recession

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The Slowdown Is For Real; Is Deflation Next?

What can we say about today’s GDP report? Not much that hasn’t already ben said: the economy is slowing down quite quickly. Growth in the second quarter fell to 2.4%, compared with 5.0% in the last quarter of 2009, and 3.7% in the first quarter 2010. That’s fairly dramatic and a much more rapid slow down than is normal. There is no way that this cycle can be characterized as being normal. The track we are following is truly one of a kind and so we lack precedence to give us comfort as we try to forecast the next few quarters.

What we do know is that history tells us that recessions and recoveries following crises caused by banking and financial implosions are always difficult. Evidently that is the one precedent seemingly being played out again.

It is becoming tiresome to repeat the obvious: we face a massive shortfall in demand which is causing an equally massive shortfall in resource usage to linger on. Jobs. Jobs. Jobs.

Interestingly a sharp debate about the nature of unemployment has now broken out in the ranks of analysts.

One camp argues that the downturn is healthy in that it is forcing inefficient sectors such as construction, where we had vastly over-invested, to shed jobs and thus – eventually – allow those workers to be re-trained for more useful and productive purposes. This analysis relies on the traditional, classical, view of economic cycles as being purges to be welcomed, rather than as crises to be avoided. Joseph Schumpeter, he of the “creative destruction” theory of capitalism is the leading architect of this viewpoint.

Others, myself included, regard this as nonsense.

We hold that ever since Keynes pointed out that capitalism can be saved from its own excesses through a combination of monetary and fiscal policy, society has no need of Schumpeterian purges. Indeed such purges are counter-productive and consign large numbers of people to horrible lives unnecessarily. Given that we know how to avoid such cycles, we believe that society owes it to itself actually to avoid them.

Which camp is correct?

The clues are all within the nature of current unemployment. Were this a ‘purgative’ cycle we would expect unemployment to be focused on those industries and sectors where inefficiencies had built up. Other industries should be less affected. But we don’t find such a pattern. Unemployment is both deep and widespread across the entire economy. For the Schumpeterian view to hold we would have to argue that the entire economy is rotten and not one sector. In which case there seems to be no informative or predictive content to the theory. Empty theories aren’t worth much.

In contrast the Keynesian view is holding up well to empirical testing.

This is, indeed, a cycle we could have dampened or ameliorated if we had employed the right counter measures in the right strength early enough.

Meanwhile, that the economy is now headed for more slowdown is a certitude.

Worse for all of us, all the characteristics of a depression are lingering near the surface. Sufficiently close that we are still under threat of a true calamity.

One example: this week has seen the auction of large amounts of bank debt at record low interest rates. US Bancorp was able to sell five year paper at the lowest interest rate ever paid by a bank. Think about that for a moment. The lowest rate ever paid by a bank. What leaps out from that is that we have absolutely no threat of inflation at present. None. In fact the real and present danger is deflation. So clear is this threat that, for the first time I can recall, members of the Fed are talking out loud about what they would have to do were deflation to set in. This is an incredible turn of events. Especially in light of the fact that the Fed officials making all the noise include some of the inflation hawks who were recently advocating hiking interest rates to stave off the inflationary threat of the massive build up in money supply engendered by the Fed’s bailout activities of 2008 through last year.

Textbook monetary theory says that such a huge build up will, inevitably, manifest itself as a surge in inflation. There will be too much money chasing too few goods. So prices will rise to bring about a balance between money supply and the goods being produced. That’s how we get inflation.

One of Keynes’ greatest insights was that, under certain circumstances, this traditional relationship will not hold. He argued, correctly, that if business expectations are severely limited, and if the prospect for profit from new investment is constrained by the lack of demand, businesses will not invest spare cash. They will hoard it instead. So the increase in money supply will simply sit in bank vaults and go unlent. This is exactly what we are seeing currently. The economy is awash with cash. Bank reserves are accumulating at rapid rates. But there is no, or little, demand for credit. Similarly households are sitting on what cash they have – debt pay downs and savings are taking a higher priority than consumption. We are saving too much, by which I mean we are saving more than we want to invest, and that is depressing demand. Our economy has fallen out of balance.

