In the current presidential campaign, which hasn't even worked itself up to a real frenzy yet, the economy might prove to be the most important issue. There are ominous signs that it may well push everything else offstage in the coming months.
When the Titanic was designed, it was endowed with a feature that was to have made it unsinkable; a series of watertight compartments that ran the length of the ship. If a collision took place, the compartment where the damage occurred would flood, but the flooding would be confined to that one compartment. Even in the extraordinary case of a collision so severe that two compartments would flood, the Titanic still would not sink. It had all been calculated in advance. This was the source of the hubris that sailed with the ship when it embarked from Southampton in 1912. But the Titanic was riveted together, not welded, so when it struck an iceberg on the night of April 14, the force of the impact not only produced a huge gash in one compartment but also popped rivets in the skin over the next two, flooding them as well. Three flooded compartments were too many. The ship that the White Star Line declared "God Himself could not sink" sank anyway, taking 1,500 lives with it.
In the middle of 2007, the US economy hit its own iceberg, in what has come to be called "the subprime mess"; profligate moneylending which led to mountains of bad loans that evolved into even more profligate bundling and "securitizing," so that when these flimsy structures began to shake apart the financial effects were felt far and wide. By most accounts we just barely managed to squeak through. The Fed ran to the dike not only with billions in guarantees and liquidity, but along the way slashed interest rates faster than at any other time in history. Is the sub-prime mess over? Hard to say. The answer you get depends on who you ask, but the assault being waged this week against Fannie Mae and Freddie Mac might prove instructive.
There are other looming threats to the economy.
For instance the recent surge in the price of oil, which has doubled in the past year. Same is true, to a lesser extent, of the price of food, although neither price spike has had much impact on the CPI, which over the years has become almost perfectly insulated from reality by the addition of formulas and adjustments that minimize or take out altogether the very effects it should be measuring. Sooner or later a vicious wage-price spiral will result, which will hit wage earners hardest since the CPI, now as much fairy tale as fact, will be brandished to "prove" that prices really aren't as bad as they think.
Then there is the falling dollar, which has gone from $.75 to $.63 against the euro over the past year, a not insignificant slide. While this has an up side (i.e. American goods become cheaper overseas, although not in China, which does not allow its currency to float) it also means additional inflationary pressure at home.
The Fed is in danger of getting caught in a fatal squeeze. It now needs to both keep rates low (because of liquidity issues) and to begin tightening them (to stave off inflation). If in fact the subprime crisis isn't over, i.e. more crippling losses remain to be unearthed, house prices continue to sink, foreclosures mount etc., and inflation eventually gets rampant enough to impress itself even on the CPI, the Fed may find itself in a position where it can't do much of anything. Too many watertight compartments will have holes in them.
If this is where things are headed, it is too late to do anything about it now. What has been set in motion is too massive to be stopped, however after disaster has struck and the smoke finally clears some useful lessons will have been learned. Curiously, these will probably be similar to the ones taught us in the 1930s, although the measures they prompted were later discarded, in the 1980s and '90s, as too restrictive. By then, people had again begun to think the economy was unsinkable.