The Fiscal Beauty Contest Starts

The realisation that endless government borrowing could not be sustained really started with the (still unfinished) Greek crisis. As the risks of sovereign debt became apparent, risk aversion, and sometimes panic, have gripped the markets for government debt.

In the title of this post, I mention a beauty contest. However, in some respects, what we are looking at is not a fiscal beauty contest - but a fiscal 'least ugly' contest. I proposed that the world was about to enter a beauty contest some time ago as, whatever happens, many of the major debtor nations are going to have to keep borrowing for a while yet, and that means ongoing access to credit. I highlight this, as it looks like the UK is about to embark on a path of radical change in fiscal policy, with a firm and decisive attempt to seek to deal with the UK's fiscal problems:

George Osborne braced the country for cuts in government spending of up to 20 per cent as he laid the ground for an austerity programme to last the whole parliament.

The Chancellor announced an unprecedented four-year spending review in which every Cabinet minister will have to justify in front of a panel of colleagues every pound they spend.

Mr Osborne said the task ahead represented “the great national challenge of our generation” and that after years of waste, debt and irresponsibility it was time to rethink how government spent its money.

There is, of course, a huge gap between rhetoric and achieving action on the ground, and this means that such announcements need to be treated with caution. The inspiration for the fiscal retrenchment is Canada in the 1990s, and the process will involve a careful review of each element of government expenditure, including asking the vital questions of whether any activity might be necessary or contribute to the economy overall. Whilst a similar process worked for Canada, this was undertaken in less stressed times, so that it may be more difficult to emulate the Canadian example than might be believed.

The interesting point about the case of the UK is that they are increasingly faced with little choice but to cut back savagely. Whilst not personally having any respect for the ratings agencies, I nevertheless accept that they impact markets. As such, the latest from Fitch highlights the necessity of action in the UK:

Britain's debt problems returned to the spotlight Tuesday after Fitch Ratings warned of the need for bigger austerity measures in a report that rattled investors but could help new Prime Minister David Cameron justify severe spending cuts to a worried public.

In its first major statement since Britain's Conservative and Liberal Democrat parties formed a coalition government last month, Fitch warned the U.K. "faces a formidable fiscal challenge" and needs to be more ambitious in cutting its debts. The warning comes as new U.K. Treasury chief George Osborne prepares on June 22 to unveil emergency measures to cut Britain's budget deficit, which at more than 11% of gross domestic product ranks among the largest among advanced countries.

The point of the Fitch report is that, in the least ugly contest, the UK still has a long way to go. However, as each country seeks to beautify their balance sheet, the pressure on other countries to follow suit will increase. In other words, even if the UK seeks to be fiscally sound, other countries will be forced to outdo the UK, as they too seek further funding. This is from the same article quoted earlier:

"As more European countries respond to market pressure by tightening fiscal policy more aggressively than originally planned … there is a risk that the U.K.'s existing deficit-cutting targets begin to look distinctly weak," Fitch analysts said.

This coordinated shrinkage in debt growth follows the coordinated growth in debt, or going from feast to famine. Whilst the view of this blog has always been to recognise the dangers in the growth of debt, and the absolute necessity to reform to fiscal responsibility, the coordination of the fiscal consolidation over so many economies presents significant dangers. In particular, the consolidations will force a drop of activity over many economies simultaneously, and with that drop in activity, each country that consolidates will see a major drop in imports, further ratcheting each economy down.

This potential systemic shock over many economies risks a collapse in confidence, and therefore a hard economic 'undershoot'. By this, I mean that the drop in activity will in turn undermine confidence more broadly than the real consequences of austerity might reasonably point to. This might further ratchet down economic activity. Just as the debt fuelled activity created massive over-confidence, the collapse in debt driven 'growth' might create under-confidence. And to add to the potential nose-dive, there is the talk of fiscal retrenchment in Japan:

Despite the prime minister's hair-raising words [that Japan will face a sovereign debt crisis if it continues on the current path], markets did not bat an eyelid, with the Japanese yen, the Nikkei stock market index and Japanese government bonds unmoved.

"Fiscal austerity measures are long overdue," said Chris Scicluna, deputy head of economics at Daiwa Capital Markets in London.

He forecasts that the government's budget deficit will be 8% of GDP this year, a number that Mr Kan has promised to reduce to zero by the end of the decade.

Having said all of this, the current move to fiscal austerity is not as severe as is popularly believed. It might be noted that Japan is not planning to pay down debt, but just slow the accumulation of debt. The same might be said for most of the so called austerity measures, as can be seen in the following chart:

The problem is this. The beauty contest is now enacted, and the only possible result is an ever fiercer spiral of fiscal consolidation, with the effects of this spiralling economies ever deeper into recession/depression. The chart just shows that there is still a long way to go to achieve a realistic and long term fiscal correction. The beauty contest will ensure further measures will change the shape of the chart.

The trouble is that, having splurged in the wake of the financial crisis, having simultaneously strained fiscal positions towards breaking point, there is nowhere left to go. Had it been the case that only a few small economies had built up so much debt, the world economic system might have been able to absorb the retrenchment, albeit with some pain. However, this is not what happened, and the collective market awakening to the risks of sovereign default can not be turned back. Even Japan, with its willing army of domestic savers, is twitching.

Then there is the US. With the 'safe haven' and reserve currency status, the US has chosen to remain on the path of ongoing growth in debt and spending. There is further talk of more more fiscal stimuli. The US is getting into ever deeper trouble, all the time relying on the safe haven and reserve status to last to eternity. In my last post, I discussed the risks in being perceived as a safe haven, and this is the latest news on the US trade situation:

WASHINGTON — The U.S. trade deficit rose to the highest level in 16 months as exports fell for the second time in three months, a potentially worrisome sign that Europe's debt troubles are beginning to crimp American manufacturers.

The Commerce Department said Thursday the trade deficit widened to $40.3 billion in April, up by 0.6 percent from March. U.S. exports dropped 0.6 percent, while imports declined by 0.4 percent.

U.S. manufacturing has been a standout performer as the U.S. recovers from the worst recession in decades. But the concern is that Europe's debt crisis will slow growth in that part of the world and dampen demand in a key U.S. export market.

