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THE LOOMING GLOBAL ECONOMIC SITUATION

In March of 2009 the sobering thought at Harvard University’s gathering on the Global Economic Crisis was there was a real chance of total economic collapse. This is from the little summation of what I gathered from that:

“The government is trying a fancy move with Fiscal and Monetary Policy that has an unknown chance of success. The cause of the problem is a consumer debt addiction fanned by competitive forces that caused lower standards at about every phase of business judgment including the adoption of compensation incentives that rewarded short term production at the expense of future sanity.  The object of the government's game seems to be to get Americans to save 10+% of income (the new mantra is "save, baby, save")  and yet for the time being increase total debt by massive federal spending to stave off the otherwise resulting unemployment (15%+ unemployment would compound the problem immensely) and hopefully targeted at a few good things, but likely mostly wasted. Then at the last minute, before our foreign trading partners pull the plug, raise interest rates, taxes, and cut government spending (including cutbacks in Medicare and Social Security). There is not much confidence that maneuver can be performed. This thing is bad…”

 

 

In February 2010, 50 people from around the world gathered to review the big picture. About 75% were non-US and 25% US. As it is with learned people, communication is often in parables, rather like an encryption system where a key from the sender combines with the key of the receiver to produce a unique message, subject to misinterpretation. Never-the-less, this summarizes what I think was communicated in either the informal sessions of the participants or the formal sessions with the faculty.

The economy has not responded to the fiscal and monetary policy. Fiscal stimulus (tax cuts/government spending) is based on a multiplier effect where a dollar of spending or tax cut is thought to produce some multiple of economic growth. The multiplier becomes one or less when sovereign debt hits 90% of GDP. That is charted to occur within the next 10 years, perhaps much sooner. It appears that under current conditions the multiplier has been overstated and is already “trivially small”. The total public debt in the US has just crossed the 90% mark, with the difference being agency, state, and local debt, some of which will be federalized through bailouts. Federal debt itself, now at 64% and rising rapidly, is already triggering discussions of a possible downgrading of US credit by credit rating agencies.

The monetary policy tool of reducing interest rates to simulate activity has reached its mathematical limitation. It has been held near 0% and still no traction. The Federal Reserve Bank (Fed) executed a creative maneuver to put further liquidity into banks and avoid a wave of bank foreclosures and FDIC claims. It did this by trading a credit on a bank’s reserve account for its illiquid mortgage backed securities of indeterminable value. How the computation was made to determine how much credit to trade for the assets is unknown, but there is speculation that the formula provided enough credit for the assets to put enough into the bank’s reserve account to make its reserve to liability ratio sufficient to pass a stress test or meet a liquidity standard. This maneuver appears up on the Fed books not as cash printed and in circulation but as a manufactured entry in the reserves of the banks.

There simply are not qualified borrowers for the money so there is no need to “print money” for injection into the money supply. The amount of cash actually printed and put in circulation since TARP has not been that much as a percentage of GDP. That and the low velocity at which money in trading hands is one reason for the lack of immediate inflation pressure. As a result of swapping the troubled assets for the increased reserve account, the Fed and ultimately the taxpayers essentially created and now own a hedge fund that no private entity would buy. The Fed took on the role of the “bad bank” where troubled assets were collected. Bernanke successfully read the lessons of history and prevented an immediate liquidity collapse and an immediate second great depression. In the process the liabilities of the Fed doubled. Although the TARP money was absolutely necessary to provide the liquidity and stabilize the system, a side effect was a sad joke. The banks got the money for no interest and turned around and put it in Treasury Bills and pocketed a year of interest producing profits and handsome bonuses. There are no more magic tricks in the Fed’s hands.

Bluntly put, in so far as fiscal and monetary policy goes, we are out of gas. Apart from Winston Churchill’s observation that God protects drunks, fools, and the United States of America.  things are dire.

Uncle Sam is spending far more than he takes in. He has 3 choices: raise taxes, cut spending, and borrow more. For political reasons adjustments to taxing and spending appear off the table. The option historically pursued is to borrow. When he borrows money, he sells a promise. The amount of money he gets for his promise to pay it back depends on essentially 3 things: the confidence of the buyer the Uncle Sam will pay it back as scheduled with money with equal purchasing power, expectations of how money would perform in alternative investments, and special considerations. Those factors determine the rate of interest Uncle Sam must pay. Because Uncle Sam was backed by the biggest economy, had never defaulted, had the number one military, had a stable political situation, and his currency was not subject to disproportionate depreciation over time and could be easily traded for other currencies, the confidence in him was rated Triple A. As a result he had to pay less interest. In times of geo-political or economic stress people instinctively flee to safety. Habitually, they flee to Uncle Sam. Even when there are rational reasons for less confidence in his promises, he has so far been able to continue to sell them on his terms, albeit much of it is dangerously “short term” debt. In the last 20 years another reason evolved that allowed him to continue to sell his promises on his terms.

