The Crisis of 2009 - the Fault of Markets or Governments?

This post started out as an attempt to address the many interesting and often enlightening comments that have been made against the posts. However, in attempting to address two comments in particular I found that the responses led me onto a completely different track. This is one of the benefits of having having so many intelligent and incisive commentators on the blog. They spur new ideas and considerations.

In this case, I found that my rather meandering answers to their questions somehow morphed into something entirely new, a defence of free market economics. There are ever more calls for interventions in every market, more regulation, more controls, and all this adds up to is ever more government interventions. However, as I wrote my answers, it seems that everything that has gone wrong in the world economy can be directly, or indirectly, traced to government interventions. Despite this, the blame for this crisis is being laid at the door of the free market?

A good place to start is actually to look at the root cause of the problems, which I have detailed throughout this blog (e.g. here). This is the massive input of labour into the world economy, which has happened as a result of both India and China entering into world markets. This has led to the effective doubling of the available global labour force in a period of about ten years. It can not be emphasised enough here, that the massive dumping of labour into the market is not the fault of free markets, but is the result of a correction of government intervention in China and India. Both of these countries were artificially holding their labour back from the market until recent times. It is the sudden reversal of a government managed market distortion that has caused the shock to the world system. Governments in countries like China held back their labour force in a way analogous to a dam, only to let the dam open as a flood. Thus we have a massive imbalance in the available labour as a sudden shock to the global economy.

The real surprise in this distortion is that the free market system has managed to integrate such a massive input of labour as effectively as it has. However, the free market system is quite simply incapable of adjusting quickly enough to absorb this level of input flooding in. Whilst the system is flexible, it is simply not able to adapt quickly enough.

Another element at the root of the curren crisis is also the result of government intervention. In conjunction with dropping a massive labour supply into the world market, there has been an ongoing distortion in the world market.

As is pointed out by Lord Keynes (a commentator - not the original Keynes), we do not live in the perfect world of free trade, of genuine open competition. Lord Keynes points to the myriad ways in which competition is distorted, and quotes the quasi-mercantilist approach of China as detailed by Clyde Prestowitz:

Today, China is already the largest market in the world for steel, mobile phones, cement, aluminum, and electronic components. Within 20 years, it will likely be the largest market in the world for just about everything. If you are a manufacturer, you will pretty much have to succeed in the China market to have a chance of surviving anywhere else. In theory, you can serve the China market by exporting, but there are some good reasons why you might not. Because Chinese labor is inexpensive, production processes that are capital-intensive in the advanced countries can be “dumbed down” and made much less capital-intensive in China. As a manufacturer, you cut both your wage and your investment costs. On top of that, the Chinese government at local, provincial, and national levels will offer substantial investment incentives -- such as long tax holidays, capital grants, free land, low utility rates, worker training, and other benefits -- to companies willing to put plants and research-and-development facilities in China.

These investment incentives confound free-trade theory. They are, in fact, distortions of the market, and therefore of questionable legitimacy under the rules of the World Trade Organization. This has never been challenged because other countries have investment subsidies, too. (American states offer tax deals to induce companies to invest.) China, however, subsidizes investment strategically to capture new industries at higher levels than anyone else.

Prestowitz goes on to say the following:

Nor are there government policies to maintain U.S. advantage; it is assumed that American genius and free markets will automatically result in U.S. leadership.

Prestowitz is making a perfectly valid argument that China is following a beggar-thy-neighbour approach, and that the approach is nothing to do with free and fair trade. However, he also makes the point that the West has used its own variants of such policies, just with less aggressive mercantilist intentions. As Pretowitz points out, there is a belief that US brilliance will suffice.

I have long argued that China has been using unfair trade to gain unfair advantage, and that the US should have long ago confronted this problem. The posts can be found here and here, and I detail many of the unfair trade practices, as well as a threat by the Chinese government to destroy the $US.

However, the picture painted by Prestowitz, whilst perfectly valid, does not emphasise enough one of the real keys to the success of China. That key is the drive and determination to succeed at every level of Chinese society. I have lived in China for several years, and I was trying to think of an illustration of that drive. I then remembered a little street food restaurant that I used to use for my breakfast. It was open seven days a week from six in the morning until 11 at night, and every day, every hour, it was manned by the married couple who owned the business, with their daughter occasionally helping out.

