If the U.S. economy had to be summed up in one word, the word would be unsustainable. From entitlement programs to trade deficits, the U.S. economy cannot continue indefinitely on its current course. Sadly, changing course is difficult and political impossibilities are quickly giving way to mathematical impossibilities. The economy will soon come face to face with problems that cannot be solved and it will crash. The crash will be major and recovering from it will take many decades.
The Weak Dollar
Large trade and budget deficits have been weakening the dollar in the past few years. The dollar has fallen 30% against the Euro and 20% against the yen. With the war on terrorism and cheap overseas labor, it is unlikely that the dollar will end its slide any time soon.
The only reason that the dollar hasn’t fallen further yet is that countries that are dependent on exporting to the United States have been propping it up artificially. They have been buying up dollar based assets as fast as they can in order to maintain a strong dollar and high employment levels in their home countries.
This dollar propping will soon end as it becomes clear that the U.S. stock market and real estate market are both very over valued. As well, it is clear that government bonds are not paying enough interest to even cover the weakening of the dollar. In short, the United States has reached its credit limit.
As foreigners face the dilemma of high unemployment or very risky and unprofitable investing in the United States, the system will start to fall apart. If foreigners try to continue the game of trading goods and services for debt, the problem will only grow. At some point foreign currencies will strengthen and the dollar will weaken drastically.
When this devaluation happens, we are all in for a troubling wakeup call. The U.S. government will be unable to borrow at a serviceable interest rate. Consumers will be unable to pay back debt, let alone buy new things.
The lifestyles of U.S. citizens will drop dramatically. The average family of four will have to lose about $6500 in purchasing power just to eliminate the trade deficit. That does not even include the money that would be required to pay back the decades of chronic trade deficits. As well, it does not include the $6000 in extra taxes that would be needed to close the budget deficit.
Overseas, things will also be bad. Unemployment will rise drastically in Asia as the U.S. economy can no longer absorb hundreds of billions of dollars in exports. China and other developing nations will likely suffer from civil unrest because of the unemployment problems.
The Popping of the Housing Bubble
Traditionally, the cost of a home should be between two and three times the gross annual income of its household. In many U.S. markets, the ratio of housing to income is more like four, five, or even eight times.
These ratios are only possible because of very low interest rates and reasonably stable employment levels. The weak dollar or even a brisk breeze could easily pop the housing bubble. When it pops, things are going to get very messy.
The bubble burst will begin with an increase in mortgage rates or the unemployment rate. It will be followed by an increase in foreclosures and a drop in home prices. Soon banks will start losing money as foreclosed homes don’t make enough money to cover outstanding balances. Eventually Freddie Mac and Fannie Mae will be in serious trouble.
Investors who have purchased mortgages will also be in serious trouble. The group of losers will range from retirement plans to overseas businesses.
Coupled with the weak dollar, the popping of the housing bubble will have major effects on the economy. The stock market will die and people’s life savings will disappear overnight.
A substantial drop in the dollar and the bursting of the housing bubble will happen regardless of a terrorist attack. An attack would certainly expedite the process however. In addition, an attack would be so costly, directly and indirectly that investment in the U.S. could disappear.
The psychological and economic costs of a major terrorist attack would likely be worse now than during September 11th. This would be the case because we have our guard up and defending against attacks would almost look futile.
As many experts have said, an attack is a matter of when not if. Hopefully terrorists will fail 100% of the time, but we all know that that is impossible.
Oil prices will certainly be a problem when the dollar weakens, but in this section I would like to focus on the long-term outlook with respect to oil. I claimed that the coming crash would last decades, and oil is a major reason why.
Imagine that your grandfather left you some land that ends up having oil on it. You decide that you want to develop the land and keep track of your oil production. If you were to graph the oil production it would start at 0 barrels per year. This would be the case because you would have no wells dug.
As you start to add wells the amount of oil produced would increase. There would be a point at which you have dug all of your wells and production would start to level off. Eventually the wells would start to run dry and the production would begin to decrease each year. Finally, there would be so little oil that it would not make economic sense to extract it and you would have no production.
The graph of oil production would end up looking like a bell curve. You would start with 0 barrels a year and end with 0 barrels a year. At some point in the middle you would hit peak oil. That would be the year where you had the most production.
If you were to think of the 48 contiguous US states as a big oilfield, it hit peak oil in the 1970s. After that point, oil production has fallen as the number of depleting wells began to outnumber the number of new wells.
If you were to think of the entire world as an oilfield, it has not hit peak oil yet. It is difficult to estimate when it will happen, but most estimates are between 2006 and 2036. Regardless of when peak oil actually hits, it is important to realize that oil production will level off in the coming decades and will possibly begin to decrease.
Despite a leveling of supply, demand will grow dramatically in the coming decades. Even with economic problems and technological innovation, demand will be too much for oil producers to meet. The industrialization of China and Indian will be a major cause of this increased demand.
The imbalance of supply and demand will make oil exporters rich and oil importers like the United States, Europe, and Japan poor. It will kill the dollar and will add to the rate of inflation, which will approach absurd levels. It will be like the 1970s except worse and it will last indefinitely.
The Generational Problem
The United States had a baby boom after World War 2 and then had a baby bust starting in the 1960s. The result of these demographic changes is that there will soon be a disproportionate number of old people.
