CynicusEconomicus

The Economic Shift in the World Economy

2012-01-26T13:27:00.000-08:00

I have started this post without a title, as I'm still trying to sort out which might be the best subject for a post. The slow motion car crash of the Euro is always tempting. Then there is the current state of China, which increasingly appears to be in trouble. Then there is the US 'recovery' or the latest discussions at Davos.

For the last point, an interesting perspective was aired at the forum in Davos, and it may be that it can tie together some of the many stories that are being discussed. This from Jeremy Warner of the Telegraph:

The contrast between Western gloom and Eastern optimism is again striking this year, and it is something that goes beyond the immediate challenges of the eurozone crisis.

According to forecasts aired by Indonesia's minister for creative industries, the total size of the world's middle class will more than double to 4.9bn by 2030, with 85pc of the growth occurring in the developing world. By then, some 65pc of this middle class will be in Asia.

Long term predictions of this sort are always going to be suspect, but few would disagree with the thrust of what the Indonesian minister is saying.

The article mirrors something that I wrote in 2009, in which I discussed the emergence of the Asian middle class, in contrast to the Western middle class whose spending power was in decline. I used the Tata Nano (perhaps a poor choice with hindsight) and SUVs as an example to illustrate the point. Whilst SUV sales were falling the Nano was the coming thing. The shift represented the move from wealth being concentrated in Western middle classes (the SUV), to a dispersion of the wealth to the East (the Nano), and with the Western middle classes moving down to meet the rising Eastern middle classes in the middle.

Another of the stories that I had kept in mind for a future post ties into the story of the decline of the middle classes in the West. It comes from the New York Times, and is an explanation of why the Apple iPhone is not made in the US (there is also a visual presentation of the argument here). It is a long article, but there are some points that are clearly made. The first is that it pops the fantasy that gripped the Western world; that the East would do all the clever work and that the East would simply be the cheap labour. Again, it has been a theme of this blog that this was just not going to happen. I have argued that all of the key services would, in the end, follow manufacturing.

The most interesting thing about the Apple story is that Apple still does have the design knowledge and experience, and this is still undertaken in the US. The problem is that there are so few jobs that this creates. Instead, the article argues persuasively that it no longer about the availability of cheap labour, but the flexibility of Chinese companies, and also the proximity to all key suppliers that makes manufacturing in China a compelling case. In addition, China has an army of engineers and technically trained staff, skilled manufacturing employees and so forth. The result is that Apple has a compelling case for manufacture in China. It is the underlying reason for why the middle classes of the US are being hollowed out. Those skilled jobs are going to China, for example the solidly middle class engineering jobs, and the skills of the US workforce must inevitably decline over time in relation to countries such as China.

It then just becomes a matter of time before the most highly paid jobs, such as those in design and marketing, likewise commence the move Eastwards, as the Chinese workers 'upskill', as Asian markets grow in relation to Western markets, and as the key skills to 'make stuff' become ever more concentrated in the emerging markets.The worrying element of this is that China has created a virtuous spiral. The more manufacturing it undertakes, the more compelling the case for manufacturing in China.

All of this appears, then, as a done deal. But is it?

To date, all of the massive growth in China has taken place in the context of 'state capitalism', in which China has carefully guided the rise in its economy with a combination of massive investment in state companies, and measures to ensure a competitive currency, and a policy of obtaining technology from the West through demands for technology transfers and outright technology theft. It is a story that is told in a recent Economist special report. But it is not just China that is following a state capitalism model, but as the report details, state capitalism is increasingly being endorsed around the world.

After all, who can argue that China's model has been a success to date? The real question is one of how long it might continue?

I am certainly having my doubts that it is a model that can be sustained. I recently used an analogy to explain to friend why I thought the Chinese model might now be in some trouble. When China first 'opened for business', the country was in a parlous state following the years of chaos characterised by Maoism. The first advantage was that China could almost do no worse. The second advantage that flowed from this is that, in terms of state capitalism, China could safely invest in infrastructure and almost guarantee a return. My analogy was that it was like throwing a dart at a dartboard from one foot away from the board, with the bulls eye dominating most of the board. As time has moved forwards, the person throwing the darts is moving steadily further away from the board, and the bulls eye is shrinking back to its normal size. It now takes skill to hit the bulls eye, and there are more misses than hits. Just one example of this in action is the case of cities being built but remaining unoccupied.

The second problem with the Chinese model is that it requires the acquiescence of trading partners. The special report points out the increasing queasiness of key trading partners when faced with effectively subsidised state giants entering into international markets. The Economist article is perhaps an exemplar of a growing backlash against the state capitalist model. For example, it points to the spreading influence of the model, and the more the model spreads, the more problematic it becomes. The more companies that face competition from these state supported enterprises, the more there will be complaints to policy makers of unfair competition. There are two approaches to such complaints. One is restriction of trade, and the other is to respond in kind. In either case, the model will start to break down. The former is (I hope) self-explanatory, but response in kind will just lead to a fight that neither side will win.

I am reminded of a long while ago. I remember commenting on another Economist article (sorry, I cannot find it now) that argued that the cheap products being manufactured in China should be seen as a wonderful benefit for the West. The article argued how this kept down inflation, and provided a better standard of living to the West. They mentioned the problem of currency keeping prices as low, but thought that the benefits derived from this were positive (this is my best recollection of a long, long while ago). I do remember that I argued at the time that this subsidy of Chinese goods might appear to provide benefits, but at the cost of hollowing out their competitors in the West. I see the state capitalist model is going to raise the same issues, but this time with China's trading partners increasingly jaded about China, and with a growing sense of frustration as the impacts of the emerging market growth becomes ever more plain to see.

I am not sure that the acquiescence can continue for much longer.

Another side of the story is that of Chimerica. The funding of Western states in order to continue trade imbalances is coming to an end. It has not ended, but the limits of the model are becoming apparent. Also, the costs of the model are becoming apparent. This leaves a tough period of transition. For example, the problems of the Euro area will eventually land on the doorstep of China and the other emerging markets. This is going to take place at a time which, in the case of China, will be when the problems of the state capitalist model are starting to make themselves felt. China's property bubble is bursting, and there are signs that the Chinese economy is rapidly slowing. This from Ambrose Evans-Pritchard, who discusses proxies for the state of the Chinese economy before saying:

So how did China pull off an economic growth rate of 8.9pc in the fourth quarter?

Beats me.

I strongly suspect that the trade and power data reveal the true state of China’s economy.
There clearly was a pick up in early January but I stick to my view that China has inflated its credit bubble beyond the limits of safety – an increase of 100pc of GDP in five years, or twice US credit growth from 2002-2007 – and that Beijing cannot continue to gain much traction with this sort of artificial stimulus.

Indeed, the extra boost to GDP from each extra yuan of credit has collapsed, according to Fitch Ratings.

There are several points that can be taken from the discussion that I have presented. The first is that, as was predictable, a major shift has taken place in the world economy, and the price of the shift has been the diminishing of the Western middle classes, and the rise of the middle classes in the emerging economies. This is being noticed, and it is finally being understood. The success of the model has relied on the acquiescence of the Western world, but the continuing acquiescence is doubtful. Set against this, the stage of development of China in particular, has seen a virtuous spiral develop. However, that virtuous spiral might be upset by the consequences of the gross mis-allocation of resources that are becoming apparent. Whether the over investment in real estate by banks and provincial and city governments, or ever more questionable infrastructure investment and investment in more and more industrial capacity, this has potential to be a drain on the Chinese economy.

It is a complex situation. It is difficult to predict how it might unwind. However, the one certainty is that some kind of change is on the horizon. The pain being felt by the middle classes of the Western world will be addressed by politicians, and there is no sure way to know how they will finally respond. Of one thing, I am increasingly certain. The acquiescence of the West to a system that is destroying the wealth of the West is coming to an end.

Note: I have used the expression emerging economies but they have, in most senses already emerged. Please excuse my use of this convenience. Also, as ever, my focus is perhaps too much on China, which is simply because it is one of the countries I watch most closely.

Debt and Economic Structure

2012-01-17T13:40:00.000-08:00

In my post today, I am going to talk about the principles of structural debt reliance in an economy. It is (I hope) going to illustrate, in principle only, why so-called austerity causes a downwards spiral in an economy, and why denying the need for reductions in government borrowing are a fallacy. It is deliberately simplistic, but I hope that it will nevertheless make the point.

In order to illustrate the point, I will use a notional company that makes office 'widgets'. I choose this type of company as its products have broad applications (as all organisations use office supplies to some extent). We will imagine that our notional company makes 1000 widgets per week, and is a private company. At the starting point of the example, the government is borrowing money, but not excessively. Our widget company is supplying many organisations with their products, and they are a company in reasonable shape. Amongst their many customers are various government organisations, and these organisations purchase on average 200 widgets per week.

The widget company actually likes to supply these government organisations, as they have one particular advantage, and that is that they are government organisations. From this flow many benefits to our widget supplier. They pay on time, and most importantly, they seem to pose no credit risk. This in turn has benefits in, for example, raising finance, as the credit provided to the government is seen as rock solid. Overall, the widget company likes to supply to the government, and even hires a sales specialist who has knowledge of government procurement to help build this area of the business. Our widget maker starts to notice the growth of their business with government organisations, with government spending increasing over time. The money being spent by the government is increasingly funded through borrowing, not through taxation.

Our widget maker sees government sales creeping progressively upwards, moving steadily from 200 widgets a week, up to 300. At the same time, there are steady increases in sales from the other purchasers of widgets. With the ongoing growth in the business, our widget maker makes some new hires, and invests in new plant. The demand for their widgets is growing steadily, and they are struggling to meet the new demand for 1200 widgets per week, and will soon be turning down orders unless they invest. On current growth rates, they feel confident to invest in capacity for 1500 widgets per week. In order to grow their business, they visit their bank, and have a persuasive story of steady growth, reliable customers, and a growing stream of revenue with which to repay the loan for the new capacity. The loan is granted, and our widget company invests in expansion. All the while government borrowing is steadily increasing and the overall size of debt growing.

All is going well for our widget company, and then there appear to be tremors in financial markets. For many years, government debt has been growing, and concerns are starting to be raised about the degree of borrowing by the government. Words such as crisis start being used, and yields on government debt are rising. Raising new debt is becoming more difficult and expensive. There is talk of government cutting borrowing, and cutting services. Our widget maker is concerned, but not that concerned until the cuts to government expenditure start to be implemented. The number of widgets sold to government departments stops growing, and then starts to decline. The government sales specialist explains that the cuts by the government are limiting the spending of departments on new widgets, and that some of the government organisations are disappearing entirely.

Sales to government organisations start to fall back to the original 200 per week. It is a blow, but it is not that big a blow that our widget manufacturer cannot survive. After all, it was not just the orders from the government that were growing, but also the sales to businesses. They may have over-invested in new capacity, and repaying the financing of that capacity will be more difficult but not impossible. Time moves forwards, and the cuts of the government are starting to bite. Our widget maker once again becomes concerned. Whilst the government widget purchases have stabilised at the original 200 per week, the company notes declines in orders from some private customers. Also, some of his private customers are becoming tardy in paying their bills, and this is hitting cash-flow. The company is finding that sales overall are falling back towards the 1000 widgets per week, and they need at least 1100 sales per week to cover their cost of finance.

