Thursday, November 6, 2008

Economic Crisis - A Torrent of Bad News

I thought I would write a quick post, as there have been some items in the news which are interesting.

The first of these is a report from the IMF, which said the following:
'In its bleakest assessment yet of rapidly worsening global prospects, the International Monetary Fund predicted that industrial economies as a whole will shrink through next year by 0.3 per cent, in the worst such slump of the postwar era.

The IMF said that the toll imposed by the downturn across the West would sap the strength of the world economy and cut global growth next year to an anaemic 2.2 per cent. That is down 0.8 points from its last forecast, made only a month ago, and is below the 2.5 per cent threshold at which the world economy is judged to be in the grip of global recession'

It might be noted that the IMF reports are progressively becoming more downbeat. The reaction from stock markets was predictably negative, in yet another case of a rally of optimism being dented by economic reality.

Meanwhile the Bank of England has slashed interest rates in an attempt to turn around the economy. For regular readers, they will be aware of my lack of support for central banks setting interest rates, but I have argued that, if they must, they should have cut rates a long time ago. For those that are unaware of the mechanism by which interest rates are 'set' (targeted), I have copied an explanation of this from an earlier post:
'interest rates are set (as a target) to govern the money supply in the economy (through open market operations in the UK primarily through the London Interbank Offered Rate). The control of the money supply is managed by either buying or selling securities such as second hand government debt (e.g. bonds), or by lending to or borrowing money from banks.'
The trouble is that the banks are not playing ball, and are holding interest rates higher than the rate targeted by the Bank of England. The real problem here is that the same article details that the banks are now being pressurised to accept lower interest rates in their lending. This is what the article had to say:

'John McFall, chairman of the Commons Treasury Committee, told The Times:“These guys came in with some pretty big begging bowls asking for taxpayers’ money. They are displaying an alarming lack of social conscience. They should pass on the cuts in full.”

Yvette Cooper, Chief Secretary to the Treasury, said that ministers expected banks to pass on the cuts as fast as possible. “The Government has stepped in to make the banking system safe, to support the banks,” she said. “It is right now that the banks do their bit to support everybody else.”'

The absurdity of this position is that the reason for the banking crisis was the mis-pricing of risk, which has led to huge losses for the banks. Having been scathing about the banks for doing this, now that the banks are (rightly) being cautious, the government is now using its newly acquired whip hand to force the banks to return to mis-pricing of risk. This is exactly one of the many problems that I predicted would arise as a part of the government bailout of the banks. It also sows the seeds of further troubles for the banks in the future.

The reason for such pressure is the belief that banks need to start lending again, as there is still a fundamental belief that everything can be solved through borrowing. This attitude is implicit in many commentaries, and just one example can be found in a commentary on the problems being faced by Barack Obama:

'America is looking to its new president for a string of answers: how to stop the US economy shrinking at its fastest rate for seven years; how to stop unemployment, already at a five-year high of over 6pc, rising even further next year; how to rebuild consumer confidence, which suffered its steepest drop in October since records began in 1952; how to kick-start consumer spending, which represents two thirds of the US economy and fell in September for the first time in many years.'

It is the last part that is most telling. The key to the revival of the economy apparently lies in getting consumers spending again. Note that there is no mention of increasing wealth generating business and activity, but instead the answer lies in consumers going shopping. The question of shopping with what is not discussed, but the reality is that what they really mean is shopping with borrowed money. That is why governments are urging the banks to cut interest rates and pressuring them to lend. Whatever way you look at it, it is increasingly clear that governments view the solution to all the problems is increased consumer spending, and they do not care whether that spending is generated through increased consumer debt. Even were such a solution to succeed (which it will not), at what point would the unsustainability of such a proposition become evident? How much debt can consumers actually shoulder? In this foolish conception of economics, apparently consumers can go on borrowing for eternity.

