First we, need to examine the actual decline in CRE values by looking at data gathered by MIT:

Putting together all CRE values we find that the market has fallen by a significant 42 percent.  Now assuming this figure, that $6.5 trillion is now “worth” approximately $3.7 trillion giving us an equity cushion of $200 billion for all CRE properties in the U.S.  I doubt this figure is even that high.  It is safe to say that commercial real estate is now in a negative equity position.  The U.S. Treasury has discussed plans on bailing out this industry but not much has been done on this front since all the bailout funds have been concentrated on residential real estate and protecting the too big to fail banks.  Many CRE loans are held in the smaller regional banks that are actually small enough to fail.  The FDIC will be busy in 2010 given the above data.

Now looking at the residential market, prices fell earlier but have recently stabilized because trillions of dollars have been used to prop up the system:

If we look at residential real estate, prices are down 32 percent from their peak.  Keep in mind it is likely to fall further because many items like the Fed buying up $1.25 trillion in mortgage backed securities and keeping rates artificially low cannot go on forever.  Also, is the government going to give our a tax credit forever?  This is highly unlikely and when each program is phased out, we can expect minor shocks back into the market.  Plus, we have to remember that many homes have been in a state of purgatory because of moratoriums and other patchwork programs.  These only delay foreclosure and once they hit the market prices will continue moving lower.

Yet commercial real estate is falling with no support.  And what would be the support given that our economy is contracting so viciously?  Why would we need any more retail space near sub-divisions where people didn’t even move in?  With housing there is a price point where people will move in.  Take for example the college student graduate that is only making $10 an hour because of the poor employment situation.  He may need to move back home even though this isn’t what they want.  If apartment rents are $1,000 a month, then renting on their own won’t make any sense.  But if apartment rents are $400 in this area he may consider moving out.  This is the new calculus of the market.  And apartment pricing is seeing pressure to the downside because of massive vacancies:

And it gets even worse when we look at rental vacancies and this is where apartments fall under:

This is the highest rate on record and tells us that we have over built and the market is still unable to sop up the excess properties.  So what will happen is competition for cheap housing by lowering rents.  This is the only way to drive demand in a market where average Americans are becoming more price conscious every day.  The problem with many of the CRE projects is that they were expecting peak value rents and will have no ability to service their debt with new market rental rates.  That is, they are insolvent.  And many bankruptcies will happen because of this.  Or if you are a too big to fail bank you can simply walk away from your commitments.

Take a look at some of the ads in the San Diego area in California:

Or if having nearly one month of rent free isn’t enough, how about two flat screens?

These kind of offers are everywhere and speak to a market saturated with inventory.  At least with apartments, you will find people at the right price.  With some office buildings you won’t find anyone nearly at any price point.  Why would someone pay rent if there is simply no business demand in that area?  Places like Arizona and Nevada now have countless units just sitting empty because market demand has dried up.  The CRE bust is rolling through and it looks like very few Americans actually contemplate how much over building was done in this industry in the last decade.

And companies are not building any more properties as you might expect:

This in turn means millions that derived their income from the building and housing industry will have years to wait before any recovery begins to take place.  The CRE bust is now in full force even surpassing the disaster in residential housing.  What we can get from this massive bubble burst is our near religion with all things real estate has led us to the economic abyss.

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Comparing this crisis to the Great Depression may not be appropriate aside from the fact that we have high unemployment and an insolvent banking system.  The U.S. Treasury and Federal Reserve have jumped in with all their ammunition to save the banking sector.  The only problem is they forgot about the average American and the economy that we live in.  As we go deeper into this crisis and already have a hint as to how policy will play out it is turning out to be very similar to the Japanese contraction and lost decade(s).  Global debt is growing at breakneck speed:

Source:  Societe Generale

By 2011 global economies will have close to $45 trillion in debt.  Is this a far stretch?  The U.S. already broke the $12 trillion mark.  In order to compare our current crisis with Japan it is important to understand the history of their boom and bust:

“(Baseline Scenario) At a high level of generalization, the causes of the bubble were similar to those we have just seen. Loose monetary policy (in late 1980s Japan, and in the U.S. this decade) and high savings levels (by Japanese households in Japan’s case, China and oil exporters in ours) created a large pool of money looking for investments to buy. Rising prices encouraged speculation in both real estate and stocks. Poor underwriting standards – due to some combination of government direction of investment and self-dealing within industrial and financial conglomerates – and an unconditional willingness to lend against real estate as collateral meant that banks made hundreds of billions of dollars’ worth of loans that were sustained solely by rising prices. When prices fell, those loans lost most of their value, crippling banks’ ability to lend to creditworthy borrowers and choking the economy. The lack of credit, combined with the negative wealth effect of collapsing asset prices, dampened economic growth, which averaged 1% per year for the 1990s.”

It is important to note that Japan has been in a multi-decade malaise.  No “V” shaped recovery but a very long “L” situation.  Japan’s government sat back initially but then decided to bail out the banks and infuse massive amounts of fiscal stimulus.  The Bank of Japan like Alan Greenspan and Ben Bernanke slashed rates to their zero bound:

The above chart shows a similar path.  The big difference of course is the minor push up in the early part of this decade but this occurred in the back drop of a booming stock market and real estate bubble.  Japan has been in the doldrums since the late 1980s.  In fact, if you look at the chart above Japan has held onto record fiscal deficits for years and we are now following a very similar path.  Our current budget deficit of $1.4 trillion is enormous:

Japan contented with a busted stock market and crashing real estate sector with bailing out an insolvent banking industry and also, pushing rates to the zero bound.  The idea of letting banks keep overvalued assets at peak prices is something many of us are now getting familiar with.  With $3 trillion in commercial real estate, much of it overvalued, it will be interesting to see how banks move on this.  If current actions are any indication, banks are merely going to delay mark-to-market and value assets at inflated prices.  This did not work for Japan.  Why?  The banking sector became a vampire leeching off the productive sectors of the economy.  They couldn’t put their assets on the market because it would render them insolvent.  In the end, it stunted growth.  Keep in mind that Japan also managed to stay somewhat prosperous because it was able to export into a booming global economy.  Demand for goods such as Toyotas, Hondas, Sonys, and other high cost goods was strong.  But these are higher end products that typically ship to wealthier economies.  How will they do in the current global contraction?

