The Economy

After today’s (4/14/2000) performance it seems obvious that we’re in the midst of a severe collapse of stock prices, a.k.a. a "crash." I’m no prophet, but history teaches that long financial manias are followed by long and equally severe depressions. At the very least, we ought to position ourselves as defensively as possible. For conventional investors, that means selling all stocks and moving to Federal government T-bills or bonds, but will the conventional wisdom prove right this time around?

I am not a prophet. I can’t tell the future, so I have about the same probability of being right about events tomorrow as a quarter has of landing face side up. Most of all, I don’t want to panic anyone. Fear of hyperinflation, fear of collapse and communists and one kind or another, including Y2K, has paralysed too many conservative investors in the past 30 years. On the one hand, the last role I want to play is fearmonger. On the other hand, what do I do with all this history that screams at me night and day, warning about the aftermath of bubble collapses?

A SPECIAL REPORT

I decided to write a special report about parallels between the Great Depression and the depression we’re facing right now. I’ll be asking (and answering, too, I hope) how this crash will affect you and me. What happened in the ‘30s? What has changed since then? What would happen today?

Human nature hasn’t changed, but in many other ways the world has changed since 1929. This time around we ought to expect all the same effects, but twisted and altered by changes in communications, technology, and market institutions.

REVIVING LOST MEMORIES

The vast majority of cultural memory about the Great Depression has been lost. My parents, born in 1910 and 1915, experienced the full fury of it, so I grew up hearing about it (and hearing that our move to the poor house was always just days ahead. By the way, I have yet to see a poor house, let alone move into one, although I’m still looking over my shoulder). However, I am almost 53. Investors today from 40 down have never heard or been influenced by these Depression memories. Shoot, most of today’s hot shot investors were in kindergarten the last time there was even a bear market in stocks or a bull market in gold. They have no idea how hard times would transform their daily lives.

Below are some of the questions and categories I am pondering. If you have questions you think I should add, or memories of that time, I’d love to have them – especially your real-life stories about how you and your family made it through the Great Depression.

WHAT ABOUT TIMING?

How did effects lag causes after the ’29 crash? How long after the crash did unemployment rise? How long was it until everybody (not just investors) felt the impact? How long before it affected real estate prices?

WHAT ABOUT NEW IMPACTS?

How will changes in speed of information transfer and transaction change events? Will the government let banks fail as it did in the 1930s? My bet is no. That itself dictates an inflationary rather than a deflationary outcome. That implies that no widespread bank closures or runs on banks. Does it follow then that you can leave your money in banks? How long?

WHAT ABOUT MUTUAL FUNDS?

Like their ancestor "investment trusts" in 1929, many mutual funds will fail, Today there are more mutual funds than there are stocks, and almost half of American households have stock investments. Government & other pension funds will turn belly up. Government investment portfolios will melt. What will government do? Given the last 20 years’ performance, my guess is they’ll try to bail out everybody, resulting in a very strong inflation.

WILL BONDS FAIL?

During the Great Depression many municipalities and corporations couldn’t make good on their bonds. How would that play out today? What about the Federal government? How will Federal government debt react? What if you add a run on the dollar from overseas? What will happen to money market funds if bonds fail? Does living in the age of Junk Bonds make a difference?

WILL THE GOVERNMENT BAIL, OR BAIL OUT?

Ultimately only the power to create new money constrains the government’s taxation and monetary (See Beardsley Ruml, "Taxation for Revenue is Obsolete," American Affairs, 1/1946). Therefore the government will bail out everyone in sight. What effect will these bailouts have? I would assume that they will buffer the initial impact of the failures, but later exacerbate the effects. The monetary outcome is almost certainly inflationary. How can you protect yourself this time? Will gold and silver help, or have they fallen out of the public’s consciousness?

What about failures in municipalities, like Orange County not so long ago? (By the way, whatever happened there? Lemon lost a billion bucks for the Orange County pension fund. Who made that up? Taxpayers?) Will the taxpayers have to fork over the difference, as with the S&L crisis?

Speaking of S&L crisis, the strategy there was to streeeeeetch it out as long as possible. Will we see more of that, stretching out bond maturities, declaring interest payment moratoria? How does this threaten your portfolio, and with what specific issues? Federal government debt? Municipal? Corporate? Mortgages?

What happens when other countries default? Moratorium? Rescheduling? Write-off?

IS INFLATION COMING?

The "buffering" mentioned above transfers wealth, because the wealth always has to come from somewhere. Inflation (of any kind) can’t create wealth, it can only steal it from somewhere and spend it somewhere else (stealing from savers and paying off spenders).

In the face of the government’s widespread promotion of "moral hazard" (subsidizing markets so the participants can’t lose, as with deposit guarantee insurance) we are virtually guaranteed they will have to inflate their way out of a depression. How should you allocate your assets defensively?

