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Are We At The Verge Of The “next Great Depression”?

This paper will discuss the emerging trends in the global markets today, and how the “Zero Interest Rate Policy” (ZIRP) and Quantitative Easing (QE) Strategy could potentially lead to an economic free fall.

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About

The Great Depression started in the United States after the stock market crashed in 1929 and then gradually spread to other parts of the world. This led to a contraction of economic growth and rising unemployment rate.

The Great Recession on the other hand in a nutshell was an economic slump that originated from the defaulting of subprime loans or debts which were bundled together to form Collateral Debt Obligations (CDOs) that set off a gigantic domino effect which resulted in a number of respected and reputed banks going bankrupt, this set off a global chain reactions, that effected all the countries that had investments and dealings with corporations and banks in the United States.

This paper aims to discuss the policies that were implemented and how these policies might ultimately hurt the global economy as a whole by allowing corporations and other countries to use cheap credit, thereby ultimately causing inflation which would be up followed by control measures by the government that would trigger financial instability, which was one of the early signs of the Great Depression in the 1930s.

Executive Summary

In order to fully understand this concept, let us first understand the cause and effect of the “Great Depression” way back in the 1930s and the cause and effect of the “Great Recession” in 2008.

A large-scale loss of confidence led to a sudden reduction in consumption and spending. Once panic and deflation set in, many people believed they could avoid further losses by keeping away from the markets. Holding money became profitable as prices dropped lower because of the insufficient demand for existing supply. The supply was created in order to cater to the demand which had set in during World War 1, but after the war this demand reduced, thereby leaving farmers in debt for purchasing farming equipment.

Countries tried to solve this problem by devaluing their currencies against other currencies in order to increase their international competitiveness. The idea behind devaluing a currency is to make exports competitive. At the same time imports become expensive. This also ensures that the citizens buy commodities that were produced within the country rather than what were produced outside it.

When a currency is devalued, exports are likely to go up and imports are likely to come down. This helps businesses within a country and therefore, improves economic growth.

Now let’s fast forward to 2006, where we see the economy doing fairly well, we see a good growth in the housing market which lead to the idea that an investment in real estate was a sure deal. So banks began giving loans with the expectation that, even if the loan receiver were to default on his payment, the bank would still make a profit, because the housing rates were always going up, which lead to the creation of Collateral Debt Obligations (CDOs) which were essentially Mortgaged Backed Securities(MBS). When the real estate market collapsed in 2007, these securities declined in value, jeopardizing the solvency of over-leveraged banks and financial institutions in the U.S. and Europe.

This lead to a domino effect, where a number of financial institutions such as Lehman Brothers, Merril Lynch declared bankruptcy, ultimately causing large scale unemployment. The solution that the government came up for this crisis was Quantitative Easing (QE) and Zero Interest Rate Policy(ZIRP), which in over simplified terms is injecting stimulus packages  into the monetary system, with the intension of restarting the financial engine and reducing interest rates to zero so that people invest more of their money into the market.

And even though these methods have worked out for them in the short term, they have essentially created a ticking time bomb. Simply because of the fact that we are currently witnessing exponential growth, which isn’t cause by developing economy, but instead we see this growth due to the amount of money supply in the economic system.

If the current states of affairs continue, we will reach a point where the Federal Reserve will face two choices:-

  • To continue the Quantitative Easing strategy and create money to see growth which would result in allowing inflation to rise to such a rate that the value of the dollar will depreciate to alarming rates. Similar to what happened in the German hyperinflation crisis of 1921-1924.
  • They stop their Quantitative Easing strategy and zero interest rate policy which could result in a stock market crash and allow a sudden scarcity of money or deflation in the market similar to what happened in 1930 leading to another great depression.

Background

To better understand this topic let us first lay out a few economic concepts, Firstly money simply put is a financial instrument that has a store of value, can be used in exchange for a service or product and it is a unit of account. 

Secondly let us understand that all currencies were initially valued based on the amount of gold reserves that they possessed, simply because of the fact that money could be exchanged for gold initially, but over time there was a need for printing more money to finance government expenditure, as a result there was a rise of money supply in the market, so slowly countries started floating their currencies.

