A Depression - With a Capital 'D'

We’re glad we hoisted our Crash Alert flag when we did.

Yesterday, markets all over the world plunged to new lows…with the Dow closing below 7,000 for the first time since 1997. At 6,763…it has only a couple of thousand points left to go. Then, we can begin looking for the bottom.

“World markets are taking the long-dreaded ‘next leg down’.” Writes John Authers in the Financial Times. “The more hopeful scenarios for a swift economic rebound must now be jettisoned…”

What caused yesterday’s sell-off, according to the papers, was this statement:

“With the benefit of hindsight, the group wishes that it hadn’t made this investment.”

Thus saith Mr. Michael Geoghegan, head of HSBC, the world’s biggest bank. HSBC bought America’s “Household Finance” for $15 billion in 2003. Now, it wishes it hadn’t. The U.S. unit ‘destroyed’ $10 billion in capital, says the bank.

Of course, almost every investor in the world could say the same thing. No matter where they put their money, it got destroyed. We all wish we hadn’t done something.

And it’s not over.

HSBC is closing down its entire U.S. consumer finance business – some 600 shops nationwide.

California says it is suffering an “avalanche of job losses.” Across the country, jobless benefits are at a record high.

AIG is getting another $30 billion in bailout money. The New York Times calls it “propping up a house of cards.”

Another house of cards is General Motors. It just reported a loss of $31 billion on sales of $149 billion. By our quick calculation, it must have lost about $3,000 on every car it sold.

GM has already gotten a loan of $13.4 billion from the government. Now, it wants $16 billion more. (And poor Detroit…pity the parasites…more below…)

And don’t forget Fannie Mae. Fannie made a loss of $25 billion…now she’s drawing more money from the government too – an additional $15 billion.

Good money after bad. But the whole consumer economy is a house of cards….

Remember, this is a Depression…with a capital D…not a recession. It’s a depression because it requires a perestroika of the economy…a restructuring, not just a breather and bailouts. The debt cycle is now turning in the other direction. America could be creeping back towards a 10% savings rate – as predicted here in The Daily Reckoning – and now taken up by Nobel-prize winner Paul Krugman. Savings bottomed out in the United States in 2006, when the rate went negative. Now, they’re moving higher – fast.

This is good news for the people doing the saving, but it is the kiss of death to the consumer economy. Somehow, businesses have to get along without adding more debt to household balance sheets. House-builders have to make a profit by building houses only for people who can actually afford them. Malls have to give up on customers who spent money they hadn’t earned yet. Every business in the world has to adjust to the new economy.

Economists call it the ‘paradox of savings.’ Savings are good for the individual, but when savings rates go up, spending goes down. The economy suffers. Then, people lose jobs and income, further depressing economic growth.

Many economists came to believe that a little inflation was a necessary thing, since it discouraged saving. But people will believe anything if you give them enough education. They also thought derivatives were a healthy innovation, since they dispersed risk…and that subprime debt was a service to the nation, since it made it possible for people to buy houses they couldn’t otherwise afford.

But now it’s the “Revenge of the Glut,” says Krugman. He’s referring to another stupid idea economists had: that the United States was doing the world a favor by consuming Asia’s glut of savings.

Suddenly, Americans have wised up. They aren’t carrying water for Asia’s savers any more. As a result, the huge reservoirs of dollar savings in Asia aren’t filling up like they used to. And as a consequence (as yet unnoticed by most commentators), Asians aren’t going to be in a position to buy so many T-bonds.

Now Americans are saving for themselves. A welcome trend, as far as we’re concerned…even if it does bring a Depression.

*** The Oracle of Omaha has spoken – and he is still optimistic about the U.S. economy. The excerpt below comes from his annual letter:

“Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15-25% for many years. America has had no shortage of challenges.

“Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly sevenfold during the 1900s, while the Dow Jones industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.”

*** We’re back from our vacation with a tan…well, an Irish sort of tan. We came away with a bet too. A Nicaraguan investor has wagered that the price of Russian energy producer Gazprom will rise more than gold over the next five years.

Our Nicaraguan friend is a serious investor…and a serious student of Russian investments. While we lost money in India, he lost money in Russia. So, we were even. But now, he’s thrown down the gauntlet.

“Gold is not a very good investment,” he points out. “If you take it over the last 30 years, it has produced negative returns. The price is barely higher than it was 30 years ago, while the consumer price index has probably doubled. And even if you’re right about gold now, how much do you expect to make? Maybe it doubles. Maybe triples. But Gazprom is a real company with a real product that people really need – energy. It’s been beaten down with the rest of the Russian market. But it will come back. And when it does, it has the potential to do much better than gold. For one ounce of gold today you can buy 74 shares in Gazprom. I’ll bet that that ratio is lower 5 years from now – meaning that gold goes up less than Gazprom. How much do you want to bet?”

