Tuesday, August 30, 2011

An Agenda for Gold?

For those familiar with this blog, they will know that I am not overly supportive of a gold standard currency, but that I think that it is better than the current fiat money system (see here for my alternative). As things stand, we can now see the dangers in the current fiat system, which is the ongoing debasement of many currencies through money printing (QE- Quantitative Easing).

It never does any harm to emphasise the point that so-called QE is absolutely no different from running a physical printing press, even though there are occasional commentators who try to suggest it is different. Creating money by electronically crediting a bank with previously non-existent money is no different from running a printing press and shipping the newly printed money into the bank's vault. In both cases, money is created and an asset is purchased. It is just that the former does so without the bothersome necessity of running a physical printing press. I suspect that, if the central banks were to be undertaking the old-fashioned printing press method, there would be greater outcry against the policy of QE. Trucks filled with newly printed money arriving at banks would focus minds and attention on what is taking place. As it is, the modern method of money printing is just abstract enough to obscure the reality of what is taking place.

However, it seems that commentators are now starting to see that there is something wrong with the new policy of printing our way out of troubles, and the gold standard is moving up the agenda. This from Forbes:

There is nowhere left to hide. America’s governing elites begin to internalize the magnitude of their failure to generate jobs. CBO now predicts worse than 8% unemployment until 2014. America begins to engage, seriously, with the implications of the faltering dollar and reconsider the appeal of the gold standard. From The New Yorker to The National Interest to The Washington Monthly to The Nixon Foundation, thoughts turn to gold.
The linkage between returning to a gold standard and the urge to print money is obviously related. Once again, there is talk of printing money in the US, or QE3:

As Wall Street parses the message the Federal Reserve chairman sent in his speech Friday from Jackson Hole, the narrative that has taken hold includes, on one level or another, more action to help boost the markets and the economy.

That was supported Monday with key endorsements from Fed presidents Charles Evans and Narayana Kocherlokota, who both said they either would support further monetary measures or a continuation of the ones already in place.

Whether future moves come in the form of traditional quantitative easing or something else is what Bernanke and other Fed officials must decide between now and the next Open Markets Committee meeting on Sept. 20. The expectation for easing was heightened when Bernanke said the meeting would be extended from one to two days, indicating that serious consideration would be given to additional monetary measures.

The UK is also flirting with another round of money printing, with this from the Guardian:

Hopes of a fresh round of quantitative easing in the UK increased on Thursday after Martin Weale, of the Bank of England's monetary policy committee (MPC), used a speech in Doncaster to say there is "undoubtedly scope" for the radical recession-busting policy to be extended.

Weale, who was one of two hawks advocating an increase in interest rates until he changed his vote at this month's meeting, said the Bank could restart quantitative easing if oil prices continue to fall and the sovereign debt crisis in the eurozone worsens.

Warning that events on the continent are a greater threat to the UK economy than the slowdown in America, Weale said: "There is undoubtedly scope for further asset purchases to trigger further reductions in yields on government debt should the need arise."

The European Central Bank (ECB) is more constrained, with an inbuilt philosophical opposition to printing money:

New York professor Nouriel Roubini called on the ECB to reverse monetary tightening immediately given the darkening global picture. "It should reduce rates to zero, and make big purchases of government bonds," he said.

Frankfurt is unlikely to heed the advice. The bank's president Jean-Claude Trichet, last week stuck to his anti-inflation script and said "we do not do QE".

The ECB began buying Spanish and Italian bonds for the first time yesterday, causing 10-year yields to plunge by 90 basis points. However, an ECB statement over the weekend came with too many strings to satisfy investors. The bank is likely to be tested over coming weeks.

David Marsh, co-chairman of OMFIF, said the statement was "half-hearted" and suggested that dissenting German hawks were imposing limits. "The ECB is clearly not going in with all guns blazing," he said.

Notwithstanding the growing discussion of a gold standard, one of the great curiosities about QE is how it has now entered into mainstream commentary as if it were a perfectly reasonable thing to do. There are all sorts of justifications given for the policy, but the lack of any remit for central banks to undertake the policy is quietly ignored or forgotten. The most obvious case of this is the Bank of England, which is supposed to use monetary policy to target inflation. Despite several years of overshooting the inflation target, as can be seen from the earlier quote, QE is back on the agenda in the UK. How is it that the Bank of England's remit is forgotten by so many commentators?

