…how does it all work?

We’re doing some serious thinking this week. What is it that actually causes a depression? A stock market collapse? Or too much debt? How come government can appear to cure the problem sometimes – 2001-2007 – but not other times? How come the Japanese were not able to increase consumer prices? Even now… Japan’s inflation rate is negative. And how come, despite the most massive effort at monetary inflation ever undertaken, the US bond market still forecasts an inflation rate of less than 2%?

An interview with Richard Koo, author of ‘The Balance Sheet Recession,’ and a new book by Ken Rogoff and Carmen Reinhart are helping us understand what it going on. More to come…

In the meantime, the Dow went down 42 points on Friday. Gold dropped $7. Still no sign of the Chinese coming to the rescue in the gold market.

“Global rally shows signs of running out of steam,” says the Financial Times.

Reuters says the job data will “test the rally.” The New York Times says the ratio between job seekers and jobs available has never been worse.

The Wall Street Journal, on the other hand, tells us that greater than expected profits will support the rally. So far, the increase in stock prices has not come from increased earnings. It’s come from increased P/Es… based on the hope of higher earnings. In terms of forecast earnings, the Dow is selling at a P/E ratio of 27. But in terms of actual, reported earnings… the ratio is 180.

A friend made the mistake of asking us what to expect from the economy. We said it would go do down.

“You mean, you expect a W-shaped recovery,” he said… “a double-dip recession?”

“No… we expect no recovery at all. It’s a W without the last stroke… ”

Of course, we were exaggerating. But not much. We do not think that the economy of the Bubble Era can ever be revived. It will never recover; because it is dead.

But that doesn’t mean we will march backward forever. The economy may lose 10% of GDP… maybe 20%. But we do not expect to be slithering in the mud of the Middle Ages, with each man planting his own wheat and brewing his own beer. No, not at all. It only means that the depression must continue until it comes to an end.

“But when will it come to an end?” you ask.

“When it is over.”

A depression ends when it has done its work. It must correct mistakes. It must punish errors. It must destroy the bubble economy… and the mindset of the Bubble Era. Only then can new real, sustainable growth begin again.

So far, in 2009, 95 banks have gone broke. How many more need to go broke before the depression is over? We don’t know. This is where is gets complicated. Because the feds are determined to keep us from finding out!

Here’s how it works. The Fed lends the bankers money. Then, the bankers turn around and lend it back to the feds. The banks are happy; they’re making money on a risk-free trade. The regulators are happy; what could be safer in a bank’s vault than US Treasury bonds? Investors are happy; it looks like the financial sector is making money again. And the feds are happy; they’re able to finance their deficits.

Who’s not happy? So far, so good. But hold on…

“This is not a sustainable recovery,” says fund manager Crispin Odey in the Financial Times.

What a spoilsport! You mean, you can’t build a lasting recovery on debt and shell-game finance?

Nope. Apparently not. Just look at what has happened to the auto industry. The feds borrowed money to help Americans pimp up their rides. And this Thursday, when September sales figures come out, we find out how sustainable that boost was. Many Americans got new wheels. But now they don’t need new wheels. And now the feds are out of the auto-incentive business. So now we get to see what happens next.

“Oh Daddy, I felt so sorry for Annabel… ”

Maria was on the phone. She was telling about one of her friends… and money worries…

“She was sitting on the couch. And all of a sudden she burst into tears. She was crying because she is out of money…

“Her car broke down and she doesn’t have the money to get it fixed. And she had to go and have some medical work done. She just doesn’t have any money left…

“And she’s already working all she possibly can. She works with me at the studio. And she picks up bartending jobs on the side. She works all day… and then works at night too. But I think it is getting to her. She just can’t go on…

“I asked her if her folks could help her out. But she said that her father lost his job in the recession… and they don’t have any money to lend her.

“Honestly, I felt so lucky to have you behind me. I don’t know what I would do if I didn’t have the family supporting me. I guess I just wouldn’t be able to keep going either. I’d have to give up the idea of being an actress because it’s almost impossible to support yourself and still go to all the castings and try-outs.”

Elizabeth added a comment:

“I was talking to [a French friend]. He thinks it is typically American to expect each generation to make it on its own. Americans think they should put aside enough money to pay their retirements, and that’s all. They don’t worry about their children. They think the children should take care of themselves. Anyway, that’s what he thinks Americans think… and he’s probably mostly right about it.