The stock market path of the Nikkei and S&P 500 seems similar:

Over 20 years and the Nikkei is no where close to the peak reached in the late 1980s.  It is possible to muddle through for a very long time.  In fact, the Nikkei has been moving sideways with a tendency to the negative for 20 years.  The current stock market rally does not reflect market fundamentals and is merely a reflection of all the liquidity injected into the system.  But like Japan, all this does is keeps an insolvent banking sector walking for a few more years while the overall economy stays in a frozen pattern:

“One of the major barriers to expansionary policy was the weakness of Japan’s banking system. The asset price collapse and economic slowdown meant that increasing proportions of their loan portfolios became non-performing. Because writing down these loans to their true market values would have caused banks to become insolvent, they kept them on their books, rolling them over (extending bad loans indefinitely) in order to avoid having to take writedowns. As a result, the banks were severely undercapitalized and largely unable to engage in new lending. It was only in 1998 or 2003 (depending on whom you ask) that the government got serious about cleaning up the banking sector, letting weak banks fail or forcing banks to accept new government capital.”

This is all sounding very familiar.  Yet talking with friends about this, many dismiss this out right and say “well in Japan, they are big savers so they can do this.”  In reality, as Japan’s population has aged the savings rate has reflected the U.S.:

Analysis expect this rate to go negative:

“(Forbes) Japan has lived beyond its means since the 1990s thanks to massive domestic savings. Households own 1,441 trillion yen ($16.3 trillion) in assets, mostly deposited in banks, which then buy JGBs. Foreigners hold about 8 percent of outstanding JGBs.

An ageing population has eroded the savings rate to about 3 percent from more than 10 percent a decade ago and household assets have declined about 8 percent from a 2007 peak, mainly because share prices plunged after the global financial crisis.

Demographics suggest the savings rate could turn negative in a few years.

‘Like the United States, we will need foreign investors at some point,’ said Koji Ochiai, senior market analyst at Mizuho Investors Securities. ‘I doubt they will be attracted to such low yields.”

And this isn’t so different from the U.S.  American household net worth has taken a major hit of $12 trillion in this crisis but it is still sizeable in terms of real estate, stocks, and savings.  And this ties in with our big group of baby boomers.  They will draw down on their savings and stocks in retirement.  That is after all what a 401k, 403b, or pension is for.  To become your income in retirement.  But many are realizing that with stocks lower and the economy uncertain, some will have to defer that American dream of retirement or at least taper it down.

The U.S. Treasury and Federal Reserve are gambling with the U.S. dollar.  They believe that they can systematically devalue the dollar and slowly allow inflation to wash away our massive amounts of debt.  Japan tried this.  It hasn’t worked.  Now, with savings dwindling and the global economy depending less on exports, they are in a deep mess.  The U.S. is in a tough spot.  What many people don’t know is that in Japan, one-third of all workers are part-time workers.  The headline stats always show a low unemployment rate but these people are counted as fully employed.  One thing we have seen spike in our current recession is the rise in part-time employment:

Source:  Calculated Risk

This is the highest percentage of part-time workers we have had on record.  And there is no sign of this trend reversing.  If Japan is any guide, this is going to be a permanent reality of our new economy.  No job security, minimal benefits, and multiple jobs throughout one lifetime.  If we stay on the current path doing everything Japan has done, why are we to expect a different outcome?  Remember the big deficit we currently have?  Where revenues don’t even come close to matching spending?  Take a look at Japan:

At a certain point, the two major carry trade currencies in the world are going to meet their maker.  No country can spend this much without higher interest rates.  The current low zero bound market is more a reflection of global fears that still remain.  But there is ample evidence to examine Japan and our similarities.  Major stock market bubbles followed by major real estate booms and bust.  And Japan has demonstrated that real estate can remain depressed for 20 years:

What Japan might have bet on was some sort of asset appreciation.  This way, at least some of the value would be regained but that didn’t come to pass.  The U.S. Treasury and Federal Reserve is betting the entire country on this and putting their entire faith in the banks.  But without jobs why are we to expect that home prices will go up?  With less people buying goods, why are we to expect commercial real estate to boom?

The American dream is being deferred.  Japan had their dream postponed for two decades and it looks like they are entering a different phase of their downturn.  With our lost decade on hand already, is it possible we have another decade of stagnant growth?  Until we start seeing job and wage growth, Japan might be an outline of our future.  The American and Japanese dreams are looking very similar.

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I will put up another chart showing the longer term trend of the U.S. dollar.  However, in this chart you can see that when the U.S. stock markets made their highs in late 2007, both the U.S. dollar and domestic stock markets started trending lower simultaneously.  If anything, the local stock markets simply caught up with the overall U.S. dollar trend:

But what happened during that time when the dollar hit the 70 mark in 2008?  Let us rewind and see what was being said at the time:

“(Forbes June 2008) That in turn has helped to push up the prices for imported goods flowing into the U.S., such as oil, and fuelled a rise in consumer prices.

Bernanke called that development ‘unwelcome’. He said the Fed is ‘attentive to the implications of changes in the value of the dollar for inflation and inflation expectations’.

The euro/dollar rate, which had risen to almost $1.5630 in early London trading, dropped below $1.5450 after Bernanke’s dollar supportive remarks.

‘In short, the Fed doesn’t want to see a weaker U.S. dollar because it would boost inflation and is putting a greater weight on the currency in setting interest rates,’ said NAB Capital Markets head of currency strategy John Kyriakopoulos.

He said Bernanke’s comments suggest another interest rate cut by the Fed is unlikely unless the economy falls over a cliff, which isn’t the central bank’s forecast.”

