oftwominds-Charles Hugh Smith

The U.S./Global Economy Already has the Flu

April 28, 2009

Not to make light of a deadly disease, but metaphorically the U.S. and global economies already have the flu.

The "disease metaphor" is overused in modern-day America. Every character flaw is now a "disorder" and every series of poor daily choices excused as a "syndrome." Unsurprisingly, some costly pharmaceutical product soon pops up to sooth every "symptom" of "chronic disorder."

The Fed and Treasury have pumped the patient so full of "miracle drugs" (liquidity, etc.) the stuff is oozing out the pores. But unfortunately, the global economy and its 25%-of-global-GDP component the U.S. economy still have a dogged financial flu of unknown lethality.

Symptoms include:

* restricted borrowing

* declining employment

* declining tax revenues

* declining balance sheets

* feverish euphoria that "the worst is over" even as the illness deepens

* declining asset valuations

* rising anxiety

I'd like to place this global "financial flu" in two contexts: historical and individual.

The alarming qualities of this swine flu (that it has evolved to spread from human to human, that it has arisen outside of typical flu season, etc.) have triggered references to the global flu pandemic of 1918-19, just as the "financial flu" has launched innumerable references to the Great Depression of 1929, the Panic of 1907, the stagflation of the 70s, etc.

Let's consider these connections in turn.

To the best of my knowledge, we do not yet understand what specific elements of the 1918 flu strain's design made it so lethal to people in their prime. My reading on the topic suggests that its fatal qualities are not easy to identify; there is no glaringly unique chunk of DNA which stands out as "probable cause." The lethality of that strain may reside in RNA expression or other subtle processes not readily visible in standard DNA analysis.

Perhaps those with deep knowledge of microbiology and immune response can provide us with a better understanding than my layman's summary.

In any event, the difference between relatively benign flu's and more lethal strains is poorly understood.

Despite the millions of words expended in understanding financial panics and depressions, I wonder if our understanding of the current "financial flu" is similarly incomplete.

I am not a scholar of financial panics nor of the Great Depression, and hence my conclusions may well be simplistic or off-target. With that warning in mind, it strikes me that the Panic of 1907, the Great Depression and the current "financial flu" can all be reduced to rather simple "initial conditions."

Pared down to fundamentals, the Panic of 1907 was essentially a sudden loss of confidence. As those with capital decided not to risk lending it, short-term interest rates shot up to extremely high levels and those who needed to roll old debt into new debt were unable to do so and as a result they were driven into bankruptcy/insolvency.

The central conceit of economics is that we can measure and quantify what Keynes labeled "animal spirits" and what the rest of us call confidence.When confidence vanishes it cannot be rebuilt in a short time; the personal analogy is betrayal or the discovery that one's spouse is having an affair.

In 1907, the loss of confidence was essentially financial, and thus J.P. Morgan could assemble his colleagues and rivals and demand they step up to the plate with additional capital to calm the market's shattered nerves.

This sudden loss of confidence was thus quickly restored, and those without speculative positions or large short-term debts were not heavily impacted.

Put another way: those who took imprudent risks got burned. By and large, the prudent did not.

The Great Depression had different initial conditions and DNA. Somewhat akin to the horrendous 1918 flu which killed healthy in-their-prime victims at higher rates than the vulnerable, the Great Depression bank closures wiped out the prudent just as effectively as it devastated imprudently leveraged speculators.

This destruction of prudently saved wealth cannot be emphasized enough.Previous financial panics did of course cause banks to fold, wiping out their prudent savers, but the main-force wealth destruction occurred in risky debt, leveraged debt and speculative instruments/financial gambles.

In the Great Depression, thousands of banks closed their doors, wiping out the savings accrued by the prudent. The resulting destruction of confidence meant the prudent and imprudent alike were denied access to capital. Stripped of perhaps misleading complexities, is there any wonder why this complete betrayal of trust and destruction of prudently accrued wealth caused a lengthy Depression of "animal spirits" and a semi-permanent avoidance of risk?

Put in these terms, the loss of faith in the system and the avoidance of lending/risk were entirely rational.