“The French attitude is much different. They keep the children closer… and help them more. He’s got five children and he wants to be able to leave them something. He’s just begun a new business venture, because he says he wasn’t able to earn enough in his job.

“He makes a good point: when you have to start from nothing, you just won’t get as far. You know, it’s a bit like what Newton said. He was able to make spectacular progress because, as he put it, he could ‘stand on the shoulders of giants.’ But that’s true for everything. One generation stands on the work of the one that came before it. And if there is nothing to stand on… they have to start from scratch. They are able to do more… if they have a firm foundation to stand on. And there are somethings they couldn’t do at all without it. Maria, for example, would be forced to get a more serious job, if we weren’t helping her with her bills while she’s getting established. And Jules, too. He wants a career in music. But if he couldn’t count on us to help him, he’d probably have to do something that pays better now.

“There’s a lot to be said for the American can-do emphasis on self-reliance. But there’s something to be said for the French attitude too. The ideal is to give your children the spirit of self-reliance and the confidence that comes from making it on their own… but also to give them something to work with… so they don’t have to start at the very bottom.”

Until tomorrow,

Bill Bonner

Source: Correcting Mistakes and Punishing Errors

A majority of those polled by Bloomberg think it’s great; 61% said they thought they economy had taken off and was flying high. Stocks are up. Commodities are up. And here’s another Bloomberg headline: “Global investors give Federal Reserve Chairman Ben S. Bernanke top marks…”

The recovery has won the approval of economists and the public. It has almost everything going for it. It just won’t fly!

Comes news this morning that the US economy is still on the runway. This report from the AP explains why:

“WASHINGTON (AP) – Consumers slashed their borrowing in July by the largest amount on record as job losses and uncertainty about the economic recovery prompted Americans to rein in their debt.

“Economists expect consumers will continue to spend less, save more and trim debt to get household finances decimated by the recession into better shape. Such behavior, though, is a recipe for a lethargic revival, because consumer spending accounts for 70 percent of economic activity.

“The Federal Reserve reported Tuesday that consumers in July ratcheted back their credit by a larger-than-anticipated $21.6 billion from June, the most on records dating to 1943. Economists had expected credit to drop by $4 billion.”

Hey, not bad… economists were only off by 440%. Consumers are paying down debt more than 4 times faster than they thought. Partly because they want to. And partly because they have to. They don’t want to borrow… and banks don’t want to lend to them anyway. Consumer credit is falling at a 10% annual rate, based on July figures. Credit card debt is going down at an 8% rate.

When they pay down a dollar’s worth of debt that is one dollar less in the consumer economy. But it’s also a dollar that is not borrowed. Where the consumer spent all his income two years ago… and borrowed more so that he could increase his consumption even further… now, he doesn’t borrow… and he doesn’t spend all his income either. Now, the money that used to pour into consumer spending leaks out.

As we reported yesterday, personal spending is dropping… the figures were down in 4 of the last 6 quarters – something that has never happened before, since they began keeping records in 1947. And the level of consumer spending is down 33% from a year ago – with discretionary spending now down to a level it hasn’t seen in 50 years.

Of course, that’s just what we’ve been saying. The great credit expansion began in 1945. It ended in 2007. Credit will contract for many years. One study, also reported here, suggested that consumers would spend 14% less – even after the economy was back on its feet. We estimate that the total level of debt must go down below 200% of GDP. If that’s correct, we need to pay down about $25 trillion of debt. That won’t be easy and it won’t be quick.

And it will mean high levels of joblessness for a long time. Already, two out of five working-age Californians are unemployed. The other three are working the shortest workweeks in history. No wonder; with spending dropping, sales are falling. So businesses don’t need so many people to make, ship, sell and service their products. Then, of course, when they lay off workers to cut expenses, the unemployed workers have to cut spending!

How is it possible for a consumer economy to grow when consumers are spending less money? Of course, it’s not. This is not a genuine recovery… it’s an imposter. A fraud. A recovery impersonator.

While the private sector is paying down debt, the public sector is adding debt at a ferocious pace – about $150 billion per month. Public spending isn’t the same as private spending. It is usually spending for things that people wouldn’t buy if they had a choice. And it comes with a whole new risk attached – the risk that the feds will inflate their way out of debt rather than pay it off.