For April, exports slipped to $148.8 billion, with demand for U.S. farm products falling by $647 million and weakness spread across a number of manufactured goods from electric generators to industrial machinery and aircraft engines.

This latest news serves to highlight the dangers described in my last post, that the safe haven status is a danger to the US economy. The US is in very deep trouble, and the safe haven and reserve currency status are encouraging them deeper into a quagmire. As long as the world keeps buying US treasuries, they seem willing to keep deepening the fiscal hole, all the while importing and consuming based upon debt growth. At some stage, the markets must realise that the beauty of the US has faded, and that in reality it is looking both tired and haggardly. The trouble is, the US is still deeply entrenched in the (neo-) Keynesian dream.

In the world of the (neo-) Keynesians, the answer is not to consolidate, but to continue government borrowing, to prevent a choking of 'recovery'. No doubt, in the future, as the inevitable consequences of the consolidation take place, they will blame the problem on the fiscal consolidation, rather than on the fiscal splurge and consumer debt splurge that preceded it. This despite the fact that this borrowing and spending was supporting an economic structure that could not be sustained...and that the choices of borrowing of the scale needed to support a continuation was becoming impossible. And that is the problem with their solutions, that they can never be proved wrong, as whatever is done, it always necessitates more to be done. If the fiscal stimulus runs out of steam, have another one, and another one, and another one. If it is not working, a larger one will do the trick. If the larger one does not do the trick, then there is an even larger one that might be do the trick. In nobody will lend, print money. If that does not work, just print more.

Their solutions have just been tried, and the result is what we see before us. Massive fiscal stimuli have been tried. Quantitative easing (printing money) to fund government debt has been tried. Despite this, the economic crisis just keeps coming back. The difference now is that we can see where these policies have left the world economy - on the edge of a cliff. They can not claim that the problem is a market failure, as any reasonable economic theory must account for the actuality of markets. That actuality is quite reasonable - the markets think that, if they continue to lend to the major debtor governments, they will not have their money repaid in real terms, or will not be paid due to default. The markets have recognised that there is no clear plan for how the ongoing debt accumulation, and repayment of debt, might be achieved/sustained.

Despite all of the money flooding into the US, the 'safe haven', the doubts about the sustainability of the (neo-) Keynesian approach are mounting. It is only a matter of time before the markets confront the US. With the commencement of fiscal retrenchment elsewhere, and the drive for deeper austerity measures, eventually the markets will turn more cynical eyes upon the US economy. By that time, the US will be even deeper in the quagmire of debt.

I might summarise the position as follows; just as the consumer debt spiralled and unwound, sovereign debt has replaced that debt and must eventually unwind. The nature and the speed of that unwinding is still uncertain. The politicians and policymakers have still yet to fully play their hands, and they will be confronted with resistance from their populations as they seek to win the beauty contest. Set against the governments will be the bond markets, the judges in the beauty (least ugly) competition. Furthermore, in the tangled world of mutual dependency of one economy upon other economies, it is still uncertain where the really weak players in the world economy might be. As the debt accumulation goes into reverse, the dependencies will start to become apparent, and may present some surprising outcomes. However, one thing is certain; whatever the eventual outcome, no country is going to come out of the progressive fiscal consolidation untouched.

Note: I have been planning to discuss the neo-Keynesian approach for a while, but have lacked the time to do the subject justice. I may devote a post to this subject in the future, in particular a response to the volumes of material posted in the comments section by a regular commentator who posts under the name of 'Lord Keynes'. In the meantime, I will leave the discussion as the brief comment above.

Economic Reality - The World Got Tougher

This post is, in part, inspired by some comments on recent posts. There seems to be an ongoing denial of the reality of the current economic situation, and there is a refusal to accept quite how broken the Western economies actually are. As such, I thought I might just pull together a few points to underline exactly how bad the situation actually is.

The first point to make is that this is not the Great Depression that we are witnessing, though the downward trajectory of the world economy does mirror that event in many respects. The nature of the current economic crisis is, however, very different from the great depression. In particular, this crisis stems from an oversupply of labour in world markets. For regular readers, the following (taken from my recent Huliq article) will be familiar as one of the themes of the blog (and regular readers may therefore want to skip this passage):

The story of the economic crisis starts with the opening of China and India to world trade. Whilst both of these countries opened decades ago, it is only in about the last decade that their full impact has been felt on the world trading system. This appears to be a statement of the obvious, but the real implication is more dramatic than you might imagine; the opening of these countries has seen the world labour force roughly double in a period of about ten years.

It might be argued that the labour force has always been there, such that the doubling I propose is an exaggeration. However, in this context I have a very specific meaning for labour. I am referring to labour which is combined with technology, capital, and access to the world market. When seen this way, the increase in the labour supply represents an astounding increase in one of the key inputs into all economic activity.

This of itself might be a cause for the current crisis. For example, a massive expansion in supply would be expected to result in a decrease in the price of labour. As an analogy, imagine if the world supply/reserves of oil was to have doubled in ten years. Such a massive increase in the availability of one of the key inputs into economic activity might create revolutionary outcomes. Oil prices would be slashed, the petro economies would be in trouble, and there might be a deflationary surge and so forth.

However, it is only when we consider the relative supply of one of the inputs against the other inputs that the real reason for the economic crisis becomes apparent.

It is here that we have the real roots of the economic crisis, and where it is apparent that the emergence of countries such as China and India has created a zero sum gain. In particular, the point was reached some time ago where each gain in the economies of India and China means a relative loss in the economies of the traditionally wealthy countries. How has this situation arisen?

I have already identified that the world labour force has roughly doubled in the last ten years. At the same time, there has not been the doubling of the other inputs into the world economy. In crude terms, what this means is that the amount of inputs available to each worker to undertake economic activity has been reduced per capita.

If we take the example of oil, in 1997 output was around 75 million bpd, and output had only climbed to about 85 million bpd in 2007 (a chart here shows the output - not a good source but the chart is usefully clear and conforms to charts from better sources). What we can see from 1997-2007 is an approximate doubling of the labour force, and only a tiny increase in the output of another key component of economic activity.

