Green Shoots of Reality

As time moves forwards, it is possible to see that the mainstream media eventually catches up with the underlying realities of the current economic situation. It is interesting to watch how they take cautious steps, with a few commentators daring to speak the unspeakable, before eventually the rest of the 'herd' follows suit.

We are once again at a point where this process is accelerating, and the realities are starting to finally sink in. In this particular case, the solvency of the US and UK are now finally being questioned in a trickle of articles, hyper-inflation is being considered seriously, along with the end of the $US as a reserve currency.

The first article that is of particular interest was passed on in a comment on my last post by 'anon82', and is an article by Willem Buiter. I have highlighted this article as the author is part of the financial establishment, and therefore his opinion might be considered to carry a considerable weight. Throughout this crisis, he has veered a fine line between the delusions of conventional economic wisdom, and the heresy of accepting economic reality. In his latest article, he discusses the state of the UK economy, and is effectively accepting that the UK is structurally bankrupt. I strongly recommend the full article, as the excerpt below does not do the article justice:

As the government deficit explodes over the next few years, the actual primary surplus is likely to be primary deficit of around 8 or 9 percent of GDP. As the economy recovers, tax receipts will rise and cyclical public expenditure will decline, but the rest of the public expenditure programme (health, education, pensions) will keep on rising in real terms and as a share of GDP. It is easily conceivable that when the output gap is closed again, in 4 or 5 years time, there will still be a primary deficit of five or six percent of GDP. That means that a permanent reduction in the primary deficit will be is required of between 6.5 and 7.5 percent of GDP.

Essentially, Buiter has realised that the government is simply spending more than it can ever repay, and is accepting that the only realistic way out of the problem is to inflate away the debts. However, even with such an analysis, he is still not fully understanding the severity of the structural problems, as he still overestimates the underlying position of UK GDP. He is not accounting for the fact that, even now, GDP is being flattered by the activity that follows from the government's ongoing massive borrowing. As regular readers will know, GDP measures economic activity, which includes the activity created by debt based consumption (if this is new to you, you may want to read this post from October 2008).

I first wrote of the UK being structurally bankrupt in July 2008, and expected that the market would quickly realise that this was the case (I thought it would take six months). The point I was making in my article was that government deficits were going to balloon. I realised at that time that, as the downward economic spiral took place, revenues would collapse and expenses would explode. This would combine with a structural deficit, and plunge the UK economy into a deep crisis as creditors to the UK took fright.

At the time I wrote the article, I had not imagined the extreme policy that government would take in reaction to the crisis, and now believe that the final outcome will be worse even than I envisaged at that time. However, the important point about Buiter's article is that he is starting to recognise the structural nature of the problem. He is starting to see that this is not a short term economic crisis but rather a crisis in the very structure of the economy.

Buiter is not alone in starting to question economic assumptions. I have long been highlighting the similar points about the US economy as for the UK economy. Ever more analysts are likewise starting to question the sustainability of the US economic policy, and this questioning is emerging in the mainstream. In particular, the bland acceptance of the reserve status of the $US is finally being questioned, which has been a theme of this blog. In January of this year, I devoted an article to the subject - a response to reading on so many occasions that the reserve status of the $US would save it from collapse. It is not a post that is amenable to a short quote or summary so, if you have not read it, you may wish to read it now (see here - it is a long post!).

Since writing the post I have been tracking the moves of China to replace the $US with the RMB as a reserve currency (e.g. here). The latest news is that that Russia is again proposing development of a new reserve currency (SDRs - see here) to the BRIC economies (Brazil, Russia, India, China). The $US was immediately hit by the talk, indicating the inherent weakness of the $US.

The important point here is that there is now an acceptance that the reserve status of the $US is not a fixed feature of economic reality. Reserve status needs to be rooted in underlying economic strength if it is to be maintained, and more and more questions are being raised about the nature of the US economy. For example, there is a recent article in the Wall Street Journal that asks 'Is Your Portfolio Ready for Hyper-Inflation?', and in another article by CNBC, the many risks in the US economy are laid bare. In other words, the talk of hyper-inflation is seeping into the media, along with the increasingly dire prospects for the US economy (I have long been discussing the potential for hyper-inflation e.g. December 2008).

What is finally happening is that the mainstream media are starting to accept that the current activity of government and central banks will, in the end, have negative consequences. It is no longer a few lone voices - bloggers, conspiracy theorists, and the occasional maverick - but mainstream commentators, nation states, politicians and economists who are increasingly questioning the sustainability of the Western economies.

