Thomas Woods: Why You've Never Heard of the Great Depression of 1920

A great presentation from economist and author Tom Woods on how the unheralded Great Depression of 1920 had swiftly been resolved, the difference with the Japanese experience also of the 20s and the relevance of the Austrian Business Cycle. (source: Mises media)

Investment Is Now A Gamble On Politics

``Central bank will not allow large banks to fail. This means that it will not allow the fractional reserve process to implode through bank failures and the contraction of the money supply.”- Gary North, 'Dr. Deflation' Changes His Mind After 27+ Years

What amounted to one month of rainfall gushed over the Philippine metropolis in just 6 hours! In the wake of typhoon Onyok, a vast part of Metro Manila have been turned into a virtual swamp, enough for the Philippine government to declare the affected areas in a state of calamity. According to news reports, the devastating floods from the typhoon Saturday, had been the worst in nearly 40 years.

From our perspective, this serves essentially as an example of a high impact, hard to predict rare event which classifies as a Black Swan, in terms of weather.

While one may argue that the approaching typhoon was predictable, the intensity of the rainfall, according to the local weather bureau, wasn’t.

In as much as Black Swans happens in nature, it also occurs in the marketplace. And this has been a contingent that we have been striving to prepare for, so as to achieve the entrepreneurial goal of optimizing profits via risk identification and damage control.

Of course Black Swans don’t just apply from the negative point of view but can also be seen from a positive light. Technological innovations are just vivid illustrations of these.

Nevertheless the important point is to identify where the larger distribution of risks lies as possible source of market based Black Swans.

Deflation’s Ipse-Dixitism

The recent weaknesses in many parts of the global financial marketplace have been used by the bear camp, mostly populated by the deflationistas, to extol on their “bear market rally” theme.

Figure 1: Stockcharts.com: Falling Markets

For varied indicators as the falling Baltic Dry Index (BDI), Friday’s slump in oil (WTIC) and gold (GOLD), rallying US treasuries and the struggling enfeebled market leader in China’s Shanghai index seems to have all converged.

The bear camp argues that the rally has ended on the corroding effects of stimulus, recessionary forces regaining an upperhand, prices acting “way too far, too fast”, possible escalation of trade war and the demobilized consumers from exercising their extenuated spending powers.

While we don’t belong to the camp which advocates more inflation since we think inflation is immoral and generally baneful to the society, as a market participant we understand inflation to be a political process- where policymakers make political decisions of picking winners or salvaging select interest groups or industries or companies at the cost of the taxpayers.

As Henry Hazlitt wrote, `` For inflation does not come without cause. It is the result of policy. It is the result of something that is always within the control of government—the supply of money and bank credit. An inflation is initiated or continued in the belief that it will benefit debtors at the expense of creditors, or exporters at the expense of importers, or workers at the expense of employers, or farmers at the expense of city dwellers, or the old at the expense of the young, or this generation at the expense of the next. But what is certain is that everybody cannot get rich at the expense of everybody else. There is no magic in paper money.” (bold emphasis mine)

In other words, for as long as the governments attempt to vehemently prevent the required market adjustments from previously misdirected allocation of resources, mostly by promoting credit expansion and spending, and by government directly purchasing assets with “money from thin air”, they are undertaking inflationary programs.

Yet this avowed policy direction by global authorities to inflate and the penchant by several participants to adamantly insist of a deflationary outcome seem quite self contradictory.

Why the deflation risk is a bogeyman?

For one, we have noted that central banks have the capacity to match or even exceed the issuance of money to offset every outstanding liability a political economy has been blighted with, for as long as the banking system remains afloat.

Two, macro analysis looks at problems on oversimplified basis or from one dimensional aspect of product, labor and capital. Moreover, money is often seen as a constant, where marginal supply of additional money into the economy doesn’t impact prices.

In addition, macro analyses have been predisposed to models that apply only to selective and not on general conditions.

In the case where money is construed as a constant, this fitting remark from Professor Gary North, ``Whenever an economic theory of how the world works makes an exception for monetary theory, the proposed monetary theory is incorrect, or the general theory is incorrect, or both are incorrect.” (emphasis added)

Three, inflation is fallaciously anchored as mainly a consumer dynamic.

Fourth, deflationists disregard pricing levels from a relative perspective. For instance, deflationists tend to ignore the impact from technology’s early adopter buyers. More importantly, they gloss over the fundamental law of pricing based demand and supply allocations, where low prices extrapolate to higher demand.

Fifth, deflationists discount the transmission mechanism from monetary policies given today’s US dollar currency standard platform. Remember, 23 countries (wikipedia.org) are pegged to the US dollar which means these countries are fundamentally importing Bernanke’s policies.

And since debt levels and capital structure vary from country to country, the impact of recessionary forces or debt deflation or consumer spending retrenchment from bubble afflicted economies will be different from those countries importing US policies. In addition, a further variance would be the effect from applying the same home based stimulus programs.

As CLSA’s high profile analyst Christopher Wood in a Bloomberg article, ``It’s wholly wrong to view Asia as a correlated train wreck with the U.S. consumer.”

Therefore, deflation in an absolute sense signifies as ipse dixitism or unsupported dogmatic assertion.

Unworthy Paradigms: Great Depression And Japan’s Lost Decade

Sixth, deflation proponents generally make comparisons with that of the Great Depression and the Japan experience even if both circumstances have been totally different from today.

The Great Depression was a byproduct of an amalgam of:

-Massive monetary contraction (30%),

-Regime uncertainty or investors’ reluctance to participate in a perceived hostile atmosphere resulting from a string of adverse policies imposed, which appears to have threatened property rights and prevented the necessary price adjustments, such as wages.

To quote Benjamin Anderson from Robert Higgs’ Regime Uncertainty “The impact of these multitudinous measures—industrial, agricultural, financial, monetary, and other—upon a bewildered industrial and financial community was extraordinarily heavy”, and

-high taxes and protectionism amidst a recession which metamorphosed into a depression [see earlier post Lessons From The Great Depression: Taxes, Protectionism and Inflation].

