It is very easy in the current circumstances to focus on the crisis that is engulfing the financial system or the unfolding drama of the US bailout. However, this is not the real story, just an expression of the symptoms of the real story.
As I have mentioned before, the idea of a 'credit crunch' has taken root, and sometimes it appears to be a force with a malevolent intent. In other words it has become an animistic entity on which we can easily lump blame, and pretend that there is not real causation behind the crisis. The reality is that there is a real force out there, which is market sentiment. This is not, however, something with a life of its own, but rather the thoughts and feelings of real people with real concerns. Collectively they constitute market sentiment, but we should not forget that market sentiment comes from somewhere.
Bearing this in mind, we have to ask what is really scaring each of those individuals that constitute the market. Is it just an irrational fear, or is there some justification for the fear?
It is here that we must realise that these are panicked but mostly rational people. The panic stems from the realisation that they have been buying fools gold for many years. Yes, it looked like the real thing, but they have now had the material analysed, and the reality has dawned upon them. The big question is whether the financial crisis is driving events, or whether events are driving the financial crisis.
The truth is that there is an element of both. One is feeding off the other in an inevitable downward spiral. When I predicted this crisis in 'A Funny View of Wealth', I pointed to the idea that one negative factor would reinforce another, in what might be poetically called a 'death spiral'. This was not a prediction based upon an abstract entity called the 'credit crunch', but was based upon the fundamental problems in the economy of the UK. Many aspects of the essay equally apply to the US (and other OECD economies to a lesser extent). One of the central points of the essay was that the growth in GDP (at least) over the last ten years was an illusion. It was growth built upon asset prices inflation and a boom in credit. This is now widely accepted as the reality of the situation, but the 'commentariat' have still not grasped the reality of what this means. They are so busy charting the day to day crisis development that they are losing sight of the idea that something substantive must underlie the crisis.
In light of this I thought I would try to pull some of the strands of my thinking together and try to put the jigsaw together. In some respects I will be repeating ideas in my previous posts, but the aim is to try to integrate the ideas into a large picture. For those that have followed the blog from when it started (people to whom I am grateful, as their reading and comments encouraged me to continue), none of this will be new.
The first element to consider is that of the entry of the emerging markets into the world economy. I have dealt with this in the posts 'Why Do Economists Get it so Wrong?' and 'The Root of the Problem'. The argument, at its most basic, is that there has been a massive input of new labour into the world. The labour was always there, but the key difference is that the emergence of these economies has seen capital and technology, and access to markets, become available to this previously underutilised workforce. The result of this change has seen the available labour force available in the world roughly double in the last 10-20 years. This is nothing short of a revolution in the world economy, but few economists have understood what it really means. This is best expressed in simple terms of an example (using made up figures but referencing the real events) to make the point clear.
If we imagine that (to pick an arbitrary date) in 1990 there were 100 units of labour and 100 units of commodity utilised by that labour, and an available 120 units of commodity capacity (not all utilised), we can see a benign situation. It is a situation in which the commodity supply exceeds demands. We can see this, for example, in the long period in which oil prices were so low for so long. Now, if we jump to 2008, we see the oil prices spiking. This is because, whilst the supply of commodities such as oil has been increasing, they have not been increasing at the same rate as the available supply of labour. Let's call the supply of units of commodity in 2008 a total of 140, to pluck a number out of the air. At the same time we now have 200 units of available labour. At this point, it is apparent that there is a mismatch. The question arises as to why it is that the problem did not hit at the point where labour first exceeded the supply of commodity. This is because the labour entering the market was not as efficient at utilising the resource as the original labour. It is the catching up, the increase in both the efficiency of the new labour, and the increase in the use of the output of their own labour that has tipped the world into the current situation.
This is one element that explains the current situation, but it still does not seem to match the reality on the ground. For the last ten years, countries such as the US and UK have been booming, have been apparently successful. Logic says that, if we input a massive amount of new resource (in this case labour) such that supply is always exceeding demand, the price of labour should have fallen. This has not happened, and it seems that the Western world became ever richer, with rising salaries, ever expanding wealth. How can this be so? One of the key elements in this is that these new workers were relatively very cost effective, and therefore generated significant profit surpluses, which was then funneled back into the western economies, thus creating the boom in credit. Huge trade imbalances, massive government deficits, and a stunning growth in consumer debt was the result of a wall of money entering into the western economies.
The borrowed money was entering the western economies in ever greater amounts, all of it looking for investment opportunities. The problem is, what happens when the supply of good investment opportunities is used up? The money that is entering the economies must be utilised somehow. It is at this point that the money starts to be utilised in ever more risky ways. It is here that the origins of the bad lending lie. The money had to be utilised but could not be invested in productive assets, such as manufacturing, as the growth in manufacturing was focused on the more cost effective emerging markets. If you wanted to build a new manufacturing facility, then increasingly the logic dictated that you looked to the East. This left a huge surplus of money sitting around, and the end result was cheap and easy credit for consumers and governments alike.
