An American Future: The Shrinking Economy

A guest post in the “An American Future” series from Kevin:

An American Future: The Shrinking Economy

By Kevin at 20smoney.com

As we continue a look at America’s future, we turn to the American economy.  What I’m proposing here is that the American economy has peaked in real terms.  For the years ahead, the economy will shrink in real terms – yes, GDP might have a positive number at times due to inflation, but this is not to what I’m referring.

The American economy peaked a few years ago.  In an economy primarily driven by consumption, Americans reached peak consumption in the mid-2000’s.  Fueled by a negative savings rate and cashed-out home equity, Americans consumed to the maximum.

With an economy that is overly dependent on debt-financed consumption, the economy must continue to expand or it risks falling apart.  In the event that expansion halts, the economy can potentially crash (i.e. the financial crisis of 2008).  When expansion stalls, we see the effects through rising unemployment, foreclosures and bankruptcies.  Furthermore, with increasing numbers of Americans dependent on the government for welfare assistance, a shrinking economy or an economy that is no longer expanding puts tremendous pressure on the ability for the government to fund these programs.  Essentially, deficits increase in tandem with the number of Americans on food stamps.

In an attempt to backstop the contraction and artificially expand the economy, the government has stepped in with a multitude of actions.  First, our elected officials have passed legislation to prop up the economy via methods such as the stimulus bill, homebuyer tax credits and countless unemployment benefit extensions.  Secondly, the Federal Reserve, in addition to moving towards ZIRP (zero interest rate policy), has stepped in to purchase assets directly through quantitative easing (QE) – nothing more than creating money out of thin air (often called printing money) to buy assets and thus, inject money into the economy.

There are a couple ways to look at the Fed’s QE efforts:

1. The Fed buying assets from the financial institutions such as mortgage backed securities – This was done in an effort to “save the financial system” – essentially bail out the banks.  The hope was that by removing “toxic debt” from the banks’ books, the banks would be free to lend and reignite economic growth.  The problem is that our economy is so hampered that there is no lending – instead, banks are more akin to casinos than engines of economic growth.  The result of the Fed’s efforts here essentially allowed Wall Street bankers and traders to continue making a killing while providing no real benefit to the real economy.
2. The Fed buying Treasuries – This was and is done in an effort to help fund a Federal government that spends far more than it should.  Additionally, by printing money to buy treasuries, the demand for treasuries remains high which keeps interest rates low and interest payments on the U.S. debt manageable (see current Treasury yields).  Proponents of this strategy say this is sound policy because it injects money directly into the economy (Federal Reserve to the U.S. government to regular Americans via handouts).  The problem here is that this policy has the potential to be very inflationary since unlike the cash sitting on banks’ balance sheets, this cash is going into the real economy.

Inflationary Policies Always

One of the most common debates in recent years is whether or not the American economy faces inflation or deflation and which one is the larger threat.  Before we dive into the debate itself, let’s step back and re-address what we mentioned previously – which is that our economy is built in a way that requires expansion.  Inflation, while providing no benefit to the economy, is a form of expansion that is acceptable to keep the system going, at least temporarily.  Think about it… inflation essentially prevents a day of reckoning with regards to debt.  Inflation makes servicing too much debt possible and avoids a default.  Inflation keeps the game going when the market says it shouldn’t.

As such, the government policy with the way our economy is structured will always be inflationary.  Always.

Additionally, consider that inflation is much more stealthy to the public than deflation (until, of course, inflation gets out of control).  Rising prices are much more politically acceptable than people on the streets and out of work.

Lastly, inflationary policies keep the game going for those in power.  Bank bailouts and quantitative easing will always be a benefit to the Wall Street machine and to the huge corporations in America.  The so-called recovery of the last year has been almost entirely confined to Wall Street firms and Fortune 500 companies with access to the capital markets.  The small business owner?  No bailouts for him; and the benefits of QE to him are minimal at best.

For these reasons outlined, you can absolutely expect to see more government intervention in the economy via inflationary Fed policies and other programs in the years ahead.

What About Deflation?