Not all Chinese people are so hard working, but it is hard to see many cases of such complete single minded dedication to work in the Western world. The business was small, not very well run, but they were going to succeed, whatever it took from them. Knowing Chinese culture, their motivation was almost certainly to secure their daughter's future. Can anyone in the Western world deny that people such as these deserve their place in the sun, deserve the opportunity to secure the future of their daughter? We hear so much about the poor wages of Chinese workers, but we do not hear of these hard working people working to secure the future of their family.

There is generally considerable talk of 'slave wages' making the difference in China. However, low wages are only one part of the equation. I have seen a side by side comparison for an identical product made in a French factory and in a Chinese factory. The wage differential made the difference of a few percent, but it was in all of the other elements of the cost that the real differential lay. It is for this reason that I have emphasised that the solution is about restructuring of the Western economies. Whilst, for high labour input goods, labour cost will be a significant factor in competitive advantage, it is not the case for many products.

So where does this leave China in the world trade system?

On the one hand, they have an economic structure that is highly supportive of a competitive position, and where there is a strong argument for their success being deserved. On the other hand we have aggressive mercantilist policy, such as the control and fixing of the currency, no enforcement of intellectual property, and so forth. I have long argued that the US in particular should confront China over the latter problems, but have also recognised that the US is in no position to confront China, as China has the ability to destroy the $US (read the posts I linked to earlier for details of this). However, the lack of action, under the Chinese threat to the $US is just allowing China to build ever more leverage and exacerbates the problem. Better to face the pain for the $US now than later, when there is even less left of the manufacturing base.

What we are seeing is a world trade system that is anything but free, open and fair, and where the strong advantages of China are being rammed home with unfair trade practices. However, as has been pointed out, the problem is that to different degrees other countries are using unfair practices. It is the fact that these practices are entrenched to different degrees that makes it so difficult to deal with the particularly effective form of quasi-mercantilism practiced by China. For example, during the Asian financial crisis, there was universal acclaim for China for not devaluing its currency in line with the fall of other Asian currencies. It was apparently right to fix their currency at that time, when it suited Western interests, but not now that it no longer suits Western interests.

What you have here is a situation of 'pick 'n' mix' on the question of free and fair trade. Everyone can agree with everything, as long as it protects their own interests. This pick n mix approach offers legitimacy to Chinese unfair trade practice, and leaves complaints struggling to reach the moral high ground.

So where has this led us?

At its most basic, when a Western manufacturer tries to sell into the Chinese market they will often struggle to sell their product, as the Chinese government has held their currency at an artificially low level, and provided subsidy and incentives for manufacturers within their borders. In fact the Western company has trouble selling into any market in which they compete with any China based company. The Chinese government in following this policy has developed what can only be described as a powerful form of investment. In holding down the currency, the Chinese government makes every individual in China poorer in the short term (the investment - foregone income), as they do not have access to the same amount of goods as if they had a stronger currency, but the upside is that this relative poverty now is an investment that destroys the competitors who are unable to compete on these unfair terms (the return). It is a policy for long term success at the cost of short term wealth. It is a very effective investment, but one which is completely unfair in an open trading system and a system that creates imbalances in the world economy.

In the traditional definition of mercantilism the aim is the accumulation of bullion but, in this modern form, it is the accumulation of foreign exchange reserves. As has already been pointed out, the accumulation of such reserves has seen a transfer of power into China, which now has the power to run a steam-roller over currency markets. With that threat, they are in a position where they can face down demands for fair trade, and all the while their supply of foreign currency grows strengthening their ability to destroy currencies at whim.

In the picture painted by Prestowitz, the implication is that China has won through following this policy. It is now increasingly evident that they may have actually set in motion their own catastrophe.

The simple truth is that, as countries like China use unfair trade measures to gain advantage, imbalances build up as a result, and the world system goes out of kilter, requiring ever more government interventions to stave off disaster, but creating the foundations of the next round of disaster. China has built up a massive trade imbalance, but in doing so has sowed the seeds of their own downfall, because they have quite literally destroyed the wealth of the market on which their own growth in wealth was dependent.

