Signs now point to the Great Recession being a once in a century event, far more serious than a typical business cycle. Let’s explore why. For the last thirty years, the United States economy, and the world economy, have been the beneficiaries of at least six powerful forces fostering economic growth, some fundamental, some artificial, that amplified the business cycle on the way up, and that will in all likelihood continue to amplify it on the way down:

The good
(a) the decades-long secular trend of the lowering of both interest rates and the cost of equity capital that began when Paul Volcker whipped inflation and Ronald Reagan cut taxes;
(b) the radical increase in speed and lowering of information costs via computing and the internet that have made possible entirely new industries, and dramatically lowered manufacturing and distribution costs for goods and services of all sorts around the globe;
(c) the rise of China as a low cost manufacturing colossus, with a seemingly endless supply of cheap labor, and robber baron capitalist zeal in the business and political classes;

The bad
(d) the development of the securitization of loans, combined with sophisticated computer models, created a worldwide appetite for high leverage, in the belief that the risk was diversified;
(e) institutional restraints on banking leverage and risk-taking were loosened or eliminated, at the same time that government policy encouraged making riskier and riskier loans;
(f) the nations running big export surpluses were eager to buy the obligations of the to-date creditworthy importing countries

These factors (a, b, c) created an unusually good environment for economic growth, with the result that global GDP went from around $10 trillion in 1980 to around $50 trillion by 2006, according to the nationmaster database. Such periods of extraordinary innovation and growth have characterized the world since the industrial revolution (see page 9), and the US itself had such a growth spurt a century ago.

However, there is reason to believe that these sources of economic growth will not be there in the future as they have been in the past. Certainly that is true of interest rates — they have nowhere to go but up. It is also true that technological advances have already removed much of the friction in manufacturing and distribution, from JIT to e-commerce, etc., so maybe gains will be more incremental in the future than they have been in the last generation (but who knows?). Finally, it seems likely to us that China in the next generation will face higher costs and more complexity (eg, water, air, workers) in its development than in the last two decades, so it is arguable that the bulk of China’s one-time-adjustment to world productivity has already taken place. Thus the factors powering past growth are less available to fuel growth now.

Moreover, the generally favorable economic environment of the last generation has been a blessing, but also a problem, which points d, e, and f illustrate. Periods of relative stability lead to instability because people and institutions like banks develop higher and higher risk tolerance — d, e, and f are the perfect storm. It will be a long time before we see their like again.

Where to begin? Improvident government policies created riskier loans (remember no income verification?) Rating agencies were all too willing to rate garbage AAA, and Wall Street bankers were happy as pie to sell the stuff (the computer models supported the ratings because the numbers worked absent simultaneous value declines that overrode the “diversification” built into the portfolios). Meanwhile, the banks themselves had become unstable (in 1999, Congress repealed Glass-Steagall and in 2004, the SEC made an astoundingly improvident rule change that permitted the biggest investment banks to regulate their own leverage). Finally, the importing and exporting countries were each engaged in a mutually beneficial, but of necessity temporary, set of transactions: the importing nations could over-consume, as long as the exporting nations supported this by buying their debt. The limits of that game are visible, even if they have not quite been reached yet.

In the old days, the normal business cycle was characterized by easy credit, overexpansion in plant and equipment and inventory, cutbacks when sales failed to materialize, such as credit restriction, layoffs and inventory liquidation, and then there would be recovery. What we have in 2010 still incorporates those fundamentals, but we note a couple of elements that tend to make this time somewhat different:

(i) as we discussed regarding a, b, and c above, taxes and interest rates are going to go up, technology advances might be more incremental than in the previous period, and China’s significant contribution to lowering the worldwide cost of incremental production may be closer to its end than its beginning — all these factors suggest a weaker support base for recovery in the US and EU than has been historically the case;
(ii) the d, e, and f factors all point to continued contraction, not expansion. The financial system is still shaky and the process of de-leveraging is still underway in both the private and public sectors, and the developed world is nearing the limits of its borrowing from its third-world suppliers — or anyone else for that matter. (And on top of all this, we haven’t even discussed the impact of the tax increases starting in 1/1/11.)

So we come to the question: if the US economy and that of Western Europe face another leg down in their economic activity, what arrows remain in the quiver to fix the problem? One is benign, if difficult to implement, i.e., create a supportive business environment for the US to create jobs at home rather than exporting them. And one has uncertain but likely bad consequences, the massive Quantitative Easing of monetary policy that is being discussed even in polite company today. A government (both parties) that is not focused on these issues 24/7, when 20% of prime-age men aren’t working, is not composed of serious people.

This entry was posted on Sunday, July 4th, 2010 at 1:41 pm and is filed under business, Democrats, General, Republicans. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.