This quite literally means that the availability of oil per worker has seen a significant decline. In such a situation, there must be a consequence. If a worker in country A increases their utilisation of oil, then a worker in country B will have less oil available.

With regards to other commodities, it might be argued that the output has risen to meet the new demand from the expanded labour force. For example, copper has seen high growth in output from around 11 million tons to 16 million tons, and iron ore output nearly doubled. The problem with such expansion is that it is growth in a period of rapid development of the emerging economies, in which the demands on resources are particularly high. Think of the massive expansion of highways, tower blocks, apartments, airports and factories in China, and it is apparent where such increases might be absorbed.

I believe the logic of this point can not be denied, and I am still waiting for the mainstream to pick up on this. In the article, I go on to explain why this underlying cause led to the financial crisis. It was not lack of regulation, but rather it was the flood of money from the East into the West with insufficient investment opportunities to 'soak up' the money.

Instead of accepting that the world has changed, many analysts insist that a bit of tinkering here and there on regulation might have somehow saved us from the crisis (this has been reflected in recent comments). However, without closing borders, tariff protection, and capital controls, nothing was going to prevent the surge of money into the West from the East. Put bluntly, when any banker is handed large sums of money, they will take it and use it - they will not refuse it due to lack of good investment opportunities. The regulatory environment only had a role in shaping the nature of the inevitable bubble that would form under such circumstances.

Regulation and the financial system has been the focus of the economic crisis, with many referring to the economic crisis as a 'financial crisis', or the 'credit crunch'. Very few analysts and economists are looking at the underlying causes of the crisis, but are instead looking at the symptoms. I think that, in part, this is because the underlying reality is so difficult to accept, and in part because the problem is beyond any simple solutions. I have read the many solutions that are proposed, and they all have in common that they ignore the one single thing that really matters; the competitive position of the West in relation to the East.

For example, Krugman writes in his latest column that all can be saved, if the US government would just increase the stimuli into the economy. My response to such arguments are questions; How can this improve the competitive position of the US? Is it going to make a US textile worker more competitive? Is it going to make a toy factory more competitive? Is it going to make a furniture factory more competitive?

In other words, this does nothing to address the underlying problems. The US and Western economies are less and less able to compete.

In proposing this, he is merely proposing to add to an already unsustainable mountain of debt. Even CNBC 'gets it', and understands that the borrowing is exploding out of control and is unsustainable. They have lifted an AP article in which the level of deficits is as follows:

The country first got into debt to help pay for the Revolutionary War. Growing ever since, the debt stands today at a staggering $11.4 trillion — equivalent to about $37,000 for each and every American.

People like Krugman wish to add to this. This is insane. The figure is per head, not per worker. Included in this figure are the retired and children. Furthermore, the numbers of retired are about to explode as the baby boomer generation starts retiring, and the cost will be huge (source the Economist).




Again from the CNBC article we have the following:

The Peter G. Peterson Foundation, established by a former commerce secretary and investment banker, argues that the $11.4 trillion debt figures does not take into account roughly $45 trillion in unlisted liabilities and unfunded retirement and health care commitments.

In other words, at exactly the time that the Western world is being confronted with new and highly effective competition, the Western economies will need to support a massive fiscal expansion due to an ageing workforce. At exactly the time when the West needs to be saving money for this oncoming fiscal demand, the West is borrowing itself into oblivion. When we see the figures of debt per head in the US, there are going to be ever fewer workers to support that debt. According to the article in CNBC, the 'Interest payments on the debt alone cost $452 billion last year — the largest federal spending category after Medicare-Medicaid, Social Security and defense.'

The important point to note here is this is the figure for last year. The level of debt is rising and, if confidence in the US economy wanes, the cost of servicing this debt will also grow further, as lenders demand higher risk premia.

The most absurd part of all of this is that the economists and governments still measure this massive debt as a percentage of GDP. However, when they measure GDP it includes all of the activity from borrowing. This is a bit like a person measuring their income as their salary and their borrowing. The fact that their borrowing makes them appear more wealthy for the moment bears no relation to their actual income. If I earn £50,000 a year and borrow £10,000 a year I may appear to have an income of £60,000 but nothing will alter the reality that I only earn the £50,000 when I stop borrowing and start paying down the debt. When I start to pay back, rather than borrow, the illusionary wealth I counted in my income will be painfully apparent. I will be poor.

Within all of this debt accumulation and stimuli, the one thing that is missing is any attempt to address the fundamental problem of how the West might continue to compete with countries like China, India and Brazil. Tinkering with bank regulation is simply shutting the stable door after the horse has bolted. Borrowing more is simply digging the deficit hole deeper.

At the root of all of this frenzied activity to 'save' the economies of the West is an outright denial of reality. It is the point that I have made time and time again. How exactly are we going to pay back the debt?

The economies of the West are contracting. There is no plan for how exactly the challenge of places like China might be met. Even as I write, even as more borrowed money is poured into Western economies, the economy relentlessly shrinks, whilst government spending relentlessly rises. With each new tranche of borrowed money that appears in the economy, the potential for competitiveness in the future recedes. The cost of all of that borrowing is that the servicing of that debt must be supported at some point with ever more taxation.

It is like General Motors.

Even during the good times, they were borrowing money, and trying to support the salary, the pensions and health insurance of ever more workers. The trouble is that, the more they borrowed, the greater their costs as the debt mounted. The cost of all the benefits and entitlements, and servicing the debt mountain, was that there was less money for investment in plant and R&D, less money for all of the productive investments that might have kept the company alive. When the management confronted the workers and unions with the fact that the Japanese manufacturers in other states were costing so much less, the response was a refusal to accept the reality of the unsustainability of the position. The management caved in and, instead of addressing their cost base, they simply kept borrowing - until they reached a point of no return.

The difference between the Western governments and the GM management is that the Western governments are not even starting to confront us with the reality. Instead, they are doing the same thing as GM, and continuing to hand out entitlements that can not be afforded - and at the cost of ever growing debt. Another difference is that, in the case of countries, it is not entirely clear who might bail them out when they finally sink.

I think that this is the reason why the underlying cause of the economic crisis is being avoided. It means that we, in the West, must accept what the GM workers would not accept. We are simply uncompetitive. If we carry on as we do, then it can only end in disaster. It is not a pleasant reality to confront. Just as the GM workers refused to heed the reality of the situation, we collectively reject the reality of the situation.