It was not the sort of bet we like. Because we don’t really have an opinion about Gazprom; we don’t follow it. Still, we took the bet for $10.

“You’re on the right side of that bet,” said colleague Simone Wapler, editor of the French version of MoneyWeek. “Of course, we don’t know what will happen, but gold is low risk. Gazprom is not. Putin can take away Gazprom’s profits any time he wants. Who knows what will happen in Russia?”

*** The cover story at the Economist: “The Collapse of Manufacturing.”

Factory output in the United States just declined for the 13th straight month. Why make things if people can’t buy them?

*** Want to save money? Sell your house. Move to Detroit. The median house in the Motor City sold for $7,500 in December. How about that, dear reader? You can buy a house for the same price as the Dow stocks. A little low on cash? Put it on your credit card.

Of course, then you’ve got to live in Detroit. The papers report that life in the city is so grim 1,000 people move out every month.

We’ve never been to Detroit. Out of curiosity, we offered to take Elizabeth for a romantic getaway to Detroit for her birthday. Our offer drew this reply:

“Are you out of your mind?”

Poor Detroit. No one goes to the city for a holiday. Not even students. As near as we can tell people only go there if they have to. And then, they get out as soon as they can.

We can imagine what it is like. We lived in the Baltimore ghetto for nearly 10 years. If you want to know what it is like, there’s a TV show that chronicles life there – The Wire.

Was it disagreeable living in the inner city? No, it would have to undergo major improvements to be disagreeable. It was Hell. Drug dealers on the street corners. Trash in the alleys. Everybody with a pistol in his pants and a chip on his shoulder.

Elizabeth was once on the phone with her brother.

“What’s that noise in the background?” he asked. “It sounds like popcorn popping.”

“Oh, that’s just someone shooting in the alley,” Elizabeth replied. “I think they’re trying to settle an argument.”

We’d been there too long. Elizabeth hadn’t even noticed the gunfire.

But it shows what government can do when it tries to fix a problem. In the case of Detroit and Baltimore, the government provided massive bailouts. Education standards collapsed…so the government provided money to the local education bureaucracy. Jobs disappeared (largely because people couldn’t read or write)…so the government provided massive bailouts in many different bureaucracies – training centers, welfare, food stamps. Pretty soon, the only industry left was the welfare bureaucracy.

We don’t know how it works now, but when we lived in the ghetto a girl’s best career path was promiscuity. She got more money with each child she had…provided, of course, that the father didn’t take responsibility for it. Then, the child grew up…took drugs and stole cars…until he got sent to prison. One problem led to another – but it could all be traced to the government’s giveaways. They had the same effect in Baltimore as they had in Burkina Faso. The political elite took the money and lined their pockets…the masses become more miserable than before. And the worse conditions got, the more money the cities received from federal bailout programs.

Baltimore is still in business. But from what we read, Detroit sounds like it has become a kind of Port-au-Prince with snowdrifts. The whole city sounds like a hellhole without the warm fires.

And now Obama is proposing to make things worse. More bailouts…more giveaways…more programs…more bureaucrats… Already, the ‘rich’ support whole sections of the population. Obama says he will raise taxes on ‘the rich,’ creating even more parasites. Of course, who cares if the rich have less money? They will still live in their leafy suburbs and send their children to private schools. But pity the poor parasites.

Neither Mr. Obama nor none of the candidates for Mayor of Detroit (the last mayor is doing time in a federal penitentiary) has asked for our advice. We will give it anyway. Want to save Detroit? Here’s how:

Abolish all welfare of all sorts…no unemployment insurance…no child tax credits…no welfare…no foodstamps…no nothing, except privately-sponsored charities. Close the public schools. Kick out all the bureaucrats and all federal and state employees. Abolish all rules concerning employment – no minimum wages, no overtime, discriminate all you want. Require all residents to say please and thank you…dress properly…and sneer at people who don’t seem to be gainfully employed or polite. Declare the city an Open City and Free Trade Zone. In exchange for cutting all federal aid programs, eliminate federal and state taxes for people living in the city. Allow unlimited immigration into the city…giving all immigrants a U.S. passport after 5 years of residency. Levy a flat 10% tax to pay for basic services. Eliminate elections…have the city controlled by a town council composed of 10 citizens chosen at random.

Within five years, Detroit would be the most dynamic city in the nation.

Until tomorrow,

Bill Bonner

The Daily Reckoning