A Simple Explanation of the Great Recession and Why It Has Years To Go

From 1987 when Greenspan took over the Fed until 2009 when the US hit Peak Debt, the US private sector added $34T of debt while US GDP only went up by $9T. Rather than seeing this as a classic Ponzi Scheme, economists praised it as financial innovation. Steve Keen, an economist out of Australia, writes a trenchant essay on this topic entitled What Bernanke Doesn't Understand About Deflation that explains why this Ponzi Scheme is the greatest failure of the Fed and central banks around the world. 

His point can be understood this way: what an economy produces (GDP) plus the increase in private debt equals the aggregate demand for stuff. The increase in debt ahead of GDP means the country is living beyond its means, consuming more than it produces. At some point this cannot go on, and the debt begins to shrink. As it shrinks, GDP less the change in private debt equals aggregate demand. As debt shrinks the drop literally sucks demand out of the economy.

• At the peak of our credit bubble, new debt drove US demand to an astounding $18T, $4T beyond GDP of $14T
• By 2010, the decrease in debt turned GDP of $14T into demand of $12T - an absolutely brutal turnaround of -$6T in two years

From $18T to $12T in two years means a third of the wind got sucked out of the sails of the US economy. In 2010 alone demand is headed to a drop of 17% - about what happened in 1930. 

The next two years (1931 and 1932) saw drops of 27% and 24%. 

While our recent massive increase in govt debt cushioned our drop, it cannot overcome it, especially with State governments now facing a estimated $1T shortfall over the next three years, and political pressure rising against taking on any more massive Federal debt. 

The same problem occurred in 1930-33: excess debt from the Roaring '20s led to the depression. It is incorrectly believed that Hoover failed to stimulate. The increase in Federal debt in 1930 ($1.1B) was larger than the decrease in private debt (-$0.7B). The problem is that in the year before, 1929, the excess of new debt over GDP was much larger ($5.7B). The delta is what matters, and the drop of $6.4B (delta between +$5.7B and -$0.7B) overwhelmed govt stimulus. The debt write-offs got larger over the next three years as the excess of the '20s had to be worked off. It was only around 1934 that the horrific debt write-offs had begun to abate, and the Federal stimulus had caught up. (Steve's essay has data tables that show this.)

Our problem was set in motion over those years from 1987 to 2009 (Peak Debt), when the US went on a debt-fueled consumption bender. At some point, the piper has to be paid. The excess has to be worked off. The US lacks the productive earnings to pay off the excess debt, so it gets written down. We have years of this process still to go.

Steve opines on why this mistake was made, the mistake being the celebration of excessive debt as financial innovation: both Keynesianism and modern economics as taught today are based on a presumption of equilibrium that harkens back to neoclassical economics. In the 1930s the leading US economist, Irving Fisher, who had been a neoclassicist, abandoned the presumption of equilibrium and proffered his debt-deflation explanation for the Great Depression. Bernanke, our current-day student of the Great Depression, in his criticism of Fisher's explanation describes his theory thusly:

Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties.

This seems about right. Think of what is happening right now in real estate. Despite all the attempts to roll things forward or restart the housing markets, demand has fallen to the floor and defaults are increasing while housing prices continue to drop. Bernanke however goes on to say something which seems to completely miss the dynamic we are living through:

[D]ebt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects.

So he would say the collapse of housing in the US should have no significant macroeconomic effects? Somewhere Bernanke is making a huge mistaken presumption. His critique does not comport with the real world. Steve points the finger to Bernanke maintaining that presumption of equilibrium. In an irony of history, the presumption of equilibrium which Fisher abandoned has crept back into modern economic thinking. Steve's conclusion is priceless:

We might not be in such a pickle now if economics had started to become more of a science and less of a religion by following Fisher’s lead, and abandoning key beliefs when reality made a mockery of them. But instead neoclassical economics completely rebuilt its belief system after the Great Depression, and here we are again, once more experiencing the disconnect between neoclassical beliefs and economic reality.

Comments

[Trader123]

Nice 4 point squeeze on the S&P's heading into the close. Gee, I wonder why???

[Mamma Boom Boom]

>A Simple Explanation of the Great Recession and Why It Has Years To Go<

But, the government will always take care of us:
http://www.youtube.com/watch?v=pAldBxgRCdY

[Mamma Boom Boom]

You gotta admit, there are lots of bears out there. And, with Roger D. Jackson coming back, it's a full house!