In other words the economy is frozen despite the plentiful money sloshing about. This is what is called a ‘liquidity trap’. The economy is flush with liquidity, but is trapped in a downward spiral because there are no profitable opportunities to invest at current interest rates and in the face of current demand.

Keynes’ solution to the trap was to inflate demand by whatever means possible.

Without such action he predicted that deflation would set in and the effort to break free would get progressively more difficult. Deflating wages makes it harder for households to pay off debts, so they have to save even more aggressively. This reduces demand further … and so on.

Are we there yet?

Not quite.

There are hints of inflation. But those hints are ebbing quickly. We have been in a ‘disinflationary’ mode for months now. And those bank debt auctions suggest that the credit markets think we are on the verge of deflation. If we strip out volatile items from the consumer price index it, too, has an ominous trajectory.

The danger is clearly there.

And it isn’t as if we don’t have plenty of recent experience of the trauma deflation can bring: Japan is still deep in its malaise twenty years after its real estate bubble collapsed. One anecdote from Japan tells it all: the story goes that the best selling consumer items during the 1990’s in Japan were safes for households to horde their cash. We do not want to fall into that particular hole.

What can we do?

The Fed can stop paying interest on bank deposits. That would make it more profitable for the banks to lend.

The Fed could also buy assets from the private sector in the hope that the money thus created is sufficient to put the economy past the critical level of money supply – we would be so inundated with cash we would have to do something with it!

Or: we could try to induce inflation. The Fed could raise its inflation target beyond the 2% ceiling it now has and attempt to get the private sector to adjust its inflationary expectations.

And, presumably, we could double down on the federal deficit in the hope that more stimulus would fill the demand gap sufficiently to encourage businesses to invest and re-hire.

Then there’s the Schumpeterian approach: let the devil take the hindmost.

This could get ugly.

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Running For The Hills?

This was entirely predictable. Or at least for those of us who are not in the thrall of Wall Street optimism peddlers. US consumers are in an ugly mood.

Duh.

Anyone who expresses surprise at the sharp drop in consumer confidence should henceforth quit the analyst business. This one has been building for some time. As measured by the University of Michigan, consumer confidence dropped a whopping 9.5 points, from 76 in late June to 66.5 in early July. That wipes out all the gains since last August and suggests a particularly surly mood going into the late summer and early fall.

It’s about jobs of course. There aren’t any. Or, rather, there aren’t anywhere near enough. The US economy is going through an extremely slow and jobless recovery. It looks to stay that way as businesses hoard cash and continue to fire people rather than take anything resembling a risk.

As long as fear grips business it will sow the seeds of its own failure. Continued fear leads to falling demand, which justifies the fear. And so we spiral downward.

The feverish, and frankly stupid, proclamations of a sparkling return to growth we were treated to earlier this year are now giving way to a corresponding, and equally stupid panic. The pundits are crawling all over themselves to heap blame on Obama for not doing enough to ‘save’ jobs.

These are, of course, often the same people who decry government intervention in the economy. Quite how the administration is supposed to ‘save’ jobs without getting involved is beyond me, but logic has never been a strong point of the punditry classes. Nor has fact gathering.

Any, even cursory, perusal of the facts would have lead to a somber forecast for the economy this year. I have held fast to my prediction that anything above 1.5% GDP growth for the second half would be an enormous surprise. In that light I am gratified to see that Goldman Sachs has now downgraded its forecast to about that level. They are not the only ones to be busy getting rid of their hopelessly sunny views. The problem now is that forecasts may become too glum. Talk ‘on the street’ has switched to the likelihood of renewed recession. I am not convinced we will drop that far, but we are getting very close to the edge.

Why?

Fear, fear, and more fear.

I have no idea why this is hard to grasp.

The economy is as much an exercise in mass psychology as it is anything else. Consumers are not entirely dumb. If they are fed a relentless diet of job losses, house price reductions, rising costs in health care and education, and negative news about the economy – about the imminent socialist take over of America – then they will tend to hunker down. They will start to save cash for the disaster they fear is rushing towards them. They will spend only on essential stuff while they wait out the crisis.

The antidote is action on the part of government.

