This diary is inspired by an insightful exchange by mstein in yesterday’s diary, where he had the following scenarios:
the worldwide economic imbalances have gotten so extreme that the eventual “reversion to the mean” cannot come with a “soft landing”. The sensible but optimistic inflationist probably sees something like the 70’s, a pessimistic one sees another Weimar Germany. The sensible but optimistic deflationist probably sees another 90’s Japan, the pessimist another Great Depression.
Let me make the pessimist case here, on the basis of the document we discussed and a few others from my archives.
The pessimist starts with the fact that today’s economy is running only on debt, as the following graphs show:
(from Puplava (Financial Sense – June 2004 – The Unraveling))
(from Marc Faber (Quamnet – October 2005 – Why the Fed has no alternative than to print money)
Nobody denies that debt has reached new highs, but several arguments have been used to say that this is not so worrisome:
- the increasing sophistication of financial markets has allowed more players to take more debt in cheap and convenient ways, and this only reflects the fact that we all manage our money better;
- a part of the bulge is due to the temporary phenomenon that the baby-boomer generation, a demographically unique generation in that it is bigger than both the generation before and after it, is in its peak earning years and thus has been able to borrow more easily in the last 20 years
- the success of the central banks’ fight against inflation has brought interest rates to record lows and made debt cheaper than at any other time.
But these arguments do not hold water:
(from Puplava (Financial Sense – March 2005 – Let’s get fictional))
The debt burden is the highest ever – and this despite the record low interest rates, i.e. it is becoming increasingly difficult for households to pay for it, despite the attractive price of that debt; there is simply too much of it.
As to the argument about the baby-boom generation, it could easily be flipped: that generation is precisely at the age when it should be saving the most: having paid for its home, it can now use its high income to save for retirement years. Well, this is not happening.
Instead, that generation, instead of paying for its homes, has taken on more debt, and has basically stopped saving:
(from the Hoisington study)
The house wealth is an illusion: houses are worth more, but households actually own a decreasing fraction of that wealth, because they have been busy drawing equity from them:
That mechanism goes as follows:
- the Fed has pumped cheap money in the financial economy via ultra low rates
- households and investors can borrow more cheaply and thus afford to pay more for assets like homes (and financial assets as well)
- house prices increase
- consumers feel wealthy, borrow more money backed by the pumped up value of their house, and spend
- the economy grows.
The problem is, of course, that the economy is not growing. A Freddie Mac study quoted in the Hoisington note suggests that house equity withdrawals made up 31% of personal consumption expenditures since 2000. Other studies suggest that a very high fraction of the jobs created in the USA in recent jobs come only form the construction sector and the financial sector. Corporate profits in the USA come more and more from the financial sector (as noted in this article in the Economist last February, profits from the financial sector went from 4% of the total in 1982 to 40% today).
As noted by bonddad in his various diaries, outside the construction sector, the situation is pretty dire, with declining real wages, significant job losses (leading to a much lower employment ratio overall, down from 66.7% in 2000 to 65.2% last year).
And of course, you have this:
House prices have become so crazy in a number of places (covering a significant portion of the population) that, despite the availability of more debt, houses become simply unaffordable, or affordable only with “exotic” time-bomb-like financial instruments, such as no down-payment, interest-only loans for amounts higher than the (current) price of the asset.
Well, the crazy mechanism above, which has already lasted much longer than all reasonable observers predicted, is coming to an end:
House equity withdrawals have stopped. Thankfully, one might say – at least the increase in debt will slow down. The problem is that this will have an immediate impact on consumption. Remember the number above from Freddie Mac: 31% of consumption came from these artifical props.
Now hit with the triple whammy of massively increasing energy prices, doubling minimum payments on credit cards, and lower home equity withdrawals, US consumption can only plummet.
This brings us in a reverse cycle, as described by mstein in the above exchange:
I believe this is the potential source of a possibly very vexing problem in the future; the next “conundrum” if you will. To wit – the coming slowdown in the US economy will result among other things in a reduction in imports, most specifically a reduction in imports from China. This means a reduction in the the volume of dollars flowing into the Chinese central bank. Dollars that are used to buy huge amounts of US treasuries. At the same time, the supply of treasuries will increase as the budget deficit increases (less tax revenues and automatic increase in expenditures from unemployment benefits, war in Iraq, rebuilding NOLA etc). Increased supply, lower demand – economics 101 says lower prices (higher rates). In other words, in the coming slowdown, once the Fed starts to lower short term rates, long term (real) rates may remain stubbornly high or even increase due to the supply/demand situation. This has the potential to start a very vicious, counterintuitive cycle where high/higher (real) long rates slow the economy more which forces (real) rates ever higher. A very ugly scenario and one for which the Fed has few if any options.
This is the reverse scenario, where all the excesses of the past years are paid for, compounded. Call it depression, call it deflation, it will be painful. And this time, the feedback loop from the Chinese will work against the USA, instead of in favor:
- US consumption falls, thus Chinese exports take a hit
- China has fewer dollars, and stops buying US Treasuries
- that buying trend, which had the effect of lowering interest rates, is now replaced by a neutral, or a selling trend, which pushes long term rates up
- debt becomes more expensive, adding, for those that do not have fixed rates, to an even higher debt service burden, and thus lower consumption
Now China may decide to react to that situation in two ways:
- one, helpful, would be to encourage domestic spending, invest locally, increase wages inside the country; this would fight deflation globally and increase world demand; it might also create inflation inside China and social unrest as inequalities increase.
- the other, dangerous, would be to push the mercantilist policies up a notch, slash prices on the back of their workers to keep exports going. This would increase worldwide deflationary pressures and/or could lead to a (increasingly justified) protectionist backlash form the West against that competitive pressure.
All in all, you can expect, in these scenarios:
- lower house prices
- higher long term interest rates, even if short term rates are lowered
- lower consumption in the US
- a nasty recession, which could quickly become worldwide.
The worst part is that it is not certain that such a crisis would be enough to bring energy prices down. The inertia in demand (including much stronger growth in countries like India and China) is likely to be sufficient, even in a recessionary environment, to keep pressure on the stretched supply side.
This is admitteldy a very gloomy scenario, but when you look at the above graphs, you see that there are so many imbalances in the world economy today, which have been exacerbated by Bush policies in every way, that it appears hard to avoid.
and remember one thing: most of that bubble wealth profited only to the very richest Americans. It will be essential to ensure that they pay as much as possible of hte cost of the mirror downturn that they caused. This will be the political fight of the coming decade, together with the energy crisis.
