But this *long run* is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.
— John Maynard Keynes, “A Tract on Monetary Reform” (1923)
To know how to move forward we must first learn how we got here. This takes on even greater urgency in this election year.
The US economy was wracked by a series of booms and busts in the decades after the Civil War. In 1913 Congress broke with this policy of laissez faire to create the Federal Reserve, charged with stabilizing the banking system. Despite this (or perhaps because of this), these busts culminated in the Great Depression of the 1930’s. A solution was at hand. During the years 1919-1936 John Maynard Keynes developed a new paradigm for economics, both quantitatively clear and operationally simple. Its goal was to stabilize the economy at a low level of unemployment, an optimum equilibrium (this is a gross over-simplification). It ignored the inimical effect of rising debt levels. But then, in the long run we are all debt (Keynes had no children).
The US adopted his policy of aggressive economic management, stabilizing the economy though federal spending, plus manipulation of the money supply and value of the dollar. This worked well for many decades.
Average length of expansions:
- 1854-1929: 25 months (laissez faire)
- 1945-1980: 44 months (Keynesian management)
A side effect was erosion of traditional concepts of financial prudence. During the 1960’s and 1970’s the US economy accumulated more debt and the trade deficit deteriorated. The stress impelled President Nixon to take us off the gold standard in 1971, which led to the great inflation of the 1970’s. Only after inducing a recession, the worst since the 1930’s, was the Fed under Chairman Volcker able to restore stability to our economy. Widely hated for this strong medicine, he served only one term two terms, but never attained the heroic reputation of his successor Alan Greenspan.
The Fed was an evasion of responsibility by our elected officials. In the words of Chairman William McChesney Martin Jr.,*the Fed is like “the chaperone who has ordered the punch bowl removed just when the party was really warming up.” Its Chairman was to take the burden of making unpopular decisions off our elected officials. Then in 1987 Alan Greenspan became Chairman, and discovered that Chairman too could be famous and popular. Casting aside all considerations of prudence, he oversaw a massive increase in the debt of government, household, and corporate debt. every crisis or slowdown was met with more debt. This worked well for a long time. There were those warning that this would end badly, but they were discredited by the lack of immediate ill effects (heroin works in a similar fashion).
Average length of expansions:
- 1854-1929: 25 months (laissez faire)
- 1945-1980: 44 months (Keynesian management)
- 1982-now: 95 months (Greenspan management).
Sometime in the mid-1980’s Maria Fiorini Ramirez, then with Drexel (now one of Wall Street’s top economists) noticed that since WWII that the government’s economic management resulted in debt growing over time. More interesting, the effectiveness of new debt was decreasing. That is, new debt provided less stimulus. She speculated that when the economy hit its maximum sustainable debt load, new debt would no longer spark economic growth. Technically this means the debt elasticity of GDP goes to zero. At that point the economy would have to deleverage, marking the end of the post-WWII economic regime in America.
Growth of Credit market debt growth per dollar of GDP growth.
- 1950’s $1.77
- 1960’s $1.53
- 1970’s $1.69
- 1980’s $2.92
- 1990’s $3.15
- 2000 – now $4.95
Excerpts from the 3 January issue of Contrary Investor (as is the data in this article) **
BEA revisions to the real GDP calculation essentially wiped the 2001 recession off of the map in an academic sense, despite the fact that the NBER still considered the totality of events as a recession. … In that light, can we say that the current economic expansion is really, academically, 193 months long? … 193 months of expansion is absolutely a massive anomaly in terms of length of historical economic expansions. Absolutely nothing comes even remotely close.
… If we start the economic retrospective clock at the end of the recession in 3Q of 1982, since that time exactly 100 quarters have elapsed. Again, over that period, the US has officially experienced only 5 quarters of negative quarter to quarter real GDP. That’s only 5% of the entire period!
… Since late 1982 one of the most incredible periods of academically defined US economic growth of the last quarter century exactly coincides with what has been record US credit expansion as a % GDP over the same period. … two incredibly powerful forces up until now have act to reinforce and support each other.
All parties must eventually end
The 2001 slowdown, from bursting of the debt bubble and 9/11, were met by an unprecedented rise of debt by US governments and households. Eventually the economy responded, although quite sluggishly.
Now comes the hangover to our fifty-year long party. the “subprime crisis” is just the canary in the coal mine, defaults by the worst loans of the most vulnerable debtors. We face a slowdown, perhaps a recession. Worse, we have burned out our economic “stabilizers” through overuse (see update for more on this).