They are in trouble, and their cash flow is starting to be a problem for meeting their bills. They are themselves making late payments. They do not understand what is going on. After all, they had a diversified customer base, and were not reliant only on the growth in government orders to finance their expansion. However, they were unaware that many of their customers, just like themselves, were also supplying the government and like themselves grew (in part) through growth in government orders. And then there were the companies that supplied the companies that were supplying the government. And then there were the companies that supplied the companies that supplied the companies that supplied the government. In each case, they all see a deterioration in their revenue as government cuts bite, and each sees a negative impact upon their business.

The companies that are direct suppliers to the government are hit hardest. They are the ones now being tardy with paying their invoices. This tardiness impacts down the supply chain, with some companies not being paid for their products and services as companies start to fail. Our widget maker is now in trouble and is one of those companies. Their own suppliers are complaining about late payments, and are starting to restrict any new credit to the widget supplier. As credit from suppliers starts to disappear, and with now negative cash flow, our widget supplier is going bust. When the inevitable happens, the workers are laid off, and the bank takes a hit to its balance sheet. The liquidators sell off what remains of the plant and anything that might have value for creditors. The laid off workers look for new work, but with so many companies laying off workers, new work is difficult to find.

The laid off workers are unemployed, and they therefore tighten their belts. There is no money available for many things they had enjoyed before. For example, they would regularly go out to restaurants, but this is now completely unaffordable. It is notable that, whilst many restaurants are still in business, many restaurants are also going bust. It is not just restaurants, but other businesses that are closing the doors, such as shops, and hair dressers. And the shopfitters, and the wholesalers are also being hit. Yes, some businesses are still doing well, but the numbers of bankruptcies over a multitude of sectors are steadily rising. Even where businesses survive, they are often downsizing. Unemployment is climbing fast.

At this point I will stop. It is clear that this is a self-reinforcing downwards spiral. The managers of our widget business were, in all regards, perfectly competent business people and managed their company in a sensible and responsible way. The market gave them positive signals, and they responded. As business people, they did everything right.

Our widget maker was directly exposed to government cuts, but was also indirectly exposed. As the borrowed money flows through an economy, the structure of the economy shifts to the consumption of that money. In some cases, as in the case of our widget maker, the shift in structure is readily apparent. In other cases, the shift in the structure of the economy is less apparent. For example, the small sandwich shop near the widget maker's factory that is doing good business as a result of the increase in the labour force in the widget maker. For example, extra staff may have been taken on to service the increase in business from the widget factory.

When we imagine the many interlinked ways that an economy restructures to service the debt founded consumption, it does not come as a surprise when we see countries such as Greece slide into a downwards spiral as government cuts borrowing and expenditure. It is the only possible outcome. There are those that propose the opposite course of action, which is to increase borrowing and expenditure, but the logic of this is that the economy will simply structure more deeply into servicing the debt based consumption. It will, undoubtedly, delay the problems, but only at the cost of more pain when the ability to accumulate yet more debt finally comes to an end.

Even if only holding debt accumulation at the current rate, the problem remains that the debt is accumulating, but the structure of the economy will remain the same; it means that the problem of a debt based structure is left unchallenged. One day, the economy must restructure away from the debt accumulation as infinite debt accumulation is not possible. There will always come a point at which the debt burden becomes too much, or where markets finally perceive that it is unsustainable.

When an economy structures around debt accumulation there is no painless fix. It is simply unreal to imagine that a restructuring away from debt accumulation might be undertaken without the period of the downwards self-reinforcing spiral. It absolutely must happen. The only question is to ask how much of the economy is rooted in debt consumption, how fast and deep the cuts will be. There are, of course, some things a government might do during this painful period, such as retraining, and other ideas to try to ameliorate the pain. However, there is no avoiding that the painful restructuring is the only way that the economy can move back onto a sustainable path.

The EU Downgrades

2012-01-15T12:50:00.000-08:00

This will be quite a short post. It has been impossible to miss the news from last Friday about the downgrades of several EU countries by Standard and Poor's (S&P):

Ratings agency Standard & Poor's downgraded the government debt of France, Austria, Italy and Spain on Friday. But it kept Germany's at the coveted AAA level.

The downgrades deal a blow to the eurozone's ability to fight off a worsening debt crisis. All told, S&P cut its ratings on nine eurozone countries.

The rating agency ended France and Austria's triple-A status. It also lowered Italy's and Spain's by two notches and did the same for Portugal and Cyprus. S&P also cut ratings on Malta, Slovakia and Slovenia.

"In our view, the policy initiatives taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone," S&P said in a statement.
France's downgrade to AA+ lowers it to the level of U.S. long-term debt, which S&P downgraded last summer.

S&P had warned 15 European nations in December that they were at risk for a downgrade.

The way that the press have reacted is as if this is some kind of shock, even though the potential for a downgrade has been been trailed, as is mentioned in the quote above. S&P's statement about why they made the downgrade can be found here. It has also had an impact on the rather dubious Euro bailout fund, with this from the WSJ:

Standard & Poor's Ratings Services on Friday said it had stripped triple-A ratings from France and Austria and downgraded seven others, including Spain, Italy and Portugal. It retained the triple-A rating on Europe's No. 1 economy, Germany.

The downgrade to France, the bloc's second-largest economy, will make it harder—and potentially more expensive—for the euro zone's bailout fund to help troubled states, because the fund's own triple-A rating depends on those of its constituents. The downgrades also speak to how deeply the concerns over countries on the euro zone's periphery have penetrated its core. Worst-case fears weren't borne out: France avoided the two-notch downgrade S&P had warned of last month.

So, is this really news? In some senses 'yes', and in some senses 'no'. The most interesting thing about the ratings agencies is that they are supposed to look into the future and make assessment of asset risk, but they nearly always seem to play 'catch up' with the reality on the ground. Even the most casual browse of the financial news would have told anyone that the problems of the Euro were spreading from the so-called periphery into the so-called core. The S&P downgrade is, as always seems to be the case, just playing catch-up.

However, it is news in the sense that it has real impacts. The first impact is on the bailout mechanism, as mentioned in the WSJ article. However, another impact is upon European banks. I expected to find a raft of headlines to this effect, but a search of Google News did not turn up what I expected (perhaps my keywords were not right, and I missed the articles). In particular, those banks that hold the sovereign debt of the downgraded countries will see further erosion of their already (in many cases) strained balance sheets. The only example I found discussing this point was curiously in reference to Japanese banks:

France’s loss of its AAA rating probably won’t have any immediate effect in Japan as domestic banks’ holdings of French bonds aren’t large, Azumi said in Tokyo yesterday, according to Kyodo News.

It is now an open secret that the ECB has been bailing out European banks in the hope that they will in turn use the money to purchase European sovereign debt. This from Wolfgang Münchau in the FT:

And no, the European Central Bank’s huge liquidity boost is not going to fix the problem either. I do not want to underestimate the importance of that decision. The ECB prevented a credit crunch and deserves credit for that. The return of unlimited long-term money might even have a marginal impact on banks’ willingness to take part in government debt auctions. If we are lucky it might get us through the intense debt rollover period this spring. But a liquidity shower cannot address the underlying problem of a lack of macroeconomic adjustment.

Regular readers will know that I do not agree that the bailout was a 'good thing', but I quote this as it as it makes the point about the indirect purpose of the bailouts. I have mentioned before that there are large chunks of debt coming due in the next couple of months, and funding these chunks of debt may be a severe problem. I used this chart from the Economist before, as it paints the picture well:

When bank balance sheets are already under strain, the question is what they might do with all of the money that the ECB is pouring into their balance sheets. The new Basel accords are demanding higher levels of capital, and the ratings of assets will impact upon their compliance. The question is this; with their balance sheets already strained, when the periphery debt looks ever more dangerous, and the core debt is now being recognised as high risk, why on earth would any bank actually purchase high risk European sovereign debt?

The problem is this, that in the topsy-turvy world of banking regulation the ratings agencies really matter. They are, of course, completely hopeless in their assessment of risk, but they nevertheless have major impacts. However, it does occur to me that there is the possibility that the bailout of the banks by the ECB might come with strings attached, in backroom deals, that as a quid pro quo, the banks agree to continue to purchase dubious Euro sovereign debt. I can only speculate on this but, if such an agreement has taken place, it is a great way to increase the contagion. It really is kicking the can down the road.

Furthermore, as many (including myself) argued, the establishment of the Euro bailout fund would spread the problems into the Euro core, as countries such as France were already in a position of having too high levels of debt. A long time ago, I discussed the problem of who would be left to do the bailing out when every country was racking up too much debt. The context of the discussion was the US, if I remember correctly, but the same applies here. It has long been the case that any bailout is being funded by countries borrowing more money to enact the bailout. They are not using a net credit position to bailout, they are just borrowing more on the basis of having a better credit position than the bailee. However, when they are in a position of having too much debt themselves, they start to tip their own creditworthiness into the danger zone. Again, using your own fragile creditworthiness to support the less creditworthy is another case of kicking the can down the road.

The problem with such can-kicking is that it ratchets up the final consequences of the crisis. I have argued against the idea of contagion before, as the problem was not one that might be compared with a contagious disease, but more like a cancer that is destroying from within each country. However, the actions of trying to avert a major crisis are genuinely creating contagion. It was in the early points of the crisis that I suggested that contagion was the wrong metaphor for the problem, but it now seems appropriate. I am genuinely puzzled at what is going on. It just seems that policy-makers must actually see that they are in a hole, but they continue to keep digging it deeper.

It is not as if I am alone in questioning the endless successions of bailouts. Again, it does not take long to find voices expressing concern. What on earth do those who are enacting the policies think the end of the game might look like? Do they really believe that, for example, that one year from now that the Euro crisis will have ended, that sovereign debt problems will have disappeared, and that Europe will be on the road to economic recovery? They must, surely, have some kind of belief that this will be the case, and this must be why they continue to try to 'solve' the crisis? However, if they were to stop digging their hole for just a moment, the absurdity of this idea becomes apparent.

The crisis is getting ever larger, not diminishing. The fact that the ratings agencies are downgrading is just a belated indication of the reality of the situation, and just highlights exactly how bad things have become. When such clueless organisations have finally accepted the depth of the crisis, then it must be very, very bad indeed.

Note: A longer post than intended...

Update:

Just after I completed the post, I found this in the Telegraph:

Use of the European Central Bank's three-year funding programme is expected to exceed €500bn in February when lenders are offered their second chance to access its new long-term refinancing operation (LTRO), according to Credit Suisse.

Last month, banks borrowed a total of €489bn using the LTRO, which has effectively seen the ECB take on the role of providing a large part of the funding required by several eurozone banks.

Analysts at Credit Suisse point out the ECB's willingness to provide an increasing proportion of the short and longer-term funding required by eurozone banks has led to a widening gap in the size of its balance sheet versus those of the Bank of England and the US Federal Reserve.
The ECB's balance sheet has risen in size to close to 30pc of eurozone GDP from just over 20pc before it launched the LTRO. By comparison, the Bank and Fed's balance sheets are both worth just under 20pc of domestic GDP.

