Friday, August 20, 2010

Goodbye Post

This post will mark the end of the line for the Cynicus Economicus blog posting. It is with some sense of regret that I have reached the point where I do not really have anything new to say to readers, and risk becoming yet another commentator on 'events.' As it is, I am hoping to devote the time I spent on the blog to wade into the muddy waters of academic economics. I am not sure that it is possible to change views from the outside, so I will try to change the views from the inside. I am not confident of success, but at least it is worth trying.

When starting this blog, my aim was to inform as many people as possible of the dangers that were being hidden in the world economy, and in particular in the UK economy. My worry was that, somehow, we had lost sight of where real wealth creation came from, and had mistaken the accumulation of debt for wealth.

As time progressed, I started to look for the underlying drivers of the growing crisis in the economies of the developed world, in particular the US and UK. I started reading ever more widely, and started thinking about what had really changed in the world. I identified that massive input of labour (defined as labour combined with technology, capital, and markets) into the world had massively increased, whilst commodity output had not increased sufficiently to meed the demand of new labour, and rapid infrastructure development of emerging economies. We had seen a massive supply shock of labour, and a failure to supply enough materials to satisfy the growing demands; the result, hyper-competition.

Much of my writing has flowed from this analysis. This is the underlying reality of the world economy, and the driver behind the economic crisis. Sure, the collapse of the financial system was important, but this was a symptom of the underlying problems, and the failure to recognise the change in the world. Wealth creation has been slipping from the developed world to the emerging economies, and the financial services industry just recycled the growing wealth creation from the rest of the world into developed world debt. That this was unsustainable, and had to end in disaster, and would provide a shock to the world was inevitable.

The problem is that, when the shock hit, the reaction of the developed world was to pretend that this was a financial crisis, rather than a fundamental economic crisis. If the banks could just be saved, we could move on and get back to business. The bailing out of the banks followed, and sovereign states expanded their balance sheets with debt. If only the developed world consumers would climb back on to the debt treadmill, economies would get moving again. However, when consumers failed to comply with this lunacy, governments stepped forwards to fill the void. Keynes came back in fashion.

The days of the 'big state' were back, and intervention was the new paradigm. Whether pouring printed money into an economy, whether pouring borrowed money into the economy, the state would solve all. Nowhere did we see anyone asking a basic question; why are we really doing so badly in the developed world? Surely, if our economies were fundamentally sound, then the situation would resolve itself. There have, after all, often been hiccups, so why is it so bad this time?

Instead of asking whether the structure of our economies might have problems, the answer was to imagine that, somehow, more state intervention might provide a solution. Borrowing more money from the new wealth creators was a solution. More debt would solve the hangover from too much debt. But why did we accumulate so much debt in the first place? How did our economies structure themselves around the debt accumulation? How many people were employed, directly or indirectly, as a result of the ever increasing rate of debt accumulation? What must happen when the rate of debt accumulation slows, as it surely must? And what happens when the debt accumulation goes into reverse, and payment of debt starts to overtake new debt accumulation?

Economies such as the UK and US were structured around ever more growth in debt, and that growth in debt was hiding the shift in wealth creation. When the debt growth stopped, the developed world economies were faced with their weakened competitive position. They had been consuming more than they produced, and the competitors were accelerating their advantages, even as the developed world economies were facing the reality that their economies were structured for debt based consumption. It is and was a 'double whammy' - increased competition and economic structures in poor shape to meet the competition.

This is the heart of the problem, and the problem that nobody seems to want to recognise. Some analysts pay lip service to the problem. Some bemoan the part played by the mercantilism of countries like China (including me). However, even without mercantilism, the hundreds of millions of new and competitive workers entering the world economy was always going to change the world economy. There was always going to be a shock when countries like China and India really finally entered the world economy.

Along the way, this blog has made some very accurate predictions, and a credibility sapping error on the timing of the fall of the $US. I have been endlessly surprised at the ability of policy makers to keep the plates spinning just a little bit longer. However, as many analysts are now pointing out, short of massive money creation, there is little left in the armoury of the policy makers. Recent stories are highlighting the potential return to the weasel worded policy of quantitative easing (QE), better described as printing money.

There has been much talk of austerity of late, in particular in Europe. For example, the UK is apparently on the road to austerity. However, when looking at what is taking place, what we are not seeing is any realistic austerity, but rather a slowing in the rate of growth of debt accumulation. The arguments for ongoing debt accumulation are somewhat puzzling in the context of what is taking place in the broader world economy. There is a belief that, somehow, real economic growth (as opposed to consumption built upon debt) will return to the developed world economies, and that this will allow the developed world to grow out of debt.

But what of the competition from the emerging economies? Is everything going to suddenly go into reverse, and the developed world will return to economic ascendancy? According to many analysts, it appears that they just believe this will happen. As if by magic, all will return to how the world used to be. But why should it? Is there some cosmic law that suggests that the developed world must succeed? A recent graph in the Economist (sorry, I can not find the link) showed how India and China were the dominant economies for most of history. If anything, there is a cosmic law that suggests that China and India must succeed, with the Western success a weird exception. A few centuries of economic dominance does not make ongoing dominance inevitable, and the rise of the Japanese economy is a salutary lesson in how fast a situation can change. The difference in the modern situation is the scale of India and China - the amount of potential that is still untapped.

Within this context, the ongoing borrowing and profligacy of the developed world economies just does not make sense. The days of competition between high cost economies have gone - the developed world economies are competing with low cost economies. One way or another, the developed world must face that challenge. Borrowing money, printing money, and all of the other policies that are being enacted are simply delaying mechanisms. They are just means of hiding the falling competitiveness of the developed world.

However, even with all the policy actions, reality is still seeping in at the edges. I recently posted on the subject of the disappearing American middle classes. Slowly but surely, the standard of living of the developed world middle classes are falling, even as the middle classes of the emerging economies are rising. Whatever the policy makers do, the middle classes are moving towards a new middle, and that middle is going to be at a lower point than the developed world has come to expect as a right. It is a shift in the allocation of the resources of the world, a redistribution towards the emerging markets. In an article for Trade and Forfaiting Review, I discussed the Tata Nano as the herald of this great shift. It is a car for the new middle. we have just not reached that point yet, though we seem to be moving there ever faster.

So what does the future hold?

I am unsure. Not because there are no underlying principles that might be applied to the situation, but rather because the policy makers are unpredictable, and the markets have yet to confront the underlying changes in the world economy. The questions are how far the policy makers will go to keep the plates spinning just that bit longer, and when the contradictions of trying to support the unsupportable will finally emerge. With each day that goes by, with each new attempt to hold back the shift, the size of the problem grows.

There is only one real certainty. At some point, the plates will no longer be spinning, but will come crashing down. At that point, we enter a period of chaos. I am afraid that I have always found this to be worrying in the extreme. It is in times of chaos that opportunities arise for the world to take on a new shape, and that shape might be something that none of want to see. It is a time when fears might be stoked, divisions made, and suspicion and hatred stoked. In all my posts, this fear has been at the back of my mind. Whilst this blog has focused on economics, I have wider interests, and these include psychology, evolutionary psychology, history and political philosophy. The lessons drawn from these do not encourage me to optimism.

So it is on this very unhappy note that I bow out of the Cynicus Economicus blog. All that is left is to thank the loyal readers of the blog, and in particular those who have contributed so much to the blog with their intelligent commentary. Of particular note is Lemming, who has followed the blog from the start, and has always provided interesting comments. As one note, MattinShanghai was missed when it became impossible for him to view the blog due to Internet restrictions in China. Whilst not always finding ourselves in agreement, his views were always welcomed. Such is the nature of the Middle Kingdom that is going to play a growing role in the shape of the world.

I would name others, but am concerned that I might offend by not capturing all of those that have made a contribution. Those people will know who they are, and please accept my sincere thanks for following and contributing to the success of the blog. I sincerely believe that the quality of the debate in the comments section was responsible for the ongoing success of the blog.

