Friday, January 29, 2010

GDP Growth, Debt and Current Accounts

We should all be celebrating, should we not? The news is that US GDP grew at an annualised rate of 5.7% in the last quarter, and the UK finally moved into GDP growth, albeit that the UK GDP growth is negligible. Should this be a cause for celebration, should we not be singing the praises of those that engineered this 'recovery'? I will apologise in advance for the long quotes that follow, but these are necessary to understand the nature of the 'growth'.

The US

If looking at the source of the surge in GDP growth in the US, AFP provides an explanation:

The big GDP gains came in large part from businesses ramping up production to rebuild inventories, which economists say may skew the picture of overall activity but is a normal part of recovery. Inventories accounted for 3.39 percentage points of GDP.

Stripping out inventory adjustment, real final sales -- a reflection of the underlying pace of growth -- was at a 2.2 percent rate, the report showed.


Capital spending on equipment and software surged 13.3 percent, another significant contributor. Ian Shepherdson at High Frequency Economics called this a "key upside surprise" but added that "we can't see where this comes from and think a downward revision is likely."

The data showed exports surged 18.1 percent, making trade a positive contributor to GDP since exports increased more than imports, which were up 10.5 percent.

Consumer spending, which is traditionally the key driver of economic activity, rose at a 2.0 percent pace, down from 2.8 percent in the third quarter, and accounted for 1.44 percentage points of GDP.

In the case of the US, it is noticeable that there is some cynicism about some of the statistics, and that the rebuilding of inventories will presumably diminish as an influence. A real positive is that 'export growth was strong at 18.1% which leaves net exports contributing 0.5pp to overall GDP growth.' However, before the US starts celebrating, it is necessary to add a dose of cold hard reality. The chart that follows shows that the 'growth' in exports starts from a low base:

Then there is the imports of goods and services, which is the other side of the coin:

All this give a balance on goods and services trade as follows:

But here is the real problem. As the economy contracted, so did the current account balance. However, as 'growth' commences, a commensurate deterioration in the current account balance follows. In other words, the 'growth' is seeing the US problem of consuming more than it produces worsening as the economy 'grows'. It gives a horrible sense of deja vu...

Observant readers will note that the chart only goes to mid 2009, and does not therefore include this current spurt in 'growth'. I suspect that, once the figures are out, the line will continue the downwards trend. The preliminary figures from the Bureau of Economic Analysis suggests a growth in the current account deficit for the third quarter of 2009.

What we are seeing is the delayed effect of the government's role as a replacement for the loss of consumer debt driven economic 'growth' (the chart is 'Household sector: Liabilities: Household Credit Market Debt Outstanding') .

I do not think anyone needs to see the following chart which shows the massive increase in the government deficits, but will include it anyway.

As a final chart for the US economy, we have the GDP figures that have caused so much excitement.

It is not difficult to see what is taking place when we see these charts. As consumer debt growth tailed away, the economy fell into deep recession, and with it there was an improvement of the position of the current account balance. The current account balance started to move in the right direction as American consumers moved towards living within their means. However, as this took place, the government replaced the consumer as the driver of debt driven consumption, and we are now seeing the return to 'growth' with a commensurate decline in the state of the current account balance. The early decline in GDP reflects the time lag for the wall of government borrowed money to hit the economy but, as it works its way through the economy, 'growth' appears again.

The UK

In the UK this is what national statistics offered as an explanation of the slight GDP growth:

Services output rose 0.1 per cent, compared with a fall of 0.2
per cent in the previous quarter. Distribution, hotels and restaurants contributed most to the increase. Distribution, hotels and restaurants rose 0.4 per cent, compared with an increase of 0.7 per cent in the previous quarter. Motor trades and retail contributed most to the increase. Transport, storage and communication showed zero growth, compared with an increase of 0.7 per cent in the third quarter. Business services and finance showed zero growth in the fourth quarter, compared with a decrease of 0.8 per cent in the previous quarter. Government and other services rose 0.2 per cent, compared with a decline of 0.2 per cent in the previous quarter. Health made the largest contribution to the increase.

Total production output rose in the fourth quarter, increasing 0.1 per cent, compared with a fall of 0.9 per cent in the previous quarter. Manufacturing made the largest contribution to the increase rising 0.4 per cent, compared with a fall of 0.2 per cent in the previous quarter. Mining and quarrying output rose 1.0 per cent, compared with a decrease of 5.7 per cent in the previous quarter. Electricity, gas and water supply fell 3.3 per cent, compared with an increase of 0.2 in the previous quarter.
The same kinds of relationships can be seen in the UK data as can be seen in the US. If we start with the balance of trade, we have this from national statistics:

And then there is the current account balance:

The following is a chart of net lending which, whilst not directly comparable with the US chart, shows a similar pattern.

