A Long Economic Winter Ahead

A State divided into a small number of rich and a large number of poor will always develop a government manipulated by the rich to protect the amenities represented by their property.

— Harold Laski (1893-1950), British political theorist, 1930

Money becomes evil not when it is used to buy goods but when it is used to buy power… economic inequalities become evil when they are translated into political inequalities.

— Samuel Huntington (1927-2008), political scientist

… if financial markets are skittish and don’t have confidence in a country’s fiscal soundness, that is also going to undermine our recovery.

— President Barack Obama, June 25, 2010

Any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius, and a lot of courage to move in the opposite direction.

— Albert Einstein (1879-1955) Physicist and Professor, Nobel Prize 1921

The bond market is telling us that there could be hard economic times ahead and that deflation, for the time being, is more of a threat than inflation. Leading indicators are also pointing to possible economic weakness ahead. -The Euro zone is being pulled apart by the economic asymmetry of its members, the less productive among them (Greece, Spain, Ireland, Portugal and Italy) being unable to keep pace with the very productive German economy. The U.S. money supply M3 is contracting. The Chinese bubble is dangerously approaching the bursting point. And, the deflation of debt all over the place threatens to plunge the world economy into a deflationary tailspin. —In this context, there is a good chance of a double-dip recession next year, in 2011.

Readers know where I stand on this issue. One year ago, on July 10, 2009, when everybody and his uncle was declaring the recession over and the return of business as usual, I wrote a piece announcing that my analysis was pointing out to ten years of economic hardship entitled “We are in the Midst of the Great Baby-Boomers Economic Stagnation of 2007-2017” [http://www.TheNewAmericanEmpire.com/tremblay=1113] I wrote then that “many observers think that ‘prosperity is around the corner’ and that this recession, like others since World War II, will end as soon as the stock market, as a leading indicator, recovers and people start spending again. This is a myopic view of the current economic big picture.”

Let us keep in mind that in May of 1930, President Herbert Hoover was also proclaiming that “the danger … is safely behind us.” This was ten years too early for such a declaration. Just as in the 1930s, the U.S. economy and many part of the world economy suffer from a debt overhang that usually takes at least ten years to correct. When overall debt is four times larger than the economy, as it is the case today and as it was close to being the case in the 1930s, a debt deflation becomes unavoidable.

Economic booms built on a mountain of debt, some of which is fraudulent and speculative debt, tend to end badly. The higher the debt mountain relative to the real economy, the more serious is the following economic meltdown. This is because an unsustainable debt level means that some of the investments and projects thus financed make no economic sense and no sufficient income can be forthcoming to service and repay the debts. The first consequence is excess capacity and falling asset prices. The second consequence is an unavoidable liquidation of debts and a debt deflation. The third consequence is economic stagnation.

The danger that accompanies a protracted period of debt-liquidation and debt deflation after a binge of over-indebtedness is well known in economics. In 1933, Yale economist Irving Fisher published his debt-deflation theory of economic depressions. The core of the theory is that over-indebtedness leads to deflation, which in turn leads to an economic contraction. Fisher summarizes the links between debt liquidation and economic contraction in nine interacting steps:

1- Debt liquidation leads to distress selling.
2- Contraction of deposit currency, as bank loans are paid off, and to a slowing down of the velocity of circulation of money.
3- A fall in the level of prices.
4- If the fall of prices is not interfered with by reflation or otherwise, this is followed by greater fall in the net worth of business, precipitating bankruptcies.
5- This leads to a like fall in profits.
6- A reduction in construction, output, trade and in employment of labor results.
7- Losses, bankruptcies and unemployment lead to pessimism and loss of confidence.
8- The result is hoarding and a contraction in bank credits, which contribute in slowing down even more the velocity of circulation of money.
9- The overall deflation causes a fall in the nominal or money interest rates accompanied by a rise in the real or commodity rates of interest as prices fall.

A similar self-reinforcing spiral-down of debt-deflation and economic contraction can be feared in the coming years as the level of debt to the economy goes from about four times the economy to a more manageable two times the economy. In other words, it should not take more than $1.50 or $2 of new debt and credit to generate one dollar of new output. When it takes more debt than that to generate new production, this is an indication that the economy is becoming over-leveraged with debt.

Judging by the pronouncements made by leaders at the recent G8 and G20 meetings in June, and their collective commitment to cut governments’ deficits in half by 2013, I don’t think that politicians fully understand the danger presently facing the world economy. In fact, any new shock hitting the world economy, economic or political, risks accelerating the collapse of the debt house of cards, with dire consequences for production and employment.

Austerity fiscal measures may raise government efficiency, but they are not what will cushion the real effects of the debt deflation. Both reflationary monetary policies and overall stabilization policies are needed, especially in the banking sector, in order to make sure that producers and employers are not frozen out of new bank credit.

Rodrigue Tremblay is professor emeritus of economics at the University of Montreal and author of the book The New American Empire. He can be reached at: rodrigue.tremblay@yahoo.com. Read other articles by Rodrigue, or visit Rodrigue's website.

6 comments on this article so far ...

