What Causes a Depression?

It is a gray morning here in London. We sit in the building with the golden balls, look out the window, and wonder…

…how does it all work? We’re doing some serious thinking this week. What is it that actually causes a depression? A stock market collapse? Or too much debt? How come government can appear to cure the problem sometimes – 2001-2007 – but not other times? How come the Japanese were not able to increase consumer prices? Even now…Japan’s inflation rate is negative. And why is it, despite the most massive effort at monetary inflation ever undertaken, the US bond market still forecasts an inflation rate of less than 2%?

An interview with Richard Koo, author of The Balance Sheet Recession, and a new book by Ken Rogoff and Carmen Reinhart are helping us understand what it going on. More to come…

In the meantime, the Dow went down 42 points on Friday. Gold dropped $7. Still no sign of the Chinese coming to the rescue in the gold market.

“Global rally shows signs of running out of steam,” says The Financial Times.

Reuters says the job data will “test the rally.” The New York Times says the ratio between job seekers and jobs available has never been worse.

The Wall Street Journal, on the other hand, tells us that greater than expected profits will support the rally. So far, the increase in stock prices has not come from increased earnings. It’s come from increased P/Es…based on the hope of higher earnings. In terms of forecast earnings, the Dow is selling at a P/E ratio of 27. But in terms of actual, reported earnings…the ratio if 180.

A friend made the mistake of asking us what to expect from the economy. We said it would go do down.

“You mean, you expect a W-shaped recovery,” he said… “A double-dip recession?”

“No…we expect no recovery at all. It’s a ‘W’ without the last stroke…”

Of course, we were exaggerating. But not much. We do not think that the economy of the Bubble Era can ever be revived. It will never recover…because it is dead.

But that’s doesn’t mean we will march backward forever. The economy may lose 10% of GDP…maybe 20%. But we do not expect to be slithering in the mud of the Middle Ages, with each man is planting his own wheat and brewing his own beer. No, not at all. It only means that the depression must continue until it comes to an end.

“But when will it come to an end?” you ask.

“When it is over.”

A depression ends when it has done its work. It must correct mistakes. It must punish errors. It must destroy the bubble economy…and the mindset of the Bubble Era. Only then can new real, sustainable growth begin again.

So far, in 2009, 95 banks have gone broke. How many more need to go broke before the depression is over? We don’t know. This is where is gets complicated. Because the feds are determined to keep us from finding out!

Here’s how it works. The Fed lends the bankers money. Then, the bankers turn around and lend it back to the feds. The banks are happy; they’re making money on a risk-free trade. The regulators are happy; what could be safer in a bank’s vault than US Treasury bonds? Investors are happy; it looks like the financial sector is making money again. And the feds are happy; they’re able to finance their deficits.

Who’s not happy? So far, so good. But hold on…

“This is not a sustainable recovery,” says fund manager Crispin Odey in The Financial Times.

What a spoilsport! You mean you can’t build a lasting recovery on debt and shell-game finance?

Nope. Apparently not. Just look at what has happened to the auto industry. The feds borrowed money to help Americans pimp their rides. And this Thursday, when September sales figures come out, we find out how sustainable that boost was. Many Americans got new wheels. But now they don’t need new wheels. And now the feds are out of the auto-incentive business. So now we get to see what happens next.

Stay tuned…

Across the river is the great “City” of London…where finance is the #1 industry…

…where earnest men and women toil long hours in glass towers. What are they doing?

‘Look at this chart,’ they tell clients. ‘It shows how much you can expect to make at different risk levels. And see this curve? It is what we call the ‘efficient frontier,’ where the risk/reward relationship is optimized by proper asset allocation.’

‘Wow,’ you say. ‘You must have some pretty smart cookies working for you.’

‘Well, we do our best,’ says the young man, modestly.

In a normal economy, ‘finance’ performs a useful function – helping to match up people who have capital with people who need it. But even when it is on the level, the profession is full of bombast and flimflam.

Those numbers, presented so confidently to customers, were 9/10ths smoke and 1/10th mirror. The new book by Rogoff and Reinhart confirms a point made by our friend Nassim Taleb: both the theory and practice of modern portfolio analysis were flawed. The theory was flawed because people are not reliable. They don’t always react in the way their models predict. What they did in the past may or may not be what they do in the future. And the practice was flawed because the past that the number crunchers looked at was limited to the last 25 years; it was the period since 1980, for which they had the figures! In other words, their models were based on numbers only from the boom years.

The US dollar is getting trashed,Strategic Short Report’s Dan Amoss tells us.

The greenback “is increasingly being viewed as a ‘funding’ currency in the carry trade,” Dan continues.

“In other words, leveraged speculators are borrowing US dollars in the short-term money markets at near-zero rates to buy bonds in higher-yielding currencies like the Australian dollar or the euro. If this trend remains in place, it will continue to drive down the exchange rate of the US dollar, and drive demand for gold up.

“This trashing of the dollar is not bullish for America as a whole. It’s dangerous for the viability of the middle class. It’s good for exporters of agricultural products, specialized manufactured products, and energy producers, but bad for everyone who pays for lots of imported products, or imports that are incorporated into the supply chains of businesses that sell to US consumers.

“I think this claim that ‘a weak dollar is good for exports’ is narrow-minded and misleading. It ignores the fact that a weak dollar would drive capital out of the US, into economies that are paying a real return on their currencies.”

Until tomorrow,

Bill Bonner
The Daily Reckoning