Sunday, December 30, 2012

Middle Earth Economics

After so much gloom, I had to pass on this link as follows:


Saturday, December 29, 2012

The Fiscal Cliff

It is hard to ignore the big news of the moment, which is the US fiscal cliff. For those who are not from the US, this is a summary from the Congressional Budget Office (CBO):

  • A host of significant provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312) are set to expire, including provisions that extended reductions in tax rates and expansions of tax credits and deductions originally enacted in 2001, 2003, or 2009. (Provisions designed to limit the reach of the alternative minimum tax, or AMT, expired on December 31, 2011.)
  • Sharp reductions in Medicare’s payment rates for physicians’ services are scheduled to take effect.
  • Automatic enforcement procedures established by the Budget Control Act of 2011 (P.L. 112-25) to restrain discretionary and mandatory spending are set to go into effect.
  • Extensions of emergency unemployment benefits and a reduction of 2 percentage points in the payroll tax for Social Security are scheduled to expire. 
From the same article, this is the projection of the CBO:

CBO’s Baseline: Taking into account the policy changes listed above and others contained in current law, under CBO’s baseline projections:
  • The deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4.0 percent of GDP), almost $500 billion less than the shortfall in 2012.
  • Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013.
  • Because of the large amount of unused resources in the economy and other factors, the rate of inflation (as measured by the personal consumption expenditures, or PCE, price index) will remain low in 2013. In addition, interest rates on Treasury securities are expected to be very low next year.
 The current situation is summarised here (sorry, it's long):

WITH the clock ticking toward a New Year's time bomb of huge tax increases and spending cuts, US politicians are working to keep America from tumbling off the so-called fiscal cliff. 
The stakes in the game of holiday-interrupting brinkmanship are huge. Economists agree the $US500 billion ($A484 billion) in fiscal pain due to kick in as soon as the new year starts will stifle the gathering US economic recovery and send the United States back into recession, spelling bad news for the global economy as well.

Aides to leaders of the Democrat-controlled Senate worked behind closed doors on Saturday morning to fashion a deal palatable to both Republicans, who control the House of Representatives, and the Democrats.

A senior Republican aide said "discussions are under way". He added that details of any deal will not come out until leaders brief their caucuses on Sunday.

Both chambers would need to pass a deal by New Year's Eve. They thus have three days to get done what has eluded the White House and Congress for weeks, and will interrupt their year's end vacation in the process.

As negotiations proceeded, President Barack Obama urged Congress to protect the middle class from higher taxes and lay the groundwork for economic growth.

"We've got to do what it takes to protect the middle class, grow this economy, and move our country forward," Obama said in his weekly radio and internet address.

"Leaders in Congress are working on a way to prevent this tax hike on the middle class, and I believe we may be able to reach an agreement that can pass both houses in time," he added.

Obama met with top congressional leaders on Friday and said Senate Democrats and Republicans would work overtime this weekend to try to head off the fiscal cliff.

The president, sensing a mandate from his re-election last month, wants to raise taxes on the rich but exempt the middle class. Republicans want only to close tax loopholes to raise revenue and demand significant spending cuts in return.

But if nothing is done by the deadline, all taxpayers will see an increase.
The first point to note is the 'cliff' metaphor. It frames the spending cuts and tax increases in terms of something scary; falling off a cliff leads to harm. The use of this metaphor is of itself an argument, and and argument that says the tax increases and budget cuts are a bad thing. Framing the changes in this way also becomes an urgent call to action, and that is exactly what is taking place (albeit with no success so far). Another problem with the metaphor is that it is not actually a cliff:

For one thing, it isn't really a "cliff." The impact of the tax hikes and spending cuts will be felt gradually, over several months, so there will "be plenty of time beyond January 1, 2013 for things to get worked out."
In short, the term 'cliff' is a distortion of the actuality of the situation. The most worrying aspect of this distortion is that it is driving action, and driving hurried action. Although I am completely in favour of action to reduce the deficit, this is absolutely not the way to take action. Instead, what should be taking place is a more measured look at spending and taxation, and how the activity of government is prioritised and how it might be reformed. This is a question of what constitutes the core functions of government, and elimination of non-core functions. I do not give my view here on what those core functions are, as this is a political question, but it is a question that needs to be answered. Having answered the question of core functions, the functions thus identified have to be given priority, and hard decisions made on the allocation of finite resource to each core function, and how the underlying purpose of the function can be retained, whilst reducing the costs of the function (regular readers will have seen examples I have given for the UK where I have taken this approach, e.g. here). It is also about what share of the wealth of a country will be given over to the use of the government, and accepting that the government must operate from tax receipts and not use borrowing to dishonestly bribe the electorate with tax breaks now at future cost and provision of services funded with borrowed money at future cost.

The other point that needs measured examination is the US tax system, which is notoriously complex and unwieldy. Again, the US needs to go back to the core, and ask what taxation is really supposed to achieve. I have written on the UK tax system, but much of what I have written would certainly apply to the US. In particular, just as in the UK, the US tax system has become a political policy tool, rather than a system for collecting x amount of revenue. All taxation systems are in some respects political, but the politics should be limited to the distribution of the burden of taxation, rather than a political tool used for wider political goals. Although the arguments over the 'cliff' are focused on questions of distribution, the real problems of the current system's complexity and distortions are ignored.

Indeed, the entire debate over the 'cliff' is one of political grandstanding, rather than any serious attempt to address the real question that needs resolution; how can finite resource be best collected and used in order for government to achieve its core functions? The word 'cliff' is a problem, as it drives urgency that was never there, and plays to the desire for political grandstanding. I want to be clear here, that I believe that there is an absolute necessity to cut the deficit, but this is not the way to do it. It is urgent, but it is not 'fiscal cliff' urgent. All the term fiscal cliff has achieved is to drive out the mature debate that is necessary to enact real reform. This suits the politicians. Rather than take hard decisions, they can bury issues in messy compromises within the current system instead of facing the more fundamental and difficult questions.

Update: I nearly forgot. Thanks for the paypal donations from several readers, which I am guessing were inspired by Christmas. I would also like to wish all the readers a happy New Year!

Sunday, December 23, 2012

False Assumption, Ponzi, and the Developed World

We are now heading towards 2013, and it very, very striking that the world is still mired in an economic crisis. It is very easy for people to be caught up in the 'events' that comprise the daily news stories in the media; the events appear as more real than the abstractions that are the explanations that sit under the events. The explanations of 'events' is 'events'. Thus we have an event such as a government announcement A, leading to event B. It is wonderfully tempting and seductive to take this view, as the correlations between events can be easily determined, easily seen, and easily explained. However, the event A does not take place in a vacuum, and the event B that follows likewise does not take place in a vacuum. Instead, what is really happening is the events sit in a messy context of broader drivers, the beliefs and perceptions of innumerable actors, contesting interests, and sometimes just plain irrationality.

For example, take the belief that seems to be common in the developed world that relatively high levels of wealth are a given, a natural state of affairs. Would anyone contest that this belief is firmly entrenched? Whilst some might argue about the distribution of the wealth, for example arguing that true wealth should see more even distribution, they would still proceed from an assumption that there is and will be a relatively high level of wealth for distribution. I have now been blogging for several years, and have been thinking about economics for longer, and have not found any examples which do not proceed from an assumption that the developed world should just somehow be more wealthy. Even when articles bemoan the rise of China, they do so on the basis that, somehow, it is a natural place/position/state of affairs that the developed country should, well...... just be more wealthy.

