Archive for December 18th, 2008

From Bad to Worse

This week the federal reserve lowered interest rates to “near zero,” (a range of 0 to .25%) in an effort to stimulate the economy and borrowing.  I think this is a dangerous action since one of the problems of recent years has been unsustainable debt and low levels of savings.   Given the deflationary numbers on consumer prices out (the largest drop in consumer prices ever, I believe), it’s understandable.  But we could be on the verge of this crisis getting yet another level deeper.

In a post last month, “What’s Up with the Dollar” I warned that the dollar was at unsustainable levels.   A dollar collapse isn’t inevitable, but the combination of increased spending and cheap credit in an already debt ridden economy could ultimately cause a loss of confidence in the dollar.   Then the dollar was at about $1.25 per Euro.  It hoovered around there, but after the Fed’s rate reduction  it has plummeted to $1.44 per Euro.  That’s still better than it’s lows earlier this year, and it’s still not a crash, but we may be inching towards the next stage of the crisis.

Most observers believe the dollar will remain reasonably strong because there is no alternative.  The Euro doesn’t have the track record of the dollar, and European economies are also week.  Moreover, the US still dominates the financial markets and most investors have no choice but to put significant amounts of money in US markets.  And while one can imagine an alternative to the dollar being developed, it would take time and for now the dollar will keep value despite and in part because of the slide to global recession.

I believe there may be two flaws to this argument.  First, markets may be unpredictable but they react to demand.  There is a demand for securities and investments that are not dollar based, and more quickly than one can imagine alternate investment possibilities may spread globally, especially in Asia where economies are not in as severe straights at this point.  Second, the fundamentals are against the dollar.  I tend to go with the fundamentals over speculation on what investors are going to do.

If credit is dirt cheap — the Fed is even talking about direct lending to make access to credit easier — the money supply expands.  That should make the dollar less valuable.   Although the trade deficit is finally starting to contract, and we’re off our highs in our current accounts deficit, we still are out of balance, with a dollar artificially high in value.  The collapse of the bubble economy makes it harder to defy those fundamentals.  High debt, cheap credit, high trade deficits are a triple whammy against a currency.

The result could be a contracting economy suffering inflation.  The inflation would come from foreign goods — the kind we’ve been over-consuming — going up in price due to the increasingly less dear dollar.  It also would lead to a tightening of the money supply as the feds would have to battle inflation as well as  a recession.   The practical effect on our society would be a markedly decreased standard of living and rising unemployment.

Believe it or not, if that happens, it may be the start of a recovery.  At a point where foreign goods become expensive, American goods will be able to compete.  The trick will be to find a way to capitalize new production of actual goods that people want.  Here, inflation would be our friend.  There would be lucrative foreign markets that could suddenly use cheap American goods.   As the US starts exporting more the current account would come into balance, and soon the growth in the export sectors would start spreading and the US could begin a real recovery.

It will not be a return to the heady 1990s.  As the global economy rebalances, the US will no longer have the capacity to party at the expense of others.   Rather than consuming far more than we produce, we’ll have to have balance.

Such a rebalancing doesn’t happen overnight.  We could see unemployment hit 15%, be vulnerable to terror attacks by those seduced by the thought of bringing down a wobbling economy, and we’d have to treat China carefully, given its ability to dump American currency and assetts in a manner that would devastate the US.  It would hurt China too, so it’s likely we can convince them not to, but we’d be the weaker party in the relationship.  We could see a recession last long enough that the “D” word becomes more common than the “R” word.

But absent a political crisis that severely destabilizes the planet, this rebalancing is simply necessary — and does give us some respite from potential oil shortfalls and global warming.   US demand for oil was down 12% last year, a record drop.   That also means fewer CO2 emissions, and just as sudden jumps in demand can trigger quick oil price spikes, sudden drops in demand have an opposite effect.  Demand for oil is inelastic, so changes in demand not based on changes of supply  can have a quick and dramatic effect on the price.

However, this is going to very hard on the lives of real people, many of whom never dreamed they’d be facing the kinds of conditions and choices they face.  One question: can we as a society do things, either through policy, volunteering, or in communities to avoid families and lives being destroyed by economic crisis?   This kind of suffering may not be as dramatic as that in a war, but it can a severe psychological shock that scars people and their families even long after the crisis has past.  That will be the subject of future blog entries.

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