Krugman at it Again

I have just read an article by Paul Krugman, that yet again defends Keynesian economics. It would be amusing were it not taken seriously by so many. Let's take a look at the kick-off:

“The boom, not the slump, is the right time for austerity at the Treasury.” So declared John Maynard Keynes in 1937, even as F.D.R. was about to prove him right by trying to balance the budget too soon, sending the United States economy — which had been steadily recovering up to that point — into a severe recession. Slashing government spending in a depressed economy depresses the economy further; austerity should wait until a strong recovery is well under way.

One small detail, Professor Krugman. Keynes, unless I am mistaken, did not propose that deficits were also run during the 'good times', but that was the situation of many of the economies in the run up to the economic crisis. These deficits were not the only stimulus; there was the rapid expansion of credit in both the consumer and business spheres. I do not think that Keynes had in mind that growing government deficits were a good thing during the good times, and I very much doubt that his response to a debt bubble would be to continue the growth of the bubble, for example replacing growth in consumer debt with growth in government debt. Even if accepting Keynesian economics (which I do not), then this is nothing to do with Keynes, except in regards to ignoring his wider context.

Professor Krugman later argues that there was no real fiscal stimulus, due to state cuts in spending, and suggests that the stimulus was not enough. He then argues:

So the real test of Keynesian economics hasn’t come from the half-hearted efforts of the U.S. federal government to boost the economy, which were largely offset by cuts at the state and local levels. It has, instead, come from European nations like Greece and Ireland that had to impose savage fiscal austerity as a condition for receiving emergency loans — and have suffered Depression-level economic slumps, with real G.D.P. in both countries down by double digits.

So the US government is not borrowing and spending on a scale that can only be comparable to World War II? I mean really? What is happening is that the government is borrowing at record rates already. Is this not a massive government stimulus? Not to mention the massive stimulus of printing money, and ongoing targeting of record low interest rates. Also, he is comparing the current government borrowing with previous levels of borrowing in the good times, when there should have been no borrowing at all. In other words, the economy was already structured around servicing consumption of government borrowed money, even before the economic crisis struck.

As for the problems confronting Greece and Ireland, these are just the illustration of the problems of too high deficits. Nobody wants to lend them money. People operating in the bond markets simply doubt that they will ever get their money back if they invest in these countries. Krugman appears to address this argument (emphasis added):

Now, you could argue that Greece and Ireland had no choice about imposing austerity, or, at any rate, no choices other than defaulting on their debts and leaving the euro. But another lesson of 2011 was that America did and does have a choice; Washington may be obsessed with the deficit, but financial markets are, if anything, signaling that we should borrow more.

What Krugman is mistaking here is the fleeing of investors into the $US as a safe haven, as a winner in the 'least ugly' contest for money. However, his argument is investors want the US to borrow more! He ignores the fact that it is quite possible that the US might actually lose the least ugly contest if the US were to grow the rate of debt accumulation. He also ignores the fact that bond yields have been held down through money printing, and that any appreciation in US bond yields would see more money printing to keep the yields down. Just the promise of more money printing will, of itself, keep yields lower. He goes on to say that (again, my emphasis):

Again, this wasn’t supposed to happen. We entered 2011 amid dire warnings about a Greek-style debt crisis that would happen as soon as the Federal Reserve stopped buying bonds, or the rating agencies ended our triple-A status, or the superdupercommittee failed to reach a deal, or something. But the Fed ended its bond-purchase program in June; Standard & Poor’s downgraded America in August; the supercommittee deadlocked in November; and U.S. borrowing costs just kept falling. In fact, at this point, inflation-protected U.S. bonds pay negative interest: investors are willing to pay America to hold their money.

And if the Euro crisis was not taking place? Let's imagine a world in which there is financial stability, that sovereign debts in Europe are sustainable, that the Japanese economy is sound and so forth. If investors were to then look at the US, I think that there would be huge flight of capital. And this is the point; in the reality of today, where might the capital fly to? Yes, Professor Krugman, the US has managed to continue to accumulate debt without any major problems so far. It is not because purchasers of bonds want the US to issue more debt, but they simply cannot think of anything else to do with their money. If there were new measures that saw an increase in the rate of debt accumulation, it would simply test the status of the US in the least ugly competition. It is not a test that would be advisable.

Also, how much is enough borrowing, Professor Krugman? At present, the borrowing of the US government is at record levels. How much is needed, and for how long? What is the point at which the borrowing becomes counter-productive/unsustainable? Does it ever? At what point will taxes need to be raised to cover the borrowing? Or are you proposing that borrowing now will not mean high taxes later (in which case, the borrowing during the boom times should have led to a great boom now)? Where are all the answers to the basic questions?