The articles that worry about the sliding position of the developed world are the most interesting. They have a sense that 'something must be done', and often they will offer their policy prescriptions to fix the problem. It does not matter whether the author is left or right leaning, the aim is to maintain the relatively high levels of wealth in the country under discussion. With the right tweak of policy here, tweak there, all will be fixed. They assume that the natural position of relative wealth might be maintained, if only we could just do x, y or z.

Most of the readers of this blog seem to be well informed about economics. As such, I ask you to think about the many articles you read, and the assumptions that underpin them. You will find an assumption that the developed world not only is naturally more wealthy than the rest of the world, but also should be more wealthy than the rest of the world. There are some exceptions, in particular on the left, that the developed world is somehow sinful for being wealthier, and that the developed world should actively redistribute its wealth to the poorer parts of the world. Even here, we see an assumption of natural wealth.

The problems with the assumption of natural wealth, and that the developed world should be more wealthy is that it is just that; an assumption. It is treated like a natural force, and a right that is dictated by some kind of natural law. The problems is that there is no natural law, and no right that can be supported or defended in any way whatsoever. When a less well developed country pulls itself up by its metaphorical boot straps, sees rapid economic development, and contests for a position in the top tier of wealthy countries, there is no natural force that might stop them, or reverse the ascent. Instead, there are the complexities of the trillions of individual purchase decisions, the choices of individuals in economic entities such as firms, regulators, and policy makers.These are the real forces at work in economics, rather than some unseen and non-existent forces and rights.

I too have been guilty of the assumption that the developed world should be more wealthy. Like many others, I have argued that the developed world should act to defend its position as 'wealthy', including offering my own solutions. In some respects it is wrong-headed. There is no real reason why any particular country should be more wealthy than its neighbours, if the people of each country are equally as hard working and innovative. It seems that, in this situation, there can be no justification for one country being wealthier than another. There are, of course, situations where a particular country is just blessed, as in the examples of the oil resources available to countries in the Middle East. Putting it crudely, they just do not have to work as hard as others. Resenting such good fortune is, of course, pointless and sometimes such blessings also turn out to be a curse.

However, the world is not so simple as I paint it here. It assumes a world of competition between economic entities, based upon hard work and innovation. However, there is another competition at work, and that is the competition of systems; systems of how society is ordered. At one extreme we have what might be described as a something like a fascist state; China. All ideas that are imported into the country are subject to 'sinification', so China's system is uniquely Chinese. I use the word fascist therefore in a very loose way as the nearest equivalent. It would then be tempting to say that, on the other side, we have liberal, democratic and free market countries of the developed world. It would be a neat narrative of black versus white, but it does not hold.

However, the latter categorization is nevertheless partially true. With differing degrees of dysfunction, the developed world is democratic, and to different degrees 'liberal'. I say dysfunctional, because democracy is not working well. The system is failing. There are certain types of dysfunction that I will put to one side here, such as the shocking amount of money that is necessary to compete for the US presidency (albeit that such problems also relate to my area of concern). My concern is rather with the dysfunction of the electorate.

A significant economic challenge has developed, and that challenge is very real. We have seen a significant shift in the economic structure of the world. It has been assumed that what we are witnessing is a game of 'catch-up', in which countries such as China are seeking to chase after the on-going growth of wealth in the developed world. The idea that 'surpass' might take place is only in aggregate, not at the level of individual wealth. However, the developed world is not growing in wealth, but seeing a diminishment of wealth. The developed world is on a down escalator, even whilst the developing world is on the up escalator. As I have pointed out recently, those on the up escalator now face their own problems, but to assume that they will not continue upwards and the developed world downwards would be complacent.

It is here that I return to the dysfunction of the electorate and the question of liberal democratic and free market. In the developed world, the electorate have been seduced by the idea of the natural right to wealth in their own country. They know that there are now challengers to their position of wealth. They cannot avoid seeing this reality. Even those with the most passing interest in economics will be aware that the world has changed. Faced with the challenges of a new economic structure, instead of facing the new competition, electorates have demanded that the world remains unchanged. However, demanding that the world remains unchanged does not make the world unchanged. All that has happened in response to this demand, is that the politicians have responded to the demand by developing a pretense that the world is unchanged. Happy days are just around the corner. But the corner continues to be elusive. So what is the pretense?

The pretense is that we still operate in a world of free markets and that the world has not changed. Of course, it has never been the case that markets have ever been truly free, so we are talking about degrees of freedom. The point is that, since the economic crisis came into view, the marketplace has come to be dominated not by market signals, but monetary and fiscal policy of governments. Governments have always had a role in the marketplace, but underlying market signals could still (mostly) be discerned from the noise created by government. This is no longer true. More pertinently, it is now being recognised, even in conservative organisations like the Boston Consulting Group, that current policy is simply impossible to sustain.  They are blunt; they call current policy in the developed world a 'ponzi scheme'. This is just one extract from the report, and the content will be no surprise to regular readers of this blog:

Intensifying International Competition and Rising Inequality. Globalization has brought the promise of economic prosperity to billions of people around the world. But it has also contributed to tougher international competition and the creation of new inequalities of wealth and income in the developed world. The growth in the global labor force continues to put pressure on labor costs in developed economies. At the same time, globalization is leading to increasing inequalities in income and wealth within countries, as some groups (such as investors) benefit more from increased globalization than others (such as manufacturing workers).

Income statistics highlight this development: between 1979 and 2007, the income of the average U.S. household grew by 62 percent. Over the same period, the income of the top 1 percent of households grew by an extraordinary 275 percent and the income of the rest of the top 20 percent grew by a slightly above-average 65 percent, while the income of the remaining U.S. households grew by less than 40 percent. The incomes of the lowest quintile grew by only 18 percent.

Inequality increases the risk of social unrest and declining support for capitalism and a free society. As University of Chicago economist and former IMF chief economist Raghuram Rajan points out, “Ultimately, a capitalist system that does not enjoy popular support loses any vestige of either democracy or free enterprise.”
In the last passage, they capture the problem of democracy, and why it is that the response of governments is to pander to demands. All of the new workers who have entered the global workforce are not going to go away. The advantage of capital over labour will not disappear for a long time. This is the reality and no amount of propping up of demand, printing of money or borrow and spend will make this reality disappear. Demanding a standard of living will not make it so.

When starting this blog, I was largely a lone voice. The economic crisis was called a financial crisis, with a suggestion that, with bailouts, and some largess from central banks, the problems would disappear. They have not. They have simply been magnified. I argued for the idea that the world had entered a world of 'hyper-competition' and that is still where we stand. I am no longer a lone voice in this, and the BCG report is just one of the more 'conventional' sources that has finally recognised the changes that have taken place. The problem was not, as I have always argued, some isolated financial crisis, but a shocking change to the world economy - to the very structure of the world economy. Globalization was more than a word, but was a description of an accelerating revolution. On my bookshelf, I have a long unopened book on globalization; even when I read it several years ago, it appeared fanciful and arrogant. It now seems positively quaint. So here we are now in a world of hyper-competition. I will highlight a quote from the BCG report:

Fortunately, there is still time to act. But leaders from all social sectors—government, business, organized labor, environmental and other stakeholder groups—need to act decisively and quickly in order to secure future economic prosperity, social cohesion, and political stability. It is in the nature of Ponzi schemes to collapse suddenly, without warning. No one knows what event may send the developed world and the global economy as a whole back into crisis.
They get what I did not get when I first started writing this blog. The absurdity of a ponzi scheme continues till it doesn't. The magic of a ponzi scheme is that they can sustain themselves for so long, before the weight of the fraud finally topples them. I thought that people would see through it much earlier because, in reality, it has always been in plain sight. People just had to choose to see it. And that is the problem. When confronted with reality, we (the electorates, the policy makers, the economists, the politicians) choose to look away. A while ago, I saw a film about the Madoff ponzi scheme (sorry, I forget the name), and the most striking point in the film was the stubborn refusal to see what was in plain sight. It is the same situation in the developed world economies. After all, it can run a little longer, and we will be ok, won't we?

