Two weeks ago I published the optimistic scenario for how the post-2008 economy resolves itself, an entry that was full of wishful thinking and, in my opinion, a lot of rosy assumptions that have very little likelihood of coming to fruition. I do not think we’ll run the table, that Quantitative Easing ends with a gradual taper, leaving the housing market to rise despite rising interest rates, the stock market to climb despite increased borrowing costs and Congress able to act decisively, in a way that does not negatively impact the economy, when the carrying costs on the national debt soars. While I’ve not conducted a statistical analysis, I would give the optimistic scenario a less than 5% chance it will come to fruition.
That is not so say that the pessimistic scenario I’m outlining today has a high likelihood either, although I do find it more likely. That being said, a 5% chance that it will all work out weighed against even a 5% chance that the worst case scenario will happen should raise some doubt on how much we are risking and to what end. Ultimately, our economy is in need of a massive retooling. We’re doing everything we can to keep that from happening. If we succeed, we get the optimistic scenario I outlined, a malaise with modest improvement over where we are today. If we fail, here is one way this could go.
The Federal Reserve is not going to be able to end its QE program. Just the mild suggestion that someday in the future there will be a tapering put the bond markets in an uproar. Nobody wants to be the last one to exit this market, and so everyone sitting on a carry spread has one eye always on the exit. Note that the Fed is not suggesting a return to market rates of interest — they still intend to keep rates artificially low — just that they are going to slow that rate at which they pound rates lower with a weekly QE sledgehammer. There is a prisoner’s dilemma at work here.
So the Fed keeps printing and printing and printing. That is, until inflation shows up on our shores.
There is two important things to understand about inflation. First, the Fed’s actions have produced inflation and are continuing to produce inflation, it is just not the kind reported in the vaunted CPI. For many economists, housing prices can artificially triple from cheap credit and it isn’t inflation so long as milk prices don’t rise. Also, we are exporting our inflation. When our cheap credit allows us to buy imported goods, that money winds up in some emerging economy, driving up their prices.
Think those protests in Brazil, Egypt and Turkey have nothing to do with US monetary policy? The spark may be domestic, but the underlying fuel that burns is rising prices.
The second important thing to understand is that inflation is like ketchup in a glass bottle. You want a little ketchup so you tip the bottle upside down. One shake – nothing. Two shakes – nothing. Three. Four. Five. You give it a sixth shake and a third of the bottle spills out all at once. In other words, it is not like there is an inflation dial you can just gradually move up and down. Inflation could easily spiral on the US, especially if all of those foreign holders of dollar-backed debt (not to mention domestic holders, although they are easier to coerce) logically decided they would rather own acres of cornfield in Nebraska, some oils wells, a couple factories or a few trillion in other real assets rather than a currency that is being aggressively debased.
So the Fed keeps printing until they are forced to stop by a spike in inflation. They may still be unwilling to act, even in the face of double digit inflation, but ultimately they will be forced to abandon QE and raise interest rates. A return to the double digit rates of the early 1980’s would not be without precedent (and may ultimately be an underestimate, given where we are today compared to then).
When interest rates climb, it’s over. The Fed has lost control — or the illusion of control is gone — and the correction that was put off is now in full, unabated motion.
A federal debt of $17 trillion now has annual interest in the $2 trillion range, making things like the 2012 interest payment ($220 billion), the difficult decision of the fiscal cliff ($60 billion) and the horrors of the recent sequestration ($85 billion) seem quaint in comparison. Raising taxes, slashing entitlements, gutting the military and every other formerly unthinkable action now becomes the low hanging fruit in a debate over a federal budget that is nearly 50% interest payments.
Things at the state level are perhaps even worse. Many states have simply given up — states like Illinois, New Jersey and California — and have declared bankruptcy. Those pension obligations that were dependent on rates of return 250% greater than historic growth rates are now simply discharged, the pensioners getting pennies on the dollar in a lump sum check. Things like maintaining roads — let alone building new ones — are sporadic, where they happen at all. High speed rail systems half built with borrowed money seem like a cruel joke.
Needless to say, rising interest rates — and the steep reduction in government contracts — force many businesses to go bankrupt, the artificial gains during the cheap money era now gone exposing poor underlying business models and weak balance sheets. Those that remain have higher prices and a shrinking market. Unemployment consequently spikes and the Misery Index (inflation plus unemployment) is revived. In nominal terms, the stock market may be higher or lower, but who cares because in real terms (inflation taken into account) it is dropping dramatically.
Unlike the early 1980’s, however, housing prices do not inflate, their value already too high from prior attempts to prop up the housing market. These prices remain sticky, refusing to drop substantially. The stagnation in price freezes markets, preventing people from being able to sell and move for new work or better opportunity or being liquidated by price deflation. This is extra unfortunate as price inflation is making everything else associated with home ownership — local taxes, replacement shingles for the roof, fixing a broken window — vastly more expensive. This problem — can’t sell but can’t afford not to — is the most pronounced in auto-based neighborhoods, where demand for housing is lowest, jobs fewest and mobility problematic in the face of inflating gas prices, now over $6 per gallon in some places (even though Americans are using less).
In the end, the economy reaches equilibrium. A market rate of interest is restored, but not until the other imbalances of the economy are largely addressed. Median wages have increased bringing median house prices — which have stayed flat — back in line with income. This has not provided the average family with more resources, however, as it now takes twice as much to fill up the refrigerator and the car each month. Americans become savers again, not by choice but because they can’t afford credit, their houses and 401(k) plans have not kept up with inflation and interest rates on savings are once again respectable. The quality of life for most Americans is dramatically changed to the negative, devastating the poorest of the poor. Riots and large protests are now a common occurrence (although the government, thanks to the NSA, are able to head off the worst of the latter by detaining "evil doers" that are stirring things up).
Finally, following the inevitable path of all great empires, the dominance of the dollar is relinquished. After 70 years as the world’s reserve currency, the dollar now competes with a gold-backed Renminbi, a gold-backed Russian Ruble, and a new, northern-bloc Euro backed by a basket of commodities and currencies. The dollar, too, finds international stability only when it ceases to be a fiat currency and, once again, pegs its value to some sort of "barbarous relic" that is beyond the reach of a government or central bank to devalue.
I’ll close by saying again that this is not a prediction as much as it is an exercise in imagining possibilities. I contend that we’re so fixated on maintaining the status quo that we’re not even considering the likelihood that we’ll be successful (low, in my opinion) or the risk that something calamitous could happen (by no means certain, but much higher than I am comfortable with).
For the time being, we’re simply content with being dumb money.
You can get more of Chuck Marohn’s insights by reading his book, Thoughts on Building Strong Towns (Volume 1). It is a primer on the Strong Towns movement and an essential read for those wanting to get up to speed quickly.
You can also chat with Chuck, Nate Hood, Andrew Burleson, Justin Burslie and many others over at the Strong Towns Network. Join the ongoing conversation on how to make yours a strong town.