A look at the next phase of the crisis, as it hits the real economy

Summary

The global financial situation is complex and wreathed in fog, but at least two things are clear.

1. The financial crisis consists of fore-shocks before the main event.
2. A new geopolitical order will mark the solution of this crisis; it lies far in the distance.

This post examines the grim details of item #1.  A loss of well over $25 trillion in global wealth (homes, bonds, and stocks) before the recession really takes hold (it started early this year, but the full force has yet to be felt).

Click on the second item above to see the next post in the series.  There will be a long series of posts with good news on this site, but that time has not yet come.  But it will.

Quakes on Wall Street precede those on Main Street

Financial markets (“Wall Street”) are a virtual reality, in which millions of people react to events — and the results seen instantaneously on screens around the world.

In the real world (“Main Street) events move much more slowly.  People make decisions to hire and fire, to spend and to save, more slowly than decisions to buy or sell financial instruments.  Plans are made for periods of months or even years, and decision-makers (whether in households or corporations) only slowly change their thinking.  And the results of these decisions are only known after delays of weeks or months, and then often imperfectly through surveys.

The world is changing as deep subterranean forces move.  The effects were felt first by the financial markets.  The shock wave is just now hitting the real economy.  I suspect that “quake” will be as large — or larger — as that which has devastated most financial markets.

Do financial shocks cause real world recessions?

Much of humanity’s reasoning consists of post hoc ergo propter hoc — the logical fallacy of belief that what comes first must cause what comes next.  Since financial shocks tend to come first, they must cause the following economic shock.  Sometimes, but not often.  As we saw in the October 1987 stock market crash, which was a financial shock unrelated to any deeper event has little economic impact.

How large an economic quake should we expect?

Nobody knows, or can know.  We do not have the necessary data; what we have is only moderately reliable and available after long lags.  And the new world economy is too new, so that we do not yet understand its rhythms.

Also, this is the first downturn in the first global synchronized business cycle — that is, a cycle in which the majority of the world’s people participate.  Thanks to globalization and the spread of market-based systems, both the emerging world (most of it) and the ex-communist block participated.  Unlike previous cycles, everybody is slowing at the same time — there are no out-of-step locomotives to act as brakes. 

My guess is that it will downturn will be long and deep.  Perhaps a GDP drop of 1% or even 2% sometime during 2009 or 2010.  Global GDP has not gone negative since 1970 (there is not good global data before that).  During the major slowdowns – 1975, 1982, 1991, and 2001 — it never dropped below 1%.  Growth was unusally rapid during the recent expansion (almost an extraordinary 5%), and the downturn might be equally large.

That is what the crash in commodity prices suggests.  Oil from almost $150 to the $60’s.  The 60% crash in scrap steel prices (roughly $600 lbt to $250).  Likewise copper and the other industrial minerals, most of which now trade at prices below their marginal cost of production.

The massive foreshocks in the financial system have further destabilized the global economy.  Esp. the early October cardiac arrest of global financial system, which appears to have put an air bubble in the world’s bloodstream.   For example, during the past few weeks shippers have had difficulty obtaining letters of credit — interrupting to some unknown degree the normal flows of trade.  The collapse of the Baltic Freight Index tells the tale:

The Baltic Dry Index (BDI), the most closely watched measure of shipping costs for commodities, has plummeted more than 90% from its peak at 11,793 in May, caused by the sharp fall in demand for cargoes. The index tracking transport costs on international trade routes fell 47 points, or 4.1%, to 1,102 points on Friday, the 15th consecutive session of declines and its lowest level since September 2002. (source)

Mine is a far out of consensus position, with most economists forecasting 2009 global GDP between 2% and 3%.

Questions

All we have are questions about how the impact of the global recession on each region. 

The most important question:  how will governments react?  The Great Depression was so great due to policy errors by governments.  The developed nations that suffered the most also made the greatest errors — the United States heading the list.  Let’s hope the new Administration shows greater wisdom than the Hoover Administration.

Afterword

If you are new to this site, please glance at the archives below.  You may find answers to your questions in these.

Please share your comments by posting below.  Please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information from the FM site

To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp interest these days:

• about the Financial crisis – what’s happening? how will this end?.
• about The End of the Post-WWII Geopolitical Regime.
• A solution to our financial crisis

Diagnosis, analysis, and forecasts about the crisis

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.
4. Diagnosing the eagle, chapter I — the housing bust, 6 December 2007
5. 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.
6. Geopolitical implications of the current economic downturn, 24 January 2008 – How will this recession end?  With re-balancing of the global economy — and a decline of the US dollar so that the US goods and services are again competitive.  No more trade deficit, and we can pay our debts.
7. Let us light a candle while we walk, lest we fear what lies ahead, 10 February 2008 – Putting the end of the post-WWII regime in a larger historical context.
8. A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
9. What will America look like after this recession?, 18 March 2008  — The recession will change many things, from the distribution of wealth within the US to the ranking of global powers.
10. Consequences of a long, deep recession – part I, 18 June 2008
11. Consequences of a serious US recession – part II, 19 June 2008
12. Consequences of a long, deep recession – part III, 20 June 2008
13. A look at one page of what lies ahead in America’s history, 7 August 2008 — Death of an American industry.
14. “The Coming US Consumption Bust”, by Nouriel Roubini, 6 September 2008
15. A vital but widely misunderstood aspect of our financial crisis, 18 September 2008 — Too many homes.
16. What do we know about the financial crisis? What are the key questions?, 20 September 2008
17. Essential steps to surviving the current crisis, 23 September 2008
18. A picture of the post-WWII debt supercycle, 26 September 2008
19. Is the US economy in good shape, or in terrible shape?, 27 September 2008
20. The most important news of the month. Perhaps the year., 29 September 2008 — Warnings from our foreign creditors.
21. Status report on the financial crisis: we’re at a critical point in time, 10 October 2008
22. The economy is in shock. The effects of this will soon become visible, 11 October 2008
23. Damage Reports from home and abroad, 12 October 2008
24. Forecasting the results of this financial crisis – part I, about politics, 13 October 2008
25. Forecasting the results of this financial crisis – part II, a new economy for America, 14 October 2008
26. The coming collapse in business spending – made visible today, 15 October 2008
27. Miscelaneous news and thoughts about the financial crisis, 16 October 2008
28. The core problem of this financial crisis, which also explains how we got in this mess, 22 October 2008