San Francisco - 1906
What is the big picture on the financial crisis? There are plenty of theories rolling around the net. Most are wrong because 1) they possess no fundamental understanding of economics, 2) they do not fit with the facts (usually due to ideological bias), or 3) they are excessively moral (see point # 1, economics is not morality). Most importantly, none of the theories that I have seen are capable of predicting what is going to come next. Nobody seems to have any idea how this will play out. Today's market drama is case in point. We all know there is going to be a recession, its already started. So why a huge drop in asset prices? This should have been known and factored into prices already. The panic should be over. The banking crisis has been contained, so a total freeze of the credit markets is averted. The nightmare scenario is not going to happen. Yet the stock markets are acting as though it were. The other mystery is the US dollar. I keep coming back to this because it makes no sense and the dollar keeps getting farther out of whack. Money shouldn't be fleeing assets like oil and gold for US Treasuries. But it is, in vast streams.
I'm sensing the meta-narrative is the stock markets worry that most of the growth and prosperity enjoyed by the industrialized world in the last 25 years was built on a bubble of debt. We have had people warning since the early 1980's that the American debt party couldn't last. But it has lasted, with a few hiccups. In particular, we've had one bubble after another since the mid-1990's. The run-up of the US dollar counts as another in my view. But what if the whole system was fundmentally flawed? Could it all come apart? If so, what would that look like? I think that the answer to that question (if there was anyone smart and visionary enough to answer it) may hold the explanation for what is going to happen as this crisis evolves.
Here is a picture that tells the story about US debt.
Chart by Philip Brewer
Brewer notes that the debt drop in 2007 reflects the reduction in new mortgages as the housing bubble burst. But the key point is that US consumers have been paying for their HDTVs, SUVs, and vacations not out of wealth, but with borrowed money. At some point, the debt load becomes so large that, as a group, US consumers cannot continue to service it. As long as interest rates stay low, the crisis can be managed by lowering debt levels. But when rates rise, like during a run on the currency, fewer and fewer people can service their debt. Apart from the banking and credit crisis, apart from the derivatives time-bomb, this looks like another, much larger problem. Not only have Americans gotten rich from debt, but China, Japan, Korea, etc. have got rich making and selling things paid for with debt. Thus not only is US wealth all of a sudden suspect, so is that of its manufacturing suppliers. The economies of the Asian tigers may be built on sand.
This theory has the virtue of explaining the ongoing asset market turbulence and the attraction of US Treasury Bills. But if correct, there are two very troubling implications. First, that US Consumer spending will likely shrink not for quarters but for years, taking the rest of the global economy down as wells. Second, that the prosperity of newly emerging economies, especially in East Asia, is in threat. A significant fall-back in countries like China, Vietnam or the Philippines raises the specter of political turmoil. Rising populations need economic growth to keep individuals at the same level of wealth. They need to keep moving just to stay in place. A decline in an economy where there population bulges with youth gets amplified. For example, here is the age structure in the Philippines:
- 0-14 years: 34.5% (male 16,043,257; female 15,340,065)
- 15-64 years: 61.3% (male 27,849,584; female 28,008,293)
- 65 years and over: 4.1% (male 1,631,866; female 2,128,953) (2007 est.)
Almost half the population is going to be looking for new employment in the next 10 years. Without continuing economic expansion, where will those jobs come from?The bottom line is that this crisis is far from over. Besides the multi-year process of unwinding all the bad assets, there is a clear potential for many years of slow or negative growth in the global economy. So-far, most of the discussion has focussed on the US and Europe. But the real crisis may unfold across Asia.