Martin Wolfe, being eminently sensible:
Many are the risks of disruption. To take one salient example, the principal domestic counterpart to the huge US current account deficit is the financial deficit of US households, currently running at an all-time record of more than 7 per cent of gross domestic product. As Wynne Godley, the Cambridge economist, has pointed out, with such a financial deficit, the indebtedness of the household sector must rise continuously. And indeed it has, from 92 per cent of disposable income in the first quarter of 1998 to 126 per cent in the third quarter of last year. That rise in indebtedness has pushed household debt services payments to an all-time high of 14 per cent of disposable incomes, despite today's modest interest rates. What would happen if house prices ceased to rise or interest rates increased? Households would cut back on their borrowing. If they did, how would a sharp US slowdown be avoided?
[Oh yeah, I'm running blogads in support of the CD on the agonist, Juan Cole and Mahablog. A big risk on the blogsphere coming through, I admit...]
He points out that the present financial structure is not correctly pricing the risks in the financial markets, indeed, despite a great deal of profitability, there is almost no appetite for hedging against risk, which is why the
VIX is dragging along a cyclical bottom. (As a side note, the VIX is indicating that there needs to be a downside correction before the S&P will make substantial gains, but it isn't a strong indication yet).
When an economist sees a system is unstable, but cannot see an actor who is at Nash disequilibrium - that is, an actor who can unilaterally improve his own position at the expense of others - he worries, because it is clear that there is a great deal of money sloshing around, waiting for such an actor to appear. In the early 1970's there was a great deal of money chasing riskless reward, and OPEC picked it up off the table. We still live in the shadow of that moment.
What is funding this is a completely unjustifiable assumption on the part of consumers: that the current wave of low real wages, high energy prices and low growth in manufacturing and other core job creation engines is temporary, while the current era of very cheap money is permanent. This isn't justifiable because no matter who takes power, in which countries, under what conditions, the connection that has to be made is to slosh the current huge pool of investment demand into solving the energy problem. Whether we are going with phony fuel or the electrical economy - it has to happen. But when it does, the cost of money will go up tremendously, since there will no longer be a great deal more investment supply than investment demand.
It is unwise to bet against the inevitable.
So even as Tokyo hits fresh highs, crude oil reaches $63, as it is clear we are back on an upleg, one that will carry us above the $70 of the last one.
But it is not "atomic bombs on ships" that is the threat to the current economy, but the unsustainable nature of its shift from consumers in developed countries to profits held by a small group of people. Our choice in 1980 was to let the Arabs get richer, and keep our rich as rich as their rich. For almost 20 years, that looked like a bet that would work, that technology would eventually over run oil, and while the arab world would have a great deal of money, it would fall further and further behind the west, eventually being forced to open its doors. When it became clear that this would not happen, that far from technology out running oil, world demand for oil would push energy prices through the roof, it precipitated a crisis in American policy.
The choice was to back the neocon solution of neo-imperialism to go with neo-mercantilism. It is a natural combination. In essence, America and the developed world decided they couldn't get China to open, they could not get Saudi Arabia to open, and therefore they would have to grab the heart of the middle east, and use military force to do it. It was a catastrophically stupid mistake, perhaps the worst since the USSR thought it could enforce the "Breshnev Doctrine" in Afghanistan.
The idea, if it can be called that, was to create an Americanized state in the Middle East, one that would have consumer goods, development, and would sell us oil rights to exploit cheap. Cheap oil and a place to invest money, run by right wing ideologs who believe that any restraint on the rich is against God's Law and the Constitution. They might as well have named it New Texas and put a star on the flag.
However, the entire project was folly. The US had such a state once upon a time: Iran. Eisenhower backed coups in Iran and Iraq in the 1950's, and the one in Iran stuck - the Shah was a close US ally, pro-Western in his economic policies, and intent on building a Westernized Iran. It didn't work out, in no small part because the money that went to maintaining his regime did not go to the vast mass of non-metrolpolitian Iranians. These people revolted, and put in place a regime that knew how to make sure that social and economic corruption flowed to its backers. The regime is still in power, despite being unpopular with its own public.
Why anyone thought that mere presence of US troops would materially alter this situation, is one for the annals of moronology (not a real word, but "moros" is in fact a greek root, better constructed would be "moriology", the study of folly). Why anyone thought that a coalition of a failed state with de facto partition would produce the desired results is worthy of a Nobel memorial prize in that field.