But we are so hobbled in Washington that there is little or no prospect of substantive remedies being put together. Instead the Republicans are salivating at their chances in the upcoming elections, when they hope to sweep back into power on the back of their obstructionism. Since Obama would then be neutralized by the GOP’s ability to wear him down, and since he could reciprocate by vetoing every effort the GOP makes to undo our headlong rush into socialism, we face a grim future of nothing emerging from Washington. There could not be a worse outlook.

Meanwhile the pundits are out in force arguing that Obama’s failure was his capitulation to the left. This argument is bogus and not fact based. If anything Obama’s failure is his constant inability to embrace – or articulate – a definite position on anything. Left or right. His health care reform initiative should have been a triumph for the liberal vision. Instead he was so lame during the debates last year that he created a disgruntled cadre of opponents within his own party. Likewise his half hearted attitude towards bank reform. These are two major accomplishments that seem to be buried by the ongoing negative drag created by the economy. His problem is that by trimming towards the center on two pieces of legislation where the right is implacably opposed to any action he gave up his own base and bought nothing in return.

That would have been sensible if the mushy center of America was in a good mood and was willing to reward him for positioning in the middle. But the mushy center is also the pampered middle that needs constant coddling. It needs the warmth of a healthy economy where it can continue to avoid making choices.

By this I mean that the fundamental paradox of America – its embrace of both anti-government ideology and social programs simultaneously – creates excessive confusion in moments of crisis.

Americans are fearful of yet more government action to save the economy. That’s why austerity rings so true to the voters at the moment. They are pessimistic about the viability of Social Security and medicare, yet they are unwilling to deconstruct those programs and get angry at any reform aimed at lowering long term costs. Remember that a key driver of health care reform was the attempt to cut the cost of delivering care. Yet the public remains skeptical of ‘yet more’ government programs. This while they happily receive Social Security payments that they never contributed sufficiently to pay for.

So anti-government ideology is hampering the proper deployment of the only economic policy we have to offset the fear gripping private business: spending.

We are thus stuck in no man’s land. The public doesn’t want a return to a Great Depression, which is the logical outcome of the policies being advanced by the GOP. And it doesn’t want more government spending. It wants action but no cost. It wants to continue the Reagan dream of having it all. This is America after all.

Since that’s not possible the country seems doomed to wallow in failure for a while yet. Until someone explains the facts in simple terms.

And in this nation of perpetual elections facts will always be elusive.

One last message for the austerity advocates amongst you: I am tired of the idea that government debt is necessarily a burden on future generations and thus we should reduce our short term spending to cut the deficit. What is lost in that message is that the economy itself is also a burden on future generations if we don’t fix it. A crippled, but debt free economy is a rotten legacy to leave. The lost opportunity implied in such a scenario is far worse than the alternative. We inherited an illusion from the Reagan years: the notion that the US could avoid making choices, but could, rather, ‘do it all’ was just dumb in the face of global realities. The idea that talking about problems was un-American because it conceded that there were problems has left us without a clear strategy. We should not pass that illusion forward. That means making choices and getting involved in the discussion about policy.

Somehow I don’t think the mushy center wants to get involved in anything. Therein lies the problem: a lack of leadership has allowed the middle to get complacent and avoid resolution of the persistence of its paradoxical beliefs. Americans still want it all. In the face of the nastiest crisis for seventy years its no wonder that confidence collapses as the public watches Washington dither about.

When the soft middle runs for the hills the economy is in trouble.

Watch out.

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Poor Old Krugman

He’s getting glummer by the minute.

I can see why.

All the evidence piling up suggests that the best part of this recovery is now over, and that we are now entering a long, hard, and risk filled period of poor economic gains.

Not only this, but our policy options are in tatters. The sensible, text book approach is more stimulus. Then again the sensible, text book approach was massive stimulus back when it could stave off this malaise.

Oh well.

Moreover, the sensible approach to the banking crisis was the state takeover and cleaning up of the failed banks – Citibank I am looking at you – instead of this long drawn our and endless subsidization through the back door. It would have been painful and politically fraught. But we would have a healthy flow of credit right now instead of the dribs and drabs we now are faced with.