This does make me wonder whether governments have any idea of what they are really saying. Surely, even when dressed up with economic jargon and euphemisms, the thrust of what they are suggesting must be apparent to them.

Note 1: There have been some very interesting and insightful commentaries on the blog, starting with Lemming, who says the following:

'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?'

The idea of a reset makes sense in some respects. The trouble with such an idea is that it would be a very bitter pill for the creditors to accept, as they would have to write off large tracts of wealth as unrecoverable. In writing off such wealth, it would then cause a complete loss of confidence in all kinds of investment, as investment is built on the trust that there are rules that support a return on investment. If the rules can simply be torn up when it is no longer convenient, and the defaulter suffers no adverse consequences, then on what basis would anyone invest? Would you give an individual, £1000 to open a shop if you were told that he could do anything with the money that he liked, for example using to throw a party, and that if he never repaid the money, then there was nothing you could do about it. You might notice that he owns a house, and a car, but you would have no claim on these things if he failed to repay. You would just be told, 'tough luck'. Would you ever lend again under these circumstances?

What you have in a reset, is an 'unfair' situation and game theory has tested this. In an experiment they sit two people at a table, and say that if the two sides can agree on a division of money, then they will both get the money according to the split that they agree to. In other words they both will win if they agree. Universally, people will not agree if they think that the division of the money is unfair. In these circumstances, they would rather get nothing, rather than get an unfair share. In a reset situation, both sides would benefit, but would benefit unfairly. Game theory shows that the inclination is to not allow an unfair outcome, even at cost to oneself.

Lemming goes on to say the following:

'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?'

There is an element of truth in this. However, the current circumstances are unique, and that is why the current crisis is unique. It is the scale and speed of the introduction of productive labour into the system, with the emergence of countries like China, that is the problem that makes the bottlenecks so devastating. For example, in China, it is not an inherent fault in capitalism, but a knock on effect that arises from communism. The communist system restricted the productive potential of workers, whilst providing just sufficient resource to keep the numbers of workers expanding. When the communist system was abandoned, the workers were allowed to start reaching their productive potential, and the speed of this development reflected the strength of the capitalist system. It demonstrated the actual potential of the workers. However, in doing so, it provided a supply shock that has only recently become apparent in the evident lack of commodity to supply their new found productivity. As such, the shock is not the result of capitalism, but the removal of a distortion caused by communism. Whilst the capitalist system is flexible, this has stretched the flexibility to a literal breaking point.

The shock is evident in the current crisis, and as I described before, the world has run towards the commodity brick wall, bounced back, and will in due course start running at the wall again. Whilst the wall is moving forwards too, the runner will keep catching up and bouncing back. In other words the capitalist system is responding, but it can not respond fast enough.

DZ followed up Lemming's comment with this:

'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.'

DZ is right that there are not infinite resources, at least not for everything. However, at the moment resources are still there to meet growth, they have just not yet been harnessed. In principle there is potential for the world to rise up to an overall higher standard of living by better harnessing and extraction of resource. For example, huge areas of Russia are not fully exploited for agriculture (I read about this in the Economist some time ago, but must apologise that I do not have time to find the article). The availability of resources such as oil is more questionable, but the dominance of oil is in part due to its availability. There are arguments that when oil starts to run down that the economic incentives to develop alternatives will be compelling and will therefore spur alternative solutions/structures. This is all debateable, but I personally buy this argument.


With regards to charging interest, what happens if you are a productive person and generate a surplus. Without an incentive to utilise that surplus, why would you use it in any way? Interest allows you to use that surplus to improve the economic activities/performance of other individuals. It also allows people to lend into consumption, which is not always obviously beneficial. However, that comes down to a point of view of whether you believe individuals should be free to accumulate debt. For example, although housing has been confused with investment, for owner occupiers it is also a form of consumption (consumption of a mode of shelter, as well as social status, comfort and so forth). Would it therefore be acceptable to restrict borrowing for this kind of consumption? If this is acceptable then it is hard to find a reason to restrict other borrowing towards consumption.