Japan's stagnation, on the other hand, which has been popularly but erroneously known as suffering from deflation (technically defined as contracting money supply), had likewise been a consequence of a mélange of regulatory mess, particularly high tax regime, policies that propped up the legacy of obsolescent zombie industrial companies [see Asia: Policy Induced Decoupling, Currency Values Aren’t Everything], reluctance to liberalize due to cultural idiosyncrasies (bad management of companies due to interlocking relationships among companies and the ``disdainful of the idea of shareholder value and of traditional profit metrics” notes James Surowiecki) and the conflict of interest issues from Japan’s bureaucracy which embraced state capitalism.

The recently victorious Democratic Party of Japan (DPJ) declared it would reduce the latter’s influence, but the question is always HOW?

Moreover, Japan’s lost decade has been largely insulated from the world as most of its liabilities had been denominated in local currency. The culturally high savings quirk by the Japanese financed most of the failed boondoggles during the nearly 2 decade long of stagnation. However, demographic issues (which has been depleting savings) and current conditions (weaning off from the US consumers and reorienting trade towards China and Asia) imply that the old model is about to make a major transformation.

MAD “Mutually Assured Destruction” Policies

Seventh, deflationists often switch gears from using the monetary aspects to excess capacities or current account balances or non-monetary (usually trade) dimensions in rationalizing deflation on a global scale or data mine facts to fit their arguments.

For instance, the Global Savings Glut theory has been prevalently used as an attempt to shield the US from policy flaws which pins the blame on “currency manipulation” by Asian savers.

Hardly anyone from the mainstream incorporates the role of the US dollar, as the world’s de facto currency reserve, in the discourse of the origins of today’s imbalances.

Professor Robert Triffin rightly predicted more than 40 years ago of the accruing imbalances that a reserve currency would endure. That’s because of the incremental tensions which would amass from conflicts of national monetary policies vis-à-vis global monetary policies (provider of international liquidity). This is known as the Triffin dilemma, where the reserve currency can remain overvalued from which it would continue to accumulate deficits or undergo proportional devaluation in order to stabilize or shrink deficits [see previous discussion in The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency].

So while the mainstream goes into a perpetual blaming spree alongside with their sanctimonious omniscient prescriptions, they don’t seem to realize that this has been the operating nature of reserve currencies, especially from a “paper money” standard.

Moreover, the recent trade dispute between US President Obama and China over increased tariffs over tires have breathed “protectionism” as an excuse for deflation.

Figure 2: BCA Research China: Tempest In A Teacup, For Now

While the risk of an escalation of a trade war appears plausible, I am predisposed to the view that these politically motivated actions has been designed to wangle some short term deal with vested interest groups, particularly the labor union-the United Steelworkers or protectionist policymakers.

However we share the optimism with BCA Research when they wrote, ``However, there are good reasons to believe that the recent tensions are likely to be contained. For one, the amount of trade in question is a tiny fraction of total trade flows between the two countries. Chinese sales of tires and steel pipes to the U.S. amount to about US$4 billion a year (compared to $US230 billion of total Chinese exports to the U.S.). Meanwhile, Beijing’s action in taking the trade dispute to the WTO shows China’s willingness to resolve disputes within the legal framework of international trade rather than via direct bilateral confrontation. Overall, the Obama administration’s seemingly toughened stance towards China-related trade issues is mainly a maneuver designed to garner domestic political support rather than an outright intention to wage a trade war. The biggest risk that could significantly heighten trade tensions and economic confrontation is if the U.S. government and lawmakers once again challenge China’s exchange rate policy and tax rebates for its exporters. Bottom line: Chinese authorities will likely continue to focus on the big picture of promoting domestic growth, so long as there is no systematic challenge to the country’s trade and foreign exchange policies to complicate its growth-boosting strategy.” (bold underscore mine)

Put differently, the Tire tariff was perhaps meant as diversionary tactic or as a concession in order to diffuse far larger protectionist tensions held by some quarters in the august halls of the US congress. In short, if we are right, the controversial enactment of the Tire tariff appears to be more symbolic than of a real risk.

In addition, it would also be plain naive to extrapolate for the US to arbitrarily lure China into a trade war when US officials are aware that the Chinese holds the largest share, about $800 billion (as of July), of US treasuries or nearly a quarter share of the foreign owned pie see figure 3.

Figure 3: Wikipedia.org: Foreign Holders of US Treasuries

As the legendary trader Julian Robertson of Tiger Management says in a recent CNBC interview, ``“We’re totally dependent now on the Chinese and Japanese” [as posted in Julian Robertson: We are going to have to Pay the Piper].

In short, President Obama significantly depends on China, Japan and Asia’s largesse to sponsor his administration’s “borrow and spend” program.

This also means that it would be utter lunacy, if not suicidal, for Pres. Obama to engage in mutually assured destructive (MAD) policies, which should hurt more of the US than China. Further this would accelerate the inflationary process in the US (…unless this serves as an opportunity for the US to seize the moment from a hostile China response to be used as a Casus Belli to declare a default! But the US owes Japan and the rest of the world too.).

Since there will be lesser access to savings globally, the court of last resort will be Chairman’s Bernanke’s printing press.

Here, Mr. Robertson estimates 15-20% annual inflation rates for the US once China and Japan desists from financing the US.

Scared Of One’s Own Shadows

Last and most importantly, deflationists belittle the role of central banking in the economy and the economic ideology underpinning the global political leadership.

In short, deflationists rule out the ramifications from the political aspects of government intervention in the economy.

It is also kindda odd to see some deflationist scared to wits about the prospects of deflation when they have been influenced by the same ideology that espouse on government intervention that paves way for the inflation-deflation boom bust cycles. It’s analogous to being afraid of one’s own shadow.

Deflation basically comes in two forms. One is a consequence of inflationary policies. The other is an outcome of productivity, which means economic output greater than the supply of money. This had been much of the case during the gold standard based, Industrial Revolution.

