Friday, October 17, 2008

World Economy - What Happens Next?

As I mentioned in my last post, I thought it might be worthwhile to take a pause from the news and try to pull together what all of this means. By coincidence I finally had time to read my copy of the Economist from last week, which included their review of the situation. It was surprising to see how far they had moved towards the interpretation of events discussed in this blog. However, in several critical respects they differ.

For example, the Economist is broadly supportive of the bank bailouts and coordinated action of governments to try to fix the crisis. Across many posts I have listed many reasons to be against the bailout, so I will try to summarise the reasons for why this is an error. In one post I illustrated why this was a bad decision with an analogy of a family. The family have been spending more than their income for many years, and were already in severe financial difficulties. They are increasingly reliant on borrowing to sustain their lifestyle, are using borrowing to pay back previous borrowing, and are slowly but surely heading to bankruptcy. Meanwhile, the husband is having his working hours reduced, and the mother is facing the possibility of redundancy. In other words, their income is about to drop. In such circumstances, who in their right mind would suggest the solution is to borrow yet more money? The answer is obvious - nobody would give this advice. Instead, the advice would be to accept the reality of the situation, and tell them that they urgently need to change their lifestyle such that they can live within the means of their income. Ideally, they would also need to change enough to start paying back their debts.

For some reason, when it is a country in this situation, the solution to the problem is to borrow more money, the method of financing the bank bailout. This is the simple reality. Nobody disagrees (now) that the Western economies, in particular the UK and US, have been borrowing more money than was sustainable, but for some reason it is acceptable to get out of the situation through increased borrowing. Rather than accepting the reality that we must live withing the means of our (diminishing) income, the solution is to just borrow more money.

In a more recent post, I asked what the borrowing would be used for. We know that the money is being pumped into the banking system, but to what end? Were it to be used to invest in wealth creating assets, then I would have no argument with the Western governments extending their borrowing (whilst they still have the means to do so). However, the news suggests that the purpose of the bailouts is just to pump new sources of credit into the wider economy. In other words, it is just being pumped in to restore the supply of money to maintain the 'service based economy'. Will this money see the development of manufacturing companies, or be used for investment in new plant or technology, or be invested to develop services for export? There is no indication that this will be the way that the money is used. It is just an increase in overall debt, and is digging a deeper hole for the economy to sink into.

Governments are claiming that they will eventually recoup the money that they are lending, but the reality is that they will be encouraging the banks to lend the capital that they are injecting into the system. In so doing, they will be encouraging lending into a failing economy, which means lending against devaluing assets, lending to consumers who are increasingly likely to made unemployed, and businesses with ever greater risk of bankruptcy. In other words, the money will be used for lending into high risk, and will therefore see yet more mis-allocation of capital. In encouraging lending for the wider economic good, the governments are likely to just encourage yet more bad debt to be developed.

We then come to the question of how the money will be repaid. In my early posts on the bailouts, I emphasised the fact that this is spreading the damage done to the financial system into the wider economy through the necessary (eventual) increases in taxation. This means that the genuinely productive parts of the economy will be saddled with greater taxation, and will reduce their ability to compete. In other words much of the money being borrowed will be poured into the non-productive parts of the economy, and the cost of the borrowing will hurt those parts that have genuine wealth creating capacity. It is a recipe for long term economic damage.

So what is the bailout actually for? There is endless talk about restoration of 'confidence'. This is a very curious idea. What is the point of confidence? Does it produce wealth, does it change the underlying economic circumstances? The reason that there is no confidence is for the very reason that the underlying economic circumstances are so poor . As such, the $2 trillion being used to prop up the banks in the Western world is being used to create a false sense of confidence. This is a frighteningly irresponsible way to utilise this money, as the restoration of confidence can never be anything more than temporary, because the underlying economic reality is so poor. As it is, these massive borrowings being poured into the financial system are not even achieving this foolish aim in the short term. The rate of interest for inter-bank lending is barely moving, stock markets are still teetering on the edge of collapse, and so forth. At this stage, it is impossible to say that there will still not be an upturn in confidence, but such an upturn is unlikely, and in any case will eventually be destroyed by ever more bad economic news. (Note: I discuss why the value of money is built on confidence here, which would suggest that confidence is important. This may seem self contradictory, but the reason it is not is that confidence must have a foundation in economic reality)

So where does this leave the economies of the Western world? At the moment, the rest of the world is still lending into the Western economies. I forget which was the post in which I made this analogy, but this is a situation like the creditors to an 18th century aristocrat. His family has always been wealthy and his creditors continue to lend money in the belief that he will always be wealthy. However, the reality is that he has no prospect of ever paying back the borrowing. All it takes is for one creditor to ask for repayment, and the result will be a loss of confidence in the aristocrat's ability to pay. At that point, when the credit stops, bankruptcy will quickly follow. His income does not cover his expenditure, and without the continuation of lending, he is seen for what he is - a bankrupt who has been living on the success of his forbears.

