The Debt Cycle

A while ago, I read a comment on another website about this blog. The commentator was very positive about my analysis, but also pointed out that I was not so good on market timing. I thought that this was a very fair comment. The reason for this weakness is that I struggle with how the individuals in the market get so much so very wrong.

I thought of this today, as I saw the news on the latest falls in stock markets. The reason for the falls are the potential problems in Hungary, with yet more sovereign debt woes, and poor US unemployment data. In the case of the unemployment data, the really bad news is that much of the increase in employment is down to the mass hiring for the short term to conduct the US census. In fact, nearly all of the new jobs created were a result of the census. The really worrying aspect of this is that this abysmal performance is that it is taking place in the context of such massive government borrowing.

I have copied the chart of US federal surplus or deficit from the St. Louis Federal Reserve. It was not so long ago that such charts were seen as regular feature of economic commentary, but they seem to have fallen out of fashion. Sometimes, it seems that it might be a good idea to remind everyone of exactly how much money is really being poured into the US economy through borrowing.



This from the Wall Street Journal:

THE US deficit has reached $US13 trillion for the first time in history, the Treasury Department said yesterday.

Amid vast Government spending designed to stave-off economic calamity, the debt reached $US 13,050,826,460,886.97 on June 1.

The debt has increased by around $US 1.6 trillion in the last year and more than doubled in the last 10 years.

It now stands at just under 90 per cent of annual gross domestic product.

Below, we have the US current account. It is not a pretty sight.



In other words, the US government is borrowing mountains of money that is barely denting unemployment, and the money is helping to support ongoing over-consumption. What can be good about such a situation?

The supporters of deficit spending would argue that, without the massive deficits, the unemployment situation would be far worse. I am actually in agreement with this, and what the level of unemployment might be without deficit spending would otherwise be does not bear thinking about. However, these levels of deficit and the over-consumption can not be sustained. The cost of such massive borrowing is to just push the unemployment into the future, and that is really no solution.

I am highlighting these underlying problems for a very simple reason. As the Euro crisis accelerated, the US became (once again) the 'safe haven' destination for investors. How can we explain such a perspective? Below is a chart of US GDP, which goes some way to explain why there is a false confidence in the US economy.



If we compare the chart for the accumulation of debt and the GDP chart, the source of this 'growth' is obvious, but that does not seem to have deterred investors. The US is only 'safe' if the US government keeps on borrowing and if it stops borrowing at these levels it will very quickly become 'unsafe'. The problem is that, as fast as the US government borrows to spend the situation of the economy is still deteriorating. As the unemployment figures are showing, there is no real recovery, and the lack of a recovery is coming at a monumental cost.

$US 1.6 trillion is buying no real jobs growth. It is just preventing a massive jobs slide.

The real question that needs to be asked is where the real growth in jobs might come from. When thinking of the horrendous underlying unemployment (i.e. the level without the borrowing), it is apparent that there needs to be a huge surge in employment in many sectors of the economy. This looks to be highly improbable. What we are looking for here is not jobs growth, but a jobs miracle.

Then there is the context in which such a miracle must take place. Europe is about on the edge of commencing considerable fiscal retrenchment. With such retrenchment, the export market for US goods is about to shrink, with Europe accounting for over one tenth of US exports. Then there is the ongoing strengthening of the $US against the Euro, which will disadvantage US exporters in an already declining market. The rush of money into the 'safety' of the $US has the perverse effect of making the $US less safe by strengthening the dollar. It is the curious situation where the more a currency strengthens, the more it will build weakness in the long term. Imports will rise, and exports will fall. In this case, it is not a strengthening on the basis of underlying economic performance, but just a panicked movement of money.

This is a quote from Geithner, from a recent letter sent to the G20:

"Given the broader shifts under way in the U.S. economy towards higher domestic savings, without further progress on rebalancing global demand, global growth rates will fall short of potential," Mr. Geithner wrote, according to a copy of the letter viewed by The Wall Street Journal. "In this context, we are concerned by the projected weakness in domestic demand in Europe and Japan."

From the same article as the quote, The Wall Street Times says the following:

"The necessary shift toward higher savings in the United States needs to be complemented by stronger domestic demand growth in Japan and in the European surplus countries, and sustained growth in private demand, together with a more flexible exchange rate policy, in China," Mr. Geithner wrote.

