The Third Depression

A. Scott Piraino

The US economy as we know it will soon collapse. This has happened before, twice, and history is about to repeat itself again. This will be the third depression the United States has suffered, and it will probably be the worst.

In the Gilded Age of the 1890’s, and the Roaring 1920’s, improvements in technology and industry fueled rapid economic expansions. Capitalism was revered as the new engine of progress, while onerous government regulations were seen as an impediment to growth. These were days of “laissez faire” economics and unscrupulous robber barons.

Inevitably there was a growing disparity in incomes, but the majority of Americans were more concerned with getting rich than helping the poor. Most investors believed these economic booms would last forever, but this optimism proved to be their undoing as exuberance bid up share prices. Inevitably the day came when prices fell, and markets collapsed.

The Gilded Age ended with a monetary crisis in the first decade of the twentieth century. Incoming President Teddy Roosevelt was forced to borrow money from wealthy elites to finance the government. The Roaring Twenties ended in a more spectacular fashion, a stock market crash in 1929 ushered in the Great Depression.

Depressions are created when money disappears. People suddenly become poorer, and they spend less money. With less demand for goods and services, production declines and prices fall, causing a downward spiral of unemployment and falling incomes.

Our country has endured deflationary periods after numerous boom and bust cycles, most notably during the Great Depression. But the coming collapse will be different. Debt, and our dependence on imported oil and manufactured goods are the reasons the Third Depression will be different, and much worse.

The U.S. budget deficit climbed to a record high $412 billion last year, which was surpassed by our trade deficit of $496 billion, also a new record. This year’s deficits will be even larger. The Bush administration has projected a budget deficit of $390 billion for the year, not including $80 billion for the war in Iraq. Meanwhile our trade deficit is growing even faster, at an annual rate of $592 billion.

To finance our current account deficit, we have to import three billion dollars in cash, every working day. Our deficits now consume 80 percent of the entire world’s net savings, and our demand for debt is increasing. This is unsustainable.

Interest rates on our national debt are low only because bondholders are confident in our ability to make payments. The US dollar maintains its value on world markets because foreign nations believe we can afford our appetite for imported goods. As our economy falters and our deficits rise, the world is losing faith in our ability to finance our deficits.

This is why world markets are beginning to reject the US dollar. The dollar has lost about one third of its value against other major currencies since 2002, and has been falling at a much faster rate in recent months. The danger of course is that as the dollar declines in value, it becomes less profitable to hold, and the incentive to sell dollars increases.

If enough central banks and foreign investors began unloading US assets, other investors and financial institutions would see the dollar rapidly losing value. They would have to sell their US securities quickly, to protect themselves from further losses on their dollar denominated holdings. There would be a financial panic, and the US dollar would collapse.

This danger is very real, and our declining dollar is creating a vicious cycle which will inevitably cause our currency to depreciate more. As our dollar loses value, foreign goods purchased with dollars become more expensive. Since we are now dependent on imported goods, (see the trade deficit figures above), our shrinking dollar means higher prices for those goods.

In addition to the inflation caused by rising prices for imported wares, we have to worry about oil. The price of oil is skyrocketing even faster than the value of our dollar is falling, rising 30% in the last three months alone. As of this writing the price of oil has reached 50 dollars a barrel, and gasoline prices nationally are at a record high $2.11 at the pump.

These market forces are putting immense pressure on our economy. Higher costs for energy and transportation have been driving up prices at a 3% annual rate. Last month the Consumer Price Index jumped 0.6 %, the largest increase in four years, even when rising prices for food and energy are excluded.

While inflation is gaining momentum, recent economic reports and corporate earning statements show an economy rapidly losing steam. General Motors reported a net loss of over one billion dollars in their most recent quarter. U.S. durable goods orders plummeted by 2.8 percent in March, while new housing starts plunged 17.6 percent, marking their steepest drop in more than 14 years.

Even more telling is a report prepared by the Economic Policy Institute on April 21st. The report shows that wages and salaries as a share of national income fell to their lowest levels on record, even lower than the Great Depression of 1929. Although corporate profits are at all time highs, wages, (which represent total income for 80% of Americans), have not kept pace with inflation.

