"Gentlemen, I have had men watching you for a long time, and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves. I intend to rout you out, and by the eternal God, I will rout you out."
President Andrew Jackson 1832
Contrast the words of President Andrew Jackson who had a strong moral compass and a firm grasp of right and wrong to the words of our current President, George W. Bush.
“The bipartisan economic rescue plan addresses the root cause of the financial crisis -- the assets related to home mortgages that have lost value during the housing decline. Under the Emergency Economic Stabilization Act, the federal government will be authorized to purchase these assets from banks and other financial institutions, which will help free them to resume lending to businesses and consumers. I know many Americans are worried about the cost of the bill, and I understand their concern. This bill commits up to 700 billion taxpayer dollars, because a large amount of money is necessary to have an impact on our financial system. However, both the non-partisan Congressional Budget Office and the Office of Management and Budget expect that the ultimate cost to the taxpayer will be far less than that. In fact, we expect that over time, much -- if not all -- of the tax dollars we invest will be paid back.”
Mr. Bush fails to realize that the root cause of the financial crisis is not the housing decline. The root cause is the greed of Wall Street CEOs, including his current Treasury Secretary, the failure of government to enforce existing rules to protect consumers and the greed and recklessness of Main Street USA as they attempted to borrow their way to prosperity. In the classic Washington fashion, the banker bailout bill was repackaged by Washington PR maggots into the Main Street Rescue bill. This is what constitutes progress in Washington. A three page fascist-like bill proposed by Hank Paulson grew to a 450 page goliath pork laden bill in less than one week. The bill that passed bought off every constituent in the U.S. with pork for rum producers, toy arrow makers, and film producers, while adding an additional $120 billion to the national debt. President Bush signed the bill before the ink was dry. The market immediately proceeded to decline 450 points in minutes, declaring that it will not work. Not to worry. Another bailout bill will be on its way shortly.
President Jackson was at war with the bankers who had taken undue risks and caused much pain in the country. He was willing to allow short term pain on American families, rather than let these bankers inflict much more damage in the future. President Bush and his cohorts at the Federal Reserve & Treasury have attempted to reverse the natural capitalist cycle of boom and bust during his entire eight year administration. The reduction of interest rates to 1%, tax rebates, excessive deregulation, and encouragement by the President and Federal Reserve to speculate and spend have led to our financial crisis today. A President with a backbone and moral compass would be telling the American people that our bankers have ruined this country and have caused the coming deep recession. He would explain that it is a painful lesson that must be faced now so that future generations would not have to pay for the sins of today. Instead, he urged the American people to support a $820 billion banker bailout which will attempt to push off pain far into the future. He has clearly failed the test of leadership and doesn’t deserve to be in the same company as “Old Hickory”.
In the last few weeks I’ve heard a lot of discussion about the Great Depression. Jim Cramer has said that if the bailout wasn’t passed, we would experience a 2nd Great Depression. This has led me to try and assess the circumstances which existed prior to the Great Depression of the 1930’s versus the conditions today. The chart below is extremely disturbing. The most recent flow of funds data shows that total credit market debt is $51 trillion versus our $14.3 trillion GDP. Debt as a percentage of GDP is now 356% versus 260% during the Great Depression of the 1930’s. This massive buildup of leverage has just begun to unwind. If this is just the beginning of the great leverage unwind, then the pain will be tremendous when it really gets going. The conclusion that I reach when looking at the vertical takeoff of debt in the early 1980’s is that this country has been living a lie of false prosperity. The huge McMansions, luxury cars, high tech gadgets, granite kitchens, 2nd homes, and exotic vacations were purchased with debt. These “assets” are depreciating rapidly and consumers and companies are desperately selling assets to pay down the debt that is strangling them. The psychology of this country has begun to change from conspicuous consumption to forced liquidation and saving.
The psychology of the country has taken longer to get to this point than I thought it would. Real median household income in the U.S. is $50,233 today. It was $50,577 in 2000 when George Bush took office. The government has added over $4 trillion to the national debt during this time. This proves that most people in this country have not been able to generate enough income to keep up with inflation. And this is using the fake CPI numbers put out by the government. Using inflation rates in the real world would make the situation more dire for the average household. The only way people have been able to maintain their lifestyle has been to borrow against their house and run up their credit cards. That is a phony improvement in lifestyle. The country has been living a lie for the last twenty years. It is now time to pay the piper.