It seems to me that simply saying borrow and spend more is fatuous argument. Yes, if you borrow and spend more, employment will increase (or decrease less), economic activity will increase, and the economy may even appear to grow if you borrow and spend enough. At the same time, the economy will structure around servicing that debt based consumption, entrenching the necessity of accumulating more debt. This is the history of Greece. The trouble is that, this only works as long as people are willing to fund the debt. The Greeks got away with it for a long time under the false premise that they were as sound as other members of the EU. Then it was apparent they were not. All that has happened since is that we can now see the real size of the Greek economy when debt accumulation slows down. Therefore, my final questions for Professor Krugman are; how big is the US economy when debt based consumption is removed? Or does he believe that debt based consumption is a productive part of the economy? Does he believe spending borrowed money creates real economic growth, or an illusion of growth that is dependent upon the ongoing accumulation of more debt?

Economic Crisis: Overview

There can only be one place to start with an overview, and that is the US. I am going to start with an oddity (and that is not meant rudely), which is Ron Paul's presidential candidacy. This is from CNN:

Paul's core following has been small but fervid. However, Paul now is gaining a larger following, especially among younger voters attracted by his message of drug legalization and his comprehensive -- if utterly wrong-headed -- explanation of the country's economic crisis.

The remainder of the article is a discussion of a controversy over some newsletters, which may well damage his campaign. However, the 'wrong-headed' explanation of the economic crisis is interesting, as Paul's is an explanation founded in Austrian economics. Here are some quotes from another article:

Ron Paul warns of eroding civil liberties, a Soviet Union-style economic collapse and violence in the streets.The Texas congressman, author of “End the Fed,” also wants to eliminate the central banking system that underpins the world’s largest economy.
“Not only would we audit the Federal Reserve, we may well curtail the Federal Reserve,” [And]

Non-partisan analysts say his economic proposals – drastic spending cuts, elimination of the Federal Reserve and a return to the gold standard – would plunge the country back into recession. [And]

Paul acknowledges that his proposal to avoid that outcome – an immediate, US$1-trillion spending cut that would slash the federal budget by more than one-third and eliminate the departments of Education, Energy, Commerce, Interior, and Housing and Urban Development – could have some unpleasant side effects.

Interestingly, Paul puts his money where his mouth is, with his investment portfolio centred around physical assets such as gold and mines.

Why do I start with Ron Paul?

For the regular readers of this blog, they will know that I have some affinity, but also some severe disagreements, with Austrian economics. The really fascinating thing about Paul's campaign is that it perhaps a signal of change in the US. The 'Tea Party' movement was one harbinger of change, and Paul's movement from the margins into the spotlight is another. People in the US are starting to see that the current economic crisis is not a temporary blip, but they instead see that something is fundamentally wrong with their economic structure.The US deficit has now moved past the $15 trillion mark, and even the great followers of events, the ratings agencies, are now putting the US on the credit downgrade path:

[Fitch] changed America's credit rating outlook to negative from stable last month, citing the failure of a special congressional committee to agree on at least $1.2 trillion (£770bn) in deficit-reduction measures.In a new fiscal projection, Fitch said at least $3.5 trillion of additional deficit reduction measures will be required to stabilize the federal debt held by the public at around 90 percent of gross domestic product in the latter half of the current decade.[and]

Rival ratings agency Standard & Poor's cut its credit rating on the United States to AA-plus from AAA on August 5, citing concerns over the government's budget deficit and rising debt burden as well as the political gridlock that nearly led to a default.
In November, another ratings agency, Moody's, warned that its top level AAA credit rating for the United States could be in jeopardy if lawmakers were to backtrack on $1.2 trillion in automatic deficit cuts that are set to be made over 10 years.

Perhaps as interesting as these 'mainstream' agencies is the views of a small ratings agency called Weiss (h/t to an anonymous poster who directed me to this site), who use a grading system similar to those used in education, and have recently given the US a rating of a 'C', which puts the US sovereign debt as relatively high risk investment (about equivalent to a Fitch BBB). The state of US unemployment has, however, recently been celebrated as a harbinger of some kind of recovery:

The troubled US economy and President Barack Obama's embattled administration received a substantial confidence boost on Friday, as unemployment sank to a 32-month low of 8.6 percent in November. Official figures showed the jobless rate fell sharply from 9.0 percent the previous month, as the economy created 120,000 new jobs.

