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The depression outlook, revisited

Steve Saville
email:
sas888_hk@yahoo.com
Aug 10, 2010

Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 1st August, 2010.

Towards the end of 2008 and during the first two months of 2009, we laid out our case for the second great depression of the past 100 years. In a nutshell, our thinking was that there are two fundamental prerequisites for a depression within a semi-free economy, these being a massive credit bubble and a concerted effort by the government to prevent the corrective process from running its natural course after the bubble bursts. As far as we could tell at the time, both of these prerequisites were very much in place. Before explaining how, or if, subsequent developments have affected our outlook it is worth recapping the depression case in a little more detail.

First, there is a bigger overall debt burden today than existed at the outset of the 1930s depression.

Second, although this cannot be proved it is reasonable to conclude that the faster growth in credit and money supply during the recent boom, as compared to the boom of the 1920s, resulted in more mal-investment (more money being ploughed into ill-conceived 'bubble activities') during the past 10 years than during the 10 years leading up to the depression of the 1930s.

Third, the governments of today are making the same critical mistakes that were made during the 1930s, but they are doing so more rapidly and on a grander scale. We are referring to the fact that governments are a) trying to prevent prices from falling to their natural levels, b) encouraging and propagating the further expansion of debt, c) propping up failed business ventures, d) increasing the burden that the government itself places on the economy, e) creating a more uncertain environment and thus reducing the incentive to invest for the long-term, and f) taking actions designed to reduce savings at a time when inadequate real savings is a big part of the problem. Similar efforts occurred throughout the 1930s, which, in our opinion, is primarily why a sharp recession evolved into a depression.

Now, history only happens once so we obviously can't go back in time and show what would have happened during the 1930s if governments had stayed out of the way. We can make a sound logical argument as to why increased government involvement made the situation much worse than it would otherwise have been, but the fact that we can't replay history leaves an opening for the supporters of government intervention to put the blame on external shocks to the economy. Fortunately (or unfortunately if you happen to live in Japan), Japan's post-bubble experience shows that government intervention designed to ease the short-term pain is capable of transforming a sharp post-bubble contraction into a multi-decade depression even during a long period of global peace and prosperity.

The above is essentially the argument we made 18-20 months ago. The argument is still valid today, although there are two interesting new developments that we will now deal with.

The first and most important is that while the US government continues to act based on the terribly misguided belief that the economy can be made stronger by more government spending and greater government control over production and consumption, in other parts of the world there is an emerging belief that "Keynesian" strategies have been taken too far. This emerging belief is manifesting itself in so-called "austerity" programs.

Although perhaps well intentioned, the shift towards "austerity" by some European governments is just as problematic as the US government's burgeoning profligacy. The reason is that these "austerity" programs are designed to help bondholders at the expense of the overall economy. In particular, they are designed to keep alive the illusion that government debt is a good investment by supporting the transfer of wealth from the broad economy to the owners of the debt.

Rather than cause further damage to the economy in an effort to help bondholders, governments should acknowledge the reality that their current debt burdens are so cumbersome that default is inevitable. The sooner they default, the less damage will be done. The longer they try to maintain the illusion of solvency, the more damage will be done. In general terms, a big part of the solution is for the government to drastically slow the rate at which it redistributes wealth, regardless of whether the direct beneficiaries of the redistribution happen to be bondholders, home builders, banks, auto manufacturers, the unemployed, or other special interest groups.

The second new development is the debate that has begun in the US about whether the "Bush tax cuts" should be allowed to expire at the end of this year. One side of the debate is that failure to maintain the tax cuts will push the US economy back into recession due to the negative economic "multiplier" related to tax increases, and the other side is that maintaining the tax cuts will do more harm than good because it will substantially add to the government's debt burden. Both sides of the debate are missing the point, which is that what really matters is the total amount of government spending; not how the spending is financed.

To understand what we mean, it helps to think of the government as a giant parasite that feeds on the economy. The parasite uses part of what it eats to foster its own growth, while the remainder passes through and is excreted back into the economy. The parasite's food is a mixture of direct taxation, indirect taxation (a.k.a. inflation) and borrowing, and provided that it is growing or maintaining its current size then a reduction in one food source MUST be offset by a corresponding increase in the other food sources. For example, if the parasite doesn't shrink then a reduction in direct taxation must be made up via an increase in inflation and/or borrowing.

The above is an over-simplification because the method by which the parasite gets its sustenance will have some influence on the economic outcome, but it hopefully explains why the "Bush tax cuts" are not a 'make or break' issue as far as the US economy's health is concerned. The crux of the matter is that as long as the rate of government spending is unchanged, less wealth being sucked out by direct taxation will result in more wealth being sucked out by another method. Consequently, the only genuine tax cut is the one that's accompanied by reduced government spending.

In summary, the most significant new development is that some governments have deviated from the "Keynesian" path to the "austerity" path, but because this particular version of austerity helps government debt-holders at the expense of the productive economy it does nothing to reduce the probability of a depression. In any case, it's a good bet that the commitment to "austerity" is weak, so after it becomes obvious that the post-crash rebound of 2009-2010 is over there will most likely be a return to the destructive spending/inflating path.

Unfortunately, then, we see no reason to change our view that another great depression is in its infancy.

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Steve Saville
email: sas888_hk@yahoo.com
Hong Kong

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