A situation report about the global economy, as the flames break thru the firewalls

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.


  1. Global summary
  2. Asia
  3. What about the US?
  4. Looking ahead, what can we expect for America?
  5. Looking beyond the downturn, what can we expect?
  6. The big unknown
  7. Do you believe this forecast?
  8. Conclusions

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).

2.  Asia

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.

(b)  Triage

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:

  1. many nations abandoned the gold standard too slowly, and
  2. 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:

8.  Conclusions

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)


Please share your comments by posting below.  Per the FM site’s Comment Policy, 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).

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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:

Previous situation reports about the economy:

  1. The US economy at Defcon 2, 11 March 2008 — Where are we in the downcycle?  What might the world look like when it ends?
  2. The most important story in this week’s newspapers, 22 May 2008 — How solvent is the US government?
  3. Another warning from our leaders, which we will ignore, 4 June 2008 — An extraordinarily clear warning from a senior officer of the Federal Reserve.
  4. High priority report: a geopolitical sitrep on the financial crisis, 15 September 2008
  5. A new sitrep, as we move into phase 3 of the financial crisis, 19 September 2008
  6. A sitrep on the financial crisis: why has the treatment been so slow, so small?, 8 October 2008
  7. Status report on the financial crisis: we’re at a critical point in time, 10 October 2008
  8. Situation report: global economy, December 2008, 19 December 2008

47 thoughts on “A situation report about the global economy, as the flames break thru the firewalls”

  1. Oh boy! Smoot Hawley again!

    The combined value of exports and imports in the US declined from $10 billion to $4 billion (a lot of which was driven by the drop in the price level of around 35%). On the other hand, the economy went from over $103 billion in activity to just over $56 billion. It remains to be explained how Smoot Hawley, if we assign the entire $6 billion collapse in trade to it, caused a $47 billion wound on the economy.
    Fabius Maximus replies: This comment makes no sense to me. Can you explain it?

  2. Velocity is the key dynamic, I suspect. Ultimately it depends upon wages which depend upon people making and doing things.

    George Soros has an good op-ed today in the Financial Times: “The game changer“, 28 January 2009.

    I think Putin’s speech at Davos, although perhaps tangential to this thread, is really worth reading. That we have the Russian Bear lecturing the West on resisting the thrust to over-centralisation of the State is some sort of landmark in itself.

    I find the logic of his presentations consistently hangs together. Also his 3-hour live national interviews are something that put most leading democratic leaders to shame! In any case, he often seems to address issues of global importance far more directly and cogently than we can manage in our WOT-obsessed hysteria..

  3. Tom Grey:”I think banning CDS is too extreme, but wouldn’t be so bad. Same with CDOs, but not MBS.”

    To me, the whole idea that just one bank, JPM, can have derivative contracts on $90T when the entire US economy is only $13T seems absurd and insane. It all scares the hell out of me. What really happens if one of these medium-large things defaults? — a big city, some overseas bank somewhere, or a medium-small country. Do these contracts cascade into defaults all over the place? We’re the slowly boiling frog here, and we’re now used to $20B being handed out like Halloween candy, and $300B guarantees being made like it’s no big news.

    I’m just concerned one of these days the call comes in that $1T is needed right now or the whole thing collapses. What happens then?
    Fabius Maximus replies: The problem is not credit default swaps (most of those writing about them have little knowledge of the subject). Or interest rate swaps, etc. The problem is that these are “over the counter” instruments, traded off exchanges. No central clearing mechanism, no standard terms, no self-regulatory agency. Moving their origination and operation into the normal channels will solve the problem.

    Prudence required this to have been done years ago. Good sense required this done in 2007. Self-preservation required doing this in 2008. Now times are desperate, and it might be too late — as time and effort will be required to manage the transition. Waiting this long to act might prove to be the most serious public policy error of the cycle.

  4. Cathryn, the call came in Sept. The first 3-page Bailout was the panic response. What happens is that all the Big Banks, the private ones, all go bankrupt and those $90T contracts are NOT enforced (even die hard Free Market / Anarcho-Capitalists want contracts enforced — which is gov’t).

    The US and the World economy can handle all top 100 banks failing — with Uncle Sugar FDIC bailing out the small depositors, but the Big (rich) depositors also eat it. The gov’t bailout is to give cash to the insolvent, bet-losing rich. Which most economists think is still better than letting the banks go belly up. (As did I in Sept.) But banks do 2 main things: a) take deposits, offer interest for savings.
    b) Make loans. On (b), the US Fed can make loans, and buy commercial paper of production companies. Less efficiently than good banks, but enough so the credit crunch is not zero credit, just tough credit.