Note: I did think about posting this after Christmas. It is not full of festive spirit, after all. However, when is the best time for bad news? I am not sure. So, I end here by wishing that you all enjoy Christmas, and only give thought to economics after enjoying Christmas with your families. On Christmas day, I will raise a glass of appreciation to all the regular readers of the blog, as it your interest that keeps me posting. Thank you, and have a great Christmas.

Saturday, December 15, 2012

The RMB as a Reserve Currency: Breaking Habits of Thought

The economic power and influence of China continues to grow. In September, 2009, I wrote the following:

The last line of reasoning I considered appears to be the most probable. It is simply that China's wealth is indeed denominated in the $US, and they are just doing enough to hold the $US from free fall. The reason is that this allows them time to use the $US, which they are still accumulating in large quantities, to prepare themselves for the post-$US world. Returning to the speculative post in which I imagined what I might do if I were China, I suggested that they would also diversify their holdings into commodities (in particular gold), other currencies, and would continue and accelerate their purchase and control of commodity/resource companies.
Some quotes from a recent article from AFP:

Chinese firms have become more active in mergers and acquisitions since the global financial crisis that began in 2008, as economic distress has thrown up bargains around the world.


Between 2005 and 2011, the number of China's overseas acquisitions tripled to 177 and jumped five-fold by value to $63 billion, according to law firm Squire Sanders and intelligence service Mergermarket.


But academics said more was at work than commerce, as China seeks growing stature and competes with other countries for resources.
If you can cast your mind back to 2007, how did you think of China? The AFP reports on the unease being felt by China's growing influence. If jumping back in time to 2007, if somebody had suggested that China would be this influential, would you have taken them seriously? Whilst China was seen as important, the idea that China would be causing this kind of unease would have been dismissed as fanciful. Another point that I long ago made, at about the same time as discussing China's potential shopping spree, was that China would seek to displace the $US as a reserve currency, and develop the RMB as a potential replacement. This from April 2009:
I have a very curious sense at the moment of the world moving in slow motion. I had thought that the economic crisis would create dramatic moments, but in some respects it appears to be moving through a gradual shift.

One of the predictions that I have made, on two occasions, is the collapse of the $US and the end of the reserve status of the $US. However, it appears that the end of reserve status is being achieved with little drama, as it is apparent that the RMB is slowly but surely being positioned as a replacement of the $US as the reserve currency. We have this latest news from the China Daily:
Five major trading cities have got the nod from the central government to use the yuan in overseas trade settlement - seen as one more step in China's recent moves to expand the use of its currency globally.
From these modest beginnings, the process of moving the RMB to reserve status has continued, and I have occasionally given examples in my posts. This is recent development:

Cracks are beginning to appear; the latest sign is that China and South Korea have come to an agreement in which banks from either country are able to borrow funds from a swap line that makes loans available to companies for deals in local currencies. (Source: “China, South Korea to Boost use of Local Currencies in Trade,” Bloomberg, December 4, 2012.)

This is analysis from Reuters:

Fed up with what it sees as Washington's malign neglect of the dollar, China is busily promoting the cross-border use of its own currency, the yuan, also known as the renminbi, in trade and investment.
The aim is both narrowly commercial - to reduce transaction costs for Chinese exporters and importers - and sweepingly strategic.

Displacing the dollar, Beijing says, will reduce volatility in oil and commodity prices and belatedly erode the ‘exorbitant privilege' the United States enjoys as the issuer of the reserve currency at the heart of a post-war international financial architecture it now sees as hopelessly outmoded.

Zha Xiaogang, a researcher at the Shanghai Institutes for International Studies, said Beijing wants to see a better-balanced international monetary system consisting of at least the dollar, euro and yuan and perhaps other currencies such as the yen and the Indian rupee.
However, I would not want to give a false impression that everyone thinks that the RMB as a reserve currency is likely. For example, this rather curious article from Forbes gives a consideration of the many ways in which the RMB's status is accelerating before then oddly concluding:
Does all this mean China is about to overtake the dollar as the world’s reserve currency? Not anytime soon. A reserve currency, in our view, requires deep and credible government bond markets, an open capital account and critical mass in global financial systems. China’s central bank has laid out a 10-year plan for “internationalization” of its currency. China’s FX bands are widening, but in an incredibly cautious way. Dollar holders need not panic.
Indeed, most articles, including the Reuters one quoted earlier, give caveats, express doubts etc. It is all rather odd, as the expansion of the international role of the RMB is an actuality. Indeed, as long as I have been tracking this steady expansion, the same things are said with each new step, and always that reserve status is something for the distant future. There is a growing conflict between what is taking place, and the analysis of what is taking place. This is a habit of thought and I made the point in an article for Trade and Forfaiting Review in November 2009:

Imagine a world in which there was no international reserve currency, but that an organisation was proposing that the US dollar ought to be the future reserve currency. Would you take such a proposal seriously?

Your response might be that the US dollar sits atop mountains of debt, a shrinking economy and you would point out that the US monetary authorities are printing money to fund record government borrowing. You might actually laugh at such a prospect.

On the other hand, how would you view the Chinese renminbi? You might point out that China holds large reserves of other currencies, the renminbi rests on top of a massive current-account surplus, China’s economy is growing and that the prospects for future growth are all positive. Furthermore, China is a country of savers, with a small fiscal deficit and is an export machine selling goods around the world, ensuring an ongoing utility for the currency in trade.
I do not have a copy of the full article to hand, but recall that I argued something along the lines of the $US as a reserve currency was a habit of thought, rather than a rational assessment. Time has moved along since I wrote the TFR article, and time has supported my case, and still there is a sense that it just isn't possible, even though the step-by-step expansion of the RMB into a reserve currency progresses forwards.

However, at this stage, I am not so certain that the RMB will be the major reserve currency, but not for the reasons that are generally given (e.g. deep bond markets). As regular readers will be aware, I am increasingly cautious about the overall position of the Chinese economy. I am not entirely convinced that China can sustain its economic miracle and, as ever, see political risk in any major slowdown in the growth of the Chinese economy.

Nevertheless, if China does manage to continue its growth, then the indications are that it will continue to chip away at the reserve status of the $US. Returning to the start of the post, the influence of China continues to expand, as the Chinese state encourages firms to seek out and purchase access to resources, and also expand internationally. It is but one example of the astonishing growth in China's economic heft. That influence is being felt throughout the world, and the influence just further enhances China's credibility as a 'major player', and that, in turn, enhances the credibility of the RMB as a reserve currency. Set against this, the economic policy of the US can only continue to erode the influence of the $US. The following is a commentary on the $US and the challenge of the RMB:

Rome in its day held the reserve currency of the world, and how the mighty have fallen. Unless real changes are made, we might be witnessing the beginning of such a shift here. The rising U.S. debt levels are raising questions by many countries around the world as to the legitimacy and viability of the U.S. dollar as the reserve currency.
Politicians in Washington must wake up to the realization that the U.S. dollar’s status as a reserve currency is not written in stone. The financial markets are currently more dynamic and fluid than ever before. It takes only the click of a mouse to move money around the world.
Unless America gets its fiscal house in order, I believe we will see more agreements, such as this one with China and South Korea, which will avoid the U.S. dollar and increase the continuing questions about the viability of its reserve currency status.
The author has a point. After all, if the $US was not already the reserve currency, would you pick it out as a new reserve currency? I think that this unlikely, but perhaps you would disagree?

