Question from a reader-"I'm confused about a question that rests at the heart of efforts to revive the economy.  What ended the great depression?  Was it the war, war spending, or some other mechanism?   I think I've been taught, and I easily accepted that it was the war spending along with the 'full employment' of labor that cracked the downward spiral of the 1930's.  I just can't imagine that all the wasted resources paid for with war debt during the war could have had less of an effect on the nation's economic future than the spending now necessary to create jobs, provide healthcare, and rebuild the infrastructure of the nation."

Answer---This is a controversial topic on which economists and investors disagree, and we'll probably never know the answer.  Although the unemployment rate improved markedly from about 25% at the depths of the depression to about 11% by the late 1930s, the nation's economy was still depressed prior to the war.  Some observers claim that the New Deal programs just did not spend enough while others feel that the government spending actually hampered the recovery.

In our opinion, it was the war spending that ended the depression, although it wasn't that simple, and it doesn't mean that we can necessarily spend ourselves out of the current crisis.  Although some people erroneously concluded that the war itself was good for the economy, it was really the spending that did it rather than the war.  Viewed simply, it seems that if  a nation spends enough it can spend its way out of depression, and that the problem before the war was that the nation just did not spend enough.  Carrying this thought further, you are probably correct to think that spending on items that can be used rather than destroyed is more helpful to the economy.

Having said that, the problem is not that simple.  World War ll brought the nation back to full employment, but since so much of the wartime production was wasted there were not enough products and services on the market to meet the potential demand created by the newfound income resulting from the production of war goods.  Therefore, to prevent soaring inflation the government resorted to rationing a wide array of key products and the sale of war bonds to siphon off income into savings and depress consumption.  This resulted in a big buildup of savings that was available for consumer spending after the war.  In addition the military force was expanded to about 11 million in a population far smaller than today's.  And, of course, transferring 11 million people out of the labor force into the military was a huge factor in reaching full employment.  Let's also not forget that there was a paucity of civilian big ticket items produced during the war, resulting in a big increase in replenishment demand in the post-war period.

Therefore conditions after the war were ideal for a resumption of prosperity---lots of consumer savings, little debt, loads of pent-up demand and millions of newly-released veterans who needed housing.  In other words, there was an abundance of consumer liquidity that took many years to run down.  Conditions are obviously a lot different today.  While the economy is far less depressed than during the 1930's, consumers are still heavily in debt, savings are low, housing is in oversupply and foreigners own too much of our government debt.  Overall, we have a lot of doubt as to whether, as a nation, we can spend ourselves out of the recession, although doing nothing would be disastrous as well.  That's why we have been so bearish on stocks.   

In our view the strong rally off last year's March low is a contra-cyclical move within a secular bear market that started in March 2000.  We have been undergoing a major credit crisis, followed by severe decline in income, a collapse in asset prices and record debt.  A number of detailed studies have shown that economic recoveries following such events are of short duration and extremely weak at best.  Despite massive efforts at stimulation, we see no reason why the outcome this time will be any different, and the evidence so far supports this view.   The economy is going through a process of deleveraging debt that is creating strong headwinds against a self-sustaining recovery.

The major drivers of previous economic recoveries in the post-war period have been housing and consumer spending that was spurred by easy credit conditions.  Those drivers are just not working this time around.  Despite the herculean efforts of the Fed and the White House, credit still remains tight.  Bank loans are down 27% from a year earlier while consumer credit is down 4%, the most since World War II.  Although the monetary base has soared over the last 15 months, M2 money supply is down 0.3% and MZM money supply is down 4.2% annualized over the last three months.  The strong growth of GDP in the 4^th quarter was mostly due to a return to more normal inventory levels while real final sales remained weak.  Consumer spending has picked up a bit, but only in comparison to the extremely low level of a year earlier.  In the period ahead consumers will continue to be restricted by high unemployment, tight credit conditions, sub-par wage increases, lower net worth and the need to raise savings rates and pay off debt.  

A number of factors that helped growth in the past year will no longer be operative in the year ahead.  The cash for clunkers program temporarily spurred auto sales, which have reverted back to sluggish sales levels.  The housing credit for first-time home buyers goosed housing demand for a while, but the extension of the program does not seem to be having the same effect, and, in any event, ends on April 30^th.  Furthermore the Fed's $1.25 trillion program to purchase mortgages ends on March 31^st.   As we pointed out in our comment two weeks ago economic momentum already seems to have peaked in the 4^th quarter as a number of recent indicators have come in under expectations.

In addition we don't think the sovereign debt problems have ended with Greece any more than we thought the subprime loan problems ended with Bear Stearns.  It remains to be seen whether Greece can carry out its promises of austerity and there is no need for us to dwell on the now well-publicized budding financial crises in the rest of the EU's Southern tier.  As we previously pointed out the debt problems have not gone away, but are in the process of being shifted from private to public entities.

Some may wonder why we continue to emphasize the global financial and economic problems and what this has to do with the stock market.  In our view this has everything to do with the stock market.  The entire rally has been based on the belief that we can undergo a V-shaped recovery and that modern governments just will not allow the kind of unraveling that has followed all other major credit crises.  However, governments can only try to halt the malaise by increasing their own debt and running up huge budget deficits that cannot be sustained.  In the U.S. we are already seeing the backlash as the public, while still demanding that the government somehow create more jobs, is also rebelling against the prospect of ever-increasing deficits. 

Therefore  if the market, as we believe, is discounting events that will not happen, the disappointment will be severe---and in a market increasingly dominated by trend players, the rush for the exits can be something to behold.  The market peaked on January 19^th at 1150 intraday on the S&P 500, declined to 1044 and now has bounced back to 1122.  After the March 2009 low the index moved 62% in six and a half months, but only 4% in the last five and a half months.  In our view this is all part of a topping formation that will be followed by a substantial decline in the period ahead.    