The collapse of the economy of Iceland will probably be raising questions about the creditworthiness of other Western economies. The UK government in particular is making it very clear that the intention is to increase borrowing, and is therefore declaring that it intends to borrow its way out of trouble. Rather than trying to cut back on spending, it fully intends to pretend that there is no underlying economic problem, with no need for reform. It is business as usual, all the while with income dropping, and borrowing increasing. No explanation is being given for how this increase in borrowing is to be repaid, what source of new wealth is around the corner to allow the repayment of this ever-growing debt. The question this raises is how it is that the rest of the world will continue to lend? At what point will they ask the question of how this debt will ever be repaid?

The fundamental problem is this. As long as the rest of the world keeps lending, there is demand for the Western currencies. As long as this demand continues, it helps to prop up the value of the currencies. This in turn protects the value of the money that is being lent. What happens if the amount of lending decreases is that the demand for the currency will drop, and with it the value of the currencies. The trade balances of the US and UK in particular have been negative for a long time. Put another way, the demand for the $US and £GB is driven by lending, not by demand to buy goods and services. For those that are creditor countries, they face uncomfortable choices. If they cease lending, then the currencies of the West will collapse. If the currencies of the West collapse, they will lose huge amounts of money on the lending they have already made. On the other hand, if they keep lending, they are faced with the problem of how the money will ever be repaid. In crude terms, do they continue to throw good money after bad?

It is for this reason that I have predicted that it will not be long before the lending stops, and that this will lead to government defaults. I can only guess the time scale because, at the end of the day, it requires that the creditors of the West ask the right question - the question of how their money will ever be returned to them. It will also require them to accept the losses on their previous investments, which will be a hard pill to swallow. Finally, they will know that, with the collapse of the Western economies, they will be pulled down with along with the West. For countries like China, with very real prospects of social unrest, they will be balancing the cost of continued lending against the survival of the Chinese Communist Party. Do they continue to finance the Western world's ability to live in comfort, do they continue to lend their hard earned money to prop up a decadent and bloated Western world - for that is how they will see it. They produce, and the West consumes and does not ever pay the bill for the consumption. It is hardly a good deal for them.

So what happens if countries like China decide that enough is enough. It is at this point that the Western governments find that they can no longer pay the bills. At this point they must either print money, or dismantle huge parts of the state. The $US, the Euro and £GB will fall through the floor. The peg to the £US used by the oil states will be dropped, and the cost of oil will soar. Even without printing money, the rate of inflation in the Western economies will soar, and the result will be complete economic chaos. The reality will be that oil will be oversupplied, but the shift in the currencies of the Western world will mean that, for the West it will become relatively very expensive. The same will happen with other commodities. This is the rebalancing of the allocation of commodities that I discussed in previous posts. I spoke of the competition for finite resources between the emerging economies and the Western economies, and that the West would lose out, and find its share of world resources decline. This will be the mechanism by which this decline will be transmitted.

I have not spoken very much about the social and political consequences of what will happen, as this blog is focused on economics. However, at this stage, it is worthwhile discussing this briefly, as there will be a feedback into the economic situation. If I am right that the lending into the West must end, and the result of this end to lending is as I have predicted, then we will all be in for a roller-coaster ride. The shock to the Western world will be dramatic and painful. In these circumstances, it is an ideal environment for demagoguery. It is the moment of the populists and the rabble rousers. There is a real chance of massive social upheavals, and even challenges to democracy and capitalism. In the rest of the world, there will be similar upheavals. The biggest worry is China, which already has a state that already looks like a worrying hybrid of pre-WWII Japan and Germany. There are many flashpoints for conflict, such as Taiwan. With a government with legitimacy built upon economic growth and nationalism, what happens when the economic growth stops? The Economist magazine is optimistic about the prospects for China in this upheaval, and we can only hope that they are right. I have always been very slightly optimistic that China will pull through this period with only moderate damage, but still have many serious reservations.

I mention the political and social dimension for the reason that the result of the next stage of the crisis will lead to a situation of chaos, by which I mean chaos theory (no doubt serious chaos theorists will shoot me down on this usage, but I hope that you will understand my meaning). By this, I mean that even small events or factors may have profound consequences. The right person being in the right place at the right time, a decision of bureaucrat, a rumour - all of these offer opportunities for dramatic changes in the situation. In other words, there will be a period of huge instability, and that instability creates opportunities for small events to have profound consequences.