I will leave the blog on a final point. I hope that the regular readers will remember the slogan of the blog, and keep it in mind as the optimists sell their fantasies:

'I just don't buy you?'

Note: As the order of posts were wrong, I have deleted the post that follows and reproduced it here.
As ever, I leave all posts, good or bad, as available. However, in this case the post was still on the home page, and the only way of correcting the problem was to delete it (due to some oddities of the blogger system). As the blog is ending, I needed the post above to be on the home page.

Papering over the Cracks

Sometimes, I look back on what I have written, and look to what is appearing in the media today. I keep finding that what I have said eventually becomes mainstream thought. I am writing two posts today, one on China, and one on instability. I will apologise for the fact that both of the posts are, up to a point, covering old ground. I will admit that I am finding it ever more difficult to say anything new. Everything that I expected to happen seems to be taking place as if in slow motion. There have been some twists and turns on the way, in particular the ability of governments to prop up a broken system have been a surprise, along with resiliance in the belief that all might go back to 'normal' - meaning the developed world just getting richer. As time progresses, the new 'normal' is becoming ever more evident, and it is not the 'normal' that so many expected.


Going back to August 2008, I had the following to say:

Each of the stories above, taken in isolation, would not cause undue alarm. However, when considering them all together, then there is a worrying pattern emerging. It should also be remembered that all of the above are just examples. What is very clear is that China, and the Chinese government, are actively pursuing a policy of unfair trade at home and abroad. Quite simply, they are using economics as a tool of power rather than just enrichment.The stories that I am referring to are the many examples in which China has sought to tilt the economic playing field in their favour, regardless of the interests of others. In a recent post, I made the same point (yet again) and noted one commentator on the Seeking Alpha copy of the post grumbled at how all countries indulge in such behaviour (suggesting I was an idiot for thinking otherwise, if I recall correctly). Whilst I accept that all countries try to find a favourable outcome, it is up to other players in the world economy to put a constraint on activity that is tilting the playing field too far. This is the problem; there is a very strange passivity in the face of Chinese mercantalism, with no country willing to face the country down.

As time progressed after the post quoted above, I have pointed out many examples of the way in which China is successfully gaming the trading system, and have continually argued for governments to take action to confront China. I pointed out the way in which China encouraged the movement of production and technology into China, by restricting access without such movement, the unfair implementation of laws, the weighted dice of who wins contracts, and a host of other small and large measures which discriminate against Western business. In the light of these many complaints I have made, it is interesting to see a series of articles in the Telegraph that are devoted to China's economy.

In one article, a tax and legal advisor lists a long litany of problems for overseas businesses in China, where local firms get support and lax implementation of the law, whilst overseas companies get the full brunt of the detail of the law. This is what the author concludes with:

The truth is that tax avoidance by domestic businesses is rife and it creates an unlevel playing field for foreign businesses that are strictly monitored. These issues – and there are plenty of others – amount to what I call the "Communist price". Because business in China is so intertwined with the state, foreign companies can be shut out, both in terms of market access and in revenues. Dealing with the issue, as BASF and Siemens have done, through the German government shows that companies are beginning to understand that some issues can only be solved politically. China has not only increased its cost of business through tax and the regulatory environment, it is also prepared to flex the muscles of the Communist to its advantage, and is increasingly doing so. Businesses new to China will also need to review their business plans. I would recommend, once the financial research has been carried out, adding at least another 30pc of intangible costs to the bottom line, and preferably 50pc. While that may seem a lot, the reality will haunt those who do not factor it in. This kind of behaviour has been going on for years. However, it seems that China just keeps on getting away with it. This is not the end of the problems confronting the developed world in relation to China. It has not become virtually essential for every major company, and major economy, to have a China strategy for penetrating the Chinese market. However, the unbalanced policy of China ensure that real success in China is relatively rare, as another article points out [my emphasis]:

The first is China’s penchant to promote national champions over foreign competitors, often using backdoor regulations in breach of the spirit of their WTO commitments – the wind turbine sector or the insurance market are two prime examples. Second is that Chinese companies, protected or not, are becoming a great deal more competitive, producing products that nearly match Western ones and at appreciably cheaper costs Third, costs are rising in China (labour and inputs) and as a result margins are shrinking. This explains perhaps why British companies in China get rather vague when it comes to discussing how much actual profit they make here.This is much the same problem as I saw when working in China and whilst dealing with a large numbers of multinationals. This is going back a long time, but I remember a forlorn manager at Unilever expressing surprise that they were struggling against the local competition. That was 1999. Chinese companies are now a lot better, a lot more advanced than they were then, as another article illustrates:

This 'smart home’ concept is partly why Mr Letheren is in China. He’s hoping to piggyback into the homes of the future using the systems set up by Chinese behemoth manufacturers. “We will stream audio over the network to speakers that are smaller and more discreet. There are quite a few interesting angles. Multi-room systems can distribute audio and video around the house. There are some synergies with some very big appliance manufacturers,” he says. The other reason is more worrying. Audio Partnership is now trying to find a Chinese company to help it design its products. Not only, it seems, has manufacturing migrated to the East, but design skills, once the pride of London, are also becoming cheaper to find in China. “I am looking for design skills and maybe companies that are doing overlapping products so that we can use some of our technology with some of theirs,” he says. As hi-fi companies move away from traditional boxy sets towards wireless technology and iPod-integrated systems, it makes sense for companies to rely on Chinese firms to roll-out new designs. This flies in the face of the idea that the poor Chinese would provide the labour, and that the higher value added would sit in the hands of the developed world, who would do all the intellectual heavy lifting. This idea, so fashionable for so long, was always a delusion. Product design and other business services such as financing, will eventually move to where the 'action is' and that is not currently in the developed world. Whilst some companies are still working to this paradigm, the Chinese will eventually catch them up. When a company outsources function x, y, and z, the great fad/fashion of recent times, they also transfer the processes, systems and knowledge to the company to which they have outsourced the function. In doing so, they may make short term gains, but will eventually fuel new competitors. For example, if you can manufacture a product for a company, it is only a matter of time before it becomes apparent that you might make more money manufacturing your own products.

If you add into this mix the complete disregard for intellectual property in China, allowing companies selling within the internal market a head start, then it is apparent that China will continue to accelerate up the value chain (not to mention the cost advantages for producers who disregard intellectual property rights).

When looking at the articles appearing in the press, the reality of the mercantilism of China is finally being taken seriously. I have not, of course, covered another topic that I have often discussed, which is the manipulation of currency. I will leave that for today. I will leave the quotes with a final comment from one of the articles:

as Jeff Immelt the CEO of General Electric observed a month or two back – that foreign business will ever be allowed to ‘win’ in ChinaQuite simply, we have allowed a state to enter the world trading system that is exploiting every means at its disposal to tilt the world system in its favour. Thinking back to the commentator on Seeking Alpha, he has got is completely wrong. There is absolutely nothing to stop China's trading partners from acting against Chinese Mercantilism. Of course, each country will seek advantage in the system, but that advantage can only be gained if the trading partners acquiesce. China needs markets. Close the markets, and the Chinese state would be in deep, deep trouble. The trading partners have real leverage, but never use it.

Part of the reason is that, in particular, the US would not dare to, due to reliance on Chinese money for financing deficits. If the news that the US is starting to fund the deficit internally is true, this might be the opportunity to act. China still retains the power to decimate the US economy by dumping Treasuries, but what is the alternative - just let China keep getting stronger at the cost of US competitiveness? Another problem is the way in which China plays off the US and Europe, one against the other. Again, there is nothing to stop the two blocks presenting a unified position, except that they seem to dance like puppets on Chinese strings.

