Lately, I have been thinking whether the Great Depression was avoidable or not. With further reading, it seems that this Great Recession will become the Second Great Depression, though milder so far, largely due to better policies from the world governments. The recent European crisis, as Lena Komileva from Ft.com correctly pointed out:
… is not a liquidity crisis but a solvency one and the fiscal and political resources of the capital providers of last resort – the governments – are virtually exhausted given rising public debt levels, unstable capital markets and a strong aversion by the domestic electorates to further bail-outs. So the current crisis looks less disorderly, but it is potentially more long-lasting and far-reaching.
As the outcome, according to Mohamed El-Erian, CEO of Pimco, the latest G-20 communiqué
... recognizes that “significant challenges remain.” Some of these are behind an important change in the overall G-20 policy approach. As I read the communiqué, the Group has gone from strongly supporting growth stimulus to recognizing two critical issues: The approach has not succeeded in delivering sufficient economic escape velocity (confirming recent sluggish indicators of self-sustaining recoveries in the industrial world, including yesterday’s disappointing U.S. jobs report); and that collateral damage is being strongly felt in the form of increasingly unsustainable deficits and debts (consistent with growing core/peripheral tensions in Europe and the failure of the massive ECB/EU/IMF response to deliver any durable improvement to date).
This time is different from all the previous recessions after the World War II in the sense that it is a solvency crisis, starting from the banking system, extending to the governments as sovereign debt is mounting and quantitative easing becomes unsustainable. The crisis is far from over. Sovereign solvency issues can only be resolved by a package of solutions:
- Restructure the debt
- Largely deflate the currency
- Dramatically cut spending and raise taxes
- Export out of the debt
It has been the perfect recipe. Use Turkey as an example. In 2001, Turkey’s debt was approaching 80% of its GDP and failed to collect enough taxes to cover interest payments on its national debt. Now, its debt-to-GDP ratio is 46%. To achieve this, Turkey’s lira fell 54% against the dollar in 2001. Unfortunately, PIIGS countries cannot take the same recipe as far as they are within the euro-zone. Even if they did, today’s global economy weakness makes it hard for a swift bounce-back. As the crisis drags on, investors will eventually reach a real panicking point sometime down the road. If it happens, it will bust the whole bond market, triggering the second Great Depression.
People might not believe such doomsday talk. Surprisingly, not so many people are talking about the almost failed German debt auction on May 26th:
Germany’s issue of five-year bonds attracted bids of just 1.1 times the amount on offer, compared with 1.5 times at the previous auction last month. This was only achieved after the Bundesbank retained £1.55bn, or 22%, of the €7bn (£5.45bn) issue of 2.25% bonds on offer. Had this chunk of the debt remained on the table, Germany would probably have failed to find buyers for all of it.
If countries like Germany start to have issues selling their treasury bonds, how long will it take before it impacts the global bond market? It shouldn’t take long. That’s why Europe cannot afford the same quantitative easing as the U.S. has done in the last year. Thus, the Greece Crisis is not well contained yet. Is the Great Depression Avoidable?
Disclosure: long VXX and energy, and short finance and real estate