Don't look now, but economic momentum, as sluggish as it was, may have already peaked.  Fiscal support for the economy may be more of a restraint as the year goes by, and any attempt at additional stimulus will face major headwinds as public sentiment against further deficit increases is accelerating.  The diminution of inventory reductions probably reached a maximum in the fourth quarter when it accounted for nearly two-thirds of the rise in GDP.  The accelerated depreciation tax benefit that helped push capital expenditures foreword expired at year-end. Hiring has not picked up while wages remain stagnant and consumers are deleveraging debt. 

In addition the Fed is ending its purchases of MBS at the end of March and major increases in home foreclosures are on the horizon.  Credit remains tight as consumer credit continues to decline and commercial and industrial loans are also dropping. With both housing and consumer spending not in a position to perform their typical role of sparking an economic revival, there is no major driver for sustaining the economy once the contributions from inventories and fiscal policy wind down.

Adding to the malaise is the unusual weakness of small business in the current cycle, a phenomenon that has not gone unnoticed by the politicians or media.  This is particularly important since small business is said to have accounted for at least 50% of all employment growth in the nation over the last few decades.  While the latest National Federation of Independent Businesses (NFIB) Index has risen eight points off the bottom to 89, this is still the lowest reading in at least 24 years with the exception of some lower monthly data points in the current cycle. Even after bouncing, the latest index number of 89 is still below the lows reached in the 1990 and 2000-2002 recessions. 

Small businesses by and large are still planning to liquidate inventories and reduce employment.  For the most part they are not planning to expand.  The NFIB stated that "Too many new houses were built, too many strip malls were opened, too many restaurants started, too many new retail outlets were launched in the 2003-2007 period and all those cannot be supported by a consumer that now chooses to save."  In addition small businesses are finding it hard to get loans as the community banks that serve them are constrained by the necessity to boost their capital and by regulators urging them to strengthen their balance sheets.  That's not to say that small businesses are breaking down doors trying to get loans.  When asked about their number one problem, more mentioned a lack of sales than any other factor.  For too many, there is just no reason to ask for a loan.

In sum, we believe that economic momentum, such as it was, has already peaked and that a V-shaped recovery is highly unlikely.  Adding to the problem is the likelihood of further sovereign debt distress and the strong probability that China will be sharply reducing its commodity purchases.  The strong market rally since the March low has discounted a lot more than the world's economies are capable of delivering, and equity prices are facing the prospect of readjusting to reality.       

The Greek fiscal crisis is just a symptom of world-wide credit problems that was signaled by the emergence of subprime loan disclosures as early as August 2006.  The importance of subprime lending was not recognized until much later, but nevertheless evolved into a continuing series of economic and financial crises that continue until this day.  The problem has now extended to sovereign debt, and, as usual, the weakest links are exposed first (Dubai and Greece) only to spread to stronger entities later.  Not far behind are Portugal and Spain, then perhaps Italy and Britain.  It's not just a localized minor problem to be solved by some sleight-of-hand by the EU, but a debt crisis that could envelop the globe.

In addition to excessive fiscal deficits by some of its weaker members, the EU has some special problems for which there are no good options.  The Greek government can either undertake severe fiscal austerity measures, default, be bailed out by the EU or leave the organization entirely.  Each of these has unwanted consequences. The result of enough fiscal austerity to relieve the debt pressures is a severe recession or depression.  An independent nation generally offsets this with an easy monetary policy and devaluation of the currency, something that Greece cannot do as an EU member since they do not run their own monetary policy and share a common currency.  Default would cause havoc in the EU banking system that holds most of Greece's debt. An EU bailout would only push off the crisis since other weak members would demand the same deal.  While the Greek economy is relatively small and the Portuguese economy slightly smaller, bailing out an economy the size of Spain's would be an enormous or even impossible project.  And leaving the EU would probably bring down the organization.

Furthermore Greece's debt burden is only slightly more onerous than those of an alarming number of other nations including Portugal, Spain, Italy, Ireland, Iceland, Britain, Japan and, yes, even the U.S.  Globally, assets soared in price during the boom, supported by vast increases in debt.  Now the assets are severely diminished while the debts remain and there is insufficient income to pay them off.

The U.S. is far from immune.  Administration budget projections of the deficit indicate that the gross Federal debt held by the public will exceed 100% of the GDP within two years while the deficit will amount to 10% of the GDP.  The CBO estimates enormous deficits for the next ten years, and it doesn't end there.  And this is probably a best-case scenario that overestimates future economic growth, doesn't include GSE debt and doesn't account for the huge fiscal problems of the 50 states.

In addition the prospect of big deficits as far as the eye can see raises fears of default or currency depreciation leading to a rise in interest rates and a dampening of growth.  So far interest rates have been held down by Fed purchases of Treasury bonds and mortgage-backed securities (MBS), purchases by China and a rush to safety.  However, Treasury Bond purchases amounting to $300 billion ended on October 31^st while the program to buy $1.25 trillion of MBS comes to an end on March 31^st.  At the same time, China, while not actively selling U.S. Treasuries have sharply reduced their purchases and will probably continue doing so.

It therefore seems to us that investors are making a big mistake if they assume that Greece is too small and unimportant to matter and that the rest of the developed world is somehow isolated from the turmoil.  Greece is to sovereign debt what subprime was to private debt.  It's the possible start of a vast tsunami that threatens to overwhelm the global economic and financial system.  Investors should take heed.