The World Economy

A Longer View

 

by Wayne Daniels

November 2014

 

Here are a few observations on where the world's economies are and where they are likely to evolve over the next several years.

 

Lets see where they are now:  

Japan is officially in a recession and has announced a major new round of QE to continue for months, if not years.  Japanese interest rates will stay at zero for the foreseeable future.  Both demographics and the size of their national debt will prevent any meaningful improvement in the Japanese economy during, at least, the next 5 years.

 

The European economies continue to be stuck in neutral and will likely follow France into recession.  Most everyone (except Germany) has a national debt that exceeds GDP and must run deficits in order to pay the promised benefits to their voters.  European exports, mostly German, will continue to slow as demand worldwide continues to decline. It is quite likely that some event will trigger another financial crisis which will result in at least one and maybe more of these countries following Greece into bankruptcy: Italy, Spain, Portugal and/or France.

 

The Chinese economy is also slowing from the reported 10% per year rate of the last 20+ years to something in the mid single digit range. (Apply your own adjustment factor to bring the reported numbers closer to reality.)  In any case, their economy is trying to make the transition from being the low cost place to assemble items designed elsewhere to becoming a value added producer of items they design.  At best that transition will take a decade or so as will the transition to selling much of the stuff they produce in their domestic market.  There is ample opportunity for things to go wrong and neither transition is likely to be smooth.

 

The US economic recovery continues driven both by the massive QE over the past 6 years and the oil and gas boom.  US exports (15% of GDP) will slow along with the worldwide demand for goods and services.  The FED has officially ended QE and the 30% decline in the price of crude oil will slow new oil and gas drilling.  It is not clear where the incremental future growth will come from.  How will the US economy continue to grow while Europe, Japan, China and most of the developing world are not?

 

Where does the world go from here?

The USA, Japan and just about every other major democracy has a debt problem. All are now reaching the natural limit of Keynesism (borrow & spend to keep the economy moving) – its called bankruptcy.  When the national debt is greater than GDP, there is little to no chance that the debt will ever be paid down much less paid off. 

 

When the FED announced the end of QE in September, they also said that short term interest rates would continue to be held at or near zero percent.  The only way to hold interest rates below the inflation rate is for the FED to be the buyer of last resort and buy any T-Bills, etc. that the market is not willing to take.  Since about half of our $17 trillion national debt has a maturity of less than 1 year, that means that the US Treasury has to refinance an average of $0.7 trillion/month plus sell an additional $0.05 trillion in new debt each month. 

 

If the FED is unable, or unwilling, to keep expanding its balance sheet by buying more T-Bills, etc. (also known as QE) then the only way for the US Treasury to sell these bonds is to let the markets find a price/yield where the markets will clear.  The average interest rate on that $17 trillion of debt is currently ~ 1%.  Interest on the national debt is ~ 6% of the federal budget.  If the average interest rate on the debt went back to the historical norm – from 1950 to 1990 it was the inflation rate plus 1% to 2% - then the interest paid percentage of the federal budget would jump to around 20% of the budget.  That is the entire discretionary spending portion of the budget and no politician in need of re-election can afford to let that happen.

 

The hard choices are: Cut spending – hard because every dollar in the budget has a constituency, Raise taxes – hard because, as the Japanese just learned, a big tax increase can throw the economy into a recession.  The easier choice is to continue QE and simply cover the deficit with the printing press.  This choice eventually leads to a period of hyper inflation and the currency becoming worthless.  So far the US has avoided the inflation (ignoring supermarket prices) and the dollar has actually strengthened this year.  The USA seems to be the “least sick man” in the room at the moment.

 

Another expensive problem continues to be radical Islam.  The 10,000+ Wahhabi madrassas worldwide continue to turn out about half million 18 year old would be jihadies each year.  ISIS and other such organizations have recently become much more effective in converting all of that youthful energy into very expensive problems for the rest of the world.  One recent news story put the cost of the current air campaign against ISIS in Syria and Iraq at $300,000 per hour.  This cost is likely to go much higher if, as I expect, our current involvement escalates into Gulf War.

 

I have long been a believer in the “Muddle Through” theory of governance.  While our so called leaders rarely seem to know what they are doing, the country has found a way to get through what ever the problem(s) of the day were and wake up the next day to face other challenges.  I do not claim to know either how or why it has worked, but it has.  Maybe we have just been lucky.

 

An example of “Muddle Through” is how the oil and gas boom in the US is breaking our almost century old dependence on Middle East (primarily Saudi) oil.  Despite the best efforts of the environmental lobby and their friends in the main stream media and the Democratic party, the US has managed to bring enough new production online to drive the world price of crude oil down some 30%.  The new jobs, etc. have been great for the domestic economy and the resulting lower fuel prices are the equivalent of a big tax cut for consumers.  In addition, lower crude prices are creating problems for several countries that wish us harm.  The most vulnerable seems to be Venezuela followed by Russia, Iran and the various smaller middle eastern producers.  The longer the price of crude stays below $75/barrel, the more severe the economic problems in those countries will become.

 

Other examples are how our country has survived the more or less regular business cycles that have occurred over the past century.  Regardless of what the politicians have done or not done, the country has always muddled through.

 

I would like to think the USA and the other major democracies will find a way to “Muddle Through” their debt problem(s).  I do not see how they can, but that probably says more about me than it does about the intractability of the problem. 

 

Thomas Piketty, the French economist who works on wealth and income inequality, has documented that the income inequality gap widened from 1800 to 1914, shrank from 1914 to   ~ 1975 and has been getting wider ever since.  Here is my theory why that happened: the period from 1800 until the start of WWI was the golden age of the Industrial Revolution which created vast amounts of wealth.  Much of that wealth flowed to the leaders of the major industries – steel, oil, railroads, autos, etc.  The press labeled those wealthy industry leaders the Robber Barons.  Much of that wealth was destroyed in two world wars and the great depression and the spread narrowed. The 1950s and 1960s saw the rise of the middle class due at least in part to improved education resulting from programs like the GI Bill.  The Information Revolution began in the mid 1970s with the introduction of the personal computer.  The information revolution has also created vast new pools of wealth which has mostly flowed to the leaders of the new industries like software, semiconductors, etc.  Since 1980 the real (inflation adjusted) wages of everyone else have been approximately flat.

 

My fearless forecast for the next decade = little to no growth worldwide as Europe, Japan and the USA will all be constrained by their debt problems.  The Information Revolution will continue to produce very useful gadgets (like the smart phone) which will give just about everyone access to the world's store of knowledge.  Don't be surprised if a lot of people figure out how to use that knowledge to improve their lives.  The most important skill may turn out to be knowing how to ask Google the right question to get the information you need. There is real upside to that.

 

On the downside, the ongoing wars between radical Islam and the rest of the world will cause both sides to waste a great deal of their accumulated wealth.

 

Not necessarily the views of the blog, but the views of the author.