Sunday, June 6, 2010

Martin Armstrong - The Two Phases of the Great Depression

What follows is Martin’s relatively short take on what occurred during the second half the Great Depression and why it is different this time. I believe he makes a lot of good and valid points, but I also believe his is flat out wrong on others.

First let’s go back to August 2009, and look at what he said about the DOW back then in his paper “Will the DOW Reach 30,000 by 2015?” This is where he said, “The main resistance area is 11,000 on the DOW. We need a monthly closing above that level to signal that the March 2009 low will hold. Otherwise, we should expect a retest of the lows or still even perhaps new lows going into 31.4 months down from the October 2007 high with a rally into the next target 2015.75 reaching 30,000+.”

The way I translate that is to mean that if we fail to produce a monthly close above 11k (we closed April at 11,008 – that was the peak and it has since failed – so I say resistance held), then we are likely to revisit the lows or break them, then hyperinflate into the year 2015. Okay, fine, I can buy that as a possibility and it does fit into my general thinking that we would experience another wave of deflation and that the reaction following would then likely produce inflation and that would eventually mandate a change in the structure of our money unless that change occurs first.

Now we have M3 collapsing, we are on the verge of countries defaulting (the same as wave C of the Great Depression), and we have a rush into the dollar and US debt instruments.

So, with that in the background, let’s take a look at Martin’s latest paper:

One of the areas that I disagree with Martin on is the importance of being on a gold standard then versus now. In fact, I believe that being on a gold standard had very little influence on the events and outcomes of the Great Depression. What was much more important was the fact that the Private Bankers had taken over control of the money creation power and despite a “gold standard” managed to produce one of the largest CREDIT bubbles in the history of man. Gold absolutely FAILED to keep the total quantity of money under control – the total being the amount of sovereign money (in this case backed by gold) versus the amount backed by debt (came into creation bearing interest as someone else’s obligation).

I think a very important piece of the credit bubble puzzle now is rooted in accounting fraud. Martin is right about this point, THE MARKET KNOWS. It knows that our major financial institutions are INSOLVENT – they have marked to fantasy, they have played the shell game, they have transferred unserviceable debts onto the public rolls making them insolvent in return. Wave A down did NOT clear the DEBT, it is still there! The market knows!

Mark to fantasy accounting was one of the major contributors to the credit bubble. In 2007 FASB changed the rules back to mark-to-market. The reality hit the financials and drug the entire equity market down. Price to earnings shot to all time extreme highs because of this accounting (reality). Then, pressure mounted as the equities collapsed to reinstate mark-to-fantasy, it was reinstated and now price to earning fell right back down to a falsely marked level, yet even with accounting fraud P/E levels are still far above historic norms.

The market knows – this P/E reading is FALSE, it is marked to fantasy, the debt is still there.

It's no more complex than understanding that the growth of debt outstripped the growth of income. This is the underlying cause of the shift in CONFIDENCE that Martin and so many others discuss in the markets. Confidence allows people to take on leverage (debt) and it grows until there is an event that shifts people’s confidence that the debt can be repaid, then markets correct. It is the underlying math that leads to angst and the lack of confidence. This is occurring now throughout the entire world, not just in the United States.

At this time ALL our money is CREDIT money. INTEREST is DEFLATIONARY! It is the attempt to create never ending growth to compensate for the deflationary pull of interest that creates stupidity like attempting to grow at 2% or more per year. It is this reaction to deflation that prompts other actions to create inflation! Those other actions include dumping Glass-Steagall, lowering reserve requirements so that the banks can fractionalize more money, allowing derivatives to create more leverage, allowing banks to mark derivatives to fantasy instead of to a real market price, etc. Those are the things that create inflation when your money is entirely comprised of DEBT.

If you don’t believe that interest is deflationary, let’s do a little mental experiment like I often do – isolate it, put it in a room, and then take it to one extreme and then the other… So, in this case we have 10 people in a room and each have $100 CREDIT dollars, or $1,000 dollars total in the room. They perform transactions between one another but because they are all in debt, they must pay interest to the bank that resides outside of the room – let’s say 3% of the money is paid to the bank each period. At the beginning you had $1,000, and at the end of the first period there was only $970. The supply of money went down, that is deflation! Again, it is the attempt to counter this deflation that produces imbalances.