Now, in normal circumstances, such a massive oversupply of money would lead to inflation, and then governments would seek to dampen down the inevitable expansion in activity in the economy in order to combat inflation. This did not happen, as the measures of inflation did not account for the reduction in the cost of manufacturing resulting from the massive input of labour into the world economy. Prices for all kinds of goods just kept falling. Furthermore, wage growth was not as inflationary as it might have been, due to the ongoing threat that manufacturing would move their operations to the emerging markets. The governments of the West failed to understand that these factors were muting the signals that would normally prompt them to reign in their too fast expanding economies. Instead, they deluded themselves that all was well. The worst aspect of their measures of inflation was that they failed to take into account the inflation of asset prices, in particular housing.
One of the justifications for this was that the cost of servicing the housing debt was apparently not rising. To justify this people looked at the amount that individuals were using for repayments, pointing out that interest rates were low, thus making higher prices affordable. However, they failed to see that inflation and interest rates together the make up the actual cost of a house over the lifetime. High interest rates coincide with high inflation, and low interest rates coincide low inflation. High inflation compensates for higher interest rates by eroding the value of the debt owed, such that the two factors balance out. The problem was that everyone apparently forgot this, and therefore people committed ever greater portions of their lifetime earnings to buying their houses. This in turn inflated the prices of housing, as ever greater amounts of money was entering the market. In any market, if you increase the supply of money available for purchase of a finite number of assets then there will be inflation.
This inflation of asset prices, due to an ever expanding supply of money, apparently supported by collateral, led to a belief that the money was being lent wisely. It was not, because the necessary increase in wealth needed to justify the increase in prices was not occurring. What was occurring was the debt merry-go-round.
This was a situation in which more and more money was entering the financial markets to support house purchase, and providing ever more easy credit. The 'service economy' was born, the massive expansion in retail and leisure activities for consumers. The new expensive restaurants, the shiny shopping malls, the crystal healers, personal trainers and so forth. At the same time, governments were borrowing more and more money, and creating ever more new government activities, more government jobs, and so forth. It is here that we come to the multiplier effect.
Each £1 or $1 entering an economy has a multiplier effect. When we go to a restaurant and buy a meal, we do not only support the success of that restaurant, but also the suppliers of the restaurant, the supplier of the supplier, and so forth. This means that a service economy can generate what appears to be huge amount of productive economic activity. All of the money going into purchasing the services trickles through the economy, supporting more and more activity. This keeps employment high and, as services expand, the economy appears to grow.
The problem here is that all seems well but, if the spending on the services is built upon growth in debt, then what is happening is not actually growth in the economy at all, but actually temporary growth at the cost of future growth. When we borrow money for consumption (not investment), we are foregoing future wealth. In short, the credit boom was a massive boom in forgoing future wealth. The most dangerous part of all of this boom was that, for reasons which still baffle me, the economists who were measuring economic growth included this foregoing of future wealth as economic growth, which is why we saw ongoing rises in GDP. Occasionally there were concerns expressed about the way in which manufacturing shrank as a percentage of the economy every year, but this was all answered with twittering about 'post-industrial' economies. No one seemed to ever ask where the real source of the ever expanding wealth came from. This was the purpose of my original essay, 'A Funny View of Wealth'. In that essay, I looked at all of the potential sources of real growth in wealth, and found that there were none. I also found that the GDP growth was rising in line with the growth in debt.
The most curious part of this is that the lending to the West has continued for so long. In some recent posts, I have pointed out that this is largely due to confidence. It is the belief by those that financed the boom that the West had always been rich, that the West would always be rich, and was therefore a good credit risk, and a good investment. Just as the Western economists were pointing to 'growth' in the Western economies, so could those doing the lending, all the time not realising that their lending was going into the consumption that was actually the source of the growth. In other words they were financing the luxury lifestyle of the West in the belief that the West was an ongoing economic success, without realising that the success was entirely illusory.
It is for this reason that what should have happened, did not happen. As competition from the emerging economies became ever more effective, the logical outcome was that the West should have seen their economies adapt to the new competition. As the trade balances were turning negative, there should have been a drop in the value of the Western currencies, and this would have created a re-balancing of the world economy. Instead, the flood of money pouring into government and consumer debt, meant that there was high demand for the currencies, so that the currency could then be lent back to the consumers and governments of the Western countries. For a long time ever more money pouring into the Western economies actually continued to generate returns, but the generation of those returns was in turn reliant on an ever exapanding source of finance into credit for the Western economies. In other words, the returns were reliant on more and more borrowing, such that the returns were actually coming from more borrowed money. A debt pyramid, if you will.