U.S. Treasury secretaries have been delivering that message in various forms for more than a dozen years, pleading with Europe, China and emerging Asia to adopt policies that encourage their own consumers to boost purchases of U.S. goods and services while vaguely promising to shift American economic patterns toward savings.

How this magic transformation might take place is the big question. Europe will not pick up the slack, and China can only continue to allow its economy to grow bubbles for so long. Emerging Asia might have potential, but it is not clear why the US would win from such growth, in particular as long as the safe haven effect continues to hold up the value of the $US. The other problem is that, with a weakened Euro and £GB, Europe will see competitive strengthening in relation to the US in all export markets. As I have said, the movement of money into a 'safe haven' undermines itself.

What this suggests is that there will be no chance of export led growth as long as the $US remains a safe haven. The greater the borrowing of the US, the greater the demand for the $US to put into 'safe haven' lending, and the greater the demand for the $US, the more the value of the currency is subjected to upward pressure, and the more entrenched the problem of export led growth becomes. It is a circular process, and all the while in the background, the debt in the US continues to mount, and unemployment persists even as the borrowed money pours into the economy.

As the situation stands, there is no probability of a jobs miracle in the US that might come from export led growth. As long as the US remains a safe haven, the effect will be the opposite with import led job destruction. This in turn leads to the problem that, the more jobs that are destroyed, the greater will be the reliance on borrowing to support employment in the US, and this in turn provides the instruments to meet 'safe haven' demand for $US.

What you can see is a process in which the US economy becomes increasingly structured around debt. The more the US government borrows (as long as demand continues), the greater the job destruction in the US from increasing imports and falling exports, and the more the government must borrow to maintain unemployment, and the more the economy becomes structured around the borrowed money, the more entrenched the problem of stopping borrowing becomes........and so on, and on, and on.....

Within all of this, there is the question of where the demand for the $US would come from, were it not from buying $US to lend to the US government. The US is still a huge exporter, but nevertheless has a current account deficit. In addition, the $US is the reserve currency and the currency of trade, and there is therefore demand for the $US for transacting trade. World trade has been increasing of late, which might be a driver for demand for the $US, but that increase commences from a low point. There is also demand for $US to buy assets, such as stocks, but the greater the demand for this kind of investment, the greater the chance of asset bubbles, and the greater the perceived risk for investors.

In other words, without the government borrowing to soak up demand for 'safe haven' currency, it is unlikely that the $US would be able to hold the current valuation. In other words, it government borrowing that is entrenching and expanding the problems in the US economy. By borrowing so much, the US is both accumulating unsustainable debt, but is also providing an asset that meets the demand for 'safe haven' $US. That safe haven status is just a spur to further destruction of the US economy, as it points the US economy into a downward spiral of debt dependency. It destroys sustainable jobs, even whilst it creates (eventually) unsustainable debt supported jobs.

In a world in which many countries are seeking to export their way out of trouble, being a safe haven is not a solution, but is actually a medium/long term problem. The answer is, of course, to break the cycle, but nobody dares to do so. In breaking the cycle, the underlying problems will rapidly emerge, and the economy will tank. As such, the cycle continues, and the problem of an economy being shaped by debt dependency just grows ever more acute. It can only mean greater destruction in the future, as the underlying economy must eventually move from debt dependent employment to sustainable employment. And that means a period of massive unemployment.

Note:

I hope that the post makes sense. I have re-read it a couple of times before finally deciding to post. I have a niggling doubt that I have missed something out. Please feel free to point out where you might think that I may have missed something.

GDP Growth, Debt and Current Accounts

We should all be celebrating, should we not? The news is that US GDP grew at an annualised rate of 5.7% in the last quarter, and the UK finally moved into GDP growth, albeit that the UK GDP growth is negligible. Should this be a cause for celebration, should we not be singing the praises of those that engineered this 'recovery'? I will apologise in advance for the long quotes that follow, but these are necessary to understand the nature of the 'growth'.

