Wednesday, June 20, 2007

Coming Home to Roost

The Washington Post featured two recent columns by economic writers Steven Pearlstein and Robert Samuelson , and much like writers for the Economist, Wall Street Journal and Bloomberg, both warned of the growing likelihood of a severe downturn in the economy as a consequence of our decades-long splurge of easy credit and growing debt burden. Samuelson notes that we are likely "to discover that the long period of cheap credit has left a nasty residue." Pearlstein speaks of the distinction between the current era of cheap credit and "normal times," and predicts that "sanity will be restored" - though it won't be a pleasant return to normalcy.

Here's a scary part of the column by Pearlstein:

"It is impossible to predict when the magic moment will be reached and everyone finally realizes that the prices being paid for these companies, and the debt taken on to support the acquisitions, are unsustainable. When that happens, it won't be pretty. Across the board, stock prices and company valuations will fall. Banks will announce painful write-offs, some hedge funds will close their doors, and private-equity funds will report disappointing returns. Some companies will be forced into bankruptcy or restructuring.

"But the damage won't be limited to Wall Street and its investors. For if we've learned one thing in the past 20 years, it is that what happens on financial markets, in booms and in busts, can have a big impact on the rest of the economy.

"Without the billions of dollars flowing each year to financiers and corporate executives, there will be less money to trickle down to car salesmen, yacht makers, real estate agents, third-home builders and busboys at luxury resorts.

"Falling stock prices will cause companies to reduce their hiring and capital spending while governments will be forced to raise taxes or reduce services, as revenue from capital gains taxes declines.

"And the combination of reduced wealth and higher interest rates will finally cause consumers to pull back on their debt-financed consumption.

"It happened after the junk-bond and savings-and-loan collapses of the late 1980s. It happened after the tech and telecom bust of the late '90s. And it will happen this time.

"The recent decline in home prices and the meltdown in the market for subprime mortgages are the first signs that the air is coming out of the credit bubble. Already, those factors have shaved half a percentage point off the economic growth rate. And you can be sure that there will be a much larger impact on jobs and incomes from a broad decline in stock and bond prices, a sharp tightening of credit and the turmoil that both of those will create in the murky derivatives markets."

When "sanity" returns, it's not clear that we will have many options other than some serious belt-tightening and lots of unpleasantries, like foreclosures, bankruptcies, deprivation and unemployment. It's becoming clear that the economy is beginning to enter a period that economists tell us isn't supposed to happen, namely that economic condition that we experienced during our first national experience with Peak Oil - "stagflation." Even as prices of basic commodities - above all oil and food - are inexorably increasing, our economic system is poised to enter a period of recession if not depression-like conditions. Unlike past instances, it's unlikely that the Fed will be able to bail us out: unlike the market crash of 1987 or the crash of 2000, cheap credit is not really an option given the worries over inflation - inflation that will not go away in times of shrinking worldwide energy supplies. The Fed also cannot realistically lower interest rates, since the risk of further sell-off of U.S. bonds by foreign holders would only increase. And, unlike the 1970s, the Saudis won't bail us out by pumping more oil - growing evidence suggests they can't. Like our first encounter with stagflation, the experience will be very unpleasant indeed, one without an end in sight, and one that not many people of this generation are prepared to experience.


Defensor Pacis said...

Just found your blog. I can see again why Calvin is your favorite Protestant thinker.

Patrick Deneen said...

Calvin wasn't afraid of that great word, "depravity." It's a grand word we should re-acquaint ourselves with...