President Nixon was the First President of the United States to remove the Dollar from the preexisting gold standard. This allowed the central bank to print as much money as they needed.

Thirdly a country’s currency is considered to be strong because of the number of countries that purchase that currency, although the country’s GDP and economic development is a factor, the real value of a country’s currency is determined by the supply and demand for that currency.

Countries like India and China intentionally price their currencies relatively low, so that other countries buy Indian or Chinese goods this results in a preferable balance of trade for the exporting countries.

Now let us understand some concepts that will help us grasp the concept of how money is created.

There is ideally two ways by which money is created

  • Money Created by Public and Private Banks
  • Money Created by the Central Bank.
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Money Created by Public and Private Banks

Let’s illustrate this concept with an example, (Please note: This is just an example and the figures and percentages are simply to exemplify) Mr. A has $100 and he wishes to get a bank account and deposit his money in that bank account. Now since the bank has $100 in under their custody, they can give out a loan to Mr. B using the money they have in custody, let’s say they give out 80% of the amount they have in custody to Mr. B, Mr. B takes that $80 and puts it in bank account of another bank, now the other bank does the same thing, by giving out a loan to another person Mr. C for $64, finally by the end of 10 similar  transactions that initial $100 is now $372.51, these banks have managed to get a 272.51% increase on a $100 asset under management.

Now let us try to understand the potential fallout effects. What these banks have essentially created is chain of debt, the reason I use “chain” as an appropriate metaphor is because if one link proves to be weak, then the entire system loses balance. This system of credit can prove to be dangerous, that is why banks work so hard to find out the credit worthiness of a person. However this credit worthiness was classified, packaged and sold by way of mortgage backed securities back in 2008, and it’s with the defaulting of these financial products that factored in to the cause of the “Great Recession”.

Money Created by the Central Bank

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One of the control measures adopted by the US Government was Quantitative easing, let us try to understand this concept in simple words, it is the process by which the Federal Reserve purchases government bonds and other financial asset from the market with the objective of increasing the money supply in the market and ultimately boost private sector spending.

Now that you have understood the definition, let us go a little deeper and understand how “Quantitative Easing” is actually done. There are four major collectives that are involved in this, i.e. the Federal Reserve, the Banks, other countries and the U.S. Treasury.

Again this concept is very vast and has a number of variables to consider but let us try to understand this concept better through this accurate illustration.

The Federal Reserve announces that it would like to purchase $10 Million worth of treasury bills, so the Banks and other countries purchase the treasury bills from the U.S. Treasury with the objective of selling them to the Federal Reserve.

The Various Banks and other countries quote their prices to the Federal Reserve, and the Federal Reserve in turn purchases it from the Banks and other countries, by simply electronically transferring money to their bank accounts, thereby “creating money”. This is very good for the U.S. Treasury because it drives up the demand for U.S.

Treasury Bills and other bonds of similar nature, but this is not permanent because, when the Federal Reserve decides to sell off these financial assets, the price of these assets would drastically fall, and could have far reaching impact on not just the domestic economy but the global economy as well. 

We can better understand the fall out effects of both of these methods through an economic concept known as the economic cycle.

Economic Cycle

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It is defined as “The natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). Factors such as gross domestic product (GDP), interest rates, levels of employment and consumer spending can help to determine the current stage of the economic cycle.”

Now let’s try to go a little deeper and understand this concept through an illustration. Mr. A currently has enough money to buy 10 apples worth 10 rupees, which he pays to the farmer, who uses that 10 rupees and buys groceries from a shop, the shop pays rent to the landlord who in turn pays salary to Mr. A, now Mr. A wants to see his family eat more so he takes a loan of 50 rupees from the bank, and from the next month onwards he starts buying 15 apples instead of 10, so now the apple farmer has 5 rupees more, so he used that 5 rupees to buy more groceries in the shop, the shop keeper has an additional income, so decides to pay half of next month’s rent in advance and the same thing happens with the landlord, he decides to pay an advance on Mr. A’s salary.

