Saturday, December 13, 2008

A Snapshot of the Economy: Where do we go from here?

I wrote the following post in response to an opinion on another blog. The opinion I argued against can be roughly summarized as such:

"We need to end all of these bailouts and allow deflation to happen. The bailouts aren't working anyway, so what's the point? Assuming deflation is a bad thing is a fallacy. It's precisely what the economy needs to purge the bad debts from the system."

O.K. so those were the main points; it's an argument I hear quite a bit these days, and understandably so. The TARP plan keeps morphing into something new every week, and nothing seems to be slowing the collapse of the retail and housing sectors. However, given the levels of debt in our economy, deflation is a dangerous threat and without monetary and fiscal stimulus, it will cripple our economy for years to come.

The Bubble's Deflating...

Assuming that deflation is a bad thing for the economy is not a fallacious premise. An environment of falling wages and prices at a time when we have record levels of private debt will surely lead to a massive spike in defaults, further destabilizing our already fragile financial system.

If nothing is done to prevent this we really won’t have the capital we need to invest in alternative energy infrastructure. That is why I support the coming Fed rate cut, which will likely be 50 basis points, as well as further monetary easing by other methods. The fed funds rate is quickly approaching 0%, so cutting rates will not be an option much longer.

Nouriel Roubini has called for more monetary easing by unorthodox means to avoid a liquidity trap when we reach 0% interest. In a recent op-ed for the Financial Times, he recommends that the Fed begin purchasing commercial paper, mortgages, mortgage-backed securities (MBS) and other asset-backed securities in order to add even more liquidity to the financial system. You can read the full article here:

Believe me, I have my doubts that this will work. I am more of a Keynesian than a monetarist, but given the severity of the contraction in the money supply (which i’m sure you know is just loaned into existence), it seems worth a shot.

More than monetary easing, we need a massive fiscal stimulus in the form of investments in alternative energy infrastructure and electrified rail transport. Check out Van Jones website or his book about a new “green collar” economy for more info. His plan is solid – not saying it’s destined to succeed, but it’s sensible. At the moment, government is the only entity capable of borrowing and investing on the scale we need. This is basically our only choice because the American economy needs to be massively restructured, and fast. Our current role in the global economy is that of the reckless spendthrift of the world, and we just maxed out our credit card. The only line of credit left for us is to issue government bonds.

Unlike some, I don’t think foreign bondholders will dump Treasuries anytime soon. Where else will they park their cash? Gold? Oil? Stocks? Those have all proven to be far more volatile than U.S. bonds.

It's also important to remember that what is good for the U.S. dollar is good for China (currently the largest foreign bondholder in the world). It’s a dysfunctional, utterly destructive relationship from an ecological standpoint. But the fact is that we are co-dependent right now -- we need their exports and they need our custom, which depends on the strength of the dollar. So China can’t afford to dump its dollar reserves; and China just surpassed Japan as the largest foreign holder of U.S. govt. paper. The trend is moving in the opposite direction to that which you suggest: U.S. govt. issued paper is the safest investment out there, you don’t get a return on your money, but at least you’re not going to lose your ass tomorrow. I’m not arguing that the future solvency U.S. govt. is a foregone conclusion. It is not, particularly if we fail to restructure our economy. I’m just saying it’s a better short term bet than anything else out there.

Here’s some brief background info on the inherent, structural vulnerabilities of the U.S. economy (I’m sure you’ve heard it all before :)

The neoliberal economic policies of the Reagan administration ushered in a new era of de-regulation for the financial sector, which over the past three decades has ballooned in size to comprise roughly 20% of GDP.

This boom in finance, what Kevin Phillips calls the “financialization” of the U.S. economy, has occurred as part of the larger trend of globalization opening the world to so-called free trade.

Concurrent to the rise of finance has been another trend of globalization: the decline of America's manufacturing base. In the 70s, manufacturing was twice as large as finance; now it's just the opposite, with manufacturing only accounting for around 12% of the economy. For thirty years these trends have gained momentum, creating an economy that is utterly dependent on convoluted financial transactions, debt, and most of all, consumer spending.

Currently 70% of America’s economic activity is driven by consumption, and everything from energy to fresh produce to shoelaces is imported. Seriously, everything is imported.

Now, having made those points earlier about the dangers of deflation and how to prevent its worst consequences, I want to stress that I understand that we are past ‘peak credit’, if you will. De-leveraging needs to happen right now; the collective private debt burden in our economy needs to be dramatically lower. So some debt deflation is inevitable. That is why the banks have hoarded the bailout money rather than lending it. After watching the value of their assets plummet, they are restoring solvency to their operations, and in the process lowering their risk by making fewer, more careful loans.

All of this adds up to much less debt money circulating in the economy, or as Kunstler puts it – we are hemorrhaging pixel money. I recognize that no amount of monetary or fiscal stimulus will stop the bleeding. But it may slow the bleeding, and that’s important right now. The credit bubble has popped, and there is no re-inflating it. However, properly guided investments aimed at restructuring our economy can slow the rate that the bubble deflates. We can’t reverse it. It had to happen eventually because our total debt (public and private) to GDP ratio had reached an unsustainable level.

The total debt to GDP ratio for the U.S. economy before the subprime crisis was an incredible 3.5 to 1, far higher than it was in the late 20s before the Great Depression. In 2007 the total amount of debt in the U.S. (household, business, financial and govt. sectors) was a staggering $53 trillion. Only about $10 trillion of that is the national debt, so the vast majority was private debt, and a little local and state govt. debt.

I mention these numbers to point out that the credit bubble was largest in the private sector. The government can de-leverage later, right now we need an emergency blood transfusion from the public to the private sector.

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