Major change is inevitable

As the United States economy remains hooked up to life support, it is natural for those gathered around the bedside to see hope in each flicker of life. We humans are optimistic by nature, which is certainly an evolutionary trait that has served us well in darker ages. Even so, unfounded optimism can prove disastrous, especially when it keeps us from doing the difficult things that need to be done.

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This past weekend, my hometown paper ran an article detailing how the economic signs are starting to point up. This is a theme I see reflected recently in the Old Economy circles, that if we just build enough capacity and subsidize enough undertakings, we can revive 2005 back into existence. The beyond-wishful thinking in the piece was highlighted by this passage:

[Brainerd City Administrator Dan] Vogt said Brainerd is well positioned for an economic turnaround with available industrial land and electrical system upgrades for attractive and lower cost energy. Brainerd now has more load capacity for business and industry, Vogt said. 

This is akin to the owner of a dying mall -- one that is old, falling apart and financed with enormous government subsidies that are about to expire -- looking at the growing number of empty spaces and saying they are "well-positioned". Some see the glass as half empty. Some as half full. And some are evidently drinking stuff a lot stronger than water.

Wishful thinking is not a crime, and we can forgive those whose job it is to be optimistic. But what is exceedingly frustrating is how the entire establishment seems to be lacking even a basic understanding of how the world is changing and what the likely implications are for the United States. As Andres Duany indicated in a video we have quoted here a number of times, we are likely to never go back to where we were, a result of enormous constraints and opportunities. 

Those opportunities are numerous, but they are a product of the constraints. The quicker we understand and acknowledge those constraints, the sooner we can mobilize the tremendous opportunities for addressing them. One only need read the news last week to get a sense of what some of those constraints may be:

Peak Oil

I am a member of the drill-baby-drill party, but am not your standard Republican when it comes to my understanding of energy. We have built an entire economy on the premise of continuous, cheap energy. We are not at all resilient in the face of rising oil and gas prices. Understand that "peak oil" does not mean running out of oil -- we won't run out of oil for a long, long time -- but simply the notion that we can't increase production to match demand. The United States, even with deposits in North Dakota and elsewhere, hit peak oil in the 1970's. Geologic estimates put global peak oil somewhere between a few years ago and in the next couple of decades. Since all of our economic growth is tied to cheap energy, anything that keeps the supply of oil from increasing as fast as the demand increases inevitably means higher prices (see Law of Supply and Demand) and dampened economic growth.

In the last week, documents released by Wikileaks show that American officials believe that the Saudi Arabian government is overstating its reserves by 40%. Saudi Arabia has the only oil fields in the world believed to not currently be running at maximum output. Yes, technology will continue to increase our ability to tap into new sources of oil, but not cheaply. Gas prices sustained at $4.00 per gallon and above dramatically undermines our entire economy.

Interest Rates

We are in the midst of an unprecedented period of very low interest rates. Following the bursting of the tech bubble at the end of the 1990's, the Federal Reserve lowered rates, did so again after the September 11 attacks and, with a slight uptick in between, again with the financial crisis. The Federal Reserve, through their quantitative easing program, is printing money to buy U.S. treasuries to keep rates artificially low.

Despite this, rates are rising. It was reported this week that the 30-year mortgage rate has ticked up, threatening to further undermine the housing market. And also this past week, the U.S. Treasury Department warned the administration that higher interest rates are going to increase our nation's borrowing costs substantially. Long-term, the cost of servicing our debt is going to change every facet of our economy.

“It’s a slow train wreck coming and we all know it’s going to happen,” said Bret Barker, an interest-rate analyst at Los Angeles-based TCW Group Inc., which manages about $115 billion in assets. “It’s just a question of whether we want to deal with it. There are huge structural changes that have to go on with this economy.”

Reserve Currency Status

An odd thing happened during the recent turmoil in Egypt. When such international crisis happen, scared investors flock to safe havens, which for decades has meant the U.S. dollar. Not this time.

The United States dollar is currently the world's reserve currency. This means that banks around the world must hold dollars, and dollar-denominated debt (U.S. Treasuries), as part of their capital reserves. In an article on China, The Economist recently reported that 60% of the world's currency reserves are in dollars. Stop and consider for a moment how uniquely cheap its makes capital here in the United States, for everything from home mortgages to the national debt, when the rest of the world must transact in our debt.

The International Monetary Fund is responding to global calls for a new reserve currency by working to promote the Special Drawing Right (SDR), a composite currency comprised of a basket of different currencies. This is not an anti-American move as much as it is a defensive measure for countries concerned with our level of debt and the unsustainable nature of our economy, which the current reserve-currency policy subsidizes. 

Commodity Prices

Higher commodity prices are a function of higher interest rates, loss of reserve currency status and increased demand across the world, all of which are inevitable. Commodities like corn, sugar, beans and wheat are extraordinarily cheap here in the United States, giving families the ability to devote more of their income to housing and transportation. While there is little doubt that we will be able to continue to feed ourselves (not so with other parts of the world), it is not likely to be nearly as cheap. When combined with higher energy costs, every other part of the economy will be severely squeezed.

Our commodity reserves today are at record lows, a fact that can be attributed to a bad year, but also a product of many successive years of growing worldwide demand. There is a good case to be made that tightening commodities markets were the spark that lit the Egyptian and Tunisian flames of unrest. If so, we are likely to see more turmoil abroad in the coming years.

Will we be able to retool? Sure, but not quickly and not easily. The fact that 2/3rds of the food we eat here in my home state of Minnesota is imported reaffirms how dependent we are on a cheap-energy economy to grow, transport, process and deliver our food supply.

Fannie and Freddie

Much of the hope that local officials pin on a recovery rests in the real estate market. There is a sense among glass-half-full types that the worst just has to be over. Unfortunately, this is a belief of the heart and not of the mind, as all indications point down for residential and commercial real estate.

We've done entire podcasts and blog posts on this topic, so I'm not going to rehash it again, except to point out some news from the past week regarding the federally-supported mortgage giants of Fannie Mae and Freddie Mac. This week the Obama Administration released a report indicating that their activities should be wound down, essentially that they should be closed. They will find no argument from Republicans. 

Over half of the homes that Fannie and Freddie now hold the loan on are in foreclosure, delinquent and/or underwater. This is a national nightmare, but what it means for our optimists is that, in the very near future, purchasers of real estate will need to have such bizarre intangibles as a down payment, a good credit history, a stable source of income....you know, the ability to pay back their loan. The number of Americans that can save up a down payment drops every day, further depressing demand. There is only one way for prices to go with dropping demand, and they seemingly have a long ways yet to fall.

Conclusion 

If there is opportunity amidst all of these challenges -- and we believe there is -- it will be found not in clinging to the Old Economy but in transformation to a new reality. We can deal with these changes, but we have to start the process of retooling now. A Strong Towns approach can guide us to a more stable, resilient and productive model. The longer we delay, the longer we kid ourselves about a recovery, the more we are going to be forced to make changes in the face of ever-stronger headwinds.

Our future is not going to resemble our recent past. We need a new model, a model that builds places to last, even through great adversity. That's Strong Towns.

Follow up: Thanks to Nathaniel for prompting me to post this photo that accompanied the article in my hometown paper I referred to at the beginning of this piece. Our delusion is only magnified when we understand that what we are trying to bring back is more of this.

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