The Economy:
Doubts on the Horizon
October 4, 2005
By Peter Zeihan
Economists are second only to political scientists in their ability to dream up models and frameworks by which to measure and predict events. At Stratfor, we pay attention to many types of economic models but rely on none of them exclusively: The U.S. economy, let alone the global economy, is a beast that marches to its own tune. Economic forecasting is a bit of an art, particularly because growing access to capital and technology not only blurs the rules on which economies once ran, but also greatly shortens the time necessary for economies to react to stimuli.
The U.S. Economy: Debtors and Deficit Spending
Though it might not be obvious from watching the mainstream print and broadcast media, which have been issuing bearish reports since long before Hurricane Katrina, the U.S. economy remains red hot at the moment. For the past nine quarters, it has expanded by more than 3 percent per quarter, the fastest sustained growth since 1984-1986.
Moreover, U.S. growth has been steady and stable in the longer run as well. The recessions in 1990-1991 and 2001 were the shortest and mildest in American history, and in reality amounted to only small corrections -- made necessary by the United States' no-holds-barred adoption of rafts of computer and information technology. One would have to go back to the 1980-82 period and a pair of back-to-back recessions to find the last time dispassionate observers felt the United States had serious economic difficulties.
The "secrets" behind strong and sustained U.S. growth are three-fold.
1.- Capital is allocated on the basis of economic efficiency, not
political prerogatives. By way of comparison, capital allocation
patterns in Asia are extremely politicized, with government granting
-- or directing the disbursement of -- cheap loans to companies owned
by or linked to the state. That may generate faster growth rates, but
it often is not profitable and also renders companies dependent upon
ongoing infusions of cheap capital, particularly in times of economic
distress.
2.- Second, capital allocation patterns encourage the heavy use of
technology. If capital is treated as a scarce resource, rates of
return need to be as high as possible and productivity becomes key.
The regular application of technology is by far the best way to
improve both quality and output.
3.- Finally, there is the United States' culture of change. Unlike the
Japanese or Europeans, people in the United States people do not hold
their jobs in perpetuity: On average, they change careers -- not just
jobs -- seven times during their lives. There also is a culture of
corporate Darwinism: Unsuccessful companies are allowed to die off
instead of becoming black holes that siphon capital away from more
efficient competitors. The embrace of technology also plays into such
shifts and changes, occasionally eliminating entire sectors in favor
of new ones and necessitating a constant turnover in terms of
companies, skill sets and personnel alike.
The result has been diversification, resiliency and dynamism. No wonder that -- in terms of economic growth -- the United States recovered from the Sept. 11 attacks less than six weeks after they took place.
That said, "resilient" does not mean "invulnerable," and "dynamic" is not synonymous with "eternally progressive."
The United States does suffer from some very real problems, and the twin trade and budget deficits -- which have radically expanded in terms of both absolute and relative size -- are not exactly fresh news.
We are not overly concerned about the trade deficit, since that represents the balance of imports versus exports, and not actually money that the United States owes anyone (government bonds restrict creditors' actions more than they do borrowers'). It is primarily an issue of financing -- foreigners will continue to finance the U.S. trade deficit so long as the rate of return in the United States is higher than it is at home -- and purchasing power.
Many fret about U.S. purchasing power because most economic models report the U.S. savings rate is negative, suggesting a collision course with bankruptcy. However, while mortgage debt is included in savings rate calculations, the equity from home ownership is not. The result is that American consumers -- who are more likely than their foreign counterparts to be homeowners -- count a massive debt into their savings rates, but do not factor in what is typically their greatest asset. Don't let the three-car garages and a cell phone in every pocket fool you: A detailed balance sheet indicates that most Americans are inveterate investors -- not negligent spendthrifts.
The same, however, cannot be said of the government.
Under the Bush administration, the extremely atypical budget surplus that rose up during the second Clinton administration has evaporated, and the United States is engaged in a spree of deficit spending that would be illegal under European monetary rules. While any number of events potentially could whittle this number down, the expansion of some entitlement programs, the war in Iraq and radically increased defense and security spending due to post-Sept. 11 politics have given this deficit a lot of staying power.
