The Next Great Depression Is Almost Here

The next economic depression is coming due to crushing debt, FX denominated loans, loan bubbles, and perpetually low prime rates on fiat currencies.

To understand my line of thinking in this blog post, I strongly suggest to read an article about the many theories of the causes of the Great Depression. There are many theories regarding the causes of it and many of them seem to be able to explain aspects of it very well. In particular, debt and an inflationary money supply are featured prominently in the debt deflation theory by Irving Fisher and the theories by the Austrian school of economics.

While reading the article, please keep in mind that the US and China were the two largest economies in the world in 2018 according to the International Monetary Fund contributing 24% and 16%, respectively, of the nominal world GDP. The European Union as a whole was responsible for 22% of nominal world GDP in 2018.

The underlying problem is that the combined debt of governments, central banks, non-financial corporations, and households reached almost 400% of GDP this year [1]. This is by far the highest it has ever been and this pile of debt includes loans issued in foreign currencies [2], the debt from the forced Chinese GDP growth [3], and the massive amounts of BBB loans in the US [4, 5]. Just consider that 600 billion US$ worth of sub-prime mortgages sufficed to ignite the Great Recession in 2007 whereas there are now 2,500 billion US$ of BBB loans. The loan problem is similar in China where the government forced its banks in mid-2018 to keep buying AA- or lower rated bonds [6]. Due to to the perpetually low prime rates, I assume the situation is similar in the Euro zone.

High levels of debt make the whole economic system susceptible to failures of debtors and the banks lending to them but large amounts of debt on their own do not cause recessions (see Japan). Instead, bad performance of the economy must be combined with a kind of "trigger". It seems that many indicators of the well-being of the global economy are worsening, e.g., automotive sales are down world-wide [7] and global trade dropped to Great Recession levels [8]. Moreover, while the stock market is not identical to the economy, the two are often behave similarly. The global stock market has been driven by buybacks since at least 2018 [9, 10, 11], the S&P Small Cap 600 never recovered the losses incurred after the September 2018 stock market crash (the S&P Small Cap 600 is supposed to be representative of small and medium-sized business profitability), the cyclically adjusted price-to-earnings ratio (CAPE, [12]) is at 29, CAPE was near 32 when the Great Depression started, and it was at 33 in January 2018 [13]. Also, investors seem to be moving into government bonds meaning they prefer low risk and low interest over higher risk, higher yield business investments [14]. The hot trade war between China and the US after the breakdown of the negotiations on May 10 could have been the trigger for an economic downturn  with the first bankruptcy ever of a Chinese bank with corporate depositors as first victims [15].

There are many theories regarding the causes of the Great Depression and some of them led to (proven) tools how to avoid a repetition. Unfortunately, many of these tools will not work. The Monetarist theory argues that the shrinking money supply caused the Great Depression. Debtors will default causing banks to fail or at least liquidate loans. This leads to a contraction of money supply but after a decade of almost zero interest rates or even negative interest rates in the USA, the Euro zone, and other countries (e.g., Switzerland, Sweden), quantitative easing likely lost its effect. The Keynesian theory argues that government spending would aid economic recovery and this theory was "proven correct" when the US government spending increased at the entry into World War II and the Great Depression ended.  Unfortunately, government spending is already high. This is true for Japan, China with its debt-financed GDP predetermined by the government [3], the USA with its massive public debt and its huge spending on interest [16], as well as the Euro zone with its European central bank buying Euro zone government bonds [17] artificially decreasing interest.

With record levels of global debt and blunt tools for fighting a recession, the next economic downturn will develop into the next Great Depression.

Afterword

Originally, I intended to write a longer blog post with explanations of, e.g., GDP and price-to-earnings ratio but after the Baoshang Bank bankruptcy on May 24, 2019, and the investor move into government bonds in the following week, it seemed that the global economy was on the eve of the next Great Depression and that I had to publish immediately to keep this blog post a prediction.