It seems that there is a growing divide in mainstream commentary on the policy of printing money, with some expressing fear about the consequence of the policy and moving back to the idea of a gold standard, and others supporting the policy as a magic bullet for the economic woes that are assailing so many economies. At the heart of the debate is the question of inflation, with those who are anti-QE arguing that it is inflationary, and those in favour suggesting that the lack of massive inflation following early QE demonstrates that the fears of inflation are exaggerated. A good explanation comes from Liam Halligan:

The reality is QE has already done an awful lot of damage. America has expanded its base money supply three-fold in two and a half years – from 6pc to 18pc of national income. But even this jaw-dropping measure hasn't led to much of an expansion in monetary measures, such as M2 that include bank lending, precisely because the banks, for all the propaganda to the contrary, are still determined not to lend. They can make more money simply channelling QE money into stocks and other investments.

Crucially, the banks also remain petrified of counter-party risk in the inter-bank market. Many of them, disgracefully, are still concealing vast sub-prime losses in off-balance-sheet vehicles. So they assume other banks are doing the same. Such mistrust between the banks – "we're lying, so they must be lying" – gums up the wheels of finance and starves even creditworthy firms of the funds needed to invest and create jobs.

That's why M2 has remained flat, despite a massive expansion of base money. The way to break the deadlock, though, isn't to do more QE, but to end inter-bank torpor by forcing "full disclosure" of bank losses. Such disclosure is barely happening, on either side of the Atlantic. The UK's monetary base has also tripled, while producing – for the same non-disclosure reasons as in the US – only minimal growth in M2.

Liam Halligan has captured one element of the reason for the lack of inflation, and another is the exporting of inflation through the 'carry trade', as the Wall Street Journal reports:

For much of the past two years global investors borrowed dollars and Japanese yen at the rock-bottom interest rates set by the U.S. Federal Reserve and the Bank of Japan and then poured that cheap money into currencies like the Australian dollar and Mexican peso to earn much higher interest rates.

Now, those popular "carry trades," which profited from a difference in interest rates as high as 12 percentage points in Brazil's case, are starting to unwind as investors lose faith in the outlook for global growth and fret over financial turmoil. If it continues, it will bring an end to a rally in emerging market and commodity-based currencies that began shortly after the Fed slashed rates to near zero at the end of 2008 and it could drive up borrowing costs for banks, companies and even households in those countries.

That unwinding could be cut short if the Fed's announcement Tuesday that it would keep its target interest rates at "exceptionally low" levels "at least through mid-2013" makes carry trades attractive again. But the problem with the strategy is that it is only profitable if currencies are either stable or if the funding currency is falling against the investing currency. And if the past week's bout of global financial turmoil persists and puts emerging market and commodity currencies under more pressure, many investors will be forced to throw in the towel and buy back dollars.

The problems of the carry trade for the recipients has led to reactions to try to prevent the inflows of 'cheap' money, such as Brazil establishing capital controls:

Brazil has been vocal on one of the themes put on the table by France as G-20 chair: how to better police capital flows globally. Several emerging countries, including Brazil, have been faced with buoyant capital flows in search of higher yields, which have put upward pressure on their currencies and hurt their exports.

Countries have reacted by imposing capital controls or intervening on their currency in a unilateral way. This has prompted the G-20 to try and coordinate capital controls better, so as to avoid adverse impact on growth from disorderly moves.

This is what I had to say in TFR magazine in December 2009:

But there is also another factor, there is increasing talk of a US dollar ‘carry trade’, as a result of dramatically increased liquidity combined with near zero interest rates.

The idea is simply that a good return on investment can be made by borrowing at a low interest rate in one country, and investing in another that has a higher interest rate. In doing so, the inflationary effects of printing money are exported to the country that is the destination for the carry trade.

This was what happened when Japan resorted to quantitative easing, with the printed money going west in the yen carry trade, acting as one of the sources of excess liquidity for the credit bubbles that burst in 2007 and 2008. There is less talk of a sterling carry trade, but it’s fair to assume that, with monetary circumstances similar to the US, something similar may be taking place there (albeit on a much smaller scale).

