Summary: The global economy continues to fall towards debt deflation (see here), rare and never cured (WWII was not a “cure”.) This is a brief look at current dynamics, and the short and medium term futures. At over 2000 words, it is already too long; supporting logic and evidence must await later posts.
This is all speculation. I say this up front, to avoid having to fill the text with “perhaps” and “maybe” in every sentence. I hope I these guesses are wrong.
- Global summary
- What about the US?
- Looking ahead, what can we expect for America?
- Looking beyond the downturn, what can we expect?
- The big unknown
- Do you believe this forecast?
1. Global summary
Metrics of economic activity are almost all falling. Many are falling rapidly; some are in free fall.
The world moves from a financial crisis — in which governments bail out banks — to a larger crisis in which entire nations must need bailouts. Iceland was the first. A long sick list is growing: the UK, Ireland, Spain, Italy, and many emerging nations (esp in Eastern Europe).
Asia, so dependent on exports, falls into a depression (often defined as 4 quarters with real GDP down 10%).
- China GDP growth in Q4 was near zero, down from 13% in 2007. (China reports only quarterly GDP only on a year over year basis; quarterly annualized numbers must be estimated from this. See here for more).
- South Korea’s GDP was down 20% annualized in Q4.
- Singapore’s GDP was down 16.9% annualized in Q4.
- Japan’s exports declined at a 35% annualized rate in December, recording its 5th trade deficit in a row (the previous one was December 1981). GDP probably fell at double-digits rates in Q4.
China is the keystone, the best hope for the Asian economy to stabilize later this year. It’s high rate of growth and poor data makes relibale analysis impossible and comparisons with other nations difficult. Zero GDP growth in Q4 means China has decelerated from 13% to zero over two years — a brutal stop. Equivalent to the US going from +3% GDP to -9% (almost a depression). Except that there are few safety nets for China’s people.
From another perspective, losing two years’ growth in 2009 would mean -3% GDP for the US (painful). Since we have so much debt, we might lose 3 or 4 years growth — which might force structural changes (default or inflation).
Losing one year’s growth is -9% GDP for China. That would be an unthinkable disaster in the eyes of most economists. Which is absurd. Every economy frequently stumbles and loses a year’s growth — and China’s rapid growth means greater volatility, not less. A big bust in China in 2009 or 2010 will be hailed as a “black swan”, and demonstrate (again) that myopia about the future is one of our greatest disabilities.
3. What about the US?
(a) US banks continue to die despite massive infusions (gifts) of free money from you and I. As of December total bank lending is down slightly from October, but bank holdings of Treasury and Agency bonds at the Fed are up aprox $450 billion (see chart). Borrow at near-zero, buy bonds with no money down = great work (if you can get it). The sums required to adequately recapitalize them are preposterous. Many of our major banks will be nationalized ( today’s NYT describes the Obama team grappling with the inevitable).
(b) The inevitable crash of construction firms and commercial real estate will devastate small banks, so far only lightly singed by the devastation of the capital markets. The FDIC is already preparing for this; even the mainstream media at last sees this coming (“Smaller Banks’ Losses Expected to Bring Mergers“, NYT, 22 January 2009).
(c) Conventional monetary policy is exhausted from years of overuse (i.e., artificially low interest rates) during the Greenspan years. Untested extraordinary measures will be tried (such massive printing of money to “peg” treasury bond rates); the unanticipated side effects might be horrific.
(d) Massive tax cuts or “rebates” work fast but with astonishingly low level of effectiveness, as they will mostly be used to pay down debt or increase savings. Only 17% of the $177 billion 2008 rebates was spent, slightly less than that of the 2001 rebate.
(e) Massive spending increases will take years to have substantial effect. Nothing gets built rapidly in America (see the new CBO report on the stimulus plan). Worse, construction spending will benefit a small number of skilled tradesmen and a million immigrants from Mexico (attracting back many who left following the crash in housing construction).
(f) Most important, fiscal stimulus is vital — but only acts as a palliative (alleviates pain without curing). It does not and cannot not revitalize the economy.
