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Predicting the future of policy making

Get ready because the second dip will occur. It will be nasty: unemployment will be higher and stocks will go lower than in 2009. I am convinced that it is politically unacceptable to have the government propping up the economy as [Richard] Koo suggests it should. The question now is one of timing: when will the government stop propping up the economy? The more robust the recovery, the quicker the prop ends and the sooner we get a second leg down.

So to recap:

  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.

-Credit Writedowns, Oct 2009

I really don’t like being a doomsayer but I think this train of events accurately describes what has happened in the two years since I wrote these paragraphs. Predicting the future of policy making has been and will continue to be key to understanding where this economy is headed – and by extension what your investment portfolio will do.

The last 2 1/2 years have been a stimulus-induced interregnum in a global depression the likes of which we have not witnessed in three-quarters of a century. Policy makers went at it guns blazing after Lehman’s collapse. The result: in April 2009, we got “The Fake Recovery”. As I wrote then, “you should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery”.

So, the governments went in guns blazing. Great. Nonetheless, the scale of the overextended credit was massive; it was just too much to bear and eventually, bailout and deficit fatigue took over. You have to see a lot more writedowns and debt forgiveness before this plays out. Moreover the leveraging up of public balance sheets meant politically that the origins of this next crisis were always going to be a result of deflationary economic policy.

everyone is fixated on [paying down public and private sector debts via accumulated savings]. I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that.  More likely, the western world’s collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.

And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken.  The question still up for debate is regarding systemic risk, contagion, and  economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.

That’s where we are now. So, by October 2011, I was telling you that “with the stimulative measures that supported recovery over, the end of the fake recovery is at hand.” That’s what austerity means.

Here’s Keynesian scholar Robert Skidelsky very much on point on this today. He calls the policy response “The Wages of Economic Ignorance”:

When we ask politicians to explain these deplorable results, they reply in unison: “It’s not our fault.” Recovery, goes the refrain, has been “derailed” by the eurozone crisis. But this is to turn the matter on its head. The eurozone crisis did not derail recovery; it is the result of a lack of recovery. It is the natural, predictable, and (by many) predicted result of the main European countries’ deliberate policy of repressing aggregate demand.

That policy was destined to produce a financial crisis, because it was bound to leave governments and banks with depleted assets and larger debts. Despite austerity, the forecast of this year’s UK structural deficit has increased from 6.5% to 8% – requiring an extra £22 billion ($34.6 billion) in cuts a year. Prime Minister David Cameron and Chancellor George Osborne blame the eurozone crisis; in fact, their own economic illiteracy is to blame.

Unfortunately for all of us, the explanation bears repeating nowadays. Depressions, recessions, contractions – call them what you will – occur because the private-sector spends less than it did previously. This means that its income falls, because spending by one firm or household is income for another.

In this situation, government deficits rise naturally, as tax revenues decline and spending on unemployment insurance and other benefits rises. These “automatic stabilizers” plug part of the private-sector spending gap.

But if the government starts reducing its own deficit before private-sector spending recovers, the net result will be a further decline in total spending, and hence in total income, causing the government’s deficit to widen, rather than narrow. True, if governments stop spending altogether, deficits will eventually fall to zero. People will starve to death in the interim, but the budget will be balanced.

That is the crazy logic of current economic policy in much of Europe (and elsewhere).

Got it? Let me translate that into the way I write. Lord Skidelsky is saying that any fool could see that the private sector was getting killed by a retrenchment of consumers and businesses. Without the government filling in the gap via “automatic stabilizers”, we would already have been in depression globally as they are in Greece, Spain and Ireland. Now, the economic ignorance of our policy making elite is telling us to fight private sector retrenchment with public sector retrenchment as if that will make things better. No it will make things worse, considerably so. But, hey, that’s what people are saying we should do.

The question is why are they saying this? I think economic ignorance is probably right here. But, there is also a sense among many that even if this policy leads to depression, it is better to take the bitter pill now than throwing money at the problem and making the credit bubble worse down the line. I have a lot of sympathy for that line of thinking. This site is named Credit Writedowns for a reason and this is it.

The real problem/question is how to prevent the deflating of the credit bubble and the attendant deflationary spiral from leading to civil unrest, nationalism, and geopolitical tension. My answer is that you have to fight against austerity. Let the automatic stabilisers be robust and let them do their job until the writedowns have all been taken. That way we get a sharp break and reboot without everyone becoming destitute.

The problem is allowing the credit bubble to deflate… and then piling on by deflating the public sector at the same time. Tell government: If you want to do anything, invest in infrastructure. But on the whole, don’t intervene pro- or anti-cyclically. Don’t cut spending, don’t cut rates, don’t do QE, and don’t do cash for clunkers or that kind of palaver. Let the credit bubble deflate. But be damn sure you have robust enough of a social safety net before you do. That’s my solution: one part Austrian, one part Keynesian.

Of course that’s not how it will play out. Skidelsky has the mindset pegged right:

Of course, [austerity] will not be carried through to the bitter end. Too much will crack along the way – the banks, the monetary system, social cohesion, the legitimacy of the political regime. Our leaders may be intellectually challenged, but they are not suicidal. Deficit reduction eventually will be put into cold storage, either openly, as I would prefer, or surreptitiously, as is politicians’ way. In the United Kingdom, there is already talk of Plan A +.

