All things being equal

As a predictor of economic and financial gloom it is always tempting and wonderfully schadenfreude-like to say I told you so. In fact, I did this the other day.

But I've got to admit that I did not expect the current crisis to freeze out the credit markets as quickly and as terribly as it has done. My feeling over the past few years has been that the coming recession would be a gradual affair with many stops and starts. I predicted that the driving force behind the slowdown would be Peak Oil, and that the effect of declining oil production would lead to a Depression-like economic hit - though with a difference. What was this difference? Not much deflation, no severe decline in GDP and no big unemployment spikes beyond 20%. Instead, we would see a severe restriction in economic growth over a long period which would see unemployment levels being persistently high but without spiking. Probably the best post I made about this subject was back in March.

Yet somehow my prediction was too conservative. It seems like the US economy was much more fragile than I thought, and the current crisis seems to be leading into a more 1930s type depression with big falls in GDP and big spikes in unemployment.

One of my favourite little phases that I have created is "All things being equal - but all things are not equal". This is, in a sense, a way of describing a "Salient Oversight" - a part of the equation that has been missed. That I should be guilty of a salient oversight is wonderfully ironic.

So what is this salient oversight that I had missed? It began a little over two months ago when I saw this graph:

I even posted about it here.

The first time I saw that graph it frightened the heck out of me. It still does. The reason is not because it somehow disproved my basic belief that Peak Oil would create a horrible depression. Rather, it showed me that the US economy was ripe for disaster anyway.

Let me explain the issue with this graph. The graph shows that US credit market debt exceeds GDP by around 350%. The fact that credit markets have debt levels that exceed GDP is obviously not always a problem - the 1950 to 1980 period never saw credit market debt increase or decline precipitously despite a series of recessions and periods of high and low inflation.

But then, of course, we see the 1930s spike. That spike did not cause the great depression - it was a result of it. Moreover, credit market debt increased during that period not because people were borrowing lots in that period (the opposite in fact), but because GDP was declining while debt levels slowly increased.

And then we see the exponential curve from 1985 until today. By itself, any exponential curve should warn us of terrible danger. The lesson? The US economy was ripe to collapse. The high oil prices from 2004 onwards - brought about by production plateaus being reached as a precursor to oil supply peaking - and the subsequent interest rate hikes was what eventually set off the current crisis.

Back in 2005 I predicted that there were four things which which would create a "perfect economic storm" that would severely damage the US and world economy. These were:

1. Peak Oil
2. US Government debt
3. The collapse of the housing bubble (now referred to as the subprime meltdown)
4. An unsustainable current account deficit
   

In retrospect, the enormous amounts of credit market debt were not a 5th reason I should've added. This is because reasons 3 & 4 - the housing bubble and the current account deficit - were integral parts of the credit market debt. As the curve continued exponentially upwards and the credit market continued to create massive levels of debt, a housing bubble formed along with the desire of the market to invest in US Dollar assets (which led to a current account deficit).

But as I have mentioned before, none of this has removed the threat of Peak Oil. Instead, it has made the situation intolerably worse. Peak Oil was always going to cause a massive economic shift - but that it should occur during a time when the world's economy was already at a turning point is a horrible convergence of events. In many ways I feel like the forecaster who predicted a category 5 hurricane and the deaths of thousands, only for the hurricane to be category 6 (if that were possible) and cause the deaths of tens of thousands.

So now that I am even more gloomy, what will happen?

It is obvious that the current economic crisis will result in a substantial contraction in world economic output. This crisis was of its own making but was set off probably earlier than expected because of high oil prices that were the direct result of oil production plateaus. The economic contraction will inevitably result in a drop in demand for oil, but the danger posed by Peak Oil still remains. Once the world economy begins to recover, oil production issues will stifle growth and economic expansions will be severely limited. Unemployment levels are likely to spike high in places, and in the US I believe that unemployment levels in the "teens" is likely. Moreover, while a recovery will result in employment growth, the continued high oil price of oil will keep unemployment levels uncomfortably high for many years.

Again, the only solution to this is for the US and other countries to follow the austerity guidelines of the Washington Consensus that I have posted about here. Moreover, in order to wean ourselves off oil dependence, nations must invest in public transport and in the design of electric road vehicles.

And as for you, the reader, I simply suggest that you pay off debt as fast as you can and live within your means.