A Troubling Dawn in the Distance

Clear away the underbrush and these are the fundamental organizing principles of Western civilization.

As we search for an explanation for the “great unraveling” that we see around us in continued financial instability, a view from history would identify “confidence” and “credit” at the core Western success, and the subsequent problem children of today.

Think about it.

Western civilization is essentially premised on a simple, deterministic view that we can control events based on our perceived knowledge of the rules that create the behavior of objects.1 If we are certain that we know the underlying principles of how something works, we can then collectively set up laws, regulations, rules, systems and processes that maximize the results we seek.

In a simple example, we know we can plan for tomorrow because of our certainty that the sun will rise tomorrow, creating a new day.

It is this abstract but powerful certainty of “confidence” which forms the basis of our society. The necessity of that sense of control is all the more important given the heterogeneous nature of Western civilization, where a common intellectual framework serves to organize diverse societies.

“Credit” is the natural outgrowth of “confidence,” which enabled the mechanisms of commerce by transforming assets and collateral into abstract expectations, subject to mutually agreeable and enforceable terms and conditions.

In the roughly 500 years since the discovery of America, this deterministic view – and the tools of “confidence” and “credit” – created the greatest leap in human development and well being in recorded history.

• Consider this tangible economic analysis conducted in 1998 at the University of California, Berkeley.

• In the year 1500, global Gross Domestic Product (GDP) – all goods and services produced in the world – was $58 billion.2

• It took 300 years for that value to triple to $175 billion, in 1800.

• The march to modernity, with its ever more complex social and economic institutions, hit its apex in the 100 years of the 20th century.

• Between 1900 and 2000, global GDP has grown from $1 trillion to $41 trillion; an astonishing increase in global wealth that enabled dramatic scientific, social, political, and economic development, and created a living standard unseen in human history.3

• It bears mentioning, of course, that this march forward did not come without its own excesses, injustices and plain brutality. But it is the West’s deterministic path, never perfect but always perfecting, which bore witness from slavery, war, colonialism and monarchy to the rights of individuals, limited and accountable government, free markets and rule of law.

• And from the ashes of global calamity in the aftermath of the Great Depression and WWII, came perfecting, integrated economic, financial and social systems and processes designed to prevent global war and promote economic integration and prosperity.

• Those efforts were largely successful.

• Despite a variety of military activity after 1945, the great powers never again went to war. And the economic and financial agreements set up in Bretton Woods in 1944, which were the genesis for global rules and regulations that set international economic policy, saw startling success.

• Between 1900 and 1950, global GDP increased four-fold.  From 1950-2000, it increased ten-fold. Technological innovation, new markets and goods, efficiencies in production and shipping measured by orders of magnitude, and ever tighter economic integration all contributed to the vast, new wealth creation.

• And it was all based in confidence; that we could understand the forces around us and create rules to control those forces to our collective benefit, using tools such as credit.

• Ok, so what does any of this have to do with the granular disintegration, anarchy and uncertainty that we see around us today?

• Consider this: What if the domestic policies that we have set in motion, almost entirely with the best of intentions and consistent with our deterministic outlook, have, in fact, created forces that are beyond our control, and undermine the very institutions, policies and processes that are suppose to guarantee our economic and political security?

• Said a different way, what if the natural evolution of advanced Western societies – their continued steps toward perfection – in fact are shaping forces that will overturn the very order that is the cornerstone of our prosperity?

• What if the presence of credit without confidence has morphed into something fundamentally counter-productive, particularly in light of domestic spending priorities that are at variance with our ability to pay for them?

• The future is in front of us, friends, and a great crisis in Western civilization is in progress.

• We ignore it at our own peril.

• It is not without a little irony that today’s crisis finds us in Athens, the cradle of Western political thought, and the straight-line source of our success and prosperity.

• Today Greece is in turmoil.

• Successive Greek governments have expanded the public sector to shower an ever increasing number of Greek citizens with generous benefits; either through public employee unions, or through programs for education, health care and pensions for the elderly.

• These robust increases were not rooted in a model of economic viability – what Greece could afford – but on what was considered socially just; the right thing to do regardless of the cost.

• And each new program created a new constituency in the public for that particular program, fostering a personal selfishness amid collective and expanding government largess.

