Friday, October 30, 2009

The UK: Individual Liability for Government Debt

My original plan for this post was to highlight the disconnect between the stock market and the underlying state of the UK economy. However, there may be the start of a panic in stock markets, so it may be that the disconnect is starting to correct itself (see here for the UK and here for the US). As such, I will devote this post to a more general discussion of the current state of the UK economy, and the relationship between government debt and you as an individual.

Before starting, it is worthwhile providing some context on the UK economy. UK GDP sunk again in the third quarter, and the following are some of the reactions of analysts to the news:

James Knightley, ING

"UK 3Q09 GDP is awful with no positive news within the report ... More worryingly from sterling's perspective is the fact that the UK may be the only major economy to have contracted in 3Q09."

Brian Hilliard, chief economist at Societe Generale

"Very disappointing, the surprise comes in services where the business surveys seem to have been a little over optimistic. So we are significantly lagging the euro zone in terms of exiting the recession."

Unlike these analysts, I would not have been encouraged even if there had been 'growth' in GDP, as I do not believe that 'growth' derived from government debt accumulation is 'growth'. It is simply the foregoing of future wealth. I have written on this subject many times, and you may wish to read my most recent post on the subject (in relation to the US, but the principles are applicable to the UK). The key point is that GDP measures flatter the underlying state of the economy, as government debt accumulation drives GDP upwards.

As for more general indicators, over the last 12 months we have had a $bn 130 trade deficit, industrial production is down 11 percent on a year ago, and the official unemployment rate is just under 8% (from the economic and financial indicators in the Economist print edition). For the last indicator, I think that most people now recognise that the official measure is a fiction, and real unemployment is actually much higher.

Although there has been a brief uptick in sterling, the general trend appears to be relentlessly down:
But given the extent of the pound's rebound this week and lack of any major UK economic data or event on Friday, some analysts say the pound may give back some of those gains as attention turns to the Bank of England's policy meeting next week.

[and] "We have little doubt that the long-term fundamentally based sterling outlook has remained convincingly bearish, but there is a window where sterling could develop a `dead cat bounce'"
At present, the only significant increase in output comes from the Bank of England's printing presses (not literally, as they no longer physically print the money), and this may well be about to accelerate:

The Bank announced yesterday that it had reached its current £175 billion limit in asset purchases under its scheme of QE [quantitative easing, or QE - a euphemism for printing money], but the majority of City economists expect that it will seek permission from the Treasury to extend this limit next week.

Two thirds of the 62 economists surveyed by Reuters this week said that they expected QE to be extended by at least £25 billion, with many forecasting a £50 billion increase.

Yesterday’s money supply figures came after dire gross domestic product (GDP) figures last week, which showed that the economy was still in recession in the third quarter, contrary to economists’ expectations.

Regular readers will know that this printed money is being used to purchase UK government debt, and that it is therefore supporting the government's expenditure. It must be remembered that this printed money does not represent any kind of real growth in the UK economy, and simply (temporarily) hides the underlying state of the economy. I highlight this point because of the complete irresponsibility of government borrowing is being supported by the Bank of England (more of that later).

So what is the state of the government debt in the UK. The first problem is the matter of how to calculate debt. In a recent post on Conservative policy, I was encouraged to have identified that they are going to include Private Finance Initiatives (commonly known as PFIs) in the national accounts, a these have been used to hide government liabilities:
The Financial Reporting Advisory Board (FRAB), a body which advises the Government on its accounts, has indicated that the Treasury's previous definition of what PFI debt should fall on its books should be scrapped. A FRAB working group said the way the Government accounts for PFI makes it too easy for it to manipulate the figures so they either fall inside or outside its own debt totals.

The finding, which is expected to be endorsed by the FRAB, undermines recent calculations from the Office for National Statistics finding that only £5bn worth of PFI debt should be added to the national accounts. Its figure was far shy of the combined £48bn value of all PFI projects - but only because NHS debts were classified as belonging to the private sector.

The FRAB's working group warned that many of the PFI debts were being left off the balance sheets of both private and public sectors. It has urged the department to withdraw the system no later than 2008-09.

In addition to this, there are the many liabilities that are simply unfunded and unacknowledged. This is a report that describes the analysis of total government liabilities by the Centre for Policy Studies:
Brooks Newmark, the Conservative MP for Braintree, Essex, says in The Hidden Bombshell, published today by the Centre for Policy Studies, that government debt is actually £2,200 billion. In the book, Mr Newmark argues that the UK’s public sector net debt is equivalent to £85,610 per household and in the last year has risen by £346 billion — or by £11,000 a second.

Mr Newmark arrives at his figure by saying that official numbers do not take into account the full cost of projects financed through the private finance initiative (PFI), which by his calculation adds £139 billion to the public debt. “A major attraction of PFI is that, in theory, it transfers the risk of failure of a project from the Government to the private sector. However, in reality, the Government carries most of the risk ... £139 billion is a cautious figure as it does not include local PFI projects, some of which may fail,” Mr Newmark says.

Unfunded public sector pension liabilities, which the Government will need to pay, are also omitted and add a further £1,104 billion. Contingent liabilities, such as Network Rail, add another £22 billion. Finally, the £130 billion cost of recent interventions in the financial sector needs to be factored in — bringing the total “hidden liabilities” to £1,395 billion and the total debt to £2,200 billion.

You will note that there is some significant variation in the figures between the two reports above. However, whichever way the problem is regarded, the liabilities of the government far exceed the official liabilities. As such, the official figures for UK government debt and liabilities are gross distortions, if not outright lies.

We are now (I hope) all aware of the rate of growth in the UK's debt, which is increasing at an astonishing rate. The latest news suggests that the government does not think the rate of debt accumulation is enough, and are planning to further increase spending:

GORDON BROWN is planning a final public spending spree to help pull the economy out of recession and put pressure on the Conservatives over their plans for deep cuts.

The prime minister is keen to use the autumn pre-budget statement to announce a new “fiscal stimulus”, with billions of pounds of extra money for housing, infrastructure projects and training.

Recent figures showing that Britain is still in recession have convinced Brown that more spending will be required next year to support any faltering recovery.

However, perhaps the most worrying part of this is that the overall debts have been generated both through the 'good' and 'bad' times, and the recent spending spree just accelerates the trend. The worry this creates is that the deficit is structural and, looking forward, there is every sign that the problem will get worse. For example, the figures given above do not address the problem of government revenues, which will be strained due to demographic changes:
The population of the UK is ageing. Over the last 25 years the percentage of the population aged 65 and over increased from 15 per cent in 1983 to 16 per cent in 2008, an increase of 1.5 million people in this age group. Over the same period, the percentage of the population aged 16 and under decreased from 21 per cent to 19 per cent. This trend is projected to continue. By 2033, 23 per cent of the population will be aged 65 and over compared to 18 per cent aged 16 or younger.

The fastest population increase has been in the number of those aged 85 and over, the ’oldest old‘. In 1983, there were just over 600,000 people in the UK aged 85 and over. Since then the numbers have more than doubled reaching 1.3 million in 2008. By 2033 the number of people aged 85 and over is projected to more than double again to reach 3.2 million, and to account for 5 per cent of the total population.

As a result of these increases in the number of older people, the median age of the UK population is increasing. Over the past 25 years the median age increased from 35 years in 1983 to 39 in 2008. It is projected to continue to increase over the next 25 years rising to 40 by 2033.
This is a dual problem. As people get older, they demand more resource from the state, and as the population ages, the size of the tax base also diminishes. In other words, the output within the economy is going to be constrained at the same time as government costs will rise. If the UK currently has a structural deficit, this structural deficit is going to grow. Even if, and it is a very big if, the UK were to return to genuine economic growth, it will need to be very significant growth to offset the effects of demography.

