Strategic Investment

The Plague of the Black Debt and Beyond

”And now,” observes Adam, “we must again try to discover what sort of world this is….”

Nathaniel Hawthorne

Here’s a question for you.

Which is more important in informing your success? Your character and determination? Or the timing and circumstances of the efforts you make to get ahead in the world?

In other words, would you be just as successful if you had been born in different year or another country? And how much do macroeconomic conditions determine the reward you earn from your efforts?

All of this is closely related to the paradox that depressions can provide an excellent setting to start a business, without necessarily providing a good environment for making money.

These were topics of my dinner conversation in London a few nights ago with Simon Keeling, an old Oxford chum who was once a leading figure in the Oxford Dangerous Sports Club. Half a lifetime ago when I met Simon, he famously pioneered bungee jumping by leaping off the Golden Gate Bridge. The BBC ran a TV special program recording him in another of his headline stunts as he sailed off Mount Kilimanjaro on a hang glider.

Having broken almost every bone in his body at one time or another, Simon now gets his adrenalin fixes as a merchant banker in the City of London. He arranges M&A transactions and advises hedge fund tycoons about how to rationalize their portfolios. Just as shoe leather is the stock in trade of a cobbler, Simon traffics in success.

Rethinking the Brazilian Paradox

After a couple of glasses of Montrachet, I found our conversation revisiting some of the themes I shared with you last month after my visit to Brazil.

With Britain, like the US, sagging under the weight of staggering debts (by a strange or not-so-strange coincidence, outstanding consumer debt represents 16.6% of total annual GDP in both countries), I thought Simon would be astounded as I was to learn how differently Brazil is situated in the leverage cycle.

In Kensington, London’s richest borough, where shoppers have been subvened by decades of easy money, 20% of the shops have been closed and boarded. In Rio de Janeiro, where credit has been tight during the Bubble Years, and consumer debt is negligible, shopping malls are so crowded you can scarcely get in.

The paradox is that Brazil has thrived as a deleveraged economy and consequently does not face the quandary of figuring out how to “borrow its way to a higher savings rate” that perplexes American and British policy makers in the current depression.

The deleveraged state of the Brazilian economy is partly an artifact of punishingly high real interest rates in the recent past. As of June 30 2002, Brazilian government loans yielded 17.7%. Business loans yielded an average of 38.28%. And the average annual yield to banks on consumer loans was 60.57%. Taking out a consumer loan in Brazil made about as much economic sense as borrowing from a Mafia loan shark.

One of my mentors, the late Mancur Olson, was fond of saying that “values reflect what used to pay.” Or not pay, as the case may be. With the average annual interest rate on consumer loans bumping above 60% just a few years ago, it is easy to imagine why Brazilian consumers have tended to shun credit.

Important Lessons from Hyperinflation

I believe that the relatively recent history of hyperinflation in Brazil, which ended only in the mid-1990s, has acted almost like the mechanism of the gold standard. It has informed incentives for highly conservative banking regulation, along with sound fiscal and monetary policy.

Banking crises have historically spilled into Brazil from abroad – as they did in three years near the turn of this century. Brazil caught contagions from the “Asian flu” in 1997, the Russian crisis of 1998 and still another contagion from Argentina in 2002. There was also a financial crisis in 1999, when Brazil ended the peg of its currency, the real, to the dollar.

Candido Bracher, president and CEO of Banco Itau, one of our portfolio companies, summarized the Brazilian experience: “During the 1990s and various crises – the Asian crisis, Russian crisis, every crisis – Brazil was hit severely. We were so dependent upon foreign savings. Our foreign-exchange rate was devalued very quickly. We had to send our interest rates through the roof to attract capital. In all these cases, if there was a liquidity crisis abroad, we would be very severely hit.”

With these recent crises in mind, Brazilian bank regulators were alert to the prospect of further crises and bank failures in the offing.

In most countries, banks are obliged to maintain some minimum capital ratios – capital as a percentage of their assets (loans) – as recommended by the Bank for International Settlements in the so-called “Basel” standards. Rather than establish a simple leverage ratio, those standards entail a “risk-weighted” approach. In practice, this meant that some of what proved to be the biggest and riskiest banks in the world were leveraged to the hilt.

Part of the problem with the “risk-weighted” approach was that it tended to rest on historic track records that purported to show little or no prospect of sharp downgrades or default in debt instruments.

For example, ratings agency Moody’s “Transition Matrix for Withdrawn Ratings” based on experience between 1920 and 1996, showed only a 0.03% chance of an Aaa-rate bond falling after one year to a rating of Baa. This is why AIG sold hundreds of billions of cheap credit-default swaps that have devastated that company.

Imagine AIG’s amazement when an avalanche of AAA-rated subprime mortgage securities swooned into default.

