The Greater Depression
January 30, 2004
The language used by the Federal Reserve Open Market Committee in its
press release of January 28th contained a semantic change from previous
minutes. Instead of saying that they will keep interest rates low for
“a considerable period” the FOMC instead decided it would
just “be patient” about raising interest rates. The market,
on the other hand, has no patience. The dollar immediately strengthened
against the euro and, as a result, the US dollar gold price declined.
In spite of yesterday’s action the dollar is still
very weak, and will continue to decline for many more years. The more
it declines, the more volatile it is likely to become. In turn that will
cause an equal amount of volatility in the dollar-gold price.
The Greater Depression
Last week we discussed foreign currency crises and the increase in the
US dollar exchange rate during the Nineties. Starting with Brazil in 1992
one currency crisis after another spread across the globe causing capital
flight. Net foreign investment in the United States totaled thirty eight
billion dollars in 1992 and increased to over five hundred billion dollars
during the past four quarters. Cumulative net foreign investment since
1992 has been almost three trillion dollars.
Most of this foreign capital found a home in US bonds, increasing
US bond prices throughout the 1990s. Rising bond prices mean lower interest
rates. The interest on 30-year Treasury Notes fell from an average of
8.61% in 1990 to 5.02% as of yesterday and the yield on 90-day Treasury
Bills decreased from 7.75% to only 0.87% in the same period.
Lower interest rates meant that corporate borrowing costs
declined and that lead to an almost instantaneous increase in corporate
profits. Higher profits justified higher stock prices and the thus the
stock market bubble was born.
The reduction in interest rates that stemmed directly from
the influx of capital also caused an increase in corporate cash flows.
More cash flow allowed companies to increase research and development,
invest in capital expansion projects and spend more money on marketing.
More people were needed for all this; unemployment fell from seven and
a half percent in 1992 to less than four percent in 2000.
More jobs meant more consumers, and Americans know how to
consume. The increase in consumption increased corporate sales, which
boosted corporate profits over and above the benefit of lower interest
rates. The increase in profits meant higher stock prices and since currency
crises were continuously occurring throughout the Nineties, the booming
stock market started to attract its share of foreign capital investment.
Foreign capital investment also created demand for dollars,
increasing the dollar exchange rate. Foreign investors were able to compound
their returns on the US stock and bond markets with gains in the dollar
exchange rate, making US investments even more attractive. Capital kept
pouring into the United States.
As you can see the cycle was self propagating: it started
with foreign capital investment boosting bond prices and lowering interest
rates, the affect of which was to stimulate the economy and that resulted
in higher investment returns that attracted even more foreign capital
Rising stock and bond prices also made Americans feel wealthier,
giving them that extra incentive to spend just a little bit more at the
mall, at the car dealership and on their homes. But falling interest rates
also meant lower mortgage rates and that, thanks to all the foreign capital
being poured into the country, enabled many more Americans to buy homes.
The demand for houses caused a real estate boom. Rising
real estate prices have a greater wealth effect than rising stock prices.
Wealthy-feeling consumers spent all they had: the personal savings rate
dropped from 7.26% in 1991 to 1.69% in 2001. Not having any money did
not stop them from spending. Household credit market debt increased by
140% from 1991 to 2003. Not only are debt levels historically high, the
amount of disposable income going towards servicing that debt is the highest
it’s been in at least twenty three years, as far back as my data
goes. This is despite record low interest rates. Not surprisingly, non-business
bankruptcy filings increased by 120% from 1990 to 2002.
But these were the good times: the “New Era”
of sustainable economic expansion with no inflation because of increased
productivity. Isn’t that what Greenspan said? I find it disconcerting
that during the most exceptional economic expansion the United States
has seen since the Roaring Twenties we are also seeing record bankruptcies,
record debt levels, a record low savings rate and record low interest
rates. The latter, of course, means that the Fed is between a rock and
a hard place. “But that is not all,” as the Cat in the Hat
So much foreign capital made its way into the United Sates
that the dollar exchange rate, on average, more than doubled from 1990
to 2002. The stronger dollar made foreign products more competitive in
US markets and made US products more expensive on foreign markets, causing
the US trade deficit to increase from thirty one billion dollars in 1991
to its current level of about five hundred billion dollars.
The good news is that large trade deficits can be eliminated.
The bad news is that a large trade deficit is almost always followed by
a recession, the magnitude of which is proportional to the trade deficit.
Given the size of its trade deficit, it would be a pleasant surprise if
the United States can eliminate its current trade deficit by a mere recession.
The magnitude of the deficit suggests a depression is more likely.
A recession is defined as at least two consecutive quarters
of decline in gross domestic product. If it lasts more than a few quarters
and is associated with rising unemployment, a general decline in prices
and a loss of purchasing power, it becomes a depression.
Recessions occur when excess inventory accumulated during
the expansion phase of a business cycle has to be absorbed into the economy
during the ensuing contraction phase. Depressions, on the other hand,
occur when the economy has to catch up with excess production capacity.
This takes much longer than merely working off inventory.
When there is excess production capacity companies cut their
prices to try and stay in business. Think of the rebates we have been
seeing in the auto industry as an example. Companies also cut costs by
reducing their work force, and so unemployment rises. Higher unemployment
means fewer consumers and fewer consumers mean less sales.
Consumers now have no purchasing power left: they spent
all their money and all the money they could borrow. Corporations will
have no choice but to engage in price wars and in the short term that
will lead either to lower prices (deflationary depression) or stagnant
prices. There is a probability that fiat inflation of the money supply
could ward off deflation. We will most likely see a prolonged period of
economic stagnation if it does.
Lastly, the massive influx of foreign capital and the debt
driven economic expansion lead to a considerable investment in infrastructure.
Manufacturing capacity currently exceeds production by 33%, a historically
low level of capacity utilization and this is what causes depressions.
It is unlikely that we will see capacity utilization increase
until consumer balance sheets are fixed, and that could take a long time.
As Doug Casey often said, when the history books are written the coming
contraction could well become known as the “Greater Depression”.
I find it hard to imagine that the US dollar is going to
reverse its downward trend while US consumers pay off their debt, file
more bankruptcies and see more of their friends collect unemployment insurance.
And a declining dollar means higher gold prices in US dollars.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
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