DOWN AND OUT IN D.C.
IN THE ENTERTAINING FINANCIAL BEST-SELLER THE DAY AFTER THE Dollar Crashes, financial analyst and commentator Damon Vickers paints a one-week scenario that leads from business as usual in the currency markets to a full-fledged grassroots campaign for reform of the political system in America. Here are a couple of milestones along Vickers’s road from normalcy to lunacy and back again.
Wednesday, 10 A.M.: The US government is holding its regular auction of Treasury bills, asking the world to finance the profligate American way of life. The United States has been borrowing from Peter to pay Paul for decades, so the Treasury anticipates another routine auction of its debt to continue the global-level Ponzi scheme. But to the shock of the government and the financial markets, the world finally stiffens its spine and says, “No way.”
Sunday (Evening) to Monday (Morning), New York and Asia: Given the intricate interconnections and high correlations linking the global financial markets (high network complexity), as soon as the US debt fails to find buyers, Asian currency markets fall off the edge, sending markets around the world into free fall. The New York Stock Exchange (NYSE) opens at 9:30 A.M. and closes twenty minutes later, buried in an avalanche of sell orders.
Tuesday, 11:30 A.M.: The NYSE opens two hours late after global markets have sunk by nearly 10 percent from Friday’s close.
Friday, 2 P.M.: After a minor recovery lasting from Tuesday through Friday morning, exchanges in Europe and the United States continue to fall even in the face of a big US interest rate increase.
The story gets even uglier, as everyone is selling everything—stocks, bonds, currencies, commodities. Confusion reigns supreme as panic circles the globe. By Wednesday, the IMF and other global financial institutions establish a new world currency exchange system, decreeing that all countries stop printing their national currencies. And so things go. Question: Is this just a fantasy cooked up to titillate the imagination? Or is there a real possibility of something like this type of panic actually happening?
This question is of more than passing interest to everyone who has a bank account, a job, runs a business, or just spends money. The global economy is a wonder to behold, with a global GDP nearing 100 trillion dollars. The financial system of banks, brokerage houses, savings and loan associations, and the like serve as the vehicle by which this huge sea of money makes its way from one place to another as needed. So a freeze-up (or meltdown, take your pick) of the financial system would be like pouring sand into the lubrication system of your car. The car won’t go very far without lubrication, and neither will the world economy without the global financial system. Now let’s get back to whether the scenario above is a realistic picture of what might happen or just a fantasist’s pipe dream.
To answer this, all we really need do is look at the news from the first days of August 2011, changing a few small details of Vickers’s scenario to reflect global concerns over the debt crisis in the Eurozone, where Greece was (is?) threatening to default on its sovereign debt, add in the downgrading of US government debt by a rating agency, which in turn spooks investors who now start worrying about the creditworthiness of the United States Treasury, and then sprinkle on a bit of well-founded concern over the willingness of US legislators to act in the nation’s best interests instead of their own.
For such a Vickers-like panic to get started, many conditions would have to be satisfied at roughly the same time. These include an ongoing systemic weakness in the US financial system brought on for instance by a debt crisis or a fading economic profile in the United States, an event that serves to set off the panic, and of course, a viable alternative to investment in US stocks and bonds. The default alternative that many traditionally retreat to is gold. But it might be almost any commonly recognized storehouse of value like diamonds, oil, drugs, platinum, or most commonly, hard cash.
Amusingly, even though the investment quality of US Treasury debt in the form of long-term T-bills was downgraded by a major ratings agency, when everything came undone in early August 2011, the preferred safe haven for parking money that investors sucked out of the stock market was, you guessed it, US Treasury bills. This resulted in the price of these instruments shooting up by more than 20 percent in less than two months! But who would have thought otherwise? After all, when markets panic and sellers end up with a fistful of cash in their hands, that money has to go somewhere. Where it ended up was exactly where the conventional wisdom said it shouldn’t/couldn’t: into US government debt in the form of long-term Treasury bills. When in doubt, deal with the devil you know, in this case the US government.