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As Comptroller-General Walker has warned, the looming retirement of the baby boomers limits the government’s ability to borrow – so fiscal policy is hamstrung.
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The trade-weighted US dollar has declined to near its record lows, making holders of US bonds nervous. Monetary stimulus – printing money, lowering interest rates – risks sparking a currency crisis, perhaps ending the US dollar’s reign as the world’s reserve currency. The consequences of this could be calamitous, as the trillions of dollars held aboard as a store of value get sent home if the dollar becomes just another fiat currency.
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Currency management, debasing the currency in order to stimulate exports, has the same problem.
What happens next?
We cannot see beyond the end of the post-war economic regime. At that point we must make decisions, and we cannot see how we will choose. We have borrowed fecklessly incredible sums over many years. Will we repay these debts or default?
It is a decision we will make at all levels. Businesses will decide. Local governments will decide. Citizens will decide. The last will be a microcosm of the others. For example: your home is worth far less than your mortgage. The loan is non-recourse to you, so if you default the bank cannot chase you for the loss. Do you pay or mail the keys to the bank (“jingle mail”)?
We cannot do the same thing for America, mailing the keys to our foreign creditors – making it their problem. But we can default, or inflate the debts away to oblivion. Our creditors trusted enough in America to lend to us without collateral and in our own currency. Were they wise to do so?
Repudiating these debts will mark the end of America as a leader of the world community, and probably as a great power. It will be interesting to see how we choose. Of course our ruling elites insure that none of this gets mentioned in the Presidential campaign, least it disturb the proles. We can assist them by not telling anyone.
* In this same speech, Chairman Martin told of the economics professor who “always posed the same questions {on the final exam}. When he was asked how his students could possibly fail the test, he replied simply “Well it is true that the questions do not change, but the answers do.””
** The always interesting Contrary Investor is a subscription service, but the provide a free monthly letter here.
Update
For a brief explanation of why government efforts — esp. fiscal policy — can do little to mitigate the coming recession, see this excerpt from today’s article by Prof Nouriel Roubini of NYU, published at the excellent RGE Monitor:
While the Summers proposal is the most sensible in terms of the appropriate fiscal stimulus it will not prevent the coming unavoidable recesssion: it will only help to make it milder. The reason is that, with large structural fiscal deficits, a much larger fiscal stimulus is now not possible.
In 2000 the US was running a large fiscal surplus – about $300 billion or 2.5% of GDP; by 2004 – after two large and unsustainable tax cuts and massive defense and national security spending increase – that surplus had evaporated into a 3.5% of GDP deficit. And while the overall deficit shrank after 2004, on a cyclically adjusted basis the structural deficit is very large now. So, unlike 2001 the US cannot afford now a massive – 6% of GDP – fiscal stimulus like the 2001-2004 one. Even the Summers proposal adds up to less than 1% of GDP. That unsustainable and reckless fiscal and monetary (Fed Funds down from 6.5% to 1%) policy stimulus in 2001-2004 was sarcastically referred to as “best recovery that money can buy” by the sensible and brilliant Ken Rogoff (a “Republican” economist who was at the time the chief economist of the IMF).
So, by using all the monetary bullets (and leading to a housing bubble) and fiscal bullets (and causing a large structural fiscal deficit) in 2001-2004, we are now in a situation where the macro policy stimulus available to address the current 2008 recession (as the economy is effectively into a recession now) is much more limited than in 2001: monetary policy easing will occur but the Fed needs to worry about lingering inflation pressures, high oil/energy/commodity prices, the risks of a disorderly fall of the dollar and the risk that foreign investors will pull the plug on the financing of the huge current account deficit and lead to a disorderly adjustment of the US external deficit.
And fiscal policy is now constrained by a large structural fiscal deficit, looming long-run entitlement spending deficits, and the lack of a large fiscal surplus buffer like the one available in 2001. Worse, with home value plunging, at the state/local level revenues are plunging and fiscal deficits rising as property tax revenues are sharply shrinking. So the overall fiscal deficit for the public sector (including both the federal government and state/local governments) is sharply rising, further constraining the room for active fiscal stimulus.
Please share your comments by posting below (brief and relevant, please), or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).
For more information about this subject
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A brief note on the US Dollar. Is this like August 1914? (8 November 2007) — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
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The post-WWII geopolitical regime is dying. Chapter One (21 November 2007) — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
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We have been warned. Death of the post-WWII geopolitical regime, Chapter II (28 November 2007) — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
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Death of the post-WWII geopolitical regime, III – death by debt (8 January 2008) – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
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Geopolitical implications of the current economic downturn (24 January 2008) – How will this recession end? With re-balancing of the global economy, so that the US goods and services are again competitive. No more trade deficit, and we can pay out debts.