In the Far East there is the land of China. It has 4 times the population Uncle Sam has. It has vast natural resources. It has continuous culture spanning thousands of years. Its people are energetic, inventive, and bright. For various reasons the last 500 years it was overshadowed by the English speaking empires. Beginning in the 1970’s Uncle Sam established a trading relationship with it. Its people worked hard under conditions that Uncle Sam’s people would not. It sold its produce to the US below the cost that the US could produce it. It saved an extremely high portion of the sales price. It became wealthy. Meanwhile, Uncle Sam’s people enjoyed cheap prices. With high powered Madison Avenue advertising encouraging them to borrow to buy more of what they didn’t need in the first place and a financial system that incentivized taking unreasonable risks, Uncle Sam’s people were in a dream world of credit. They bought much more than what they earned. Most saved nothing and borrowed all they could. While Uncle Sam borrowed, his financial industry and consumers borrowed even at a faster rate. China was willing to engage in vendor financing so that Uncle Sam’s people could enjoy the really good life. One way the vendor financing was accomplished was by investing much of the profits from its exports in Uncle Sam’s promises. This special consideration and demand for Uncle Sam’s promises increased other investors’ confidence in Uncle Sam and further enabled Uncle Sam’s borrowing because it seemed China would always be there supporting the market and protecting the value of his currency. Essentially, China made a strategic decision to underwrite Uncle Sam and the good life of his people. In return, China’s production capacity expanded. Its exports skyrocketed. Its employment went up. Its manufacturers got an edge on competitors from other emerging nations. Its young people were intense and dedicated. They attended and led the classes in Uncle Sam’s schools. The strategy paid off. China became very, very wealthy. It bought about 1.5 to 2 trillion in Uncle Sam’s Treasury Bills, US agency debt, and other American obligations, in addition to stakes in natural resources around the planet. It came to own the top 3 banks on the planet. It all came about through a transfusion of US economic power. So important was this transfusion of economic blood that the Peoples Bank of China developed a novel way to put an additional floor under the dollar and subsidize Americans purchasing Chinese exports. This additional subsidy is costing the Chinese about $30 billion a year. It has been worth it. China now can feed 1.3 billion people. However, it needs to continue the growth which up to now has come from exports. China will need to make some difficult adjustments if its system has to be redesigned to rely on something other than exports to the American consumer. Perhaps that is the Chinese consumer? Such redesigning would be politically risky for the Chinese. However, China may have no choice. It is hard to transfuse blood from a turnip.

When the financial events of September. 2008 hit, Uncle Sam’s people began to save. Less was spent on exports from China. China’s trade surplus dropped to only $100 billion a year. That places a limit on what China can give to Uncle Sam for his promises. Uncle Sam needs a lot more than that. Uncle Sam needs to find someone to buy his promises. Who will that be and at what interest rate? How confident are buyers in Uncle Sam’s promise to return their dollars as scheduled with dollars with equal purchasing power when they are not motivated by special considerations? If there is possibility of his default or that he will be try to avoid repayment by inflating the dollar then the interest buyers will demand for buying his promises will go up. He may no longer be rated “Triple A”. Americans will be like the well-to-do Icelander whose house was on an acre when Iceland recently lost its rating. He found himself desperately trying to buy chickens so he could trade eggs for milk from the cow his neighbor bought. As the rate of interest that Uncle Sam has to pay goes up, the amount Uncle Sam has for his other budget items evaporates accordingly. A vicious cycle emerges.

If Uncle Sam is held to the same standards as other nations then to avoid the fate of defaulting nations the International Monetary Fund suggests he will need a credible program to reduce the real deficit by 9% over the next 10 years. To do that Uncle Sam would need to raise taxes on the middle class. There are not enough wealthy to pay what is needed. He would also need to cut all kinds of favorite programs from welfare to the USDA. These measures would be counter cyclical and lock in significant unemployment for an unknown duration. The partisan nature of the country seems to eliminate such options.

What is very likely to happen in our foreseeable future, on a schedule largely determined by some unpredictable and likely random event, will be a sudden realization by the financial markets that there is substantially more risk to US Treasuries than the market has priced into them so far. That risk will cause the Treasury to have to pay increased interest rates on the T Bills to attract buyers or the Fed will have to print money to buy the T Bills nobody else wants. In such a situation the Fed would pay for the T Bills with freshly printed money. The government would then direct inject it into the veins of the economy. Such a situation will bring into focus the question of default or inflation? Inflation at about the 10% level and no growth until sufficient debt is inflated away will likely be the selection because it requires no political decision. Since the path to inflation is not a conscious one, it is not a straight line. There is an oddity where events unfold so that there is a deflation that precedes the inflation. This would occur if the Fed sees the indicators of inflation which traditional monetary theory would call for an increase in interest rates and responds with an interest increase. If it misses the mark and directs the interest rate hike early, it risks triggering the deflation and further reducing GDP and employment, similar to the Japanese experience. Investments could decrease in value during the deflationary part of the process, in part because a commercial real estate crisis is lurking in the wings. Ultimately, however, the dollar and European currencies will depreciate. It is likely Europe will be hit harder than the US, but the US will still feel intense pain. Non-aligned and emerging nations will be choosing their dance partner for the balance of the century. The old KGB guard in Moscow will see opportunities for destabilization as a tool to get back in the game. China is not building a naval fleet simply because everybody needs one tied up in the backyard. China does not have the world’s only manned moon program just because it invented fireworks and likes to see rockets go up. It is laying the ground work to demonstrate that it can protect those aligned with it, embarrass other suitors, and contain its adversaries. Chinese currency will appreciate, as will their consumer society. Since it is generally thought there are 3 factors that determine economic power: population, capital, and know-how, it is reasonably easy to figure out who the best looking dance partner will be. The attractiveness of alignment with China is somewhat contingent upon whether it can get its internal house in order. If not, China disintegrates into a billion growling stomachs that will need somebody to blame. Nothing in life is certain.