Even more disturbing is the fact that the top 20% of households showed real increases in income. The bottom 50% lost income during the Bush years, with the bottom 20% losing 6% of income over this time frame. No wonder there is so much anger in the country regarding this bailout for the top 1%. Fifty million households make less today than they made 8 years ago. The criminal CEOs on Wall Street collected $30 million annual salaries while their companies have lost $500 billion in the last year. The average American is living paycheck to paycheck and can’t maintain a lifestyle without borrowing. The unwinding of this unbelievable debt load could lead to the next Great Depression.
Coming Depression?
There is no absolute consensus regarding the causes of the Great Depression, but some common themes become clear. I will try to evaluate today’s environment versus the conditions that existed in the 1920’s.
1. Expansion of the money supply by the Federal Reserve during the 1920’s
According to the Austrian School of economics, the Great Depression was mainly caused by the expansion of the money supply by the Federal Reserve in the 1920’s that led to an unsustainable credit driven boom. Both Friedrich Hayek and Ludwig von Mises predicted an economic collapse in early 1929. In the Austrian view it was this inflation of the money supply that led to an unsustainable boom in both asset prices (stocks and bonds) and capital goods. Ben Strong, the head of the Federal Reserve, attempted to help Britain by keeping interest rates low and the USD weak versus the Pound. The artificially low interest rates led to over investment in textiles, farming and autos. In 1927 he lowered rates yet again leading to a speculative frenzy leading up to the Great Crash. By the time the Federal Reserve belatedly tightened in 1929, it was far too late and, in the Austrian view, a depression was inevitable. The artificial interference in the economy was a disaster prior to the Depression, and government efforts to prop up the economy after the crash of 1929 only made things worse. According to Murray Rothbard, government intervention delayed the market's adjustment and made the road to complete recovery more difficult.
Alan Greenspan reduced interest rates to 1% for over a year in 2003. This act led to a speculative frenzy in real estate, $3 trillion of equity withdrawal by consumers and tremendous overconsumption built upon a foundation of debt. This speculative frenzy was exacerbated by the “Masters of the Universe” on Wall Street with their CDOs, MBSs, and other magic potions that made bad loans appear good. The Bush administration’s decision to not enforce any existing oversight of the banks also contributed greatly to the current situation. Realistically, the current conditions are worse than they were prior to the Great Depression based on the speculation that has occurred in the last eight years in stocks and real estate. Debt as a percentage of GDP is now 356% versus 260% prior to the Crash of 1929.
2. Excessive use of debt which led to a false prosperity
According to author Jeffrey Kaplan, consumerism took hold of America during the 1920’s.
“By the late 1920s, America’s business and political elite had found a way to defuse the dual threat of stagnating economic growth and a radicalized working class in what one industrial consultant called “the gospel of consumption”—the notion that people could be convinced that however much they have, it isn’t enough. President Herbert Hoover’s 1929 Committee on Recent Economic Changes observed in glowing terms the results: “By advertising and other promotional devices . . . a measurable pull on production has been created which releases capital otherwise tied up.” They celebrated the conceptual breakthrough: “Economically we have a boundless field before us; that there are new wants which will make way endlessly for newer wants, as fast as they are satisfied.”
By 1929, the richest 1% owned 40% of the nation’s wealth. The top 5% earned 33% of the income in the country. The bottom 93% experienced a 4% drop in real disposable income between 1923 and 1929. The middle class comprised only 20% of all Americans. Society was skewed heavily towards the haves. By 1929, more than half of all Americans were living below a minimum subsistence level. Those with means were taking advantage of low interest rates by using margin to invest in stocks. The margin requirement was only 10%, so you could buy $10,000 worth of stock for $1,000 and borrow the rest. With artificially low interest rates and a booming economy, companies extrapolated the good times and invested in huge expansions. During the 1920s there were 1,200 mergers that swallowed up more than 6,000 companies. By 1929, only 200 mega-corporations controlled over half of all American industry.