But since ‘nationalization’ is a nasty word, and since we lack the spine to deal with problems in a simple forthright way, we have condemned ourselves to years of weak and fraught activity.

Those among us who cry out that politics prevented strong action – the GOP seems hell bent on sinking the economy for their own electoral gain – should be quiet. We needed leadership. And got trimming. There is no excuse. As someone once said, countries get the leadership they deserve. We deserve mediocrity because we have drunk deeply the false truths at the free market well. We are collectively doomed to endure rather than prosper because we refuse to be strong together. We would prefer to fail apart.

The inadequacy of the economic policy team Obama relies upon has now been revealed by events. They tried to ‘get by’, and led us into the muck instead. We are given bureaucracy and paper clips, when we need declarative words and sharp knives.

The pile of debt we will accumulate in order to break the back of this crisis is huge. It could have been less had we acted decisively. The indenture we are handing forward is a token of our failure. The indebtedness a sign of our collective ineptitude and meager store of moral courage.

Throughout it all poor old Krugman has tried to point out the errors. He has been proven correct. But he has been far too nice. And now he’s glum about the future. Not because there are no solutions, but because he cannot see us deploying those solutions.

We are too weak.

So, please, no comments about ‘decline’ or anger about ‘Chinese competition’. No more wailing about the loss of manufacturing jobs. No more commentary on the diminished middle class.

The American economy is the world’s largest, most dynamic, and urgent. That we cannot muster the courage to use those qualities to restore ourselves to health is not due to the lack of anything other than spine.

So where is it?

Addendum:

Naturally Krugman is not alone. He is simply the most prominent. Other voices of economic sanity include Brad DeLong and Mark Thoma two of Krugman’s fellow travelers. Indeed the list of people complaining about the totally ineffectual nature of our nation’s leadership – in politics and in business – is very long.

The pity is that we are beset by a disease: bureaucracy has robbed us of an ability to be bold. Everything has to be ‘run by legal’. Everything has to be done by the book. Everything is reduced to jargon infested gobbledygook. Responsibility is diffused into ‘team’ rather than focused on individuals. We are a nation of face lifts, boob jobs, veneers of all kinds, fear, psychiatry, and denial. We are the age of analysis, when we need to be that age of ideas and action.

No wonder Krugman is so glum.

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Those Mystery Debt Issues

OK. Let me take another stab at this one.

There is no debt problem.

Now enjoy the summer.

We are beset with folks arguing that nations running big budget deficits ‘need’ to cut spending in order to assuage the credit markets. I have tried to argue this is fallacious reasoning, yet the fear continues. Indeed, every time it dies down, it pops right back up in a slightly modified form.

So let’s be logical.

First: there is absolutely no evidence in the credit markets of even mild concern, let alone panic. If there is one market where we should have confidence that current prices reflect a consensus view of the economy’s future, it is the market for government debt. History tells us that price movements in that market are a pretty good indicator of what the investors in government debt are thinking. And, by and large, these investors are amongst the most sophisticated there are anywhere. So the price of government debt is something we should pay attention to as an indicator of the sentiment – mood, outlook, or forecast – of these sophisticated investors.

What do current prices tell us?

That those investors are far more concerned about the likelihood of depression and deflation than they are about excessive debt and inflation. Interest rates in the market have dropped from the slightly higher levels they were back two years ago. Bond auctions are over, not under, subscribed. People are actively searching for government debt as a ‘safe’ investment. Let me repeat: rates are down, not up. Investors are scooping up, not divesting government bonds.

I happen to agree with the credit market’s conclusion.

The risks inherent in our current position are mostly downward. We are far more likely to fall into a repeat recession, and possibly a bout of deflation, than we are to boom ahead and run into unmanageable debt burdens and inflation. All of our most recent indicators show the economy slowing down from what was a very short and uneven burst of growth last fall and early this year. Austerity measures are simply adding to the downward pressure and ensuring that the slight chance of a boom is firmly eliminated. The credit markets are telling us that they recognize this and evaluate the future through a pessimistic lens.

That pessimism is driven, not by excessive debt, but by deficient demand.

OK. So maybe they’re wrong, and the ‘gut’ feel of the austerity advocates is right. What can we say to defuse that?

