Did This Just Trigger the Beginning of Another Depression?

FEBRUARY 7, 2016
from Casey Research

Casey Research: You believe we’re headed for an economic catastrophe. Why?

Tom Dyson: Most people don’t know it, but the collapse of a tiny Austrian bank called Creditanstalt in the ’30s triggered the Great Depression. I think a similar event has already started today.

Casey Research: How was a default in a tiny European country able to send America into Depression?

Tom: So much of finance comes down to confidence and trust. And that‘s because finance is about promises. Promises to pay or deliver something in the future in return for something now.

Think about it. A stock is a piece of paper that’s nothing but a claim on a company’s future dividends and its value in a sale or a bankruptcy.

A bond is a claim to money from a creditor in the future and maybe some interest payments.

Your bank account balance isn’t real cash. It’s just a bank’s promise to pay you that amount of cash the next time you ask for it.

The bigger the promise from a borrower (or financial instrument), the greater return it has to offer. The lender needs to compensate for the riskiness (the big promise) of the borrower.

So much of the promise usually has to do with the counterparty, or the person making the promise. If that person has a long history of making good on their promises, then trust and confidence is high.

In a complex financial system, the players trade with each other, shuffling money and promises around the system. The system becomes vulnerable to domino effects. When a big company goes bust, often its creditors go bust, too. We saw this in 2008.

Creditanstalt was the first domino. Herd mentality deserves a mention here, too.

Fashion trends… flocks of birds… schools of fish. It’s to do with the way animals are wired for survival… something hardwired into our code and the way we make decisions.

When trust evaporates in a complex market, investors go running for the door. Sell now, ask questions later. And it snowballs…

Casey Research: What does this have to do with the Great Depression?

Tom: The Depression was just a consequence of a mania that preceded it. In this case, a mania in borrowing, lending, buying, and investing. Lenders and borrowers became overconfident. Capital became too available. Much of it went into the stock market and pushed the price of stocks to unbelievable valuations.

I don’t have the figures in front of me, but if you look at any chart of stock market valuations, 1929 stands out. It has by far the highest stock market valuations in history EXCEPT the period from the late ’90s onward.

In short, there was a stampede into investments, like the stock market and businesses. People got loose with their money. They called the period the Roaring ’20s.

An extreme in herd mentality set the conditions. The Creditanstalt default was the snowflake that triggered an avalanche.

Some investors lost their trust and asked for their money back. They called their loans in. They sold their stock. And it lead to a stampede—a herd of investors moving in the same direction.

The authorities couldn’t stop it. It’s very hard to reverse these psychological changes once they start… and the Great Depression lasted for a few years.

Casey Research: Okay, so Creditanstalt triggered the Great Depression. Could a similar “chain reaction” of this sort happen today? If so, what might that look like? Walk through a few scenarios…

Tom: Yes, absolutely. We saw that chain reaction again in 2008. First, New Century Financial went bankrupt. Then, some other mortgage bond funds went down. Then, Bear Stearns went. Then, Lehman. Then, AIG. And then, the entire system… until the Fed saved it.

The Fed’s bailout restored confidence. The markets climbed back up. They stopped the avalanche. It was amazing. But it had to use some serious financial shock and awe to do it. Something it didn’t know how to do in the 1930s.

And today, it’s more likely than ever in history given how lopsided herd mentality is these days… and how interconnected the world is. I think one has already started.

The markets just had one of the worst months in history. It started with China.

In October 2015, I predicted China would further devalue its currency, the yuan. In fact, it did just that on January 7th.

Now, China’s markets are crashing. Its stock market is down 22% in 2016 (just 23 trading days) and 47% since its June 2015 peak. That’s a huge crash… much like the 1929 crash in the U.S.

A stock market crash is always the first trigger of a deflation. That’s because it has such a powerful effect on social mood. I think China is a catastrophe in motion. Especially because the country’s authorities are new to capitalism. They have 20 years of experience. That’s even less than Americans had in 1929. They at least had a half-century of booms and busts to live through. The Chinese authorities are going to bungle this. They already have…

That, in turn, is going to be bad for the rest of the world… for many reasons.

For one, China has a lot of rich people. These people have spent so much money on luxury goods, such as handbags from Paris and apartments in Vancouver. They’re going to stop spending. That’ll hurt.

China has a lot of suppliers, too. Entire countries—such as Brazil and Australia—owe a decade of growth to trading with China.

China’s devalued currency will lead to a trade war with other Asian countries. They’ll all devalue. It’s already happened. Emerging-market countries like Malaysia, Thailand, and Vietnam all devalued their currencies in 2015. Even Japan has taken part in the currency wars. It lowered its interest rates into negative territory. Depositors now have to pay the banks to hold their money.

It’ll turn the dollar into a safe haven. And it’ll cause serious pain for anyone who played the carry trade… which is a lot of people.


Casey Research: What’s the carry trade?

Tom: It’s when someone borrows U.S. dollars and invests them in Brazilian farming, Thai production, or Australian mining. It’s been a huge trade. Why? Because you can borrow dollars almost free… at 0% interest rates. And then, you can invest them at much higher rates elsewhere… typically in emerging markets and other more risky places.

The euro is also near 0% interest rates. So is the pound, the yen, and the Swiss franc. Speculators have borrowed trillions in these currencies and traded them for shaky foreign investments.

That trade will now be painful. And another set of dominoes will fall as it unwinds.

This is why what the Fed has done is so dangerous. By making interest rates zero, it encouraged risk-taking. That was the whole point. It stimulated investment, buying, and production… to generate confidence. But it also set the conditions for a chain reaction.

And it’s going to be really painful.

I see many bankruptcies in foreign countries. This week, I read about a Korean shipping company—one of the largest in the world—fighting for its life. I see pain for companies that have borrowed money and invested in risky places. Like the banks. They financed the oil boom. Now, they’re going to take multibillion-dollar write-offs.

This is seeping into American markets. The rising dollar is killing corporate profits. That will cause the U.S. markets to fall. And that’s the big one. Once U.S. markets fall 10-20% (the S&P 500 is down 10% from its May 2015 peak), social mood starts to change… and the avalanche starts.…

More saving, less spending, less borrowing, less lending, less investing.

With the down month in January, I think we’re pretty close.

And this time, it’s going to be hard—if not impossible—for the Fed to shock and awe the market into reversing sentiment. Because it’s already put interest rates at zero. I don’t think it can repeat the heroics.

We’re going to get the hangover we should have gotten in 2008 but never did… Except it’ll be even worse because of all the additional debt, bad investments, the carry trade, and the Third-World stupidity that’s happened in the last eight years.

There could be a banking crisis where you can’t get your money out of ATMs… No credit will be available for buying houses, cars, etc.

And what about the markets? I have two rules of thumb…

1) If it went up during the boom, it’ll probably go down now.

2) If it went down in 2008, it’ll probably go down now, too.


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