Nobel prize winner Friedrich A. Hayek in a speech about Choice In Currency, A Way To Stop Inflation eloquently describes the shift from stability into today’s woes,

``The chief root of our present monetary troubles is, of course, the sanction of scientific authority which Lord Keynes and his disciples have given to the age-old superstition that by increasing the aggregate of money expenditure we can lastingly ensure prosperity and full employment. It is a superstition against which economists before Keynes had struggled with some success for at least two centuries. It had governed most of earlier history. This history, indeed, has been largely a history of inflation; significantly, it was only during the rise of the prosperous modern industrial systems and during the rule of the gold standard, that over a period of about two hundred years (in Britain from about 1714 to 1914, and in the United States from about 1749 to 1939) prices were at the end about where they had been at the beginning. During this unique period of monetary stability the gold standard had imposed upon monetary authorities a discipline which prevented them from abusing their powers, as they have done at nearly all other times. Experience in other parts of the world does not seem to have been very different: I have been told that a Chinese law attempted to prohibit paper money for all times (of course, ineffectively), long before the Europeans ever invented it!”

So it is another deeply held erroneous belief that deflation is the greater evil, when 200 years of the gold standard brought about great prosperity. This is in contrast to today’s deepening intermittent boom bust cycles, which only enriches only certain segments of the society and hurts the rest of society when a bust transpires.

Deflation from an inflation bubble simply cleanses the system.

Yet the same camp of deflationists argues for more inflation.

From UK’s Prime Minister Gordon Brown (quoted by Bloomberg), ``The stimulus that we have still got to give the world economy is greater than the stimulus we have already had. What we want to do is safeguard a recovery from a recession we feared would develop into a depression.”

Moreover, the US Federal Reserve recently decided to extend and complete its $1.25 trillion buying program into the mortgage market. According to Bloomberg, ``The central bank has purchased $694 billion of mortgage- backed securities since January and plans to spend $556 billion more by April 2010 to keep interest rates down. The debt-buying is the biggest program in the Fed’s arsenal.”

Isn’t these powerful signal enough, a manifestation of both economic ideology and policy direction? It’s more than just words or propaganda, it reflects action in progress.

And as we argued in Governments Will Opt For The Inflation Route and last week’s A Deeply Embedded Inflation Psyche, for us, it has been a policy tool for the US Federal Reserve to juice up the stock market for the same reasons- economic ideology (to paint the impression of economic recovery by reanimating the irrational “animal spirits”) and policy direction.

As we previously pointed out, the US government today stands as THE mortgage market, why is this so? Aside from trying to “stabilize” the mortgage market, the US banking system holds tonnes of assorted mortgages on their balance sheets.

In short, the US government has been preventing the outright collapse of some important segments of its banking system by providing implicit guarantees on the banking system’s assets.

Moreover, the US government has also acquired ownership representation among the biggest financial institutions. This acts as another form of implicit guarantee.

Aside, the ownership accounts for interventions or interferences aimed at conveying its political objectives into the company’s business operations.

Further by undertaking quantitative easing, the US Federal Reserve reliquefies the marketplace by acting as market maker of the last resort to the illiquid markets.

If the US Federal Reserve hasn’t been the key influence of the stock market, why would issues, which accounted for most of the recent government rescues, have accrued most of the jump in the trading volume at the NYSE? (See figure 4)

Figure 4: William Hester: Without Phoenix Stocks, Volume Continues to Contract

According to William Hester of Hussman Funds (bold highlights mine), ``But almost the entire rise in volume during the last month and half has come from a handful of stocks. Examples include Fannie Mae, Freddie Mac, Citigroup, AIG, and Bank of America. These are just five. There are a couple of other stocks that are interchangeable with these companies and would produce similar results – but the characteristic they all share is that they are financial stocks that only recently were on the brink of collapse. And since the Government's rescue of these and other financial firms, the group has risen up from the ashes. For ease of reference, we'll call these Phoenix stocks.

``The rise in trading volumes in some of these stocks has been considerable. The shares of AIG now often trade with 15 times the volume they traded a year ago. Citigroup has traded at 12 times the amount from a year ago. This helps explain why the trades in these companies' shares are taking up a larger fraction of total share volume.”

Has US government zombie institutions been using their excess reserves or proceeds from the Fed’s QE reliquification program to trade their own shares or trade shares among themselves?

Figure 5: Andy Kessler: Monetary Base versus Dow Jones

Is it just merely a coincidence that monetary base has been growing while stock market has been rising (see figure 5)?

Some would argue, but the other money aggregates have turned south. However, what if banks haven’t been lending but instead speculating on assets?

Besides, there has been no clear agreement as to which of the monetary aggregates should serve as the true representative or as accurate indicator of money conditions in the US or globally. This makes the chart above “correlated but not causal”, as much as those arguing the opposite.

Further, the boom in the bond markets has also revealed that credit has been expanding but has been short circuiting the banking system.

By going direct through the capital markets, credit intermediation hasn’t triggered the banking system’s fractional reserve platform, hence hasn’t been reflected in traditional monetary aggregates.

All told, deflation seems more like a bogeyman widely used to justify more politicization of the marketplace.

Investment Is Now A Gamble On Politics

There are two more very significant developments the deflationists have sorely missed.

The recent weakness in the markets in gold, commodity and China hasn’t triggered a meaningful jump in the US dollar index to confirm the debt destruction and the impotence of central banking, similar to the meltdown of last year.

Moreover, it hasn’t reflected a general tightening of credit conditions out of default fears…yet.

Figure 6: Danske Weekly Credit

As you can see from the Danske Charts above, major credit indicators have all turned lower or has materially improved, all of which hasn't been emitting any trace of “deflation” tremors.

Moreover, there have been reports that the Fed has been exploring ways to tap the funds from the money market to implement its exit strategy. According to the Yahoo Finance ``The Fed would borrow from the funds via reverse repurchase agreements involving some of the huge portfolio of mortgage-backed securities and U.S. Treasuries that it acquired as it fought the financial crisis, the newspaper reported, without citing any sources. This would drain liquidity from the financial system, helping to avoid a burst of inflation as the economy recovered”. (emphasis added)

Yet analyst like Zero Hedge’s Tyler Durden sees this as one of the many subterfuges employed by the FED to “reflate” the system.