    On (a), the Big Banks have been doing business on the $90T of fictitious capital that is now evaporating, so 50% (or more?) of the bankers are no longer needed. It’s as big a decrease as the house construction drop, but construction workers are used to boom and bust, bankers aren’t. The sooner they learn, the sooner the unneeded bank over-investment is corrected, the sooner future growth can start.

  5. Above in the article:

    “6. The recession of the late 1920’s became a Great Depression due to a series of public policy errors. Most seriously: (2) the nation with the largest trade surplus wrecked the world trade system. America was the culprit (for #2), enacting the Smoot-Hawley Tariff Actin 1930.”

    From 1929 to 1933, GDP in current dollars dropped from $103 billion to $56 billion. Exports and Imports went from around $5.5 billion each to $2 billion each. $1.25 billion of that drop in each ocurred in 1929-1930, before Smooth-Hawley. Smooth-Hawley itself only applied to a little over 1/3 of American trade by value, because the rest was duty free.

    Simply put, whatever role Smoot-Hawley had in the contraction of world trade (which is debateable that it had any role at all), that contraction did not trigger a fall in overall American GDP that was 8 times as large. The contention is simply preposterous.

    THE underlying cause of the Great Depression was the contraction of the money supply and the collapse of the stock moarket bubble. These two things caused the huge drops in business investment ($16.5 billiont to $1.3 billion) and personal consumption ($77.4 billion to $45.9 billion), which undermined industrial production and the general economic situation.
    Fabius Maximus replies: As a minor point in this post, its of little interest to me. These things are still debated among economists, and the lack of good data about the 1930’s (GDP, unemployment, etc) makes this debate impossible to resolve.

    “the contraction of world trade … did not trigger a fall in overall American GDP”

    Perhaps you could quote me correctly before making up things and saying that they are “preposterous”. The causes of the Great Depression are many and complex. Most esp it was caused by a series of policy errors. S-H was IMO the big factor in one of the two most important of these policy errors.

    Two points:
    * The Great Depression was a global event, and so must have global causes. A decrease in US money supply was not sufficient to bring the world down.
    * Trade has a powerful multiplier, esp when other nations respond in kind.
    * Trade is more important to other nations than the US.

    The last point is often overlooked by Americans. The crash of trade during the Depression, of which S-H was one cause, made many nations unable to earn sufficient foreign currency to pay their debts — forcing either severe declines in spending or outright default.

    For one of the many works about the role of trade restrictions in deepening the Great Depression see “Monetary and Other Explanations of the Start of the Great Depression”, Allan Meltzer, Journal of Monetary Economics, Vol. 1 (November 1976), pp. 455–71.

  6. FM:”The problem is that these are “over the counter” instruments, traded off exchanges. No central clearing mechanism, no standard terms, no self-regulatory agency.”

    What’s not clear to me at all is if the ‘bad bank’ proposal includes all these contracts, or is the bad bank only intended to buy actual assets. It just seems to me, that the US government taking over these contracts would be dangerous if it was expected to pay up on them. It wouldn’t be so easy to assess a value, positive or negative, for all this stuff, and it sounds like some of these contracts might have really big potential negatives values.
    Fabius Maximus replies: Since all we know about the proposal are rumors, nothing about it is clear at this time.

  7. If Smoot-Hawley only applied to a little over 1/3 of American foreign trade, how did it cause a collapse by 2/3 in the same? Even if every item covered by Smoot-Hawley were to stop being traded, trade should have only collapsed by a little over 1/3. Worth noting:
    US Imports – 1929 – $4.3 billion ($2.9 billion duty free, $1.5 billion dutiable)
    US Tariffs – 1929 – $585 million
    US Imports – 1933 – $1.4 billion ($900 million duty free, $500 million dutiable)
    US Tariffs – 1933 – $284 million
    Tarriffable trade actually suffered a lesser collapse than duty-free trade. Smoot-Hawley obviously had little or no effect on duty-free goods, while its effect on dutiable goods was essentially nothing.
    The collapse in trade was caused by the collapse in the capitalistic economies, not vice-versa. The worldwide collapse of capitalistic economies was because of their intrinsic linkage through the banking system and gold standard. Once the American system entered into a panic through the stock market collapse and bank failures, the rest quickly followed. The collapse of quasi-colony trade economies in Latin America and similar was from the collapse in demand for their raw materials.
    Fabius Maximus replies: To repeat myself (last time), “As a minor point in this post, its of little interest to me.” There were many factors at work, and I have zero interest in establishing their relative dynamics. The importance of S-H as a cause of the Great Depression is a standard part of the economcis literature, right or wrong. Probably there are sites focused on economic history with people interested in debating you.

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