The failure then, to deal with the underlying dynamic - that the developed world is pumping, not its jobs - but its money, and therefore its autonomy - to nations that, long term, are antithetical to liberal democracy - is the basic underlying problem. Any specific instability will come because actors in these unfree nations will want to precipitate a crisis, to gain control either of key resources the west needs, or to gain control of the money which the west has piled up in the hands of a few unfree governments. It isn't "the corporations" you should be worried about, it is the princes and the apparatchniks of Saudi Arabia and China. Minting billionaires is just the way we have of coping with the fact that China and Saudi Arabia throw of huge amounts of free cash flow.
As long as that excess profit flows from the West out, and then back in again as assets, there will be continued inflation of assets - with the converse, very low rates of interest. There will also be a draining away of the West's ability to create jobs, since jobs create inflation, and they spread the wealth out from the top. The people renting us the money won't put up with that.
At somepoint, the Chinese and the Saudis will call in the loan, because the economic situation in the West will be bad enough for enough people that regimes will come to power here that will no longer tolerate the current situation. These could be regimes of the left or the right, they might be wise or foolish, but there is not enough growth on the table for their to be both jobs created in the West, and massive piles of money parked in the financial system.
The solution is to find a way to tax Saudi Arabia and China. Protectionism is not a tax on them, it is a tax on some workers to the benefit of other works. Shuffling money around the bottom is a Reaganite waste of time. Pseudo-progressives who think that protectionism is a good idea are simply socially liberal Reagan Democrats. Bush has given us protectionism, and the result is a huge loss of American jobs, the McMansion boom, and a poor recovery.
Instead the imbalance isn't one of moving old jobs from here to other places - this has been going on for decades, and is going on now at the same pace it did during the 1990's. The problem is that new jobs are not being created here. Those who want the old jobs are welcome to go down into the coal mines any time they like, in fact, we are on a collision course to have a lot more coal mining, and alot more coal mining accidents. But if you want only to keep the old jobs, then wages will go down to equilibrium with other people who can do those old jobs. A textile worker in China makes $2/day.
The solution then, is liberalism. Liberalism is about taxing inflation. When a Republican says "you will have more money in your pocket!" he is really saying "you will pay more money for everything!" Taxes don't reduce buying power if they are designed to slow down overheating prices. Instead, most of the time, a tax cut is a pay cut.
What can go wrong is that we have a house of cards of debt and misallocated capital. We have repeatedly voted against allocating that capital where it is obviously needed - transforming the energy and monetary system. Taxing some workers to help others is a waste of time and money, it will solve nothing - though it will benefit a few people who are trying to make their pensions, sell their houses and head for Florida - instead, one must tax where the inflation is, that is, where the money is, and spend on where the problem is. And the problem is not that the US doesn't have enough aircraft carriers or spygate systems. It is that we can manufacture more than we can run with energy. What happened to agriculture in the early 20th century - that is, it dropped in terms of what it was paid dramatically - is happening to manufacturing. It will never again be an easy road to individual worker prosperity.
The future lies in maintaining a grid of power and communication systems, it is energy that is going to be the high reward activity for the next generation, and the sooner we begin to focus on it, the better off we are. To do this means moving money out of building McMansions, and into building wind turbines, microgrids, telecommuting systems and shifting our monetary base out of knocking down trees and putting up houses.
There are, at this point, two options. One is that at some point the deteriorating band width of oil and energy ("peak oil") and the negative effects of sink shortage ("global warming") will force a great deal of money to go from borrowing to build McMansions and fill them, and into energy generation and clean up. Think of the cost of Katrina, now imagine that cost every year to clean up the effects of greater climatic instability. Imagine $5/gasoline as a permanent fact of life. Now realize that that money will come straight out of consumption. This leads to a catatstrophic meltdown of the financial system.
The other road is to restructure the global monetary order. The tools to do this are in place: the WTO, IMF, the UN and Kyoto can be used to restructure the global financial system around creating more energy density. Kyoto can be designed to transfer money from those who are creating less GDP per unit of carbon, to those who generate more. IMF can be used to balance the world financial system, and WTO can be changed from its present intent - where developed nations say to less developed ones "spread your legs so I can rape you" - to one which promotes a genuinely fair trade order.