Now, Martin later says this, “There is NO direct ratio of money supply to the rate of inflation. It is simply a matter of CONFIDENCE.” While it is true that it is not exactly direct, there is most definitely a correlation between the quantity of money and PRICE inflation. It is this correlation that enhances or destroys confidence.

This time in the room there are two people, a VERY bright and irritating light, and only one pair of sunglasses. If both people in the room possess only one dollar, then the MOST the glasses can be bought for is one dollar! However, if both people possess $100, then the glasses may be purchased for considerably more! It is the easy availability of money that gives them supposed confidence to pay more, and without the money it is mathematically impossible to pay more.

So, Martin goes onto say:
“In order to create a 1930’s style depression the United States would have to adopt the very advice the IMF is telling Greece that failed in the 1930s and will destroy the nation politically.

…By insisting that there be a balanced budget, the IMF is supporting the bond holders at the expense of the people.

…The reason why I do not believe there will be a Great Depression is because it would”

His response is cut off, but he is saying there will not be a Great Depression. Well, no two depressions are the same, but the parallels between then and now are stunning, and the greatest difference between then and now is not the gold standard, it is that per capita debt levels are still much higher now than then, and the credit bubble is much more global now than then!

Austerity is not a choice once income cannot support debt, it is brought to you. The only way to change that is to either clear out the debt or to change the system (and clear out the debt).

INCOME to DEBT – this is the key. So, the government took private sector debt and made it public. The math is impossible, sovereign countries have no bankruptcy procedure, they can either default or print (if able). People are now realizing that countries cannot repay and thus confidence is being lost. Money can be created, but as long as incomes cannot service debts, then balance cannot be restored. The proof of this is in the amount of “money” now held at the banks, but yet they can’t lend to consumers who are saturated with debt as their incomes cannot support even more. The same is now true for all western governments of the world. This is why we see the diminishing productivity of debt over time that has now entered a phase transition into less productivity for new debt entering the system, and it is why adding debt at this stage produces lower employment.

The psychology of wave C down is different than the psychology of wave A down. The government has attempted the bailouts, they failed because their actions were opposite those required to bring the math under control. That is what destroys confidence – and the cycle repeats, only this time is on a much higher order than the Great Depression of the 1930s.

If monetary change does not occur during this deflation wave and our reaction is to print without debt, then we will get hyperinflation later that will destroy any value remaining in our money as the quantity gets even further out of control. This could produce equity lower, then much higher. But for now, the total quantity of money is contracting.

The alternative to printing without debt is to print and use the money to directly pay down debt. That is an equity for debt swap, it can work to print money and keep the total quantity of credit and non-credit money under control. That would require many deliberate actions such as I’ve outlined in Freedom’s Vision. In the mean time history may not be repeating, but it is certainly rhyming except on a more grand and global scale.

Europe has now seen the loss of confidence, the Euro is sliding even faster in reaction to their bail out. We now have Geithner talking up more stimulus while Europe and the IMF are talking austerity. The dollar is strengthening because global deleveraging is occurring and the holders of debt must scramble to get dollars in order to pay down debt. The United States for now is continuing to finance our debt, but that WILL change and Geithner/Bernanke will learn the same lesson learned by the Europeans. Confidence is destroyed when the math is so obviously out of whack, make the math even worse and at some point they too will encounter a phase transition in confidence – I believe we are setting up for that now.

The bottom line is that Martin brings up valid points, but not all of his points carry validity and neither do his conclusions that he often plays in both directions. Hey, I don’t pretend to know the exact outcome, but I do know BS when I hear it. People who claim to know the exact outcome are immediately suspect and thus let’s take what knowledge we can and move very cautiously into the future. I still think that history shows those “other” events are coming. Our governments and bankers are losing control and they will do extraordinary things to attempt to remain in control.

Martin is right that ultimately it is the people who will win the day – they always do. Unfortunately, history also shows that between here and there will be much more pain. While money and governments are a construct of man, we are slow to change and we repeat mistakes as the pendulum swings. Two steps forward, one step back.