Where we are now is a matter of great debate: Are we in recovery? Or is the depression deepening?
No one knows for sure. Investors stumble around in the dark, bumping into data and knocking over lamps. It would be nice if someone would turn on the lights. But that’s not how it works.
The best we can do is to try make out the shapes of the biggest pieces of furniture in the room. What else is out there? We don’t know.
Broadly speaking, the period we are in is deflationary. It is a period of credit contraction (at least in the private sector), de-leveraging and depression. How can we be sure? Well, let’s turn on the lights…
Take a look at this chart, for example. What it shows is not a ‘jobless recovery.’ It shows no recovery at all.
This slump is worse than any since World War II because it is correcting an expansion that dates all the way back to 1945! Credit began increasing right after the war. It kept increasing until 2007. Then, in the private sector, it began going the other way.
That trend continues.
It makes sense from a theoretical point of view, too. Every big credit expansion is followed by a big credit contraction. As credit expands, more and more mistakes are made. You can see how this works by looking at the mortgage industry. The first borrowers were solid. Subsequent borrowers were not-so-solid, but they were still generally reliable. The last borrowers – at the height of the frenzy in 2006 – often had no jobs, no income, and no plausible way of repaying their mortgages. Those mistakes are now being corrected.
Overall, credit is still expanding – thanks to the US federal government. But credit is contracting sharply in the private sector…where it counts most. Business lending is falling at a 16.6% rate… the steepest plunge since 1948 (when businesses stopped borrowing for war production). But government borrowing is more than making up for the shortfall in private borrowing. Overall, credit-market debt is up 5.5% in the seven quarters since the business cycle peak in December 2007.
Private sector credit down. Public sector credit up. What to make of it?
We can presume that eventually the government will run into the same wall the private sector hit in 2007-09. Looking through the history of economic crises, so well documented for us by Carmen Reinhart and Ken Rogoff, we see that crises in the private sector typically lead to crises in the public sector. As the private sector sobers up… the public sector goes on a spree. It won’t be long before it, too, crashes and burns.
We can anticipate how this crash in public debt will come about. This passage, from a brief account of French financial history called The Undying Debt by Francois Velde, is a story of the past. It may also be a story from the future:
With the opening of hostilities [in WWI], the Bank of France suspended the link between francs and gold, and part of the war was financed with large issues of paper currency. When France’s prime minister Poincare re-established the link in 1928, he could only do so at 20% of its pre-war parity.
In other words, the French got into a fix. They got out by defaulting on 80% of their obligations. The history of French financial management is not so different from that of any other nation. Time after time, France found itself a little short. And time after time, it defaulted…devalued…and reneged on its promises. Over nearly three centuries, a government debt equal to ten ounces of gold – with a present value of about €7,850 – was reduced, says Velde, to €1.20. That’s about “enough to buy a café crème at the bistro on the way out from the Treasury.”
(I don’t know what bistro Velde is talking about. A café crème usually cost me twice as much!)
Returning to the image we led off with, investing is not just like trying to find your way through a room in the dark. It’s like trying to find your way through a room in the dark…when the furniture is all moving! Trouble is, in the here and now there is so much furniture moving around, it is hard to make a move without tripping over something.
Under these conditions, I’m not sure we can come to any useful conclusions about how one price will move relative to the others. Which will go down most, the dollar or the euro? Will copper rise in dollars? Or fall against cotton? Will bond prices go up before they go down? We can’t say.
But we can say that governments are very good at borrowing…and not so good at re-paying. So even if credit-contraction and deflation is the trend of the moment in US financial markets, government credit-creation is rapidly expanding…and that’s inflationary.
That’s why we are wary of government debt. We own no US Treasuries…or any other form of government obligation. Shorting US and European government bonds is probably a good speculative play.