The US economy may be expanding as government statistics claim, but the majority of Americans are actually getting poorer. US household debt now stands at $10 trillion, ( a record high, of course), and has been increasing by over one trillion dollars per year since 2002. Americans cannot spend enough money to lift the economy out of the doldrums, nor can they afford higher prices, or higher interest rates.

The trembling dollar, inflation jitters, and pessimistic economic data sent all three US stock indexes to their lows for the year in April. The Dow Jones declined by 3 percent, the tech-heavy Nasdaq dropped by 4 percent, while the S&P 500 lost 2 percent. The market is waiting for the other shoe to drop, and in April the warnings became more shrill.

In testimony before Congress two weeks ago, Fed Chairman Alan Greenspan warned that “these deficits would cause the economy to stagnate or worse“.

He’s right, and he knows our economic problems are even worse than our deficits, a declining dollar, and inflation. Derivatives are financial holdings that derive their value from other securities. These new financial instruments have created a speculative bubble unlike anything ever seen, and pose a mortal danger to our economy.

In a letter to shareholders, billionaire investor Warren Buffet warned that derivatives were “time bombs, both for the parties that deal in them and the economic system“. He went on to explain how derivatives work, and why they are so dangerous:

“Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction -with your gain or loss derived from movements in the index.”

“Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties (sic) to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands.”

In 1986, the global market for derivatives stood at just over one trillion dollars. By 2004, The U.S. Comptroller of the Currency estimated the value of derivatives held by U.S. commercial banks at around $84 trillion. That’s eight times the size of the US economy.

Derivatives are now one of the pillars of our financial system. Fannie Mae, a federally subsidized home-mortgage corporation, has recently admitted to $8.4 billion dollars in losses stemming from derivatives. JP Morgan Chase has $43 trillion in derivatives contracts, by far the largest portfolio of any commercial bank.

The implosion of one of our banks or lending agencies due to losses on derivatives would cause a panic, and wipe out the US economy. And the fact is, many of our financial institutions are only solvent as long as their derivative holdings are profitable. This situation is now very dangerous because 87% of derivative positions consist of interest rate contracts.

Alan Greenspan is trapped, and he knows it. The Federal Reserve must raise interest rates to improve the rate of return on dollar investments, and keep foreign investors from abandoning the US currency. But higher interest rates will slow down the already moribund US economy, and create immense losses on derivative contracts.

Monetary policy cannot save us from an impending financial reckoning caused by our soaring levels of debt and speculation. The only people who can get us out of our economic difficulties are the very people who have put us in this mess. Yet the Bush administration appears to be blithely marching the United States over the brink of an economic abyss.

After the economic crises following the Gilded Age and Roaring Twenties, there was a backlash against the excesses of capitalism. Teddy Roosevelt reined in monopolies, and passed the first income tax into law. During the Great Depression, Franklin D. Roosevelt raised taxes on the wealthy to finance his New Deal legislation.

Unfortunately, we don’t have a Roosevelt in office to champion the majority against business interests. President Bush has repeatedly cut taxes for our wealthiest citizens, and signed more free trade agreements, while our deficits have soared. He and his cronies have offered nothing but the same warmed over Reaganomics that created our trade and budget deficits in the first place.

If the US Government does not take drastic action immediately to reduce our deficits and increase investment in the US economy, one or more of the following scenarios will take place:

1) The dollar’s value will depreciate until enough investors and foreign central banks decide to unload our currency, causing a financial panic.
2) Higher interest rates will cause multi-billion dollar losses in derivatives trading, and when a financial institution admits to the scale of those losses, there will be a financial panic.
3) Too many Americans will foreclose on variable-rate mortgages and credit card debts, causing a default in a bank or lending agency, and a financial panic.
4) Fearing any of the above eventualities, US and global stock markets melt down as investors liquidate their holdings, causing a financial panic.

Either way, the house of cards that Reaganomics built will soon collapse. We have a right to be angry about the economic calamity we are about to experience, but we have no right to be surprised. This is the Third Depression after all.

Published in: on May 2, 2005 at 7:21 pm  Leave a Comment  

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