• The iron law of economics is that there is no such thing as a free lunch.

• But in a democratic system that un-tethers expansion of social programs of the public sector designed for select constituencies – unions, students, the elderly – from how they will be financed, political and economic realities necessarily collide. The public good is suddenly undermined by the well being of the government-dependent individual.

• That, in turn, paralyzes the political system, which can only reconcile economic reality and social expectations either by ignoring them, or taking steps that will all but assure that political leaders are voted out from power.

• In Greece, elected officials chose a mix of denial and hope, essentially cooking the books to avoid having to face the painful fact that the government was providing a level of public benefits completely at odds with Greece’s ability to pay for them.

• So they borrowed.

• A lot.

• As a new member of the European Union (EU), Greek leaders found that money was cheap, debt was easily off-loaded to hungry bond holders in other EU countries, and rosy estimates of future economic growth would take care of the rest. Similar to justifying a fancy new car on the high wage job you know you will get in a few years time.

• But that’s not the way it worked out.

• The spending spree instead, has left the Greeks with a sovereign debt that is equal to 124% of Greece’s GDP. So if you took everything Greece produces in one year and dedicated it to debt reduction; every salary, every manufactured good and service, the Greeks would still not be able to retire their outstanding debt.

• The current Greek Prime Minister, determined to get to the bottom of Greece’s exploding debt, uncovered activities by previous governments which borrowed money to pay the interest on their debt. This is akin to taking out a new credit card to pay the minimum balance on your AMEX.  Anyone who has been in that situation knows where that ends.

• And now that the full proportions of Greece’s crisis are known, there is a crisis of confidence. Suddenly, Greek debt does not look like a good risk, so fresh loans – credit – to carry over existing, annual budget deficits, have become vastly more expensive. Greek debt is now untouchable for less than 18% interest, compounding the government’s debt woes.

• And the only way out for the Greeks is nothing short of draconian cuts in spending and tax increases, designed to bring the budget into something approaching balance, and give investors’ confidence that Greece will not default on its debt and continue to pay its bills.

• Of course, the draconian spending cuts and tax increases are borne by the very people who were so recently recipients of Greek government largess.

• You can imagine that there is not a lot of appetite to accept cuts in services, pay and benefits, as well as an additional tax burden on less income, simply to pay foreign creditors. All this in an economy already suffering from high unemployment and anemic economic growth.

• So the Greeks have taken to the streets in demonstrations that have become full scale riots, many organized by labor unions, protesting their unwillingness to accept the new reality. This has set economic reality on a collision course with democratic politics, where political leaders are at grave risk of being voted out of office for taking steps that are essential for national economic salvation.

• That collision, fuels an ongoing crisis of confidence and credit, which continues  in an unnerving downward cycle.

• And the contagion is spreading.

• Once the Greek model was exposed with all its flaws, other, over leveraged economies in the EU have now come under scrutiny, particularly Portugal, Ireland and Spain. These three countries have public debt that is respectively, 90%, 80% and 60% of GDP.

• And all three are running annual budget deficits that call into question each country’s ability to control and service its debt.

• Ireland is running a deficit at nearly 12% of its GDP, Spain at 8.9% and Portugal at 7.3%.  Thisconfidence crisis is causing the credit price of borrowing to increase for these countries, which like Greece, compounds the original problem and creates an unvirtuous cycle of decline.

• Germany and France, as the anchors of the EU, are stepping in with a bailout plan to save Greece, while pressuring other, vulnerable governments in the EU to take aggressive action to curb their borrowing.

• The EU bailout is no more popular with Germans than service cuts and tax hikes are with Greeks. German taxpayers are incensed that their frugality and relative cost consciousness is now being used to subsidize the reckless borrowing by the Greeks; essentially rewarding bad behavior.

• And this has significant political implications.

• While German Chancellor Angela Merkel was able to pass the Greek bailout plan through the German Bundestag, voters will have the opportunity in regional elections in North Rhine-Westphalia on May 9th to let their voices be heard. This has the potential to jeopardize Merkel’s  control of the upper house of the German parliament, and her continued ability to govern decisively, creating another confidence dilemma and a collision of economic realities with political practicalities.

