Depression is Like Dentistry – Necessary and Painful

Bill Bonner - Mon 22 Jun, 2009

California to Make Deep cuts in School Budget as Depression Teaches us a Lesson

Paris, France

Monday, 22 June 2009

There are two major schools of thought on the bailout:

First, that the banks are still in trouble and need to be nationalized (Roubini, Krugman).

Second, that the banks are still in trouble, but that a public/private partnership can recapitalize them as they work their way out of the hole (Geithner, Gross).

As usual, we play hooky. Here at the Daily Reckoning, we’re not in either school.

In our view, the banks are in trouble because they lent too much money to too many people who couldn’t pay it back. They should take the verdict of the market... and hang.

Hey... won’t this cause a depression?

Ah... here is where we really part company with our fellow bipeds. We are in a minority... such a small minority that all its adherents put together could probably fit into an elevator. Because we believe that a depression is just what America needs... and what it’s going to get regardless of what the meddlers do. In fact, we think they will turn an ordinary depression into a Great one. Or maybe even a “greater depression,” as our old friend Doug Casey puts it.

Stocks barely moved on Friday. The Dow lost 15 points. Oil lost $1.76. Gold and the dollar moved little – the former up, the latter down.

California demonstrates what has to happen in an honest slump. They’re preparing for “deep cuts” in school budgets, say the papers. Naturally, the education lobby is howling. But most of the money spent on ‘education’ is wasted anyway. Cutting back might even help kids learn something.

Consumers are cutting back too. That’s probably the most important new trend to come with the post-Bubble era. Consumers are thinking small... smaller houses, smaller utility bills, smaller cars, smaller debts, smaller retirements.

That’s a change that’s likely to stick. They’ve seen where thinking big got them. Now, small is beautiful.

More on the big trends... after the news:

Andrew Vaughan sends us this note about the looming threat of inflation...

“A whole new generation is about to be whacked by inflation and high taxation once again. You must make sure that you’re not one of them, by acting now while inflation figures are negative and the threat seems remote.

“‘Equities are the best long-term investment – they protect you from inflation’ is a widely voiced sentiment, but one typically without any understanding of the science behind it. It is also only a half-truth, because some companies have no prospect whatsoever of protecting their shareholders from inflation. So which equities can protect us, and why?

“You’re not going to get the answer by looking at valuation yardsticks such as the PER or dividend yield. Nor will measures of financial strength, such as cash generation or debt levels give you a clue. Instead you need to understand the underlying business itself, and the markets in which it operates.”

Editor’s note: Andrew Vaughan is Investment Director of The Zurich Club, a private global network of knowledgeable investors. In the latest issue of the Club’s monthly newsletter, you’ll learn how to find the best inflation-beating equities. Click here to sign up.

And more thoughts...

*** Forgive us for repeating ourselves; but this is important. The main source of economic growth over the past 25 years was consumers’ willingness to go into debt to buy things. This spurred industries in Asia to marvelous feats of production. In the US, it caused a big increase in corporate profits. You see, labour is industry’s biggest expense. Taken all together, US companies pay US employees who buy the goods and services their employers produce. So, businesses have the revenue from selling to employees on the right side of the ledger and the cost of paying wages on the left.

But when employees began to buy more on credit, it was like a bartender who never asked customers to pay up. The companies had more revenue than ever. But they had no offsetting labour cost. Employees were spending money they never earned, so the extra sales went to the bottom-line as profit.

Earnings rose on Wall Street over the last quarter century as customers went further and further into debt. The companies selling credit – the finance industry – did especially well. And now its pay-back time. The bartender wants his money! Earnings and sales are falling as customers try to get out of debt. They collect the same wages – for a while – and cut back on spending.

Remember the chart we showed you on Friday? Consumers are saving more and spending less. This is a good thing for the individual consumer. But it is a bad thing to the economists who believe in consumer-led GDP growth. All of a sudden, the consumer is acting as though he had some sense. Naturally, government officials are determined to put a stop to it.

More banks were shut down last week. Banks go bust all the time. Nobody particularly cares. But some banks are said to be “too big to fail.” If they go down, people believe, they take the whole economy with them.