This from Mr. Durden (bold highlights mine), ``And the Fed finds a way to screw everyone over yet again. Contrary to expectations that the Fed will use reverse repos to remove excess liquidity (which, by definition, such an action would) it appears that Bernanke's wily scam is to push even more money out of money market funds and into capital markets. Even though banks currently have about $800 billion in excess reserves which the Fed is paying interest on, and which would be a damn good source of liquidity extraction as the Fed considers to shrink its ever expanding balance sheet, the Chairman is rumored to be considering money market funds as a liquidity source…All in all, the Chairman is determined, come hell or high water, to part consumers with their savings: whether it be through zero deposit interest rates, through money market guarantee removals, through talk of inflation or, ultimately, through actions like these. After all, America has gotten to the point where the Fed is beating the drum on the need to keep blowing the capital market bubble bigger and bigger: anything less, and just as Madoff investors discovered, the entire pyramid collapsed overnight, and where people thought there was $50 billion, there was really $0.”

In addition, even while the Fed has declared that it would undertake the completion of its $1.25 trillion QE program by buying $556 billion more on mortgages, there seems to be a problem, it is only left with an estimated $10 billion for US treasuries which is expected to be expire by October.

This implies that should foreign central banks continue to recycle their surpluses on short term Treasury bills, the yield curve should soon steepen as the long end rises (on condition that the Fed holds course by not additionally monetizing US treasuries).

And rising treasury yields places further constraints or pressures to the financing of US government programs.

This from Professor Michael S. Rozeff (all bold underscore mine), ``The government will have problems funding its programs. It will be under pressure to raise taxes and cut back on its programs. Since it will be reluctant to do either, the problems will fall upon the dollar and on the government debt. This will place the government in an untenable position because the higher interest costs of the debt will add to the deficit. A negative feedback cycle will occur in which deficits cause higher interest costs which cause more deficits which cause higher interest costs, and so on. No amount of taxation can solve the government’s fiscal problem that lies ahead. Greater taxes will only make them worse by slowing the economy. That option is foreclosed.”

Ultimately, this brings us to the potential outcome of deflation-inflation debate.

Again Professor Rozeff, ``The two problems – the dollar and debt – are joined. If the FED tries to save the dollar, it affects government debt adversely. The FED can relieve pressure on the dollar by deflating its bloated balance sheet. To do that it needs to sell off the mortgage-backed securities that it has accumulated and not buy the rest that it is now in the process of buying. If it ever does sell off these securities, it will pressure the government debt market. This is very unlikely. Instead I expect it to pay interest on reserves, which will not solve its problems and will only add to the government deficit and start an exponential process of increase in interest paid. If the government tries to save the debt market by having the FED support it as it is now doing, that affects the dollar adversely. The central bank and the government are between a rock and a hard place. One or the other or both of the dollar and the debt are slated to have problems. Enactment of Obama’s health care and energy measures, even in diluted form, will confirm the existing course. Their rejection will be more favorable for the dollar and for government debt. As the political winds shift, so will the fortunes of the dollar and the government debt markets. Investment is now a gamble on politics.”

In short, the US government, not the US consumers, has become the ultimate driver of marketplace. And investing returns would mean reading accurately from political tea leaves.

And once emergent weaknesses in the marketplace becomes increasingly pronounced, governments will be expected, given their Keynesian interventionist ideology, to massively re-inflate the system to the point where the political option would translate to the extreme choice of ‘Mises moment’ endgame: relative deflation possibly via a default or a currency crisis.

Lessons From The Great Depression: Taxes, Protectionism and Inflation

Economist Art Laffer of the Laffer Curve fame gives us an enlightening perspective from the experiences of the Great Depression.

We will be quoting Art Laffer extensively from the Wall Street Journal,

1. Taxes and Protectionism were key factors...

``While Fed policy was undoubtedly important, it was not the primary cause of the Great Depression or the economy's relapse in 1937. The Smoot-Hawley tariff of June 1930 was the catalyst that got the whole process going. It was the largest single increase in taxes on trade during peacetime and precipitated massive retaliation by foreign governments on U.S. products. Huge federal and state tax increases in 1932 followed the initial decline in the economy thus doubling down on the impact of Smoot-Hawley. There were additional large tax increases in 1936 and 1937 that were the proximate cause of the economy's relapse in 1937.

``In 1930-31, during the Hoover administration and in the midst of an economic collapse, there was a very slight increase in tax rates on personal income at both the lowest and highest brackets. The corporate tax rate was also slightly increased to 12% from 11%. But beginning in 1932 the lowest personal income tax rate was raised to 4% from less than one-half of 1% while the highest rate was raised to 63% from 25%. (That's not a misprint!) The corporate rate was raised to 13.75% from 12%. All sorts of Federal excise taxes too numerous to list were raised as well. The highest inheritance tax rate was also raised in 1932 to 45% from 20% and the gift tax was reinstituted with the highest rate set at 33.5%.

``But the tax hikes didn't stop there. In 1934, during the Roosevelt administration, the highest estate tax rate was raised to 60% from 45% and raised again to 70% in 1935. The highest gift tax rate was raised to 45% in 1934 from 33.5% in 1933 and raised again to 52.5% in 1935. The highest corporate tax rate was raised to 15% in 1936 with a surtax on undistributed profits up to 27%. In 1936 the highest personal income tax rate was raised yet again to 79% from 63%—a stifling 216% increase in four years. Finally, in 1937 a 1% employer and a 1% employee tax was placed on all wages up to $3,000.

``Because of the number of states and their diversity I'm going to aggregate all state and local taxes and express them as a percentage of GDP. This measure of state tax policy truly understates the state and local tax contribution to the tragedy we call the Great Depression, but I'm sure the reader will get the picture. In 1929, state and local taxes were 7.2% of GDP and then rose to 8.5%, 9.7% and 12.3% for the years 1930, '31 and '32 respectively.

