The economy is in shock. The effects of this will soon become visible

Summary:  Nothing has happened, yet something has happened.  A financial shock is an elusive event, largely psychological in its immediate effects.  We can fight through this by staying cool and rational, and working together.  As America has in past times of crisis.Look around after the events of last week.  America’s industrial plant remains undamaged.  It’s great natural resources remain.  America’s greatest resource, its skilled and hardworking people, remain in place.

Yet something has happened.  It is a financial event, the real-world effects of which we will see in the coming weeks and months.  Continuing to use the medical analogy of previous posts, the economy has suffered shock.  More specifically, this is like circulatory shock, which Wikipedia defines as follows:

{Shock} is a serious, life-threatening medical condition where insufficient blood flow reaches the body tissues. As the blood carries oxygen and nutrients around the body, reduced flow hinders the delivery of these components to the tissues, and can stop the tissues from functioning properly.

We can carry the analogy one step farther.  This is like Cardiogenic shock, caused by the failure of the heart to pump effectively.  The US economy went into cardiac arrest early last week, as the flow of money (the blood” of the economy) slowed due to a near-collapse of the financial system (its “heart”, but not its soul).  If not restarted, the economy will slide into a depression (GDP decline of 10% or more) in a few weeks.

The impact is great, but only slowly becoming visible to the general public from articles like these:

  1. Grain piles up in ports“, Financial Post, 8 October 2008 — “international buyers find themselves unable to come up with payment, forcing sellers to shoulder often substantial losses.”
  2. Capital One Ends Financing of NY, NJ Car Dealers“, Bloomberg, 10 October 2008 — “”Banks are seeing the bottom fall out of the dealership business and they don’t want to be caught sitting there owning a bunch of Chevys, instead of getting cash.”

The meeting in Washington this weekend of world finance ministers may be the last opportunity to stop this slide.  But even if successful, this brief interruption will have severe effects.  The most significant will be a collapse of business spending and investment.  Businesses want cash, and are fearful of making investments in plant, land, or people.  This will rapidly slow the economy, no matter what measures the government takes during the next few months.

To some as yet unknown extent, people (”households” in econo-speak) will slow their spending and boost savings, also slowing the economy.

The result is Keynes’ paradox of thrift, an immediate response to an economic shock.  From Wikipedia:

The paradox states that if everyone saves more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population. One can argue that if everyone saves, then there is a decrease in consumption which leads to a fall in aggregate demand and thus leads to a fall in economic growth.

Like most economic dynamics, there is negative feedback from this.  Over time, as the shock passes (more from the Wikipedia entry):

First, {as} demand slackens and prices fall, the resulting lower price will stimulate demand, which tends to limit the decline in demand. Second, and perhaps more important, “savings” represent loanable funds; an increase in the supply of loanable funds tends to lower interest rates and stimulate borrowing, so a decline in consumable goods with a short time horizon is offset by an increase in production in sectors with longer time horizons. For example, the demand for personal electronics might decline, but the demand for such things as real estate would be stimulated by favorable borrowing conditions.

This is good, but not necessarily fun.  Just one example, for now.  Investment in the energy sector will likely crash in reaction to the crash of oil and natural gas prices.  Drilling high cost prospects (e.g., deepsea, arctic, coal-bed natural gas) is irresponsible if not irrational when one can buy reserves on Wall Street at less risk for lower prices.  That not only will mean that we will be far less prepared for peak oil (whenever that occurs), but might mean much higher prices in the future (2010 – 2012).  Think of this as putting an air bubble in the pipeline carrying the worlds energy supply.

Multiply this a hundredfold to see the disruptive effect of this on the global economy.

Focus on the solutions as an antidote to panic

For a summary see A solution to our financial crisis.  An economic downturn has 3 stages, each with a different goal.

  1. First Aid — Stabilize the financial system to avoid a depression.
  2. Treatment — apply fiscal and monetary stimuli to mitigate suffering during the recession and get a global recovery in 2010.
  3. Recovery — restructuring and reforms to prepare for the expansion after 2010, and the new world beyond that.

A global recession like this requires global coordination, otherwise national policies might conflict and offset their effects.  This weekend’s meeting is a first step in this long process.  At some point we might be forced into the “The Master Settlement of 2009″.

Afterword

If you are new to this site, please glance at the archives below.  You may find answers to your questions in these, such as the causes of the present crisis.  I have been writing about these events for several years; since November 2007 on this site.  As you will see explained in these posts, the magnitude of the events now happening is beyond what most Americans have — or can — imagine.

Please share your comments by posting below.  Please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information from the FM site

To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp interest these days:

Some FM posts about the current crisis

  1. How should we respond to the crisis?, 24 September 2008

A few of the most important posts warning about this crisis

This crisis has long been forecast by many, including in articles on this site.  Even now that we are in the whirlwind, these provide valuable background material on its causes — and speculation about the results.  To see the all posts on this subject, go to the FM reference page about The End of the Post-WWII Geopolitical Regime.  Here are some of those posts.

  1. A brief note on the US Dollar. Is this like August 1914?, 8 November 2007 — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
  2. The post-WWII geopolitical regime is dying. Chapter One, 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
  3. We have been warned. Death of the post-WWII geopolitical regime, 28 November 2007 — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
  4. Death of the post-WWII geopolitical regime, III – death by debt, 8 January 2008 – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
  5. Geopolitical implications of the current economic downturn, 24 January 2008, – How will this recession end?  With re-balancing of the global economy, so that the US goods and services are again competitive.  No more trade deficit, and we can pay out debts.
  6. A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
  7. What will America look like after this recession?, 18 March 208  — The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
  8. The most important story in this week’s newspapers , 22 May 2008 — How solvent is the US government? They report the facts to us every year.
  9. The World’s biggest mess, 22 August 2008 — A brillant ex pat looks at America from across the ocean.

Originally published at Fabius Maximus blog on October 11, 2008 and reproduced here with the author’s permission.

One Response to "The economy is in shock. The effects of this will soon become visible"

  1. Guest   October 12, 2008 at 5:30 am

    Pox on those who are responsible for this mess and particularly THE FEDERAL RESERVE BANK. May they be damned.