This fact shows better than any statistic that what counts in the world of finance is trust. In other words, belief. Will the institution that holds your money be there to pay off when you need it? Or will the doors be barred when you and thousands of others come to take home their cash? The US government has been the platinum standard in this regard since the end of the Second World War. Whether that privileged position will remain a few years from now remains to be seen. But for now the US Treasury in Washington, D.C., seems to be the best of a pretty unappealing set of alternatives.
Since the story of a collapsing US financial sector is inextricably intertwined with the fate of the American economy, or for that matter the entire global economy, I focus here on the way complexity overload has led to the ongoing global financial crisis. This story will lead to the account of a deflationary storm brewing on the not-so-distant horizon, an X-event that threatens to send the entire world economy into a tailspin that will take decades to pull out of.
FROM TODAY’S PERSPECTIVE, IT STRETCHES THE IMAGINATION TO think of how much faith the global community put into the hands of the central banks and financial regulators to ward off any threat to the integrity of the world’s financial system. As Paul Seabright termed it in an article in Foreign Policy, we constructed an “Imaginot Line,” a nod to the static defensive fortifications that failed to protect France against German invasion in World War II. Seabright identifies three principal economic defenses against financial crisis, each of which was vulnerable on its own, but which taken as a troika seemed impregnable in 2008.
The first level of defense was deposit insurance. This part of “the line” was put in place to protect against the notion that the banking crisis of the 1930s was caused by panic and bank runs by small depositors and retail businesses. Enter deposit insurance à la the Federal Deposit Insurance Corporation and the problem vanishes—at least for those smaller depositors.
The so-called moral hazard problem, in which banks with insured depositors have no motivation to be careful with how they invest (i.e., loan out) their depositors’ money and depositors have no motivation to choose carefully the banks in which they place their funds. This symmetry serves to underpin the second level of defense. The solution to the moral hazard problem was to put in place a complicated structure of financial regulations, which required capital requirements for the banks to prevent them from playing fast and loose with the money of small retail depositors. But those rules did not address large professional investors, who were supposed to be ready to bear their own risks. The safety net was assumed to be failure-proof, which meant that whatever risk was in the system would be borne by others, not by the investors themselves. As late as 2003, Robert Lucas, the Nobel laureate in economics, was telling the American Economic Association that the “central problem of depression prevention has been solved, for all practical purposes.”
Finally, the third leg of the defensive triangle, central banking. From the 1930s onward the central banks were given the job of keeping prices stable, and as a secondary task to promote economic output and keep a lid on unemployment. In this tripartite “protection racket,” the central bank was seen as the court of last appeal that would absorb any cracks in the edifice emerging from either of the first two lines of defense. So what went wrong?
To put it compactly, the fatal flaw in this system was that any problem that came up was seen by each of the three “sheriffs” as falling within the jurisdiction of one of the other two. For example, regulators saw the speculative aspects of mortgage contracts as a problem for the central bank, while the central bank saw it as a problem for the regulators. And no one saw it as a deposit insurance issue. Does this sound familiar? Every problem that came in one of the three doors was immediately shuffled off to one of the other two departments. In short, no one was in charge. This benign, self-protective neglect meant that the very act of reducing apparent risks in fact magnified the true risks dramatically.
The end result was that belief in safeguards that didn’t really exist led people to think it was safe to take risks that were in actuality orders of magnitude greater than what they thought to be the case. The shared belief that the authorities had the situation under control was totally misplaced. The resulting metaphoric meltdown of the financial system is quite analogous to the real-world meltdown that took place at Japan’s Fukushima Daiichi nuclear reactor in March 2011 we recounted in Part I. This was a case of too little complexity in the control system (the combination of the height of the wall and the generator location) being overwhelmed by too much complexity in the system to be controlled (the magnitude of the quake and the ensuing tsunami).
The financial system collapse arose from the same sort of complexity mismatch. Speculators saw a prolonged period from the 1980s onward in which the markets offered only profits without even the potential for losses arising from taking on too much risk. So financial schemers created a dazzling array of increasingly complicated financial instruments that ultimately even their creators didn’t fully understand. Credit default swaps (CDSs) are probably the most well chronicled of these exotic instruments, involving what amounts to insurance contracts that pay off if a particular debt obligation like the bond payment due from a country is not met. Credit default swaps are not true securities in the classic sense of the word in that they’re not transparent, aren’t traded on any exchange, aren’t subject to present securities laws, and aren’t regulated. They are, however, at risk—to the tune of $62 trillion (the best guess by the International Swaps and Derivative Association). As a result of these “instruments of mass financial destruction,” the complexity of the financial services sector shot off to a stratospheric level.