``The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I'd give to all who will listen, it is that U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s. Net legislated state-tax increases as a percentage of previous year tax receipts are at 3.1%, their highest level since 1991; the Bush tax cuts are set to expire in 2011; and additional taxes to pay for health-care and the proposed cap-and-trade scheme are on the horizon."

2. Inflation (hidden taxes) Amidst A Depression

``...the U.S. in the early 1930s was on a gold standard where paper currency was legally convertible into gold. Both circulated in the economy as money. At the outset of the Great Depression people distrusted banks but trusted paper currency and gold. They withdrew deposits from banks, which because of a fractional reserve system caused a drop in the money supply in spite of a rising monetary base. The Fed really had little power to control either bank reserves or interest rates.

``The increase in the demand for paper currency and gold not only had a quantity effect on the money supply but it also put upward pressure on the price of gold, which meant that dollar prices of all goods and services had to fall for the relative price of gold to rise. The deflation of the early 1930s was not caused by tight money. It was the result of panic purchases of fixed-dollar priced gold. From the end of 1929 until early 1933 the Consumer Price Index fell by 27%.

``By mid-1932 there were public fears of a change in the gold-dollar relationship. In their classic text, "A Monetary History of the United States," economists Milton Friedman and Anna Schwartz wrote, "Fears of devaluation were widespread and the public's preference for gold was unmistakable." Panic ensued and there was a rush to buy gold.

``In early 1933, the federal government (not the Federal Reserve) declared a bank holiday prohibiting banks from paying out gold or dealing in foreign exchange. An executive order made it illegal for anyone to "hoard" gold and forced everyone to turn in their gold and gold certificates to the government at an exchange value of $20.67 per ounce of gold in return for paper currency and bank deposits. All gold clauses in contracts private and public were declared null and void and by the end of January 1934 the price of gold, most of which had been confiscated by the government, was raised to $35 per ounce. In other words, in less than one year the government confiscated as much gold as it could at $20.67 an ounce and then devalued the dollar in terms of gold by almost 60%. That's one helluva tax.

``The 1933-34 devaluation of the dollar caused the money supply to grow by over 60% from April 1933 to March 1937, and over that same period the monetary base grew by over 35% and adjusted reserves grew by about 100%. Monetary policy was about as easy as it could get. The consumer price index from early 1933 through mid-1937 rose by about 15% in spite of double-digit unemployment. And that's the story.

``The lessons here are pretty straightforward. Inflation can and did occur during a depression, and that inflation was strictly a monetary phenomenon."

Depression Stories: Are We Worst Off?

With stock markets melting around the world, what would seem more timely than to compare today's conditions with that of the Great Depression.

Here are two articles showcasing sundry charts dealing with such comparisons.

First, comes from Barry Eichengreen and Kevin O'Rourke's A Tale of Two Depressions (Hat tip: safehaven.com/John Maudlin)

Volume of World Trade worst than the Great Depression

Falling world industrial output in line with the Great Depression

See the rest of the charts here

Mssrs. Eichengreen O'Rourke concludes (underscore mine): ``To summarise: the world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30."

``The good news, of course, is that the policy response is very different. The question now is whether that policy response will work."

Council of Foreign Relations' Paul Swartz makes the same comparison but this time it's more US centric.

Industrial production hasn't fallen in the scale of the Depression

"Although the labor market has deteriorated more than at any time since World War II, it is much healthier than during the Great Depression."

"The federal budget has deteriorated far more rapidly than in any past recession, in part due to the first economic stimulus and bank bailouts.The current stimulus implies an even larger and more prolonged deficit in the future."

See the rest of the charts here

Concluding remarks from Paul Swartz, ``The collapse in the federal government’s finances is unprecedented, raising questions about how the government deficit will be brought under control.

``By most measures, the current recession is far milder than the Great Depression. But the appendix shows that house prices have recently fallen much more sharply than in the 1930s."

So essentially we have two opposing opinions.

Eichengreen-O'Rourke sees Depression like developments for the world and cheers on government policy actions while Mr. Swartz sees it otherwise and worries over government deficits.

That's the nature of economics, divergences in interpretations. What you see depends on where you stand-perhaps influenced politically or ideologically or from personal bias.

Taking The Hyperinflation Risk With A Grain Of Salt?

``But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a ‘crack-up boom’ and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis." Ludwig von Mises in Interventionism: An Economic Analysis (p. 40)

Recently a link from last year’s TV interview of an eminent Cassandra, Mr. Gerald Celente, was posted at a social community network. Mr. Celente prophesized, not only of the “greatest” depression for the US, but of an environment marked by “revolution, food riots and tax rebellions”. Such development would bring about America’s “ceasing to be a developed nation” or essentially would translate to the country’s defacement as the world’s premier economic and financial power by 2012.

The accompanying the link had a note from the link author who questioned about how such an interview was “allowed” to be aired and what was this “doomsday” scenario all about.

We have long known about such extreme views (which should include James Kunstler-another Cassandra who believes of the real risks of a world at war arising from the unsustainable energy infrastructure from which the world currently operates and survives on), but has refrained from discussing it because of our “optimistic” predilections. Nonetheless, on the account of the “ripeness” of the occasion, this article will attempt to elaborate on the risks of such concerns.

Cognitive Biases and Censorship

As Julius Caesar remarked, ``People readily believe what they want to believe."

Obviously the late great Caesar alluded to people’s proclivity to act in social norms. And as social norms, popular views are often dressed up as lies which are repeated so often and digested as the reality or the truth, especially when buttressed or promulgated by figures considered as “authorities” in their fields or from the bureaucracy. Yet, most people only look at the superficial and intuitive side of any issues without belaboring on the tacit intents proposed by the advocates or of its unseen consequences.