[…]

If nothing works, it will be time to sprinkle the country with what Milton Friedman called “helicopter money” – that is, put purchasing power directly into people’s pockets, by giving every household a spending voucher with an expiration date. This would at least keep the economy afloat pending the development of the longer-term investment program.

It would be better if such schemes could be agreed upon by all by G-20 countries, as was briefly the case in the coordinated stimulus of April 2009. If not, groups of countries should pursue them on their own.

That’s exactly right, both in prediction and tone. So, as Christopher Wood predicted a year and a half ago “the endgame will be a systemic government debt crisis in the western world”. And you can forget about Skidelsky’s ideas of renewed coordinated policy stimulus a la April 2009 fake recovery mode as a response. The helicopter drop of which Skidelsky speaks is probably how this eventually gets resolved. Brodsky and Quantaince talked about just such a plan to stabilize the global monetary system last year. I don’t see any of this happening before we try the deflationary route first.

And while I have called the Age of the Fiat Currency a 38-year (and now 40-year) experiment in (credit) inflation, I recognise that the deflationary route leads to chaos and military confrontation. Policy makers will panic when they see the economic ills their policies create for voters who will revolt in protest. I call it the Scylla and Charybdis of inflationary and deflationary forces in which policy stimulus is removed and then only after everything collapses, do policy makers press the red button; and then they act super-aggressively, leading to wild swings in asset prices, cyclical inflation, currency wars and the like.

Ominously, “this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.” And we are beginning to see this now. It will continue.

P.S – since this post is a bit over-the-top Armageddonish, I would really appreciate push back. Don’t feel like you have to agree with me here. But I warn you; I’ve run through this thing a million times and have responses ready! Frankly, I just don’t see where the coordinated policy response is going to come from in a world of bailout and deficit fatigue and nationalistic recrimination. April 2009 was the last chance for that. I seriously think Angela Merkel is trying to bridge this thing. But the gulf between the Barrossos and the Juergen Starks of the world is pretty large. You don’t bridge that gap in a deflationary environment.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

42 Comments

  1. J.D. Stein says:

    What you describe in your post was all very predictable for those who understand the connection between the private, government and foreign sectors, along with how modern fiat currencies work – or don’t work in the case of the flawed structure of the euro. 

    What remains challenging is the timing.  Ultimately, it is the private sector, particularly households, who will determine the magnitude and timing of any deflationary spiral. 

    Despite all predictions to the contrary, households have shown a remarkable ability to keep the “fake recovery” going by lowering their savings rate despite stagnant incomes.  There is no reason that can’t continue for another year or more in the U.S as households take savings as a percent of disposable income from 4% down to 2% or lower.

    European and U.S. households have also been surprisingly benign in their populist uprisings, despite high unemployment rates, government incompetence, and income inequality.  Sure, there are “Occupy Movements”, but anyone who walked through Zuccotti Park could see it was a side show – a mere blip amidst a vibrant, complex city – filled with citizens content with living their lives in peace despite day-to-day challenges.

    Bottom line, I agree with your basic script, but try to never underestimate the ability of both government and households to prolong days of reckoning.

    • Agreed. During the Depression savings rates went negative as the economy collapsed and people ate into their savings to survive the downturn.

      You noticed that I gave the global economy 3-4 years for this to play out, meaning originally I saw the ability to prolong the day of reckoning as lasting through 2012-2013. I think that still sounds just about right. 

      • J.D. Stein says:

        Right.  The timing is why investing purely based on big macro themes is so challenging – about as challenging as ignoring macro themes with an exclusive focus on fundamental, bottom up.  I have found the best method is to utilize macro to get the big picture correct, but then adjust tactically based on sentiment and valuations.

        What I find amazing is how many investment managers and hedge funds knowing they needed macro after the 2008 disaster allowed their political views to point them toward Austrian or Keynsian schools, rather than take a pragmatic approach and focus on which economic frameworks actually predicted the collapse.

        • People are very much driven by ideology and that makes it difficult to discern the facts impartially, something I see as the road to underperformance in a macro-driven environment like now. The question stock pickers need(ed) to ask is which sectors do I pick and what will PE’s do in the up and down cycle?

          I think we are still in a secular phase of PE compression so that the down cycles are vicious and certain sectors (banks, for instance) will lead to the downside as well as the upside. We saw banks explode out of the gate in March/April 09, and they have since rolled over. I think the next roll-over comes via cyclicals and high beta.

          But , as you say, timing is difficult here. I think rotating out of low quality and getting defensive by overweighting utilities, consumer staples, etc is the right posture in this environment. There is nearly no upside to waiting to rotate out of LinkedIns and Netflix’s of the world. Those stocks may fall apart individually, but as a sector the momentum has already shifted.

        • Anonymous says:

          The problem is few predicted this crisis. Even the Queen asked why no one predicted it. 

  2. J.D. Stein says:

    What you describe in your post was all very predictable for those who understand the connection between the private, government and foreign sectors, along with how modern fiat currencies work – or don’t work in the case of the flawed structure of the euro. 

    What remains challenging is the timing.  Ultimately, it is the private sector, particularly households, who will determine the magnitude and timing of any deflationary spiral. 

    Despite all predictions to the contrary, households have shown a remarkable ability to keep the “fake recovery” going by lowering their savings rate despite stagnant incomes.  There is no reason that can’t continue for another year or more in the U.S as households take savings as a percent of disposable income from 4% down to 2% or lower.