The US

If looking at the source of the surge in GDP growth in the US, AFP provides an explanation:

The big GDP gains came in large part from businesses ramping up production to rebuild inventories, which economists say may skew the picture of overall activity but is a normal part of recovery. Inventories accounted for 3.39 percentage points of GDP.

Stripping out inventory adjustment, real final sales -- a reflection of the underlying pace of growth -- was at a 2.2 percent rate, the report showed.

[and]

Capital spending on equipment and software surged 13.3 percent, another significant contributor. Ian Shepherdson at High Frequency Economics called this a "key upside surprise" but added that "we can't see where this comes from and think a downward revision is likely."

The data showed exports surged 18.1 percent, making trade a positive contributor to GDP since exports increased more than imports, which were up 10.5 percent.

Consumer spending, which is traditionally the key driver of economic activity, rose at a 2.0 percent pace, down from 2.8 percent in the third quarter, and accounted for 1.44 percentage points of GDP.

In the case of the US, it is noticeable that there is some cynicism about some of the statistics, and that the rebuilding of inventories will presumably diminish as an influence. A real positive is that 'export growth was strong at 18.1% which leaves net exports contributing 0.5pp to overall GDP growth.' However, before the US starts celebrating, it is necessary to add a dose of cold hard reality. The chart that follows shows that the 'growth' in exports starts from a low base:

Then there is the imports of goods and services, which is the other side of the coin:

All this give a balance on goods and services trade as follows:

But here is the real problem. As the economy contracted, so did the current account balance. However, as 'growth' commences, a commensurate deterioration in the current account balance follows. In other words, the 'growth' is seeing the US problem of consuming more than it produces worsening as the economy 'grows'. It gives a horrible sense of deja vu...

Observant readers will note that the chart only goes to mid 2009, and does not therefore include this current spurt in 'growth'. I suspect that, once the figures are out, the line will continue the downwards trend. The preliminary figures from the Bureau of Economic Analysis suggests a growth in the current account deficit for the third quarter of 2009.

What we are seeing is the delayed effect of the government's role as a replacement for the loss of consumer debt driven economic 'growth' (the chart is 'Household sector: Liabilities: Household Credit Market Debt Outstanding') .

I do not think anyone needs to see the following chart which shows the massive increase in the government deficits, but will include it anyway.

As a final chart for the US economy, we have the GDP figures that have caused so much excitement.

It is not difficult to see what is taking place when we see these charts. As consumer debt growth tailed away, the economy fell into deep recession, and with it there was an improvement of the position of the current account balance. The current account balance started to move in the right direction as American consumers moved towards living within their means. However, as this took place, the government replaced the consumer as the driver of debt driven consumption, and we are now seeing the return to 'growth' with a commensurate decline in the state of the current account balance. The early decline in GDP reflects the time lag for the wall of government borrowed money to hit the economy but, as it works its way through the economy, 'growth' appears again.

The UK

In the UK this is what national statistics offered as an explanation of the slight GDP growth:

Services output rose 0.1 per cent, compared with a fall of 0.2
per cent in the previous quarter. Distribution, hotels and restaurants contributed most to the increase. Distribution, hotels and restaurants rose 0.4 per cent, compared with an increase of 0.7 per cent in the previous quarter. Motor trades and retail contributed most to the increase. Transport, storage and communication showed zero growth, compared with an increase of 0.7 per cent in the third quarter. Business services and finance showed zero growth in the fourth quarter, compared with a decrease of 0.8 per cent in the previous quarter. Government and other services rose 0.2 per cent, compared with a decline of 0.2 per cent in the previous quarter. Health made the largest contribution to the increase.

Total production output rose in the fourth quarter, increasing 0.1 per cent, compared with a fall of 0.9 per cent in the previous quarter. Manufacturing made the largest contribution to the increase rising 0.4 per cent, compared with a fall of 0.2 per cent in the previous quarter. Mining and quarrying output rose 1.0 per cent, compared with a decrease of 5.7 per cent in the previous quarter. Electricity, gas and water supply fell 3.3 per cent, compared with an increase of 0.2 in the previous quarter.

The same kinds of relationships can be seen in the UK data as can be seen in the US. If we start with the balance of trade, we have this from national statistics:

And then there is the current account balance:

The following is a chart of net lending which, whilst not directly comparable with the US chart, shows a similar pattern.

