After an initial spot of trouble with the banks and General Motors, the 2008-09 recession has not been particularly painful in terms of corporate and governmental defaults. Recently Detroit defaulted in the largest municipal bankruptcy since the Great Depression, but Detroit has always seemed a special case. However the signs are growing that as US economic sluggishness is prolonged, defaults may begin to appear with greater frequency. In this perspective, the next few years could prove uniquely painful in modern history.
As the billionaire hedge fund entrepreneur Ray Dalio recently explained in a YouTube video, the current downturn differs from all
others since the Great Depression in that it is accompanied by massive deleveraging.
Non-financial, non-government US debt, which averaged 138.4% of GDP in the 30 years 1978-2007, according to Fed statistics, peaked at 192% of GDP in 2009 and has since been declining by 5.1% of GDP per annum. To get back to the 1978-2007 average level will, at the present rate of progress, take until the spring of 2020.
That will give us a period of subpar growth of 11 years, far longer than anything since the 1930s unpleasantness. Dalio's analysis also explains the enormous puzzle (to me and others of either monetarist or Austrian economic persuasions) of why we haven't had any inflation, in spite of Ben Bernanke printing money like a madman and money supply increasing at roughly double the rate of nominal GDP.
The main deleveraging mechanisms, reducing consumption, restructuring debt and redistributing income from the rich to the needy, are all deflationary, tending to reduce incomes and prices. To counteract this, the Fed can print money as it is today doing, buying Treasuries and inflating the amount of money chasing the fewer goods demanded. Keep this process in balance, and neither hyperinflation nor massive government default will occur.
There are however two aspects of current Fed policy that tend to work against the necessary deleveraging, thus prolonging the current unpleasant period of sluggish growth and high unemployment. First, by buying mortgage bonds as well as Treasuries it is inflating the housing market artificially and causing homebuyers to rush in, increasing their leverage and thus reversing the deleveraging. If the Fed wants to buy $85 billion of bonds per month, they should all be Treasuries.
Second, the Fed's zero interest rate policy is irrelevant to its objectives in this kind of recession and highly damaging to the US economy when prolonged as long as it has been (let alone until 2020). Low interest rates re-kindle spending in an ordinary recession, but in a recession where deleveraging is necessary they simply delay the deleveraging.
In addition, they encourage hedge funds and other intermediaries with access to ultra-cheap credit to engage in deals that at best are marginally profitable and at worst destroy value - as well as increasing the level of debt in the economy, of course.
Needless to say, the cheap leverage also produces asset and commodity price bubbles, all of which cause massive losses when they burst. Finally, negative real interest rates prolonged for half a decade or more discourage saving and encourage consumption, thus effectively de-capitalizing the economy as well as leaving millions of the middle-aged without adequate assets for retirement (bursting bubbles don't help middle-aged savers, either).
It's typical of the Ben Bernanke Fed that, even when it lucks onto a policy (quantitative easing) that is entirely by chance appropriate, its rationale for that policy is incoherent at best, and it proposes to reverse its appropriate policy before doing anything about its damaging one.
The federal funds rate should be set in present circumstances at around 3%, an appropriate level of interest rates when inflation is in the 1-2% range. This level of interest rates would encourage deleveraging, and remove most of the bubbles and pathological leveraged behavior, while the Fed's bond purchases, of Treasury bonds only, prevented the deleveraging from leading to deflation.
Those who imagine we can survive until 2020 deleveraging gradually, suffering no worse than we are now, are over-optimistic. Even with optimal Fed policy, deleveraging periods don't work like that. There have been two such periods in US history. The most recent, referred to by Dalio and well known in outline to all of us, was the Great Depression of the 1930s.
As discussed recently in these columns, because of foolish policies, that episode was much deeper than the current one, producing a 25% downturn in real GDP at its nadir in late 1932. It also bankrupted about a third of US banks in 1932-33, as well as innumerable corporations.
Deleveraging was accomplished the hard way, with massive deflation that was only alleviated by the US devaluing its own currency by about 40% against gold in 1933, thus providing the additional money that Dalio recommends.
Notably, even after recovery from the deepest trough was well under way, the economy stumbled into a second depression in 1937-38, which accounted for another round of bankruptcies. This was accompanied by an almost complete drying up in debt and equity capital market activity in the late 1930s, caused partly by the de-capitalization of the investment banks through the Glass-Steagall Act.
