Monday, October 20, 2008

Our sins and our debts ...

... are often more than we know, or so runs an old English proverb.

Linking to a post by Fabius Maximus, I recently pointed out the heavy level of societal indebtedness in America, especially household and consumer debt. The developing economic downturn will probably be an international episode, lasting part or all of a decade, like what Japan went through in the 1990s, the so-called "Lost Decade." (The recession proper might be short, but not the subsequent stagnation.) Post-bubble, the name of the game is deleveraging, working off debt, renegotiating debt, and (in some cases) defaulting on debt. The need to undo some of this indebtedness (the dead hand of the past) will put a definite crimp in everyone's style for at least a while, now and in the future.

The so-called "credit crisis" we've just passed through isn't really a "credit" crisis so much as a "creditworthiness crisis". If you have good credit and can prove it, you can borrow, even though the terms will be tougher. What has lending markets paralyzed is distrust of borrowers in unknown financial condition. Many are fine, some are struggling, and some are bankrupt. Helping bankrupt actors (banks, businesses, individuals) continue to borrow is a big mistake; it just prolongs the crisis and sends good money after bad. We have ways of dealing with bankruptcy, including deposit insurance for bankrupt banks. The right thing to do -- and what was done in the savings and loan crisis of the early 90s -- is to let the bankrupt go bankrupt, compensate depositors, collect and sell assets, and allow the non-bankrupt to prove their creditworthiness. Once everyone's financial state, both good and bad, is clarified, lenders will start lending again.

Friends keep asking me if (especially if Obama wins) we'll get a new New Deal. The answer is no, we won't. The New Deal did not cure the Great Depression, but undoubtedly prolonged it. The world economy is far too interconnected to allow such economic experiments today: socialism requires, among other things, a closed economy and a fairly closed society. We're moving farther and farther away from conditions that made such maneuvers possible.

It is possible that reckless politicians could launch a trade war, fueled by demagoguery about globalization and alleged "deregulation." Investor concern about this, here and elsewhere, is one of the reasons for the big drops in stock exchanges worldwide in the last month. If it starts to develop, it must be stopped dead in its tracks. It would leave the world a less secure and poorer place, impacting the poorest countries the most.

But there are reasons closer to home why we won't be seeing a new New Deal, and that is that governments are no longer in the strong position vis-a-vis their economies the way they were in the 1930s. Western governments today are among the world's biggest debtors. Given the global economic integration we have now, inflating away the debt (by printing money) is not an option, and governments cannot raise taxes much, if at all. Both options would cause investors to flee and a much more serious credit crisis. The remaining possibilities are deflation (which I think we're definitely heading into in any case, central banks being unable to stop it) and a higher probability of government debt defaults. I don't think the US federal government is in that situation, but a number of states and municipalities are.

In a sentence: governments will not be counteracting private retrenchment; they will themselves be retrenching.

Deflation will bring some good things, the most important being the undermining of "commodity dictatorships" like Russia, Venezuela, and Iran. Commodity prices are sensitive barometers of demand. With demand slackening off, all such governments are and will remain in serious trouble.

Although I strongly doubt the conventional wisdom that the Democrats will gain in Congress -- given Congress' unpopularity, they're more likely to lose some seats in the House -- my recommendation is to sit back and let an Obama administration go about its wrecking work. Voters will quickly suffer a shattering disillusionment once the Candyman Messiah is discredited. The real question is whether an effective conservative movement can be rebuilt from the wreckage of the last ten years. What we're seeing now -- a Republican administration looking the other way in the face of government-enabled bad debt, effectively nationalizing banks, extending government credit far beyond anything ever conceived, and so on -- is what happens when you don't have a conservative party or effective conservative politicians.

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