When I wrote my first essay on economics, 'A Funny View of Wealth' in November 2007, I wrote of the illusion of wealth in the UK, pointing out how the underlying basis for the apparent wealth of the UK economy was actually just the accumulation of debt. I described how, when the debt fuelled growth disappeared, the economy would spiral downwards, as unemployment rose, as the 'service' economy contracted. This is what I said in my conclusion:
All the while this is happening the government will fall into crisis. With a falling pound, an economy collapsing around them, and an already overstretched borrowing position, they will be faced with ever more expensive borrowing, meaning higher interest rates, or massive cuts in public expenditure. There will be no room to manoeuvre. The only solution will be to cut back on expenditure. Continuing to borrow will be too expensive, and would destroy the value of the pound, as well as creating an even deeper crisis of credibility that the UK government can manage the economy. As the government is forced to cut back, many of the new state sponsored jobs that have been developed over the last ten years will start to disappear. This will not impact immediately, where funds have already been allocated, and contracts remain, but the process will accelerate over time. Some regions, such as the North East, will be hit very hard, as their economies are largely dependent on the state sector.When writing this, I was just focusing on the UK economy, but much of what I said might have been applied to economies such as the US. At the time of writing the diagnosis of the problem was radical, and there was still a widespread belief that all was well with the economy of the UK. In the years since writing this, I have seen how the analysis of the situation has gradually and steadily moved into the mainstream. The idea that the pre-crisis boom was built upon a bubble is now accepted, and one illusion has been partially blown away.
The situation overall will be a massive contraction in the UK economy, a contraction that will see the UK step back in time in terms of economic development. The contraction will need to be deep and severe enough to reverse the illusory gains of the previous ten years (or even longer), and will require that the UK restructures its economy from top to bottom. It will, in effect, be the most significant crisis to hit the UK since the World War II. The only way out of the crisis will be to alter the fundamentals of the UK economy back to producing more goods and services for export led growth, and away from debt based growth in services. It will be a long, and very painful adjustment that will see the UK lose its place as one of the worlds’ leading economies, and recovery from the crisis will take many years.
It would be nice to end this conclusion with a sunny and positive note for the future, and to say that the UK economy will bounce back. However, this would require major changes in the structure of the UK, changes that will be hard to make. I worry that the politicians will not have the courage to lead the people of the UK through such changes, and therefore wonder whether the bounce back is possible.
In May 2008 I wrote an update, and suggested that sub-prime would just be the start of the financial crisis, that the situation would only get worse. A short while later, in a fit of frustration, I commenced my critique of the idea that GDP represents anything other than an illusion. It is a theme of this blog that GDP is a useless metric, and I expressed my frustration as follows in June 2008 (for the UK):
MEASURE THE GDP GROWTH IN TERMS OF £ sterling, SUBTRACT THE GROWTH RESULTANT FROM TEMPORARY IMMIGRATION, SUBTRACT THE AMOUNT OF CONSUMER CREDIT GROWTH, SUBTRACT THE MORTGAGE EQUITY WITHDRAWAL, SUBTRACT THE GOVERNMENT BORROWING, AND RECALCULATE REAL GDP GROWTH.I have since refined this basic point, and continue to express my frustration. Despite this, I still see economists and analysts talking of economic growth in the economy, when what they are really referring to is debt based growth in activity. It is an illusion that has yet to be punctured. We can still see celebrations of 'return to growth' which is based upon nothing more than activity stimulated by government borrowing. At some point, this metric, so beloved of policymakers, will finally be recognised for the delusion that it really is.
A short while before writing of the problems of GDP, I wrote of the 'Cigarette Lighter Problem'. The problem I identified was determing why a cigarette lighter purchased in a developed country conveninece store might cost nine times the price of an identical lighter purchased in a similar Chinese convenience store. Somewhere in the developed economy, some sector of the economy must be adding massive amounts of value to justify such a differential. The problem that arose was to understand where so much added value might be found, for example in comparison with a fast modernising China. The answer to the problem is that, in part, the price of the lighter is founded in an economy that is awash with debt.
My experience of living and working in China has had a profound effect on the way that I have viewed the economic crisis. It presented a reality check, a perspective on the way that the world economy has been reshaped by the massive input of labour into the world economy. I will not rework a post that I have recently made, in which I have reiterated my underlying explanation of the economic crisis as a massive supply shock from the increase in the world labour force. I suggest you read the most recent post on the subject here for an outline of the argument (though the argument was first presented in the blog in July 2008).
What I will emphasise is the consequence of the change in the structure of the world economy. We have entered a period of hyper-competition, and the developed world is losing to the emerging economies. What we are seeing is a massive shift in the distribution of wealth from the 'developed world' to the 'emerging economies'. This is the foundation of my thinking and views on the economy, and the argument is the foundation for my complete rejection of every response that has been made by policymakers to the economic crisis. Whatever happened, if you drop a massive surplus of labour into the world economy, competition would inevitably intensify, and the only response is to become more competitive.
In an article for TFR magazine, I used the example of the Tata Nano and SUVs to represent the fundamental shift in the world economy. Whilst the Tata Nano has order books that it can not meet, the sale of SUVs have shrunk. For the latter, the SUV represents a concentration of debt fuelled consumption, and could not be sustained, and for the former it represents the rising middle class of the developing world and the redistribution of wealth towards the developing world. The process has seen a move of the world market, in which the middle is progressively moving down and broadening, with emerging middle classes taking a greater proportion of global wealth.