Credit default swaps are not the only contributors to the complexification of the financial services sector. High-speed computerized trading, the Glass-Steagall Act deregulating banks and allowing them to engage in speculative trading, as well as the enormous profits that investment banks and hedge funds have racked up over the last thirty years have each made their own contribution to a level of complexity in the sector that swamps the ability of bankers and traders to fully understand and even try to control.
But what about the regulators, the insurers, and the central banks? By now, you know the answer. The complexity of this control system was actually weakened by legislative action such as the aforementioned Glass-Steagall Act at a time when the complexity of the financial system they were charged to oversee was growing exponentially with each new boutique product served up by the wizards of Wall Street. The central banks and the regulatory agencies had basically the same tools at their disposal in 2007 that they had had for the preceding fifty years. The emerging complexity gap was a disaster waiting to collapse the system. The crisis we’re still “enjoying” is the real world’s way of rectifying this imbalance, a process that involves painfully wringing out the unsustainable risk and leverage in the financial system.
In case you’ve been asleep for the past couple of years and didn’t notice, the complexity gap between the financial system and its regulators is still growing. To see how it will most likely be closed, we need to take a longer and harder look at the way the US economy has been transformed over the past few decades, and how that transformation has given rise to the precarious state we find it in today.
TOO MUCH REALITY
A CHARACTER IN T. S. ELIOT’S PLAY MURDER IN THE CATHEDRAL remarks, “Humankind cannot bear very much reality.” Although this statement was made in the context of the assassination of Thomas Becket in Canterbury Cathedral in 1170, nothing much about human nature has changed since Eliot penned these words, and for that matter, since the time of Becket’s assassination. One such overdose of reality rests at the very heart of the post-2008 Great Recession. A deeper look at the ultimate cause of this financial collapse sheds much-needed light on why a global economic collapse becomes more likely with each passing day.
The conviction in 2011 of billionaire hedge-fund manager Raj Rajaratnam on the grounds of insider trading brought a vast outpouring in the media about the lack of prosecution of those the general public see as the ultimate culprits who perpetrated the crash of 2007–2008. According to media pundits, the public wants the blood of the bloodsuckers on Wall Street. The Rajaratnam trial served to focus this sense of outrage. In the words of economic columnist Robert Samuelson, “The story has been all about crime and punishment when it should have been about boom and bust.” In his analysis of the Great Recession, Samuelson goes on to note that the political left and right each have their own set of culprits, but that neither side is really able to make their story stick. Perhaps this is why so few actual “criminals” have been brought to the dock. Rather, the correct reply to the question of who really made the crash is, We all did.
The big question is why virtually everyone bought into the boom times and dismissed any naysayer as a Chicken Little? The answer is not hard to come by: very few traders or investors who were active in the market in the years before 2008 had experienced anything other than prosperity. It was a state of affairs that people simply took for granted. This confidence was coupled with an underlying belief that economists—like the Fed’s Alan Greenspan or those at the International Monetary Fund and the European Central Bank—had mastered the science of how to maintain a stable economy, and that their expertise would rule out another 1930s-style Great Depression. In short, everyone took a stable, prosperous economy as a taken-for-granted background reality, a state of heavenly economic grace that would persist forever. Samuelson argued, “The most significant legacy of the crisis is a loss of economic control.” These thoughts were echoed by the Nobel laureate Paul Krugman, who described the emergency not as one of housing or even economic (mis)management, but a crisis of people’s faith in the entire economic system. Investors no longer believe that highly complex, risk-free moneymaking machines like collateralized debt obligations, auction-rate securities, or any of the other fancy financial instruments dreamed up by the “wizards” of Wall Street will function the way they are supposed to. This loss of trust in a system leads to a kind of self-fulfilling prophecy of just the sort described above. Wow. So it can happen here. And it can happen again.
