Summary: This is the first in a series looking at the US and global situations. Here we look at one of the large processes ending the post-WWII era — the leveraging and deleveraging of the developed nations. It’s as much a psychological and political process as an economic one. It’s a large crisis, but putting it in a larger context show we have no reason to panic. Properly dealt with, it will become a boring chapter in our grandchildren’s history books.
The US recession ended in the 2nd quarter of 2009, as the governments’ (all levels) fiscal and monetary stimulus stabilized domestic demand — at great cost. But the recovery has not yet begun. Many economists and Wall Street analysts call this a recovery because they see it as another post-WWII recession, just unusually long and deep. That’s an incorrect template. As Richard Koo of Nomura research (here and here) and others explained in 2007 and 2008, this downturn has little in common with its predecessors. Those were caused by combinations of excess inventories and Federal Research actions to control inflation. This downturn is, to use Koo’s term, a balance sheet recession. The stresses it creates will end the post-WWII era. We need to see the larger picture in order to understand why and how.
For three decades the developed nations have accumulated too much debt, in different ways at different times. Government debt in some nations (e.g., Greece, Italy). Household debt (e.g., in the US and Spain). Business debt (e.g., Japan, banks in the US and Europe). We know that imprudent borrowing has bad effects, just as we know that overeating leads to bad health and immoral behavior sends us to Hell (sometimes here, sometimes in the hereafter). We enjoy these behaviors today, while their consequences remain in the future. Eventually the future arrives. Heart attacks, divorces, and the long recession.
Not only do the developed nations suffer from high debt loads, the global financial system itself has become dysfunctional. This makes solutions difficult to imagine, let alone implement. To mention just a few weird things which we’ve come to accept:
- Since LBJ the US government has not acted as responsible foundation for the world economic order (e.g., issuer of the reserve currency).
- Europe’s leaders took a wild gamble, establishing a currency union before social or political unification (details here).
- The world’s poor (emerging nations) lend money to the rich developed nations.
- Governments of emerging nations (with low debt levels) are deleveraging while the developed nations (with high debt levels) borrow more. As seen in this graph from a report by Bob Janjuah and Kevin Gaynor, Nomura, 29 November 2010 (the IMF forecasts are optimistic):
We know these things like we remember our Sunday School lessons. Right and proper, but no reason to change our behavior today. The story of the next two decades will be the arrival of long-term trends, dominating current events. It’s happening right now in a slow and accelerating manner. These are problems to be solved, not sins to be suffered.
(1) Phase one: problem recognition
Debt is a political issue, as public policy controls both private and public lending. As debt levels rose, Cassandras warned about the obvious peril of continuing such imprudent behaviors. Effective corrective action required a generation or two of action taken before disaster strikes. Unfortunately, ignoring the alarms produced no ill effects and appeared to prove the warnings false. Warnings became “old news”.
Large majorities of both Democrats and Republicans voted against reforms to limit the growth of public and private debt. Now that phase has ended; we passed the last exit to avoid the crash. Such inaction is a commonplace of history. Problem recognition takes time and effort, hence the utility of Kubler-Ross’ somewhat bogus but useful metaphor about the stages of death and dying or the Observation-Orientation-Decision-Action loop. William Lind describes the extreme example: the period before WWI. For two decades Europe slid towards the cliff.
One pebble touched off an avalanche. It did so because it occurred, not as an isolated incident, but as one more in a series of crises that rocked Europe in its last ten years of peace, 1904-1914. Each of those crises had the potential to touch off a general European war, and each further de-stabilized the region, making the next incident all the more dangerous. 1905-06 witnessed the First Moroccan Crisis, when the German Foreign Office (whose motto, after Bismarck, might well be, “Clowns unto ages of ages”) compelled a very reluctant Kaiser Wilhelm II to land at Tangier as a challenge to France. 1908 brought the Bosnian Annexation Crisis, where Austria humiliated Russia and left her anxious for revenge. Then came the Second Moroccan Crisis of 1911, the Tripolitan War of 1911-1912 (a war Italy actually won, against the tottering Ottoman Empire) and the Balkan Wars of 1912-13. By 1914, it had become a question more of which crisis would finally set all Europe ablaze than of whether peace would endure. This was true despite the fact that, in the abstract, no major European state wanted war.
But despite this history, so obvious to us, Niall Ferguson showed that people were complacent right up to the outbreak of war in August 1914: “Political risk and the international bond market between the 1848 revolution and the outbreak of the First World War“, Economic History Review, February 2006. “To investors, the First World War truly came as a bolt from the blue.”
Phase one is over. We can no longer avoid the consequences of our imprudent behavior. We might not have time to even mitigate the consequences. It’s time to prepare for the collision. Sound the alarms. Fasten your safety belts. Place your tray tables and seatbacks in the upright position. Pray.
(2) Phase two: unpleasant economic realities
Now the world enters the next phase, when long-feared economic consequences arrive. We finally see, emerging from our mental fog, the too-large debts (the results of past spending) and our liabilities (promises of future spending). Our global political and financial mechanisms have become dysfunctional after decades of patchwork reforms. It’s a transitional period, as was 1914 – 1945.
Political processes will determine how we respond. Economics will determine the result, judging if we’ve made things better or worse. The response of each nation depends on many factors, such as:
- Our understanding of history and economics. This return of faux economics in the US and Eu is an ominous sign (aka the Austerians, the policies of Andrew Mellon and the Weimar Republic that helped create the great depression).
- Our social cohesion. Will groups work together, or use tough times to gain economic and political advantages? The US displayed impressive cohesion during the 1930′s; Germany displayed cohesion of a different sort.
- Our wisdom. Will nations cooperate to build new global financial machinery?
These decisions made will help determine (among other things) the great nations’ pecking order in the 21st century. We cannot accurately make forecasts, since only time will tell how each nation performs under the immense stresses to come. Here’s one guess: Why China will again rise to the top, and their most important advantage over America.
(3) About timing (addition to the post)
Identifying the problem is a trivial exercise. When will these things happen, crises and solutions (good or bad)? Nobody knows. History suggests that we overestimate the rate of change over short time horizons — and underestimate it over longer periods. Restated, the slow accelleration of events creates the optical illusion of incremental change.
As a metaphor, consider a complex mechanism placed under stress. Some parts are ductile, and visibly deform under stress. Some are brittle. They appear strong until they suddenly fracture, wrecking the machine. As we look at the wheels and cogs we can only guess at which are the weak links.
In a fascinating and distubing article at TomDispatch, Alfred W. McCoy (Prof History, U of Wisconsin-Madison), reminds us that Rome is almost unique in its long, slow decline. More often Empires crash.
Despite the aura of omnipotence most empires project, a look at their history should remind us that they are fragile organisms. So delicate is their ecology of power that, when things start to go truly bad, empires regularly unravel with unholy speed: just a year for Portugal, two years for the Soviet Union, eight years for France, 11 years for the Ottomans, 17 years for Great Britain, and …
Originally published at Fabius Maximus and reproduced here with permission.