Minimal Bank Capital Ratios: A Crisis Waiting to Happen

US banking regulators swallowed the same cocky assumption about systemic risk. They designed banking regulations the way AIG wrote credit-default swaps: on the mistaken faith that there would never be a credit collapse.

In the US, the effective capital ratio was often as low as 4%, though it had to be no less than 5%to meet the standard for “well-capitalized” banks owned by bank holding companies – a group that includes the top 20 US banks. Their capital ratios at the onset of the crisis varied between 5% and 8%.

Although American and British bank regulators played a major role in negotiating the Basel II accords (initially issued in June 2004 to help protect the world banking system from risks arising from bank failures) they choose to adopt the minimum permissible capital ratios as their regulatory norm. Brazilian bank regulators went the other way entirely. They insisted on limiting the leverage in the banking system to minimize the risks and costs of a future banking crisis.

All Brazilian banks must maintain minimum capital ratios of at least 11%. But many Brazilian banks have capital ratios of 16% or more – double, or even triple, the levels in the US and Britain.

There has been a lot of jabber in political circles about the Great Wipeout and the supposed difficulty of keeping banking regulation up to date in the face of rapid technological change.

Don’t believe it. The evidence suggests that authorities in the US, Britain and other rich industrial countries actively abetted and encouraged explosive leveraging of debt in their economies by minimizing capital ratios.

US Reserve Requirements – A System Fail

They did the same thing when it came to reserve requirements.

Reserve requirements for Brazilian banks have been dramatically higher than those in the US, Britain and other leveraged economies. The purpose of bank reserves is to absorb losses and provide liquidity to stabilize the financial system in times of crisis. The drawback of high reserves, from the perspective of politicians and aggressive bankers, is that they deleverage the system.

In Brazil, banks must sequester 30% of their deposits with the central bank. In the US, the notional level of reserves is 3%. But in reality regulatory interpretations have allowed US banks to operate free of any reserve requirements.

Due to “deposit reclassification” and other slippery interpretations instituted by the authorities to increase leverage in the banking system, US banks have been permitted to count their vault cash toward their reserve requirements, rather than actually depositing reserves with the central bank.

This may not be quite as silly as counting the cost of the bank safes, desks and furniture in the lobby toward reserves. But it’s close. Even without any notional reserve requirements, banks would have to hold vault cash in any event – for use in their day-to-day operations in ATM machines and to satisfy customer withdrawals.

US reserve requirements have been effectively nil for many years. Ironically, the Fed took a dramatic step on October 6 2008 to make holding reserves more attractive to banks. On that date, the Fed began paying interest on banks “required and excess reserve balances.” Even so, total reserve balances currently on deposit with the Federal Reserve amount to less than $9.5 billion – a trivial sum compared to a banking system whose total liabilities now total $13.5 trillion.

When Lehman Brothers went bankrupt last September and the global credit crisis hit its most severe moment to date, US banks had virtually no reserves upon which to fall back. The amounts they could have swept out of their ATM networks could not come close to backstopping their liquidity needs.

The Political Roots of the Economic Crisis

By waving bank reserve requirements, the US authorities determined that taxpayers would provide the reserves for US banks. It has long appeared to political authorities that abetting the growth of leverage improved the ability of consumers to generate wealth and obtain the good things that wealth affords, such as a new car, the latest fashions or, more importantly, a home.

Even if this implied long-term ruin to a degree they failed to grasp, it was politically irresistible for politicians of both the right and the left to employ credit and leverage to facilitate the temporary growth of prosperity. The same political impulse that impelled politicians in the US and Britain to scrap the gold standard also impelled them to favor easy money and ever greater leverage in the economic system.

As a result of this consensus, banking systems in both countries have been skirting the consequences of insolvency for the past nine months. In my view, there is a high likelihood that living standards that were inflated by decades of easy money will be deflated in the years to come as the North Atlantic economies are deleveraged. (Note that multi-trillion-dollar Treasury and Fed sponsored bailout programs now support 73% of the balance sheet of US banks; the costs of these bailouts have only begun to be tallied.)

In Brazil, by contrast, the authorities were much more concerned about avoiding the potentially ruinous consequences of a banking crisis. Consequently, they adopted more measured and conservative banking regulation. Having experienced recurring crises as they sought to distance themselves from the hyperinflation of the 1980s and early 1990s, they were more sensitive to the downside of leverage.

And rather than vitiating reserve requirements, Brazilian authorities successfully restrained the growth of debt by mandating high bank reserves.

When the global economic crisis triggered by the subprime collapse suddenly hit Brazil in September 2008, the authorities were in a position to respond. Of course, the crisis in Brazil was minimized because the Brazilian banking system was solvent. The conservative regulation of Brazilian banks assured that unlike American and British banks, Brazilian banks were not highly leveraged.

During the liquidity strains caused by the flight of billions of dollars in hot money, the central bank of Brazil simply allowed the banks to access their reserves deposits to absorb losses and increase liquidity. In other words, Brazilian taxpayers were not called upon to backstop the banks because they had adequate reserves.