Now keep in mind this was only a month before the peak, and a few months before the stock market tanked.  In fact, the Federal Reserve has encouraged a weak dollar since 2001 thanks to Alan Greenspan and his rate cutting magic.  Cutting interest rates by default encourages a weaker currency.  Just take a look at this chart:

As I have repeatedly stated, the Federal Reserve and U.S. Treasury are determined to implode the U.S. dollar.  They are desperate and are trying everything they can to create inflation.  If you look at the initial chart, the only thing that reversed this was the implosion of the global markets.  People at this point ran back to the U.S. dollar for safety.  That pushed up the U.S. dollar Index from 70 to 89 during the March 2009 panic.  Since that point, the U.S. dollar has fallen 12 percent while the stock market has jumped 44 percent:

This is a fascinating observation.  In this past decade it would seem that the only thing that would cause the Dow to rally is a weaker dollar.  So this begs the question how much of the rally is because of a weak dollar?  Probably a good portion.  Why would the S&P 500 rally 50 percent from the bottom with weak earnings rivaling those of the Great Depression?

If we look at the global markets, we see that they arrived to the market correction one year later but got hit even harder and have yet to recover as much as the U.S. market:

The Dow World Index fell 59 percent in a few months and since that time, is now back up 38 percent.  The U.S. Treasury and Federal Reserve are on a path to destroy the U.S. dollar.  They can claim a strong dollar policy like they did in 2008 but they have been making it weaker as time goes along to keep the debt spending binge going.  And with trillions in new fiscal programs, it seems like we are going to need to borrow much more.  The question is, in what direction will the dollar go?  If globally things get bad again and they may, there might be short term pressure pushing the dollar up.  Looking at the Fed funds rate you might wonder who in their right mind would want to put money into the U.S. dollar but keep in mind in a year with deflation, people simply don’t want to lose their money.

You have countries like Ireland, Iceland, Japan, or Spain that are in even worse shape than the U.S.  So the flight to safety is still a big concern.  Yet the question of the U.S. dollar strength will have much to do with the health of the stock market.  Can the U.S. dollar rally while the stock market goes down?  It did from October of 2008 to March of 2009 so don’t bet against it if we hit another global tough patch.

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Let us look at a chart showing year over year changes in CPI and also, tax revenues from the state of California:

What we are seeing here is the story of two decades of bubbles in California.  First, we had the 1990s technology bubble followed by the real estate bubble.  You’ll notice on the chart how quickly revenues can fall. The problem in a state like California that has had to fix $60 billion in budget gaps this year is that the real estate bubble came just in time to save the technology bubble bursting.  This time, there doesn’t seem to be another bubble waiting and already there are projections for another budget short-fall for the next fiscal year.

In a sign of current price destruction deflation, the state is actually lowering the income tax brackets for the first time in 30 years.  You heard correct, lowering the tax brackets:

“(LA Times) Reporting from Sacramento – While Californians are still feeling the sting of income and sales tax hikes signed into law earlier this year, now comes news that state tax authorities plan to take a little more from their pockets.

For only the second time in 30 years, the tax board is lowering the point where each tax bracket begins, bumping many people into a higher category. At the same time, officials are cutting back some deductions. Everyone will pay more, even people whose bracket or income doesn’t change.

The extra sums will total as much as $140 per family, on top of the increases previously enacted.”

On top of the increase in taxes, every income bracket is going to feel the menace of demand destruction deflation.  Now why would the state do this?  To increase revenues.  That is why with the S&P 500 jumping over 50% in a few months, people need to be cautious how companies are making their money.  Most of the jump in “earnings” has occurred on the “cost savings” side more so than the consumer spending side:

It is rather apparent that spending and consumption which make up a big part of our economy are not leading the charge in earnings.  When you have 26,000,000 unemployed and underemployed Americans, it is easy to save money from a company perspective. This is not a growth model but one time earnings from demand destruction.

Even more evidence of this demand destruction, Social Security announces no cost of living adjustments:

“(AARP) For the first time in 35 years, older Americans will receive no cost-of-living increases (COLA) in their Social Security checks in 2010 according to Congressional Budget Office estimates. The forecast is based on expected low inflation, in contrast to 2009 when the COLA added 5.8 percent to Social Security benefits.

Next year’s zero COLA is bad news enough for many retirees living on fixed incomes during a recession. But millions of them also face much higher Medicare Part B premiums next year.”

Is this sounding familiar?  But given the rising cost in healthcare, many can expect a hike in their Medicare Part B.  What does this mean?  Less money for consumption.  And with many baby boomers entering retirement in the next few years, a perfect storm is starting to brew.

If we dig into the CPI we notice that things such as food and healthcare are going up.  For someone on a fixed $1,000 a month from Social Security, this might be a big burden.  Many retirees (of course not all) already have their home paid off if they own (one third of American homeowners own their home free and clear).  So food and healthcare become their major expense.  And these few areas are going up.  Discretionary items like a home (yes, to own a home is a choice since there are rentals), vacations, and automobiles are taking major hits in prices.  Go on eBay or take a look at your local newspaper and you will find deals in these area.

Ultimately earnings will have to occur from growth including job growth.  To assume these deep cost cuts are a way to make earnings and rally the S&P 500 is simply a way to make Wall Street wealthier while most average Americans scrimp by.  We still have major issues that will add further demand destruction.  $3 trillion in commercial real estate loans are out there.  With demand going down as we have seen, who will buy/lease that space?  Many boomers are going to be downsizing in the next few years.  In terms or rampant inflation, this is still something not in the equation.

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Why this is important to understand is that it helps to focus on an otherwise black box of important information.  The idea that consumers will not borrow is only true if they are held to some form of standards (i.e., jobs, income, etc).  Remove those and people will borrow and spend as the cash for clunkers program has demonstrated.  And the question of why banks are holding off so much in excess reserves is that of the interest rate.  Why would you lend money if you can keep it socked away risk-free and earning interest?  This notion needs to be explored with a simple example.  If the Federal Reserve jacked up the interest to 20 percent there would be virtually no lending because banks would simply hold on to reserves and earn risk-free interest.  But paying the interest rate theoretically gives the Fed some room to navigate.  How so?  Well they can technically pay zero percent on reserves and thus force banks to find some form of lending to make.

