Saturday, November 21, 2009

The King Canute Economy

I have had a good day in browsing through the economic news, as I found three very interesting articles which together represent a consistent theme (although I say lucky, I mean only in the finding but not the implications of the content). The first of these comes from Ambrose Evans-Pritchard, the second Peter Schiff, and the last Liam Halligan. For the former, Ambrose Evans-Pritchard, I often disagree with his analysis, but can not dispute that he often identifies some fascinating stories on the economy. Today, I came across an article which is of particular interest, and some highlights are given below:
In a report entitled "Worst-case debt scenario", the bank's [Societe Generale] asset team said state rescue packages over the last year have merely transferred private liabilities onto sagging sovereign shoulders, creating a fresh set of problems. [this was exactly my argument at the time the first bailouts were being undertaken]

[and]

Governments have already shot their fiscal bolts. Even without fresh spending, public debt would explode within two years to 105pc of GDP in the UK, 125pc in the US and the eurozone, and 270pc in Japan. Worldwide state debt would reach $45 trillion, up two-and-a-half times in a decade.

[and]

Inflating debt away might be seen by some governments as a lesser of evils.

If so, gold would go "up, and up, and up" as the only safe haven from fiat paper money. Private debt is also crippling. Even if the US savings rate stabilises at 7pc, and all of it is used to pay down debt, it will still take nine years for households to reduce debt/income ratios to the safe levels of the 1980s
I strongly recommend reading the article in full. All in all, this is not far from the kind of scenario that has long been painted on this blog. Shifting debt from the private sector onto the public sector, at exactly the time that the public sector would be starved for revenues, was always going to be a disaster.

In another article Peter Schiff, a long term bear, touches on another theme of this blog - the role of China in the world economy, and the artificial low level of the RMB in relation to the $US. The SocGen report and Schiff's report are actually just looking at two sides of the same equation. If we put the two reports side by side, it is apparent that both of the reports are actually discussing exactly the same problem - which is that governments have sought to replace private debt with government debt, and that the only route out of the debt is eventual currency devaluation. In replacing private debt with public debt, the imbalances in the world economy will be maintained. This is an extract from Schiff's article:
While the peg certainly is responsible for much of the world's problems, its abandonment would cause severe hardship in the United States. In fact, for the U.S., de-pegging would cause the economic equivalent of cardiac arrest. Our economy is currently on life support provided by an endless flow of debt financing from China. These purchases are the means by which China maintains the relative value of its currency against the dollar. As the dollar comes under even more downward pressure, China's purchases must increase to keep the renminbi from rising. By maintaining the peg, China enables our politicians and citizens to continue spending more than they have and avoiding the hard choices necessary to restore our long-term economic health.

[and]

As demand falls for both dollars and Treasuries, prices and interest rates in the United States will rise. Rising rates will restrict the flow of credit that is currently financing government and consumer spending. This change will finally force a long overdue decline in borrowing. So, not only will Americans lose access to the consumer credit that funds their current spending, but the things they buy will also get more expensive.

Our short-term loss will be in sharp contrast to the gain felt by foreigners, who will be rewarded with falling consumer prices and a more abundant supply of investment capital. In other words, the American standard of living will fall while that of our trading partners will rise.
As for Liam Halligan's article, he reports on a report from the OECD as follows:
Less prominent was the admission that: "The upturn in the major non-OECD countries, especially in Asia and particularly in China, is now a well-established source of strength for the more feeble OECD recovery". So the Western world is relying on the emerging markets – the far-flung economies of the East – to pull them out of this slump.

The West's debt-soaked consumers, firms and governments badly need to "de-leverage" – which channels resources into interest and repayment costs, rather than expansion. The likes of Brazil, China, India and the others, meanwhile, have far, far lower debts than their Western rivals, so can spend the next few years "levering-up" – taking on more credit, in turn fuelling growth even more.

All of these articles relate to and article I wrote a long time, explaining the underlying change in the world economy, and which explained the economic crisis as the shift in wealth generation from West to East. In particular, the opening of the East saw a sudden massive expansion of the labour force (labour meaning with access to capital, markets and technology).

My argument was that the massive credit and housing bubbles were simply masking the underlying change in the world economy that flowed from the supply shock of new labour into the world economy. I have written several versions of the article, but my version on Huliq is a short version and can be found here (note: there is an error - zero sum 'gain' should be 'game'), or a fuller discussion can be found here.