The current "financial flu" shares two features with the The Great Depression: one is the explosive expansion of speculation, leverage and debt. For many, that is parallel enough. But it seems to me there is a key difference: unlike those destroyed by their bank's closure in the 1930s, today's prudent investor/earner is still whole.

Those who prudently paid off their mortgage rather than increase it are not being foreclosed. Those who put down 30% and refused to buy in at the top may well have suffered a decline in net worth but they are not wiped out. Their small fixed-rate mortgages are far less of a burden and thus far less of a risk than large option-ARM adjustable-rate mortgages taken on at the top of the housing bubble.

Those who prudently lived on 50% or 65% of their net income built up enough savings to give them time to fashion a Plan B when unemployment or medical catastrophe struck. Those who saw through the bogus false prosperity of this decade and the housing bubble stayed put or rented; they paid down high-cost debt with lower-cost debt but did not borrow more.

Those local banks which continued prudently loaning money only to prudent, low-risk borrowers, who avoided the allure of loaning vast sums to mall developers and builders of "luxury homes" on the outskirts of town, are still whole and still well-capitalized.

For a variety of cultural reasons it is somehow not quite cricket to point out that the imprudent are being wiped out while the prudent are not. Yes, wealth is being destroyed across the entire global spectrum, and those at the bottom of the heap without assets or social safety nets are suffering terribly through no imprudence on their part.

But in developed and developing economies, those who took on imprudent speculative risks and leveraged debt are being wiped out, as is the natural order of capitalism; the fatal flaw in the system is not that these excesses are being purged but that the State in all its vast powers is attempting to protect the staggeringly imprudent from the losses which are rightfully theirs.

One did not have to be wealthy or a member of the Plutocracy to take on extraordinarily risky, leveraged debt, and thus it is not just the wealthy and well-connected who are suffering the consequences of imprudent bets placed at the top of speculative bubbles.

But it is the super-wealthy members of the financial Plutocracy who are buying "protection" from the State's own Plutocracy. By all rights, the insiders of every mortgage mill, investment bank and insolvent lender should be bankrupted and their ill-gotten gains seized and divided up amongst legimitate investors (those who were conned into buying "safe" bonds issued by these scoundrels, etc.)

Furthermore, the market should be allowed to price their remaining assets at auction, now not later.

The second feature the current "financial flu" shares with the Great Depression is a systemic loss of faith in the system--for perfectly rational reasons. What makes Fed Chairman Ben Bernanke's widely touted expertise in the Great Depression especially pathetic is his inability to grasp its key driver: a rational, semi-permanent loss of confidence and faith in the financial system.

The rational response to a loss of faith is to save, pay down debt and refuse the false blandishments of additional leveraged/unsecured/risky debt.

What few observers note about Japan's "Lost Decade" (now roughly two decades long, but who's counting?) is that it is not only a financial phenomenon that can be massaged and tweaked by policy but a systemic loss of confidence in the entire Japanese system and economy.

Those who know Japan well know all that is left unspoken out of respect and a desire to avoid loss of face: Japan has by and large refused to face the structural flaws in its democracy and economy. The policy tweaks are just that, tweaks, often hollow and for public show. Beneath the surface, the economy is esentially the same one which took shape in the post-war ruins of the late 40s, infected with many of the same elites and structures which existed before World War II.

Thus Japan is doomed to stagnation until its populace demands real adaptations to new realities instead of doomed pandering to established elites. (Though not a scholar of Japan per se, I did study the language, economy, geography, history, culture and literature at university and we have many friends in Japan.)

In a similar vein, Bernanke and his minions are not "saving" the U.S. financial system--they are dooming it to semi-permanent stagnation by protecting the investment banking elites from losses. That the system is rigged is now painfully obvious; that the guilty will never be prosecuted is now abundantly clear; that no real reforms will be made is now obvious, too.

So exactly what rational reason does any prudent citizen have to believe the system is fair, just, transparent, an open market that establishes risk for all to judge with a system of oversight which demands equally forthright accounting from all firms large and small, etc.? Answer: none.