Let us take a look at the excess reserves picture:

It is fascinating to look at the data even closer because you can see once the policy was announced, excess reserves spiked up at the same time:

Now it is a mix here between crisis and interest.  Clearly the large majority of reserves occurred because of Fed liquidity and backstops but also, the interest rate clearly had an impact and probably has a longer term impact for what will occur.  Now the idea of course is that the Federal Reserve will ideally lower the rate on member banks as the crisis ebbs and slowly lending will filter through the economy in some form of controlled inflation.  But as we all know, institutions like Goldman Sachs have better ideas than the petty interest rate and have done well in the crisis despite the fundamentals of the economy being mired in problems.
As long as the interest rate is high enough in terms of market risk for member banks, the excess reserve will remain high.  Many banks don’t have the trading wherewithal (and political connections) of a Goldman Sachs.  Yet one major issue of course is whether member banks would want to lend this money to the consumer or simply use it as free subsidized gambling money for the stock market casino?  Given the pulling away of 8,000,000 credit cards and interest rates being jacked up, the average consumer is seeing no benefit.  And with banks like Wells Fargo and Bank of America offering near zero percent rates on savings accounts, the banks seem to be the only folks with access to free flowing capital.  It is also the case that banks have detailed knowledge of their balance sheets including future bad debt that may require usage of some of the additional funding.

The Fed has been running the printing press as we all know:

The velocity of money has slowed in the current economy.  That is, the average frequency in which a unit of money (say the dollar) is spent in a specific period of time.  This is important in actually seeing if there is risk of inflation.  Take for example the following:

Economy with 2 institutions and $50 of money, a home builder and supermarket:

-The homebuilder buys $40 worth of food from the supermarket

-The supermarket spends $50 in adding a new room with the homebuilder

-The homebuilder buys $10 worth of sodas from the supermarket

So in essence $100 of money changed hands in this timeframe.  Assuming this is all that took place in one year, the velocity was 2 / yr.  Now why is this important?  The actual amount of money exchanging hands is important and keeping funds in excess reserves doesn’t allow it to be free in the economy.  The problem is whether there is enough real activity in the market to justify further lending (especially with a high unemployment rate).  The only reason we are allowed to do this is because the U.S. dollar is still a reserve currency.  Can you imagine the other side of the coin?  Imagine a new country called Spendville.  This country spends nearly all their money and saves virtually nothing.  Would you invest your money there?  Maybe.  If the interest rate were set high enough possibly.  That is what occurs with emerging markets.  But in this case, Spendville is the U.S. but we have the reserve currency.  Yet China and other nations are starting to voice their concern.  What is certain is if we keep our same path, the interest rate will have to rise to compensate for the added risk.

The Fed gave us a nice example of this back in October of 2008:

I would love to see what kind of assets current banks are valuing at these levels to quote off their excess reserves.  It would be fascinating to see a breakdown of which banks have the highest excess reserves.  Think we have any luck getting that breakdown?

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Even as early as last year, anyone trying to compare the circumstances of the United States with the lost decade in Japan appeared to be out of line with mainstream economist and the media.  Yet if this financial crisis has taught us anything, it is that the experts can be wrong by a wide margin.  Given our recent economic circumstances, Japan style stagnation is looking more and more likely.  Even the media is now using the phrase “zombie banks” in reference to banks that were kept artificially alive during the Japanese lost decade.  Noble Prize-winning economist Paul Krugman had this to say recently in Beijing:

“(Telegraph) We’re doing half-measures that help the economy limp along without fully recovering, and we’re having measures that help the banks survive without really thriving. We’re doing what the Japanese did in the nineties.”

Mr Krugman said that the recent stress test results had bought the Obama administration some time, but that questions remained as to whether banks have enough capital to fulfill their role in the wider economy.”

So why is Japan suddenly being used as a comparison?  First, it is important to understand what happened in Japan in the first place.  Japan like the U.S. has been fond of boom and bust markets.  First, let us take a look at some of these bubbles:

The 1980s witnessed an enormous boom for Japan.  The Nikkei boomed and so did real estate.  If anything, they had a double bubble just like we did with the 1990s technology bubble followed by the 2000s real estate bubble.  Japan’s bubble was fueled by euphoria that current prices were justified because of future earnings potential but of course, the pace was completely unrelated to fundamentals and like all bubbles, burst.  This is where we follow Japan down the same path.  Japan’s banking system made enormous amounts of bad loans on over priced real estate.  Instead of taking over banks temporarily, wiping out shareholders, giving bondholders a haircut, and finding a true value of the assets the government decided to zombify the banking system.  That is, it didn’t take banks into receivership and take the painful short-term medicine but kept pumping money into them hoping that someday, they would come back.  What occurred?

Two lost decades.  As you can see from the chart above, both asset prices and stock prices have been steadily collapsing for nearly 20 years.  The Nikkei peaked at 38,915 on December 29, 1989.  Today it stands at 9,324, a drop of 76% over 20 years:

It is important to note that Japan not only injected money into their failing banking system, but spent trillions in fiscal stimulus.  Of course, much of this was largely fueled by cheap money through dropping interest rates:

Japan took rates to zero and was the first country to experiment with quantitative easing which clearly did not work.  That is why with all this market volatility, it is surprising to see the U.S. Treasury and Federal Reserve repeat the same mistakes.  If you look at the above chart, and expand it out keeping rates low, it does not necessitate a healthy economy in the end.  What it does is protects the elite of the banking system.  And that is the irony, the overall banking sector has done horribly in Japan even with all the handouts but like our system, banking executives in Japan also did well during this time:

It is amazing that the S&P 500 ran up nearly 40% in two months given all the current news.  First, we need to remember that nearly 25,000,000 Americans are either unemployed or underemployed.  That is a significant drain to the health of our economy.  And the recent optimism in the banking sector is completely unfounded.  The American banking system by technical definition is insolvent.  The only reason they are turning any kind of profit is because of artificial injections of money through massive bailouts.  The current banking model is designed for high flying real estate and fast trading of toxic securities and derivatives.  With that model shutting down, banks really have no sustainable model.  Japan faced similar issues.  That is why if you look at the above chart, for nearly 20 years Japanese banks have been struggling to find their footing.  Aside from the current misplaced optimism, banks are still in horrible shape.  What has occurred is our current policy is right out of Japan’s playbook.  If history is any guide, let us count the similarities:

(1)  Stock market bubble – pops

(2)  Real estate bubble – pops

(3)  Massive injections of capital into banks – no nationalization

(4)  Enormous fiscal stimulus

(5)  Banks keep toxic assets on books

(6)  Record low interest rates – can’t go lower than 0 can you?