Bluntly put, people are basically faddish and tend to look for grounds to confirm or substantiate their beliefs or are predisposed to absorb only the quality of information which they believe suits their palate. In behavioral finance, this is known as the CONFIRMATION bias or “the tendency to search for or interpret information in a way that confirms one's preconceptions” (wikipedia.org).

Applied to social trends, the acceptance of mainstream views (or seeking “comfort of the crowds”) or conformity represents as the more psychologically rewarding route than in defiance of them (regardless of the validity of the observations or theories).

For instance, the mainstream has repeatedly mocked, jeered or scorned at those who warned of the illusions of the wealth derived from unsustainable debt driven boom. Contrarians were deemed or labeled as “killjoys” or “partypoopers”. Eventually as the boom turned into a bust, losses turned into reality, and the “IN” thing or “THE” social trend is now to be a pessimist.

The contrarians, who were previously the “outcasts”, have been exonerated and have now commanded sufficient clout of an audience enough to be embraced by mainstream media. In short, since media’s role is to sell what is mostly in popular demand, the Celente interview represents as pessimism becoming an entrenched social trend.

And that’s why gloomy videos have found their way into social networks. And that’s why too, we should expect more of these until perhaps we have reached the stage of “revulsion” or “capitulation” for one to reckon the US as in a “bottoming” phase.

Remember, throngs of “finance and banking” professionals or organizations (such as banking institutions, insurance and hedge funds) have not been eluded from such basic human frailties of “crowd” following or falling prey to “confirmation bias”. As the present bust or crisis clearly shows, technical expertise or even quant algorithmic models can’t substitute for the process ability driven emotional intelligence which is more a required attribute in the analysis of the market’s risk-reward tradeoff. As we have discussed in many occasions, most of them have even fallen prey to Ponzi schemes as the Bernard Madoff or the Robert Allan Stanford case.

I won’t suggest anyone to disregard extreme views especially if the Cassandra sports a good track record in projecting major trends and this includes Mr. Gerald Celente.

Yet, a remarkable past may not necessarily extrapolate to another successful forecast. Since any mortal can only wield so much of limited information in a highly complex world, like anyone else, his views aren’t infallible. The point is to understand the merits of his argument than simply to dismiss it out of the Pollyannaism or blind optimism or from the outrageous belief of a messianic salvation from the present leadership or fanatical subscription to the economic school of orthodoxy.

Worst of all, is the implication for the socialistic bent of “censorship” by those intolerant of diametric or contradictory perspectives. One should ask: would it be better for us to adhere to fantasies masquerading as truth and eventually suffer? Or would reading an expository “falsifiable” mind be a better alternative as to recognize potential risks and prepare for them?

The Fundamental Problem: UNSUSTAINABLE DEBT

So what seems to ail the US economy so much as to risk turning its political economy into an emerging market?

This from Bloomberg, ``Bill Gross, co-chief investment officer of Pacific Investment Management Co., said the Federal Reserve’s purchases of Treasuries and mortgage securities won’t be enough to awaken the economy.

``We need more than that,” Gross said today in a Bloomberg Television interview from Pimco’s headquarters in Newport Beach, California. The Fed’s balance sheet “will probably have to grow to about $5 trillion or $6 trillion,” he said.”

The Fed’s balance sheet is roughly around $2 trillion with an additional $1 trillion more for the QE as it gets implemented. This brings the Fed’s balance sheet around $3 trillion. Mr. Gross has asked to double the size.

Now this from Jeremy Grantham an erstwhile ferocious stock market bear whom has turned into a raging bull recently said, ``To be successful we need to halve the level of debt. Somewhere between $10 trillion and $15 trillion will have to disappear."

So how do we do that? ``Grantham sees three ways, according to the Wall Street Journal, “to restore the balance between private debt levels and asset values.” That is by “1) Drastically write down debt, 2) let the passage of time wear down debt levels, 3) “inflate the heck out of our debt” and reduce its real value.” (bold highlight mine)

In short, the fundamental problem comes with the government policy induced overdose of debt intake as shown in Figure 1.

Figure 1: American Institute for Economic Research: Total Debt by the US

AS you can see, the debt ratios for the US economy mostly held by the private sector have exploded beyond the nation’s paying capacity, according to the AIER, ``The debt-to-dollar ratio currently tops $3.50, more than double the ratio of 50 years ago.”

Given the unsustainable debt structure from which the US and the world economy has been built, the recent collapse in the financial markets (estimated at $50 trillion-ADB) and the subsequent meltdown in global trade, and investments (or deglobalization) has managed to reduce parts of such massive scale of imbalances.

But the adjustment process has a long way to go.

The US Federal Reserve’s Agency Problem

However instead of allowing for an orderly rebalancing of the US economy by permitting institutions that took upon the unnecessary burden of the speculative excess to fail or undergo bankruptcy proceedings, the US government has been pushing to revive the past Ponzi financing model by substituting the losses from these institutions with taxpayer money…to no avail so far.

And the Federal government’s heavy handed interventions in many significant parts of the economy and the prevention of price discovery has contributed to the prolonged nature of recovery and has added uncertainties in the marketplace, by distorting market price signals and altering the incentives for market participants which has been skewed towards prospective actions of the government.

The recent fracas of over the bonuses is a case in point.

Take this article from the New York Times,

``As public outrage swells over the rapidly growing cost of bailing out financial institutions, the Obama administration and lawmakers are attaching more and more strings to rescue funds.

``The conditions are necessary to prevent Wall Street executives from paying lavish bonuses and buying corporate jets, some experts say, but others say the conditions go beyond protecting taxpayers and border on social engineering.

``Some bankers say the conditions have become so onerous that they want to return the bailout money.”

In other words, some banks have resisted availing of government bailouts because of the burdensome conditions imposed on them, which is not helping the situation at all. As we said earlier the incentives in trying to normalize bank operations are being contorted by minute by minute changes in government intervention. Investors look for stability in policy.

And how much of these government intervention has been affecting the banking industry? The same New York Time article admits…

``At the height of the savings and loan crisis in the 1980s and 1990s, Congress and regulators adopted new rules known as “prompt corrective action” that required the government to quickly close weak financial institutions if they could not raise money to absorb mounting losses.