Government spending does not bring a durable, real prosperity. (If it did… think how easy it would be to make people rich; governments love to spend money!) It may look like a recovery. It may have shiny wings and spiffy-looking stewardesses. But it won’t fly.

*** The World Economic Forum has taken the US down from the number one position. America is no longer the world’s ‘most competitive’ economy. That title goes to Switzerland.

Meanwhile, the US banking system is rated #109 in the world – just below Tanzania. US banks became leveraged casinos during the bubble years. They’ve still got a lot of leverage… and are still trying to relive those glory days when players lined up to spin the wheel… and free drinks flowed by Niagara Falls.

*** “Keeping up with children is a full-time job,” said Elizabeth last night. “There is always at least one of them who needs help. Sometimes more than one.

“Sometimes I wonder if we shouldn’t devote ourselves more fully to helping them. That’s our main project, isn’t it? It’s the thing that is most important, isn’t it?

“So… shouldn’t we go to where they are… and give them advice… help them get their careers and families established? I mean, we’re in Europe. Our children are mostly in the US. Shouldn’t we go back so we would be available to help them? Maybe we should rent a house in Los Angeles and stay there until Maria’s acting career is on a more solid footing, for example. At least, she’d have somewhere to go for Thanksgiving…

“The prevailing view in America is that children leave the nest when they are 18 or 21… and then, they’re on their own. But that’s not the view here in Europe. In Paris, I know lots of parents who stick with their children all their lives. They spend their vacations together. The parents buy an apartment for the children. They direct their careers… and pass judgment on marriage prospects. Not that the children always listen, but one generation is not left to its own devices. That’s why inheritance is such a touchy issue in France. People aren’t expected to make it on their own… they’re expected to get as much support from the family as possible…

“Sometimes I think we should take the same attitude. And we do to some extent… Still, I’m not sure the children would appreciate our help. I’m not even sure our help would really be much use. Sometimes they just need to make their own mistakes…

“Besides, we have our own projects… our own lives. I just don’t know what is best…”

Source: A Recovery Impersonator

And down in Flawda, the Miami Herald reports that the unemployment rate has risen over 6% – its highest level in 13 years. Florida, along with California and Nevada, is where house prices are falling fastest. Many of the people who used to work in construction, or real estate, or installing granite countertops, or financing houses are now looking for work.

And here, we pause a moment to remember what a joke of an economy we Americans have created. We mentioned it last week. Fortune magazine reported a study that compared Germans to Americans. It found that Americans did not work more hours, after all. We work about the same number of hours as Europeans, generally. But Americans tend to do their work at low-skill, service jobs – like flipping hamburgers or cleaning driveways. Germans work at real careers, cook their own hamburgers and clean their own driveways. Germans put in fewer hours “on the job,” as a result.

But in the curious way in which statistics become confused with knowledge, the statistics on hamburger joint revenue get fed into the figures for GDP growth. Then, it looks like the U.S. economy is doing better than the German economy, even though both groups may be eating exactly the same number of hamburgers. And then, too, U.S. economists and politicians believe they have found the secret to economic success; because the US model puts people to work…and boosts GDP growth. Soon, they are giving advice to the Chinese and wagging their fingers at the Europeans. It’s only later, when the credit runs out and their service industries go broke…that they get the punch line – good and hard. Then, they have to cook their own hamburgers again.

Bill Bonner
The Daily Reckoning

Source: The Word on the Street

The trouble with following the financial news is that there is so much of it. Everyday brings news information, new facts, new theories – dozens of them. The financial news becomes like a dense Russian novel, with so many characters coming and going that we forget the plot.

Of course, if you’re reading Dostoevsky this summer, you can always stop, flip back and figure out what is going on. In the financial markets you can never stop. The news just keeps coming…the absurd character keep popping up…the intrigues and sub-plots get denser and more confused.

And yet, it’s in the financial markets that the plot really matters.

A serious investor is probably better off with neither television nor newspapers to distract him. In fact, he would probably be better off never reading The Daily Reckoning either. It would force him to pay attention to only what he actually knows or can find out. He might study a local bank, for example…meet its management, explore its ledgers, and parse its financial statements. He might find that it is a good investment – or a bad one. In so doing, he is much more likely to be right than the fellow who reads Barron’s and decides that it is a good time to get back into the bank shares.