The parallels are unmistakable.  Another important similarity is giving money to banks does not mean they will lend:

This chart sums it up.  There is an increase in M2 yet bank lending steadily declines for over a decade.  Of course, the Japanese banking officials came out to the public stating that injecting capital into banks would cause lending but the above proves otherwise.  And this is happening in the U.S.:

We can take the above chart to the 1950s and you will not see banks holding any excess reserves that will show up on the chart.  All of a sudden the chart pops, banks are hoarding money.  Why?  They are flat broke!  You would think that with trillions injected into banks, they would start lending to the public.  Well if we just look at Japan, we already know that lending is not going to happen:

What is occurring is failed banks are being subsidized by the taxpayer.  The bailouts will stagnate our economy for at least a decade while we keep feeding the Hungry, Hungry Hippo banks.  Oh, and another thing that I forgot is we are seeing a fall in general prices:

Exhibit A:  Japan

Exhibit B:  U.S.

Now we are looking at the prospect of deflation.  Looking at this data and reasons it seems like we are doing everything Japan did.  I saw someone argue that the Japanese had more savings and that is the difference.  Well, yes.  In fact, that only makes it worse for us since we have less of a buffer.

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Four banks and one credit institution failed on Friday.  This is now becoming a common Friday ritual.  On February 13 four banks were also taken over by the FDIC.  Multiple bank failures on one day are now growing in size.  Yet the FDIC is quickly blazing through their insurance fund and soon, the taxpayer is going to be paying the bill.  The American taxpayer is already bailing out many of the larger financial institutions.  These are the 19 banks included in the smoke and mirrors government stress test.  What a surprise that all banks looked fine especially since the U.S. Treasury allowed banks to self report on many items.  150 people were involved in examining trillions and trillions of dollars in assets.  It was the ultimate bread and circus event for the masses.

American households are quickly realizing that all the trillions committed to bailouts are essentially going to prop up the banking oligarchy that appears to be running the country.  This is reflected in polling although the mainstream media hardly talks about this because they are hungry for advertising revenues which come from these sectors:

Source: Gallup

You would think that with only 18 percent of Americans having some confidence in their banking system that the media would be shedding a more critical eye on the banks.  That is not case.  And as I will show with the following four graphs, nearly 2 years into this financial crisis, the vast majority of Americans have not seen any noticeable help.  A country with 24 million unemployed and underemployed citizens and we are asked to bailout the perpetrators of one of histories greatest debt bubbles.

Gross Domestic Product

Gross domestic product is the aggregate figure of a nation’s economic vitality.  Gross domestic product can be broken down as follows:

GDP = consumption + gross investment + government spending + (exports – imports)

A large part of our GDP comes from consumption (over two-thirds).  If you stop and think about this, a country that spends more than it earns is bound to get into economic trouble eventually.  And this balance completely shifted in the last 30 years.  This credit bubble started 30 years ago and you will see that in a subsequent graph.  The fairytale that was pushed onto the American public was that it was okay to consume more than it produced.  In fact, not only was this okay but it was okay to consume and do this with debt.  It is fascinating that we call this mess the credit bubble when in reality, it is a debt bubble.  How often have you heard politicians, Wall Street, or the mainstream media call this the debt bubble?  George Orwell would be proud.

Now the chart above is important.  As you can see, on a year over year basis GDP is contracting at the fastest pace since the early 1960s.  Most bailout recipients are betting (hoping) there will be a second half recovery because there is a growing populist anger against the banks and Wall Street and rightfully so.

And going back to our initial equation, consumption has been decreasing while government spending is attempting to make up for that fall in the equation.  We are also exporting less and definitely importing less as measured by traffic at our busiest ports.

Household Debt and Excess Reserves

The above chart is rather telling.  As you can see for yourself, household debt has been increasing by leaps and bounds for the past 30 years.  It has gotten to the point where households have as much debt as our nation’s annual GDP.  We have been spending our way to prosperity (or at least the illusion of it).  I’ve also included in the chart part of the nice little gift we are handing out to banks.  If you recall, the entire purpose of the bailout was to help American families have access to credit.  That was the argument at least.

The chart above shows since the 1970s (and even before that) banks never carried any size of excess reserves.  Why?  They have been lending money out like maniacs for 40 years.  All this money was handed out to consumers to spend and spend on things increasingly made abroad.  We were told that manufacturing and making “things” was a waste of time and should be relegated to “third-world” countries.  But recently, even banks don’t believe this.

The jump in excess reserves, money that was supposed to trickle down to American consumers is being hoarded to deal with problems on bank balance sheets.  Ask yourself this, if banks were so healthy like the stress test told us, then why are they holding onto $700 billion in excess reserves?  The answer of course is that they are not healthy and are looking out for themselves.  The entire premise of bailing out the banks was false.  The reason we bailed out the banks was to protect Wall Street and the banks.  Period.  It had nothing to do with protecting the American consumer who is already maxed out in debt as you can see from the chart above.

Industrial Production

As the largest economy in the world, we still do produce a lot although as you can see from the above charts we have been consuming more and more. Industrial production is contracting at the fastest pace since the 1970s.  The trouble with this is that in the 1970s, there was a legitimate reason for the decline in industrial production.  That reason was we were shipping manufacturing jobs overseas:

So much of that fall in the 1970s had to do with this.  But now, the contraction is largely due to the economic consequences of spending too much all fueled by debt.  While Americans are now having to do more with less, banks (the select 19 at least) are having an unlimited line of credit to the U.S. government.  Over the past few months, 20,000 Americans are losing their jobs per day.  Many are realizing they have no safety net yet watch their tax dollars go to pay executive compensation and bailout banking giants who profited by creating the biggest debt bubble ever known.