So the feds step in... either to nationalize the big banks… or to subsidize them. This, we are told, avoids worse damage.

Does it? How? If a bank has made a bad loan, there is a real loss of capital. Money has been spent – perhaps on concrete... perhaps on software... maybe on champagne. It’s not coming back. But, then come the bailouts. The people who made the mistakes are given an opportunity to make more of them – by the same people who were looking over their shoulders when they made the first ones.

What exactly happens to the money they receive is a matter of hot dispute. Some goes to pay the bankers’ bonuses. Some goes to pay their health spa fees and some gets lent out – in loans that are either better or worse than those that got them into trouble.

None of this corrects the mistakes. Depression is a natural thing. In our lexicon, it is the end of a major credit expansion. It is the point in the economic cycle when it becomes clear that many of the things for which credit was used were not good uses of money. The losses, mistakes and bad investment positions need to be recognized, worked out and written off. It takes time. And it is painful. But like dentistry, it is sometimes necessary.

You can paint a rotten tooth white and pretend you’ve fixed it. And there are a lot of people ready with a paint brush. But that won’t stop the pain. Better to yank it out... and get on with

As consumers stop spending, business sales and earnings fall... and so does employment. The unemployment rate is now over 10% in more than a quarter of the states. It’s sure to get worse. By the end of the year, it should be over 10% nationwide. As people lose jobs, they begin to think even smaller. Las Vegas holiday? Forget it! New car? Not without a subsidy; otherwise, we’ll stick clunker. Go out for dinner? Nah... let’s stay at home... and we’ll plant a garden too!

Welcome to a depression. Not such a bad thing, really. Just a period of adjustment... a time for fixing, re-organizing, downsizing, and mending. There’s a time to every purpose under heaven. This is the time to take stock and shape up.

But wait again. It doesn’t FEEL like a depression. Where are the soup lines? Where are the Okies packing up and moving to California? Where are Ziegfield Girls, the Civilian Conservation Corps and Eleanor Roosevelt? How come this depression’s not in black and white?

Well... because this is a 21st century depression. This depression is in living colour... and it comes to a world that is much richer than the world of the 1930s. Besides, it is just 1930... not 1932. Give it time.

*** And here’s the latest from Argentina. The country faces a financial crisis with elections only a week away. Nestor Kirchner, husband of the present president, is running against a man who seems to know a lot about money. Francisco de Narvaez increased his own wealth 900% in the four years 2004-2008. How did he do that? Well... that’s what everyone wants to know. De Narvaez has been accused of drug dealing... but so far nothing has been proved.

We turn again to Argentina to try to understand how financial crises work. Studying major financial crises in America requires too much patience... and remarkable longevity. The last depression in the US was in the ‘30s. And you’d have to go back to the War Between the States to find currency troubles anywhere near to those Argentina suffered in the last 25 years. “Argentina has a financial crisis about once every 10 years,” say the locals. “And each crisis lasts about 10 years.”

If you had 100 billion pesos in 1983 you would have been a very rich man. And if you had held onto your pesos for ten years... at the end of the period you’d have just enough money to buy a cup of coffee. Then, in order to prevent further inflation, the American-advised Menem government started linking the peso to the dollar. One peso = one dollar. End of story? Not exactly. Since it had solved its currency crisis, the Menem government could borrow money again (people didn’t have to worry about the inflation risk.) It barely hesitated. It borrowed heavily – though not as heavily as the US currently – and soon ran into more trouble. Then, in the early 2000s, another crisis struck. If you’d held your coffee money for the whole decade ’93 – ’03, you got a shock at the end of it. The Argentine government froze your bank account and devalued the peso by 2/3rds.

You’d have to go back to the Roosevelt administration to find a similar episode in the US. The New Dealers reshuffled the deck, just like the Peronists would do on the pampas 7 decades later. Team Roosevelt closed the banks, seized the gold, and then devalued America’s money – again, by about 2/3rds.

The upcoming election in Argentina could go either way, we are told. One poll puts Kirchner ahead by 10 points. Another puts him behind by 5 points. And who knows what will come out in the news!