I must emphasise that I have nothing against the economic rise of China. Having lived in the country, I have a great affection for China, and in particular the ordinary people I have met. I wish them well. However, I see no reason why the developed world continues to accept the mercantilism. China would, in any case, rise. It would just be more gradual if they were forced to trade in the world system on a more even basis.

Note: I do not claim to be alone in these views of China, or the first to identify the problems of China in the trading system. However, I became aware of the problems, and formulated these views when first arriving in China in 1997, with experience on the ground. I must admit, however, that even I am surprised at the rate of China's ascent.

The Chaos in the World Economy

Back in 2009 I wrote an article for TFR magazine in which I suggested the following:

Just as with the profligate eighteenth century aristocrats and the emerging industrialists, investors have failed to recognise the real risks that are emerging and where the great opportunities might lie. In failing to recognise this change, investors are moving from one high risk, advanced economy into another; from one major OECD currency into another, as each piece of bad news about each economy is absorbed. What they fail to realise is that all of the advanced economies are at great risk during the transition and that there is no safe currency into which they might run. As such, it is possible to expect volatility in currencies as the reality of the transition for individual countries becomes more apparent, along with the implications for each currency. With the movement of wealth from one economy to another being built upon false assumptions, the markets will continue to react in unpredictable ways. So, as we move through the transition into a new shape of the world economy, currency-related volatility can only grow.This process of markets swinging from positive to negative on news has been going on for some time, but it now seems that the swings are becoming ever more erratic. The driver of the volatility in markets are the endless floods of news, each of which serves to raise fears about the major developed world economies. Europe sinks in and out of crisis, and the indicators for the US economy are interpreted as positive one week, and negative the next. Even the £GB has managed to be seen a new safe haven as the data from the US and Europe sends new jitters into markets.

Phil Jordan from Monument Securites said that even Britain was emerging as a sanctuary as yields fall to a fresh low of 2.84pc, though in this case the money is rotating away from the US. "Clients are selling US Treasuries to buy Gilts. The US economic data has been so bad investors are looking for other safe havens," he said.But in another article on the 20th August we find the following:

Sterling[Image] fell to a three-month low against the dollar as investors sought out safe haven investments and as traders weighed up strong UK retail sales figures against indications of more weakness in mortgage[Image] lending. The hot safe haven of the moment is the Swiss Franc:

Following the release of dismal U.S. housing data, the Swiss franc hit an all-time high against the euro for the second-straight day. The euro fell to a series of record lows, most recently at CHF1.2971 during New York trading. The dollar also fell to its lowest levels since January against the franc. As "dark clouds continue to hang over the U.S. economy," and investors hold a "more cautious stance on the yen prompted by the latest currency related comments from Japan," the Swiss franc is the most attractive of the three traditional safe havens, said Vassili Serebriakov, foreign exchange strategist at Wells Fargo in New York. My intention here is not to analyse the details of the markets, but to simply highlight the underlying fear that is driving markets. As most of the readers of this blog, like myself, are regular readers of the financial and economic news, a thoughtful review on the last few months will find that the hunt for safe havens is becoming ever more erratic. Even gold appears to be reviving strongly in the face of fears about economic instability. It seems that the world economic system is growing ever more chaotic, and some, such as Monument Securities, now appear to be seeing a major crisis brewing in the near term:

Stephen Lewis from Monument Securities said bond yields have dropped further than they did in the "flight to safety" extreme of late 2008, a sign that markets fear that underlying conditions are even worse today than they thought then. "Now they fear the global economy will remain in the mire for decades," he said. The following is from Morgan Stanley:

"The question is not whether they will renege on their promises," he writes of rich country governments, "but rather upon which of their promises they will renege, and what form this default will take."


Mares writes that while there has been much discussion of rising debt levels in rich country governments, even those scary-looking numbers understate the scale of the problem. "Debt/GDP ratios are too backward-looking and considerably underestimate the fiscal challenge faced by advanced economies' governments," Mares writes.[and]Just to drive the point home, however, Mares likens the deteriorating fiscal situation in countries like the United States and Japan to the fix many bubble-era Sun Belt house buyers now find themselves in. To extend the analogy, bondholders are like the banks the lent to these poor saps when the housing bubble was whipped into a frothy peak. "On the basis of current policies," Mares writes, "most governments are deep in negative equity."The point in all of this is that unsustainability of the current situation is becoming ever more apparent. If you read the article in TFR, I explain why process of realisation has taken so long, comparing the persisting belief in the developed world to the belief that a fading aristocrat is wealthy just because his family have always been wealthy. The implication is that once the true level of wealth of the aristocrat is discovered, then penury will follow. However, it is hard to overturn such beliefs, but it seems that people like Mares are looking under the facade, and finding a picture of illusory wealth.
Whilst once people like myself (the pessimists) were a small minority, it seems there are additional new voices of concern appearing every day. It is perhaps these new voices that are driving the fear upwards, and driving the ever more erratic search for 'safe havens.' If this is the case, then there can only be more chaos to come, as ever more voices join those of the pessimists. In particular, when casting around the news on the world economy, it is becoming ever harder to maintain an optimistic stance for those who have been so inclined. As ever, it is just a question of where the tipping point might be, and what will be the spark that will finally create full blown panic.
ConclusionI did not intend to link the two posts together when I started writing, but several links did occur to me. Perhaps the most important one is the lack of attention to the underlying problems of the structure of the world economy. China continues as before, and the debtor states continue accumulating debt and consuming more than they can produce, and more than they might ever repay. Nothing changes, and without change, stability in the world economy will be impossible. In the case of confronting China, and reforming at home, the developed world is confronted with potential for pain, and nobody appears to have the courage to face the problems and reform. It all comes back to this - at some point, hard choices will have to be made, and delaying those choices is the ambition of the politicians and policymakers. Better to try to paper over the cracks than deal with the underlying problems.....In other words, the same old story that has been the subject of this blog for so long. Papering over the cracks rather than fixing the real problems.

Thursday, August 19, 2010

Headlines, Headlines, Headlines

For those who, like me, regularly browse the finance and economy pages of the news, there are days when you see a shocking collection of headlines. Today, the trawl through the news started with the Telegraph, went on to the Reddit Economics and Economy and Markets pages, at which point I thought I would start the post (I would normally continue on to several other sources). Whilst normally I approach posts with a general theme, today will be different. Today, the point is to just show how utterly dysfunctional/chaotic/unbalanced the world economy actually is. We have seen the masters of the universe pulling on their policy levers, and the result - well, the result is in the news. I will start with the Telegraph.

The Telegraph finance pages lead with the story that 'Wall Street Tumbles' in what they describe as 'shock' data on joblessness and a contraction in factory activity. The most interesting part of this is that anyone might be shocked by the ongoing travails of the US economy. Whilst there may be bounces, there is no way that the US economy might recover until such time as the problems of the credit bubble are finally removed. Whilst government and the Federal Reserve have sought to bury the problems with loose money and fiscal stimulus, there is no getting away from the fact that large sectors of the economy are still unbalanced as a result of the credit bubble. In a simplistic example that I often use, the shiny new shopping malls no longer have the customer base that they once had.

The second headline in the Telegraph that I noted was that Western companies are starting to feel the pressure of rising wages in China. However, the more interesting point is how China is continuing with its policy of currency manipulation in order to maintain exports:

The changing landscape has major implications for Chinese exporters, with an average profit margin of just 3pc. High-tech companies in wind power, solar, and transmission equipment that have recently broken into world markets will face stiffer headwinds. The Shanghai Composite Index of Chinese equities has been lagging all year on fears of a profit squeeze. The bourse is down 20pc since last November.

The erosion of export margins may explain why Beijing is still dragging its feet on a revaluation of the yuan, despite ever louder calls for retaliatory sanctions in Washington. China's currency has fallen slightly on a trade weighted-basis since the dollar-peg was replaced in May by a crawling band, a clear sign that the authorities are worried that the economy is cooling too fast. Beijing has tried cool the property boom with credit curbs but it is hard to use such tools in a surgical fashion without collateral damage. The growth of factory output ground to a halt in July, on a month-on-month basis.