- A happy ending to the current economic recession (12 February 2008) – The political actions which might end this downturn, and their long-term implications.
- What will America look like after this recession? (18 March 208) — More forecasts. The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
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The most important story in this week’s newspapers (22 May 2008) — How solvent is the US government? They report the facts to us every year.
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The geopolitics of inflation, an introduction (17 June 2008) — Inflation is probably not what you think it is.
To see the all posts on this subject, go to the archive for The End of the Post-WWII Geopolitical Regime.
My only criticism of this very good post is that it optimistically assumes that the only problem lies with the apparent decreasing ability of the United States’ economy to handle its debt load. Another potential problem could be that the United States’ creditors, China in particular, might not be able – much less willing – to service the United States’ debt.
China has potential problems such as a shaky financial structure, an unstable population, pollution ( which is a symptom of economic inefficiency ), and questionable quality control (as the recent lead toy episode illustrates ). So China very well could wind up with economic difficulties for its own internal reasons which could cause it to withdraw from financing sharp nosed, white skinned barbarians across the ocean.
Something similar happened in 1929. In the late twenties, the United States had financially propped up the Wiemar Republic. With the stock market collapse, it no longer could do so. The rest, as they say, is history.
There are many potential problems, esp as at the regime-end it looks like a large knot of many strands of twine. This just examines one such, and does not assume the non-existance of other problems.
I see China and the US as two drunks leaning on each another. Can either stand alone? If one falls, does the other also? Both systems are deeply flawed, albeit in different — perhaps opposite – ways.
From a Stratfor email looking at 2008 trends:
“Quietly developing in the background, the global economy is undergoing a no less dramatic transformation. While we expect oil prices to retreat somewhat in 2008 after years of surges, their sustained strength continues to shove a great deal of cash into the hands of the world’s oil exporters — cash that these countries cannot process internally and that therefore will either be stored in dollars or invested in the only country with deep enough capital pools to handle it: the United States. Add in the torrent of exports from the Asian states, which generates nearly identical cash-management problems, and the result is a deep dollarization of the global system even as the U.S. dollar gives ground. The talk on the financial pages will be of dollar (implying American) weakness, even as the currency steadily shifts from the one of first resort to the true foundation of the entire system.”
Thoughts?
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Fabius Maximus replies: Superficial nonsense. Stratfor provides excellent geopolitical analysis, but their economic views are somewhat less useful than those of the Economist, whose motto is apparently “Always either interesting OR correct, but never both”. The US dollar was the “true foundation” in 1970, and has been slowly — in fits and starts — becoming ever less so. Over the last few years this evolution has accellerated, albeit still slow as befits changes in such giant forces.
“Monetary stimulus – printing money, lowering interest rates – risks sparking a currency crisis, perhaps ending the US dollar’s reign as the world’s reserve currency. The consequences of this could be calamitous, as the trillions of dollars held aboard as a store of value get sent home if the dollar becomes just another fiat currency.”
Yeah, our leading export these days is the dollar. China sends us stuff, we send back dollars (and bonds, etc.) As long as those dollar-things are kept as reserves the big ball keeps rolling. While I don’t believe the world is dumping the dollar as a reserve currency, I’ve seen many stories that nations are going to the Dollar/EU mix. I’m thinking what’s changing is that in the past we benefited from a monopoly of the dollar as a reserve currency and now there’s competition. Nations can smoosh the percentage slider either way from Dollar or EU, and in the new environment the USA needs to take care to make sure the dollar is competitive as a reserve currency — as usual, we won’t start paying attention to this until it becomes a disaster.
“We cannot do the same thing for America, mailing the keys to our foreign creditors – making it their problem. But we can default, or inflate the debts away to oblivion. Our creditors trusted enough in America to lend to us without collateral and in our own currency. Were they wise to do so?”
The dollar is now falling relative to other currencies, so even if it doesn’t look like inflation here, we are already effectively inflating the debts away from the perspective of guys overseas who own US bonds. The Ottoman story explained the consequences of this pretty well. Owning bonds in a falling currency doesn’t look like such a great bet. To preserve value, those guys are going to want buy income producing properties, American companies, land and buildings — the Citibank deal, for example.
As long as there’s something to buy here with the dollars the party can continue a little longer, but eventually what happens is they simply own everything. We become serfs to foreign powers. We rent homes owned by them; we work at companies owned by them. Our taxes are used to pay interest that goes to fund projects in their countries.
