American Economy: The Perfect Storm by Josh Sidman

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by Josh Sidman
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Sept. 26, 2007

American Economy: The Perfect Storm

As pretty much everyone knows by now, the American economy is in bad shape, and it looks like things are going to get a lot worse. We are all familiar with the general reasons for why we have ended up where we are – i.e. excessive borrowing, overly loose monetary policy leading to two consecutive bubbles (the internet bubble and the housing bubble). What might not be so obvious is how all of this is going to play out from here.

For a long time I didn’t have a clear picture as to how things were likely to develop. I knew there were serious problems developing, but I could envision two equally likely outcomes – the first being recession and the second being inflation. One of these two outcomes invariably results any time a country pursues irresponsible, unsustainable economic policies. If a government is too loose in its monetary policy and unrestrained in its fiscal policy, this leads to an excess of money. Money needs to find a use, whether it be consumption or investment, so when there is too much of it sloshing around it inevitably leads to over-consumption or over-investment. Either of these phenomena then leads to inflation (i.e. a decline in the value of money relative to real assets). Alternatively, overly tight monetary policy combined with high taxation leads to the opposite extreme. Businesses can’t find enough money to operate, firms fail, and unemployment results.

The one saving grace of most economic crises is that there is usually a viable remedy, even if the remedy is likely to be painful in the short-term. When inflation gets out of hand, the government can raise interest rates, raise taxes, or cut spending. Likewise, when unemployment gets too high, the government can cut interest rates, cut taxes, and increase spending.

Unfortunately, the situation the United States now faces is particularly troublesome, since we are being threatened from both sides of the economic spectrum at once. While in normal times unemployment and inflation don’t occur simultaneously (since they spring from opposite causes), it is possible to have both at the same time. This happened in the 1970’s when the domestic economy was stagnant (causing unemployment) at the same time that skyrocketing oil prices led to inflation. This rare occurrence (called “stagflation”) is uniquely problematic because the remedy for either of the symptoms makes the other symptom even worse. For example, if during a period of stagflation the government tightens its monetary policy (in order to combat inflation), the already bad employment situation will be made even worse. Conversely, if they pursue an easy-money policy (in order to alleviate the unemployment), the already high inflation will get even worse.

As I said above, over the past few years of trying to make sense of the turbulent financial picture, some signs seemed to indicate that we were headed for recession, while others seemed to indicate the opposite, inflation. Now that the situation has started to unravel, it looks more and more like we will not be facing a normal crisis of either recession or inflation, but rather a period of the economic equivalent of a “perfect storm”, i.e. stagflation.

All of the talk about the economy currently focuses on the weak housing market and the Fed’s attempts to alleviate the problem by cutting interest rates. Unfortunately, I think it is very likely that this will not prove to be a viable solution. Due to the extremely high level of debt (both public and private) any attempt to loosen monetary policy will cause a diminished ability to borrow and will lead to inflation. Everyone knows that the ability of the US government to continue functioning is predicated upon the on-going ability to borrow ever-larger sums of money from abroad. For a long time, due to the US dollar’s preeminent position among world currencies, there was a seemingly endless supply of people willing to lend us money. However, economic realities can only be ignored for so long. Nobody in his right mind is going to continue to lend money indefinitely to someone who consistently squanders the money and fails to create economic value.

Over the past few years we have started to see the first signs that global economic participants are no longer willing to use the US dollar as the sole store of economic value. Some governments and corporations which formerly held all of their excess wealth in the form of dollars have changed to a policy of holding diversified portfolios of world currencies. This trend, coupled with the current domestic need for loose monetary policy will lead, in my opinion, to the dreaded stagflation.

If the Fed continues on its current path of lowering interest rates in order to stave off a recession, the US dollar will start to lose value against other currencies (something that is already well under way, particularly vis-à-vis the Euro). As the value of the dollar becomes increasingly questionable, foreign investors will demand a higher rate of return on their investments (to compensate them for the depreciating value of their holdings) if they are to continue to lend us money in the amounts needed to keep our government solvent.

The Fed only has control over short-term interest rates (in particular, the Fed Funds rate and the Discount Rate). Long-term interest rates are determined solely by market forces, and long-term interest rates are what ultimately matter to the economy. After all, if you are a business looking for financing or a homebuyer looking for a mortgage, is doesn’t do you any good that short-term rates are low. You need to borrow for the long-term, and if long-term rates are high, your economic prospects are diminished.

The final ingredient which appears likely to make this scenario a reality is, paradoxically, the health of the global economy. As economies in Europe and Asia experience robust growth, their governments will eventually have to raise interest rates in order to prevent their economies from over-heating. This will further tie the hands of the Fed in its ability to cut US interest rates, since higher rates in other countries will mean that global investors will demand a higher rate of return on dollar-denominated assets in order to continue providing capital to us in the quantities required. So, just when the bottom is dropping out of our real estate market and the cries are being raised for aggressive rate cutting by the Fed, our dependency on foreign capital combined with strong growth abroad will make it impossible for the Fed to keep interest rates low. In order to balance our national finances while simultaneously preventing a loss of confidence in the dollar, there will be no choice but to significantly raise long-term interest rates (again, this is a process that will be automatically performed by the market, rather than deliberately by the Fed). I believe we could see long-term interest rates climb well above 10% within a few years, and if you think the current carnage in the housing market is ugly, just wait until the rate on 30-year mortgages climbs to 10 or 15 percent.

Thus the perfect storm. Just as the speculative frenzy that led first to the internet bubble and then to the real estate bubble is winding down, the government’s ability to remedy the problem is likely to be curtailed as a result of the ever-present need to borrow more foreign money. Therefore, even if the Fed tries to prevent a recession by dropping interest rates to rock-bottom levels, this will do nothing to alleviate the real problems caused by the unwinding of the bubbles, and the only consequence will be the simultaneous decline in value of the dollar.

I don’t have the foresight to see how and when this will all work itself out, but it is increasingly clear that there are no easy solutions and that we are headed for economic problems of historical proportions.

2 thoughts on “American Economy: The Perfect Storm by Josh Sidman

  1. Pingback: Stagflation: The Two-Headed Monster by Josh Sidman « Dandelion Salad

  2. Pingback: Housing: When a Slump Becomes a Crash by Josh Sidman « Dandelion Salad

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