And later:

The ECB's decision to increase its exposure to banks has effectively seen it provide the "bazooka" markets had been urging it to use to help stem the debt crisis.

Spanish banks that borrowed money using the LTRO are thought to have used most of it to buy Spanish government debt, leading to a lowering in yields.

Interesting, is it not? It still does not discuss the problem of the downgrades for the bank balance sheets, but it is there in the subtext. I still suspect my Google News search was looking for the wrong key words, so if anyone has seen an article on the effect of the downgrades on bank balance sheets, a link would be welcome.

Productivity in the US?

2012-01-13T12:59:00.000-08:00

Sometimes, by pure coincidence, I come across two articles on related subjects but which seem to be entirely contradictory. In this case, two articles discuss productivity in the US, and (in some respects) are at odds with one another.

The first article appears in the Atlantic, and says the following:

In the past decade, the flow of goods emerging from U.S. factories has risen by about a third. Factory employment has fallen by roughly the same fraction. The story of Standard Motor Products, a 92-year-old, family-run manufacturer based in Queens, sheds light on both phenomena. It’s a story of hustle, ingenuity, competitive success, and promise for America’s economy. It also illuminates why the jobs crisis will be so difficult to solve.

And later:

Yet the success of American manufacturers has come at a cost. Factories have replaced millions of workers with machines. Even if you know the rough outline of this story, looking at the Bureau of Labor Statistics data is still shocking. A historical chart of U.S. manufacturing employment shows steady growth from the end of the Depression until the early 1980s, when the number of jobs drops a little. Then things stay largely flat until about 1999. After that, the numbers simply collapse. In the 10 years ending in 2009, factories shed workers so fast that they erased almost all the gains of the previous 70 years; roughly one out of every three manufacturing jobs—about 6 million in total—disappeared. About as many people work in manufacturing now as did at the end of the Depression, even though the American population is more than twice as large today.

It is actually a very interesting article in general (the main subject is employment in manufacturing), and worth a read. In support of the statistics in productivity, it also gives some examples of how new technology is reducing the demand for labour. On the other hand, we have an article from the Washington Monthly (not a publication I have come across before), which has the following to say:

[...] both of these corporate strategies— domestic productivity improvements and global supply chain management—show up as productivity gains in U.S. economic records. When federal statisticians calculate the nation’s economic output, what they are actually measuring is domestic “value added”—the dollar value of all sales minus the dollar value of all imports. “Productivity” is then calculated by dividing the quantity of value added by the number of American workers. American workers, however, often have little to do with the gains in productivity attributed to them. For instance, if Company A saves $250,000 simply by switching from a Japanese sprocket supplier to a much cheaper Chinese sprocket supplier, that change shows up as an increase in American productivity—just as if the company had saved $250,000 by making its warehouse operation in Chicago more efficient.

The article suggests that the statistics on productivity try to account for this kind of problem, but also that there are many blind spots, such as the following:

Consider refrigerators, for example, like the ones made in the Whirlpool plant mentioned earlier. Refrigerator imports from lower-cost countries such as Mexico, Korea, and China now total almost $4 billion annually, up 19 percent since 2007. Clearly these growing imports are displacing domestic production and employment— but how much? Today the official statistics treat imported refrigerators as if they cost the same as U.S.-made refrigerators, so that $4 billion of imports is assumed to displace $4 billion of domestic production. But a more accurate measure would take into account the lower cost of Chinese- or Mexican-made appliances, so that $4 billion of imports might really displace $5 billion, $6 billion, or even $8 billion of domestic production. Unfortunately, the BLS does not track the relative price of imported and domestic fridges—or almost any other product, for that matter. Scale this problem up by a factor of a million, and you begin to see how pervasive import price bias really is.

The interesting contrast in the articles is that it is quite likely that both articles are, in some degree, correct. There has undoubtedly been significant improvements in US productivity, as exemplified in the examples given in the Atlantic article, but the argument in the Washington Monthly that the statistics flatter the situation appears to be convincing. The Washington Monthly goes on to draw some conclusions and suggestions in light of the flattering figures, and you may or may not agree with these. However, the is one point that is made that I think is particularly important, which is that the the inaccurate figures on productivity shape the debate on economics in the US:

Indeed, our misleadingly high productivity figures help enable a whole political culture of confusion and complacency. Only after we accept that the official figures have led us astray can we hold a true political debate about what type of economy we want to have.

The point is well made, and highlights the potential dangers in statistics. It is a problem that anyone interested in economics continually confronts, which is to try to understand what we are looking at when we see the statistics that are so frequently cited by the media, policy-maker and economists. Regular readers will know that one of my concerns is the concept of GDP, which is particularly problematic. However, the problem seems to be widespread. One particularly interesting website that addresses the problems is Shadow Government Statistics (SGS), which gives alternatives to official US statistics. For example, for unemployment in the US, they have this to say about their methodology for unemployment rates:

The seasonally-adjusted SGS Alternate Unemployment Rate reflects current unemployment reporting methodology adjusted for SGS-estimated long-term discouraged workers, who were defined out of official existence in 1994. That estimate is added to the BLS estimate of U-6 unemployment, which includes short-term discouraged workers.
The U-3 unemployment rate is the monthly headline number. The U-6 unemployment rate is the Bureau of Labor Statistics’ (BLS) broadest unemployment measure, including short-term discouraged and other marginally-attached workers as well as those forced to work part-time because they cannot find full-time employment.

The methodology produces this chart of current US unemployment rates:

The contrast with official statistics that are reported so widely is quite dramatic. More differences can be found in SGS for many of the statistics that are so widely reported in the media.

The problem is that, even though we might be aware of potential problems with statistic x and statistic y (for example as I am aware of the problems with GDP) we are often unaware of the problem with other statistics that we take at face value. Up to the point that I read the Washington Monthly article, I would have accepted the statistics on productivity in the US without any particular concern. The problem that this raises is to what statistics should be readily accepted and which should be questioned. In pragmatic terms, it is not possible to investigate the source and methodology for every statistic that we read (and perhaps later quote).

That all statistics should be approached with caution is not a new insight. Although it is wrongly attributed to Disraeli, the famous quote of 'lies, damned lies and statistics' is rightly widely cited. The only way around the problem, it seems, is to continuously scan the environment for critiques of the statistics that are used. However, like all of those interested in economics, I will nevertheless use statistics that might be problematic, and do so in the belief that they are both meaningful and accurate, only to find at a later date that they are not as meaningful as they first appeared.

The real worry that arises from this is that the critiques statistics do not generally get a wide airing, and that dubious statistics remain as the accepted version of reality. If the understanding of the productivity statistics in the US are as problematic as suggested (and my view is that it is a convincing case), the statistics will indeed encourage complacency in policy formulation, and in the media, and in the electorate. More importantly if thinking of the average politician, will they be looking for alternative views on statistics, or will they simply accept what is seen as 'official'? I would suggest that only the most contrary politician might question the official statistics, and such a politician is likely to be sidelined, or seen as an outsider (or out of the mainstream).

I have been trying to think of politicians who do indeed argue against the official economic statistics, and cite the critiques of the official statistics, and have come up with a blank (at least for the UK, examples welcomed if you can think of any - there may be obvious examples I have not thought of). I suspect that it is only a very brave politician who might go against the 'official', for fear of being regarded as a 'crank'. This will, in turn influence economic policy ideas, as a policy typically requires some kind of statistical basis. If unable to cite alternatives to the 'official' statistics, or those that are widely accepted, then any policy proposed will be dead in the water from the outset. Official statistics might be compared to a super-tanker that takes miles to turn around through sheer momentum. Even where a valid critique of the statistics appears, they official statistics appear to be unstoppable through sheer momentum.

The point is this. Assuming that the Washington Monthly critique of productivity statistics is correct, will the critique make any difference whatsoever? I have cited the critique, and I am sure some others will do so. However, the limited discussions of the article will be unlikely to halt the super-tanker of the official statistics, and might at best nudge them into a slight change of course (however, perhaps the Washington Monthly is more influential than I give it credit for?). Everyone will continue to cite the official statistics, and everyone will continue to act on the basis of the 'reality' that the statistics present, and policy will therefore be founded in fundamental errors. My worry is this; that it takes a crisis to turn these super-tankers around. Only then will the critiques that have been presented actually gain traction.

As ever, comments welcomed.

Note: Apologies for the delay in the publication of some of the comments in the last post. This was due to my own administrative error.

Atlas Shrugged

2012-01-07T15:21:00.000-08:00

This is a somewhat unusual post, as it is really a review of a book, and the relevance of the book to the situation today. The book is Atlas Shrugged, by Ayn Rand. I am now three quarters of the way through the book, but could not quite resist reviewing the book so far, as there are elements that are relevant to the world of today. I understand that the book is also being made into a two part film (it is a very long book), and will be interested to see how they interpret the work.

As mentioned, the first point about the book is it is very, very long. In places, unnecessarily so. Ayn Rand was an immigrant to the US, and there are times that this shows through in the language. There are certainly moments when I became irritated with the writing style (the overuse of the word 'astonished' was one example). However, and bearing in mind that I have a tendency towards being a little verbose, I should stress that this is not a huge problem.

As to the content, there is both good and bad. There is an element of caricature in the characters, and moments that are a little too much towards Mills and Boon. Notwithstanding this, the book has a lot to say that is relevant today, and perhaps that is why the book is being made into a film. The plot is quite straightforward, and I will use Wikipedia for a summary (sorry it is long):

As the novel opens, protagonist Dagny Taggart, the Operating Vice President of Taggart Transcontinental, a giant railroad company originally pioneered by her grandfather, attempts to keep the company alive during difficult economic times marked by collectivism and statism. While Dagny runs the company from behind the scenes, her brother, James Taggart, the railroad's President, is peripherally aware of the company's troubles but will not make any difficult choices, preferring to avoid responsibility for any actions while watching his company go under. He seems to make irrational decisions such as preferring to buy steel from Orren Boyle's Associated Steel, rather than Hank Rearden's Rearden Steel, despite the former continually delaying delivery of vital rail. In this as in other decisions Dagny simply goes ahead with her own policy and challenges him to repeal it. As this unfolds, Dagny is disappointed to discover that Francisco d'Anconia, a true genius and her only childhood friend, first love, and king of the copper industry, appears to have become a worthless playboy who is destroying his family's international copper company, which has made him into one of the richest and most powerful men in the world.

Hank Rearden, a self-made steel magnate of great integrity, has recently developed a metal alloy called Rearden Metal, now the strongest and most reliable metal in the world. Hank chooses to keep the instructions to its creation a secret, sparking jealousy and uproar among competitors. False claims are made about the danger of the alloy and are backed by government agencies. As a result of this, pressure is put on Dagny to use conventional steel but she refuses. Hank's career is hindered by his feelings of obligation toward his manipulative wife, mother, and ungrateful younger brother, who show no appreciation for everything he provides for them. Dagny also becomes acquainted with Wesley Mouch, a Washington lobbyist initially working for Hank Rearden, whom he betrays. Mouch eventually leads the government's efforts in controlling all commerce and enterprise, intentionally destroying the common man's opportunity to build a largely successful, free market business. The reader also becomes acquainted with Ellis Wyatt, the sole founder and supervisor of the successful enterprise Wyatt Oil. He is a young, self possessed, hard-working man–one of the few men still loyal to Dagny and Hank's efforts in pushing for a system of business free of government meddling and control.