Just as consumer lending goes into reverse, as in the US, the UK government steps in to replace consumer borrowing with government borrowing:

And finally, there is GDP growth figures:

What we are seeing is the same pattern as the US, but at an earlier stage. Just as the US moved towards growth, and the current account balance started moving in the wrong direction, the same is happening with the UK. Just as the US government replaced the consumer as a borrower, the same has taken place in the UK.


Whilst they are not following exactly the same pattern, there is an uncanny similarity in the relationships between the charts for the US and the UK. What we are seeing is not economic 'growth', but growth in debt. It is not the first time I have said this, but it is worth saying it again. This is like measuring a person with a salary of $100,000 and adding borrowing of $20,000 to suggest that he has an income for the year of $120,000. Sure, his purchasing power has increased, but his income has not. Just as the individual can now spend more than he earns, so can the US and UK. This is reflected in the current account and trade deficits.

None of this is economic growth, but is instead a steady process of national impoverishment. It is the feel good of consuming more than you produce, and the hell with the consequences in the future. It is a road to ruination, and I will therefore not join any celebrations for the increase in GDP. It is the height of irresponsibility.

Monday, January 18, 2010

China: A brewing confrontation?

It seems that China is, at last, really being noticed by mainstream analysts. When I see really, I am referring to the key part that China is now playing in the world economy. Of particular note is that the growing share of the world export market held by China and that China is now the world's largest automotive market (mentioned in a recent post).

Perhaps it is these statistics that have served to focus minds.

The actual analyses that are being offered, and the opinions about what might be done about China, are varied. A good contrast can be found between Dylan Grice of Socgen and the Economist magazine. Grice notes that different standards are applied when analysts and investors view the Chinese economy, and provides an example in the comparison of value between Lloyds of the UK and ICBC of China. Both are part government owned, both have potential risks in their loan book, but Lloyds is potentially subject to malign government intervention, whereas ICBC is actually subject to malign government intervention. Despite this, the valuation of ICBC is much higher.

Grice sees this as an example of irrational exuberance on the part of investors towards China. He notes that there is a boom in credit in China, and questions the idea that an infrastructure investment boom will not lead to a bust, citing studies that show that such a bust is possible.

The Economist offers a very different perspective, giving their article the title 'China's Economy: Not Just Antother Fake'. They commence their article with the many aspects of the Chinese economy that might look bubble like, and make comparisons with the conditions in Japan before the Japanese economy popped. However, they go on to say the following:
Scary stuff. However, a close inspection of pessimists’ three main concerns—overvalued asset prices, overinvestment and excessive bank lending—suggests that China’s economy is more robust than they think. Start with asset markets. Chinese share prices are nowhere near as giddy as Japan’s were in the late 1980s. In 1989 Tokyo’s stockmarket had a price-earnings ratio of almost 70; today’s figure for Shanghai A shares is 28, well below its long-run average of 37. Granted, prices jumped by 80% last year, but markets in other large emerging economies went up even more: Brazil, India and Russia rose by an average of 120% in dollar terms. And Chinese profits have rebounded faster than those elsewhere. In the three months to November, industrial profits were 70% higher than a year before.
In a later article (1), the Economist discusses the rise and rise of China's exports, and asks whether the growth might continue. They again compare China with Japan, and note that Japan's exports peaked once Japan had moved up the value chain. However, in the case of China, it is possible to move up the value chain, and keep lower value exports, as China can substitute the low for high value in the coastal cities, and still keep the low value in the inland provinces.

An even more optimistic assessment of China's prospects comes from Foreign Policy magazine (sorry, no link and reliant on memory for the article details). The thesis of the article was one in which China would rapidly develop to become the most dominant economy, and signals the decline of Europe and the US in comparison. Whilst the Western economies might not decline in absolute terms, the article saw them losing economic power and influence.

