I do not see a worldwide recession. The economies of heartland Europe and other parts of the world have decoupled from the American economy over the last decade. Emerging giants (China, India and Russia) and other economies appear to have a fundamental growth scenario. I tend to believe that the American economy is set to lose the froth on top and the U.K.’s economy might follow. Therefore, we ought to examine the question from a distinctly American point of view.
It is a difficult era for the American economy. The EU is now the top economic producer in the world. High energy prices are exposing inefficiencies in American consumption, even though the overall energy bill of America is proportionally smaller than, say, thirty years ago. The issue is that other efficiencies are squeezed out of the American economy and there is little wiggle room in fiscal balances. The bitter truth is about the hyper-economy and how it is set to face the consequences of irresponsible borrowing. Assortments of public and private debt, one-way bets on income growth, and negative savings have converged with other factors such as an expensive war and anti-immigration policies.
I warned about this pressure cooker last January in my World Economic Forecast. And since that forecast, the fragile econo-system has suffered drought in North America (and Australia) and a 75% rise in grain and animal feed prices have ensued. I think the prices of other basic foods, such as milk and dairy products and meat, will jump by 30-35% over the next few months.
Credit crises are uniquely American cocktails for domestic consumption. No other economy has such a varied mixture of private and public debt stitched together with computer-assisted assumptions, rosy forecasts and a thin margin for error. The herd behavior of “smart” bankers, finance bosses and rating agencies has blurred the dividing lines of competition and collusion. Once again, they have found ways to circumvent regulations and land in familiar failures. (Deutsche Bank recently reported that losses from the sub-prime mortgages, and other knock-on losses from consumer loans, will equate to about 4.5% of U.S. GDP - about $500 billion in today’s money).
This loss will burden the financial hub of America as it sums up to about a third of primary capital in this sector. Other main sectors such as construction and automotive sectors are already in recession. Generally, banks can lend about 18 times their primary capital. A thinned out capital base means reduced lending capacity within the banking system. This is bad news for a country addicted to borrowing. A “small” loss of about $300 billion in the banking sector will translate to a massive reduction of $5.4 trillion (equal to the aggregate GDP of Mexico, Brazil, Russia, Saudi Arabia and Taiwan…or merely $18,000 per American) in lending capacity -- in a country where the federal government incurs a trillion dollars of new debt every 14-15 months.
This financial problem will evolve into a tough political question for Americans. Does this scenario compel the government to rescue the nation and bail out the irresponsible behavior of finance houses? Or should we sit back and watch the meltdown? Is the template of the Reagan-era Resolution Trust Corporation coming back, even though the RTC rescue plan was a much smaller program? The first RTC cost the taxpayer about $550 billion in 1980s (worth roughly $2.3 trillion in today’s cash). A repeat of that plan will cost about $3.5 trillion in 2007 money and cause a 35% jump in federal debt. This leap in national debt would put America in the ranks of other developed, but highly indebted, stagnate economies—Japan today, or Italy or France in the 1990s, all come to mind.
A more realistic, cheaper alternative to a clone of RTC is also a very un-American solution: direct government injection of capital into banks, or an outright nationalization of the banks. Several European countries resorted to such actions in the 1970s and 1980s because it was the cheaper alternative. The French socialists nationalized all banks in the early 1980s and argued that doing so was the cheapest solution. The value-added tax increases during the Mitterrand era paid for the exercise. In any case, Uncle Sam is compelled to raise government revenue, probably in form of a national sales or consumption tax with a wide base.
The devalued dollar and recent oil prices merely reflect a vote of no-confidence in America’s borrow-and-spend system. As such, the $100 face value of oil is a fabricated deflector of facts. It is a false psychological milestone akin to the “sudden death” hallucinations about the Y2K computer bug. Adjusted for inflation, a barrel of oil fetches about the same purchasing power as it did in 1979-1980 (around the Iranian Revolution and the start of the Iran-Iraq war) but about 10% less than what it was worth during the Pennsylvania Oil Rush in 1860s.
How do we turn things around? First, we ought to realize that the rosy scenarios of falsified low inflation and Wal-Mart capitalism are about to end. Stealth inflation in asset values (of shares, real estate, etc.) is now apparent, and Chinese import therapy can no longer mask real inflation. Second, it is a fact that China is a prime consumer of raw materials and the world’s second largest consumer of oil. A new power station comes online in China every ten days, even though an average Chinese consumes a mere one-seventh of the energy consumed by his American counterpart. Third, we should realize that America’s financial losses are beyond the means of the rest of the world to help, and thus a worldwide concerted effort (akin to Britain’s IMF rescue in the 1970s) is impossible. Finally, and like Japan of early 1990s, America must look at the past two decades as a memorable jazz age of easy life in the past. This means it must reinvent its financial discipline.
It is bound to be a painful decade ahead, if only to serve as a reminder of classic fiscal discipline as the first lesson in sound economics.
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