How to prepare for a new US depression

A new depression in the US is practically inevitable, says Doug Casey in the Daily Reckoning. You can take your pick from the likely causes: the probability that we’re going to hit Peak Oil in the near future, escalation of the War on Terror, the massive US trade deficit - or all three. So what are the signs to watch out for - and how can investors protect themselves, or even profit from the coming storm?

By Doug Casey

published 27 June 2006

in Features

It's been said that if you spend 15 minutes a year thinking about the economy, you're wasting 13 minutes.

That's generally true. But as an amateur historian, I can't help myself. And I'm forced to believe that this is a time when the subject is worth some real thought.

My view is that the longest, and certainly most important, trend in history is the ascent of man. I have little doubt that it will not only continue but accelerate.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

But that doesn't mean there won't be nasty setbacks along the way. As I have said before, possibly the best definition of a depression is a period when most people's standard of living drops significantly.

You can also define it as a period when distortions in the economy and misallocations of capital are liquidated. The distortions are almost always the result of government intervention in the economy, through things like taxes, regulation and currency inflation.

Those are the factors that caused the unpleasantness that began in 1929. Since the US government is exponentially more powerful and invasive today than it was in either the 1920s or the 1970s, I expect the consequences will be much worse this time around. Things could have come unglued, and almost did, back in the 1970s. I don't see how the US will dodge the bullet this time.

Although that's not really a good analogy, in that, for reasons we don't have time to explore in depth, a depression in the US is probably inevitable this time.

Preparing for a depression: inflation vs. deflation

The only serious question in my mind is whether it will be essentially deflationary in nature, as it was the case in the US in the 1930s, or inflationary like in Germany in the 1920s. My guess is the latter because the government is so much more powerful today. Or it could actually be both at once, in different sectors of the economy.

How?

US inflation could drive interest rates to 20%. This would collapse the bond and housing markets, wiping out trillions of dollars of purchasing power - which is deflationary.

Meanwhile, that same inflation doubles the cost of food and fuel. In other words, the opposite of what we've mostly had for the last generation, when we had 'good' inflation in stocks, bonds and property, but stable or dropping prices in 'cost of living' items. This time the pattern could reverse, which would be a nightmare for most people.

And as people become more focused on speculation in a generally futile attempt to stay ahead of financial chaos, they inevitably divert effort from economic production. Which will decrease the general standard of living even more.

Preparing for a depression: Peak Oil and the threat of WW3

The situation isn't made easier by the possibility that we're facing Peak Oil - the start of a secular decline in world oil production. Or the fact that Americans, both individually and collectively, are deeply in debt and living on the kindness of strangers.

The problem with debt is that it artificially increases the standard of living. But when it is paid off, especially with interest, it reduces the standard of living in a very real way.

Wrap this economic environment around the so-called War on Terror, which could easily turn into World War III, and you're looking at the perfect storm. The odds of a major conflagration are very high, and it's not being adequately discounted.

If Bush starts a war against Iran, or if another incident like that of 9/11 occurs, or even if the trend of the last five years accelerates, the US is going to be locked down like one of its numerous new federal penitentiaries. And that will be accompanied, and compounded, by mass hysteria among Boobus americanus.

At that point, your investment portfolio will be among your lesser concerns. People forget that, in every country and time, there's a standard distribution of sociopaths and misdirected losers.

In normal times, they seem like normal people. But when the time is right, they show their colours, and they love to get jobs with the government, where they can lord it over their betters.

Preparing for a depression: how bad will it be?

You may be asking yourself: Is the US Greater Depression really inevitable? How bad will it be? Is there another side to the argument? Can it be avoided?

I suppose it's not absolutely inevitable. Perhaps friendly aliens will land on the roof of the White House and present the government with a magic technology that can undo all the damage it's done. But we live in a world of cause and effect where actions have consequences. That being the case, I expect truly serious financial and economic trouble. And the US government will make it vastly worse by trying to 'do something' instead of recognizing itself as the cause and backing off. I don't see any way out.

