Thursday, March 13, 2008

Extreme uncertainty about the future.

There is a lot of speculation going on currently about the likely course of further events. While economists have generally agreed that economy has already entered the recession, there is still a big ongoing debate about 'what next'.

You will find plenty of experts out there who predict anything from mild and short recession, to mild and long, to severe and long depression, and almost any other imaginable type of recession. Some predict deflation, some inflation, some stagflation, and yes, every imaginable type of -flation has someone predicting it. Well, most of these folk are paid economists and have to earn their salary, so fine.

But if you are a 'normal' person trying to figure out what will come out of this historical market turmoil, understand one thing: nobody has a frigging idea about what is coming, and all predictions are just a wild guessing game. There just isn't a sensible way to estimate the future state of a very unstable system that is desperately searching for an equilibrium and is not finding it, where moves by just a few big financial players can have gigantic consequences. Everyone who dares to make a prediction in this environment is effectively betting that they can see inside the minds of all the market players involved and how said players will react to the events that, well, just never happened before.

So what are the uncertainties and who are these 'important players'?
1. Federal Reserve: Bernanke is playing with fire. Credit crunch is a strong deflationary force, and all his experimental measures are done in order to mount a strong inflationary force to oppose it. It is very hard to balance two very strong forces. By continually raising their bets and directly taking on big risks, Fed officials put themselves in a situation where if anything goes wrong with their plans, they will trigger hyper-inflation, effectively killing any trust in US financial system. While attempting to mitigate a big crisis, they risk creating an enormous one.

2. Foreign central banks: China, Japan, India, Russia, Brazil - those countries together hold several trillions of US Treasuries, many (most?) of them short-term T-bills. The reason is that they have been pegging their currencies to dollar, effectively supporting the dollar and financing US deficit. China alone is buying around $60 billion USD every month. If not for this support, dollar would have been much lower than even it's present all-time low mark. Now, these countries have much to lose if dollar tanks (they lose their savings) and therefore they will do everything they can to continue supporting the dollar. But they are not omnipotent - this intervention creates significant stress and dislocations in their economies, and at some point they may simply be unable to continue their support. They certainly know this, and they have been probably watching Bernanke's antics with great unease. They have already been watching their dollar-denominated savings depreciate by 20% a year for the last 4 years. If Bernanke mis-steps, they may well decide that dollar is toast no matter what, and they should save as much as they can right now. If dollar panic by foreign central banks happens, dollar will lose all its value faster than you will hear the news about it. Just ask the people who lived in Soviet Union in the early 90s about how such things go. Again, foreign governments will try to avoid this at all cost, but this thing may simply be bigger than what they can handle.

3. US Congress. If you want a testament to how economically retarded the members of Congress are, look no further that the latest idea by Johnny Isakson on how to 'save' the housing market. He suggests Congress gives $15000 dollars to anyone who buys a home. Of course, all this would do is push house prices $15000 higher... If I had to guess what the Congress' role in the coming events will be I would say it's to pass several measures to help the economy, each having a negative impact in reality. However, where things could get really dangerous is if anti-immigration and anti-outsourcing lobby can convince Congress that it's all fault of evil foreigners. If Congress tries to 'save' US economy by imposing tariffs and starting trade wars, that would be one of the surest ways to finish off both the US dollar and US economy. Also, in case of severe crises politicians tend to equate saving the economy with robbing their own citizens.

So, is there hope? Considering that Bernanke hasn't misstepped yet, I think there is a significant chance (maybe even higher than 50%) that he will be successful in moderating this unwind and preventing a chaotic cascade of defaults. The debt deflation will slowly continue, offset by Fed's gymnastics. Many companies will default, but over a longer time span. Banks will not be able to lend much but won't be allowed to fail either, in what Mish calls zombification of banks. For economy, it is equivalent to banks going bankrupt but being instantly nationalized. In this scenario, US is looking at a decade or more of zero to negative growth, but the upside is that unemployment rate could stay low and most people would get by without severe pain. In terms of economic damage this would be equivalent to experiencing another Great Depression (we can't avoid taking this damage anyway) but spread over a long period of time it would do only moderate harm to most people.

On the opposite end of hope, it is possible that Fed overshoots, or Congress overreacts, or something else happens that plunges US into a real depression with GDP contraction of over 10% in a single year. If everything goes as wrong as it can, the economy could contract by as much as 50%, the dollar could go the way of peso, and most people would lose their savings (not that Americans have much saved).

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