[Michael]

Barclays surveys the hedge-fund community and their most recent survey shows the hedge-fund community at 47% BEARISH.

Roger is meaningless.
No real trader in their right mind would obsess over a stock like MCD that shows such little volatility.

[Mamma Boom Boom]

>Roger is meaningless.<

I wouldn't say he's meaningless, I'm sure he's a very nice man, and his family all love him very much. He just never learned to trade the markets. (kic..kic)

[Daniel - Taz]

Be careful here

The Euro Swiss cross looks like a disaster. Equities should follow. SOX at new low for the year.

If the market fails to sell off tonight in a meaningful way shortly, one could almost put a nail in the coffin of the bear case.

[JT]

I stopped by a number of blogs after the close today. . . Kenny, Daneric, Trading to Win, Evil Speculator, etc... and I am at a loss as to explain how any of these people can make a living trading the market.

99% of the people posting on these blogs are PERMA-BEARS. If anything, there appears to be a "bubble" in pessimism!

Unreal.

[vipul garg]

'bubble' in pessimism-JT

thats a neat one.

[DG]

I read Keen's article and went over to his blog to read the full version. I find Fisher's arguments about debt deflation more compelling than Bernake's hand-waving of the problem of too much private debt as merely redistributing capital from debtors to creditors. I find it awfully hard to think it's coincidental that the two great financial crises of the last 80 years both just happened to start when private debt reached saturation levels.

Anyway, the market's providing plenty of long and short trading opportunities and you'd have to be crazy not to take trades on both sides of the market when all it's doing is traversing the same trading range for months now.

[Rally Time!]

Market has rallied 80% off the lows and bears are STILL disbelievers! That tells me this market has more upside. SPX 1300-1350?

Rally wont stop until bears throw in the towel.

[Daniel - Taz]

Sharp move higher here in OZ looks like short-covering with Financials and Discretionary stocks lagging badly here, TRIN of 0.43, and very nice bearish divergences in both the Aussie Yen cross and the $A-US$.

Sep 1 is also circa 60 days from the price low so a very good spot for a reversal if the market has any bearish intentions at all.

[OracleLurker]

I hate it when the bulls win.

but that appears to be what is going to happen here. I think we could get 1-2 more days of ugliness max before this cycle is done - and most likely it's already done.

[Account Deleted]

Dow Jones futures before opening bell

[Michael]

Aussie GDP was better than expected, and so was the Challenger lay-off data, but most significant was the solid Chinese PMI data . . . hence yesterday's big rally in the iron ore, coal, and copper names.

Bears are in for a lot of pain.
Prechter's "nested" 1-2's are about to get blown out of the water.

[Michael]

Investors Intelligence Numbers.

Bulls: 29.4%

Bears: 37.7%

Can't recall the last time I saw the Bullish percentage below 30!

[Les]

Hedge fund liquidation probably completed in the last week. Everyone has been looking for a bounce in the last week, not just you permabulls.

If you check back in 2008, hedge fund sentiment was in a similar state going into Q3 and Q4.

[twitter.com/DrBubb]

Great article, Y.
"this Ponzi Scheme is the greatest failure of the Fed and central banks around the world."

Indeed it was. Greenspan identified "Irrational Exhuberance", and then proceeded to feed it, by giving speculators a free "Greenspan Put." In return, they fed his ego, and called him "The Maestro", as they collected their big bonus checks, and found all manner of ways of keeping the game going through more debt and lower rates.

What the US needs is an unpopular Fed chairman. I can still remember Arthus Burns, who thought it was his job to take away the punchbowl, rather than spiking it, as Greenie did.

[Michael]

"If you check back in 2008, hedge fund sentiment was in a similar state going into Q3 and Q4." - Les

Not sure what data you are citing but the recent Barclay's survey of hedge-funds cited 47% Bears.

As far as EVERYONE looking for a "bounce" over the last couple of days... you couldn't be more wrong.

Every Elliott Wave "follower" was looking for a 3-3-3 to the downside given Prechter's "nesting" of 1-2's. Even if you did not have his bearish count, most EWavers were still looking for a Wave 5 to the downside taking out the 1010 low to finish off the sequence.

Just look at Daneric's Elliott Wave blog. Full of DREAMERS drinking Prechter's "Kool-Aid". Same thing with all of those amateurs over at "Trading to Win".

