The Next Ten Years – Part I: There Will Be Blood

The Road to Perdition -

The majority of Americans may believe that the economic crisis knocked them off their destined course to wealth and prosperity, but the truth is that we were never as rich as we thought we were when cheap credit and cheap oil expanded our purchasing power unnaturally beyond the limitations of our productivity, of minds and machines, to generate an economic surplus.

If we were honest we’d admit, like a lottery winner who has spent all his winnings on cars and drugs, that the era of free-wheeling fun has come to an end.

We had a blast, but it’s over.

At least some of us had fun. The dot com speculators who sold at the top. The housing bubble speculators who got out in time. The Wall Street investment bankers who played it both ways, selling junk on the way up and shorting it on the way down.

Too bad for everyone else, for those who missed out, for the paycheck workers and the stock mutual fund buy-and-hold investors. The losers along with the winners will have to shoulder the burden of coping with cheap oil and credit era debris. The inherent unfairness of this outcome of the credit bubble era will pose yet another threat to the long standing presumption of American political stability and security that underpins the relative safety of US capital markets.

Debt Debris

The collapsed credit bubble has left us with a debt overhang that diverts the cash flow of households and business toward payments of principle and interest, preventing our economy from reaching its full output potential. Failure to write down the bubble era debt consigns us to corrosive debt deflation that demands more government stimulus spending to keep the top line of the economy growing while eroding the bottom line -- the purchasing power of income and savings -- with cost-push inflation, an artifact of a persistently weak dollar.

Richard Koo refers to his condition euphemistically as a “balance sheet recession.” That’s banker-speak for using public funds to try to close an output gap created by the collapse of a credit bubble that enriched creditors without holding them to account. As we see later in this analysis, Japan's experiment with applying Keynesian stimulus for decades rather than for a brief period to close an output gap as Keynes intended, will be among the great economic failures that befall the world in the coming decade.

Left-leaning economists deploy semi-scientific language to argue that we need to use public funds to prop up the economy until it becomes self-sustaining. They ignore the fact that the policy only works if the private sector can be primed to borrow more money into existence than it is retiring via debt repayment, else the dependence on deficit spending becomes structural and the spending perpetual, at least until the nation runs out of credit in a decade or two.

Right-leaning economists argue for cutting government spending and taxation to free up producers to hire and consumers to spend, ignoring the fact that when an over-indebted economy is in an output gap a reduction in government spending reduces the economy's primary surplus, shrinking the economy further, either in real or nominal terms, and worsening its fiscal position. It's like a mortgage lender demanding that a borrower sell the car he needs to use to get to work, so that income that he is spending on car loan payments can instead be used to pay off the mortgage. It's self-defeating.

Once an over-indebted country in an output gap begins to have difficulty repaying foreign debt, because debt payments exceed available tax revenue net of outlays, that nation will only dig itself deeper into a hole if policy makers attempt to reduce budget deficits by means of spending cuts. According to economist Sebastian Edwards, “Perverse fiscal dynamics – where the country fails to generate a primary surplus large enough as to stabilize the debt to GDP ratio – usually generates a vicious circle, where failure to stabilize the debt ratio results in higher cost of funds, lower growth, and in an even larger required primary surplus.”

The so-called debate about debt ceilings, spending cuts, and entitlements reductions is a red herring. The public debt crisis arose from the 2007 - 2008 private credit market crisis, not the government liabilities that have been building for decades.

The mistake of both the left and the right is thinking that we can escape an output gap without facing up to the politically unpopular task of demanding that creditors take a loss on loans taken out during the credit bubble era.

We need a private sector debt cut, not a tax cut.

Trillions in mortgage debt against fictitious housing value remains on the balance sheets of households after home prices deflated 25%.

These debts should not exist. They resulted from an over-abundance of credit and deficiency in lending discipline.

But Main Street’s credit bubble era debt is Wall Street’s political cash flow entitlement.

The banking lobby will make sure that the next president and Congress keep the bogus debt service payments flowing, no matter that principle and interest payments on mortgage debt now consume 30% of the average household budget, followed by transportation costs at 19% and rising, food costs at 14% and rising, insurance costs at 12% and rising, and health care costs at 6% and rising. Throw in a value-added tax proposed by Paul Volcker and others to balance the budget and we can kiss what’s left of our Postcatastrophe Economy goodbye.

Debt deflation is not the only holdover from the cheap credit era that is keeping us stuck in an output gap. At the same time the bill is coming due for building a transportation infrastructure that is dependent on cheap imported oil.

In the short-term, high oil costs push the US economy ever closer to negative real growth territory.

In Q1 2011, consumer price inflation averaged 3% according to the MIT Billions of Prices project, while the Bureau of Labored Statistics' revised Q1 GDP number confirmed a 1.8% real annual growth rate. In the same quarter the BLS reported a 3.7% nominal GDP growth rate and an average 2.2% inflation rate. When we subtract 2.2% from 3.7% we get a real GDP of 1.5% not 1.8%, but enough quibbling. If the nominal GDP growth rate was 3.7% and we use the MIT versus the BLS numbers, we get 0.7% real GDP growth, and I estimate that in Q2 2011 the economy contracted in real terms. This is the beginning of the first Peak Cheap Oil Cycle recession, a recession in real but not nominal terms. As we see later in this analysis, real GDP recessions are far more painful and political destabilizing than the nominal recessions.

In the short run, bad energy policy is heightening stagflation. In the long run it drives destructive public policy.

Forgotten Lessons and the Repetition of Fatal Errors

The private credit crisis that gave rise to our current economic crisis is a product of the second large scale credit bubble in 100 years.....

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