Two years ago, a student at the University of Michigan asked Berkshire Hathaway (NYSE: BRK-B) Vice Chairman Charlie Munger to compare the 2008 financial crisis to the Great Depression. Munger, as usual, didn't mince words:
It's nowhere near as bad as it was in the '30s. This is hog heaven compared to the '30s. That was unbelievable. I lived in the 1930s. We didn't have this social safety net. You know what people did in the '30s? They moved into one another's houses. That's what families were for. It was just pain and trouble.
It's been obvious for a while that the past few years weren't as bad as the 1930s, but it struck home when the Treasury published this picture last week, comparing current job losses to the Great Depression and several other severe financial crises:
Source: U.S. Treasury.
The Treasury, as you might imagine, chalks up the comparative difference to the government's response -- namely the TARP bank bailout program, the 2009 stimulus package, and the Federal Reserve's unprecedented amounts of quantitative easing (money printing). All of those policies were either ignored, or not done as vigorously, during previous crises. At the late economist Milton Friedman's 2002 birthday party, Fed Chairman Ben Bernanke quipped: "I would like to say to Milton: Regarding the Great Depression. You're right, we [the Fed] did it. We're very sorry. But thanks to you, we won't do it again." As far as many are concerned, Bernanke and the Fed didn't do it again. And it shows in this chart.
Billionaire hedge fund manager Ray Dalio -- an underappreciated mind who has been right more than almost anyone else over the last five years -- has a more detailed explanation.
In Dalio's eyes, the financial crisis and its aftermath is all about deleveraging, or the process of getting rid of unsustainable amounts of debt built up during the bubble years. He explained it last year with a simple example. Imagine someone who makes $100,000 a year and has a net worth of $100,000 with no debt. That person can safely borrow about $10,000 a year for several years, meaning they can spend $110,000 a year even though they only make $100,000. The flip side to all that spending is that someone else is earning $110,000 a year. "For an economy as a whole," Dalio writes, "this increased spending leads to higher earnings, that supports stock valuations and other asset values, giving people higher incomes and more collateral to borrow more against, and so on." That describes our economy from 2000 to 2007.
But it can only last so long. Eventually, debt service payments take up too much of income, and everything breaks apart. "The person spending $110,000 per year and earning $100,000 per year has to cut his spending to $90,000 for as many years as he spent $110,000," to pay down the borrowing spree, says Dalio. That means some one else can now only earn $90,000. And it means the economy grinds to a halt, as it has since 2007.
Deleveraging explains why our economy is so slow. But it also explains why our jobs situation has fared so much better than other financial crises.
According to Dalio, America's recovery over the last three years "would win our award of the most beautiful deleveraging on record."
Since 2009, private debt in American has declined (mainly through default) faster than government debt has risen as a percentage of GDP. So the economy's total debt-to-GDP ratio has dropped -- that's the deleveraging. It's not an easy feat: America is one of the only developed nations in the world to actually achieve a deleveraging in recent years; Japan, the U.K., Germany, Canada, and others have all seen debt-to-GDP ratios rise over the last three years.
What's made our recent deleveraging beautiful? "Since everyone eventually gets through the deleveraging process, the only question is how much pain they endure in the process," Dalio recently wrote. "The differences between how deleveragings are resolved depend on the amounts and paces of 1) debt reduction, 2) austerity, 3) transferring wealth from the haves to the have-nots and 4) debt monetization [printing money] ... beautiful ones balance these well and ugly ones don't."
Deleveraging by its nature is deflationary -- it causes prices to fall -- which leads to falling incomes, which makes deleveraging even more painful, and so on. It turns into a vicious cycle. Dalio calls that an "ugly deflationary deleveraging." That's what happened in the Great Depression. In contrast, when too much money is printed, you get an "ugly inflationary deleveraging." That's what happened in Latin America in the 1980s, and Germany in the 1920s, when prices increased a trillion-fold in five years.
The trick to a beautiful deleveraging, Dalio explains, is for the central bank to print enough money to counteract deflation while not overdoing it and setting off runaway inflation. It's the Goldilocks "just-right" level. The economy as a whole is able to shed debt, but the Fed provides just enough support to keep nominal wages from falling and growth from declining, which lets you keep deleveraging at a sustainable rate. Striking that balance that has eluded policymakers in nearly every other financial crisis. Getting it right for the most part -- so far -- this time around helps explain the performance in the chart above.
"The key going forward will be for policy makers to maintain balance so that the debt/income ratio keeps declining in an orderly way," Dalio wrote.
Understatement of the year. If there is one lesson from the history of deleveragings, it's that sometime, somewhere, policymakers will push things out of balance. With the economy still fragile, even a small mistake could cause things to get ugly, fast. Pain and trouble, as Munger might say.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.