Instead of accepting the reality, like spoilt children, we bleat about our entitlements. At the heart of it all is that we think that we are entitled to our wealth. It has still not entered our complacent minds that, as long as a Chinese or Indian worker is willing to work for half our wage, we are too expensive. Instead we blather on about sweat shops, when most Chinese workers are simply grateful to be given freedom from the grinding life as a peasant on the land. As I once argued with an individual, are you willing to stand outside a Chinese village and turn back the peasants who seek a better life in the cities?

This is the reality. The people in emerging economies want to get richer, and have a life like ours. As time passes by, they are going to take a greater share of the wealth in the world. They are hungry for success and willing to compete with us.

The real question that is not being raised is this; are we willing to compete with them?

All of the actions of government to date mirror the actions of GM. The entitlements continue, the cost base is growing as ever more workers retire. The numbers of retired in need of support grow such that each worker must shoulder a greater burden of retirement costs. The borrowing to support the benefits grows, the cost of servicing the debt grows, even as output and competitiveness declines in a slow death spiral.

How bluntly can I put this?

We are in a competition. We are losing.

To use the metaphor of a marathon race, we seem to believe that we can win the race by putting more fat on our bodies. The fact that this means that we have more weight to carry eludes us. The more that we fall behind in the race, the more we eat...and the more weight we have to carry through the rest of the race.

It is time to grow up and face reality.

Note 1:

I have some quotes from some very early posts which are perhaps appropriate to this article. Many refer to the UK in particular, but apply more broadly to what we have seen, for example, in the US. The point is that, since I wrote these posts, the situation has simply become worse, not better. As the crisis emerged, the underlying reality was apparent. We are not facing the competition, we are refusing to restructure, and refusing to accept that the world has changed. I present the quotes as a progression of frustration:

November, 2007: An economy built on bubbles...

The UK has been seen as a stable and expanding economy, an economic success, and this belief has attracted the inflows of money available for lending. The problem here is that it is the inflow of cheap money that has supported debt accumulation by consumers, and this in turn has made the economy appear so successful.'

November, 2007: The illusions of economists....

I am sitting in China as I write this, and I feel a sense of regret. For the last few years I have had a deep foreboding about the UK economy. In particular my mind has continually returned to the question of ‘where’s the beef’, by which I mean where is the real earning, the real source of wealth in the UK economy. However hard I have looked, I have failed to see it, and now I suspect that the myth of the economic success of the UK economy is about to be exposed. My sense of regret is that I did not write this earlier. The majority of mainstream economists have remained convinced that some kind of economic miracle has been taking place in the UK. Miracle is a carefully chosen word, as it best describes the fact that only a miracle could allow the growth of the UK economy to be sustainable.

November, 2007: How bad it will get....

The situation overall will be a massive contraction in the UK economy, a contraction that will see the UK step back in time in terms of economic development. The contraction will need to be deep and severe enough to reverse the illusory gains of the previous ten years (or even longer), and will require that the UK restructures its economy from top to bottom. It will, in effect, be the most significant crisis to hit the UK since the World War II. The only way out of the crisis will be to alter the fundamentals of the UK economy back to producing more goods and services for export led growth, and away from debt based growth in services. It will be a long, and very painful adjustment that will see the UK lose its place as one of the worlds’ leading economies, and recovery from the crisis will take many years.

June 2008: Refusal to face reality and the delusion of the right to wealth....

Even as I have witnessed all of my predictions being correct, I have felt like a dismayed onlooker watching the progress of a car crash. Whilst my rational mind is observing, my emotional self simply can not grasp what is happening. Basically, like everyone else, it is very hard for me to accept that the severity of this economic crash can be as dramatic as it will actually be. Whilst reason says that this is going to be a disaster, the underlying belief that the UK economy can't just collapse still persists. After all, the UK has had crises before, and always returned to wealth and growth. Surely it must?

I read a very interesting example of this kind of thinking when I was reading some philosophy of science (sorry, I forget where I read it). The example given was a chicken that woke up every morning, and every morning the farmer fed the chicken. As a result the chicken believed that the farmer was a good thing - right up to the point where he chopped off the chicken's head. In the same way we have come to believe that the UK has some right to have the status of being a wealthy and successful economy. It always has been in the past, so why not now? The truth is that a successful economy is not a 'right', but something that has to be earned.

The trouble with the UK is that we expect wealth as a 'right'. It is this same thinking that has infected my thinking, and stopped me from considering the depth and severity of what is now occurring in the UK economy. In my essay, I suggested that the gains in GDP over the last 10 years will be lost, as the UK economy shrinks. However, I now think it will be far worse than this.

In particular, the problems with credit and the banks are going to reach their real crisis in about six to eight months time. The reason is that the fallout of the sub-prime fiasco is just the start. The next phase will be the consumer credit crisis and the SME crisis - and the results will be equally as dramatic, but with the added pain of hitting the banks when they are already suffering severely.

So what are these crises. The first is that consumer credit was already reaching breaking point, where many households were borrowing to repay borrowing. This was, in any event, unsustainable. Added to this factor, the story of inflation needs no more retelling. Finally, we have the spectre of rapid increases in unemployment, and it will be this development that will spark the second banking crisis. In particular the number of delinquent loans will start rising rapidly as unemployment increases, and accelerating concerns about the already weak balance sheets of the banks will see even greater tightening of credit conditions. Furthermore, unemployment will see even more mortgage defaults, and the banks will be trying to sell assets into a falling market. Quite simply, their losses are going to be staggering.

The second problem will come from the Small / Medium size businesses. As the economy turns down, think of the small traders - such as restaurants, who are already only marginally profitable. These will rapidly fail, in many cases leading to losses for the banks. Even the medium size companies, with a better financial base, are going to be negatively effected by the consumer downturn, and their failures will hurt the banks even more.

Remember that these problems are going to hit the balance sheets of banks when they are already tattered, and hit the reputation of the banks when their reputations are at a low.

