The US economy at Defcon 2

This analysis is far from the consensus viewpoint.  Unlike the consensus view, however, this has the advantage of accurately predicting the events of the past year. 

  1. The deleveraging of the US economy is putting “torque” on the US financial system.  This is a process which cannot be stopped prior to completion, although the government will try.  The US economy resembles a rock balanced at the top of a cliff.  It was stable hanging on the top; it will be more stable at the bottom.  Hence the need for Defcon 2 — defense condition 2, one level below the maximum. 
  2. As a result of #1, our financial fabric is ripping.  Weak links have been breaking one by one over the past year or so.  As each link breaks, there is more stress on the remaining links.  The tear is getting longer and wider due to several positive feedback loops.  In general, everybody’s (households’, businesses’, investors’ and creditors’) tolerance for risk decreases, and the inevitable reactions slow the economy. 
    1. Households and businesses increase their saving and reduce their spending.  This is good for our future, but reduces current economic activity.
    2. The price of credit increases (the premium of the rate at which you borrow above that the Treasury pays).  Investors sell things.  Creditors cancel loans, or do not roll them over at maturity. 

  3. We have not had an “average” recession in twenty-five years.  So we are “due” for a moderate downturn.  Or even a severe one like 1973-75 or 1980-82.  However, I suspect this downturn will be different.  This is might not be a cyclical event, but a historical inflection point:  the end of the post-WWII economic and geopolitical regime.  That would be serious, but should not be confused with Armageddon.  Life will go on.
  4. Massive government intervention must occur soon, or the eventual cost of mitigation will rise several fold.  The current tools of fiscal and monetary stimulus plus mild intervention (the “super SIV’ and “Hope Now” plans) are grossly inadequate to the scale of the problem.  But this downturn may be evolution in action, the consequences of our past actions.  If so, what damage will the government do attempting to prevent the inevitable?
  5. Fear of change mutes adaption to these changes, even among possible beneficiaries (e.g., China).  Change means uncertainty, and requires altering current behaviors and relationships.  Most people are conservatives about things which concern them personally, especially those with power (e.g., political, economic).  A professor can more easily speak of global revolution than a Governor of the European Central Bank decide to raise rates (to fight inflation) which the global hegemon lowers them.

How this downturn evolves is impossible to say.  Anyone making confident and specific predictions should be regarded skeptically.  The path we travel depends on decisions by political leaders of America’s creditors (e.g., Japan, China, Saudi Arabia).  Perhaps even they do not have a plan to deal with these developments.  Equally importantly, how will America react?  We have borrowed with no thought of repayment, the perfect image of fecklessness.  Will we choose to remain Americans and pay our debts?  Or default (either by outright refusal to pay or through inflation), and become something else?  Something less

Whatever the path, the end state of this process is clearer.  There are a few likely outcomes.  Here is the one I consider most likely (and one of the most favorable).

  1. US household and business debt loads will be reduced to sustainable levels.  As a result the US financial system will be largely nationalized (de facto if not de jure).  If the Democratic Party takes power, they will also largely de facto nationalize the health care system.  The combined effect will be the largest expansion of governmental power since the 1930’s.
  2. The US dollar will decline until US goods and services are again competitive on world markets, so that the trade deficit is small or zero.  We will export more.  Being poorer, we will import less.
  3. The greatest global imbalance of our time is that the hegemonic power is also the biggest borrower.  Usually creditors make the rules, not debtors.  This is probably a temporary anomaly, and today the world is moving to a multi-polar system in which the US will have far less geopolitical and economic influence.
  4. The effect of a global downturn on Japan and the EU could be severe.  Japan has never fully recovered from the lost decade of the 1990’s.  The European Monetary Union (EMU) is structurally unstable.  Probably no monetary policy devised by man can work for both the core of Germany and France AND the rapidly growing stars (e.g., Ireland), and the southern rim (e.g., Spain and Italy).  Italy may face the choice of depression or leaving the EMU (see here for analysis, also here and here).
  5. The large creditor nations seem to be the likely beneficiaries.  While the transition might prove painful, their vast savings (both household and national) gives them options we lack.

The fall of the Persian Empire has some similarities to our situation, although very different in its overall dynamics.  A vibrant multipolar system followed the fall of a strong hegemon.  “State to state” conflict increased.  More than offsetting this however, the vast hoards of treasure amassed by the Persian rulers were considered useless by the new Greek rulers.  Instead they put this “money” back into circulation, producing the glories of the Hellenistic civilization. 