While economic conditions worsen and government agencies continue to enforce their control on successful businesses, the naïve, yet weary mass of citizens are often heard reciting the new, popular street phrase, "Who is John Galt?" This sarcastic phrase is given in response to what tend to be sincere questions about heavy subjects, wherein the individual can find no answer. It sarcastically means, "Don't ask important questions, because we don't have answers", or more broadly, "What's the point?" or "Why bother?"
Dagny begins to notice the nation's brightest innovators and business leaders abruptly disappearing, one by one, under mysterious circumstances, all leaving their top industrial businesses to certain failure. The most recent of these leaders to have vanished is Dagny's friend Ellis Wyatt, who, like the others, has suddenly disappeared into thin air with no warning, leaving nothing behind except an empty office and his most successful oil well now spewing petroleum and fire high into the air (later to be named "Wyatt's Torch"). Each of these men proves to be absent despite a thorough search put on by ever-anxious politicians, who've now found themselves trapped within a government that has been "left to dry", by its leaders in business — utterly helpless without them.

In a romantic subplot, Dagny and Hank fall deeply in love. Rand refers to their love as a purer kind of love than the one that most men and women experience. These two people have a similar purpose in life, and they see in each other a kindred soul. In the universe of the novel, men and women with purpose are rare and, to an extent, deified — thus making their love especially sacred. Hank and Dagny go on a vacation drive across the USA. They discover, amongst the ruins of an abandoned factory, an incomplete motor that transforms atmospheric static electricity into kinetic electricity. Deeply moved by the significance of a motor which has the potential to completely transform the world, Dagny sets out to find the inventor.
In the final section of the novel, Taggart discovers the truth about John Galt, who is leading an organized "strike" against those who use the force of law and moral guilt to confiscate the accomplishments of society's productive members. With the collapse of the nation and its rapacious government all but certain, Galt emerges to reconstruct a society that will celebrate individual achievement and enlightened self-interest, delivering a long speech (seventy pages in the first edition) serving to explain the novel's theme and Rand's philosophy of Objectivism, in the book's longest single chapter.^[21]

Whilst reading the book, it is impossible not to miss the comparisons with the world of today. In the book, the corruption of the world of industry is one in which favoured Washington insiders gain favours and run their businesses into the ground, all with the support of the government. When thinking of the too big to fail banks, the comparisons are clear. Similarly, the rescue of GM and other failing firms, as well as the Solyndra scandal, are all similar in principle. However, the other point of comparison is more general, which is the obsession with corporate social responsibility, and the pressures being placed upon companies to conform to vague concepts of doing social good. As Rand argues persuasively throughout the book, provided that a company is succeeding on its own merits (i.e. without state support), the employment and output of goods/services that the company provides is sufficient social good of itself.

It was this aspect of the book that was very striking for me. Although I have not done so in this blog, I have on occasion railed against the concept of corporate social responsibility. One particular bugbear is when public companies provide support for charities. This gives a glow for the management of the company, when they give large sums of money, and the CEO will undoubtedly receive acclaim for his generosity to the charity. However, the problem is that it is not the CEO who is being generous, but the shareholders of the company, who see their money being given away without their consent, and who receive none of the acclaim. I would guess, if actually asked, many shareholders might approve of the donations. However, if the questions were asked as to whether they would personally give their own money to charity x, in preference to charity y, then they would probably disagree with donation.

The other point is the incessant bullying of companies by various NGOs, often with the media acting as cheerleaders for the NGOs. Instead of facing down the NGOs, businesses do not have the guts to say 'no' to their incessant demands. I think of one particular example of this bullying, which was the use of palm oil by Cadbury, due to the linkage between palm oil and deforestation. This caused a storm, but in what way is Cadbury responsible for deforestation? The responsibility for this lies in the political structure of the country in which the deforestation is taking place. If the NGOs believe that it is wrong to deforest, their target should be the politicians in the country in question. It is not the responsibility of a company, it is the responsibility of the politicians. The role of a company is to act in the interests of shareholders, not some wider societal good that is determined by a particular interest group. Furthermore, who do these interest groups actually represent? It is not as if they are representative of society, they are not in this sense democratic, but are instead a self-selecting group that represent only themselves.

In this sense, Atlas Shrugged eerily parallels the world of today. People seem to have forgotten that the purpose of business is to produce stuff, and to make profits for the shareholders, and this should be the limit of the business. This is enough good to do in the world. This is not to say that a business might not generate external costs, such as pollution, but these 'externalities' are the matter of reasonable legislation of government, which should ensure that they are met with fair law and regulation that genuinely reflects the costs imposed upon society. A company is a part of society - how can it not be - but its role is not to do abstract social good, but to produce goods and services, whilst employing people along the way. One disturbing manifestation of this can be found in much of the business literature, and that is the use of the term 'stakeholder'. This is the idea that companies are not just accountable to their shareholders, but to anyone who might have an interest in the company, such as suppliers, NGOs, government, employees and so forth. Apparently, as is implied in the term, they have a 'stake' in the company.

But do they? They have not put their money into the company. They do not own it. In many cases, with public companies, the actual owners of the company are pension funds, and the investment funds of ordinary people. These owners of the company should be the only interest of the management. For example, they have no obvious obligations to their suppliers, except to pay them for the goods or services that they supply. They certainly have no obligations to NGOs. For the government, they only have an obligation that they pay their taxes, and operate within the bounds of fair laws that constrain the company from imposing external costs (such as pollution) upon society in the broad. The claim that these different groups hold a 'stake' in the company is to suggest that they have rights that are comparable with the owners of the company. This is the undermining of the principle of property rights. As Ayn Rand puts it, it is 'looting'.

Another point made in Atlas Shrugged is the role of the academic world in the corruption of the role of business. The idea of stakeholders can be found in academic literature, as well as reams of material on corporate social responsibility, and other equivalent ideas. Academia appears as a cheerleader for these concepts, and provides an intellectual gloss for activity which seeks to undermine the rights of the owners of property, the shareholders, in favour of self-aggrandising management, and the nebulous notion of stakeholders. They dress this up in the clothes of ethics, but how is it ethical for a CEO to take all of the social praise, from the media and luminaries, for spending money that should rightfully (for example) be returned to a shareholder as part of their pension. Again, as Ayn Rand puts it, it is looting. And it is looting that the vast majority of society cheers about.

Even the shareholders of a company might cheer this corruption on, with no realisation of how much money they are losing as they do so. This is another element of Atlas Shrugged. With the media, the government, and academia all singing from the same hymn-sheet, the real costs of the distortions to business, the immoral nature of the looting, is lost from sight. In the book, the costs lead to a horrific decline in the standards of living of everyone, as the concept of the social good comes to dominate business, but the link between the decline in living standards is not linked to the distortion of the priorities of business. Instead, the problems of business give greater excuse for yet more intervention in business for the 'social good', creating a downwards spiral. Today, the role of social good as an impediment to the proper operation of business is there, but is in no way as extreme as in Atlas Shrugged. However, it is impossible not to notice that the pattern and direction in the Western world is leading towards the dystopia that is the subject of Atlas Shrugged.

In short, there is much to recommend Atlas Shrugged. The purpose of a company is that it is there to generate the wealth that allows us to have a better standard of living. That is enough. It is the point that shines most brightly in Atlas Shrugged.

Update, 9 January:

As you will see below, there have been some interesting comments on the post below. After writing the post, I read out the post to a friend who, whilst agreeing with the points made, noted that it would upset some readers. I now have the first comment which expresses discontent with the views. I will address the points made the author, point by point and address my reply to the author.

I always found your economic analyis insighful, but have to say, am beginning to find your politics repugnant to the extent that it's difficult to post on this without breaking your language rules.

Thank you for the kind comments, and the language rule is unbroken. As for politics, we will see.

"I think of one particular example of this bullying, which was the use of palm oil by Cadbury, due to the linkage between palm oil and deforestation. This caused a storm, but in what way is Cadbury responsible for deforestation? The responsibility for this lies in the political structure of the country in which the deforestation is taking place. If the NGOs believe that it is wrong to deforest, their target should be the politicians in the country in question. It is not the responsibility of a company, it is the responsibility of the politicians."
This is so utterly, utterly ignorant of the realities on the ground in places where the deforestation is occuring I amazed that someone who has travelled at all could come out with such ****. Perhaps China is the only place you've been, but it ought to be obvious that the political and social structures in many places are simply not up to protecting local populations from the predations of Cadbury's or other large corporations that operate in countries with weak governance.

Here you suggest that there is weak governance in the countries in question. I agree with this wholeheartedly. However, it is not the responsibility of corporations to address the many problems in the world, but to act within the laws and bounds of the countries in which they operate. There are far worse problems in the world than those you allude to, such as starvation, war, and so forth. Just as it is not the purpose of corporations to address these problems, it is not their role to address problems of poor governance. The world is a very imperfect place, and corporations could use their profits (or reduce their profits) to address many of the problems. However, the argument given here is that this is not their role in the world, and that individuals (or possibly other institutions) have this role.

Your example of Cadbury 'predating' is an interesting one. As I understand it, Cadbury's only role was buying palm oil, and was not involved in any way in any direct actions in creating palm oil plantations. In doing so, they simply contributed a small amount to global demand for palm oil. As it is, any number of arguments might be applied to problems in the supply of any number of commodities or products around the world. Most companies buy a multitude of different commodities and products, and with each purchase, there may be some problems that might raise issues somewhere in the supply chain. Even something as mundane as purchasing a desk for an office might find that any number of the components or the manufacture of the product might, at some stage, offend the ethics of group a, b or c. How is a company to navigate in a world filled with so many breaches of so many groups ethical principles?

Also, are all of those ethical principles sound? I have long noted those that decry the sweatshop labour in Chinese factories, and who argue that Western nations should not do business with countries that do not have proper labour standards. My argument to such people is that they need to stand in the road of a Chinese peasant village, and try to turn back the people who leave the villages for the better life in the city. I do not think they would receive a positive response from those who are fleeing to something they view as better. I am being a little simplistic here, but as you are a long-standing reader of the blog, you will be aware of the full argument. My point here is that, there are some issues that are framed in ethics but where there are different arguments as to what is even ethical. Again, how can a corporation navigate such contests? For example, I have previously made a case that so-called fair trade is unfair trade, and would encourage companies to shun such products so that real fair trade takes place.

And it is not just me that sees these problems. I did a quick search on child labour, and found this in the Guardian:

According to the UN, a fifth of India's GDP is produced by 55 million children. And, as anyone who has lived or travelled in developing countries will readily attest, the situation is similar across the globe. There are more than 200 million child labourers worldwide, excluding domestic labour, Unicef estimates.
The trouble with Gap's promise not to use child labour is that it immediately raises the question: what would these poor Indian children be doing if they weren't making clothes? Well, in New Delhi, they are likely to wind up hawking on the streets, begging or perhaps worse.
According to available statistics, the vast majority of working children do backbreaking farm work and more than half are engaged in hazardous or dangerous activities, such as working in mines. In addition, an estimated 1.2 million children are trafficked, forced into debt bondage or other forms of slavery (5.7 million), or into prostitution and pornography (1.8 million).
In societies lacking a social safety net, orphans, children from very large families or with sick parents have to find a way to make a living to support themselves and/or their families. In fact, hard as it may be for us to stomach in the affluent west, millions of children would view making clothes, under the right conditions, as a relatively attractive prospect.

