The Second Great Depression
Note this is the original post from August 2004 - Visit http://www.greatrecession.blogspot.com
This site is to herald the coming of the next Great Depression which I have chosen to call the "Great Recession".
I am happy to stand on record that the unravelling of the Western, and especially English-speaking economies will commence in 2005.....perhaps 2006 at the latest. I make this statement August 10th, 2004.
Now lets address the reasons behind this unravelling, and how this will unfold.
When history looks at the reasons for this Great Recession 2006-2011 it will no doubt focus on the (almost) unparallelled expansion in the money supply during the period 1997-2004. This period roughly corresponds in history to 1921-1929, the "Roaring Twenties" leading up to leading up to the "Great Depression".
During the Roaring 20's the equity market in the United States grew dramatically on the back of a wild expansion in credit. This was fueled through equity investments on margin loan and through consumer spending on goods such as radios and motor vehicles, through what was then a new financing technique called 'hire purchase'.
The Great Recession has a similar pedigree, but with the added perils associated with mortgage refinancing and mortgage securitisation. These have perhaps been the two most critical drivers for the expansion in credit in the west from 1997 until 2004.
Alan Greenspan, in an effort to avoid a serious economic adjustment after the "Tech Crash" of 1997 has maintained interest rates at extremely, and retrospectively, irresponsible levels. Many of the world economies have followed suit and set likewise expansionary interest rates. In the case of Australia, while interest rates have been higher than those in the United States, they have also been extremely expansionary leading to rampant inflation (by other than conventional definitions).
How is this the case? Especially when the Consumer Price Index ("CPI") in both the United States and Australia has remained within "target" parameters. The simple answer is that the CPI is not a reliable measure of inflation, nor will it, in the future be considered a reliable measure of monetary policy.
These low inflation rates have translated themselves into a boom in household debt. This has been accompanied, in the U.S., by an massive expansion in government debt, and a current account deficit of 5% of GDP (at the time of writing).
Just as hire purchase and margin lending pump-primed the 1920's monetary expansion, so to has mortgage refinancing and securitisation fueled the nineties and noughties.
Mortgage refinancing is the easiest to explain. The ability to draw the equity from one's house through refinancing has exascerbated the credit boom considerably. Housing prices have risen greatly in many Western economies the US, UK, and Australia included. As housing prices have risen consumers have sought to access the equity contained in their properties. The mechanism for this has been refinancing - effectively securing a higher level of debt against the same asset.
Banks are (naturally) eager to lend, as high household debt translates into even higher profits. The funds released through refinancing have been directed to renovations and consumer spending. In Australia the car market has boomed and one must wonder exactly how many plasma TVs have been funded through mortgage refinancings.
Unfortunately, rises in housing values have been illusory. Real wages have not been rising and are most likely declining. Western workers are becoming LESS not more competitive. Lower paid workers in India, China, and Eastern Europe are competing against the West, and successfully so. Rental yields in Sydney for example, have declined from averages around 5% to averages around 2% or less.
In Australia, it appears that property prices have risen inversely to interest rates. Effectively, Australian households have maintained their mortgage debt service obligations as a percentage of income. So as interest rates have declined, borrowings have increased...either by renovating, upsizing, or refinancing for consumer purchases. The long term fundamentals for property investment have been undermined and purchasing behaviour for real estate has been driven by a continuous expectation of future capital gains.
But what if these property price rises over the last 8 years were to reverse themselves?
Mortgage securitisation is a more sinister and remote animal. But to explain its effect fully we must first understand how Reserve Banks try to control the money supply in the economy and the expansion of credit.
Banks in Western economies are generally controlled by a 'thing' called a "capital reserve". This specifies how much of their debt exposure needs to be offset by equity. This equity is held in reserve to insure against adverse circumstances...like a default on the debt they hold. However securitisation takes this debt off balance sheet; the mortgage debt is packaged into a bundle and sold off to bondholders. So effectively, the bank is no longer liable for this debt as it has been placed in a Special Purpose Vehicle ("SPV") which does not appear on the balance sheet of the bank. Hence, it does not affect the banks capital adequacy requirements. The bank can securitise as much mortgage debt as it likes with having to place equity in reserve.
The securitised debt is not protected under the umbrella of a reserve bank's capital guidelines. Defaults on securitised mortgage debt in 2007-2009 will no doubt be a key catalyst in the unravelling of the Western financial system.
So we find ourselves in August 2004, with the wood stacked, and the kindling primed (I think I smell kerosene also). So what will be the 'match' that lights the fire?
This debt expansion has ridden the back of historically low interest rates. Now excluding all other factors, eventually the debt burden of the expansionary economies would inevitably cause an adjustment in interest rates. Eventually the credit worthiness of these debt-ridden economies would progressively decline leading to a compensating increase in interest rates.
Recently several factors have combined to bring the 'flame' right to our faces. That flame is oil prices. At this moment we face a number of converging forces leading to a rise in oil prices:
- increased demand in developing economies, i.e. China and India
- the Iraq insurgency
- the possible Yukos liquidation
- the Venezualian recall vote of Chavez
- general capacity constraints
If expectations regarding oil supply get out of control through either physical supply limitations, or simply the mechanism of fear itself, then prices will rise, perhaps dramatically.
When that happens...the match hits the kindling, and it all starts. It could be very soon perhaps this month or next. If oil prices are reigned in then the adjustment may take until late 2005.
So what should I expect?
There inevitably will be massive declines in both property and equity markets with a wholesale destruction of wealth not seen since the early 1930's. There is a credible possibilty of a cascade failure in the banking system leading to a liquidity crisis (i.e. ATM's do not hand out cash).
As a medium term response, expect a full-scale rejection of economic rationalism and a vast increase in government economic regulation.
What do I do?
Well...number 1...number 2...and number 3...KILL DEBT! No matter what it takes, get out of any geared investments. Reduce debt at all costs!
Move to cash. Take your superannuation/pension out of equity into cash, and ideally true cash, not mortgage backed securities.
Move to gold. Gold has been a galactic dog of an investment pretty much since 1980, during the Afghanistan mania. However, gold moves inversely to the equity market. If you want to be more defensive than cash - choose gold. If the scenario outlined above proves true then gold will appreciate dramatically.
I am not a tranditional 'gold bull' and this is not a gold bull website....but if you want to take a position on the Great Recession then gold is it.
Lastly, if things come to pass as described then the next decade will represent a tremendous moral challenge for us all.
I encourage you to confront this challenge with all the courage and human dignity that you can find.
- Peter Murray
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