In an article in the Atlantic in 2010, Derek Thompson and Daniel Indiviglio, senior editors of the magazine, outlined five ways for the economy to dive in for a double-dip recession—or worse. I’ve listed them here in the order the authors thought was most to least likely. I leave it to readers to scramble this ordering to suit their own beliefs about the ranking in light of events at whatever time you happen to be reading this chapter.
Housing Falls Off the Cliff: Closely allied to the huge unemployment problem in the United States is the anemic housing market. Weak home sales and increasing foreclosures continue, and perhaps even escalate, putting further downward pressure on housing prices. This in turn makes it very difficult for homeowners to get out from under mortgages they can no longer afford, thus contributing to an even greater number of foreclosures. The end result is that lower home prices encourage people to save more and spend less, leading to a precipitous drop in stocks and a further tightening of credit markets. Ultimately, growth turns negative and the economy teeters on the edge of a massive deflationary spiral.
Consumer Spending Continues to Decline: People’s belief in an economic recovery dwindles, and spending slows to a trickle. The stock market sees nothing but gloom and doom, as business revenues flatten out, unemployment continues to rise, and the government does nothing but print more money. The markets start selling off a percentage point or more several days in a row, and as people see their savings disappearing faster than a trickle of water in the desert, they cut back on spending even further. Again, growth turns negative and deflation looms.
The Return of Toxic Assets: In their bailouts, the Treasury Department intended to actually purchase the toxic real estate assets held by the banks. But as they couldn’t quite figure out how to do this quickly enough to help, the banks simply took the money—but held the “assets.” As home and commercial real estate values continue to fall, so do the values of these toxic assets that still sit in the vaults and on the books of all the major banks. As the assets suffer another round of losses, markets sell off, credit dries up, and growth turns negative yet once again.
Europe Comes Undone: Slow growth in the southern countries of the Eurozone leads investors to demand higher rates of return for the bonds of these countries. This leads to further austerity measures, basically tax increases and spending cuts, which in turn strangles the most important export sources for goods, especially China and even the United States. In a flight out of the euro, the dollar then actually appreciates for a while, further hammering US exports to Europe. Again, the stock market eventually tanks as manufacturing dries up and trade deficits reach an unsustainable level. The American consumer cuts back once again, strangling the domestic market, and (you guessed it) growth turns negative.
Debt, Debt, and Too Much Debt: Uncertainty in the American political process causes buyers of US Treasury notes to demand higher interest rates to balance the risk of an increasingly whimsical Congress. This leads to a reduction of the value of pension and mutual funds holding US government debt, forcing people to save even more and spend less. This dynamic then gives rise to a Hobson’s choice of either cutting taxes to promote consumer spending or raising taxes to keep bond buyers happy. Either alternative ultimately leads to a deflationary economic collapse.
In fact, all the above gremlins have been jumping out in force over the past year, and the priority ordering for what’s going to sink the economy bounces around from day to day like a drop of water on a hot skillet. Right now, the Eurozone debt problem seems to have the upper hand. But who knows what will be flavor of the week tomorrow? Actually, it doesn’t matter, because any one of them is quite sufficient to send us into terminal financial and economic collapse.
So much for looking at the recent past and immediate present. We’ve seen governments in Europe and the United States try to throw money at the problem of the increasing complexity of the financial system without much success in reducing the gap between the system and its regulators. If anything, that gap is widening. So I’ll spend a few pages now describing the probable consequences of this failure. What can we expect to see in the near term economic and financial profile of both the United States and the world? This is where things really start to get interesting.
THE INCREDIBLE SHRINKING PIE
RECENTLY, I WAS LISTENING TO A LOT OF SUPPOSEDLY FINANCIALLY savvy talking heads and sifting through a morass of financial blogs, each giving its idiosyncratic postmortem to the unwashed as to why the markets were going down instead of skyrocketing. In this lengthy search for financial nirvana, I decided to look at some of my regular sources, ones that publish what I believe are among the more thoughtful analyses of financial and social happenings. There I found the following statement from Steven Hochberg at Elliott Wave, International, bringing into focus a lot of puzzling aspects about what’s taking place right now. Here’s what he said in his newsletter on September 8, 2011:
America is downgraded by S&P and one of the greatest American investors in history, Warren Buffett, is put on negative watch by the same ratings agency (the bonds of Berkshire Hathaway). Short-term US government paper is yielding zero. US stocks are crashing and gold continues to rally strongly. According to most US dollar prognosticators, the greenback should be crashing to oblivion. It’s not; at least not yet. Instead, the US dollar index remains above…the major low established in March 2008, over three years ago. The only explanation for such behavior is deflation.
