The D Word

A Recession is when your neighbor loses her job,
A Depression is when you lose yours.
(old adage)

As the economic downturn continues, a lot of people have started to wonder if we’re heading into a Depression. Teevee shows, when they bring it up at all, usually prefer the term “D Word” so as not to scare anyone. Should we be scared?

A Depression is when there is a sudden shortage of money in the economy, making it difficult or impossible to function normally. The last time we had one, in the 1930s, there were distinct events that led up to this shortage of cash, such as:

Agricultural Crisis: The Dust Bowl was an “outside event” that hit at precisely the wrong time, destroying many farms throughout the nation and reducing hard working people to poverty.

Bank Failures: It is common to see the thousands of banks that failed in the 1930s as nothing more than the result of the Depression sinking into the economy. In truth, there were as many as 500 bank failures per year in the late 1920s, most of them small farm banks in the Dust Bowl. The 9 we’ve had so far in 2008 are small by comparison, but it’s worth watching.

Credit Crunch: The Roaring 20s were based on relaxed credit standards which resulted in business failures and foreclosures as early as 1925. By 1928 there was a serious shortage of credit throughout the nation, just as there is now.

Fed Action: The Federal Reserve had one big problem that we don’t have today: the Gold Standard. Because the US Dollar was backed by one ounce of Gold for every $20, Europeans bought up Dollars as rapidly as they could. The Federal Reserve actually raised interest rates in 1928 to combat inflation caused by a rapidly rising buck. We ended the Gold Standard in 1934 to finally work around this problem.

Stock Market: While most people will tell you that this marks the start of the Great Depression, it was only the most visible and obvious signal. The cash and credit shortages gripping the nation were already showing up as lower earnings and a feeling of looming dread. Wall Street took a dump because it was already scared bad, and not the other way around.

We have many of the key elements in place to have a real Depression. I’ve seen this coming for a bit over a year now, having writing an April Fool’s piece in 2007 about the Fed dropping money from helicopters. We may yet have to, since that’s the way you put money back into a system that desperately needs it. Well, not with helicopters, necessarily, but by printing lots and lots of money.

The problem with this scenario is that the Dollar is starting to look like a third world currency, and it’ll only get worse if oil is priced in something else. Every company in every nation that buys oil has to have either a reserve of greenbacks or at least some kind of hedge against its future value. If oil is priced in Euros or Gold we suddenly have a lot of extra Dollars in the world, meaning the value has to drop. It’s already north of $1.50 to the Euro and holding. We don’t have a lot of room to print more Dollars.

I see something like a Depression ahead, and I think we’re staring it right in the eyes. As John Mauldin says, over and over, “Inflation is not the problem.” No, the problem is that we are losing a lot of Dollars that exist only on computers at home while there is a excess of Dollars overseas. That’s a recipe for real disaster. Can we avoid it? I think we can, but it will take a lot of skill. Print too fast, and we’re buying $500B in oil denoted in Euros. That’s when we totally lose control and Depression becomes inevitable.