Tuesday, November 4, 2008

Barack Obama or John McCain - Who Will Address the Reality of Economic Crisis?

It is impossible to ignore the US election, and whoever wins will face the current economic crisis. As such, how do the economic policies of the two candidates stack up? This from the Economist back in October:
'Both plans are costly. Long before this week, Mr Obama had proposed sending cheques to the middle class, to be partially paid for with a tax on oil companies’ “windfall profits”. But with the collapsing price of crude, the package’s net cost has now shot up from $50 billion to $115 billion. Jason Furman, Mr Obama’s economics director, estimates the latest round of proposals will take that up to $175 billion over the next two years. Mr McCain’s pre-existing tax plans would have caused the deficit to balloon more than Mr Obama’s, and his campaign says his latest proposals will cost another $53 billion. The timing is awful: the Treasury announced on October 14th that the government’s fiscal 2008 deficit was $455 billion, not the $389 billion projected in July.'
In other words, both candidates have their own version of continuing the delusion that government borrowing is the solution. The Economist also gave a more detailed briefing on their respective economic policies, but I will not detail their policies here as their policies are unlikely to be realised. The situation is such that, whatever they say on the stump will have to be adapted to the realities that they are about to confront, which is the ongoing collapse of the US economy. In such a situation, what their individual policies have been, becomes irrelevant. What matters is who is better able to adapt, be pragmatic, and accept the reality of the situation.

This comes down to a judgement call about the character of the individuals, and I have no insight on this subject that I can offer readers, and therefore will remain neutral on the subject. I can only suggest that, for US readers, you ignore what the candidates said they will do, and ask yourself how they might respond to an ever worsening economic situation. Will they bury their heads in the sand, or will they confront the reality, and devise a policy that will address the fundamentals of the economy. Are they likely to heed the populist calls, or will they have the courage to lead the US people and confront them with a need for real and fundamental change? This is a question of realism and character, rather than an analysis of their policy record.

As I have said, these are judgement calls about the character of the individuals in question. I am happy to offer my opinions on questions of economics, but in no way feel that I have any greater insight than anyone on this question. I only know the right question to ask, but do not know the answer.

I have had some interesting comments in the last day or two. In particular MattinShanghai offered an insightful comment on the change in the common understanding of wealth as follows:
'What seems to be happening in developed countries is the taking over of the real productive economy by rent-seeking finance capital, which basically tries to "squeeze" it for all its worth. This applies to companies (via M&As and LBOs), prospective landlords (via mortgages) and individuals, who are encouraged to take on ever-increasing levels of personal debt. According to current economic orthodoxy, asset stripping, outsourcing and offshoring, "creates wealth", so its all for the best, isn't it?'
Matt's discussion is based upon the thinking of Adam Smith, and you can read the comment he makes in full at the end of 'A funny view of wealth'. To all of the readers of this blog, I would strongly recommend a reading of Smith's 'The Wealth of Nations'. I have always felt that all the economists since Adam Smith have been trying to fight with his ghost. It has been a long while since I have read 'The Wealth of Nations', but it was an inspiration for me, and is probably the inspiration for much of my thinking on economics. In other words, if you find that this blog makes sense, then you would almost certainly appreciate the work of Adam Smith (I may reread it myself, and see how much my thinking actually is founded in his impressive work).

Ignatius also made the following comment, regarding 'A funny view of wealth' (it is heartening to see that people are still reading it):
'A critical remark, though: You argue that immigration as well as emigration is bad for the UK economy. Obviously, ceteris paribus, both statements cannot be true at the same time: You either have too many or to few young workers - given the age distribution of the "native" UK population, I'd rather vote for the latter ...'
The key difference is that immigration is often from countries which are economically less developed than the UK. As such, they are likely to be providing remittances to their country of origin, thereby removing wealth from the UK to their country of origin. I also divide immigration into 'good' and 'bad' (I am simplifying here). In particular all temporary migration is bad, as the migrant is likely to return home with a large cash sum, removing wealth from the economy. UK workers going to another country to work, and returning home with a lump sum is a positive for the UK. The trouble is that much of the recent emigration from the UK is to settle permanently in another country, and they take their wealth with them, thereby removing wealth from the UK. By contrast, immigrants from less developed economies are unlikely to be bringing such wealth with them (excepting the super-rich 'non-doms'). Also, emigration from the UK is to countries such as Australia, where entry requires high levels of education/skills meaning that most of the migrants are exactly the people that are a positive for the economy. Equally, immigration of unskilled migrants into the UK is a bad thing, but immigration of highly skilled/educated migrants is a good thing on balance. These are generalisations, and do not do the subject justice, but a re-reading of my original post will hopefully clarify the matter. As such, I recommend reading the original essay. With regards to the age distribution, the introduction of an effective points system, and actively promoting immigration of highly educated and highly skilled workers would be a partial way to address this problem.