Instead of allowing their currency to float, they hold it down, and hope to support their own economy by exporting into the west, thereby pushing the West further into the ground. All the time, they are destroying their customers, and doing so at the cost of holding their own people in relative poverty. As a simple example, allowing the RMB to float freely and rise would dramatically pull down the cost of Western medical equipment, and allow for cheaper and better health care. One of the key reasons for Chinese people saving so much is the cost of health care as this is largely provided on a cash payment basis. That very high savings rate holds back the growth of their internal consumption of their own production, as well as the products from other countries. The result of the RMB rate is an artificially high cost of medical equipment and medicine. This in turn feeds into the cost of medical care, and this feeds into higher savings rates, and this feeds into less domestic consumption. In other words we can find just one small impact of the artificial currency level and see that it is just one of the many small distortions that ripple through markets as the result of government interventions, leading to its own problems, its own imbalances.

The implication of writers like Prestowitz is that China is winning in this great game of beggar-thy-neighbour. However, as we view the slide of the Chinese economy, it does not look much like a winner. It will not be long before the trade barriers start to go up in retaliation, or the collapse of their export markets sucks them down. In either case, they can not win in the long term, and the cost for China may be very high indeed. It might be that they see the kind of instability that leads to bloody war and revolution. Returning to the little ripple caused by health care costs, the switch to internal consumption in the Chinese market is, in part, held up by the very distortions that have led to the rapid economic expansion. As their exports collapse, they need that switch to the internal market, but one of the reasons for consumers keeping their wallets closed is the cost of health care, and that is partly the result of the mercantilist policy on currency.

I have just chosen one example of the problems that the Chinese government intervention in the exchange rate creates, the cost of health care. However, it is if we imagine a full float of their currency that we see the extent of their difficulties. If they float the RMB, China will likely collapse. With so much accumulation of foreign reserves, such a strong balance of trade they are in a position where any float would see the RMB soar to astronomic levels. The result of such a change would be to wreak destruction on their export machine, and create a massive inrush of imports. Whilst they might retain a strong balance of payments position, they would see large sectors of their export industry wiped out overnight, as well as seeing foreign companies suddenly emerging as effective competitors within their own markets. Quite simply, the artificial exchange rate has insulated their business from tough competition.

In short, they have accumulated this massive reserve of power and wealth, the massive accumulation of foreign reserves, at the cost of trapping themselves. They must keep exporting as a large part of their economy is structured towards this goal but, in doing so, they are impoverishing and destroying their customers. The only way they can save their customers is through a move to fair trade, but the destruction to their economy of such a move would see their country likely collapse into chaos. If they keep going as they are, their customers will go bust, and they will eventually collapse with them, and if they abandon the policy that is destroying their customers, they will also collapse. If their customers call time on their unfair trade, they threaten to sink the $US, but in doing so China will destroy the massive reserves they have accumulated, along with their customers. They could try to manage the rise in their currency, but they would still need to make the rise in the RMB fast enough to prevent a trade war, and to prevent the destruction of their customer base. The shock would still be too great.

In other words, their quasi-mercantilist policy allowed them to grow at a rapid rate, but the rate of growth has turned out to be an illusion. One way or another, they sink or swim with those upon whom they directed their mercantilist policy. A balanced and fair trade policy might not have offered such astounding rates of growth, but the rate of growth might have been sustainable and solid.

In one of the posts on China that I linked to, I suggested that China was balanced on a knife edge, that as the Western economies crumbled, maybe China had the capability to soak up the losses with growth in internal consumption. However, their mercantilist export policy meant that this was never going to be possible. They could have allowed their reserves, for example, to be used to pay for the building of a system of health insurance, or a basic social security net. Such a move would have allowed for their people to have the confidence to spend some of their huge reserve of savings. They need not have followed the expensive and overly complex state models of the West, but come up with at least some form of security for their people. Now it is too late. They can not change the savings culture of their people overnight, and can not therefore stimulate internal demand. They can not overnight structure their economy from their reliance on exports to the West.

