Recession, Isolationism and Megadeath

Been quiet here because reality intrudes...

This got me back.

The title of this post is Isolationism, Recession and Megadeath. No, that last is not a reference to this. But what I do mean is explained below.

I don't think it takes much knowledge of economics to realize that we are at the brink of a precipice. In a very fundamental way, we don't know what it going to be happening to the economy until the data starts coming in: anything before that is speculation at best. We don't even know if there is going to be a fundamental, structural break in the economy - where demand and supply shifts drastically, leaving tattered wreckage in the wake of the storm - or whether we are facing a "simple" recession that is going to put a damper on the economy for a while until enough heat is built up to get a head of steam back up.

There are arguments for both cases. I tend to the latter, as the business makers of today have tools at their fingertips that allow them to make rapid changes in their businesses that were unthinkable even a decade ago. Or, more exactly, the things that clever folks were dreaming about are, to an incredible extent, now reality for many, and indeed help run businesses. Things like just-in-time computer-assisted logistics, allowing advanced and sophisticated purchasing to be automated, bringing it to smaller businesses; things like virtual business units, formed as needs and markets arise, but also disbanding when they are no longer profitable; things like inexpensive and wide-spread CAD and direct prototyping; things like giant container ships, reducing shipping costs per unit to almost nothing; things like viral memes and guerilla marketing; things like the Internet audience and the Long Tail.

While any recession is unpleasant - and I've tried to find work during several of them, not recommended - I simply don't see this becoming the kind of structural break that some are implying: that Wall Street is dead and there are no more investment banks in the US (try telling that to Brown Brothers Harriman, for instance: there are quite a number of similar big players that are not publicity hounds).

What is happening, and this is true of any recession, is that the time has come when companies and individuals, indeed governments and entire countries, have to pay for their mistakes, their errors of judgment and their stupid pet tricks (sorry, Dave, to steal that name for this purpose). Recession happen when collective mistakes are made and clog the system, starting usually when smaller mistakes generate larger problems that can be safely ignored as long as everything else is going fine. But when the problems snowball and start to be unavoidable, that's when consumers hunker down and stop spending; that's when companies stop hiring and try to get their costs back under control (meaning that their purchasing managers start actually doing their jobs); that's when structural weaknesses are exposed and make necessary adaptation impossible.

Let's keep with the usual definition of a recession: two consecutive quarters of negative growth. Not slowdown - the so-called growth recessions - but actual contraction of the value added in the sum of economic activity in a geographical area known as a country (you can, with decent numbers, break this down to statistical areas, but let's stick with countries right now...).

What causes recessions? There is basically only one answer: mis-allocation of capital. Now, this is a very Austrian answer (in the sense of the Austrian school of economics, more here).

There are basically two sides to this story: on the one hand, you have the people who use capital foolishly; on the other hand, you have people who finance the mis-allocation.

Now, what does this have to do with recessions? How can people making stupid choices about how they spend their money lead to a contraction of the economy? After all, spending is what drives the economy, right?

Yes. But spending is a function of demand - generally speaking, you spend only on things you need (in the broadest sense of the word) - and as such has everything to do with psychology.

We avoided a recession after 9/11 not because the Fed shined in managing the shock to the system - it did - but because people listened to President Bush, who probably averted a recession single-handedly by exhorting people not to withdraw and cocoon, but rather to not change their behavior: he asked Americans to go out and spend. This averted a crisis of confidence.

This is increasingly the problem facing the US today, but it started with a crisis of confidence in the banking system. This is what causes depressions, not merely recessions: when it becomes virtually impossible for those with money to assess the risks that are entailed in loaning to people who want to borrow the money.

Why this convoluted sentence? Because you have investors - the people with money - who demand that they get paid for the use of their money. In order to determine that price, you have to assess the risk that the money will not be paid back. Invest in US government bonds? No risk, low prices for the money. Invest in corporate junk bonds? High risk, high prices for the money. There is a direct and causal relationship between risk and interest rates. Interest rates, after all, are nothing other than the price of using someone else's money.

Now, when the government intervenes, it screws things up. I don't mean sometimes, I mean always. Without exception. The question is how much it screws things up. The problem the government has is that it is driven by politics, not by economists: politicians call economics "The Dismal Science" because it makes them very, very depressed when it points out how much they are going to screw things up when the government interferes in the economy.

I've mentioned the below before, but bear with me.

The sub-prime crisis is to a large degree the logical follow-up to the Community Reinvestment Act of 1977, which basically said that if banks wanted preferential credit conditions - critical to remaining competitive - then they must make loans to borrowers that did not, under normal conditions, qualify for a mortgage to conditions that were not onerous. Basically, the banks are tested to see if they are, in effect, cherry-picking their customers and lending only to the wealthy: if this was so, they were found in non-compliance, which affected their deposit requirements, which, as we all know, is the fundamental leverage the Fed has over the banks.

This meant that the banks were, by law, required to make loans to customers that would not normally have qualified, or, more exactly, who would have qualified only for rather expensive loans, either through a risk premium (front-loading) or higher interest rates.

This was tightened in 1995 under Clinton to ensure that the banks "properly" serviced their community, i.e. their geographic area, and didn't "red line" distressed economic districts to avoid making bad loans. How did they check this?

Why, the Home Mortgage Disclosure Act, which gathered the data that activists (hi, ACORN, that's you) then used to argue that the banks were, in fact, discriminating against minorities and lower-income communities. This dated from 1975, which preceded the CRA from 1977/1995.