But here at The Daily Reckoning, we are not investors. Our job is to keep an eye on the financial news and try to make sense of it. It is a vast and confusing story; our mission is to try to keep track of the main plot.

Yesterday brought more complicating details. The Dow sold off another 109 points. Oil rose $3.44. The dollar was up slightly…still at $1.49 per euro. And the price of gold leaped up $16.90. The 10-year T-note rose to yield 3.94%.

We suggested a possible plot outline yesterday:

Boy meets girl. Boy and girl go on spending spree. Wall Street and Washington collude to cause them to spend more than they could afford and to go much further into debt than they should. Boy and girl can’t pay their debts; they’re losing their houses. The moneybags who lent to them are going bust.

Subplot: Meanwhile, on the other side of the planet, the foreigners who kept selling them gadgets and gizmos are running into trouble. So, they’re buying less stuff to make gadgets and gizmos with. And, wouldn’t you know it, the people who sell them stuff – oil, copper, coal and so forth – are also running low on cash, because the price of their stuff is falling.

As the curtain went down last week, it looked as though the whole world economy were sinking into a soft, slow, Japan-like mud.

The storyline seems solid enough. The facts seem to fit more or less. But we have a strong feeling that there are more twists and turns in this plot…and that, when the show is over, the story will turn out be very different.

In the first place, the boys and girls may be in bigger trouble than we’ve seen so far – and there may be more of them.

“Skies Darken for Retailing as Spree Fades,” says a headline in the Wall Street Journal. U.S. retail sales fell in July for the first time in five months. Rising sales were misleading anyway; they were more a reflection of higher prices and rebate checks than of an actual increase in either the consumers’ willingness or ability to spend more.

Meredith Whitney, one of the few professional analysts who foresaw the subprime crisis, says that the downturn will be more severe than people yet realize. One in ten households overextended itself in the bubble period, she points out. Bankruptcy, default, and foreclosure rates will inevitably worsen as these Jacks and Jills roll down the hill.

Toll Bros., one of the country’s biggest builders, announced that revenues were still going down.

Anyone waiting for the financial industry to return to the glory days of 2006 may have a long wait. As a credit-fueled boom turns into a bubble, it takes more and more lending to produce an additional increment of GDP growth. In the real boom years after WWII, it took about $1.40 worth of credit to produce $1 worth of GDP growth. The ratio rose sharply after the Reagan Revolution…and now stands at about $6 of credit to every extra dollar of GDP. Of course, that is why Wall Street made so much money – it was selling credit. But it’s also why that story is history; that show is over. As the cost of growth – in terms of credit – rises, so does the cost in terms of debt service. Even at 5%, the cost of $6 of credit is 30 cents per year. If it produces $1 of GDP growth, that extra output would need a 30% profit margin to break even. Not very likely.

And the good news just continues to pour in from the housing sector. RealtyTrac reported this morning that bank seizures of U.S. homes have risen 184% since the group began tracking this data in 2005. Banks have repossessed close to 3 times the amount of homes in the United States, when compared to last year’s stats.

One in four houses sold in America today is sold at a loss, says a report on CNNMoney. That totes up to a lot of losses for the whole financial chain…the homeowner, the mortgage company, the builder, the real estate agent, and the investor who bought a mortgage-backed security.

This epic rise in foreclosures is depressing home values throughout the country. The S&P/Case-Shiller index shows that home prices fell 15.8% in May.

Real estate website Zillow.com reports that in the year leading up to June 30, almost 25% of all homes sold in the United States pulled in less than the seller originally paid.

CNN.com reports: “In Merced, Calif., 63% of homes sold during the past 12 months brought in less than what the owner paid. Prices there have fallen 40% over the past 12 months and 56% from their 2006 peak.

“About 63% of sellers in Stockton, Calif., lost money during the same period, 60% in Modesto, Calif., 55% in Las Vegas and 38% in Phoenix.

“And the trend has worsened in recent months. In Merced, 74.9% of sellers took a loss when they sold during the three months ended June 30 compared with just 28.7% during the same period in 2007.”

The bottom is still not in view – Zillow.com says, “With $3.9 million unsold homes on the market, prices will have to come down even more before the market stabilizes.”