China's foreign investment body SAFE has bought record amounts of bonds from Japan, Korea and other Asian countries over the last three months. While this is part of a normal shift away from the US and Europe, it is also a way for Beijing to hold down its currency against these competitors. It is difficult to separate motives in such a policy.

Indeed, it is difficult to see the motives of China. The problem is that, as Mervyn King recently observed, everyone sees expansion of exports as the way out of economic troubles. Not everyone can, of course, achieve this as somebody must be importing in order for another country to export. With this in mind, China's game will become increasingly contentious. And then there is the Chinese property bubble, with the Telegraph article saying the following:

Meanwhile, China Daily reports that 70pc of all flats in Hainan, 66pc in Beijing, and 51pc in Shanghai are empty, based on a survey of electricity use. They are presumably owned by investors and speculators.
It was something I observed first hand whilst living in China and reported in this blog a couple of years ago. The reason why the apartments are left empty is that Chinese people will pay a premium for an apartment that has had no occupants. This is the reason why they lie empty, rather than being rented out. Of course, had they been rented, then the investment bubble would have popped, as declining rents through excess supply would have (at least eventually) offered a market signal. Thus a peculiarity of the Chinese market has translated into a massive bubble.

The Telegraph, being a UK newspaper, inevitably reports on the UK economy. In one report, the Bank of England is suggesting that the UK economy is extremely fragile, which I thought was stating the obvious. Meanwhile, the government deficit continues to grow, though the article frames the story in terms of not as fast as before. Regardless of the framing, the UK continues to sink ever further into debt. Perhaps, in an odd way, the most interesting story is that the retail chain Poundland is doing well. For readers who are not from the UK, this is a store that stocks very, very cheap goods and they are reporting that all income groups are now using their stores. It is a sign of the times - the new frugality. However, assuming that the shop has not changed greatly since I last visited one, the shop's cheap goods seem to be disproportionately originating in China. In other words, the new frugality plays to the strengths of the emerging economies - low cost.

It is also perhaps symbolic of something that I long ago discussed, the meeting in the middle of the rising middle classes of the emerging economies and the sinking middle classes of the developed world. This point leads me to an article picked up on Reddit, which is a Spiegel Online article:

While America's super-rich congratulate themselves on donating billions to charity, the rest of the country is worse off than ever. Long-term unemployment is rising and millions of Americans are struggling to survive. The gap between rich and poor is wider than ever and the middle class is disappearing.
The article paints a grim picture for the middle classes, of stagnating wages, and growing unemployment. However, the extent of the problem is so broad that:

But even though Federal Reserve Chairman Ben Bernanke continues to pump money into the market, and even though the government deficit has now reached the dizzying level of $1.4 trillion, such efforts have remained unsuccessful.

"The lights are going out all over America," Nobel economics laureate Paul Krugman wrote last week, and described communities that couldn't even afford to maintain their streets anymore.

The problem is that many Americans can no longer spend money on consumer products, because they have no savings. In some cases, their houses have lost half of their value. They no longer qualify for low-interest loans. They are making less money than before or they're unemployed. This in turn reduces or eliminates their ability to pay taxes.

I suggest reading the article in full. However, in the same list of headlines, I also found a very similar story in the Guardian:

America appears to be a society splitting down the centre, shattering the middle class that long formed the cultural bedrock of the country and dividing it into a country of haves and have-nots. "A once unthinkable level of economic distress is in the process of becoming the new normal," warned Nobel-prize winning economist Paul Krugman in a recent New York Times column. Or, as Steven Green, an economics lecturer at Baylor University, put it to the Observer: "We are really in a tough spot right now."
These articles paint an ugly picture, and it is only getting worse. It is worth remembering that it was not that long ago that people were painting a picture in which the actions of the US government to 'save the economy' were working, that the bailout of the financial system saved the world economy.

So how is the world economy? I will return to the Telegraph, this time to the economics section, for a snapshot of the news. There is the unsurprising headline that the Greek crisis refuses to go away, with reports of capital flight out of Greece, and growing doubts about whether the EU bailout might work. Furthermore, it is not just Greece as an exception, according to an article about Moody's assessment of the situation:

"Genuinely adverse debt dynamics were only expected to materialise in 15 to 20 years. The crisis has 'fast-forwarded' history, eroding all the time available to adjust, " said the group's quarterly Sovereign Monitor.

Moody's fears that the US will crash through its safety buffer by 2013 if growth falters (adverse scenario), with interest payments topping 14pc of tax revenues. The debt-to-revenue ratio has already doubled in three years to 430pc.

The US, UK, Germany, France, and Spain are all at risk of an "interest rate shock", either because they must roll over a cluster of short-term debt (US, France, Spain) or because deficits are so large.

Countries that "fail to demonstrate the level of social cohesion required to stabilise debt" will lose their AAA rating. "Intra-generational" conflict between young and old requires careful handling. States that delay pension reform risk spiralling downwards.

Moody's said the world had changed since Europe's debt crisis. None of the large sovereign states can still assume it is credit-worthy. "The burden of proof now falls on governments," it added.

And then there is the headline about China's ongoing rise, as it finally overtakes Japan's GDP, with economists predicting that China is set to become the world's largest economy, but just arguing over timing. However, my final article comes from a link to the Economist in Reddit, concerning the rivalry between India and China:

Autocrats in Beijing are contemptuous of India for its messy, indecisive democracy. But they must see it as a serious long-term rival—especially if it continues to tilt towards America. As recently as the early 1990s, India was as rich, in terms of national income per head. China then hurtled so far ahead that it seemed India could never catch up. But India’s long-term prospects now look stronger. While China is about to see its working-age population shrink (see article), India is enjoying the sort of bulge in manpower which brought sustained booms elsewhere in Asia. It is no longer inconceivable that its growth could outpace China’s for a considerable time. It has the advantage of democracy—at least as a pressure valve for discontent. And India’s army is, in numbers, second only to China’s and America’s: it has 100,000 soldiers in disputed Arunachal Pradesh (twice as many as America will soon have in Iraq). And because India does not threaten the West, it has powerful friends both on its own merits and as a counterweight to China.
So what can we make of these headlines? Was the world economy saved when money was poured into the financial system, when government debt exploded to support flailing economies, when the policymakers tugged on their levers to save the world economy?

The headlines I have chosen are selective, but they are not unusual. What we see is instability, and ongoing shifts in the shape of the world economy. The emerging economies are getting richer, but are also unstable. The developed world economies teeter on the brink, and none of the policy levers seem to actually work. Tensions between the emerging economies, and between emerging economies and developed economies are rising. Alongside the economic rebalancing, there is a rebalancing of power.

If we jump back in time again, none of this should be happening. The masters of the universe were supposed to have known what they were doing. Have they really saved the world economy, or have they simply created ever more chaos. Take a look at the stories above, and I think you may be able to answer the question yourselves.

Saturday, August 7, 2010

Chinese Mercantilism

I will start with an apology that it is so long since my last post, which is due to my having been busy with my 'real' work. There were a host of subjects that I would like to cover, but the subject that grabbed my interest was China.

One story about China of particular note was an Economist article on the situation of labour in China. The increasing cost of labour in the coastal areas is creating ever more incentive for the movement of less skilled work into inland China, and that this will see/and is the result of the coastal provinces continuing their steady rise up the value chain. This process has been ongoing, and will allow (in principle) for China to maintain economic growth for a long time yet, all the while without losing the ability to compete in the lower value added industries on which its initial success was founded.

For the rest of the world, this ability to manage a transition from low value added to high value added whilst retaining the former, presents an ongoing problem for competitors. This is the key difference between the emergence of China and countries like Japan, South Korea and Taiwan; the depth of China's labour market. This depth will allow China to compete in every segment for a long while yet, allowing an ever greater dominance of Chinese exports.