The fundamental problem that the UK is facing is that there is no sector of the economy that is currently offering such opportunities for real economic growth. I have, on several occasions (even in the Guardian newspaper Comment is Free section) asked for answers on where the growth in the economy might come from. The problem was that I asked for specifics; which sector, and why the sector might grow? I have never once had a clear answer.

Without such growth, the borrowing of the UK government can not be sustained. Moreover, the current contraction in the economy may linger for many years to come (and I believe will become far, far worse). In sum, the structural size of the deficit is likely to continue to grow. In the face of this politicians of all hues simply hope that (as if by magic) the UK will grow itself out of debt, without ever explaining how. This is a hope with no foundation whatsoever. The world has changed and is a more competitive place, and there is nothing to indicate that the UK is well placed in the competition. It returns to the question of which sector will produce the growth.

All of this serves as context for the current state of government borrowing. Even with the massive levels of government borrowing, which flatters the actual state of the UK economy, the UK economy continues to shrink. Not only is the borrowing expanding at unprecedented rates, it is expanding faster than forecast, and that is before the latest proposed increase in spending:
Figures from the Office for National Statistics show that national debt is now equivalent to 59% of the UK's gross domestic product after borrowing grew by £14.8bn in September, compared with £8.7bn for the same month a year ago.

Total net public borrowing now stands at a record £824.8bn, up from £695.2bn (48.4% of GDP) a year earlier.

The £14.8bn borrowing in September was, however, lower than economists' expectations of £15.3bn.

The Treasury has officially stated that it expects borrowing for the current financial year to reach a record £175bn but economists expect it to be revised higher in the Pre-Budget Report, expected next month.

Vicky Redwood of Capital Economics said: 'At this rate, borrowing still looks likely to reach over £200bn, compared to Alistair Darling's £175 billion forecast.'

The fiscal position is indeed dire, and the problem is just going to get worse. Furthermore, even as government revenues continue to collapse, along with the collapse in the UK economy, there are still no firm plans to address the gaping deficit. The Conservative party is making some vague gestures in the direction at reducing the rate of debt accumulation, but not actually addressing actual reduction of the debt:
George Osborne, the shadow chancellor, laid out a detailed “austerity package” at the Conservative conference last month with £23 billion of cuts to Whitehall spending, quangos and public sector pay.
This is hardly an 'austerity package' but represents some tinkering at the edges, and I suspect that much of it will disappoint if enacted. I would normally give a figure for the debt that is accumulating, but will instead point you to the UK debt clock here. When you look at the clock, you should note that this is based upon treasury forecasts, not the real size of the actual debt. You will note the speed of the accumulation. Even on such inaccurately low figures, the debt is as follows:

£13,536 for every individual in the UK. That includes children, pensioners and the unemployed, none of whom contribute to servicing the debt. And it is growing at a record rate.

If the Centre for Policy Studies is correct that the real liability is three times the official figures, then the liability is nearly £40,000. However, within these figures there is a mix of potential and actual liabilities, so that it is hard to see where the final debt might lie. Even if we were to accept that the real liability is just half as much again, then the figure would jump to something like £20,000 per individual. And I repeat, it is growing at a record rate.

The purpose of this discussion is to highlight something about government borrowing - that the borrowing is actually being undertaken in your name, and that you are liable for the borrowing. Barring a few quasi-commercial entities, the only income the government has is the income of individuals and businesses. I highlight this point, because it always sounds more comforting when we hear the abstracted terms 'government borrowing' and 'government spending'. The terms hide the essential reality that the government is adding debt that you will pay. It seems an obvious thing to say, but I am not sure that most of us really overcome the abstract way that government debt is presented.

A useful way of thinking of government debt is if the government borrowing were to appear in your letter box every month in the same format as a credit card statement, with your individual share of the debt allocated to you. Although there is considerable argument about the real state of the overall debt, imagine if each person in your household were to receive a statement showing a debt of £20,000, and a demand for repayment of a percentage of the total debt (to continue the credit card analogy). This is what you would see on the credit card type statement over the last year:
  • Your monthly payments on the debt
  • The debt increasing faster than your payments
  • The minimum payments on the debt increasing in absolute terms
  • The increase in debt reflecting in a higher amount of interest repayments per month, as you are paying more and more just to service the previous debt
  • The speed of the increase in the size of the debt accelerating at an ever faster pace
  • An overall massive increase in your debt
  • That a greater proportion of your income will be needed to service the debt, month on month
If you were to see this on a real credit card statement, and if you are financially responsible, you would want to know that your future income would certainly increase, your costs were about to decrease, or a combination of the two. Without this you would be worried. The trouble is that there is every indication of increasing costs and decreasing revenues, so most sensible people would call a halt, before getting into deeper debt. The answer of the UK government is to increase the rate of debt accumulation.

Returning to the arrival in the letterbox of our personal portion of the government's debt obligation, how might your children feel if they saw their statement suggesting that they already hold a debt of £20,000, and they can see that the obligation is growing at an ever faster rate? Furthermore, how might they feel if you tell them that their share of the debt, by the time they start working, will grow as there are ever less people actually servicing the overall debt. The demographic change means that they will see more and more debt loaded into their statement, as the numbers of individuals retiring from the workforce increases. Their debt burden is set to explode, unless there is a magical period of hyper-growth of real output within the UK economy.

The debt on the statement that you hand to your child will already be something like £20,000, and, I am guessing that they will not have too much optimism about the future. Not only will they have to pay for the huge interest on the debt, maintain repayments on their share of the debt, they will also have to pay taxes for current expenditure.

The problem is that we have simply become used to thinking about these government debts as abstracted from ourselves as individuals. If you think of opening your credit card type statement, and seeing this actual debt accruing, you would be outraged. The way that the government gets away with profligacy is by abstracting away from the reality that they are putting you in debt. It is in their interest that you never see the debt in this way, but the reality is that this is what is actually happening. For example, when the government spends money to stimulate the economy, it is like you spending money on your credit card. In both cases your personal debt obligation has increased, in both cases activity in the economy increases. Whilst government pays a lower interest rate than you might (for the moment at least), in both cases your personal debt burden has increased.

The point of this post is to serve as a prompt for you to think about the underlying reality of what the UK government's debt means for you as an individual. It is not really the government's debt, but is in fact your debt. The government will not pay back this debt, you will. The politicians pretend that debt accumulation is a solution. But how convincing a solution would it appear if the consequences were to appear every month in your letter box, in the same form as a credit card bill? I suspect that the pseudo-intellectual arguments that are presented to the public would never withstand such an open approach. If the reality were presented in this way, not as an abstraction, you would see the justifications for the accumulation of the debt for what they are. Fantasy or outright lies.

Whatever your personal political affiliation, my suggestion is very simple. When the government borrows money, take it personally. It is you that they are putting in debt. When minister 'x' of minister 'y' self-importantly makes an announcement of spending more on 'a' or 'b', think of how it might look on your credit card type statement.

Take it personally because they are adding to your personal debt

Note 1: The credit card type statement is, of course, an impossibility due to the overly complex tax system, and changes in each individual's life circumstances seeing alterations in their share of the obligation. Also, for some individuals, such as the retired and unemployed, they would not see any obligation at all on their statement. However, I hope that it is an interesting way of seeing government debt.

