Fabius Maximus on the Economy

Fabius Maximus, in a post titled "New recommendations to solve our financial crisis (and I admit that I was wrong)" reassesses the financial situation in light of recent developments. Fabius' thoughts on the economy are always valuable and thought-provoking, and his newest predictions (showing his willingness to admit he was wrong and reassess things) are the best analysis of the global economic situation I've seen so far. I definitely recommend the whole thing, but here are some excerpts:

For deep theoretical reasons our financial system is collapsing. I have discussed some of the reasons in other posts (see below for links), but the causes are irrelevant now. Whatever the cause of a cardiac arrest, the paramedics’ job is not to advise dieting and exercise — but to restart the heart.

The US economy is sliding into deflation. Deflation trashed Japan’s high-savings economy for a decade; two decades after the crash it remains weak. Deflation is potentially lethal to a high-debt economy like America’s.

The evidence of the early stages of a deflationary contraction is all around us. Just to mention a few: collapsing commodity prices, the price of gold falling, the US dollar rising almost 20% since mid-July, and the collapse of yields on one-year Treasury Inflation Protected Securities (TIPS). All are extraordinary. TIPS were priced for inflation a month ago.

Perhaps the global economy as well, in the downturn of the first global (or most global, ever) business cycle. The center is cracking (the US, the EU, and Japan). So are some nations on the fringes (e.g., Eastern Europe, Argentina, Pakistan). And points in between, also (e.g, Iceland, South Korea). This is a tear in the fabric of the global economy, which accelerates as it grows.

So far only the financial markets have felt its full force, but soon we will see the real world impacts on trade, employment, incomes, etc. Some leading indicators suggest the magnitude of the coming storm, such as the Baltic Freight Index down 90% from its peak on 20 May (to learn about it see Wikipedia, or this Slate article).

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The result: By default the government becomes the primary economic actor. Its spending and investment decisions drive the economy. Not just immediately, but — as a result of the investments it makes — for many years after normal processes are restored. We saw this in Japan during the 1990’s. It borrowed and borrowed, but frittered the money away on largely unnecessary projects (e.g., bridges to nowhere, train stations in the middle of nowhere). This kept their economy rolling, but the debt remains and they have little to show for it.

Now we in a situation like Japan circa 1990. Interest rates must go to near-zero. Government spending programs must be rapidly initiated on a scale not seen since WWII. Government decisions will determine what America looks like for the next two decades (at least). Who gets loans, what kinds of infrastructure to build, what kind of training programs for young people and the older unemployed … it is a long list.