Dow 1500?

Are we living in a new Depression era?

A few years ago I was working in the IT shop of a national US homebuilder.  Even though the world was chanting “there is no housing bubble” it seemed obvious to me that we were in a major housing bubble.  This company couldn’t build houses fast enough.  Growth was astronomical.  Folks, this is housing we’re talking about.  If housing typically grows at a rate of 2% a year, and you see it growing at 20%+ for several years, you can bet your sweet bippy it’s a bubble.

The burst of a housing bubble set off the Great Depression.  But, like the Depression of the 30s, the burst of a housing bubble is only a symptom of the problem.  It isn’t the problem itself.  The problem was – and is – runaway borrowing and lending.

Check out this chart showing the ratio of consumer debt to GDP.  What was the situation in the late 20s?  People assumed that the market was invincible and bought in ravenously, often going deeply into debt to cover their speculation.  Likewise in the last 10 or so years.

I am not sure what is a healthy, sustained lending rate (expressed as the lending / GDP ratio), but it must be below 100%.  Let’s say that a healthy or stable rate of lending is approximately 50-70% of GDP.  If that’s so, then the banking system is going to have to contract the amount of lending by roughly 30-50% in order to regain a stable aggregate lending rate.

What macroeconomics teaches us is that inreases in lending results in an increased money supply.  And decreases in lending result in a decreased money supply.  When the money supply decreases, we call that deflation. Without aggressive efforts to bolster the money supply, we are going to enter a sustained deflationary period.

Contractions in the money supply from 1929-1933 drove the Dow down 89%.  If the current recession / deflation were to take a similar course, the Dow would bottom out around 1500, roughly erasing the last 25 years of growth.

That doesn’t have to happen.  What is required is twofold:

  1. Banks must be supported by all means necessary.  They must not be allowed to fail.
  2. The money supply must be bolstered through monetary and fiscal policy.

The problem with aggressive monetary policy is that the lowest interest rate available is 0%.  And during a deflation, even a 0% loan is bad for the borrower: deflation causes the money I’m paying back (later in time) to be worth more than it is today.  We already are approaching a 0% federal funds rate.  We can’t be significantly more aggressive than that.

And the problem with fiscal policy is that it’s fiscal policy.  First off, we have to borrow in order to spend aggressively.  Our national debt is already out of control.  It’s inconceivable that we can keep borrowing at an increased rate – especially from other economies who may be even worse off than ours.  Then we have to spend the money internally, which looks like huge inefficient government service programs.

It’s going to get interesting, folks.  We are likely heading into a deflationary spiral – one of the most intractible economic problems that can be faced.  There have only been three significant deflationary spirals in US history: one in the early 1800s, one after the Civil War, and the Great Depression.

Deflationary spirals are economic contractions caught in a self-reinforcing feedback loop.  The logic is this: people believe that times are going to get tougher, so it makes sense to contract (spend less).  Decreased spending causes times to get tougher:  prices drop, and, facing dropping prices and scarce revenue, it makes sense to spend less.

Andrew Muse agrees, and points out

I think the important thing to realize is that people are saying things like “capitalism as we know it may be over” and “the DOW might drop to 3,500? – it doesn’t matter if they are true, it only matters that some people believe they might be true.

I hope 3500 is the floor, Andrew.  If 1933 repeats itself, we’ll all be wishing for 3500.