Under the Bretton Wood II system creditor nations keep their currencies “cheap”, amassing vast pools of foreign exchange as a by-product.  Japan and China each have over a trillion dollars saved (aprox $1.8 and $1 trillion).  For Japan this is offset by the massive debts accumulated during their insane spending during the 1990’s (e.g., villages with large train stations, bridges to nowhere).  But China has the ability to do better, using this wealth to stabilize their economy during the transition and improving the lives of its people.  To mention just one example, the billions spent to build secondary and tertiary sewage treatment facilities would employ millions and change the face of China.

The years ahead will be interesting ones, for both us and future students of history.

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.

To see the all posts on this subject, go to the archive for The End of the Post-WWII Geopolitical Regime.

11 thoughts on “The US economy at Defcon 2

  1. One aspect of this development, which I think is generally correct, is that the American body politic will have to deal with being forced to forgo large defense spending and will be, at most, only one of several Great Powers. For complex yet deeply ingrained reasons, a large standing military has been a core feature of post-WWII American society. Despite the collapse of the Soviet Union and despite some subsequent Clinton cutbacks, there was no demobilization, such as had once followed the end of the Civil War or of WWI. The current Air Force Tanker contretemps demonstrates that widespread enthusiasm for big Pentagon projects remains rampant.

    All of this has been accompanied by quite a lot of jingoism and chauvinism, as the widespread use of yellow ribbon bumper stickers, flag lapels, and similar paraphernalia demonstrates. In short, while there is quite a lot of economics going on here; something psychological also is involved. A loss of superpower status and of a large standing military appears likely to cause a blow to the American psyche.

    The closest analogy to this that I can think of is the French Third Republic. Humbled and weakened by the Franco-Prussian War, France no longer dominated Europe. Episodes such the Dreyfuss Affair stained its record; this was the France of Devil’s Island. Yet this also was the France of the Impressionists; and perhaps it is in something like Impressionism that we Americans should seek our consolation. The politics, at any rate, are not going to be fun.

  2. Greenspan knew what he was doing by providing free money to all for so long. To debase the dollar and bring us to the situation we now must face, The AMERO. We will fight an economic war with countries we once controled who now provide the very money we live on and fight our convential wars with. The labor from Mexico, the resources of Canada and our tech, once again we can bring ourselves out of this dark hole we have made for ourselves.
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    Fabius Maximus replies: You touch upon one of the odder aspects of the Presidential campaign. Both Hillary and Obama in effect denounced the NAFTA treaties, threatening to re-negotiate or even unalaterally alter them. That is not a nice way to treat our two major — and most reliable — sources of oil.

    As for “economic war”, I am not a fan of describing so many forms of confict as “war”. War is a special and horrible thing, and broadening the concept blurs this red line — and perhaps encourages us to lightly cross it.

    As for Greenspan, when this is over I suspect no American child will be christened “Alan” for several generations.

  3. “Fabius Maximus replies: You touch upon one of the odder aspects of the Presidential campaign. Both Hillary and Obama in effect denounced the NAFTA treaties, threatening to re-negotiate or even unalaterally alter them. That is not a nice way to treat our two major — and most reliable — sources of oil.”

    A serious issue that US citizens will have at the next years is that, with the lower purchase power of the dolar, the US wages will be third world wages. That will be worse to US citizens psyche than lose the status of only superpower. So, I guess the Mexico’s labour will be a strong issue at future political campaings. And yes, that is not a nice way to treat one of yours major and reliable sources of oil. But I fear that, soon or later, someone will have the idea that the US oil’s problem can be solved with military conquest. South of Rio Grande. That will be less nice.
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    Fabius Maximus replies: I doubt the US dollar will decline so that US wages are like those of the 3rd world. Our infrastructure and productivity are far greater, which will support higher wages. And invading Mexico would be nuts, too nuts I suspect even for the neo-cons. Not too mention the millions of Hispanic people in the US who retain emotional ties to Mexico.

  4. But I fear that, soon or later, someone will have the idea that the US oil’s problem can be solved with military conquest. South of Rio Grande. That will be less nice.

    Actually, Bismark’s stratagem for pacifying the humiliated French Third Republic was to encourage it to colonize North Africa. For reasons explored on John Robb’s blog, there is quite a lot of global guerrilla activity going on in Mexico right now, which would provide the basis for an unpleasant welcome to any such American expedition. For reasons explored on the Oil Drum, Mexico’s oil production seems to have peaked.

  5. The neo-cons would not support invasion of Mexico because the neo-cons are rich whites who like having cheap Hispanic gardeners.

    The poor whites who are crashing in their buddies’ basements because they can’t make alimony payments — and the poor blacks who can’t even get hired at McDonald’s — *they* are the ones who will be willing to do anything possible to strike back. They would support official war … or less organized means of nastiness.