There are some disturbing parallels between what was happening during the 1920s and what has been happening in America in the last 10 years. Today, the richest 1% own 21% of the nation’s wealth. The bottom 50% has experienced a 4% drop in real disposable income in the last eight years. During the dot.com boom of 1998 – 2000, small investors used massive amounts of margin debt to speculate in companies with no earnings. When this bubble collapsed, a lesson should have been learned that would last a lifetime. Instead, Alan Greenspan lowered interest rates to 1% and encouraged everyone to take out an Adjustable Rate Mortgage. The speculation in real estate reached phenomenal heights by 2005. The downside of that speculation is now only half finished. Stabilization of house prices is at least another year away and another 20% to the downside. That would still leave prices high on a historical basis. Home prices did not fall on a national level during the Great Depression. In the last ten years, there have been hundreds of mergers, particularly in the financial industry. The repeal of the Glass-Steagall Act in 1999, spearheaded by Senator Phil Gramm, allowed the massive consolidation in the industry. This is why our financial institutions have become too big to fail and are on the brink of collapsing the world economy.
3. Excess speculation by a small group of wealthy investors
The administrations of Warren Harding and Calvin Coolidge are considered the most corrupt in American history. Coolidge’s administration was committed to laissez-faire non-regulation government. He announced to all Americans, “The business of America is business.” The top tax rate was lowered to 25% in 1925, the lowest top tax rate in any decade since. Exports boomed due to the low value of the Dollar versus the British Pound. The ruling elite of society were the Wall Street speculators. Only 1.5 million people out of an entire population of 120 million invested in the stock market. Ben Strong, attempting to help Britain, reduced rates in 1927. This ignited a speculative frenzy in 1928 and 1929. Margin loans increased from $3.5 billion in 1927 to $8.5 billion in 1929. Stock prices rose 40% between May 1928 and September 1929, while daily trading rose from 2 million shares to 5 million shares per day. The market reached a peak of 381, with a PE ratio of 23 based on normalized earnings, on September 3, 1929.
Ben Strong died in October 1928. Therefore, he did not witness the terrible pain inflicted upon Americans by his reckless policies. Alan Greenspan has not been so fortunate. He is able to witness how his reckless interest rate reductions have resulted in a worldwide financial collapse. He continues to defend his actions, but his legacy will forever be linked to this disaster. These low rates caused a speculative frenzy in stocks and then housing. The Bush administration’s belief in allowing free markets to regulate themselves led financial institutions to take ridiculous risks using massive amounts of debt. Despite two ongoing wars and growing budget deficits, the Bush administration decreased taxes on the wealthy. The dollar declined dramatically in the last eight years, resulting in increased exports. The PE ratio of the market reached an astronomical 38 in 2000, before crashing below 20 by 2003. Currently, the PE ratio of 25 exceeds the level at the peak prior to the Crash in 1929.
The stock market declined to 41 by 1932, an 89% decline in three years. The PE ratio of the market declined to below 5 by the mid 1930’s. The market did not return to its 1929 level until 25 years later, in 1954. As the market began to fall, prominent Wall Street CEOs did their best to prop up the market. Charles Mitchell of National City Bank on October 21, 1929, a few short days before the crash, said, “I know nothing fundamentally wrong with the stock market.” George Harrison, the new Federal Reserve Chairman, provided tremendous amounts of credit to the banking system in 1929 and early 1930, attempting to keep the party going. In the last few months, how many times have we heard Hank Paulson, John Thain, and other Wall Street cheerleaders tell us the banking system is safe and sound? Ben Bernanke has reduced interest rates dramatically, pumped money into the banking system, and taken bad assets onto the Fed balance sheet. So far, this does not appear to be working. The market has declined 30% from the peak, but is overvalued on a historical basis with profits about to plunge during the coming downturn.
4. Government responding with tighter credit, higher taxes and higher tariffs
Ben Bernanke, a self proclaimed expert on the Great Depression, concluded that missteps by the Federal Reserve in 1930 and 1931 resulted in the financial crisis becoming a depression. After the stock market crashed, speculators began selling dollars for gold in 1931. This caused the value of the dollar to plummet. The Federal Reserve raised rates and reduced the money supply by 30% to try and prop up the dollar. Investors began to withdraw their dollars from banks, and banks began to fail. By the end of 1932, 9,000 banks failed. People hid their cash under their mattresses. Bank deposits were uninsured, so when banks failed, people lost their life savings and businesses failed. Panic and fear gripped the nation. The remaining banks hoarded their cash, refusing to make loans to businesses. Treasury Secretary Andrew Mellon declared, “Liquidate labor, liquidate stocks, liquidate real estate, values will be adjusted, and enterprising people will pick up the wreck from less competent people.”