How Brazilians Became the New Scots

Speaking soon after the crisis, Banco Itau’s Bracher said, “None of the Brazilian banks has come under the suspicion of being weak. The balance sheets are very strong. The Brazilian corporate sector is extremely underleveraged. The Brazilian citizen is underleveraged. The credit to [gross domestic product] ratio in Brazil is just above 30%. It used to be in the low 20% range. And 30% is still quite a low figure.”

By contrast, total government corporate and individual debt in the US is now $33.9 trillion – or about 240% of GDP.

Another statistical mirror of Brazil’s difference position in the leverage cycle is the fact that only 32% of the home sales in Brazil in a recent year were assisted with a mortgage of any kind. Leverage is a low as it can be when you have to make a 100% down payment to buy a house. And the mortgage credit that has heretofore been available in Brazil (for less than a third of buyers) did not take the form of 30-year amortization with a low introductory rate. Brazilian mortgages have been extended for only 10 years at punishingly high interest rates.

Through an ironic twist of history, Brazilians have become the new Scots. They abhor debt the way my Scots ancestors once did.

No, the Brazilians did not suddenly become Presbyterians. The Brazilian distaste for debt was formed in the crucible of economic trauma. And with an average of 60.5% interest rates on consumer loans as recently as June 30 2002, its no wonder consumers in Brazil have tended to shun credit.

This all happened recently – within a lifetime – after Simon jumped off the Golden Gate Bridge and after my Brazilian bride had lived through a trillion-fold increase in the price level during her childhood in the 1980s.

That trillion-fold inflation coincided with complete stagnation in real income growth in Brazil. This underscores one of the many paradoxes in economics. Although hyperinflation rewards debtors by wiping out the value of money, it also wipes out credit.

In the aftermath of hyperinflation, credit usually becomes scarce and the costs of borrowing rise. As a consequence of hyperinflation, Brazil has had the world’s highest real interest rates for the past decade. High real rates encourage savings and punish borrowing.

That is why Brazil has had a savings rate of plus or minus 25% in recent years. The savings rate in the US has hovered at plus or minus zero before bouncing as the crisis worsened.

Crash Proofing the System, Brazilian Style

The fact that the US government was considered unquestionably credit worthy encouraged US officials to take a cavalier attitude about protecting the nation’s balance sheet. Brazilian officials, on the other hand, conscious that Brazil’s ability to borrow internationally had been repeatedly called into question during crises as recent as 2002, took much more care to strengthen their fiscal and monetary posture.

Four major planks in Brazil’s financial framework dramatically underscore the more measured and conservative approach Brazil has taken:

1. The Brazilian constitution contains a provision prohibiting “quantitative easing.” The Brazilian central bank, the Banco Central do Brasil, is constitutionally prohibited from granting loans to the federal treasury. Nor can it lend to government agencies or purchase primary issue Brazilian government securities.
2. Since 1999, Brazil has instituted a Fiscal Surplus Rule, which has resulted in an average annual primary budget surplus of 4-5% of GDP.
3. The passage of the Fiscal Responsibility Law approved in Brazil in May 2000, committed Brazil to recognizing the skeletons in the closet – the off-budget unfunded and contingent liabilities that have become so menacing in the United States. When these came to light, the Brazilian treasury realized that the net present value (NPV) of public debt – today’s value of future costs and benefits – should be increased by about 6-8% of GDP due to unavoidable future payments for pension entitlements, public guarantees and judicial settlements.
4. An important aspect of the Fiscal Responsibility Law is a provision forbidding the federal government of Brazil from bailing out any sub-national government. This means lavish pensions and other spending commitments cannot be made by states and municipalities and pawned off on the federal treasury.

America’s $104 Trillion Problem

Contrast this with the US, where unfunded liabilities have been ballooning to a fantastic degree. The president of the Federal Reserve Bank of Dallas, Richard Fisher, recently gave a speech in which he decried the US government’s unfunded liabilities, which now exceed $104 trillion.

Left unreported was the fact that the discounted present value of entitlement debt, over the infinite horizon, reached $104 trillion. This is almost eight times the annual gross domestic product of the United States—and almost 20 times the size of the debt our government is expected to accumulate between 2009 and 2014. […]

And while the announcement that the Social Security trust fund will begin its decline one year earlier is an important fiscal event, the swelling of overall entitlement debt to more than one hundred trillion dollars has far more serious implications for economic growth—implications we are poorly positioned to address given the budget deficits we face today.

One spoilsport budget analyst reacted to Fisher’s comments by calculating that meeting the unfunded liabilities of the US government will require a 68% increase in US federal taxes.

Clearly, US politicians were thinking ahead when they established the peculiarly predatory system of taxation that made income taxable by citizenship rather than residence. If the US taxed as almost every other country does, by domicile, the airports and ports would be crowded with people heading for the exits.

