Debt, Democracy, and a Double-Dip Economy

We are used to planning for the future knowing that things never work out exactly like we thought they would. Formally or not, we base our plans and actions on highly probable outcomes. I know that whenever I eat pasta I get sauce on my shirt and sometimes in my hair. It is predictable. So I wear a shower curtain at the dinner table. That’s what we do. We plan and prepare for events that have highly likely outcomes. And accordingly we do NOT plan for EVERY possible outcome. Some things are highly unlikely with almost zero possibility. While eating, I might learn that Madonna is going to join us for pasta primavera. For such a possibility I should be wearing only my best shower curtain. But, of course, I don’t because there is no way she is going to show up in Bloomington for dinner at my house. Accordingly we don’t worry about Martians or Charlie Sheen at the dinner table.

But there are events that fit in between the highly probable and improbable and we give them our attention.  We might say that we have a contingency or back-up plan for things that might happen, even if the probability is low. We buy life insurance policies when we are young because it is a prudent thing to do despite the fact that we might live through seven colonoscopies. Business firms hold costly inventories in the case that buying for their products is higher than normal. To NOT prepare for these possibilities is to be imprudent or we might call it risky behavior. NOT preparing for one-in-a-million unlikely events is excusable. Not preparing for somewhat unlikely events is not.

Today we don’t seem to know one unlikely event from the other. A terrorist plot to fly airplanes into tall buildings on US land used to be unthinkable – but now we spend a lot of money protecting ourselves from that kind of behavior. A financial crisis grips the US and the world – something that few of us prepared for but now has governments rethinking regulation and how markets should function. A revolution breaks out demanding democracy in Northern Africa and the Middle East – surely a plot for a futuristic novel but now all of us are scrambling to deal with the likely contagion.  One might argue that we should have known that all these things would happen. But the truth is that not enough people REALLY thought any of them would around the time they unfolded. They were pretty-much black swans. A black swan is a major event with very low probability – sort of like me driving to town without Betty telling me I picked the wrong route.

Today we are pausing to ask about the possibility of another major economic crisis or if such an outcome fits this black swan description right now.  To resolve this issue we have to calculate the probability of another economic collapse.  If a strong downturn is really highly unlikely, then it would be wasteful and costly to try to prevent it. But if it is not a black swan and there is something we could do, then we would conclude that our policy makers have their heads in the sand.

Recent events make me want to revisit the likelihood of another recession. We were cruising along pretty well in the last months – with lots of data pointing to a firmer economy. We are now seven quarters beyond the official end of the last recession.  Risk factors are well known and discussed frequently – the housing market needs more time to heal, government budgets need fixing, and emerging markets are causing threatening price rises of commodities, including oil. But the general consensus of most economists and the stock market is a rosy outlook with a small probability of a recession.

So why is Larry so cranky? I ranted recently about jeopardy – the idea that these risk factors should be given more of our attention. I particularly believe that government deficits and debt need our immediate attention.  Can we handle the debts now? Sure! But that’s not the point.  The point is whether or not we can handle the consequences arising from a few low probability events or shocks.  And last week pointed out how very unprepared we are.  Last week the political disturbances abroad caused oil prices to shoot up and our journalist herd quickly taught us how to spell S-T-A-G-F-L-A-T-I-O-N.  Last week we read and heard again about the 1970s and how and why a large and sustained rise in the price of oil might cause simultaneously higher unemployment and inflation.

A few journalists and economist s wrote more thoughtful explanations about why an oil crisis of the proportions we are experiencing today might not lead to as much economic wreckage as in the recessions of 1974 and 1980. But the point has been made. A black swan flew into our lake and left a big poo-pee. Maybe our economy will stick its nose up and go on with growth anyway. Or – maybe some white swans will join her and make the mess much worse. Right now we don’t know.

But this illustrates our choices. If we had a more normal debt position such an event might knock us around for a while – but having a large chain around our necks make us weaker and unable to deal with a large oil/commodities price shock right now.  If you had six months of earnings saved and in the bank when a bout of unemployment hit you, life would go on. If you have nothing but debts when unemployment strikes that is a much different situation. In that case it really hurts and you have few good options.

If stagflation hits the US – whether because of oil or the prices of other commodities – the US government budget position and debt will worsen even further.  The recession part of stagflation means that tax revenues will decline and spending will increase. The inflation part means many things – but surely interest rates will rise and cause mandatory government spending to increase.  And as most people know – stagflation puts the government and Fed in a no-win battle with inflation and unemployment.  Using traditional demand-focused policy tools, any policy designed to slow the rising inflation will make the unemployment worse. A policy more focused on the recession and unemployment will make the inflation worse. With fragile confidence today, can we really flirt with these outcomes?

Is the probability of stagflation high enough to warrant a faster and stronger approach to US debt problems? I think so. Clearly recent days indicate that the demand for democracy and the impact on oil prices is no longer a black swan.  But is the probability of continued disruption of oil markets high enough to warrant all the difficult political and economic changes that go with a fiscal solution? Clearly the expected payoff of a solution is huge. Imagine the newspaper story detailing the immense losses connected with the following headline – US unemployment rate rises past 10% as the consumer price index reach 6% in 2011. Why don’t we demand more from our representatives in government?  Let’s get this debt under control before the next sneeze becomes pneumonia.