What we are seeing in the reports and the analysis of the three articles cited here, is the process of governments seeking to hold back and resist the fundamental change that has taken place. The change that I am referring to is that there is a massive redistribution of wealth, and that there is now a situation of hyper competition throughout the world. In an article for Trade and Forfaiting Review magazine, I explain this in simple terms by making a comparison between the fortunes of SUV car manufacturers and the Tata Nano car:

While the US and, to a lesser extent, Europe are seeing catastrophic contractions in their car markets, the Tata Nano has a massive waiting list among Indian car buyers, keen to upgrade from two wheels to four. The contrast between the old industry, perhaps best exemplified by General Motors, and this innovative upstart illustrates the new shape of the real-world economy.

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 of US 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.

The point is that SUVs represent a concentration of car-owning wealth in the hands of the few, and the Nano is the shift of that car-owning wealth into the hands of the many. It is representative of the underlying shift in real wealth, which is redistributing towards the East, and levelling down the West in the process.

It is a crude characterisation of the change in the world economy, but many large companies such as GE are already changing their product lines to meet these changes. The middle of the market has shifted down whilst broadening. The problem is that these changes are real, and are taking place now. Governments are seeking to withstand the reality of the changed circumstances of the world. The trouble is that, as much as any government might resist the change, it is unstoppable. Nobody is going to put the 100s of millions of new workers back in a box - and there are still large reserves of labour ready to enter the market.

It is only when the economy is seen in this light that we can truly see the madness of government policies - whether the policy of China, the US or the UK. Each country is seeking to maintain an equlibrium that never actually existed. The credit and housing bubbles in the West flattered the underlying condition of economies such as the UK and US, and the world economy was misdirected to feed the illusion of wealth in the West. The overall structure of the underlying economy is the Tata Nano economy, but all governments are seeking to maintain the SUV economy. In doing so, the imbalances are becoming ever larger, as ever more is owed by the current account deficit countries to the surplus countries. The growth in the imbalances is simply going to make the final adjustment ever harder.

I call this the 'King Canute Economy'.

In the legend of King Canute on the sea shore, it is popularly represented that King Canute was so arrogant that he actually sought to hold back the tides. However, King Canute was actually demonstrating that, for all his power, there were some forces which he could not overcome. As we contemplate the actions of governments around the world, it is possible to wonder whether they have ever heard King Canute's story.

In the case of King Canute, he ended up with wet feet. In the case of the world economy, the consequences might not be so mild.

18 comments:

  1. A large amount of the OECD government debt could be cut right down by nationalising the banks and writing off or restructuring the debt, in a way that minimizes its impact on the real economy.

    Peter Schiff is utterly wrong to believe that the US requires debt financing from China or indeed any other country.

    A fiat money system with a central bank allows the banks to create all the credit needed in the domestic currency for the private sector, and governments can simply have central banks buy excess bonds, if there is a short fall in the public domestic purchasing of bonds (as indeed was the standard practice in many post-World War II Western countries like Australia, using the so-called "tap system" of financing government debt).

    As I have pointed out in the past, the belief that monetizing government debt is inherently bad or that it inevitably leads to hyperinflation is utterly wrong.

    Some other comments:

    Nobody is going to put the 100s of millions of new workers back in a box - and there are still large reserves of labour ready to enter the market.

    No, but Western economies can use trade and industrial policies to maintain their industrial sectors, just like Germany.

    The overall structure of the underlying economy is the Tata Nano economy, but all governments are seeking to maintain the SUV economy.

    Then the solution is government policies to direct investment towards better, cheaper and more fuel efficient cars and other types of industry needed today. Yet again industrial policy is the key.

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  2. Peter Schiff is also wrong to say that

    "As demand falls for both dollars and Treasuries, prices and interest rates in the United States will rise. Rising rates will restrict the flow of credit that is currently financing government and consumer spending."

    He clearly still thinks with a "gold standard" mentality, and doesn't understand how a fiat money system actually works.

    Just like Japan in 1990s, the US could run large fiscal deficits for years and still keep its interest rates at near zero. The US Fed has, and always will have, the power to do that.

    The real danger is not fixing the
    zombie banks that could kill the real economy. Not fixing them was a major mistake made by Japan in the 1990s.

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  3. Hi Cynicus

    interesting analysis amongst the madness as usual. Now that all this debt is owed by the US government what's to stop them from saying thanks for all the stuff but we're cancelling the debt. Any issues with that speak to our extensive nuclear arsenal and multiple carrier groups. They can then rebuild their manufacturing base behind high tariff walls with the fed providing any needed credit.
    Another scenario is the debt, deficits and zero interest rates build up the imbalances until a tipping point is reached. See http://johngaltfla.com/blog3/2009/11/18/the-day-the-dollar-died/ for a scary and entertaining imagining of what could happen.

