The Case For an Economic Depression

by Justin Weinger on September 21, 2007

The more I think of it, the more I can’t help but believe that we’re on the verge of an economic collapse on par with The Great Depression.

The American economy is built on a house of cards. Consumer spending makes up two-thirds of our GDP, which means we’re not a productive country, like how we were in the years following World War II, but that we’ve become a country of consumption and, most importantly, debt.

Most people are living beyond their means, buying things they not only don’t need, but can’t afford. For the last two years, and probably this year as well, the country’s net saving has been negative, meaning people have been spending more money than they’ve been earning.

On top of that, you’ve got seedy lending practices that helped perpetuate the housing and credit bubbles. These exotic loans were fine when the value of the house behind the loan was increasing 15% a year, but this growth certainly wasn’t expected to last forever. There’s a reason the saying “what goes up must come down” has been around for so long – namely because it’s true. Now we’ve got hundreds of thousands, if not millions, of people who owe more on their house than what the house would fetch out on the market.

Couple this with the fact that they’re facing higher mortgage payments on a house that’s losing value and you’ve got yourself a housing epidemic of unimaginable proportions.

That’s not to say that this is all the lender’s fault. Nobody held a gun to the borrower’s head and told them to take out loans that they couldn’t afford, or use creative financing to get into a house that was much bigger than what they needed. Many borrowers knew better, took a risk and got burned.

Regardless, falling housing prices will be catastrophic for the American economy.  We’ve been pulling out our imagined wealth in the form of home equity and using the money to fund our purchases.  What’s going to happen when this money is no longer available?

Finally, we have a global economy that is built on the belief that energy (specifically oil) will continue to be inexpensive as long as we need it. Our world runs on oil. Slowly but surely, demand has overtaken supply and since there’s no foreseeable drop in the demand for oil and there’s no foreseeable increase in supply, the cost of continuing the world’s growth oriented style is going to increase exponentially.

In two or three years, $80 for a barrel of oil (which recently happened for the first time) will appear amazingly cheap. Unfortunately, the only things that could prevent an energy crisis would be 1) vast economic slowdown throughout the world and/or 2) a decrease in the world’s population. If you get a chance, check out Soylent Green, a 1970’s Charlton Heston disaster flick, because it may very well be a glimpse of the future.

Don’t get me wrong, I understand that markets and businesses go through up and down cycles. My concern is that we’ve been in an up cycle since essentially 1991 (with the exception of a few months following the dot-com bust and 9/11) so I can’t help but think that we’re overdue for an equally strong downturn. And because of the things that I’ve pointed out, I’m afraid that this downturn is going to be more of an economic depression than a recession.

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{ 7 comments }

Kenneth September 21, 2007 at 11:58 pm

So What!!!….

First, I’ll say I’m an avid fan of your blog because I respect your point of view when it comes to finances. I think you are like minded and probably quite conservative with your money. I have a certain respect for people who choose to learn how to manage finances, and for that matter give enough crap about their own financial situation to actually do something smart, like live debt free and save money.

Anyway, on to my point… “So what?!“ Yeah, we’re over due for a market correction, it’s obvious, and I agree with you, it will happen. Will it be the great depression again, I don’t think so. Here’s why:

The great depression was a world wide epidemic, encompassing more than just one country. If you haven’t noticed, it’s only the US Dollar that is falling like a rock right now. Well duh, what is going to happen when you spend billions on an un-winnable war? Politics aside, and probably contrary to popular opinion, the “all mighty dollar” pales in comparison to some other currencies, especially when factoring those counties’ surpluses in cash. Don’t believe me; check out how much cash China has in the bank.

So really, sure the US is due for a recession to self correct the absurd housing costs, but get this… The people affected the most are the dumb ones who took out Adjustable Rate Mortgages, so yes, SOME citizens will give an ARM or a leg during our upcoming recession, but those of us able to actually manage money, realize the consequences of a contract, and only sign up for loans we can afford will be largely unaffected. If anything, the depression will just separate the “men” from the “boys”, meaning those willing to work hard will continue making income just fine, while those lazy folks will just be broke and on the street. The US offers us that opportunity, and always has. Those bight and resourceful can always find a way to survive given the worst obstacles… maybe it’s just part of some complex “natural selection” process.