So where do I stand on the question of the prospects for China? In a series of articles (see links in the notes at the end) I have offered a cautious view of China's prospects. In my first article, at the start of the economic crisis, I suggested that China, on balance, would be likely to come out of the crisis stronger:
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. In the meantime the Western world needs to accept that it is no longer in a position to continue with its complacency. China poses a real and ongoing threat to the world economic order, and will continue to grow at the expense of the West, unless the West responds by restructuring of their economies through (real) improvements in education, lowering their cost base, and taking an aggressive approach to intellectual property and fair trade (for why, see here).
You will note that this is a very cautious prediction. I have highlighted some of the potential problems in the Chinese economy, such as the frothiness of the housing market, potential for dud lending by the Chinese banks, and (above all else) the potential for social unrest if Chinese growth ever goes into reverse, and many other concerns.

Within all of the discussions of China, there is often a fundamental problem. This is the idea that China sits as a stand alone entity, in which the policy of China might just be continued. I have frequently highlighted the mercantilism policy of China, and have long been arguing that, unless China acts to trade more fairly, it should be subject to trade sanctions. I have highlighted the manipulation of currency, the theft of intellectual property, and the conditionality of inward investment (with insistence on the transfer of technologies), as well as many other problems.

In August 2008, for example, I argued strongly that it was time to get tough with China, and highlighted a series of unrelated stories, all of which pointed to China using mercanilist methods to enhance their economic position. Whether they are making threats to destroy the $US, using the media to slander overseas businesses, arranging theft of intellectual property, China appears to be set on a course of establishing itself as THE economic power of the world. For example, I have previously mentioned the use of hacking by China to steal commercial secrets from overseas competition, and (again) this is actually starting to be noticed more widely.

The purpose in highlighting these points is that there has been a complacent attitude to the mercantilism of China, but the winds of change are blowing. China has a club to beat the world with, which is the holdings of massive foreign reserves. In an early post I highlighted that it was better to face down China now, rather than later. The ongoing growth of reserves held by China would just make confrontation ever more difficult. The complacency over the method of the ascent of China is now disappearing, but the potential dangers of confronting China have now grown. Nevertheless, there is an increasing recognition that something has to give. This from Roger Bootle in the Telegraph:
The looming threat to the world economy comes from the same source which contributed so much to the financial crisis, namely the draining of demand from the world economy through excessive Chinese saving. But now it will come at a time when most countries of the West are in no position to offset this effect through more stimulus policies and indeed, as in the case of the UK, may actually be about to tighten fiscal policy. We may be not far off the point where, if the Chinese don't take steps to make their trade with the West more balanced, then the West will take steps to do it for them.
Such sentiments can be found elsewhere, and I even find myself in agreement with Krugman, who is arguing against allowing the ongoing manipulation of the value of the RMB. However, what remains missing from these analyses is the complete picture. It is not just the matter of currency manipulation, but the many other policies of the Chinese government in conjunction with the currency manipulation. There is a pattern here, and I long ago discussed this in another post, saying the following:
It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.
I have not detailed the many individual stories that support the argument of this post, as they can be found in other posts (see list at end). The important point is that, if considering the future of China, it is necessary to consider the actions of China's key trading partners. My best guess is that the situation will not be endured by China's' trading partners much longer - that China will be confronted over the mercantilism. This is, of course, in the hands of politicians, who are by their nature unpredictable. What approach, when, or how they might seek to address the problems, and how China then responds, will play a key part in the determination of whether China continues on the current upward trajectory.

My best guess is that China is heading for very troubled waters. I do not think, as the economic crisis proceeds, that the world will sit by and watch as China continues with the current policies. At the same time, China knows that it must continue to grow if it is to achieve social stability, and that means that it fears make any concessions. In fact, from the point of view of the Chinese government, China MUST continue to grow. That means that they will not back down easily, as the mercantilism is a key element in the level of their growth. In other words, the stage is being set for a confrontation, and the outcome of the confrontation might have profound effects on the ascent of China.

(1) 'Fear of the Dragon', Economist print edition, 9th January 2010

Note: Links to previous posts on China. These posts are the ones that are largely focused on China, but there is discussion of China in other posts. From Trade and Forfaiting Review:

Shanghai Suprise

From the Blog:
  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 (post indirectly associated with China)
  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. Sep, 2009, The Rise and Rise of China
  14. Sep, 2009, China and Treasuries: A Puzzle
  15. Oct, 2009, The Great 'Shift' China and the West
  16. Jan, 2009, China on Track - The Car Industry
And the role of China in the development of the broader economic crisis can be found here (on Huliq).