Just as consumer lending goes into reverse, as in the US, the UK government steps in to replace consumer borrowing with government borrowing:

And finally, there is GDP growth figures:

What we are seeing is the same pattern as the US, but at an earlier stage. Just as the US moved towards growth, and the current account balance started moving in the wrong direction, the same is happening with the UK. Just as the US government replaced the consumer as a borrower, the same has taken place in the UK.

Conclusions

Whilst they are not following exactly the same pattern, there is an uncanny similarity in the relationships between the charts for the US and the UK. What we are seeing is not economic 'growth', but growth in debt. It is not the first time I have said this, but it is worth saying it again. This is like measuring a person with a salary of $100,000 and adding borrowing of $20,000 to suggest that he has an income for the year of $120,000. Sure, his purchasing power has increased, but his income has not. Just as the individual can now spend more than he earns, so can the US and UK. This is reflected in the current account and trade deficits.

None of this is economic growth, but is instead a steady process of national impoverishment. It is the feel good of consuming more than you produce, and the hell with the consequences in the future. It is a road to ruination, and I will therefore not join any celebrations for the increase in GDP. It is the height of irresponsibility.

China: A brewing confrontation?

It seems that China is, at last, really being noticed by mainstream analysts. When I see really, I am referring to the key part that China is now playing in the world economy. Of particular note is that the growing share of the world export market held by China and that China is now the world's largest automotive market (mentioned in a recent post).

Perhaps it is these statistics that have served to focus minds.

The actual analyses that are being offered, and the opinions about what might be done about China, are varied. A good contrast can be found between Dylan Grice of Socgen and the Economist magazine. Grice notes that different standards are applied when analysts and investors view the Chinese economy, and provides an example in the comparison of value between Lloyds of the UK and ICBC of China. Both are part government owned, both have potential risks in their loan book, but Lloyds is potentially subject to malign government intervention, whereas ICBC is actually subject to malign government intervention. Despite this, the valuation of ICBC is much higher.

Grice sees this as an example of irrational exuberance on the part of investors towards China. He notes that there is a boom in credit in China, and questions the idea that an infrastructure investment boom will not lead to a bust, citing studies that show that such a bust is possible.

The Economist offers a very different perspective, giving their article the title 'China's Economy: Not Just Antother Fake'. They commence their article with the many aspects of the Chinese economy that might look bubble like, and make comparisons with the conditions in Japan before the Japanese economy popped. However, they go on to say the following:

Scary stuff. However, a close inspection of pessimists’ three main concerns—overvalued asset prices, overinvestment and excessive bank lending—suggests that China’s economy is more robust than they think. Start with asset markets. Chinese share prices are nowhere near as giddy as Japan’s were in the late 1980s. In 1989 Tokyo’s stockmarket had a price-earnings ratio of almost 70; today’s figure for Shanghai A shares is 28, well below its long-run average of 37. Granted, prices jumped by 80% last year, but markets in other large emerging economies went up even more: Brazil, India and Russia rose by an average of 120% in dollar terms. And Chinese profits have rebounded faster than those elsewhere. In the three months to November, industrial profits were 70% higher than a year before.

In a later article (1), the Economist discusses the rise and rise of China's exports, and asks whether the growth might continue. They again compare China with Japan, and note that Japan's exports peaked once Japan had moved up the value chain. However, in the case of China, it is possible to move up the value chain, and keep lower value exports, as China can substitute the low for high value in the coastal cities, and still keep the low value in the inland provinces.

An even more optimistic assessment of China's prospects comes from Foreign Policy magazine (sorry, no link and reliant on memory for the article details). The thesis of the article was one in which China would rapidly develop to become the most dominant economy, and signals the decline of Europe and the US in comparison. Whilst the Western economies might not decline in absolute terms, the article saw them losing economic power and influence.