Deficit spending can be a dangerous game. Typically, it should be used only to kick-start growth during times of recession. Sustained deficit spending not only draws capital away from the typically more efficient private sector, but also leaves the broader economy addicted to government-administered stimuli. Woe to the economy that undergoes a recession in such circumstances: that means that one of the few tools left to the government is even more deficit spending. Japan faced just such a circumstance in the 1990s; it now carries a national debt in excess of $6 trillion and a sustained budget deficit of more than 6.5 percent of GDP -- and that is before any debt rollovers are taken into account.
One of the few bright spots in the budget deficit picture is that the debt is cheap to maintain. The wide differential between U.S. interest rates (currently at 3.75 percent) -- and those in Europe (2.0 percent) and Japan (0.0 percent) makes investments in the United States appear more attractive than other destinations. That has sent a flood of foreign money into American debt markets, helping to keep financing cheap for the government and private citizens alike.
Because of all this, the budget deficit is not ideal, but current levels of strong economic growth and international financing make it tolerable. So long as growth remains relatively robust, a large budget deficit may be slightly worrisome, but it is ultimately an issue that the United States has plenty of time to address.
Or is it?
After Katrina
The impact of Hurricane Katrina on the U.S. economy was hardly passing. Total cleanup and recovery costs have been estimated between $200 billion and $300 billion, and that does not include the cost of perhaps repositioning New Orleans in a location on the safer side of sea level. Government entities currently expect the overall impact to be relatively mild, chipping about 0.5 percent from U.S. growth in the third and fourth quarters.
We are concerned about three specific effects of Katrina.
First, the U.S. federal budget was already deep into the red when the hurricane struck. Adding another $200 billion of fresh deficit spending, on top of current policies, is not going to improve the bottom line in the near future. The need for credit in the impacted regions is already massive, and with the government -- unavoidably, we must note -- now diving even deeper into the red to fund the recovery and reconstruction, the cost of credit can only rise, retarding growth.
Second, Katrina damaged the Bush presidency.
We normally do not concern ourselves overmuch with the ebb and flow of presidential approval polls -- President Bill Clinton's term in office is sufficient testament as to the ability of how even a divisive and besieged leader can continue to lead. However, Katrina may have changed the calculus for the Bush administration, by stripping away the support of the political middle and pushing his back to the wall in the approval polls. The president's hard-core supporters were, immediately following the hurricane, the only ones left in his camp -- and should that base of support begin to crack, his run as a president who can do more than merely preside would effectively come to an end, with very real implications for U.S. foreign policy quickly following.
There are plenty of opportunities for such cracks to appear, even if the Katrina recovery is textbook perfect. Tom Delay, a firm Congressional ally, is now facing money-laundering charges in Texas. Karl Rove, the president's political strategist, stands accused of violating national secrecy laws. The nomination of White House counsel Harriet Miers to the Supreme Court might mollify centrists and liberals in Congress and help the president woo the U.S. political center, but Bush could well forfeit the endorsement of some bedrock supporters, who demand a more conservative nominee. And of course let us not forget the Iraq war, the quintessential vote-killer.
In the face of a national disaster a president needs to project the image of being larger than life in order to engender confidence. That is a quality that the Bush administration held in spades after the Sept. 11 attacks. But at present, respect for the president is difficult to find. The apparent lack of confidence in the government is echoed in a level of business confidence that borders on narcoleptic. These are not attitudes that make people want to go out and spend money, no matter how loudly the "employee discount" automobile ads may blare.
Third, there are signs that Katrina has done what the Sept. 11 attacks and the Iraq war failed to do: stymie U.S. economic demand. The figures on this point are extremely preliminary, but they are worrying nonetheless: Hurricanes Katrina and Rita at one point managed to shut off all oil production from the U.S. sector of the Gulf of Mexico, as well as 80 percent of normal natural gas output. As of Oct. 4, 90 percent of crude production remains offline, along with 45 percent of natural gas. So far, the storms have denied the U.S. market of approximately 50 million barrels of crude oil and a quarter-trillion cubic feet of natural gas.
Refining has been similarly affected. At the storms' height, some 4.7 million bpd of refining throughput was offline, and some 2.2 million bpd remains so today.