    European and U.S. households have also been surprisingly benign in their populist uprisings, despite high unemployment rates, government incompetence, and income inequality.  Sure, there are “Occupy Movements”, but anyone who walked through Zuccotti Park could see it was a side show – a mere blip amidst a vibrant, complex city – filled with citizens content with living their lives in peace despite day-to-day challenges.

    Bottom line, I agree with your basic script, but try to never underestimate the ability of both government and households to prolong days of reckoning.

    • Agreed. During the Depression savings rates went negative as the economy collapsed and people ate into their savings to survive the downturn.

      You noticed that I gave the global economy 3-4 years for this to play out, meaning originally I saw the ability to prolong the day of reckoning as lasting through 2012-2013. I think that still sounds just about right. 

      • J.D. Stein says:

        Right.  The timing is why investing purely based on big macro themes is so challenging – about as challenging as ignoring macro themes with an exclusive focus on fundamental, bottom up.  I have found the best method is to utilize macro to get the big picture correct, but then adjust tactically based on sentiment and valuations.

        What I find amazing is how many investment managers and hedge funds knowing they needed macro after the 2008 disaster allowed their political views to point them toward Austrian or Keynsian schools, rather than take a pragmatic approach and focus on which economic frameworks actually predicted the collapse.

        • People are very much driven by ideology and that makes it difficult to discern the facts impartially, something I see as the road to underperformance in a macro-driven environment like now. The question stock pickers need(ed) to ask is which sectors do I pick and what will PE’s do in the up and down cycle?

          I think we are still in a secular phase of PE compression so that the down cycles are vicious and certain sectors (banks, for instance) will lead to the downside as well as the upside. We saw banks explode out of the gate in March/April 09, and they have since rolled over. I think the next roll-over comes via cyclicals and high beta.

          But , as you say, timing is difficult here. I think rotating out of low quality and getting defensive by overweighting utilities, consumer staples, etc is the right posture in this environment. There is nearly no upside to waiting to rotate out of LinkedIns and Netflix’s of the world. Those stocks may fall apart individually, but as a sector the momentum has already shifted.

          • Brad says:

            Bottom Line – Corporate greed and corruption within the Central Banking System, Federal Reserve, Freddie Mac, and other large American corporations has collapsed the American economy.  This collapse has resulted in a deliberate and increasing financial struggle for many low and middle class citizens.  Dissatisfaction by a large segment of this population is currently being conveyed via the Tea Party and Occupy movements, as well as political rhetoric focused on a return to the US Constitution.  If change does not occur, this dissatisfaction will progress into a revolutionary class war in the United States.

          • Anonymous says:

            The Tea Party might have been a grass roots organisation once but they have been hijacked by the Koch brothers organisations. the Tea party are definitely not doing so well in the polls and may be out before long. The Occupy movement has far more potential and support, and as the police over react the public reaction will turn against the police. The Tea Party are becoming irrelevant, the Occupy movement are becoming more relevant peoples circumstances deteriorate. 

        • Anonymous says:

          The problem is few predicted this crisis. Even the Queen asked why no one predicted it. 

  3. Anonymous says:

    You wanted responses. Here is my take on the crisis. When I started following your blog it was the excess debt and how that was dealt with that attracted me. Yes the three solutions are:-

    The Japanese route, where by government runs a deficit till the economy has cleared its debt. It has maintained stability and worked because japan had the funds and savings to do it. That is not possible in the US or Europe. 

    The Swedish route where you refuse to bail out the banks and they collapse. The creation of good banks and bad banks restores moral hazard and allows the debts to be repaid and the cost to the nation to be minimised. This is not being done in the US or Europe because of political capture in the US and UK, and the fact that the big European banks are state owned. 

    Finally the original 1930′s US solution. Which is very austrian and Hayek, Minksy to start with to eliminate the debts rapidly and then Keynesian to rebuild the economy. This has elements of the Swedish system in that banks are wound up. This is my preference. 

    Once you have engineered that debt write down you need to plan for the rebuilding. A green economy will have numerous benefits for the US and Europe. It will lower the energy import bill, reducing the trade deficit again reducing the burden on the fiscal deficit. It will create lots of jobs rebuilding a new green economy and will be environmentally beneficial as well. Installing insulation is both labour intensive and beneficial. That will create jobs and reduce overheads for families. It will also be less liable to leakage overseas than say some other scheme. 

    I would also raise capital gains taxes to marginal income rates, eliminate housing subsidies for home buyers. Basically stop the bubble ever again. Wealth is accumulated from making things and providing services. Asset appreciation is not sustainable and policies should end that fantasy. 

    Once you have deflated the asset and credit bubbles, you need to build firewalls to stop them again. This could be capital controls so Germany cannot export its surplus to the periphery. Central banks should cap total domestic lending to stop such bubbles, and if necessary give business loans priority over households. This will stop new businesses being crowded out. They should also have savings targets, and these targets should not include homes and stocks. Then a policy of interest rate collars and caps to maintain savings rates so that the paradox of thrift is no longer a problem. If individuals have adequate savings then they do not have to cut spending when things get tough. This creates a stability to the economy.  

    Fighting inflation should be the preserve of the government not central banks. Central banks should manage savings rates to avoid a paradox of thrift in future and financial stability. The lender of last resort should be very restrictive, and if required it should be paid for with dismissal of the entire board and disqualification from any company directorship for life. That will end the gravy train for directors who might set up a new company if allowed. If they have such moral hazard they might be more responsible.