The failure to stimulate the economy with increases in the money supply was a huge mistake. The United States had the flexibility to stimulate the economy. At that point in history the U.S. was the biggest creditor in the world, with a trade surplus of $638 million. Instead of stimulating the money supply, the government attempted to protect American businesses by passing the Smoot-Hawley Tariff in June 1930. This bill increased taxes on imports which led to retaliation by other countries and contributed greatly to the worldwide downturn. World trade declined 67% by 1933. Herbert Hoover increased the top tax rate from 25% to 63% in 1932. All of these government missteps led to a downward spiral in the economy. In 1930 the GNP declined 9.4% and unemployment rose from 3.2% to 8.7%. In 1931 the GNP declined a further 8.5% and unemployment surged to 15.9%. The worst year of the Depression was reached in 1932 with GNP declining 13.4% and unemployment reaching 23.6%.
After the election of Franklin Roosevelt in 1932, his New Deal programs made people in the country feel like progress was being made, but unemployment remained above 14% throughout the 1930s. Roosevelt’s plans to redistribute wealth from the rich to the poor prompted millionaire businessmen Du Pont and J.P. Morgan to plan an overthrow of Roosevelt by military coup and installation of a fascist government. They tried to convince General Smedley Butler that they would provide an army of 500,000 and unlimited funding. The plot was foiled when the general reported it to Congress. Desperate times sometimes lead to desperate measures. The Depression did not truly end until 1939 when the U.S. borrowed $1 billion to begin rearmament in preparation for war.
Thus far, in this current financial crisis no one can accuse the Federal Reserve or the Administration of not responding with injecting liquidity into the system or reducing interest rates sufficiently. The discount rate has been reduced from 4.75% to 2% in the past year. The Federal Reserve has increased their balance sheet by over $1 trillion in the last 9 months. The government has committed in excess of $1.3 trillion of taxpayer money to keep the financial system from imploding. The question that has yet to be answered is whether these actions are just pushing on a string. Are the current conditions so extreme that we are destined for a severe recession or possible depression? The country has a national debt of $9.6 trillion, annual deficits of $600 billion, unfunded future liabilities of $53 trillion, a trade deficit of $600 billion, inflation of 6%, two wars costing $12 billion per month, and a weak currency. Therefore, we have not entered this extremely dangerous period with strong economic fundamentals.
In the last few years Congress has become much more protectionist. The sale of U.S. ports to an Abu Dabai company was blocked. The acquisition of a U.S. oil company by a Chinese oil company was also blocked. Worldwide trade negotiations recently broke down with no agreement. Free trade is being threatened. In 4 weeks the country will likely elect Barrick Obama President and Congress will be overwhelmingly in the hands of the Democratic Party. Mr. Obama has made it clear that he will increase taxes on those earning more than $250,000 and corporations. His plans include health coverage for all Americans and major spending initiatives on education and infrastructure. With colossal deficits, a protectionist Congress, tax increases coming, and gigantic spending initiatives, the next four years are setting up to be exceptionally difficult for the U.S. economy. The parallels to the early 1930s are eerie. The next administration could easily make policy mistakes which would cause a 2nd Great Depression.
Boundless Morass of Uncertainty
The $820 billion bailout package will not fix what is wrong with this country. Hank Paulson will buy bad assets from any financial institution in the entire world for some yet to be determined price. Many smart people, including John Hussman, Nouriel Roubini, and Chris Whalen have concluded that the plan will not work. The banks need a direct infusion of capital to begin their recovery process. This entire exercise in futility will be overwhelmed by events in a matter of days. The American taxpayer will never see a dime of that $820 billion paid back. When was the last time a government program actually worked? Corrupt politicians, Washington bureaucrats, Wall Street fat cats, and clueless commentators have failed to realize that the gig is up. Our entire financial system has been built upon deception, lies and debt. The only thing keeping the system afloat has been blind faith in our government and financial leaders to do the right thing. The whole world now has seen that these leaders were lying and the blind trust has been shattered into a billion pieces.