The article goes on to suggest that a company opens its own factory, to ensure better conditions for the children. They should develop an ethical child labour policy? Again, how might corporations navigate these minefields? You go on to say:

If money from international corporation X goes on buying cocoa or whatever from country y, with a small portion going to pay bribes to ensure that environmental laws aren't implemented, or aren't ever created in the first place, this the resultant enviromental problems and human suffering is absoultely the responsibility of the corporation. Do you really think that just because this money is paid in another country, or perhaps through one or two middlemen, the responsibility of the corporation or cadbury's somehow evaporates?
In influencing politicians in whatever coutry, how is an NGO going to match the spending power of large corporations?
Thank god not everybody thinks like you.

Here, you seem to be implying that Cadbury's is involved in bribery. I have seen and heard of no such evidence, and this seems more than a little unfair on Cadburys'. If bribery plays a role in the production of palm oil, would it not be better to focus attention and effort on those involved in the bribery; to highlight the actual malfeasance rather than to pick on a company that plays no active role in such malfeasance?

As far as I understand the situation, bribery is illegal everywhere, but the problem is one of enforcement of the law. Hong Kong was an exemplar of what can happen when the laws are enforced, with the island seeing a rapid decline in rampant corruption once laws were enforced. If wishing to address these kinds of problems you discuss, rather than picking upon corporations with no direct involvement, the efforts should be directed to the government in question. However, if a company is involved in bribery, then the pressure groups need to find evidence of this, and they can campaign for the appropriate prosecution within the country that the crime took place. I would approve of such action. You go on to say:

On the subject of these externalities, I think you greatly underestimate the external costs that are created by many industries. I would say that the amount spent on this "corporate social responsibility" is so low that it doesn't in many cases even cover a tiny fraction of the external costs borne by society at large, and is in fact more aimed at the feel good factor that you talk about - both so the CEO can feel good, and also so that customers can feel less guilty.

It is interesting that you focus here on the costs of industry, with no mention of the benefits. This is exactly the point that is made in Atlas Shrugged. Every industry has some cost on the wider world, even if indirectly. However, what we also have to accept is that they also have benefits, and that these benefits (in most cases) outweigh the costs. We must balance these costs and benefits. The benefits of industry are entirely lacking from your comment - but we need industry! On the whole, industry makes our lives better....

You talk about consumers feeling less guilty. However, why should consumers feel guilty in the first place? If they are exchanging their productive labour for the productive labour of another, then they might be seen to be acting in a moral way. This is a problem highlighted in Atlas Shrugged. To produce, exchange and consume is not a bad thing. In fact producing is a force for good, and this is the good that companies actually do in the world. It is a point I made in my original post. The guilt you describe is the start of the problem.

I agree that, sometimes, corporate social responsibility is sometimes as much about a 'feel good' factor as anything substantive. It returns me to my point in the post about pattern and direction. We are not in the world of Atlas Shrugged but moving in that direction. It links to your point about 'guilt'; we are being persuaded that companies should take on obligations over and above the good that they actually do. The costs may not be large as yet (in some cases, and in some cases they will be large), but they are and will continue to grow if we load on to them the baggage that you imply in your comment. This is the whole point of Atlas Shrugged; we forget at our peril the merits and the good of the profit motive, and substitute is with vague ethical concerns for the social good. As I have said, the output of industry improves our lives, and that is enough of a good in itself .

I have tried to illustrate the problems with your comment, and I would welcome a response.

Note: Many thanks for the links and other comments, which all add to the arguments made here. Greatly appreciated. Also, it was nice to see you commenting again, Lemming (previous post).

Update On Krugman Post

2012-01-05T15:26:00.000-08:00

I recently posted a couple of times on Paul Krugman's output of dubious Keynesian thinking. In the first of the two posts, I quoted Krugman as follows (my emphasis):

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.

My commentary on this was as follows:

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.

And then I quote Krugman as follows (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.

My commentary on this was as follows:

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.

Happily, an interesting study in the UK confirms exactly the points that I made. Although the study is for the UK, it is not difficult to see the points of comparison with the US:

Britain's borrowing costs are at a record low not because the UK is a "safe haven" but due to the Bank of England's money-printing programme, new rules requiring lenders to hold more gilts and the eurozone crisis, according to an analysis of the official data. [summary from the sub-head]

As you can see, the report mirrors my view of the reason for the low yields in the US, although I did not mention banking rules in my post. The interesting point here is that Krugman goes on and on about the fact that others do not use evidence, and that he grounds his work in the evidence. However, what he does not discuss is that he uses the evidence which confirms his own views. This is known as confirmation bias, and something to which we all sometimes submit. However, it is Krugman's continual attempts to delineate himself from other by claiming evidence that is so notable.

So, yes, US treasury yields are low. No, this is not because investors want the US to grow its debt.

Krugman, yet again...

2012-01-02T13:02:00.000-08:00

Yes, another post on Krugman. Apologies.

This time he is claiming that nobody understands debt. Apparently, he does.

The first actual point he makes is this:

People who get their economic analysis from the likes of the Heritage Foundation have been waiting ever since President Obama took office for budget deficits to send interest rates soaring. Any day now!

And while they’ve been waiting, those rates have dropped to historical lows. You might think that this would make politicians question their choice of experts — that is, you might think that if you didn’t know anything about our postmodern, fact-free politics.

I think I covered this point in my last post. He goes on to discuss the analogy with family debt, and says:

First, families have to pay back their debt. Governments don’t — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.

And a family just needs to grow it's income faster than the growth of debt. Just as with a family, if income is not growing fast enough, then the debt becomes a crippling burden. He then goes on to compare the debt levels after the World War II, and correctly claims that the US had substantial rises in income, despite the huge debt levels accrued during the World War II. This is true, but what has it to do with today. In World War II the debts accrued because the productive capacity of the US was turned over to destructive capacity. At the end of the war, the economy returned to productive capacity. Where is this huge switch going to come from today? There is no possibility of such a switch around today, because the circumstances are completely different.

Even more worrying is that this is the current account of the US, taken from Econbrowser:

This is a historical view of the US current account (from here), that includes the 1950s, and gives the current account as a percent of national income.

So, Professor Krugman. The current situation and post World War II are comparable in exactly which way? When you are running large current account surpluses, it is not so difficult to get out of debt. However, the US is going in the opposite direction. Again, think of the family and whether they are growing their income. No, the current account deficits are being funded by debt.This brings me neatly onto the next part of Krugman's analysis:

It’s true that foreigners now hold large claims on the United States, including a fair amount of government debt. But every dollar’s worth of foreign claims on America is matched by 89 cents’ worth of U.S. claims on foreigners. And because foreigners tend to put their U.S. investments into safe, low-yield assets, America actually earns more from its assets abroad than it pays to foreign investors. If your image is of a nation that’s already deep in hock to the Chinese, you’ve been misinformed. Nor are we heading rapidly in that direction.

The charts seen above show that this is irrelevant. The US economy is borrowing and consuming more than it produces overall. This is what a current account deficit represents. He does at least concede that debt is not entirely harmless:

Now, the fact that federal debt isn’t at all like a mortgage on America’s future doesn’t mean that the debt is harmless. Taxes must be levied to pay the interest, and you don’t have to be a right-wing ideologue to concede that taxes impose some cost on the economy, if nothing else by causing a diversion of resources away from productive activities into tax avoidance and evasion. But these costs are a lot less dramatic than the analogy with an overindebted family might suggest.

So the danger with higher taxes is that it causes avoidance and evasion? That's it? If that is the case, then higher taxes must be assumed to have no negative impact upon the economy, provided that the system prevents avoidance and evasion. Why not then, raise taxes to 80% of all income, and some of the new tax revenue to absolutely prevent evasion and avoidance. With sufficient resource thrown at the problem, then it would be impossible to evade or avoid the tax. Is this what he is saying; that the only problem with high taxation is avoidance and evasion? Really? What does Krugman mean by 'if nothing else'? This is simply fatuous.

Krugman then goes on to suggest that history shows that countries can live with high levels of debt, but does nothing to compare levels of debt with the ability to service debt. And this is exactly the point, and what modern Greece illustrates. Compared with some historical examples, Greece's debt looks relatively benign. However, it was not benign because Greece was, like the family going too far into debt, unable to service the debts it was accumulating. The growth in debt was exceeding growth in income, with ongoing and growing current account deficits rooted in debt:

Yes, Professor Krugman, it is always possible to give examples from history of high levels of debt. But are they applicable to the current situation of the US, or of other economies whose overall circumstances are different from the examples given.

Why do I pay so much attention to Krugman? It is because he is influential, and because he is an exemplar of how black can be turned into white. He has a great ability to mix up examples and illustrations which do not have applicability to the current situation. For example, in the post-WWII scenario, there was no direct equivalent of the hyper-competition that comes from the BRIC economies. The US position as the world's leading and largest economy saw no similar challenge. However, apparently, the situation post-WW II is comparable to now. It is a view that will give false comfort, and lead to complacency. Such muddle headed thinking needs to be challenged.

Note: Regular readers will know that I do not believe that governments of developed economies have any reason to borrow in the first place, but I will leave that to one side for this post.

Krugman at it Again

2011-12-30T16:03:00.000-08:00

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

2011-12-26T13:27:00.000-08:00

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 borrowingthat one central bank official has said will slow growth in theworld’s second-largest economy if not controlled. With pricesdropping in China’s real estate market, economists warn thatlocal authorities won’t be able to repay their debt because ofpoor cash flow and falling revenue from land sales they rely onfor much of their income.

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

The 231 borrowers whose public filings were reviewed byBloomberg raised a combined 354.1 billion yuan by sellingsecurities this year. They have credit lines from banks of atleast 2.3 trillion yuan that have yet to be drawn down, thedocuments 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'scurrency undervalued had cost American jobs and that a fairerexchange rate would help cut an annual trade gap Washington putsat more than $250 billion.

"By using the excuse of a so-called 'currency imbalance',this will escalate the exchange rate issue, adopting aprotectionist measure that gravely violates WTO rules andseriously upsets Sino-U.S. trade and economic relations,"foreign ministry spokesman Ma Zhaoxu said in a statement postedon 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 totransform from a "made in China" to a "designed in China"market, with the government pushing for innovation in sectorssuch 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?

Regulation and the EU crisis

2011-12-16T13:51:00.000-08:00

The current spat between the UK and France over whose economy is in worse shape is like two people, one with both arms broken and the other with both legs broken, arguing about who is in better condition to play a game of tennis. All they are achieving is to focus attention on the fact that both of them are not in a fit condition. In doing so, to mix metaphors, they are both placing each other further into the firing line. As it is, the firing line is already broadening:

Bank of America Corp., Goldman Sachs Group Inc. and Citigroup Inc. had their credit grades cut by Fitch Ratings as the impact of financial regulation and market turmoil weighed on the industry.
The lenders’ long-term issuer default ratings were cut one level to A from A+, Fitch said yesterday in a statement. Barclays Plc, based in London, Credit Suisse Group AG, Deutsche Bank AG and BNP Paribas SA also had their grades lowered.