Even so, I still think there may be a strong argument for getting out. Unless you are convinced that the fiscal and monetary framework, the tax regime and the prospect of monetary disruption are almost completely irrelevant to your prospect of success, you have to recognize that the United States faces dire straits in the years to come. “Weimer Republic, the Sequel” is almost a best case scenario. (One aspect of the unfunded entitlement liabilities to which Fisher refers is that they are not susceptible to being erased by hyperinflation; Social Security and other government pension funds are indexed to inflation.)

How Social Spending Will Bankrupt America

Another hint that it is later than you think: the primary Social Security deficit has already kicked in. Already, less money is being taken in through payroll taxes than is being paid out to retirees. The forecast that the Social Security trust fund will be depleted in 2016 counts accrued “interest” owed by the Treasury to the Social Security account. This is a noble fiction, much like borrowing money from your left trouser pocket, placing it in your right pocket, and promising to pay interest to your left pocket on the money you proceed to spend.

Equally, almost $90 trillion of the unfunded entitlement debt is owed for medical entitlements to retirees. It is far from obvious that hyperinflation would obliterate these obligations, rather than raising them to a higher nominal value.

The real issue facing the US economy is that it is being bankrupted by the accumulation of social costs. In almost every field, costs in the US have hypertrophied – largely, I believe, as a negative consequence of long-term US stability.

US health-care spending is $4,271 per capita – higher than any other country. It is 2.5 times higher than health care spending in Britain and 14 times higher than health care spending in Brazil. US military spending is 20 times higher on a per capita basis than military spending in Brazil. (British military spending per capita is only 12 times the Brazilian level.)

Why are US costs so bloated compared to other countries?

Well, when a government has established a long track record of being able to make good on its obligations, political favors become the equivalent of “money in the bank” – rules such as entitlement laws become equivalent to capital because they pay dividends.

About 30 years ago, I wrote a book analyzing the pernicious consequences of this shadow wealth in government favors, which I called “transcendental capital.” Even then, I brooded that it was destined to destroy American prosperity. One of the proudest moments in my sometimes sketchy career as an original thinker came when the late Nobel Prize-winning economist F.A. Hayek, sent me a letter praising my analysis of “transcendental capital” as “one of the really significant contributions to its field.”

What I thought then and what I think now is that life moves on. Prosperity is a restless guest: one that enjoys open horizons, low taxes and sound money. Although there may be a strong component of individual DNA at work in informing success, more people will get what they want out of life when they operate in a sound macroeconomic environment. A country and people burdened by the greatest debts the world has ever seen are handicapped, plain and simple.

A Better Solution for Your Future

It is logically possible, of course, that social costs in the US could be deflated short of complete economic collapse… but the record is not encouraging.

The same spoilsport who calculated that the US unfunded liabilities will require a 68% increase in taxes, also entertained the option of cutting “discretionary” spending (defined as everything other than interest on the national debt and entitlement programs) sufficiently to put the present value of future outlays into balance. Apparently, proceeding without a huge tax increase would require a 97% reduction in spending.

I don’t see that happening.

Raising taxes and printing money are the paths of least resistance in politics. You can see how unlikely it is that health-care spending can be brought down to globally competitive levels, from the fact that Americans are about to accept a prescription for better health from a smoker who proposes to curtail health-care costs by spending trillions more.

If you are young enough, flexible enough and smart enough to want a better solution for your future than waiting for US costs to be curtailed, you can simply to take your talent somewhere more promising.

Where should that be?

I have had a lot to say about Brazil in this issue and recently in other monthly issues and updates. This is no doubt partly because I have a beautiful Brazilian wife whose family is well connected and have made it a pleasure for me to learn about that country.

(You can learn about it in our upcoming “Introduction to Brazil” trip scheduled for November. For more details, contact Luisa Woods at info@crisisstrategyalert.com)

That family prejudice disclosed, I firmly believe that Brazil is the most attractive of the BRIC countries. And it seems to me to represent the world’s economic future. Brazil is a vast country, incomparably endowed with natural resources, including the world’s largest arable surface. The recent discovery of up to 70 billion barrels of oil off the Brazilian coast will bring a tremendous boast to Brazilian GDP.

In fact, I forecast that by the middle of this century Brazil will be the world’s richest large country. Embedded social costs are low. Living costs are low. Debt ratios are negligible compared to the US. The nation’s banks are solvent.

All the economic mistakes that have hobbled the US since the middle of the last century are still to come in Brazil. Presumably, as its stability becomes more apparent, Brazilian politicians will encourage an increase in leverage in that country that will lead to a subprime problem many decades in the future. Meanwhile, a lot of money will be made there.

Why not put some of it in your pocket?

A Final Lesson from History

In 1886, when Andrew Carnegie was one of the world’s richest men, he wrote Triumphant Democracy to sing the praises of the US. A big part of his argument was focused on the heavy indebtedness that burdened Russia, France and other European nations. As Carnegie put it, “National debts grow troublesome. Year after year the burden they lay upon the productive energies of nations becomes harder and harder to bear.”

