Fiscal Cliff Now or Economic Armageddon Later

In light of the recent US “fiscal cliff” and “debt ceiling” discussions I would like to bring the bigger picture of “Economic Armageddon” into view. In the middle of October, Professor Deen Kemsley led a discussion with Freeman students on the longer term outlook of the world economy, and the consensus was that if the global crisis were to occur, it would be a category 3 economic hurricane. Of course after the storm, the sun would rise again; the communities and families would have a chance to become more united than ever, and many new opportunities would sprout, especially for those who were prepared. So, how can we get ready? Thankfully, we had some locals in the audience who’d lived through many a hurricane and here’re some tips from the group discussion: build a strong network of friends through selflessness – “give, don’t just take”, be prepared in terms of housing and food, stay on top of personal finances and minimize debt, and finally, improve your education and other skills to raise your employability. I think these tips are useful even if one is not particularly worried about a storm – click here to see the video of the lecture.

Going back to the “fiscal cliff” concept, it will suffice to say that if there are no changes, at the beginning of 2013, certain tax cuts will expire and the government spending will automatically be reduced – The Fiscal Cliff Drama, in WSJ Graphics. In principle, higher taxes will reduce consumer consumption, or the demand for goods and services, and reduced government spending will also decrease the demand for goods and services. In anticipation of these events, businesses will scale back investment and production, causing reduced growth in the gross domestic product aka the fiscal cliff. On the brighter side, this combination of reduced spending and higher taxes could bring an additional 7 trillion into US treasury to pay down the US debt. Incidentally, businesses have already started scaling back, as the growth of investment spending has been declining in 2012. The report for Q3, 2012 shows that the seasonally adjusted annualized capital investment spending declined by 1.3% compared to that in Q2 (look for “capital spending” graphic in the WSJ website linked above).

The “fiscal cliff” goes hand in hand with the “debt ceiling” vote, since the government has been spending more money than it has coming in by, in part, issuing IOUs (treasury bonds, notes, and etc…). In May 2011, the US government reached the $14.29 trillion debt limit and both parties were working on the long term solution for reducing the government deficit – President Obama proposed a plan to reduce the deficit by 4 trillion through both spending cuts and tax increases while the House Republicans would only sign a deal that included larger spending cuts and no tax increases. In the end, the government reached a deal to raise the debt ceiling to 16.4 trillion together with some spending cuts. However, this deal did not address the longer term issue of eliminating the deficit and the proverbial can was kicked down the road (The New York Times – Federal Debt Ceiling (National Debt)). Sometime around Jan 2013, the government will need to increase the debt ceiling once again, but will it be another band-aid or a long term solution? This brings us to the topic of “Economic Armageddon”.

At the beginning of the discussion, Prof. Kemsley presented the students with the worst-case scenario – what would happen if a category 5 economic meltdown were to occur. Here are some highlights: Japanese government defaults on its debt obligations, while the inflation reaches 23%, the unemployment gets up to 35%, and the real GDP falls by 40% compared to today’s value. (Sorry Japan, I didn’t mean to pick on you, remember, it’s all hypothetical!)

Europe is not faring much better – Germany could no longer stand bailing out other countries like Greece and Spain and pulled out of the European Union. The unemployment in Spain is now 40% and the crisis in Italy follows soon thereafter, with unemployment of 30%. France, this was a bit of a surprise to me, fails a few months after Italy, but Germany is faring a little better, as expected, with unemployment of 15%. Thinking about these numbers and the public turmoil they would entail, I remembered that the European Union received the Nobel Peace Prize in 2012 – good thing they are prepared!

Moving on to China, with its European customers in decline, the Chinese GDP is still growing, but only at 2%. Some of this growth is fueled by the spending from the Chinese government and the overcapacity bubble is emerging. Australia is struggling with 16% unemployment, as its housing bubble has burst and the demand for its commodity exports has dropped. India, with its heavy reliance on exports, is now facing 30-40% inflation and high unemployment. Finally, the US is in depression, despite the steady interest in the US government bonds from the rest of the world. US deficits run from 2 to 3 trillion dollars a year, unemployment is at 24%, and the real DJIA is at $4000.

Now, you might ask, “How could we possibly get to a category 5 meltdown?” The answer, as Prof. Kemsley explained, lies in inherent system instabilities. As more and more strands of instability are introduced, the chance of collapse increases. He illustrated this based on the sand castle collapse analogy – a castle can reach different heights depending on the faults that exist in its grain structure. I would add that even a fault-free sand castle will collapse under its own weight once it reaches a theoretical height limit for a given base diameter (See: How to construct the perfect sandcastle). Returning to the world economy however, Prof. Kemsley presented the six biggest instabilities that could lead to the collapse:

a)      The printing of money by the US and the EU to pay for government spending, potentially leading to high inflation.

b)      Approximately 16.3 trillion of debt in the US. Last year, the US paid almost 360 billion in interest on its debt, even with historically low interest rates (See – Interest Expense on Debt Outstanding).

c)       Germany’s dilemma of staying in the EU and continuing to bail out other nations or pulling out and risking a significant reduction in its exports and huge turmoil/bank run in Southern Europe.

d)      Potential collapse in Australia’s housing market.

e)      Japan’s high debt/GDP ratio ~ 230%. Most of the debt is held by the Japanese citizens who are net savers but the population is aging and the citizens will become net spenders.

f)       Off-balance debt in the US – 16.3 trillion doesn’t account for future Medicare and Social Security payments. If these liabilities are included on the balance sheet, as they would be for a publicly-traded company, the debt on accrual basis would be anywhere from 120 to 250 trillion.

Regarding the aforementioned strands of instability, Prof. Kemsley pointed out that they are all contributors to the bigger issue of lack of integrity in the global financial system. For example, prior to the housing bubble collapse in the US, different parties contributed to the loss of trust and integrity: home owners cheated on the applications and spent above their means, in some cases hoping for capital gains, banks overlooked bad applications and developed elaborate schemes to lure unsophisticated consumers, investment banks repackaged mortgages and maximized profits without some of their leaders understanding the risks, politicians misappropriated public funds, taxpayers hid income, and credit agencies either did not dig deep enough to recognize the bad ratings or avoided publishing them. It is this very same issue of integrity that now faces the US government as it tries both to avoid the “fiscal cliff” and to pay down the debt. Let’s hope that we can get back on track. However, remember that even if the “Economic Armageddon” were to happen, there would be many, many sunny days ahead – stay prepared, stay safe, and reread the first paragraph for our tips! Farewell.

Article by Timur Ivannikov (MBA14 from Russia) based on Prof. Deen Kemsley’s “Knowledge is Power” lecture

Photography by Han-I Chen (MBA13 from Taiwan)

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