So where do I stand on the question of the prospects for China? In a series of articles (see links in the notes at the end) I have offered a cautious view of China's prospects. In my first article, at the start of the economic crisis, I suggested that China, on balance, would be likely to come out of the crisis stronger:

So where does this leave the economic future of China? Where would I place my bet? Would it be on ongoing growth, recession and instability, or what outcome? The honest answer is that I would not place the bet at all but, with a gun to my head forcing me to to make the bet, I would choose continued economic growth, albeit at a slower pace than before. In the meantime the Western world needs to accept that it is no longer in a position to continue with its complacency. China poses a real and ongoing threat to the world economic order, and will continue to grow at the expense of the West, unless the West responds by restructuring of their economies through (real) improvements in education, lowering their cost base, and taking an aggressive approach to intellectual property and fair trade (for why, see here).

You will note that this is a very cautious prediction. I have highlighted some of the potential problems in the Chinese economy, such as the frothiness of the housing market, potential for dud lending by the Chinese banks, and (above all else) the potential for social unrest if Chinese growth ever goes into reverse, and many other concerns.

Within all of the discussions of China, there is often a fundamental problem. This is the idea that China sits as a stand alone entity, in which the policy of China might just be continued. I have frequently highlighted the mercantilism policy of China, and have long been arguing that, unless China acts to trade more fairly, it should be subject to trade sanctions. I have highlighted the manipulation of currency, the theft of intellectual property, and the conditionality of inward investment (with insistence on the transfer of technologies), as well as many other problems.

In August 2008, for example, I argued strongly that it was time to get tough with China, and highlighted a series of unrelated stories, all of which pointed to China using mercanilist methods to enhance their economic position. Whether they are making threats to destroy the $US, using the media to slander overseas businesses, arranging theft of intellectual property, China appears to be set on a course of establishing itself as THE economic power of the world. For example, I have previously mentioned the use of hacking by China to steal commercial secrets from overseas competition, and (again) this is actually starting to be noticed more widely.

The purpose in highlighting these points is that there has been a complacent attitude to the mercantilism of China, but the winds of change are blowing. China has a club to beat the world with, which is the holdings of massive foreign reserves. In an early post I highlighted that it was better to face down China now, rather than later. The ongoing growth of reserves held by China would just make confrontation ever more difficult. The complacency over the method of the ascent of China is now disappearing, but the potential dangers of confronting China have now grown. Nevertheless, there is an increasing recognition that something has to give. This from Roger Bootle in the Telegraph:

The looming threat to the world economy comes from the same source which contributed so much to the financial crisis, namely the draining of demand from the world economy through excessive Chinese saving. But now it will come at a time when most countries of the West are in no position to offset this effect through more stimulus policies and indeed, as in the case of the UK, may actually be about to tighten fiscal policy. We may be not far off the point where, if the Chinese don't take steps to make their trade with the West more balanced, then the West will take steps to do it for them.

Such sentiments can be found elsewhere, and I even find myself in agreement with Krugman, who is arguing against allowing the ongoing manipulation of the value of the RMB. However, what remains missing from these analyses is the complete picture. It is not just the matter of currency manipulation, but the many other policies of the Chinese government in conjunction with the currency manipulation. There is a pattern here, and I long ago discussed this in another post, saying the following:

It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.

I have not detailed the many individual stories that support the argument of this post, as they can be found in other posts (see list at end). The important point is that, if considering the future of China, it is necessary to consider the actions of China's key trading partners. My best guess is that the situation will not be endured by China's' trading partners much longer - that China will be confronted over the mercantilism. This is, of course, in the hands of politicians, who are by their nature unpredictable. What approach, when, or how they might seek to address the problems, and how China then responds, will play a key part in the determination of whether China continues on the current upward trajectory.

My best guess is that China is heading for very troubled waters. I do not think, as the economic crisis proceeds, that the world will sit by and watch as China continues with the current policies. At the same time, China knows that it must continue to grow if it is to achieve social stability, and that means that it fears make any concessions. In fact, from the point of view of the Chinese government, China MUST continue to grow. That means that they will not back down easily, as the mercantilism is a key element in the level of their growth. In other words, the stage is being set for a confrontation, and the outcome of the confrontation might have profound effects on the ascent of China.

