I’m currently immersing myself in literature about the Great Depression and reading Benjamin Roth’s “The Great Depression: A Diary”. It’s like reading the mind of an investor that lived through the Great Depression. In this article, I will discuss whether I believe we are heading for another depression similar to the one the world experienced in the 30s, what can be learned from the Great Depression and how to survive the coming economic collapse.
In a healthy economy, interest rates are set by the free market. If an investor or business owner wants to borrow money, they have to do so at rates that are dictated by the demand and supply of money. This keeps credit markets in an equilibrium.
In the fractional reserve banking system, banks only have to keep a small percentage of depositors’ funds in their reserves. Traditionally, the reserve requirement has been around 10%.
If a person deposits $100, the bank only has to hold onto $10. The other $90 can be lent to other people or businesses. The paradox is that the person depositing the $100 has a claim on that money. The bank owes these $100 to the depositor.
At the same time, the bank lends $90 to another person. This other person can take the $90 and deposit it at another bank. The second bank owes $90 to the second person. But these same $90 are owed to the first depositor as well.
(The Bank of Amsterdam operated as a full-reserve bank)
In other words, multiple people have claims on the same money. If both of them were to withdraw their $90 at the same time, the banks wouldn’t be able to pay both of the depositors. And if 1% of the world’s population withdrew their money from banks, the entire fractional reserve banking system would collapse.
In the past, many banks went bankrupt because of bank runs. A bank run is when large numbers of depositors attempt to withdraw their money all at the same time. The problem is that banks don’t actually have the money anymore because they lent it out to other people. And if everyone tries to get their money at the same time, the banks that were involved in this fractional-reserve “scheme” can’t keep their contractual obligation to pay all depositors.
When banks lend out a depositor’s money, and the person borrowing the money deposits it at a second bank, the second bank is only required to keep a small reserve as well. The other 90% are lent out again and end up in a third bank.
Let’s say person one deposits $100 at bank one. Bank one keeps $10 in its reserve and lends $90 to person two. Person two takes the $90 and deposits it at bank two. Bank two keeps $9 in its reserve and lends $81 to person three. Person three takes the $81 and deposits it at bank three. Bank three keeps $8.10 in its reserves and lends out $72.90 to person four.
This form of fractional-reserve banking leads to an expansion of the money supply. Money is quite literally “lent into existence”.
Many people mistakenly think that new money can only be created by central banks. This is not the case. Commercial banks create money by lending it into existence through the fractional-reserve banking system.
In the United States, commercial banks keep their reserves at the Federal Reserve. During the Covid-19 pandemic, the Federal Reserve reduced the reserve requirement to zero. This means banks could lend money into existence without having to keep any reserves at all.
If commercial banks keep more money at the Federal Reserve than they are obligated to as part of their reserve requirement, they can lend these excess reserves in the form of overnight-loans to other banks that are in need of liquidity.
The Federal Reserve sets the target interest rate on these overnight loans. This is known as the Federal Funds Rate. It’s the interest rate banks charge each other when engaging in overnight lending of excess reserves. Central banks all around the world operate this way.
The Federal Reserve and other central banks can control the money supply in two ways: By cutting interest rates and through Quantitative Easing.
(Federal Reserve by AgnostikPreachersKid)
When the Federal Reserve cuts the Federal Funds Rate, other interest rates such as interest paid on bank deposits and mortgages follow. Setting the Federal Funds Rate has a ripple effect on economy-wide interest rates.
When the Federal Reserve lowers the Federal Funds Rate, it is flooding the economy with “cheap money”. Interest rates can be seen as the cost of money. And by keeping interest rates low, the cost of money is reduced and borrowing is encouraged.
The more people borrow money, the more money is lent into existence. This expands the money supply in the fractional-reserve banking system and “stimulates” the economy.
During a market crash or economic collapse, the Federal Reserve and other central banks lower the interest rates to flood the economy with money and encourage more spending.