Monday, December 10, 2012

Krugman: The New Luddite

I know, I post too often on Krugman's musings in the New York Times. However, I could not resist the later missive from Krugman regarding automation (robots, and I presume he also means software that automates tasks currently performed by humans, but that is a guess):
If this is the wave of the future, it makes nonsense of just about all the conventional wisdom on reducing inequality. Better education won’t do much to reduce inequality if the big rewards simply go to those with the most assets. Creating an “opportunity society”, or whatever it is the likes of Paul Ryan etc. are selling this week, won’t do much if the most important asset you can have in life is, well, lots of assets inherited from your parents. And so on.

I think our eyes have been averted from the capital/labor dimension of inequality, for several reasons. It didn’t seem crucial back in the 1990s, and not enough people (me included!) have looked up to notice that things have changed. It has echoes of old-fashioned Marxism — which shouldn’t be a reason to ignore facts, but too often is. And it has really uncomfortable implications.

But I think we’d better start paying attention to those implications.
Welcome to the new Luddite approach to the improvement of the human condition. The robots will move wealth to the holders of capital from the workers.....and that is bad for us all. And what, might I ask, does he think happened in the industrial revolution? The hand loom weavers were put out of business due to automation. It was one of the heralds of the greatest changes in the history of mankind, and one from which we all now benefit. The industrial revolution was, in some respects, a painful process, but also served to create the potential for the huge benefits that we now enjoy.

In the modern and developed world, the adjustment to this new source of productivity should be less painful, albeit that the transition will not be easy either. However, unlike the industrial revolution, we are not transitioning from a system that was for many people barely above subsistence. Today, we are not barely above subsistence, but that is not to say that the transition will not be hard for some people. If you have spent years learning to do something like a search for legal precedents, the automation of this process will be a hard blow. However, for all of this pain, automation will have positive benefits alongside of these costs. In the case of legal services, access to the support of the law will be more affordable to those who would otherwise struggle to have access to the services, and that may matter a lot to many people. It is no different to the access to relatively cheap cloth that will have made new clothes more affordable to poorer people; at a cost to the hand loom weavers in the short term.
Just as the spinning jenny benefited the capitalists, the providers of automated legal searches will benefit the owners of law firms who adopt the technologies that are now available.

The examples of automation creating wider economic benefits are so many that it is difficult to know where to start. The end of canals in the face of the competition from more efficient trains (which created a boom and bust that left the UK with a railway system paid in full by the loss of the capital owners), the redundancy of the typing pool with the advent of the PC and so forth. In all these cases, automation has the result of getting more from less labour, and that means more 'stuff' per unit of employed labour, even in the case of the indirect effect of removing the typing pool. As fast as labour is being removed, more output is being created per worker, meaning that more 'stuff' is available per worker. With greater output of stuff per unit of labour, labour is freed to do new things. It is, just as happened in the industrial revolution, a situation in which new jobs arise to replace the old jobs, as people find new stuff to produce, as the emerging surplus of labour is absorbed in producing 'stuff' that was previously only afforded by the few. It is the process which generates greater wealth.

One wonders, when Krugman says that there are 'uncomfortable implications' and suggest that those implications 'need attention', what exactly he might mean? Does he mean that we should halt the current process of automation, perhaps smash the robots? I mean really, what does he mean? He leaves his article vague and open, hinting at ominous consequences. However, those consequences have precedents that (for once in economics) are clear. We see the result of the precedents all around us in the developed world; more than enough food, better health, heated and comfortable homes, our many forms of entertainments, our freedom to access information, and so the list goes on.

Think of the example of the impact of the PC on the typing pool. It saw what was a hard earned skill eventually made redundant (however, I taught myself touch typing, so not entirely redundant, but I do not need the level of skill of the typing pool where there is no 'backspace'). Should we have looked at the 'uncomfortable implications' of this shift? For a typist, it was undoubtedly not a good situation. However, would we turn back the clock, and stop this change if we could? We could certainly reverse the change, by making word processing software illegal, and blocking any web services that might offer a similar facility. In a few year time, with the magic of backspace button gone, we would have huge numbers employed in typing pools. Those same individuals will be drawn from the labour force, and will be an opportunity cost; the opportunity to do something else which is genuinely in more demand.

What we are discussing here is nothing more than a variant of the broken window fallacy; that breaking a window is a good thing as it creates employment. In breaking the window as a deliberate act, it creates employment, but employment with no real point. Better that the people employed in repairing the window are engaged in productive labour with a genuine demand, rather than an artificial 'created' demand. In the same way, better people are employed in new avenues than artificially supporting, or creating, employment through the rejection of more efficient means of engaging the same labour. It is a make-work scheme where there is no need for the work. Better that the labour is employed in creating real value.

If ever there were evidence that Krugman has nothing to offer, this rather odd article is the evidence. It is no wonder that he leaves the 'implications' and solutions unsaid. If he were to say clearly what his article implies, he would be ripped to pieces. It is, as the title of this post implies, nothing more than a disingenous revival of Luddism. Krugman hides in ambiguity, but the 'implications' are clear; break the machine to save the interest of labour. He cannot see that, painful as the adjustment might be, labour is also the recipient of the benefits of automation.

Further, Krugman writes from a US perspective, and the potential benefits to the US worker are obvious; the cost of labour differential is diminished through automation. Maybe the labour will no longer be the crude repetitive labour of yesteryear, but all those 'on-shored' factories that benefit from automation will nevertheless create new employment opportunities. There may, in other words, be losers from automation, but there will be many more winners; and the win will keep on delivering, just as the industrial revolution today reverberates to the benefit of all in our day-to-day lives. 

Thursday, December 6, 2012

The UK Mid Year Budget Statement

The mid-year budget statement has prompted concerns about the UK economy. It is a classic case of 'incrementalism' and fiddling. For example, see here for benefits reform and the silliness of framing the limited reform with the discussion of 'Mummy Tax'.

This is gloomy pre-statement commentary from Alexander Heath in the Telegraph:

Psychologists call this cognitive dissonance; unkind folk would see it as plain cowardice. What is clear is that such self-deception has reached epidemic proportions when it comes to the economy, and has contaminated all major political parties as well as many professional forecasters.
In the absence of shock and awe supply-side and tax reforms, which are not on the cards, our long-term growth prospects are bleak. George Osborne’s greatest problem, as he prepares to deliver the Autumn Statement, is that the British economy is stuck in a rut.
He has grasped something of the reality. In the UK, we are now starting to see something of the negative spiral that follows in the wake of attempts to incrementally cut government borrowing growth in the face of an economy that is structured around servicing the growth in borrowing (sorry, for the convoluted sentence). However, this from the WSJ:

The U.K Treasury painted a grim economic picture, acknowledging that growth was weaker than the government expected and that a tough austerity plan would drag on longer than planned.

Treasury chief George Osborne, who presented his closely watched twice-yearly economic update Wednesday, delivered a triple whammy of bad news. He conceded the economic recovery was taking longer than expected; that he would likely fail to meet a key self-imposed debt goal; and that government cost cutting would continue until 2018, three years longer than initially planned. At that point, the U.K. will have experienced eight straight years of austerity.

Mr. Osborne and the Conservative-led coalition government is halfway through its five-year term. Having come to office promising to fix Britain's weak economy, Mr. Osborne is under immense pressure to demonstrate that his strategy is working ahead of the next general election, due 2015.
Except for the misuse of austerity, it is a reasonable summary. The pressure is no doubt building to get the money printing presses running again:
Sterling edged up from one-month lows against the euro on Wednesday after a gloomy UK budget statement which traders said was in line with expectations.

