The Liberty Papers

Let me sketch out something before I head into the meat of my post. This isn’t another thought experiment or a hypothetical. This is what I see in the next 1-4 years and beyond. Part of my post is a prediction, and the rest is a bit of a doomsday scenario. But I’d definitely like to hear from my co-contributors, and readers, to see if you think I’m crazy.

The housing boom was largely funded by creatively-financed mortgages to subprime borrowers. Most of these loans seemed like no-brainers in the bull real estate market, but as interest rates rise, prices have stagnated in some markets, and outright dropped in others. This asset bubble was largely caused by an enormous credit expansion, and the ability to underwrite these loans was made even easier by the fact that the risk could be offloaded onto the mortgage-backed securities and derivatives markets.

Right now, with a sagging housing market, rapidly increasing default rates, high housing inventories, and a slowdown in the building and construction industries, we’re seeing trouble. We’re in a state where recession looks incredibly likely. My sketch is largely borne off what I’ve personally witnessed in the 2001 recession in the technology industry.

So here’s what I see. The slowdown in the subprime mortgage and building industries will increasingly push the default and foreclosure rate up. As a result, the mortgage-backed securities market and other housing-based stocks, which are reaching insane levels of “irrational exuberance” and are often highly leveraged (particularly derivatives), will crater, increasing the pressure. I think recession is on the way, and perhaps worse.

The above doesn’t sound very pretty. I don’t see any way out of it, though. The problem occurs with what happens after this, which is where it has the potentially to get really ugly. As I said, what I wrote above is what I predict. What sits below is a worst-case assumption of what might happen.

After the 2001 recession, when the government was coming off small surpluses, we had very low interest rates, and the political will to cut taxes, we were able to protect against a major economic crisis. We don’t have the same situation now. The government is running enormous deficits (and has added several trillion to the debt), the politicians are debating raising taxes, and interest rates likely won’t be able to hit the rock-bottom levels we had in 2002.

What does this mean? I don’t think we can spend our way out of this. I don’t see any way for us to have liquidity in a stagnant housing market and a tight credit market. In a tighter credit market, with rising interest rates, the cost of borrowing to cover deficit spending will not be feasible for the government. I don’t see an engine for economic growth appearing to cover the recession. There’s only one way for this liquidity to arrive, and that’s for the government to print money. Loads and loads of money. Helicopter drops of money. And the result is stagflation. This is quite possibly the worst thing our government can do, but I don’t trust any politicians to take the tough medicine– I expect them to print money.

Further, if things get bad, you can expect a quick increase in the level of socialism in this country. In an effort to placate both American big business and American voters, you’ll see the government take over health care. As a result of the inflation government will cause, you’ll quickly see them try to institute price controls and wage controls, like the 1970’s. All the while, they’ll blame scapegoats like outsourcing companies, while their own inflationary policies are causing the problem.

Wait, though, it gets worse. America isn’t an empire in the conventional sense of the word, but we are an economic empire. The dollar is the currency of the world, from middle eastern oil to the reserve currencies of countless nations. During the Great Depression, or during the stagflation of the 1970’s, other nations were stuck with the dollar, because nothing else was suitable. But if the dollar starts dropping in a major inflation, they now have options. And if they drop the dollar, it’s all over. All of a sudden, America won’t draw on the world for our own stability. Considering the actions of our politicians, that’s a bad, bad thing.

We may be witnessing the end of America as the world’s superpower. It may be the end of our status as the economic empire of the world. Some across the globe, of course, will cheer. After all, they feel like America is the premier force of evil in the world. For all the bad that we’ve done, though, we’ve been a pretty stable force, and worked to prevent the spread of fascism and communism, across the globe. America’s economic system has been the safe-haven for the world. When a position of power is vacated, what typically fills it is rarely positive. The end of the American empire will likely result in more instability worldwide.

What sort of instability? Well, the political will to police nuclear proliferation will likely disappear. The ability to call on America to send peacekeepers to Darfur, or mediate between Israel and the Palestinians. In fact, you can likely expect Israel and the Palestinians to reach full-scale war, as the lack of American support will embolden Iran and the Arab world to start hostilities, and Israel to fight for survival. China moves on Taiwan, obviously, and starts rattling sabers with Russia for lands in Eastern Siberia. Militant Islam secures its foothold in South Asia and Africa. More of South America succumbs to socialism. In short, a lot of bad things.

All in all, this paints a very bad picture of our potential future. I can’t say that I consider this outcome likely, but at the same time, I don’t see it as an impossibility. Right now, it’s one of those things that I’m just thinking about contingency plans in case things get really bad. I’m not going to suggest to anyone here that they start building a bunker and stockpiling canned goods. But I am going to suggest that you keep your eyes open, and make sure you know what to do to either handle this sort of instability, or profit from it. At least if you see it coming, you’ll know which way to dodge.