Wednesday 16 June 2004

Pic of the day: Untergang des Abendlandes? No, the picture is not from the real news, but from the online game City of Heroes, which was designed, at least roughly, before 9/11. This doom and gloom picture is from Boomtown, one of the city zones destroyed by the Rikti invasion and not yet rebuilt. I don't think the current US economic policy will be quite that devastating, but it's not super either.

World economy update

I know you look to me for the latest news about the world economy, before they happen! Actually, it is pure logic, no divination or prophecy. For all I know, the world we know may be gone tomorrow. But we cannot plan for that. We can plan for well known economic factors such as inflation, currency balance and international trade. These things are complex but not mysterious. It is like the weather: You cannot predict it in detail, but you can get a good idea if you get an overview. There are no satellite photos of the world economy, but you can still piece together enough information easily with the Web or reliable magazines and newspapers.

I haven't written much on this topic lately, but that is because nothing has changed. Things go according to plan. Last time I wrote, I conceded that I had under-estimated the Bush administration in its willingness to borrow against the future to cover up the current economic downturn. This is still the most prominent feature of the world economy. The USA is still the buyer of last resort, to which others can export if they are willing to give credit. More and more credit, ever more credit. This is great fun as long as no one doubts the willingness of USA to pay its bills eventually. But the day the first doubt comes ... Light help us all.

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The dollar is overvalued right now. It needs to slide a lot more. The reason why it keeps up is probably in part old habit. Another part is the growth in American economy; even employment is picking up. Bush may still be presiding over the largest loss of jobs since the Great Depression, but this may not hold true at the end of the year. It looks like it will be a true double-dip after all, not just a blip on the falling scale as I first thought.

A third reason for the dollar to stay afloat is the expectation of higher interest rates. This really follows from point two, the growth. If the economy moves toward the point where capacity is fully used, inflation will take hold. To avoid this, interest rates must be so high that people don't start new projects unless they are sure to be profitable. That's a lot higher than now. Right now, real interest rates (interest after tax and inflation) are negative. That means you can actually waste money and get away with it, as long as you don't waste too much. With positive real interest rates you need to earn money to pay the interest, and you must think before you invest. This is the normal state of things. The situation now is not at all normal. So investors expect rates to go up. Not just once, but repeatedly.

Alan Greenspan, Chairman of the Federal Reserve, seems to be in no hurry. Yeah, he says, we'll raise the signal interest rate a little bit eventually, but inflation isn't really the problem. Not all economists agree with this. In fact, the highly reliable and well informed magazine The Economist expresses worry that Greenspan may be too relaxed. Inflation, once it takes hold, is a self-fulfilling expectation of ever higher prices. It has turned out to be hard to contain in the past.

I agree that inflation is sure to pick up in the USA. I think, however, that this is not the worst that can happen. Also, I believe that inflation there will not come from a pressure on wages due to labor shortage. Inflation will come from imports.

***

Here is the scenario I expect. The Fed will only slowly raise interest rates. As a result, the dollar will once again start to slide. After all, the interest rates in a country makes a big difference in whether you want to buy bonds or put your money in their banks ... the lower the interest rates, the less likely you are to place financial assets there. So there won't be much pressure to buy American dollars, and the currency will slide. This will make it easier to export from the USA, but it will also make imports more expensive, and this cost will pressure the inflation upward a bit. However, this is going to keep the economy growing. It will be harder for the rest of the world, which will no longer find it so easy to export to the USA. But this is a transition that is needed. The world needs to learn to find other markets, because in the long run America can't just buy much more than it sells. That should really go without saying, but many people don't think at the big picture, just their own little business.

Now let us take a look at the alternate scenario, in which interest rates rise sharply. There are two direct effects of this, one for businesses and one for private economies. In both cases, they will be less likely to borrow money. Now remember that private borrowing has been unusually high for many years. During the "long boom" in the Clinton era, people borrowed and spent like they tend to do during a boom. But then when the dotcom bubble burst, people continued to spend during the slowdown. This was a major reason why we only got a soft landing rather than an actual Great Depression which would most likely have spread to the rest of the world, so I am not really complaining. By then it was really too late to step on the brakes, that should have been done before. So people kept borrowing and spending, borrowing and spending. They still do. The average American has quite a bit of debt by now. If interest rates go up, that debt could soon become unpleasant, making most people feel poorer. Not just feel ... they would actually have less money left to shop for.

Now much of the private borrowing in the USA is mortgage on homes, and this does not change at once when interest rates rise. But on the other hand, mortgage is taken out for a long time, so interest rates are a really big part of it. For every little bit the rates rise, you get much less money out to buy a home for. So even a moderate rise in interests would really cool down the private property market. This would again pressure down the value of existing homes, making their book value less and making it harder to use them as security for consumer loans. So you would still get a pretty strong downward pressure on consumption.

At the same time as customers start buying less, corporations would find it harder to borrow for new investment, and so they would hesitate to employ more people. Now things start to add up. People have less money, and they feel poorer because their homes are less worth, and they have a hard time finding a job. I think a moderate inflation is not so bad in comparison.

Of course, if the economy really picks up speed, it could be far from moderate. If all the employable people are employed, inflation would run amok for sure. But i really don't see that happening. The dollar is still overvalued, and will likely remain so for a long time. Some currencies, such as China's, are pegged to the dollar so it cannot slide compared to them. As the country slowly sinks down in debt, it will take more than optimism to get it back up to speed. The years when the USA saved the world economy may be drawing to a close.

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"Die Untergang des Abendlandes" (the sinking/destruction of the evening country) or officially translated as The Decline Of The West, is a book by Oswald Spengler. It sets forth the reasonable theory that all cultures have a finite lifespan, and concludes that the western culture is doomed really soon. It may charitably be called "depressing and obtuse". Oh, and it was published in 1918-1922.