But forecasts from finance minister George Osborne that Britain would miss its debt-reduction and growth targets left the currency looking vulnerable.

Analysts said the poor UK economic outlook might revive prospects of more monetary easing by the Bank of England and increase the risk of a credit agency cutting the UK's top-notch rating, both of which would be negative for sterling.
 The OBR is taking a negative view, saying that:

The independent Office for Budget Responsibility predicted the UK economy would shrink slightly this year and grow less over the next four years than it had forecast in March. Robert Chote, chair of the watchdog, said: "What's striking is the weakness of the recovery over an extended period of time."
I hope that, for regular readers of this blog, that the 'weakness of the recovery' is in fact unsurprising, and that they already realised that the UK economy has only now just started an unavoidable process of shrinkage i.e. any economy which is structured around servicing debt growth cannot shrink the debt growth without negative consequence. Worryingly, the current state of affairs is leading to threats to the UK credit rating:

The chancellor's statement did nothing to dispel fears that the UK could be stripped of its triple A credit rating. Both Moody's and Fitch, two of the three major rating agencies, put negative outlooks on the UK's rating this year.
Whilst the ratings agencies are generally hopeless, they are still important. They make a major difference due to their role in banking regulation and their pronouncements have real impacts. I seem to recall that George Osborne placed the credit rating of the UK as one of the drivers for his policy, so any significant downgrade would certainly add to the pressure now being placed upon the government. This is Bloomberg's view on the mid-year budget statement:

In lieu of real change, he proposed a set of well-intentioned but ultimately insignificant policies, restricted by the need to make the package as a whole fiscally neutral. Osborne did not need to be this cautious.

The chancellor did act to redirect government money in a few ways likely to produce growth. He said he’d reduce the nominal rate of corporation taxes to 21 percent from 24 percent in 2014 (compared with 35 percent in the U.S.). He also increased by a factor of 10 the amount of capital investment that U.K. companies can make exempt from taxes each year, to £250,000 ($402,300) from £25,000.

Osborne scraped together £5 billion to spend on schools, transportation, and flood defenses. He also set up a body to eliminate the regulatory gridlock that’s blocking development of shale gas in the U.K. and promised tax breaks for exploration, ahead of a new policy aimed at increasing Britain’s production and use of natural gas. These are all intelligent ideas that may boost construction and employment in the near term, and growth in the longer term.
I am inclined to agree that there was no real change, but suspect that, if shale gas lives up to its promise, then this will have very significant impacts through the potential to lower energy costs; a factor in living standards but most importantly in the cost of manufacturing. However, this will not really have any major impact for several years, and before it will be a positive contributor to a more competitive economy and better living standards. In the short term, there may be a small impact through increased investment, with the activity that follows from this, but it will not be enough to significantly lift the economy. As such, although a positive, it does little to address the problems in the short term.

Nor will the rest of the measures. The problem that will now face the government will be the political pressure to reverse course. For example, I disagree with Bloomberg's view, which is inevitably echoing around the media, that the government should give a 'modest boost' to the economy by relaxing budget constraints. The one thing that the government should not do is relax on this issue.  
Regular readers will know my answer is to take more aggressive measures on government spending, at a cost of short term pain, in order to avoid a worse situation in the future. However, I accept that the real pressures mounting for the government to loosen will make this nearly impossible at this moment in time.

As a pragmatic compromise, instead, the government should follow what is (in some respects) sometimes good advice, but which is given as advice for the use of additional borrowing (i.e. the projects will increase borrowing). Rather than funding through additional borrowing, those projects which address genuine problems in infrastructure should be given as a priority but as a priority that displaces current levels of spending on consumption based services provided by the government. 
In other words, the government should cut spending to fund investment (and I mean investment in the sense before the distorted use of the word as a synonym for government spending). Where there is genuine need for certain types of infrastructure (and I here accept the current reality that government will fund this), it is a better way to use borrowed money than borrowing for consumption.This will require cuts in services, and the answers I give on how to cut remain the same.The answer is to ask which services are a priority, and then to make choices according to the priorities.

In my mind, this is best achieved by asking the question of whether service x or y is really the role of the government, and cutting anything which is not a core government function. It is a question of 'luxury' over 'necessity'. The economic question is 'what can the UK afford?' but the answers as to what is necessity and luxury are political questions. The other answer is the one that I have discussed previously in my sections on reform. Having established the priorities, how can they be delivered in a way that is cost effective, but also hold to the principles on which they were established? As an example, I have proposed reforming benefits, such that there is still a (generous) safety net for those who are confronted by bad luck / unexpected difficulties, but where the costs of the system are minimised.

As the situation stands, the UK is continuing down a road which does not address the fundamental problems of the UK, with reductions in borrowing growth that will not address the underlying economic problems, and without the kind of substantive reform necessary to lay a real foundation for economic recovery. I believe that I long ago expressed the concern that the UK government would try to resolve the UK's economic problems with incremental cuts and policy measures, and this is exactly the path being followed. The trouble with this approach is not just that overall debt continues to grow whilst the economy shrinks, but also the problem is that the inevitable contraction in the economy leaves the government open to pressure to reverse course mid-term. It is, in summary, self-defeating even when taking a political perspective.

I can never make up my mind what prevents the solutions that are possible to help resolve the problems of the UK economy; is it lack of courage, political consensus or lack of imagination, or the economists whispering 'easy' solutions in the ears of politicians. Perhaps it is all of them. I started the post with Alexander Heath's article, and who proposes cowardice; in light of the self-defeating nature of incrementalism, perhaps he is wrong? Perhaps it is just lack of imagination?

Thursday, November 29, 2012

The Rating Agencies

There is a fascinating piece of news that I have just stumbled upon in Bloomberg, regarding the EU and the ratings agencies:

Credit rating companies face curbs on when they can assess government debt and restrictions on their ownership under draft plans agreed upon by the European Union to limit the industry’s influence and tackle conflicts of interest.

Investors will also get the right to sue ratings companies if they lose money because of malpractice or gross negligence in the plans agreed upon yesterday by lawmakers from the European Parliament and Cyprus, which holds the rotating presidency of the EU.
The interesting point here is that the Basel banking regulations entrenched the ratings agencies within the financial system. Essentially, the ratings agencies became the key to the level of capitalisation of the banking system. The small detail that the ratings agencies were paid by said same banks to undertake the ratings did not cause concern in the bizarre world of banking regulation. No doubt there will be many who will applaud the EU for taking action against the agencies; they really are, in some respects, the guys with the black hats. However, we must also remember that their power in the market was underpinned by a regulatory framework; the Frankenstein that created this monster was the regulators.

The problems with this latest move from the EU is that it does not seem to be founded in a genuine motivation for reform, but rather to de-fang the major ratings agencies, which are coincidentally downgrading sovereign debt. One suspects that the motives here are not entirely about the aim stated in the article, which is about 'financial stability'. The reason I am doubtful about the intentions is that the stated aim is to address conflicts of interest. This is the most simple problem to fix, and does not require this rather odd approach. It is so absurdly simple to fix the conflict of interest that the solution given absolutely must have different motivations; the absurdly simple answer to resolve conflicts of interest would be to ban any rating of any financial product that is paid for by the issuer of the product. It does not matter whether the product is a personal pension, or a complex derivative product.

Also, with regards to sovereign ratings, this is one of the few areas where (relatively) there is little conflict of interest. How curious is it that this is the focus of the attention of the EU? The following passage from Bloomberg tells the story:

On sovereign debt ratings, lawmakers and officials agreed that each credit rating firm must pick three days a year when they would be allowed to give so-called unsolicited assessments of governments’ creditworthiness, according to Jean-Paul Gauzes, a lawmaker involved in the talks. Ratings firms may get a chance to issue unsolicited ratings -- those that haven’t been requested and paid for by a client -- outside those dates if they can justify it to regulators.

“Credit rating agencies will have to be more transparent when rating sovereign states, respect timing rules on sovereign ratings and justify the timing of publication of unsolicited ratings,” Barnier said. “They will have to follow stricter rules which will make them more accountable for mistakes.”
Here we have the distinctly curious situation of the lawmakers seeking to restrict the access to the ratings when the ratings are paid for by entities that need an independent rating; it is the very opposite of the absurdly simple solution to conflict of interest. Just as the rating of a derivative should be paid for by the potential purchaser, the same with bonds. In this case, this is exactly what the ratings agencies are doing. They may be useless at their job, which is not the point of this post, but they are in this case presumably acting in the interest of the purchasers, not the issuer. This is how the system should work, but that is what is being attacked. In summary, this is simply an attempt for the EU to try to bury the crisis that is threatening the EU and the Euro project.

The news should be greeted with outrage, but the visceral ant-ratings agency feeling will probably see applause from many quarters. Whilst I would like to see the agencies de-throned, this is not the solution, and it tells us more about the terror being felt in the upper echelons of the EU than it does anything substantive to fix the agencies.

Tuesday, November 20, 2012

France Downgraded

For regular readers, they will know that I do not have much (any?) respect for the ratings agencies, but will also recognise that their pronouncements have impact. When they pronounce, the world listens, and in the case of the banks, they must listen due to capital adequacy regulations. This is from Reuters:

France lost its prized triple-A badge from the Standard & Poor's in January and so Monday's move by Moody's was not surprising but it underlined doubts about Socialist President Francois Hollande's ability to fix France's public finances.
This is a commentary from the same article:
"I don't expect it (the downgrade) to have an immediate knock-on impact today on access to and cost of funding," said Espirito Santo analyst Andrew Lim of the possible impact on the banking sector. "But it's symptomatic of the wider concerns of a plain-vanilla negative impact on the economy being suffered in the next few months and quarters. Spain, Italy and peripheral Europe are weakening and France's exposure to them is something to be aware of."
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more:
Whilst the Euro sank a little, it is not seen as a harbinger of crisis, or at least not yet. Another article notes some of the upcoming risks:

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.
It is a very good point. When those doing the bailouts look less creditworthy, there are the makings of a future crisis. This from the Wall Street Journal:

The European Financial Stability Facility is widely expected to receive a credit rating downgrade within the week, allowing it to resurrect plans to issue bonds after the rescue fund's second-biggest backer--France--saw its rating trimmed.

A downgrade could marginally curb demand for EFSF debt. It would normally make it harder for borrowers to raise funds. But for the EFSF, it would help resume plans to finish its 2012 funding program after it was forced to shelve a three-year bond sale Tuesday due to the rating discrepancy between the EFSF and France.

The EFSF--Europe's short-term bailout fund that has helped raise cash for Greece, Ireland and Portugal--said Monday that it planned to sell three-year bonds denominated in euros.But the decision later in the day from Moody's Investors Service Inc. to strip France of its triple-A rating complicated the proposed EFSF deal, as it left the rescue fund's rating standing above that of one of its key backers. The EFSF described the decision to shelve the deal as "technical." Under its so-called Deeds of Guarantee rules, it was forced to pull it despite having attracted more than 3 billion euros ($3.8 billion) in investor demand.
A piece in the Australian is highly critical of the (relatively) new French President, Francois Hollande (in some respects, a rather silly piece describing how he is enjoying the perks of power, but also with some more serious material):

Unfortunately, economic indicators suggest otherwise: unless it acts fast, "la belle France", for all its fine talk could become the latest and most significant victim of the eurozone debt crisis.

Economist Nicolas Baverez was one of the first to predict France's downfall a decade ago. He argued last week that the President, whose popularity has plummeted faster than that of any of his predecessors since his election in May, is in denial of the financial tsunami that could batter his palace walls by next year.

"He has missed at least three opportunities to begin a recovery," said Mr Baverez, warning that unless Mr Hollande quickly implemented reforms, the country would face the humiliation of being forced to go cap in hand to the eurozone and the International Monetary Fund for a bailout.

"In 2013 our country will be the world's biggest borrower of euros, bringing recession, soaring unemployment and an inevitable financial crisis," said Mr Baverez. "Germany will make France pay dearly for its backing."

[and later]

As thousands of people marched through the streets of Paris last week as part of a pan-European protest against austerity, student Laurent Botti, 21, handed out leaflets accusing Mr Hollande of being a "clone" of the conservative Mr Sarkozy.

"He has betrayed us," Mr Botti said, complaining that Mr Hollande had presented himself in the election as Europe's anti-austerity champion but had ended up siding with "big business".

Whatever the case, something has to be done, quickly: public spending accounts for more than half of French GDP, the highest share in the eurozone. No government has balanced the budget since 1981, thus public debt has risen from 22 per cent in those days to more than 90 per cent. The economy is stagnant and will hardly grow next year. More than 10 per cent of the workforce - and close to a quarter of the young - are without work.
This story has a particularly interesting aspect. Hollande campaigned on an anti-austerity ticket, and is now confronted with the power of the bond markets to discipline perceived high risk states. I found this an interesting story in light of a very thoughtful piece in Spiegel recently (I have growing respect for this publication, as one of the few outlets that offers real depth of analysis). This particular point came to mind when seeing the French downgrade:

The attempt by countries to bolster the faltering financial system has in fact increased their dependency on the financial markets to such an extent that their policies are now shaped by two sovereigns: the people and creditors. Creditors and investors demand debt reduction and the prospect of growth, while the people, who want work and prosperity, are noticing that their politicians are now paying more attention to creditors. The power of the street is no match for the power of interest. As a result, the financial crisis has turned into a crisis of democracy, one that can become much more existential than any financial crisis.
I have long railed against government debt, and continue to wonder why governments in mature economies need to borrow at all. The Spiegel analysis is quite correct. Democracy, and the belief in democracy is now on the chopping block. We can see this most clearly in the countries that are already going through the most severe crises, such as Greece.

The problem that we, meaning all of the electorates of the Western democracies (to varying degrees) face, is our own immaturity. Whilst some of the democracies are very mature in terms of age, the behaviour of the electorate remains immature. When we see protesters on the streets of Europe, protesting against austerity, we have a picture that is analogous to the teenager having a tantrum and demanding a new iPad. The fact that his parents are already in debt, and cannot afford the iPad is entirely absent from his thoughts.

In the case of Francois Hollande, he promised the goods and the French electorate duly elected him. However, when coming to power and facing the reality of France's economic situation, he is now being forced to backtrack. The result is that his popularity is plummeting (sorry, cannot find the link for this). The problem faced by Francois Hollande is the problem faced in so many countries. The electorate demand a standard of living that is higher than can be funded from the output of the economy. To return to the article in the Australian:

The figures tell only part of the story. A report commissioned by Mr Hollande from Louis Gallois, a respected business leader, blamed the eurozone's heaviest social charges on payrolls, over-regulation and exceptionally high taxes for undermining France's competitiveness.

Genevieve Forestier, who abandoned her dream to set up a fashion label last year to take a job in a lawyer's office instead, could not agree more. "All the social charges and taxes are enough to put off even the most enthusiastic of entrepreneurs," she said. "The worst thing, though, about running your own business in France is that once you've hired someone it is virtually impossible to fire them. I've heard of a case where an employer had to continue paying a worker's salary even though he was in prison."

