In the media these days, we’re hearing a great deal of noise concerning whether we are headed towards another Great Depression. Lots of words are being written about the likelihood of such an event happening but there are many things that are different about 2008 and 1929 (not the least of which is internet porn but I digress). One of the big differences that I hadn’t thought of is that in 1929, the U.S. had a current account surplus and most of Europe had a current account deficit. When the world fell into the depression, the U.S. suddenly had a tremendous overcapacity of production because Europe could no longer support the supply of goods coming from the U.S. What we needed to do at the time, among other things, was to cut production and increase domestic demand. What we did instead was enact the Smoot-Hawley Tariff Act which can be fairly summed up as having significantly worsened the depression. This Act attempted to restrict farm imports so that domestic farmers could increase their exports. This lead to many retaliations in other countries to restrict imports from the U.S.
Today, the situation is different. The U.S. runs a very significant current account deficit. Over the past 20 years or so and more so in this decade, we have become a nation of spenders and profligacy, both on an individual level and a governmental level. We can do this because in the global balance of payments, there are other countries that have historically been willing to finance our overspending by running surpluses. Of course, China is number one on the list. As anyone who has bought anything in the last 20 years knows, we import a great deal from China. On top of that, China finances our debt by buying our Treasuries.
If we want to compare our current financial meltdown to 2008, we must understand this reversal of roles. While there are many other differences, this one is important, especially for the Chinese role in the future. We would hope that the Chinese understand this history and would avoid our mistakes of the past, specifically trying to artificially keep exports high. Unfortunately, it appears that they do not. It would seem that the Chinese are trying to devalue their currency and subsidize exports in an artificial attempt to keep exports high.
The Chinese economy may very well collapse if these actions run the same course of 1929. The Chinese currently have a huge overproduction problem that has been masked largely by the spending of the American consumer. Because the American consumer could not continue to spend more than he earns, consumption on our side of the Pacific is down and falling like a rock. This has significant implications for China as without the American consumer, the Chinese must both cut production and attempt to increase domestic consumption. Instead, in an apparent attempt to save its own skin, the government is doing the opposite by devaluing their currency and attempting to artificially keep exports high.
What happens next is anyone’s guess but I’m betting we’re going to see some pretty terrible things going on in China. The Communists have never been known for standing for revolution but when unemployment in China hits 15 or 20 percent and babies start to go hungry, that’s likely what they’ll get. On top of that, I think there’s a non-zero, increasingly non-trivial chance that the U.S. may default on our debt. Were that to happen, those billions of U.S. Treasuries would be worthless and China would experience something very similar to 1929.
All those stories we’re reading about our current mess and how it compares to the Great Depression may yet turn out to be true but not in the way many of them think. While this is far from comforting, it’s important to understand how this time will be different from history if we want to do anything about it.
Interestingly, while the price of gold on the market over the past 6 months hasn’t been particularly stellar, the physical acquisition of gold has been growing more and more difficult over the past few months. The Perth Mint has stopped orders because demand is so high and I believe the American Mint has as well. There is a gold rush on that isn’t currently reflected in the price of gold on the open market but it probably will be soon enough.
These are scary times we’re living in and while I hold some optimism for the future, the next 5-10 years may be pretty difficult.
Thanks to Naked Capitalism, Michael Pettisand Tim Iacono for some fine writing that helped link many of the pieces above together. If you’re interested in our current situation, I highly recommend adding them to your RSS feed as they are smarter and have a better understanding of these things than I ever will.