This, in some senses, is stating the obvious. However, what is not obvious (apparently) are the points made in my essay about the money-go-round that has been the base of the UK economy. It is the lack of any fundamental strengths in the UK economy that will make the difference. It is like the game of 'Kerplunk' where, when you pull out enough straws, the balls come crashing down. Right now, the straws are being pulled.

So what now? I guess, wait and see. The only thing I think I would suggest is to make sure that any savings that you have are not in one bank, or one organisation. There are likely to be a quite a few bank failures, with the risk in about 6 months time. If the disaster has not happened in a year, then we can start smiling again. [we do not appear to be smiling now]

July 2008: The dilemma that is not being confronted....

Taxation as a percentage of GDP has risen, and will need to rise further as tax revenues decline with recession, and expenditure increases (e.g. from paying benefits - increase in unemployment). Alternatively the government will need to cut services, thereby further increasing unemployment. In fact, whatever the government does, there is no solution, as increasing tax will further hurt the economy, or cutting services will increase unemployment. In short, increase tax/decrease tax - both will have the short term effect of plunging the economy deeper into recession. For the long term, cutting services is the only answer, but will Gordon Brown have the courage to make that decision? It is also worth noting that, whilst many other countries have been cutting taxation, Gordon Brown increased taxation. The expansion in the UK of the state and increased taxes have created a structural problem in the economy, and there is no way to unwind the problem without severe pain.

July 2008: Confronting the competition....

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.

July 2008: It is not the credit crunch, it is the lack of competitiveness....

As it is, I am relieved that finally the severity of the situation is starting to sink in. My ongoing worry is that the economists will start to blame the 'Credit Crunch' (an animistic beastie that serves as an explanation for all woes), rather than face the reality that the structures of the Western economies are now unsupportable. Until they grasp this idea, I worry that policy will carry on down the same road that has already led to this economic dead end.

However, I remain optimistic that the economists may (when confronted with the raw reality) manage to untangle themselves from their charts and discredited theory to actually think about the situation and how it has arisen. One of the first signs is the re-emergence of monetarism, though that of itself will only provide a small part of the answer. Click here for an example of the monetarist debate in the Telegraph.

If I was to summarise the root of the problems that we are seeing, I would have to refer you to my post on the 'Cigarette Lighter Problem'. At some point I hope to expand on this article, as I am still not sure that readers are grasping the magnitude of the problem that it represents (as it is an article that has received no comments).

In the meantime, reach for your hard hats, as the ride is about to get bumpy. As I have said before, the next shock will come in about 6 months when the second tranche of bad loans hit the balance sheets of the banks. As the economy turns down, unemployment goes up, a large amount of the credit that has been dished out irresponsibly will go bad. There will be at least a few bank failures, so spread your risk across institutions.

July 2008: The competition explained.....

For the moment I will focus on China, as that is the country I know most about.

In the case of China, it opened to the West following the reforms of Deng Xiaoping and, from a modest start, saw an accelerating pace of growth, albeit starting from a low base. The momentum of that growth only started to be felt in the late 90s. At that time, for consumer goods, the whole Chinese economy (if I remember correctly it was a person from Nestle who I spoke with) was of similar size for consumer goods as Germany. Although there had been excitement about China before this, it was only at this point that everybody started to take notice, and that the pace of growth really represented a major shift in the world economy.

So what was happening when China opened up. The extraordinary thing that occurred was actually the conjunction of two vitally important processes. The first of these was the introduction of a massive source of labour into the world market, in this case nearly a billion new units of labour (and no, they were not all poorly educated, as even in the late 90s China was churning out large numbers of university graduates). Now this, of itself, was not important. There had always been large sources of cheap and untapped labour around the world, but most of the labour remained under utilised. What made the real difference with China, was the massive investment and technology transfers that were taking place from West to East.

China emerged onto the world market with a government that was uniquely business oriented (at least by the 90s), with their legitimacy built upon the foundations of ongoing economic growth. To facilitate such growth they built infrastructure, and a framework that told the Western businesses that it was a safe bet to invest in China for the long term. The result was a flood of foreign direct investment, and a flood of technology and know-how into China.

It is at this point we come to something rather special about China, and that is Chinese culture. The miracle in China was that Mao ever managed to pull off the communist revolution. I will not to into history here (even though I have a passion for modern Chinese history), to explain how it happened. The important point I would like to make is that there is something in Chinese culture which seems to make them (in general) naturally good businesspeople. If you visit Vietnam, Malaysia, Indonesia and so forth, you will find Chinese businesspeople at the top of the economy, despite their being minorities.

So what does this conjunction of factors add up to? The first point to make is that, in order for a massive supply of labour to be brought into a market, it takes more than just existence. In order for the labour to come into play, it requires the technology, capital, infrastructure and will. In the case of China, all of these elements came into play.

The result is that China had actually managed to bring a huge amount of labour effectively into the world market,. That process is still continuing, and still has substantial reserves still waiting to come into the market. This labour includes every level of skill and education.

Basic economics says that if supply increases, then prices will come down. We then have to ask what will happen when such a large pool of labour enters the world market? Will the price of labour go down? Well, of course it will........it is basic economics. What has made the real difference here is that the entry of this labour has been supported by an equalisation of capital and technology. All the Chinese had to do was learn how to do business, something for which they seem to have a cultural talent for. This has also occurred over the last twenty years.

Now if we accept this, how does this explain the current state of the world economy? The first thing to note is the balance of payments deficits of the West have been supported by capital accumulation in the East. This has seen a massive transfer of wealth from West to East. The East has continued to lend to the West on the basis that, like the West itself, it believed that the West was naturally more stable and a solid economic bet (sorry for the metonymy here, but it simplifies the expression of the ideas). As such the West has been going steadily further into debt, with both consumers and government borrowing like madmen. All the time both the lenders and borrowers were under the illusion that this situation was sustainable.

The result of all of this spending was an illusion in the Western world that nothing had changed. We had moved into the post-industrial service based economy. The share of manufacturing in the economy steadily declined and the economists all accepted this as a perfectly sustainable new economic order. The reality was that massive borrowing was just delaying the inevitable, the readjustment of the world economy to the massive input of productive labour. In delaying the impact of this adjustment, the imbalances have actually become far greater than they would otherwise have been. Even now, the West is still not prepared to take on the new competition of the emerging economies, in particular China. If anything, the West is in a far more grave situation than would have otherwise been the case. The massive debt that has been accumulated must now be repaid, and this at a time when the West desperately needs capital to invest in rebuilding collapsing economies.