I hope that I have addressed the points in the comments. There were some other comments I would like to have addressed, but I have run out of time. As a general point, it is really good to see such thought provoking comments on the blog.

Note 2: I have just made one of my regular visits to the New York Times and it makes bleak reading. Retailers are reporting shcocking falls in sales, another report tells of stock market falls inspired by negative news such as General Motors struggling to keep its head above water, and poor figures on unemployment. The 'Obama bounce' is rapidly disappearing, as the hard economic news onces again bites optimism.

Perhaps the greatest concern is that the Chinese economy is also showing signs of strain. Regular readers will be aware that I have always had mixed views on what would happen to the Chinese economy in this crisis, but erred towards the possibility that the economy would hurt, but not as badly as others. This is becoming less and less certain. We have yet to see how the Chinese government might deploy the substantial reserves to support the economy, but the negative side of that for the Western countries is that there is less and less chance of China using the reserves to prop up the world economy. There is also the problem that, if China draws on the reserves, in particular the $US reserves, this will also bring about a collapse in the value of the $US and thereby destroy some of the value of the reserves. It is a very tangled web.

The real worry is that, if the Chinese economy slows sharply enough to bring about hardship, the potential for unrest in China remains high. There have been many reports over recent months of simmering discontent with the government, and my own sources within China are suggesting that there is some anger over government behaviour in general. The consequences of unrest in China are very, very disturbing, so we should all hope that China can ride out the problems without too much damage.

Note 3: I have not posted this link for a while, but for new readers, I would recommend that you read this post if you would like to understand why we are really going through the current financial crisis.


8 comments:

  1. Mark,

    Thanks for another stimulating post.

    First, a little correction. The game of "veto" you described in your answer to Lemming is not part of game theory but one (of many) empirical experiments which disprove one of the foundational assumptions of mainstream economic theory, i.e. the theory of the "rational agent". These experiments essentially show that humans have naturally built-in notions of "fairness" and will punish free loaders even at a cost to themselves.

    As far as the main theme of your post goes, I've been recently reading articles and interviews by Prof M. Hudson, which can be found on his website:

    http://michael-hudson.com/

    The articles especially relevant to our current discussions are the two parts of "The Mathematical Economics of Compound Rates of Interest". Here is one extract which seems to pinpoint our current predicament (remember this was written some years ago):

    ===
    All classical economists, including Marx, focused on profits as the
    economy's motive force, but this has not turned out to be the case in recent decades. Seek profits involves risk, ties up capital, and
    requires entrepreneurial effort. It is easier, less risky and even
    minimizes taxes to lend out one's savings to others to manage,
    collecting interest for the service of providing this wealth. What is
    remarkable is that unearned revenue is now being encouraged in
    preference to earned profit, above all in the form of asset-price
    inflation.

    [...]

    What is neglected especially is today's most characteristic pattern of lending: the investment of savings to extract interest charges that are recycled into new loans rather than financing new means of
    production to help economies' grow their way out of debt. Such a
    pattern of recycling savings serves to enlarge the volume of financial
    claims attached to existing productive assets. These financial claims on wealth (bonds, mortgages and bank loans) are lent out to become somebody else's debts in an exponentially expanding process. In recent decades such claims have grown more rapidly than tangible investment in factories and farms, buildings and homes, transport and power facilities, communications and other infrastructure.

    For the past two decades, economies have been obliged to pay their
    debts by cutting back new research, development and new physical
    reinvestment. This is the essence of IMF austerity plans, in which the currency is 'stabilized' by further international borrowing on terms that destabilize the economy at large. Such cutbacks in long-term investment also are the product of corporate raids financed by high-interest junk bonds. The debts created by businesses, consumers and national economies cutting back their long-term direct investment leaves these entities even less able to carry their mounting debt burden. They are forced to live even more in the short run. Interest rates rise as debt-strapped economies become riskier, for as Adam Smith observed, "interest rates usually are highest in countries going
    fastest to ruin." And as interest rates rise, yet more money is
    shifted away from direct investment into lending at interest, until
    the system is torn apart from within. Capital flees abroad, the
    currency falls and unemployment rises.

