\nThe editor suspects the most uncomfortable aspect most Americans will have with the New Normal is its foundation assumption: there is a \u201cfundamental realignment of global economic power and influence\u201d away from the developed nations, principally the USA, toward the newly developing, previously without \u201cany systemic influence\u201d nations such as China and India. The world is indeed turning upside down: the South (developing nations) is beginning to overtake economically the North (developed nations).<\/p>\n
Why?<\/p>\n
Because of the \u201cpronounced accumulation of financial wealth by a set of countries \u2026 that were previously more used to being debtors and borrowers than creditors and investors\u201d. The Developing nations are now capital rich.<\/p>\n
Why?<\/p>\n
Because the formerly powerful, previously lending, nations (USA, et al) had relied over an extended period of time on debt to mask the reality they were spending\/consuming more than they produced or earned. The major source of developed nation\u2019s debt financing was the export fueled economies of the developing nations (think of Saudi oil sheiks, Chinese manufacturers, and Indian outsourcing firms). The wealth accumulated through export allowed vast amounts of developed nation dollars to flow to the central banks of developing nations. In turn the developing nations formed nationally-owned investment banks called sovereign funds. These sovereign funds returned\/reinvested the profits derived from exports to the original developed nation in the form of purchase of treasuries (federal deficit) and mortgage debt from the decade\u2019s long housing boom in USA, Ireland and England.<\/p>\n
This worked more or less well through the \u201890s and early 2000s but all good things come to an end.<\/p>\n
How?<\/p>\n
In case you missed it, the last years of this fantastic debt\/consumption boom were sustained by \u201cthe proliferation of new financial instruments\u201d, the now ever-popular derivatives (swaps (AIG), CDOs (large banks)) and structured investment vehicles (SIVs or off balance sheet debt holding corporations\u2014yes, think of Enron, AIG, Lehman and the large banks which even today own 80% of all residential mortgages). Economic developers saw an explosion in TIF financing and municipal debt in general.<\/p>\n
When these financial innovations exploded post 2007 (triggered by the busting of the American housing boom, itself triggered by the incredibly abusive sub-prime mortgage lending), the developed nations (and their financial systems) were for all intents and purposes INSOLVENT, i.e. facing bankruptcy. When a financial system collapses (very rarely) currency collapses, credit and lending terminates, existing debt is foreclosed and the overall economy collapses. How does one recover from this? Ask FDR, Hitler, Churchill and Stalin. The lesson of the Great Depression (a la Keynes and Bernanke) is to avoid this financial collapse in the first place. Avoiding a financial collapse is very hard to do because who is left with sufficient resources to purchase all these toxic assets, thereby injecting massive capital into the economy. Put it another way, to whom do the major insolvent banks mail the keys to their assets?<\/p>\n
To the Lenders of Last Resort: The Central Banks (Federal Reserve) and the National Government<\/p>\n
So much (about half) of the now worthless derivatives and significantly depleted loan\/mortgage portfolios were duly purchased by (in the American case) the Federal Reserve (our central bank) and the Department of Treasury which became the administrator\/executor of Fannie\/Freddie May\/Mac and TARP (several trillion dollars in these transactions). To further ensure the economy didn\u2019t fall off the proverbial cliff into the Great Depression, a massive + trillion dollar stimulus followed. Viewed in its most positive sense, the federal government had injected nearly $3 trillion dollars into the 2009 economy. This does not include GM, Fannie and Freddie, and AIG.<\/p>\n
In essence, the federal government purchased nearly half of the toxic assets and derivatives incurred by the private banking and finance system. That\u2019s where the toxic stuff went, and that\u2019s where it remains today! It hasn\u2019t gone away\u2014it\u2019s still alive and well, buried in the books of the federal government. The unpurchased portion of the toxic assets remains in the banking system; only half of that has been written down to this point.<\/p>\n
The point of all this is that the financial system has collapsed. In its wake the relationship between many developing nations and developed world has been irretrievably reversed. The page has turned. We are NOT going back (according to El-Erian) to the old system. It\u2019s over. Kaput! Instead we have now entered into a transition era, the New Normal.<\/p>\n
What is the New Normal?<\/h2>\n
