"Wall-street or Main-Street?"

Nov 2009

The US stock markets have risen more than +50% from their lows in a short span of 6 months. Quite a performance for a country that has been hit by one of its worst financial crises.

At one end, Wall Street is embarking on expectations of higher economic growth. A strong political will to 'bail out" large companies like General Motors and Goldman Sachs has led to a series of stimulus packages. This included unconventional measures like allowing companies to borrow directly from the Fed and the government taking large equity stakes in many private companies. All this has led to increased money supply which along with loose monetary conditions has helped to maintain the recovery momentum.

At the other end of the spectrum, there are skeptics who have a contrary view that this recovery is not real. They say that the increased liquidity in the system is resulting in inflated asset prices. They describe this as an "economy on steroids" meaning that the recovery is just the effect of stimulus and loose monetary policies. Once these stimuli are pulled out, the economy will resume its collapse.

The contrarians cite the continued high unemployment rates in the US with more job losses every day to contradict the "we are on a recovery path" message repeated by the US government.

Job losses are increasing albeit at a slower pace going by the official releases. Critics say that the official numbers are hiding the real truth. There are thousands of people falling off unemployment compensation each week; and this is not at all reflected in the official numbers. According to shadowstats.com, the real number is above 20%. That’s a big number and a big problem - if it’s correct. That number is very close to that of the 1930s depression - so where is this ghost of a recovery?

Chart I: U.S Unemployment

Source: Courtesy of ShadowStats.com

The next shoe to fall?
We also had another bad news during the month. Bank of America reported a loss greater than $2 billion with credit card defaults that have begun to hit the hardest. This tells us that the consumer is not financially very healthy. Banks have not been lending freely as they used to do before: more loans to consumers may mean more future defaults! This extra cautious attitude of the banks now makes it difficult for even the consumers with a good track record to borrow. All this will further lead to credit contraction: it will become very difficult for consumers and businesses to obtain credit for spending. This will further reduce spending and make it difficult for any economic recovery to be lasting and sustainable.

Main Street is convinced that the economic recovery is not real.

The bullishness on Wall Street is mainly liquidity driven.
The money created out of thin air by the government and the central bank seems to be driving asset prices higher.

If the main street scenario worsens - the government stimulus does not work and U.S economy deteriorates further - it would take the economy very close to a Depression kind of scenario.

Under such circumstances, the US central bank would double the dosage of money infusion and lending so as to avoid a depression and deflation. This action of resorting to printing money at the drop of a hat is the result of a belief that reduction in U.S money supply in the 1930s caused the Great Depression.

Unless corrective measures are taken, it is possible that we are heading towards a scenario best described as "An economic depression of an inflationary kind". This means that the world (led by the US economy) would have declining growth, persistently high unemployment, and - worst of all - liquidity driven bubble in asset prices.

This would be far worse than the Great Depression in the 1930’s. In the 1930’s people’s incomes were declining as they lost jobs but the price of goods and food also kept in slipping sharply.

Here, people will have no jobs but they will face higher prices for every product.

We won’t reach there immediately, it will take its time, but the process may be underway. It could be stopped - but we don’t know how.

In any case, a scenario of monetary inflation - which might support stock markets and real estate at superficially high levels - is also good for gold. Gold is likely to be one of the few assets to see run away appreciation in its capacity as the ultimate currency and a store of value.

We don’t know where the global and US economies are headed as there is still too much uncertainty. But it would be wise to ensure that you convert some of your paper money into gold before US lands up in such a scenario - or before gold prices reach much higher levels.

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