The interesting point here is that, as a result of the carry trade, Japan itself did not experience the inflationary effects of printing money. The case of Japan is cited as the reason why inflation will not take place in the UK and US. However, there is a fundamental difference between the UK, the US and Japan.

During the period of the carry trade, Japan was generating a large current account surplus, so the flood of yen onto the market did not result in significant currency weakness. By contrast, both the UK and US have been (and continue) to run large current account deficits. In both cases the currency is already sitting on weak foundations and, therefore, export of the dollar and sterling into the carry trade will simply put more pressure on the value of those currencies. They are flooding the market with currencies for which there is already a potential over-supply.

What we can see is a problem looming on the horizon. Output in both the UK and US has fallen (and is still falling in the UK), which means that some of the effects of the reduction in credit are already ‘eaten up’.

Furthermore, the governments of both countries are stepping in to fill the void of private credit contraction with government borrowing. If the money sitting in central banks were to enter into the economy, there would be a real increase in the money supply and this would cause rapid inflation. On the other hand, if the money exits the economy via the carry trade, it will severely weaken both nations’ currencies and re-enter the economy through the back door of import-price inflation.

At the moment, the increase in money has not entered into the real economy, but it will do at some point. I suspect that it will be through the back door of the carry trade.

What we can see in Liam Halligan's analysis and my own explanation is the reason why it is that we do not currently see massive (or hyper) inflation in the money printing economies. However, what we can also see is the potential for inflation to start a rapid upwards climb in the QE economies. The only way that the money supply might be reduced is to reverse the QE, which would mean selling the government bonds that have already been purchased and destroying the proceeds of the sale. Could markets absorb such a sale when government debt is already flooding the markets? It seems improbable.

For the proponents of QE, the lack of massive inflation is used as a justification for continuation of the policy. For those who are arguing for a return to gold, they can see that somehow, at some point in time, the massive expansion of the monetary base in QE countries must eventually see a rise in inflation. For the latter, they are not always clear in their understanding/explanation of why massive inflation has not taken place. However, their instinct that QE must eventually have a price is correct. Furthermore, the price is already being paid around the world as easy money has flooded into other economies. That in turn is creating distortions in markets, and those distortions will ripple back towards the countries that caused the problem in the first place. Again in TFR, this is what I had to say about 'extreme policy' in the context of the 'carry trade':

From enactment to (unpredictable) result, there is a period during which the effects of the policy build and interact with the results of other policies and the markets, both domestic and international.

It can therefore often take a long time before the full effects become apparent. As they do become apparent, the other actors respond with their own policy provision, and the effects of that policy will again take time to impact.

Among all of the major economies, the responses to the economic crisis have been extreme policy making. We are only now seeing the full impacts of those policies, and the reactions to those policies are building. The underlying problem is that, the more extreme the policy of one actor, the more likely that the response of another actor will be extreme. The world economy is a dynamic system, and the actions of each policy will, in the end, lead to a response from other actors in the world economy.

As such, when actor ‘A’ pulls on policy lever ‘X’, they really cannot see the outcome of their own actions. The larger the actor, and the more extreme the policy, the greater the chance that the reaction of other actors will also be extreme. The greater the reaction of these actors, the greater the reaction that will be forthcoming in response.

And so it continues, creating an ever more unstable system; the more the levers are pulled, and the harder that they pull on them, the greater the potential for the policy intentions to be confounded, and the greater the general instability.

We can see this instability taking place. We see, for example, the Swiss taking ever more radical measures to try to lower the value of their currency in the face of the 'safe haven' purchases of their currency. We can see the instability in the surge in the gold price. We can see the instability in the on-off panics in markets. Every day we see more examples of the instability.

One way or another, the effects of extreme policies such as QE ripple out into the global economy, only to eventually wash back in unpredictable forms. The great conceit of the policymakers is that they think that they know what they are doing. In the end, the call for a return to a gold standard is really a call for the policymakers to take their hands off the levers of monetary policy, as they do not really understand what happens when they pull on the levers.

Saturday, August 13, 2011

A ramble towards a conclusion

Spiegel Online is one of those rare media outlets that is intelligent, and also gives due space to explain the stories that are covered. I may not agree with their analysis, but it is certainly one of the more worthwhile sources. I was therefore interested to see their headline that asks whether the world is going bankrupt. I will quote from their conclusions:

It has become evident that debt-to-GDP ratios of 80, 90 or 100 percent will sooner or later cast doubt on a country's creditworthiness. Even supposed paragons of fiscal virtue such as Germany must be careful. The German debt ratio of 83 percent is too high, given the ageing population. Who is supposed to pay down that debt in the future?

I am not entirely convinced that the story supports their headline, but it is nevertheless interesting to see recognition that the current situation cannot continue. Perhaps even more startling is Edmund Conway in the Telegraph. Regular readers will remember that I was extremely critical of his stance on quantitative easing (money printing) by the Bank of England, but he seems to have completely reversed his previous support for this dangerous policy. In a surprising article, he traces the roots of today's crisis to the abandonment by Nixon of the gold standard. This is an example of his analysis:

Over the past 40 years, in the absence of a coherent international monetary system and under the veil of floating currencies, countries which would otherwise have been penalised for doing so were allowed to borrow enormous amounts (eg. The US and UK, or Greece). Other countries (eg. China or Germany) indulged them by lending enormous amounts. In the meantime, investors convinced themselves that the apparent economic growth fuelled by this debt was genuine rather than an artificial product of a binge.

The 2008 crisis represented the first recognition that those increases in asset prices and economic growth were chimerical. The recent relapse represents a recognition that the losses have merely been transferred on to sovereigns' balance sheets.

Even more interesting is the growing view that the $US is looking ever more fragile as the world's reserve currency. For example, the New York Times is taking a moderate position, where they posit that the $US has a long while to go yet as the reserve currency, but nevertheless see the writing on the wall:

Still, recent actions have clearly hurt the dollar more. And it is the bleeding from a thousand cuts, both inevitable and self-inflicted, that will eventually cost the dollar its dominance.
Even more interesting is commentary from Peter Hartcher of the Sydney Morning Herald. He commences his story with a comparison between US defence cuts and China's first aircraft carrier being completed. His story is rooted in the shift in power between East and West, and he sees the $US decline as a key element in the shift:

It's not just that the creeping shift of power from West to East has become a rush. We've known about that for years. There is something else going on, too. You can see it in the price of gold. An ounce of gold traded for about $300 a decade ago. This week it hit an all-time high of $US1800. Why?

Some investors have lost faith in the US dollar. It was the official global reserve currency for the first 25 years after the Second World War and the de facto reserve currency after that. Even the governments of the G-20 nations are actively discussing the idea of spreading the risk, creating a new reserve system comprising the currencies of multiple countries. This was unthinkable just a couple of years ago.

But while confidence in the US might be sinking, there is no corresponding rise in confidence in China. "You can see it in the price of gold," observes one of Australia's leading investors, Kerr Neilson, the head of Platinum Asset Management. "There is a system change under way."

Apparently, according to this commentator we have all known about the shift for years, but of course this is not true. Certainly when I was writing about the end of the $US as a reserve currency, and the great shift in wealth, when starting this blog, it was a radical position. It is now moving into the mainstream. Certainly the rise of China was widely discussed, but it was not posited that this would be at the cost of the fall of the West. China was supposed to rise up to meet the West; it was not supposed to happen that China would rise and the West would fall, only for both China and the West to meet somewhere in the middle. However, if you look at one of the key themes of this blog, the limits on resource growth and increases in the world labour force, it was the only possible outcome.

The DNA of the current panic is the recognition of the simple fact; the West is getting poorer right before our eyes. The allocation of limited resources in the world is shifting to the East, and that means that there is less to support the lifestyle of the West. Sure, commodity output is increasing, but just not enough for China (and the East more broadly) to rise up without seeing a fall in the West. I forget where read it, but a recent article discussed the shift of interest in US companies from serving the domestic market to an ever greater focus on the emerging markets. It has been going on for many years, but the article noted that this was a change in degree. Somewhat surprisingly, the Governor of the Bank of England has explicitly stated that the standard of living in the UK is in decline. All around us, we can see the shift in wealth, and it appears to be accelerating.

I put emphasis on the word appears. It has long been the contention of this blog that the shift has just been hidden with debt. For example, when (or rather if) governments adopt genuine austerity measures and stop borrowing from overseas, and consumer borrowing funded through overseas lending stops, the true level of real wealth will be revealed. Instead of thinking of this lending in abstract terms of money, I have always viewed it as the borrowing of resources and labour. It may be counted in money, but in reality it is always the lending of resource and labour. The complication in this system is that the resource is measured in units of money where the units might be changed to cheat the lenders. However, in all events, when the borrowing stops, there is going to be a change in the standard of living experienced by the borrowers.

It is becoming obvious that, faced with declining standards of living in the West, the solution to the problems is seen as defaulting on debt through currency devaluation, which a recent article in the Financial Times heralds as currency wars:

Yet with Tuesday’s announcement the Fed committed to easy money for the foreseeable future and signalled it was ready to loosen further. Thus the conditions are dangerously propitious for the currency wars to break out again.

A currency panic, with destabilising moves in exchange rates reinforcing collapsing asset markets, is one of the few problems from which the global economy has mercifully been spared throughout the global financial crisis. Even in the extraordinary movements of this week, there are few signs that leading currency markets have become disorderly. The falls in the dollar against the yen and Swiss franc have been accompanied by a rally rather than a sell-off in the prices of Treasuries, even at longer maturities. Investors appear to be responding to (justified) fears about the underlying strength of US growth rather than betting on market meltdown or sharing Standard & Poor’s views on US fiscal solvency.

Yet, although it is hard to imagine that the world’s leading economies are having much good fortune, their governments are riding their luck as far as currencies are concerned. If there is a re-emergence of serious political tension over exchange rates – perhaps a flight out of the euro pushing the dollar higher – the global economic order still does not have a credible means of co-ordinating currency management.

As this article recognises, the game is out in the open. It is also a rather apt way of describing the situation. Was it Bismark who said something about war being diplomacy by other means? In this case, what we are seeing is war by other means. It cannot end well. More to the point, it does nothing to address the real problem, which is access to resources. The only real solution to the overall problem is expansion of resource availability overall, and I am not sure what the solution to this might be. There are some bright spots, such as the emergence of technology to access shale gas. This might allow for greater supplies of one of the key inputs into the world economy, which is energy.

However, on the other side of the equation, there is still a pool of labour that is not fully integrated into the world economy, but is nevertheless entering into the world economy. The entry of this labour will be resource intensive, continuing the trend of the last 10-20 years, with the necessity of building resource hungry infrastructure. And then there is the nature of this new labour. It is comprised of individuals who have very little, whose resource use is just somewhere above that required for survival of themselves and their families. Any improvement to their resource makes a huge difference to their lives, and they will grab any opportunity to raise themselves up. Visit the countryside in China or India, and you will see what I mean. And who can blame them for wanting a better life?

And then there is the West. We have the infrastructure. We have opportunities and systems that have allowed us to have lifestyles that this emerging labour could only dream about. However, it was not enough for us. We wanted more, and more and more. We voted in governments that told us that we could have more and who borrowed in our names, and we borrowed to support our lifestyles, all the time thinking that it was our 'right' to enjoy our huge share of the world's resources. Well, it is time for the West to wake up, and accept that the game has changed. What excuse was there for countries with fully developed infrastructure to borrow money, or why did so many individuals borrow so much when their wages might allow for a reasonably good life? It was borrowed because we wanted to consume more than we can produce. We came to a point where we thought that we deserved to enjoy such a high standard of living as a right.

We have done so much in the recent past to support our idea of wealth as a right. The trouble is that it is not a right that is exclusive to us. The peasant on a Chinese or Indian farm is perfectly entitled to compete with a worker in the West for a greater share of resource. People talk of sweat shops, and unfair competition resultant from poor wages. However, as I once expressed in a previous post, I would not want to be the person that turns a young Chinese girl back to her village, when she seeks a better life in the city. Standing on the road to the village, and telling her that she is going to be exploited for working for so little will not convince her not to leave. For her, it is a better life than that which she has now. She deserves the better opportunity.

So we come to the underlying problem. How can we insist that we should have the disproportionate share of resources as our right? What is it that makes us somehow so different? On what basis do we found our belief that we will always be so much more wealthy? I have yet to see any argument that can explain this.