Thursday, January 14, 2010

The Winds of Change

Since first starting to write on the economy I have slowly developed a picture of the world economy, and that picture has alarmed me. As I wrote recently, it is a picture in which policymakers have an illusion that they are in control, but a reality that they are not really able to predict the consequences of their own actions within a dynamic and interconnected system.

I have also long highlighted the problem of the use of GDP figures, on the basis that they do not really signal anything of value in relation to the underlying health of the economy. All the figures provide is an illusory sense of comfort, in which borrowing by governments and consumers, as if by magic, is recorded as income. A typical example can be found for the UK on the BBC news website:
The National Institute of Economic and Social Research (NIESR) predicts that the economy returned to growth, bringing an end to the recession.


NIESR said the pace of growth appears to be increasing. It estimates that there was a 0.2% increase in GDP in the three months ending in November.
The fact that the 'growth' is accompanied by massive government fiscal deficits is not apparently an issue. I sometimes feel that I am repeating myself endlessly in highlighting this problem, but the trouble is that it will not go away. GDP 'growth' is widely believed to signify that an economy is moving in the right direction, and it is believed by policymakers, economists and (of course) much of the general public. Even as governments rack up ever more unsustainable debt, analysts scrutinise every minute shift in this largely useless metric.

There are many excuses made for fiscal profligacy made on behalf of governments. There is the idea of stopping a 'downward spiral'. The argument goes like this; if we can only spend enough, then we will put money in the pockets of consumers, and they will continue to shop, and continue to pay their mortgages, and this will halt the downwards spiral. The reason for the problem, which is that (in aggregate) nations were spending more than they were earning is ignored. The solution is, in the end, founded upon an idea that it is possible to borrow and spend your way to wealth. Note, not borrow to invest, but borrow to spend.

One commentator on the blog insists that government debt is different to personal debt. For example, the suggestion is that government debt is supported by the tax base, and the size of the tax base is large enough such that, if need be, the money might be repaid. This is the argument that government might put money in consumers' pockets to save the economy now, only to take more out of their pockets in the future. This will happen, of course, once the economy returns to 'growth'. The 'growth' that is created is, of course, the 'growth' created by government borrowing and spending rather than the kind of growth that will lead to exports and a return to current account surplus.

It seems that the policymakers recognise this, as lax fiscal policy is accompanied by lax monetary policy, including printing money. This serves to debase the value of currency, and allows for the (potential) rebalancing of trade, and the erosion of the value of debts held in the devaluing currency. It is the hope that governments might borrow and then stealthily default on the debt by reduction in the value of the debt. The fiscal stimuli act to tide the economy over and the intention is that the true value of the debt will never be repaid. As the country emerges from the crisis, as exports once again pick up, all will be well as the debt is repaid in currency that is devalued and export growth will pick up the slack.

That is the theory, but no policymaker speaks of it openly.

The problem is this; the policy can only work if the providers of credit are willing to be duped. That is the essential flaw in the policy. To date, the governments following this kind of policy have gotten away with it so far, and I am thinking of the UK and US in particular.

I have talked about the steady erosion of belief that is the foundation of these kinds of policies. It is the belief that the rich world countries will always be rich - that one way or another the wealth will always be there as if by some divine right. The rich world has always been rich, and always will be. This is simply a question of belief, and has no logical or empirical foundation.

Wealth is something that is created through hard work, dynamism, creativity and investment. It is achieved by out-competing the competition. There are many ways in which this might be achieved, but nonetheless, it is the bedrock of wealth creation. It is the aggregate of each individual's contribution within the economy to the creation of value.

What wealth creation is not is borrowing to spend, or creation of money with no foundation in an increase in output of value. Both of these are illusions of wealth, although the former might allow for a sense of real wealth for a while - if the country can get away with not repaying the money. As an analogy, we might think of a person borrowing to finance going on an expensive holiday. They really gain the benefit and enjoyment of the holiday whether they do, or do not, repay the loan that funded it. The fiscal profligacy of governments is providing the benefits in the hope that the full cost will never need to be repaid.

The problem is this; governments have promised their electorates that the 'holidays' are permanent, that we might continue with the lifestyles financed by borrowed money. Even as they are making such promises, they are quietly and surely defaulting on their borrowing. As I said earlier, the whole edifice rests upon creditors being duped. They must continue to believe that being paid in devalued currency is an acceptable deal.

