A long economic winter ahead
Online Journal Guest Writer
Jul 8, 2010, 00:14
State divided into a small number of rich and a large number of poor will
always develop a government manipulated by the rich to protect the amenities
represented by their property.� --Harold Laski (1893-1950), British
political theorist, 1930
�Money becomes evil not when it is
used to buy goods but when it is used to buy power . . . economic inequalities
become evil when they are translated into political inequalities.� --Samuel
Huntington (1927-2008), political scientist
� . . . if financial markets are
skittish and don�t have confidence in a country�s fiscal soundness, that is
also going to undermine our recovery.� --President Barack Obama, June
�Any intelligent fool can make things bigger, more complex, and more violent.
It takes a touch of genius, and a lot of courage to move in the opposite
direction.� --Albert Einstein (1879-1955) Physicist and Professor, Nobel Prize
The bond market is telling us that there could be hard economic
times ahead and that deflation, for the time being, is
more of a threat than inflation. Leading indicators are also
pointing to possible economic weakness ahead. -The Euro zone is being pulled apart by the economic asymmetry of
its members, the less productive among them (Greece, Spain, Ireland, Portugal
and Italy) being unable to keep pace with the very productive German economy.
-The U.S. money supply M3 is contracting.
-The Chinese bubble is dangerously
approaching the bursting point. -And, the deflation of debt all
over the place threatens to plunge the world economy into a deflationary
tailspin. In this context, there is a good chance of a double-dip recession next year, in
Readers of this article know where I stand on this issue.
One year ago, on July 10, 2009, when everybody and his uncle was declaring the
recession over and the return of business as usual, I wrote a piece announcing
that my analysis was pointing to 10 years of economic hardship, entitled We are in the Midst of the
Great Baby-Boomers Economic Stagnation of 2007-2017. I wrote
then that �many observers think that �prosperity is around the corner� and
that this recession, like others since World War II, will end as soon as the
stock market, as a leading indicator, recovers and people start spending again.
This is a myopic view of the current economic big picture.�
Let us keep in mind that in May of 1930, President Herbert
Hoover was also proclaiming that �the danger . . . is safely behind us.�
This was 10 years too early for such a declaration. Just as in the 1930s, the
U.S. economy and many part of the world economy suffer from a debt overhang
that usually takes at least ten years to correct. When overall debt is four
times larger than the economy, as it is the case today and as it was close to
being the case in the 1930s, a debt deflation becomes unavoidable.
Economic booms built on a mountain of debt, some of which is
fraudulent and speculative debt, tend to end badly. The higher the debt
mountain relative to the real economy, the more serious is
the following economic meltdown. This is because an unsustainable debt level
means that some of the investments and projects thus financed make no economic
sense and no sufficient income can be forthcoming to service and repay the
debts. The first consequence is excess capacity and falling asset prices. The
second consequence is an unavoidable liquidation of debts and a debt deflation.
The third consequence is economic stagnation.
The danger that accompanies a protracted period of
debt-liquidation and debt deflation after a binge of over-indebtedness is well
known in economics. In 1933, Yale economist Irving Fisher published his debt-deflation theory of economic
depressions. The core of the theory is that over-indebtedness leads to
deflation, which in turn leads to an economic contraction. Fisher summarizes
the links between debt liquidation and economic contraction in nine interacting
1- Debt liquidation leads to distress selling.
2- Contraction of deposit currency, as bank loans are
paid off, and to a slowing down of the velocity of circulation of money.
3- A fall in the level of prices.
4- If the fall of prices is not interfered with by
reflation or otherwise, this is followed by greater fall in the net worth of
business, precipitating bankruptcies.
5- This leads to a like fall in profits.
6- A reduction in construction, output, trade and
in employment of labor results.
7- Losses, bankruptcies and unemployment lead to
pessimism and loss of confidence.
8- The result is hoarding and a contraction in
bank credits, which contribute in slowing down even more the velocity of
circulation of money.
9- The overall deflation causes a fall in the
nominal or money interest rates accompanied by a rise in the real or
commodity rates of interest as prices fall.
A similar self-reinforcing spiral-down of debt-deflation and
economic contraction can be feared in the coming years as the level of debt to
the economy goes from about four times the economy to a more manageable two
times the economy. In other words, it should not take more than $1.50 or $2 of
new debt and credit to generate one dollar of new output. When it takes more
debt than that to generate new production, this is an indication that the
economy is becoming over-leveraged with debt.
Judging by the pronouncements made by leaders at the recent G8
and G20 meetings in June, and their collective commitment to cut
governments� deficits in half by 2013, I don�t think that politicians fully
understand the danger presently facing the world economy. In fact, any new
shock hitting the world economy, economic or political, risks accelerating the
collapse of the debt house of cards, with dire consequences for production and
Austerity fiscal measures may raise government efficiency,
but they are not what will cushion the real effects of the debt deflation. Both
reflationary monetary policies and overall stabilization policies are needed,
especially in the banking sector, in order to make sure that producers and employers
are not frozen out of new bank credit.
Rodrigue Tremblay is professor emeritus of economics at the
University of Montreal and can be reached at firstname.lastname@example.org. He
is the author of the book �The Code for Global Ethics.�
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