I have previously written about the mainstream 'getting it', in the follow on from the UK budget. However, the endless talk of 'green shoots' drowned out the cynicism. What we are once again seeing is the 'green shoots' of acceptance of reality. I suspect that this time the momentum, and the withering of the green shoots of recovery, will carry the acceptance of reality further forwards into the mainstream.

I have just completed an article for Huliq and a further article of Trade and Forfaiting Review (both submitted today for publication, so not yet available). The two articles take very different approaches, but both emphasise that something profound has taken place in the world economy. That profound change has been the theme of this blog.

Whilst it is positive to see that the mainstream are now finally accepting that the situation, and the responses of government, are leading towards disaster, the problem remains that they are still fixated on the wrong explanations for the economic crisis. In particular, they still actually believe that the financial crisis caused the economic crisis, rather than seeing that an underlying economic crisis caused the financial crisis.

This is a matter of ongoing concern. Without an accurate understanding of what went wrong, of the underlying causation, a recognition of the severity of the situation will still not necessarily lead to solutions that might resolve the crisis. In particular, there is a need to recognise that the entry of China and India into the world economy has seen the world labour force double, and that such an input of new labour (one of the key inputs of economic activity) is at the heart of the crisis. As I have explained elsewhere in this blog (e.g. my most recent discussion can be found here, or an earlier discussion here), this has created an era of hyper-competition, and the traditionally wealthy countries have yet to adapt to this situation.

As such, whilst it is encouraging to see that there is a greater acceptance of reality, there is still a risk of continuing to pursue solutions that fail to address the underlying problems. In particular, the only long term solution is to adapt the economies of countries like the UK and US to meet the challenges of hyper-competition. The only way that might be achieved is through deep structural reform of the economies. As Buiter recognises in his article, there will be strong resistance to such reforms, but without such reforms there can be no eventual recovery.

In short, the recognition of the depth of the crisis is a start, but there is still a long way to go before we might start to see solutions that might make a real difference. My worry is that it will take the full severity of the crisis arriving before the world finally addresses such solutions. I further worry that, at that time, it will be too late.....

As Expected £Sterling Tumbles

It would be hard to have missed the furore over the recent comments of Alastair Darling. In the original interview he said:

'Britain is facing "arguably the worst" economic downturn in 60 years which will be "more profound and long-lasting" than people had expected'

Regular readers of this blog will know that I will applaud such frankness and recognition of the economic reality that is now confronting the UK. It is not that the loss of confidence that such a statement suggests is a good thing of itself, but rather that the people of the UK need to be prepared for the changes that must be made to the way in which the UK economy is structured. I have already made some suggestions for ways in which the UK might be restructured, for example in health, benefits and education. The big question remains as to whether anyone will grasp the reality of the necessity of change, or whether the politicians will retreat into populist 'head in the sand' measures.

Of particular note in the furore that followed Darling's statemnt was discussion of whether he was making a comparison with the right period of time. A good example of such discussion can be found in the Times. As is usual, what all of these commentators are missing is the profound and unique changes that have occured in the world economy, notably the massive increase in the supply of available labour. As I have discussed before, we can use the past as a starting point in understanding the economy, but we also need to be aware of the particular circumstances that apply in each case. No situation is ever the same, and until the economists and politicians wake up to the real differences this time, then nothing will be done to resolve the problems.

One of the outcomes of Darling's comments has been to accelerate the fall in the £sterling. The £GB is falling against the Euro, the Yen and the $US, and is likely to fall further relative to these currencies. I emphasise the word relative, as both the Euro and $US will also come under pressure, as the inevitable adjustment in the world economy continues (the Yen may be more stable). The £GB will just be in a situation where the weakening will be greater than the weakening of the other currencies. The curious point here is the mindset that the $US, £GB and Euro (and the Yen) are measured largely one against the other, but that it will be how these perform against other currencies that will really matter. The weakening of all of these currencies will not make sense unless they are measured against a wider basket of currencies, in particular the Yen and RMB (the problems of the RMB I have detailed elsewhere).

