Magnitude of Current Credit Destruction is Deflationary

Periodically in history, the expansion of credit creates the illusion of prosperity which, regretfully, ends in the inevitable bust which seems to be the case today. The sheer magnitude of credit destruction occuring right now is depressionary. The return to growth will be a long and painful process. Words: 625

In further edited excerpts from the original article* Moses Kim (www.expected returns.net) goes on to say:

In a functioning gold standard, current account imbalances self-correct. However, in our fiat-based system – with the dollar as the reserve currency – current account deficits persist as foreigners use their acquired dollars to purchase Treasuries. This sterilization process holds inflation in check, while suppressing interest rates. Crudely, massive current account deficits serve to reinforce the creation of credit and perpetuate the historic debt bubble.

The Bubble is Deflating
Unfortunately, the bubble has started to deflate. To see how this depression will potentially play out, we will have to turn for guidance to:

a) The Great Depression saw an enormous expansion in credit that led to the debt driven “Roaring Twenties”. People were similarly under the illusion that a new era of prosperity was at hand, regardless of increasing debt obligations. The bubble eventually popped, and excessive margin on stocks led to the stock market collapse in 1929. Massive debt liquidation hindered economic growth for over a decade.

The current debt crisis dwarfs that of the Great Depression for many reasons. To begin, indebtedness is more widespread, spanning the government, consumer, and corporate sectors, whereas, during the Great Depression, debt was isolated to the government sector. The magnitude of debt is also greater. At the onset of the Great Depression, interest bearing debt was 170% of GDP; in 2008, total interest bearing debt reached 350% of GDP. This monumental debt burden doesn’t even take into account unregulated derivatives, which are perhaps the biggest threat to our financial system.

Warren Buffett called derivatives “weapons of financial mass destruction”, and indeed they are. The collapse of Lehman almost brought down our whole financial edifice. The truth is, Lehman was a small player in the derivatives game. Anyone who thinks the threat of systematic collapse has been averted is underestimating the potential effect of over 500 trillion dollars in derivatives imploding as counterparties default.

b) The “Lost Decade” in Japan provides another illustration of a collapsing debt bubble. The level of total household debt as a percentage of disposable income reached 130% prior to Japan’s collapse. U.S. households reached similar levels of indebtedness in 2008 before the start of the current crisis.

Using stocks as a means of comparison, we can expect a downturn in the Dow in line with the Nikkei’s 80% collapse. Although this may seem unfathomable, the Dow is certainly pointing to this possibility.

In addition the Japanese were saving at a rate of 11% when their debt bubble imploded, which left them in a relatively strong financial position. In contrast, our savings rate was close to 0% in 2007, with consumption playing a far greater role in our GDP growth. This suggests the retrenchment in our consumption, reflected by collapsing personal consumption expenditures, will have a tremendous negative impact on our GDP.

Economists and media pundits who are calling for an end to the “recession” this year plainly do not understand the nature of credit in our system. The sheer magnitude of credit destruction occuring right now is depressionary. The return to growth will be a long and painful process. Like all bubbles, the U.S. debt bubble is ending.

*http://expectedreturns.blogspot.com/2009/06/case-for-depression-part-2-credit.html (Expected Returns is a blog dedicated to a spin-free analysis of current economic events and the gold market.)

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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