Sunday, October 4, 2009

The Depression Has Begun

SeekingAlpha is a great website. The economic analysis offered there is usually several times better than whatever you can get in the mainstream media.

Edward Harrison's new article 'Recession Is Over; Depression Has Begun' is case in point.

Harrison tries to explain the historical roots of our current economic crisis. Harrison challenges conventional thinking and argues that the U.S.'s economic policy of the 1950s-1970s was not really Keynesian, just as our economic policy during the 1980s-2000s was not really free-market. Instead, he tries to take an apolitical perspective and he argues that excessive debt is the root source of the current crisis. The economy's structural problems were masked by "the financialization of the American and British economies." By this he is referring to the growth of the financial sector and the reliance on a series of economic bubbles, inflation and (artificial) asset price appreciation for economic growth. The housing crisis and resulting financial crisis finally forced the economy's structural problems to the fore.

There is nothing terribly new here. Other writers have hit on these points before but Mr. Harrison brings it all together in a very eloquent and well-sourced narrative.

Here is Harrison's summary of the historical events that led to our current situation, in his own words:

1. A depression was borne out of high levels of private sector debt, the unsustainability of which became apparent after a financial crisis.

2. The effects of this depression have been lessened by economic stimulus and government support.

3. Government intervention led to a reduction in asset price declines, which led to stock market increases, which led to asset price stabilization and more stock market increases and eventually to asset price increases. This has led to a false sense that green shoots are leading to a sustainable recovery.

4. In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized.

5.Because large scale government deficit spending is politically impossible, expect a second economic dip within three to four years at the latest.

What does Harrison think of the U.S. government's response to the crisis? He states that all of its efforts essentially boil down to a desperate attempt at increasing asset prices, or at least preventing them from declining further. This is true of the TALF program, the TARP program, the proposed elimination of marking-to-market accounting, near zero interest rates and the Capital Assistance Program. The government is basically trying (and somewhat succeeding at) "reflating" the economy.

In the longer term, Harrison believes that there are only two things that can prevent the American economy from experiencing a significant contraction: (1) prolonged, large-scale government deficit spending to replace contracting private consumption, or (2) transforming the American economy so that it can run a trade surplus. Option #2 is basically impossible to achieve, he argues. Option #1 is politically impossible in the long-term. When that government spending thats propping up the economy ends, expect a serious economic contraction more severe than the first (which will finally convince policy makers and the public that we're in a depression).

Edward Harrison's analysis is without a doubt one of the best I've read in a long time. I seriously encourage you all to go read it in full. However, I have a few questions/comments I would make to Harrison.

1. Harrison doesn't address the possibility that excessive government spending could weaken the U.S. Dollar to the point where its status as the world's reserve currency could be seriously challenged. What does he make of China, Russia and other emerging economies talking about replacing the Dollar for reserve currency purposes? What does he make of Tiger Management's Julian Robertson warning about the Dollar's future? What does he make of the World Bank's president's recent comments? On his biography page it states that Edward Harrison was a diplomat earlier in his career, therefore his insight would be particularly valuable. Is this all just political posturing or is it a serious challenge?

2. I want to focus on one point Harrison makes: he comments on the "financialization" of the American economy. This is a reference to the fact that economic growth in the U.S. (and U.K.) has been very reliant on the manipulations of (and growth of) the financial sector. I think this point deserves deeper examination. As I see it, not only is this not a normal recession, its not a "normal" depression in the sense that our economy is radically different from the way it was in the 1930s. Lets say government spending propped up the economy for an extended period during which much of the private sector's debt could be unwound and paid off, where would growth come from after that period ended? What sector(s) of the economy would be able to sustain the American standard of living after that period ends? Does he expect sectors like construction and retail to come back in full force? Judging from his economic analysis of the years 2000-2006, I doubt it. Does he expect much of the financial sector to be repurposed? And if so, to what ends? Even if most private sector debt is unwound during a prolonged decade-long period of Keynesian support of the economy and slow but steady economic growth returns after that, isn't it true that we would still need a return to trade surplus conditions in order to pay off our public debt which would, by then, probably be massive?

3. Harrison remarks that the U.S. is following the deflationary, secular bear-market model that Japan experienced during the "lost decade(s)." He should explain to laymen such as myself why, after two decades of economic stimulus and propping up the economy through deficit spending and efforts at preventing asset price declines, Japan was still unable to prevent long-term economic contraction and bear-market conditions. What did it do wrong and what is the U.S. doing right or differently which would allow us to succeed? Remember, Japan is still experiencing historic year-over-year deflationary declines as of last month.

4. Harrison comments that we can expect "an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government" over the next decade as a result of the coming economic volatility/instability. An extremely important point, I think. Nice euphemism by the way ... "more muscular." What are Mr. Harrison's thoughts on cutting military spending and government spending in order to lessen the possibility that desperate and bankrupt governments will turn to war and authoritarianism as a solution to their problems? I'm leaning towards it being a good idea, at least if we can convince the rest of the world (by which I mean, the other big military spending countries besides the U.S.) to go along with it as well. Unfortunately I don't see any politicians from the two major parties who have the political will or foresight to press for something like that on the global stage. I'd be particularly interested in Mr. Harrison's thoughts on this matter since he is a former diplomat.

I really, REALLY encourage you to go read the article. Most of the rest of the financial media is still standing amazed at the fact that Wall Street firms are still up to their usual "tricks" (massive derivatives trading, over-leveraged banks, "flash trading," etc). Duh. Did anyone really expect that to change? I expect more from my readers. This article is far more forward-thinking, paints a far broader picture and is much better sourced than most of the junk that the mainstream media is printing.

That's all folks!


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