Sunday, September 21, 2008

The Next Great Crisis

We're entering a dangerous period indeed. The government is currently planting the seeds of the next crisis. As I argued in One Nation Under Debt, we should never have allowed the debt to grow so large (2/3rds of GDP) in what was essentially peacetime. If the bailout doesn't go well and if the economy remains soft (and hence government receipts low), we could be looking at a national debt to GDP ratio of 100%. We could probably survive that, if nothing else bad happens. But guess what? The mere fact that we are down greatly increases the likelihood of getting whacked by additional negative shocks.

The probability of a natural catastrophe has not increased but our ability to respond effectively to one is impaired due to the difficulties at AIG (a major insurer) and in the capital markets more generally. At least two major recessions were exacerbated by natural catastrophes. The explosion of Mount Tambora in 1815 led to the "year without a summer" in 1816, disrupting agricultural markets in North America and Eurpe that culminated in the Panic of 1818/19. The Great San Francisco earthquake (1906) has been implicated in the Panic of 1907 because it created a massive flow of gold from British insurers to the West Coast, which induced the Bank of England to raise interest rates, which, in turn, burst an asset bubble.

Of course we don't know when or where the next major hurricane, earthquake, or volcanic eruption will occur. Nobody (I hope!) can cause one, and nobody can stop one, so such a shock will be random, dumb luck. Maybe one will hit us, maybe one won't. Such is not the case for manmade catastrophes. Terrorists must be salivating at the thought of hitting us hard while we are down. Hackers are undoubtedly gearing up to make attacks on technical network infrastructure that might fall into disarray during bankruptcies, quick forced mergers, and the like. And nation state enemies like North Korea and Russia are already beginning to behave badly. Another big shock might be all she wrote for the U.S. dollar.

I'm not being alarmist here, or if I am so is the Wall Street Journal which ran a short article yesterday (Septembe 20, 2008, B16) called "Stocks Gain -- So Does the National Debt." The article notes that the dollar could go either way at this point because "currency markets might see the fiscal cost [of the bailout] as a good trade-off against the bigger risk of letting the U.S. slip into a deep recession." That's right. But, as noted above, if the bailout does not go well, the national debt swells further, and we get whacked with another shock, the dollar could plummet again, to the point where the U.S. government may have to borrow in euro, sterling, yen, etc. At that point, we have to suffer very high interest rates and borrow only domestically or revert to emerging market status and borrow in other currencies, with all the attendant default risks.

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