The Future: Averting Disaster

The future – the happiness and prosperity of mankind – will be determined by how global supply and global demand are brought back into balance. If the means are found to expand aggregate demand sufficiently and sustainably, then the global excess supply will be absorbed and the global economy will begin to grow again. If, on the other hand, equilibrium is restored by a collapse in supply – back to a point at which there is real demand, a point determined by the current income and purchasing power of the individuals who comprise the world’s population – then globalization will collapse and the world economy will plunge into depression. Should that occur, millions of people around the world could starve before the decade is out. The geopolitical repercussions of such a scenario would be beyond dire.

The outcome will be decided by government policy. The current government policy of supporting global aggregate demand by borrowing, printing and spending trillions of dollars without correcting the imbalances at the heart of the crisis are unsustainable and they will fail. Failure will mean disaster. If disaster is to be averted new policies must be crafted and implemented. Those policies must produce a steady and sustainable increase in global aggregate demand – in contrast to the recent unsustainable credit-driven approach – in order first to bring global supply and demand back into equilibrium and then to allow them to expand in tandem.

How will the future play out? Consider two scenarios: the Bad Future which will emerge out of current policies, and the Good Future and the policies necessary to achieve it.

The starting point for both scenarios is the present. At present the world is on the brink of disaster because global supply greatly exceeds global demand or, at least, the damand that people can afford to pay for out of their income. This imbalance between supply and demand has come about because governments abandoned gold-based sound money and began creating fiat money in vast amounts. Financiers became free to create credit without limit once all credit was denominated in currencies without a restraint of gold backing. A credit explosion produced an equally extraordinary expansion of industrial capacity (supply) around the world. Purchasing power (demand) only kept pace thanks to a surge in consumer debt. The rise in real income was insufficient because globalization pushed down wages in the developed economies and adverse demographic trends held them down in the developing economies.

When the consumer debt bubble popped in 2008, global demand crashed but global supply remained in place. Subsequently, governments have spent trillions of dollars attempting to absorb the excess supply so as to prevent a global depression. They continue to do so.

When the collapse in private sector demand occurred, government knew they must replace the shortfall with government spending to prevent a depression. In this they succeeded. Their policies are not sustainable, however. Moreover, there is no sign they possess any understanding — much less strategy – of how to permanently resolve the worldwide imbalance between supply and demand. Therefore, the bad future scenario is based on the probable assumption that governments will carry on with current policies as long as they can. Let’s consider how this is likely to unfold.

The US government is propping up the US economy with annual budget deficits in excess of $1 trillion, roughly equivalent to 10% of US GDP. Government spending puts money in the pockets of American consumers and US consumption pulls in imports, which will result in a trade deficit of approximately $500 billion in 2011. That deficit is a subsidy to the rest of the world. However, despite massive government spending, the US economy has begun to weaken again and US unemployment remains stuck at 10%. Jobs aren’t being created in the United States because, with wages in the manufacturing sector that are 40 times higher than the prevailing global wage rate of $5 per day, the US economy is simply no longer viable as it is currently structured.

With debt to GDP of less than 75%, the US government would have no problem continuing to prop up the economy with even larger deficits for many years to come. (Japan’s ratio of government debt to GDP is 225%.) However, a political backlash against government deficit spending has made additional government “stimulus” politically impossible for now. That leaves only monetary policy; and with interest rates very near zero, monetary policy means creating more money — much more money — an act the Fed refers to as Quantitative Easing. During the past two years, the Fed created $1.7 trillion, which expanded its balance sheet by 170%. At the time of writing, the second round of Quantitative Easing, QE II, is being launched. This will involve the creation of approximately $75 billion a month through mid-2011 and, perhaps, much longer.

QE II is the next step forward in the direction of the Bad Future. The Fed is printing money and using the money to buy US government bonds. This will allow the government to continue propping up the economy with trillion dollar budget deficits without pushing up interest rates and crowding out the private sector. That is because the government won’t have to borrow from the private sector. It will obtain its funding from the Fed. This arrangement will stave off a depression in the short run, but it does nothing to correct the underlying imbalances driving the crisis. Eventually, one of two things will happen. Either there will be a political backlash against free trade, as it becomes increasingly obvious that free trade is not working out very well for the average American, and trade tariffs are put up. Or, the Fed will create so much new money that inflation will accelerate causing a stock market, bond market and dollar crash; social unrest in the United States as the savings of the middle class are destroyed; and food riots or worse elsewhere around the world as commodity prices soar and food becomes unaffordable for the two billion people who earn less than $2 per day.

Either way, within five to ten years, the US economy will collapse in depression and drag the global economy down with it. Globalization will collapse. International tensions will rise. Hunger will spread. Tempers flare. And then BANG: the Bad Future ends very badly.

That future is not inevitable. All that is required to bring about a Good Future instead are policies that expand global aggregate demand so that demand is sufficient to meet and keep pace with the growth in global aggregate supply. That could be accomplished in a number of ways. A steadily rising global minimum wage that takes wage rates from $5 to $15 per day over the next 10 years would give a tremendous boost to global aggregate demand. A reorientation of the US government budget away from spending that supports consumption to spending that underwrites investment in high tech industries would restore American economic viability, boost US wages and bring international trade back into equilibrium. The creation and well thought out employment of more Special Drawing Rights (SDRs) would not only augment global aggregated demand, it would also greatly advance the global development agenda.

A Good Future, one in which we all live happily together in a world of steadily increasing prosperity, can only come about as the result of the formulation and implementation of far sighted policies by governments, at both the national and international level.

Without such government intervention, equilibrium in the global economy will be restored, but it will be restored in a Bad Future where global output collapses back to a level that can be supported by global income as it is currently distributed – a level of output perhaps 25% to 50% below the current level. That future is one that must not be allowed to happen.

Regards,

Richard Duncan
for The Daily Reckoning

P.S. For more perspective from Richard Duncan you can visit his blog on economics in the age of paper money at www.richardduncaneconomics.com.