An Experiment in Scotch

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.