I hope that I have covered the criticism, but would also like to emphasise that I welcome any criticism, as it helps me to focus on any weak points in my analysis or my communication of that analysis. Therefore, thank you Ignatius for your comment.

Two anonymous posters have asked what will happen if the UK defaults on debt, and focus on the external consequences rather than the internal. This is a very large question.

I have previously detailed the options for governments in the case of no longer being able to borrow, and it is not a pretty picture. With regards to countries that trade with the defaulting government, there are some obvious consequences. One of those is that lending to the government would probably continue, but come with hefty (IMF-like) strings attached, and would probably require rescheduling of previous debt under onerous terms including rescheduling in a different currency. The default would also make trading with the defaulting country high risk, as the currency would be considered unstable. In these circumstances, trade would not be conducted in the domestic currency, but in another more stable currency. This would be a way of shifting the currency risk towards the country in default. It is a short answer, but I hope that it suffices. In other words, the reform that should anyway be undertaken within, will be forced from without. A better solution is/would have been to implement the reforms now. This would allow for a more gradual and less painful adaptation to the changed world economic circumstances and would be a controlled reform rather than a shock.

In both cases the country would have to learn to live within its means, but internal reform offers the opportunity to make the transition with less pain. As I have long argued, it is only reform now that will allow creditors to continue to support economies such as the UK economy as it makes the transition to a leaner and more competitive economy. Every day that goes by with ever more borrowing just digs a deeper hole, and governments desperately need to reduce expenditure such that the depth of the hole is minimised and allows that we can eventually climb back out. If creditors can see that we are reducing borrowing, and can see the prospect of an eventual return to surplus, then they will keep lending. Instead, what they see is an increase in the size of the deficits, and will be wondering at what point the deficits might ever reverse.

For those that doubt that the creditors are getting cold feet, this from the Times:

The domestic priorities of Saudi Arabia could well be put before helping Western economies, which have been put at risk by global economic turmoil.

“Saudi Arabia does not want to be seen as a milch cow,” said a senior British government figure. At a three-hour meeting with King Abdullah on Saturday night, Mr Brown secured his agreement to attend the summit on November 15 to discuss reform of the international financial system. The pair dined, then talked long into the night through an interpreter

This is the question that I raised some time ago. The creditor countries are faced with tough choices. Do they keep throwing good money after bad? If they stop lending, they see the market for their products/commodities collapse, but if they keep lending, they are effectively subsidising the wealth of the West with their own wealth. More from the same Times article:
Privately Saudi officials have acknowledged that in recent decades the state has failed to invest in the country’s infrastructure and public services and now want to rectify this. They intend to invest in education and skills, as well as to improve the living conditions of ordinary families.
In other words, bailing out the Western economies comes at the price of denying their own people the benefits of their wealth. It is very much as I have suggested before. The big question is how they will chose to proceed. If they cut the lending, then they will suffer, and if they keep lending they have to live with the idea that they must just continue to support the wealth of others at the expense of themselves. It is a classic 'rock and a hard place' situation. However, it illustrates how fragile the current economic situation actually is. As a note, thanks to Stephen for the link on the subject of the visit to the Gulf by Gordon Brown.

Jim G, on a related subject asks the following:
'I now watch Gordon Brown, smug faced, tell everyone that the UK's debt is lower than most if not all of the Europeans. Is this true? Is he including in his figures, the off book stuff, such as nuclear decommissioning, PFI deals etc. Is the UK really in a better position than the rest of Europe or is this another "no more boom and bust" statement? I've looked for some stats, a report, anything but can not find any comparisons between countries.'
This is a very pertinent question. There are two issues. One is that the measure of debt is made relative to GDP, and as I have argued previously, GDP is overstated by around a third (a 'guesstimation'). With regards to the real liabilities of the government, the Economist thinks that all of the liabilities would roughly double the real levels of debt. It also reports that 'Britain's deficit as a share of GDP was among the highest in the 15 old member of the European Union' (Economist print edition, November 1-7, 2008, 'So Long Prudence. We had Fun but....', p55-56). In other words, there is absolutely no comfort to be found in the UK debt situation. Also, even were it the case that we were not as bad as others, this would be a relative measure and would not alter the simple fact that the situation is bad. If one person has a broken leg, and another has a broken leg and arm, we would not say that either person was in a good condition to play a game of rugby.

This has been a slightly rambling post, and has covered a lot of subjects. I hope I will be forgiven for this, but there were a lot of interesting comments. Of all of the points in this post, I think the most important is that it appears that my belief that creditors are getting cold feet is correct. I have taken a single comment in an article as the basis for this, which is hardly overwhelming evidence, but I think that it may be a good indicator, and fits with my previous speculation.