After a year that saw joblessness linger around 9.0 percent, the report was welcomed with relief. "Woo-hoo!" said Robert Brusca, chief economist at FAO Economics. "The jobs numbers are looking better."

However, the same report goes on to say that:

Economists pointed to a worryingly sharp drop in the number of people looking for work -- which helped push down the unemployment rate further than would have been the case.
That could mean more and more jobseekers feel defeated by the relentless slog of finding a new position and are dropping out of the hunt all together.

"The drop in the unemployment rate was caused in part by a decline in the labor force of 300,000," said Jeffrey Rosen of Briefing.com.

Most importantly, remember that this is all taking place whilst the US government continues to stack up horrendous annual deficits, and while the Federal reserve is keeping interest rates at astoundingly low levels. My view of the US is filtered through the media, but I suspect that what is driving support for Ron Paul is that people are seeing that, for all the activity of the Federal Reserve and the government to save the economy, many people are not feeling it on the ground. They have commenced the process of simply not believing anymore. They are starting to see that the US economy is built upon foundations made of sand.

However, at the moment, the US bond market is still seen as a safe haven, and this in turn relates to the ongoing problem of the Euro area crisis. I will revisit a chart (original post here) from the Economist, which presents a compelling reason why the Euro crisis might move into high gear early next year:



February, March and April are all looking like crisis points. The ECB, in the background, is pumping credit into European banking markets, and printing money to indirectly facilitate finance sovereign debt purchases. However, as one commentator points out, thanks to Basel, the banks are already stocked up with sovereign debt, and why would they further increase their exposure to high risk Euro sovereign debt? I am not a great fan of the BBC, but this from Gavin Hewitt looks like a good summary:

As Europe edges towards the close of a year, the patient remains in casualty. It has defied all solutions.

The last summit which senior European officials billed as the meeting "to save the euro" was a non-event. The row over treaty change a distraction. The inter-governmental agreement largely codified much of what had been previously agreed. It may well be helpful to enforce tighter discipline, but its impact lies in the future.

The central dilemma lies unaddressed: debt and lack of growth. Countries are squeezing down their deficits, but their debt mountains have only grown. In many European countries there is not only negligible growth but countries are sliding back into recession. The task of regaining financial health will only become harder.

The same article goes onto discuss the leadership of Germany, and how national stereotypes are re-emerging with ugly portrayals of Germany now a commonplace.These kinds of representations of Germany may just be the start, and we might well see the fracturing of Europe back into the original nation states. Resentments are rising, and the strains of externally imposed austerity are becoming ever more clear. In the meantime, the leaders of the Euro nations, in particular the interestingly named Merkozy (Merkel and Sarkozy), impotently attempt to stem the crisis. February will be the first big test. I have commented on the Euro crisis several times, so will leave it here.

I also presented a broad review of the UK in September, so will not revisit the UK in depth here. However, I noted that there was an interesting new article on the state of house prices and affordability in the Telegraph. The article notes that the requirement for a 20% deposit for house purchases, alongside economic uncertainty has led to a record low of first time buyers. The inevitable knock-on effect of this, if it continues, will be a further decline in house prices. Notably, London has no areas which are affordable for first time buyers, suggesting a massive over-valuation of property at present, and with 'affordable' housing mainly being located in the North. Another point of passing interest is that Brazil has now overtaken the UK as the world number six economy in total size (is this at all meaningful? I am not sure what it means in pure economic terms, though it may be significant in terms of geopolitical power).

Overall, my argument for the UK remains the same. It is an economy in deep, deep trouble, and the attempts to address the problems are not sufficiently radical enough. Whilst the government talks of austerity, they continue to spend monstrous amounts of borrowed money, and have yet to confront the underlying problem of the UK; that large sections of the economy are structured around debt based consumption.I suspect that the Bank of England and the government will be faced with growing problems next year as the impossibility of austerity and maintaining living standards come into stark focus. I can imagine that the answer will be more money printing, but with diminishing returns in propping up the sick economy.

The Euro crisis might have gilts seen as a safe haven for a little longer, but it is just as likely that the coming economic woes will start to lead to questions about the viability of the UK's economy overall. This is a question that might have been asked back in the time when the economic crisis first became apparent, and I suspect that, if confidence is lost, the consequences will be harsh. In the end, I do not expect much rational thought on gilts, but rather the possibility of panics into gilts - with the potential for panic out of gilts. It will be nothing to do with fundamentals of the economy (which would be panic out), but rather it is about that abstract idea called 'sentiment', as well as the panics in other markets. It is the reverse of a beauty contests, and is instead a 'least ugly' contest, with the judges all wearing glasses that distort the view of the contestants.