Note 2: There are more calls for expansion in quantitative easing, and I am certain that the Bank of England will continue. Inflation has finally fallen close to the 1% point at which they must write a letter of explanation. This from the Telegraph:
The Bank's Monetary Policy Committee, which is meeting this week, will be pushed by economists to raise the amount of bonds and gilts it plans to buy by a further £50bn, following the recent news that unlike almost any other major economy Britain remains mired in recession. The increase would mean the Bank would soon be holding bonds worth more than 15pc of Britain's entire economy in its balance sheet – unknown territory for any developed world central bank in modern history.
The only problem with the scenario of falling inflation is the weakening £GB, which will see inflation imported in higher prices for goods from overseas. Just as I predicted a continuing inflation before QE, specifically because of the fall in the value of the £GB, the same will happen again. Just as before, there will be a time lag due to orders already in the system, but inflationary pressures will reappear. Whilst the $US has also been suffering, and trade is still (for the moment) largely priced in $US, the UK economy is in a worse state than the US, is printing proportinally more money, and the £GB will therefore trend lower against the $US over the short to medium term. Comments on this welcomed.

Note 2: It seems that the UK is about to break up the too big to fail banks, which is a rare piece of good news. It appears that this is being imposed upon the government by the EU, rather than being domestic policy. However, it is happening, and it is finally something with which I can agree. On the other side of the coin, I suspect that there may be some further interventions and other shenanigans, but have not had a chance to look into the detail. If you have more details, please feel free to add something on this, as it may be a while before I post again.

US Economic Growth Deconstructed

I had planned a review of the UK economy and stock market, but I was overtaken by the news that US economy ‘grew’ by 0.9 percent in the third quarter. A fairly typical explanation for the growth can be found in a Telegraph article as follows:
The primary reason US economic output has rebounded so strongly is the slug of growth contributed by state programmes, including "cash-for-clunkers" and similar stimulus schemes.
As such, I thought it might be worthwhile to return to the well worn subject of GDP growth. What we are seeing is the mirage and magic of statistics. I will explain this as clearly and simply as I am able through an analogy, and show why this is all 'magic' growth.

Imagine that I am a farmer, and that my output of food is not quite enough to feed my family. As a result, I have frequently turned to my neighbour, who has each year lent me enough food to make up for the shortfall. As each year goes by, I am borrowing more and more from my neighbour, and I am starting to owe him a great amount of food overall. Finally, one year, a river floods and damages many of my crops and drowns some of my animals. My output is reduced to an even lower level, and I am going to struggle to meet my family’s needs.

Once again, I turn to my neighbour, and ask to borrow even more food to take my family through the next year. He agrees and loans even more food than on previous occasions, and I add the borrowed food to the store of my own farm’s output in the barn. At the same time, I also do something to address the problem of the shortage. I decide to change the systems of measuring the output of my farm. For example, instead of counting my units of corn in whole kilograms, I change the units so that one unit becomes three quarters of a kilogram. With my new system, I now measure my output from the current year as all of the food in the barn, and find that I have increased my output of units of food overall for the year.

I look at the large pile of food in the barn, and behold that, despite the problems of my lack of output of food; I have actually achieved an increase in output. There are more units of food in the barn than in comparison with the previous year.

As my generous neighbour is lending me so much food, he comes around to visit my barn, and see how I am running things. As reassurance, I count out my units of output, and show him how much my output has increased. I am very pleased with myself, and I smile with pleasure as I count the units. Then I note that my neighbour is frowning and I am puzzled to find that my neighbour does not share my pleasure.

He asks whether I am going to repay him in the old units of kilograms or the new units of three quarter kilograms. Now I start to frown, and suggest that he does not understand the situation. For every unit he has lent me I will, of course, return one unit as a repayment. I am a little grumpy. Can he not see that my output has grown? Can he not see that, if I can keep up this rate of growth, I will achieve a level of output that will allow me to easily pay him his food back? I wonder at his lack of confidence in me when I have demonstrably improved my output.

I am left wondering that my neighbour simply does not understand output. My neighbour is left wondering how much longer he will continue to lend me food.


I finally got around to reading this week's copy of the Economist magazine. On reading the magazine, I was struck how many of my views which were previously considered radical (if not barking mad), are now mainstream. There was even one section where they contrasted financial wealth with 'real' wealth, which is almost a perfect mirror of my first article, 'A Funny View of Wealth' (which predicted the economic crisis in the UK). The Economist also addressed the relationship between the US and China, and much of their analysis mirrors the analysis I offered a long time ago (though with different outcomes), and the same applies to the prospects for the $US (again with different outcomes).

I should also mention that I predicted a $US collapse for April of this year and got it wrong. However, the possibility of a $US collapse is now being discussed in the mainstream. What I am really saying is that, in about 6 months time (a wild guess), expect to be reading that the growth in the US economy was not genuine growth at all.

Saturday, October 24, 2009

The US - The Real Economy and the False Economy

Do you remember the stress tests for the banking system in the US? They were the subject of negotiations by the banks with regards to the outcomes, making them remarkably relaxed stress tests. There was an assumption in the stress tests for an unemployment rate of 8.9% (a curiously precise figure), and 10.3% in 2010. The unemployment rate had already reached 9.8% in September, with expectations of further rises. In other words, the worse case scenario was not indeed the worse case scenario.

Despite this, it appears that business as usual is continuing in the world of banking. When we consider that the stress tests were heavily negotiated and the worse case scenarios are being broken, this is a puzzle.

The real economy is, as you would expect, having an impact upon the banks. Bank of America, the second largest lender against credit cards is reporting massive losses on their lending, and bank failures continue at a shocking pace (106 so far this year). And then there is the exploding numbers of mortgage foreclosures, including prime loans, such that foreclosure counsellors are being deluged with requests for assistance. Commercial real estate loans in default have now reached about 6% of all loans. Small and medium size businesses are seeing continuing high levels of arrears on loans, with those that are moderately delinquent increasing (but a tiny fall in the numbers that are severely delinquent). PIMCO are warning of ongoing high levels of defaults on corporate bonds, but S&P are offering a more sunny outlook than their previous forecasts, but still at a high level.

Some might point to the positive increases in industrial output, and suggest that there is a genuine improvement on the horizon. However, it is not perhaps as bright news as it first appears:
September's increased output was due largely to a 3.5% increase in durable output, including a 7.4% increase in the production of automotive products. Nondurable output increased 0.5% in September. Within major industry groups, manufacturing output rose 0.9%, mining output rose 0.7%%, while utilities fell 0.7%
The first point of note is the increase in automotive production, which is likely the final residual effects of the 'cash for clunkers' stimulus working through the industry. This from the Wall Street Journal:

Retail sales fell 1.5% in September with the end of the "cash for clunkers" program, but consumer spending rose in many categories, lifting hopes that the economic recovery is gaining momentum at the start of the holiday shopping season.

Excluding sales of autos and parts, total retail and food sales increased 0.5%. It was a welcome sign of consumer activity after the deepest downturn in a generation. August sales were revised downward 0.5 percentage point to a 2.2% increase. The government's monthly retail-sales tally isn't adjusted for inflation.

The same article goes on to say the following:

Indeed, sales at motor-vehicle and parts dealers plunged 10.4% in September, following the expiration of the "cash for clunkers" trade-in program. But consumers spent more on smaller and less pricey items. Sales at clothing and accessories stores grew 0.5%. Restaurants, bars and grocery stores gained 0.2% and furniture sales rose 1.4%, in part because home sales have stabilized with help from the government's $8,000 tax credit for first-time home buyers -- a credit that is due to expire Nov. 30.

While they are heading back to stores, many consumers are doing so with trepidation. After a three-month shopping hiatus, Lauren Madrid, a 26-year-old who works in communications at a San Antonio university, returned to her regular haunts -- the mall and Target Corp. -- in August. But Ms. Madrid said she was making fewer shopping trips and going with a mind toward buying specific items. "I didn't buy a stack of T-shirts I'd never wear," she said. "Instead, I bought a cute summer dress that I knew I'd wear and appreciate properly."