The illusion really is coming to an end now and this is the reason for this post. The continuation of the policy maker's game all hinges on 'belief'. That belief is now being eroded as, day by day, more and more questions are being raised about what the policymakers are doing. The expression 'sovereign default' is appearing ever more frequently, and the policy maker's economic flim-flam is starting to be being seen for what it is; a fraud. I have just been reading the World Economic Forum's (WEF) report on the risks within the global economy. The following quote is of note:
The worst case scenario of overlapping economic recessions with political instability and social turbulence, triggered by untenable fiscal deficits and unsustainable government debt burdens, might not, after all, be impossible.
In their highlighted risks section, they say the following:
In response to the financial crisis, many countries are at risk of overextending unsustainable levels of debt, which, in turn, will exert strong upwards pressures on real interest rates. In the final instance, unsustainable debt levels could lead to full-fledged sovereign debt crises.
They express particular concern for the UK and US, saying that "Governments, in the US and the United Kingdom in particular, are now faced with a set of tough choices, all with consequences for future global risks." They highlight the increasing of structural costs, such as the ageing of populations, and the absolute necessity for credible plans of how the fiscal deficits might be reduced. They point out the problems with formulating such plans; that the politicians need the courage to tell their electorates of the tough choices.

Their assessment of risk in reality hinges upon the idea that countries like the US and UK are living beyond their means. They are borrowing more than they can repay, and the only way to resolve the situation is for the countries to live more modestly (if you can excuse the metonymy). In saying this, they are replicating the argument that this blog has made from the first post.

The WEF is not alone. Many others are expressing their concerns, such as Nouriel Roubini. In a recent article in Forbes, he says the following:
The severe recession, combined with a financial crisis during 2008-09, worsened the fiscal positions of developed countries due to stimulus spending, lower tax revenues and support to the financial sector. The impact was greater in countries that had a history of structural fiscal problems, maintained loose fiscal policies and ignored fiscal reforms during the boom years. Going forward, a weak economic recovery and an aging population is likely to increase the debt burden of many advanced economies, including the U.S., Britain, Japan and several eurozone countries.
Roubini highlights the risks for countries such as the UK and Spain for sovereign default, but suggests that the reserve status of the $US will allow it to be amongst the last of the 'at risk' countries to face 'investor aversion'. I am not so sure, but believe that, if a country like the UK defaults, the initial reaction will be to flee to the 'safe haven' of the $US, before a rapid realisation that this is jumping out of the frying pan into the fire.

Roubini and the WEF are just some of the increasing number of analysts who are questioning the activities of policymakers. The voices talking of the unsustainable deficits are increasingly loud, and they will be making an impact. The nerves of investors in sovereign debt will be jangling. It is no longer just bloggers such as myself who are raising these concerns, but commentators with high profiles.

In my mind, it is just a question of timing now. When will the dominoes start to topple? It is still possible, in principle, that crisis might be averted. It is possible that the policymakers will pull back from fiscal irresponsibility. It is possible, but looks increasingly unlikely. They have promised to 'save' their economies. The big questions now are the questions of when it will start, and what will provide the push.

Note: At the start of last year, I made a prediction of crisis for April, and was proved to be completely wrong. The underlying principles I highlighted were the same as here. Why might I be right this time, when wrong before? The problem in my first discussion was that, I had simply not factored in the strength of 'belief' in countries like the UK and US. A sovereign crisis requires loss of belief in the creditworthiness of the country, and that belief has proved to be far more resilient than I imagined. It is why I have emphasised the high profile of commentators who are raising the concerns. It is more difficult to shift firmly held beliefs than I thought, but nevertheless it is possible for belief to shift. I believe that the process is now rapidly advancing.

Monday, January 11, 2010

China on Track - The Car Industry

In my last post of just a few days ago, in a broad (and rather rambling) review of the world economy, I discussed Chinese mercantilism, and also the shift of wealth to the East. One commentator quire reasonably pointed out that I was lumping together too many economies, which is entirely fair. However, within the discussion, I did single out China, and that is because the economic power developing in China is founded, in part, upon mercantilist policy. This, and the rise of China, have been longstanding themes, and I have sometimes faced criticism, in particular the size of the US economy in relation to China is given as a reason for my over-egging the pudding.

There is little doubt that, per individual, the average wealth that remains in the US far exceeds that of China, though the current economic adjustments are seeing that differential shrinking (and the full impact has yet to be felt - see previous articles for the underlying real size of the US economy). However, having said this, the speed at which China's economy is growing is quite astounding. I return to this subject, as a couple of articles captured my attention in my general browsing of the economics/business news.