Inflation and Deflation

The menace of deflation is making the rounds.  Cheaper homes.  Automobiles that now cost thousands of dollars less because of falling demand.  Cheaper fuel.  Stagnant wages.  All these are signs of deflation.  As the chart above will show, this is the first time we have seen a year over year drop in the CPI since the mid-1950s.  We keep hearing that eventually, we will see inflation because of all the bailouts.  That would only be true if banks weren’t hoarding the money to prop each other up.  The money would have to make it into the hands of consumers to cause any inflation.  Yet that is not happening.  Also, since the crisis started nearly $50 trillion in global wealth has evaporated.  So even though we are committing approximately $13 trillion to bailout our economy (largely Wall Street and banks) there has been more money destruction than money creation.  So that is why we have yet to see any signs of inflation.

The disturbing path we are following is largely what Japan did in bailing out their banking system.  They now have some of the largest government debt burdens in relation to their GDP because of these bailouts.  And what was the result nearly 20 years later?  A stagnant economy with their stock markets still at lows and their real estate market still near the bottom.  Yet some people made out like bandits.  These were those tied to the largest banks.  Is this sounding familiar?

The bottom line is once Americans realize in mass that they are largely bailing out banks to save banks, not the country, they will start asking more important questions.  And the above polls reflect this change.  Yet watching the mainstream media you would not know this.  Hearing politicians talk you would think that we are all for committing trillions to save Wall Street.  The vast majority of Americans do not support these actions.

Just read what was released by New York Attorney General Andrew Cuomo regarding Bank of America’s shotgun marriage to Merrill Lynch (the entire letter is worth a read):

“Despite the fact that Bank of America had determined that Merrill Lynch’s financial condition was so grave that it justified termination of the deal pursuant to the MAC clause, Bank of America did not publicly disclose Merrill Lynch’s devastating losses or the impact it would have on the merger. Nor did Bank of America disclose that it had been prepared to invoke the MAC clause and would have done so but for the intervention of the Treasury Department and the Federal Reserve.

Lewis testified that the question of disclosure was not up to him and that his decision not to disclose was based on direction from Paulson and Bernanke: “I was instructed that ‘We do not want a public disclosure.”

Basically Ken Lewis, CEO of Bank of America did not have the guts to do what was right and the U.S. Treasury and Federal Reserve basically sacrificed the American taxpayer to save another crony bank.  Ken Lewis wanted to back out because Merrill Lynch had horrific losses which made the deal a bad one.  Yet the U.S. Treasury through Paulson realized that the only way they were going to get political power to save Merrill Lynch was if they linked it up to a large institution most Americans are familiar with.  Bank of America.  Lewis greedy and hungry naively jumped into the deal to own a Wall Street broker powerhouse and got screwed.  Once he found out the fact that the firm had lied (shocker) about losses it was too late.

Once BofA had Merrill, Paulson basically told Lewis if he backed out he would be replaced.  You keep hearing systemic risk non-sense but Lehman Brothers failed and we managed.  Yet how could they allow one of their own to fail?  This folks is how Americans are bailing out banks and Wall Street while each day 20,000 additional Americans become unemployed.

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So what are some of the causes of this depression?  First, production during this time was increasing on a global scale.  So it is important to understand that.  Yet what occurred is that prices fell at an incredible velocity.  Just like any major calamity, the major turning point came when the Vienna Stock Exchange collapsed in May of 1873.  The French economy was hurt because it had to make war reparations to Germany from the Franco-Prussian war.  In the U.S. much of the price collapse was based on tighter monetary policy.  The U.S. made a strong attempt to go back on the gold standard after the massive expansionary cost brought on by the Civil War.  The U.S was doing virtually the opposite of what is currently going by taking money out of circulation.  As we know, the U.S. Treasury and Federal Reserve in our current environment are exercising one of the most expansionary monetary policies ever witnessed.  Yet the problem of course is this money is making it into the hands of banks and we are witnessing depression in prices once again.

It is interesting to note that the “greenback” which was specie came about in August of 1861 and was authorized via the Legal Tender Act of 1862 and stayed in circulation until 1971.  This brought on rampant speculation and fraud including the building of the Union Pacific and exploded with the 1869 Credit Mobilier panic.  There was a railway building bubble which collapsed in 1873.  If you think of the housing bubble you can understand how over building in any industry can come crashing down once a fiat system is over leveraged.

Many nations around the world enacted protectionist policies to protect industries that were being hurt.  There were fierce movements of nationalism during this time which pushed economies into their respective corners.  Tariffs were enacted and President Harrison won the 1888 election on a protectionist message.  Many believed and followed the tenets of classic liberalism and believed the government had little role to intervene in the economy and many followed this.  This cannot be said for our current crisis.  We are intervening like never before.  Massive bailouts.  Gigantic injections of liquidity.  Fiscal and monetary stimulus.  We are throwing everything at this crisis.  Yet the world markets have still seen $50 trillion in wealth disappear.  The problem of course is that we have been delaying any major correction for 30 years by hiding the technology bubble and housing bubble and now we are facing one major correction.

The Long Depression although it “only” officially lasted 65 months ran well into the 1890s:

The economy was in and out of depression many times for 30 years.  Yet the U.S. was expanding  and wholesale giveaways of water, timber, fish, and minerals pushed major expansions and for those who were wealthy led to the Gilded Age.  Another huge crash occurred in 1893.

And if you think bank runs are something from the past just think of the electronic bank run on IndyMac bank.  Here is how the old bank runs used to look (New York City 1873, 4^th National Bank):

Another factor setting off the crash was the implosion of the Jay Cooke & Company.  This was a major component of the banking establishment.  It collapsed when it found that it was unable to market several million dollars in Northern Pacific railway bonds (does this sound familiar?).  At the time, much of the investment banking establishment was salivating for railroads much like our recent investment banks went off the edge with real estate.  When the funding source dried up or too much over building occurred, multiple external forces collapsed the market.