[and]

Furthermore, it will become apparent that many of the things that we have taken for granted in the West will become unaffordable, such as bloated government and welfare states. Quite simply, if we are to compete with the East, we must either be adding significantly more value than the East can manage, or we need to have at least a comparable cost structure. The latter option looks more realistic.

As I have said, this is a very quick review and is short on facts and figures. However, the principles are very clear, and I believe rational. The current crisis is therefore a rebalancing of the world economy and, unless the West responds to the reality, the problems will persist, if not get worse. We have had very little competition and took 'top dog' status as a natural course of affairs.

We are now learning that this is just not the case.

(this last post is not very well written, but I hope the message is clear)

I could continue with ever more sections from previous posts. As time has gone on, the one thing that is unchanging is the refusal to accept the reality that we are being confronted with. As each stage of the economic crisis progresses, the focus is on anything but the underlying reality. This is not a financial crisis, but an economic crisis.

With each prediction from governments and economists that recovery is around the corner, more problems appear. The current talk of 'green shoots' is already fading. Why - because nothing has yet been done to address the underlying problems.

Note 2: I do not have time to address all of the comments from the last post, but have managed some replies in the comments section. All comments are appreciated, as are the links to various articles. The latter are often very useful leads for me, so thanks.

Note 3: This from the Times today:

Secret “doomsday” plans for 20% cuts in public spending are being prepared by senior civil servants, who fear politicians are failing to confront the scale of the budget black hole.

Whitehall mandarins have begun creating detailed dossiers containing reductions in expenditure that are far deeper than the more modest savings being proposed by Labour and Conservative politicians.

[and]

Senior civil servants have let it be known that they are sceptical about the claims made by both main parties on public spending.

While Labour wants to increase expenditure despite the £175 billion budget deficit, the Tories, using figures from the Institute for Fiscal Studies (IFS), have acknowledged the need for cuts of up to 10%.

Mandarins, fearing a prolonged recession and a collapse in tax revenue, have begun planning for more severe cuts of up to 20%.

The dossiers will be handed to cabinet ministers the day after the next general election, whichever party wins.

Jonathan Baume, general secretary of the FDA, which represents senior civil servants, said: “It could be even worse for some departments than the IFS has predicted.”

Lord Turnbull, the former cabinet secretary, echoed the warning. “The civil servants will have to assume that whatever both parties are saying today, in the end they will have to be bolder. What politicians say on the record will underestimate the magnitude of the task,” he said.

It seems that at least the civil service is starting to deal with reality. The trouble is that the collective 'we' that are the public, and the politicians, are simply not ready for this.

Economic Reality Bites Back!

The crisis has, in many respects, followed the course that I predicted. Economic reality intruded on the fragile (false) restoration of confidence that followed the bailout. In the UK, the economy contracted by 0.5% in the last quarter, which will come as no surprise to regular readers here, and Mervyn King has now warned of a recession. The result was carnage for the £sterling which suffered massive falls. Meanwhile around the world stock markets plunged in a state of panic. From the US there is an endless stream of bad news, an example of which is that General Motors and Chrysler are now heading fast towards bankruptcy, and the once mighty Ford is in deep trouble too. These once unstoppable behemoths are symbolic of the underlying problems that are seeing the Western economies contract. Meanwhile, US house prices continue to slump.....

So far, all of this has played to the script that I have been writing for a long time. However, not all has followed the script. The $US should also be plunging, but instead is strengthening as funds are pulled from investments in emerging economies, seeking 'safety' in the $US and Yen. As the article I have linked to points out, there is outright panic driving such moves. An analogy that might explain this is a person running from an angry bear, only to seek safety in the Bear's cave.....where mother bear and her cubs are waiting, and where father bear will soon return. The result of the flight to illusory safety has rocked the world with for example, Russia at risk of sovereign default. Once again, this is not following my script, but any script can not account for panic and emotion driven decision making. In other words, the world financial system has left rationality behind. As with the return to panic, at some point soon, events must return to the script, as there is an underlying economic reality driving events. An explanation of that reality can be found here.

As if there were not enough problems, OPEC is seeking to reverse the one positive in the crisis, the drop in the price of oil. I predicted a long time ago that oil would fall to $60 per barrel, though not as quickly as has happened. I saw the drop in commodity prices as one of the elements in eventual recovery from the crisis. I have previously described how commodity supply is at the heart of the current world rebalancing (and crisis), and in order for the world economy to return to growth it is necessary to increase supply of commodities. As such, OPEC cuts in production are just the opposite of what is needed.

Another worry is that China is now feeling the pain of the crisis. I have always considered that China is on a knife edge, that it was uncertain how the country would ride out the storm. One of the positives that I identified is that China's huge reserves would allow them to cushion the impact, and the Chinese government has duly announced massive infrastructure spending to ameliorate the impact of the world slump. In other words, the money put away for a rainy day is already being utilised. Whether this will be enough to ensure stability in China remains to be seen, but they are in a position of having significant resource at their disposal, even if the value of that resource is heavily weighted in high risk $US. This reminds me of a comment / question that I received as follows:

Following on from Lemming regarding China stopping lending, surely the consequences for them will be a lot worse if they do suddenly stop? Your link points to an article that indicates that the Chinese authorities are trying to stimulate exports by increasing export tax rebates; surely if the West's economies & currencies collapsed it would make it even more difficult for China to compete in the world markets, as well as destroying their potential markets for an even longer period?

Like a bank lending to a business, I can see that it's in their interest long-term to stop lending so much to the West but surely it would be in their own interest to stop lending gradually, rather than suddenly, so they can recoup at least a portion of their previous lending?