The situation is now one in which the world has already changed. We are just seeing the consequences, but we are failing to adapt. We must change to meet our new circumstances. That means that we can no longer take for granted that we will have all that we had before. That means that we must think hard on what we think are the priorities for where we allocate our diminishing resource. For example, is it health care, or is it education? How can we make our systems work with less resource, and what are our priorities within each area?

What we now see is that the attempts to solve the so-called financial crisis were simply delaying mechanisms. It was never a financial crisis, but an economic crisis. All around us we can see the chaos as the fundamental change in the world economy forces itself firmly back into view. Sure, the central bankers and policymakers squeezed the problems from view for a while. But still the economic crisis forces itself back into view. However much we may not like it, we are all variants of Greece. But when we are confronted with reality, who is there left to bail us out? In a recent Economist article, the discussion was one of how France, if it extends itself much further on bailing out others, will teeter towards its own crisis. It is the absurdity that the massively indebted are saving the even more massively indebted. Their credit is, for the moment, just a bit better than the bailee....

This is a somewhat rambling approach to a post. It was not my intention to go down this particular route, but it seems that, wherever I look at in the news, the footprints lead me back to the same place. This post is a reflection that the surface symptoms all lead to the same underlying causation. If we look at the surface, we can not deal with the problem, or rather we can not confront the problem. The comments and quotes that started the post are starting to reflect the explanation of the economic crisis that emerged when I started this blog. The trouble is that the shifting understanding of the commentators, the move towards the position of this blog, have not gone far enough yet. They are starting to 'get it', but they still have not confronted the hard reality of the new shape of the world economy. They still do not fully accept the hyper-competition of the new world economy. It is brutal, but there is no way to avoid confronting it.

Note: I had a comment on my last post in which a regular reader accused me of taking an ideological position for tracing the roots of the crisis back to the final impacts of communism/socialism. If my fundamental premise that the economic crisis is a result of the shock entry of so much labour into the world economy is accepted, this is not an ideological position. The governments in countries like India and China rejected the global capitalist economy, and developed systems in which most of their labour force were utilised in a way that was barely above subsistence. When they abandoned this path, and sought to connect their labour into the capitalist world economy, the flood of new labour can only be explained as being resultant from the previous policy.

Sure, there are very significant problems in the way that the capitalist system met the change that this entry caused, but that does not take away the fact that the problem started somewhere. Perhaps a more appropriate point would have been to comment on my use of 'capitalist' as a broad brush characterisation, as there are elements of different economies that might suggest that this term is being misapplied. However, for the sake of ease, it seems a good shorthand for the contrast between, for example, the Chinese system pre-Deng reforms and the system joined post-Deng reform. Also, socialist for India might be described as misnomer. However, post-Independence India followed the lead of the Soviet Union in economic policy, albeit with Indian characteristics (to adapt an expression used for communism in China).

I was a little disappointed with the tone of the comment. However, as the comment came from a longstanding follower of the blog, I nevertheless thought I would respond.

Friday, August 5, 2011

Round 2?

The underlying and fundamental problems in the world economy are once again bubbling into view, and the headlines are filled with panic. Stock markets have fallen around the world, and it might be that the slide will continue on Monday. Or perhaps not. I am not sure whether this is the start of the final act of the economic crisis at this stage, but it certainly has the potential to be so. In particular, there is a growing sense that the so-called recovery is nothing more than an illusion. There is a growing sense that the central banks and politicians cannot fix the problems, and have not fixed the problems. There is growing sense that the macro economists do not know what they are doing. In other words, there is a growing loss of confidence in those who think that they control the economy.

Somewhat predictably, Krugman takes a partisan stand, and calls for more government intervention. According to Krugman, government can just make new jobs, and all will be well:

Well, it’s time for all that to stop. Those plunging interest rates and stock prices say that the markets aren’t worried about either U.S. solvency or inflation. They’re worried about U.S. lack of growth. And they’re right, even if on Wednesday the White House press secretary chose, inexplicably, to declare that there’s no threat of a double-dip recession.

Earlier this week, the word was that the Obama administration would “pivot” to jobs now that the debt ceiling has been raised. But what that pivot would mean, as far as I can tell, was proposing some minor measures that would be more symbolic than substantive. And, at this point, that kind of proposal would just make President Obama look ridiculous.