Not surprisingly, new firms seldom get off the ground and France has fewer small and medium-sized companies than Germany, Italy or Britain. At the same time the government continues living beyond its means. Mr Hollande agrees that the state should spend less, but some of the cuts thus far seem cosmetic.

The prospect of France losing market confidence terrifies European Union officials. It might need a bailout on such a scale that the mechanism to preserve the euro would be overwhelmed.
It is a crude piece of commentary, but nevertheless captures some of the problems being faced by France. As France has lost competitiveness, the debt has been increasing. This is the story that sits underneath the economic crisis. The immaturity of demanding 'x' standard of living in economies that can only really afford 'x-' standard of living. Even as the emerging economies were rising in competition with the mature economies, the demands for ever higher standards of living increased. It was the role of governments, whatever it might take, to deliver these ever higher standards. This from the Spiegel article:

When the debts of companies and private households are added to the public debt, the sum of all debt has grown at twice the rate of economic output since 1985, and it is now three times the size of the gross world product. Economies in the developed world would appear to require credit-financed demand in order to continue growing -- they need consumers, companies and governments to go into debt and to put off paying for their demand until some unspecified point in the future. Of its own accord, this economic system produces the compulsion to drive up the debt of public and private households.

Governments delegate power and creative force to the markets, in the hope of reaping growth and employment, thereby expanding the financial latitude of policymakers. Government budgets that were built on debt continued to create the illusion of power, until the markets exerted their power through interest.

Interest spending is now the third-largest item in Germany's federal budget, and one in three German municipalities is no longer able to amortize its debt on its own. In the United States, the national debt has grown in the last four years from $10 trillion to more than $16 trillion, as more and more municipalities file for bankruptcy. In Greece, Spain and Italy, the bond markets now indirectly affect pensions, positions provided for in budgets and wages.
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more:
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more:
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more:
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more:
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more:

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more:
One of the notable points is about household debt. We can see the mentality that is driving the electorate, which is in turn driving the politicians, by visiting an electrical store. Why pay now when you can pay later? We know that the people who enter the store, with a tight household budget already, deep down know that the purchase of the latest shiny good is going to put their overall budget at risk. However, they still buy. They just want that shiny new good. This is the mentality of the electorate, and it is no surprise that we get politicians who pander to this immaturity. There is a fundamental lack of maturity, and self-justification is given for poor budget choices.

As such, when the politicians, economists, and policy makers seek to justify yet further increases in debt, they are pushing at open doors of an immature electorate. We, the electorate grasp at their justifications willingly, as they are telling us that they can 'magic' into existence the shiny goods that we desire. And, as if by magic, they seem to keep on making them appear. However, it is just another variant of the electrical store offering 'buy now, pay later'. The Spiegel article understands the point. It subtitles the article 'betting with trillions'. The principle is this; increase the borrowing to solve the problem of previous borrowing. It is perhaps the greatest wager ever made. It is a wager that might collapse the global economy. We, the electorate, are collectively urging them to raise the stakes.

Friday, November 2, 2012

GDP And 'Economic Growth'

It seems a long while since I discussed the Economist article in which Hurricane Katrina was given a positive slant due to its potential to add to GDP growth (so long ago the I do not have a link). I was therefore fascinated to see this account:
Paul Ashworth, chief US economist at Capital Economics, said in a note that while the initial impact of the storm on the economy could be quite large" when the clean-up is taken into consideration the "overall impact on GDP growth could even be positive."
He said, assuming all output was lost in the two regions for two days, it could mean a 0.7pc loss for the quarter as a whole.The economy expanded 2pc in the last quarter.
However, he cautioned that this was an extreme assumption: "These back of the envelope calculations undoubtedly overstate the loss of output. Not all output has been lost, particularly not across the whole East Coast region. Some people will be working as normal, others will be working from home."
Regular readers know that I have long railed against the use of GDP, which I see a being close to useless, if not positively dangerous. This analysis just highlights the point. It was therefore extremely encouraging to find an article by Bob McTeer, a former Dallas Fed President, who recognises the danger in the use of GDP:
Generally and loosely speaking, a higher GDP, reflecting both higher spending and higher incomes, is a good thing. However, if the higher GDP is boosted by hurricane clean-up and repair, that’s not so good. The problem is we don’t get a subtraction for the destruction of existing assets; just an addition for replacing them. At least one might think of the clean-up as “shovel ready” projects. Wars are similar in that they generate GDP without bringing with them a higher standard of living.

My favorite example in school of the short-comings of GDP (GNP then) was provided by the question what happens if a man marries his maid. If she keeps doing the household chores as a wife, they are taken out of the market place and GDP shrinks. Getting hair cuts at home or eating at home more and eating out less would have a similar impact on GDP without necessarily reducing standards of living. Just remember that GDP was designed to measure output in the marketplace, not to measure economic well-being.
The article seems to imply that the faults of GDP are well recognised, but this is not apparent when considering the almost fetishistic focus that is made on the GDP measure. One of my biggest bugbears is the government debt to GDP ratio. It is now a commonplace, and frequently replaces the hard number of the actual cumulative total of debt and GDP growth is used as a signal that an economy is capable of servicing debt. In the case of our earlier commentator, we can see quite how dangerous GDP actually is.

In the case of Hurricane Sandy, hurrcane damage will apparently be able to improve the governments capability to service debt. Never mind that the government will be borrowing a bucket load of money to pay for the clean up of the devastation and destruction of assets; this will better allow the government to pay back its debt because, you see, GDP will grow from the fallout of a hurricane. I can see no better illustration of the fallacious thinking of those who worry about GDP slipping when governments cut back on borrow and spend. Borrowing to create activity in an economy, as I have argued previously is seen as a perpetual growth machine which is 'lossless'. In this case, the loss and replacement of perfectly good assets apparently creates economic growth.

No doubt some commentators will claim that government 'investment' is different; it creates long term growth. For example, many such people will propose project 'x' or 'y' as an investment. What they do not discuss is that these projects will come on top of borrowing for consumption. Also, as I discussed in a recent post, in one case I found a proposal to 'invest' in new rail infrastructure for the UK, even though rail is heavily subsidised such that this is not an investment with a positive return, but an investment to increase expenditure into the future (not withstanding that it might have quality of life benefits). 'Yes', there are some genuine investments that might be made, but these should not be made on top of borrowing for consumption. However, the term 'investment', as used by government, is often highly malleable, and is often nothing to do with investment but is rather concerned with expenditure for consumption.

The case of the US is interesting, as I have seen arguments made that the US has under-invested in infrastructure, and then present the idea that investment now is the solution. Again, why was the US government borrowing during the 'good times' and not investing in these apparently neglected projects? Why were they borrowing for consumption rather than for investment? Why is it that these economists were not railing against the government borrowing and consuming in the good times, when they could have been borrowing to invest in these projects? The answer is simple; they do not want to make the hard choices. Every element of government spending can be found to have a justification, but that justification does not include confronting the hard choices of either raising taxes or choosing between priorities within the constraints of the actual tax revenue available.

It is much easier to just borrow the money and leave the problem of paying until later. As I have long argued, at least in developed economies, there is no real reason why governments should be borrowing at all, barring major natural disaster or events like World War II. They have a strong base of income to draw upon, and can pay for both expenditure and investment from that income. Even if taking a Keynesian position, governments are not supposed to be borrowing and spending for consumption during the good times, but are supposed to only do this during the bad times.

I reiterate the point; those who support government borrowing and spending have never wanted to make the hard choices - either persuade the taxpayers that they really need to pay more taxes, or confront the difficult problem of priorities for expenditure. Instead, they propose borrowing and spending, during both the good and bad times. As they do so, they hide behind fig leaves such as GDP, which hides the long term damage that they are inflicting upon the economy; they persuade people that the economy is 'growing', even whilst the debts mount, and the activities which are developed through borrow and spend boost GDP. The real problem is cowardice; they cannot persuade people to pay for the expenditure of the government, so they pass on the problem of paying to the future. They believe that all of those government expenditures are 'good', but do not have the guts to make their case honestly and openly and subject the real cost to the scrutiny of voters. It is a tragedy, and I can only wish that voters would start to punish this cowardice.

Tuesday, October 23, 2012

Krugman and Money Bubbles

In a recent NYT piece, Krugman suggests that 'money is only a “social contrivance”. It’s a convention, which works as long as the future is like the past.' He then goes on to say later:

A final thought: the notion that there must be a “fundamental” source for money’s value, although it’s a right-wing trope, bears a strong family resemblance to the Marxist labor theory of value. In each case what people are missing is that value is an emergent property, not an essence: money, and actually everything, has a market value based on the role it plays in our economy — full stop.
Before reading the rest of the post, you should really read his full discussion, as this post will not make sense without you doing so. For me, the problem is his idea that there is no fundamental source for the value of money. It is wholly fantasy.

Here, for the sake of simplicity, I will treat the following as 'money'; base money (e.g. bits of green paper, and money created by the central bank through open market operations, and debt money (e.g. bonds, bank credit etc.). I know that we could debate the question of differences between these money types, what should be included in money etc. However, my purpose here is specific, and you will (I hope)understand why I characterise money in this way.

For me, the most important thing about money is not about the nature of the money, but about the demands that money might make on the economy. For example, each unit of money is a future demand for x value of product and services in a particular economic unit, typically but not always a country. The interesting thing about money is that it can very broadly be divided into 'now' money, and money in y period of time, or money in y period of time and z now etc. In other words, money units have a temporal dimension. This gives us something of an idea of how money can be seen to be founded in something. This is that the value of money is determined by the demands that might be made on the total value of output in the economic unit.

The important point about this is that, at given moments in time, there is a combination of credit money and base money in any economy. However, at any given moment, there is a total level of output of value in the economy. I use the word value here because what value might be is subjectively derived; for person A, they may value a new television over a Wedgewood tea set, even where the tea set has a higher price. However, regardless of what individuals value, there is a total output, however difficult that might be to measure accurately, but with relative prices making the best proxy that we have for perceptions of value. The point is that, with a given labour force, given technologies, given skill sets, and so forth, there is finite amount of value that can be created in an economy at any given moment.

You will notice here that I am treating an economy as if it is an economic island, which is false. Economies are not islands, and an economy's output is also contingent on the value creation in other economies. For example, if country B makes a product better/more cost effectively (I leave this loose here) than country A, then the country A output of value is questionable unless they do something to match the country B output of value. As such it possible to have potential for output of value that will not be realised, as there is a real world of competition. Therefore, the potential output of value of an economic unit is not its potential, but its potential in relation to other economic units. That potential is continually shifting, dictated by policy, individual and corporate endeavour etc.

The value of money is therefore contingent upon several factors; temporal, quantity, and the potential value of output of the economy which the money represents. For example, the bond market is driven by second guessing the relative influence of these factors, albeit that the second guessing is often crude and misdirected. The key point here is that each monetary unit, given these contingencies, at any given moment in time, represents one x percent of the total value of output in the economy. In other words, money is rooted in the total output of value in the economy, at a given moment in time. There can only be, as an economy is currently structured now, x amount of value of goods/services that can be purchased. I am being simplistic here, as some people simply hold the 'now' money, so that it ceases to be a demand on the economic unit, even though the money exists. In this circumstance, it makes no call on the output of value at that moment. It is another contingency on how money is valued, but by not making a call on the value in the economy now, it allows for a call on value tomorrow. For example, for a bond that has matured, might not be used as money now, but to buy more bonds with a view that this will allow an even greater capture of value in the future.

There are several things that are important when viewing money and value of output in the future. It is quite possible to issue more money now in the expectation that output of value will increase in the future to match the increase in money. Creating a greater supply of money, with the contingency that output of value will match the increase in supply is a risk. If output of value does not increase commensurate to the increase in money, then there is a problem. The value of output per unit of money has diminished. Most damaging of all, is when the demand for the value of output sits outside of the economic unit; if the demand is within the economic, it might represent a transfer, for example the liquidation of a mortgage debt.

However, even then, it is possible that the issuance of too much mortgage 'money' might be inflationary, and problematic. If the mount of money created for mortgages increases faster than the value of the value of the housing stock, this means that there is a specific and narrow price inflation, but also with a wider price inflation in the economy as a whole, as that mortgage money transfers into the economy. It just takes time. The housing bubble was this process in action. The rate of mortgage money creation increased faster than the value of housing stock, and also prompted bubble activity, such as building McMansions as a process of trying to soak up some of this new money creation. This brings me back to the problem of external credit, which is far worse, as it never represents an internal transfer.

The external funding of new money in the economy, such as mortgage debt, is a future external demand on the output of value in the economy. In all cases, it quite literally means that in the future, a demand will be made on the value of output in the economy such that some of that value output will no longer be available within the economic unit. The greater the value of the money created through external debt, the greater the demand on future output of value. This kind of demand can accumulate to the point where the external demands on the total output of value are so large, that an economy has no reasonable chance of servicing the value without having so many goods and services flow out of the economic unit that the actors in the unit will be reduced to penury. This is Greece now.

The curious part of the Greece story is that it is divorced from base money, and the problems are entirely created by creditors realising that the output of the Greek economy is not able to provide the value that they expected, or rather that Greece is unwilling to deliver that value as the loss of that value of output from within the economic unit of Greece is too hard to bear. The external debt of Greece is simply a massive demand on the value of the total output of value of the economic unit called Greece.

The idea that monetary units have no foundation, except in a social construction is simply not true. It is founded in the output of value in the economy for which a particular currency pertains. It may be complex, due to the contingencies that I describe. This is why all debt markets are so complex. However, there is one thing that is certain. If the aggregrate money supply increases faster than the value of output, the value of each unit of money will be diminished. We must also remember that the value of each economic unit is contingent upon the ability of each unit in each area of business, and that the aggregate of the ability will inherently effect the value of money, as this will impact upon the ability to realise potential output of value in an economy. Finally, externally created money is the highest risk, as it will absolutely make a demand on output of value in the future, and that value, if repaid will mean less output of value in the economic unit. Even if the economy does grow in an economic unit, a portion of that growth will no longer be available in the economic unit. The economic unit will have less output of value at the time that the demand is made for the output of value.

The final point is this; expanding money supply without an ability for increases in the output of value destroys the value of money. Borrow and spend is exactly this, and external borrowing is horrendously risky.

Note: This started as a short and quick and 'dirty' post, but did not turn out that way. I hope it all hangs together, and I have avoided some complexity that might have been added due to time constraints, and to keep the ideas as simple as possible. The nature of internally generated debt money is a case in point. Comments, as ever, welcomed. Feel free to be critical and pick holes. I published despite this despite being loose ideas with critiques in mind; I would like to refine these ideas, and critiques (constructive ones) and suggestions will help. In short, I have thrown the ideas 'into the ring' to see how they stand up to critical eyes. Regular readers will know that I have considered money before (sorry, no time to find the link, but it would help in supporting this post), and this is just some further thoughts/evolution/adaptation of the earlier longer and more detailed consideration.