Thursday, July 31, 2008

Can the Economics of the Past be used to Predict the Economic Future?

I have had several comments on my posts and, time allowing, I will try to respond to them. One interesting question was:
'I suppose we are used to economic cycles, with booms and busts of varying degrees. Are you saying that this time it's going to be very different? Has anything similar happened in history before?'
I would hope that it is apparent from my many posts that this time it will be 'different', at least in the sense that it will be different from the economic cycles that we have been used to. The point of my posts is to say that something has changed profoundly, in particular there has been an economic shock in terms of too much labour in relation to the available commodities. In particular the amount of labour has increased without the commensurate increase in commodities necessary to make all of the labour productive. In this case, until commodities catch up, there will be a redistribution of wealth. Whilst capacity constraints in commodities are nothing new, the unique factor here is the massive input of available labour. Globalisation has allowed capital to move freely, and this has allowed a large amount of new labour to become potentially productive. This has created an oversupply shock.

It is worth noting at this point that I have predicted that oil prices will fall back. How can I square this with what I have said with regards to commodities and labour? The answer is that, until the point is reached where the economies are sufficiently rebalanced, there will be turmoil in the world economy. One of the elements that has unbalanced the world economy has been the supply of finance into Western consumption. This had led to a poor allocation of capital into the West, and the world economy will fall back until the damage done by the credit bubble is corrected. In the interim, commodities will fall back as the West contracts, but demand will again pick up as the East continues growth in a couple of years time. However, as the East grows again, the West will stagnate, for the reasons set out in 'The Root of the Problem'. As the East continues expanding it is likely that the world supply of commodities will continue to bump up against the metaphoric brick wall of supply constraints, with supply continuing to lag growth. All of this assumes that there will be stability in the world trading system, which is not guaranteed. There is a real possibility of a retreat into protectionism in the next few years.

There is a further question asked in the comment as follows:
'In our current situation are these experts' views valid in any way, shape or form?'
This question relates to the use by experts of previous bear markets to predict the current market. My answer is that my opinion is just one of many. If you are looking for investment advice, the majority view would be that you should listen to these experts. On the other hand, you may wish to take my views into consideration. I do not think that the state of the world economy is comparable with the past, and therefore the 'expert' predictions are built on foundations of sand. All prediction is based upon past experience, but I believe that past experience is only a guide to current situations, and needs to be tempered in light of the fundamental differences of the current situation. To date I have not seen any acknowledgement of the shock of the oversupply of labour, so I am very dubious about most predictions. The oversupply of labour into the world market is (in my mind) what has really changed, and changes the entire dynamic of the world economy. Until the experts grasp this, they are missing a vital element in appraising the economic situation.

I have also had a question from another person who has posted anonymously. The question was regarding the prospects of Thailand, China and Brazil. I have discussed China elsewhere and have admitted that there are many question marks over the future. In particular, if China suffers a drop in exports (very likely) then will it be able to maintain social stability? Has it reached the point at which it can grow without export led growth? There are also possibly imbalances in the Chinese economy to factor in, but otherwise there is no reason why China will not continue to grow, and grow fast (with maybe a blip in growth in the next couple of years). As for Brazil, I will have to confess insufficient knowledge to have a strong opinion on the future. For Thailand, there is no reason for it not to continue to grow but, in Thailand, the real constraint is political risk. It is basically a very unstable country, and therefore the consideration is primarily political risk.

This brings me to the subject of political risk which I have alluded to throughout this post. Globalisation has had an astounding effect on the world. One of those effects is that a huge number of people have been raised out of poverty. Few would argue that this is not a good thing. The problem that has arisen as a result of this, however, is that there are now imbalances in the world economy. We are now in a situation where politicians, in particular in the West, will need to address these imbalances. As the West is pressured by the competition of the emerging economies, there is a real likelihood of demands for protectionism. If this happens, the turmoil will increase further. The problem that really arises is that we are entering into a period of world instability. As much as we would like to think otherwise, economics is the great driver of events.

If a situation of economic turmoil arises (as I have predicted), then political turmoil will surely follow. I have already mentioned this in relation to China. However, this political turmoil is likely to become more pronounced over the next couple of years, and everywhere will be effected. The question in my mind is to ask how politicians around the world will deal with the problems that are arising. It is here that the problems start, as this largely depends on the nature of leadership, and how the leaders will deal with crises. It is very difficult to say how they will react, but I am rather gloomy about the situation.

The basic point that I am making is that the problems of the world economy are now set in place. There is no reversing them and, one way or another, they will now permanently change the structure of the world economy. However, there is no way of telling what the final change will be, as this is now in the hands of individuals. We can sketch out general scenarios, but can not make predictions.

One scenario is that the trading system remains open, and that the rich world responds to the entry of the emerging economies by reforming and meeting the challenge. Another scenario is that the rich world retreats into protectionism, and that the world economy sinks back. Yet another scenario is that the turmoil will create social unrest, and the response will be conflict. All of this depends on how individuals respond to the challenges that are arising. There are more scenarios that can be proposed but I hope these illustrate the potential for varied outcomes.

In such a situation, I would be very cautious about predicting whether China, Brazil or Thailand are good bets. The only certainty is that counties such as China now have a large part to play in the world economy, but whether that is a stable rise or a chaotic rise is a matter that can not be predicted.

You may gather from this post, that I find the current situation very worrying. This would be to understate my concern. Returning to the first questions (using the past to predict the future), we do have worrying precedents to the current situation of economic instability. The situation today is unique, but the idea that economic instability creates political instability can be carried forward as a general principle.

The shape of the world has changed, and is continuing to change. At present the majority of economists and politicians have not fully grasped the nature of the change and that is a dangerous situation. As the current economic crisis unfolds, I will do my best to give a view on how it will impact on the world economy, and what I believe should be done to ameliorate the crisis. However, the situation is going to get ever more complex in the coming years.

1 comment:

  1. Hi Mark

    I was being slightly disingenuous when I asked my question about whether "this time it's different", as I know that you have said it is the case many times before.

    However, I still keep hearing 'experts' being quite complacent about the situation. On The World This Weekend at lunchtime Vicky Redwood, economist at Capital Economics, said that the reluctance of banks to lend to each other meant we might have a "technical recession" but hopefully not as bad as the early 1990s. (I asked around, and in my circle, nobody could remember the recession in the early 90s!). Another expert seemed to be suggesting that the problem is a "contagion" spreading through the economy, which makes it sound less than a fundamental problem.

    As I understand it, both of these analyses are very shallow (only looking at the symptoms, not the causes), and these experts tacitly admitted that they are having difficulty making accurate forecasts. It made me wonder whether it ever occurs to them to step back and look at the 'bigger picture'. I suspect not.


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