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Muddling Through Malaise   (December 7, 2007)

Astute reader Jeff neatly summarized the important "inflation/deflation" question we are all pondering: do we get hyperinflation as the Powers That Be labor to reinflate speculative bubbles, or are we facing Japan-style deflation?

I was wondering if you could write about what you think the government will do to make it seem like everything is just fine to the masses. I have read they will create hyperinflation by printing and devaluing the dollar down to 40. I find it hard to believe that Paulson and the Fed would go to that extreme as they would be looked upon in history as the guys who destroyed the dollar. I have also read that deflation is what is going to happen no matter what they try to do. I can see the housing deflation already which I think needs to happen. I just hope they don't make things so much worse that it is already. Its so hard to figure how what to do with any saving. Thank you very much for your time and great blog.
The only way I know to address such enormously complex topics is to start with what we know or can readily surmise.

1. Politicians are bound to try to "fix" or "resolve" any financial crisis. Though politicians are required to praise "the market economy" in front of microphones, as soon as their contributors and/or constituents are screaming they drop that pretext and rally round a mandated or government-funded "fix."

To do nothing simply isn't acceptable in "Can Do" America, even when the last thing the "patient" (the U.S. financial system) needs is more meds and operations. Just as in our dysfuntional medical system, the "caregivers" (politicians) are under extreme pressure to "do something."

Will you ever hear a doctor in America say, "Folks, I am sorry to say that your family member is dying, basically of old age, though we call it 'multiple organ failure.' We're going to keep him/her comfortable but beyond that, anything we do will only waste time and money and very likely increase the suffering of your loved one."

In a similar way, you will never hear a politician say, "Folks, lending and speculation got completely out of hand, and several million irresponsible borrowers and a large number of speculative investors and lenders will have to go bankrupt and start over. Any attempt to make the problem go away with phony fixes will only make it worse."

This is why I anticipate a decade or more of Malaise with a capital M: a long, fruitless period in which the nation muddles through. "Fixes" are proposed and enacted, but since they aren't acting on the root causes, they will do nothing but spackle over the rot to make things look presentable for the next election cycle.

2. Non-U.S. players have the same game plan as U.S. politicos: keep the ailing giant healthy enough to use his credit card to import oil, goods, etc. As I have written here recently (Self-Interest in an Interconnected World 11/29/07), central banks and other non-U.S. players know their own prosperity is dependent to some degree on healthy U.S. demand for their goods and commodities.

I know, I know--China and India are the New Big Players and they can now "decouple" from the U.S. Perhaps--but please take a look at this chart of global oil consumption by nation. Petroleum use is as good a proxy for economic and financial activity as any, and as you will note, the U.S. market (as a consumer of other nations' exportable goods) is significantly larger by this (or any other) measure than China and India put together:

oil consumption by nation
U.S. 20.5 million barrels a day (MBD)
China: 6.7 MBD + India 5.5 MBD = 12.2 MBD

As a footnote, the U.S. military uses as much oil as an entire country (Greece). (Note that capital U.S. Navy ships like submarines and aircraft carriers are nuclear-powered and don't burn oil.) US military oil consumption

In other words, non-U.S. governments such as the Gulf oil states and Asian exporters know full well they need the U.S. as a robust market for their own goals of robust prosperity to be met. They will weigh in as needed--but mostly without blaring PR--to pursue their own self-interest, which may require actions like propping up the dollar, etc.

3. The foundation of the inflation/deflation question is supply and demand. In terms of the dollar, or any currency, if there's no demand for the buck the price drops. If there is more demand than supply, the value rises.

The basic argument runs thusly: the U.S. Treasury, Fed and U.S. money-center banks can create stupendous sums of new dollars which then overwhelm demand. This is what has caused the dollar's decline against other currencies and against gold--a massive imbalance between supply of dollars (ever-growing) and demand (weakening as holders get tired of declining value).

But there are other forces potentially at work in currencies, forces touched upon here in The Economist Cover Dollar Indicator (12/3/07). If economic conditions deteriorate in Europe or Asia, for whatever reasons, then the dollar might actually gain favor as a relative "safe haven."

Just as "hot money" has flowed to China to reap the gains of the yuan strengthening, a nasty outbreak of Avian Flu in China (for instance) might reverse that trend as traders lock in their gains and exit to "safe haven" currencies.

In other words, for reasons beyond the Fed or Treasury's control, demand for dollars could conceivably exceed supply and the "price" would rise. This possibility is currently discounted to near-zero, but we should recall the old adage that when the U.S. sneezes, the rest of the world catches cold.

Currencies are relative to each other, but all currencies have declined against gold in the past seven years. In a world flooded with new paper money, paper money buys less "real world" goods. One way to see this is to look the U.S. stock market priced relative to gold (DJI/gold ratio, courtesy of Harun I.):

Here is the dollar/oil ratio, again courtesy of Harun I.:

Bottom line: priced in gold or oil, all major currencies have declined in value. Thus the question might be: what might retain its value against all currencies? For many people, the obvious answer is gold or other precious metals.

As for currency valuations, we should note that some $3 trillion trade on the forex (foreign exchange markets) every day. No government agency can control the global currency market for long, and so we have to be alert to forces beyond the U.S. Treasury and the Fed. For context, here is a chart of the trade-weighted dollar 1970-2007:

4. How much of U.S. demand for housing, goods and even oil is based on low-cost/easy borrowing? How much demand is there for more debt? As lenders tighten standards and shun risk, we have to question how much the Fed dropping the Fed Funds Rate will do to boost borrowing and consumption. We also have to ask how much demand there is for more debt.

Asking about the supply and demand illuminates all questions. If the supply of money available for lending shrinks (due to fear/risk avoidance), then the cost of borrowing will rise regardless of the Fed Funds Rate. If demand for new debt drops as people decide to start saving and reduce debt, then "new money" will go begging no matter how low the "teaser rate" may be.

If demand and supply both contract, then there will certainly be less spending/consumption. If the supply of goods exceeds demand, the price of the goods will fall.

We all tend to want a global answer to big questions, but in such an interconnected world, the answers are necessarily tentative and contingent. What essentials are in short supply, and can not be increased or replaced with substitutes? You might answer oil, and you would be largely correct--it's increasingly difficult to expand oil supply, and substitutes are still a small part of global energy.

But my answer would be: fertile soil and fresh water. What if the demand for fresh water and agricultural goods exceeds the supply? Then the price could rise dramatically, even as the oversupply of houses, computers, iPods, BBQ grills, etc. cause prices of those goods to plummet. Courtesy of frequent contributor Harun I., here is a chart of wheat:

What might retain its value against all currencies? perhaps we should include soil and fresh water along with gold and precious metals. How much can any government do to increase supply of arable soil and fresh water? How much is beyond any government control?

Governments must attempt to "fix" supply and demand imbalances, but the levers in their control are few in number. They can certainly effect markets, but only for short periods of time and only at the edges. Or so these charts suggest. That is why I anticipate the best that any government will manage in the coming years is "muddling through malaise."

Thank you, Alberto R., ($20), for your generous contribution to this humble site and for your inspiring words. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

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