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Outlook for the economy – grim

December 13, 2010 09:21

For those easily depressed, read no further. There is little positive that follows regarding the economic future.

From Monty Pelerin’s World

In this article the outlook for the economy is discussed. This outlook is my opinion and is probably worth no more than what it costs you.

For those easily depressed, read no further. There is little positive that follows regarding the economic future. For the adventuresome, however, volatile and potentially dangerous times present opportunities to make large amounts of money. Of course they also present opportunities to lose lots as well.

Unfortunately traditional investors are apt to be seriously harmed by following traditional investing rules. The tragedy is that most of us, whether it be due to risk aversion, age or other responsibilities, do not want to be “gunslinging” hedge fund type investors. We would prefer challenges more boring with a future more certain.

That kind of investing scenario, at least for the next decade and perhaps more, is not likely to be available. To be forewarned is to be forearmed. Wouldn’t your investment strategy this century be different from last?

Collapse of the Economy

In the previous installment of this series it was detailed how the United States government is hopelessly insolvent. It will be unable to meet some or all of its obligations which will lead to a collapse of the US economy. This collapse is likely to be preceded or accompanied by the governments of much of the rest of the developed world. Europe is teetering on the brink.

In the US, the question is what form a collapse will take. Two very different scenarios are likely:

Economic collapse with minimal inflation (perhaps deflation)
A hyperinflationary economic collapse

In my opinion, one of these two events is virtually inevitable. Both are devastating, yet each produces a different pathway to disaster. The first occurs if the government runs out of money; the second, if they do not. It really may be just that simple.

Government is trying to avoid the first outcome. For politicians mitigated pain is always preferred to unadulterated pain; deferred pain is always preferred to pain today, no matter how much pain will be imposed in the future. The first scenario is immediate pain while the second is larger future pain.

Quantitative easing is about avoiding scenario 1. The notion that it will help the economy is a charade to hide the fact that the government is already out of money. Tax revenues supplemented by market-based Treasury sales are no longer sufficient to cover out-of-control spending and the deficits produced. QE will “print” the money to enable government to continue to send out checks and pay its bills. It is a desperate attempt to avoid the first scenario that will fail.

It is unclear whether government knows their policies will produce the second outcome or whether they are hoping that somehow they will skate through one more time. Similar Keynesian-monetarist strategies have been employed since World War II, especially so since the early 1970s. Never have they been of this magnitude. Every economic slowdown has been met with an intervention designed to alleviate economic pain and adjustment. Each slowdown eventually passed, whether as a result of or in spite of the interventions. As expressed by Thomas Sowell:

It is not a matter of faith that a market economy can recover on its own. It is a matter of faith that politicians speed recovery.

Many politicians probably realize that more of these policies will not save the country. However, to the extent that it defers the event, it extends their political lives.

After 40-plus years of repeated interventions, government grew is too big, too powerful and too inept. Taxes, rules and regulations diminished the private sector’s ability to compete and drove jobs and capital overseas. The productive sector is too small to support the ever-growing parasite sector.

The interventions distorted relative prices and artificially lowered interest rates. These artificial signals produced massive malinvestment of capital and encouraged unsustainable levels of debt. Much of the capital investment has been squandered and is irretrievably lost. The economy has reached the point where it can no longer efficiently. It can no longer sustain these distortions, especially the impossible to service debt levels.

The economy can take no more. To properly recover, the economy needs to purge itself of the distortions and excesses. That is the role of economic corrections when they are allowed to run their course. Government has been unwilling to allow this to happen, putting us in today’s critical condition. As Ludwig von Mises observed long ago, there is no way to prevent a correction:

There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.

In attempting to prevent economic corrections, the government has bankrupted itself, weakened the economy, impoverished segments of the population and ensured that the pressures they contained for decades will result in the Greatest Depression.

Compounding the economic conditions are longer-term societal and geopolitical trends. These are beyond our immediate concern, but clearly influenced our economic/financial condition and outlook. For one person’s take, read The Decline and Fall of the American Empire.

What Type of Collapse Will We Have?

The answer to this question is not as clear as it might seem. The government is trying to avoid the first type, which will produce the second. Intent, however, does not guarantee outcome. In case you haven’t noticed, government does not do things particularly well. Often their intent damages objects 180 degrees from their aiming point. Markets (i.e., people) are more powerful than all governments combined and can unravel the best laid plans of mice and governments.

In my opinion, we end up with alternative 2, a hyperinflationary depression. My opinion is based on the belief that there is already enough liquidity in the system to end up there and that government will likely double or triple the current amounts if they do not collapse trying.

To be sure, there are plenty of excellent analysts that have a different opinion. Mish adamantly believes we are in for deflation. Edward Harrison, in an excellent and well-reasoned article, presents the case for deflation.

Hyperinflation and depression are not mutually exclusive terms, despite what Keynesians might believe. A hyperinflationary depression is not oxymoronic but quite plausible and logical.

A hyperinflation is generally and rather arbitrarily defined as inflation exceeding 50% per month. All hyperinflations must end up in depressions because, once inflation gets to high levels, people refuse to hold or use depreciating money. A barter economy develops when merchants refuse to accept money. Barter is very inefficient and drives down the number of transactions, GDP, employment and other key measures of economic activity. This collapse is a depression.

It is impossible to determine what triggers the loss of faith in money just as it is impossible to determine which snowflake caused the avalanche. The video immediately below provides one scenario as how it might start.

There are other ways in which hyperinflation might start, probably none as definitive and dramatic as shown in this video.

Preparing for the Future

While I believe that we will have an economic collapse, that does not mean one sets their portfolio up only for that eventuality. A real possibility is a prolonged malaise, not unlike what we had in the late 1970s, only worse. Even if one of the collapse scenarios eventuates, there could be a prolonged Japanese-type stagnation that precedes it.

Any investment strategy must be flexible enough to adjust to changes. No matter how “sure” you are of what is going to happen, you don’t know, at least not with certainty. (To better understand “certainty,” read this article.) We are in uncharted waters made even more dangerous by a government that will do anything to survive, even if it makes matters worse in the longer term.

In the next part of this series, we shall look at the two collapse scenarios and also the Japan stagnation scenario. Portfolio ideas/strategies will be presented for each. There is no need to look at a normal investing climate for two reasons: