Wednesday, July 20, 2011

A Crescendo of Crisis - Explained?

Even though I have a hectic schedule at the moment, I could not resist the urge to post. I opened up Reddit, and several news sources, and it was interesting to see the brewing of so much potential crisis. For the sake of ease, and a sample of the point, I will use the Daily Telegraph to illustrate the point. The headlines and quotes are as follows:

Euro Reaches its Eleventh Hour

The German chancellor and the French president were barraged with pleas from political and financial leaders to reach agreement on bailing out Greece – or risk the collapse of the single currency.

The leaders have been told that today's crucial summit in Brussels was the "last chance saloon" for the euro project.

Wall Street Paralysed by US Debt Talks

The White House and Republicans and Democrats in Congress have 10 days to raise America's $14.3trillion debt ceiling. Failure to do so would see the government default on its debts, which Federal Reserve chairman Ben Bernanke has warned would be a catastrophe.

Investors' confidence that politicians would avoid that outcome has dwindled as the deadline approaches.

And for the UK, we have a commentary titled 'Britain's deleveraging nightmare threatens its triple A rating'. This is a quote from this commentary, and a chart from the same article follows:

Yet a substantial part of the Chancellor’s plans for eradicating the deficit rely on quite brave assumptions about the scope for future economic growth. With nine months of economic flatlining now under our belts, these assumptions are looking ever less credible. The Office for Budget Responsibility will almost certainly have to trim its forecast of 1.7pc growth for this year in its next update, and many will begin seriously to doubt its independence if it doesn’t adjust longer term forecasts down too.

In other words, the whole economic strategy hangs on a quite slender thread which could easily break and plunge the UK into the same vicious cycle of one austerity programme after another that has been forced on the European periphery. Now look at the graphic below, from a recent update to the McKinsey Global Institute’s study into the economic consequences of the credit bubble.
It is really not difficult to see the commonalities in these stories, all of which are about the problems of sovereign debt. The most interesting point in the story above is that the author, Jeremy Warner, recognises the real problem; that paying off the debt has hardly begun (in fact all the countries in question are still running up more debt).

In the wake of the so-called 'financial crisis', governments and central banks have sought to borrow money and flood the world with money as their respective solutions to the problems that they saw developing as a result of the crisis. These were the magic bullets that would pull the world back from the brink of another great depression. Lined up behind both policies was a mainstream economics profession that sought to justify these actions, with argument isolated to the extent, breadth and detail of the policy. There were, of course, some exceptions, notably the Austrian economists, who railed against the policy solutions and were largely ignored by policy makers.

What we have seen since is a roller coaster ride. As the policymakers pulled their macroeconomic levers, they would promise salvation and that they would 'fix' the world economy. The same theoretical models that failed to see the oncoming problems would now fix the world economy. Well, I have a question for these titans of economic theory; does it look like it is working, or are the scale of the problems just getting larger and larger? The most extraordinary thing about the mainstream economics profession is that they simply refuse (as an economics professor described to me) 'to look out of the window at the world around them'. They are firmly fixated upon models which have already failed, and continue to fail as even as they keep on using them.

At the heart of the problem is that they have forgotten what economics is supposed to represent, which is the exchange of labour (however subjectively that labour might be valued). If person A uses their labour and makes item X, and person B wants item X, person B must offer something from their own labour which person A wants in exchange. Whilst it is quite possible that person A will give item X on credit, at some point person B must start giving person A something that they want. If not, it is likely that person A will no longer give person B credit (unless they are a charity or a fool). It is really not that difficult to understand.

If we scale up these simple principles, it is apparent why the macroeconomic levers are causing more harm than good.

Lets say that person A is making item X and they are willing to exchange two of item X for one of item Y made by person B. When they exchange two of item X for one item Y, all is well and good. However, if we see that person A is regularly exchanging three of item X for one of item Y but ask that in the future person B will give additional item Ys, then they are giving credit. This is all ok, as long as person B is able to return the additional item Y in the future. The problem arises when this is the situation:

  • Person B is buying 12 item X per year.
  • Person B can make 5 item Y per year for exchange, unless they reduce their own consumption of item Y (4 per year).
What we see is a shortfall in the capacity to ever return the owed item Ys - unless of course the following take place:

  • They reduce or forgoe their consumption of item Y
  • They reduce of forgoe their consumption of item X
Now, it is quite possible that person A will provide item X on credit for a good long while. However, unless person B is able to dramatically increase their output of item Y, there is a point at which they must reduce their consumption of item X or Y. When credit is offered, it is done so on the basis that it will be repaid at some time in the future (+with interest). This is completely obvious.

The problem for person B is that their lifestyle has been based upon consumption that can not be sustained in the long term. In fact, they must reach a point at which their overall consumption equals their total output of Y minus the number of Ys owed to person A (according to how the repayment is structured). Prior to this, their consumption was total output of Y + the credited amount of Xs. If we think on this a little, we can see that the move from taking credit to repayment of credit is problematic for the quality of life of person B. They either have to reduce consumption, or increase the amount of labour that they do in order to continue to consume as much as they did when they were taking credit. The only other possibility is that person B manages to find a new technology or process which will allow them to make item Y faster, or a new item which, relative to person B's total input of labour, is valued more highly by person A.

In absence of the last option, there is no escaping the fact that person B will see their quality of life negatively impacted; either through less consumption or through more labour. In both cases, person B is poorer than they thought that they were.

So how do the macroenomic solution stack up against this fundamental reality of economics?

First of all, let's look at printing more money and other monetary solutions. Do these in any way increase the overall capacity to produce Y, or create a new item which will be valued more highly by person A? The answer is: 'No'. What it does do is to reduce the amount of Ys that are owed to person A, thereby cheating person A (they use the devaluation to reduce person A's capacity to buy item Ys, as the credit is held in abstract monetary units rather than in units of Y). The knock on effect of this will be that other people will see person A being cheated, and will no longer trust person B with credit. In all cases, as person B refuses to give any further credit to person A, there will be less of item X for person A to consume.

However, there is something interesting in this option. In printing money, the value of the medium of exchange between person A and B has shifted. In the real world, person A and B represent a large number of people consuming more variety of goods than X and Y, with money acting as the medium to reduce complexity in transactions. In reducing the value of the money for exchange with persons B, the ability of persons A to individually exchange their Y products for X products is reduced. In this way, they have been made poorer and are less able to consume X products. In the real world, if I am paid in £s and the value of £s reduces in relation to Euros, I am less able to buy as much Belgian beer as I was before - unless the amount of £s that I am paid is increased in relation to the fall in value in relation to the amount of X goods that I buy. For example, in the UK, inflation is eroding spending power, as wages are falling behind inflation.

This is a way of adjusting the consumption of X goods by individuals, and reducing the amount of debt growth as a result of reducing consumption of X goods. It is simply another mechanism to reduce the quality of life of person Bs, but doing so in a way that is less directly obvious.

How about borrowing more? This appears ok in the short term but is just making the problem worse in the long term. For a while longer, it is possible for person B to consume as much item X and item Y as before, but only at the cost of greater reductions later. I think that there is no need at this stage to point out the obvious dangers in this approach. However, it is worth noting that the borrowing takes place without the explicit expression of the future cost to quality of life. This is the way that politicians buy votes of voters now, at the cost of quality of life in the future. It is simply dishonest. The voters will have a poorer quality of life in the future - unless person A who is giving credit is cheated (see earlier discussion). In either case, the politicians are not telling the truth.

Whilst it is possible that somehow Person B will find some way to increase output/create a new item to exchange at higher value, this is (at best) a gamble. Also, if this outcome were achieved, without the overhang of debt, everyone would be better off in proportion to the improvements in output that this represents. This improvement in quality of life will be diminished by the necessity to repay past debts + interest.

I really do not think that any of this very complicated. There are complexities in the systems that are operational in economies, but the underlying principles upon which those systems rest are relatively simple. The complexities of the operations simply serve to hide/obscure the very simple principles. In the case of the mainstream macroeconomists, they are buried in the complexity, and never seem to pause to think about what sits underneath the complexity. This is why their solutions are so fundamentally wrong. They simply do not understand what they are looking at, and never look out of the window at the world.

Note: This is a hurried post, and I hope that the logic follow, and more importantly is expressed in such a way that my intended meaning is conveyed. Please feel free to point out errors in logic/expression where you find them. Also, if you disagree, as ever, feel free to point out why.


  1. This comment has been removed by the author.

  2. Always great to see a new post CE.

    It seems straightforward enough to me, but ignores the almost religious idea that future growth will 'raise all boats'. So the only problem is one of 'cashflow', that is, staving off collapse long enough for spontaneous growth to take hold again and restore stability. So maybe the politicians genuinely believe that their policies will not enslave the Greek (and other) people for generations, but merely tide things over for long enough for the boom to return. And they can point to history to support this idea.

  3. I've been musing lately about whether the debt crisis, the scandal last year surrounding some MPs' expenses and, now, the phone hacking scandal are in some way connected.
    At first glance, they are 3 quite separate things, but I wonder whether the prospect of the magic money tree disappearing is somehow prompting people who are 'in the know' to start breaking ranks. If so, lots of things might break in the coming months.
    I'd be very interested in your views on that, and in the views of other readers.

  4. We must have fiscal integration is the plaintiff cry from the EU.

    IOW's Come into my parlour says the spider to the fly. First we must destroy the sovereign state, then we can have order from chaos.

    Why is it so difficult for people to see that the EU is the template for the NWO?

    Why is it so difficult for people to see that our politicians have sold out their nations to the world's power elites?

    Why is it so difficult for people to see that no matter what party they vote for they get the same. (More left progressive redistribution and more right transnational corporatism, both funded by unfettered neoliberal economics)

    Where has all our industry gone and why?
    (Too long a story)

    Why is it, despite the unholy mess that Britain is in, mass immigration continues unabated?

    I could go on.

    I'll be back.

  5. Your post refers to a country/economy producing good X or Y. Presumably production of a service would do just as well provided that there was a demand for that service in the foreign economy?

    Perhaps the major problem with the UK economy is that it has for sometime forgone goods production and put all its eggs in the basket of financial services/the City.

    I can accept that a well functioning financial services centre (rule of law, expertise, capital) can add value to an economy by enabling the distribution of capital to productive enterprises - infrastructure development, manufacturers, business etc.

    But a financial services sector surely can't be the economy? People in the UK seem to believe that having very smart bankers and lawyers and city types sitting in office blocks and emailing each other can actually create real wealth as if by magic and act as the foundation stone of a prospering economy.

    My question to you - how much of the activity that takes place in the City is actually genuinely productive and how much is unproductive at best and destructive at worst?

    All the bankers and traders I've ever talked to seem genuinely to believe that banks somehow create wealth through the putting together of deals and clever non-zero sum trading.

    I think that the above is relevant to the debt problems discussed in your post because it's not just the size of the debt that matters but whether the economy actually has any underlying productive ability to service the debt.

    If the UK's GDP is inflated because of the inclusion of phony/unsustainable financial services activity then the debt position is a lot worse than indicated by debt/gdp metrics.

  6. Lemming: Good to see your commentary Lemming! But history is not a guide to what is taking place now, and this is a basic error that is being made. The circustances of today are different, in that the emerging economies have emerged...

    Anonymous: I think the connection is as much about the idea that during 'good times' people are not so interested in delving into such matters, but you may be right.

    MarkyMark: Yes, my scenario includes serviced, but I am simplifying. With regards to banks, they can create wealth as service providers e.g. arranging currency exchange and taking fractions of the exchange as commission. The problem arises when they trade and gamble on their own account with tax payer guarantees sitting behind them. Even lawyers can add value, for example in setting up legal frameworks for a project finance deal. So, in principle, banking can be a real wealth creator. However, we have set up a system where banking can be a real wealth destroyer - the wealth of you and me...

  7. Bankers and all those in financial services are under delusion that money creates wealth.Money creates more money but it never creats wealth, it only distributes it.And it looks to me that delusion of those running the society is too deep.
    Wealth had been created and distributed before invention of money.Wealth exists in its own right,money not.
    If we take goods as a thing and money as a reflection/shadow of this thing on which the thing is being passed around, then by inflating that shadow you are not going to inflate the thing(goods).However if the society chooses to accept the reflection of value as a value in itself then the only way to fill up that ever inflating reflection is to keep putting in more efficiency,productivity,units of labour into the real thing(goods)so it can catch up with the growing reflection.The winners are those who own the reflection(money).The implications?The labour in the West had been putting in more and more productivity for less and less disposable income because the ever growing reflection was being distributed in complex ways among those who own the reflection(capital).We could afford support/nonproductive high-wage industries like banking,insuring,lawyers,bureaucracy,public sector nonjobs,social securities etc. only because almost limitless manufacturing productivity was being sucked up into those industries.After all you need capital not for its own sake but for real goods which was provided by manufacturing.So those working only in support/low value/no value added industries lived a high life just by 'virtue' of holding the capital which was enforced by law as a legal tender.Banking is no more value added than pizza delivery service, it only disctributes goods thru the means of legal tender.But squeezing the labour for so many centuries,the delusion of those holding the capital set in.
    Then the delusional ones got an idea- we can move production to places where labour can crush even more goods into the reflection, which in effect will allow us to get even richer without adding effort and time on our part.Magic!
    However the labour was no more 'theirs'.Was the 'property' of the different jurisdiction.So the outsorced productivity that was being sucked up into non productive industries(consumption) in the West now is to be exchanged for by some real goods.The labour in the West has no more means of production in their hands and the capital holders stand before the naked truth that their 'high value added' activity was only consumption afforded only through the courtesy of the labour.Will this tragedy shatter their delusion?

  8. I read the following today on ZH:

    "We expect Moody's to retaliate promptly to Dagong's downgrade of the US by downgrading China in kind, and so the great race to the mutuall assured D-rating of the two great superpowers will enter its second of three laps... A race which will be won by China once it realizes that its $1.2 trillion in US paper will never be repaid."

    It seems ZH is of the opinion that China will be first to lose out from the US being unable to pay back its debt.

    This reminds me of the adage: if you owe the bank a thousand dollars and can't pay its your problem; if you owe them a million its their problem.

  9. Great to have another posting ce. Thanks.

    Anonymous, somewhere above, writes a fantastic comment regarding the reflection/shadow nature of money and how this ever more complex self serving illusion has essentially created systemic rot. Lack of growth rending the veil.


  10. if you owe them a million its their problem.

    Not so at macroeconomic level.America does not owe China money but productivity expressed in us money.If US defaults,China will no more supply goods/productivity/.US will have to start producing things they obviously need for their consumption otherwise they would not import them from China.The only way to do it is to restructure their economy, which means that tens of millions of people in US will have to quit their comfy non jobs in finance industry and other nonproductive activity industries and start really contributing to US productivity.And I dont think they feel like changing their office jobs for factory lines.Hence so much beating about the bush like QE,bonds,securities you name it.But sooner or later it will come to an abrupt stop like it did in Greece which is only first in line of EU countries.They also prefered rioting and looting instead of realizing that their useless economic activity is to be exchanged for real productivity. So now in EU case Germany and other EU countries' productivity is riding on the vehicle of EU bailouts and loans towards the greeks' consumption.How long before the Germans realize that the surplus productivity they put in banks in money form for their later consumption is being immediately consumed by somebody else?

  11. The issue of labour structure is important as has been pointed out be CE, it's not really (unsustainable) demand that's the issue.

    I posted a few days ago
    "After World War II it was relatively easy to get a decent-paying job in manufacturing right after high-school, investors mostly stayed within their national boundaries. When people complain that manufacturing jobs are transferred overseas because labour is cheaper there, they forget that it is only because they were born in a Western country that they could even think of demanding multiples of a foreign-labour wage. Both provide the same labour and there’s not a huge productivity difference, why then is it expected that the company compensates one much higher simply for carrying the right passport?

    The vast majority of Western workers would see their purchasing power fall dramatically were they to provide the same labour outside their home country. That ranges from blue-collar workers to waitresses to clerks. When people talk about a lack of demand in the U.S. they fail to acknowledge that demand is nothing else but purchasing power and there is no fundamental reason why an American worker at McDonalds should demand higher purchasing power than a Chinese university graduate. There is simply no way that any system where this is the case can be upheld for long. There may be some premium for living in the ‘right’ country but certainly not as high as it is today. The labour structure and wage demands in the U.S. however do not reflect this.

    Looking at the labour structure in Asian countries this issue becomes clearer. The Asian system provides two main benefits: one is the lower level of taxation of the economy and labour which increases competiveness vis-à-vis Western rivals and secondly, and less transparently, by lowering the cost of essentials such as food, the wage level of export-industries can be lower without a corresponding loss in standard of living as the cost of living is reduced thanks to the structure of labour. Otherwise unemployed workers compete in low-skill areas and drive down the price of going out, having dinner outside or simply having a good time by enjoying the vast amount of human services."

    Things aren't gonna get better.

    Firat Uenlue

  12. I agree that the US needs to restructure its economy so that it generates real wealth, but I fear the societal discloation this will cause will probably be too much to for the majority to bear so they will likely end up rioting and protesting against any change to the status-quo.

    The Chinese will of course have to do the same - shifting from an export economy to focusing on serving domestic consumers.

    But given the Chinese government's financial resources and ability to dictate policy, and the strong business ethic and tenancity found in the average Chinese worker, I would think China would achieve a more effective and faster restructuring.

    If the US continues to pay China with increasingly worthless money, at some point the Chinese will say enough is enough and stop additional Treasury purchases. But at that point their T-bill holdings will take a huge hit, so what will happen to the Chinese government's finances?

    Or are the Chinese already disposing of US$ assets on the quiet and diversifying into other currencies, natural resources, metals etc, biding their time so they pull the rug from under the US at a time that suits them?

  13. I'm probably one of the last to say it but - welcome back. I visited here on the off-chance that you *might* be back (I was pining for some calm, measured analysis and informed comment) - and here you are. So thanks for making my day. Right. Time to 'get up to speed' !


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