Economic Crisis - The Mainstream Starts to 'Get It'

If you are new to the blog, I recommend starting here.....as this will introduce you to some of the key ideas on why we are in the current economic crisis.

An unusual post for the blog, in that I will express some frustration, but hopefully the post will also serve a purpose. Regular readers will know that the economic crisis has so far almost perfectly corresponded to the course of events that I predicted. I did not predict the economy through some mystical process, but quite simply by always keeping in mind Adam Smith and ignoring the views that were so obviously without any logic or consistency. I just asked if the condition here is x, and over here it is y, what will follow? It really is not very complicated - none of it ever was. It just required shutting out the nonsense that was endlessly bombarded on us all from the 'experts' and various commentators. It just required thought....

I have not been alone in suggesting that the Western economic system is in deep trouble, but I have felt very alone in the explanation that I have given. I am now pleased to say that people are starting to recognise at least part of the problem. I quote from an FT article as follows:

'Asia’s part in America’s financial downfall has been two-fold. First, shiploads of cheap goods from China and other low-cost producers helped keep a lid on US prices. That lulled the Fed, with its tight focus on the consumer price index, into thinking it could have it both ways: high growth with low inflation'

And

'While it lasted, China and others were able to grow at supercharged rates by lending to Americans so that they could import its products.'

I can remember, about three years ago, sitting in on an economics lecture and describing this process with an analogy of a conveyor. Strangely enough, after my explanation, everyone in the class 'got it'. I described how, if you took one piece out of the system, the system would shut down, and that the consequences would be dire. If a class of people (without an economics qualification between them) could 'get it', it makes me wonder how this has come as a surprise to so many people, in particular people who should know better, and who are often paid large amounts of money for their insights. It is very puzzling indeed.

I never stop reminding myself of the price that this (foolish and avoidable) crisis will extract from so many people. The foreclosures, the bankruptcy and unemployment that are now going to hit the UK and US like a storm. It is when I think of this price that I feel some resentment at those who had the opportunity to prevent this mess. If I could see what was coming, why were they unable to? Or did they suspect that this was going to come, and just pretend that it would go away - enjoying the sunshine and pretending that the storm clouds might just pass by. I doubt even this explanation.

However, unlike a few people out there, I do not believe that this is a grand conspiracy of the government or international bankers. I quite simply do not believe that they are competent enough to manage something like this. In fact, I would take comfort in the idea that the economic crisis was the result of a master plan, as at least it would suggest that there was some intelligent thought at the commanding heights of the economy. The conspiracy theorists try to scare us with the ideas of cunning and clever shady and secretive groups. How much more scary is it to just accept that those that lead the economy are just incompetent?

To illustrate how incompetent, I will give an example that I have mentioned several times in this blog. It is the measurement of GDP. This measure takes overall economic activity as a measure of the health of an economy. What it does not measure is the source of that activity. All I did was ask a simple question; if we are borrowing huge amounts of money from overseas and we add in the multiplier effect, are we seeing GDP growth resultant of growth in debt, as magnified through the multiplier effect? I then checked the rate of growth in debt, and the growth in GDP, and there it was. Over the last ten years (which is as far as I ever looked) growth could be explained almost exclusively by growth in debt. I did not have the time and resource to do calculations, but it was not necessary, as simple heuristic (guesstimation) made the scale of the problem clear. It is very simple - look at the growth in the GDP of the UK and look at debt growth together, then consider how every time you spend money it multiplies activity in the economy (through the company receiving your money paying various suppliers, wages etc.)

From this simple idea, we know that the UK economy MUST contract back to at least 10 years ago, but it will probably contract further because the economic conditions at that time were far more favourable (e.g. China was still not a major player, and we were not saddled with the hangover of the debt binge). This is not clever and not complicated.

I hope that, as I explain this, you will sense why I am frustrated. It really is not rocket science. It is all based upon very simple ideas. It is something that we could teach to a monkey. So how did so many get it wrong?

I also hope now that you are concerned. The reason for this post, aside from expressing my frustration, is to point out that the same people who managed to fail to understand these very simple ideas, are the people who are still proposing the solutions. They are the same politicians, economists, bankers and all the rest of the people at the commanding heights of the economy, who are still in charge.

