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The Coming US Economic Decline Is Easy To Understand In Historical Terms

|About: JPMorgan Chase & Co. (JPM)

When you look at the US since the end of World War II, it is easy to understand the argument of why we will now go through major economic decline. But this is not what you read in the newspapers. I think most who read this article will find the logic very convincing. The article concludes with some projections of the world we will face in the coming years.

When World War II ended, the United States was the only major world economy that was left intact by the war. Not one bomb fell in the mainland US. The manufacturing capacity of virtually every other major power was seriously damaged if not destroyed. This reality provided the US for several decades of easy growth that permitted a high school graduate to work in a car factory and be a member of the middle class in economic terms.

By the 1990´s, the world recovered much of their manufacturing capacity and had state-of-the-art plants with much lower cost salaries for their employees in the factory than the US. Recently, salaries in the US could be 6 times higher than Asian salaries for the same manufacturing position. (However, the gap is now narrowing some due to high inflation in Asia.) Manufacturing in the US has declined from a peak in June 1977 of 22% of non farm payrolls to 9% in March 2012. This is a 60% decline. Given manufacturing is a key driver for much of the economy, the 60% decline in manufacturing has a much broader impact on the total economy.

The ensuing economic decline was caused by this increasing lack of competitiveness. This simply is the way competition works. It is not we had bad government, unfair competitors or other excuses. When you have a 60% decline in the single most important driver for employment, you are going to have problems with your debt and national income levels. The US did not have competition in the 1950's through 1970´s. Today the US has competition everywhere.

As we became less competitive, we used more stimulus to try to deal with the lack of our fundamental competitiveness and resulting economic activity. I believe Alan Greenspan will go down in history as an unintentional bad guy, as it was he who first started extensive and more or less non-stop use of stimulus. Greenspan started the economic bubble that now haunts us. History will consider the stimulus from 2000 through 2007 coupled with the creation of financial instruments such as Collateralized Debt Obligations and the reunification of commercial and investment banking through the Citibank deal as a period of profound errors by the Fed and US government policy.

Stimulus is an effective short-term policy to deal with temporary economic imbalances, particularly at the beginning and middle of an economic cycle. Used continually, it simply creates a monetary bubble which history shows will always explode at a certain point of high indebtedness.

The reunification of investment and commercial banking introduced enormous risks into the financial system. The recent JP Morgan (NYSE:JPM) financial statements show clearly how earnings have shifted away from low risk commercial banking to high-risk investment banking, particularly where it becomes nearly a casino investing in derivatives. Most profits in recent years came from the JPMorgan Treasury Office investments that we now know to have high-risk elements as opposed to commercial banking that is much less risky in this financial structure. The inevitable loss this year from the JPMorgan Treasury wiped out the gains from commercial banking.

In short, much of what we read in the newspapers simply does not deal with the major consideration: the inevitable loss of competitiveness by the US vs. other nations recovering from world War II during the last 60 years. When we became less competitive and the economy was growing inadequately, we resorted to stimulus and other policies that artificially promoted economic growth which created a large unsustainable financial bubble.

We did have one good chance to avoid this financial bubble. At the conclusion of President Clinton's term, the US budget was in balance. A continuation of that policy would have avoided the current financial bubble. But the US decision to involve itself in two wars and cut income taxes created an imbalance that we have not been able to escape

The US debt to GDP now exceeds the 90% level where debt levels historically become uncontrollable and end in collapse. This is best explained in Rogoff's and Reinhardt´s book, This Time is Different. The current annual deficit is $1 trillion dollars per year and growing, increasing every year the debt ratio to GDP.

The US economy will have to reset. This means major losses when the current financial bubble collapses either by inadvertent "popping the bubble" or being deflated purposely. The financial bubble "pops" when lenders lose faith in the US government to pay its debt and interest rates soar leading to economic problems. Alternatively, the bubble is deflated by the US purposely deciding to raise taxes, cut the deficit and deal with the problem. Either way, there will be a dramatic reset of the economy: losses on real estate loans, derivatives, and interbank loans such as those to Europe. The financial losses inevitably lead to losses in jobs, business values, stock market prices (SPX) and increased interest rates for those businesses that survive the downturn. Deflation, NOT inflation, is the problem we will have to deal with. Deflation is caused by multi trillion dollar write-offs in the financial system of loans that cannot be repaid. These write-offs in financial loans decrease the total money supply and cause the deflation. One number illustrates this. A ½ of 1 % loss of the $600 trillion Credit Default Swaps will cause the loss of an amount equal to 100% of the capital of the banks worldwide. A significant part of the worldwide banking system will fail in the downturn. The human cost will be extraordinary and it is not clear to what extent the US social network for the most needy will provide support.

In a few years, the "reset" will be complete and economic growth will start again but with a new balance of the US vs. the rest of the world. Manufacturing will continue to be a low percentage of total employment. Natural US strengths will grow in banking, high technology, manufacturing automation to regain manufacturing competitiveness. Probably farming and natural gas will play important roles in the "reset" US. For the middle class and wealthy, the US will continue to be one of the most desirable places to be. For people with low skills and education levels, the US will be a hard place to live with employment providing low salaries compared to the cost of living. Investors will find it is best to be out of the markets or short during the coming downturn, but then return to the markets in a few years when growth starts again. Investors will have the buying opportunity of the century when growth starts again.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.