    Capital rules should be simple. So simple that even someone like Tim Geithner can understand them. Tier one capital around 15% or higher equity would make them safer and no need for fancy risk models, which are questionable when they should be definitive.   

    Also investment banks should be partnerships, with no public shares. This will reduce them and reduce their risk. What is needed is complete unwinding of the Big Bang in the UK and full restoration of Glass-Steagal in the US. The Europeans need to end the belief in universal banking. That might come soon as France gets dragged into the periphery by its big banks. The UK had no such banks until the 1980′s yet still dominated world banking for more than a century.  

    What actually stimulated policy in the thirties was fear of a communist uprising in the US. Without a stake in society the masses were liable to rise up and over throw them. That was the main driver of the New Deal and the creation of the housing bodies to give workers a stake. Unemployment payments are a way of a nation keeping stable. They need to be permanent and liveable. Neither of which applies to the US. Long term that undermines the stability of the nation. Without jobs and an income you have nothing to lose by revolting. Greece with no unemployment system is suffering because of that. Also cuts to them is a factor in the UK riots over the summer. Poverty was a big factor in the UK riots. Some of the reactions will lead to the UK becoming more ungovernable. Riots will return when the coalition try making further cuts to benefits and refusing to raise taxes on the rich. 

    Don’t forget that the deficit in the US was caused primarily by the cut in taxes under George Bush along with his unfunded wars. The low interest rate policy was responsible for the debt bubble. So interest rates need to rise to kill the bubbles and encourage savings again, and an increase in taxes to reduce the deficit would help.

    • But it’s not about what we would do but rather what they will do.

      • Anonymous says:

        In that respect absolutely nothing till they have to. US politics is very corrupt as is Japanese politics. Extend and pretend is a policy of sorts. The process of staying in office is all that matters. In the US the policy is to get through the Presidential elections, in the hope that the economy survives or implodes depending on the party. 

        Within Europe national interests will prevail and the Euro will ultimately break up, because of a lack of public support. National politics is about survival now, so could there be a change in policy to survive?

  4. Anonymous says:

    You wanted responses. Here is my take on the crisis. When I started following your blog it was the excess debt and how that was dealt with that attracted me. Yes the three solutions are:-

    The Japanese route, where by government runs a deficit till the economy has cleared its debt. It has maintained stability and worked because japan had the funds and savings to do it. That is not possible in the US or Europe. 

    The Swedish route where you refuse to bail out the banks and they collapse. The creation of good banks and bad banks restores moral hazard and allows the debts to be repaid and the cost to the nation to be minimised. This is not being done in the US or Europe because of political capture in the US and UK, and the fact that the big European banks are state owned. 

    Finally the original 1930′s US solution. Which is very austrian and Hayek, Minksy to start with to eliminate the debts rapidly and then Keynesian to rebuild the economy. This has elements of the Swedish system in that banks are wound up. This is my preference. 

    Once you have engineered that debt write down you need to plan for the rebuilding. A green economy will have numerous benefits for the US and Europe. It will lower the energy import bill, reducing the trade deficit again reducing the burden on the fiscal deficit. It will create lots of jobs rebuilding a new green economy and will be environmentally beneficial as well. Installing insulation is both labour intensive and beneficial. That will create jobs and reduce overheads for families. It will also be less liable to leakage overseas than say some other scheme. 

    I would also raise capital gains taxes to marginal income rates, eliminate housing subsidies for home buyers. Basically stop the bubble ever again. Wealth is accumulated from making things and providing services. Asset appreciation is not sustainable and policies should end that fantasy. 

    Once you have deflated the asset and credit bubbles, you need to build firewalls to stop them again. This could be capital controls so Germany cannot export its surplus to the periphery. Central banks should cap total domestic lending to stop such bubbles, and if necessary give business loans priority over households. This will stop new businesses being crowded out. They should also have savings targets, and these targets should not include homes and stocks. Then a policy of interest rate collars and caps to maintain savings rates so that the paradox of theft is no longer a problem. If individuals have adequate savings then they do not have to cut spending when things get tough. This creates a stability to the economy.  

    Fighting inflation should be the preserve of the government not central banks. Central banks should manage savings rates to avoid a paradox of thrift in future and financial stability. The lender of last resort should be very restrictive, and if required it should be paid for with dismissal of the entire board and disqualification from any company directorship for life. That will end the gravy train for directors who might set up a new company if allowed. If they have such moral hazard they might be more responsible.

    Capital rules should be simple. So simple that even someone like Tim Geithner can understand them. Tier one capital around 15% or higher equity would make them safer and no need for fancy risk models, which are questionable when they should be definitive.   

    Also investment banks should be partnerships, with no public shares. This will reduce them and reduce their risk. What is needed is complete unwinding of the Big Bang in the UK and full restoration of Glass-Steagal in the US. The Europeans need to end the belief in universal banking. That might come soon as France gets dragged into the periphery by its big banks. The UK had no such banks until the 1980′s yet still dominated world banking for more than a century.  