Did he say deflation? Just about everyone has heard of inflation and many of us know vaguely what it means: increasing prices. But deflation is a word that’s nearly dropped out of the dictionary over the past few decades. What is it and why is it so important?
Speaking literally, deflation is simply the opposite of inflation: a decline in prices rather than a rise, perhaps together with a contraction of credit and a decrease in the amount of available money. Sounds good—on the surface. Who wouldn’t like to see the price of gasoline, iPads, and T-bone steak go down? But like a lot of things that look appealing at first glance, a bit of digging turns up some pretty nasty features we’d like to stay as far away from as possible. Here’s why economists and policymakers fear deflation like the plague.
The central problem is what’s often termed the “deflationary spiral,” a nearly one-way street to no economic growth, no jobs, and very little hope. These are the steps of that precipitous decline that constitutes the deflationary spiral:
And so it continues, lower prices to fewer consumers to still lower prices to fewer buyers ad infinitum as the entire economy slows to a crawl and ultimately reaches a floor and stops dead in its tracks. This nosedive is extremely difficult to pull out of since those who have money begin adopting the attitude, “Why buy today when prices will be lower tomorrow?”
There are several economic delicacies involving the relationship between labor costs, material costs, time lags, and the like that enter into the details of this story, muddying the waters a bit. But these fine points are unimportant for the issue that concerns us here, namely, the events that cause deflation to get started in the first place. In other words, now that we know what happens when we’re in the grips of a deflationary spiral, how does the process actually start?
THERE ARE THREE POSSIBLE (BUT NOT MUTUALLY EXCLUSIVE) PATHS to that fateful first step on the road to deflation:
The end result of any of these paths is that less money is available to be loaned to consumers and to people developing businesses. This means that credit, which is the lifeblood of any modern economy, dries up, so that less money is being spent. That factor, in turn, starts the deflationary spiral. Incidentally, this is the principal reason why governments like the United States turn cartwheels in order to prevent banks, especially big banks, from failing.
Our current economic crisis is clearly a combination of Paths A and B, since no one can remember the last time the US Federal Reserve actually raised interest rates or the last time anyone expressed more than a pro forma concern about inflation.
Conventional wisdom has it that the way to break out of the deflationary spiral is to lower interest rates so as to put more money into circulation. That flow of money is then supposed to jump-start the economy, leading to more jobs, more consumption, and eventually to an increase in prices. But what happens when the deflationary spiral starts at a time when interest rates are already at near rock-bottom levels, which in fact is where they’ve been since early 2000? Unlike inflationary times when the central bank can raise rates as much as it likes to hold back price increases, rates cannot drop below zero to combat deflation. Often this factor is termed the “liquidity trap.” The only way out of it is for the government to pump huge amounts of money into the economy through spending. This is how governments around the world ended the Great Depression of the 1930s.
Today, this spend-till-you-drop path is pretty much closed out as well, due to the massive indebtedness of the United States and the countries of Europe (not to mention the influence of anti-big-government movements such as the Tea Party activists in the United States). To inject the much needed cash into the economy, governments must somehow have that money available. It can come from several sources, each with its own set of associated problems. The obvious first source is lenders like China, Japan, and other Asian countries, who have been sending their burgeoning savings abroad to support an out-of-control lifestyle in the United States and Europe for years. Or it can come from running the printing presses 24/7 to magically make the money appear from paper. Lenders are now very leery about putting good money after bad into the US Treasury. Moreover, the creation of money out of paper opens up the very real possibility of hyperinflation. It’s difficult to imagine, but this is an even worse solution than enduring a period of deflation as a way of wringing the excesses out of the financial system created by the speculative bubble of the 1990s. Hyperinflation will wipe out the dollar, it will wipe out what remains of the American middle class, and it will eventually wipe out the entire economy. If you don’t believe this, have a quick look at Weimar Germany in the early 1920s, or for that matter, Zimbabwe today. Other candidate sources for funding include raising taxes on either individuals or corporations, both politically taboo topics just about everywhere. Moreover, it’s difficult to see how taking money out of the pockets of citizens or corporations can help pump up consumer spending, which represents over two-thirds of an economy like that in the United States. Finally, there’s the “PIGS solution,” being tried today in Portugal, Ireland, Greece, and Spain, which calls for tax hikes plus savage cutbacks in government services, ranging from health care to pensions to education.
