2013-02-21

About that Depression: gold tells the tale

Here are several charts, all looking at the total credit market (which includes government debt at all levels). As you can see from the first picture, the growth of credit was a fairly consistent trend. The chart became exponential due to compounding interest. As the second chart shows, the previous decade saw credit growth at a minimum of 7.5% annually before the crisis. Going back to 1949, the slowest year saw 5% credit growth. The only comparable period to now in terms of decline in credit growth rates is the 1980s, when the country saw inflation rates decline throughout the decade. Slowing credit growth that took a decade in the 1980s, and still ended at the prior historical low for credit growth, occurred in a year across 2008/2009 and went to Depression era levels.




Based on history, if a recovery were underway, credit growth would be at least around 5% per annum. At that rate, the total credit market would be about $9 trillion higher than the latest figure indicates, a "credit gap" of 16%. Were the economy to grow credit at the higher 7.5% rate of the previous decade, the "credit gap" grows to $15 trillion, or 27% of GDP. As I have written previously, in Why QE3 will completely fail, the Fed's quantitative easing policies are not enough to fill this gap. There is very low money velocity because there is no demand for credit: the Fed is not printing new money, it is mainly monetizing the federal deficit. Federal deficit spending is the only thing keeping total credit positive and forestalling an "all out" depression. Without the federal deficit, the Fed would be powerless. Now you can understand why Paul Krugman and other Keynesian economists continually attack "austerity" and federal spending cuts.

Further, as I explained in State of play in Q32012: Fed and U.S. government policy is not enough to offset deflation:
There are many ways to estimate how much the Federal Reserve would need to print in order to create inflation. One way is to consider the ratio of credit money to M2. Assuming the economy will return to its “starting position” in 1980, when base money (M2) was one-third of credit money, the economy either needs to deleverage $25 trillion or the Fed needs to print $8 trillion. I do not hold this out as a definite estimate, but I believe these huge numbers are reflective of the depth of the current crisis.
I posted this graph of the ratio:

At the current rate of decline in this ratio, the bottom could be reached around 2020. If the Fed prints more, it will bring M2 up faster, if it doesn't print, private credit will deleverage falling faster than the federal government can leverage up.

While I agree with the general opinion of people such as Peter Schiff and Marc Faber, who point out that Federal Reserve policies and deficits will debase the dollar, in the short-term of 5 to 10 years (assuming no crisis), deflation remains a threat. In general, those arguing that inflation will come say that it doesn't matter if there's deflation, there will be a new QE policy. And there's some truth to that argument; ultimately I suspect they will be proven correct. Yet this week, we saw that Federal Reserve policymakers are growing concerned about Fed asset purchases. The Fed did not anticipate 2008 and they are unlikely to anticipate the next crisis.

Gold is the smart money. (Literally, it is the best money today.) The weakness in gold since the announcement of QE3 reflects the ongoing deflation. However, Fed printing is slowly having an effect, which is why we see higher lows during gold corrections. The net effect for now is inflation, but deflation looms large and suppresses gold rallies. If the Fed slows its quantitative easing, if the federal government reduces the deficit, we could see deflationary forces overwhelm the economy, along with further weakness in gold. Stocks will be pummeled as they were in the summer of 2010 and 2011, or even 2008 if a crisis erupts.

I expect the government and central bankers will take extreme measures in the end, most likely after another major financial crisis wipes out enough debt for organic growth to resume. Aggressive policies at that point will be unnecessary and will lead to rapid inflation, and then we will see precious metals hit their peak. Until then, the forces of deflation remain strong. The U.S. is truly caught between the Scylla of inflation and the Charybdis of deflation. Deflation is the unmovable object upon which trillions of federal debt and Fed monetization can barely make a dent. Slowly, slowly, inflation grows in strength, chipping away at deflation, but outside of a major positive shift in social mood, we will not see high inflation in the next few years. The United States (and most of the developed world) is in a depression and it ain't over yet.

Looking at gold today, at $1580, down rapidly from around $1700 last month, but up from sell-off lows Wednesday—a bottom here is very bullish, particularly if stocks continue to fall. The most bullish scenario for gold is a flat/rising gold price as stocks tumble and set up the next round of quantitative easing (or at least turn those inflation hawks at the Fed into doves). If we see gold continue to tumble, watch out. We could be headed for the worst market decline since 2008.

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