Can the Economics of the Past be used to Predict the Economic Future?

I have had several comments on my posts and, time allowing, I will try to respond to them. One interesting question was:

'I suppose we are used to economic cycles, with booms and busts of varying degrees. Are you saying that this time it's going to be very different? Has anything similar happened in history before?'

I would hope that it is apparent from my many posts that this time it will be 'different', at least in the sense that it will be different from the economic cycles that we have been used to. The point of my posts is to say that something has changed profoundly, in particular there has been an economic shock in terms of too much labour in relation to the available commodities. In particular the amount of labour has increased without the commensurate increase in commodities necessary to make all of the labour productive. In this case, until commodities catch up, there will be a redistribution of wealth. Whilst capacity constraints in commodities are nothing new, the unique factor here is the massive input of available labour. Globalisation has allowed capital to move freely, and this has allowed a large amount of new labour to become potentially productive. This has created an oversupply shock.

It is worth noting at this point that I have predicted that oil prices will fall back. How can I square this with what I have said with regards to commodities and labour? The answer is that, until the point is reached where the economies are sufficiently rebalanced, there will be turmoil in the world economy. One of the elements that has unbalanced the world economy has been the supply of finance into Western consumption. This had led to a poor allocation of capital into the West, and the world economy will fall back until the damage done by the credit bubble is corrected. In the interim, commodities will fall back as the West contracts, but demand will again pick up as the East continues growth in a couple of years time. However, as the East grows again, the West will stagnate, for the reasons set out in 'The Root of the Problem'. As the East continues expanding it is likely that the world supply of commodities will continue to bump up against the metaphoric brick wall of supply constraints, with supply continuing to lag growth. All of this assumes that there will be stability in the world trading system, which is not guaranteed. There is a real possibility of a retreat into protectionism in the next few years.

There is a further question asked in the comment as follows:

'In our current situation are these experts' views valid in any way, shape or form?'

This question relates to the use by experts of previous bear markets to predict the current market. My answer is that my opinion is just one of many. If you are looking for investment advice, the majority view would be that you should listen to these experts. On the other hand, you may wish to take my views into consideration. I do not think that the state of the world economy is comparable with the past, and therefore the 'expert' predictions are built on foundations of sand. All prediction is based upon past experience, but I believe that past experience is only a guide to current situations, and needs to be tempered in light of the fundamental differences of the current situation. To date I have not seen any acknowledgement of the shock of the oversupply of labour, so I am very dubious about most predictions. The oversupply of labour into the world market is (in my mind) what has really changed, and changes the entire dynamic of the world economy. Until the experts grasp this, they are missing a vital element in appraising the economic situation.

I have also had a question from another person who has posted anonymously. The question was regarding the prospects of Thailand, China and Brazil. I have discussed China elsewhere and have admitted that there are many question marks over the future. In particular, if China suffers a drop in exports (very likely) then will it be able to maintain social stability? Has it reached the point at which it can grow without export led growth? There are also possibly imbalances in the Chinese economy to factor in, but otherwise there is no reason why China will not continue to grow, and grow fast (with maybe a blip in growth in the next couple of years). As for Brazil, I will have to confess insufficient knowledge to have a strong opinion on the future. For Thailand, there is no reason for it not to continue to grow but, in Thailand, the real constraint is political risk. It is basically a very unstable country, and therefore the consideration is primarily political risk.

This brings me to the subject of political risk which I have alluded to throughout this post. Globalisation has had an astounding effect on the world. One of those effects is that a huge number of people have been raised out of poverty. Few would argue that this is not a good thing. The problem that has arisen as a result of this, however, is that there are now imbalances in the world economy. We are now in a situation where politicians, in particular in the West, will need to address these imbalances. As the West is pressured by the competition of the emerging economies, there is a real likelihood of demands for protectionism. If this happens, the turmoil will increase further. The problem that really arises is that we are entering into a period of world instability. As much as we would like to think otherwise, economics is the great driver of events.

If a situation of economic turmoil arises (as I have predicted), then political turmoil will surely follow. I have already mentioned this in relation to China. However, this political turmoil is likely to become more pronounced over the next couple of years, and everywhere will be effected. The question in my mind is to ask how politicians around the world will deal with the problems that are arising. It is here that the problems start, as this largely depends on the nature of leadership, and how the leaders will deal with crises. It is very difficult to say how they will react, but I am rather gloomy about the situation.

The basic point that I am making is that the problems of the world economy are now set in place. There is no reversing them and, one way or another, they will now permanently change the structure of the world economy. However, there is no way of telling what the final change will be, as this is now in the hands of individuals. We can sketch out general scenarios, but can not make predictions.

One scenario is that the trading system remains open, and that the rich world responds to the entry of the emerging economies by reforming and meeting the challenge. Another scenario is that the rich world retreats into protectionism, and that the world economy sinks back. Yet another scenario is that the turmoil will create social unrest, and the response will be conflict. All of this depends on how individuals respond to the challenges that are arising. There are more scenarios that can be proposed but I hope these illustrate the potential for varied outcomes.

In such a situation, I would be very cautious about predicting whether China, Brazil or Thailand are good bets. The only certainty is that counties such as China now have a large part to play in the world economy, but whether that is a stable rise or a chaotic rise is a matter that can not be predicted.

You may gather from this post, that I find the current situation very worrying. This would be to understate my concern. Returning to the first questions (using the past to predict the future), we do have worrying precedents to the current situation of economic instability. The situation today is unique, but the idea that economic instability creates political instability can be carried forward as a general principle.