[and] Credit ratings of the world’s biggest lenders have come under pressure amid weak economic growth and doubts about whether European regulators have done enough to end the sovereign-debt crisis. Lenders in the region must raise about 114.7 billion euros ($149 billion) in capital to help address the turmoil, the European Banking Authority said last week.
Fitch downgraded Barclays and Zurich-based Credit Suisse to A from AA-, while lowering France’s BNP Paribas and Deutsche Bank to A+ from AA-. Fitch corrected an earlier version of its statement to announce that Frankfurt-based Deutsche Bank was cut one level instead of two. Morgan Stanley’s long-term issuer default rating was affirmed at A.

And, of course, sitting underneath all of this is sovereign debt exposure. In 2008, I wrote a post which clearly lays the blame for this debacle in the right place; the banking regulators. I used a Bank of England paper on the impacts of the Basel accord framework (from the Bank for International Settlements, BIS) to highlight the problems the regulators were causing; in particular the idea that risk could be identified and codified by a group of experts. This is what I had to say about the first Basel Accord:

So here we have a determination of risk which assumes that, for example, OECD based banks are safe. We now see that this is not the case, and many of the banks in the OECD would, without government support, now be bankrupt. We also see that lending into government securities is also 'safe' but, as I have argued elsewhere in this blog, countries such as the UK are extremely unsafe at present.

So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.

Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.

For Basel II, I had the following to say (the quote is from the BoE paper):

Another interesting feature of Basel II is that the accord put the credit rating agencies centre stage in the assessment of risk:
Under the standardised approach banks will slot assets into weighting bands according to ratings from ligible rating agencies (ie recognised by national
supervisors in accordance with specified criteria).
The BoE paper acknowledges that the rating agencies may be no better than the banks at assessing risk, but fails to acknowledge that there is a central conflict of interest - that the ratings agencies are paid for conducting the rating by the banks themselves. The importance of the poor preformance of these ratings in the current financial crisis can not be overstated. However, they were critical to the entire Basel II system:
Exposures to borrowers without a credit rating will be placed in an unrated band that will carry a 100% weight (ie 8% capital charge), but regulators are requested to review the default experience of the particular market (and individual bank) to decide whether this is sufficient. Undrawn facilities to corporates of less than one year, which currentlycarry a zero weight, will be weighted at 20%.
At the heart of all of this regulation is an unfounded belief that, somehow, there are a bunch of people with sufficient wisdom to determine risk, and therefore create a system in which risk of failure is abolished. Such a point view can only do one thing - create complacency. It creates a situation where, provided you meet the rules, you must be sound.

So here we are, years later, with banks having gorged on mountains of 'safe' sovereign debt (as a note, in some financial jurisdictions, they continued to ask banks to report based upon Basel I), and the ratings agencies playing 'catchup' with reality in their issuance of downgrades. Just to add to this wonderful array of regulation, the Basel III accords, a response to the crisis, are now about to be implemented and will require banks to hold larger capital buffers (see here for a summary from BIS). Although market pressures were already leading to banks increasing their buffers, the impact will be for banks to conserve capital to meet the new requirements with implementation of the rules in 2013. In light of the problems of 2008, this might seems like a good idea, but is closing the stable door after the horse has bolted. Or if I can stretch the metaphor, slamming the stable door shut whilst the horse is half way out of the door.

What really worries me however is the tweaking of the principles of Basel II into the overall structure of the Basel II accords (see full document here, note 1). For example, the new accord places greater emphasis on stress testing, but remember this:

When the European Banking Authority (EBA) published the results of ‘stress tests’ on 90 banks across 21 countries in the EU in July 2011, Franco-Belgian bank Dexia was given a clean bill of health. Barely three months later, however, Dexia needed a €4bn bailout package. The bank had been unable to raise the cash it needed on the financial markets, largely due to concerns about its ability to withstand losses on its €3.4bn exposure to Greece.

Also, for the external rating of assets, they seek to mitigate what they call 'cliff effects' (which I have understood to be 'falling off'), but the ratings agencies are still front and centre alongside the bank's internal risk assessment. The internal risk assessments are seen as an additional check:

Finally, the proposal will seek to reduce to the extent possible reliance by credit institutions on external credit ratings by: a) requiring that all banks' investment decisions are based not only on ratings but also on their own internal credit opinion, and b) that banks with a material number of exposures in a given portfolio develop internal ratings for that portfolio instead of relying on external ratings for the calculation of their capital requirements.

Just to add to the interest and conflicts of interest, for example Moody Analytics boasts that their systems are used by the major banks in supporting Basel I, II and III:

We also provide an integrated economic capital solution for Pillar II ICAAP requirements, as well as an internal rating framework with proprietary and customizable models and scorecards. Additionally, we also provide solutions that allow you to allocate and price risk more effectively and to integrate risk management into the business at the point of origination, increasing operational efficiency and optimizing risk and return, which will be critical in a world with higher capital requirements. Our products are complemented with comprehensive analysis and stress testing tools and expert advisory, implementation and customization services to assist you in all phases of your project.

This will be the same organisation that has, in recent times, been an exemplar of effectiveness in spotting high risk assets, as well as objectivity. For those of you unfamiliar with Moody's I pulled this story up from the WSJ to illustrate the point:

Yuri Yoshizawa, managing director of global structured credit, intends to leave the Moody's Corp. unit at the end of June, a person familiar with the situation said Friday. This person said Ms. Yoshizawa made the decision to step down. She couldn't be reached for comment.

The operation overseen by Ms. Yoshizawa was criticized as an example of what went wrong when rating firms analyzed CDOs and other mortgage-related deals before the worst of the financial crisis. Lawmakers and other critics say ratings firms like Moody's awarded their highest ratings to questionable mortgage bonds in order to win business from issuers of the bonds.

Collateralized debt obligations were among the hardest-hit investments during the crisis, causing tens of billions of dollars in losses for investors, many of whom were attracted to their high ratings.

At a Senate hearing last April, Ms. Yoshizawa was prodded about the back-and-forth between analysts and bond issuers as the analysts worked on ratings for new bonds. "There was always pressure from banks," she said, noting that the relationship could get contentious and "very abusive."

Emails between Ms. Yoshizawa and Moody's colleagues emerged during the investigation by the Financial Crisis Inquiry Commission, a panel formed to explore the causes of the crisis.

An October 2007 email showed that the firm's market share in CDOs had fallen to 94% from more than 98%. In her reply, Ms. Yoshizawa asked colleagues to "take a look at the deals we didn't rate … to double check the information and to let me know any of the 'stories.' "

Some critics cite the email as an example of pressure on Moody's analysts to win business. Ms. Yoshizawa told lawmakers last year that she couldn't recall ever removing an analyst from a transaction as it was being rated because of arm-twisting by banks, though she said future deals might be assigned to a different analyst.

So here we have the situation. Banking regulations determined that OECD sovereign debt was safe, banks gorged on the debt, and the debt was not safe. As Basel was adapted, it placed ever greater influence in the hands of ratings agencies who have a track record of being hopeless at assessing risk, have chronic conflicts of interest, and who only manage to downgrade assets at the point at which they are about to collapse (if not after they have collapsed). On top of this, the internal risk assessment looms large. It is hardly inspiring of confidence.

Most worrying is that, those who are determining policy think that this is all a good idea. Now that really does present a worrying picture.......

Note 1: I have not read the whole document (not an easy read, but interesting in places), but summaries can be found elsewhere.

Are we close to the end?

2011-12-09T15:25:00.001-08:00

I once read a comment about this blog which said that the analysis was good, but a shame about the market timing. I always keep this in mind now. As such, I ask you to approach this post with a great deal of caution. However, with cautionary note out of the way, I have to ask whether we are nearing the point at which the Euro crisis spirals out of control. There are flashing warning signs, but there also (temporary) fixes (again) being floated in the news. One serious indicator was an article in Spiegel, which describes the outflow of money from Greece:

With disarming honesty, the central banker explained to the lawmakers why the Greek economy isn't managing to recover from a recession that has gone on for three years now: "Our banking system lacks the scope to finance growth." He means that the outflow of funds from Greek bank accounts has been accelerating rapidly. At the start of 2010, savings and time deposits held by private households in Greece totalled €237.7 billion -- by the end of 2011, they had fallen by €49 billion. Since then, the decline has been gaining momentum. Savings fell by a further €5.4 billion in September and by an estimated €8.5 billion in October -- the biggest monthly outflow of funds since the start of the debt crisis in late 2009.

I also noted some similar, but less dramatic stories for the other 'at risk' countries, with money being moved into Scandinavia and (strange things happen) the UK, and out of Europe altogether. Today, in a story that has been effectively trailed by central bank interventions, another story appears suggesting that European banks are on the edge of crisis. At the moment, the wild card in the story is China. I discussed the possibility of China entering the picture when they had a stronger hand a while ago, saying:

The Chinese were seen as a hope, but they do not appear to be playing ball. However, I emphasise 'appear', as the Chinese will likely dive in if they can use the opportunity to strengthen their economic position versus the EU:

China had offered help in return for European support to grant it either more influence at the International Monetary Fund, market economy status in the World Trade Organisation, or the lifting of a European arms embargo [...]

Aside from these obvious benefits, there would be other repercussions. China's help would mean large scale purchases of Euros, which would see the Euro harden against the RMB, thus making European exports less competitive and Chinese exports more competitive. The shift in the currencies would see stronger competition from China, and those European manufacturers that are struggling already might well be pushed underwater where China offers direct competition. In other words, it is a short term fix, with long term painful consequences.

There is (again) talk of Chinese intervention coming to the rescue, but it is still not confirmed. Bearing in mind my previous comment on China using the crisis as a bargaining opportunity, this interesting story comes from the Telegraph, which I will quote at length:

Hopes were further bolstered by improvements in the borrowing costs of Italian and Spanish government debt, which have soared in recent weeks on concerns about escalating risks. Yields on 10-year Italian bonds, which were recently above the critical 7pc level, fell 0.12 percentage points to 6.33pc while those on Spanish debt edged down 0.07 points to 5.71pc.
The rally came late in the day, as traders digested the news and after it emerged that China would consider stepping up its role in the crisis. According to Reuters, China's central bank has taken steps to create a new vehicle to manage two investment funds worth a total of $300bn – one to target investments in the US and the other focused on Europe.
"I guess they're hoping that China's going to be the white knight that rides to Europe's rescue," Joe Rundle, head of trading at ETX Capital, said. "I think in time China will probably step in and have an effect on Europe, but it's going to be very much on China's terms rather than European terms."

Chinese involvement has long been sought by the international community, as it has trillions of dollars at its disposal. For its part, China has long craved the freedom to invest in Europe and the US – but, to date, has met political resistance. However, the politics have changed now that stricken eurozone members hope to raise hundreds of billions of euros to cut their debts by privatising state-owned assets.

And the source of the story, this Reuters article (my emphasis):

The euro gradually strengthened on the summit news and waslater boosted when a source, who asked not to be named, toldReuters China's central bank plans to create a new vehicle tomanage investment funds worth a total of $300 billion, part ofwhich will be focused on investments in Europe.
The euro rose to a session high of $1.3422 after the China news emerged from around $1.3380 beforehand to trade with gains of around 0.5 percent for the day.

