What they won't talk about on Capitol Hill
Fear that a hobbled banking sector may
set off another Great Depression could force the U.S.
government and Federal Reserve to take the unprecedented step
of buying a broad range of assets, including stocks, according
to one of the most bearish market analysts.
That extreme scenario, which would aim to stave off
deflation and stabilize the economy, is evolving as the base
case for Bernard Connolly, global strategist at Banque AIG in
In the late 1980s and early 1990’s Connolly worked for the
European Commission analyzing the European monetary system in
the run up to the introduction of the euro currency.
“Avoiding a depression is, unfortunately, going to have to
involve either a large, quasi-permanent increase in the budget
deficit — preferably tax cuts — or restoring overvaluation of
equity prices,” Connolly said on Monday.
“If conventional monetary policy is not enough to produce
that result, the government may have to buy equities, financed
by the Fed,” Connolly said.
In other words, Connolly sees the Mother of all Helicopter Drops on the way — a fiscal stimulus that makes the one Bush signed yesterday look like chump change in tandem with the Fed stepping in to prop up stocks. (We’ll leave aside questions of whether this already occurs under the aegis of the Plunge Protection Team for the moment.)
Connolly sees all manner of parallels between the runup to the Great Depression and our present circumstances. But in the Great Debate between what happens next — 1930s deflation or 1920s Weimar hyperinflation — he appears to come down on the Weimar side of the argument, without acutally saying so:
The build up of a credit bubble in recent years was similar
to the late 1920s run-up to the Great Depression, he said.
Then, investors were very optimistic about new
technologies, and stocks rose against a backdrop of low
inflation, and a trend toward globalization. There was even an
equivalent of the modern day subprime mortgage debt meltdown in
the form of U.S. loans to Latin American countries which had to
be written off.
“The big difference is the attitude of central banks and
specifically the attitude of the Fed,” Connolly said.
Some economists have blamed the U.S. economy’s travails in
the 1930s on the Federal Reserve’s hesitation to inject
reserves into the banking system.
However, today’s Fed has tried to preempt the danger of a
protracted economic slump and has responded swiftly to a credit
crunch in the past year and gathering signs of deterioration in
the economy, Connolly said.
Connolly says a 2% Fed funds rate is a certainty, and a Greenspanesque 1% can’t be ruled out. But that alone won’t be enough to reflate things, hence his Fed-buys-equities scenario. And if that doesn’t work:
“If we don’t avoid depression, the only thing worth holding
is cash,” he added.
Does he mean ever-depreciating dollars?
Shades of 1981 — the year every asset class fell — stocks, bonds, gold, cash, you name it.