Meanwhile the UK economy is plunging further into gloom, almost exactly in line with my predictions. As each day passes, the headlines become more and more gloomy. For example, in the Times they report that mortgage approvals have sunk 71% to an all time low. A Guardian columnist has the following to say:

'Adding to the gloomy picture, a CIPS survey showed today that the manufacturing sector shrank for the fourth month in a row. Mortgage approvals fell to 33,000 in July, the lowest since the data series began in 1993, according to Bank of England figures released this morning. House prices fell in August for the eleventh consecutive month, according to a separate report from property consultants Hometrack. '

I have, of late, been making less posts than in the past. This is in part because the progress into economic collapse is very much in line with my previous predictions. I am in a situation where I am now just watching the inevitable collapse of the UK economy. The remaining question marks are when it will be that the UK economy will sink far enough to need the support of the IMF, as I predicted some months ago. The UK is structurally bankrupt, and it is just a question of when, not if, the UK will need support. The other question mark is when the next credit crisis will occur, at which time there will be several bank failures.

It is very likely that the current plunge in confidence in the UK economy is the beginning of the end. As I have discusssed elsewhere, confidence is the magic commodity of economics, and loss of confidence is the precursor to the collapse of the banks and the precursor to a 'cap in hand' visit to the IMF.

There are several outstanding questions that I have not yet covered and the state of the Chinese and Indian economies will need to watched carefully, as there is still a question mark over how these will fare in a situation of falling demand for their export of goods and services. In particular, there is potential for unrest in China if Chinese growth stumbles with the fall in Western demand. China is balanced on a knife edge, but I still feel that the Chinese government is in a position to ameliorate the fallout from the damage being done to the OECD economies. However, regular readers will know that I am very cautious on this issue.

The other question that needs some attention will be the supply and price of commodities. The world economy has metaphorically bounced back from the wall of commodity restraints, such that demand will fall back for a while yet. I have, for example, predicted that oil will continue to fall back in price over the next two years (wars and other potential blocks to supply allowing - I add this in light of Russia's recent behaviour). However, the overall trend in demand is going to increase upwards in the coming years, and the question then is at what point we will next hit the commodity wall. My best guess at the moment is that we will hit the wall again in about 3-4 years time. Key in this will be the growth in supply, so this needs to be watched carefully. However, in the current state of adjustment, the world economic system is going to go through a period that may be described as chaotic, such that any such prediction is dangerous (e.g. if China falls into unrest, then what will happen to the economy in China?)

I have several posts that are still outstanding. One of these is a review of UK government spending, another is the position of Japan. However, I would also like to continue with some solutions to the structural problems within the UK. As such, I will try to address the problems of regulation in the UK economy for the next post, provided that there is no compelling news that deflects me from this aim.

Are the cynics 'Doomsters'?

I have had another interesting comment to one of my posts, and I will reproduce the key parts below:
-------
'I have recently been discussing the economy with a friend of mine and I find it quite frustrating that whatever I say about the problems we face, he is of the view that the economy will be back to normal in a couple of years. I suppose what I particularly don't like is:

(a) It implies that he has some wisdom that I don't have. I'm just responding to the 'doomsters'.
(b) He sees nothing peculiar about ordinary people earning more money from their house than they do from their job, and that this is perfectly sustainable.
(c) He does not share my wonder at just how lucky we are (were) here in the West.'
---------

I like this comment because those of us who are cynical about the UK economy have probably had similar conversations.

Dealing with point (a) first, this is the idea that, somehow, the so called 'doomsters' are just bleating on about nothing. The root of such thinking is the complacency that comes from the attitude that, just because we have been doing well in the past, we will do well in the future. The UK has had a successful economy, and has been very successful, so there is nothing to argue with on this point. However, the question to ask of such people, making such assumptions, is on what basis would past performance guarantee future performance? The key part of this approach is to ask what it was in the past that created such economic success.

It is at this point that our friend may start to scratch his/her metaphorical head. It is actually not a simple question. If we start to examine it, we will start to consider at what point our economy did become a success, and need to ask why this happened, and why it continued to be such a success. The question gets really complicated.

One virtual certainty in the foundation of the success of the UK economy was that we led the industrial revolution. The trouble is that the reasons for why the industrial revolution took place is still a matter of some debate. If we then start to ask the question of why we continued to be such a success, the question becomes even more complicated. What does it take to make a country an economic success?

Of course, if there were a formula, then every country would be following it. As such, just in asking the friend the 'why' questions should, of itself, start to undermine the sense of complacent certainty that he/she holds. If we can not even agree on what made the UK successful in the past, on what basis can we be certain of success in the future.

At this point, it might be worthwhile to point out to the friend that, even if we were to be able to identify the cause of past success, and we could demonstrate that we were doing the same now as we were in the past, would our past approach work in the different world that we live in today?