It is curious that there is so much excitement in markets based on anonymous tip. However, provided that Europe will play ball, it is quite possible that China will finally intervene. Let's be frank - the European politicians are increasingly desperate, and will probably accede to nearly any vaguely acceptable demand by China (by which I mean demands which the public will not see as outrageous, rather than demands which might actually be outrageous). My best guess is that, right at this moment, China is dangling a bailout in front of Europe and playing some extremely serious hardball. As a note, the rumour of the Chinese bailout fund was probably an agreed leak by the Chinese government to wave the sight of potential 'salvation' in the face of Europe (using unofficial sources to float policy is not unusual in China, and leaves the Chinese government a line of retreat if they change their minds/or as need be).

The only other option open to the politicians is the ECB starting the printing presses. I would expect that, to turn the situation around, would probably require the greatest money creation exercise in history. However, alongside the latest package of measures, there is some talk (again talk) of the ECB turning the presses:

To further reassure bond markets so that investors continue to buy eurozone government debt, the condition that the private sector would automatically bear losses if the ESM was triggered has been dropped. At the same time, the European Central Bank (ECB) has committed to making up to €20bn of bond purchases a week and China has reportedly begun plans to create a $300bn (£190bn) investment vehicle to buy privatised assets.
Thomas Harjes, an economist at Barclays Capital, welcomed the announcements as positive news. "This may not amount to a single 'bazooka', but it does add up to a substantial package of measures," he said.
However, Louise Cooper at BGC Partners questioned whether it would be enough to settle bond markets. "These are positive developments but are not enough. We were promised the 'Big Bazooka' but got far less," she said. "Wasn't this supposed to be the week that saved the euro? Well, it didn't."

I would guess that the ECB is fully aware that, if they start the presses rolling, it will be ever harder to turn them off. You can imagine the special pleading, the 'social crises' that would be rolled out to get another hit of freshly printed money. If they do start printing, I do not think that it will be much more substantial than this mooted amount, and this is likely not going to be enough. As for the whole package, as the second quote above indicates, it is still unconvincing for many.

In short, there are potential avenues to stem the tide but these are still doubtful. However, each avenue will, in the long term just serve to ratchet the underlying problems upwards. They may delay a Euro road crash, but they will not solve the problems, but will just make them even worse in the long run. In the meantime, we can only look on and take guess at what events will bring.....but it is starting to look like crunch time.

Note 1: I would comment on the possibility of a Europe-wide downgrade, but this is (as usual) the ratings agencies following events. Their 20/20 hindsight is truly something to behold.

Note 2: A bit of a rushed post as I have a mountain of work to catch up on. However, with the 'events' taking place, I could not resist a brief post. Sorry not to respond to comments.

What do we really know?

2011-12-07T11:39:00.001-08:00

Some of you may have read the recent story from Bloomberg, which has revealed the massive loans that were made by the federal reserve to some of the world's major banks, or rather the 'too big to fail' banks:

The Federal Reserve and the bigbanks fought for more than two years to keep details of thelargest bailout in U.S. history a secret. Now, the rest of theworld can see what it was missing.
The Fed didn’t tell anyone which banks were in trouble sodeep they required a combined $1.2 trillion on Dec. 5, 2008,their single neediest day. Bankers didn’t mention that they tooktens of billions of dollars in emergency loans at the same timethey were assuring investors their firms were healthy. And noone calculated until now that banks reaped an estimated $13billion of income by taking advantage of the Fed’s below-marketrates, Bloomberg Markets magazine reports in its January issue.
Saved by the bailout, bankers lobbied against governmentregulations, a job made easier by the Fed, which never disclosedthe details of the rescue to lawmakers even as Congress doledout more money and debated new rules aimed at preventing thenext collapse.
A fresh narrative of the financial crisis of 2007 to 2009emerges from 29,000 pages of Fed documents obtained under theFreedom of Information Act and central bank records of more than21,000 transactions. While Fed officials say that almost all ofthe loans were repaid and there have been no losses, detailssuggest taxpayers paid a price beyond dollars as the secretfunding helped preserve a broken status quo and enabled thebiggest banks to grow even bigger.

Interestingly, in a letter to a US senator, the Federal Reserve is claiming that the Bloomberg story is filled with errors. The reason why I am posting on this story is that there was a fascinating snippet that came from the C-Span service, which shone a little light on what was taking place in 2008, as the economic crisis became apparent:

Now the interesting thing is that it is not clear where this information comes from. A senate hearing has the senator discussing the issue with Bernanke and Paulson (go to 1 hour and 50 minutes). In the discussion, Kanjorski suggests a similar scenario to the clip above, and asks for comment from Bernanke and and Paulson. They do not directly agree that the event took place, but they also do not refute it. When presenting the discussion of the bank run in the hearing, Kanjorski starts by saying that he had heard about a money market run from a friend in Wall Street, and that some newspapers were anonymously reporting this. He then goes on to say that 'he has evidence of this in some of our conversations' (presumably with Bernanke and/or Paulson), before saying 'with you and other experts'. He dates the event to 11-11:30 last Thursday, which is generally given as September 18, 2008.

I conducted a Google news search for the terms 'money market' and bank run for the 17th through to the date of the hearing, and could not find these 'anonymous stories' that Kanjorski discusses. This may be because I simply did not pick them up from the results, but I thought I would at least check to see if I could find them. However, I do find it distinctly odd that this is such a huge, if not momentous story, but all of the details are vague, and the sources are undefined. Why is it that we get no confirmation or denial from Bernanke and/or Paulson? Was it to avoid a fall in confidence? This might be seen as a justifiable reason, but I cannot help but think that this kind of information should be available (I have never supported the bailouts in the first place, so disagree with these arguments).

The other interesting point is that the date given by Blooomberg for 'neediest' day is December the 5th, a Friday. A good summary of the position of the world at the time of this stress can be found in this piece, dated 10 December:

Nations in Europe’s single-currency zone agreed Sunday to temporarily guarantee bank refinancing and pledged to prevent banks failing as part of a raft of emergency measures designed to get credit flowing again.
It was Europe’s most unified response so far to the global financial crisis and addresses a key part of the problem: banks’ reluctance to lend to each other. That has helped fuel the crisis that has pulled down some of Wall Street’s most storied names and is threatening the core of the U.S. and European economies.
After the Dow Jones industrial average ended its worst week in history, plummeting more than 18 percent last week, world leaders scrambled all weekend for a way to unblock money markets before they open Monday.

The ripples of the crisis were spreading with, for example, December 12th seeing the merger of Halifax and Lloyds TSB in the UK:

Halifax Bank of Scotland's bad debts and other charges have risen by two-thirds in two months as corporate and consumer loans buckle under economic pressure.

The banking giant, whose shareholders yesterday approved its takeover by Lloyds TSB, said its charges for bad debts and asset devaluations were £8bn for the year to 30 November, up from £4.8bn at the end of September. It also warned that more pain lay ahead, sending its shares down 23 per cent and hurting those of other British lenders. Shares in Lloyds fell by 18 per cent, RBS was down 15 per cent and Barclays lost 8 per cent.

My question here is as follows; was the December 5th bailout due to another bank run, or was it preventative? Again, this needs to be made public. What were the drivers of this huge bailout, and how were the bailouts decided upon, such as the reason why bank x got amount y? Bloomberg have done us all a great service in providing some of the information surrounding the bailouts, but I cannot help but be concerned that there still remains so much opacity. The questions are endless....

The point in this post is really to say that there seems to be two worlds. One world is that of the politicians, the central bankers, the too big to fail banks - and the other world is the rest of us. I think of Kanjorski's comments about his hearing the news of the bank run from a friend in Wall Street, and the conversations that he has had with Bernanke and Paulson, and the opacity of explanations, and wonder at what is now taking place in this 'other world'.

At the moment, we have the European crisis in full swing but the official statements, the press releases and so forth, are not really telling us the story. We are, as when the economic crisis first broke, almost certainly being kept out of the full picture. Those holding the levers of power are having their private discussions, and the impact of those discussions, and the decisions that flow from them will impact upon all of us. I am not sure that this can, under any circumstances, be justified. The excuses that the underlying story is kept under wraps to 'maintain confidence' simply does not excuse this opacity.

The point here is that there are not really two worlds, as they are directly connected. However, it seems that the decisions taken and information being held in one world are being undertaken without any real reference to the second world. The disconnect is artificial, and it is wrong. Those in that first world perceive themselves as 'the wise', but do not reconise their ongoing failure. They pull policy levers here, they pull policy levers there, and they keep the levers, and the drivers of their actions, hidden from the second world.

If they had succeeded in stemming the economic crisis, I might be content. However, they promised resolution, but have only succeeded in making the scale of the crisis ever larger. They are not wise; their record tells us that they are fools. They have forfeited any excuse for being privileged insiders who exclude the second world from information, and proper scrutiny of their decisions. I guess my real question, the burning question is this; what are these fools now up to behind closed doors?

One Billion Idiots

2011-12-01T11:29:00.001-08:00

As Europe sinks further into the sovereign debt crisis, I thought I would write about something of the foundations of the crisis. I have insultingly titled this post one billion idiots, and you are probably one of them. So was I, before I wrote this, and presumably so were many of my regular readers at one time. It is not pleasant to be called an idiot, which is why I have stressed that I too was an idiot.

This post is really for those who have still not asked the most simple question in the world; a question that every person in every developed country should be asking. My regular readers have now (I hope) asked the question of themselves, but there are many people who have yet to ask this simple, but powerful question. So what is this amazing question? I hope that you will not be disappointed, but suspect that you will be when you first see it.

Why is, and why has, the government of my country been borrowing money?

So, there it is. disappointed?

I suspect that you are indeed disappointed. It is a question that we have stopped asking, as it now so 'normal' that governments borrow money, we have forgotten that there should be a reason for their doing so. But what is that reason?

In the democracies of the rich world, as elections approach, there is discussion of economics. We listen to the to the back and forth of debate, we listen (if attentive) to the detail of the economic policy of party x and party y, and balance in our minds which has a better policy. Those of us who are most attentive might, just might, take into consideration whether party x and y will increase or decrease government borrowing. After all, governments borrow money, but they should not borrow too much money, should they?

Do you not think that this is odd, that we never really ask the one question that matters; why is it that both party x and party y both build borrowing into their plans for the economy? It is simply assumed that government borrowing is a normal state of affairs and that the question becomes one where we take into consideration how much they are borrowing, one against the other.

I am referring here to the 'rich developed countries', embodied in the OECD. These countries have something in common. They have complex and developed infrastructure in place. They have (had?) a large and wealthy tax base. They have the potential to raise enough money to pay for all of the functions of government from the wealthy tax base that sits as the foundation of the revenue of government.

So why is, and why has, the government of my country been borrowing money?

It is only when we ask this simple question that it becomes apparent that we have been idiots. There is no good reason, outside of (arguably) war (and less arguably) natural disaster that might justify government borrowing. However, there are bad reasons, and we are partly to blame for these.