In the meantime, no doubt, everyone will watch the outcome of the US election with great concern. I do not know the right choice, and hope that the judement of the people in the US will be correct. The handling of the US economy will have a profound effect on the world economy as a whole, so that the choice made in the election will have profound effects for us all - for good or for ill.

Note 1: Death To Bubble Addicts posted a link to a very funny video. Whilst the situation is serious, humour about it is not a bad thing, so thanks for the link.


  1. Mark, I'm still thinking along the lines of a comment I made a few months back in which I asked whether the financial system is so broken, that only some sort of 'reset' can get things back on track. It seems to me that nothing has gone greatly wrong with the world's ability to produce sufficient 'stuff' for most people to live adequately, but that capitalism has tied itself into such knots that it cannot be untangled without destroying society in the process. Can we continue with capitalism in its present form?

    I think in previous posts you have described how the world economy expanded to such a degree that bottlenecks in the supply of essential raw materials, like oil, caused the expansion to halt, thereby causing an inevitable crash (the economy must expand constantly to keep paying off the interest on loans..?) If a requirement of capitalism is to constantly expand the amount of economic activity towards infinite size (and it sounds as though it is) then the bottlenecks you describe are unavoidable, and no degree of ingenuity can get around them, whatever Adam Smith says. Isn't capitalism just a giant pyramid scheme which collapses as soon as a bottleneck in the supply of energy or raw materials or cheap labour is reached? And like all pyramid schemes can't you point to persuasive evidence that 'it works' right up until it collapses?

  2. America's foreign policy will determine their economic destiny.

    Under Obama's stewardship, Iraq is to be left behind, the gravitational pull is to Afghanistan and Pakistan - ultimately to Russia and China.

    Is Iran off the hook?

    Obama backers gaze is focussed on Russia, there's a lot of energy out there still up for grabs. Besides, America sees Russia as an obstacle to their NWO designs. watch this space.

    China is cosied up to America for now, it is all very fluid out there.

    Some opinion says America can do it, Ossetia and the Georgian affair could be just a taster.

    Change? Can they do it? All we can do is watch and wait.

  3. Thank you for your reply to my question about defaults. You seem to have a talent for explaining finance in a way that is comprehensible even to the less educated in such matters like myself. If you ever write a "finance for dummies" book, let us know :-)

    I have a follow up question on regards to defaulting, and would appreciate your opinion. Trading in a safer currency I anticipated, but as the usual de-facto currency, the US Dollar seems to be in more and more risk with the state of the US economy, what do you think is likely to replace or supplement it as a safe currency?

    If a currency that is a good candidate is to be found, would it be a good thing to invest in for purposes of savings, ie convert current savings to the safe currency while the exchange rate is still favorable, and would this be a good move in the long term or would instability in rates mean it is too uncertain for a guarantee of savings especially if converting back could make the effort invalid through currency rates?

    My parents and myself are not in any debts, mortgage or otherwise, but as they are just entering retirement any advice regarding keeping hold of our savings in uncertain times would be very appreciated.

  4. In reply to lemming, I would respond that you have to divide capitalism up into trade and interest.

    Most economists says that "interest is like trade" but interest is not like trade.

    If a society deals with interest, then like lemming said, we have to assume infinite growth. However the world is not full of infinite resources. So it becomes a pyramid scheme with the initial lenders gaining the lion share of resources and the guys at the bottom working to pay of ever increasing debt until they give up, which cause market crashes to reset things.

    However, take away the "interest on loans" concept away and you are left with trade. Trade is all about dealing in resources so you will have winners and losers but the economic system then doesn't depend upon infinite growth. Instead we rely on increasing productivity to maximise usage of finite resources.

  5. dz

    Thanks for your comments on my post. I also asked a question a few months ago about 'money as debt' and fractional reserve banking: why do we have such a system? I can see that the current system is largely self-regulating and doesn't require any central planning to make it work, and it provides levers for external control of inflation and economic expansion. I presume that a level of inflation is desirable for governments and bank(st)ers because it stimulates investment and economic activity..?

  6. You are welcome Lemming. I believe the reason for Fractional reserve banking, seems to be a way for banks to support the "interest on loans" concept. FRB is a perverse trade, as its about dealing with resources that they do not possess (i.e. lending money that far exceeds deposits)

    If business takes loan with interest and becomes profitable, banks are happy as business can pay the interest from profits.

    If business takes loan with interest and makes a loss, banks know the business will not be able pay the interest as they have not made any profits

    The reason why banks need "Fractional reserve banking" as insurance to be able to carry on lending more in the hope of finding enough borrowers who make profits and cover up losses from defaulters.

    Why do goverments and banking elites wants to keep the "loan on interest" concept?

    Its all about weighting the risk in in favour of lenders who can keep on lending money to the public and keeping everyone happy.

    Personally I also think its laziness. Its much easier for banks to say give me guaranteed interest than taking the time to only lend to good businesses. This of course leads to interesting side effects...


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