In a free market, interest rates are subject to supply and demand. When central banks set interest rates, they are manipulating the cost of money and keeping it artificially low.
When the money supply is expanded by fractional-reserve banking and interest rates are manipulated through central planning, this distorts businesses’ ability to plan and leads to malinvestment.
In the words of Robert Batemarco from the Mises Institute:
The basic idea is that the creation of money (which is also credit, since that new money is loaned into existence) increases the supply of loanable funds and lowers market interest rates without increasing the supply of voluntary saving. This misleads investors into believing that more resources have been made available by savers for investment projects than actually have been made available. Thus, projects are started on too big a scale since many investors try to exercise a claim on the same productive resources. In so doing, they will bid up the resource prices, slashing the profitability of many of these investment projects.Robert Batemarco on Fractional-Reserve Banking
This is a summary of the Austrian Business Cycle theory which attributes boom and bust cycles to cheap credit and malinvestment.
Recessions and depressions, while painful in the short-term, are the “bust” part of the boom and bust cycle. The malinvestments made as the result of cheap credit end up being unprofitable.
The artificial boom created by expanding the money supply and manipulating interest rates can’t be sustained forever and leads to an eventual bust.
These recessions and depressions have historically been relatively short. Once all the malinvestments were “flushed from the economy”, real growth could continue. Or another boom and bust cycle began as a result of cheap credit and history repeated itself.
In the last two decades, the boom we’ve experienced has become so artificially big and systemically risky that central banks couldn’t let the “bust” happen. In 2008, the boom and bust cycle wanted to unwind. The economy came crashing down. Banks and investors that made malinvestments faced bankruptcy.
But instead of letting these bankruptcies happen, banks that were considered “Too Big To Fail” were bailed out.
This prevented the world from entering a depression similar to the Great Depression. Unfortunately, the can was only kicked down the road.
Instead of allowing the economy to “cure itself”, the artificial boom was maintained by central banks around the world. Interest rates were cut further and kept low for a decade. In Europe they even turned negative. Additionally to keeping interest rates artificially low, central banks engaged in record levels of Quantitative Easing.
All of this continued flushing the economy with cheap money. Businesses that would have gone bankrupt in a free market were artificially kept alive and became “zombie companies”.
Instead of letting all the malinvestments go bust and allowing the economy to deleverage, central banks took these malinvestments and put them on their own balance sheets.
This prevented a deflationary depression and kept the false boom going until 2020. In that same year, Covid-19 spread all across the world. Businesses were forced to close as governments issued lockdown mandates.
The Federal Reserve cut the Federal Funds Rate to zero, removed all reserve requirements for commercial banks and started purchasing $120 billion worth of government bonds a month as part if its largest scale Quantitative Easing program to date.
Two years later, at the beginning of 2022, the Federal Reserve has “threatened” to increase the Federal Funds Rate and taper its Quantitative Easing program. The mere act of announcing these actions sent financial markets tumbling again.
(Illustration of Wall Street Bubbles published in Puck magazine in 1901)
The economy wants and needs a desperate “bust” to flush all the malinvestment from the last decades out of the economy. After a painful economic reset, real growth could continue — Or a new boom and bust cycle would begin.
The problem is that the false boom has been of such magnitude hat there is way more systemic risk than ever before in the economy.
The sovereign bond market is in a bubble, and if credit markets begin a deflationary spiral, interest rates would increase and make government debt even less sustainable than it already is.
You can read about this in my article on the “Everything Bubble”.
The global economy, governments and central banks are in such a fragile situation that an economic reset is almost inevitable at this point. The question is whether this economic reset is going to be of deflationary or hyperinflationary nature.
I personally believe heightened inflation or hyperinflation is the more likely scenario in the long-term.
Central banks around the world, and especially the Federal Reserve, cannot let a deflationary depression happen. A bust of this magnitude would lead to debt deflation, which means the borrowing cost of the United States government would increase.