What a government is doing when it borrows money is giving us something which we will have to pay for later. Governments will tell us that they, the government, are borrowing money. But they are not borrowing the money; 'we' the taxpayer are borrowing the money. We are borrowing the money because, collectively, we will pay back the borrowing. So why are governments borrowing money on our behalf?

We, those who have to repay the borrowing, collude in the illusion that the borrowing is not our own. When we see party x or party y, we balance questions of how much taxation we will be paying under government x, and what services and benefits government x will provide for us. It may be that we vote for party y, because they will hold down taxes. Or it may be that we will vote for party y, because they will increase spending on benefit a, b or c. If we take the former, they are holding taxes down, in part, by borrowing money. In the case of the latter, the benefits are, in part, provided by the borrowed money. Whichever the permutation of taxes, services and benefits, these are provided, in part, through borrowed money.

But remember, they are not borrowing money, we are borrowing the money; we the taxpayers.

What we see is that the politicians appear to be generous to us; they are holding taxes down, or they are now providing a better service a, b or c. However, regardless of whether it is party x or y, they are bribing us with our own money, hidden in the form of debt. The real difference between party x and party y is how they use that additional money from our borrowing to please their own constituency of voters.The key election questions in the end resolve around how our tax money is distributed, and how our newly created debt is going to be distributed as it come due. If the debt allows for tax cuts, or holding back tax increases, person a votes for it, even though they MUST pay for it later. Or, even better, because party y will make person b pay most of it later. And the same situation with a promised improvement in service/benefit a, b, or c, all being subsidised now with debt that we must later pay.

This is why we are idiots. We are allowing governments to bribe us with our own money. Blinded by our own interest, as a constituency to be bribed, we allow the dishonest practice to continue. In all cases, in all developed and mature economies, governments should operate on current revenue. There is no reason to borrow, excepting to subsidise through debt, the interests of different constituencies; to bribe these constituencies through accumulation of taxpayer debt.

It really is that simple, and that is why we are idiots. We allow this situation, and we have colluded with this situation.

Note 1: I know that, for regular readers this is a little repetitive. However, I am struggling/attempting to make this point as clearly as possible, so that as many people as possible start to ask the question (comments/suggestions/alternative accounts welcomed). I returned to this subject as a result of a comment in which the commentator suggested that it was necessary to borrow money during economic downturns. It was the thought that we have become so used to government debt, people are just unable to see the possibility that a government might save money during the good times to ease the problems during the bad times. It is an answer that is obvious but somehow we became so used to governments signing debt on our behalf, we forgot that they might also save on our behalf.

Note 2: Lord Sidcup - thanks for the link to the Marxist economist. The author is heading in the right direction; he 'sort of' grasps the problem, but can't see that underneath the OBR figures (which he rightly identifies as dubious), there really is a structural problem. I also liked the link to the Hayman article. In particular that there is no playbook (I think that was their expression) for the current situation with global debt. There really is no precedent that we can look at, in particular if you throw into the mix a dysfunctional currency union. Of particular interest is the element that deals with psychology (one of my errors in the early days of this blog was to think that market participants would be logical in their approach to investing), as this has a large part to play.

Note 3: Death to Bubble Addicts - also, thanks of the link. I have looked at Chris's work on and off. The title of the presentation of 'unfixable' sets it on the right course. I liked the point early on about the impossibility of investing when we do not know what the ECB or Federal Reserve will do next week. The perfect exponential is interesting, and the 'red squiggle'. I think he underestimates shale gas (a subject I keep meaning to post on), but he is right that (at some point) we face some big questions, but the last question at the end of his talk is perhaps very pertinent.

Note 4: Sorry to not respond to other comments, links, but out of time....just a final note on the massive support being given to Europe from the US. If ever there were an indication of how serious the situation is, this is surely about as clear as it can be. I am going to be pushed for time for a while, but may come back to this later if possible.

The Downwards Spiral: the UK

2011-11-29T08:56:00.001-08:00

The headlines; the UK economy is sliding and government borrowing is not going to meet projections:

The Government is set to borrow £111 billion more over the next five years than previously expected, with borrowing peaking at £127 billion this year before declining to £53 billion by 2015/16.

The Office for Budget Responsibility (OBR) has now issued its latest review, and it makes interesting reading. Perhaps the most worrying aspect of the whole thing is that there is an assumption that (by some miracle) the Euro will somehow muddle through. This is from 'Economic Outlook', 1.16:

On the assumption that the euro area struggles through its current difficulties, we expect the economy to gain momentum gradually through next year. But the headline measure of GDP is likely to be broadly flat until the second half, partly due to various one-off factors. Consistent with this profile, we have revised down our central forecast for year-on-year GDP growth to 0.7 per cent in 2012, compared to the 1.2 per cent average forecast among external analysts.

And this is section 1.21:

Our central forecast assumes that the euro area finds a way through the current crisis and that policymakers eventually find a solution that delivers sovereign debt sustainability. A more disorderly outcome is clearly possible. This poses a significant downside risk to the central forecast, but one that cannot be quantified in a meaningful way given the numerous ways in which it might unfold.

There is an important point to note here. The central forecast assumes that there will be a Euro solution. It is hard to match this forecast with the events that are taking place. As we have seen over the past few weeks, the descent into crisis is accelerating, not slowing for the Euro. For example, today we have a headline that Italy has had to pay over 7% on ten year bonds at the latest auction. Last week a German bond auction was a worrying dud. Whilst there are arguments about the cause, it is still indicative of a wider 'loss of faith' in the Euro. In a recent post, I showed a diagram of risk exposures to sovereign debt crises, and the UK was just one of the countries with a heavy exposure to European sovereign debt defaults (also, see OBR report p.63 for details). And, of course, Europe is a key element in the UK's international trade.

Bearing in mind that the OBR forecast overall is therefore probably a work of fantasy, there are some interesting elements in the report. The OBR has belatedly started to recognise something that regular readers of the blog will already know; that the UK's problems are deeper than previously realised. This is a neat summary from the Wall Street Journal:

The OBR said the output gap--the difference between what the economy can potentially produce and what it is producing--is smaller than previously thought, reducing it to -2.7% for 2011 from the -3.9% estimated in March. This means that more of the deficit is structural, making Osborne's goal of eliminating it more challenging.

Regular readers will know that I have little time for the notion of the 'output gap', and have argued that it ignores the underlying structure of the UK economy that is based upon ongoing growing debt fuelled consumption. These figures are a finding of what should have been obvious, but the figures still flatter the situation. There are large sectors of the economy that are still largely distorted to service consumption based upon debt, and these are only just starting to contract.

The final point I want to pull from the OBR is the useful analysis of consumer disposable income, confidence and spending. The big picture is that consumers are not pulling out their wallets, and there is little prospect of doing so for a while yet. This should come as no surprise in light of rising unemployment in combination with low wage growth versus inflation. The situation is just going to get worse, and this will lever the economy down, as the sectors of the economy that service consumer spending shrink back, and in turn this increases unemployment.

All in all, even without a Euro crisis, the UK economy was likely to be hit very hard as the government sought to reign in growth in borrowing. Also, it must be remembered that this dire economic outlook is set against a backdrop in which government borrowing levels are still outrageously high. So-called austerity still means supporting the economy through a huge stimulus from the government, and a stimulus that is funded by borrowed money (borrowing that is secured against future taxpayer income). Even using the OBR's optimistic forecasts, and bearing in mind that the off-balance sheet obligations are not included, the national debt will grow from 67% of GDP to 78%. However, I do not like these circular understandings of debt ratios. The net debt forecast is £bn; 2010-11 = 905, 2011-12=1044, 2012-13=1182, 2013-4=1300. This does not look very austere to me.

Some newer readers might be surprised at the word 'stimulus' used above. However, what else can we call such huge government borrowing (or rather taxpayer borrowing facilitated - signed for on behalf of taxpayers by the government). It is a massive stimulus to the economy but, despite this (and low interest rate) stimulus, there is only one way ahead for activity in the UK economy; it will shrink. The structural problems in the UK economy were built up as a result of years of debt-fuelled consumption, the government filled the gap in growth in debt based consumption, and is now trying to reverse this course. On top of this, there is the crisis in the Euro zone. The only direction the economy can go is down; there are no sources of economic growth. This is from Tullet Prebon's Dr. Tim Morgan, commenting on the autumn statement (distibuted by email):

The real problem which confronts the UK is that the economy has been skewed by a bubble-decade of private borrowing and public spending, a decade for which Osborne’s predecessors must shoulder most of the blame. Interest rates were kept too low, individuals ramped up their borrowing on the basis of unsustainable property price escalation, and the previous government spent not just up to, but far beyond, a boom whose real bubble nature it completely misunderstood.

This is precisely correct. The fundamental problem is this. The UK is borrowing gargantuan amounts of money in the face of almost certain economic contraction. As such, it is borrowing ever more money with reduced prospects for income to service the borrowing in the future. It is not really as complicated as many would like to propose. Something must give. In recent times, the bond markets have been relatively kindly to the UK, but it can only be a matter of time before they start to work out the contradictions in the UK economy, or start to see the contradictions playing out in the statistics. The OBR's blated recognition of the structural nature of the deficit is just the start. The OBR have yet to recognise quite how terrible the situation is.

In a recent post, I discussed the way in which governments would piecemeal address the problems in their economy - a small cut here, an adjustment there. The only way out of the mess is for governments to confront the underlying problem that they simply cannot afford to continue spending on what I called 'luxuries'. The only route out, however painful is to have a medium term target of zero borrowing, however painful that might be. As it is, this is what I said for the countries that were debt laden:

As it is, each country that faces crisis will no doubt continue to nibble at the luxuries. As they do so, they will fail to address necessity versus luxury, and the crisis will continue as each nibble fails to achieve stability, and thereby forces a new nibble at yet another luxury. It is the way that Greece has gone, and the way ahead for the other overly indebted countries. Nibbling into oblivion.

This is the current state of the UK. For all of George Osborne's good intention, he is nibbling in the face of a catastrophic downward spiral. It is not enough, and this will become apparent over time. Right now there may still be time to determine what is an absolute necessity and what has to be consigned to luxury. As it is, as Greece found out, if no action is taken soon enough, others may well make that determination for the UK.

Note: Thanks for the comments on recent posts. One question that came up was to ask how a Euro break-up might develop, and what consequences. I have been giving a lot of thought to this, and the problem I am confronted with is this; any break up of the Euro would be an event that start a period of 'chaos'. By this, I mean that we cannot predict either government or market reactions to this kind of event in the short term, as there will be some kind of panic resulting from the crisis. The short term reactions will largely determine the nature of the medium term actions, so prediction is simply not possible. I can only say that in both the short and medium term (five years out), it will not be good.

In light of this, and the potential complexity of the situation, without even having comparable situation to draw upon, I am ever more puzzled at the confident assertions of those who predict x, y or z. Just for a start, think of the possibilities for core Euro zones versus complete break-up. What will finally determine the end game? What will Germany do if Greece defaults, or Spain, or Italy? What will France do, and how will that interact with Germany's approach. What about the ECB - will it ride to the rescue in the face of conflagration? Will that save the Euro, or just delay the day of reckoning? There are endless scenarios, and it seems that predicting one type of outcome would be extremely difficult. However, with the number of predictions out there, perhaps someone will get it right?