Theory Versus Reality: My Economic Predictions

Economic predictions are notorious for being wrong. The next ten years are predicted to be anything from glorious to catastrophic; economists have all their bases covered. In the midst of economic confusion and chaos, we only have one tool available for explaining the world around us: theory. Different schools of thought offer mutually-exclusive theories about how the world works.

The school of economic thought I identify with – the “Austrian” school – has been criticized especially hard for predicting economic crises that haven’t happened. Supposedly, the lack of price inflation and severe recession since 2008 are proof that Austrian theories are inaccurate.

I am not sympathetic to these criticisms, for many reasons. First, the relationship between theory and reality is misunderstood. I will elaborate more in the future, but suffice to say that economic theory is not – and cannot – be disproven with data. It sounds blasphemous, but it’s true. A theoretical proposition like “The minimum wage causes unemployment” is not contradicted by country X having a high minimum wage and low unemployment. The reason is simple: it’s impossible to control for all variables in the real world. Countless different factors determine the unemployment rate in a country; we’re forced to say something counter-factual like, “The unemployment rate in country X is higher than it would have been without a minimum wage.” But this is a topic for another post.

The second reason I am not abandoning Austrian economic theories is because I actually understand them. In fact, I am willing to stake my reputation on this. Hold me to it: if the economic predictions I am about to make do not come true, then it’s reflective of my own lack of understanding. I will admit I’m wrong and be forced to revise my worldview. But, if my predictions turn out right, I hope the same revisions will be made by those who don’t currently agree with me – e.g. 90% of the talking heads on financial news networks and a significant portion of professional economists.

So, I will present my own predictions for the US economy, and instead of fully explaining why they will happen, I’ll focus on why they haven’t happened yet. The overarching prediction is simple: the US economy is heading towards a massive economic crash. This crash will coincide with the global financial system being restructured away from the US dollar, which will lose a large percentage of its value due to inflation.

These events will occur for three main reasons: the Federal Reserve artificially keeping interest rates at 0% for 6+ years, the US government’s astronomical public debt of 17+ trillion dollars, and obtuse banking and financial regulations which have created artificially huge banks and moral hazards in financial markets.

During the early 00’s, we saw something similar. The Federal Reserve held interest rates at historic lows for a historically long time. Federal regulations and interventions (the FDIC, Fannie Mae and Freddie Mac, etc.) created enormous distortions in financial markets, which manifested themselves in the housing boom, and as we saw, the entire financial system was deeply tied into the housing market. Once the bubble started to burst, the whole financial system imploded. This was the market’s attempt at correction. Had “the bust” been allow to happen fully – had the correction been free to serve its purpose – then we likely wouldn’t be facing the next, larger financial collapse. Instead, the Federal government intervened, and the Federal Reserve ballooned its balance sheet and cut interest rates even further to the unprecedented level of 0%. In other words, the problems which brought us the ‘08 collapse were compounded many-fold. And to the extent the intervention was worse, the subsequent market correction will be worse.

So, when will the big collapse happen? When you understand economics, the answer becomes crystal clear: we have no idea. Trying to predict specifically when some economic event will happen is simply guesswork. There’s no way to know beforehand, as that would require knowing all the plans, values, and choices of hundreds of millions of people at once. Anybody could have predicted in the 1920’s that the Soviet Union was bound to collapse at some point for economic reasons. And they would have been right. But, they would have had to wait seventy years to see it happen. I think this is why so many people fail to grasp sound economic theory – the cycles take decades to play out.

The same criticism of the Soviet Union’s centrally-planned economy can be directed at the United States economy. It only takes an understanding of basic economics – just the fundamentals – to see the the inevitable correction we’re headed towards.

But why hasn’t the correction happened already, and why hasn’t inflation been more severe? I have a few hunches. Most importantly, World War II. The US economy/dollar has an enormous capacity for manipulation because of how WWII ended. In 1944, the Bretton Woods system was established, making the US dollar the world-reserve currency – an unprecedented status in monetary history. Because the dollar was redeemable in gold, this meant countries across the globe could use it as a stable currency; many explicitly “pegged” the value of their own domestic currency to the dollar. Various important commodities were (and still are) internationally priced in USD. So, for more than half a century, the dollar has been in high demand across the globe.

This high demand has allowed the Federal Reserve to create trillions of new dollars without immediately feeling the effects. In effect, the dollar’s status as the world reserve currency allows the United States to export inflation, especially since we went off the gold standard in the 1970’s. Between the government debt held by foreign countries, the USD traded globally by private businessmen, and huge bank reserves currently sitting in vaults, trillions upon trillions of dollars are kept from circulating through the United States economy.

