All over the world, people are really concerned about the economic situation. Their fears are made worse by the diverse prognostications of economists and politicians. Some are saying that we are heading for depression. Others are saying that the worst is over. This confusion is making people confused and fearful.
Two important influences are shaping the modern economy;
- Credit Crunch
The entire world is now experiencing the consequences of these two events.
Improved communications and transport over the last few decades have released a tremendous globalisation of the world economy. The increased division of labour has resulted in a tremendous increase in production all round the world.
Production has moved to the places where it can be done most efficiently. Manufacturing has moved to China, India and South East Asia where wages are lower than in the west. Highly technical tasks have stayed in the developed countries.
Western producers have an immense supply of cheap capital goods to support their activities. People in the West have benefitted from an endless supply of consumer goods, which has improved their standard of living.
The people of rural China have found work opportunities that did not exist before their economy opened up. The only ones to suffer have been blue collar workers in the industries that have moved offshore.
The world experienced a similar deepening of world trade in the nineteenth century, but this was brought to an end by World War 1. In many ways, the current globalisation is a continuation of that one that was cut short by the closing of shipping lanes during two world wars and the cold war. The credit crunch is the most recent threat to globalisation.
Credit Blow Out
During the past decade there has been a tremendous expansion in credit all round the world. This started when the US Federal Reserve cut interest rates after the Dotcom bubble crashed in 2001 and was supported by a flood of savings from Asia. Since then a huge surplus of money has been sloshing around the world distorting markets everywhere.
The growth in money was exacerbated by a whole lot of new banking tricks developed by banks in the United States and copied all round the world. These included securitisation of mortgages and moving debt into off-balance sheet subsidiaries. Cheap money was available to everyone everywhere, including many who could not afford to pay the money back. Leverage went deeper and wider than ever before.
This flood of easy money had several effects:
Loose credit created the housing boom. All round the world house prices rocketed upward as banks provided huge mortgages to anyone who asked.
Easy credit fuelled a consumption boom. Consumers used their credit cards to purchase more and more consumer goods, particularly electronics. This boom was exacerbated by a wealth effect, as rising house prices made homeowners feel like they were rich.
Cheap money enabled people to buy cars that they could not afford and did not need.
Low interest rates make many marginal investments viable, cause capital investment to be distorted.
This credit blow out is finished, so the world is moving into a decade of tight money. Money will become difficult to borrow. Many people and businesses will find their loan applications turned down, as banks tighten lending criteria.
The credit crunch is particularly damaging to several sectors of the economy.
1. Finance Sector
The financial sector is already under tremendous pressure as the credit crunch bites. Losses will increase and more banks and finance companies may collapse.
When banks write off bad loans, the bank's capital is reduced. Depositors are only affected, if the bank collapses. The worst pain will be felt by the bank's shareholders and management. Declining asset valued and squeezed credit has produced a massive deleveraging of the entire economy.
During the past decade, the finance industry took an enormous share of corporate profits. These profits are now gone. Many banks are still hiding major losses that will not disappear by being ignored. Unemployment in this sector will be huge and bonuses are will disappear.
2. Housing Crash
The housing industry experienced massive over-investment, fuelled by the boom in house prices and funded by cheap credit. That boom is over and the slump in house prices is well under way. The situation is worst in the UK and the United States, but the collapse in house prices is spreading round the world.
The construction industry will be quiet for the next few years. An enormous number of unwanted houses have been built. Selling the backlog of houses will take several years, so many people in the construction industry will need to find different work.
Most homeowners will not be seriously affected by the decline in house values, if they remain in work and are able to pay the interest on their mortgage. They will be able to sit out the crash and wait for house prices to increase in a few years time. This might not happen soon. In previous cycles, at least five years went by before houses prices returned to the peak of the previous boom.
People with high debt levels will suffer, if they have to sell their houses. Those who get sick or lose their jobs might be forced to sell, if they are unable to make their mortgage payments. Some will find that the price they get for their house is less than what they owe their bank. This will be very painful.
Lawyers do not usually suffer. They will earn less from conveyancing, but they will make plenty from foreclosures and sorting out the credit tangle.
Freddie Mac and Fannie Mae have already gone belly up. This leaves American taxpayers in the strange position of guaranteeing their own mortgages.
3. Auto Industry
The American car industry has been dead on its feet a decade, but has managed to sell cars by dishing out crazy car loans. The days of selling cars with no repayments until 2020 are over. The credit crunch has now exposed the auto industry as a dead horse that will not be flogged. The big three are so sick that generous healthcare cannot revive them. The auto industry is too big to fail, but also too big to bail out. The industry will take tons of taxpayer money, but a big shake out will be needed, if it is to survive.
