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What lies ahead for the US economy? the global economy?

26 July 2010

Summary:   As described in the first post of this series, Hidden truths about the state of the US economy, we can no longer make reliable forecasts for the US economy.  We’ve sailed off the map, as the post-WWII era has ended.  But we can describe likely scenarios.  This describes a grim one. The next chapter is Some thoughts on the political implications of a long recession.

To keep it simple, there are 3 likely scenarios for the American economy over the next decade.

  • Recovery:  structural reform (reducing the government and trade deficits) and slow growth in employment and incomes.
  • Stagnation:  no employment growth, continued large trade and government deficits, flat to slow GDP growth (aka the long healing).
  • Another “dip”.  Continued recession.  We’re Japan worse than Japan.

Economists and financial gurus discuss the first two scenarios at length. Here we look behind the third door.  The most interesting scenario; threats to our survival are always interesting.

Contents

  1. A quick look at the current state of the US economy
  2. What will we see if the US economy takes another drop?
  3. How will the government respond?
  4. Global effects and implications
  5. What will the new world look like?

(1)  A quick look at the current state of the US economy

Supposedly the US economy began a recovery early last summer.  While manufacturing has recovered, two other major indicators remain weak — suggesting the bounce was narrow.

The mild improvement since the Spring 2009 lows in employment, income, and GDP (everything except manufacturing) despite the massive stimulus should surprise nobody, since the downturn was broadly similar to that of 1929.   For more about this important but often-ignored point see

Looking ahead, the two major sets of leading indicators paint different pictures.

The Conference Board’s Leading Economic Index (LEI) remains at peak levels, although flat for the past 4 months.  But the 7 (of 10) components that reflects non-financial activity has been flat since December (these are weighted to represent half the total index).  Worse, 5 of the 7 peaked in March or April.  See the graph here, the components here.

The Economic Cycle Research Institute’s Weekly Leading Index (WLI) peaked in April, and has since fallen 10%.  The WLI Growth index is at -10.5%, a level seen only during recessions (record back to 1969) — and it’s below the 1982 and 1990 lows.  We cannot look at the components, as they’re secret.  See the indexes here.

What are the odds of another downturn?  It’s not a useful question.  The current state of economic theory does not allow reliable forecasts, esp in the midst of regime change ( for more this process see A look at the future of the world’s political and economic order).  But the odds are substantial.  My guess is 1 in 3, perhaps even 1 in 2.

This website has accurately forecast the nature of the this downturn, in a rough sort of way.  For details see Forecasts and Warnings, section 6 of the reference page Financial crisis – what’s happening? how will this end?.

(2)  What will we see if the US economy takes another drop?

As I said in February, a second dip might be worse than the first (we’re weaker 3 years into this event).   As always, the timing is uncertain.  Perhaps gradual slowing during the next six months, with a recession late this year or early next year.  If so, what will result?

  • Households and businesses rapidly retrench, causing a drop in sales and investment
  • Employment falls, although perhaps slowly  from reduced hiring (as firings even now run at roughly 15 million annualized)
  • Increase in bankruptcies and foreclosures, as we slide into another bout of Fisher’s debt deflation (see here for an explanation)

It will prove Paul Krugman right, that we’re in a liquidity trap.  It will prove Koo correct in his 4th and most important forecast — that we are in a Japan-like cycle (see here for details).

Unless stopped, this decline probably will accelerate in 2011.  Especially if Europe and Japan also slide into recession.  But it will be stopped.  But how quickly?

(3)  How will the government respond?

Both the government and Wall Street see the threat, however unlikely they consider it.  Continued slowing will produce calls for action.

Fiscal action would be effective, and could take effect on a large scale in a few months — if implemented as done in 1932-33.  But unless we have a rapid crash, rapid reaction is IMO unlikely before the November elections (esp as Congress will go home in October to campaign). 