The shape of the world has changed, and is continuing to change. At present the majority of economists and politicians have not fully grasped the nature of the change and that is a dangerous situation. As the current economic crisis unfolds, I will do my best to give a view on how it will impact on the world economy, and what I believe should be done to ameliorate the crisis. However, the situation is going to get ever more complex in the coming years.

China - What Future?

When you visit a Chinese bank, you will likely be presented with a series of buttons that you can push so that you can rate the service level of the cashier. The buttons, of course, are there to encourage the cashiers towards good service. The reality is that the buttons should be marked from 'surly' to 'downright obnoxious'. The state owned banking systems, despite the best of efforts, remains unreformed.

It is only a few years since the Chinese banking crisis, when the Chinese government bailed out the banks and placed their mountain of bad loans into a special fund. My question is; has anything changed since then?

The answer, in the opaque world of Chinese business, is that no one will know until the government decides it is time to know. In a previous post I pointed out that the Chinese construction boom may be a bubble. In particular, large numbers of apartments are being built, and individuals are investing in them only to leave them empty. One of the curiosities of Chinese property is that, as soon as a person has lived in an apartment, the value of the apartment falls. The result is lots of investors are leaving apartments empty in the hope of the value of the apartment increasing. This looks very much like a bubble.

In addition to apartments there are the endlessly multiplying malls and department stores. In an expanding economy, it may be that there is a real demand for these. The question is whether there is the demand for the numbers that are being built. I can only comment on the city I lived in (Xi'an), but it did appear that the construction was already outstripping demand and that this did not seem to deter new construction starts.

In light of this, I must conclude that there may still be some suspect lending from the Chinese banks. This is pure speculation, but is based on experience 'on the ground'. This raises the possibility that there is also bad lending into business, in particular to the state owned firms. Such lending is not so visible, so it is impossible to say if this is the case. However, if there is bad lending into construction, it is not too great a leap of imagination to think that other lending may also be bad. Having said this, if it does go wrong, if the banks have been lending poorly, then the Chinese government has the finance and will to bail out the banking sector. As such, whilst a risk to the Chinese economy, the danger of bad lending is more that it will hurt the economy, rather than a banking crisis destroying the economy.

On the other side of the equation there is a growing, and aggressive private sector, often managing to grow their businesses without any help from the banking system. Go to a Chinese province such as Guangdong, and you will see the reality of such businesses. For example, I lived for a while in a city called Zhongshan, which is now supplying the majority of the world's lighting. Just outside the main city is a town with literally hundreds of factories all devoted to manufacturing and selling lighting. It presents international buyers with an incredibly competitive one-stop shop. As for lighting in Zhongshan, the same for many other markets. They nearly all have similar clusters.

In effect China is creating clusters of excellence, where whole cities or districts are specialising in particular products and markets, and doing so in a highly competitive way. This allows all of the benefits of network effects, whilst creating an environment of incredible cost efficiency. Each cluster generates its own supporting infrastructure, and economies of scale. Each firm is continually looking at its neighbour, and any new technology, new process, will spread rapidly through the cluster.

This kind of arrangement is very common, and may be part of the reason for the success of Chinese manufacturing. It has certainly turned China into the old cliche of the 'workshop of the world'. We are now all aware of the resulting exports.

The big question for the future of the Chinese economy is how their economy will cope in the coming recession. If we think of the area of Zhongshan that manufactures lights, what will happen when the export orders start to decline? We know that, in a housing market downturn (crash) less people will move house (a time at which people are likely to buy lighting), and that there will be less house building, less office construction and refurbishment and so forth. Export orders will certainly decline.

It is at this point that we come to a big question mark.

The Chinese economy may, or may not be, at a point where internal growth within China has the potential to take up the slack. Has it yet reached that point? It is very difficult to say. It is a finely balanced point, but the economic growth of the coastal areas is now being replicated in the interior. Can the growth in the interior maintain the momentum of the coastal cities? The Chinese government has huge reserves to draw upon should the economy falter, and may seek to use those funds to further develop the interior of the country. There is also an ongoing and dramatic process of infrastructure investment which may help carry China through the bad times.

Furthermore, China has being making ever stronger inroads into markets such as Africa, and South America. Whilst these can not replace the US and European markets, they may serve to ameliorate the effects of a downturn.

As you will note, there are many question marks here. There are many 'experts' in China trying to wade through the piles of figures trying to see what will happen with China. The trouble is that many of the statistics are either opaque or suspect. In this situation, it is just as well to rely on intuition.

In one respect, if China remains stable, we can be sure that China will continue in growing its share of the world export market, even if the size of the market overall declines. China, as has already been mentioned, has benefits of scale. In addition to this, it still has a large untapped pool of labour which will serve to provide labour for growth for many years yet.

In the point above, I have mentioned stability. This is one of the big question marks over China's future. The Chinese government relies upon economic growth and nationalism for its legitimacy. If the economy does falter, and this brings hardship to the rising Chinese middle classes, then there is real potential for instability. With over 100 million often discontented migrant labourers, disenchanted ex-military (traditionally they leave the military and go straight into a comfortable job in a state owned enterprise, but this has stopped), even more disenchanted peasant farmers, all that is needed is a discontented middle class leadership to create an explosive situation. And a spark.

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).

Note: I am sure that many readers would want a more firm outlook for China. However, in the case of China, sound information is lacking. As such, it is difficult to see how anyone can really predict what will happen next. The worrying part about this is that China is increasingly important in the world economy, and therefore what happens there is of great importance. Such a large question mark means that policy formulation becomes less certain.