Despite all this talk of inflation, the reality is that deflationary forces are very real and present in today’s economy.  As the title of this article says, the economy is shrinking.  Economic activity has been and is still slowing.  Yes, I know corporate profits are up for multi-national companies due to massive cost cutting via layoffs and international revenues.  But, for the main street economy, the small businesses, the economy is still shrinking.  Home values continue to fall.  Unemployment remains high.  Wages are stagnant or dropping.  Meanwhile, the average Joe still holds crushing amounts of debt.

The proper market-based response to these deflationary forces is to file bankruptcy, write down debt and adjust one’s standard of living.  Essentially, a reset or a restructuring of the economy is needed and the market-based economy is attempting to push us in that direction.

Make no doubt about it, a reset of the economy would be incredibly painful.  The orderly American society could potentially quickly unravel.  With millions looking for food stamps, unemployment checks and other handouts, those in power could be thrown out on the street (or worse) – now, do you see why those in power will fight deflation to the point of destroying a currency?

Where Do We Go From Here?

Over the coming years, the world will be watching as the leaders and central planners of the American economy attempt to hold this thing together.  The aim is to get back to the days where talking heads such as Larry Kudlow describe the economy as the “Goldilocks economy.”  The term goldilocks economy is used where there is just enough inflation to keep the economy “growing,” but not too much as to severely or rapidly compromise purchasing power of the masses.

This “goldilocks” balance will be increasingly difficult to maintain as we move forward for a number of reasons.

1. The American public is getting increasingly anxious about the deficits – This could have an impact on future stimulus bills and possibly unemployment benefits.
2. Government intervention is having less and less effect on the economy – the previous stimulus effect was a few months before wearing off, each go around of the housing tax credit has a shorter and shorter benefit.  Future stimulus will need to continue to be larger in order to have meaningful impacts.
3. Bailouts are creating moral hazard in many areas of the economy – for example, many Americans are now “strategically defaulting” on their mortgage because they see others getting out from burdens of their mortgages.  These actions caused by moral hazard will continue to put pressure on the economy.
4. The inflationary effects of QE may start to show up more in people’s every day lives – Imagine the disruption of significantly higher gas prices, food prices, etc.
5. Additional taxes (i.e. VAT tax) might be needed to help the government’s fiscal situation - additional taxes will be largely unpopular and will compromise an economic recovery.

I worry we’re moving towards a nasty combination of deflation and inflation – deflation in the “average Joe” economy in the form of continued foreclosures, bankruptcies, struggling small businesses and high unemployment while the inflationary policies cause inflation in risk assets such as stocks and commodities.  In an effort to keep profitability in a contracting economy, companies might produce products with less quality or diminished quantity (a form of stealth inflation).  Either way, it looks like diminished purchasing power is in our future regardless.

Whether or not these policies lead to a currency crisis where the dollar is thrown out as the global reserve currency is yet to be seen.  The fact that the other currencies are in similar terrible shape (Euro) has helped the dollar maintain some relative strength.  Don’t be fooled, however, the strength is indeed relative, not absolute.  In a fiat currency “race to the bottom,” everyone loses including us.

A loss of purchasing power will continue to move Americans toward a lower standard of living (a trend I identified in the previous article that is unavoidable).

To sum up, the American economy is broken in a way that will continue to lead towards contraction.  The economy cannot expand in real terms with the way it is currently structured.  In an effort to do whatever it takes to maintain the illusion of expansion and prevent the harsh realities of a crashed economy, the politicians, the Federal Reserve and the corporate elites will act in unison to implement inflationary policies.  These policies will only benefit those in power – at least for as long as the game continues.  High inflation coupled with a weak economy will crush what’s left of the American middle class.

So, how does one survive such a scenario?  Where is the opportunity within an economy that is a “shrinking pie” where the number of hands grabbing for a slice are constant?  How can we invest to protect capital and maybe generate some level of real return?  The next two articles in this series will focus on these questions and discuss finding opportunity and how to invest in the American shrinking economy.

Author: Kevin blogs at 20smoney.com

For more reading, consider the following:

• Mark from Fund My Mutual Fund discusses the American economy as a ponzi scheme
• My article on 20smoney about Stealthy Inflation
• Moses at Expected Returns explains how we have deflation and inflation

Share/Save