Another aspect of the Economist article that was interesting was the concentration of strikes in China in foreign enterprises, reflecting points I made a long, long time ago. The point in question was the way in which China seeks to bring in foreign investment, methods and technology, whilst at the same time weighting the dice against the foreign companies. In the case of strikes, the authorities seem very willing to look on (and take no action) in the case of strikes in foreign companies, but far less willing to tolerate stikes within domestic enterprises. In a post I made a long time ago, I pointed out the many ways in which China sought to disadvantage foreign companies, and it seems the policy is ongoing.

Although in some respects investing in business in China is a risky choice, China is managing to weight the dice even further in their favour. A while ago, I discussed rare earth metals, and that China (which is the dominant producer) was seeking to restrict exports. This is a recent article on the subject:

The United States Magnetic Materials Association (“USMMA”), a trade association representing domestic high performance magnet producers and suppliers, today warned of impending shortages of rare earth materials needed to support domestic manufacturing in support of emerging green technologies like wind generation, hybrid vehicles, and new battery development, high-tech consumer products like mobile phones, PDAs, MP3s, and national security and defense systems.

Late last week, China, the world’s largest rare earths producer, announced new plans to cut rare earth export quotas by 72 percent for the second half of the year. According to China’s Ministry of Commerce, foreign shipments will be capped at 7,976 metric tons, down from 28,417 tons for the same period last year.

In restricting exports, until such time as alternative sources can be brought on stream (15 years according to the US government), China is effectively forcing companies that use rare earth metals to set up operations in China. In so doing, they will rapicly accelerate the process of manufacture of high-tech devices and the importation of other technologies. All the while this is taking place, despite discussion of RMB revaluation, the RMB remains undervalued. The head of the IMF China mission recently had this to say:

WASHINGTON (Dow Jones)--China's currency is "substantially" undervalued despite Beijing's recent decision to appreciate the yuan, the head of the International Monetary Fund's mission to China said Wednesday.

China has held up the IMF staff report for the fourth year running, objecting to the fund's characterization of its currency and pressing the board to omit its finding.

"The RMB remains substantially below the level that's consistent with current fundamentals," said IMF China Mission Chief Nigel Chalk, referring to the renminbi, another name for the yuan, on a conference call with reporters.

Under pressure from Beijing, the IMF board was at odds how to define China's exchange rate. "Several directors agreed that the exchange rate is undervalued," the IMF said in a notice posted late Tuesday evening. "However, a number of others disagreed with the staff's assessment of the level of the exchange rate, noting that it is based on uncertain forecasts of the current account surplus."

What we are really seeing is yet more of China's strategy of mercantilism, in which they continue to seek any advantage that they can get, without any regard to the concept of free and fair trade. Of course, the most interesting point about China's mercantilism is the resultant strength of China's export machine. In a recent article in the Telegraph, Edmund Conway illustrates the essential problem that is confronting the Western economies:

[Mervyn King]Sitting at a summit listening to his fellow central bankers and finance ministers go round the table and explain how they would escape from the economic doldrums, he realised, with both horror and amusement, that they all had precisely the same plan: export their way out.


In other words, the US and UK's plans to focus on exports as a source of growth in the future are dependent on the world's big exporters – and specifically China – suddenly discovering an appetite for those American and British goods. Fail in this and a double-dip recession is almost assured.


The reality is that just as the US and UK are in most need of demand from Chinese consumers for their goods, Beijing is facing an economic crisis of its own, and is resorting to its most reliable weapon: exporting the hell out of it.
This is the problem writ large. China will do anything to keep economic growth going and, as long as they do so, their export policy will hinder any possibility of rebalancing of trade, and will continue to see the hollowing out of Western productive capacity, increasingly including higher added value goods and services. The most puzzling aspect of this is that, despite lots of noise from China's competitors, the noise just remains that; noise. It never translates into substantive action, in particular from the US.

For the underlying reason for the lack of action, the answer must lie in the reliance of the US government on Chinese funding of deficits. It is a spiral of decline, in which the purchase of treasuries by China holds down the value of the RMB, China uses the low valuation to support exports, the exports depress and destroy productive capacity in the US, and the US needs to borrow more money from China, to make up for their poor economic performance. The more money they need to borrow, the more fearful the US government becomes about taking action to halt the spiral. As I have long argued, China must be confronted, but in order to do so, the US must take the pain that will follow such action.

And such action will indeed be painful....but the potential extent of the pain just keeps growing. That is the nature of the spiral.


None of this is to say that all is perfect in the Chinese economy. For example, as I posted a couple of years ago, the Chinese construction boom has been spurred by the purchase of apartments that have been left empty, and which have been purchased as speculative investments. This trend has (finally) been noted by several analysts, and suggests that a severe bubble is in place.

I have also been looking at some of the HSBC reports on China, and they have made interesting reading. China, due to the opaque nature of the government, is a country where you feel that analysis is somewhat like trying to read tea leaves for the signs of the future. One interesting report was that there are some problems on the horizon for China's local government, with this from an HSBC (1):

New Century Weekly – a financial newspaper in China – reported this week that a recent China Banking Regulatory Commission (CBRC) investigation had found that of the RMB7.7trn extended to local financing vehicles as part of stimulus funding, 23% (or RMB1.8trn) went towards projects that may ultimately have problems in servicing their loans.
The problem was that, as part of the Chinese fiscal stimulus, local governments were forced to borrow from banks to fund infrastructure projects, and these loans are now going sour. It seems that, even in a country like China, where there is a strong need for new infrastructure, fiscal stimulus presents risks that (to use a cliche) bridges will be built to nowhere.

There are plenty of other signals that suggest that the dragon may not be as fit as it appears, and it will be interesting to see how China fares in the coming year. As I have mentioned the opacity of China is such that analysis of what is taking place is never easy.

(1) HSBC Research, 29 July, 2010, China Economic Spotlight,

Tuesday, July 20, 2010

Update on Krugman Post

I am making a very quick post, as James Galbraith has responded to my last post on the Seeking Alpha version of the post. I have copied the response below:

On the matter of my beliefs. Krugman's quote from me was this:

"So long as U.S. banks are required to accept U.S. government checks — which is to say so long as the Republic exists — then the government can and does spend without borrowing, if it chooses to do so … Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system."

Read it again with the *very next sentence* included:

"So long as U.S. banks are required to accept U.S. government checks — which is to say so long as the Republic exists — then the government can and does spend without borrowing, if it chooses to do so … Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system. The actual risks in this system are (to a minor degree) inflation, and to a larger degree, depreciation of the dollar."

Does this help resolve what I "appear to believe."? I trust so. What I actually believe is now so thoroughly on the record, there really is no excuse for writing about it without getting it right.

Thank you. James Galbraith
I have, of course, copied this over as James Galbraith should be in a position to set the record straight on what his actual views are.

Saturday, July 17, 2010

Krugman Surprises!

Well, the arch stimulator, the deficit spender in chief, has accepted that there is a limit to government deficits and money printing. This is from Krugman:

So there is a maximum level of debt you can handle. In practice, if it makes sense to say such a thing with regard to a stylized model, at some point lower than the critical level implied by this model the government would decide that default was a better option than hyperinflation.
Krugman is responding to Jamie Galbraith, who appears to believe that money printing and deficit spending can resolve all ills (a regular commentator on the blog appears to hold similar beliefs). I must also add Krugman's caveat to his acceptance that massive deficit spending and money printing might cause hyperinflation:

Now, I’m sure I’m about to get comments and/or responses on other blogs along the lines of “Ha! So now Krugman admits that deficits cause hyperinflation! Peter Schiff roolz” Um, no — in extreme conditions they CAN cause hyperinflation; we’re nowhere near those conditions now. All I’m saying here is that I’m not prepared to go as far as Jamie Galbraith. Deficits can cause a crisis; but that’s no reason to skimp on spending right now.
I highlight this from Krugman, as his analysis is very interesting, and I would recommend reading the article in full. It has a few equations, but is largely user friendly. When you are finished reading, you can come back to this post.