As you may gather, I am profoundly worried by the current situation. I was able to predict this crisis, but was not able to predict the way in which governments would react. The way they have reacted is a way that will ensure that the crisis leads to economic disaster. In choosing to try to borrow their way out of trouble, in failing to reform their economies to lower costs and prepare the way for real wealth creation, they have sent a message to their creditors. That message is that they must continue paying for the comfort of the Western lifestyle, at the cost to their own people, or they must face the consequence of massive economic upheaval, and consequent chaos. I believe that creditor governments will be trying to work through this question, trying to see how this can all end. I can not be the only person raising these questions. At some point in time, the complete lack of logic in the current situation must come to an end. There is no way that the creditors to the West can be happy to be supporting the Western economies, with little prospect of ever gaining any return. At some point, it just must come to an end.

I am sorry for such a gloomy post, but my aim has always been to try to analyse situations in as realistic way as possible. For new readers, there are many points in here that require deeper explanation, such as the role of commodity supply in the world economy. You may want to take a look here to understand why the situation is as I say it is. You may also want to take a look at the other posts that I link to at the top left side of the blog. This all may sound like an extreme take on the situation, but there is a disturbing logic in this analysis to be found throughout this blog. Even as I write this, it is a sunny day, and the world outside appears normal and unchanged. The best way to understand how deceptive this calm might be is to imagine the tourists sunbathing on the beaches of Phuket, just before the Tsunami struck. In a matter of minutes, their world was turned upside down.

Note 1:

Ishmael asked the following question:
'My question was in regards to the system of fractional reserve banking and the criticisms that have been made in a few documentaries especially "money as debt" and "zeitgeist" and "zeitgeist addendum"

This article can explain the debate better than I.

I was wondering on your opinion on this matter as my financial knowledge is a little basic, Is a crash inevitable or is there another mechanism at play that mitigates the effect of exponential debt plus interest?'
I have not seen either of these documentaries, but I do discuss fractional reserve banking and my post on the subject can be found here. It is a rather unusual perspective, but if you stick with it, I hope that you will find it interesting. My article on government borrowing and interest rates may be of interest as well.

Note 2: An anonymous poster has mentioned how easy it is to make fake coins, in reference to my cynicism about the Amero conspiracy theories. Thanks, for the contribution, which is helpful.

Note 3: I have the following from an anonymous poster (edited):
'I know the idea is to get the banks and mortgage providers lending again, but they cannot go back to lending to people who will never be able to repay the loan.(sub prime)

With the economy about to take a dive, (and I suspect never to recover to pre crash levels) what sort of an economy will follow?

The only exponential growth in the Western world is people, Britain (and America's) populations are rocketing and it is my guess this is where the growth is to be conjured, as I suspect it has for the past eleven years. '
The answer to this is relatively simple and also terribly complex. The one certainty is that the economy of Western countries will be considerably smaller. As to what kind of economy, that is the complex question. Increasingly socialised, protectionist, or lean and mean and ready to face the competition in the world? That, to a large extent, is in the hands of the politicians and where democracy is in play, that is in part in the hands of each individual with a vote. Will the voters look to the state to 'fix' the problems through protection, endless state interventions, or will they decide that they want to regain their place in the world? This ceases to be a question of economics, but becomes a question of politics.

Note 4: A very late reply to Phil (apologies)
I’d like to offer a further point of reflection: while in the West we continue the “Debt Economy Delusion”, what the biggest producer of real wealth - China - will do?
12 October, BBC News website had an article, “China agrees land reform package”.
The article quotes Xinhua news agency:
"The Communist Party of China Central Committee on Sunday approved a decision on major issues concerning rural reform and development," Xinhua said.
Its commentary added: "The global credit crisis freezing up the world's finances may be a blessing in disguise for China as it aims to modify its economic structure after three decades of breakneck growth."
My take is that, as the global crisis will restrict external demand for Chinese goods, China will expand its internal market, the biggest single market of the world.
And what will happen then, monetary speaking? Will the Yuan increase its (now artificially lowered) value?
And, as we are at it, what will happen to major world currencies?
This is a very interesting comment. The RMB will certainly have to significantly increase in value, at some stage or another. I tried to keep my own money in RMB for that reason, but holding money in China is problematic. There are many possible drivers for a large upward revaluation, including threats of protectionism, and it is difficult to say when the CCP will allow a major revaluation. Add into this mix the questions about internal stability, and what might happen if China falls into recession, and life gets more complicated.