    No doubt a point must come at which the burden shakes the public out
    of its hope that matters somehow will return to normal. In the end the global economy must be obliged to do what Adam Smith said every debtor economy historically has been obliged to do: let its debts go. (Now that global debts are becoming dollarized, it is less possible for a national economy simply to inflate its way out of debt and make Smith's less costly "pretended payment.")
    ===

    And finally, a few personal observations "from the ground" here in China. The economy seems to be (dare I say it) collapsing. All the shopping malls around me are deserted (save for sales clerks). Door to door salesmen have appeared trying to sell credit cards. A big Burger King on Nanjing road is 90% empty most of the time. The state news reported yesterday that 60,000 factories have gone out of business in the last couple of months (including 3,700 out of 6,000 toy factories). Recently we've visited some of our subcontractors and the situation there seems to be as dire as it has ever been. Interesting times..

    ReplyDelete
  2. Very good that you-re still posting. I have learned much from your site.

    Am glad you/lemming discuss a 'reset' as I have been intrigued by this idea. As the amount of debt in the world is revealed to dwarf eh, 'real' assets etc. the idea of some kind of reset could easily gain ground. There are perhaps many good reasons it would unacceptable / unpalatable / wrong, but I cant agree with your application of game theory to present economic realities.

    The huge amount of personal debt in the UK/US etc could ensure that self-interest helps the population go for a reset. It seems to me that Western populations are willing to live a high degree of economic unfairness provided it can be disguised by a willing media. (Trickle-down as one example). Having lived in the US I think it is clearly a spectacularly unlevel playing pitch (economically). The middle/"working" classes were happy to live with this, provided they could see themselves among the winners, following a dangled carrot that moved ever upwards. Now that the carrot has been shown to be debt-fuelled / illusory. They will see themselves as victims of the financial elites and could accept some kind of reset, providing a good story was told and plausible scapegoats identified.

    ReplyDelete
  3. Here's an article in today's Times which appeals to me:
    http://www.timesonline.co.uk/tol/comment/columnists/guest_contributors/article5076270.ece

    Now that would be a nice world to live in.

    ReplyDelete
  4. tin-foil hat wearerNovember 9, 2008 at 5:44 AM

    Cynicus E posted:
    "The absurdity of this position is that the reason for the banking crisis was the mis-pricing of risk, which has led to huge losses for the banks. Having been scathing about the banks for doing this, now that the banks are (rightly) being cautious, the government is now using its newly acquired whip hand to force the banks to return to mis-pricing of risk."

    Could the agenda behind this be the "shovel-them-in-as-quick-as-you-can" immigration policies of all three main parties?

    To keep the "money as debt" banking system going (for a little while longer) they need an ever increasing population and the natives have below replacement birth levels.

    No money for housing immigrants >

    no immigrants >

    system collapses >

    elites lose control !

    ReplyDelete
  5. Thanks Mark for your response and in general for providing a narrative that is a compelling alternative to mainstream media on one hand and conspiracy theories on the other.

    Loans for investments
    An alternative to having "interest with loans" as an incentive for people with surpluses to give loans would be "loans for shares".

    "loans for shares" is more risker than "interest with loans" for the lender but it will mean that lenders will have to take care in giving loans for investments that will likely to payoff (real wealth creators). Surely, if this is the case, then the whole society will benefit as a result?

    Loans for consumption
    Its something I didn't think about, especially big ticket items like houses and cars. Perhaps alternative like part buy - part rent schemes might lead to more sustainable consumption? Overall I would say that would it not be better to encourage lenders to give loans for investments rather than consumptions.