The disproportionately old population creates two major problems. One is that the cost of caring for the elderly will increase due to their increased numbers. The other problem is that the elderly will become increasingly powerful as they increase in numbers. The results will be more total retirees and more benefits for each retiree.
Over the coming decades this generational problem will become enormous. The cost of Medicare, Social Security and government pensions well begin to dwarf incoming taxes. The ensuing deficits will leave the government with impossible choices. One would be to increase taxes over 100%. Another choice would be the politically impossible cutting of benefits. A third and most likely choice would be printing money to cover the huge deficits.
Anyway you slice the problem the end result will be decades of high inflation, high taxes, and high political turmoil.
Between the twin deficits and the overvaluation of U.S. assets, a dollar correction is a certainty. Another certainty is the bursting of the housing bubble. On top of both of these economic certainties, terrorism looms as very likely destructor of the U.S. economy. The three problems together will surely destroy the U.S. economy in the coming years.
In the long run, the problems of peak oil and demographics will keep the U.S. economy in shambles for decades after it crashes.
When will it happen?
I believe that the crash could happen any day. It could be postponed for a few years if U.S. tax payers and homeowners are willing to go even more in debt. This is conceivable because Japan and Europe may be willing to loan the U.S. money in order to boost their exporting. The continued pattern of debt for goods and services cannot last more than a couple years before the U.S. has unserviceable amounts of debt and has to start printing money.
In addition to the continuation of debt for goods and services, the U.S. will need interest rates to remain low. Low interest rates are very unlikely to happen as the dollar weakens and foreigners start losing more and more money on U.S. investments.
When foreigners lose their nerve to invest in the U.S. or long-term interest rates rise by more than a couple of points, the game is up. The housing bubble will be unsustainable, people will go bankrupt, banks will go bankrupt, and the economy will crash.
Will it be inflationary or deflationary?
I have given this some thought and have concluded that the crash will be inflationary at first. Housing prices will fall a lot, but most goods, services, and commodities will get more expensive. When the U.S. begins its inflationary crash, the rest of the world will begin to enter a deflationary one. Eventually the U.S. dollar will bottom out and the U.S. will join the deflationary depression. Any recovery will be constricted by the generational problem and the peak oil problem.
The rest of the world will suffer from deflation because they will no longer be able to run trade surpluses with the United States. This will leave the world with too many goods and too few consumers. The result will be too much business competition, high unemployment, and loan defaulting.
The U.S. will suffer from inflation because it is in debt. This is true of the government, businesses, and consumers. It is not in the interest of decision makers to allow for deflation. Inflation will eliminate debt without the hassle of having to pay it back. Deflation would make debt even less manageable and would economically destroy the country.
The downside to inflation is that the rest of the world will demand higher interest rates. This would in turn leave the government with the decision to either print money, or cut spending, raise taxes, and raise the Fed rate. I think they are more likely to print money and I hope they do; what good is a good credit rating if you own nothing. I would rather us own our land, businesses, and consumer goods and leave foreigners with worthless paper than the other way around.
How should one prepare financially and otherwise?
Be in good health. This is very important at any time, but especially in bad economic times. With the likelihood of civil disorder and bankrupt institutions, medical services may not meet demand. This will be especially true when the baby boomers begin to retire.
Have a close social network. With the possibility of unemployment and homelessness, having people around is a good idea. There will likely be cuts in government services as it tries to save the dollar from becoming worthless. You cannot, therefore, count on the government during tough times.
Own a fuel efficient and reliable car. Oil and automobile prices will likely trend upwards as the dollar weakens. As well, make sure you don’t buy an expensive SUV. The payments and gas costs may destroy you financially when the economy goes south.
Don’t have adjustable rate debt. If you have credit card debt, pay it off soon. If you have and ARM for your home, you may want to think about selling it before the housing bubble pops. Think of all of your possessions that could be taken away if you could no longer pay your debts. What would you have left?
Think about renting. Even if you have a fixed rate mortgage, it may be a good time to get out of the housing market. This is especially true if you are in a hot housing market.
Let’s assume that you have taken all of my advice and are now renting a home. You are driving a fuel efficient Kia that is paid off. You have a close family and network of friends. You eat your vegetables and jog regularly. As a result of selling your home, you have $50,000 in the bank. As well, you have $20,000 in your retirement plan. What else should you do?
You should own about $10,000 in physical gold. This would be an insurance policy against very bad times, or hyperinflation. You should plan on keeping the gold for years to come and only sell if you need the money to buy food or have some other pressing need. Depending on how end-of-the-worldish you are, it may be a good idea to own a couple hundred pounds of rice and a firearm with plenty of ammo.
Consider investing your retirement money in foreign stocks or possibly liquidating it. If you are getting a significant employer match for contributing to your retirement account, then you may want to continue. Don’t add money that is not matched however.
Keep a descent amount in a savings account. The cash may come in handy during tough times. If inflation kicks in, you will have the money available to buy high interest investments.
If you have all your debts paid off, a reliable car, some gold, and some money in the bank, then you can think about investing. I would recommend being conservative and investing in oil companies or gold. The market will likely get very volatile for many sectors of the economy.