The first comes from the Telegraph, and has the following to say:

Monday's data echoes figures released last week from Global Trade Information Services which showed that China shipped products worth $957.7bn in the first 10 months of 2009, while Germany sold goods worth $917.7bn.

"One thing is for sure, China is the leading exporter globally," said Zhang Yansheng, director of the Institute of Foreign Trade of the National Development and Reform Commission, to the state media.

However, analysts cautioned that the strong year-on-year growth in Chinese exports should be put into context: the comparison month of December 2008 was a dire one for trade, as the economic crisis brought factories and shipping companies to a standstill.

There are caveats within the report, and I deliberately included these. However, the trajectory is firmly upwards. I suspect that the improvement in the position of China for exports (relative to the rest of the world) is set to accelerate, unless of course a new era of protectionism commences. At the moment, this is a hunch based upon the ongoing importation of technology into China, the diffusion of that technology, the growth in the number of graduates entering the labour market (both from internal and overseas universities), and the mercantilist policy of currency manipulation.

The other related piece of news that grabbed my attention is the matter of China becoming the world's largest car market. This from the Times:

There have been few worse years for the US motor industry than 2009. Sales plunged, two of the big three — General Motors and Chrysler — went into bankruptcy and now it emerges that the US market was outstripped by China for the first time.

The China Association of Automobile Manufacturers revealed yesterday that a record 13.6 million light vehicles were sold in China in 2009, compared to around 10.4 million in the United States.

Small wonder then that carmakers gathered in Detroit for the city’s Motor Show — widely considered the most important on the world circuit — are increasingly looking to China for sales growth.

This is not the end of the story, however, as the wider story also supports the idea of the accelerating rate of China's development. Again, from another article in the Times:
Chinese automakers have already begun to signal their ambitiousness. Geely’s recent takeover of Volvo, Beijing Automotive’s purchase of technology from Saab and Sichuan Tengzhong’s impending purchase of the Hummer brand are viewed as mere appetizers for more extensive M&A as the decade unfolds.
Whether these purchases will make money in their own right is questionable, but these kinds of purchases will serve to accelerate the technical capability of Chinese car manufacturers. We should remember that it was not so long ago that South Korean cars were viewed as poor quality, and also that Japanese cars were once considered to be very poor quality. In isolation, these purchases are not that meaningful, but I suspect that we will see more and more companies with strong technical bases appearing on the shopping list of Chinese companies - in many, many sectors.

In some respects, this is just an acceleration of a process of learning that has long been played out. For example, when I first arrived in China, I met a person from the UK who was literally teaching a Chinese company the basics of effective ceramic manufacturing. I forget the name of the company, but suspect that many of us will probably have the products from the company somewhere in our homes.

As a summary, China is learning fast, and is putting in place the necessary antecedents to move up the value chain. A few years ago, the prospect of China developing a competitive homegrown car industry would have been seen as wildly optimistic. However, it is very likely that, as the Chinese car industry consolidates, grows in experience, it will emerge as a serious competitor. China is increasingly securing the resource, training the people, and importing the technology to take on the best of the rich world. It has some way to go, but we should not underestimate the potential for rapid development - in all sectors.

Sunday, January 10, 2010

The Masters of the Universe

I have not posted for a while, but have two three quarter finished posts which I can not quite manage to finalise. The reason for the procrastination is that there are so many elements in the world economy that are flashing warning lights. Each element, of itself, might not be a major concern, but collectively they add up to some major concerns. The problem is how to convey concerns about such wide swathes of the global economy. I will do my best, but will apologise in advance for a lightly referenced and perhaps rather rambling post.

The other problem is the sheer volume of views and opinions on what is taking place. As Ambrose Evans-Pritchard of the Telegraphs says, it is time to rip up the textbooks. He is talking about the ongoing and partially hidden crash in US housing, and the underlying unemployment rate of just over 17%, and makes comparisons with the Great Depression. In my case, I long ago ripped up the economics textbooks, as they never made any sense, but it is interesting how many mainstream commentators are now taking this view.

What we saw in 2009 was the final and last gasps of the enactment of the textbook economic theory that has dominated policy over the last few years. The economists and policymakers have now shot most of their monetary and fiscal bolts. In other words, the politicians, the economists, and the central bankers have continued pulling and pushing on the levers of the economy in the hope that reality might be forced back into its box. We have seen fiscal stimuli, and a flood of printed money into the world, and this has been used to finance record government deficits. We have seen bailouts, guarantees of toxic assets, the concentration of the banking systems into ever fewer too big to fail players.