The reason I highlight this is that Krugman accepts the principle of seigniorage, an inflationary taxation, and accepts that (somehow) 'the government must persuade the private sector to release real resources'. However, there is an almighty assumption in the entire article that he is looking at a closed system, one in which the resources are closed. He does not exclude the consideration that the 'private sector' might include overseas provider of resources, but seems to believe that they will accept the seigniorage that those within the country might accept. He also fails to note that, even those within the country indulging in money printing have an option of moving their funds to a currency that is not subject to seigniorage.

Here is the problem for, for example, the United States. About $US 4 trillion of US government debt is held overseas, and the US is reliant on continued overseas provision of 'resource' being funded by overseas creditors. If these creditors believe that seigniorage will result in inflation, a tax on their holdings of $US, they will start to find better investments, unless the interest rate offered exceeds the seigniorage. At present, the US has been benefiting from the safe haven/reserve currency status to offset these fears in troubled times. However, as I have long argued, this can only last so long. This view is now starting to become mainstream. This from HSBC (1):

It’s not hard to see how in six months time we will all say it was obvious that the dollar would eventually fall. The US has a highly indebted economy, the global imbalances needed to unwind as the US needs to export more, and EM countries need to import more. Meanwhile, the Europeans have aired their dirty debt in public and taken some measures to address it, whilst the US has not. By this time everyone would have forgotten about the risk on/ risk off fad just as quickly as Dubai disappeared off our radars. As the US economy slows and others in the world raise rates to fend off inflation the dollar will come under pressure. The euro break up premium is coming out and the next phase in this rotation will be a weaker USD and we very well may have seen the first signs of this – the worm is turning.
In this scenario, of a falling $US, the US is left in the uncomfortable 'Chimerica' system, in which China continues to fund deficits in order to keep their export machine turning. Again, as I have long argued, China will eventually reach a limit, the point at which they will no longer continue to subsidise the US with credit that will never be fully repaid (or paid at all?). This is the real 'resource' that Krugman is discussing. Having a borrower tax you on your lending to the same borrower is not really a very attractive prospect, especially where the tax leaves you lending at real negative interest rates.

Then we come to the creditors within the US economy (see graphic here). Just over 60% of US government debt is held by the Federal Reserve and 'intragovernmental holdings', and a further 6.2% held by state and local governments. We then have the curiosity of the circularity of government taxing other branches of government with seigniorage. All I can say to such an idea is 'Huh?'

Then there are the other domestic holders of US government debt, such as pension funds, mutual funds and so forth. If they are lending money to the US government, they do so in the interests of their own investors. Just as with overseas lenders, they might reasonably expect a positive real return on their investments, and there is no real block to moving their investments into currencies that might offer such a real return, except habit and a fear of greater risks in overseas investments. The point at which fear of domestic risk is enough to overturn fear of overseas risk and habit is a difficult one to pinpoint, but nevertheless there is such a point - it is just a question of where? Volatility in world markets has served to reinforce fears of overseas investment, but expectations for the US economy, and US government policy, are a factor in the volatility. It would not take much for a panic to commence.

To put this into context, China is once again pulling back on investments in treasuries:

China reduced its holdings of U.S. Treasury debt in May as total foreign holdings of government debt posted a slight increase.

China's holdings fell by $32.5 billion to $867.7 billion, the Treasury reported Friday.

There is increasing speculation that the Federal Reserve is about to restart the printing presses, and this will only serve to undermine confidence in the $US, as this means more seigniorage:

The US Federal Reserve has already pumped some $1.2 trillion (£780bn) into the US economy to try to promote recovery.

The continued fall in prices will add to pressure on the central bank to take further unconventional measures to push inflation into positive territory.

These measures may include increasing the money supply via further quantitative easing or intervening in the US government bond markets to hold down long-term interest rates.

In recently released minutes from the Fed's June meeting, policymakers raised the possibility of further action later this year, if the economy slows down further.

For the moment, lets play with the scenario that just overseas creditors stop the purchases of treasuries, and that the 'resources' of these overseas lenders will not be available in the US economy. The first impact will be that the demand for US dollars will fall, and with it the value of the $US. This will, of itself, be an inflationary impetus, as all imported goods, services and commodities will increase in price. The second impact will be that, the resources which were formerly entering the US economy (as a result of overseas credit) will no longer be available within the economy. You then have a situation within the economy of a greater supply of money, and less resources available within the economy.

As an offsetting factor, the supply of credit within the economy may be contracting at the same time, due to a wider reluctance of overseas creditors to provide credit in the US economy, except at interest rates that might offset the devaluation of the $US. However, that reluctance will further fuel inflation by reducing demand for $US for private lending into the US economy (further devaluation), and by increasing the cost of credit more broadly within the economy.

All of this will take place whilst the US economy is working under a burden of the existing debt, meaning that a proportion of internally generated resource will be needed to service the existing overseas debt. Even if the size of the debt is being diminished by inflation, there will still need to be an extraction of that internally generated resource to provide payments for overseas debts, and that will be proportional to the level of inflation. The relationship is this; the more resources going to overseas, the higher the inflation in the economy, the higher the inflation in the economy the less resource will be extracted to overseas. Whichever way it is regarded, it is an inflationary impetus - at least until the debt is repaid.

Now let's add in the private domestic investors in government debt. If they start to worry about achieving such poor returns on government debt, they may overcome their fear of overseas investments. In this case, we have an additional problem of capital flight. US dollars will appear in larger numbers on the currency markets, and further depress the $US, and this will provide a further pressure for devaluation of the $US. Likewise, private investment overseas will appear more attractive, depressing investment in private businesses, which will already be suffering from the withdrawal of the use of overseas resource in the economy, due to the lack of credit being provided to the US government. In other words, there will not be credit available to expand the resource generated within the US economy, and make up for the shortfall of resource that was previously provided from overseas.

The only answer for the government is to print yet more money, which will short term ameliorate the problems, but will medium term just heighten the problems. The problem is that it is only possible to go so far with massive deficits and printing money. The US economy is currently reliant on a combination of habit and fear, the 'safe haven' effect, and the inherently unstable 'Chimerica' system.

Krugman is right that there is a limit. The key point in his analysis is he has accepted something close to my own analysis, that money must relate to the provision of privately provided 'resource'. In other words, he seems to accept one of the key arguments of this blog; which is that abstracting money from real goods and services is delusional. In so doing, he is accepting that, in the long term, currency valuations and wealth must be determined by output within an economy. He simply fails to see that, in a world of mobile capital, that there is no such thing as domestic policy acting in isolation. As long as investors have choice, they will seek the best or safest returns.

Real negative interest rates for investors are the danger for economies indulging in deficit spending and money printing, as investors will only accept these up to a point. Words like 'safe haven' and 'reserve currency' are evaluations, and evaluations might change. I recall some time back, an analyst suggested that the $US was nitroglycerin, and we are seeing the US government packing ever more explosive under their currency. In reality, the $US has been nitroglycerin for a long time. It seems that it has just taken more of the explosive to be added for analysts to realise the dangers. Who knows, perhaps even Krugman might get there?

Note 1:

I have been noting that there has been ever more widespread talk about a Chinese property bubble, and this was something I discussed in July of 2008. I can not find an article that mentions this, but I have recently read about the problem of investors keeping apartments empty, and this reminded me of one of my first commentaries on China. I went back to the original article, and found this:

My essay was focused just on the UK and one of the assumptions was that the UK was going to suffer more than any other economy in the current downturn. I knew that the US was going to hurt, and hurt badly. However, the US economy has greater flexibility than the UK, and I therefore expect the pain to be shorter lived, albeit it will still be very bad indeed. I believed Germany and France would hurt, but not too badly. For Italy, I believe that they will suffer very badly indeed. They no longer have the freedom to use their currency to save their economy, and many of their businesses are facing tough competition from the emerging economies. They lack the flexibility or will to rise to this challenge, and will need a crisis before they can even think of rebuilding their economy.