The essential problem is that unemployment increases will continue to eat into consumer spending, and for those in employment, there is a shift from credit based expenditure to saving money. With the US economy having been distorted so far into credit based consumption, there can only be expansion in credit defaults across the whole US economy.

What this amounts to is the simple reality that the underlying point of the banking system, loans to individuals and commercial entities, is not a sector in a good state of health. In fact, in aggregate it is looking very ugly. A recent article in Forbes had this to say:

Do banks know something the rest of us don't?

Despite pressure from politicians to take federal bailout money and lend it to companies and consumers to kick the economy out of its doldrums, banks continue to horde cash in dizzying amounts.

Weekly data released Thursday by the Federal Reserve show excess reserves held at the Fed--the equivalent of banks stuffing bills into shoe boxes for storage--topped $1 trillion this week, a record, after climbing steadily since the markets froze up last October.

This is really no surprise. At this moment in time, would you want to be lending into the US economy? For all of the talk about recovery, the banks know that the economic crisis has a long way yet to run. They do know something that 'the rest of don't', and that there is no realistic prospect of a real recovery in the US economy. Despite this, the media, government organisations, and politicians continue to talk up the economy. For example, the Beige Book, the Federal Reserve's review of the economy, has offered a relatively upbeat review, albeit with caveats:

The Federal Reserve's Beige Book released on Oct. 21 reported "stabilization or modest improvements in many sectors," though often from depressed levels. Residential real estate and manufacturing were the more positive sectors of the economy that were helping the recovery. Reports on consumer spending and nonfinancial services were mixed, while commercial real estate was one of the weakest sectors. Transportation activity generally declined. Tourist activity was varied.

The Beige Book indicated that there were more reports of gains in activity than declines, although nearly every reference to improvement was qualified. That's consistent with what we've seen from the data and heard from Fedspeak. Regarding wages and prices, Districts generally reported little or no increases, but there were occasional references to downward pressures.

What we are seeing here is a positive spin upon the most modest of indicators, and disregard for the underlying state of the US economy. Of course, many will point to the stock market as a positive sign, and this article from Bloomberg appears to contradict everything I have said:

Oct. 22 (Bloomberg) -- U.S. stocks advanced for the first time in three days as better-than-estimated earnings at companies from Travelers Cos. to McDonald’s Corp. boosted speculation that the worst recession since the 1930s is over.

Travelers jumped 7.7 percent and McDonald’s climbed 2 percent to help lead the Dow Jones Industrial Average higher, while New York Times Co. and PNC Financial Services Group Inc. also rallied on better-than-estimated results. American Express Co. climbed 3.8 percent to a one-year high after Moody’s Investors Service said credit-card defaults declined.

Perhaps the most interesting part of the article is the report that credit card defaults declined, which appears to contradict the experience of Bank of America. With unemployment increasing, it is not clear what might actually be driving a decline in credit card defaults, so I view this with some suspicion. One possible explanation is that the decline is due to consumers pulling in their horns, which would mean that the relative numbers of defaults might be increasing whilst the absolute numbers are falling.

Another interesting point is that McDonald's will inevitably do well in a recession, as cash constrained consumers are more likely to trade down in their choice of food. In a recession there will always be winners as well as losers. However, this does not explain some of the positive improvements in earnings data over the estimates, and this needs some consideration. A long while back, a friend who had worked at the highest levels of a multinational FMCG company suggested that, if he were heading a company, he would manipulate the financial data to get the bad news of the economic fall-back over in one go, which would allow for earnings in the following year to appear to be positive. It does occur to me that this is a possibility, but I am unsure. However, the same Bloomberg report says the following:
Profits have topped estimates at 79 percent of the companies in the S&P 500 that have released results, according to Bloomberg data. That would mark the highest proportion in data going back to 1993. Earnings fell for a ninth straight quarter in the July-September period, according to estimates compiled by Bloomberg, and are projected to return to growth in the final three months of the year.
The point here is that there does seem to be some basic disconnects between the real economy, earnings and the stock market. With the economy in very bad shape, excepting the natural winners like McDonald's, the news should be relentlessly negative... but this is positive news due to exceeding estimates, not increases in earnings. This appears to fit with my friends assertion, but it is difficult to see how such a contention might be supported with hard facts.

What I am trying to do is paint a picture of the real economy and the false economy. On the one hand, we have banks that are now under stress greater than that which was the worst case scenario, we have huge numbers of bank failures, money being kept on the sidelines due to the terrible state of credit markets, rising unemployment, increasing numbers of foreclosures, and on the other we have a booming stock market.

Something is wrong in this picture. It looks very much like many people will be losing a considerable amount of money on the US stock market in the near future.

Note: I will probably conduct a similar review of the UK economy for the next post, as the picture looks to be very similar. This from Financial Advice:
Despite the fact that UK GDP (Gross Domestic Product) was a disappointing -0.4% during the last quarter, against an expectation of 0.2% growth, the UK stock market ended on a high today adding 60 points to 5268. But why is the UK stock market racing ahead when the UK economy appears to be going into reverse?
An interesting point - to be continued....

I would also like to return to one of my pet subjects at some stage, which is the $US versus the RMB. The plot continues to thicken, but I would like to review the UK economy first ('events' allowing).

Friday, October 16, 2009

The Underlying Size of the US Economy

I would like to start this post with a hypothetical item of government spending, such as building an extension to a government building, and track some of the money that might be spent. The example uses the US, but the principles apply to any country. The reason for this example will become apparent later, and may be a little disturbing.

As soon as the money for the extension is approved, there will be a surge in economic activity. Project management groups will be formed, an architect firm hired, contractors will be tendering, and medical suppliers will be preparing for large orders. In this case, I will just track some of the spending as it passes to the firm of architects. Depending on the nature of the contract, money will eventually start being passed to the architect firm, and that money will arrive in the firm's bank account. Once in the account, the money will be used for a range of purposes, such as the cost of operations, cost of office space, and legal and other services. All of these economic activities will be partially supported by the government expenditure. For the next movement of the money, I will concentrate on the salary paid to the workers in the firm, and in particular one of the architects.

Let us imagine that one of the the less senior architects is a man who works on the project for 6 months, and all of his pay is therefore coming from the hospital extension project. We might imagine that the architect is an average type of individual in a professional occupation, and that he is married with a young family and earns $100,000 per year. We can therefore imagine his spending, with his income covering a mortgage, payment on a car loan, and fairly large expenditure on consumer items, and consumption of services like trips to restaurants. All of these will be paid with government money. If we just consider the example of expenditure on consumer items, we might think of a toy purchase for one of the architects. He will visit a store, and we can imagine that he spends $50 on a toy for his daughter's birthday.

The $50 originates in government money for the extension, and it now lands in the till of the retailer selling the toys. The retailer then banks the money, and the money will then be utilised for a range of purposes. If we imagine that the toy has a $25 mark-up, then $25 of the money will be used to reorder the toy. The toy is made by a company based in the US, but with manufacturing overseas in China. As such, some of the money will be used to pay for the manufacturing in China, and we will just imagine that $10 covers the cost of manufacturing a replacement. That means that £15 will go to the US company, and will pay for the operations of the company and profit, with $10 'leaking out' of the US economy into the Chinese economy.

As with the architect firm, the $15 that goes arrives in the US toy company will contribute to staff salaries, pay for the costs of the office, pay for business expenses and so forth. If we imagine one of the office staff, part of the pay of the person will come from the sale of the toy, and that money has come from the architect, and that money has come from the building project, and that money has come from government expenditure. The money for the building extension is rippling through the economy creating activity....Whilst the headline amount of the money diminishes at each level, the money is utilised many times over in multiple transactions.