We can all agree that many things need to occur to stabilize the U.S. economy as a whole – and there may be more of these ’supershocks’ to the system on the way. There’s no reason, however, for you to not make a little money in the meantime. Our friends at Strategic Investment have put together a Financial Survival Library – and it’s a must-read for anyone who wants to stay afloat in the current market climate. Click here for all seven of the financial survival steps.

*** While the United States may be in greater trouble than the markets realize, China may be in less. In other words, the slump in the West may not be so soft. In the East, it may not be in a slump at all.

Retail sales in the United States are falling, but sales in China are going up at 23% per year. Even after inflation, they’re going up at 15% – the fastest pace in 9 years. Sales of gasoline are increasing at a 55% annual rate.

Incomes are rising too – real, after inflation incomes are going up at an 8% annual rate.

In other words, maybe China is not slowing down very much, after all.

Remember, if these big, emerging economies can continue to grow, it will keep the pressure on prices for raw materials. This then makes the situation worse for Americans; they pay more for food and fuel…even as their incomes and assets fall in price.

*** “Oh yes, we met a couple of years ago,” said a new friend at a party last night. “You said to buy gold. At the time I thought it was a little flakey…buying gold, that is. But then the price went up…and I thought of you.”

“Well, it isn’t going up now,” we replied. “But we wouldn’t give up on it. Not yet. Most analysts think the crisis in the financial sector is pretty much over. They think we’ve seen the worst. They don’t expect any more major banking failures. They think the dollar is coming back. And they expect the rate of inflation to moderate. They’re looking for a huge soft landing for the entire world economy.

“But financial analysis, at least on this kind of macro level, is mostly fraud. It’s impossible to keep track of all the various inputs – many of them purely psychological or emotional – and make a logical judgment about what will happen. You can form an opinion. But your opinion is usually driven by some kind of philosophical prejudice. Say, for example, you just don’t like to see all those Wall Street hotshots making huge bonuses for doing something that you know is mostly a kind of razz-ma-tazz designed to wow the little guys in the market. Then, you’re sure that they’re going to get their comeuppance, one way or another. So you look around and try to find justifications for your point of view. And there are so many facts and theories around, you can always find whatever you’re looking for.

“You know, things in the financial markets have been going very well for a very long time. Major stock market indices are down only about 15% from record highs. No major economy is even – for now – in a recession. Unemployment in the U.S. still hasn’t risen to 6%. Gold is no higher than it was 28 years ago – in nominal terms. People still lend money to the world’s biggest debtor – the U.S. government – at only 3.94% for 10 years. And the dollar is still taken as a ’store of value,’ even though there are trillions of them in central bank vaults…and a whole rickety tower of dollar-based credits reaching up to the sun.

“But investors talk as though it were the end of the world. It’s not. It’s only the beginning of a major correction…and probably, only the beginning of the beginning.

“And when it is over, people will want more than 10% yield before they will lend to the feds. The world’s monetary system will probably have collapsed and been replaced with something new. Stocks will probably sell for less than 8 times earnings. Ten percent of the U.S. population will probably have gone bust – that’s 30 million people. And gold will probably sell for more than $2,000 an ounce.

“Of course,” we had to admit, “between here and there, anything could happen.”

[Ed. Note: But we know that our long-time DR sufferers have been paying close attention, and preparing for the long correction ahead. In fact, some very savvy investors have taken it upon themselves to secure an extra paycheck - without the hassle of extra work. If you haven't secured your extra income yet, don't wait any longer. The next payday is tomorrow, August 15…learn more here.]

*** “Won’t these string beans ever stop?” our cook wanted to know. She’s already filled the freezer with them…and already stuffed every jar we own with canned green beans. And she’s served them up at every meal in every possible way. Fried. Steamed. Grilled. Boiled. Braised. In soufflés. In casseroles. In soups. In stews. In salads. She’s probably slipped them into some desserts too, but we didn’t detect them.

Damien had just come up to the kitchen with another 5-gallon bucket full of them.

“Oh no…not more green beans,” said Edward. “We eat green beans all the time. I’ll never want to see another green bean as long as I live.”

“Then don’t look in the pantry,” said the cook.

Until tomorrow,

Bill Bonner
The Daily Reckoning

Source: The Plot Thickens…