Basically government can only react in one of two ways:

Give money to the bankrupt (print new money)

Delay redemptions (or interest & principal payments). Will they extend maturities on T-bills & bonds?

As opposed to what the public has known for the past 15 years, i.e., it’s easy to make money, it will become very hard to make money, indeed, even to make a living. What can one do? Move to the country? Move to Germany where they have better welfare?

WILL THE GOVERNMENT INTERVENE IN OTHER WAYS?

The federal government is even more interventionist now than during the Great Depression. Does the WWII period, with rationing and other interventions, imply anything? What about the experience of World War II? Are there certain goods one ought to stockpile now?

HOW DO YOU KEEP YOUR BALANCE?

In the face of a possibly long and severe depression, how does one maintain and promote

independence

self-protection

self-reliance

a gracious life

effectiveness, influence, and service to your community in time of stress?

WHAT WILL BE NEW IN THIS CRASH?

In 1929 it was "investment trusts." Today it is derivatives. The derivatives revolution since 1980 has multiplied many times the number of financial derivatives – up to $100 Trillion world wide, according to the Bank for International Settlements.

Derivatives can help to transfer risk and spread it out, but only when volatility is relatively low, i.e., when no catastrophe and panic exists. Under those conditions, because derivatives interlock so many fates, they will make the collapse worse. In other words, they can reduce individual risk only when they’re not needed, but when they are needed, they will increase systemic risk. How will derivatives play themselves out in this next depression?

WHAT ABOUT REAL ESTATE?

Real estate values suffered badly in the Great Depression. This time real estate has blown up into a far bigger bubble than stocks, fueled by government guarantees. Government sponsored entities (GSEs) like Freddie Mac, Fannie Mae, and FHLB have flooded the mortgage market with new money. In addition, securitizing mortgages has been an engine for creating new real estate money. GSEs have been operating lately on the thinnest of profit margins, with incredible levels of debt, all of it underlain by derivatives. Remember the LTMC crisis in September, 1998? During that panic the market for mortgage backed securities, which this GSEs create, literally ceased to exist. There were no bids at any price.

Lately I talked to a subscriber who is a long-time real estate appraiser. He said it takes three to four years for real estate to bottom. What’s important to remember is that real estate is a borrowed money market. He expects the secondary market to crash first, the mortgage backed securities. That will happen when the mortgagees can no longer make their payments.

Second, interest rates will rise, choking off new buyers.

Third, fewer and fewer people will be able to qualify for loans (remember recently when banks were advertising home loans at 125 – 150% of appraised value? You won’t see that again soon. Standards will tighten up faster because of the previous over-extension. Even at 12% there won’t be much mortgage money available. And it won’t matter how much money Greenspan pours into the system, lenders (newly burned) will be exceedingly chary to lend. It will be a classic case of the Fed pushing on a string. After the most over-extended market in history, it will take a long time for real estate to recover.

HOW WILL DEPRESSION AFFECT SOCIAL AND POLITICAL ARRANGEMENTS?

Incredible wildcards in American society today make it difficult to predict how depression will hit society and politics. In 1929, 32% of all Americans still had a primary residence on a self-sufficient farm. Today 1/8 of one percent do.

Over the past 70 years America has experienced a huge drop in self sufficiency exactly while dependence – on government and other entities outside the family – has soared. My friend analyst Bob Meier speculates that in a depression America would decompose like Germany after the Thirty Years’ War. In 1932 millions of Americans had never had any contact with a state, let alone federal, official. Today the Federal government owns 40% of land and controls the minutest aspects of our lives. What people would surrender is far different today from 1929.

Rather than falling back on self and family, we could see an extreme voluntary enslavement of people, similar to the 200 years after the Thirty Years’ War in Europe or the Dark Ages after the Roman Empire. Will people quickly surrender to the Age of the Great Protector? Already it is very difficult to distinguish between the modern corporate relationship and the classic feudal model. The corporation gives security in return for total, unquestioning obedience and loyalty. Modern states expect the same.

WHAT WILL HAPPEN TO MONEY?

In the 1907 panic and in 1934 banks issued script that for the duration of the emergency circulated as currency. Today would the government only have to create debit cards charged to the Federal government? They already issue food stamps and welfare benefits that way. That would allow them to re-liquefy the economy ten times as fast as printing physical currency.

WHAT ABOUT DEBT?

Individual, corporate, and government debt are at historic highs. How will that worsen the depression? Since far more debtors than creditors vote, debtors will get some kind of relief? Where am I exposed as a creditor, and how can I curtail that exposure?

WHERE AM I MOST VULNERABLE?

This is the question we have to ask ourselves individually, and with ruthlessly clear sight. Where am I most exposed financially? Where are my investments? Where do I make my living? What happened to that area during the Great Depression? What would happen to it in a depression today? What has happened since 1934 to change the outworking of the Great Depression today? Will those changes make it more or less brutal?

-- F. Sanders

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