The problem that you see here is simple: strictly speaking, the banks haven't been making straight-forward mortgages, based on purely the numbers and not based on politically-motivated government interference, since the 1980s. While this hasn't led directly to the sub-prime problem, it underscores how political pressure distorts the market: it created the sub-prime market as such. Previously, the banks didn't make the loans: they were then required by law to do so, and in doing so, created the hole that became the sub-prime swamp. If there were no sub-prime loans, there would be no sub-prime crisis. Plain and simple.

So what does this have to do with isolationism?

Isolationism in the US is a recurring theme, one that recurs when three conditions are met. First you have disappointment with US involvement overseas, usually either disappointment that the US intervention somewhere, which made sense at the time, has turned out to be either significantly more expensive in terms of money and lives, or those involved are so completely and totally ungrateful that it grates on US sensibilities. Second, US workers start losing their jobs to foreign competitors, which are generally seen as being somehow unfair to US workers, not allowing them to compete on the basis of quality of work or some other metric. Third, politicians get involved in order to take advantage of disappointment, using these discontents to further their own political careers.

Hence the isolationism of the US after WW1, which was arguably the worst failure of US politics in the 20th century, as the withdrawal of the US, at that time the emergent superpower, from European politics meant that the worst sentiments of the Allied powers - to punish Germany for the war - were not leavened by Wilson's sentiments of restructuring international relations to avoid wars.

Isolationism is now gathering momentum once again. It is driven by disappointment - that the US intervention in Iraq has cost so much in terms of money and lives, but also the disappointment that the US has been so lambasted for doing the right thing, especially as the critics fail to say what the "proper" right thing should have been.

It is also driven by opportunistic politicians, with the Democrats here clearly taking advantage of the disappointment and discontent to score political points.

What does Isolationism have to do with Megadeaths?

Well, first of all what is Megadeath? It's actually a simple concept, one that shouldn't surprise: megadeaths are deaths in the millions. This happens when things go really, really wrong: building large cities on flood plains or in the shadow of volcanoes are some examples; the large-scale mass wars of the 20th century are others; making economic and financial mistakes that lead to starvation in the Third World are others. What is important is the concept: megadeaths are, invariably, demographic, economic and political catastrophes.

So what is the connection? Simply put, this:

As the scale of the economic crisis becomes clear and comparisons to the Great Depression of the 1930s are tossed around, there is a very real danger that America could succumb to the feeling that we no longer have the luxury of worrying about distant lands, now that we are confronted with a "real" problem that actually affects the lives of all Americans. As we consider whether various bailout plans help Main Street as well as Wall Street, the subtext is that both are much more important to Americans than Haifa Street.

This is the situation we have right now: that we, collectively as Americans, become even less interested in what is going on in the world. If anything, we don't care much right now, and the danger is becoming even less interested.

One problem with this emotion is that it ignores the sequel to the Great Depression -- the rise of militaristic Japan marked by the 1931 invasion of Manchuria, and Hitler's rise to power in Germany in 1933, both of which resulted in part from economic dislocations spreading outward from the U.S. The inward-focus of the U.S. and the leading Western powers (Great Britain and France) throughout the 1930s allowed these problems to metastasize, ultimately leading to World War II.

Is it possible that American inattention to the world in the coming years could lead to a similarly devastating result? You betcha.

While Kagan here is being a tad provocative (you betcha), he is absolutely right.

Why does this then happen? We know that the US already basically ignores the rest of the world, besides the news junkies and recent immigrants, but it is when the politicians start making decisions to deliberately ignore the rest of the world that the real troubles begin.

Why? Simply put, because there are those out there whose geostrategic ambitions are held in check by the fact that US politicians do care about what happens in the rest of the world. We've seen wars unleashed when a US politician was careless about drawing lines (Korea is one; the Iraqi invasion of Kuwait was the other, albeit carelessness by a diplomat brought about that one).

Whatever the parallels between the current economic situation and that of the early 1930s, the current international environment is by any comparison more dangerous for the U.S. than the one that led to World War II. This is not hyperbole, particularly considering a last factor. When France and Britain ignored developing dangers while handling them would have been possible and relatively inexpensive, America was able to bail them out, if at terrific cost. There is no one to save us if we make similar mistakes in the coming years.

The current economic crisis is extremely grave. It is hurting many Americans today and will hurt many more as it unwinds. It will end, however, as economic crises always do. The question is how long the recovery will take and how bad things will get before it takes hold.

This question should be at the forefront of voters' thinking as they consider the economic proposals of the two candidates for president, but not necessarily as they decide whom to vote for. Better policies can speed the recovery; worse ones can slow it -- but none are likely to prevent it.

Hence the title of this post: Recession, Isolationism and Megadeath.

Bluntly put: the recession, if it leads to isolationism and mistaken policies that lead to a worsening, and not an improvement of the situation, can, literally kill millions if it leads to new conflicts and a continuation of economic problems. Think of what the response might be if Iran detonates a nuclear bomb in Haifa: if you've been reading this blog for a while, you would know how many millions of Iranians would then die (and that'd be just the start).

That is why anyone recommending isolationist policies - like getting rid of NAFTA, like wanting to institute protectionist policies (such as unions and limiting competition from overseas), like wanting to increase tariffs to protect industries - must be seen, implicitly, as someone who wants war, who wants conflicts, who wants megadeaths.

There is a causal relationship. Don't pretend there isn't. This time it won't be a European war, but rather it may be one in the Middle East that leads to the destruction of one Israeli and 20 Iranian cities; it may be in Asia between China and Taiwan (how long does anyone think the Chinese would be deterred from bullying Taiwan into submission or destruction if it wasn't for the Seventh Fleet?); it may be in Western Asia between India and Pakistan, both armed with nuclear weapons.

Regardless, if the US turns its back on the world, bad things happen. Very bad things.