    FiatPete

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  4. @Lord Keynes
    I really despair that your solution to every problem seems to be bigger government, more control & more regulation. I hope you are not anywhere near any levers of power. That would be terrifying.

    @Cynicus
    Thanks for the post. Your overriding point seems to be that slowly, surely, people are coming around to your way of thinking. I've noticed a fair bit of that myself, just lately.

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  5. I realised I forgot the link for a discussion of America using it's military might to reset the imbalances and cancel the debt. See http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/6575883/China-has-now-become-the-biggest-risk-to-the-world-economy.html for the original article and comprehensive comments. Also I wonder how much China relies on American grain imports. Lack of food leads alot quicker to riots than lack of flat screen TVs.
    FiatPete

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  6. I really despair that your solution to every problem seems to be bigger government, more control & more regulation. I hope you are not anywhere near any levers of power. That would be terrifying.

    I find this fairly amusing.
    So presumably you find Sweden or Germany terrifying?? After all, virtually all the policies I recommend can be found there.
    Perhaps you break out in cold sweats at night at the thought of the UK becoming like Scandinavia?

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  7. The Rational MartianNovember 22, 2009 at 7:58 PM

    I have to say LK has a point. The policies he is recommending, while far from the utopian free market ideal that many of us, including myself are fond of, seem most likely to work in a society where free markets are not run by hare-brained nitwits with a direct line to the Treasury.

    After all, China's success today owes mostly to state directed economic policy.

    In my view, either we should have really free markets with banks folding like nine-pins as a consequence of their broken balance sheets, or we need a publicly run utility banking sytem, like roads and highways, to cater to the basics and let the speculators live or die by their luck. At this time, we're stuck with the worst of both worlds.

    To quote Deng Xiaoping, it doesn't matter if a cat is black or white, as long as it catches mice.

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  8. Please Read, the article is from someone who experianced the collapse of his country.
    http://www.silverbearcafe.com/private/10.08/tshtf1.htm

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  9. Sorry, url should read.
    http://www.silverbearcafe.com/private/10.08/tshtf1.html

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  10. I think CE is saying that whatever is done to 'fix' the problem, the underlying cause is still there - that the standard of living in the US / UK is unjustified in terms of productivity of these countries.
    We are living off past glories, with the illusion maintained by credit.

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  11. Off topic, but I trust everyone here is enjoying the CRU 'Climategate' scandal?

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  12. What happens if the state turns off the life support machine?

    http://www.spiked-online.com/index.php/site/article/7750/

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  13. Another great article. I'm wondering what you make of what is going on in Dubai, right now. Do you think it shows that the east needs to start selling to the east, rather than the west? I am assuming that Dubai is in trouble, because rich western investors are far thinner on the ground now.

    Also, hav you thought about offering advertising on your site? I run a business, http://sellmyclothes.co.uk which buys clothing and other items from the general public, in the uk and would be very much interested in advertising as most of your traffic is British.

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  14. With Climategate and this Copenhagen summit coming up, I've been thinking more about the ideas behind 'Climate Change'. Does anyone else read ulterior motives into it?

    For example, is this just the West's ploy to kill off Asian competition? Is it a way of imposing 'One World Government' in the area where it really matters: economics? Is it a way of dissipating the effects of 'Peak Oil'?

    I'm not suggesting that the CRU people were consciously part of a global conspiracy, but that they were on a bandwagon that is potentially very convenient for an awful lot of governments.

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  15. Have to say i have been reading your blog some 14 months now and what you have been saying over that time is now very main stream in all the none red tops.you have been well ahead on the curve.

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  16. I don't think it's a conspiracy so much as Western countries being away from the equator. If climate change happens, it's the hottest, poorest, and most populated areas in the world that are vulnerable. There have even been studies that have linked warm climates with poverty in third world countries. Something about hot weather that makes people lazier.
    (http://www.npr.org/templates/story/story.php?storyId=106697286&ft=1&f=1001)
    Peak oil will damage the United States and maybe Britain the most. They are the only two powers that still have delusions of grandeur about competing directly with the emerging global economies. Much of the EU has modest expectations for their economies and standard of living. Their modesty might be attributed to their proximity to Muslim extremists and their shrinking native populations.

    There is no conspiracy. The developing countries with the research funds are keeping tabs on the climate and (even North Korea) looking at their crop yields. They don't want political instability.

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  17. Blogs are so informative where we get lots of information on any topic. Nice job keep it up!!
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