One of the interesting things about an artificially low currency is that drives economic growth through export led growth, but at the cost of the relative wealth of all the individuals in that country. To give an example, a Gucci bag may be significantly more expensive than it otherwise might be with a balanced exchange rate. That differential means that, in real terms, the potential purchaser of that bad in China is poorer. In short, the people in the country do not get a 'fair' price for the imports that they buy. If you look at it this way, China could overnight become significantly more wealthy, just by revaluation. However, in doing so, could they maintain their economic growth? It is not certain at the moment that this is, in any event, possible. It really is a very complex point. How much of China's success is due to the artificial currency rate? I am not sure on this, but think that it is significant a factor. However, the cost of this approach is now coming at them through the back door, through the damage that the undervaluation has helped create (unbalancing the world economy).

As you can see, a very involved answer, and one that illustrates the inter-connectedness of the world economy. I think I have already answered the questions on currencies in the main post, so will not answer that question further.

Note 5: Another anonymous poster asked this:
This whole business has led to a potential cataclysmic political sea change.

Is neo Liberalism dead in the water?

The ramifications to the answer to this question is mind boggling.

If the answer is yes - What next?
I have answered one of the questions in the main post. Neo liberalism dead? Another one for the politicians, I believe.

Note 6: Hilly asks the following:
'Is the extent and volume of the losses incurred internationally (100s of billions of $) simply due to this over-lending, over-valueing, over-selling etc.. not just in housing (which does incur the losses) but in the levels of borrowings bothprivate & commercial that are being defaulted currently or are anticipated to be so, plus governmental overspending of future incomes?'
I am not sure I grasp your underlying question here, but if you can clarify it, I will try to answer it (time allowing).

Note 7: In reply to a question below:
It's just occurred to me. (I'm not the sharpest tool in the shed) Are we, (West) in the absurd position of being lent money by China to enable us to buy their goods?

It's a sort of merry-go-round that could continue for ever.
This is something I have discussed previously in this blog. You are absolutely right, except about the ability for this to go on forever. The lending will only go on as long as the lending creates a return. As soon as the returns diminish, the merry-go-round stops. It was an unsustainable economid model and part of what we are seeing is the collapse of this model. It was not just China, but all of the creditor nations who have funded the West to buy their products. It sounds mad when you think about it, but this is why I make the Aristocrat analogy. Think of the situation where the aristrocrat buying his tailoring on credit.

Note 7: More questions (see below). I only have a little time so I will just answer a couple of those raised (all too briefly). Answers are in italics.
'The economic backdrop to the 21st. century is the mantra of ever increasing growth in a world of diminishing supplies of raw materials. (is this the same as your commodities?) The production of raw materials (commodities) relative to demand are decreasing even though output in absolute terms has increased. See post here.

Where has all the money gone? Has it been consumed on trips to Disneyland, McMansions, SUV's, snowmobiles, second homes, etc.etc. The short answer here is yes. Much of the money has gone into consumption, and therefore has been spending now at the cost of foregoing future wealth.

With the present arrangement of China having become the workshop of the world, they have amassed shed-loads of dollars amounting to hundreds of billions, what are they supposed to do with this mountain of money? Not hundred of billions but fast heading towards $2 trillion. That is one of the problems that they face (and other creditors are facing). The West is not producing enough of what they want to buy at a price they are willing to pay. That means that the value of the currency must devalue. Once it is no longer used to fund Western borrowing, then there is no demand for the currency, and the value of the currency falls.

The only thing they can do with it is lend it back to the West or buy up Western assets as investments. Yes, see above. But they will no longer want to lend it, as their little prospect of the ability of the West to repay. We are not making enough goods that they want etc. (see above answers). This is one of the points in the above post, so I think I will need to rewrite it, to better explain this.

With the World's dwindling resources I cannot see manufacturing returning to the West, which again prompts the question, where is the wealth generation to come from? Please do not buy peak oil and the rest of the scare stories out there. oil must peak at some point, but there is no firm uncontested evidence that resources are dwindling, and peak oil has been predicted since the 1930s. It could be now, or it could be later. I was posting months ago that oil would drop to $60 when the peak oil believers were predicting $200. Last time I checked it was at $75. Overall demand has outstripped the ability for suppliers to meet the demand, but demand is now falling back as the Western economies contract. Again, see post here. The main problem is bottlenecks, not the amount of material (a curious example is the inability to produce the huge tyres for the monster trucks used in open mining)

As an aside, how can the West (Britain) embark on an economy of manufacturing when the have just announced another round of cuts on carbon emissions? Expect 101 ways for this to be quietly abandoned in the coming years. I think that you will find hard times will diminish the enthusiasm for action which damages economic prospects.

