Why The Economy Won’t Recover For A Long Time

People that have read my musings/alarms/rants over the last half year will know that I anticipated that the economy would pause in its downturn in the spring/summer (although in February I was starting to get doubtful it would) and then plunge far worse in the fall than it has thus far.

My reasoning was simple and twofold. The first was that I thought there would be a very similar pattern to the Great Depression, and the latter was all about time lags for ill effects. When the markets finally gave way to reality starting with the Lehman Brothers collapse, a massive amount of credit was destroyed, and layoffs skyrocketed. I always felt that the government could stabilize the markets (at great risk to itself, more on that in a moment) but that there would be no way to reignite them. Reading memoirs of the Great Depression, they talked about how the first leg down seemed terrifying and then everything stopped (contrary to popular belief the government did intervene massively in the economy in 1930), people rushed back into credit/stocks, suppliers bought tons of raw materials, and everyone sat around and waited for buyers to come back. They didn’t. At first the working hours were cut in an effort to retain jobs while savings were used to fund operations, but eventually companies folded and unemployment skyrocketed at breathtaking rates…leading to a complete collapse in the credit market and a runaway deflationary spiral. The government then stepped in and became the major player in the economy.

We are in a very similar situation now; in a few ways much worse. There are two simple posts on Mish’s blog that really drives this home. The first concerns jobless claims that are starting to fall and have been inappropriately viewed as a good thing. There are millions of people that have been laid off in the last 9 months, have been unable to find any work, and will have their benefits cut off in the coming months. Despite talk of “green shoots” there are actually fewer jobs now than earlier in the year, which is contributing to record unemployment length of unemployment. While initial claims have fallen marginally, that is primarily due to a cutback in hours with hopes for the better, rather than improvement in business. (A prior post has links to data on both ofthese assertions.) Sound familiar?

As people start coming off the unemployment rolls in droves, they will quickly go from being “jobless” to “poor,” especially as few people have much emergency savings. This will lead to a new wave in foreclosures and other defaults, and a huge increased burden on state welfare programs that are already strained to the brink. Many states will face crises of unprecedented magnitude. Of course this will cause a massive contraction in credit.

Speaking of a massive contraction in credit, the numbers are crazy already. Private credit absolutely collapsed in the first quarter and even government borrowing couldn’t overcome it. It will be interesting to see what the second quarter numbers are, but based on reports of credit tightening, it is probably still decreasing at a rapid clip (albeit probably not fast enough to offset government treasury issuance). World trade has not recovered, and trade surpluses have disappeared with the exception of China who is spending a lot more on commodities and other non-US assets…and will get hit really hard in the next wave of decreased spending. This means that soon foreign demand for treasuries will abate and treasury issuance will have to absorb domestic investment. Of course this will crowd out private sector investment even more, and lead to more job losses.

That gets into why things are worse than the Great Depression this time around. The simplest reason is that the amount of debt in the world is much larger, so there is a lot more to be potentially destroyed. The second reason is that during the Depression, the government stayed mostly out of the debt side of the economy; it did try to pump up things in 1930-31, but there weren’t trillions of dollars in guarantees or purchasing of toxic assets. The government only came in on a large scale to purchase things once the excess leverage had been wiped out, and doing so earlier this time means that we are betting the credibility of the government on arresting the slide in asset values. If it fails to then they will most likely start printing money to pay off debts.

Which brings me to the final point. In the Great Depression the US was a creditor country, so there was by definition asset inflow into the country to stabilize the currency and treasuries even as they were issued en masse. Many debtor countries had to partially default on their debts and had major currency devaluations. Ironically, this meant that the US fared worse than Europe and other debtors at the time, as devaluation allowed them to correct faster. This time I’m not so sure, as we’re much more dependent on energy and consumer imports, and a sharp devaluation will trigger even more deflationary forces. Mish says, “Those who get hyperinflation out of this picture must be reading the playbook in Bizarro World because it sure is not the playbook here” but I think he is too concerned with the amount of credit/US dollars, not appetite for U.S. assets abroad. I agree with him that there will be massive deflation as the total amount of credit collapses, but due to decreased global trade and the massive amount of treasury issuance (that quite frankly there isn’t enough money in the world to absorb) there is a good chance that the dollar will lose its reserve status. If that happens we could see simultaneous deflation (wages decrease, assets decrease, massive job losses) while undergoing a currency devaluation and raising the price of imports. I’ve seen this possibility raised only by a couple of people, and never by any economists, so while it seems completely obvious to me, it could also be entirely crazy (although I’d note that it would simultaneously fulfill the fears of both “opposing camps”). However, it would be by far the worst combination for the U.S.

The way to mitigate this is clear: we need to clear up consumer balance sheets and start developing manufacturing capability to make more stuff for domestic consumption and exporting if there is a major currency devaluation. However, there will be very little international investment as trade will decrease and the government will have a hard time providing even basic necessities to the populace. This means that there will be two outcomes: either the government effectively centralizes (or mobilizes is how I put it) the economy by raising taxes and issuing a massive amount of treasuries to suck up domestic investment, or the government will start using the printing press to pay for its programs instead of issuing treasuries, accept the devaluation and hope the money is invested wisely instead of in a new asset bubble. In either case, success or failure will be defined by three things: massive cuts in government spending for things that aren’t essential, a retrenching of the consumer out of discretionary goods and into paying down debt and investments in new industries if you are fortunate enough to have money to do so, and for the government to coordinate long term energy and development infrastructure with industry.

In essence, it will require us to become more self supportive, and will be a set back for globalization. This is hardly new: the last 600 years has seen waves of immense global connectivity and trade give rise to massive imbalances that eventually resulted in collapse and retrenching. The details are always different, but the main determinant for success is always political and scientific.