    I also remember that you talked about government given loans as an idea for more sustainable welfare system.

    ReplyDelete
  6. No comment needed.

    http://jameshowardkunstler.typepad.com/clusterfuck_nation/

    People of a nervous disposition should refrain from reading this.

    ReplyDelete
  7. anonymous

    I, too, enjoy James Kunstler's blog. Something in my upbringing or genes has made me a naturally conservative person. I have always felt deeply uneasy about 'waste' and that my fellows never question their right to consume unnecessarily huge amounts of stuff - generally made from irreplaceable materials and energy taken from the earth. Plus, I have never understood how they thought their lifestyles could go on forever, borrowing huge amounts against the future on the assumption that nothing would change. I have always felt that there was something wrong with me; that they knew something that I didn't. It actually gives me great pleasure to find that there are other people who are not cranks and crackpots who think the same as me.

    I have read several references recently to the demise of the 'work ethic'. I would be interested in other people's opinions on this: if we are all going to consume half as much stuff as before, does that mean that we *must* work considerably less as well? Personally, I am happy to work part time, for a much reduced salary if everyone else is too (it sounds like heaven, in fact). Until now, it has not been an option, as we have all been on that runaway treadmill servicing our useless consumption.

    Or will the 'new arrangements' simply expose the fact that the West has been surviving thanks to foreigners and that, even if we manage to write off our past debts, we must still work 40 hours a week to look after ourselves even at our new low level of consumption? We were told in 1978 that the microprocessor was going to give us lives of leisure - and I still feel bitter about that! Why did it not happen?

    ReplyDelete
  8. Lemming

    I've been following Kunstler for about four years now, he's very good at what he does, but like so many bloggers out there, they do not get the big picture.

    The big picture (my take)

    The world's movers and shakers have decided (in their infinite wisdom) that for a multitude of reasons the world and it's peoples cannot continue in the same vein as before.

    Something must be done about it.

    Anyone who cannot not see that since 9/11 things have gone seriously awry in the the world, must be living on another planet. I will not be pedantic and list all the things that are 'in the air' (as I speak) as I think they are self evident.

    In short the movers and shakers have a 'plan' to deal with this unsustainable state of affairs. This plan has become widely known as the New World Order.

    Nation states are to be a thing of the past, the world is to be split into geographical entities to be drawn together and administered (governed) by the United Nations and associated Non Governmental Organisations. (NGO's)

    The EU is the pilot model.

    This enterprise, (NWO) is a joint Anglo American project for the 21st century and is up and running. Brown and Cameron are in the thick of it.

    The general idea is that there are far too many people in the world and must be drastically reduced.

    Dwindling raw materials must be conserved and obviously be for the benefit of the world's elites.

    The much reduced population is to be micro managed, there will be no middle class, it will be multicultural (minus whites) private property will be abolished.

    Global Citizen, Globalisation, New World Order are the established buzzwords. Mass immigration from the third world to Western nations is the manifestation that we can see before our eyes.

    The West is now post industrial. Is this economic meltdown part of it? Brown says there must be a global solution too this problem. Why is mass immigration still going full tilt whilst jobs are disappearing? Why is Right and Left politics now consensual? We no longer have a meaningful choice.

    Why is the media so overwhelming 'on message'?

    What the heck is this War On Terror all about? It's an illusion, there's no such thing and never has been - just an excuse to go after oil in the Middle East.

    I could go on and on. It is far more intricate and eye watering than what I have laid out so far, it has taken me four years of solid probing on the Internet to make any sense of it all.

    I'm not asking people to believe it at face value, but you must admit things are happening that on the surface simply do not make sense, and as long as people remain glued in front of that television set then they will never find out - until it is too late.

    Just get googling - just try 'NWO' for starters, you will be amazed at the journey it take you on.

    I apologise for this rambling disjointed essay, but no matter what I write, the vast amount of subject matter cannot be addressed in in a few posts.

    ReplyDelete

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