Personally, I think we have a better chance of falling into marshal law than hyper inflation. Why, because American’s have a unique right (worldly speaking) to own a gun. I think a majority of them would defend their home from repossession with bullets long before bowing to banks given a situation where a majority of their neighbors where in the same situation. Luckily this is not likely, because the majority of home owners should be smart enough to not have signed up for those really crappy loans thinking their 15% annual gains would last. Those that dumb deserve to be upside down right now. If nothing else, that keeps them from moving and getting even deeper in stupid financial situations. Let me be clear though, it wasn’t the lenders fault these people are screwed, it’s theirs. Obviously you agree with that part.

In the end, I think those who are smart with money and debt free will ride out any recession no matter how severe. If anything, I foresee the rich getting richer and the poor getting poorer. Oh wait, that’s what’s been happening since 1991. Hmmm…

Brian Carr September 26, 2007 at 10:01 am

First off, thanks for taking the time to write the lengthy comment.

I appreciate your point of view regarding the fact the Great Depression was a product of failing economies around the world, not just the United States. That being said, I don’t think it would take much for the rest of the world to slip into a prolonged recession with the US. The reason I feel comfortable in saying this is because the world economy now runs on credit. If these credit markets fail, and with the fact that many, many people are leveraged to extremes it’s not a foregone conclusion that they won’t, then we could slip into world-wide economic problems.

I certainly agree with you regarding the mortgage mess, however, you have to look at how this will affect the economy in general. If we have millions of people instantly lose all credit worthiness and/or stop spending money because their mortgage just went up $800 per month, then our economy will collapse. 2/3rds of the economic activity in the US revolves around consumer spending. If that well dries up, the ripple effects throughout the rest of the country (jobs, salaries, etc.) will be terrible.

I only partially agree with you regarding who should get the blame for this. For years, it was standard operating procedure to require 20% down payment and a fixed rate loan in order to buy a house. Everything seemed to be fine. Then, all of a sudden, lenders began getting creative because they figured out ways to exploit the “American Dream” – which revolves around home ownership – and come up with crazy mortgages. I think deep down, lenders knew they were creating situations that would ultimately be hazardous, but, why ask questions in the midst of record profits?

Thankfully, many lenders, in having to choose between having a foreclosed property on their hands and swallowing hard and reworking some of the terms and conditions of the loans they originated in order to help people stay in their homes, are reworking the loans to mutual benefit. Ultimately, I think this is the best solution for EVERYONE involved. The reason being, it’s not a bailout – the home owner is still responsible for payment of the mortgage, the bank still gets paid, and, hopefully, everyone’s learned a valuable lesson.

Kenneth September 26, 2007 at 10:29 am

Wow, thanks for the reply!

Here’s a little more view into my blame on the consumer instead of the bank:

If a car company produces a car that goes really fast, but they tell you when you buy it that you will get an expensive speeding ticket every month starting 2 years from now, and you still buy the car, then how is this the car companies fault?

Sure, people took out these loans thinking they would just refinance again before the loan adjusted. That again is their own fault, now looking at historical trends, and thinking that their house would continue appreciating over and over. Personally, I believe refinancing your house for “spending cash”, depleting one of our best investments, is a dumb thing to do. It has its purposes, but it’s not magically free income to replace other sustainable revenue sources.

My personal believe is that education is the key to financial stability, not the responsibility of a bank or lending institution. As long as people are willing to sign up for high risk loans, they will continue to offer them. Also, financial responsibility reduces the credit problem you mentioned. Is it just that people are addicted to living beyond their means, hoping they will win the lottery or something?

