Tuesday, December 19, 2006


2007: Duck and cover or Duck in clover?

As I read year end financial analyses and predictions, I am reminded of how far removed from reality the capital markets are. Let's be frank: there is no way to predict the financial future with any great precision, because it's a completely artificial world. If the rest of the world wants to let the US run its economy on borrowed money, it can do so indefinitely. Economics can only predict equilibrium positions, that is, where things will go eventually if nothing changes. It cannot predict how change will occur. The optimists believe that the US dollar will gradually fall, making US export industries competitive, restoring the current account to balance. So this great explosion of debt in the US will have allowed Asian living standards to rise such that they can become the next great engine of growth, and they in turn will lift Africa and Latin America. Indeed, over the very long term, that is what would happen if resources were infinite. To the extent that human beings can create new resources through creativity, we will amaze ourselves at how foolish the pessimists were to doubt the limuts The pessimists point out the limits. All the "peak oil" talk is bulls--t, since there are more hydrocarbons than we know what to do with in the form of methane clathrates, heavy oil, and tar sands. But we can't burn it at the rate we are burning it without causing devastating losses to productivity of farms and oceans through global warming. Could global warming be part of the solution to the problem? I think it can. Tidal and windwmill generators can not only produce more energy from greater wind and wave action, but they will to some degree reduce the destructive effects of global warming. Similarly, solar collectors can be used to shield parts of the earth from excessive sunlight, while generating power. But the sheer scale of global warming means that we are going to have to work together or face death on a scale the world has never yet endured. These stupid resource wars and ethnic conflicts have to stop. The waste of resources on militarism has to stop. The endless concentration of wealth and power in a few hands has to be reversed. To be a pessimist, all one need do is believe that human nature will not change. But to do the best possible job of financial prediction, one must understand what has happened in the recent past. The Bush regime has dumped something like ten trillion dollars into the global economy. Precise calculations are difficult, because this money was created in a number of ways: governmental deficits, consumer debt, shifts in margin/reserve requirements, and so on. The money did not follow the normal path, but was selectively delivered to the wealthiest, with the middle class receiving some hush money. So, assets have been bid up even as wages and producer prices for many commodities have been weak or declining. No nation has the power to repeat that large of a helicopter drop of cash. Financial markets respond to changes of money in the system, or perhaps more precisely to expectation of changes. If no one is putting money into the system, they will fall. The money can arrive in many forms. It can come as consumers with money to spend driving up profits. It can come as investors with cash to buy stocks. It can come as monopoly forcing prices and profits up. It can come as lower interest rates making consumer or business borrowing easier. It can come as margin borrowing. It can even come because human ingenuity increases productivity, meaning that fewer resources are consumed in production. It can vanish through natural disaster, war, corruption, civil disorder, or simple fear. The 1990s were, apparently, a productivity-driven boom. This decade has borrowed every bit of growth from the next. All I know for certain is that the current situation is not sustainable and that there will be consequences to what is called "the punch bowl." My guess is that books are being cooked and that an honest appraisal by the new CBO Director and the new Congress will put an end to the borrowing. For what they're worth, not much, my predictions for 2007: bad (a market correction of, say, 20% in the late spring followed by a 1990-style recession); 2008: worse (global slowdown, markets flat or declining; stagflation in the US). But not the nuclear winter predicted by Nouriel Roubini. I think Asia is just beginning to rise, and that it will indeed become a powerful locomotive. For contrary views, see for example almost everyone else. The short form: Our baseline forecast points to a sustained global expansion through 2008. After expanding at a 4.8% average pace over the 2003-06 period — the strongest four years of global growth since the early 1970s — we are forecasting a modest downshift to 4.3% in 2007. Such an outcome would be well above the 45-year growth trend of 3.7%, suggestive of a global economy that is coming in for a classic soft landing. Our first cut for 2008 calls for a fractional re-acceleration to 4.5% global growth. The global downshift in 2007 should be broad-based. The US and Europe are expected to lead the deceleration in the developed world, and a slowing of Asia ex Japan stands out in the developing world. In the US, we expect a housing-related “growth recession” to persist through 1Q07, with important knock-on effects for export-led economies heavily dependent on US demand — especially China, Mexico, Canada, Japan, and other Asian economies tied to China’s supply chain. China’s progress in cooling off an overheated investment sector should provide another impetus to the coming global downshift. Yeah, could happen. Maybe.
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