What I am (I hope) showing, is the way in which the money spent by government generates economic activity way beyond the headline figure of the actual expenditure. Each of the activities that the money generates, as the money use multiplies throughout the economy, is recorded in the GDP figures. It is a very complex process to track, and economists have great difficulty in trying to work out how much government spending increases activity throughout the economy. For example, one review of academic literature (see note 1) identifies that different fiscal expenditure in different situations and countries can lead to multipliers of between zero and four.

It is actually quite easy to see why the multiplier effects of government spending are so difficult to calculate. For example, the spending of government money on infrastructure such as a steel bridge might have very different effects according to the individual economy. If the economy has a strong steel industry, then the multiplier will likely be much greater, as otherwise a large portion of the expenditure will rapidly 'leak out' of the economy to pay for the purchase of the steel from overseas suppliers.

What we are therefore left with is a big question mark over how much activity each $1 of government expenditure might generate within the US economy. In light of the estimates of between zero and four, I will proceed on the basis of a multiplier of three, as the study cited suggests higher multipliers occur in larger economies. Furthermore, a large proportion of the US economy is based upon services, which again suggests a high multiplier. This means that the US might even have a multiplier of four, but I will stay with three as a more conservative estimate.

Having come this far, you may be wondering what all of this means, and why I am discussing this in so much detail. The reason is relatively straightforward. I want to give a (very, very) rough estimate of the real size of the US economy - the size if there were no borrowing from overseas. When we see that way that government spending multiplies in the economy, it is apparent that borrowing money from overseas (translated into government spending) will inflate the GDP figures more than the headline borrowing figures suggest.

Starting with the basics, the US economy for 2009 will produce about $14 trillion of GDP, the federal deficit is expected to be something like 12% of GDP for 2009 overall, and according to the Congressional Budget Office the deficit for the fiscal year (just ended)was $1.4 trillion. In order to isolate the effects of overseas borrowing, it is necessary to find out how much debt has been sold overseas. I naively thought that I might find these figures relatively easily, but this has proved to be problematic (see note 2). For example, I searched the Treasury website, and only found an 'estimate' of the overseas holdings of US government debt. Likewise, the St. Louis Federal Reserve (an excellent resource normally) only offers the following chart, for overseas federal debt holdings:

According to the chart, overseas holdings of federal debt have increased in the first six months of 2009 by $305.3 billion, making an annualised rate of overseas accumulation of US debt of around $600 billion (assuming that overseas investors continued to buy US debt at the same rate). It might be noted that the fiscal year in the US does not match the calendar year, so there is some more fudge in the numbers. However, we might make an approximation on the total amount of GDP that is actually due to the multiplier effect, by multiplying the figure by 3, which gives us $1.8 trillion.

Now at this stage, it would be normal to then minus the $1.8 trillion from the overall size of the economy ($US 14 trillion). The first problem is that some of the borrowed money will be servicing interest payments on previous borrowing ($182 billion), such that it will not create activity. The second problem is that there is the question of how much private borrowing is sourced from overseas lenders, in particular consumer borrowing. I have tried to identify how much of this borrowing originates from overseas, but have been unable to come up with any firm figures. I will therefore just take a guess at the impacts of these two factors and raise the overall total to $2 billion, implying something like $127 billion of consumer credit provided by overseas lenders (remember the multiplier of 3), an extremely conservative guess.

With the current figure of $14 trillion, the correction to remove the activity resultant from overseas borrowing would mean that the real size of the economy is just $12 trillion. In other words, something like 17% of the US economy is funded by overseas borrowing. You may note that there is a large amount of 'fudge factor' in all of this, and comments and critiques are therefore welcomed (especially from those who are more numerate than myself - which is most people).

What does this mean?

As I have frequently pointed out, measurement of GDP is flawed in any economy that has a net accumulation of debt, for the very reason that the activity in the economy includes debt activity derived from overseas borrowing. The problem becomes particularly acute when measuring the ratio of debt to GDP, as the activity from debt is included in GDP. Even more curious is the idea of GDP growth, when a country is accumulating debt, but nevertheless economists are predicting 'growth' for 2010.

The real concern is the question of what would happen if the overseas lenders were to stop lending. In this event, the US economy would quickly revert to its real size, and that would be significantly smaller than today. The results of any halt in credit provision for the US are extremely worrying, as support for a large percentage of the economy would disappear. The result would be that unemployment would explode upwards, government could not operate at current levels, and the shock would likely precipitate a broader collapse in the economy.

The problem that is faced by the government is that for the years preceding the economic crisis, the economy was also being flattered by a combination of overseas borrowing for government expenditure, but in combination with consumer borrowing that originated in overseas credit. I am guessing that, if it were possible to strip out the effect of borrowing for the three years preceding the crisis, the same kind of results would emerge. In other words, I believe the problem is structural, meaning the current level of the economy can not be sustained. As such that there is no possibility in the near term of achieving anything near pre-crisis economic conditions unless creditors continue to fund the US at current levels.

This is improbable.

One reason is that the printing of money by the Federal Reserve and size of deficits are already alarming creditors such as China, with China giving implicit threats to stop lending. A devaluation of the $US might provide a solution to the problems by eventually return the US economy to its true size and wealth relative to other countries. However, ongoing $US devaluation will just accelerate the point at which overseas creditors refuse further lending. In other words, it will precipitate a crisis before the adjustment is completed. In the event of no further credit, the US would face the prospect of rapidly transitioning to the real size of the economy.

The only solution that I can see is for the US to first freeze the growth in borrowing, and to then implement a clear and binding plan to reduce borrowing aggressively over the short to medium term, with a clear plan for a return to surplus in five years time. This plan would give confidence to overseas creditors, and allow a more orderly transition to the real size of the economy. Such a plan would be very, very painful, as the economy would still shrink dramatically. However, it would be less painful than the sudden collapse that might take place if overseas lenders were to stop lending.

The problem is that, at present, there are no such plans. Instead, deficits stretch to the horizon, overseas creditors express their doubts, and the $US is steadily sinking. In other words, my very rough estimates may be put to the test.

Note 1: Spilimbergo, A., Symansky, S., Blanchard, O., Cottarelli, C., & Hall, W. (2009) 'Fiscal policy for the crisis', Centre for Economic Policy Research, Paper No. 7130, January 2009.

Note 2: I used the Treasury website here, and downloaded the document titled 'Ownership of Federal Securites'. Actually getting firm numbers on actual sales of new debt is very difficult, and news reports, for example, seem to focus on debt type and/or sales to particular countries. A fairly tpical example is the following report:
WASHINGTON (MarketWatch) -- Net foreign purchases of long-term securities increased to $28.6 billion in August from $15.3 billion in July, the Treasury Department said Friday. Net foreign purchases of long-term U.S. securities were $ 32.9 billion. Of this, private investors purchased $21.3 billion and foreign official institutions bought $11.6 billion. U.S. residents purchased a net $4.3 billion of long-term foreign securities. China's holdings of Treasurys slipped $3.4 billion to $797.1 billion in August. So far in 2009, China has increased its holdings of Treasurys by $57.5 billion
If you have a definitive source of sales to overseas, a link would be appreciated, or more accurate figures. I am surprised that this data is so hard to find....perhaps I am looking in the wrong places..

Friday, October 9, 2009

The Economic Policy of the Next UK Government

At this moment in time, it appears that (barring any major blunders) the UK will elect Conservative government at the next election. Several readers have asked me to discuss Conservative economic policy, so this post is a response to those requests. Before starting, I should emphasise that I do not have any particular loyalty/affiliation/position which predisposes me to any of the contenders in the election. In particular, regular readers will be aware that I have a libertarian 'lite' point of view, and none of the UK political parties come close to such a perspective. I am therefore looking at policy from the point of view of which party has the least negative approach.