The sad truth is that at the end of the day, the Germans have very little choice but to be the guarantor of last resort.

• The alternative is a cascade of sovereign debt failure that not only threatens to trigger sustained recession across the continent, undermines the European Monetary Union (EMU) and the Euro, but will ultimately undermine the stronger EU countries in the longer run as well.

• Who do you think is holding all that bad debt anyway?

• It’s German, French and other international banks.

• This leaves the Germans with the unappetizing choice to either stem the hemorrhaging now by extending emergency credit – and hope that a sense of stability in Greece will buy time for other, troubled European economies while the nascent economic recovery takes hold – or watch as sovereign debt failure cascades from nation to nation and ultimately impacts the heart of Germany’s financial system, plunging the Germans and other economies into crisis and renewed, deeper recession.

• But at just the moment Germany needs to marshal its political will to forestall an epic crisis, elections threaten to undermine the government’s ability to react, now and in the future.

• If Merkel’s Christian Democrats lose on Sunday, how likely is it that the ruling Christian Democrats will go out on a limb for the sake European unity or concerted European economic policy when such action will be at a premium? And what will that do to confidence in the European economic system?

• If additional evidence is needed concerning the collision of economic and political reality, look at Great Britain.

• The UK public debt is currently 59% of GDP.  This year, Britain is running a budget deficit of nearly 13% of GDP. In the last two years, British voters have been rocked by the financial crisis of 2008, and the ensuing recession, which has increased joblessness and cut economic growth, while government spending has soared.

• Thursday’s national election in Britain represented nothing quite as much as a vote of noconfidence in all of Britain’s political parties.

• The ruling Labour Party suffered repudiation and its worst defeat in nearly a century, losing 91 seats in the 650 seat Parliament. While David Cameron’s Conservative Party soared, gaining 97 seats, the victories were not enough to provide the Conservatives with an outright victory and the ability to form a government.

• Nick Clegg, leader of the Liberal Democrats, who turned the election upside down with dazzling performances during three, American-style debates, effectively gave voice to voter disaffection, but actually lost five seats in Parliament.

• This means that Britain will have its first “hung” Parliament (one that requires either a coalition to govern, or which is governed by the largest Party winner, if still a Party with a minority of seats) since 1974.  Such governments are notoriously unstable and weak (the 1974 government lasted only eight months). And it could not occur at a worse time, when strong, united and decisive leadership is a prerequisite to address the most compelling economic and fiscal questions.

• At least at this point, British voters are having none of it, fed up with Labour, yet still suspicious of the Conservatives and uncertain of the Liberal Democrats. Financial and economic uncertainty, and voter frustration has led to national political gridlock.

• Everyone knows what the problems are – spending and debt – but no one is prepared to give up their slice of the pie, be it student stipends, cuts in the National Health Service (NHS) or other programmatic reductions.

• The collective European narrative, dynamic and alarming, is one that we in the US ignore at our own peril. The parallels are disturbingly real.

• US unemployment figures for April are out. The major media outlets trumpet 230,000 jobs created (after accounting for temporary Census workers), while unemployment crept up to 9.9%.4 This figure does not include an additional 2.4 million Americans who have given up looking for work entirely.

• US GDP grew by 3.2% in the first quarter of 2010. This was slower than the 5.6% growth of the fourth quarter of 2009, but still represents welcome news and evidence of a positive trend that began late last year.

• The challenge, as this Journal laid out in a January 11, 2010 posting, is that gains in productivity have kept up with or exceeded gains in economic activity, demonstrating a sustained lack of business and investor confidence in the US economy, resulting in continued, structural unemployment.

• For instance, if GDP grows by a healthy three percent, but labor productivity increases by 1.5%, then the job creation rate is effectively 1.5%.  Under the same scenario, if the labor force increases by two percent, then there will be a net increase in unemployment.

• Consider this formula as it is applied to data from the last three years:

*Data from the Department of Labor/BLS and the Department of Commerce/BEA

• Since productivity gains during a recession are driven in part by a negative sense of the future business environment and the absence of the need for additional workers, the huge productivity gains during Obama’s first year are not only a matter of business efficiency, but almost certainly represent structural uncertainty by business leaders and investors about the future economy based on the President’s stewardship and policies.