A final note on the US/Chinese Trade War: While the US Tariffs may increase consumer prices, it is also true that the Chinese government flooded the world market with subsidized raw materials and subsidized products [18, 19]. With this idea in mind, I really wonder if the trade war spells the end of China's massively debt-financed industrial growth because Chinese companies might be forced to compete at real market price.

References

    [1] E. Tiftik and K. Mahmood, "Global Debt Monitor – January 2019," Institute of International Finance 2019.
    [BibTeX] [Download]
    @techreport{TiftikM2019,
    author = {Tiftik, Emre and Mahmood, Khadija},
    title = {Global Debt Monitor -- January 2019},
    year = {2019},
    url = {https://www.iif.com/Portals/0/Files/Global%20Debt%20Monitor_January_vf.pdf},
    institution = {Institute of International Finance},
    }

    [2] T. Durden, Lira Plummets On Turkey's Plans To Transfer \$6.6 Billion From Central Bank, 2019.
    [BibTeX] [Download]
    @misc{Durden20190513,
    author = {Tyler Durden},
    title = {Lira Plummets On Turkey's Plans To Transfer \$6.6 Billion From Central Bank},
    year = {2019},
    url = {https://www.zerohedge.com/news/2019-05-13/lira-plummets-turkeys-plans-transfer-66-billion-central-bank},
    }

    [3] M. Pettis, What Is GDP in China?, 2019.
    [BibTeX] [Download]
    @misc{Pettis2019,
    author = {Michael Pettis},
    title = {What Is {GDP} in China?},
    year = {2019},
    url = {https://carnegieendowment.org/chinafinancialmarkets/78138},
    }

    [4] J. Edwards, The risky `leveraged loan' market just sunk to a whole new low, 2019.
    [BibTeX] [Download]
    @misc{Edwards2019,
    author = {Jim Edwards},
    title = {The risky `leveraged loan' market just sunk to a whole new low},
    year = {2019},
    url = {https://www.businessinsider.nl/leveraged-loan-record-87-percent-covenant-lite-2019-2/},
    }

    [5] L. Roberts, What Could Go Wrong? The Fed Warns On Corporate Debt, 2019.
    [BibTeX] [Download]
    @misc{Roberts20190509,
    author = {Lance Roberts},
    title = {What Could Go Wrong? The Fed Warns On Corporate Debt},
    year = {2019},
    url = {https://realinvestmentadvice.com/what-could-go-wrong-the-feds-warns-on-corporate-debt/},
    }

    [6] T. Durden, China Launches Quasi QE To Support Banks and Sliding Bond Market, 2018.
    [BibTeX] [Download]
    @misc{Durden20180718,
    author = {Tyler Durden},
    title = {China Launches Quasi QE To Support Banks and Sliding Bond Market},
    year = {2018},
    url = {https://www.zerohedge.com/news/2018-07-18/china-launches-quasi-qe-support-banks-and-sliding-bond-market},
    }

    [7] M. Snyder, Here Are 15 Numbers That Show How The Global Economy Is Performing, And All Of Them Are Bad, 2019.
    [BibTeX] [Download]
    @misc{Snyder2019,
    author = {Michael Snyder},
    title = {Here Are 15 Numbers That Show How The Global Economy Is Performing, And All Of Them Are Bad},
    year = {2019},
    url = {http://theeconomiccollapseblog.com/archives/here-are-15-numbers-that-show-how-the-global-economy-is-performing-and-all-of-them-are-bad},
    }

    [8] T. Durden, Global Trade Collapsing To Depression Levels, 2019.
    [BibTeX] [Download]
    @misc{Durden20190515,
    author = {Tyler Durden},
    title = {Global Trade Collapsing To Depression Levels},
    year = {2019},
    url = {https://www.zerohedge.com/news/2019-05-15/global-trade-collapsing-depression-levels},
    }