As I have previously discussed, economies such as China which have been financing Western economies have a dilemma. If they stop lending, then the value of their holdings will collapse, along with Western economies. However, they must realise that any continued lending will throw good money after bad. My feeling is that the comment is very sensible, but China will need to utilise the resources at its disposal in the support of its own economy. They are, in effect, between a rock and a hard place. If they divert their surplus to the US and Western economies, they will help avoid a general collapse, but at the risk of a collapse in their own economy. In addition, such a diversion will only delay the onset of the rebalancing of economies. It may be possible that they can balance both internal and external problems, but I am not sure that they have enough resource to manage both. Do they have the will to do so? Recent news suggests that they do, but it is difficult to be sure.

As I have discussed before, at this point in the crisis, it is increasingly the decisions of individuals driving events, and how China acts in the crisis will be driven by a few leaders at the head of the CCP. Perhaps the most telling article in the latest round on the financial crisis is an article on the 43-nation Asia-Europe Meeting, in which the following was said:

Mr Miliband said the meeting had highlighted the significant shift in economic power towards the east but also how interlocked everybody's interests were in tackling "deep imbalances" in the system.

"I don't think it's just the fact that we are meeting in The Great Hall of the People and we listened to the general secretary of the Chinese Communist Party talking about the need to prop up global capital markets that brings home to one that there is this big shift in economic power," he said.

This has been the point at the heart of this blog. World economic power had shifted to the East, and now we are witnessing the global rebalancing. Bailouts, international talks, action plans and all of the rest of activity of Western politicians directed towards saving the Western economies are fighting against this shift. In other words, all of the activity to 'save' the economies is entirely pointless.

As I have long, and consistently argued, the only thing that will save the Western economies is reform that will allow them to compete with the emerging economies. Bailouts, more borrowing, Keynesian boosts to economies will only serve to make the economies more debt laden, and less able to adapt to the economic reality that wealth has moved East. Still, despite this reality, the politicians and economists are scurrying around, scrabbling for solutions, and imagining that there are magic wands that can change reality.

Note for new readers: I strongly recommend that you take a look at the links at the top left hand of the page. These will explain why it is that the world has changed, and why the change has led to this crisis. As far as I know, this is the only place that has a comprehensive explanation of the underlying roots of this crisis that actually explains the question of 'why?' I would expect that, if you read the explanation, you will understand my pessimism. You may want to start here....

Note: I have had a very pleasant comment (see below). However, I would caution readers to read other opinions before making investment decisions. Whilst to date my track record of predicting the economy has been extremely good I am, like anyone, fallible. As such, I would suggest looking at a variety of sources. I am personally very confident that I have understood the situation more clearly than many economists, but my views would be contested by any number of economic 'experts'. I will add this warning to each of the pages in the blog.

World Economy - What Happens Next?

As I mentioned in my last post, I thought it might be worthwhile to take a pause from the news and try to pull together what all of this means. By coincidence I finally had time to read my copy of the Economist from last week, which included their review of the situation. It was surprising to see how far they had moved towards the interpretation of events discussed in this blog. However, in several critical respects they differ.

For example, the Economist is broadly supportive of the bank bailouts and coordinated action of governments to try to fix the crisis. Across many posts I have listed many reasons to be against the bailout, so I will try to summarise the reasons for why this is an error. In one post I illustrated why this was a bad decision with an analogy of a family. The family have been spending more than their income for many years, and were already in severe financial difficulties. They are increasingly reliant on borrowing to sustain their lifestyle, are using borrowing to pay back previous borrowing, and are slowly but surely heading to bankruptcy. Meanwhile, the husband is having his working hours reduced, and the mother is facing the possibility of redundancy. In other words, their income is about to drop. In such circumstances, who in their right mind would suggest the solution is to borrow yet more money? The answer is obvious - nobody would give this advice. Instead, the advice would be to accept the reality of the situation, and tell them that they urgently need to change their lifestyle such that they can live within the means of their income. Ideally, they would also need to change enough to start paying back their debts.

For some reason, when it is a country in this situation, the solution to the problem is to borrow more money, the method of financing the bank bailout. This is the simple reality. Nobody disagrees (now) that the Western economies, in particular the UK and US, have been borrowing more money than was sustainable, but for some reason it is acceptable to get out of the situation through increased borrowing. Rather than accepting the reality that we must live withing the means of our (diminishing) income, the solution is to just borrow more money.

In a more recent post, I asked what the borrowing would be used for. We know that the money is being pumped into the banking system, but to what end? Were it to be used to invest in wealth creating assets, then I would have no argument with the Western governments extending their borrowing (whilst they still have the means to do so). However, the news suggests that the purpose of the bailouts is just to pump new sources of credit into the wider economy. In other words, it is just being pumped in to restore the supply of money to maintain the 'service based economy'. Will this money see the development of manufacturing companies, or be used for investment in new plant or technology, or be invested to develop services for export? There is no indication that this will be the way that the money is used. It is just an increase in overall debt, and is digging a deeper hole for the economy to sink into.

Governments are claiming that they will eventually recoup the money that they are lending, but the reality is that they will be encouraging the banks to lend the capital that they are injecting into the system. In so doing, they will be encouraging lending into a failing economy, which means lending against devaluing assets, lending to consumers who are increasingly likely to made unemployed, and businesses with ever greater risk of bankruptcy. In other words, the money will be used for lending into high risk, and will therefore see yet more mis-allocation of capital. In encouraging lending for the wider economic good, the governments are likely to just encourage yet more bad debt to be developed.

We then come to the question of how the money will be repaid. In my early posts on the bailouts, I emphasised the fact that this is spreading the damage done to the financial system into the wider economy through the necessary (eventual) increases in taxation. This means that the genuinely productive parts of the economy will be saddled with greater taxation, and will reduce their ability to compete. In other words much of the money being borrowed will be poured into the non-productive parts of the economy, and the cost of the borrowing will hurt those parts that have genuine wealth creating capacity. It is a recipe for long term economic damage.