After the Civil War many people found employment in the railway boom.  Outside of agriculture it was the largest employer and also had the most money at risk.  In fact, there are many parallels with our current employment situation and how many people are dependent on the finance and real estate industries.  Once that industry imploded, many people found themselves out of work.

Europe recovered much quicker from the crash.  For example, German businesses managed to avoid the major wage cuts brought on by the depression in the U.S.  Also, the major influx of immigrants kept cheap labor on the market for the U.S.  In 1876 unemployment reached 14% in the U.S. which is another interesting point from the Long Depression.  For the most part, the Great Depression saw wider unemployment – as stated before much of the problems occurred by the price depression being seen in goods and wages.  The U.S. also was the cheap labor market similar to what China and India are today.  Some of the problems in Europe occurred because of cheap American goods flooding the markets.

How things change.  The Long Depression was a troubling and long economic worldwide contraction.  The Long Depression, the Great Depression, and our current crisis all have a global entrenched component.  It would be wise for us to learn from these past events.  In fact, our current crisis resembles much of what Japan did with their baburu keiki (asset bubble).  Massive fiscal stimulus and injections into otherwise insolvent banks.  We are in unchartered territory here.

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The flaw with that thinking is that first, you assume government measures of inflation or economic activity are correct.  First regarding inflation, we had a decade long asset bubble fueled by easy credit and the government completely missed out on this because of the way inflation is measured, they look at a data point called owner’s equivalent of rent.  That is, how much would it cost to rent your current place?  This missed many data points since homeownership came close to reaching 70 percent at the peak and many people had exotic loans which many times understated the actual price of the home cost by as much 50 percent.  That is, you might have an adjustable rate mortgage paying $1,500 a month but the true 30-year fixed monthly cost would run you closer to $3,000.

Second, the government was late to the game in calling the recession.  First, many relied on the National Bureau of Economic Research to call the recession.  They were 12 months late here:

As the above points out, the NBER isn’t exactly precise on calling recessions and frankly, their job is more of a historical one.  We also had critics using the outdated model of calling a recession by looking at two negative quarters of GDP growth.  Of course this didn’t happen because in the first half of 2008, the government sent out those stimulus checks which barely kept us in the positive.  So by that measure, we weren’t technically in a recession.  Yet those rebate checks were part of fiscal stimulus and you see how weak of an impact that had on the economy.  And don’t think this was chump change.  $167 billion and look how it helped our economy.  When you have $49 trillion in combined debt, $167 billion is a drop in the bucket.

As I’ve argued before, the Federal Reserve and U.S. Treasury are determined to destroy the U.S. dollar.  There policies are still clinging to a thought that believes monetary policy is the way to go.  Only recently, have they opened up their rhetoric to support fiscal stimulus.  After $8 trillion now committed to various bailouts, they are finally realizing that monetary policy is not the way.  $8 trillion is 57% of our annual GDP.

Yet this isn’t to say fiscal stimulus is the solution either.  Think about how that tiny fiscal stimulus of $167 billion worked out.  All it did was kept GDP slightly positive and spurred some consumer spending.  In the scheme of things, this may be slightly better since at least those on main street get some more money instead of those on Wall Street but this did little to help the economic situation.  The government is now proposing a nearly $1 trillion stimulus package.  First, let us look at how large this really is:

This is going to push our total deficit close to 10 percent of our annual GDP.  That is the largest amount since World War II.  Think about that for one second.  We are fighting this economic battle like the Axis Powers.  The chart above is optimistic that this fiscal stimulus will be enough to boost the economy.  Yet the real question is will it?  If $8 trillion committed to bailouts with nearly $3 trillion shelled out hasn’t helped, why are we to expect that $1 trillion in fiscal stimulus is going to stop this recession?

This argument tends to get politicized, one side favoring monetary policy and the other fiscal.  I think most Americans favor something that works.  We already know monetary policy doesn’t work because of corrupt and misguided plutocrats at the Federal Reserve.  Yet the Congressional Budget Office may be too optimistic on how quickly we will be up to stable growth in our GDP:

I’m not faulting the CBO here since they are simply putting out their forecast.  Yet why are we to think that things will already stabilize in 2010?  Last year we saw that 2.5 million people lost their jobs and this trend doesn’t seem to be abating.  The incoming administration is looking to add 3 million jobs which will simply replace those lost in 2008.  Yet is that reason enough for growth?  The fact of the matter is we are incredibly deep in debt.  These historical actions tell us the government is at a point where this has to work.

Yet if we look at places like Japan and their lost decade (two), they had a stagnant economy for nearly 2 decades.  They followed the same path we are, monetary policy failed (Bank of Japan dropping rates to near zero), capital injections into banks, infrastructure programs, and all this happened on the back of a stock market and real estate bubble.  Yet Japan is a saving country.  We are a debt spending country.  The only way we can keep going is if the world is willing to fund our spending.  Now with the Federal Reserve and U.S. Treasury trying to destroy the dollar, why would you as a foreign country want to invest in something you knew was systematically trying to be de-valued?  At a certain point, foreigners will stop because they either are broke or simply do not want to be put in a losing investment.

Take a look at Japan:

The bubble in Japan went full force from 1987 to 1990 and then popped.  Keep in mind the above chart doesn’t show all the monetary and fiscal stimulus injected into the system when the bubble popped.  Even with that, the stock market and real estate declined (is declining) since 1990.  That is why I’m not as optimistic as the CBO that we’ll be back and running at full steam by 2010, certainly by 2011.

People are pointing to the Great Depression and the New Deal as example of fiscal stimulus pulling us out of economic funks.  I’m not sure I agree 100% with this.  There are good things that came out of this like the FDIC, Glass-Steagall, financial regulations, and programs to help the poor.  Yet when I look at the data, it seems that fiscal stimulus only blunted the pain of any economic downturn for the average family instead of actually pulling an economy out of the dumps:

I think the average working person does not concern themselves with micro and macro economic forces, the Federal Reserve, or monetary policy.  I can count on one hand how many times the Federal Reserve has been mentioned on mainstream television.  Yet the unemployment rate is something the average American does feel.  This hits home probably the hardest.  The above chart highlights unemployment during the Great Depression.  As you can see, even after the New Deal, unemployment stayed above 20 percent for 3 more years, and never dropped below 14 percent until we entered World War II.