Perhaps the most interesting major player in the world economy is China. In some respects, since emerging as a major economy, the Chinese have played a 'blinder'. They have played the world trading system to their advantage, seduced foreign investors, stolen their technology, and managed a mercantilist exchange rate in the face of opposition. The exchange rate success has seen the hollowing out of large swathes of Western industry, with China now dominant in many sectors of manufacturing. They have invested hugely in infrastructure, and the result has been to see astonishing economic growth. However, it may be that the state led growth in China's economy may be reaching limits, and that China has replicated the errors of the West (and Japan).

With regards to the massive investment in infrastructure, as China first emerged onto the world's stage, the Chinese economy was in a terrible state. At that time, any number of state led investments such as building new roads, building new power stations and so forth, were likely to have positive returns. In a country with terrible infrastructure, it would be difficult to find projects that might not see a positive outcome. This is from Bloomberg (visit the site for a very good Flash graphic on Chinese bank exposures to local government debt):

The findings suggest China is failing to curb borrowing that one central bank official has said will slow growth in the world’s second-largest economy if not controlled. With prices dropping in China’s real estate market, economists warn that local authorities won’t be able to repay their debt because of poor cash flow and falling revenue from land sales they rely on for much of their income.

Provinces and cities are going deeper into the red to finish projects, from the Manhattan on the east coast, to highways in northwestern Gansu and a stadium fronted by Olympic rings in Hunan, central China. Many were started as part of China’s stimulus program to beat the 2009 world recession. The financing companies accounted for almost half of the 10.7 trillion yuan in all local government debt tallied by the official audit.

The 231 borrowers whose public filings were reviewed by Bloomberg raised a combined 354.1 billion yuan by selling securities this year. They have credit lines from banks of at least 2.3 trillion yuan that have yet to be drawn down, the documents show.

 And regarding the export model, this from Ambrose Evans-Pritchard:

Professor Victor Shih from Northwestern University said the government implicit’s debt is near 100pc of GDP when hidden borrowing by local authorities is included. It is questionable whether the banking system can easily pump up the economy again, even if ordered to do so.
Fitch Ratings warns that there has already been a "massive build-up in leverage", eroding the ability of lenders to generate genuine economic growth by expanding credit. The IMF says banks could be "severely impacted" if the soft-landing turns hard. The receding tide this year is likely to reveal whether or not banks are bathing naked.

Capital is already leaving the country. China’s $3.2 trillion foreign reserves have begun to shrink. Officials in Beijing have warmed of a "grim" year to come, muttering about the possible need for a weaker yuan. Any such currency move would set off a storm in Washington, risking a trade war.

The Politburo knows that China’s growth model has hit its limits, with over-reliance on exports. Investment is running at 46pc of GDP and the national savings rate is 54pc, both signs of a massively distorted economy.

There are multiple problems here. The first is corruption, with local authority politicians using mega-investments as a means to line their pockets. The second problem is one that I referred to earlier. In the early days of development, a blind fool could find good potential investments in China but, as developments are completed, a more nuanced approach to investment is needed, and the chances of successful projects diminishes. The combination of corruption and ineptitude is likely seeing the point at which the number of financially disastrous projects is now multiplying out of control. Finally, I remember an interesting saying from my time in China, which is roughly 'the emperor is over the mountain and far away'; in other words, the central state is not in full control of the provinces, which can and often do go their own way.

What we are starting to see is the emergence into light of serious structural problems in the Chinese economy. Several years ago, just after leaving China, I commented on the huge numbers of apartments being built but which remained empty, as they were an 'investment' purposes (unused apartments have a higher value). Then there were the shopping malls that lacked any evident business that might explain their survival. At the time, I asked whether perhaps there were growing bubbles in the Chinese economy, and we may now see the real bursting of these bubbles; resulting in ever more strain on the Chinese banking sector.

I rather like the term being applied to China, which is that of a 'hard landing'. The Chinese model was a great success, but only in the early stages of the country's development. There seems to be an amazing confidence that the Chinese government can manage the economy, but this is based upon the early stages of China's development, but the limits of the effectiveness of such state led economic management are now kicking in. The Chinese state is no more competent than any other state at economic management; it is just that, in the early years, it was difficult to do anything but move the economy upwards and at a rapid pace.

