Great News: Smoot Hawley II

As if spending 75% of the near trillion dollar “stimulus” package on things such as contraception (ha, nice pun there) wasn’t enough, it appears this great piece of legislation making the rounds of the Senate as I write this is full of incentives to buy American only – another nice legacy of the 1930′s.  Let’s see, to complete the ruin of our economy, all that is needed is a tax increase in a few years.  I am not even close to going out on a limb to predict that once we get any sign of economic improvement, the tax increases are coming.

Add to that a possible re-emergence of trade wars, and you’ve got the perfect re-enactment of the 1930′s without even having to read a history book!

All Bets Off – Massive Deflation And Fed Still Lowers Rates

All the ingredients are coming together for protracted, painful and seriously impaired economic conditions.  As stated in an earlier post,  a deflationary crash is characterized in part by a persistent, sustained, deep, general decline in people’s desire and ability to lend and borrow.   It appears we are in the midst of one.  Consumer prices, after a record decline in October, set another record in November, pushing inflation down to 1.07%.  After a year that saw inflation hitting almost 6% in July, this is a painful indicator of things to come.  In spite of OPEC’s threat to drastically cut production, oil prices are still relatively low.

Worse, the Federal Reserve appears to be acting counter-intuitively by lowering interest rates to “zero to .25%“, leading to speculation that once our economy does rebound, hyperinflation will be the next crisis.  It doesn’t help that our government continues to spend money it doesn’t have.

On top of all this, President-Elect Obama announced that his “stimulus plan” will be somewhere between $600 billion and $1 trillion.  The spending spree never ends.

The time to voluntarily liquidate assets has passed.  Foreclosures dipped in November, but few expect that trend to be anything but temporary in spite of Fanny Mae’s Christmas gift to renters of homes in foreclosure proceedings.  Best to hold on to assets and try to keep as much cash on hand as possible.

We can hope that the aggressive moves by the Federal Government will prevent another depression, but it sure seems like we are about to embark on the same policies of the Roosevelt administration that arguably kept the country in a depression for an entire decade.  One of the proponents of further governmental intervention is oddly a scholar of the Great Depression.  Fed Chairman Ben Bernanke believes that the cause of the Great Depression was the lack of action by the Hoover administration to stop banks from failing and by keeping interest rates too high.  In Bernanke’s mind, it was Hoover’s inaction that caused the depression, not Roosevelt’s activism.

There are (at least)  two arguments as to what caused the Great Depression.  One argument postulated by Irving Fisher and furthered by Bernanke states that debt deflation caused the Great Depression and, in at least Bernanke’s case, government inaction during the 3 1/2 years between the stock market crash of 1929 and the swearing in of Franklin Roosevelt caused productivity to become depressed and unable to recover in spite of FDR’s programs for an entire decade.

Fisher was not exactly on target with his arguments in his lifetime (from wikipedia):

The stock market crash of 1929 and the subsequent Great Depression cost Fisher much of his personal wealth and academic reputation. He famously predicted, a few days before the Stock Market Crash of 1929, “Stock prices have reached what looks like a permanently high plateau.” Irving Fisher stated on October 21st that the market was “only shaking out of the lunatic fringe” and went on to explain why he felt the prices still had not caught up with their real value and should go much higher. On Wednesday, October 23rd, he announced in a banker’s meeting “security values in most instances were not inflated.” For months after the Crash, he continued to assure investors that a recovery was just around the corner.

Once the Great Depression was unavoidable to notice, he theorized that debt deflation was a major cause – debt deflation that could have been avoided (according to some) had the Hoover administration taken more aggressive steps to intercede.

The other argument is that it wasn’t Hoover’s inaction that led to the Depression but the Smoot-Hawley Act of 1930, which raised tariffs on goods sold to trading partners and led reciprocal action, skyrocketing unemployment and global isolationism.   Those who would argue this would point that both low interest rates and ample liquidity were available in 1930, but that due to economic uncertainty, few wanted to borrow and take risks.  Further, FDR prevented the economy from pulling itself out of the depression by overly taxing the population (specifically the producers) and redistributing wealth using a “trickle-up” philosophy of using government to employ the people.  Even with FDR’s policies, unemployment was still over 19% in 1938.

You can argue both arguments are right and wrong.  It is plausible that at least having a Federal Reserve that would have released funds to troubled banks could have avoided the panic that led to over 9,000 banks failing in the 1930′s.  However, there is ample evidence that government intervention did more to exacerbate the Depression than remedy it.  The primary force that led us back to economic expansion was the Second World War.