Carnegie believed – wrongly, as it turned out – that democracy had defeated the temptation for America to burden itself with debt. “Our great advantage which the Democracy has secured for itself in America is its comparative freedom from debt. The ratio of indebtedness to wealth is strikingly small.”

What a long way the US has come in a century and a quarter.

America was the still largest creditor nation in the world when I was a child in the 1950s. Today, it is the largest debtor nation in history.

This bodes ill. It may be too melodramatic to say that America’s run is over. But as far as I can determine, no country ever became great or stayed great because of all the money it owed.

James Dale Davidson

editor, Crisis Strategy Alert

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Green Shoots Turn Brown: Is the “Deflation Trade” Making a Comeback?

Here a few snapshots from your investment world, as highlighted by the conventional thinkers wearing “green-tinted glasses.” Crisis Strategy Alert members will recognize these as illustrations of what the late senator Daniel Patrick Moynihan termed “the leakage of reality from American life.”

• CNBC perma-bull Jim Cramer has started celebrating a new boom, suggesting that economic growth could accelerate to a 4% annual rate by the end of the year.
• Barclay’s Bank claims the recovery from the downturn could be more vigorous than consensus expectations.
• Ninety percent of economists polled in a May 27 survey said they believe the recession will end this year.
• Merrill Lynch goes further: it is proclaiming that the “recession ended in April.”
• Consumer sentiment took a bigger than expected jump in June.
• The Conference Board Leading Economic Index (LEI), intended to forecast future economic activity, has risen – another big positive in the estimation of the “green shoots” lobby.

Let’s look a little closer at these supposed “green shoots” of recovery.

Reuters reports that US consumer confidence has risen to its highest level since February 2008 “as expectations grew that the worst economic recession since the Great Depression may be ending.” This from a recent Reuters report:

The Reuters/University of Michigan Surveys of Consumers said its final index of confidence for June was at 70.8 from 68.7 in May, equaling February 2008′s reading.

This was above economists’ median expectation for a reading of 69.0, according to a Reuters poll.

The index of consumer expectations edged lower, though, to 69.2 in June from 69.4 last month.

Such a sizable gain has usually indicated that an end to the economic downturn is on the horizon, as consumers begin to increase their spending on houses, vehicles, and large household durables,” the Reuters/University of Michigan Surveys of Consumers said in a statement.

Note that although sentiment rose, expectations fell.

The LEI was up an average of 1.16% a month during April and May. There are 10 components of this index. Topping the list is the surging stock market. A 2.6% gain in the S&P 500 increases the LEI by about 0.1%. So the 8.8% average monthly gain in both April and in May contributed 0.34% – about a third of the total gain.

Another large contributor to the jump in the LEI is the yield spread between10-year Treasury notes and the overnight federal-funds interest rate. The LEI is credited with a 0.1% gain for the month if the 10-year rate averages 100 basis points more than the federal-funds rate for that month. With the average spread about 300 basis points over the last two months, this has contributed 0.3% to the monthly growth rate of the LEI.

Another important contributor to the LEI is the rise in consumer sentiment.

Together, these three indicators – stocks prices, the interest rate spread and consumer sentiment – account for 75% of the rise in the leading economic index over the last two months. Note that other than the yield spread, a majority of the LEI rests upon what other people think rather than hard economic numbers.

True, the yield spread is based on hard numbers. But it is far from obvious that the wide spread is bullish under current conditions. The Fed has driven the federal-funds rate to practically zero. And long-dated Treasury yields are being spooked by the need to finance a ballooning multi-trillion-dollar federal budget deficit and by the specter of dollar depreciation.

Even an apparently solid contributor to the LEI, the vendor performance measure, is actually less convincing than it seems. For one, the vendor performance measure, although based on real data, is a diffusion index. That means a value below 50 indicates that the number of manufacturing supply managers who said conditions worsened last month outnumbered those who said they got better. The reported May value for the ISM’s overall manufacturing PMI was 42.8; the vendor performance (or supplier deliveries) component used in both the LEI and the PMI was at 49.8.

These are improvements over the still weaker numbers reported earlier in the year. And in that sense, they may rightly encourage optimism. But they are hardly robust evidence of “green shoots” when a 57.2% majority report deteriorating conditions. The hypothesis that “green shoots” are taking hold everywhere is remote from the facts.

Prosperity Is Not “Just Around the Corner”

The green shoots hypothesis is an echo of the famous promise so diligently and soberly proclaimed by President Hoover in 1930 that prosperity was “just around the corner.”

Half a century before CNBC was invented, Hoover told the nation without a hint of irony that “the worst effects of the depression will be over within 90 days.”

