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Death of the post-WWII geopolitical regime – death by debt

Larry Kummer, Editor

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:


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:

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.

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).

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

  1. 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.
  2. 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.
  3. 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).
  4. 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.
  5. 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.
  6. A happy ending to the current economic recession (12 February 2008) – The political actions which might end this downturn, and their long-term implications.
  7. 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.
  8. 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.
  9. 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.

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