Unfortunately for Bernanke, debt deflation is intensifying in spite of his actions to improve liquidity.  What may come from all these measures, however, could spur the same depressed conditions that he is trying so hard to avoid.  If liquidity does improve, even moderately, inflation will be a large concern.  The question will then be whether it would be better to allow inflation to run amok or to raise interest rates and threaten the improving economy.

One thing I feel relatively certain in predicting:  so long as the government intervenes in the economy, there will not be a lot of certainty in the markets, which will result in further volatility.  And, it doesn’t appear the government is planning on taking its hands out of the economy anytime soon.

Consumer Price Index Plunges In October

The consumer price index plunged “by the largest amount in the past 61 years” in October.  This may be an indicator of a very deep recession, if not a depression.

A depression is characterized in part by a persistent, sustained, deep, general decline in production. They are typically preceded by a deflationary crash.  A deflationary crash is characterized in part by a persistent, sustained, deep, general decline in people’s desire and ability to lend and borrow.

Deflation requires a precondition: a major societal buildup in the extension of credit (and its flip side, the assumption of debt). Austrian economists Ludwig von Mises and Friedrich Hayek warned of the consequences of credit expansion, as have a handful of other economists, who today are mostly ignored. Bank credit and Elliott wave expert Hamilton Bolton, in a 1957 letter, summarized his observations this way:

In reading a history of major depressions in the U.S. from 1830 on, I was impressed with the following:

(a) All were set off by a deflation of excess credit. This was the one factor in common.
(b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke.
(c) Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance.
(d) None was ever quite like the last, so that the public was always fooled thereby.
(e) Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.
(f) Credit is credit, whether non-self-liquidating or self-liquidating.
(g) Deflation of non-self-liquidating credit usually produces the greater slumps.

Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan – for business start-up or expansion, for example – generates the financial return that makes repayment possible. The full transaction adds value to the economy.

Non-self-liquidating credit is a loan that is not tied to production and tends to stay in the system. When financial institutions lend for consumer purchases such as cars, boats or homes, or for speculations such as the purchase of stock certificates, no production effort is tied to the loan. Interest payments on such loans stress some other source of income. Contrary to nearly ubiquitous belief, such lending is almost always counter-productive; it adds costs to the economy, not value. If someone needs a cheap car to get to work, then a loan to buy it adds value to the economy; if someone wants a new SUV to consume, then a loan to buy it does not add value to the economy. Advocates claim that such loans “stimulate production,” but they ignore the cost of the required debt service, which burdens production. They also ignore the subtle deterioration in the quality of spending choices due to the shift of buying power from people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).

Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.

Inflation this year has crept up to a peak in July and has stayed at or near 5% ever since, until October, when it plunged to 3.66%. We all know that the oil prices have been deflationary for the past few months and it appears this is the driving factor in the deflationary prices.   I personally haven’t seen prices (other than gas) get lower, especially food.

However, given the above, the question may shift from whether inflation will eat at your bottom line to whether deflation eats away at production and dries up your clients’ ability to pay.  Based on the above, the best bet is to hold on to as much money as possible and to the extent you hold assets that are devaluing, consider liquidating to cash.  Prepare for lower income for the coming years and offset the loss in revenues by keeping your firm in sound financial condition so that you are better able to help serve your clients without the struggle of wondering how you will pay your employees.

The way to do this is to identify areas you believe will affect your income next year.  There are plenty of indicators out there but any prediction is just that.  The lower the expectation, the better opportunity to absorb worse conditions.

After you have identified where you will lose and make money, focus on assigning resources towards strategic targets that you believe will improve revenue.  Although never a fun endevour, it is time for hard decisions related to re-aligning your staff to optimize your ability to serve your clients during a time when cash flow may be strained.

Implementation must be consistent and applied universally.  This of course is the most difficult part of any change, but the future your firm, and/or your best talent, may depend on it.

As always, measure against your forecasts and in this case, worrying about others is irrelevant.  Focus on your own predictions and work towards achieving your own goals.  What happens with other firms can be compared after the economy recovers.

I’ve never lived through  a depression.  I am not sure I can even fathom it.  However, I do recognize the plethora of signs that our economy is not just taking a temporary hit – it is part of a global downturn marked by the largest expansion of credit in history.  Something others have noted invariably lead to deep losses in production.  And there is no denying that there will be massive layoffs in the coming year and our auto industry is facing its own collapse.  Production can’t improve in this environment.

Plan accordingly.