    What actually stimulated policy in the thirties was fear of a communist uprising in the US. Without a stake in society the masses were liable to rise up and over throw them. That was the main driver of the New Deal and the creation of the housing bodies to give workers a stake. Unemployment payments are a way of a nation keeping stable. They need to be permanent and liveable. Neither of which applies to the US. Long term that undermines the stability of the nation. Without jobs and an income you have nothing to lose by revolting. Greece with no unemployment system is suffering because of that. Also cuts to them is a factor in the UK riots over the summer. Poverty was a big factor in the UK riots. Some of the reactions will lead to the UK becoming more ungovernable. Riots will return when the coalition try making further cuts to benefits and refusing to raise taxes on the rich. 

    Don’t forget that the deficit in the US was caused primarily by the cut in taxes under George Bush along with his unfunded wars. The low interest rate policy was responsible for the debt bubble. So interest rates need to rise to kill the bubbles and encourage savings again, and an increase in taxes to reduce the deficit would help.

    • But it’s not about what we would do but rather what they will do.

      • Anonymous says:

        In that respect absolutely nothing till they have to. US politics is very corrupt as is Japanese politics. Extend and pretend is a policy of sorts. The process of staying in office is all that matters. In the US the policy is to get through the Presidential elections, in the hope that the economy survives or implodes depending on the party. 

        Within Europe national interests will prevail and the Euro will ultimately break up, because of a lack of public support. National politics is about survival now, so could there be a change in policy to survive?

  5. Brad says:

    I appreciate the artistic side of economics.  Global markets and politics have an uncanny ability to adapt and evolve.  Specific to the current US… the occupy movement, Tea Party, dead-lock created austerity, Republican fringe candidates (one in particular), etc… are today’s examples of tomorrow’s world.  Things adapt both individually and as a whole.  To dismiss these things as a mere blip is a mistake.  That aluminum can we are kicking changes slightly every time our foot taps it.    
    As a whole, society will systemically evolve as we continue to accept that past decisions have lead us to today, and today’s decisions will lead us to tomorrow.  Your opinions are on point, but backward thinking.  We must accept our past and move forward.  Do not underestimate the resilience of people, adaptability of markets, survival of the fittest and the general theory of evolution.  I would source examples, but it is late and I have other work to focus on. 
      

    • Anonymous says:

      “society will systemically evolve…”

      Society better hurry up with its evolving. Given an individual’s propensity to brush aside one’s better judgement in favor of groupthink and polarising ideology, the result is a society that is about as smart as a slime mold when it comes to avoiding disasters.

      “Do not underestimate the resilience of people, adaptability of markets,
      survival of the fittest and the general theory of evolution”

      There is a problem with arguments that apply the same principle (evolutionary theory) to vast differences of scale (cell, organism, herd, society) in that there is always an implication, or even an assumption that improvement applies naturally to all levels of abstraction. What improves the cell, improves the organism, improves society. Anyone familiar with the problem posed by the evolution of altruism knows how dangerous it is to rely on such assumptions. A mutation that improves a predators ability to hunt will quickly spread to the rest of the herd through selection pressure, yet this doesn’t guarantee against the eventual collapse of the herd as the improved hunting efficiency rapidly decimates the prey and results in a shortage of food. Successful multi-celled organisms outlive the cells of which they are constituted via a strategy that exploits survivorship bias –  continuous renewal by rapid cell replacement. The organism would hardly notice if both cell death and replication rates were to suddenly double. The fear is when a successful society deploys such a strategy against its own constituents. For instance, one guaranteed way to increase the average wage of the country is for the police to replace pepper spray with assault rifles in all subsequent encounters with unemployed Occupy movement participants.

      • Brad says:

        Expressing that a shift toward austerity will slow the economy is short sighted, unfair and obvious… 
         
        My point is that most debate today is backward thinking.  The mistakes leading to our current situation were made over many decades.  Casting blame on anyone working toward a solutions, in present time, is futile (regardless of the theory).  Truth is, no matter who takes office we will see slow growth.  What is unfortunate is that…  within 3 years many people will point fingers and say that we should have listened to the other guy. 
         
        I view todays situation on a spectrum that merely includes economics.  On a macro scale, the evolution of the United States is only one piece of a globally evolving system, and 3 years is a relatively short time frame. 
         
        I also feel that technological, medical, and environmental advances have expanded the human evolutionary process from the physical to the intellectual.   

  6. Brad says:

    I appreciate the artistic side of economics.  Global markets and politics have an uncanny ability to adapt and evolve.  Specific to the current US… the occupy movement, Tea Party, dead-lock created austerity, Republican fringe candidates (one in particular), etc… are today’s examples of tomorrow’s world.  Things adapt both individually and as a whole.  To dismiss these things as a mere blip is a mistake.  That aluminum can we are kicking changes slightly every time our foot taps it.    
    As a whole, society will systemically evolve as we continue to accept that past decisions have lead us to today, and today’s decisions will lead us to tomorrow.  Your opinions are on point, but backward thinking.  We must accept our past and move forward.  Do not underestimate the resilience of people, adaptability of markets, survival of the fittest and the general theory of evolution.  I would source examples, but it is late and I have other work to focus on. 
      

    • Anonymous says:

      “society will systemically evolve…”

      Society better hurry up with its evolving. Given an individual’s propensity to brush aside one’s better judgement in favor of groupthink and polarising ideology, the result is a society that is about as smart as a slime mold when it comes to avoiding disasters.