How bad will it be? In historical terms, the last depression was relatively short and mild. The longest depression on record was the Dark Ages. Residents of the old USSR and Mao's China suffered through a depression that lasted decades.

I'm not predicting it will be that bad, if only because the US has basically much sounder traditions and institutions and vastly more accumulated capital. But it's hard to overestimate how serious this could be. I sometimes joke that it will likely be worse than even I think it will be.

Getting back to whether it's truly inevitable, it's a question of degree. The recession of the late 1970s and early 1980s involved a terrible stock market, 15% inflation with interest rates to match, 10% unemployment and a near war with the USSR. But the country not only hung together, it went on to a tremendous rebound. My guess is, however, that the last 20 years of good times will later be viewed as an economic Indian Summer before a harsh winter.

The good news, of course, is that no matter what the economic conditions, technology - which is the mainspring of human progress - will keep advancing. And many Americans will continue innovating, saving and improving conditions for themselves and their associates. Also, it's entirely possible to go through even the worst of times and not get hurt. Indeed to profit from them. If the price of a house you want now but can't afford falls 75% (as outrageous as that may sound at the moment) and you own investments in high-quality gold stocks, you're much better off. That house now really only costs you one-sixteenth of what it did before.

Of course it's a problem for the guy who has to sell his house...but I always prefer to look at the bright side of the equation. There's time now to structure your affairs so that you're on the right side of the trade.

Preparing for a depression: key indicators

Keep your eyes peeled for signs that indicate it's about to get ugly. One obvious indicator to watch is how the price of gold is running. Gold is the only financial asset left in the world that's either safe or cheap. It's also under owned and largely unrecognized, which is why the smart money has been moving into it.

Then there's the CPI itself - although I don't think it's very accurate, in that all the adjustments, exclusions, weightings and what-nots the US government has insinuated into it over the years makes the CPI as much of a floating abstraction as the dollar itself.

It's funny how the US government plays with figures for fear of hurting confidence. They believe the economy rests mainly on confidence, which, ironically, in today's world, is true.

Unfortunately, confidence can blow away like a pile of feathers in a windstorm - and we have a class-5 hurricane coming.

If the economy were sound and people for some reason lost confidence, the currency and the banks would be unhurt, and the next day things would go back to normal. But that's not the world we live in. So, higher CPI numbers are another thing that could destroy confidence and supercharge the gold price. They're coming.

Higher interest rates, which we're already seeing in the US, will inevitably burst the housing bubble, which is floating on a sea of mostly adjustable-rate debt, a lot of it interest-only or even with negative amortization. Higher rates will also crush bonds and probably stocks. And they'll devastate the economy since everybody is deeply in debt.

However, I feel the Fed will keep short-term rates - which are really the only ones they control - as low as possible for as long as possible. For one thing, they don't want a recession, which this time could snowball into the Greater Depression. For another, my guess is that they want to gradually depreciate the dollar against other currencies, in part to decrease the chronic, massive trade deficit. And because increasing the number of dollars makes people think they're richer than they really are, it can stimulate some additional spending...but these days that spending is mostly done on credit, so it is only illusionary.

The biggest single problem, however, is that there are trillions of US dollars outside of the US. Unlike Americans, foreigners have no reason to hold them. And at some point very soon, perhaps when the Fed finally hits the wall on its ability to raise rates, these overseas dollars are going to start flooding back home, while the products and titles to real wealth flow out of America.

Therefore, when the trade deficit starts turning around - which most people will think is a good thing - that will be the real tip-off the game is over. Trillions coming back to the US will skyrocket long-term interest rates and inflation. The dollar will go into freefall.

But although I think these are the things to watch, to my way of thinking it makes no sense to wait until the stampede starts to try to get out the door. If you haven't done so already, take advantage of the current correction in gold to begin repositioning your portfolio for what's next.