Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

25 October 2011

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.


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  • At Sat Oct 29, 09:53:00 PM EDT, Anonymous Anonymous said…

    Dear Jay,

    I'm 46 years old and often feel like I have no creative ideas left. However tonight and as most nights I have what few (in my mind) good ideas I have left. Tonight I envisioned you and Michael Moore collaborating to turn "Jay Diatribe" into a Michael Moore Movie? Or at least part of theme of a Michael More movie?


    Jay you are great at reducing complex thoughts down to material that educated people can understand and appreciate, while Michael is gifted at turning these same thoughts into material the masses can understand and appreciate. I believe if you and Michael collaborated to turn the Occupy Wall Street (OWS) Movement into big screen production that you two could greatly educate America and do a lot of good for our country! Is it worth at least reaching out to Michael to explore the possibilities?

    I can envision a film with repeated cuts to Michael and OWS, repeated cuts to Jay and his Diatribe thoughts and maybe a few cuts to other Americans thoughts such as my son and others on how to fix this economy.

    Jay, your reasoning is so stimulating and thought provoking even it is not 100% correct that it is too valuable not to seek prime time on TV or in a production with the likes of Michael Moore?

    I think at this time in our nations history, the general publick is fed up with mainstream media and ideas, therefore, that is why Michael Moore and you may make an exellent team?

    Best, Rod H.

    OK, I'm probably crazy, but I like to dream sometimes. :(

  • At Wed Nov 09, 10:52:00 AM EST, Anonymous Anonymous said…

    Jay -- I'm curious as to how you suggest people "prepare for the coming Second Depression?" I agree with you that the over-leveraged financial system is heading for a crash, but I'm at a loss as to what I should personally be doing. For 401Ks, getting out of stocks into bonds? For personal debt, getting debt free or going deeper in debt in anticipation of global jubilee? Do I buy a gun and a little piece of land and get ready for full on survivalist mode? I know you are not infallible, but I am curious as to what you are doing and/or what you suggest.

    Thanks. Doug in DC

  • At Sat Dec 03, 04:29:00 PM EST, Blogger jay said…

    This comment has been removed by the author.

  • At Sat Dec 03, 04:44:00 PM EST, Blogger jay said…

    Dear Doug,

    That’s a great question.

    As financial planners always say, the answer depends on how much you have, how old you are, and whether you have a family to support. But, generally speaking, I would take four measures:

    1. Preserve capital, even if you have to forego income, until the future becomes clearer.

    2. Where possible, put money into real, tangible assets or securities that directly represent them (real property, oil, lithium, uranium, etc.). But understand that, in a depression or even a recession, they will lose value, too.

    3. Sharpen your career and self-sufficiency skills and be prepared to use them.

    4. Sharpen (or acquire) foreign-language and cross-cultural skills and (especially if you are young) be prepared to emigrate or live abroad to find better opportunities.

    As this post describes, my own retirement benefitted greatly from foreseeing and largely avoiding the Crash of 2008. I lost only about 5%, and that from re-entering the markets prematurely. But in order to protect myself I had to sit out most of 2008, the tail end of the bubble.

    If you are young, you might survive another such downdraft (if you have a strong stomach) by holding throughout. But someone my age never could have, and many my age are suffering accordingly.

    A derivatives-overhang crash could come any time in the next two years (or even longer). That’s a long time to sit out. But if your assets aren’t liquid enough to get out on a few days notice, or if your career doesn’t permit constantly watching the markets, I think you’re better off waiting to see if the gambling epidemic will resolve itself. At present, I see no evidence that it will, let alone that is has started to.

    If you've got a strong stomach and a penchant for options and hedging, you could make money from the volatile ups and downs that are sure to come. But doing so requires lots of time and lots of expertise.

    It’s a shame, because the real economy is doing quite nicely worldwide. Without the pathology of global finance, it could be moving us toward a new Golden Age.

    In normal times, I would just invest in the excellent ABC companies that do real things. That’s what Warren Buffet appears to be doing. But these are not normal times, and I’m not Warren Buffet.

    The disease of finance is real and dangerous and could completely gum up the works. It was finance, not real industry, that caused the Great Depression and the Crash of 2008. And finance will no doubt cause the next great crash. So it pays to be cautious, the more so the older you are.

    That said, I don’t think it’s time for survivalist mode. There will always be places in the world with prosperity and economic opportunity. They just might not be here. They might be in places like China that rogue bankers have not yet taken over.



  • At Sun Dec 04, 02:00:00 PM EST, Blogger jay said…

    Dear Rod,

    I’m replying to your earlier comment last because it took me a long time to figure out how.

    Of course I’m grateful for your compliments and your confidence in me. And of course I would love to have the big audience that Michael Moore’s cinematic and self-promotional gifts have given him.

    But I’m at a loss to figure out how to get it. Moore already has produced an anti-Wall Street movie entitled “Capitalism: A Love Story." In my view it wasn’t nearly as effective as his earlier movie on health care in America, entitled “Sicko.

    Both films drew the inevitable ridicule and pseudo-“analysis” from the right-wing propaganda machine. I doubt whether either movie convinced many fence sitters, despite Moore’s enormous audience (infinitely greater than mine).

    Based on what I have read, some responses to this blog, and new research on human psychology, I now think the public mind is extremely resistant to change. Current psychological research shows that most people make up their minds based on emotional impressions and personal experience and fit the “facts” into them by a process of rationalization. As a result, their conclusions and opinions are extraordinarily resistant to real facts and rational analysis of the type this blog tries to provide.

    With its trained advertising and PR folk and political consultants, Fox is well aware of this research. That knowledge makes it the most effective propaganda machine in human history, far surpassing Goebbels’ Nazi apparatus.

    So Fox and the rest of the right-wing propaganda machine are going to be extremely hard to fight. That’s one reason why I recommend canceling cable and satellite TV subscriptions: they support Fox and other propaganda outlets whether you watch them or not.

    Anyway, neither my skill at analysis nor Moore’s skill at cinema can do the job alone (or combined).
    Add to that the facts that Moore and I are completely different types of people and probably would not get along (despite having similar world views), and I think your suggestion is impractical.

    My own dream is reaching the public through a combination of reason and emotion, as Harriet Beecher Stowe did in Uncle Tom’s Cabin. Her task was hard enough: making citizens of a country accustomed and inured to slavery understand what it was like to be a slave. My task would be even harder: making people understand emotionally the logical consequences of a system of beliefs that has yet to play out, and whose worst consequences might somehow be avoided.

    Slavery was no abstraction for Stowe and her time. It was present and actual. I must deal with abstract dangers that may or may not come to pass. How do I do that and, at the same time, make an entertaining and absorbing story, without drawing the inevitable claims of improbability or lack of realism? I have some nascent ideas but none so far seems worth pursuing.

    I do take your point that change requires a far wider audience than my blog now enjoys. But I also believe change requires different methods, which I do not command. So I continue to plod onward, hoping that my rational analysis might inspire someone with greater video, persuasive and/or story telling skills to do what I cannot.

    All I can promise is that I won’t give up. And I can only make that promise because I, like other writers, write what I do the way I do because something inside me compels me to do so.




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