As for Spain, this country was largely off my radar. I was aware that their economic growth was largely built on construction. However, I did not realise how reliant. I read an article in the Telegraph which suggests that Spain may be a candidate for the hardest hit in the current turmoil. It seems that they have allowed a property and construction bubble to rage out of control, and the popping of the bubble will be catastrophic.

Japan I will leave for one side, as I plan to talk about it more at a later date. I also plan to discuss China at a later date, but will just mention a couple of points for the moment. The first point is that it is quite possible that China has a construction bubble. Whilst I was in China I noted that there were lots of apartment blocks being built, and that it was very popular for these to be purchased by investors. In many cases the investors were leaving the apartments empty (Chinese people like to buy property brand new, once it has been lived in the value falls), and they were holding on to the apartments in an expectation of increases in value. In addition to this there has been a boom in the construction of shopping malls, and I noted that they were already (back in January) starting to exceed demand. If the Chinese economy is pulled back due to world demand for exports dropping, it is likely that such investments will lead to a bust. It is also worth considering the state of the Chinese banks. If they are lending into construction in this way, will there be a repeat of the previous Chinese bad lending problems of a few years ago? What other bad lending is buried in their books?

Set against this is that the finances of the Chinese government are very healthy, as are the levels of savings in China. The real question with China is how much their continued growth is reliant on exports, and how much growth can be sustained within China. I will readily admit that I am not sure on this at all. I am not sure that anyone is. My best guess is that China will also hurt, and hurt badly, with a significant potential for civil unrest as a result.
I was wrong about the US, whose policy has gone in the opposite direction to that which I expected. As for the other points, I think I have mostly been right (but missed Greece entirely). With regards to China, I elaborated in the promised later post (again July, 2008) with the following:

So where does this leave the economic future of China? Where would I place my bet? Would it be on ongoing growth, recession and instability, or what outcome? The honest answer is that I would not place the bet at all but, with a gun to my head forcing me to to make the bet, I would choose continued economic growth, albeit at a slower pace than before.
However, I should also mention that I expected a $US collapse a long, long time ago, and was absolutely wrong (the optimism expressed in the first post quoted above rapidly dissipated in the face of actual US policy responses). However, the reason I gave for the problems with the $US are exactly the reasons that analysts are now discussing. As for Japan, I struggled for a long time to 'get' Japan, and never delivered on the article. Perhaps some time in the I think I do now have a rough handle on the Japanese economy.

(1) HSBC Global Research, July 2010, Currency Outlook.

Sunday, July 11, 2010

When Cash Spending is Not Cash Spending

I have just seen a commentary which reminded me of an analysis I made long ago in another post. In the analysis, I pointed out that, even when a consumer went to pay for something with cash taken from their income, they were still spending borrowed money. In other words, even the financially responsible, spending only from their income, were in reality spending borrowed money.

I am aware that this is a difficult idea to grasp, but it is nevertheless the case. The first way in which the individual is spending borrowed money is that they are not actually paying the correct level of taxes to support government expenditure. In simple terms, if the government was not borrowing, but still providing the same services, the tax rate would be far higher. As it is, the government borrowing is the borrowing of the individual, as that individual will, at some future point in time, have to pay higher taxes than they would otherwise have done. This means that, as they make each purchase, a proportion of that purchase is paid for by money the individual is indirectly borrowing through too low taxation.

The second way in which the person is spending borrowed money is somewhat more complicated. For the sake of ease, we will just look at government borrowing, but a similar situation applies for private borrowing. If we return to our individual paying cash, and imagine that he is buying a car, part of his payment comes from borrowed money indirectly derived from government borrowing. When the car dealership accepts the money from the individual, they will have increased revenue, and that revenue will pay for many other things, such as their staff salaries. A proportion of the money indirectly borrowed by the individual making the purchase then ends up in the hands of the staff of the car dealership. The dealership staff will then go on to spend the borrowed proportion of the money, and that will then be used by whichever organisation is in receipt of the money from the staff.

In other words, the money that was originally borrowed by the government percolates through the economy, and it becomes ever more difficult to separate the borrowed money from the money earned as 'real' income. As the borrowings of the government are transmitted through the economy, it becomes apparent that what appear to be 'cash' sales actually are always utilising borrowed money.

As I have said, it is a difficult idea. You may wish to see my first post on the subject, 'The Cigarette Lighter Problem' as I was just starting to grasp at the concept, and it may therefore help in understanding the ideas behind it. The reason for my return to this subject is the curious case of Greece. This is a commentary on the subject:

Since 2000, Greek unit labour costs have risen by almost 40pc. Meanwhile, German unit labour costs have barely risen. This loss of competitiveness by the southern countries is central to their current poor economic performance and their lack of viable prospects for the future.

If governments are obliged to cut back and consumers and/or companies are lumbered with excessive debts, it is to exports that these countries must look for salvation. For the eurozone as a whole to achieve prosperity and economic success, accompanied by stability and sustainability, will require the solution of both these problems. But are they simultaneously soluble within the current financial framework?

If the southern members – "Club Med" – are to regain competitiveness within the euro, the only way is for their costs and prices to increase more slowly than costs and prices in the remainder of the eurozone, led by Germany. (Let us call these countries Germany.) If costs and prices in Germany are barely rising at all, then Club Med must regain competiveness by deflating – ie. costs and prices actually falling.

The key point in this commentary is the wage inflation in Greece. How was this achieved? For the following, you may wish to view here, which has an excellent collection of charts for the Greek economy. Greece has apparently achieved an increase in productivity per head, and also TFP. This might be seen as an explanation for the growth in wages (at least partial). However, if we look at charts for labour market participation rates, we can see that these rates have also climbed. The question is, why?

The answer is that there was a mass of borrowed money percolating through the economy, pushing up activity, wages and employment, as well as providing employment for a larger workforce. This is an example of how an economy might become distorted as it becomes structured around deficit spending.

This is why the only real solution for Greece is to lower wages and costs throughout the economy. When the borrowed money disappears, the Greek economy is left with a structure in which wages are too high, and that is because the borrowed money created wage inflation. Everyone in the whole economy were laying their hands on borrowed money, even if they were apparently spending cash earned from income. In essence, it is the reality of the 'Cigarette Lighter Problem' with a harsh spotlight shining on it.

What we see in the case of Greece is the illusion of wealth appearing over all of the statistics, and this is partly why Greece managed to appear to be in a sustainable position for so long. Many of the statistics appeared to be positive, but they were only positive because they were not accounting for the borrowed money that every individual in Greece included in their spending. The borrowed money allowed the rapid wage inflation that is reported in the article. And the lesson from the case of Greece and the Cigaretter Lighter Problem - I will let you draw your own conclusions.

Friday, July 9, 2010

Structural Change - The Necessary Pain

The economy of the UK is, it seems, about to undertake some significant structural change, and it is going to hurt. A lot. We still do not know the details of the forthcoming cuts, but analysts are already starting to pull out their calculators, and work out how they might impact upon jobs and businesses. The cuts were never just about reducing the number of civil servants, but about the knock on effects in the wider economy. This from the Telegraph, reporting the analysis of Begbies Traynor:

"We are concerned that the levels of business distress will increase again, potentially from the first half of 2011, once the full effects of the coalition government's fiscal tightening measures impact the economy and particularly amongst those private sector businesses most dependant on public sector contracts," said Ric Traynor, executive chairman of Begbies Traynor.