(1) 'Fear of the Dragon', Economist print edition, 9th January 2010

Note: Links to previous posts on China. These posts are the ones that are largely focused on China, but there is discussion of China in other posts. From Trade and Forfaiting Review:

Shanghai Suprise

From the Blog:

1. July 2008, China - What Future?
2. August 2008, China Propping up the $US
3. January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
4. January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency (post indirectly associated with China)
   
5. February 2009, China's Pivotal Role in the Next Step for the World Economy
6. Fenruary 2009, China and the US - Fighting on the Edge of a Cliff
   
7. March 2009, Economics and Power, the Loss of US Power
8. March 2009, China, Gold and the $US
9. April 2009, China as the World Economic Power?
10. April 2009, The RMB as the Reserve Currency
11. May 2009, China, the RMB and the $US
    
12. July 2009, The RMB as the Reserve Currency - an Update
13. Sep, 2009, The Rise and Rise of China
14. Sep, 2009, China and Treasuries: A Puzzle
15. Oct, 2009, The Great 'Shift' China and the West
16. Jan, 2009, China on Track - The Car Industry
    

And the role of China in the development of the broader economic crisis can be found here (on Huliq).

The Underlying Problems in World Trade

Regular readers will know that I am very cynical about the talk of recovery in the Western economies. I recently posted on the optimism for the US economy, and pointed out the many indicators that suggested that the economy is a long way from recovery. Similar arguments may be made for the UK economy. However, for this post, I thought I would return to the underlying nature of the economic situation, and there are a few factors that I would like to highlight.

The first of these is that the balance of trade, and current account balances of the UK and US are still in negative territory. Rather than detail the situation as it stands, I will try to illustrate the profound problem this represents through a gross simplification. I hope I will be forgiven this method.

If we were to imagine a world in which there were only two trading countries, that their trade was confined to two products, and that their trade was undertaken as barter, we can strip out the complexities of currency, and see the underlying problem. For the example, we will imagine that one country exports packs of pharmaceutical pills, and the other country toys. In country A, they manufacture 100 packs of pills per day, with 100 workers manufacturing 1 packet of pills each per day. In country B, they manufacture 100 toys per day, with 200 workers producing half a toy each per day. The workers in country B are willing to exchange 1 toy for 1 packet of pills in barter exchange. As such, the productivity of country A is twice that of country B, implying that country A is by far the wealthier country.

The problem that then arises is as follows; Country A is consuming 80 packets of pills per day, but also consumes 40 toys per day. Furthermore, Country A is saving nothing, whilst Country B is saving some. In the table below, it is possible to see how, after five years of this arrangement, Country A owes country B a whole years labour per worker. I make no pretense that these are real figures, but they serve to illustrate principles ( I hope the table is clear, as Blogger shrinks the images down, which is very annoying). As a note the exchange value is 1 toy for one pack of pills, such that each represents 1 unit of output.



What we are looking at in this table is a country B with large numbers of workers, with low productivity, but relatively small consumption levels and a high savings rate overall. I have put a separate column for savings in the table, but the debt owed by country A is (of course) representative of savings. The point in having a separate column is just to emphasise that the individual consumers in country B are very thrifty and cautious, and they therefore hold back from committing all of their stored wealth as credit to Country A. In other words they keep a store of toys (money) ready for exchange in the event of emergency. The model only shows the export trading part of the economy, and this store of toys is there for the exchange of goods and services, but still represents stored value.

The purpose of the table is to show what happens when one country over-consumes, and another under-consumes. Despite the high productivity of Country A, they are still in deep, deep trouble. By seeing the trade in terms of barter rather than currency, it is apparent that it is labour that is being exchanged.

Typically, what we see is such ideas hidden under mountains of economic theory, and obscured by many complicating factors. However, if we look at trade in these simple terms, it is possible to see how, in the end, one worker ends up owing another worker a huge amount of their labour. In this scenario, each Country A worker owes country B an entire years worth of labour. When considering this, it is necessary to also factor in to the equation that no individual is able to actually give a year of their labour to repay debt, so this labour must be repaid over time. As such, of course, the labour that is providing the credit in goods would (and does) demand interest for foregoing the consumption that they might achieve now for future consumption.

The table does not therefore fully express the severity of the situation for country A.

