Tuesday, February 09, 2010

But what if they're wrong?

Right now the markets are doing their best yo-yo imitation again, this time in response to the PIIGS debt crisis (PIIGS=Portugal, Ireland, Italy, Greece, and Spain. Eastern Europe and the Baltic states also have some serious financial problems. Many don’t think the UK is in all that great shape, either. And then, of course, there’s Dubai. Oh, and did I mention Turkey?) The immediate concern is Greece, which is running an enormous deficit and may soon be unable to finance its debt in the bond markets, thus risking a default. Greece’s economy is relatively small but everyone’s fear these days is of contagion, a chain reaction. One default will cause interest rates to spike for all the other unhealthy countries, risking their defaults. Pretty soon a third of the EU is insolvent, overly exposed banks are tottering, and it’s fall 2008 all over again.

US markets are way up today (though still bouncing around quite a bit) on the news that the EU has agreed to “help out” Greece. Is this a bailout? Details will be worked out in coming days, the new EU economic affairs commissioner says. And the devil will certainly be in the details. German tax payers are not excited about paying for Greece’s fiscal irresponsibility—but the Greeks aren’t either, apparently. The government has only just begun reigning in spending and already there are strikes with many more promised to come. And if Greece is bailed out, who else will be coming to Strasbourg (EU headquarters) hat-in-hand?

By why should we care about Greece, or the PIIGS, or even Europe? Near the end of his life, Otto von Bismarck is reported to have said that the next Great War would begin over “some damn fool thing in the Balkans.” In 1914, of course, that is exactly what happened. Today’s economic interconnectedness is not unlike the diplomatic alliances which quickly pulled most of the world into war. The lack of real understanding of the consequences of those connections is also similar. What would happen if Greece defaulted on its debt (or Portugal or Spain or Dubai)? No one really knows, and for that reason no one wants to try it and find out.

The United States remains the world’s single largest economy but it has obviously been rocked on its heels. There is some awareness by the average worker/voter that these global imbalances are playing a role in our domestic economic problems. For a generation now we have known that our dependence on foreign oil is a problem. For nearly as long we have watched with alarm the movement of manufacturing overseas to countries with much lower labor costs. With the economic reversals of the current recession, real wages and living standards have been flat for the past decade. Some would argue they are actually in decline.

On the positive side China and India, the two previously impoverished and largest nations on earth, are booming. Of course, the resulting prosperity is being very unevenly distributed, and they are both experiencing all the other complications of modern industrial economies, including urban congestion, pollution, crime, rampant political corruption, and social disruptions of all kinds. Brazil, Vietnam and other Third World countries are having similar experiences. And they all view with suspicion the developed First World’s sudden concern with global warming and greenhouse gases—which the developing countries are all now producing in abundance.

The real issue, however, is much bigger than Greece, or the PIIGS, or even the EU, for that matter. We are all in a global economy now and no one really knows what that means. We are learning as we go along, and that’s not a particularly comforting realization. We know there are major global economic imbalances and that they are major problems. Two disturbing things about that reality are 1) the economic and political experts have no idea how to right those imbalances and 2) those imbalances are getting worse. This is not a good thing.

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The official story of both the previous Bush and current Obama administrations is that, through their daring and aggressive actions, the country was pulled bank from the brink of economic catastrophe. Now we must simply wait for the admittedly painfully slow recovery, and then our economic ship will be righted and sail along happily once again. They may be right. There are also reasons to worry that they are partially, or even very, wrong.

What’s of concern now is not just disagreement on the cause of this “Great Recession” but even what really happened in 2008. A helpful explanation I read recently is that government officials see the events of 2008 as essentially a “panic,” an economic psychological event. What’s necessary then is to restore confidence, calm the markets, and get everyone to start investing, hiring, and spending as before.

There is another unofficial view, however, that the situation is more serious—perhaps much more serious. For those who espouse this position, 2008 was not simply a panic but a real economic crisis, exposing significant problems which need to be dealt with now if we are to avoid similar or worse crises in the future.