One of the problems with conventional economists and investment advisors is they are deserters from the field of economic history; they seem to know next-to-nothing about past leverage cycle corrections – even the Great Depression.

Consider the frequently stated observation that the current downturn today is nothing like the Great Depression because unemployment reached 25% in the Great Depression and is currently reported at only 9.4%

What should you make of that?

Well, not much.

Unemployment is not what it was at equivalent time in the Great Depression; it is worse. (The main differences between then and now is that President Obama is making more broadly infatuating promises that “prosperity is just around the corner” than Hoover did in 1930 – at a similar period after the crash.)

For more perspective on unemployment then and now, consider that the household survey that determined the unemployment level for the 1930 census took place in May of that year. The unemployment rate at that time was determined to be 5%. By June 1930, the unemployment rate had edged up to 6.3%. Unemployment continued to rise to 8.9% by December 1930 – and then kept on going up.

The point is the massive unemployment that touched a quarter of all American workers at the depths of the Great Depression did not happen all at once immediately after the stock market crash in of 1929. In fact, for years after the 1929 crash few knew that what became the “Great Depression” was anything out of the ordinary.

This is sharply illustrated by the fact that when the editors of the New York Times looked back on the events of 1929 as that year came to close, they did not even take the stock market crash to be a big story. In their view, the most significant development of 1929 was Admiral Byrd’s visit to the South Pole.

It took years of failed stimulus projects and misguided interventions to turn the crash in stock prices into the worst economic calamity yet known in the history of the United States. On current evidence, the present episode may prove to be worse.

The Great Unemployment Scam

Taken at face value, today’s headline unemployment rate of 9.4% (14 months after the peak in industrial production in April 2008), is already worse than it was at end of 1930 (18 months from the corresponding peak in June 1929).

But the underlying employment picture is actually far worse than this comparison suggests. That’s because we no longer count unemployment as it was measured in 1930. Whatever else can be said about Herbert Hoover, he was a stickler for honest statistics. He may have tried to put a positive gloss on the bad news, but he did not try to fudge the numbers.

The official unemployment statistic picked up in today’s headlines, the Bureau of Labor Statistics (BLS) U-3 measure, does not count everyone who is unemployed and underemployed.

But that’s not the only problem with the numbers. The government also inserts an official fudge factor – which in May amounted to 220,000 fictitious jobs. These so-called “birth/death” statistical adjustments arbitrarily add fluctuating numbers of jobs to the total measured employment. This supposedly accounts for jobs supposedly being created by new businesses that are supposedly too small and young for the government to detect. U-3 is also flawed in that it doesn’t count people ineligible for unemployment benefits.

But rather than waste time parsing this statistical flummery, let me take you straight to the point. The BLS does produce a more comprehensive snapshot of the true employment picture. And one that is far closer to the approach to measuring unemployment that was in place under President Hoover.

To get a real picture of the current unemployment levels you need to focus on the grossly underreported U-6 data set known as “alternative measures of labor utilization.” The U-6 data set includes everyone counted in U-3, plus “all marginally attached workers” and people who aren’t working full-time but wish they were (i.e., the underemployed). (Marginally employed covers “persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past.”)

When you add up U-3 and all the underutilized workers, the official U-6 rate for May 2009 is 16.4%. In other words, the employment picture is twice as bad 14 months after the recent peak as it was in December 1930, 18 months after the peak prior to the Great Depression.

If you take care to analyze the data, it’s easy to see that there are not many green shoots growing. In fact, when you put aside the hype and look more carefully, indicators such as employment, industrial production, stock prices and international trade are all tracking their trajectories from the Great Depression… or worse.

And many measures of economic health are considerably less robust than they were in 1930. Economic historians Barry Eichengreen and Kevin H O’Rourke have compiled comparative data for today’s economy and matched it to similar economic data after the peaks in industrial production, which occurred in June 1929 and April 2008.

Colorblindess Has Taken Over the Mainstream Media

Contrary to the fantasies of colorblind commentators that “green shoots” are taking root, or that the “recession ended in April,” the reality is that industrial production, stock prices and world trade are all as bad or worse than they were in a comparable period in the Great Depression.

For more details, see Barry Eichengreen and Kevin H O’Rourke, “A Tale of Two Depressions.”

There has been a small up-tick in consumer spending – a blip largely attributable to the $787 billion stimulus spending approved by Congress in February.

Unlike many observers, I doubt that politicians – even an acclaimed wizard like Mr Obama – can roll back the leverage cycle through inspired manipulation of the banking system and the hocus pocus of spending trillions of dollars out of an empty pocket.

When you study past unwindings, it is remarkable how methodical and irresistible they are – regardless of the very different historical contexts in which they have occurred. A few months ago, I reviewed haunting similarities between events in 1720, following the collapse of the South Sea Bubble, and events today.

I doubt Obama’s efforts to reinflate the credit bubble will prove any more successful than the efforts of clever men and the Bank of England almost three centuries ago to support the shares of the South Sea Company.