We can now add in some rather unusual factors for both the UK and US. In both cases they saw a massive increase in immigration, for the former the immigration of Central European workers, for the latter Mexican workers. In addition to these workers also helping to hold down wage inflation (in addition to competition from emerging economies), they also created even greater activity levels in the destination economies, adding even more growth to the GDP and also accelerating demand for housing. They came in large numbers due to the boom in the service economy, which in turn was built upon the boom in credit. In other words, the mass immigration was an upward lever on the economies, on the bubbles that were forming. The trouble is that immigrant workers are, in most cases, a negative impact on an economy, in particular if they are temporary. Each immigrant worker who comes on a temporary basis intends to return home with a cash sum. When they return home, they are therefore taking real wealth out of the economy. Furthermore, if they return home in large numbers, one of the props for the housing market price rises is removed, as demand will go down.
It is now that we come to what I call 'The Cigarette Lighter Problem'. It is not of itself a problem, but the expression of a more fundamental problem. In the post I detail how a lighter in a Western economy costs about nine time the price paid in China. In paying this price for an identical product, delivered in an identical way to the way it was delivered in China, I point out that there must be some part of the economy generating huge amounts of added value to support such a price. At the same time I consider the economy of China, which increasingly has the same infrastructure, the same technologies (at least in the cities), increasing productivity, and so forth. In such circumstances, how can the price differential be maintained? Can such a large differential be justified?
The answer to the cigarette lighter problem is actually the answer to the problems that the West is now facing. The differential is built upon the flood of money that has entered the economies of the Western world, such that it is the lending that is actually the root of much of the difference in the price. There is no part of the economy that can explain such a massive differential, and we can only conclude that a large part of the price differential is that the emerging economies are paying for a large part of the differential. I am aware that this is a difficult concept to grasp. It is the idea that when we enter a shop and do something as simple as buying a lighter, we are paying for it in part with money that was actually borrowed from other countries.
So now we return to the problems that we are seeing today. The first point of note is that commodity prices are now falling back (notwithstanding the irrational pouring of money into commodities out of panic). The reason for this is that, now that the flow of money into the Western economies is drying up as the debt spigot is switched off, the economies of the West are contracting, with a commensurate contraction in those who were exporting to them. In other words, demand is fast contracting and contracting back to a level where supply once against exceeds demand. I like the analogy here where world demand was a person racing forward, only to hit a wall, and bounce back before once again commencing progress. What will happen is that, having bounced back, the running forward will again occur at breakneck speed in the future, only for the runner to bounce back once again. All the time, the wall is moving forwarded, but never fast enough for the speed of the runner who will keep running forward and bouncing back.
It is here that we see the underlying problem for the Western economies. As I have discussed, there are many new workers in the world and, in order for them to be productive, they will need to have access to resource, to commodities. The situation is now one in which the runner has bounced back, and there is an excess of supply of commodities relative to demand. However, if we remember, the amount of commodities available to the world economy has not increased in a way commensurate with the supply of labour. As such, until such a time, not everyone will be able to have the same share of the available resource that was utilised by the West. It will not be possible, until that time, for the emerging economies to 'rise up' to the standard of living of the Western world. There is simply not enough available resource for this to be possible.
Many economists claim that international trade is not a zero sum game. They claim that everyone can benefit, as trade will help everyone get richer. This is absolutely true, but only if there is not competition for limited resource. In such circumstances of competition, the situation today, there are winners and losers. The big question that this raises is one of who will win and who will lose?
My argument is that the West is not well placed to win in this new competition. Our economies are bloated with fat, and due to the excesses of the credit boom, loaded down with debt. Our governments are inefficient and complacent, our advantages in education are diminishing as our education systems fall victim to faddish dumbing down, our technology is being exported wholesale to the emerging markets, we carry the weight of welfare systems that are unsustainable, and we tie up our businesses with regulation, and tie the hands of business behind their backs by ethical laws, so called 'green' policy, and demands for abstract notions such as 'corporate responsibility'. On top of this, you can see a culture of expectation, that government has the answers, that we have a right to wealth, and a culture or complacent expectation. Compare this with the hard working emerging economies, in particular in Asia, who revere education, who will do anything to secure the betterment of their family position, whose governments are hungry for success, and determined to find their place in the world (I am really talking of China here), and who are pursuing aggressive mercantilism policy.
In such a situation, I have to ask how we can win? It is the reason for this blog, and the reason why I have written about structural reform. However, these are the least read and least commented part of the blog. I suspect that, on the one hand, we can accept intellectually the arguments that I am putting forward, but not actually accept the reality of the inevitable consequences. Those consequences are that we must adapt to being poorer. Whilst the world overall is getting richer, a greater share of that wealth is going to move to the emerging economies, and it will happen at the expense of the West (or OECD if you prefer). The way that the wealth is redistributed will not be even. Some countries will fare better than others. I have always argued that the UK is going to be one of those hardest hit, and everything that I have seen in the last few years, and more recently confirms this. On the other hand, I used to believe that the US would hurt, but the flexibility and dynamism of the US culture and economy would pull it through (such that there would be pain, but not as bad as for example the UK). However, events of the last week appear to suggest that the path being taken is to try to magic away the problems with ever more borrowing. I am now very pessimistic.