Had their currency been free floating, they might not now have their reserves, but there might also have been a better balance of growth between export and internal growth. The massive growth in their industry might have still been export oriented, but not so fatally so. Furthermore, with a free floating exchange rate, their rise would have been more measured, and not led to the destruction of the customers that provided for that growth.

As it is they now own the massive reserves of currency, but the question arises as to how those reserves might be deployed without destroying the value of those reserves. In order to utilise those reserves, they need to start buying things from the US, with most of their reserves held in $US. However, their mercantilist policy has left the US in a position where they have less and less to sell to the East. What does China want from the US, that is does not now manufacture at home? Yes, there will be some things, but they will be relatively expensive because they have trapped themselves in their own currency game. The only way that China will be able to use those reserves will be to sell large amounts of the reserves and, in doing so, destroy the value of those reserves. Their massive reserves are, in other words, valueless paper.

I hope that this is becoming clear. Whatever China does now, the imbalances that it created have left it with no options for riding out this crisis. If they float their currency they fall into chaos. If they fix the rate at which they maintain their exports, they will suffer retaliation, or simply proceed to economically destroy their customers. Yes, they will accumulate yet more reserves of yet more useless paper...but to what end?

Their mercantilist policy once looked to be a very clever road to success, and has given them economic power. The trouble is that the economic power they have gained as a result is as illusory as the apparent economic success in the West over the last ten years. It is the economic power, to borrow a phrase from the cold war, of Mutually Assured Destruction. They can not escape the fact that their economic fate is entwined with the West, and they are now locked into a morbid lover's embrace with the West, even as the west plunges over the cliff edge.

Is this a case of free market failure? I think that it would be hard to pin the blame on the free market under such circumstances. One of the great balances of trade, the rate of exchange of currency, was allowed to be manipulated. This manipulation caused imbalances that a floating currency would long ago resolved.

However, there is another guilty party in all of this, and that is the US. In this respect, I agree with the analysis of Prestowitz. The US has issued useless paper on a scale that is quite simply astounding. As Prestwitz says, the attitude has been:

If the Chinese are foolish enough to exchange low-priced consumer goods for cheap U.S. paper, let the party continue.

So the Chinese exchanged their hard earned currency for what is now evidently useless paper. And the exchange was one in which the Chinese exchanged their hard earned labour by lending to the consumers who would then buy their goods, and would repay that debt with ever more paper with ever less value.

The US has used its position in the world currency system, has abused its position, to pour ever more paper into the world markets to fund their own boom in consumption. The same argument, to a lesser degree, can be made of many other Western countries, such as the UK. However, whilst they followed a similar route, none could manage the scale of the US, where the strength of their status as a reserve currency gives them so much more potential to get away with it over such a long period of time. I have said it before, and will say it again, the $US is the biggest bubble that the world has ever known.

However, the issuance of the useless paper is not a great money for nothing scheme that will hurt the Chinese. The US may have got huge amount of product in exchange for useless paper, but it will eventually hurt the US too, as it will eventually bounce back to the US as a horrendous devaluation of the currency which will destroy the wealth of the American people.

Once again, the bubble is not the result of a free market failure, but is the result of government central banks being able to issue fiat currency. If they were constrained by ensuring that the money had some underlying contractual value, such issuance of money would never have been possible.

Once again, this is not the failure of markets, but the manipulation of markets, of debasing the value of the very thing upon which markets are built - money. In one sense, yes, there has been a market failure. The US should have been punished for the irresponsibility of its actions a long time ago. However, once again, the markets have been distorted, with governments around the world, again with China as a good example, following mercantilist approach such that they have followed policy of actively seeking to accumulate $US reserves. This is not demand to support trade between countries, but a modern misguided attempt at the accumulation of 'bullion'. The market did not create demand for this bullion, but government policy. If there were just the purchase of $US for trade between countries, then the bubble would never have grown as it has done. If it were trade alone that determined the value of the $US, it would have sunk long ago, as the $US just does not produce enough that others want to buy. Quite simply, there is relatively very little demand for the $US to allow trading with the US.