The Republicans have adopted Lenin’s tactic of “the worse, the better” (as described here).   They’ll fight all proposals to arrest the downturn, citing their newly developed faux economics.  AKA Austerian economics, the neologism coined by Rob Parenteau (The Richebacher Letter), a variant of Mellon’s liquidationist theories that helped produce the Great Depression.  Will they continue this in 2011, even during a deep recession?  Or will their victory in the November elections encourage them to double-down, crushing the Democratic Party as FDR did the Republicans?  Will Obama effectively respond?

That leaves the Fed, whose leaders understand the danger and will respond quickly.  But the Fed’s conventional tools can do little.  Short rates are near zero, and increasing bank reserves might have little effect.  So they’ll start where they left off in Spring 2009:  aggressive and unconventional actions.  Such as direct purchases of long maturity treasuries to lower interest rates.  And most importantly, buying risk assets (e.g, loans) to support asset prices and encourage lending/investment.

Eventually Congress will enact a large-scale fiscal stimulus (and the will Fed monetize it, as necessary).  Much depends on how quickly they respond, the size of the package, and how well they craft it.  There will be great pressure to design this according to trickle-down economics:  tax cuts for the rich, so that they might spend some of it on consumption and investment (rather than save it, which is fact where most of it will go).   And direct aid to politically powerful constituencies (i.e., agribusiness, government unions, large corporations).

Building useful infrastructure and advanced education would be valuable, but do little to re-elect congressmen.  Our ability to overcome this political gravity will test our political cohesion and collective wisdom.

Most important, both monetary and fiscal action provide only first aid (like morphine and bandages).  Using the crisis to make structural reforms (as did FDR)  is necessary to put us back on track for eventual growth.   The most important reform during the 1930′s was to see and break each nation’s golden fetters (which existed only in our minds).

What are our golden fetters?  Or inability to understand the process at work in this downturn — and the resulting ad hoc responses — has been our greatest difficulty.  For details about these fetters of the mind — then and now — see

What reforms are needed?  Here’s are two that should be near the top of the list:

(4)  Global effects and implications

Japan and Europe probably will sink with us. 

  • The UK response will mirror ours, due to our similar cultures and political systems.
  • Europe will see large-scale structural change; either unify or break apart (probably the latter)
  • Japan will either undergo large-scale structural change (e.g., reforms like those of Meiji Restoration or Turkey under Ataturk) or suffer regime collapse
  • The emerging nations will see interesting and unpredictable changes.

The great recession marks the end of the post-WWII global political/economic regime, and the transition to a new era.   The transition might be short and relatively smooth.  The two previous transitions were neither.  They lasted 3 decades (1789-1815, 1914-1945).   We can make some guesses about this period.

  • The political dynamics of this downturn are murky, as the governments of most western nations have lower levels of legitimacy than they did in 1914 and 1950.  Hence their ability to respond by increasing government regulation, as they did in the 1930′s and after WWII, seems problematic.
  • The two past transitions were scarred by long wars.  With nukes ending the era of conventional war, a difficult transition might see new modes of conflict.  Such as high-intensity 4GWs and economic warfare.  For an description of one scenario of the latter see Words to fear in the 21st century: Lǎo hǔ, lǎo hǔ, Lǎo hǔ.
  • A long transitional period will carry us into the climax of peak oil and the demographic wave (the global aging crisis and adjustment to a negative population growth society).  Those societies who adapt best will be the leaders in the next era. 
  • Technological change during a long transition acts as a wild card.
  • Some nations will not survive in their present form.  Just as the Russian, Austro-Hungarian, and Ottoman Empires did not survive the previous one.   What follow such collapses might be better (or worse).

For more about transitions see

(5)  What will the new world look like?

“Choice. The problem is choice.”
— Neo in The Matrix Reloaded

We cannot make reliable predictions about the new world, as the outcomes are path dependent — resulting from choices we do not yet understand.   The decisions each people make will define them in the next cycle.  Let’s hope we choose wisely.

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