  6. Invade Mexico for oil? Not only is that crazy and not even remotely likely, but it would be kind of pointless. Mexico will not remain one of our “major — and most reliable — sources of oil” for very long; their production has already entered into a steep decline, new investment/exploration won’t yield significantly large finds, and any new fields will take a while to ramp up production.

    Not to mention that Mexico’s oil production would be rather less “reliable” if they were engaged in a hot war (or a prolonged guerrilla war) with the United States.
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    Fabius Maximus replies: I believe this overstates the situation. Cantarell is in steep decline; total production for Mexico is slowly declining. As you note, this results largely from insufficient re-investment of funds. That is an easily fixed problem, if they have the political will to do so. New funds could increase production in 5 – 10 years. The public data is insufficient to determine a peaking date for them given adequate funding, let alone “investment/exploration won’t yield significantly large finds”, but from what I have seen peaking seems very likely during the next two decades.

  7. Well, if we are speaking of crazyness… CENTCOM commander Admiral William Fallon resigned. And you know what kind of crazyness I am talking… never under-estimate the neocon’s crazyness.
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    Fabius Maximus replies: Sometimes “changing people is changing policy” — but usually not. I seriously doubt Bush has the political capital to bomb Iran at this time. Nor is he a tyrant able to bomb anything, anytime. Certainty is not possible with such things, but the odds suggest that the wild talk about the significance of Fallon’s exit seems exaggerated imo. This article presents a more plausible alternative: ““Fox” Fallon Wasn’t Hounded Out“, Fred Kaplan, Slate (12 March 2008).

  8. Invade Mexico! Are you crazy!

    Mexico is going to invade the US, not later than 2048, reclaiming its lost half and even going beyond that.

    General Grant wrote that: “The Southern rebellion was largely the outgrowth of the Mexican war. Nations, like individuals, are punished for their transgressions. We got our punishment in the most sanguinary and expensive war of modern times.” (source)

    That might be true, but remember that a thief is not only punished he is also forced to return the stolen goods, the Americans were punished for the “most unjust” (Grant’s words) war but they did not return the spoils of that war (land that is full with gold & oil).

    The Mexicans paid dearly because they “shed American blood upon the American soil,” but actually they didn’t and under the rule of Double Jeopardy they are more than entitled to do so now. The founding fathers emulated the Roman Republic, but now, 250 years later, one should start to prepare for the invading barbarians who after making themselves indispensable for the functioning of the Empire will move on mass and take all for themselves.

    The US Army cannot even invade Iran at this point; any action against it would have to be done by the navy and air force, because the army is effectively kaput! I doubt very much that it can invade the homeland of a sizeable part of its own soldiers!

    FM wrote: “This is might not be a cyclical event, but a historical inflection point: the end of the post-WWII economic and geopolitical regime. That would be serious, but should not be confused with Armageddon. Life will go on.”

    Life always goes on, that is of little consolation to the dead! Not only the US will not survive but the whole European/Western/Liberal/Capitalist/Democratic tradition/culture/history of the last 500 years, what I call the European Supremacy, is going down the drain, not as the result of the sub-prime debt but because of ultra-long-term historical trends.

  9. Care for defcon1 on the econ front? We are back to negative short term interest rates, and the bank system is beginning to look like the villages that we had to destroy to save. I posted elsewhere tonight that the fed ‘saved’ the banking system, but there was some bad news about the currency.

    FM, help me out a little here on a characterization. The air is thick with declining empire analogies. If we stay within a Roman frame of reference, is GWB more of a Nero or a Calligula type? He has been far more than a passive observer to this decline and fall, that is certain.
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    Fabius Maximus: That the air is filled with panic at the minor events to date shows how even a paper cut seems like the end of the world to a pampered aristocrat. Nothing of significance has happened yet. The Roman frame of reference is perhaps apt, but useless on specifics. The Empire lasted for centuries after Calligula. Comparison of Bush to Calligula is disturbing, showing quite a lack of awareness how bad things can get.

  10. João Carlos: “the US wages will be third world wages.”

    Not to worry! From Lewis H. Lapham’s “Notebook” column in the May 2008 issue of Harper’s magazine. An observation upon sight of a sad gentlement at January’s World Economic Forum in Davos, Switzerland:

    “Even if America were to be reclassified as a Third World country, he would discover that Third World countries are by no means as unpleasant or as dangerous as they can be made to seem by the editorial writers at the New York Times. The girls are good-looking, the golf courses up to the standard of those in Palm Springs, the nightclubs trendy, the secret police efficient and courteous, the income spread between the haves and have-nots in line with the one to which he was accustomed here at home.”

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