The point is that it’s now time — long past time — to get serious about the real crisis the economy faces. The Fed needs to stop making excuses, while the president needs to come up with real job-creation proposals. And if Republicans block those proposals, he needs to make a Harry Truman-style campaign against the do-nothing G.O.P.

As is usual with Krugman, it is the evil republicans blocking more spending and, if only money was spent on job creation, the economy would grow. More government action is the solution, not the problem. Similar arguments are appearing from less heavyweight commentators, for example Polly Toynbee in the Guardian:

Faced with a new crisis, it stretches credibility to imagine Osborne invoking the spirit of Roosevelt's New Deal, but that's what's needed, with a job guarantee for every young person. That investment would be every bit as cashable for the future as roads or railways, since the great social debt now accumulating will be more burdensome for future generations than mere financial debt. No one is counting the social deficit, the costly damage done to this generation of young people, though the evidence shows that a workless youth does life-long harm, some never finding their feet again, becoming the workless parents of the next generation.

Today's Guardian editorial suggests that:

But even in the US and the UK, governments have all but removed their stimulus policies – with the result that both economies are now stuttering. The result may look like a financial crisis; but it is really a failure of government.

Apparently, the crisis is due to a lack of stimuli. However, in both the UK and the US, governments are continuing to borrow and spend at a shocking rate. Even if it were true that the US debt deal were really going to deal with the monstrous deficit (which it will not), this has had no impact yet. However, even the prospect of some fiscal tightening is being blamed for a new crisis. If this is the start of the final act, the actuality of ongoing massive spending and borrowing will be forgotten by the economics profession, and the economic crisis will be turned into a narrative of simultaneous tightening causing an economic crisis. The mantra will be, 'if only the governments had not simultaneously undertaken austerity measures....'

However, even Krugman has got something right:

It’s not just that the threat of a double-dip recession has become very real. It’s now impossible to deny the obvious, which is that we are not now and have never been on the road to recovery.

For two years, officials at the Federal Reserve, international organizations and, sad to say, within the Obama administration have insisted that the economy was on the mend. Every setback was attributed to temporary factors — It’s the Greeks! It’s the tsunami! — that would soon fade away. And the focus of policy turned from jobs and growth to the supposedly urgent issue of deficit reduction.

Regular readers of this blog will already know that there has never been any kind of real recovery, just lots of chatter - lots of optimism that is continually dashed with reality. All the policy and chatter did was to paper over the cracks, whilst the problems of the foundations saw the cracks widening even as new paper was being added to hide the consequences. In the mainstream media, it is becoming apparent that some commentators are starting to realise that there is a real very fundamental problem. This from a Telegraph editorial:

It is equally vital, as the pressures grow, that the world stays true to the free market principles which have been the cornerstones of post-war prosperity. The crisis of the last four years is not the fault of free markets as such, but of the way they have been distorted and corrupted by public policy and the unchecked excesses of finance.

In the search for the underlying causes of today’s rolling series of debt crises, it is hard to ignore the extreme trade and financial imbalances which have grown between countries, fed both by the mercantilism of China’s dash for growth and the absurdities of the single currency. The resulting build‑up of external indebtedness among deficit nations is now tearing the world economy apart.

Yet the pretence continues that somehow or other, we can just carry on as we are. Political leaders must find the courage to tell the truth about the fix we are in, and the painful choices that must be made to deliver a sustainable future.

They are groping towards the reality that has been the theme of this blog. They have still not fully grasped the nature of the change in the world economy; that the joining of China and India and other (so-called) emerging economies into the world economy had dropped a massive pool of new labour into world markets. The resulting hyper-competition is driving the current crisis, and the response of much of the Western world is denial of this reality and the consequences and impacts of this massive economic shift.

The answer of the Krugmans of the world is for greater government borrowing, printing more money. How these will address the problem of hyper-competition is never discussed, because the actuality of the hyper-competition is never acknowledged. They think that the massive disruption of the massive input of new labour into world markets is not the cause of this crisis, but rather it is a financial crisis caused by irresponsible banks. It is impossible to deny that the banks played a role, but as I have argued elsewhere, the banking crisis was a symptom of an underlying cause:

The summary of the situation is that the emerging economies lent their new found wealth from their increasingly large workforce into the West, and in doing so allowed the emergence of the so called 'service economy', or 'post-industrial economy'. The lending was built on an unfounded belief that, because the West had been economically dominant for so long, it would always be in a position to pay back the lending. The problem with the lending was that there were no productive wealth creating opportunities to soak up the money, (e.g. investment in manufacturing was being directed towards the emerging economies themselves) such that the money pouring into countries like the UK and US was directed into asset price inflation (real estate), consumption and consumer credit, and excessive government borrowing.

