Wealth Building Lessons

Yesterday, one of my friends asked me if I thought the US would face a depression. He was pretty certain that a depression would occur, and it would be just like the previous depression where there were no jobs, no money and thus no food.

Some of the commonly stated reasons for the Great Depression are unequal distribution of wealth, lack of savings, high tariffs and war debts, over production in industry and agriculture, and the stock market crash and ensuing panic.

Given these reasons and the fact that we’re currently experiencing all of them, I can understand why one would think that a depression is imminent.

There is a large disparity in terms of wealth distributions and income. Hedge fund managers are making incredible sums of money. The top 25 managers made $8 billion last year. The general population has almost no savings, the government is paying hundreds of billions for a war that makes no economic sense, there is a housing bubble in some of the most populated areas which is causing an artifical boom in consumer consumption. Its also very likely that businesses are currently increasing their capacity for production and if the housing market crashes, consumer consumption will plummet and they will be faced with immense over-production. Sounds like all the ingredients for a good depression are in the mix!

That being said, I don’t think we’re in for a depression. I think the main reason for the Great Depression was the lack of liquidity. This theory is supported by monetarists like Milton Freidman.

According to Monetary History of the United States, 1867-1960 by Miton Friedman and Anna Schwartz, the Depression was caused due to the Federal Reserve exercising the wrong policies (namely contracting the money supply) and that they could have, in fact, prevented a recession from turning into the depression.

Right now there seems to be a ton of global liquidity sloshing around and Federal Reserve Chairman Ben Bernanke, has pretty much said that they would be ensuring liquidity by cranking up the printing presses.

It does seem like the Feds will be manipulating the money supply and the interest rates to keep the economy afloat. I don’t know how successful they will be at maintaining this so-called “goldilocks economy but I’m sure they’re doing all they can to try and avoid another Great Depression.

Due to these reasons I don’t think there will be another depression, in the terms of there being no jobs and thus no money.

Instead I think there is a higher chance of the dollar experiencing severe devaluation due to the US Government printing more money under the excuse of creating liquidity. This also has the added benefit of providing the US Government an escape from its multi-Trillion Dollar Debt situation.

Here’s a great explanation from The Trumpet:

Based on the Federal Reserve’s past proclivity to expand the money supply every time there is a crisis, politicians will likely take the seemingly easy way out: simply print the additional money needed to repay debts and promised entitlements under Medicare, Social Security, Medicaid and government pensions—the $53 trillion-plus worth. This way, the government can prolong the façade of a healthy fiscal business model a little longer—paying debt and promised benefits with devalued dollars.

As long as the dollar doesn’t devalue too sharply or quickly (loss of value is the result of expanding the money supply relative to demand), paying debt with devalued dollars could sound like a pretty good deal for the U.S. In fact, the U.S. has been doing this for a while. The government is able to borrow money from taxpayers and foreigners, spend it, then pay back the money later at a discount. Crafty. At the very least, it decreases any incentive for politicians to get out of debt.

However, this scheme is very risky because of the sheer levels and pace of our accelerating debt, especially in light of future entitlements promised. While inflation temporarily alleviates the symptoms, it does not fix the cause of America’s overspending habits. And runaway inflation may result from the massive amounts of money that would need to be printed. To this point, foreign lenders have been willing to accept dollars, but at some point, when they decide that they no longer enjoy having their dollar holdings constantly losing value, especially at a precipitous pace, they could decide to dump them.

If that occurs, America’s “crafty trick” of devaluing the dollar certainly won’t seem so crafty. The trillions of dumped dollars would come flooding back into the U.S., causing the dollar to drop like a rock and creating inflation on an unprecedented scale.

Because of the devaluing of the dollar, we will see a sharp increase in inflation and a rather large correction in our standard of living. I use the word ‘correction’ and not ‘drop’ because most of the U.S. population lives beyond their means. If they lived within their means, they wouldn’t be buying $500,000 homes on a $50k salary and driving $35,000 cars. (If you don’t know what I’m talking about, you’ve obviously never been to Southern California).

But whether its a ‘drop’ or a ‘correction’ in the standard of living, there will be tough times ahead for those who haven’t hedged against it.

In a follow-up post I’ll discuss some investment strategies to profit from a falling dollar and an inflationary period.

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