One Salient Oversight, Two Years Ago

One Salient Oversight sends me a link to a piece he wrote two years ago. I took the liberty of simply stealing most of it:

America is about to be hit by a perfect economic storm. It – and the rest of the world – will be changed forever by it. The fact that the storm will hit is easier to prove than trying to work out when, but chances are that the wind and the waves are beginning to be felt.

The first problem is that there is an unsustainable housing price boom in the US. Analysts have been complaining about this for more than a year now. The fact is that the boom in house prices in the US is outstripping any growth in the average wage – which essentially means that, at some point, the prices will have to fall. The growth in house prices has led to many homeowners to borrow against their equity, and to spend this money either improving their houses or to purchase consumer goods. The growth of US consumer demand since 2001 has essentially been driven by this process. But what happens when housing prices fall? Consumer demand will go into reverse, with people no longer borrowing against their dwindling equity, no longer improving their devalued houses, and no longer spending much. We’ll see unemployment and maybe even a technical recession. Yet if this were the only problem, then recovery would be easy. But this is a perfect storm, with many different problems converging into one.

The second problem is that the US is running an unsustainable current account deficit. In layman’s terms, this means that America is spending more money than it earns, and is making up the difference by using a credit card. Essentially it is the goodwill of international investors in propping up the US currency that has allowed the nation to remain so prosperous. Many have criticised these international investors, especially the central banks of China and Japan who keep their own currencies low to allow a trade advantage. While there is a grain of truth in this complaint, the US dollar is nevertheless the ultimate responsibility of America itself. As it stands, the dollar is overvalued, and, apart from money printing to devalue the currency, the only other solution to restore the balance of trade would be for the Federal Reserve Bank to raise interest rates and choke off demand. Given the precarious state of the housing market, such a move would undoubtedly plunge America into recession – the only difference is that the after-effects of such a recession would be less severe if the Fed were to act now to force a recession, rather than letting the situation run its natural course. If that occurred, the market would eventually turn against the US dollar and harshly devalue it. No country, nor even individual for that matter, can continue to prosper by relying upon borrowed money. Eventually it will have to be paid back. Better sooner than later.

The third problem is that the US government is running an unsustainable budget deficit. It is supremely ironic that the political party that preaches most about about fiscal responsibility – the Republican party – is the same party that has presided over some of the most damaging fiscal deficits and overspending in US history. And this goes back to Reagan. Supply side economics, which relies upon the mistaken and never-proven-in-practice idea that lowering tax rates will actually raise the amount of tax revenue, is still popular in political circles, mainly because it relies upon that wonderful political tactic of promising tax cuts and painting their opponents as lovers of taxation. It is a very clever political tactic – a pity it results in economic hardship. In order to bring the government back into fiscal balance, the US must choose between raising taxes, cutting spending, or a combination of both. No matter what the choice is, the natural result will be economic hardship. Nevertheless, it is better for the pain to be felt now rather than later – if fiscal irresponsibility continues, the end result will be far worse.

The fourth problem is that the US economy relies heavily upon cheap oil imports to run its economy. The problem with this is not so much geo-political, but geological. A growing chorus of experts has been warning for some time now that there is a natural limit to how much oil can be pumped out of underground reservoirs. Known as Peak Oil, such a situation will not lead to the world running out of oil, but will result in an ever-decreasing supply of oil as the years go by. The result of this will be ever increasing petrol prices, with a commensurate growth in inflationary pressure on other goods and services. The US, more than any other country, relies upon roads, freeways and motor cars for its economy to continue. Europe and Asia, by contrast, have sophisticated and integrated public-transport systems that will become increasingly cost-effective the further oil prices rise. In this area, the US has further to fall than other industrialised nations. Peak Oil is probably already hitting us now – have you wondered why oil prices are so high? It is because supply cannot keep up with demand.

It is this last point that has got me most concerned – the first three points together are bad enough, but it is the peaking of oil production that will be the real killer over the long term. I don’t think we’re looking at a recession here – we’re looking at a long term economic downturn, maybe the equivalent of an economic depression if some oil experts are to be believed.

One thing is for sure – while this perfect storm will hit America hard, it will have knock on effects for the rest of the world. We won’t survive unscathed.


The above was written by One Salient Oversight on Aug 16, 2005.