Radical thought with no obvious answer: None of this would matter if our circumstances were such that we no longer needed credit. We could then simply repudiate and run off laughing while our creditors, in the words of an old professor of mine would “go wee wee all the way home.”
The point of making such a radical thought is not, in itself, to provide a solution. Rather it is to stimulate creative new approaches. So how do we ( and by “we” I do not necessarily mean the federal government but rather each of us, all of us, or any subset thereof in any possible arrangement ) adjust our affairs so our credit rating no longer matters so much?
Why is this a “radical thought”? Solving problems by stealing, defaulting on debts, and such are the norms of history. America was an attempt to rise above that. We can “default and run off laughing”, leaving behind the dreams and work of Americans before us who hoped for better. All those who looked to us for inspiration and leadership would learn that it was all a lie, or that somewhere along the line America’s blood became thin and weak.
On an operational note, we borrow the stupendous sum of roughly 5% of our national income from foreigners. A typical recession is a 1.5% drop, so going cold-turkey on borrowing would mean a very severe downturn. I suspect this is far more likely to result from foreigners taking away America’s national VISA card than us deciding to stop spending like drunks.
“America was an attempt to rise above that. ”
William Jennings Bryan would have disagreed with you on that.
“A typical recession is a 1.5% drop, so going cold-turkey on borrowing would mean a very severe downturn. I suspect this is far more likely to result from foreigners taking away America’s national VISA card than us deciding to stop spending like drunks.”
We may be closer to this than most think: Fighting Inflation, China Freezes Energy Prices
Why would Bryan have disagreed that “America was an attempt to rise above that.”
The Progressive Movement, which Bryan co-opted in 1896, sought ( among other things ) to relieve farmers’ debt by putting the United States on the silver rather than the gold standard, thereby inflating the currency. There was quite a lot of rhetoric associated with the 1896 election about whether or not meeting debts with silver or gold money was the way to go. Suffice to say that your position sounds like McKinley’s while Bryan and his cohorts would have disputed you vigorously.
Update: My apologies. It was, of course the Populist and not the Progressive Movement that Bryan co-opted in 1896. A late night typo.
That’s an interesting point. Who can say what Bryan would think? The bi-metallic movement, which he endorese, was an effort to reverse the Fourth Coinage Act of 1873, which moved the US from a gold/silver standard to a gold-only standard.
In modern terms — which few would have understood in 1896 — the question was what level of monetary growth was necessary for the rapidly growing American economy. Bankers wanted deflation, which increased the real value of their assets (loans). Debtors, esp farmers, wanted inflation. The bankers won, and we got a series of brutal depressions until WWI — an example of “be careful what you ask for.”
My guess is that Bryan would not support measures designed to stiff our creditors. He wanted a fair monetary system that was not tilted toward creditors. We already have that, borrowing at low rates on easy terms to a degree probably never seen in the history of the world. The current debate, as seen above, is about how we can avoid paying back what we fecklessly borrowed. I think Bryan would greatly resent comparing our borrowing to support lavish consumption with that of 19th C farmers trying to support families in the harsh conditions of the American mid-west.
We cannot see beyond the end of the post-war economic regime.At that point we must make decisions,and we cannot see how we will choose. We have borrowed fecklessly incredible sums over many years.Will we repay these debts or default.
It is a decision we will make at all levels.Businesses will decide. Local governments will decide. Citizens will decide. The last will be a microcosm of the others. Your home is worth far less than your mortgage.
Peter
http://www.mydebtconsolidation.name
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Fabius Maximus replies: I agree. We cannot see beyond choices we have not yet made and do not understand.
(Ach, I should have posted here originally)
“Widely hated for this strong medicine, he served only one term.”
Cunctator, this is an extraordinarily poorly researched article. I have to wonder where you get your facts.
1) Volcker was unpopular in the early 80s for his interest rate policies but by the middle of the decade he was recognized as the hero who beat inflation.
2) We know this because he was reappointed to the Federal Reserve, indeed, I have no clue how you arbitrarily decided he was a one-termer, by President Reagan, despite the fact that Reagan was in the other party AND Reagan’s allies had been some of his most vicious critics.
3) Reagan was applauded for this move.
I say again, did you do even the most perfunctory research for this article?!?
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Fabius Maximus replies: You are correct, of course, that Volcker served two-terms — not one. However, I recall the period quite well — Volcker was widely hated. This is not incompatable with Reagan re-appointing him. FDR was widely hated, but did quite well at the polls.
There was little recognition “middle of the decade” that inflation had been beaten. For example, note continued high real interest rates, which bond investors demanded as insurance against the return of inflation. The low interest rates of the 1990’s (and today) show that inflation is considered to have been beaten.
In developing a language to discuss this problem, we should consult J. L. Austin’s How to Do Things with Words.
Austin considers statements that are neither true nor false, but rather verbal acts. E.g. “I now pronounce you man and wife.” Austin states such sentences, while having no intrinsic truth content, can be either “happy” (i.e., succeed ) or “unhappy” (i.e., fail ) “I now pronounce you….” might fail for any number of reasons. E.g., the official lacks the authority; the bride is not of age; the groom is already married; the wrong ceremony was used; the bride has been kidnapped; the groom is mentally handicapped; or even that this is a scene in a play.
As the debt crisis grows, various verbal acts are more apt to be unhappy rather than happy, as various social, political and financial instruments ( which have resulted from verbal acts ) fail.
Indeed, it would be possible to develop “ironic advocacy” whereby one apparently advocates actions which, given current social ideals, should work but which, given current social realities, won’t. Eg. “Congress should enact a financial Superfund to clean up the financial mess.” The point of which would not be to achieve the financial Superfund but rather to cast Congress in a bad light.
A restatement of my prior post:
Given the maxim, “The Law does not require the performance of a futile act,” what meaning does “Rule of Law” have if the scenario Fabius Maximus describes above also is given?
Thought-provoking post (as usual here). Thank you.
Looking forward to retiring narcissistic baby-boomers & what George Soros correctly calls America’s entrenched “feel good” politics, are there circumstances when the world’s sole military power might ‘restructure’ its debt to foreigners? The thousand ‘corrective’ policies might include taxing all interest income earned in the US (with hefty tax deductions for qualifying domestic taxpayers, of course).
Are there circumstances when foreign creditors might collusively impose retroactive ‘debt covenants’?
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Fabius Maximus replies: Nobody can say how this will play out. Perhaps our creditors will impose on us the debt replayment plans the IMF has so often imposed on others. Including taking a blue pencil to our government spending. What might a creditor committee of foreign leaders say about our military expenditures?
Pingback: The last opportunity for effective action before disaster strikes « Fabius Maximus
Fabius,
You wrote in the above post in Jan 08: “Repudiating these debts will mark the end of America as a leader of the world community, and probably as a great power. It will be interesting to see how we choose.”
So now that we are soon to complete $1.75T of QE, QE that has worked so far, what do you see for the future of QE, the reaction of our foreign creditors, and the impact on America’s leadership position?
I think you completely miss my point on QE. If the Fed wants to swap Treasuries for MBS, or if the Treasury wants to issued debt in order to purchase Citigroup common stock, I am not including that in the Fed gov deficit or in the QE numbers. But the ~$1.5T deficit projection for 2009 excludes Treasury borrowing for the purpose of asset purchases; and the $1.75T of QE excludes any other swaps/sales/purchases of assets the FRB may have done with its balance sheet.
The Federal deficit is projected >$1T annually for several years. MBS/agency QE-enabled rotation in Treasuries provided cash flow to fund the 2009 deficit without outright and direct monetization of net Treasury issuance. That dog won’t hunt come 2010. With FCBs accumulating dollar reserves at a much lower rate than they did pre-2008, and with those same FCBs comfortably weighted in the short end of the yield curve, how do you think they will react to QE 2.0, 3.0, etc., each in magnitude of >$1T and with an overweight towards Treasuries as opposed to MBS? Or if you don’t think QE 2.0, 3.0 is on the horizon, what will be the mix of purchasers for Treasuries in 2010-2012 and the resulting rate on the long bond?
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Fabius Maximus replies: It’s a problem, one that many folks have written about. It’s difficult to see how the government’s financing requirements can be met without monetizing a large fraction. Of course, with monetary velocity and credit still declining there is no current cost to doing so. Hence the vast literature on “exit strategies”, how to normalize monetary policy following this event. Japan did it successfully, if you call their situation normal.
There are few or no domestic limitations to monetizing the debt during a recession, esp a deflationary contraction. The external limit is the stress monitization puts on the currency. And that is probably manageable, as the US trade deficit shrinks during a recession (assuming we slow roughly like or more than the rest of the world) — and so much of the world’s borrowing was done in US dollars, creating a demand for dollars to repay debt even as our trade deficit (the primary mechanism for injecting dollars into the world economy) shrinks.
As I said, it is difficult to see how all this will play out.