The US economy has been slowing for some time (the average real growth of GDP from 1980-2005 was 3.01%, while it was 3.95% from 1950-1979), as the economy has shifted more toward finance, insurance, real estate, advertising, and retail. These activities are economically unproductive, meaning they do not directly result in fundamental value creation in the economy (even though they increase GDP). This growth in the unproductive economy creates a drag on the US economy, making it more vulnerable to the financial crisis. Over the long term, the US economy will shift back toward productive activities, like manufacturing and agriculture.
If the economy has been hollowed out by its turn toward economically unproductive activities, why has the stock market seen an incredible run since 1980, with the broad Wilshire 5000 up 1025% at its peak in 2007? For the answer, follow the money.
Specifically, follow the mountains of cash that have been created out of thin air; not just in the last year, when the Federal Reserve has found all sorts of novel ways to pump nearly $1 trillion to investment banks and other firms in a massive effort to re-inflate markets. For the entire period since 1980, broad money creation (M3) has increased 8% per year. You can’t create money on this scale without seeing some inflation, either in consumer prices, or in assets (like stocks and real estate), or both.
Before a tsunami, the sea recedes, exposing the ocean floor and making a sucking noise; then the great wave hits. The US and global financial crisis is in the sucking phase right now, sucking away all the money that has been shoveled into it, but the next phase is certain to be highly inflationary, as the consequences of decades of money creation manifest.
It is particularly interesting then that we begin to see the first call for a new ‘financial order’ from French President Nicholas Sarkozy. The French have a long tradition of chafing under the international rule of the dollar, and my guess is that Sarkozy is seeking to position the Euro as the emerging reserve currency. In the short term, the dollar will continue to attract investors seeking a safe haven from global turmoil in financial markets. But as the crisis fades and the US economy continues to deteriorate while the Federal government continue to pile up huge deficits, investors will look for a stable currency for international transactions.
In the US, most people are looking for the leader who will ‘fix’ the economy: stop foreclosures, get home prices back to rising 15% per year, get gas prices, food prices, and unemployment down, etc. Not all of these things can be done. We got ourselves into this by thinking we could spend all we wanted and pay it back later, and, though it will be a difficult adjustment to make, it will ultimately be better for the world without the US as the ‘spender of last resort’.