There is currently a worldwide run on the banking system. The pictures from the Great Depression show people standing in line to get their cash out of the banks. We are in a different age that allows bank runs to occur in seconds rather than days. Companies and wealthy people in the know are pressing buttons and transferring billions in cash out of dangerous shaky financial institutions. With leverage of 30 or 40 times their cash balances, banks are collapsing around the globe. The average American does not see this happening and is being kept in the dark by the all powerful lords of finance. The market hailed the investment by Warren Buffett last week in General Electric. Of course, no one from CNBC would ask why GE would sell stock at a 10 year low price after buying back billions when the stock was in the $30’s, pay 10% interest to Mr. Buffett when market rates are 4%, and stop dividend increases after decades of increases. GE is in much worse shape than anyone is willing to admit. Governments throughout the world are desperately trying to stem the tide of defaults, but confidence in the Ponzi scheme has been destroyed. Behind the scenes, Ben Bernanke and Hank Paulson are scrambling to provide enough liquidity to keep the system from imploding. A worldwide coordinated, reduction in interest rates will occur soon as a last ditch effort.
For the 1st time in many years I saw something that shows promise for our country’s future. Despite the rhetoric from President Bush, Hank Paulson, Ben Bernanke, Nancy Pelosi, Barney Frank, all CNBC commentators, and various ultra-rich Wall Street shills, the American public was firmly against this bailout bill. I sense that the “ME GENERATION” is finally ready to accept the consequences of their selfish lifestyle over the last 30 years. The materialistic frenzy that has been the hallmark of the Baby Boom Generation is coming to an end. It is being forced upon many, but will be the choice of many more. The worldwide deleveraging will lead to a new mantra for this generation, frugality and living beneath your means. The psychology of the whole world has changed in a fortnight. Our leaders are so consumed by their own agendas that they have not realized the implications of this psychological change. Chaos and turmoil reign in the markets today. The population of the U.S. will turn inward and seek comfort in more simple pursuits. This will ultimately be a beneficial change for our society. But, the immediate result will be wrenching for the country.
The Catch-22 of our current economic system is that if everyone in the country lives within their means, the economy will collapse. The spending of money we do not have is what has driven our “Great” country for the last three decades. We can always count on Government to not live within its means, so deficit spending will continue and most likely accelerate. But, consumers have been dependent upon the stupidity and recklessness of banks, credit card companies, retailers, and auto makers to help them live above their means. This part of the American Dream is lying in shambles. Banks will not lend, credit card companies are cancelling credit lines, retailers are closing stores, and auto makers have stopped financing cars. Part 2 of our economic crisis has just begun. Having worked for a big box retailer and a major public homebuilder, I have witnessed first hand that faulty pie in the sky assumptions about growth will lead to dreadful strategic decisions that have huge negative financial consequences to those companies.
The coming Holiday season will be the worst for retail in decades. Most retailers generate 50% to 75% of their profits in November and December. Early in 2009, the avalanche of retail bankruptcies will begin. The big box retailers who built their expansion plans upon demand that was a debt induced fallacy, will experience tremendous losses. They will begin to close stores by 2010. Automakers will continue to see sales decline to levels never thought imaginable. All three major U.S. automakers could go bankrupt by 2010. House prices will continue downward. Two or three major homebuilders will go bankrupt by 2010, while hundreds of small builders will collapse. Mall developers and commercial developers have taken on billions in debt in the last decade. As tenants go bankrupt and the rents dry up, hundreds of large public developers will declare bankruptcy. These losses are not factored into the numbers of the 8,500 banks in the U.S. By the time this crisis is finished, we are likely to be left with 5,000 banks or less. The official unemployment rate will easily surpass 7% and possibly reach 8% by 2010. Based on the unemployment calculation used during the time of the Great Depression, we already have unemployment of 15%. This could conceivably reach 20%. The PE of the market is still above 20. Profits will plunge in 2009 and irrational pessimism could propel the Dow to its 2002 low of 7,200. That would be 28% below today’s levels and almost 50% below the all time high of 14,000.
Even if we somehow avoid a true depression, the next few years will be extremely painful. The question is whether we come out the other side as a stronger Nation or a weaker declining Nation. The words of Congressman Ron Paul should be the rallying cry for our great country.
“The issue boils down to this: do we care about freedom? Do we care about responsibility and accountability? Do we care that our government and media have been bought and paid for? Do we care that average Americans are being looted in order to subsidize the fattest of cats on Wall Street and in government? Do we care? When the chips are down, will we stand up and fight, even if it means standing up against every stripe of fashionable opinion in politics and the media? Times like these have a way of telling us what kind of a people we are, and what kind of country we shall be.”
It is time for our citizens to accept the bitter medicine of bad times, but to learn from our mistakes and put this great nation back on course as the beacon of democracy that our Founding Fathers envisioned.
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Madman
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