Second: take a look at worldwide cash flows.

The aggregate shortfall of demand worldwide is creating a staggering amount of cash. This is simple arithmetic. If people are earning, but not spending, they have an excess of cash. They become creditors. The global private sector is generating about $3 trillion in spare cash each year at the moment. Don’t forget that it is the private sector in retreat when we have a recession. So private sector savings have shot up. This includes businesses who are sitting on ‘war chests’ of cash, consumers who are paying down credit cards, and everyone else who is simply not spending. With consumption and investment this slack, the world is awash with cash. And cash is useless as an investment in itself.

So what happens?

People look for places to invest. One such place is government debt. In other words governments create debt to offset the step drop in private sector demand, and the private sector buys that debt rather than take the risk of making direct investment or consuming. So the sytem comes back into balance.

It is only when the private sector starts to see better investment opportunities within its own domain – i.e. within the private sector itself – that problems could occur. In this case investors would want to withdraw their cash from government debt and invest it in higher return, but also higher risk, projects and activities. This point of change in the attitudes and flows of cash is what could cause a run up in interest rates. Only then does the larger money supply implied by the bulge in government debt become a potential inflation problem.

It is at this moment that government funding strategies need to change course and the private sector be allowed to forge ahead.

We are nowhere near that inflection point. This is the constant and firm message from the credit markets.

In fact, if anything, those markets are crying out for more debt and thus more stimulus.

Ah … but what about all this debt? Is it not a burden on the future?

No.

It is an investment in creating that future.

The cost of living through a period of very low growth, and potentially through deflation, is vastly greater than the cost of the debt necessary to reflate growth and get GDP back to its historic levels. The higher rate of growth will allow the debt burden to be reduced as a percentage of the economy. The cost of the debt as a percentage of total government spending will increase, but as a percentage of the total economy it will be a minimal increase, if any.

People who wring their hands about passing on debt burdens to future generations would be better advised to focus on the economy itself. Given the choice between an anemic economy with low debt and a vibrant economy with higher debt, future generations would be stupid to choose the former over the latter. Vibrant growth begets opportunity, and ways in which to pay down debt, that are not on offer in a sluggish economy. And it is opportunity we should be handing down to the future, not our own fearful withdrawal from growth. In other words we should not enforce our own view of austerity on the future, but seek to create the opportunity for future generations to make their own choices. The best way to do that is to get the economy back to healthy growth.

Does this mean we have no fiscal issues?

No.

I have repeated timer and again: we have major budget funding issues to deal with.

But they do not relate to the recession, or the debt needed to fend off depression.

They relate to our fundamental choices: how to pay for retirement and health care, how to pay for defense, and how to offset the imbalances that our economic freedom produces within society. For the past thirty years or so we have followed a relentlessly self-regarding path with respect to those choices. We have focused on the self and not the community. Individualism trumped society at every turn. That created great wealth for some, and a massive redistribution of the economy’s earning power away from the middle class to a much smaller percentage of the population. It exposed the fragility of the middle class, which was a post war phenomenon based upon a very different social arrangement. It returned much of that middle class to the edge of poverty – month to month living – and away from the ‘American Dream’ of comfortable retirement ‘earned’ by a life of virtuous hard work.

The hard economic reality is that virtue and hard work do not guarantee anything. We are now learning that. The institutions put in place after the Great Depression to mitigate this hard truth, and to allow the middle class to enjoy a modest version of the life the wealthy have always enjoyed, were swept away once we started to view them as encumbrances or barriers to our continued advancement. We were beguiled into thinking we could all be rich, if only those institutions were abolished. Instead, we simply watched society revert to the older distribution of wealth, with more and more of us ‘doing the right thing’ but still being left behind.

A particularly hard lesson is that the focus on the individual withdraws funding from the community. Our bedraggled infrastructure speaks volumes about our choices. We assumed the roads, rails, and schools would repair themselves while we bought retirement homes, played golf, and had our faces and various other body parts uplifted.

Which brings me to one last comment about debt:

As always there are two sides to the story. Debt and deficits can be productive or they can be destructive. A debt created in order to invest in a productive asset is never a bad thing as long as that asset pays more than it cost to put in place. Government spending on infrastructure, and even on consumer protection, falls into that category. But debt that is incurred without a productive use is both frivolous and, ultimately, damaging.