The capitalist model has been badly damaged. The top 3 banks in the world are state owned by the People’s Republic of China. The western economic model seems to cramping up on a poison of debt. Democracy in the US is paralyzed by bickering partisans egged on by their campaign contributors. The United States is waking up to find that numerous trends and reasonable projections showing it rapidly fading into second position in world influence. The Iraq and Afgan wars have depleted its military. Its European allies sense something disconcerting. The US no longer has the answer, the will, or even the power that they once relied on. France, Germany, and the Netherlands find themselves looking to each other even as they are besieged by debt threats from Greece, Spain, and Portugal.

The UK sees its face of a century ago in the US, perhaps victim of some genetic defect of Anglo speaking super powers. Must the US UK golden age be at an end? Perhaps history holds a clue.

In 1914, the first age of globalization was in full bloom. Commerce and culture flourished. Business people conducted themselves as if their world was much more stable and predictable than ours is today. British students attended classes at German Universities which were the ranking universities on the planet. Yet, under an unsuspecting surface the paradigm was shifting and poles aligning so that a single trigger could nearly instantly transform the surface. The morning of June 28, 1914 was the last morning the sun would rise on that surface. An assassination of an archduke would end it all. The aftermath of that found a Germany of 1923 in the grips of hyperinflation. Its currency was destroyed and the foundation for a series of events leading to a second world war in place. History suggests just 3 years earlier for a period of 3 months in 1920 a window of opportunity presented itself. Had the politicians of the German government made the unpopular decision to fight inflation the events of 1923 likely would have not occurred. The politicians were fearful of unemployment and a workers’ riot. They conformed with the popular sentiment of trying to use inflation as a tool to eliminate reparations to the allied powers. The politicians did not act. Desperate warnings were ignored. The opportunity was lost. The rest is history.

The US in a period ending before the 2010 elections has a similar short window of opportunity to ramp up necessary policy in a way that manages the inevitable pain. In this window a very bitter medicine can be administered in measured doses. The deficit needs to be reduced. There is an opportunity to raise taxes on all classes perhaps by a taxing package that includes a consumption tax. There is an also opportunity to make cuts in spending with the cuts focusing most on areas that contribute less to GDP. Interest rates need to begin to rise to begin to reflect the risk of loaning to Uncle Sam and to encourage savings. Cost ineffective regulations on the productivity of industries that produce exportable products need to be relaxed. This policy will result in a temporary reduction in living standard and locking in the present rate of unemployment; perhaps even increasing it, albeit for a shorter time than would otherwise be the case. The financial industry needs to be reigned in so that it can not skim the system. If this is done, American’s will know that brighter days are not just political rhetoric. They are indeed ahead. Businesses who now are reading the tea leaves that suggest a sunset on the capitalist system will know that after the darkness of night the sun will rise on a profitable day. Our allies will have faith that the old America is capable of disciplining itself and is coming back stronger and more dependable than ever. Emerging and non-aligned peoples will know that there is no need to choose a dance partner because the dance for the rest of the century is an open one. A rebounding America will demonstrate to China that a consumer economy does not have to have a fatal outcome. Bright, energetic, and strong peoples with a capacity to learn from the past have more to gain by cooperation than by nationalism and isolationism. Separately we may leave foot prints on the Moon, but for us to establish a permanent base on Mars, an ark for humanity, the effort of all the human species is needed. Strong societies would realize there is no margin in conflict.

The realities of the partisan system bring us back to sharp reality. Unified policy is impossible. Each side must beat the other. An election is on the horizon. The rhetoric must roll. Each must play to its core, defend its principles, and make sure the other fails. The game must go on. Is there any chance that Americans would vote yes to higher taxes, fewer freebees, higher interest rates, and several years of hurtful unemployment simply to stabilize the currency, make American strong again, and assure Western principles a seat in the cockpit of the future?

One might expect the answer is a resounding no, but I found myself in a world renowned place with bright people from many nations, sharing an uncertain future, speaking the same language, considering the options, and desperately trying to discover a way to bring a future defined by our common will into being.

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