4. Looking ahead, what can we expect for America?
2008 was a financial crisis, affecting mostly “Wall Street.” 2009 will be the year “Main Street” gets hit. The damage to the real economy so far is trivial to what will happen over the next two years. There will be two big stories.
(a) Business bankruptcies
Going into 2007 we knew that our financial sector was unusually strong, well-managed with strong balance sheets. False! Going into 2009 we know that our non-financial business sector is well-managed (outside of some weak sectors, like autos), with strong balance sheets. Expect to be disappointed and astonished yet again.
Everybody wanst bailouts. Worse, the expectation of bailouts means that few preventive measures will be taken. It’s call moral hazard. We see this at work in California. Already de facto bankrupt, nobody gives an inch. No lower government spending, no lower government wages, no reduced government employment, no higher taxes. Why compermise? The Fed will not let California go broke. Or the auto companies. Or the universities. Or the banks and insurance companies. Or millions of households.
There is not enough money to bailout everybody. Triage will be necessary, like Kate Beckinsale does with lipstick on the foreheads of the wounded at Pearl Harbor (one of the saddest scenes in the 2001 movie).
Those who will die anyway: no treatment.
Those who will recover anyway: no treatment.
Those will will recover only with treatment.
Making these harsh decisions might be Obama’s greatest challenge.
5. Looking beyond the downturn, what can we expect?
The consensus confidently — almost to a man — anticipates inflation, against which the Fed will fight either successfully (optimists) or unsuccessfully (doomsters). This is absurd.
People are already preparing for this “inevitable” outcome by sifting to shorter-term debt. As the end of the downturn approaches — inflation can only manifest itself only in times or full employment or via a currency crisis — everyone will take stronger measures. Even elderly ladies in Peoria will own inflation-protected bonds, short-maturity bonds, and hoard gold bars in their basement.
These measures will foreclose inflation as a workable option. As the government is forced to either issue vast amounts of short-term debt or monetize the debt, inflation becomes useless as a tool. Short-term debt becomes an albatross during inflation: interest expense skyrockets as interest rates soar.
Hyperinflation always remains an option, as does atomic war and mass suicide. None of these are “solutions” in any meaningful sense. With a history of vast deficits behind us and larger deficits ahead (from boomer’s retiring), the government will choose Door #2: default. We will just not pay all our obligations. This is historically the most common solution.
How we decide who to pay — and how much to pay — will test America as it has seldom been tested.
- Do we pay our foreign debts?
- To what extent do we renege on promised social security and medicare benefits?
- To what extent do we raise taxes vs. defaulting?
6. The big unknown
The recession of the late 1920’s became a Great Depression due to a series of public policy errors (see here for more information). Most seriously:
many nations abandoned the gold standard too slowly, and
the nation with the largest trade surplus wrecked the world trade system.
America was the culprit (for #2), enacting the Smoot-Hawley Tariff Act in 1930. We can only guess at the equivalent of mistake #1, but the prime candidate for #2 is China devaluing the RMB to boost its exports.
7. Do you believe this forecast?
Probably not. Consider the many warnings by top individuals and institutions — over decades — that our fecklessness would eventually result in problems like today’s. See We have been warned. Death of the post-WWII geopolitical regime for a few warnings during 2003-2006.
Or consider the responses to my post “The geopolitics of inflation, an introduction” (17 June 2008), in which I said:
For example, rapid global growth may increase consumption faster than capital investments can increase the supply of commodities. As food and energy consume more of people’s budgets, expenditures on other things must drop. Discretionary purchases go first, and so the economy slows as those business reduce spending (capex, headcount, hours, wage rates — it all adds up). Eventually some people cannot make their monthly loan payments (credit cards, auto loans, mortgages, etc). Now the financial sector suffers form rising defaults. This is deflation, caused by rising commodity prices and too-tight monetary policy.
… Which is worse for a high-debt economy like ours, inflation or deflation? To grossly oversimplify… The 1970’s had the “great inflation”, a bad decade for America in many ways. The 1930’s had deflation, and saw the Great Depression.
