In a recent post, I sought to understand why I had called the collapse too soon, and suggested that perhaps the mechanism was anchor prices, an idea proposed by Dan Ariely. Essentially, this is the idea that the first price we see anchors our price expectations, and I extended the idea to the value of economies. In one example, if I recall correctly, Dan Ariely identifies how DVD players started off very expensive, and how, as the price reduced, we had a sense that they were bargain prices - even though all DVDs were less expensive. We were still fixated on the original price, not the price now.
I raise this example as, one way or another, despite our natural tendency to anchor, prices do indeed fall. In the case of the Western economies, we are starting to see the shift in the perception of the value of the economies, though the 'stickiness' of the anchor is still there.
This brings me on to the news, which indicates that S&P have put the UK's rating to a negative outlook, a move that is often a precursor to a sovereign downgrade. I have long been waiting for the markets to 'get it', and have long been puzzled that it has taken them so long. However, this is not necessarily a reason to conclude that the 'end' is now nigh. A metaphor might express the situation, which is to see the anchored valuation of the UK economy as a dam, and this is an additional crack in the structure of the dam. Just as with a dam slowly developing cracks, with the structural integrity weakening with each new crack, it is hard to say which crack will finally result in the deluge.
In my discussion of the climax of the crash, I speculated that the £GB would be the first to fall, and that the $US would follow after. In saying this, I recognised the inherent stickiness in our valuations of economies, and saw a necessity of the £GB falling in order to create enough of a crack in the dam to see the $US fall:
From my point of view, it will be the collapse of the UK economy that will be needed to shatter the belief in the US economy, and will be the final impetus to push the $US over the edge. Such a collapse might even see a brief run to safety into the $US, before the realisation hits that it is a run into dangerWe have this quote from the Times, in which the latest US bank insolvency is discussed:
Investors were also concerned that the US may be next in the firing line after Standard & Poor’s sounded a warning about Britain’s AAA credit rating.What is happening is that doubts about the sustainability of both monetary and fiscal policy in the UK and US are steadily leaving ever more, and ever deeper, cracks in the dam. However, the belief that the US must come through this economic crisis remains, and therefore I still believe that only a £GB rout will finally destroy the $US. However, as the dam analogy makes clear, this is at best only a guess, as there are many other cracks that are appearing, and they might cumulatively be enough to burst the dam.
When I first started to suggest a $US collapse, I was probably seen by many as being a lunatic out on the fringe. The view of the fragility of the $US is increasingly spreading into mainstream thinking. I flicked through the headlines and conveniently found this article in the Financial Post:
The nature of the fragility of the $US is not, however, as simple as it might first appear. Another article perceptively highlights one of the underlying problems with the idea of a $US collapse, by pointing out that all of the major currencies are looking very 'ugly' at the moment:
The U.S. dollar's day of reckoning may be inching closer as its status as a safe-haven currency fades with every uptick in stocks and commodities and its potential risks - debt and inflation - are brought under a harsher spotlight.
Ashraf Laidi, chief market strategist at CMC Markets, said Wednesday a "serious case of dollar damage" was underway.
"We long warned about the day of reckoning for the dollar emerging at the next economic recovery," Mr. Laidi said in a note.
Mr. Laidi said economic recovery would weigh on the greenback as real demand for commodities, coupled with improved risk appetite, caused investors to seek higher yields in emerging markets and commodity currencies. This would draw investment away from the U.S. dollar, which was dragged down by growing debt and the risk quantitative easing would eventually spark a surge in inflation.
The British pound has been a beneficiary, rising on May 21 to a high against the dollar this year of $1.58. But a downgrade of the UK's outlook by Standard & Poor's has just taken the wind out of the pound's sails. The rating agency's assessment is a timely reminder that it is not just the US which is running a double-digit government deficit, doubling its debt in the space of a few years and praying that money printing - £125bn in the UK's case - will generate economic recovery.If we put ourselves in the mind of a scared investor, it is increasingly difficult to see where exactly we might want to place our wealth, such that it can be secured in these turbulent times. All of the major economies are in free fall, whether Europe, Japan, the UK or the US......What the investor is left with is the 'emerging market' economies, and these have traditionally been seen as the markets with the greatest risk.
The euro, too, has been winning admirers. Yet its previous chaste appeal - in the form of German opposition to money printing - has been tarnished a little by the European Central Bank's decision to buy E60bn of covered bonds. The ECB considered buying more than twice that, according to Bloomberg. That is hardly surprising given the eurozone's slump is so shockingly deep. The German economy shrank 6.7pc in the first quarter from a year before. The comparable dip in the US was 2.6pc. Now which currency is the ugliest of them all? [emphasis added]
On the one hand we have the high anchor valuation of the traditional leading economies, and on the other we have the risks associated with the emerging markets. It is no wonder that the signals from financial markets are so confused.