So we have a debased $US.....

.....and if you thought that the manipulation of money already detailed were not enought, Jeremy, a commentor, posted a link to a Youtube clip in which experts on gold discuss the interventions of central banks in the gold markets. One of the most important points of the discussion (I believe) was the consideration that gold is a competitor to fiat currency. In particular, there has been a significant move of individuals into private holdings of gold. I have discussed at some length that fiat currency is built entirely on confidence, and the move into gold is indicative of the erosion of that confidence. Again, I recomend this clip, as it is very illuminating. One of the points that is raised is that central banks have been shown to be regularly intervening in the gold markets. The interviewees debate why on earth central banks, issuing fiat currency, might have any interest in the gold market. As is identified at the start, gold is still a competitor to fiat money, so the only explanation for the interventions that makes sense is to hold the value of gold down, to make it unattractive in relation to the fiat money. Again, there is government intervention in markets, and in this case in support of their own increasingly debased fiat currencies.

Then we come to the other market distortions that have allowed the US to continue to borrow and issue useless money. One of the greatest distortions can be found in the Basel accords, in particular Basel I. As I have detailed in my previous post on the banking system, the accords actively encouraged banks to buy up issuances of government debt. OECD sovereign debt is a key constituent of the capital adequacy ratios of banks. It is quite extraordinary that banks have been actively encouraged to lend to governments. The idea that governments should borrow at all is in any case quite absurd, but that rules for the financial system should be implemented to actively encourage lending into governments just heightens the absurdity. As I pointed out a long, long time ago, such lending pulls money away from the private sector and only serves to increase the cost of capital for the private sector, which has to compete with the ever growing government deficits by attracting higher interest rates.

For the sake of convenience, I will quote my post on Government borrowing:

Another reason why government borrowing is influential is best illustrated by a simplification. I am an individual investor and wish (for whatever reason) to make an investment in £GB. I will be faced with a range of choices for where I might to wish to put my money. For example, I may wish to lend into the consumer markets (e.g. putting my money into a building society account where it will be used to provide mortgages), or invest in companies (e.g. stock market), or I can lend to the government (e.g. bonds) and so forth. In each case I must make an assessment of risk and reward. If we take the example of lending of money to the government through the purchase of bonds, these kinds of bonds are considered to be 'no-risk' (a misnomer - as they do have risk) and therefore are highly competitive in the respect that they are relatively very safe investments (in some cases they even allow for inflation). By comparison non-government lending looks pretty risky.

In this situation, my investment decision would, if all investments were offering the same yield, be to go for the government bonds. Why take a risk on putting my money into unsafe instruments such as consumer lending. As such, non-government competitors must offer me a premium over lending to the government in order to give me an incentive to invest my money in their asset. As such the government becomes a formidable competitor in the market for where I invest my money, and set a benchmark on the minimum yield I will accept. In doing so, they are distorting the markets, and setting an effective minimum interest rate in the market.

And this is just the start of the negative effects of government borrowing. For more detail, you may wish to visit the original post. Once again, we have a massive distortion in the market, a distortion in which governments can set the baseline on the accepted level of return on investments, can draw money away from investment into productive private business, and all on the basis that they have a legal entitlement to extract cash from their populations at some point in the future to pay for their borrowing.

I do not intend to reproduce my post on the banking system here, but the encouragement of lending into governments is not the only distortion that has been caused by banking regulation and the interference of governments into the banking market. What I will do is answer another of the comments that I have received. Chas H offers this point on my proposed reform of banking, which I will quote in full:

Thankyou for another well argued post. I would welcome the kind of explicit presentation of risk that you propose, but I see two obstacles to making it work.

1) We live in a culture which does not understand risk. Thus many people buy lottery tickets with a real belief that that they stand a good chance of winning the jackpot. At the same time many people become neurotically anxious about the miniscule risks to health presented by eating certain types of food.

2) We live in a risk-averse society which is burdened down by absurd legislation and precautions to remove risk.