The dip in 1938 was a push to balance the budget which sent the nation back into recession.  So it would seem, that fiscal stimulus was the only game in town for a very long time here.  That is problematic.  What we can agree on is the unemployment rate did improve.  I’m sure many workers actually appreciated working instead of looking for handouts even if it was government work.  Having a few bucks for food gave people a sense of dignity instead of soup lines.  Yet the above doesn’t show that this spurred a sustainable economic model of growth.  Yet we have to be fair as well since GDP did grow during this time:

So what are a few things we can learn from above?  First, GDP did improve under the New Deal.  Yet how much of the growth was based with government programs?  A lot.  In fact, the recession in the later 1930s showed how much.  The government started cutting back and trying to balance its budget and you can see what happened.  Next, World War II turned on the rocket burners for GDP.  After the war, GDP slammed on the breaks.

We are in a tough spot.  The danger we face is the major reliance on government for jobs in the upcoming years.  Japan serves as a recent model of massive government intervention (with no major war).  The Great Depression shows us that fiscal stimulus isn’t always a panacea.  I think most Americans want a country that has sustainable growth, that values hard work/production, and has a future for our younger generations.  Yet we have currently become a country that wants quick fixes.  We have never seen a housing and credit bubble like the one we just had that has wiped off $50 trillion in wealth globally.  To think that one year is going to change everything is naïve.  We have spent beyond our means and the piper must be paid.

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This isn’t simply a conjecture but is based on facts.  When Ben Bernanke was quoted as throwing dollars from helicopters what he meant is he had no regard for maintaining the actual value of the USD.  What he was discussing is battling the menace that is deflation.  Bernanke is an expert regarding the Great Depression.  I’m not sure that when he took the Federal Reserve chairman position did he realize he was actually going to have to face a situation which would put his theory into practice.

What we are facing is deflation and we have not seen prices drop this fast since the Great Depression:

That is why we are already dealing with the prospect that this recession will have deep impacts like nothing we have seen since World War II.  The fact that consumer prices have been falling over the past 4 months is significant.  This is not a one month event.  We have seen incredible drops over this time:

August 2008:              -0.1

September 2008:         0.0

October 2008:             -1.0

November 2008:         -1.7

The major question is will this continue.  Most of the recent historical drops have to do with the bubble in oil bursting and automotive sales simply falling off a cliff:

*Source:  Suddendebt.blogspot.com

The above chart in automotive sales is extremely telling.  Sales have fallen off a cliff.  What has occurred is we have spent our future today.  That is, we have enough cars floating in the marketplace to satisfy years of demand.  That is something that is being missed with the auto bailouts.  One part is yes, American automakers have missed the boat in creating cars people want to buy.  Yet the bigger problem is people simply have no money to buy any additional cars unless more unhealthy credit is extended.  This is something that the U.S. Treasury and Federal Reserve would love to see happen.

Every action they have taken comes at the cost of individual financial success.  They are purposely making it useless to save money.  At least, that is the psychological warfare they are trying to do.  How so?  First, you drive interest rates so low that it is almost pointless to save:

The Federal Reserve has kept interest rates at historical lows for this entire decade.  Alan Greenspan was the first to take rates to historical lows and was only beaten by his predecessor in Ben Bernanke.  This is problematic.  One primary reasons the housing bubble took off for so many years was the fact that credit was flooded into the system.  This of course came at the expense of the U.S. Dollar:

Since 2000 the USD has fallen by nearly 20 percent.  That is significant in terms of a country’s currency.  As you will also notice in the chart above, we had a bounce from recent lows that has increased the value of the USD by roughly 10 percent.  Why the sudden jump?  The fact that the USD was up in 2008 is by no means any help by the Federal Reserve or U.S. Treasury.  The reason the USD rallied last year was the destruction of the decoupling myth.  What it turned out was other countries around the world had equally bad or even worse balance sheets than the US.  So a flock to safety occurred.  In dire times the USD still holds that throne.

Even with negative rates on treasuries, people still felt the need to store their money in the USD.  During this time Ben Bernanke manipulated the effective funds rate to go from 3.94 percent in January of 2008 to our recent zero percent.  We have never seen it this low since the Great Depression.

Keep in mind that it would be very simple for our government agencies to increase the value of the USD.  All they would need to do is to raise rates to attract more capital in the system.  Capital, not devaluing the currency.  But that is the least of their worries.  What they want is for people to spend more and more.  That is why credit and debt is flooding the system:

This is an important chart.  First, the U.S. consumer is tapped out.  They are carrying roughly $14 trillion in debt with auto loans, student loans, mortgage debt, and credit card debt.  The spike highlighted in red above is banks keeping additional funds in excess reserves.  This is money that they can lend without putting their reserve limits at risk.  Yet they are not.  Why?  Look at the blue line.  If you were a bank, would you lend to a consumer market with nearly $14 trillion in debt?  Of course not.  Yet the Federal Reserve somehow thinks this is the solution to our problems.  Give banks which were at the center of creating this mess access to more funds at the expense of taxpayers.

The Fed is already pushing the limits on its own books putting nearly $3 trillion of questionable assets on its books.  This housing bubble has its roots in 1979 and only took off starting a decade ago.

From every early indication we are getting, the Fed is determined to keep this gig going.  What this means, is hard assets like gold will probably have another positive year.  By the way, gold was another winner in 2008 even after tanking.  The reason for gold is more basic.  Where else will people store their money.  In zero percent treasuries?  Globally?  Under the mattress?  It seems like gold will be one of the few last spots.  The Fed and U.S. Treasury seem to indicate further policies that will slam the dollar.  Yet here is another problem.  Other global central banks are doing the same thing which almost negates our own actions.  The race to zero interest rate policy has started.

The U.S. Treasury and Fed which have a responsibility in protecting a stable dollar are set to destroy it.

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