What’s important to keep in mind here is that undoing deflation involves more than just pumping money into the system. The solution is at least as much psychological as it is economic, since the effect of a growing complexity gap often manifests itself in a slowdown in a society’s belief that tomorrow will be worse than today (negative mood) leading eventually to a belief that tomorrow will be better, much better than today (positive mood). Once this shift in polarity takes place, people start spending money again because they believe they will either get a job or keep the one they already have. But no amount of government cheerleading or upbeat self-help books and articles is going to bring this about. In fact, the usual way it happens is that some big-league X-event takes place that shocks people out of their funk and into a new psychological orbit. Ominously, this shock is usually a war, a big war—yet one more good reason to pull out all the stops to avoid sinking into the economic depression that is the end point of the deflationary cycle.
For the sake of argument, let’s assume that the world of the coming decade or two or three gives us only the second-worst outcome, a global deflation accompanied by a worldwide depression, and manages to avoid the hyperinflation that would tear the world economy apart. What would it be like living in such a world?
Earlier, I made the remark that the word deflation is hardly ever uttered in polite company nowadays, and that one big reason for this is that—as mentioned earlier in connection with the seemingly relentless growth of markets—there is no one alive today in the United States who can remember living through such a period. However, there is an entire nation of more than 130 million people who are alive today who can give a very up-to-the-moment account of what it’s like living in such a world. Of course, I’m talking about Japan, a country that’s been in a deflationary depression for over two decades with no end in sight. In many ways, the Japanese experience since the late 1980s is a kind of dress rehearsal for what the rest of the world can expect to see in the coming years. So it’s worth a few paragraphs to detail the “lowlights” of that experience.
BY LATE 1989, THE GROUNDS OF THE EMPEROR’S PALACE IN CENTRAL Tokyo was reputed to be worth more than the entire state of California. Can you imagine? Just a few months later, in early 1990, Japan underwent a similar type of property and stock market bubble burst that the United States and Western Europe experienced in 2007–2008. For example, at its high on December 29, 1989, the Nikkei Stock Index in Tokyo—the Japanese equivalent of the Dow Jones Industrial Average in the USA—stood at 38,876. Now, twenty-two years later, it is less than one-quarter of this level. So deflationary bear markets like the one Japan (and soon the rest of the world) is experiencing can take a long, long time to recover (think decades). As a benchmark of comparison, the Dow Jones Industrial Average took twenty-three and a half years to regain its level just prior to the Great Crash of October 1929. So despite massive amounts of monetary inflation going on around the world nowadays, especially in Japan itself, no one thinks the Nikkei will regain its 1989 high anytime in the foreseeable future. The Japanese economy collapsed into a deflationary spiral in early 1990 and has not pulled out of it since.
The situation is not any better for housing prices in Japan either. Currently, the average price of a home sits at the same level it was at in 1983, nearly three decades ago. And while newcomers to the debtor’s prison like Greece, Italy, France, and the United States get all the front-page attention nowadays, Japan actually faces the world’s largest sovereign debt to other nations, about 200 percent of gross domestic product, a financial burden accompanied by major social problems like an increase in poverty and rising suicide rates.