The only prudent response to the charade of "reform" and "renewed growth" is: we don't get fooled again.

Bernanke is powerless to restore confidence because his every action is designed to protect and mask the very excesses and Plutocratic over-reach which enabled and fed the financial meltdown. Rather than healing the system he is spreading the disease of no-confidence into every nook and cranny of the global economy.

Now everyone on the planet knows it's all lies: the stress test, the unemployment numbers, the massaging of the Federal budget, the true size of the Fed's manipulations, the true size of the Plutocracy's stupendous systemic losses, and on and on.

The great irony of the present Depression-in-the-works and the Great Depression of the 1930s is that all this debate over policy is misguided.None of President Roosevelt's policies worked, other than ameliorating the suffering of hunger via make-work and social-safety net spending. None of the policies restored "animal spirits" or faith in the system because it was still abundantly clear that the system hadn't actually been reformed or fixed.

This profound loss of faith cannot be healed with bogus accounting or policy tweaks. Indeed, those scarred by the 1930s Depression never did feel comfortable borrowing vast sums of money, and many never trusted banks.

The voters of Japan attempted to vote in real change in the 1990s, but their efforts were eventually stalled by the usual Powers That Be. Having failed to bring about real change, in a way democracy itself has been discredited; people just give up and make the best of what's left.

The loss of faith in the U.S. financial system is profound, and it will not be "fixed" by blatantly phony "reforms." Frequent contributor Harun I. summarized the situation very succinctly:

I wonder if most people examine their self-talk? As we bandy about words like 'recovery' and 'recession', do we, as a majority, examine these words in any sort of meaningful context?
Do we look at the charts posted on your site and others like it and think in terms of debt based economic growth and manufacturing based economic growth as a context of recovery and recession?
Those charts are parabolic while "production" was minimal. In the context of debt based growth, government (which is really the taxpayer, which by the way is consumers) has stepped in to try to maintain the parabolic trajectories, and contraction is still occurring. Recovery, in the context of the current economic paradigm, is a return to parabolic growth rates of debt. The unsustainable, the imprudent and all the associated fraud has become the necessary 'norm' to which we must return.
(Weird accounting: If government (revenue) = taxpayers = consumers, how can the savings rate rise in the face of parabolic government spending?)
In contrast, the sustainable and prudent is now a recession that must not be allowed to happen. We have already stepped off the Orwellian cliff.
If normal growth in a debt based economy means massive unemployment, and serial bubble blowing is the only way to maintain full employment, then we obviously need to reconsider our assumptions. I believe this reflects some of your ideas about scalability traps.
And so I wonder, if everyone thought of 'recovery' in its true context, which is understated as "irrational exuberance", is this the course we are to pursue? And if so, what is the expected outcome?
Is this psychological pattern much different from that of any other collapsed society?
Everything begins with first decisions. When we embarked down the path of this experiment all answers to problems were directed toward how to make it work until it became too disruptive to change it when it became obvious that it could not work. And so, it appears that politicians adopted an attitude of "not on my watch" bubble blowing patchwork solutions instead of exercising the courage to make unpleasant decisions.
Now the only way that "change" occurs is in the wake of some sort of disaster. But knee-jerk solutions are usually the wrong solution to structural deficiencies.
Change that you can believe in is now at hand. It is not going to be what most expected.

I will leave you with this thought-provoking comment from essayist/analyst Zeus Y:

Swine flu as the "endogenous event"? My intuition says yes and no. No, in that it won't be decisive. Yes, in that it will pull us further toward the necessary precipice. Think about it in personal terms. I don't know about you, but my major decisions and evolutions came when my personal "swine flu" (metaphorically) mixed with other stressors to create a tipping point. Truth be told, I think people are unconsciously longing for this tipping point, even as they are consciously dreading it. Often diseases and other catastrophes provide an excuse to let go.

Thank you, Harun and Zeus. I will have more to say on these topics but suffice it to say that I believe the first of several tipping points is at hand. Letting go of a failed model of "success," a failed identity and a failed financial system is painful but positive once we reach the "letting go" moment of surrender/release.

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