Depression, this lasted 65 months.  You’ll also notice that since 1933, the longest duration of economic contraction has been 16 months.  We are already on month 14.  Do you really see things jumping up by April of this year?  If you don’t, then we are talking about the longest contraction since the Great Depression.

I would also argue that the recent relatively light recessions have lined us up for a mega economic contraction.  First, we have been cooking the books on unemployment and inflation for nearly 2 decades.  We have jumped from one epic bubble in the 1990s with the technology boom to the real estate bubble of the 2000s.  So for nearly 2 decades, we have operated in a world where the data understated the true nature of what is really going on.  First, most of our growth has come at the cost of stunning credit expansion.  This credit expansion made up for our loss in productivity and gave us a false sense of growth.  Also, the last recession was simply averted by Alan Greenspan dropping rates in a deregulated climate and created a recipe for disaster in a world where business ethics simply did not exist.

If you think the Great Depression stock market was horrible, we already have two nations past that level:

Austria and Iceland are already seeing a much deeper crash in their equity markets than the U.S. did during the Great Depression.  Also, it is early in the game since these occurred recently.  The average peak to trough found in the research is 3.4 years.  Assuming our domestic peak of August of 2007, just to stay with the average we are talking about late 2010 or early 2011 for our bottom.

The severity of this crisis will shift the field of economics.  First, I think the Milton Friedman school of monetary thought has taken a major hit.  Sure, the argument can be made that during the Great Depression the Federal Reserve did not act as aggressively as possible.  This was debated for decades.  We had our first real chance to put Bernanke’s theory to the test.  It failed horribly.  First, a mistake made which I think is made with most neoclassical economist is they believe in the notion of some ideal equilibrium level.  It simply does not exist.  This would presuppose that there is an ideal level to be at.  For example, should a Goldman Sachs trader make $1 million a year or $20,000 a year?  Ideally the market would set this price but when you have the central bank in bed with the government, the salary is whatever the crony capitalist say it is.  That is not equilibrium.  That is a plutocracy and we are now in the field of political science, not economics.

Never have we seen such an incredible and unprecedented action taken by the Federal Reserve.  They have failed.  This year we are going to put the neo-Keynesian school of thought to the test with another spectacular action on the fiscal stimulus side.  Will this work?  I’m not sure.  Look, as much as I criticize Bernanke for his ideologue view of monetary policy I would love to have been proven wrong and seen everyone making beacoup money (all of us and not just those in the finance sector), real estate at stable levels, and all of us able to afford the fruits of our labor.  But again, the world doesn’t work that way.  That theory is now proven wrong in the theatre of life.

I’m sure the vast majority of us want to see the country succeed.  If fiscal stimulus does the trick then I’m sure few would argue.  But even if we look at the fiscal stimulus of the Great Depression, what we see is that it did improve the lot of many Americans, added some needed regulations to the market, and gave us some of the social safety nets that we currently have.  Yet we now live in a very different world.  Those same safety nets are now a looming problem with baby boomers starting to retire in force and our workforce stagnating.  Families simply aren’t having the number of kids that those in the early 1900s did.  The fact that we aren’t even discussing Social Security or Medicare should tell you how severe this current crisis is.  Let us assume we tackle this problem.  Then what?  We will need to confront the massive debt of our country at some point.  This is already being acknowledged yet we are also told that we are going to run massive deficits in the short run.

The fact that we are now battling with deflation tells us that we are probably going to have a Japan like recession or worse, something like the Great Depression.  Why are we to believe otherwise?  We are committing the same actions.  Are we trying to make our U.S. dollar, the currency of our country strong?  Absolutely not.  Ben Bernanke and the U.S. Treasury are trying forcefully by holding rates at near zero to devalue our dollar.  Take a look at this chart looking at the CPI:

We are very likely going to see a year over year decline with inflation (aka, deflation).  It is hard to see how we get inflation because that supposes that the government has some mechanism of forcing wages up.  They don’t.  Unions have very little power in our country today.  Take a look at what is happening in California for example.  Starting February 1^st 2009 the Governor has placed thousands of state employees on furloughs that will run until June of 2010.  This includes 2 days off a month.  Sounds good right?  Well that is a 10 percent pay cut.  So as you can see, we are not seeing prices rise.  In Bernanke’s ideal world, the flooding of the system with liquidity and now actual capital to the banks, was to get people back on that hamster wheel and going out to spend again.  The notion was that prices would once again go up because people would start bidding on these items again.  But there is one small problem.  Americans are already tapped out on debt!  They need actual real wages to go up.  Take a look at the explosion in debt:

American households are still burdened with a historically high amount of debt.  So it is hard to see how deflation doesn’t occur.  As most Americans know it, inflation or deflation is associated with the price of assets or goods.  This is normally the ancillary impact of changes in the money supply.  Yet looking at the CPI, this is a basket of goods and their price so I think it is fair to look at the price of goods as a sign of inflation or deflation.  First, let me give you an anecdotal taste of deflation.  The liquidation of Circuit City and the job losses of 34,000 people.  I was driving to the store today and saw street spinners highlighting the 30 percent off at the local Circuit City.  The fact that they are slashing prices and moving everything out is typical of deflation.  We can expect more of this.  In fact, the prices of many items were cheaper.  Initially, this may seem like a blessing but deflation is equally damaging to an economy.

For an economy like ours so dependent on spending and consumption, deflation will make this into a depression.  Just think about it.  Why would you buy a home today if you knew it would be cheaper tomorrow?  Why would you buy a car today if you were worried about your employment?  That is the issue with deflation.  Bernanke’s mistake was that he thought he had the power to induce inflation which he clearly cannot.  The consumer psychology has changed.  Even if people had access to credit (which they don’t) it is wrong to assume they will spend it again.  The gig is up.

The size of the fiscal stimulus may cause some short-term stability in prices in some sectors but the magnitude of this problem is much larger than that.  I simply do not see how a world in a depression like atmosphere will see prices coming up in the next few years.  Even the historical data doesn’t show that.  Yet I am hopeful things will get better.  In fact, the last few months show the savings rate going up.  Hopefully people take this new found austerity in stride and remember that life isn’t only about that gigantic McMansion with granite countertops courtesy of a back breaking mortgage.  When we reach the bottom of this, if anyone tries to talk about how great and infallible real estate is, just try remembering this worldwide depression to temper your expectations.

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