Tuesday, June 23, 2009

Depression Myths

There are a lot of myths about the Great Depression. Most people who know anything about economic history know that FDR's New Deal was a colossal failure (too bad these people are not part of the Obama administration).

In the simplest terms, if the New Deal was at all successful, then why did unemployment stay about 14% for FDR's entire term prior to WWII? That's 8 years! EIGHT YEARS! You would generally think if the New Deal was at all successful we'd see some economic growth prior to WWII, but we didn't. It wasn't until after global warfare had subsided that we started to grow again, and it was largely because the New Deal was dismantled after the war.

Anyway, it's not hard to see how the New Deal was a failure. What is harder to see is when the government did something good. Generally, when government does something right, especially something to avert a disaster, no one notices. For example, if the government prevented nuclear war from occuring and nothing happened, no one would notice because nothing happened.

A big 'nothing happened' during the Harding administration in the early 20's. The Panic of 1920 had the potential to launch the US into a depression a decade earlier.

Check out this very good article about Harding and the Panic of 1920. GDP plunged 24% in a year, and the unemployment rate more than doubled. But we got out of it because the government drastically slashed taxes and let the private sector rebound.

It amazes me how historians paint the picture of the 20's as some sort of disaster waiting to happen. It was a period of immense economic growth. Most periods of growth eventually result in overleveraging and a recession. The question though is how society deals with it. By adopting big government, anti-business approach, a correction can quickly turn into a Depression.

Wednesday, June 17, 2009

Short Term Pain Is Better Than Long Term Bust

The best way out of an economic crisis and national debt is long-lasting economic growth. With more economic growth, tax revenues increase since people are making more money. Demands for government entitlements go down, so government spending goes down. The combination of higher tax revenues (without even necessitating higher rates) and less expenses allows the deficit to contract.

Also, since GDP is growing, the debt/GDP is less, so bond investors have less to worry about in terms of interest payments.

The Obama administration seems to cavalierly assume we will have roaring economic growth in 2010 and 2011, so roaring, that the government can also raise taxes on businesses and we will still have 3% growth.


Never before has increased taxes, more government beaurocracies, and increased governmental regulation produced economic growth. The best we can hope for is European-style growth of 0-2% a year. I may add that if our economy is modeled after a Western European social welfare state, our average GDP per capita still has about 20-25% to drop, meaning some sort of lasting recession or weakened dollar.

If Obama's economic prescription is our future, we have to expect this sort of scenario. The administration's proposals and economic ideas have been tried before and we see the results in Japan and Western Europe. We will ultimately end up in the same place.

The thing is....how do we get there? If it's a slow bleed, as it has been over 2009, it will happen. Our economy will be meager for the forseeable future, but nothing downright terrible. We can expect the S&P 500 to not reach 1500 again until 2020. We can expect a lower quality of life for all, at least compared to what we could have been.

However, if it is violent change downwards, then the public will likely wake up and rally against these changes. Furthremore, if the way we get there is through inflation, which effectively will wipe away a lot of the government debt, it will give us a cleaner state with which to start.

By having 10% inflation or so for a few years, not CPI inflation mind you but including energy/food, people will begin to see the effects of these policies quicker. I believe this sort of inflation would occur through a weakened dollar, so wages would remain static for most, services would cost about the same, but costs for commodity items, like food and oil, would rocket higher. We will all be a bit poorer, but at least we will see what is happening.

The public will rally against the big government spending and will demand massive decreases in government beaucracy. This will pave the way for tax cuts and more economic growth in the future.

In short, if the pain is slow, it will continue. If it is swift, then the public will rally against the failed policies, and we do indeed have hope for remaining the economic powerhouse of the world.

Saturday, June 13, 2009

Don't Bet On A Soft Landing Into The New Normal

With the recent financial crisis, Mohammad El Erian of Pimco has predicted a 'new normal,' categorized by 1-2% economic growth (instead of close to 3%), tightened lending, and more government.

The basis of these predictions are fairly sound. With increased government and taxes, we can expect rates of growth similar to those in Europe and Japan, which are about 1%. This is because the government is more inefficient than the private sector, and more resources are devoted to the government than to businesses.

I agree with a lot of this analysis, but I think the economic and political situation will be more volatile than this. If our politicians really wish for our economy to mimic a Western European social state, then the average standard of living still has about 25-30% to drop off. This would match the average GDP per capita of most Western European states. When you count in the fact that our country is burdened with a drug war, large military, and more debt, you may expect even worse...though our country's labor system is much more flexible than those countries (and will be even if bills like Card Check pass).

With all that is going on, I do not see us soft landing into this new normal, just like we didn't soft land into the recession. What will be the switch that causes a massive drop, similar to how Lehman Brothers's collapse sparked the fall meltdown, is not clear. It may be the actual tax increases going through, but I remain skeptical this will even occur.

More likely, I believe it will be some sort of inflation, since this is a hidden tax that cannot be controlled. What I see from Obama and the Democrats is a steadfast optimism and blindness to the budget deficit. They always expect far more taxes to be raised from tax increases, far less spending to be done, far more economic growth than is possible, and far more efficiencies resulting from legislation than could happen. The combination results in these highly optimistic budget projections that only a fool would trust.

Thus, I believe we will run deficits far exceeding what the administration expects. At some point, bondholders will get worried and demand higher rates. The explosion in interests rates may cause another economic downturn, or the Fed may step in and print money resulting in inflation. Either way, I don't think we will crash due to higher taxes. The deficit may be the trigger, but it will be the effects of it, eitehr high interests rates or inflation, that will be the ultimate weapon of calamity.