A discourse on the current recession and on economic cyles

Economics is one of my favorite subjects.  (namely macro-economics mind you.)  This is because trends can be found and you can use these trends to make numerous predictions and better yourself especially if you do not get too greedy and realize that above all else no matter how you invest money, it’s a risk.

Now we as a country (US) are in a recession that looks to be getting worse.  But I want to take a moment an analyze what recessions are in general and what causes economic activity to bottle up so to speak in cycles.  This will explain everything that we are seeing and I will explain to everyone what I think the future holds.

The main thrust or impetus of any economic system is the growth rate of GDP.  I have discussed this in vague details before in such ideas such as “energy consumption always follows economic growth” but in this case I am focusing on the pure details of what drives an economy on the macro scale.  If you look at the growth rates in the US:

Chart from: http://www.tradingeconomics.com/united-states/gdp-growth

Its pretty clear what happened if you review this over time and realize what happened in the economy.  There are two places that the economy started going up, and I will point out that both moments occurred when Quantitative easing was used to help the economy out.  QE (as I will call it) will be explained in more detail in a little bit, but basically the economy during the recession was never allowed to bottom out, it was artificially manipulated so as to prevent this.  There were two possible outcomes from this manipulation: (the outcomes are simplified here)

1) Stagnation, long period of recession combined with high inflation

2) A longer lasting recession that would both last longer and have a second more severe drop.

The long-term indicators do not point towards or away from 2 in any way.  Yes, we have suffered huge drops in the stock exchange in the last couple of weeks.  But these drops do not tell the story that the long-term indicators will.  The growth for Q3 2011 for instance will tell us where the economy is going.  The drops we have seen can not tell us anything yet.  They are not large enough to point towards a general worsening recession and longer lasting perhaps.  And they do not rule out inflation either, so we are still in the same boat as we were before.  That being said, do not panic, and realize that the best time to invest is when prices are low.

The illustration I just gave is a small piece of the recession puzzle.  Generally, an economy over-extends itself during times of plenty.  This is done by people spending money they do not have and otherwise building up “bubbles” as they are called now in various areas of the economy.  There are numerous examples of this but the one I will discuss will be the real estate bubble.  In this case, people kept investing money they did not have in housing whether as speculators or as owners and they over-spent.  At some point, the macro economy gives kind of like an individual who over-spends.  The economy can not continue to grow past a certain point for an extended period before it suffers “blow-back” as I would call it.

This is besides the point for us, we have already experienced this event once.  The economy could not handle the spending of money and the best way to describe this is that everything was over-priced for what it was really worth.  As expected, prices dropped and inflation threatens to become deflation as is the case during depressions.  The drop in prices of everything from stocks to good to even the most basic necessities is mainly from the curse of a lack of demand.  People tighten their belts, they panic, they otherwise throw caution to the winds and invest in hard currency such as gold, precious metals, etc. with no thoughts of diversifying.

This is shown to be a mistake in the end in most cases, because by the time people start to come out of the panic, the economy has hit rock bottom and prices rebound.  And the individual who panics tends to lose the most money versus the stubborn man who holds onto his stocks despite their losses and realizes that the market goes up and it goes down.  Selling on panic might be human nature, but it’s probably the main cause of recessions and depressions and how they get so bad.

Human nature might factor in to a large extent, but Government involvement can also factor in.  The US Government went through QE twice as I mentioned before.  The first time was slightly justified giving the deflating economy and the fact that this is desired to not happen.  But following the advice of Keynes (whose philosophy I will not go into as that is a book onto itself…) they spent vast amounts of money and put us into debt to the tune of 8 trillion dollars (or more than doubling our national deficit.

Some of this spending was necessary.  To the extent it happened: no.  This is a simple answer, but the economy will do what it will do and as during most recessions the largest problem is that every item as I said which was over-priced during the boom years is just coming back down towards its real worth.  You can not fake this in most instances, and by devaluing the currency,  you simply cause inflation which is useful to stop deflation at times, but only when the deflation is an actual event versus the simple fact that the items were just over-priced.   That goes into depression discussions which I will tell people is a completely different can of worms.  During a depression, not only is unemployment higher, but the dollar actually becomes devalued.  It’s a severe case of a recession which according to modern theory can be completely alleviated….but the cost is what I am going into now.

The cost of QE is especially seen in terms of inflation.  This year the inflation like I was telling people started ticking up quite a bit.  This was a result in the currency becoming devalued.  This is why a third round of QE might not happen, because if it does, I guarantee you (95% confidence) we will reach stagnation stages.  Stagnation is when the economy just can not advance because of two contradictory facts: inflation combined with recession which is rare, but the two play off of each other and as such the feedbacks keep it inside the system for a number of years.  The US experienced this during the 1970’s as a reference point.  This is a very ugly system but the debate among many is whether depressions can be completely avoided and just have worse recessions.  This is a fine line, because when you manipulate any macro-economy, it tends to do what it wants not what you want it to do.

The US economy for instance is stuck in a recession that is quite simply going to continue longer and end up being worse whether the worse means another bubble burst or stagnation.  Either result can be faulted at QE, and conversely on the Feds and the current President who started the QE.  This is not the say the original recession can be blamed at all on either, because like I said, it’s a simple economic cycle.  But the downside is that if the economy had not been fiddled with in reference to QE and massive debt and spending, we might have started to come out of the original recession by now.  Maybe that is just a guess, but every case of artificially manipulating the macro-economy typically results in unfavorable results that might have been just as bad as doing nothing at all.  I don’t know the answer to that statement.  I think that the Fed for instance should be playing the economy like a precision fine piano versus a full rock concert.  The involvement should be subtle and be gentle bumps versus the stomping and grinding we have seen over the last few years.  Regardless, the largest loser during this recession is our currency which has taken the hit for other things.  The effects of this will be seen over the next 20 years whereas most recessions tend to only last a couple of years.

PS: I thought the US had learned its lessons from the 1970’s and Ford and Carter’s attempts to fix the economy.  But maybe too many people forget or do not study history so we just repeat those same mistake over and over ad nauseam.

PPS: The drop in the economy rather surprised me being as large as it was.  I had figured originally that we would see the markets drop slowly and lose approximately 5% more value then they have as of now by the end of the year.  I had thought that inflation was going to be the story and that we had a much larger chance of stagnation.  Whichever is the case for our immediate future, rest assured that either result has its own issues and that we will have hard times for a few years.  Do not panic is my advice once again.  Personally, until I see more long-term indicators, I am 50/50 on which direction our economy will eventually take.  QE is not ruled out as far as I am concerned, but the effects of this would be fairly well seen.  Inflation as high as it is today makes this a fool’s errand.

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