Yet despite the massive shutdowns in both production and refining, crude oil stocks have dropped by less than 1 percent from pre-Katrina levels. Far more noteworthy is the fact that while gasoline production at one point was down a full 2 million bpd per day, and some 4.2 million people have evacuated from -- and most of them since returned to -- the hurricane zones, U.S. gasoline inventories have actually risen by more than 5 percent. Put another way, U.S. energy demand -- at least as far as gasoline is concerned -- has dropped.
Americans are not quick to cut back on gasoline consumption if they can help it. The last time that occurred was in the aftermath of the 1979 Iranian revolution; the result was an energy-induced recession.
It is possible that the United States once again might find itself on the cusp of such a phenomenon.
Recession Dawning?
Let's approach this from another angle.
One of the more reliable means of predicting a recession is to chart the payoff of bonds of different maturities, often referred to as the "yield curve." Short-duration bonds pay out very little, while longer-duration debt instruments generally provide a larger payout because they represent a higher level of risk. A healthy yield curve reflects that.
When a recession dawns, businesses tend to react by locking in as much cheap credit as they can. That quickly forces the short end of the yield curve up, causing the curve to invert.
Congratulations. You are now in recession.
The United States has not had an inverted curve -- which, bear in mind, is a very forward-looking indicator -- since the peak of the dot-com bubble in 2000. At that point, frothy over-optimism for companies such as petpsychotherapy.com led to an inverted yield curve, followed by a stock market fall-off and then a recession. On average, the time passed from yield curve shift to stock market reaction is about three months, with recession following another three to six months after that. In this example, the recession began in March 2001.
As of this writing, the United States does not yet have an inverted yield curve -- and it is not a given that one will materialize – but we do note that the curve has been flattening for the better part of a year; the gap between short- and long-term yields is only about one-tenth as large as it was a year ago. If the yield curve inverts in the next couple of months, the United States likely would be eyeing a recession at some point in the first half of 2006.
But the real kicker at the moment is not gasoline demand or the yield curve. If the United States fell into recession in the current environment, levels of deficit spending are already so high that there is not a great deal of room to maneuver on budgetary matters without risking a Japanese-style economic malaise . That means that the responsibility for jolting the economy out of recession would fall to the Federal Reserve Board -- which, without much fresh cash from the government to stimulate demand, would need to maneuver monetary policy extremely adroitly.
At that point, attention normally would turn to Federal Reserve Chairman Alan Greenspan, who has adroitly manipulated policy throughout practically all of the 1982-2005 U.S. expansion. But here again, there is a new question looming: Greenspan is leaving the Federal Reserve in January 2006, and he does not yet have a clear
successor -- and certainly no one waiting in the wings to equal his track record. The country must face whatever turmoil is ahead without a trusted hand at the wheel.
It is interesting to note that, despite his career-long habit of staying out of the United States' internecine political debates, Greenspan has, in the past year, developed a propensity to speak his mind (albeit in extremely couched terms). In most instances, such discussions involve pontification about the problems that his successor will face. These range from the budget deficit, to the instability in the housing market, to the touchy, vote-losing issue of unsustainable Social Security payments.
The common theme winding through these discussions is simple and striking: the United States is living dangerously. Freddie Mac and Fannie Mae, the two quasi-state mortgage mega-firms, have almost totally crowded competition out of a $5.5 trillion debt market -- raising the prospects that the potential fall of only two companies could crash the entire country's financial structure. The country's Social Security outlays, as currently envisioned, will bankrupt not just the pension system, but the total budget within a generation. And of course, the budget deficit vastly reduces the United States' room to maneuver.
It is not going to get any easier. The baby boomer generation is in the process of retiring -- a trend that will peak in about eight years. Since Generation X is so much smaller than the boomer generation, the net payments into the Social Security accounts will not be sufficient to keep the U.S. budget viable. The U.S. budget picture is as good as it is going to get until a generation younger and more numerous than Generation X matures -- meaning when the children of today's 20-somethings finish college.
Ultimately, U.S. military, cultural and political power is based on the breadth, depth and stability of the U.S. economy. Money breeds power and influence, attracts the best of the world's minds and allows the country to buy useful things, like aircraft carrier battle groups. Should current trends continue for a few more years, structural factors will force interest rates to rise, the economy will chronically weaken, and something will have to give.
In the early months of 2006, the United States may get a very small taste of what is to come.
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