As I said at the start of this very long post, the crisis in the financial system is actually based upon an element of rationality. It is not some strange force, but a reflection of the underlying economic problems, and the shock of the intrusion of reality into the delusions that have been held by so many. I have said many times that what we are witnessing is the inevitable rebalancing of the world economy. Everyone will hurt in the process and we will enter a period of economic chaos, with possible political chaos flowing from the pain.
Pure and simple, the world economy is a mess. The reactions to date are not encouraging. It seems that nobody has yet accepted that the errors of the past can not be fixed overnight, that the gross misallocation of capital in the Western world must have consequences, and that the West must come out of this poorer than it started, and considerably so.
In this post I have not done full justice to all of the points that have been made in previous posts. I have just sat down at my computer and churned this out without any plan or structure, so I hope that it makes sense to you. In places I have oversimplified, and not accounted for the many inter-connections that have driven all of this disaster. I have not referenced much of the post. I apologise for all of these faults, but I am (as ever) constrained by the demands of my 'real life'. I hope that you will understand.
If you do find that the argument put forward here makes sense to you, then I would suggest that you take time to look through the blog, as there is far more in depth explanations and discussions. I have given links at the top of the post, which take you to some key posts. However, do not neglect the archives. I had myself forgotten some of my previous posts, and on occasion have been pleasantly surprised to find some of my own explanations that I had forgotten, but which helped me make sense of the current situation.
Note for Regular Readers: I will not be posting as often as in recent times as my 'real life' will be very busy for the next month and a half. Also, I want to avoid getting sucked into 'punditry' and would rather focus on the wider issues. As such I will continue to post, but will try to restrict my posts to implications as the crisis unfolds.
Note added 28th September:
I have just posted a comment in a forum, which may be worth adding here:
The justification for the bailout is to avoid a repeat of the Great Depression. However, the world is not in the 1930s, so why would an imagined solution to a 1930s problem fit the circumstances of 2008. . There is no evidence that it would have worked then, and even if had worked then, would that suggest that this would solve the different crisis that is occuring today?
As I have detailed above, the crisis actually stems from some very particular circumstances.
Note 2, added 28th September:
One comment on this article accepted the principles of what was said in the post as saying
'Absolutely wonderful post. Although I am somewhat more optimistic than you that people in OECD countries can bounce back and become competitive when they are under greater competitive pressure'Whilst my posts are unremittingly gloomy, I also believe that the OECD (Western) economies can bounce back. However, the first step is the recognition of the reality of the changed world, and it is the lack of recognition that concerns me. Another comment noted that there was a problem of arrogance in the US, and this is perhaps a related point to the one I am making here.
Another poster has added a comment against 'A Funny View of Wealth' asking:
'What will be the effect(s) of continued mass unskilled imigration from third world countries?'My answer to this is that I suspect that, as the economy turns down, the borders will probably close to any significant immigration (Central European immigration notwithstanding). However, this is a matter of politicians making choices, so it can only be a guess. However, if the borders remain relatively open, it is likely that numbers will diminish as the Western economies will start to look less attractive. Whilst the West will still be relatively wealthy comapred with many countries, economic migration probably needs fairly strong motivation, and the prospect of arriving in a country with surging unemployment is probably not going to help with that motivation.
Lemming (a regular commentator), asks a perceptive question as follows:
'The brave, clever and perceptive thing to have done would have been to stifle 'growth' (debt) with the future in mind. But at what point would such a suggestion stray into the realms of 'socialism'?'This raises the question of how much intervention governments should undertake in markets. My argument has consistently been that the problem actually arose as a result of government regulation (see 'The Market and the Crash') which caused a false sense of security. I have also been critical of the very idea of government borrowing and the setting of interest rates by central banks (see 'Government Borrowing and Interest Rates'). Removing regulation, and the ability of central banks to set interest rates would probably have avoided this crisis. In particular, without the regulation the activities of the banks would have caused alarm much sooner than was the case when they met regulatory requirments (implying that they were 'sound') and would have also prevented the need for off-balance sheet structures, CDOs and all of the other problematic activities.
Lemming goes on to ask:
'Did any government in the world conspicuously do the right thing over the last decade?'I can think of no example. However, I am a market purist, where I believe that the only role of government is in the prevention of market concentration and monopoly, fraud, insider trading and so forth. This serves to remind me that I still need to finish my post on regulation, which will discuss such issues in more depth. Hopefully this will answer your question as this is too big a subject for a quick comment.