However, in 2009, whilst everything appeared to change, very little has really changed. Whilst many of the 'rich world' countries have fallen into deep recession (if not depression), there has been no change in the underlying reality of the world economy. On the surface, we can see all of the activity of governments to 'save' their economies, but the changes are restricted to appearances, not to the actual way in which their economies are really structured.

What do I mean by this?

It is very simple. Whilst governments intervene in ever greater swathes of the economy, nothing has changed in the underlying competitive position of the 'rich world' economies that are in such deep troubles. Except for the devaluation of currencies.

It is the lever of last resort. If you can not compete, do whatever you can to devalue the currency, and then your workforce will be cheaper relative to the work force of your competition. It is a strategy that directly reduces the standard of living of every person paid in that currency. It punishes the savers, punishes the investors, but if it is taken far enough, eventually the economy will once again be 'competitive'. It is an economic policy of impoverishment, however it may be dressed up.

However, even with such devaluations, all is still not as it should be. The imbalance at the heart of the world economy has not gone away. Even as the $US falls, the RMB falls with it, making the Chinese economy ever more competitive, and ensuring that Chinese goods and serviced continue to win on the back of mercantilism policy. Nothing has changed, as no country yet has the resolve to face down Chinese mercantilism, even as the policy of China slowly but surely destroys swathes of industry around the world. Even in the depths of recession, the pre-crisis current account deficits persist in many countries.

In the latest mercantilist move, China is now talking of restricting the export of rare earth metals, over which they have a virtual monopoly. These metals are vital commodities in the manufacture of a huge number of goods:
Worldwide, the industries reliant on REEs [rare earth metals], which produce anything from fibre-optic cables to missile guidance systems, are estimated to be worth £3 trillion, or 5 per cent of global GDP.
If you want to manufacture using these materials, best you have a base of supply and manufacture in China. Even the possibility of a freeze on exports will result in industries moving to China. And the response to this latest mercantilism policy? Nothing. No threats of trade sanctions, no action whatsoever. As before, China just continues its economic power grab, and the reaction is nothing of any substance. As I have said, nothing has really changed. Wealth creation will continue its inexorable shift to the East.

Then there is the structure of trade that is associated with the shift of wealth. Nothing has changed there either. Just as before, much of the 'rich world' continues to consume more than it produces. Sure, consumers are no longer the primary drivers of the debt binge economy, with the government seeking to fill the holes created by the retraction of consumer borrowing, but the essential reality of consuming more than is created continues. Nothing has really changed though because, in the end, government borrowing is consumer borrowing, as consumers will eventually pick up the bill.

There is one change that results from the debt binge of governments. The belief in the wealth of the 'rich world' is eroding, and the ability for the rich world to raise finance is eroding with this belief. It brings us full circle to the problem of printing money to pay the government's bills. If ever there were an exemplar of the underlying reality that this is a means to finance government profligacy, the Bank of England should metaphorically step forward. Tasked with maintenance of steady CPI inflation, the Bank of England claimed that the policy of printing money was to stave off deflation. Even as CPI inflation threatens to climb upwards, the original purpose of the policy is de-emphasised, and the policy continues.

For a while, the massive government borrowing of countries like the US and UK appeared to be possible. It seemed that the world accepted that all would be well, that the rich countries would continue to be rich, and were good for their debt. It seemed that countries could even 'get away with' printing money to finance government spending. I for one, never believed that such a situation could be possible, and was certain that it would all rapidly end in tears. However, throughout 2009 governments 'got away with it'.

As we enter into 2010, this looks unsustainable. More and more cracks are appearing in the edifice. Whilst each crack appears to be meaningless of itself, cumulatively they are destroying the integrity of the structure. There are the bilateral deals by China to trade outside of $US, the emergence of a petro-currency, the withdrawal of PIMCO from US and UK bonds, the shift of money into commodities, the carry trade of the $US and so many other small cracks....

The big question is this. Who is going to continue to finance the debt binge of the deficit countries in the coming year?

The cracks in the edifice of belief in the inevitability of the 'rich world' being rich mean that the supply of endless credit may well be coming to an end. In many countries, and I think of the US and UK in particular, though there are many others, there is the belief that the current structure of their economies might, somehow, be maintained. There is a lack of understanding that, in the end, that structure is built upon the credit provided by other countries, and without that credit, the structure can not be sustained. Even as the structure is crumbling before our eyes, there are many commentators, analysts and politicians claiming that this is a temporary aberration, and that all will one day return to normal. There are even claims that the economic crisis is coming to an end.