The problem in making the comparison is that any comparison with the Labour Party will flatter the party with which the comparison is made. It would be difficult to do much worse than the current government. In particular, as regular readers will know, there is the ongoing problem with current policy of printing money and fiscal incontinence in conjunction with previous fiscal profligacy. The debt in the UK is soaring, and the only thing propping up the issuance of debt is the Bank of England's purchase of gilts through the weasel worded quantitative easing (printing money).

It might be noted that the Conservative party were unwilling to challenge the fiscal profligacy in the past, with their formulation of 'sharing the proceeds of growth'. As such, their past policy was to follow Labour into a fiscal black hole, by promising to match and continue the policy of growth of government expenditure. It now seems that the Conservatives have accepted that the current levels of government expenditure are unsustainable, and are starting the process of adapting their policy according to this point of view. For the most part, I will be using the Conservative policy document on the economy (available for download from the Conservative website here) as this is a clearer statement of their intent than speeches or the opinions of commentators. It is written by David Cameron and George Osborne, and is therefore a good indicator of policy.

However, before examining the policy document, there is one piece of news that I find very encouraging. David Cameron, the Conservative leader, has spoken out against the current practice of printing money:
Without mentioning the central bank, Cameron told his party’s conference in Manchester that he opposed creating money, saying “sometime soon that will have to stop, because in the end, printing money leads to inflation.”
As a result, he has been subjected to criticism, in particular from David Blanchflower, who recently left the Bank of England Monetary Policy Committee:
David Blanchflower, who left the bank’s Monetary Policy Committee in May, said Cameron’s speech yesterday was “bizarre” and if put into practice may tip the U.K. into a “depression.” Shamik Dhar, a former Bank of England economist, said “at best this is wrong and at worst downright dangerous.”
Regular readers will know that I have been firmly against printing money from the outset of the policy, and I therefore see the discussion of an end of the policy as a very encouraging point. However, it is highly unlikely that the policy can continue up to the point of the next election, so this is a moot point. This is also a wider problem in the consideration of Conservative policy. Whilst they are currently offering policy considerations (as they must), it is not entirely clear what kind of economy they might inherit. For the moment, I will put this to one side, and look at their policy as if it might be implemented now.

The first section of their document is titled 'Fiscal Responsibility', which is an encouraging start, and they appear to be serious about the idea in principle. In particular, they are proposing the establishment of an independent oversight body, similar to the US Congressional Budget Office (CBO), which will report on the fiscal sustainability of government fiscal policy. As a statement of intent, this is a positive, and inclusion of private finance initiatives on the government balance sheet are all well and good. However, it might be noted that the US is still firmly on a path of fiscal profligacy despite the CBO. Also, whilst this is a positive, the UK already has independent oversight in the form of the Institute of Fiscal Studies, which is genuinely independent.

More worrying is that the remit of the organisation will be to look at fiscal policy and consider the sustainability of the policy 'adjusted for the cycle', and a proposal that there is 'a balanced current budget adjusted for the cycle'. It is in this statement that the major concern arises. Whilst the policy discusses the consideration of uncertain forecasts, it still allows for governments to borrow money based upon assumptions of some kind of knowledge of where the economy might be in the 'cycle'. It therefore ignores the fundamental solution to fiscal responsibility, which is that, barring disaster such as war, government should have no need to borrow.

After all, the government has a massive tax base, and should therefore be able to fund activity out of current income. In particular, if the government wishes to instigate a counter cyclical policy, it should save for a rainy day, a phrase that is included in the policy document. However, their policy implies that a government can save for a rainy day, and still borrow when the rainy day arrives. Why not simply save during the good times, and spend the saved money when the rainy day arrives? There is no need for government to borrow, except in times of war or disaster. It might be noted that, as a result of past borrowing, it will be a long, long time before a government is able to actually save money for a rainy day, as they will have a long period of paying down current debt.

Section 2 of the document is also headed with an encouraging title, which in this case is 'Financial Responsibility'. However, within the document are many worrying ideas. Perhaps the most worrying aspect is that the policy sees a transfer of considerable responsibility to the Bank of England for financial stability. As I have pointed out in previous posts (e.g. here - a long post), the regulatory framework and monetary policy of central banks made a significant contribution to the financial crisis, and giving them more power appears to be a perverse solution to future financial stability.

One of the cornerstones of the policy is that the Bank of England will have responsibility for spotting market-wide risks. This sounds very appealing in light of the disaster that has overtaken the financial system, but assumes that the Bank of England can actually see the risks in advance. As I have endlessly pointed out in past posts, the Basel rules (the foundation of bank regulation) included provisions such as very low capital adequacy ratios for lending into OECD banks, and for lending to OECD governments. With regards to the former, the OECD banks were the ones that were found to be insolvent, and the non-OECD banks were the ones that came out of the crisis relatively unscathed. In other words, the understanding of risk in the financial system was 100% wrong. Furthermore, there are now question marks over the sustainability of OECD government debts, which are still treated as zero risk.

The question here is very simple. If the central banks and regulations based upon their view of risk were so wrong in the past, why on earth should they get it right in the future?

On a more positive note, the policy discusses giving the Bank of England new powers to deal with banks when they are failing. However, there is no mention of the real problem, which is the so called 'too big to fail banks'. I have largely argued against regulation, but do believe that regulation should deal with the problem of 'too big to fail' banks, and that means breaking up 'too big to fail' banks, and ensuring that no bank is of a scale that it might create a systemic risk. The one lesson of the financial crisis that cries out for new regulation is the one area that is ignored.

Instead of dealing with the underlying problem, the Conservative policy instead moves into the emotive area of 'Tackling Reckless Bonus Structures'. If the policy were to address the issue of 'too big to fail', there would be no need to tackle reckless bonus structures, as excessive risk by a bank would result in insolvency, and the insolvencies would act as a warning to other banks. The point here is that banks must be small enough such that governments feel no need to ever rescue them when they fail.

Another problem that is not addressed is the ongoing ability of banks to pay organisations to rate their standing and rate their products. Again, the Basel rules encouraged this practice by having the ratings provided by the bank paid ratings agencies used as the basis of capital adequacy. The simple solution is that financial institutions should not be allowed to pay any organisation to rate anything. Ratings should be paid for by the purchaser of the product, not the seller. In allowing the banks to pay for ratings, the development of a market for independent ratings is throttled. Again, with an encouragement of genuinely independent ratings agencies, there would be no need for regulatory interference in banking bonuses. Excessive risk would be punished by independent ratings.

Another policy outlined in the policy document is closely related to this problem. The Conservatives are proposing tighter regulation of consumer credit. Some of their proposals, such as greater provision of information, and a cooling off period for store credit cards are very good. However, they fail to tackle one of the central problems of the provision of financial information, which is that the providers of the information are often working on commission from the financial institutions. Once again, the financial institutions are paying for ratings of their products, and this should be made illegal.

Another problem they fail to tackle is the provision of so-called interest free credit. I describe this as so-called, as it is an impossibility. The only way that interest free credit might be offered is if the cost of the credit is loaded onto the selling price of the item. Under such circumstances cash buyers are subsidising the credit of others, and this is an encouragement of indebtedness. It is a fraud to describe any retail credit as interest free, as all credit has a cost (even if a cash rich retailer offers this, there is an opportunity cost). The same might be said of teaser rates, and a whole host of methods that encourage consumers into excessive debt through provision of distorted information and downright fraud (e.g. self-cert mortgages in the hands of commissioned advisers).

With regards to taxation, the picture is more encouraging. As I identified in a previous post, the taxation system is far too complicated at every level. The Conservative policy recognises this and proposes the establishment of an Office of Tax Simplification which will be tasked with the simplification of the whole tax system. Of particular note is that there will be significant oversight of the taxation system, including a commitment to preventing 'stealth' taxation. This is a worthy aim, and it just remains to be seen whether the new organisation can actually deliver on the ambition inherent in the office's name.