It is only when these questions are asked that the complacency of such thinking really becomes apparent. Furthermore, when we do consider the changes that are taking place in the world economy, the lack of clarity of thinking of such optimists comes into stark relief. In particular we are now going through a revolution just as profound as the industrial revolution, in this case the IT revolution, and we have still not yet felt the full impact. To understand how such changes can have an impact, a good starting point is the humble clock. This simple piece of technology was a necessary antecedent for the industrial revolution, as time keeping is central to modernity. Just think of a railway timetable, the shift system in a factory and the impact of this taken-for-granted technology becomes clear. As another example, if we think of the introduction of electricity, it took many years before all of the impacts were felt, and many of the impacts were unexpected. For example it became to build single storey factories rather than multi-storey, creating a series of improvements in the cost of building a factory and also offering gains in efficiency in many industries.

On top of the technological changes we also have changes in the shape of the world economy. In the past there was, to put it simply, less competition. We now have new economic challengers in China, India, Russia and Brazil (the BRIC countries - I believe that in one of my last posts I may have missed out Russia - apologies for that), as well as the many other emerging economies. It is argued that the rise of this competition is, in part, due to technological change, a point of view that I will not disagree with. However, whatever the source of this change, the reality of the change is inescapable.

As such, if you have a conversation with a friend who exudes the complacency that it will all be OK just because it was OK in the past, I hope that my suggested line of questioning will give them pause for thought.

As for point (b), a few questions are again called for. If a person is earning more in a year from the increase in the value of their house than from their salary, what is the actual source of this wealth? Where does it come from? What source of growth is generating sufficient wealth to make such a massive increase in the value of an asset? Another way to ask the question is to ask what kind of wealth is the UK producing more of in comparison to the past. Is it manufacturing output or productivity increasing (in the case of productivity, it is increasing enough to justify this increase in wealth), is it an increase in the extraction/processing of commodities, are we selling more services overseas than previously, are we exporting more, are we attracting more tourist money than we spend as tourists ourselves, and so forth.

The answer that you may receive is some muttering about services, or the city. However, if we look at the value of services we have to remember that these are redistribution of wealth (this is too complicated to explain and justify here - see my essay 'A Funny View of Wealth' if you wish to grapple with this complex subject), not creators of wealth (excepting where the services are sold overseas or to tourists). If we look at the city, yes it has grown in wealth and power. This is reflected in the trade statistics that show an uplift in the balance of payments for services. However, on looking at the numbers, it becomes apparent that this is not significant enough to explain this apparent rise in the value of a property.

What all of this translates into is one big question mark over the source of the apparent increase in wealth. In order for an asset to rise in value (in a sustainable way), something must have generated the wealth such that people can afford this. The alternative is that people must be getting poorer as, if the cost of living in a home has increased, without an increase in wealth to support such an increase, then people are having to spend more for the same, at the cost of less wealth to use elsewhere (I would also like to cover the supply and demand issue, but that is again too large a subject for this brief review).

As for the final point (c) I had a similar conversation a few years ago regarding our good fortune. The person reacted very poorly when I suggested that we were the luckiest people in history - to have been born in the late 20th century in the Western world. I was told at the time that this was arrogant. Even now, I am very puzzled at this reaction. In my mind this was a simple statement of fact. We have long life expectancy, healthcare, excellent economic opportunities, security from most external threats, freedom and so on. Even now I find it odd that this would be a contentious point.

However, having said all of this, I am not sure that we can take all of this for granted any more. As I have already suggested, the world has changed and is still changing. The rising power of the East is a fact of life, and the impact of that rise is only now becoming apparent. It is for this reason that I argue against the complacency that seems so prevalent. Just repeating that 'it will all be OK' will not make it so.

So what is to be done?

So what is to be done to fix the UK economy? A perfectly fair question, you might think.

However, the problem is that it is too late to fix the problems that are now occurring. There is no magical legislative wand that can magic away the structural problems in the UK economy. It is the idea that such a magic wand exists that is part of the problem. What can be done is to put in place the infrastructure to allow a recovery in the future. The problem is that such infrastructure would require politics and politicians with great bravery, and such politicians do not seem to exist. Instead of facing the reality of the world that we are now in, they pretend that nothing has changed. Such an approach is reassuring in the same way that rushing towards a cliff in a car with no brakes is reassuring. Whilst the driver claims that there is no cliff, that does not make it so.

The first step in reforming the UK economy is to recognise that the world has changed. During the period that we built the current infrastructure the level of competition in the world was far less than it is now. Even the entry of Japan into the world trading system can not be compared with the entry of the so called BRIC economies (Brazil, India and China). The entry of these countries into the system of world trade has created a huge surplus of cheap labour, and the western world has to accept that these economies can not be ignored.