This would make the already unsustainable debt levels of the United States government even less sustainable. It would also put pressure on the US dollar as world-reserve currency and threaten the United States geopolitical position.
Given the problematic situation the United States government is in, the Federal Reserve will have to resort to ever more extreme monetary policy to keep the bubble inflated and prevent deflation.
But what if the Federal Reserve isn’t able to prevent a major deleveraging event? What if central planners and policy makers make a mistake and the “Everything Bubble” pops?
While I think it’s unlikely, this would lead to a deflationary depression. We’re talking about an event comparable to the Great Depression.
As discussed already, central banks will try to do everything in their power to prevent deflation from happening.
Inflation is better than deflation for those who are in debt. The United States government is the biggest borrower in the world. Debt deflation would harm the United States government more than anyone else.
Letting deflation happen would be political suicide for any central banker or politician. Nobody wants to let “it” happen on their watch. This is why I believe we won’t see a deflationary depression but a hyper-inflationary melt-up, followed by an economic collapse and currency reset.
Whenever there is a financial crash or economic downturn that poses a big enough systemic risk and could lead to debt deflation, central banks will flood the economy with money. They will do this by keeping interest rates near zero and eventually introducing negative interest rates like the European Central Bank did.
They will also engage in nuclear levels of Quantitative Easing, way beyond the $120 billion a month that we saw during the Covid-19 crisis.
Finally, they’ll introduce a Central Bank Digital Currency to gain more fine-tuned, surgical control over the money supply, interest rates and the economy. And other “tools” such as cash carrying taxes, wealth taxes and bail-ins will be used to help bail out bankrupt banks and governments.
Despite all this there is a chance that central banks fail to “save the economy”.
The tools currently available to central banks are becoming less and less effective. Certain things, such as outright buying stocks and corporate bonds aren’t permitted under the Federal Reserve Act.
The Federal Reserve will have to set up “Special Purpose Vehicles” to surpass these restrictions and these will need to be approved by the US Department of the Treasury.
In case the Federal Reserve hikes interest rates and tapers its Quantitative Easing program while ignoring signs of an incoming recession or depression for too long, or other “policy mistakes” are made by the Federal Reserve, this could lead to an economic collapse that takes place so quickly and poses such a large systemic risk that it cannot be prevented.
This would have far reaching consequences for the global economy. Banks, corporations and governments would face bankruptcy. The stock market and real estate market would collapse. Debt deflation would take place, putting immense pressure on individuals, companies and governments that have borrowed money.
I believe the likelihood of another depression similar to the Great Depression is small. The systemic risk involved in such an event and the implications for governments that have been on a debt binge since the 70s are much more severe than they were in the 1930s.
During the Great Depression, most countries were still on the gold standard. They didn’t have the benefit of a pure fiat currency system where the money supply can be increased without any backing requirements. And the economy wasn’t nearly as globalized back then as it is today.
When the warning signs flash and debt deflation is imminent, central bankers will do everything in their power to make sure “it” doesn’t happen.
I’m 75% confident that we’ll see heightened inflation or even hyperinflation in the next few decades. This will be brought about by central banks engaging in extreme monetary policy to keep the bubble in sovereign bonds inflated, prevent deflation and avoid a further decrease in the sustainability of the United States government debt.
This doesn’t mean that we won’t see major volatility and market crashes in the short-term. It’s also not a bad idea to occasionally ask questions like: “What if I’m wrong?”, “Could I be missing something?” And “Is there a non-zero chance that something unexpected happens?”
The truth is that nobody knows for sure what the future holds. We live in turbulent and unprecedented times. History can help us make better predictions about the future, but they are still predictions and not guarantees.
Because of this, I prefer erring on the side of caution and accepting a 25% chance that there could be a deflationary depression that cannot be prevented through monetary policy.
