The Business Cycle, Recessions, Depressions, and Academics Gone Wild

The bulls out there fall into two camps:

1. Those that believe that the economy is recovering
2. Those that believe that inflation is on the way

The bears out there fall into one camp:

1. The economy is terrible and the market is going to crash

Here at Dredd, we tend to believe they're all a little bit right and mostly wrong. The real economy is nowhere near recovery. It will take considerable debt reduction in the private sector, through defaults, inflation, and/or time to rebuild consumer balance sheets in order to bottom in the economy. This implies stable jobs, real increased wages (real vs. nominal--consumers are broke because of inflation over time), and a stable currency. Since over 70% of the economy is consumer spending, the economy is going to have to make fundamental changes to solve the problem. That includes producing more things for other countries to buy (rebuilding the manufacturing base), fewer consumer-oriented businesses (retail is going to get much, much smaller), and increased savings from consumers (capital) that will ultimately be used to build new businesses.

At this present time, instead of this process happening naturally through defaults and bankruptcies, the government is assuming the role of the consumer and going into more debt. The base of our problem, however, is debt. So obviously, the government not allowing debt to be liquidated by assuming the role of an overburdened consumer in too much debt is probably going to end badly.

The risk to the government (and ultimately, the event that will make this very bad beginning of a depression into a full blown nightmare depression) is the effect of this behavior on the US dollar. Right now, consumers are saving for the first time in decades while government actions work to make the dollar itself weaker over time. This is the result of a belief in Keynesian and monetarist theories, in our opinion, incorrectly applied.

In brief, Keynesian theory states that for a government to make a recession less painful, it should step up spending when consumers are forced to retrench. It should do this through manipulation of short term interest rates, which in the US are now roughly zero percent. Of course, the corollary is that when the economy is good, the government is supposed to stop spending and save--which we did not do in the last 8 years, instead opting to cut taxes while ramping up an expensive war.

The monetarist theory roughly states that it is more effective to increase the money supply (inflate) during recessionary times. It approaches the problem in a similar fashion as Keynesian theory, but using money supply versus interest rates as the means to accomplish the same objective--increase government spending when consumers slow.

The Fed and the US government have opted to do both and apply Keynesian rate reductions and monetize debt to get us out of this recession.

Here's the problem. It's not a recession. It's a depression. The government is applying a band-aid to a cancerous skin lesion. It will not--it cannot--solve the problem.

A recession occurs as part of the natural business cycle. Businesses build up inventories based on increasing demands, they ultimately over project the demand, and then the demand dries up because the market is saturated with product. Then it takes some time to work off the inventories, during which time unemployment rises and the economy slows. However, once the inventories are worked off, things pick back up and are off to the races.

A depression occurs when there is too much debt in the system. At some point, people (or business or government) simply cannot take on more debt, and the person is in default.

People have been consuming far too long in the US relative to their incomes. So has government. The debt problem has to be resolved. At the same time, the government is trying to help consumers (and banks, notably) solve debt problems by borrowing money (taking on more debt)or printing more money (monetizing debt). It seems rather illogical that one can solve a debt problem with more debt. But that's government for you.

It appears that the government has, at best, misdiagnosed the problem and exacerbated it. At worst, they have allowed the Fed to save the banking system at the pure expense of generations of Americans to come. After all, something's got to give in this race, and it's likely to be confidence that the government call pull it off.

And that's where the dollar comes in.

In a fiat monetary system, like all countries have today, the currency is based on faith and credit. In other words, it is based on the premise that the government is "good for the loan." However, at some point, the debt level cannot be sustained and that will result in loss of faith, and a likely sell-off of the currency.

Are we at that point? It's hard to say. But we're following the dollar relative to other currencies to determine how much faith there still is out there in the dollar. Meanwhile, the politicians and Fed continue to plan on more spending, which implies more debt.

What will happen if they run out of willing buyers? Will the Fed simply find a way to print more money (inflate), or will the US have to default? It's clear that one of these two options is the end game. If the US dollar is basically the stock of the United States, what do you think will happen to the stock when it's common knowledge that it cannot repay its debts?

This will probably not end well. Hopefully the charts will keep us informed as to how the situation is progressing. We are auctioning off more debt even as we speak. Yesterday's auction results were not fantastic for 2-year notes, but they were okay.

Stay aware...