If we apply such a principle to the real world, thinking of the US (like Country A) and China (like Country B) as obvious examples, it is possible to see that something, somehow, absolutely has to 'give'. If we remove the complications of currency, it is possible to see that there is huge amount of labour owed by the US to China. It is also possible to see that China has the savings that will allow it to ride through the current downturn. For real current account balance figures, the US can be found here, and China here.

Inevitably, life is not as neat as the illustrative example, but the principles are what really underpin the nature of trade. It is the exchange of labour between two countries, not the exchange of money. Money is just an intermediary that represents the equivalent of toys and packets of pills.

If we think of the world in terms of this underlying exchange of labour, then it becomes clear that the previous current account deficits of the US has put the economy very, very deep in debt. If we then view the ongoing current account deficits, then we can see that the problem is just getting worse, albeit at a slower rate. The US is confronted with choices, none of which are very palatable. The first choice is to accept the reality of the debts, and therefore do what is absolutely necessary. This is to live in a frugal way until the labour owed to China is repaid. This means, in practical terms, a significant decline in living standards, with a massive decline in consumption, as more of the value of labour is switched to exports. For China, this means that they would not have to work so hard to achieve the same living standard, or they might still work as hard and have a far higher living standard.

After all, if the US starts to use its labour to repay debts, then the value of that labour will flow into China in the form of goods and services.

It is at this point, that life gets somewhat more complicated. It is the question of how this might be achieved.

The simplified model ignored currency in order to illustrate the underlying principles of what has taken place in the world economy. However, the reality of the world is that it does have a currency system. The underlying problem that the US must confront is that, at current valuation of the $US (albeit it has fallen back recently), it can not compete with Chinese labour in many sectors (thus the ongoing deficits). This is a very curious situation.

What we currently have is a belief that the ongoing deficits and the existing debt of owed labour do not matter when considering the value of the $US. It is the only explanation of why the $US might be valued in the way that it is. In part, this is a result of a false confidence in the productive capacity of US workers and the US economy as a whole. Another part of the problem is that China has a nasty choice. The only way that they might be repaid for the labour owed by the US is to accept that part of the existing debt of labour owed be wiped off the slate. I will try to explain this difficult concept...

When Chinese labour was exchanged for promissory notes from the US, there was a belief that the US would eventually exchange the labour for the full value of the notes. The problem arises that, if the US were to make this exchange on the original terms, then US labour would be unable to exchange their labour for the products of Chinese labour. Quite simply, they owe too much of their labour, and repayment would mean that they are living in relative poverty. In short, their consumption would fall back to a degree where they would by buying very, very few goods and services. The Chinese economy is largely centred around provision of their labour to provide goods and services to the US economy, and the halting of the consumption in the US would leave many companies without a market.

Now if we return to the table example, it is apparent that the Chinese are very productive, but consume very little. They are cautious consumers. In order for the situation to be rectified, they need to consume more of their own output. In other words they need to live more wealthy lives. The trouble is that, for cultural and systemic reasons, they are cautious, and would rather not use their acquired wealth for immediate consumption. If they were to consume more of their output, then they would be in a position of living relatively wealthy lives, and this would be further bolstered by the repayment of the labour owed to China by the US.

The problem then arises as to what will happen to all the factories that have, in effect, been lending the labour to the US? If the US economy collapses, then there is no market for their goods. If they demand that the US repays the debt of labour owed (on the original terms) the US will be very poor, and will be unable to afford to buy any of the products of Chinese labour.

The Chinese are now in an uncomfortable position. It is apparent that the US would struggle to have its workers repay debt, and this would be a political nightmare to enact. Nobody likes to move from apparent wealth to actual relative poverty. As such, instead of accepting the underlying reality that is represented in the current account deficits, both the US and China are doing the equivalent of sticking their fingers in their ears and singing 'la, la, la, la!' at the top of their voices.

The real problem, however, is what the US is doing to try to rectify the problem. It is apparent that US labour has been doing the same as the country A workers in the table. They have been consuming more than they produce, and now owe significant amounts of their labour to China. Now that they are confronted with repayment of their debts, they simply do not want to pay. Furthermore, they are demanding that their ability to consume more than their output is continued.