    [9] T. Durden, When The S&P Hit A Record High, The Only Buyer Was Buybacks; Everyone Else Was Selling, 2019.
    [BibTeX] [Download]
    @misc{Durden20190507,
    author = {Tyler Durden},
    title = {When The S\&P Hit A Record High, The Only Buyer Was Buybacks; Everyone Else Was Selling},
    year = {2019},
    url = {https://www.zerohedge.com/news/2019-05-07/when-sp-hit-record-high-only-buyer-was-buybacks-everyone-else-was-selling},
    }

    [10] P. Immenkötter, Buybacks: the dilemma of high prices, 2019.
    [BibTeX] [Download]
    @misc{Immenkotter2019,
    author = {Philipp Immenk\"{o}tter},
    title = {Buybacks: the dilemma of high prices},
    year = {2019},
    url = {https://www.flossbachvonstorch-researchinstitute.com/en/comments/buybacks-the-dilemma-of-high-prices/},
    }

    [11] L. Roberts, The Great Stock Buyback Debate, 2019.
    [BibTeX] [Download]
    @misc{Roberts20190502,
    author = {Lance Roberts},
    title = {The Great Stock Buyback Debate},
    year = {2019},
    url = {https://realinvestmentadvice.com/the-great-stock-buyback-debate/},
    }

    [12] Investopedia, CAPE Ratio Definition, 2019.
    [BibTeX] [Download]
    @misc{CAPE,
    author = {{Investopedia}},
    title = {{CAPE} Ratio Definition},
    year = {2019},
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    }

    [13] J. P. Hussman, You Are Here, 2019.
    [BibTeX] [Download]
    @misc{Hussman2019,
    author = {John P. Hussman},
    title = {You Are Here},
    year = {2019},
    url = {https://www.hussmanfunds.com/comment/mc190408/},
    }

    [14] T. Durden, Trader: Bond Yields Signal All Is Not Right With The World, 2019.
    [BibTeX] [Download]
    @misc{Durden20190528,
    author = {Tyler Durden},
    title = {Trader: Bond Yields Signal All Is Not Right With The World},
    year = {2019},
    url = {https://www.zerohedge.com/news/2019-05-28/trader-bond-yields-signal-all-not-right-world},
    }

    [15] T. Durden, "A Big Wake Up Call": Chinese Bond Market Roiled By First Ever Bank Failure, 2019.
    [BibTeX] [Download]
    @misc{Durden20190527,
    author = {Tyler Durden},
    title = {"A Big Wake Up Call": Chinese Bond Market Roiled By First Ever Bank Failure},
    year = {2019},
    url = {https://www.zerohedge.com/news/2019-05-27/big-wake-call-chinese-bond-market-roiled-first-ever-bank-failure},
    }

    [16] T. Durden, Endgame: Starting In 2024, All US Debt Issuance Will Be Used To Pay For Interest On Debt, 2019.
    [BibTeX] [Download]
    @misc{Durden20190501,
    author = {Tyler Durden},
    title = {Endgame: Starting In 2024, All US Debt Issuance Will Be Used To Pay For Interest On Debt},
    year = {2019},
    url = {https://www.zerohedge.com/news/2019-05-01/minsky-moment-starting-2024-all-us-debt-issuance-will-be-used-pay-interest-debt},
    }

    [17] D. Lacalle, The ECB's Monetary Trap, 2019.
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    @misc{Lacalle2019,
    author = {Daniel Lacalle},
    title = {The {ECB}'s Monetary Trap},
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    }

    [18] A. Home, The cold military logic behind Trump's trade war, 2018.
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    @misc{Home2018,
    author = {Andy Home},
    title = {The cold military logic behind Trump's trade war},
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    author = {{United States Department of Defense}},
    title = {Assessing and Strengthening the Manufacturing and Defense Industrial Base and Supply Chain Resiliency of the United States},
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    note = {Report to President Donald J. Trump by the Interagency Task Force in Fulfillment of Executive Order 13806},
    url = {http://defense.gov/StrengtheningDefenseIndustrialBase},
    }