It is not just their cheap labour that creates the threat. It is also the relative freedom of their businesses from regulation and interference from government. A few years ago, I saw the cost model for a range of products with a direct comparison of costs in China and France. In China the products were significantly cheaper but labour costs only constituted about 5% of the cost differential. The rest of the cost difference was built into the entire structure of the economy.

The answer that is commonly provided to solve this problem is that the western economies need to move up the value chain. We can provide the services that support the BRIC manufacturing base. We can do the product design. We can offer our skills in marketing, or consultancy and so on.

This is the great dream that ignores the reality. As the BRIC countries go on expanding their manufacturing, the services that support such wealth creation will naturally move to be nearer to their customers. That means the banks, the legal services, the designers, the marketers and so forth. They will not reside in the UK, the US, or France. They will follow where the money leads. For example, if we take the idea that design can be done in UK and manufacturing done in China it is completely unrealistic in the long term. Good design needs to include an understanding of the manufacturing process, to maximise the resources and technology available. If manufacturing is moved to China, over time, that knowledge will be lost in the UK, but will be gained in China. It is a recipe for long term decline. The same can be said of many of the ideas for moving up the value chain, whether it is consultancy, accounting or any of the other 'strengths' in the Western economies.

However you look at it, for any medium to large sized country, you need a base in manufacturing. Without such a base it will be impossible to remain a competitive economy.

So how do you encourage and maintain a manufacturing base? Here is where the real problem resides. The question to ask is why is so much manufacturing moving to the BRIC economies. As I have already mentioned, it is not just cheap labour, although that is a part.

The real key is that governments have piled huge amounts of legislation on top of companies, such that they are hobbled and no longer able to compete from a base in the UK. A crude example of this is the minimum wage, which tells an employer that they have to pay a wage that may be uncompetitive if they wish to manufacture in the UK. As a result, jobs and wealth are lost to the UK, and instead of productive people the UK has a huge roll of unemployed (and often unemployable) individuals. This adds cost to the government who have to pay for the unemployed, and that cost is passed onto the companies in the form of taxation. How can this make sense? No doubt, some economists will reel out statistics to say 'it ain't so', but simple reason would tell you that, whatever anyone says, if you are competing on labour cost, a minimum wage hobbles the ability to compete.

What of all of the other employment legislation? I worked on a project that was looking at the cost of the European Working Time directive for road transport companies. This crazy piece of legislation had a shocking effect on the costs of companies. The cost of recording and managing the information was quite startling. Furthermore, the rules did not allow drivers to work as they wanted to work, but restricted their freedom, and thereby restricted the flexibility of the businesses. It seems that the European Union knew better how much they needed to earn than the drivers did (it should be noted that safety was already protected through other legislation).

This example is just one example of interfering legislation that both removes the flexibility of labour, as well as imposing costs. The question is; for what? It is not entirely clear what this legislation achieved, except in generating huge costs for all those required to implement it, and to restrict the earning potential of drivers.

Another labour cost is one that is outlined in my essay 'A Funny View of Wealth'. This is the idea that the welfare system already creates an alternate minimum wage. I have quoted a section of the essay below:

'As mentioned before, all things in the UK are not equal due to the minimum wage, but also because the UK employer needs to compete for labour with the UK benefits system (which is an indirect minimum wage that applies to anyone entitled to social welfare benefits). This system allows an individual to remain economically inactive, or to choose an option of accepting a low paid job for very little real remuneration despite a major increase in the expenditure of their labour. In such cases the value of the labour expended is far below the minimum wage as it needs to be calculated as the weekly pay minus the benefits, to give an actual wage for the work done. The rational person in this situation might reasonably ask whether the loss of their free time to work is worthwhile for what will often be little financial incentive as, in this situation, the UK worker is often working for extremely low wages'

I will not address this subject further here, as it is a subject that requires a more detailed review which I will deal with on another occasion. What is worth noting is that the welfare state has now become the 'burden state'. It is no longer a safety net, but an alternative to productive activity.

For the moment, I am just addressing a couple of the problems in the structure of the UK economy. I am very aware, as I write, that this is not a subject that can be covered in a single, off the cuff, post.

As such I will call a halt here, and start addressing some of the concerns in a series of posts over the coming weeks or months. For the next post, I will take a detour, and give an example of where government money is being spent to 'help business'. I think that you will agree that it is a sad and rather pathetic tale, and I hope that you will agree that it highlights the stupidity and waste of government.