The analysts and commentators point to their indices, and say that, 'yes, things are looking up'. GDP is growing, or house prices rising once more, or industrial output has ticked up. The indicators are trotted out to suggest that all will be fine once again. The magic of governments and central banks pulling on their levers has worked. That the only explanation for such upticks is due to the largess of government, and that the largess of government is built upon overseas credit, is ignored. Strip out that overseas credit, and the situation looks very, very different.

Then there is the stability of the financial system. The banks appear to be making hay again, with business as normal having resumed. Meanwhile, in the background, do we really know what is going on? How much of that business as normal is resultant from the support of government and central banks? How much of this has been the socialisation of losses, the manipulation of accounting rules, the propping up of the house market through guarantees, and all of the other levers being pulled in the background. How much of the financial system sits upon the implicit guarantees of government, and how much risk is being transferred to the state?

What happens if the implicit guarantees of the state can no longer guarantee the financial system, because the states themselves are no longer seen as a guarantee? This is circular, as the more guarantees provided by the state, the greater the liabilities of the state, and the less the guarantee of the state might be seen as a guarantee.

I am not sure that anyone can actually pull apart the increasingly tangled knots between the financial system and the state. They appear to be mutually dependent, with the state providing guarantees, and the financial system funding the state with financial support through bond purchases to shore up their capital ratios, and so forth. How convenient that bank capital adequacy encourages the holding of government debt. Going back to Renaissance Italy, bankers were granted licenses and monopolies if they were willing to lend to the state on preferential terms. Nothing has changed.

But that supposedly rock solid capital that the banks are accumulating in the form of government bonds might, itself, be less solid than it is supposed to be. The same framework on capital adequacy that says that such bonds are safe is the same framework that said that lending to an OECD bank was safe - even though this proved not to be the case. Except....except, the lending to other OECD banks did prove to be safe, as governments and central banks stepped in and socialised the losses. The difference this time is that, if government debt goes sour, who might step in and socialise the losses?

Ambrose Evans-Pritchard is right when he suggests that we should rip up the economics textbooks. What we are seeing is a grand experiment, in which economists and policymakers are attempting to structure wealth in economies by fiat. As each lever is pulled, as each policy is enacted, there are ripples through the world economy. Flooding $US into the markets whilst holding interest rates low sees the export of $US popping up and creating bubbles elsewhere. Backstopping the mortgage market sees foreclosures reduced, but at the risk of calling into question (contributing to doubts about) the financial viability of the state. Holding the value of the RMB down leads to greater trade imbalances. Each policy has a consequence, and each policy interacts with the policy pursued by every other government.

In other words, as each lever is pulled, the consequences defeat the intention of the lever puller. For example, if the trade imbalances destroy the economic stability of the destination of Chinese exports, where will this leave the Chinese economy? The more each state pulls on the levers, the greater the turbulence between each of the economies. The world economy is a dynamic system, such that policy in one country impacts on the economy of another country, which then reacts with its own policy provisions, which then impact upon other countries. It is an endless cycle of reactivity, with each reaction driving further reaction, and developing an increasingly unstable system as each country enacts ever more dramatic policy to counter or ameliorate the effects of the policies of other countries.

A simple example is the relatively recent Japanese policy of printing money to stave off deflation. With rock bottom interest rates, the newly printed money was simply exported into other countries in the so called 'carry trade'. Within Japan, deflation persisted, whilst the newly printed Japanese money appeared in other countries, contributing to the process of asset price inflation in the countries that were the destination of the carry trade. The policy levers were pulled, but the consequences were far from those that were intended.

What textbook might be able to predict the outcome of such a dynamic system? Despite this, we see the policymakers pulling on their levers, and offering confidence that they know what they are doing. Apparently, the masters of the universe are in control.

I simply do not believe it.

As I said, nothing has really changed. The policymakers continue pulling their levers, continue to react, continue to seek to 'control' their respective economies. The only thing that has changed is the scale and scope and intensity of the policy. As they pull harder on ever more levers, the imbalances grow, the risks grow, and the consequences become ever less predictable. I was worried in 2009, but somehow governments succeeded in shoving reality back into its box. Can the masters of the universe continue to do so in 2010?

I am not convinced. Welcome to 2010.

Note: Thanks to Lemming who posted the link to the rare earth metals story, and thanks in general for the many interesting comments.