Optimists may think we can avoid the 1930s pattern, given that the Fed has avoided the mistakes of its 1930s predecessor and through its bond purchases is producing a reflationary effect similar to FDR's manipulation of the gold price. However for another look at what can go wrong, we should look at the earlier period of deleveraging, after the Panic of 1837.
Kondratieff long wave theorists in the 1980s saw a similarity between the 1930s depression and that after 1873, but in reality the 1873-96 deflation was relatively benign, accompanied as it was by astonishing technological changes in transportation, refrigeration, energy and business management that raised living standards for almost all Americans even as prices declined.
If we regard the deleveraging cycle as an 80-year cycle rather than a 60-year cycle (to match 1929 and 2008) the previous such cycle's inception moves to 1837 rather than 1873, and the parallels become much clearer.
The bubble before 1837, like the current one, involved a great deal of speculation in real estate and other assets. Land in my Poughkeepsie street, for example, changed hands at $25 a square foot in 1836, making my back garden, in an unimproved state, with neither drainage nor power links, worth more in cash terms in 1836 than the house and garden together are today (and some 50 times as much in real terms).
When the Second Bank of the United States stopped facilitating interstate payments after its federal de-chartering in 1836 and re-chartering as a state bank, the country's money supply collapsed and the costs of interstate payments soared, with the entire New York banking system suspending gold payments on May 10, 1837. The result was a deleveraging recession and a rash of bankruptcies, beginning in 1837.
In the days of small government, most recessions were very short lived, although they might be quite deep. This one was different. After a mild alleviation in 1838 the recession returned in force in 1839-40, just in time to elect "Old Tippecanoe and Tyler Too" in a revulsion against the incumbent Democrat Martin van Buren.
At the same time, prices declined sharply. In this case, not only was there no central bank creating extra money to alleviate the effects of deleveraging, but the banking system, as in the early 1930s, was liquidating what money there was - 40% of banks went bust, including the Second Bank itself in 1841.
That year, 1841, was the nadir, although hard times lasted until 1843 and partially through the 1840s, and it was after this point that states themselves began to default, with Pennsylvania the most important. During the bull period before 1836, states had extended themselves funding wild infrastructure schemes, having witnessed the success of the Erie Canal in the 1820s. Of course it didn't help that many of the state schemes were canals, about to be made obsolescent by the railroads.
The state defaults soured mostly London-based investors on US credit as a whole and it was not until the 1850s, after the 1849 California Gold Rush had once more provided liquidity, that the London market fully reopened to American securities, in particular the new railroad bonds.
The patterns of the 1930s and 1837-43 downturns are sufficiently similar to our own problems that we can expect the latter part of those downturns to repeat, at least in part. In particular, the level of debt defaults is likely to soar in years to come.
Borrowers have been cushioned by the Fed's easy money policies and negative real interest rates, and have entered into commitments that in a sluggish economy with interest rates rising they will be unable to honor. In the private sector, the leveraged deals of 2006-07 have mostly been refinanced, but going forward it is likely many of those re-financings will come unstuck, as will the deals carried out in the low-rate optimism of the last couple of years.
In the public sector, Detroit has already declared bankruptcy and Puerto Rico is tottering on the brink, bedeviled as it has been by a drop in economic activity of a full 20% since 2006, comparable in scope to the Great Depression itself.
Other states such as California and Illinois have also been excessively sanguine in their budgeting, and have done nothing to remove the very expensive grip of the public sector trade unions; a further even modest economic downturn should push them over the edge. Countless medium-sized cities have found their tax bases decimated by the housing decline; if housing's rebound peters out as interest rates rise, as seems likely, they will equally be unable to pay their bills.
Finally, there is the big daddy of them all, New York City, which has survived with a substantial tax increase and smoke-and-mirrors accounting, as Mayor Michael Bloomberg has used his knowledge of Wall Street's dodgier techniques to paper over the cracks. With the new mayor elected this autumn likely to be a man who is financially inexperienced, naive and very left-wing, the chances are very high indeed of the City undergoing a repeat of its 1975-76 travails, this time without a bailout by the financially weakened New York state.
In the last five years, Ben Bernanke has allowed us a financial holiday from history, with defaults and disasters being remarkably scarce, given the severity and duration of the downturn. This is about to change.
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com. Copyright 2005-13 David W Tice & Associates.)