This is where the debt fearing amongst us have a point.

Most of our current debt problems relate to the Bush tax cuts that produced no lasting wealth creation. They were simply a shift of wealth from one segment of the population to another. GDP did not rise in response to the massive debt we incurred to pay for those tax cuts. Nor did investment. We have no enduring infrastructure. We have no new roads, rail systems, no new schools, no great research initiatives, and no burst of private sector invention. All we have is appalling job creation and an enlarged number of marginally poor people. Oh … and two wars. There is no asset being passed on to the future, simply a problem.

The problem being that we refused to face our limitations. Or that we were limited at all. It became ‘unAmerican’ to talk about the limits to growth. It was ‘unpatriotic’ to mention that we needed to make choices explicitly. Instead we were led into a period of avoidance and implicit choice. The cynicism of which is breathtaking. How else we we justify the Reagan deficits? How else do we explain the plunging into debt that the 1980’s brought us? How else do we explain our apparent comfort with the 2011 expiry date put on those Bush tax cuts? It seemed like a long way off at the time. And we didn’t care about the dire budget consequences we would face when the expiry came up. Instead we basked in the few extra dollars we all received at the time. As an example of extreme fiscal folly, those tax cuts, and our complicity, are hard to top. It is extraordinary that the generation culpable for that series of decisions is now suddenly concerned about fiscal rectitude, just as the baby boomers ‘threaten’ the stability of the budget that they denuded of funding.

Perhaps it is this that so disturbs many folks that they are now fearful of all debt.

If so I hope I have reduced that fear and helped focus us on the real issues.

So allow me to end this by repeating, and modifying, my opening line:

There is not debt problem.

But there is a choice problem.

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Deficits and The Economy: Time To Get Worried?

The big question now has become: are we falling back into recession?

Who knows?

There is plenty of evidence mounting that the US economy is slipping back from its early recovery pace into a much lower, and therefore more risky, pace. The downward revision of first quarter GDP, from the original 3.1% to the more recent 2.7% is just one example. The stubborn refusal of private businesses to hire workers is a sure sign of that sector’s collective gloomy and fearful approach – private sector hiring is still anemic and was insufficient to offset the seasonal lay-offs of government workers brought onboard to do the census. Real estate is mired in a deep slump and shows no sign of recovery. On the contrary each report on housing seems to ring up a new historic low for activity. And even the springtime euphoria in manufacturing has now given way to a two month drop in factory business as measured by the Institute of Supply Management. US factories appear to be suffering the backwash from the Euro zone difficulties, where European austerity plans imply less imports from America.

In short nothing looks as rosy as it did back in April and May.

It is in this weakening context that we should assess policy. In particular we should take a good long hard look at the Federal deficit.

I have beaten this drum incessantly, so bear with me one more time.

Now is not a time to reduce the stimulus. Not at all.

Yes, that implies big and growing deficits. But, as I have stated many times, a big portion of that deficit is cyclical: it will go away when – and if – the economy picks up a head of steam.

And, yes, we have a definite and large deficit problem. We spend far too much on defense and on health care. We cannot afford to keep those expenditures at their current level without getting a more secure funding for them over the long haul. Our deficit problems are rooted in the insane and reckless budgets of the Bush era, not in the emergency and temporary measures of the Obama era. We need to keep that in mind as we argue over the next step in policy.

Take a different tack: if we adopt austerity measures now, or even in the next few months, the odds of a repeat recession shoot up rapidly. There is absolutely no evidence that the private sector is ready, willing, or able to carry the load. Just the opposite: businesses appear only too willing to reduce themselves in order to protect profit in the short term. This weakness and timidity sets in motion the classic downward spiral of the a ‘paradox of thrift’, which only the government can break.