"It will not be until after the Government's Comprehensive Spending Review in October that we will know for certain the allocation of spending cuts, but there is a growing risk that, even if the UK avoids a double dip recession, it could develop a twin track economy, with public-sector dependent industries facing higher levels of financial distress than sectors which are less directly linked to government spending cuts."

Those sectors most heavily dependent on public sector spending include construction, IT, recruitment, advertising and business services.
The trouble is that this is an analysis which only goes so far. When these private sector organisations hit a brick wall, they will, in turn, hurt other private sector companies that provide goods and services for them. And then there is the withdrawal of the money from the economy as many of these workers, both directly and indirectly employed by the government, move from having employment income to unemployment income. In other words, the cuts in government expenditure will ripple out through the wider economy.

Is this a reason not to cut?

Some might argue that the knock on effects presents an argument not to cut. Better to keep on spending, as the consequences that ripple through the economy are too hard to contemplate. The problem with this view is that, somehow, somewhere, all of the activity of the people working for the government, and the businesses that service the government, must have an origin in productive output from the private sector.

This is not an easy concept to deal with, as the interaction of the public and private sector results in complex relationships. For example, a nurse working in the NHS represents a consumption of resources, but has a real output in terms of health outcomes for patients. This output is real, and might mean a worker being able to work and originate more added value within the economy. However, if we imagine that the nurse was not employed in the NHS, and instead worked in the private sector in another role, then that nurse would be creating an output that might be an origin of the added value that might pay for other nurses.

However, life is not that simple. We do not think of nurses just as adding value in the economy, but performing a role that is rooted in a sense of justice. i.e. many of us think that all people should have access to health care. As such, we do not restrict the activity of nursing to just help people who might go on to add value within the economy. In light of this, the NHS represents a net consumption of added value generated elsewhere in the economy. In order to pay for this, we must be generating sufficient added value elsewhere. Each nurse, for example, will consume goods and services from their pay, and those goods and services may originate from within the economy, or from an external economy.

When the nurse does her shopping, she may buy an avocado imported from another country, and that must be paid for from goods and services exported from the economy. Likewise, when the nurse drives to work in her car, that car may may be imported and somebody somewhere must be providing goods and services to allow for that import. If the nurse buys a domestic good, it may well be that the manufacturer of that good needs to import raw materials, and those must also be paid for from the export of goods and services. There are very few economies that even start to have the potential for autarky and, in the UK, autarky is an impossibility (if the UK is to maintain a reasonable standard of living/quality of life for the people).

Within this nurse example there is a balance at which there will be the 'right number' of nurses to ensure that there is the maximum value creation in the economy to pay for the health services. If there are too many nurses, there will not be enough creators of value to pay for the nurses...of course, it is the aggregate of all people employed in government consumption of value added in the economy that matters, and that is the question of priorities (e.g. the choice between one nurse versus one policeman).

The point that I am making here is that, overall, government is a net consumer, and is entirely reliant upon the added value that is generated within the private sector to fund this consumption. The amount that a government might sustainably consume is entirely dependent upon the amount of added value that is created in the private sector, and this is an unavoidable reality. The problem that arises in government consumption is that, in order to consume, there is an opportunity cost. If worker 'x' is employed in government activity, they are not employed in potential added value creation in the private sector. Likewise, if a company is utilised in supporting government consumption, the workers in that company are involved in that net consumption, rather than the creation of added value which might pay for that government consumption.

Somebody, somewhere, somehow, must be producing goods and services for export (and internal use) in order to support an economy, unless that economy is autarkic. That means that they must have an output which not only provides for domestic needs, but also a surplus to sell at a profit to other countries. Furthermore, the more added value that these enterprises create per unit of labour, the more goods and services that will be available for consumption within the economy, and the more available for export.

It is here that we meet the relationship between government net consumption and the wider economy. Government consumption must not reach a point at which they are consuming so much that there is insufficient surplus to pay for the imports of the country, as the country is not autarkic. If a country is autarkic, the amount consumed by the government is a splitting of resource between private and government consumption, and that is a political question. In the case of a country that needs/wants to import, it is a question of economic necessity that the country produces sufficient surplus of added value which is available to pay for the imports. The greater the consumption of the government, the less surplus is available for export.

We can see this in taxation. If a government is over-consuming relative to the private sector output, there will be higher taxation (or government borrowing). Taxation is the removal of added value in the economy into the hands of the government for government consumption of that added value, meaning that the added value is not available for export. The situation is somewhat confused by the fact that, for example, government employees are taxed, but the origins of the added value is in the private sector. In the case of government borrowing, this just means a deferral of the removal of that added value for consumption now.

What we have is a basic reality that the extent of government consumption is, in the long term, going to be constrained by the opportunity cost of employing 'x' number of people in servicing that government consumption. The principle is simple. If a person is employed as a result of net consumption of the government, they are not employed in creating the added value for the government to consume. In practical terms, this is the constraint upon government; that constraint is, in the end, determined by the absolute numbers of the workforce creating added value in the private sector, and the productivity of those workers.

If an economy is exceptionally productive, it is possible for the private sector to give an absolute greater amount of their added value to the government, and still be able to succeed in competition with others, but the total added value taken from the private sector must be determined by the relative productivity of the total number of workers within the private sector (excluding those supporting government consumption). The question for each economy is how productive the private sector is - or how much added value each worker produces. Fantastically productive workers, in relation to other countries, will allow for a larger public sector than those other workers (whether a large public sector is ever a 'good thing' is debatable, and not the subject of this post).

We can now return to those private sector workers who are (potentially) going to lose their jobs as a result of cuts in government expenditure. As they lose their jobs, some will still be in receipt of government money, in the form of unemployment benefits, but their net consumption from the economy overall will be reduced. They will be consuming less, and will therefore overall contribute to a lessening of the proportion of government consumption within the economy. They are being paid less, and all of the other expenses that surround each employee's activity disappear.

Furthermore, the skills and experience of that employee will become available to the private sector where they might contribute added value that might support government spending overall. Indeed, some employees made redundant will make this transition without any recourse to further government expenditure of overall resource. They will switch into new jobs straight away.

Buried within this scenario, of course, are the personal consequences for those that do lose their jobs. For some, this will be a major problem, and will be distressing. They will be angry at the government that has made the cuts. However, I would argue that this is a misplaced anger. The anger should be directed at a government that created an unsustainable job in the first place or, put another way, a government that sought to consume more overall than the economy could sustain. In over-consuming the resource of the country, they structured the economy in a way which was unbalanced, encouraging workers into sectors and activities that could not be sustained.

For the individuals who took work that was rooted in over consumption by the government, they had no way of knowing that their position could not be sustained over the long term. It really is not their fault that they lose their jobs, but the fault of a government that created an unsupportable structure. This is cold comfort for those workers. Likewise, the businesses that will go bust structured themselves to support the over-consumption, and it is not the fault of the proprietors that they have gone bust. They were incentivised by the government to direct their resources to unsustainable government consumption. Again, this is cold comfort when the axe falls upon their head.

The problem of austerity is that, whatever happens, the shift from government consumption of resource means that those employed in activities to support that consumption are going to be hurt, whether now or later. Someone must be hurt by a transition back to a sustainable path. That this is not their own 'fault' does not alter the absolute necessity of change. The best that can be done is to try to ameliorate the effects. We can all agree on the fact that this is unfair for the businesses and individuals involved, but to place blame on the 'cutters' is to place the blame on the wrong people. It was those that distorted the economy onto an unsustainable path that shoulder the responsibility.

I will end this post with a quote from an interview with the Chief Executive of HSBC, who seems to grasp the point:

"The reality is that is may be good to have full employment, but if that employment is driven by public employment it's telling you something very clearly... something is not functioning in your society."
In this quote, he is grasping the essential reality. Something is wrong when government consumption exceeds the ability for the economy to pay for the consumption.

Note: Over consumption in the private sphere offers similar problems, but the purpose of this post is to discuss government austerity measures.