Excessive debt is the problem and DELEVERAGING (debt reduction) is the critical dynamic of the New Normal.<\/span>Why can\u2019t we go back to the good old days? For the same reason we are now in an era of New Normal. We are in debt and we can\u2019t go back until we have reduced the debt sufficiently so we can free up cash for business investment and consumer consumption. Excessive debt is the problem and DELEVERAGING (debt reduction) is the critical dynamic of the New Normal.<\/p>\n Household\/credit card debt, home mortgages underwater, housing prices decline while other houses are foreclosed (25% of all sales 2010), commercial real estate enjoys excess supply, commercial mortgages still need to be refinanced and corporate balance sheets need to be repaired before we can even think of leaving the New Normal.<\/p>\n No one is predicting when all this will clear up, but moderate estimates assume the better part of a decade and El-Erian himself has hinted it could last a generation.<\/p>\n According to El-Erian (and others as well) the US and the developed world will \u201crevert to the mean\u201d by which he means that the artificially stimulated \u201csugar high\u201d growth of the last decade (6-7% nominal GNP) cannot be sustained. Instead we will, after recovery from the Great Recession (which by the way has been over nearly a year), grow GNP in a restrained 2-3% annual rate, insufficient to quickly re-employ the nearly 10% unemployed and additional roughly 10% who are part time employed or who have left the labor force entirely. We will have restrained growth because the costs of excessive debt rob the consumer and the corporation\u2019s discretionary income for consumption or investment. Since consumer demand will be muted, the need to grow the production capacity of firms (equipment and hiring) is also muted. Wage increases, in an era of widespread unemployment and under employment, will also be muted. We will grow mostly through organic (i.e. natural growth in population) growth incrementally propelled by weaker immigration, impaired social and geographic mobility, and reduced birth rates.<\/p>\n Besides deleveraging (and real estate oversupply) there is a second reason why we cannot pass quickly through the New Normal and return to the old ways. Re-Regulation! All these bailouts and stimulus deficits, not to ignore the simply wonderful time we had coping with the Great Depression, created the rather illogical belief that we don\u2019t want to go through this again. This preference for avoiding future pain was entrusted to governments and their response was\/is to regulate the institutions and practices which were responsible. As of this writing, the shadow finance market (derivatives)) has been enlightened by reforms which have fundamentally reshaped the derivatives market, the investment banking system, and the secondary markets. Indeed, this regulation has been global in scope, with Basel III setting a new framework for a semi-regulated international finance system. There will be no more sugar highs in the intermediate term.<\/p>\n We have indeed turned the page. We cannot go back to the 2007 financially induced liquidity. The major banks themselves, despite their predilection for bonuses, are still quite fragile, with shattered business models, and still holding considerable amounts of toxic assets in their portfolios. Despite all the \u201cofficial\u201d encouragement from populists and elected officials, they cannot easily lend at volumes seen pre-2007. The revamped, more regulated financial system is still healing.<\/p>\n Because growth is muted and regulation increasing, we will not create an \u201cescape velocity\u201d, i.e. growth that is sufficiently high for a \u201csustained economic expansion to set in\u201d.<\/p>\n We need time to heal and that is precisely what defines the New Normal.<\/p>\n Now it gets complicated!<\/p>\n The patient in the New Normal hospital (consumer and corporations) has been told to rest in bed, take their medicine and diet. Fat chance the patients will do what they have been told.<\/p>\n After ten or twenty years of hearty partying, it is not likely we will willingly lay back, diet, and heal. For the New Normal to work, however, the patient has to cooperate. But no one without a job (and one out of ten is) is willing to live on unemployment benefits forever, even if they could. Many patients will demand immediate solutions, magic pills, dramatic action and even revenge. El-Erian suggests that in the present initial phase of the New Normal \u201cWe are leaving the \u2018old\u2019 world but we are not quite in the \u2018new\u2019 one\u2026 we are at the point of maximum confusion\u2026 human nature is to resort to an \u2018active state of inertia\u2019\u201d\u2014El-Erian\u2019s words for we want to go back to the good old days and party and will insist on immediate solutions and a quick recovery period. And who can provide this speedy recovery? Why the National Government and the Federal Reserve of course!<\/p>\n There is one, very obvious problem, built into the above scenario \u2013 how did they pay for it?<\/p>\nIf You Thought It Was Simple This Far\u2026<\/h2>\n
![\"\"](\"https:\/\/journal.c2er.org\/wp-content\/uploads\/2011\/02\/Kenneth_Rogoff.jpg\" "\\"Kenneth_Rogoff\\"")
<\/a>Reinhart and Rogoff\u2019s work is less than a book and more like 400 pages of graphs and charts. They analyze the effects statistically of the last 800 years of financial crises and offer some startling findings. These findings after considerable peer review remain substantially unaltered and hence are taken quite seriously, despite one\u2019s ideological tendencies. Their central focus is why and what happens in a collapse of the finance system. Their 800 year database reveals (in support of El-Erian) the paramount cause of financial crisis is debt accumulation or currency \/ trade imbalances. In virtually every instance, several years after the debt-induced collapse of the private finance system a second wave deterioration, and sometimes collapse, of the public finance system occurs.