Given that heightened inflation and even hyperinflation seem more likely than deflation, I have personally allocated my investments accordingly. I’m bullish on stocks, real estate, gold, commodities and bitcoin long-term. All of these should serve as decent inflation hedges and preserve or even create wealth during a period of heightened inflation or hyperinflation.
But what if there is a deflationary economic collapse?
When there is a deflationary depression, cash is the best asset to hold. During the Great Depression, those who were invested in stocks and real estate lost almost everything.
(A crowd of people gathering outside of the New York Stock Exchange)
Families that were once rich and lived from dividends and rental income became poor. The companies that issued their stocks went bankrupt, stopped paying dividends or took such a hard hit that they dropped 90% or more.
Those who owned real estate didn’t generate any income because nobody had money to pay rent. They couldn’t sell the properties either because there were no buyers. Banks foreclosed the properties. Other real estate property owners destroyed their properties to avoid having to pay property tax on real estate properties that didn’t generate any rental income.
During the Great Depression, government bonds as well as physical cash and gold stored in a private vault was the best way to preserve all or at least some wealth during the depression.
Cash is the best asset to hold during a deflationary depression because the prices of assets like real estate, stocks and consumer goods drop. Anyone who held significant amounts of cash during the Great Depression could scoop up real estate properties and stocks for dirt cheap.
The problem was that many people thought the bottom was in and bought stocks at a “bargain” but the market continued dropping. Almost nobody predicted how low stocks would go. But those who had cash outside of the bank and invested it in assets close to the bottom, and were able to hold onto these assets for the next 3-5 years, were able to turn a great profit from the Great Depression.
Despite my belief that continued inflation is more likely, I keep a small percentage of my wealth in fiat currency. In the event that I’m wrong and the Everything Bubble bursts, this fiat currency gains purchasing power against other assets.
The dry powder can be used to pay for expenses or to scoop up bitcoin, stocks and real estate at a discount. It’s not a bad idea to position yourself in a way that you can profit from both inflation and deflation.
If the artificial boom continues, your assets appreciate, serve as a hedge against inflation and preserve your wealth. And if we experience a bust, you have an emergency fund and dry powder to buy assets at an incredible discount.
If you position yourself for both scenarios, you don’t have to be right.
It’s important to note that in case of a major deflationary economic collapse, money held in banks isn’t safe. Those that had bank deposits during the Great Depression couldn’t get their money out of the banks.
There were lines of people every day silently making a run on the bank and withdrawing their money, leading to countless bankruptcies and bank closures on a daily basis.
(Florence Owens Thompson looking for a job during the Great Depression in 1936)
Eventually, most banks closed. The few that reopened put limits on withdrawals in place. This meant you either lost all your money (there was no FDIC insurance back then), and if you were lucky enough to have deposits at a bank that didn’t go bust, you were only allowed to withdraw small portions of your money.
This illustrates why fractional-reserve banking can be seen as a fraud. While the bank contractually owes you the money you deposited, it cannot pay it back because multiple people at different banks have claims on the same money.
Having some physical cash or gold in a private vault or stored in a safe at home can help mitigate this counter-party risk associated with banks.
While gold isn’t as good of an asset to hold during deflation as fiat currency, it can be expected to preserve wealth better than stocks and real estate. For example, if most assets crash 90%, the price of gold might only drop 40%. This isn’t as good as holding fiat currency which gains purchasing power during deflation, but it would still allow investors to preserve wealth better than most other assets.
One thing that deflationary and hyper-inflationary economic collapses have in common is food shortages and supply chain disruptions. Having a property with a food garden or a piece of farm land might prove extremely valuable.
When comparing the Weimar hyperinflation of 1923 and the Great Depression of 1931, soup kitchens, food riots, starvation and outright poverty are present during both periods.
During the Weimar hyperinflation, money was available in unlimited quantities but had no purchasing power. During the Great Depression, the purchasing power of money went up but nobody had any of it.
Prepare for both extremes and position yourself accordingly.