With world industrial output tracking the downtrend after the 1929 crash with great fidelity, this summer we are due to see another unmistakable leg down, which may deal an unequivocal blow to the “green shoots” optimism. Among the leading candidates to trigger this abrupt re-crystallization of sentiment, is publication of the June employment figures at 8:30am EDT on July 2.

My guess is that even the heavily fudged BLS U-3 data set will show unemployment spiking into double digits, as the impact of mass closures of auto dealers and bankruptcy of GM and Chrysler trickle into the economy. And before the current depression is over I would not be surprised to see the headline unemployment numbers match those from the Great Depression, as history’s greatest leverage cycle unwinds.

In any event, the economy is much weaker than the “green shoots” hypothesis supposes. This implies a notch down in the stock market, which could be especially severe in the banking sector. The renewed evidence of contraction implies illiquidity and a return of the deflation trade: dollar up, bonds up; oil, stock prices and commodities other than gold down.

This rising unemployment rate will weigh heavily on the banks, which have been bailed out repeatedly over the last 14 months. So consider going short the SPDR KBW Bank Index ETF (NYSE: KBE) above $17.50 for a move back down to the low teens.

Could This Be the Best Trade of the Summer?

I also suspect that an attractive summer trade will be to short oil. Peak gasoline demand is typically established on the July 4 weekend. I see a very limited prospect that summer driving will surprise on the upside, thus high oil inventories will weigh on prices come the fall.

Add to the mix the fact that the dollar should strengthen this summer (as the stock market drops), and the thought of shorting oil becomes an even more attractive opportunity.

One way to take advantage of the coming oil decline is by buying shares of PowerShares DB Crude Oil (NYSE:SZO). But don’t pay more than $55 a share.

This exchange-traded note tracks oil. Plus, it allows you to be short of oil in an account that does not allow you to short shares outright.

Of course, a big feature of oil trading lately has been the weakness of the US dollar. But beware of being short the dollar now. A feature of the “deflation trade” is that the dollar rallies as contraction intensifies.

As emphasized in past issues of Crisis Strategy Alert, one reason why the dollar rallies when deflationary forces are most intense is that many players in the world are heavily short of dollars. The US government and legions of dollar debtors are banking their hopes of short-term salvation on continued dollar depreciation. Judging by the remorseless efficiency of markets in thwarting “easy outs” in the past six depressions, I don’t expect this to work this time either.

For reasons I analyze elsewhere in this issue, it is almost certainly true that the dollar is doomed over the longer term. A decade from now, by the time the full tale of this depression is told, I expect the dollar to have gone the way of the Argentine peso. But before that happens, there are many more acts of the drama to unfold.

One problem right now is that too many people are expecting dollar weakness. Consider this contrary indicator from the “Economy & Business” section of the Washington Post: “Fading of the Dollar’s Dominance: Other Nations See Opening to Boost Their Currencies.”

The article contained the following convincing detail: “Last week, the leaders of Brazil, Russia, India and China – whose governments are some of the world’s largest dollar holders – jointly declared the need for a ‘more diversified international monetary system,’ sparking a drop in the greenback on world markets.”

Yes, the dollar is doomed… but not just yet.

It is destined to rally again as world economies lurch further along the deleveraging process. A stronger dollar will also place downward pressure on oil prices. That’s because much of the recent rally has drawn inspiration from dollar weakness.

Paradoxically, I don’t expect the price of gold to react like the price of oil to a renewed bout of dollar strength. In past depressions, gold has tended to rally in real terms during contractions. Hold your gold and gold stocks.

Meanwhile, any substantial uptick in the dollar/Brazilian real exchange rate should afford an opportunity to increase your Brazilian government bond position: Brazilian Government Bond 105756BJ8.

I do not recommend taking profits in this position just yet. We are ahead, as of last month, by approximately 35% since January. This is primarily an income play. And we have a lot of slack to protect ourselves from a retracement in this position. So hold your position for a 12.9% annual income and the likelihood of large currency gains over the maturity of the bond.

As we have already said in Crisis Strategy Alert, Brazil has discovered about 70 billion barrels of oil in recent years, which will make the country a major oil exporter. With the US headed towards runaway inflation and Brazil on a much sounder financial footing, the Brazilian real will trade to parity and above against the dollar – a prospect that implies still higher gains from our Brazilian government debt.

If the dollar rallies back to R$2.10 or higher, use the dollar rally to double your position in the Brazilian government bonds.

I do recommend taking profits in the WisdomTree Dreyfus ETF Brazilian Real Fund (NYSE:BZF), however. I see no compelling reason to remain long this position during the summer period when the stock market is in jeopardy of retracement as the “green shoots” turn to brown.

James Dale Davidson

editor, Crisis Strategy Alert

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The Anatomy of a Failed Electronics Giant
And how to profit from its demise…

Technology comes and goes… and so do technology companies.