A more problematic area is the discussion of tax reduction. Whilst there may be arguments for and against any level of taxation, the discussion of tax reduction is a purely academic debate. In the current fiscal situation, it is unlikely that any reduction in the overall level of taxation might take place. As such, the discussion of tax reductions looks to be disingenuous. For example, they discuss a reduction in corporation taxes, but also propose a raft of so-called green taxes. In doing so, they will likely give with one hand, only to take away with another.

The instigation of the 'green' taxes also has potential to add to the complexity and cost of the management of taxation, thereby potentially undermining the stated aim of tax simplification. The real answer to the problem of taxation is genuine simplification, and I outline how this might be achieved in a post here (I have since come up with ideas as to how the proposed system could be streamlined, and will post on this at some time in the future).

The final section of the policy document again has an appealing title, which is 'A More Balanced Economy'. The analysis of the problem is very sound, as they identify that most of the 'growth' in the economy has been related to government, housing and retail/wholesale and related activities, and note that manufacturing has 'flatlined'. They do not however note that the 'growth' that these describe is actually resultant from borrowed money, so not real growth at all, but rather foregoing of future growth. It is the great myth of GDP growth, which does not represent real growth at all (see here for why).

As a solution to the unbalanced growth, they look at the essential infrastructure of the UK, including diverse policy areas such as education, welfare reform, and road building. As such, their proposals are that reform in the infrastructure will encourage improvements in the balance of the UK economy. This is a difficult proposal to evaluate without an evaluation of each individual policy and, even then, it would still be difficult to determine cause and effect in terms of the re-balancing of the economy.

One point that they do not discuss is the UK economy in terms of the world economy. In particular, there is no discussion of the mercantilism practices of countries such as China, which actively result in unfair competition in manufacturing, and also in the theft of intellectual property. Whilst the emerging economies will, in all cases, be tough competitors, the mercantilism policies utilised undermine the potential for re-balancing the UK economy. This is perhaps the single most important area of policy, how to deal with mercantilism, but it is not addressed in any form.

There is one area of the policy document that will actively work against the redevelopment of manufacturing, which is the implementation of so-called green policies. These appear throughout the entire policy document, and are largely focused on the issue of carbon dioxide emissions in relation to the idea of man made global warming. At this point, I should mention that I am a man made global warming skeptic, so you may wish to bear this in mind. However, even if believing that global warming is man made, there is a fundamental problem in the implementation of 'green' policy; it will fall hardest on manufacturers who are large energy users. These companies will be faced with increasing costs due to the green policies, and this will undermine their competitive position. This will result in outcomes that will work against the re-balancing towards manufacturing.

The reasons for these outcomes are very simple; not all countries are going to follow the same level of 'green' policy, and those that implement the strongest policy will provide competitive advantage to those that follow the weakest policy. In such a situation, all that will happen is that the carbon dioxide emissions will simply be displaced from the 'green' country to the competitors with less 'green' policy. In many cases, this will lead to higher emissions, with countries like China being less efficient in their energy utilisation. In other words, without binding standards across every country, 'green' policy will simply shift manufacturing overseas, and will likely increase overall output of carbon dioxide overall. Unless there are universal standards, this is simply a policy to encourage further declines in manufacturing.

In this analysis, I have outlined a broad brush view of the proposals of the economic policy of the Conservative Party. However, I have only covered a fraction of the detail, and have been selective in what I have examined. I would therefore suggest that you read their document in full, to see the many points and detail that I have not included. It should also be noted that some of the details have yet to be filled in by the Conservative Party.

With regards to my overall assessment, I view their approach as a positive in comparison with current policy, but that is an assessment that commences from a low benchmark. Overall, I see the policy as tinkering with the current system, with a few improvements here and there, and some profoundly negative policy, such as the 'green' elements of the policy. The most encouraging idea is the simplification of taxation, which is a long overdue reform, but I have reservations about whether this will not see new complications enacted in, for example, the implementation of 'green' policy.

Altogether, what is really lacking is a radical rethinking of the underlying principles of what government, and government institutions, are actually there for. I have discussed several reforms which address these fundamental issues (such as the post linked to earlier on taxation). I am not proposing that the posts that I have presented on reform are the only answers, or that they are the best answers, but in each post I have asked what the underlying purpose of the government is for the area under discussion.

What is lacking in the conservative policy is this questioning. What are education, welfare policy, tax policy supposed to do, and how might they be achieved? Instead, the Conservative policy document commences with an assumption that, somehow, what is policy today is the starting point, rather than starting thinking from the principles of what policy in each area needs to finally achieve. It is policy built upon the legacy of what has gone before, rather than asking what the policy should deliver, and then proposing how that delivery might be achieved. It is the reason for the tinkering approach, rather than a root and branch examination built upon the underlying purpose in the policy.

As I have emphasised throughout the blog, the world is changing fast, and is becoming a far more competitive place. There are many good points in the UK system (from my point of view), such as the universal access to healthcare. In order to be able to afford such benefits, the rest of the system must be addressed, as well as how those benefits are delivered. I have, for example, linked to the post on tax reform. One of the aims of this reform is to free up huge amounts of potentially productive labour that is currently tied up in the complexity of managing the tax system. It is only if these root and branch reforms are made that the UK will be able to continue to afford to continue in the provision of state funded healthcare. I have also posted on reform of the health service, the provision of unemployment benefits, and education.

In a tougher world, these kind of deep rooted reforms, with likely better proposals than mine, are the only way that government might actually be able to afford to continue with the many benefits that the UK has formerly provided. In some respects, the Conservative policy is going in the right direction, but I suspect that, by the time they reach government, their policy will need to face up to a much harder reality, a reality imposed by a tougher world. The UK is not as wealthy as it still appears, and is still living on overseas borrowing. At some point, that borrowing must stop, and only radical reform will allow for the UK to continue with a good lifestyle when exposed to the real level of wealth in the economy. Quite simply, there will be no room for fat.

There remains in the Conservative policy a belief that the UK is wealthier than it actually is. They are confusing the living standard that has been supported by debt with the living standard that will be imposed when the debt stops. This is perhaps the reason for their timidity. It is this failure to face up to the underlying reality of the UK economy that really leaves me unconvinced. However, perhaps by the time they reach government the reality may be so plain, that they will indeed adapt? On this I can only speculate.

Wednesday, October 7, 2009

The Great 'Shift' - China and the West

We are living through one of the times in history when a major and irrevocable shift is taking place. It will be a time that will be the subject of controversy amongst historians and, no doubt, there will be arguments about causation, about what set off a chain reaction of change. They will perhaps ponder and wonder that so many people were so blind to what was actually taking place before their eyes.

The shift that we are witnessing is the move of economic power from the West to the East. It is a well worn theme on Cynicus Economicus, that we are seeing the rise of China, and the fall of the US, and the process is now accelerating. Alongside the fall of the US, we are also seeing further declines in countries like the UK.

When I first arrived to work in China in 1997, I could see the emergence of an economic juggernaut. Sure, there were huge problems, and I encountered the legacy of communism in a generation of senior managers who were next to hopeless. Despite that, when I finally left China, I could see that the future was going to be Chinese. I could see a generation of hard nosed business people emerging.

The experience in China shaped my thinking on economics. On the ground in China I could see the massive investment from the West shaping a new and dynamic China. The Chinese welcomed us with open arms and, when I first arrived, were still somewhat in awe of the success of Western business. However, as time progressed, I also saw that Westerners were seen as a soft touch, who would overpay on everything.

