Green Shoots of Reality

As time moves forwards, it is possible to see that the mainstream media eventually catches up with the underlying realities of the current economic situation. It is interesting to watch how they take cautious steps, with a few commentators daring to speak the unspeakable, before eventually the rest of the 'herd' follows suit.

We are once again at a point where this process is accelerating, and the realities are starting to finally sink in. In this particular case, the solvency of the US and UK are now finally being questioned in a trickle of articles, hyper-inflation is being considered seriously, along with the end of the $US as a reserve currency.

The first article that is of particular interest was passed on in a comment on my last post by 'anon82', and is an article by Willem Buiter. I have highlighted this article as the author is part of the financial establishment, and therefore his opinion might be considered to carry a considerable weight. Throughout this crisis, he has veered a fine line between the delusions of conventional economic wisdom, and the heresy of accepting economic reality. In his latest article, he discusses the state of the UK economy, and is effectively accepting that the UK is structurally bankrupt. I strongly recommend the full article, as the excerpt below does not do the article justice:

As the government deficit explodes over the next few years, the actual primary surplus is likely to be primary deficit of around 8 or 9 percent of GDP. As the economy recovers, tax receipts will rise and cyclical public expenditure will decline, but the rest of the public expenditure programme (health, education, pensions) will keep on rising in real terms and as a share of GDP. It is easily conceivable that when the output gap is closed again, in 4 or 5 years time, there will still be a primary deficit of five or six percent of GDP. That means that a permanent reduction in the primary deficit will be is required of between 6.5 and 7.5 percent of GDP.

Essentially, Buiter has realised that the government is simply spending more than it can ever repay, and is accepting that the only realistic way out of the problem is to inflate away the debts. However, even with such an analysis, he is still not fully understanding the severity of the structural problems, as he still overestimates the underlying position of UK GDP. He is not accounting for the fact that, even now, GDP is being flattered by the activity that follows from the government's ongoing massive borrowing. As regular readers will know, GDP measures economic activity, which includes the activity created by debt based consumption (if this is new to you, you may want to read this post from October 2008).

I first wrote of the UK being structurally bankrupt in July 2008, and expected that the market would quickly realise that this was the case (I thought it would take six months). The point I was making in my article was that government deficits were going to balloon. I realised at that time that, as the downward economic spiral took place, revenues would collapse and expenses would explode. This would combine with a structural deficit, and plunge the UK economy into a deep crisis as creditors to the UK took fright.

At the time I wrote the article, I had not imagined the extreme policy that government would take in reaction to the crisis, and now believe that the final outcome will be worse even than I envisaged at that time. However, the important point about Buiter's article is that he is starting to recognise the structural nature of the problem. He is starting to see that this is not a short term economic crisis but rather a crisis in the very structure of the economy.

Buiter is not alone in starting to question economic assumptions. I have long been highlighting the similar points about the US economy as for the UK economy. Ever more analysts are likewise starting to question the sustainability of the US economic policy, and this questioning is emerging in the mainstream. In particular, the bland acceptance of the reserve status of the $US is finally being questioned, which has been a theme of this blog. In January of this year, I devoted an article to the subject - a response to reading on so many occasions that the reserve status of the $US would save it from collapse. It is not a post that is amenable to a short quote or summary so, if you have not read it, you may wish to read it now (see here - it is a long post!).

Since writing the post I have been tracking the moves of China to replace the $US with the RMB as a reserve currency (e.g. here). The latest news is that that Russia is again proposing development of a new reserve currency (SDRs - see here) to the BRIC economies (Brazil, Russia, India, China). The $US was immediately hit by the talk, indicating the inherent weakness of the $US.

The important point here is that there is now an acceptance that the reserve status of the $US is not a fixed feature of economic reality. Reserve status needs to be rooted in underlying economic strength if it is to be maintained, and more and more questions are being raised about the nature of the US economy. For example, there is a recent article in the Wall Street Journal that asks 'Is Your Portfolio Ready for Hyper-Inflation?', and in another article by CNBC, the many risks in the US economy are laid bare. In other words, the talk of hyper-inflation is seeping into the media, along with the increasingly dire prospects for the US economy (I have long been discussing the potential for hyper-inflation e.g. December 2008).

What is finally happening is that the mainstream media are starting to accept that the current activity of government and central banks will, in the end, have negative consequences. It is no longer a few lone voices - bloggers, conspiracy theorists, and the occasional maverick - but mainstream commentators, nation states, politicians and economists who are increasingly questioning the sustainability of the Western economies.

I have previously written about the mainstream 'getting it', in the follow on from the UK budget. However, the endless talk of 'green shoots' drowned out the cynicism. What we are once again seeing is the 'green shoots' of acceptance of reality. I suspect that this time the momentum, and the withering of the green shoots of recovery, will carry the acceptance of reality further forwards into the mainstream.

I have just completed an article for Huliq and a further article of Trade and Forfaiting Review (both submitted today for publication, so not yet available). The two articles take very different approaches, but both emphasise that something profound has taken place in the world economy. That profound change has been the theme of this blog.

Whilst it is positive to see that the mainstream are now finally accepting that the situation, and the responses of government, are leading towards disaster, the problem remains that they are still fixated on the wrong explanations for the economic crisis. In particular, they still actually believe that the financial crisis caused the economic crisis, rather than seeing that an underlying economic crisis caused the financial crisis.

This is a matter of ongoing concern. Without an accurate understanding of what went wrong, of the underlying causation, a recognition of the severity of the situation will still not necessarily lead to solutions that might resolve the crisis. In particular, there is a need to recognise that the entry of China and India into the world economy has seen the world labour force double, and that such an input of new labour (one of the key inputs of economic activity) is at the heart of the crisis. As I have explained elsewhere in this blog (e.g. my most recent discussion can be found here, or an earlier discussion here), this has created an era of hyper-competition, and the traditionally wealthy countries have yet to adapt to this situation.

As such, whilst it is encouraging to see that there is a greater acceptance of reality, there is still a risk of continuing to pursue solutions that fail to address the underlying problems. In particular, the only long term solution is to adapt the economies of countries like the UK and US to meet the challenges of hyper-competition. The only way that might be achieved is through deep structural reform of the economies. As Buiter recognises in his article, there will be strong resistance to such reforms, but without such reforms there can be no eventual recovery.

In short, the recognition of the depth of the crisis is a start, but there is still a long way to go before we might start to see solutions that might make a real difference. My worry is that it will take the full severity of the crisis arriving before the world finally addresses such solutions. I further worry that, at that time, it will be too late.....