But those dollars haven’t disappeared. Just because they aren’t circulating now doesn’t mean they won’t in the future. If holders of US dollars start losing confidence in their value – if they suspect too many new bills have been created – then they’ll want to get rid of them. This starts an inflationary spiral. As more people exchange their dollars for tangible goods, prices start rising, which causes even more people to lose confidence; this makes prices skyrocket and makes the general standard of living plunge. This is the textbook story of inflation, and it has happened countless times throughout history.

The groundwork for this event has already been laid – the dollars have already been created – but we can’t know when it will happen nor how severe it will be. It could be hyperinflation; it could be stagflation like the 1970’s. It might be preceded by deflation; it might start with a stock market crash. Impossible to know with certainty. (Though, if I had to guess, it seems plausible that a deflationary crunch will precede an inflationary spiral). Only one event is needed to start the dominoes falling: a change in people’s confidence. At some point, people will realize the USD has terrible fundamentals, and then the inflation becomes inevitable. But until that point, the charade will continue.

Of course, when we understand the essential role of “people’s confidence” in economic phenomena, it becomes clear that we can’t predict with any specificity when events will occur. We can’t see inside the minds of millions of people or predict their decisions even five minutes from now, much less five years.

In the same way that the USD dollar has been perceived as a safe currency, the US government has been perceived as a safe government. United States bonds – loaning the Federal government money – has been synonymous with a “safe investment” for the last three generations. This is true worldwide, and as a result, the national debt is currently over $17 trillion dollars. Now, I don’t know what the upper-limit of national debt is, but I do know that at some point, people’s confidence in the United States to pay back its debt will be eroded. Maybe it’s $20 trillion, maybe $50 trillion. Maybe $100 trillion. I don’t know. But I do foresee a big problem at current debt levels: paying the interest on our loans.

Right now, with interest rates at historic lows, it doesn’t cost the government too much to make payments on its debt. But when interest rates start rising 5% or 10%, that won’t be the case. A good example of this is Greece; they have found their upper-limit of public debt, and it’s causing a massive crisis of confidence. For decades, Greece has been borrowing money to pay for public programs; it hasn’t caused any crisis. But anyone who understands economics can rightly predict: at some point, creditors will stop financing a country which can’t get their national debt under control. It might take 30 years, but it will happen. And now, Greece is facing a mountain of problems; they might even be forced from the European Union’s monetary system.

This brings me to my final point. One major reason the dollar crisis hasn’t started is because other currencies look even worse – the Euro in particular. Again, for basic economic reasons, the Euro is doomed to eventually fail. Centrally-planned currencies will collapse for the same reason centrally-planned economies will collapse. It’s just basic economics. But given the historic reserve-currency status of the USD, and given the strength of the United States military, the dollar looks pretty strong in comparison to the rest of the field.

In fact, depending on European events, we could even see a significant strengthening in the dollar before it collapses. If Greece, for example, were forced to leave the Euro, what would happen to Portugal and Spain, who also share astronomical levels of government debt? What about Ireland and Italy? We might see the dominoes start falling in Europe before they do in the United States, and if that’s the case, the USD will undoubtedly strengthen as it becomes more in demand. This could kick the can that much further down the road.

For this reason, anybody who really understands economics is forced to make watered-down and open-ended predictions. We just can’t know what exactly will happen in the future. Perhaps some incredible new technology will be created which raises everybody’s standard of living tenfold. If that’s true, we won’t feel the pain from a dollar crisis. Perhaps all the trillions of dollars sitting in bank vaults will be burned – in which case we won’t have to worry about them circulating through the economy. It’s unlikely, but I’m not going to claim it’s impossible. I can’t foresee the clever ways the government and central bank might delay the inevitable; they are incredibly good at it.

Though these predictions might sound doom-and-gloom, they are really not. They’re quite simple conclusions from uncontroversial premises: governments can not borrow limitless amounts of money; central banks can not print limitless amounts of money, and to the extent that the money supply over-expands, prices will rise. If these premises are true, and the United States does not radically change course, then we are indeed headed towards severe recession.

I realize that putting absolutely no time-frame on these predictions is boring. So, for the sake of good fun and speculation, I’ll disregard my own advice. If I had to guess, I would be very surprised if the US dollar lasted another fifteen years without a serious crisis. And I wouldn’t be surprised at all if it happened within three. Of course, this kind of speculation should not be mistaken for sound theory.

My position is not unique; many prominent economists also foresee a crisis coming. These same economists also predicted the previous ‘08 financial crisis. I only hope that people realize this is not coincidence. The reason a small group of people have been able to make these predictions is because of their theoretical understanding of the world. It’s easy to spot the problems after-the-fact; hindsight is 20/20. But to be able to see through economic chaos and predict beforehand that a crisis is coming – that reflects the remarkable accuracy of a theory, and everybody should be willing to adjust their worldviews accordingly.