… Fed Chairman Bernanake is an expert on the Great Depression, and well understands the danger of deflation to the United States. He — that is, the government — has powerful tools to fight inflation and deflation. However, success is not necessarily easy, painless, or guaranteed. There are other factors influencing the outcome, making it difficult for the Fed to induce inflation to offset rising commodity prices.
… Deflation can result from almost any destabilizing event, if it results in a contraction of bank credit — usually through loan defaults. Credit is a channel connecting the initial event — rising commodity prices, Asian inflation, or economic warfare — to deflation. That’s why the Central Bank response to even non-economic events (e.g., Y2K, 9/11) is so important.
When I wrote those words we were already — unknowingly — in the early stages of debt deflation. Although many eminent economists were warning of deflation (see quotes I provide in the comments), the comments were uniformly hostile.
Your explanation on deflation seems plain wrong to me. … I can refer to my university degree on economics. (source)
Given the incentives (no one wants to owe money in a time of deflation), inflation looks a lot more likely. Given this, and our current situation, and absent some sort of financial sector collapse (and concomitant money supply contraction), I would have thought that deflation is very unlikely.
The current environment for the US dollar seems inflationary. The rising price of commodities suggests inflation. The current head of the Fed’s academic career suggests a predilection for inflation over excessive monetary tightness. Rates of interest vs rates of inflation suggest inflation. The US’s position as a debtor nation suggests that inflation is more likely than deflation, if the US government has anything to do with it. Your own analyses seemingly suggest inflation. (source)
This disbelief is significant. We, as a nation, do not see the dangers described in this post (warned of by so many for so long) and so make no preparations for them (see this post for a powerful example). Our myopia not only has brought us to the brink of disaster, but also left us unprepared for its consequences. For more on this see:
- Making us dumber, chanting “Dude, where’s my recession?”, 3 June 2008
- All we have to fear is our optimism, 12 November 2008
Economic booms and busts are the natural working of our system. Busts resolve imbalances that we lack the wisdom or discipline to fix ourselves. Such as Bretton Woods II “system”, a global economy built on insane and unsustainable borrowing by American households — who became for a moment in time 20% of the global economy.
Even now — two years into the downturn (starting with the December 2006 collapse of the mortgage brokers) fast action by the American people — through our businesses and government — can mitigate the downturn and lay the foundation for a strong recovery in 2011. No situation is hopeless.
Keynes, IMO the greatest economist so far in history, has words of wisdom that apply to us as well as in his time.
We are suffering, not from the rheumatics of old age, but from the growing-pains of over-rapid changes, from the painfulness of readjustment between one economic period and another.
But this is only a temporary phase of maladjustment. All this means in the long run that mankind is solving its economic problem. I would predict that the standard of life in progressive countries one hundred years hence will be between four and eight times as high as it is to-day. There would be nothing surprising in this even in the light of our present knowledge. It would not be foolish to contemplate the possibility of a far greater progress still. (source)
This is a nightmare, which will pass away with the morning. For the resources of nature and men’s devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid.
We are as capable as before of affording for everyone a high standard of life — high, I mean, compared with, say, twenty years ago — and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time. (source)
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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.
- Good news about America, a collection of articles!
Previous situation reports about the economy:
- The US economy at Defcon 2, 11 March 2008 — Where are we in the downcycle? What might the world look like when it ends?
- The most important story in this week’s newspapers, 22 May 2008 — How solvent is the US government?
- Another warning from our leaders, which we will ignore, 4 June 2008 — An extraordinarily clear warning from a senior officer of the Federal Reserve.
- High priority report: a geopolitical sitrep on the financial crisis, 15 September 2008
- A new sitrep, as we move into phase 3 of the financial crisis, 19 September 2008
- A sitrep on the financial crisis: why has the treatment been so slow, so small?, 8 October 2008
- Status report on the financial crisis: we’re at a critical point in time, 10 October 2008
- Situation report: global economy, December 2008, 19 December 2008