One way to summarize the crisis viewpoint is that the economy is being seriously distorted by attempts to patch over the consequences of the global economic imbalances. This is what is causing the “bubbles,” the artificial markets of recent years that have inflated and then disastrously blown up, e.g. the housing bubble most recently and the tech bubble before that. Bubbles give the illusion of growth and prosperity for awhile, and then they pop. In the aftermath, the economy as a whole has moved little, if at all, but with significant resulting chaos and disruption. The housing excesses (in both quantity and quality) in the 2000s were just as economically pointless and unproductive as the tulip bulbs of 17th century Holland.

The concern is that the 2008 TARP bailouts and 2009 deficit-financed stimulus have (again) swept our economic problems under the rug. The current run-up in the stock market is at least a mini-bubble, the result of the government pumping billions of dollars into the economy with nowhere for it to go. While everyone acknowledges too many houses were built at too high prices, we are again hoping for prices to rise and home construction to rebound. Consumer wages and assets have fallen yet we are again hoping they will start borrowing and spending. We just need to get the economic juggler juggling again (paying no attention to those marbles rolling around the floor) and everything will be fine.

The causes of the 2008 economic convulsion will be analyzed for years to come—which is not particularly comforting to realize. To this day there is no consensus among economists or historians on either the cause of the Great Depression eighty years ago, or on what finally pulled the world out of it. The conventional answer to the latter, a world war, is also hardly reassuring (but that, too, is disputed).

What was catastrophically unique about the housing bubble was that it was fueled by an enormous growth of credit. Most of that debt has been transferred to the federal deficit or is still hidden on the books of the TBTF banks via fantasy asset valuations. The story is much the same across Europe, especially in the PIIGS and the UK. The strategy seems to be to play an international high-stakes shell game: keep shuffling the bazillions of dollars of global debt around so no one will notice. In the meantime, wait for tax revenues and asset prices to rebound and—poof!—the debt will disappear.

Needless to say, there is a lot of doubt this scheme is going to work. Or the strong suspicion is that it will only work by the creation of yet another bubble, with the same disastrous results. This strategy is derisively described as “kicking the can down the road.” Of course there is the very real possibility that the can will be run over and flattened before it gets to its “destination,” as Greece’s problems are rudely reminding everyone.

Since this scheme requires the rebuilding of “confidence,” Western leaders are unanimously insisting that the corner has been turned and recovery is underway, however slowly. None will publicly express doubt that the juggler can keep all his balls in the air. Joining them in this phalanx of optimism are, of course, the world’s bankers and financiers (including, very likely, your own investment advisor). Their survival depends on them being right.

But what if they’re wrong? Given they’re huge miss in not anticipating the most recent economic meltdown, that has to be recognized as at least a possibility. And there is ample reason to suspect it is much more than just a possibility. What’s scary, though, is that it’s not at all clear what the alternative strategy should be.

Most of those who say we are in the midst of a serious economic crisis believe we need to stop playing financial games and swallow the necessarily painful medicine. But then what? Big banks are allowed to fail, inept businesses go bankrupt, prices fall even further, government shrinks, wages fall, unemployment rises—and then where are we? The assumption is, that like a diving plane, the economy will eventually resuming flying at a new, though lower level. But what if the economic pilots can’t pull the nose up in time?

Another possibility, it seems, has to be at least considered: namely, that there is no answer. Is it possible that our long-running, free market capitalist system has finally run its course? It may not just be irony that within less than a generation of the demise of communism, its rival system, capitalism finds itself on the ropes. Perhaps the longer view of history will be that something fundamental about industrial society came unraveled at the turn of the millennium.

This doesn’t mean we are necessarily on the verge of some economic cataclysm or dystopian future. It could be the world is on the verge of something new and different—and better. Wrenching global economic disparities and ecological deterioration certainly argue that a better system could well be awaiting discovery. Getting there, however, as history and present events indicate, will likely involve significant trauma and upheaval. In any case, it may well be time to stop patching the old wineskin and instead start looking for a new one.

Update: Baseline Scenario has a comprehensive summary of its revised global economic forecast, which corresponds to many of the issues I address above. Its final point: 22) We are steadily becoming more vulnerable to economic disaster on an epic scale.

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