In the post, I argue that the world economy was being constrained by the limits of resources. With emerging economies soaking up huge amount of resources for infrastructure, and with supply constraints on commodities such as oil, the world economy was sharing a limited supply of resources over an ever increasing number of workers. In an earlier post, I presented an analogy. I described commodities as a moving brick wall to growth, with the world economy running behind this wall of constraint. As the economy runs forwards, it hits the wall and tumbles backwards. The world economy then gets back on its feet, and once again runs towards the wall only to eventually bounce back again. Below is a chart of oil production and consumption from the Economist and a chart of oil prices that tells the story.

China alone has increased oil consumption by over 4m barrels per day in the last decade. It is a picture of the brick wall. Note the upwards spike in 2007, and the upwards spike leading up to the current crisis. I have to emphasise, that other commodities have seen greater increases in output, but that the infrastructure demands of the emerging economies is a countervailing force, such that prices are reflecting the high demand.

The worrying part is that economies such as China are still going through the process of integration of their labour into the world economy. The process is not yet complete, and the problem is that the bounce backs will therefore continue, and the competition will become even more intense. For example, China is engaged in a process of seeking surety of supply of key resources around the world. This is a chart from Foreign Policy, representing 2005-9:

It is a trend that has been accelerating. Somebody in China seems to know the nature of the game that is being played out in the world economy. The Chinese development of a blue water navy also tells the story. In the end, economics is about recovery of resources and application of labour to add value to resources. With constraints on the volume of resources and massive increases in the volume of labour, this must lead to hyper-competition. It is really not that complex.

When thinking of the Krugmans of the world, we see no discussion of this simple idea. If you increase the workforce by 10% but only increase the resource by 5% then something is going to happen to the distribution of resources. Government spending on 'creating' jobs, or money printing, they claim can make a difference, but it does not address the underlying and substantive problem. More government action is the solution proposed.

Another problem with the commentary I am reading is the belief that this is a crisis of capitalism. Today's Guardian has a picture of an evil capitalist monster, and it is a view that is gaining currency. However, the real reason for this crisis is not capitalism, but the actions of communist and socialist governments before they started the process of opening their economies. They created barriers to the integration of their labour force into the productive and enriching capitalist world economy, and then suddenly started 'dropping' the labour into the world economy at a rate that the capitalist system could not absorb. It is why we see the increasing divide in incomes between the rich and the rest. It is not the evils of capitalism, but rather the last terrible contribution of years of rejection of capitalism in countries like China and India. They created a flood of new labour into the world economy, and the result is that labour has been devalued.

What we have in so much commentary is policy that is blind to the causes of this crisis, and solutions which replicate in varying degrees the fundamental causes of the problems; government constraints and interference with free market capitalism. Whatever anyone does, short of cutting of the supply of new labour, the situation cannot go back to the old 'normal'. The only way to deal with the crisis is to accept and embrace the hyper-competition, and that means addressing the structure of economies. When competition was less fierce, it was possible to have many luxuries in economic structures; for example, cradle to grave welfare or expending resources on any number of unproductive activities. The question that needs to asked is what can each economy really afford based upon their real productivity (i.e. not borrowed money). What are the real priorities within the constraints of the actual competitive position of the economy? Each economy must address this question, and address the question reflecting upon the hyper-competition that now characterises the world economy, and their relative strengths and weaknesses.

I do not know if this is the start of the final phase of the economic crisis; the moment when the reality that borrowing and spending and printing money are part of the problem not the solution. I hope that this is the moment, as the longer the denial of reality continues, the worse the problem will get. The crisis should have taken place a long time ago but, against my expectations, governments and central banks have buried the problem for longer than I ever thought was possible. Perhaps they have some last measures that they might yet deploy to 'save' the situation (but which will just create an even bigger problem in the future)? At this stage, I do not know, but we will see how events develop over the coming months.