A Second Great Depression
Are we slip-sliding into a Second Great Depression, which would again be global but would make the current so-called “Great Recession” look like a walk in the park? The answer is by no means certain, but it’s a distinct possibility.
The problem is that all the Very Serious People (as commentator Paul Krugman calls them) are working on the wrong problem. They are all trying to patch the leaky boats of insolvent or illiquid banks.
They are doing this―or in the EU’s case, just now threatening to do it―with public money. It’s a completely haphazard exercise, quintessentially ad hoc. It’s like trying to patch a leaky hull half-buried in water with a bucket of sticky tar. You can’t really see the leaks clearly, and you have no idea where the next one will spring up.
That in itself wouldn’t be so bad if the Very Serious People knew what they are doing and had a plan. But they don’t. They’re just temporizing and hoping their bucket of tar, paid for by global taxpayers, will last at least as long as new leaks spring up.
But that’s not all. It’s not even the beginning. You see, the Very Serious People are working on stabilizing bad banks and illiquid governments, one by one, as nervous markets declare them leaky. They haven’t even begun to address the root cause of the leaks: a global epidemic of financial gambling.
As usual, numbers tell the tale (1 and 2). Take the US for example. As of the second quarter of 2011, our annualized GDP was about $15 trillion [Table 1.1.5].
Now GDP for a nation is analogous to income for an individual or corporation. But what’s the size of the economy, analogous to its total value, net worth?
For a rough estimate you can use a valuation technique that business people use every day. It’s called capitalization of earnings. You take a reasonable, current interest rate, express it as a fraction, takes its reciprocal (i.e., divide one by it) and multiply that by the income. The result is the value of an income-earning asset according to the capitalization-of-earnings method. For example, if you rent your house out at $1,000 per month, or $12,000 annually, and you consider a reasonable interest rate to be 5%, then your house, as a business asset and according to this method, is worth 20 times (1/0.05) that income, or $240,000.
Traditionally, in normal times, business people often considered ten percent a reasonable rate of return. If so, our entire economy would be worth ten times (one divided by 10%) its income, or about $150 trillion. That number seems not unreasonable, as estimates of the aggregate value of all our real property alone are in the $40 to $60 trillion range.
But these, of course, are not normal times. Interest rates are at historic lows, in the 2.5 to 3 percent range for putatively risk-free Treasury bonds. So let’s say a reasonable, risk-adjusted rate of interest today is about 4 percent, for a capitalization ratio of 25. Then our entire economy is worth $15 trillion times 25, or about $375 trillion dollars.
Now, what’s the significance of that? Well, recent reports estimate (1 and 2) the total value of outstanding derivatives in the US alone as $600 trillion dollars. In other words, the Masters of the Universe have created a highly complex and entirely imaginary financial castle in the air. And all by itself, this airy castle has an aggregate face value of the better part of twice the worth of our entire economy, i.e., close to twice our collective total net worth.
If that doesn’t scare you, you’re a better man than I am, Gunga Din. Here are all our Very Serious People, busy applying sticky tar to the leaky, underwater hull of our collective boat, while above them (and us!) looms this huge, leaky tank of water about twice the size of the boat. Talk about focusing on the wrong problem!
And Paul Krugman, despite his Nobel Prize and consistently superior writing style (in both senses of the word “superior”) is one of those Very Serious People. Ever since 2008, he has never stopped banging the drum for more stimulus and less short-term obsession over deficits. Of course he’s right: the classic Keynesian solution to every economic dip since (and including) the (First) Great Depression has been to run short-term deficits so the government can “prime the pump” and put people back to work.
But no one, including Krugman, is paying any attention to the root cause of the Crash of 2008, and the continuing cause of our global financial precariousness: gambling.
Bubbles have happened before, lots of them, ever since the Dutch tulip bubble of the seventeenth century. But we’ve never before had an entirely imaginary global financial system, amounting to nearly twice the total net worth of the world’s largest national economy, based entirely on gambling.
So this time really is different, but not on the upside. Today’s difference makes this continuing crisis much worse than anything in human history, and possibly not susceptible to any of the simple remedies, like Keynesian pump priming, that have worked before.
The various articles that, a few months ago, announced the $600 trillion derivatives overhang all said, in effect, “Don’t worry, the Very Serious People have all those derivatives under control.” But they never explained why or how. We―interested people, politicians, governments, and non-financial experts―are asked to take it all on faith. But isn’t that precisely what we were asked in 1929, in the Saving-and-Loan Crisis, and before the Crash of 2008?
Anyone who believes the Very Serious People really have an answer, let alone that it works or that they actually understand what is going on, is the veriest rube. Financial “reform” was supposed to provide some transparency in the derivatives market. But it hasn’t yet even begun. The relevant federal agencies are still writing the rules. And the people who make piles of money from these obscure and totally non-transparent markets are doing their level best to make sure that whatever rules emerge won’t hold them back a bit.
Just think, again, of the numbers. Right now, as I write this, the Very Serious Politicians in the EU are whipping themselves into a frenzy. They are stretching as hard as they can (and squeezing their taxpayers as hard as they can) to come up with a 1 trillion euro bailout fund. Converted into dollars, that’s about $1.4 trillion, give or take. How far do you think that bailout fund will go if the $600 trillion derivatives house of cards begins to collapse?
And collapse it will. It’s just a matter of time. No one is minding the store. No one, least of all the avid traders in this blackest of black markets, has any idea of the big picture. That was crystal clear in 2008, and it’s even more crystal clear today. When they say, “Don’t worry. Everything’s fine!” the translation is “Don’t bother me! I’m making my fortune, and I’m on track to have my penthouse in Manhattan, my summer home on the Riviera, and my 150-foot yacht with full crew standing by off Capri long before the whole toxic mess blows up.”
The solution is clear but radical. That whole gambling casino―derivatives, interest-rate swaps, debt-default swaps, and every other instrument (perhaps excluding simple commodities futures) that gambles on uncertain future events―has become a cancer on society. And, as the numbers above show, the tumor is now far larger than the patient.
So the only way we can possibly survive is to quarantine, separate, and excise the tumor from the real economy, and eventually outlaw all but the most demonstrably beneficial gambling instruments. Otherwise, what eventually happens to all gambling addicts will happen to us. The bet will come along that starts the $600 trillion house of cards falling, and all of us will lose. Big.
Excising the huge tumor was what I and many observers thought we were trying to do in 2008-2009. But we never followed through. The gamblers were throwing too big a party. They got us to bail them out, and then they bought us off with piles of money and deeply entrenched political power. Nothing important changed, and the casinos stayed in business. They even grew.
Now the EU’s pols are poised to do the very same thing again: bail out the casinos and gamblers, let their game go on, and hope the next Great Unraveling will occur when they are safely out of office and running global charities for the increasingly numerous victims of their folly.
What assurance do we have that the same collapse won’t happen again, much bigger this time? Absolutely none. We have strong evidence to the contrary. The collapse of Dexia is a precise mirror of the collapse of AIG here that precipitated the Crash of 2008. And the world’s chief casino, Goldman Sachs, is the same one that, by making collateral calls, helped pull the plug in both cases.
All we have is assurances of Very Serious People like Tim Geithner and the CEOs of the casinos that things are under control. If you believe them, you deserve what’s going to happen to you and yours if you don’t start preparing seriously for a Second Great Depression. And this time, like the first time, it will be absolutely global, with the possible exception of China, because there is no sign that any Very Serious Person, anywhere in the world, is wising up.