It is not just their internal problems that present headwinds. The world economy is in a dire condition, and that will have knock on effects for their export model. As mentioned in one of the earlier articles, there are also rising tensions with trade partners. This is a story from Reuters:

U.S. Senate vote opened a week of debate on the Currency Exchange Rate Oversight Reform Act of 2011, which would allow the U.S. government to slap countervailing duties on products from countries found to be subsidising their exports by undervaluing their currencies.

U.S. lawmakers, eyeing 2012 elections, said keeping China's currency undervalued had cost American jobs and that a fairer exchange rate would help cut an annual trade gap Washington puts at more than $250 billion.

"By using the excuse of a so-called 'currency imbalance', this will escalate the exchange rate issue, adopting a protectionist measure that gravely violates WTO rules and seriously upsets Sino-U.S. trade and economic relations," foreign ministry spokesman Ma Zhaoxu said in a statement posted on China's official government website (www.gov.cn) on Tuesday.
"China expresses its adamant opposition to this." 

This has been going on for a long while. Threats and counter threats. However, as the economic condition of the OECD countries continues to worsen, it is only a matter of time before countries say 'enough'. It does not help that China continually instigates measures to harm the operations of the multinationals in China (e.g. see here), which I have discussed at length in previous posts on China.

So far, all bad. However, set against these headwinds, there are still positives in the Chinese economy. They now dominate markets for many goods, and it is hard for competitors to re-emerge in these markets in face of the economies of scale China has achieved. Again, I have previously spoken about the amazing clusters of businesses in a particular sector, where there is fierce competition within the cluster, but also where there is an amazing adaptability to changes in the market. I saw one such cluster in the city of Zhongshan, which was manufacture of lighting, and the growth and development of the cluster was spectacular.

Another positive is that China is fast moving up the value chain. They have taken the developed world's intellectual property, have ignored intellectual property rights, and benefited from this process for many years. However, they are now themselves fast moving up the technology ladder:

China became the world's top patent filer in 2011, surpassing the United States and Japan as it steps up innovation to improve its intellectual property rights track record, a Thomson Reuters research report showed on Wednesday.

The report said the world's second-largest economy aimed to transform from a "made in China" to a "designed in China" market, with the government pushing for innovation in sectors such as automobiles, pharmaceuticals and technology.

It said published patent applications from China were expected to total nearly 500,000 in 2015, following by the United States with close to 400,000 and Japan with almost 300,000.

As I have said, in some respects, China has played a 'blinder' of an economic game. In other respects, it has shot itself in the foot. As the situation stands, China must now confront the limits to state led growth, and the consequences of the problems that have resulted to holding onto the model for too long. I am not sure that the Chinese government is sufficiently adaptable to manage a transition to a more hands off approach. In addition, as the world economic crisis continues, there is likely to be a period in which the Chinese export machine will stutter alarmingly. This, and the problems of the state model, may indeed see a very hard landing. If so, then there is always (as I have long argued) the potential for severe social unrest. Indeed, in many respects, China is powder keg that simply lacks a fuse and spark. Any severe drop in growth might provide these two elements.

However, as is always the case with China, some big caveats. As any commentator on China will tell you, it is an opaque world, and nobody is ever sure of what is really going on in China. Likewise, the machinations of the Communist Party are such that the intentions and actions are obscured from any clear analysis. In short, we will see.....

Overall, what can I say about the current state of play. I have not covered Japan, due to lack of time (and never being as confident as I should be in understanding Japan's economy), but have covered some of the major economic players. Overall, it is not a pretty sight. The economic crisis is in full swing in the US, UK and the EU. The promised salvation of the world economy by China looks overly optimistic; it looks as if China will have its own problems. The politicians and central bankers are still pulling at their policy levers, but the levers now have less and less impact upon the world around them. I never discount the possibility of yet another set of radical policies that might 'kick the can' a little further down the road, but I am not sure how much further that the can might be kicked.

It is going to be an interesting year......

Note: Jonny, thanks for an interesting video clip. I have not looked at the ESM in that much detail to see the points made in context, but it seems to fit with the general themes of opacity that I have discussed previously.

Update:

I just found this story a little while after the original post, which is pretty telling:

The [UK] Treasury is working on contingency plans for the disintegration of the single currency that include capital controls.

The preparations are being made only for a worst-case scenario and would run alongside similar limited capital controls across Europe, imposed to reduce the economic fall-out of a break-up and to ease the transition to new currencies.

Shocking stuff?