Naive question perhaps, what is the difference between borrowing money and the government printing its own? In other words why borrow when you can print it? This one is not a short answer, so I will (time allowing), try to address is another time. The simplest answer...Both options are bad, but printing money is worse.Not a naive question, but a very good one deserving a proper reply.
I am afraid that time has run out (explaining the rushed responses above). I will try to put more time to answering questions but must balance my limited time against the general posts. As such I will do my best to keep answering as many comments as possible.


  1. Having just all too rapidly read your latest post, as always it seems to raise more questions than answers, Here I will just cherry pick a couple of questions before revisiting and taking a more leisurely intake of your offering.

    The economic backdrop to the 21st. century is the mantra of ever increasing growth in a world of diminishing supplies of raw materials. (is this the same as your commodities?)

    Where has all the money gone? Has it been consumed on trips to Disneyland, McMansions, SUV's, snowmobiles, second homes, etc.etc.

    With the present arrangement of China having become the workshop of the world, they have amassed shed-loads of dollars amounting to hundreds of billions, what are they supposed to do with this mountain of money?

    The only thing they can do with it is lend it back to the West or buy up Western assets as investments.

    With the World's dwindling resources I cannot see manufacturing returning to the West, which again prompts the question, where is the wealth generation to come from?

    As an aside, how can the West (Britain) embark on an economy of manufacturing when the have just announced another round of cuts on carbon emissions?

    Naive question perhaps, what is the difference between borrowing money and the government printing its own? In other words why borrow when you can print it?

    I read somewhere the other day, where someone compared the bailout as applying more heat to boiling water in the hope it would get hotter - I thought this was rather good.

    We live in a world of virtual reality. (five minutes of watching TV is enough to prove this)

    I've said it before, we now live in an upside down world, nothing is as it used to be, image over substance, spin, smoke, mirrors, is today's zeitgeist, the world is suddenly flat again, all natural laws have been suspended. (no need to comment on this)

  2. It's just occurred to me. (I'm not the sharpest tool in the shed) Are we, (West) in the absurd position of being lent money by China to enable us to buy their goods?

    It's a sort of merry-go-round that could continue for ever.

  3. It may be true that the US is losing ground in real wealth that comes from the creation and manufacturing of things.. That these emerging economies who are making and producing everything from cars to toys are not beating us at everything.. However, I would bet a weeks pay we make more cheeseburgers here in the US than anywhere else in the world..

    North Port.FL

  4. In today's DT Alistair Darling says that the government will embark on a Keynesian spending spree and that "We can allow borrowing to rise" as previous debt repayment over the past 10 years has made such a course of action possible.

    Mark, from what you've been saying for the last few months, this sounds to be the complete opposite of what we should be doing - it sounds like a blunder of epic proportions. Are you absolutely sure that our creditors will be turning the taps off any time soon? Is China, in fact, happy to fund our lifestyles indefinitely so they can simply 'buy' the West in the long term? To me, that sounds like a perfectly rational explanation, and Western politicians who espouse globalisation would be more than happy to facilitate it, I imagine, even if they were unaware of exactly what they were signing up for.

  5. Okay
    I hear a lot about how confidence is crucial to keep our economies going. This seems an insane value or human trait to base economies on, but it has worked for a long time.

    My point is; if the politicians and financial elites could use whatever means to get confidence high again, is it possible that after after a correction things could stay the roughly the same/ a lower level ) for many more years, if not indefinitely?

    Also, there are all these interbank debts looming, Credit Swaps etc, why don't the most important banks get together and write them off? I assume that would be painful, but as its all abstract wealth created as debt, what would it matter?

  6. Darling's plan of bringing spending forwards is truly dreadful. I can only imagine that he thinks that it might boost the economy prior the the next election as a last ditch effort for labour to avoid complete wipeout. I suspect the chances of that are nearly as small as the grey nobbly organ situated between his ears. Either way, we can reasonably expect sterling to get trashed in the process and look forward to some serious inflationary pressure moving into 2009.

  7. I've stumbled across the website of an academic economist who predicted the current crisis long ago and who has a very similar analysis of the current situation as found in this blog.

    I don't know if you will find this is useful, but I'm highlighting it just in case.


    "Opium Wars II, The Revenge"
    Coming soon to a market near you...

  9. Hi,

    I am new to your post, just wondering if middle class of china, india and middle east become biggest consumer of Chinese products than what would be shape of western economy


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