In my mind the world’s leaders have gone crazy: they are all so hell bent on budget cutting in order to appease the credit markets that they have forgotten the long term consequences of their actions. They are all willing to abandon long term health for short term ‘confidence boosting’. As if the markets can’t see the devastation that could arise from this austerity mania. There is almost a collective reverse bubble psychology at work. No politician wants to be sen as ‘weak on deficits’. They conveniently forget the lessons of the 1930’s and rely instead on the economic theories of the last thirty years. But those theories are bankrupt. They were wrong when they were first floated, and they have been exposed as wrong by this crisis. Quite why otherwise intelligent people are still clinging to those policies baffles me.

Inertia?

Ineptitude?

Ideology?

All of the above.

Take the Germans: in good teutonic style they adopt austerity in order to get their house in order. They neglect to note, or admit, that their economy is built upon foreign consumption. That consumption sucks in German goods. So as long as the rest of the world is willing to remain profligate the Germans can be austere and feel good about being ‘correct’.

But: what if the rest of the world also gets a bout of austerity?

Who will buy those German goods? Not the Germans. They are facing austerity cutbacks. The austerity logic breaks down when the entire world goes in the same direction. There is no one to provide the consumption necessary to drive the world growth machinery.

This is why the Chinese have become so important.

The financial markets, and the more optimistic folks in the financial media, have been relying, in their forecasts, on Chinese – and to a lesser extent the rest of the emerging world – to maintain demand so as to allow the ‘old world’ to make the painful budget adjustments they need to without falling back into recession.

Which is why the most alarming news this week has been that the Chinese economy is showing very distinct signs of slowing down.

Get ready for a nasty shock later this year when the GDP numbers come perilously close to zero. Especially as the effects of last year’s stimulus fade away. I still expect us to eke out growth over the near term, maybe in the range of 1.5% to 2.0%. But it doesn’t take much – a Chinese slowdown and all that Euro austerity? – to eliminate it.

Which brings me to a question often asked: the pile up in US debt is presumed to have bad consequences. Especially: the credit markets are presumed to be jittery about our budget. How dow we know when the threshold is reached and the world won’t support our profligate ways any longer?

The short answer is that no one can possibly tell. The longer answer is that I don’t really care anyway.

The reason is this: with the world in a swoon, money has to go somewhere. The US is still, by far, the world’s largest economy, and it is still very stable. Yes the US has long term imbalances that must be eliminated. And, no, there is no sign that US voters will support the kind of cuts needed – can you imagine a Presidential candidate advocating defense spending cuts along with a increase in the retirement age and proper health care reform? We have just been witness to the deep rooted divisions in the US that prevent fiscal rebalancing. It is unlikely that we will succeed any time soon.

But: the rest of the world is in such bad shape that even a profligate and badly managed America looks safe. How else do we explain the drop in US bond prices? Were we reaching the threshold of pain for our creditors and early sign would be their unwillingness to buy our debt. Our bond prices would be rising. This is not happening. Bond prices are falling and demand for our debt is rising. In other words we have a huge capacity – still – to borrow.

We should use that capacity in order to guarantee our recovery. Our borrowing capacity remains one of our greatest assets. We should increase, not decrease, government spending to fill the demand gap. Those bond prices tell me that the markets are fine with the deficit. For now.

Which brings me to another question: are we spending our money wisely?

Not at all.

We are pouring it down the sink holes of two needless wars rather than into programs that have strong stimulative effects. Defense – offense? -spending has nowhere near the impact that increasing unemployment payments does. Neither come close to grand government works programs. This is the proper criticism to level at the anemic stimulus program of last year. And yes, it was anemic in the context of our problem.

Politics prevents us from solving the problem: we have to water down all our programs in order to reach ‘compromise’. We cannot get enough votes to extend unemployment relief even though the cost of so doing is but a week or two of our war expenditure. We have to include specious tax cuts even though all the evidence – and there is tons of it – tells us that tax cuts are just not stimulative.

Which brings me to the real reason to be worried:

Lack of leadership.

From the White House, to the opposition, to business, to academia, to ourselves. No one is willing to think on the scale that the crisis deserves. No one is willing to stand firm against the pull of the mushy center. No one wants to take responsibility and eliminate the fear that pervades the economy. Everyone, it seems, is afraid.

And that simply begets more fear.

And it leads us into wrongheaded policy making, like austerity at a time of slack demand.

That’s why I am worried. You should be too.

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