The Perfect Economic Storm

[marmar]

from The American Prospect:


The Perfect Economic Storm

The speculative binge in hedge funds, private equity, derivatives, and subprime mortgages is pushing the larger economy into a general downward spiral.

Robert Kuttner | July 31, 2007 | web only



Historically, October has been the month for big financial busts. But this year, October could come early.

Investors and ordinary citizens have good reason to worry about a perfect economic storm -- a deepening loss of confidence in the dollar, leading to higher interest rates; higher rates and anxious creditors bringing a crashing end to a hedge-fund, private equity and merger binge that depended heavily on cheap borrowed money and that kept the stock market pumped up; the boom in "sub-prime" bait-and-switch mortgages ending in a morning-after of sinking housing values; inflationary pressures in food, oil, and other commodities further spiking interest rates -- all unsettling financial markets, and putting a new squeeze on consumers borrowed to the hilt.

The historical parallels aren't comforting. In the years 1971-73, the United States devalued the dollar and went off the gold standard. Oil exporting countries, compensating for a weaker dollar and angry at U.S. support for Israel, hiked the price of oil. This triggered a decade-long period of stagflation -- high inflation, tight money, sluggish growth, shaky banks.

If anything, the U.S. is more vulnerable today. In that era, America enjoyed a net inflow of earnings from global investments, ran a trade surplus, and lent far more than we borrowed. As tourists of the 1960s appreciated, visiting Europe on a pittance of five dollars a day (in 2007, $5 buys coffee), the dollar was over-valued relative to Europe's play-money currencies, and overdue for a correction.

Today, however, our trade deficit is more than 6 percent of GDP, and we borrow heavily to finance both private capital needs and government debt. Until lately, optimists insisted that cheap foreign debt-financing would continue indefinitely and prop up the dollar, because it was in China's interest to keep underwriting American purchases of its ever-expanding exports.

But, swollen with dollars, China is behaving more like an activist investor. The Chinese government's investment arm has begun buying not just debt but real assets, including 9.9 percent of the private equity fund Blackstone and a big chunk of Barclays bank. We can't count on China -- or anyone else -- funding America's burgeoning foreign debt at bargain rates indefinitely.

If the dollar slide turns into a crash, the Federal Reserve would face the unhappy choice of either hiking interest rates to raise foreign confidence in the dollar (thus deepening domestic recession) or letting the dollar sink further and increasing imported inflation. .....(more)

The complete piece is at: http://www.prospect.org/cs/articles?article=the_perfect_economic_storm

[Stargazer99]

1. My dear old Auntie was right about the Republicans

She said (in the 1950's) never vote for a Republican because all they do is get us in a war and a depression. Bingo! I don't think this was prophetic her comment was from experience.

[Double T]

2. When the whole damn economy falls apart, NO ONE should act surprised.........

wall street and corporate america's greed is the catalyst for our inevitable demise.

[Flarney]

3. At what point would my 401k take a bigger hit from a seemingly imminent crash

than from early withdrawal penalties? This has really been nagging at me lately...

[marmar]

4. ME TOO!

:think:

[Double T]

5. Less of SOMETHING is always better than a lot of NOTHING.

[dmallind]

6. Wouldn't really matter

If any of this economic SHTF musing comes true, the dollars you take out will be worth about as much as 1970s rubles.

I suppose you could take it out and buy gold or something, but then the value of gold is only useful in what it can be traded for in real terms. Having gold worth tens of thousands of useless dollars an ounce doesn't help you much, and if we have massive economic upheaval who will trade gold for food and shelter and fuel?

Good job it's all mostly Malthusian paranoia topped up with schadenfreude really.

[Flarney]

7. I thought I might at least take out enough to pay off all unsecured debt or something... (n/t)

[dmallind]

8. Sure that might be feasible

Although one good thing about hyperinflation is taht as long as you stay employed, wages rise very quickly in nominal terms too, so that $5000 car loan may look a lot smaller.

Of course staying employed in that scenario may be tricky.

[nick303]

9. Are you seriously planning for hyperinflation..

in the US?

[dmallind]

10. It's what we'd get if the doom and gloom comes true

But me? Nah. Currency markets are much more balanced than they were in the 30s or even 70s. We are not an isolationist economt, and we have the biggest consumer market in the world. Exporters will continue to protect the dollar from flopping too low by buying up our bonds, simply to protect their own markets. Equities have an eight-digit strong contingent of dollar cost averaging investors via 401Ks and 403Bs to prevent serious crashes (remember all the panic early this week was about a 2.5% drop!).

Could there be rough times ahaead? Sure - our excessive deficit spending will force increasing interest rates eventually as will the need to give foreign investors SOME reward for propping up a falling currency. It will further squeeze out some poor credit risks from access to capital, but people forget that's the way it wa anyway until the 80s. I certainly don't think we're due for a 1929 crash or a depression.

I'm merely a common or garden MBA undergrad econ guy so I wouldn't listen to my opinion over that of true experts with no pressure group ax to grind, but my best suggestion is to avoid heavy debt, especially in adjustable instruments, keep an eye on bonds, and buy equities whenever the market drops, because it will come back more quickly than in past volatile times. Hardly unique advice, and probably good for any economic situation, but no need to panic that's for sure.

BTW before the strawmen champions come to play, please note there is a huge gulf between "no need to panic" and "gosh everything's wonderful and Bushco is doing a bang up job of economic stewardship". I'm not even close to the latter coast of that gulf so save yourself the effort.