      “Do not underestimate the resilience of people, adaptability of markets,
      survival of the fittest and the general theory of evolution”

      There is a problem with arguments that apply the same principle (evolutionary theory) to vast differences of scale (cell, organism, herd, society) in that there is always an implication, or even an assumption that improvement applies naturally to all levels of abstraction. What improves the cell, improves the organism, improves society. Anyone familiar with the problem posed by the evolution of altruism knows how dangerous it is to rely on such assumptions. A mutation that improves a predators ability to hunt will quickly spread to the rest of the herd through selection pressure, yet this doesn’t guarantee against the eventual collapse of the herd as the improved hunting efficiency rapidly decimates the prey and results in a shortage of food. Successful multi-celled organisms outlive the cells of which they are constituted via a strategy that exploits survivorship bias –  continuous renewal by rapid cell replacement. The organism would hardly notice if both cell death and replication rates were to suddenly double. The fear is when a successful society deploys such a strategy against its own constituents. For instance, one guaranteed way to increase the average wage of the country is for the police to replace pepper spray with assault rifles in all subsequent encounters with unemployed Occupy movement participants.

      • Brad says:

        Expressing that a shift toward austerity will slow the economy is short sighted, unfair and obvious… 
         
        My point is that most debate today is backward thinking.  The mistakes leading to our current situation were made over many decades.  Casting blame on anyone working toward a solutions, in present time, is futile (regardless of the theory).  Truth is, no matter who takes office we will see slow growth.  What is unfortunate is that…  within 3 years many people will point fingers and say that we should have listened to the other guy. 
         
        I view todays situation on a spectrum that merely includes economics.  On a macro scale, the evolution of the United States is only one piece of a globally evolving system, and 3 years is a relatively short time frame. 
         
        I also feel that technological, medical, and environmental advances have expanded the human evolutionary process from the physical to the intellectual.   

  7. Johan says:

    Where do you see gold going in this timespan?

    • Brad says:

      I sold real estate for gold and asian stock 5 years ago.  Things can change, but I am now considering the correct non-western currency and us bonds.  5 years from now, I will likely move back into real estate.

  8. Johan says:

    Where do you see gold going in this timespan?

    • Brad says:

      I sold real estate for gold and asian stock 5 years ago.  Things can change, but I am now considering the correct non-western currency and us bonds.  5 years from now, I will likely move back into real estate.

  9. cswake says:

    “I recognise that the deflationary route leads to chaos and military confrontation”

    Wouldn’t be fair to say the inflationary / stimulus route will also inevitably lead to social unrest and chaos as the special interests disproportionately direct funds to the privileged?

    • That’s a fair comment. For example, if you get a 5% deflation, you usually see unemployment and/or wage deflation too and that leads to debt distress and social unrest. With inflation 5%, wages don’t adjust and so you get debt distress and social unrest again. 

      I just don’t see the spiral upwards for inflation because the debt makes this a deflationary cycle. Some people talk about inflation/hyperinflation. I don’t see it because any inflation in this environment creates demand destruction as wages don’t move in concert. On the other hand I do see the spiral downward via asset prices and defaults in the case of deflation.

  10. cswake says:

    “I recognise that the deflationary route leads to chaos and military confrontation”

    Wouldn’t be fair to say the inflationary / stimulus route will also inevitably lead to social unrest and chaos as the special interests disproportionately direct funds to the privileged?

    • That’s a fair comment. For example, if you get a 5% deflation, you usually see unemployment and/or wage deflation too and that leads to debt distress and social unrest. With inflation 5%, wages don’t adjust and so you get debt distress and social unrest again. 

      I just don’t see the spiral upwards for inflation because the debt makes this a deflationary cycle. Some people talk about inflation/hyperinflation. I don’t see it because any inflation in this environment creates demand destruction as wages don’t move in concert. On the other hand I do see the spiral downward via asset prices and defaults in the case of deflation.

    • That’s a fair comment. For example, if you get a 5% deflation, you usually see unemployment and/or wage deflation too and that leads to debt distress and social unrest. With inflation 5%, wages don’t adjust and so you get debt distress and social unrest again. 

      I just don’t see the spiral upwards for inflation because the debt makes this a deflationary cycle. Some people talk about inflation/hyperinflation. I don’t see it because any inflation in this environment creates demand destruction as wages don’t move in concert. On the other hand I do see the spiral downward via asset prices and defaults in the case of deflation.

  11. Anonymous says:

    Edward,

    For the most part, I fully agree with your forecast. You’ve been dead-on accurate so far, and there is little I can question in your forecast in how this plays out…with one exception.

    I do question the “helicopter drop” of money thesis. I read the article you linked to, and found this quote in it:

     >>>  The bigger inflation event (QE3?) would use newly created base money for
    the immediate benefit of debtors. Sending checks to indebted homeowners
    made out to their creditors would be an example of quantitative easing
    that would be popular among the masses and economically stimulative. It
    would allow a new credit bubble to expand and prices of goods, services
    and assets to increase. We think this form of QE — broad debt
    socialization – is inevitable. It would require coordination among
    central banks and fiscal policy makers, which would demand a general
    acknowledgement that nothing else would work. (This would not be a
    de-leveraging event, but a transfer of debt from private to public
    balance sheets.) Frankly, we do not see this materializing yet. <<<

    First off, we've already had a very large broad private debt socialization – and clearly, it hasn't worked. Secondly, even if the Federal Government and the Federal Reserve could find the political will [ a VERY BIG "IF"] to create some scheme to directly pay off private debts of homeowners, credit card debt, student loans, etc…I see little possibility of it igniting some new "credit bubble" as the author states. Debt revulsion has clearly started, and even if you wipe clean the balance sheets of individuals/corporations there is no guarantee that banks will want to lend and, more importantly, that qualified people will want to borrow.