In this issue of Crisis Strategy Alert, I want to talk about a technology company that was an industry leader but is now nothing more than a money-losing behemoth.

On May 14 this company announced a loss of $1 billion – its first yearly loss in 14 years.

To make matters worse, its projected loss to March 2010 is another $1.2 billion.

Of course, management is scrambling to stem the bleeding. But the Nikkei Weekly, a newspaper in Japan, has said the moves “smack of desperation.”

The company will eliminate 16,000 jobs and shut down three plants in Japan. But I’m afraid none of these things will help the company much.

You see, a technology company is only as good as its best product. And the products this particular company has today just don’t cut it against the competition.

• Its music players are too expensive (and not nearly as popular as Apple’s iPod).
• Its video game console is too expensive (and the game developers are complaining that it costs way too much to develop games for it).
• Its TVs, laptops, PCs and practically every other device it makes just cost too much money.

In the current economic environment, when the consumer is debt laden and worried about finding a job, the last thing they want to do is spend twice as much on electronics.

So who is this company that overcharges on products and is bleeding cash? It’s the Japanese juggernaut Sony Corporation (NYSE:SNE).

Sony used to be a good company. It used to be looked up to as one of the leaders in the electronics world. Its brand name used to demand a premium. But all of that has changed…

The Rise and Fall of the Playstation

Let’s begin with video game consoles.

You might not know it, but the video game industry generates $15 billion in sales in the US alone. And this industry was one of the big reasons why Sony did so well earlier this decade.

The video game console that Sony released in 1999, the Playstation 2 (PS2), has sold over 140 million units. That makes it the best selling console in the world. It was also the fastest selling console – it sold 100 million units within just five years.

Gamers loved the PS2. They gobbled up as many games as they could. And since Sony receives a royalty anytime a PS2 game is sold, Sony was made lots of money.

But here’s the thing with industry leaders like Sony. After beating the competition hands down, it began to get complacent.

It let its developer relationship slip. After all, developers had to develop for the PS2 or they’d likely lose money.

It’s as though Sony felt invincible in the console market. The company (wrongly) believed that nobody would take away its the crown.

So this once great Japanese firm developed its grandest vision yet. It decided that the next video game console it made, the Playstation 3 (PS3), would not only have a custom built central processing unit but also have Blu-Ray disc player.

The purpose would be threefold.

First, Sony wanted to expand its lead in the video game industry with a truly unique console. Second, it wanted a CPU the company could sell on to third parties. And third, Sony wanted to establish a dominant next generation video format.

But there was a hefty price to all of this…

When Sony finally put the PS3 on the shelves, it cost the company $800 to manufacture. The problem was that this new console only retailed for between $399 and $499.

The end result was that Sony took a loss on every PS3 unit it sold.

To put this in perspective, Sony sold 5.5 million PS3’s in its first year – handing the company a loss of about $1.925 billion.

And to make things even uglier, the PS3 is significantly more expensive to buy than the competition today (and Sony is STILL losing money on it – $40 per console to be exact).

The cheapest PS3 you can buy is around $299. The cheapest Wii (the industry leader today) is $250. And the cheapest Xbox 360 (second place in the industry) you can buy is $199.

Oh, and the Wii and Xbox 360 are both being sold at profit, unlike the PS3.

And with a higher price, the PS3 is also a slower selling console.

For Sony, the PS3 was a massive failure. And the company continues to lose money on it.

Furthermore, because the PS3 isn’t selling well game developers are moving on to greener pastures.

Out Goes the Walkman… In Comes the iPod

The video game industry is only one example of how Sony lost a coveted leadership role in the industry.

Sony, as you may recall, was also the leader in the portable music industry.

Who hasn’t owned a Walkman? Almost everyone I know has – after all, Sony sold over 100 million of these innovative portable cassette players.

But where was Sony when music started moving to the digital MP3 format? The answer is: with its pants down!

Apple Inc, a company that was in the throes of bankruptcy, put out the groundbreaking iPod and instantly changed the company’s fortunes completely.

Today, Apple is the industry leader in portable music players. It has sold over 173 million iPods since it introduced the device in October 2001.

The last area of leadership Sony enjoyed (past tense) was its TV business. But over the past four years, Sony has lost $2.3 billion in this business, thanks to bad bets on Plasma TV’s (which have been overtaken by LCD’s). Half of these losses occurred in the past 12 months.

Then there’s that little issue of cost again. Why buy a 32-ince Sony Bravia LCD TV for $499 when you could just buy a Samsung for $450… or an Apex HDTV for $379?

Sony is a perfect example of how a technology company can fail to adapt in an ever changing world. As a result, it’s been conquered on three separate fronts – video games, portable music players and TVs.

This makes a short on Sony Corporation (NYSE:SNE) a great way to play the company’s long-term decline.

Charles Delvalle

senior analyst, Crisis Strategy Alert

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