The people of the United States have enjoyed a decade-long consumption spree, funded by easy credit. Many Americans will carry on spending, because the do not know any other way to live. Others will be forced to put their credit cards away.
Huge shifts in consumer spending patterns will cause real pain for retailers. Those who are selling discretionary goods financed by higher purchase or credit card will find their customer base had disappeared.
Those who work in the retail sector may find they are getting less hours and many will loose their jobs.
The consumption boom has lead to an overinvestment in shopping malls and retail outlets. Some of these investments will decline in value as the retail sector is rationalised as a greater share of household budgets are allocated to paying off debt and buying necessities
Fools at the Wheel
The biggest risk to the world economy is the men who pull the levers of power in the government and the financial system. They have considerable ability to get things wrong while trying to put things right. Most depressions are caused when unexpected events are exacerbated by political and financial leaders. The credit crunch is the result of foolish responses to previous troubles. The capabilities of our political leaders have not improved with time, so they still have massive ability to stuff things up.
The Federal Reserve is currently pumping credit like a thirsty man at a dry well. The Fed knows nothing else, but boosting credit is just more of the same; more of what created the credit crisis in the first place. Massive credit creation may limit the worst of the immediate damage, but it will spawn terrible problems for the future. Current policies will leave a lake of liquidity. When confidence conspires and leverage ramps up again, the world economy could spin into hyper-inflation.
The central banks are now pushing the banks to do more lending, but this is naive. Their solution is the same as the problem. Reckless lending got the world into a mess, so more lending will not save it. A new borrowing binge and spending spree will not restore the economy.
Bush and Obama's rescue package for the banking sector may restore banking confidence, but it will not resolve the problem, because it rewards weaker lenders with new capital. In free market, the competent and wise people who prepared for hard times usually take over the assets of the reckless and incompetent. This time the reverse is happening. Governments are taking from the prudent people and businesses that built up wealth and giving to the careless, foolish and bungling banks. That cannot be good for the economy.
The American financial system is seriously flawed. It will eventually collapse when God has had enough of American shenanigans, but until that happens, it will lurch from minor crisis to minor crisis and from power to more power.
Bernanke and Co Ltd are throwing the kitchen sink at the global credit crisis, but they produced the crisis, so it is unlikely that they understand the solution. That does not matter, as wrong solutions often appear to be efficacious, and appearances are all that count in the political world.
At the moment, it is not certain how things will go. There are two possibilities.
The actions of the political and monetary authorities might be effective. Sometimes the wrong solutions are effective for a while, even if it stores up problems for the future. The capital injections of central banks may be enough to unclog the banking system. Collapsing gasoline prices and declining mortgage interest rates might make households feel confident enough to take out their wallets and start spending again. The world economy might respond by changing up a gear and moving slowly back into growth mode.
Government policies might fail. Unemployment could surge upward meaning that more and more households would be unable to make their mortgage payments. An increasing number of mortgagee sales could cause house prices to collapse even further. More toxic bank debt might be exposed causing the banking system to collapse. A big wind down in consumer spending could bring business activity crashing to a halt. These effects could joint together in a vicious circle of decline.
The political and financial authorities hope that the first option will prevail, but they cannot be certain.
One outcome is certain. The credit crash will lead to an immense increase in state power. Huge losses in personal and economic freedom will be welcomed throughout the world by people who want to be rescued from troubles.
Slouching to the Beast
The politicians and bankers will prop it up their economies, but they will be sowing the seeds that sprout into the next problem. That is fine, because political powers never want correct solutions. They cannot eliminate problems, because they need the next crisis to justify an expansion of power.
Mistakes by political leaders do not mean state power will diminish. State power will increase dramatically throughout the economy and society, as people demand political action to solve the problems their political leaders created. The main consequence of the credit crunch will be an enormous increase of state power throughout the world.
America is slowly grouching toward being the Beast. The home of market capitalism and the bastion of independence is becoming the breeding ground for state power. Faith in the state has been growing rapidly in the United States over the last few decades. The state has now made a huge series of interventions in the economy and most Americans are cheering. People who would not accept telephone number that includes the digits 666 are glad to have the state bailing out the banks and auto makers. They will never be a credible resistance against the creeping power of the state again.
The credit crunch will not destroy American power. The productive base of the United States is strong enough that after a brief hiccup its world empire will keep on expanding. The only impact of the credit crunch will be a sharp shift from freedom and independence towards state subservience and control. This radical change will happen without even a whimper of protest.
Updated December 2008