For example, just about everyone now accepts that the US and UK have a problem with debt. Despite this, they still are proposing borrowing more. Have a look at my last post to see the simple lack of thought, lack of connection to reality involved in this decision. In the last post I am again addressing the problem with simple principles, and once again, it is not rocket science. The analogy is imperfect, but it is difficult to argue with the principle that, when mired in debt, taking on more debt is not going to be the solution. No charts, no complex equations, no volumes of theory. Just a little bit of reason....The only circumstance under which any borrowing should be made, under the current circumstances is for (real) investment, or for natural disaster, or war.

I have mentioned that the mainstream is starting to 'get it'. However, even now they have not understood that we have hit a brick wall of commodity supply, and that we are entering an era in which competition for resources has created a 'zero sum' game, complete with winners and losers. They do not 'get it' that the Western economies can not recover unless there is serious reform, because they are simply less and less able to compete. The devaluation of currencies (which has a long way to go yet) in comparison with the currencies of the 'emerging economies' will eventually deal with the trade deficits, and re-balance the wealth to realistic levels (the West will be poorer). However, in order for the economies to really start to generate wealth again, this will not be enough. The bloated fat of government, waste and endless regulation have to be addressed and resolved. In order to win in the coming era of intense competition, borrowing more money, saddling the Western economies with yet more debt, is just about the worst thing that a government can do.

When I wrote my essay on the state of the economy, and the prospects for this crisis last November, I held a vague hope that someone would read it and think it through. I sent it to a member of the Conservative Party (Boris Johnson), hoping that somehow it would make a difference ( I can be foolish too). It did not.

As I said, a frustrated post. The people making the decisions, are still getting it terribly wrong, and ordinary people will pay the price for their poor understanding. How can the message get through?

Note:

I have been reading with a sense of puzzlement the latest twist in the crisis. This is the Irish Republics decision to guarantee all of their bank deposits, rregardless of size. It is a quite extraordinary gamble. I wonder whether they knew that such a move would attract offshore money seeking safety, but bearing in mind rumours of an imminent Irish bank failure this looks more like panic, and is therefore probably a happy unexpected consequence.

As with all such actions, there are potentially large prices to pay. The first is that, it may force other countries to follow suit, thereby creating a domino effect, where everyone has to do the same in order to avoid (the very important) deposits going overseas, in which case it will force every country to take an extraordinary risk with their finance. In other words Ireland has attracted deposits, thereby shoring up their own banking system, but at the risk of destabilising other banking systems. More to the point, what happens if banks do collapse in Ireland?

We can run through some scenarios (not predictions). What if, for example, the UK followed the Irish approach. Is it not possible that the money that is flooding in would flood back out? Might this sudden loss of deposits start a panic (even though they were additional business since the crisis). In doing so then there may then be a collapse. Alternatively, as the money comes out of the institutions, if they were weak and only being supported by the fresh deposits, might the progressive withdrawal push them over the edge (that they were in any case facing prior to the new deposits). However, this may happen midway through the outflow, and thereby saddle the Irish government with the bill for guaranteeing foreign depositors.

On the plus side, if Ireland is the only country that takes this course of action, they may actually have achieved the miracle of shoring up their financial system (at least in the short to medium term). No doubt some pundits will then start to suggest that the Ireland solution is appropriate elsewhere, conveniently ignoring that the solution only works if it is a point of differentiation, otherwise it just serves to expose the government to horrendous liabilities.

In the meantime it is a solution that has the effect of weakening the banking systems of countries that have not implemented the same measure. Not a very good solution all round.... but they may get away with it if others choose not to follow.

Note 2:

Meanwhile the bailout continues to make painful progress towards passage. I rather liked this quote from the FT:

'In a move intended to shore up confidence in banks, the legislation would give the US’s Federal Deposit Insurance Corporation the unlimited ability to borrow from the Treasury for a temporary period.'

Confidence in the banking system being gambled with confidence in the government finances. An interesting trade.

Meanwhile the real world continues the plunge over the precipice entirely disregarding bailouts, and excitement in the financial centres. Just one example in the news is that 'UK House Price Fall Most on Record'. The same article details further falls in the £GB, and another article reports that M&S are suffering tumbling sales. In other words, whilst the financial world looks to the magic wand of the bailout, the reality on the ground is grinding away at the roots of the debt driven economy.