Added into this mix, we must also factor in the extraordinary actions of the Western governments, in particular the policy of Quantitative Easing (QE, or printing money). The UK and US are both embarked upon this policy, both countries are using the policy to support their bond markets, and both countries are steadily expanding the policy. The major overseas purchasers of the bonds are now becoming increasingly restless, and suspicious that the policy is going to lead to an inflationary default on debt, as is highlighted in a recent article:
For now, the dollar doesn't appear to have anything going for it. The US Federal Reserve has cut its benchmark interest rate virtually to zero. Worse, it is printing money and using the freshly minted cash to buy US Treasuries. The Chinese, the US's biggest foreign creditor, have made it quite clear that they take a dim view of this "policy mistake", as China's central bank put it. Undeterred by eastern frowns, some Fed governors have been gunning for even more money creation to buy bonds, according to the minutes of the last Federal Reserve meeting.Just to add to the toxic mix of Western policy, the EU has also started down the road of QE, though as yet they are not buying EU government debt with their freshly printed money. However, for the UK and US, overseas creditors are increasingly worried about the credit worthiness of the countries. The negative report from S&P is an indicator of the worries for the UK, but the signs are also not positive for the US. Russia is now shifting reserves into Euros, The Democratic Party in Japan is threatening to only purchase US debt denominated in Yen (making funding of US debt a Japanese election issue), and China is shifting its mass of $US debt into short term instruments out of fear of US inflationary policy.
However, the policy of QE, rock bottom interest rates, and massive government borrowing and spending might be enough to prevent the real collapse in the economies in the very short term. As I have often pointed out, this is a short term fix with very high long term costs. As such, for domestic purposes these policies may serve the politicians in the short term, but only at the price of destabilising their ability to raise finance in the future, and even greater general economic damage later. This is at the heart of the worries of overseas creditors.
One of the arguments that has, in the past, been provided for the stability of the $US was the reserve status of the currency. Even this foundation for the $US is increasingly being questioned, and I have long been writing about the many activities of China in which they are gradually positioning the RMB as the replacement reserve currency. A search on Google news produced a flood of articles on the subject, of which the following is just one example:
Once again, my early posts on the subject might have been seen as the ravings of a lunatic, but nevertheless the idea of an RMB reserve currency is gaining increasing credibility. The only difference now between myself and many commentators is that they see the shift as being long term, whereas I see it as a rapidly accelerating process. I suspect that the difference lies in the fact that they are not recognising the vulnerability of the $US, and that if the $US does collapse, it will not be able to retain reserve status. In other words, they are focusing too much on the RMB's growing strength, rather than the inherent weakness in the $US.
May 15 (Bloomberg) -- The yuan may gain as much as 5 percent against the dollar this year as China promotes wider use of the currency, according to Bosera Asset Management Co., the nation’s second-largest fund company.
China has signed 650 billion yuan ($95 billion) of foreign- exchange swap agreements in the past six months with countries including South Korea, Argentina and Belarus and plans to promote the use of the currency in cross-border trade. The renminbi may become one of the world’s three major currencies within 30 years, joining the dollar and the euro, Li Quan, executive vice president of Bosera, said in a telephone interview yesterday.
“Demand for yuan-denominated assets will grow as China is trying to make the yuan a global currency,” said Shenzhen-based Li, whose firm oversees 178 billon yuan of assets. “At the same time, concern about dollar devaluation will prompt investors to inject more capital into emerging markets, especially China.”
What all of this amounts to is that the shift in the shape of the world economy is slowly becoming visible in financial markets.
However, this is not the whole story.
One of the other points that I have previously discussed in the blog is that the world economy is pointing in the wrong direction, which is towards illusory wealth of Western consumers. I have suggested that, in order for recovery to take place, account must be made for the shift in wealth around the world. In a recent article for the Trade and Forfaiting Review, I used the Tata Nano and the US car industry as an illustration of how the movement of wealth will shift economic structures:
The important point about the Tata Nano is that it is meeting a new demand from a rising middle class in emerging economies. In the interim, the credit-fuelled demand for SUVs, the mainstay ofSince writing the article, I saw another article in which the shift in the structure of the world economy is already becoming apparent:
car industry profits (until recently), is collapsing. On the one side there is a car that rests upon an unsustainable credit-fuelled consumption boom, a car that flattered the aspirations of the indebted, and on the other there is a car that meets the rising aspirations of the world’s new wealth generators. US
I have long argued that the financial crisis is a symptom, not the cause of the underlying economic crisis, and it becomes ever more apparent that this is the case. The boom in house prices and credit bubbles simply masked a more profound underlying change, whilst magnifying the consequences. Whatever happened, the wealth was shifting to countries like China, but the indebtedness of the Western economies has made the change more devastating, and also has hobbled the ability of the West to recover.
General Electric yesterday became the latest big manufacturer forced to change course and make cheaper and simpler products to cope with the decline in purchasing power around the world.
