Consequences of a long, deep recession – part I

Summary:  this series speculates about the consequences of a deep and long recession over the next few years.  How might we react?  How might this change America?  This post examines our alternatives.  The second post discusses possible changes in our financial system.  The last chapter looks at the effect on Americans, and America.  Our next President will face these challenges, so your vote in November is important!  This series is an expanded version of my post of 12 February.

History shows the difficulty of predicting the short-term path of economic or political events.  However, we can often see the medium-term with greater clarity.  In January 1942 none could forecast the events of the next 44 months, but it did not take an expert to see that the US would defeat Japan.  So it is with the current economic down cycle in America.

As discussed in previous posts, one of our most serious burdens is the liabilities we have accumulated — with no thought of payment (this is moral weakness, lethal to many regimes throughout history).

1. Direct obligations, such as treasury bonds.
2. Indirect obligations, such as government insurance programs (flood insurance, FDIC).
3. Implicit obligations, such as to the government-sponsored entities (e.g., FNMA).
4. Largest of all are the promises — legislated but changeable — of our welfare programs (e.g., Aid for Dependent Children, Social Security, Medicaid, Medicare).

As I said here, there are only four ways to get rid of one’s excess debt (that, debt that cannot be repaid):

1.  Growth:  given time and rapid wage growth, the debt burden becomes manageable.  We pay it off ever more easily as incomes grow.  That was the dream solution to America’s high levels of household debt and large long-term government obligations.  It burst in 2000, and will not return in time to help us.

2.  Inflation, reducing the real weight of our debt.  This requires two things.  First, real growth in wages (no signs of this).  Second, either the cooperation or blindness of bond investors — they must either accept negative real after-tax yields, or remain oblivious to rising inflation.  The consequences are severe if our creditors (domestic and foreign) rebel.

3.  Debt can burn off the hard way as debtors default on their loans.  Both recessions and declining home prices drive defaults (involuntary and voluntary, respectively).  This is equivalent of surgery without anesthesia, resulting in bankruptcies, homelessness, decaying neighborhoods, and bank failures.

4.  Socialization of the debt.  The government can spread the burden of debt, in many different ways (that so many of our creditors are foreigners makes this more attractive).

• They can legislate to change contracts (e.g., mortgages):  reducing interest rates and payment terms, preventing or slowing foreclosures.  This spreads the debt burden from debtors to creditors.
• They can change the rules of the bankruptcy courts, with the same result as above – spreading the debt burden from debtors to creditors.
• They can directly intervene in the markets, extending loans (absorbing the resulting losses) or buying property from debtors or creditors (e.g., as the Resolution Trust Company did after the commercial real estate bust in the early 1990’s.)

Socialization is the seemingly easy path.  Done well, we have reforms like those Solon instituted for Athens — laying the foundation for its future greatness.  Done poorly, we have increased moral hazard leading to another cycle of rising debt and speculation – except that the next crash will imperil a larger part of the society, or even all of it.

It’s all about choice.  Every downturn gives us the opportunity to determine what America will become.  We weigh our fidelity to our principles, our history, our forefathers — vs. our ability to collectively withstand pain (financial, social, political).  These are collective decisions, because all large-scale economic events have a decisive political component.

Speculation about the future

So what path will we take?

1. Inflation is impractical (for reasons too complex to discuss in this post).
2. Large-scale defaults would likely lead to a deflationary collapse of our financial system.  The government will not allow that to happen as the consequences would be apocalyptic.
3. I believe that instead we will socialize the debt, the least-painful and most operationally feasible alternative.

Not all will agree.  Robert Taft, and Andrew Mellon will have their modern equivalents, advocating the hard path that leads to long-term prosperity.  President Hoover wrote in his Memoirs that Mellon, as Secretary of the Treasury, had

… only one formula:  liquidate labor, liquidate stocks, liquidate the farmers, and liquidate real estate…. It will purge the rottenness out of the system.  High costs of living and high living will come down.  People will work harder, live a more moral life.  Values will be adjusted, and enterprising people will pick up from less competent people.

We already hear similar recommendations.  Are they correct?  Ask God for when you see him, for the question is irrelevant in this world.  Politicos adopting such views will find themselves unemployed after the elections of 2008 and 2010,  in the dustbin of history alongside the Republican politicos defeated in 1932.

For more information from the FM website

Reference pages about other topics appear on the right side menu bar, including About the FM website page.   Such as…

• The End of the Post-WWII Geopolitical Regime

Other posts about the end of this era:

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.

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