They have no idea what they are doing. Frequently post false information and "fit" data towards their BEARISH Perma-Bear bias.

And when the market surges upward like today, they start posting about every CONSPIRACY THEORY in the book ( today's was the NY Fed Pomo operation ) to blame their ignorance and losses on.

If you had your nose to the grindstone yesterday, you would have noticed that the coal, iron ore, and copper stocks were UP yesterday even with crude oil getting smashed for $2.00

That was a head's-up" on the China PMI.

Good Luck.

[Mamma Boom Boom]

Can we take out 1130? Yes'm!

[Edwin]

Can we take out 1,081..the 50 day SMA? Hmmm!

[Michael]

Read Binve's blog last night and said that he had no problem being 85% short in his trading account and sitting through a Wave 2 retracement.

How could someone who claims to be a TRADER have no problem "sitting" through a 30 handle rally in the S&P?

If I managed my risk capital like that, I'd be Bankrupt in less than three months.

[Rally Time!]

I warned of this Labor Day week rally all week.

[Chico]

Prechter's "nested" 1-2's are about to get blown out of the water.

Seriously! As I commented the other day, that count was a complete joke. I'm sure they'll have a revised nested 1-2 count shortly!

[Rally Time!]

Ignore the broken record wrong-way Bears! Corporate profits are SOARING

20 most profitable companies
Fortune 500 earnings soared this year, despite a feeble recovery, as companies cut costs fast and deeply. From Goldman Sachs to Google, here are the biggest winners

http://money.cnn.com/galleries/2010/fortune/1004/gallery.fortune500_mostprofitable.fortune/index.html

[Mamma Boom Boom]

Like a big freighter, slowly we turn up.

[Rally Time!]

So far there is hope and relief, next stop OPTIMISM

[Michael]

The rally in Big Coal and Iron Ore continues...

ACI: +1.50
ANR: +1.74
BTU: +2.00
CNX: +1.45
CLF: +3.35
JOYG: +2.45
FCX: +3.95
WLT: +4.28

[Krieger]

Here is an interesting trade recommendation by Neely

http://www.traders-talk.com/mb2/index.php?act=attach&type=post&id=17764

Going long TBT looks interesting

[Wave Rust]

glad to see some bulls
could last a week or two ,,,, or maybe more :-)

but your johnson is shrinking ,,,, or so I heard ,,,, just don't look

wave rust

[Wave Rust]

kreiger,

have had a sell on treasuries for more than a week ,,, maybe longer. but they wouldn't settle right ,,,, got freaky nearly every day.

but i agree with neely's rate call

it may become a $$ buy too.

wave rust

[Wave Rust]

michael

this move has to get an impulsive look real soon, within 5-10 days.

some traders hedge, others just reverse, others stay with their bias until the pain becomes unbearable or, they get a margin call.

my market 'truck' has D for drive and R for reverse. i use both alot cuz i'm usually in some trade or position most of the time.

----
Duncan,
I have been watching for signs of a separation and divergence between the economy and markets ,,,, kinda like what happens at important bottoms especially when sentiment gets grossly bearish, which it is right now.

good possibility of that now, imo, where the economy flattens its downward sloping track for a little while. like '74, '82 and '87 sentiment and market lows. but the markets take off and lead some type of recovery because only the very few believe it enough to play the long side. some say thats smart money

or, maybe thats just my shrinking johnson thinking for itself. :)

wave rust

[Wave Rust]

aw shoot,,,, i wrote the 'i' word.

DG is gonna pound that one.

all the best DG :)

wave rust

[test]

 

WAY TOO MANY web surfers were following the Hindenburg Omen last week.

[Mamma Boom Boom]

Volume a little lopsided...

21-1

[Edwin]

Can we take out 1,081..the 50 day SMA? Hmmm!

[JT]

Anyone with half a clue understands that the NYSE list of new highs is filled with interest rate "proxies" like utilities, preferreds, closed end bond funds, etc.

That is why this "indicator" is totally useless AND so many naive, ignorant amateuers have flocked to it.

Just about every PERMA-BEAR blog from ZeroHedge to Daneric to Kenny to Binve to Evil Speculator to Trading to Win has obsessed over this indicator and the several "signals" that it has flashed in the last couple of weeks.

In any event, I want to thank all of the PERMA-BEARS and their sentiment for allowing our little trading group to take their "bias" as a hugely CONTRARY indicator.