    I also see virtually no possibility of that type of scheme happening politically. It would be deemed a bailout, no matter how it is presented. As you've mentioned many times, bailout fatigue has clearly set in. The odds of seeing another big stimulus like in 2008 are very low to begin with. The odds of having the government decide to "pay the bills" of individuals – an amount measured in trillions of dollars – would be far, far lower. Like zero, in my opinion.

    Finally, I disagree that Congress will suddenly decide that the "deficit doesn't matter" and send money to individuals to be used to pay off debts. While Congress clearly could care less about the deficit as it stands now….reigning in the existing deficit is a totally different matter than expanding it with new programs that are deemed bailouts. In the future, I see a government that has no hope of tackling the existing deficit (or even enacting common sense legislation due to hyper-partisanship), but also a government that will also be unable to expand the deficit through grand new programs or bailouts.

    I guess my forecast follows yours closely except that I don't see some sort of "inflationary event" initiated by the government…aka, helicopter drops of money. We may – and probably will have – at some point a currency crisis that causes the USD to plummet, resulting in much higher prices of imports. And undoubtedly the Federal Reserve will at some point launch a repeat of QE2, which will be just as ineffective as QE3 was in terms of solving the economic problems. But QE3 and a currency crisis is a far different situation than turning on the printing press, sending money directly to individuals, and starting a massive bailout.

    Instead, I see what's happening today essentially continuing until, quite frankly, the interests of the government (and the elites who have captured it) and the financial industry diverge. Once that happens, which won't occur for many years, we'll likely see the mother of all Depressions as the bad debts are finally forced to be written off, the financial industry is radically restructured in ways still unknown, and the economy is allowed to essentially reset. It is during this time that I think you could see the printing press turned on (due to interest payments on the debt taking up so much of government spending), as the government starts to spend money on social welfare programs.

    I also don't see this all playing out in just a few years. Yes, we'll be in a recession in 2012 or 2013. But just like after 2008, we'll emerge from it, have weak growth, then go back into another recession a few years later. In my opinion, the next recession will NOT really change anything except increase the debt, the deficit, polarization, nationalism and the partisanship seen in the government.

    The USA, despite all its problems, is still the 700 pound gorilla. It has a huge and diversified economy, and can incur much more damage than smaller countries (its reserve currency status helps, too!). And as Japan has clearly demonstrated, some governments can continue to borrow for very long periods of time – far beyond the point at which it seems rational. The USA will be able to limp along for many years before it is forced to come to terms with the governmental and private debt. And when it does, I believe it will be through massive writedowns – likely helped along by laws that allow debts to be more easily written down.

    PS – I don't know enough about Europe to make a rational forecast, hence my focus on the USA. But if I had to take a guess about where Europe is going, it would be as you suggest – a complete splintering of the European Union. As your post about how Italy could leave the Euro demonstrated, once one country leaves – many more are going to pile in to the same boat – putting ever-more pressure on the remaining Euro countries. Eventually, some European country is going to determine that the very high "cost to leave" the Euro is less painful than remaining in it. And when that happens, well…there goes the Euro.

    • I don’t think we disagree here. I wrote:

      “And you can forget about Skidelsky’s ideas of renewed coordinated policy stimulus a la April 2009 fake recovery mode as a response. The helicopter drop of which Skidelsky speaks is probably how this eventually gets resolved. Brodsky and Quantaince talked about just such a plan to stabilize the global monetary system last year. I don’t see any of this happening before we try the deflationary route first.”

      If you read that closely you will see I am saying we will not stimulate. We will go with austerity and debt deflation and only when things have fallen apart will they run try the helicopter drop. It will be a long time before we get to that stage.

      • Anonymous says:

        Edward,

        One question then…do you actually think the “helicopter drop” will actually solve anything? You mentioned above this line:

        >> The helicopter drop of which Skidelsky speaks is probably how this eventually gets resolved.

        I guess that is something I’m having a hard time understanding – how can a helicopter drop of money actually solve anything. The debts in the USA and Europe are just so massive that it seems to me it would take far, far more than a mere helicopter drop to pay them back. You have trillions of dollars of underwater mortgages in the US (and presumably elsewhere, too), tens of trillions in unfunded liabilities, and corporate balance sheets that are stuffed with debt. And god knows what on bank balance sheets. To me, it seems a one or two trillion dollar helicopter drop direct to individuals might “cushion the fall” a bit, but I can’t see it actually solving any problem.

        PS – Sorry to have made you read through my last rambling post!

  12. Anonymous says:

    Edward,

    For the most part, I fully agree with your forecast. You’ve been dead-on accurate so far, and there is little I can question in your forecast in how this plays out…with one exception.