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This goes on for a while and everybody is happy simply because of the fact that their purchasing power has now increased , they are all satisfied with their income until the bank tells Mr. A that it is time for to pay interest, and he has completely utilized

all of the money he borrowed, so now Mr. A has only 5 rupees to buy 5 apples, this affects the farmer who also can buy 5 rupees worth of groceries, the shopkeeper also loses money, he pays half his rent to the landlord, who in return pays only half of Mr. A’s Salary and the next month he will have no money to buy apples, so he will have to use his savings. If we plot this scenario on a graph we will see a sine wave diagram.

This economic cycle takes place in two forms, long term and short term as illustrated in the figure above. The fact that we need to understand is that we are right now in the recovery stage and are moving towards the Boom stage and the rate at which this is happening is simply because of the amount of cheap credit that is available in the market and once we reach a stage where the huge debt has to be repaid, then the economy will see a drastic difference for the worse, and this will affect not just the United States of America but the world as a whole.

The Graphs and tables below illustrate the amount of debt that is held by some foreign countries

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From the data above we say without a doubt that any change to America’s economy will drastically affect the global economy.

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Chinese Economic Stability Risk

Let’s understand the worst case scenarios with a few examples, China Currently hold 1263.4 Billion Dollars’ worth of US debt, China is currently facing one of their biggest stock market crashes, and all this happened due to a market wide scare that has set in after sharp drop in prices.

Something that we must first understand is that even though China has the potential to become a global powerhouse, its investing culture is still immature and remains backward.  During the “Great Recession”, China struggled to meet its government’s 7% economic growth target, this was caused by a number of factors, and when the Real estate market crashed, Authorities encouraged people to speculate and invest on stocks.

This pushed the markets up to record highs, but it must be kept in mind the fact that this growth is fueled by speculation and therefore it can also be brought down by speculation.

Over the past few days government authorities and “private” Chinese brokerages and companies have taken up measures to push back the market

  • Brokerages and mutual-fund companies said they would buy billions of dollars’ worth of Shanghai shares.
  • A state-owned investment firm said it would buy China-based ETFs
  • Twenty-eight companies said they would put planned initial public offerings on hold, as IPOs had been the focus of the most intense speculation.
  • Regulators also increased the kinds of assets that can be used as collateral to buy stocks, to include people’s homes.

And despite all of these measures the downtrend continues, and a number of investment advisors such as Morgan Stanley and Citigroup have advised people to stay away from Chinese markets.

From the information above, it’s safe to speculate that China is looking at a serious economic downtrend, and with this understanding let’s move back to our study, where in during this moment of crisis, China may look to do the same thing that the US has done, that is to print more money and fuel their economy with debt, or they can choose to cash in on the debt that they already have with the US, which would be very bad news for the US treasury because that would mean that the supply would exceed the demand for bonds in the open market and ultimately result in a drop in value of these bonds, and therefore compromise the integrity of economy as a whole.

Although this scenario is unlikely, it is still an option for the Chinese government, another observation we must make is that China’s industries are dependent of business from countries like the US, so they would share mutual interests.

The concept that we must understand is that these economies are linked not just by trade and commerce, but financially as well, and any economic debt or crisis will greatly affect the economic system. At this point we can recall the illustration of how banks create money and the economic cycle, where our current economic situation is quite comfortable simply because the debt driven economy has increased our purchasing power and therefore we are satisfied, but there will be a stage where that debt reaches its maturity period and it would be time to pay that debt back. In such a scenario, we would be looking at a very different picture then we are used to right now.

Federal Government Expenditure

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The data below aims to identify the correlation between government expenditure and consumer price index. Granted there are a number of factors that affect inflation, but let us look at this from a data  interpretation perspective; we see an exponential growth in expenditure which is almost mimicked by the consumer price index, so there is a positive correlation excluding the period of the “Great Recession” where we see negative correlation caused by deflation.

