Will There Be A Financial Meltdown?

If you an individual who has been reading the doom and gloom blogs for the past year or so you are far more likely to believe in that doom and gloom scenario where the debt overhang of the world topples civilization back into the stone age.  On the other hand, if you are one of those individuals who have made a point of nay-saying the doom and gloom writers and believe that the world economies are only suffering from a minor set back then you see a bright and rosy future in the financial world.  I would suggest that neither case is correct.  Many individuals really don’t know what happened in October of 1929 and the years after.  Yes, the market crashed and the prices of stocks plunged towards worthlessness.  But back up a minute and I will give a thumbnail account that well help us to see what is ahead for the world.

First, the market was oversold.  In simple terms, the prices of the individual corporate issues of stock were trading at levels that could not be sustained.  If the book value of a company’s stock is ten dollars, then this represents what one might reasonably expect a single share of stock in that company is worth if the company was sold, lock, stock, and barrel, or liquidated.  It’s like asking what your net worth would be on some unit of value basis is you died tomorrow and all your assets were sold and debts repaid.  Usually the book value of a stock represents a fire sale price, hence the actual value of a company’s stock might be based more on future earnings, or forward averaged earnings per share.  Of course the real earnings per share is based on past activity, that is, what did the company gross on sales minus the costs of business (materials, labor, and other expenses).  The results is either earnings or loss and is divided by the number of shares of stock outstanding.  A share of stock gives you the right to participate in the distribution of any earnings of the company.

During the 1920s, the end of the great war saw an expansion of business in the United States and across the world.  America became the world’s steel maker.  We also entered other markets.  Prior to that war, we were an up and coming country who was competing on the world stage for business and we went after it with a vengeance.  And we were as cut-throat as any other country when it came to getting more than our share.  This required more financial leverage.  Remember, there are two ways to grow any business.  Accumulate profits for reinvestment or borrow for reinvestment.  The roaring twenties saw a boom in borrowing.  Individuals went into debt to buy automobiles and houses.  Stores offered merchandise on credit.  Banks were anxious to lend to farmers who bought new equipment and more land.  Businesses wanted more capital and obtained it through great loads of debt.  And in the stock market there was such pent up demand for obtaining shares of stock that one could buy, often on one hundred percent of margin, shares of a great many stocks.  It was the boom in credit that created the crisis of 1929.  Who lost when the credit bubble burst, because that is what did happen, what kinds of loss were incurred?  A great many people who literally lost their shirts in the market were those who had acquired unsecured positions in stocks.  Buying on margin is a bet that the price of a given stock will rise and give you a good profit when you sell your position.  If you can buy a stock for $10 a share and ride that price up to $21 a share then you have doubled your money and the cost may have only been a $1 a share.  But what happens when the price goes down?  Your lender may get nervous if the price drops to $9 or $8 a share.  Then he might issue a margin call, meaning that you must make up the difference between what you paid for the stock and what its price is right now even though you have not sold that stock and formally suffered a loss.  That share of stock is your leveraged asset.  When the credit bubble bursts, then a chain reaction is set in motion.  If the price of stocks was bid far too high in relation to book value and earnings potential then at some point that price will start to fall.  when that happens then those who bought on margin, who bought puts and calls at the wrong price, all those who used credit to speculate in the market are liable to great losses as price falls.  That problem of finding a bottom at which a stock’s price will stabilize is that there must be enough buyers to buy all at that price.

The real problem is when stocks and bonds are used in an intertwined way to serve as collateral for investment credit.  Let us say that one had bought Russian government bonds before the takeover by Lenin and the Communist Party.  Now you use those bonds as collateral for manufacturing expansion loans or bonds in your company.  The Russian government bonds are repudiated by the present Russian Communist government and their value falls to nil.  That interest coupon payment is no longer being made and you have lost your original capital investment.  Perhaps you now need to find a bank, any bank, and obtain corporate notes or paper at any interest to shoe up the loss of your asset.  In the meantime other businesses are having similar problems and perhaps you make industrial goods and machinery.  Now they start canceling some of their orders.  You have to shut down one of your assembly lines and lay off a few workers.  That means that those who have been laid off can’t pay their rent and will have to cut back on other consumption.  Some have their automobiles and washing machines repossed.  And so it continues, first that rapid free fall in a few areas and then the long fall back with consumer goods.  When FDR took over as President approximately 25% of the men in America from the age of 18 and older were unemployed.  We don’t count the farm populations or farm labor and that part of the American population was about one half of the American males of working age.  But farm prices fell.  Crop failures were beginning and the years of the great dust bowl age were starting.  But government policies were very perverse as the federal government moved to prop up milk prices so that farmers could make a thin profit on their milk production and children stared as families could not afford to buy that milk which meant that the farmers were producing too much milk at those prices and had to pout that extra milk out.  The wages or unionized employees was increasing but men weren’t being hired.

The dislocations are specific to the era involved.  So what happens when the credit boom finally goes bust?  A lot of people will lose money or assets.  When the housing boom burst in 2008, many people saw that they had paid far too much for their homes, had insufficient down payments for the loans they took, and that their mortgages were under water, meaning that they owed far more than the house was worth.  Who would sell a house at market prices when you would still need to pay the bank $50,000 or far more just to sell the house.  And if you were part of that ten percent unemployed and couldn’t make your mortgage payments then you were really hurting.  So now we have so many individuals whose retirement funds are invested in municipal bonds and the city goes bankrupt.  There goes your retirement.  And the dominos keep falling.  Many retirees in that position will see their benefits and pensions reduced to as low as ten percent of their advertised value.  If you bought a house five of ten years before your retirement and counted on that pension to pay your mortgage what will you do now?  The price of housing will fall again and reach new lows because there will be few buyers.  People who bought new cars may have them repossed because they can’t make the payments.  Ultimately billionaires will become only multimillionaires as they see their investments decline in relative value.

Almost every developed country economy depends consumer spending for 65% of its GDP.  When consumer spending drops significantly below that towards 50% and below, then we see a general depression where prices fall along with wages.  Deflation is the order of the day.  The Federal Reserve Board cannot create inflation when there is no hard cash and all electronic cash is highly dependent on credit.  Yes, people will starve, families will not have roofs over their collective heads and clothing will be years old.  The decent into depression will be relative.  We won’t know just how poor we will be and once we are there it won’t matter.

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