    I do question the “helicopter drop” of money thesis. I read the article you linked to, and found this quote in it:

     >>>  The bigger inflation event (QE3?) would use newly created base money for
    the immediate benefit of debtors. Sending checks to indebted homeowners
    made out to their creditors would be an example of quantitative easing
    that would be popular among the masses and economically stimulative. It
    would allow a new credit bubble to expand and prices of goods, services
    and assets to increase. We think this form of QE — broad debt
    socialization – is inevitable. It would require coordination among
    central banks and fiscal policy makers, which would demand a general
    acknowledgement that nothing else would work. (This would not be a
    de-leveraging event, but a transfer of debt from private to public
    balance sheets.) Frankly, we do not see this materializing yet. <<<

    First off, we've already had a very large broad private debt socialization – and clearly, it hasn't worked. Secondly, even if the Federal Government and the Federal Reserve could find the political will [ a VERY BIG "IF"] to create some scheme to directly pay off private debts of homeowners, credit card debt, student loans, etc…I see little possibility of it igniting some new "credit bubble" as the author states. Debt revulsion has clearly started, and even if you wipe clean the balance sheets of individuals/corporations there is no guarantee that banks will want to lend and, more importantly, that qualified people will want to borrow.

    I also see virtually no possibility of that type of scheme happening politically. It would be deemed a bailout, no matter how it is presented. As you've mentioned many times, bailout fatigue has clearly set in. The odds of seeing another big stimulus like in 2008 are very low to begin with. The odds of having the government decide to "pay the bills" of individuals – an amount measured in trillions of dollars – would be far, far lower. Like zero, in my opinion.

    Finally, I disagree that Congress will suddenly decide that the "deficit doesn't matter" and send money to individuals to be used to pay off debts. While Congress clearly could care less about the deficit as it stands now….reigning in the existing deficit is a totally different matter than expanding it with new programs that are deemed bailouts. In the future, I see a government that has no hope of tackling the existing deficit (or even enacting common sense legislation due to hyper-partisanship), but also a government that will also be unable to expand the deficit through grand new programs or bailouts.

    I guess my forecast follows yours closely except that I don't see some sort of "inflationary event" initiated by the government…aka, helicopter drops of money. We may – and probably will have – at some point a currency crisis that causes the USD to plummet, resulting in much higher prices of imports. And undoubtedly the Federal Reserve will at some point launch a repeat of QE2, which will be just as ineffective as QE3 was in terms of solving the economic problems. But QE3 and a currency crisis is a far different situation than turning on the printing press, sending money directly to individuals, and starting a massive bailout.

    Instead, I see what's happening today essentially continuing until, quite frankly, the interests of the government (and the elites who have captured it) and the financial industry diverge. Once that happens, which won't occur for many years, we'll likely see the mother of all Depressions as the bad debts are finally forced to be written off, the financial industry is radically restructured in ways still unknown, and the economy is allowed to essentially reset. It is during this time that I think you could see the printing press turned on (due to interest payments on the debt taking up so much of government spending), as the government starts to spend money on social welfare programs.

    I also don't see this all playing out in just a few years. Yes, we'll be in a recession in 2012 or 2013. But just like after 2008, we'll emerge from it, have weak growth, then go back into another recession a few years later. In my opinion, the next recession will NOT really change anything except increase the debt, the deficit, polarization, nationalism and the partisanship seen in the government.

    The USA, despite all its problems, is still the 700 pound gorilla. It has a huge and diversified economy, and can incur much more damage than smaller countries (its reserve currency status helps, too!). And as Japan has clearly demonstrated, some governments can continue to borrow for very long periods of time – far beyond the point at which it seems rational. The USA will be able to limp along for many years before it is forced to come to terms with the governmental and private debt. And when it does, I believe it will be through massive writedowns – likely helped along by laws that allow debts to be more easily written down.

    • I don’t think we disagree here. I wrote:

      “And you can forget about Skidelsky’s ideas of renewed coordinated policy stimulus a la April 2009 fake recovery mode as a response. The helicopter drop of which Skidelsky speaks is probably how this eventually gets resolved. Brodsky and Quantaince talked about just such a plan to stabilize the global monetary system last year. I don’t see any of this happening before we try the deflationary route first.”

      If you read that closely you will see I am saying we will not stimulate. We will go with austerity and debt deflation and only when things have fallen apart will they run try the helicopter drop. It will be a long time before we get to that stage.

      • Anonymous says:

        Edward,

        One question then…do you actually think the “helicopter drop” will actually solve anything? You mentioned above this line:

        >> The helicopter drop of which Skidelsky speaks is probably how this eventually gets resolved.

        I guess that is something I’m having a hard time understanding – how can a helicopter drop of money actually solve anything. The debts in the USA and Europe are just so massive that it seems to me it would take far, far more than a mere helicopter drop to pay them back. You have trillions of dollars of underwater mortgages in the US (and presumably elsewhere, too), tens of trillions in unfunded liabilities, and corporate balance sheets that are stuffed with debt. And god knows what on bank balance sheets. To me, it seems a one or two trillion dollar helicopter drop direct to individuals might “cushion the fall” a bit, but I can’t see it actually solving any problem.

        PS – Sorry to have made you read through my last rambling post!

    • I don’t think we disagree here. I wrote:

      “And you can forget about Skidelsky’s ideas of renewed coordinated policy stimulus a la April 2009 fake recovery mode as a response. The helicopter drop of which Skidelsky speaks is probably how this eventually gets resolved. Brodsky and Quantaince talked about just such a plan to stabilize the global monetary system last year. I don’t see any of this happening before we try the deflationary route first.”

      If you read that closely you will see I am saying we will not stimulate. We will go with austerity and debt deflation and only when things have fallen apart will they run try the helicopter drop. It will be a long time before we get to that stage.