In his recent book addressing lessons the ongoing Japanese deflation offers to the world, Richard Koo, chief economist at Nomura Securities, makes the following statement about Japan today: “Millions of individuals and companies see their balance sheets going underwater, so they are using their cash to pay down debt instead of borrowing and spending.” This decline has been a very corroding experience for the Japanese. In the 1980s, Japanese people were confident, looking forward to the future, and eager to create a new world order in Asia. Today? Well, it’s a nation that has lost its self-confidence, fearing a future that its aging, shrinking population is in no position to confront. As a small indicator of this fact, in an article published in the New York Times in 2010, Martin Fackler reports a Tokyo apparel shop owner saying, “It’s like Japanese have even lost the desire to look good.”
A very painful indicator of the effect of a life of deflation and economic stagnation is the attitude of young people toward consumption. Instead of streaming into Akihabara, the high-tech district of Tokyo, to scoop up the latest in electronic gadgetry, many young Japanese refuse to buy any expensive items. As Fackler also noted, a generation of deflation has gone beyond just making people unwilling to spend. It has given rise to a deep pessimism about the future and a fear of risk. Consumers now see it as foolish to buy or borrow, which further accelerates the downward spiral. Hisakazu Matsuda, a keen commentator on this phenomenon, calls Japanese in their twenties “the consumption haters.” He says, “These guys think it’s stupid to spend.” Another observer, Shumpei Takemori, an economist at Keio University in Tokyo, remarks that “Deflation destroys the risk-taking that capitalist economies need in order to grow. Creative destruction is replaced with what is just destructive destruction.”
How did the Japanese government try to pull out of this spiral? No points here for guessing the answer. They did just what Western governments are doing right now. They cut interest rates to zero in 1999 and left them at this literally rock-bottom level for seven years. In addition, the government enacted one bailout scheme after another, together with offering an endless series of stimulus packages. But all to no avail. Added to this is a seemingly potent, but actually impotent, combination of monetary and fiscal policies, along with market and protectionist regulations. To date, nothing has worked. More than two decades after the deflationary spiral started, Japan is still on the edge of total economic collapse. As an indicator of this fact, in early 2010 the Japanese Statistics Bureau reported that prices in Japan have been falling for the past twelve straight months, and that land prices are half what they were twenty years ago. One year later, the situation has hardly improved. In August 2011, Junko Nishioka, chief economist at RBS Securities Japan, noted that “Consumer prices are unlikely to rise much…as weak consumer sales are likely to trigger further price competition.”
In fairness to Western economies now struggling with the same problem, there are major differences between the Japanese situation and what we see in the United States and Western Europe. The United States can simply print bundles of reserve currency and export it to the rest of the world for products like cars, T-shirts, computers, and other gadgets that will distract people’s attention from the real problems the country faces. Moreover, even during the difficult period in Japan, savings grew and the country continued to produce real goods for export. So what to do? The only thing that’s certain is what not to do: do not, repeat do not, continue to pile deficit upon deficit. If there was ever a real-life example of the principle that you can’t borrow your way out of a deflation and bring the economy back to life, Japan is that example. Pushing the problem onto future generations can only ultimately lead to an even bigger social crash. On this dynamic, but hardly uplifting note, let’s try to summarize the dimensions of the emerging global depression.
ADDING IT ALL UP
THE AUSTRIAN-AMERICAN ECONOMIST JOSEPH SCHUMPETER INTRODUCED the term “creative destruction” to describe the process by which the disappearance of outmoded, unnecessary components of an economic system are destroyed to free up space for innovative, new forms of economic production and consumption. We are in the destructive phase of Schumpeter’s picture right now, as the global financial and economic systems are transiting from the “old world” of the post–World War II set of structures and rules for economic, political, and social discourse into what will become the standards for the first half of the twenty-first century. The problem of the moment is that no one really knows what that new global structure will be. All that’s known for sure is that it will be something very different from the old regime.
Like all dynamical processes, the destruction phase of the Schumpeterian cycle must have an engine driving the process. In this chapter, I’ve argued that the engine turning the financial and economic worlds upside down is a rapidly approaching period of massive deflation (or, perhaps even worse, hyperinflation). Thus, whatever the picture turns out to be in the longer term (ten to twenty years downstream), there’s nothing nice on the immediate horizon. Only when the global system has settled into the creative phase will we reap the benefits of what’s to come in the balance of the current century.