The US engineering and financial conglomerate, which makes medical scanners, joins companies such as Sony and Unilever in seeking to develop less complex, better value products that will tempt customers in the face of the global recession. The shift away from cutting-edge technology and premium brands towards value for money is affecting a broad swath of businesses, from medical diagnostic equipment to soap powder.
GE is moving billions of dollars in research funds away from developing high-specification medical equipment towards lower-cost technology. Over the next six years GE Healthcare will devote half its $1 billion R&D budget towards low-cost products designed for use in emerging markets and remote areas, up from only 15 per cent today, John Rice, GE’s vice-president, said.
In the meantime, the governments of the Western world are seeking to sustain an economic 'shape' that was itself a product of an illusion. The change in the shape of the world economy has already taken place, and is just now become clear to see. As the illusion is dissipating, the world, the markets and individuals are starting to see the underlying reality. It is primarily the governments of the West that still seek to persuade us that we are in the illusory world that has already passed from existence, and seek to persuade us that it is still within reach. It is an illusion that flatters our dreams and aspirations, and is therefore an illusion that is aimed at a receptive audience. It is pushing at an open door.....we want to believe....
An interesting comparison again comes from Dan Ariely in a lecture that he gave recently (see video here). He shows a picture of two tables, where the length of the tables is an optical illusion in which one looks longer than the other - but they are in reality both the same length. Even having demonstrated that the tables are the same length, we can not help but still see one table as longer than the other. If you see the image below, it is possible to see the illusion in action. I can tell you that the tables are the same length, but still they appear to be different (image from here)
We have a resistance to seeing reality.
Even when we are told something is real, we can not help but hold on to our original perceptions. Whether the length of the tables, or our anchor valuation of the economy, we are sometimes resistant to abandoning our previous perceptions.
As we look on at the shift in the world economy, it is possible to see how enduring the illusions are. Even as ever more evidence mounts to suggest that we are witnessing a different shape, still we cling to the illusory world of old. We are still insistent upon the illusion that the West is still wealthy, that one way or another, it simply must be. Every day another measure tells us that the size of the economy is an illusion, but still our perceptions revert back to the illusory size.
The problem is that reality is still reality. Just as we must accept the reality that the tables are the same size, so must we accept the real size of our economies. It is this wilful disregard of reality that is, in part, driving us ever deeper into the ditch. I suspect that many in government have started to grasp the reality, but they are clinging on to and promoting the illusion, if only for their own selfish ends.
The underlying purpose of this blog has been quite simple. I have sought at every stage to paint a picture of the underlying reality of our economic situation. In doing so, at many stages, I am sure that I have been seen as raving, of being an 'end is nigh' doomster. The trouble that arises is that, as the economic crisis progresses through each stage, the scale of the disaster is becoming increasingly evident. What might have been viewed as ravings of a doomster eventually creep into the mainstream. Whilst getting some points wrong, the general thrust of the thesis of the blog appears to be correct.
The thesis is that the West is not, and will not be, as wealthy as it thought. A major change has taken place, and there is no prospect of reversing that change. Western governments, with their profligate interventions, are simply denying the world that sits before them. In denying reality, they are simply pushing the decline ever further, and to a point where any recovery of our former wealth becomes ever more impossible.
As with any other commentator on the economy, perhaps I am also subject to illusions, and might be perceiving an illusory world. The trouble is that, as time has progressed forwards, the world looks ever closer to the one in my perceptions. It is not a heartening thought.....
Some responses to comments on the last post.....
Jonny, in response to your question about how the Bank of England might cause deflation in the RPI, perhaps the BoE February inflation report will clarify. I hope this is the right report, but they point to lower interest rates impacting upon the RPI. I was going to quote from the report, but my Internet connection has gone into a tailspin, such that it is very slow today (rather frustrating...). Apologies for not being able to offer up the quote (assuming I have the right publication and date).
Anon82, I think that you will find that my post on the US economy may shatter any illusions of any significant recovery. Many of the points might apply to the UK economy.
Gingellenator, I have discussed the inflationary default for a long time across many posts. I would like to provide you with a link, but this is an argument that has evolved through several posts. As such, time allowing, I might pull the thoughts together at a later date.
Sobers, you are quite right to question how QE might be reversed. You might note that there are no credible or serious plans for this, just vague assurances. It is hardly comforting.....
Anonymous, on the subject of the Bloomberg house price article. I am very impressed with your dilligence, and am unsuprised to find that yet another positive indicator is not at all positive.....For curious readers, you may want to compare and contrast the following two articles:
Adam, thanks for the Austrian view on inflation, which is an interesting contribution, in particular as it is so relevant to the post.
Clauswitz, thank you for your kind comments.
Kecske, thanks for the link to the article on hyper-inflation. I had picked this one up on Reddit. It is certainly interesting, but I have some reservations. I would like to discuss these, and may come back to it in the next post that is relevant.
Anonymous and Anonymous82, many thanks for the links on the S&P downgrade....very useful.