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  1. MichaelKenny said on July 7th, 2010 at 11:17am #

    Yet another non-European know-all pontificating on the euro’s supposed demise! “The Euro zone is being pulled apart”, he claims! Well, I live in the eurozone and I don’t see any sign of it being pulled apart! Quite the contrary. Everything has now quietened down. Wall St’s attack on the euro has failed, essentially because European leaders resisted and, once people realised that the whole thing was not an economic problem but a political manipulation disguised as ecomomics, the population rallied behind their leaders, as people always do when they come under foreign attack. Nobody in Europe is predicting the demise of the euro! Nobody in Europe wants their country to leave the euro! Nobody wants to leave the EU! Thus, people like Mr Tremblay can pipedream all they want. The euro is alive and well and living in Europe!

  2. Cameron said on July 7th, 2010 at 6:45pm #

    Economic winter or economic disaster?
    If one doesn’t understand a problem then one comes up with a wrong solution.
    Is it a recession or a depression? One the one hand it’s compared to 1930s depression and on the other “double dip recession” is mentioned. What double dip? When was the first recession over?
    The problem is in secular fall in rate of profit. In 1970s governments did everything to overcome the fallen rate of profit from lowering interest rates artificially to corporate tax cuts to making money/credit easily available to both corporations and general public. Increased government spending and consumers spending (borrowed money) propped up the economy and now…
    In short secular fall in the rate of profit is a consequence of competition in capitalist system. Competition forces capitalists to deploy more automation. More automation means less and less labor needed to manufacture the same commodity. Less labor means lower profit compared to total capital used. A point is reached when the rate of return is too small to make it worthwhile to expand.
    By now governments and many ordinary citizens are burdened by heavy debts. Of course government’s massive debt is indirect debt imposed on people. This is one problem.
    There is a huge under utilization of capacity. There is simply less aggregate demand for all the goods produced. Because of excess capacities, capitalists are not investing in building more capacity and banks don’t see any reason to lend money. Unemployment will continue to rise. Spending trillions of dollars in the last two years has managed to prop up the economy for just one year. This is another problem.
    What got the US out of the depression last time was World War ||. The destruction of factories and work places in Europe and Japan and other places brought the US out of the depression. It wasn’t spending and reflation, etc. Fewer and fewer factories destroyed in the war meant less aggregate fixed capital. Less fixed capital enhanced the rate — profit/total capital.
    The “reflationary monetary policies and overall stabilization policies” is NOT a solution. I don’t even know what the “overall stabilization policies” is but I do know this. Reflationary policies is another word for hyperinflation which is indirect tax on working class. How in the world will people will be able to have a decent life with runaway inflation? Look the rich is getting richer and the poor is getting poorer. Isn’t that enough for you?
    The solution is to produce goods to satisfy needs not to satisfy the need of capitals (profit). Production for profit is the major cause of miseries for the majority. We need to abolish private ownership of means of production. That is we must transcend capitalism. Anti-capitalist socialism is the only alternative. Capitalism is unnatural and irrational. It’s time to change.

  3. mary said on July 8th, 2010 at 12:26am #

    Michael Kenny is living in cloud cuckoo land if he actually believes what he has just written.

  4. mary said on July 8th, 2010 at 4:37am #

    No long economic winter ahead for this crowd it would seem. The only usual suspects who ae missing are Clinton, Blair, Bono and Al Gore. Even the war criminal Kissinger is in the list of jet setters.

    Carbon footprint? What carbon footprint?

    “For the first time at this World Cup there was unmitigated travel chaos before a match as fans bound for Durban flew in from all over the country for the semi-final between Spain and Germany.

    Over a dozen private jets carrying the likes of Mick Jagger, Charlize Theron, Leonardo di Caprio, Paris Hilton, Black Eyed Peas, the King and Queen of Spain and, most bizarrely, Henry Kissinger caused regular passenger flights to circle King Shaka International airport for hours, if they were even lucky enough to get off the ground on time at all.

    Next time any of those stars are fronting a telethon in aid of global warming, it will be worth the transatlantic phone call just to ask them about their own carbon footprint.”


  5. Mulga Mumblebrain said on July 8th, 2010 at 8:29am #

    mary,are you enjoying the Bettencourt scandal and the travails of that malignant dwarf Sarkozy,as much as I? To think that a Jewish billionaire would be accused of handing out envelopes of cash to fix the French political system. Who would have thought it possible? It must just be anti-semitic hate speech,or even,G..d knows,a ‘blood libel’.

  6. mary said on July 8th, 2010 at 8:40am #

    Mais oui Monsieur!

    We were looking them all up yesterday. The weird thing is that Bettencourt’s father and husband were both members of a Nazi and supposedly anti-semitic outfit called La Cagoule.

    I expect everyone knows that her father founded L’Oreal (That ‘Because we’re worth it’ heavily advertised rubbish) and that they are on the BDS list. Their factory in Israhell is built over the remains of a Palestinian village.

    Who would want to live in France with that horrible lot. They appear to be even more hypocritical than the British.


    Why L’Oreal is on the BDS list. bdsmovement.net/?q=node/601

    No conflict. It’s just the shekels and the euros that matter to Sarko.