``The rules were a response to a consensus that keeping weak institutions open longer, under an earlier practice known as forbearance, damaged healthy banks competing with the government-subsidized ones and ultimately destabilized the banking system. By shutting weakened institutions before their losses grew, prompt corrective action was also seen as less costly to taxpayers and the deposit insurance fund.

``Administration officials say that some of the banks at issue today are simply too large to be seized by the government, making comparisons to the savings and loan crisis less meaningful.”

But this is exactly what has been happening today, damaged banks have been competing with government subsidized ones at the expense of the industry and the economy. And much worst, those subsidized are banks have been TOO LARGE to be seized by government, which is why the accrued losses have led to a creeping nationalization. See figure 2…

Figure 2: BCA Research: Top 20 Banks

According to the BCA Research, ``The Chairman of the FDIC, Sheila Bair, contends that U.S. banks are well capitalized. However, she must be referring to the multitude of small banks, rather than large banks (i.e. there are many small banks that are well capitalized). The top 20 financial institutions have a thin capital cushion of only 3.4% (defined as tangible capital/total assets). In other words, it would require a writedown of total assets of only 3%-4% to wipe out all tangible capital for the largest banks. The FDIC data on the broader banking universe confirms that the capital cushion of large banks is much less than their smaller counterparts. Moreover, toxic assets are concentrated in large financial institutions.”

As you can see the risk profile of the top 20 banks have largely been because of the Level 3 assets which simply means ``Assets whose fair value cannot be determined by using observable measures, such as market prices or models.” (investopedia.com)

And what are the possible Level 3 assets? Perhaps figure 3 may provide the explanation…

Figure 3: OCC: 3^rd quarter Report: The Average Credit Exposure to Risk Based Capital

The average credit exposure to risk based capital in percentage is 317.4% for the 5 largest banks as of the third quarter of 2008! The pecking order of the riskiest banks: HSBC (664.2%), JP Morgan (400.2%), Citibank (259.5%), Bank of America (177.6%) and Wachovia (85.2%).

Moreover, consider that 96.9% of the total derivatives of the US commercial banking system is held by the just these 5 institutions according to the Comptroller of the Currency Administrator of National Banks!

In other words, of the 8,451 banks and savings institutions insured by the FDIC, or of the 7,203 commercial banks operating in US (Plunkett Research), 5 banks have essentially held hostage the entire industry, if not the economy!!!

Free market anyone?

Why is this?

Could it be because the US Federal Reserve is a privately held corporation, bestowed with a monopolistic power to create and manage the country’s legal tender, whose complex web of owners could be some of the same institutions that are presently being rescued?

According to James Quinn, ``Most Americans believe that the Federal Reserve is part of the government. They are wrong. It is a privately held corporation owned by stockholders. The Federal Reserve System is owned by the largest banks in the United States. There are Class A,B, and C shareholders. The owner banks and their shares in the Federal Reserve are a secret.”

As Henry Ford once wrote, ``It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

So could Mr. Celente’s dire projections have been partly premised from such agency problem or conflict of interest issues that would perhaps gain national consciousness over the coming years?

Regulatory Arbitrage + Regulatory Capture=Market Distortion

In addition, considering the US banking industry have been a heavily regulated industry, why have the core institutions, which originally attempted to disperse risk by introducing financial innovations, ended up with the “risk concentrations”?

This from Gillian Tett of the Financial Times, ``After all, during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks.

``But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Société Générale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else.

``Unfortunately, most of those banks have been shedding risks in almost the same way – namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street.

``Far from promoting “dispersion” or “diversification”, innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG’s inability to honour its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers.”

Institutions as the AIG Financial Product (AIGFP) circumvented or went around regulatory loop holes to ante up on leverage and increase risk exposure in order to generate additional returns. Arnold Kling of Econolib.org quotes Houman Shadab, ``AIGFP was treated as a bank for its counterparties' risk-weighting purposes, but AIGFP was not regulated as a bank (or an insurance company) for its own CDS credit exposures (had it been, it would've had to set aside capital/reserves).”

In short, this hasn’t been a free market problem as some anti-market pundits paint them to be, but one of regulators conspiring with Wall Street participants to “game the system”.

For Wall Street it had been one of regulatory arbitrage (profiting from legal loopholes) but for the regulators it has been one of regulatory capture (situations where government acts in favor of the interest groups of which it is regulating).

As we have previously quoted Robert Arvanitis Risk Finance Advisers, in Seeking Beta: Interview with Robert Arvanitis, ``Being mortal, the bureaucrats desire to avoid pain is as dear to them as the desire by their counterparts in private industry to seek gain. And it is far more profitable to game the rules, for example, than to enforce them. And any system can be gamed.”

To quote Mr. Celente, ``It was Fed finagling, Washington deregulation and Wall Street’s compulsive gambling that created the crisis.”

Yet people have been distracted by the most recent BONUS issue, which simply implies that Americans have been looking for an issue to vent their wrath on (a misguided one though).

To consider, the enormous backlash over the $168 Million is a pittance over the money spent by US taxpayers ($178 BILLION) to sustain AIG counterparties as Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion). Big foreign banks also received large sums from the rescue, including Société Générale of France and Deutsche Bank of Germany, which each received nearly $12 billion; Barclays of Britain ($8.5 billion); and UBS of Switzerland ($5 billion) and some 20 largest states (New York Times).

Yet as the Federal government expands its presence into industries these governance conflicts, e.g. as in the proposed bonuses of Freddie Mac and Fannie Mae, will certainly serve or operate as a major disincentive that would impact diverse institutions from meeting desired goals, which eventually results to an increased overall inefficiency in the system.

Again, with big government comes the inevitable ramifications: resource allocation inefficiencies or wasteful spending, incompetence, corruption, dispensation of favors to political constituents, conflicts of interests, governance conflicts which may lead to organizational demoralization and reduced productivity, bureaucratic rigidities (tendency to be too technical or legal), crowding out of private sector investments, massive distortion of incentives, a vague pricing system which increased uncertainties and other impediments –all of which obstructs on the US’s economy wellbeing.