As for the 20% down payment, my only argument there is a completely personal one as well. I own two houses, both on fixed rate loans, both I bought with 100% funding and near sub prime loans. The difference is, I have an “Un-American” credit rating, and I keep enough money in the bank to cover the loans for a reasonable time. I don’t think allowing someone with good credit to buy a home without a down payment is a bad idea. I’d rather keep my cash in the bank as a buffer to pay my mortgage should I need to. I guess most people don’t save money, or you wouldn’t have a reason to blog about it.

Brian Carr September 26, 2007 at 10:41 am

Thanks for your additional insight.

That is a pretty good parallel regarding the fast car and the ARM mortgage, and I certainly do agree with you that people shouldn’t have taken out these loans. Unfortunately, they did, whether it was due to lack of education, greed or (gasp) dishonest lenders.

I also agree with you regarding the fact it’s probably not a great idea to use your house as an ATM. My only argument for it would be to use the equity in your home to pay for something that will IMPROVE your life, e.g. your child’s college education, home improvements, etc. I don’t think people should have used their home equity to pay off car or credit card debt, even with the tax benefits. That is, it’s a bad idea only if the spending habits don’t change.

Living a frugal, fiscally responsible life requires some sacrifice. I would love to drive a brand new BMW, but I chose to drive a Dodge Neon because it’s cheaper and more practical.

In terms of the down payment, you do bring up a good point regarding having cash on hand vs. sinking it into a down payment. I guess that answer would have to come down to an educated, personal decision.

Kenneth September 26, 2007 at 6:54 pm

Hmm, never thought of the dishonest loan officer/lender angle. I wonder how many people got into ARM mortgages and didn’t even know it, or know what it meant. I guess that sort of relates to proper education though. Believe it on not, I’ve talked to people who didn’t even understand compound interest!? I learned that stuff in grade school!

Sure, refinancing has a positive side. I know several people upside down on their mortgages who think using it as a cash machine was one of them.

Sacrifice compared to say….letting credit card companies own your financial freedom with interest charges? I prefer to think of holding onto some of my money as a priority, that way it feels empowering, where as sacrifice sounds like you’re really loosing out. I’ll elaborate… (and this is a good topic for you if you haven’t written about it yet)

One of my favorite subjects to mention when talking to people who are drowning in debt is, “How much do you pay a month for TV?”. It blows my mind people who can’t feed their kids or cannot afford to buy diapers, have every channel, two DVRs ($10/mo rental!), the high speed internet option, and are three months behind on all their bills, but the priority is to pay the TV bill before shopping for groceries. Sorry, but giving up a $200/month TV addiction when you’re kids are starving, is a priority.

Not driving a Dimmer, well that’s a sacrifice, they drive so nice! Too bad my wife traded her old one in for a Ford!! 🙁

Brian Carr October 1, 2007 at 9:13 am

I guess my liberal use of the term “self sacrifice” was probably a bit unwise – it’s not a sacrifice to drive a junky car over a nicer car. A sacrifice would be picking up an extra job in order to pay for your kid’s school supplies.

I intended to more or less go down the path of people needing to be able to make the distinctions between needs and wants. I need a reliable mode of transportation to get me to work; I want a 7 Series BMW.

Dk March 10, 2008 at 8:57 pm

Sorry to be making noise on an old post – but wow how relevant this is to what is happening right now.
I think you are spot on about a depression being in the works as we speak.

It has much to do with the housing crisis, but also to do with outsourcing and excessive corporate greed.
It is truly spooky to read the reflections on the original great depression because of how similar those reflections are on the current crisis:
Marriner S. Eccles who served as Franklin D. Roosevelt’s Chairman of the Federal Reserve from November, 1934 to February, 1948 detailed what he believed caused the Depression in his memoirs, Beckoning Frontiers (New York, Alfred A. Knopf, 1951):

As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth — not of existing wealth, but of wealth as it is currently produced — to provide men with buying power equal to the amount of goods and services offered by the nation s economic machinery. [Emphasis in original.] Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.

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