The US government, rather than telling them the hard reality that it is repayment time, is telling them that they can, in fact, continue to consume more than they produce. In order to allow this to happen, they are using several rather dishonest measures. The first of these is that they are attempting (and currently succeeding) in persuading many countries, organisations and people, that the US is in a position to one day repay the debt of labour owed, and that the US has sufficient future output to repay even more debt to the labour of others in the future. The curious part of this is that, up to this point in time, they have offered no explanation of how the US might actually achieve such (increasingly massive) debt repayments.

The second measure that they are enacting is the policy of printing money, and the eventual devaluation of the $US. This is a measure to allow the US to default on the debts of the past. In the table, the barter exchange rate is 1 toy = 1 packet of pills. However, in the real world currency is an intermediary, and devaluation of the currency is a way of post hoc arranging that 1 toy = something like 0.6 packets of pills. In other words, they are reneging on their debt, and breaking their promise to pay.

Whilst this may resolve past debts through dishonest means, it still leaves the US with an underlying problem. The apparent wealth that they have enjoyed is, in part, due to living on the labour of others. However, if they do not repay their past debts, that labour will be withdrawn (e.g. if they devalue their currency, China will no longer lend their labour). At the time that the labour is withdrawn, the US will find that it is reliant upon the output of its own labour, and that labour is insufficient to support the standard of living that was possible with the labour input of countries like China. They will find that they are very much poorer than they imagined, and that is a painful situation to confront.

Perhaps this is too simplistic. I would welcome comments on the situation, and how the underlying premise might be wrong.

Having said all of this, it might appear that I am painting China as an innocent party in the current problems. However, as I have emphasised in the past, China has manipulated its currency in a policy of mercantilism. In so doing they have systemically under priced the value of their labour, and used this to ensure positive trade balances. The cost of this has been borne by Chinese workers, whose purchasing power of imported goods has been diminished, and whose earnings have not properly reflected the market value of their labour. For example, by holding the value of the RMB at an artificially low level, the cost of imported goods has been held high, meaning that each worker is relatively poorer than they might otherwise be. This has also had the effect of overpricing US labour, such that it is not competitive.

The result of such a policy is that China has protected its domestic manufacturers in the home market, and subsidised their exports through underpricing their labour. In so doing, they are making an investment in the future of China, as the result of the underpricing is that they are able to compete unfairly, by undercutting US companies and putting them out of business. I remember reading an article in the Economist a long while ago that suggested that a country in receipt of subsidised goods should be grateful that they are able to consume the products at a discounted rate. However, the result of such subsidy is to destroy businesses that might otherwise compete with such products.

What we can now see in the relationship between China and the US is a very messy situation. The US owes a huge amount of labour to China, and is unable to pay this debt without a massive retrenchment in consumption. That the US is not facing up to debt, and is increasing debt, is a problem that will simply not go away. Whilst US consumers are now starting the painful process of debt repayment, the government is increasing its debt to attempt to maintain living standards in the US. However, in doing so, the overall debt in labour owed to other countries is still increasing. This despite the fact that the US is both unwilling and unable to service existing debts as their economy is currently structured.

Meanwhile, China continues to under price its labour, and therefore continues to undercut the labour of the US, such that it continues the process of hollowing out US capacity to ever repay the debt. In doing so, it drives the US ever further into a ditch.

Quite simply, when we remove the complications of currency, and think of the debts owed by one country to another in terms of labour owed, the madness of the current situation becomes apparent. It is also possible to see that the actions of governments are quite simply making a very bad situation worse, and that the final outcome - or denouement of the situation - will be ever more extreme.

Note 1: I hope that all of this makes sense. I showed the post to another person before publication to see whether there were any errors in my thinking, and the response was very positive. I am aware that many readers of this blog are very astute, so I will also look to you to identify any problems in my thinking. My concern is that, when expressed this way, the gravity of the situation becomes so profoundly obvious, that I simply must be missing something. I look forward to the comments.

Note 2: I have had some interesting links that are pointing to increasingly negative sentiment for the $US. The link provided by Don Keyes is a good summary of the situation. Is this the start of the $US collapse? Quite possibly...but I have predicted the collapse before and been wrong. Like any sane person, I do not want to see a $US collapse. However, set against this, better sooner than later....the longer the US government and Federal Reserve follow their mad policy, the greater the long term damage to the US and world economy.