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.