IF YOU have been following the news lately you may have observed that the term used for the consequences of 2007-2008's world financial crisis is "A Great Recession". I would like to go one better and say that this is "A Great Depression" that will be most felt in the United States. It may seem a little extreme, but make no mistake, the US is in a depression. Let me explain why.
Recessions are usually the result of capital being concentrated in a particular sector that becomes overheated, an example being the NASDAQ dot-com bubble which spectacularly burst in 2000. Speculators pump capital into a particular nation or sector within it then flee to other sectors, leading to a boom-bust cycle.
But what is currently unfolding is not your typical recession. This time it is the bubble in debt on a worldwide scale that has burst and is causing the problems we see today. The debt bubble is what has made this crisis so much more devastating.
One cause of all depressions is debt crisis. The Great Depression of the 1930s can be traced back to Europe's debt defaults in Europe on loans from the United States that could never be repaid. What we have now is a similar scenario, with America witness to the largest debt bubble in history. Since the end of World War Two the US has created debt on an unprecedented scale in all sectors of the economy which accelerated in the 1980s and peaked in 2007.
Household, corporate (financial and non-financial) and public debt have all exploded to levels even exceeding 100 per cent of GDP. The bursting of this mother of all debt bubbles is causing the devastation we see today and the interconnection of the global economy implicates the rest of the world. The scale of the damage will be relentless as de-leveraging takes place to reduce the velocity of money and consequently the money supply. When de-leveraging occurs (debt implosion) it has the effect of deflating prices and that is why we have seen house prices fall by as much in the US since their peak a couple of years ago.
The reason house prices were able to climb so high was the availability of 30-year mortgages. Homes in the US are generally more expensive than in Europe or elsewhere because the 30-year mortgage gives buyers the ability to bring forward earnings for the next 30 years which increases money supply and leverage and results in higher prices. If homes could only be bought with cash up front the prices would be much lower.
Bringing earnings forward 30 years has pushed prices up steadily for decades and led to people viewing property as a savings bank. But the events of the last two years shattered homeowner's confidence in their old store of wealth, which will have damaging consequences for their future economic outlook. The reason they call it depression is that people begin to fear for their future and become depressed, which causes a vicious circle of reducing spending and hoarding cash, which leads to a fall in the velocity of circulation and money supply which in turn puts downward pressure on prices and leads to further contraction in the economy.
The cause and severity of this crisis can be attributed to the irresponsible actions of the New York investment banks in pooling and repackaging mortgages. Thinking somehow that this would mitigate risk and leave them free of needing to worry about the quality of the individual borrower, the banks sold them to investors across the globe and thus exposed the rest of the world to these toxic assets. Add to this the fact that AIG, the largest insurer in the world at the time, had sold billions of dollars of credit default swaps - a kind of insurance that banks use against debt defaults - over the counter.
As mortgages began defaulting in 2007 and accelerating into 2008 it was inevitable that AIG would be liable to pay out. But since the contracts were sold through unregulated, over-the-counter transactions, it was revealed that AIG did not have the capital (collateral) to pay out. The company therefore declared bankruptcy, causing widespread panic around the world.
What this showed was a complete failure by regulators that enabled AIG to sell these contracts without having capital backing - akin to buying a futures contract on a cotton harvest you never even intend to plant. In setting up their office in London, AIG were able to avoid regulators.
Now we see authorities dealing with this in their usual way and bailing out the failed financial institutions that caused this mess in the first place, claiming it was necessary to save the world from disaster, which is absurd.
For the past year the response of most Western governments to the crisis has been to once again print their way out of it. History has shown that fiscal stimulation rarely attains its ends and the result could be a loss of confidence in government by the public that could lead to a currency crisis. This will be evidenced by a flight of capital, causing the purchasing power of the currency to fall and therefore rising prices as a natural compensation.
We are already seeing this with capital leaving the US in the form of a carry trade once synonymous with Japan, where in the '90s the yen was sold to buy other currencies in search of higher yields. Japanese politicians destroyed their economy by leaving rates low in the belief that borrowing and growth would be stimulated, forgetting that capital can move overseas seeking higher interest rates.
The consequence of incompetent politicians who lack understanding of the problems and focus purely on the next election is that we are now witnessing a carry trade taking place on the dollar that will ultimately be its doom.