It is for this reason that there must be bank failures on an ongoing basis, and the regulation of banks to make them 'safe' need to be abolished. There needs to be a regular reminder that risk in investment is real, and this will create caution. Such failures will help prevent systemic risk of the kind that we are witnessing. Yes, individuals will be hurt in such bank failures, but it is a discipline on the business of banking, and reminds us all that risk is real and exists. As for point 2, this is exactly the problem. Individuals are currently in a position where they can take huge risks with their money, and then, if that risk goes bad, they suffer no consequence, as the loss is absorbed by everyone else. That is the nature of the previously implicit/explicit (and now just explicit) government guarantee of the banking system. If we remove the consequences of risk, greater risk can be taken with a sense of impunity, encouraging systemic risk taking.

This leads me to a question from a regular commentator, Lemming, who asks whether capitalism and Fractional Reserve Banking can only survive in a situation of growth. The answer to this is that FRB is a matter of risk. In times of growth, the risk is on the upside, and in times of contraction it is on the downside. Even during these bad times, some investments will continue to make money. The trouble is that people just don't like losing their money or accepting that they are risking their money. It all comes down to explicit acceptance of risk. During contractions, there will be more bank runs and bank failures. As some institutions find that they have utilised their depositors funds unwisely, they will find that depositors will lose confidence in their ability to manage their money and secure returns on their investment. In all such cases they will then be subject to the risk of a bank run, in which their available cash reserves are insufficient to meet depositor demand for cash. This will just serve to ensure that people scrutinise their decisions more carefully.

It can best be summarised this way. If we think of the average person opening a deposit account in a bank, how much care do they ever take over that process? They simply look for the highest rate of interest....without any acknowledgement that their higher rate might come with a greater risk to the capital. Such is the government regulated and implicitly and increasingly explicitly backed banking system.

This is not capitalism. This is a dream of a one way bet. Risk free investment.....It is the heart of the problem that I identified in my banking reform post.

Once again, we are very far from failures caused by the free market, and can see that the root of the problems is in the regulation of markets. I give an example in my post on the banking system that directly links developments in the financial crisis to responses to the Basel Accords, and the example that is given by no less than the Bank of England. They spotlight how growth in securities was directly encouraged as a result of Basel I. Again, this is detailed in the banking post. If you read the post in full, it is evident that market failure was not the cause of the financial crisis, but rather it is the endless interventions of government.

I have given some examples here of some of the root causes of the current financial crisis, and none of them are the result of market failure, and all of them are the direct result of government interference and manipulation in markets. As hard as I look, whenever I look to the roots of the problem, I find not market failure, but rather problems that are the direct or indirect result of government interference, manipulations, and regulation of markets.

A long time ago, I listened to a recorded lecture from the von Mises Institute. I can not reference it here, as I forget the details of where I found it or who the speaker was (apologies). One of the key elements of the lecture was that Marx got it fundamentally wrong when he said that he was describing the capitalist system. He was, in fact, describing a mercantilist system, and the reason why Marx's analysis was so wrong was that he thought he was analysing something that was in fact something else.

As I have written this post, this observation came to mind. People are readily describing the economic crisis of today as a failure of free markets. It is nothing of the kind, but represents the distorting effects of governments on markets. There has been no free market, but rather a series of market interventions. What we are seeing are ripples of chaos that emerge from the many distortions in the markets created from those interventions.

One distortion is the withholding of labour from the market, followed by the sudden release of that labour into the market. Another distortion that followed is the artificial currency exhchange rates that allowed the accumulation of worthless paper, issued because government has been allowed and encouraged to borrow, and allowed to run a policy of endless expansion of money. Meanwhile, the banking system has been regulated into ever more distorted activity, and the regulation offered guarantees of the system, encouraging horrendous risk taking through a promise of an unlimited guarantee of the system.

Mercantilism, government intervention, regulation and distortion of markets. If we wish to find a culprit for all that has happened, it is not the fault of free markets, but it is the fault of the endless interventions in the markets. Quite simply, blame for the mess we are in is being put in the wrong places.

Note 1: My apologies for not answering the many comments but, as you can see, I became somewhat distracted.

Note 2: Mercantilist is not a very good term, but it does appear in the dictionary, and seems more convenient than discussing the subject as an 'ism'.