The establishment of joint ventures was just one example of the many ways in which the Chinese would extract great deals. When I first arrived in China, all of the consultants were urging investments in joint ventures, and would prattle about notions such as 'guanxi', without any real knowledge of what they were talking about. The Western companies would send out a senior executive with orders to arrange a joint venture. When they arrived in China, they would be presented with four or five prospective joint venture partners, all of whom would have opaque business operations.

In the end, with all of the partners similarly opaque, the Western executive would settle on the least ugly partner. The documentation would then be drawn up, and the business would commence. It was at that point that the Western company would find out that they were supporting a whole raft of pensioners and other commitments in the joint venture. As part of the deal, the Western company would introduce new technology and process, train the management and the workforce. The trouble is that they were training the people ready for a new company to be established by their joint venture partner, and the new company would take all the technology, process and training, and open a competitor company. The competitor would be free of all of the social commitments and other costs.

Then there were the deals where, in order to win a contract, China would insist on technology transfers. I remember a GE power station turbine deal with technology strings attached, or the opening of an assembly plant by Airbus in order to secure deals in China. In so many cases, the price of doing business in China was risking the very thing that made the Western companies such a success; transfer of technology and process.

Then there is 'outsourcing', the rush to China to cut costs at the price of de-skilling the Western work force. It is not just the factory workers, but the designers and engineers who end up de-skilling. A good designer or engineer will understand the process of manufacture. Whilst there may be a legacy of good designers, as time goes by, the great design will emerge in the location of the manufacturer, and that will mean China. It will take time, but it will happen. The other trouble with outsourcing is that, as the manufacturers undertake the work, they will gain scale and experience, and will one day seek to move up the value chain. They will be in a position where all they need know is how to market and distribute their products. Outsourcing may make profit in the short term, but often at the cost of the future of the company doing the outsourcing.

Alongside this, there has been the artificial manipulation of currency by China, and no respect for intellectual property rights. The countries of the West have allowed this to take place, and now appear powerless to stop such practices.

There is a reason why I have returned to the subject of China. I have long argued that the ascent of China will progress far faster than most analysts and commentators suggest. I have long argued that China will emerge as the winner from this crisis, and have argued that their currency will be the new reserve currency in the future. Over many, many posts, I have tracked their steady process of internationalisation of the RMB, and consistently argued that the $US is so weak that it must collapse. I have returned to the subject as the mainstream media are finally really starting to understand what is taking place. Amongst the many articles, it is this article from Ambrose Evans-Pritchard that inspired me to return to the subject:

Beijing does not need to raise money abroad since it has $2 trillion (£1.26 trillion) in reserves. The sole purpose is to prepare the way for the emergence of the yuan as a full-fledged global currency.

"It's the tolling of the bell," said Michael Power from Investec Asset Management. "We are only beginning to grasp the enormity and historical significance of what has happened."


"Everybody in the world is massively overweight the US dollar," said David Bloom, currency chief at HSBC. "As they invest a little here and little there in other currencies, or gold, it slowly erodes the dollar. It is like sterling after World War One. Everybody can see it's happening."

"In the US they have near zero rates, external deficits, and public debt sky-rocketing to 100pc of GDP, and on top of that they are printing money. It is the perfect storm for the dollar," he said.

"The dollar rallied last year because we had a global liquidity crisis, but we think the rules have changed and that it will be very different this time [if there is another market sell-off]" he said.

The self-correcting mechanism in the global currency system has been jammed until now because China and other Asian powers have been holding down their currencies to promote exports. The Gulf oil states are mostly pegged to the dollar, for different reasons.

This strategy has become untenable. It is causing them to import a US monetary policy that is too loose for their economies and likely to fuel unstable bubbles as the global economy recovers.

The article was a response to news (since denied) that China, France, Japan, Russia, and the Gulf states were planning to abandon the $US for pricing of commodities. Ambrose Evans-Pritchard argues that the currency of pricing commodities is of no importance, but this is something with which I disagree. This is what I had to say on the subject of the emergence of the RMB as a reserve currency in April:
However, the real key to reserve status is when trade is more broadly conducted in the RMB, such as move to trading oil in RMB. Perhaps Venezuela will offer such an opportunity? An article here suggests that Venezuela may need to turn to China for financial support, and this may well present an opportunity for China to start this process:
In Latin America, the external funding situation remains relatively stable but in the case of further deterioration of capital flows, the solid economies would be able to tap the IMF or the Inter-American Development Bank (IADB) for non-conditional lines of credit, while the economies with less sound macroeconomic frameworks such as Ecuador, Argentina and Venezuela would most likely only be able to obtain funds through more formal conditionality or by turning to lenders like China.
Returning to the question of whether it is possible, I see no reason to prevent the RMB from taking on this role. There has been talk about the RMB not being 'liquid' enough, the lack of depth of their financial markets. However, I take a fairly simplistic view, which is to ask whether a currency has the underlying strength of being able to be used to purchase goods and services. The answer to this question is, of course, 'yes'.
It appears that ambitions for pricing of oil in RMB are far more ambitious than I first thought. Whilst the story has been denied, there is an underlying logic to the story that belies the later denials. It is only a matter of time before we see commodities priced in RMB.

In order for the RMB to succeed the $US as the reserve currency, it was always going to be necessary for the $US to collapse. The US has undertaken policy that will ensure such a collapse, and it is simply for the reason that the US is fiscally incontinent, printing money, and pouring the wealth of the future into zombie banks. When the $US falls, the US will finally see the forces of inflation unleashed, as the massive imports of commodities, goods and services surge in price. It is at this point that the underlying reality of where real economic power lies will finally become clearly visible. It is at this point that the real wealth generating capacity of the world will emerge into the light.

When the US is no longer able to borrow, when it is reliant upon what it actually produces, rather than borrows, it will be apparent how bad the situation has become. The same will be true of several other economies, such as the UK. For many years, these economies have been subsidised by the economies to the East and, without any further subsidy, they will find life is far harsher than they have ever imagined.

The rise of China is no mystery but, no doubt, the historians will manage to find controversy, manage to bury all of this under complexity. The economists will meanwhile suggest that the transfer of economic power emerged out of the banking crisis. The reality is far simpler.

The Western world was complacent, arrogant, and bloated. Collectively, the West allowed the emergence of a new competitor who used mercantilist policies to accumulate the modern equivalent of bullion, they allowed the export of all that had made their economies such a success and, when confronted with reality buried their heads in the collective sand of borrowing and money printing. Whatever happened, once China opened to the world, a new economic challenge was inevitable. However, the way that the West met the challenge has ensured that China will emerge as the great economic power.

As we move towards the end of 2009, we are entering into a new world, a new economic structure. We are witnessing a change in the world that will be viewed in hindsight as one of the defining moments of the 21st century.

Note 1: I have not referenced as many points as usual. However, many of the points made are consolidating the points made in previous posts, and these provide support for the case that I am making. I have listed some previous articles on China and the $US, if you are interested in seeing my case in greater detail, and the evolution of my thoughts on China's rise:
  1. July 2008, China - What Future?
  2. August 2008, China Propping up the $US
  3. January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
  4. January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency
  5. February 2009, China's Pivotal Role in the Next Step for the World Economy
  6. Fenruary 2009, China and the US - Fighting on the Edge of a Cliff
  7. March 2009, Economics and Power, the Loss of US Power
  8. March 2009, China, Gold and the $US
  9. April 2009, China as the World Economic Power?
  10. April 2009, The RMB as the Reserve Currency
  11. May 2009, China, the RMB and the $US
  12. July 2009, The RMB as the Reserve Currency - an Update
  13. September 2009, The Rise and Rise of China
Note 2: Am I repeating myself here, or does this post add to past posts? Comments welcomed. If readers feel I should move off this subject for a while, I will do so.