"Trading to Win" might want to call themselves "Trading to Be A Loser" given their idiocy.

In fact, those guys better make sure that their wives continue to work to pay the bills - - - cause they couldn't trade their way out of a "paper-bag".

They have NO IDEA how to make money.
Thanks guys!
:)

[A Friend You Haven't Met]

Anxiety makes us attach importance to things that otherwise would be benign because we want so desperately to have a reason for feeling so panicky. Thus we see "nested 1-2s" and "impulse waves" and "head and shoulders" and spend time and money on "Elliott Waves" and "NeoWaves." Subscription sellers are special types of jerks because they prey on the anxious. Stocks/bonds/the economy will rise fall but there will always be a market for those eager to hear that it is crashing.

If you think you might have anxious tendencies, PLEASE try to see a good therapist and do not waste time and money making scumbags richer. Anxiety is the problem, in itself.

[Mamma Boom Boom]

JT, I can't figure out what your rant has to do with this site. Are you losing it? Maybe you should think about 'wrist management'.

[Greg]

A Friend Not that Eager To Meet, I doubt anyone could put it better.

[cjmorris]

Based on the bullish gibberish in the comments section, this Labor Day pop seems short-lived.

[JT]

"Stocks/bonds/the economy will rise fall but there will always be a market for those eager to hear that it is crashing."

P3!
P3!
P3!

LMAO.

[JT]

Looks at this absurd EW "count" from Daneric and how he labels intermediate (1) being complete with a 5-wave down sequence that shows a terribly failed 5th wave...

http://3.bp.blogspot.com/_TwUS3GyHKsQ/TH6_OhWEdsI/AAAAAAAAHWg/NomzgBfuiaE/s1600/spx60.png

Funny that his wave 1 and wave 3 EQUAL each other in length, and the wave 5 winds up being "fitted" to the chart given today's explosive rally!

I wonder if Prechter/Hochberg will stoop as low in tonight's STU.

LOL!

[DG]

aw shoot,,,, i wrote the 'i' word.

DG is gonna pound that one.

all the best DG :)

wave rust

Hey wave rust,

Best to you, too!

Yeah, lots of moves since March 2009 that start out looking Impulsive. Nice rally today that does the same. Proof will be in the pudding over the coming days. Problem is that if today was a wave-1, we'd need a pretty massive move up to get an Extended wave-3 of that Impulse. That's where they've all failed, both on the upside and the downside, for a long time.

Ironically, Neely is actually looking for an Impulse here (although his Impulse could take the form of a Terminal, given his larger wave count), so it would be nice to get one.

[Mamma Boom Boom]

>Ironically, Neely is actually looking for an Impulse here<

What kind of duration is he looking at? I might believe this thing could run til Christmas.

[DG]

"What kind of duration is he looking at? I might believe this thing could run til Christmas."

Feasible. A was 3 months, B, if it's over, was 4 months, so C should be a minimum of 3 months and probably closer to 3.5. Yeah, that takes us close to the end of the year.

[twitter.com/DrBubb]

"So far there is hope and relief"
You want HOPE?
Here's Hope: http://www.youtube.com/watch?v=7f1ovurzU2s
Which may have as many legs as this market.

[Broken Clock]

Where's good old Rog???

I see that MCD closed at year another new 52-week high.... LMAO!!!

Maybe he can find that slow freight train out of Newark tonight and just put himself out of misery.

[DG]

Where's good old Rog???

I see that MCD closed at year another new 52-week high.... LMAO!!!

Maybe he can find that slow freight train out of Newark tonight and just put himself out of misery.

Posted by: Broken Clock | Wednesday, September 01, 2010 at 04:22 PM

Wave theory is deceptively simple on its surface, but the market is unrelenting in its punishment of poorly-constructed wave counts.

[El Coro]

Poorly constucted is any brain that falls for idiott wave or ninny wave or any other batch of crap that pretends to predict markets by looking at charts like an ecg

[OracleLurker]

Well i had it wrong. This morning at 6:50AM it was clear I had it wrong - I could have "hoped" things would some how turn around but instead I just flipped from 50% short to 100% long and being wrong wasn't such a big deal - it never is when one's approach is driven by what the market is actually doing, as opposed to what we would like it to do, and you have clear parameters for entering and exiting positions. I don't regret staying committed to the trend because I believe that is always the best approach - the market always signals it's intentions before you have to take obscene losses if you know what to look for.