There are two pictures of the world economy. In one picture, in the mind of policy makers and many economists, there is a belief that the SUV economy still exists or might exist. Their responses to the economic crisis is to try to recreate the SUV economy, and to reject the notion of the Tata Nano economy. It is the most grand of all the illusions. It is the belief that the real state of the world economy has not shifted. It is the belief that if we can only return to the consumption levels represented by SUVs, all will once again be well.
The problems of such an illusory picture of the world economy is best expressed by the obsession with consumer spending, and the price of housing. As an example, even as Greece spirals downwards, the worry is that, if Greece implements the austerity necessary to start to live within its actual wealth generating capacity, it will see a downwards spiral as unemployment increases, activity decreases, and revenues for the government slump. What this actually means is that, if borrowed money is removed from the Greek economy, we will actually see the real level of wealth creation in the Greek economy, and it will not be a pretty sight.
As for Greece, the same might be said of countries like the UK and US. The massive borrowing in both countries are an attempt to maintain the illusions of the SUV economy. It works like this; if you borrow money, the money lands in the pockets of consumers who spend, creating more activity, and they then pay taxes from that borrowed money, thereby increasing government revenues and increasing GDP.
The problem is that part of the money that is returned to the government is actually rooted in the borrowing of the government in the first place. The government gives out borrowed money, only to have a portion consumed before some of the government borrowed money is returned in taxation. The more governments borrow, the more money that appears in the economy, and the more money, the greater the activity, and the greater the activity, the greater the tax revenues.
It is all so neat, except that the increase in revenues is the result of borrowed money in the first place. The government is just indulging in a borrowed money merry-go-round, with each round of activity simply resulting in the consumption of a proportion of the borrowed money. All the time this takes place, ever more unsustainable deficits are accumulating.
If we look at Greece, we are simply seeing the potential for the underlying reality of the Greek economy to be revealed. The Greek people are expected to react with anger to the austerity that they are facing. The problem is that their government has, in effect been feeding them an illusion that they are wealthier than they actually are. The Greek people, it seems, simply do not want to accept that they are much poorer than they believe. They are no different to the people in countries such as the UK or US. In all cases, people just want the credit taps held open, and want to believe that they can continue to live beyond the means of their real collective output of wealth.
The problem is that Greece is simply the first in a line of countries that must finally accept that they are really much poorer than they think. This returns me to exactly where I started in my essay 'A Funny View of Wealth'. It is the idea that the consumption of borrowed money is the same as wealth creation. It is the fundamental illusion of the economists and policymakers. It is the illusion upon which so many other illusions are built. It is the foundation of government policy, economic analysts, and much of the commentariat.
However, as we are now seeing with Greece, and the threat of sovereign debt default contagion around the world, reality must one day intrude on the delusions of the SUV economy. In the Greek crisis, we finally are seeing the opening of eyes. The aggregate output of each individual that comprises the output of the Greek economy simply does not create enough added value to support the aggregate consumption of each individual. The reality is that, if a Greek individual is earning Euro 20,000 per year, the government is also borrowing over 2000 Euro's on his behalf and using that money to support the activity of the individual, and other individuals, within the economy. It is a self-reinforcing loop of delusion.
This is economics. The economics of illusion. And reality is starting to shine a painful and illuminating light on the illusion. Maybe, just maybe, the policy makers can just deflect the light of reality a little longer. A bailout of Greece might delay the illumination, but nothing will alter the reality that Greece, Spain, Portugal, Ireland, the UK, the US, are all in the same illusionary world as Greece. Many more might be added to the list.
All these countries share the same problem that can be summed up as; they have 'a funny view of wealth'.
A few of the latest headlines suggest that the Greek problem is spreading, with gilt yields already rising. Meanwhile, the EU support for Greece remains opaque, leaving the situation unresolved at the time of writing. It also is notable that an increasing number of writers are expressing concern about the lack of credible plans in the UK to tame the government deficit. In many cases these are the same authors who supported the massive intervention in the banks, and supported the fiscal deficits. Regular readers will know that I would have seen no such interventions, and would have allowed the very painful adjustments needed in the UK to take place sooner rather than later. The policies of the UK government and central banks have now just made the scale of the underlying problems even greater.
I wanted to write a post about China, but have been distracted by the Grrek crisis. I noted some interesting stories which seem to confirm my worries about China's role in the world economy. For example, I have previoulsy highlighted how China has used $US reserves to threaten the US before. In the early example I cited over a year ago, they used a proxy to make the threat during a period of trade sensitivity. They have done so again, this time using the military to make the threat. This method allows the government to deny the threat, whilst still having it 'out there'.
Another story reports of UK companies seeking to leave China due to the way that they suffer at the hands of the Chinese government's mercantilist policy. Again, it touches on a theme I made in earlier posts in which I described the way that the Chinese government would seek to diminish overseas companies in China.
I have long suggested that the RMB is being positioned as a replacement for the $US, with many suggesting that this is fantasy. However, the idea is steadily moving into the mainstream, as in this quote: 'The Chinese are very interested in the yuan becoming more important internationally'. It is hardly an endorsement of my thesis, but it is the baby steps towards it, and I have noted that this kind of view is gaining currency. With more time, I could have dug out similar views, and views closer to my own views (e.g. Roubini).
Another article that grabbed my interest is one which doubts the Chinese economic miracle is sustainable. I frequently include caveats in the discussion of the rise of China, and believe that there is potential for China's trajectory to turn. In particular, if the economic crisis does accelerate, I am not sure whether China will be able to manage to pull itself through unscathed, in particular if there is a serious challenge to China's currency manipulation from both Europe and the US. However, in the meantime, China looks to be well placed, and in a position to continue shopping for resources and new technology to help ensure the ongoing rise.
All of these points really need expanding, but time allows a brief summary only.
I will be away for a couple of days, so may take a while to publish your comments.