Great Depression 2.0: Is it Over Yet?

It's been almost a year since I wrote Great Depression v2.0: Missing Piece Of The Puzzle.

Let's review some main points. We have had only one full blown worldwide Great Depression for comparison: 1928 - 1938 (there is a point of view that it only ended in 1942). There are also two known (to me) depressions which were not international: the Depression of 1873-1879 in the US and the Great Japanese Depression: started in 1989, still counting.

There is one common thread binding these three crises. Each one had three components: a real estate boom which went bust, a financial crisis and a structural crisis. A lot was written about the first two factors, but the structural crisis component somehow avoids economists' attention. Which is unfortunate, because it's key. There are a lot of examples of financial crises, which were resolved relatively quickly. There are examples of real estate crises which didn't crush economies: 1990 - 1991 in the USA, 2003 in the UK and plenty of others.

A structural crisis is different. It's created when some new technology or market change, or combination of both changes the way a significant part of the economy works. Initially there is a boom, as the new technology creates new jobs and new demand for products. But later on, old industries get killed by the new technologies. In an ideal case, the economy adapts quickly enough to the change, no other big crisis happens and everybody is happy. Examples: personal computer revolution of 1980s, first phase of the internet revolution in the end of 1990s. Below are the not-so-ideal cases.

By 1873 in the US there was a huge buildup of railroads. A lot of money was invested in them and the associated real estate. Railroads changed the way the economy worked, creating a structural crisis. Whole industries (for example, cattle runs, the Pony Express mail, shipping between the East and West coasts around the Horn) were about to be destroyed. Maybe this process could have been less destructive, but in 1873 the country adopted the Gold Standard, triggering severe deflation and financial crisis. A real estate crisis quickly followed.

By 1928 the developed world mostly switched from the horse to the internal combustion engine in transport and agriculture. It was a huge structural change, which was going relatively smoothly. But at the end of the 1920s the US was hit by a real estate crisis, and a stock market drop in 1929 created a financial crisis. Welcome, Great Depression. The structural change was worldwide and so was the depression.

By 1989 Japan achieved great success as an exporter of excellent and inexpensive products. Japanese companies became world leaders in car, heavy equipment and electronics manufacturing. Unfortunately, the internal economy changed slower than export-oriented; sometimes economists joke that there are two economies in Japan. The Japanese, being extremely conservative people, invested most of their savings in real estate. Some money started moving to the stock market in 1980s, including a lot of foreign money. There were two bubbles in Japan by 1989: real estate (several blocks in the center of Tokyo were priced higher than all of the real estate in California) and stock market (P/E of Nikkei was, if I remember it right, around 57!). It's the longest running depression in the modern world now.

Bernanke just said that the recession is technically over. Great. If we get out of this crisis next year, I will be the first to propose the installation of a giant gilded statue of Mr. Bernanke right in front of the Federal Reserve building. I have my doubts though. The three depressions mentioned above didn't finish until the structural imbalances were worked out. It takes time. The Japanese Great Depression is an example of what happens when the government and the Central Bank try to fix a depression using financial tools alone: nothing. I just hope that the people of Japan started the necessary structural changes by voting LDP out of power.

The current structural crisis is a result of a double whammy: internet plus globalization. A lot of good things happened as a result of the two, including fast development of poor countries such as China. But this development also created huge imbalances. There are whole industries which have to downsize and restructure. First of all, everything related to information. Newspapers, TV, magazines, music, phone services, books. Another imbalance: the prices of commodities. Most of them are overpriced, compared to historical trends. Mining industries and agriculture didn't keep up production with demand. But they will catch up, eventually. Big imbalances need a long time to be worked out.

Of course, we can hope that the governments and central banks of the world managed to fix the current crisis and everything is going to be just fine soon. Hard to believe though.

How does depression affect investments? Long term, it depends on societies, governments and central banks making the right decisions and not trying to sweep problems under the carpet. That's the difference between the Great Depression of the 1930s and the Japanese Great Depression. Let's suppose we are going the American way, not Japanese way. If it's true, now is the time to buy, buy, buy. Despite the high probability that we have several years of worldwide depression ahead of us. The best time to buy stocks in the 1930s was in the middle of 1932, when the Great Depression was just flexing its muscles. The current depression is running faster than before but my assumption is that we are in the equivalent of 1932 now.

What to buy? Forget about commodities. Long term, they are dead as an investment class. Depression = deflation, forget about other inflation fighting investments. Invest in the future, in new technologies. Most of the tech companies don't have any debt and have a lot of cash. Cash is king during deflation. Some of the companies will fail, some will win, but as a class, techs will win. Banks will win since they can get money from the Fed. Sin always wins: tobacco companies pay huge dividends and usually do great in a crisis. Don't know about anything else.

The danger is, as usual, in assumptions. If we go the Japanese way, cash is the only way to go. I'm betting on the American way.