People have been so used to an inflation that they factor it in when they calculate their investments or set up their 401Ks. But this was not the case always. If we were to look back in time at the same comparison we would notice that upon the event of any war, the government’s expenditure would go up and ultimately push inflation up too, but as Government expenditure came down, inflation would follow. After World War 2, we don’t see a drop in the government expenditure, and we don’t see any fall in consumer price index.

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This again goes back to the illustration of how, having excess purchasing power which is primarily fueled by the availability of cheap credit and capital in the market can lead to high inflation. One simple observation that you should understand is that despite the fact the at the inflation rates rise and fall over time, the consumer price index does not, and this is one of the main reasons why the value of money depreciates over time.

Difference between present and 1930

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Unemployment Rate

Now that we have understood the potential fallout effects, let’s take a step back and try to analyze, what differentiates our current predicament from what happened in the 1930s. One very crucial point to be noted is that we don’t have a scarcity of money in the market like the 1930s, this scarcity of capital lead to a number of businesses and banks closing down which ultimately lead to widespread unemployment. The graph and table below helps us understand the difference between then and now.

However one may argue that because of the abundance of cheap credit in the market, companies are able to use this money to restart and grow their business, but at the end of the day it is still debt and it has to be paid back, to which the next data set would paint a clearer picture, where we seek to analyze the correlation between unemployment and industrial production.

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From the data mentioned above we mostly can see negative correlation between the two economic factors, which tells us that with a growing industrial output, we see a fall in the unemployment rate, and post 2009 we see a healthy growth in industrial output.

A possible worry or an observation to make here is that we see positive correlation on certain time periods, and each of these time periods have an event or moment to possibly explain their volatility. Such as in 1969 which was the closest the US has come to experience fiscal tightening of 5% of the GDP in the post-WW II period.  In that situation, President Johnson and the Congress raised taxes by enacting the Revenue and Expenditure Control Act.  The goal was to pay for the Vietnam War and try to curb inflation. 

In the 1990s however the economy was in recession from July 1990 - March 1991, having suffered the S&L Crisis in 1989, a spike in gas prices as the result of the Gulf War, and the general run of the business cycle since 1983. A surge of inflation in 1988 and 1989 forced the Federal Reserve to raise interest rates to 8% in early 1990, restricting credit into the already-weakening economy. GDP growth and job creation remained weak through late-1992.

In 2002, we saw the stock market crash which was known to be “the internet bubble bursting” where a number of internet companies went bankrupt, coupled with a number of tech companies that went down in value and also the outbreak of a number or accounting scandals triggered one of America’s biggest  bear markets.

And in 2007-08 we see the event of the “Great Recession” which affected the global economy as a whole and pushed down the industrial production.

However in 2015, we see a downtrend, which may not be much of a concern, considering the fact that only half the year is completed, but it is something we should keep in mind.

Conclusion

The US Economy is currently fueled by large amounts of debt, and we may be riffing off into a bottomless cliff, if we continue to adopt the same policies we are now. From this study we can understand that the federal reserve is going to reach a point where they would have make a choice to dismantle the zero interest rate policy  and curb down on printing money for their quantitative easing strategy, which could possibly lead to stock market crash resulting in  another recession or a slump in a future point in time caused by a market scare coupled with the vast public and Government debt that has been accumulating over the past few years, or they can choose to continue the quantitative easing strategy and zero interest rate policy causing inflation to go up and ultimately depreciating the value of the dollar, which was similar to what happened in Germany where they had experienced hyperinflation.

A Possible negative fall out of this policy will be the depreciation of the dollar value, but this would pave a path for competitive foreign trade and hope to improve the industrial output and save the crashing economy similar to what happened in the 1930s.

Investors must plan their investment strategies based on the possibility of both these scenarios, so as to not be caught wrong footed when it actually happens.

Either of the cases, do not look very promising for the global economy, and this is something that needs to be discussed by central banks of the world, because if we allow this to continue the result would be far more devastating than the “Great Depression” due to the Globalized economy that we are currently in.

References

  • Bloomberg.com
  • Federal Reserve Economic Database (FRED) (research.stlouisfed.org)
  • Marketwatch .com
  • Wikipedia.com


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