Thursday, January 22, 2009

Canaries in the Economic Crisis

You can find any economic prediction you'd like for the future. Some prognosticators predict the beginning of a recovery by the end of this year. Others predict another Great Depression. Most predictions fall somewhere in between. The truth is that all predictions are based on known information, and extrapolations made from known information. But the current economic crisis has been driven by largely unexpected developments that come out of the woodwork and pop nasty surprises. Note that we say "largely unexpected" because a few lonely voices decried the prevailing wisdom that real estate prices on a national level could never fall, and questioned the wisdom of extending the opportunity for home ownership to those those that could buy a home only by taking out mortgages they couldn't afford. The warning signs were there for those that were careful enough to look.

Now that we're in a deep recession, we're more concerned than ever about the future. It's impossible to make firm predictions, because there isn't enough firm information. There are, however, canaries that may give early warning of problems. Some are familiar; others may not be. Here's a not necessarily complete list of canaries.

U.S. real estate market. We all know about this one. It continues its destructive rampage. There are lots of foreclosures pending in the residential real estate market that and more are likely in the future. To make things worse, the commercial real estate market is now struggling, with a lot of construction projects in deep doodoo. Even rental properties may falter, since rents are starting to fall as the economy slows. This will lower the value of rental properties, and landlords that are heavily leveraged may find the going tough. The problems in this market run into the trillions of dollars. No amount of federal assistance or subsidy can turn this market around. The most that the federal government might accomplish is to soften the downturn. The U.S. real estate market is an important canary.

Europe. The Euro-block is in recession and its members are arguing among themselves about what to do. While they have a nominally unified monetary policy, they maintain individual national fiscal policies. Thus, they have a serious coordination problem. To make things worse, the specter of trade protectionism haunts Europe, as many nations appear to be growing fonder of the idea of trade barriers at their borders. Trade barriers were one of the critical factors in the 1930s that threw the world economy off the tracks and into depression.

In addition, the U.K. is reaching a critical point in its economic crisis. The pound has fallen dramatically in the last few months (losing over a third of its value against the dollar in the last six months), and the U.K.'s largest bank, Royal Bank of Scotland, is on the verge of being nationalized. The U.K. real estate market is more leveraged than the U.S. real estate market (hard to believe, but U.K. lending standards were extremely lax). With its economic growth in recent years derived to a large degree from financial services (although not so much today), while its manufacturing sector declined, the U.K. is caught in a bad place with almost no way to turn around.

Russia is another worrisome canary. The ruble is under enormous stress, with oil prices having fallen as they have. The Georgians are breathing easier, since Russia must now focus on its economic problems. One suspects that the recent Russian natural gas embargo of the Ukraine (which resulted in natural gas shortages in many parts of Europe) was motivated in part by the need for Russia to boost its revenues from energy sales by any means possible. To maintain "harmony" with Russia (we use the term advisedly), European nations may have to pay it subsidies in the form of higher energy prices. That, in turn, would push Europe's economy farther down the slippery slope. And the ruble could be devalued. That would destabilize the financial markets at a time when they can hardly stand more instability.

American companies do a lot of business in Europe--or not. Watch European economic trends because they could portent trends in the U.S.

Japan. Japan has the second largest economy in the world. Although we tend to see it as an aggressive exporter, Japan actually imports a lot and has recently run trade deficits. Although oil accounts for a large part of Japan's imports, Japan does buy a lot of consumer goods from other countries. The Japanese economy is sliding down the slippery slope, and its government is scrambling as fast as the Obama adminstration to develop a stimulus package. However, the Japanese government, in spite of almost 20 years of economic stagnation, has never been able to develop an effective stimulus policy. If Japan keeps sliding, it will import less from the rest of the world.

China. China has the world's third largest economy (having just surpassed Germany). The Chinese government has announced a stimulus package that, in proportion to its national economy, is larger than the Obama administration's proposal. This measure may help stabilize things in China. But don't count on it to do much for the U.S. economy. In dynastic China, the government stockpiled grain in years with good harvests, and released grain from the imperial graneries during famines. Today's nominally Communist government in China is simply following in the tradition of its imperial predecessors. The people will be fed, and social harmony will be maintained. But the barbarians outside China are on their own. Notwithstanding its image as an export nation, the Chinese import a fair amount from the U.S. (things like agricultural products and scrap that's used as raw material for manufacturing). If China's economy keeps slowing, U.S. exports there will fall.

Oil Prices. The price of petroleum is a wild card. It's leveled off in the high 30s and low 40s. That's a damn sight better than $147 a barrel, where it was in mid-2008. A drop in the price of oil (and other energy sources) provides a direct stimulus right to the consumer. The nice thing is that much of this stimulus comes out of the pockets of nations that are hostile to the U.S. and might use oil revenues to do injury to the U.S. If oil prices keep dropping, that will be good for the economy. But, if they rise again in the spring, as some predict, expect an adverse impact on an already chastened consumer.

U.S. manufacturing. U.S. manufacturing is the quietest canary. But it may be the most important. In times past, the manufacturing sector played an important role in leading the economy out of recessions. A recent exception was the 2002 recession, from which recovery was achieved in no small part by ultra-easy Federal Reserve monetary policy. We know today that easy money doesn't produce a lasting recovery. Indeed, one reason why banks aren't lending now is because they bought into the whole easy money thing the last time around, and made a shipload of bad loans that plague them--and us--today. Current government policy might prevent panic and collapse. But it's unlikely to produce recovery. Manufacturing may be just about the only game in town. Keep an eye on it as an indicator of future trends.

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