Obviously, governance policies based on populism will do harm than good.

Signs of Resurgent Inflation?

Now that the US policymakers appear to be losing out of ammunition, they have begun to openly resort to the crudest of all central banking policy approach-money printing.

As mentioned above our money experts have recommended “inflating away debts levels” which means reducing the currency’s purchasing power (or raise price levels) in order to diminish real debt levels, from which our policymakers have obliged.

According to the Economist, ``Mr Bernanke showed his own will on Wednesday March 18th, when the Fed’s policy panel said it would purchase $300 billion in Treasury debt, mostly maturing in two to ten years, starting next week. It will also boost its purchases of mortgage-backed securities to a total of $1.25 trillion from a previously announced $500 billion, and its purchases of debt issued by Fannie Mae and Freddie Mac, the mortgage agencies, to a total of $200 billion from $100 billion.”

But since the US is privileged to have her debts denominated on her own currency, when she can’t payback her obligations, instead of defaulting, she may resort to flooding the economy with money enough so as to reduce the value of liabilities at the expense of her existing creditors-i.e. local savers and foreign creditors.

Of course, these will temporarily benefit those who own financial assets, because “money out of thin air” will likely be absorbed by the institutions who will sell their portfolio of treasuries or mortgages to the US government. Eventually, the proceeds can be expected to be recycled into the financial markets. Although the policymakers are hoping that a revival in the capital markets will fire up the credit process by reigniting the speculative “animal” spirits.

Unfortunately the “moneyness” of Wall Street instruments (e.g. structured products, MBS, ABS etc…) has been lost and is unlikely to be revived anytime soon.

But on the other hand, any flow of credit to parts of the world where credit conditions have remained unimpaired is likely to fuel a surge in asset prices first, then consumer prices, next. Apparently such dynamics appear to have emerged, see Figure 4.

Figure 4: A Return of Inflation?

Oil has sprinted beyond the $50 mark and this has been accompanied by Dr. Copper (upper window) and even some industrial metals. Oil’s rapid rise may suggest of a rising wedge or a forthcoming decline. Anyway, the surge in key commodity prices comes alongside with a rally in Dow Jones Asia (ex-Japan) seen at the pane below the main window and Emerging Markets index (lowest pane), as the US dollar index suffered its 3^rd largest one day decline.

The unfortunate part for the US is that a resurgent inflation will likely induce more sufferings to the middle and lower class and possibly worsen the political scenario by provoking a “class” conflict.

When price levels of consumer goods are raised at a time when unemployment is high or possibly even growing, where real income levels are also diminishing, and where corporations faced with a struggling environment will be faced with higher costs of operations, these combined could redound as the ingredients for a large scale hunger triggered political malcontent.

Moreover, inflation, as seen through higher cost of money and shrinking purchasing power, is likely to wreak havoc on the cash flows of those attempting repair their overleveraged balance sheet by increasing savings and paying off debts.

And the orthodoxy is putting so much hope that the authorities will know the right time when to close the barn doors before the horses run astray, a hope that seems unfounded to begin with as the authorities have failed to recognize the crisis in advance or limit the scale of its impact.

Again from Mr. Celente, ``What "steps?" The Bernanke Two-Step? Adjust interest rates or print more money? Neither stopped the credit crisis from worsening, the real estate market from tanking or the stock markets from crashing.”

Figure 5: yardeni.com: Net Foreign Selling Are These Signs On The Wall?

The United States’ Treasury International Capital flow have registered a significant net foreign selling (excluding US T-bills) last January see figure 5, although as an important reminder-one month does not a trend make.

While others have argued that such fall in capital flows may have been a function of reduced growth of foreign exchange surpluses, the growing restiveness by global policymakers over the US dollar, could be another incipient dynamic at work.

Over the past weeks we heard resonating voices suggesting a move away from the US dollar as the world’s reserve currency- from Joseph Stiglitz, a UN Panel and Russia at the G20, which was reportedly backed by China, India, South Africa and South Korea.

While there has been no unanimity on the possible replacement, most have recommended the IMF’s Special Drawing Rights or the old European Currency Unit Ecu, albeit both of which have been “combinations of currencies, weighted to a constituent's economic clout, which can be valued against other currencies and against those inside the basket” (Reuters).

Importantly, a new currency can’t takeoff without OECD participation which includes the US. Thus, such cacophony appears to be more symbolic- an implied protestation over the risks of imprudent government spending.

Take The Risks of Hyperinflation With A Grain of Salt At Your Peril

Finally, we can’t discount the risks from the ravages from hyperinflation.

As we brought up in 2009: The Year of Surprises?, a tip over from deflation expectations towards a ramping up of inflation will be a tough act to manage. If government starts to tighten as inflation rises, the ensuing effect will be a sharp fall in prices from which government will need to restoke the inflation engine again.

Again to quote Murray Rothbard in Mystery of Banking,

``But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races. Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,” doing something like tripling every hour. Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and Phase III’s runaway psychology is as follows: “The value of money is disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it matters not what, so long as it isn’t money.”

In essence Mr. Celente’s Tax Revolt, Food Riots, Revolution and the return to a banana republic or the state of an emerging market is nothing more than a function of hyperinflation. (Of course, we’re not suggesting that this will surely happen, but what we are saying is that the present actions of the US policymakers have been increasing the odds for such risks to occur. America’s hope depends on the world to absorb those surplus dollars enough to pull the US out of its debt trap.)

So for those hoping against hope that the present administration will deliver the economy’s much needed elixir in defiance of the fundamental function of the natural laws of economics, good luck to you. No economy has survived by merely the government running on the printing press, ask Dr. Gideon Gono.

One must be reminded of US 33^rd President Harry S. Truman’s noteworthy comment, ``It's a recession when your neighbor loses his job; it's a depression when you lose your own.”

Take this risk with a grain of salt until such scenario becomes a personal depression.