So what is the bailout actually for? There is endless talk about restoration of 'confidence'. This is a very curious idea. What is the point of confidence? Does it produce wealth, does it change the underlying economic circumstances? The reason that there is no confidence is for the very reason that the underlying economic circumstances are so poor . As such, the $2 trillion being used to prop up the banks in the Western world is being used to create a false sense of confidence. This is a frighteningly irresponsible way to utilise this money, as the restoration of confidence can never be anything more than temporary, because the underlying economic reality is so poor. As it is, these massive borrowings being poured into the financial system are not even achieving this foolish aim in the short term. The rate of interest for inter-bank lending is barely moving, stock markets are still teetering on the edge of collapse, and so forth. At this stage, it is impossible to say that there will still not be an upturn in confidence, but such an upturn is unlikely, and in any case will eventually be destroyed by ever more bad economic news. (Note: I discuss why the value of money is built on confidence here, which would suggest that confidence is important. This may seem self contradictory, but the reason it is not is that confidence must have a foundation in economic reality)

So where does this leave the economies of the Western world? At the moment, the rest of the world is still lending into the Western economies. I forget which was the post in which I made this analogy, but this is a situation like the creditors to an 18th century aristocrat. His family has always been wealthy and his creditors continue to lend money in the belief that he will always be wealthy. However, the reality is that he has no prospect of ever paying back the borrowing. All it takes is for one creditor to ask for repayment, and the result will be a loss of confidence in the aristocrat's ability to pay. At that point, when the credit stops, bankruptcy will quickly follow. His income does not cover his expenditure, and without the continuation of lending, he is seen for what he is - a bankrupt who has been living on the success of his forbears.

The collapse of the economy of Iceland will probably be raising questions about the creditworthiness of other Western economies. The UK government in particular is making it very clear that the intention is to increase borrowing, and is therefore declaring that it intends to borrow its way out of trouble. Rather than trying to cut back on spending, it fully intends to pretend that there is no underlying economic problem, with no need for reform. It is business as usual, all the while with income dropping, and borrowing increasing. No explanation is being given for how this increase in borrowing is to be repaid, what source of new wealth is around the corner to allow the repayment of this ever-growing debt. The question this raises is how it is that the rest of the world will continue to lend? At what point will they ask the question of how this debt will ever be repaid?

The fundamental problem is this. As long as the rest of the world keeps lending, there is demand for the Western currencies. As long as this demand continues, it helps to prop up the value of the currencies. This in turn protects the value of the money that is being lent. What happens if the amount of lending decreases is that the demand for the currency will drop, and with it the value of the currencies. The trade balances of the US and UK in particular have been negative for a long time. Put another way, the demand for the $US and £GB is driven by lending, not by demand to buy goods and services. For those that are creditor countries, they face uncomfortable choices. If they cease lending, then the currencies of the West will collapse. If the currencies of the West collapse, they will lose huge amounts of money on the lending they have already made. On the other hand, if they keep lending, they are faced with the problem of how the money will ever be repaid. In crude terms, do they continue to throw good money after bad?

It is for this reason that I have predicted that it will not be long before the lending stops, and that this will lead to government defaults. I can only guess the time scale because, at the end of the day, it requires that the creditors of the West ask the right question - the question of how their money will ever be returned to them. It will also require them to accept the losses on their previous investments, which will be a hard pill to swallow. Finally, they will know that, with the collapse of the Western economies, they will be pulled down with along with the West. For countries like China, with very real prospects of social unrest, they will be balancing the cost of continued lending against the survival of the Chinese Communist Party. Do they continue to finance the Western world's ability to live in comfort, do they continue to lend their hard earned money to prop up a decadent and bloated Western world - for that is how they will see it. They produce, and the West consumes and does not ever pay the bill for the consumption. It is hardly a good deal for them.

So what happens if countries like China decide that enough is enough. It is at this point that the Western governments find that they can no longer pay the bills. At this point they must either print money, or dismantle huge parts of the state. The $US, the Euro and £GB will fall through the floor. The peg to the £US used by the oil states will be dropped, and the cost of oil will soar. Even without printing money, the rate of inflation in the Western economies will soar, and the result will be complete economic chaos. The reality will be that oil will be oversupplied, but the shift in the currencies of the Western world will mean that, for the West it will become relatively very expensive. The same will happen with other commodities. This is the rebalancing of the allocation of commodities that I discussed in previous posts. I spoke of the competition for finite resources between the emerging economies and the Western economies, and that the West would lose out, and find its share of world resources decline. This will be the mechanism by which this decline will be transmitted.

I have not spoken very much about the social and political consequences of what will happen, as this blog is focused on economics. However, at this stage, it is worthwhile discussing this briefly, as there will be a feedback into the economic situation. If I am right that the lending into the West must end, and the result of this end to lending is as I have predicted, then we will all be in for a roller-coaster ride. The shock to the Western world will be dramatic and painful. In these circumstances, it is an ideal environment for demagoguery. It is the moment of the populists and the rabble rousers. There is a real chance of massive social upheavals, and even challenges to democracy and capitalism. In the rest of the world, there will be similar upheavals. The biggest worry is China, which already has a state that already looks like a worrying hybrid of pre-WWII Japan and Germany. There are many flashpoints for conflict, such as Taiwan. With a government with legitimacy built upon economic growth and nationalism, what happens when the economic growth stops? The Economist magazine is optimistic about the prospects for China in this upheaval, and we can only hope that they are right. I have always been very slightly optimistic that China will pull through this period with only moderate damage, but still have many serious reservations.

I mention the political and social dimension for the reason that the result of the next stage of the crisis will lead to a situation of chaos, by which I mean chaos theory (no doubt serious chaos theorists will shoot me down on this usage, but I hope that you will understand my meaning). By this, I mean that even small events or factors may have profound consequences. The right person being in the right place at the right time, a decision of bureaucrat, a rumour - all of these offer opportunities for dramatic changes in the situation. In other words, there will be a period of huge instability, and that instability creates opportunities for small events to have profound consequences.

As you may gather, I am profoundly worried by the current situation. I was able to predict this crisis, but was not able to predict the way in which governments would react. The way they have reacted is a way that will ensure that the crisis leads to economic disaster. In choosing to try to borrow their way out of trouble, in failing to reform their economies to lower costs and prepare the way for real wealth creation, they have sent a message to their creditors. That message is that they must continue paying for the comfort of the Western lifestyle, at the cost to their own people, or they must face the consequence of massive economic upheaval, and consequent chaos. I believe that creditor governments will be trying to work through this question, trying to see how this can all end. I can not be the only person raising these questions. At some point in time, the complete lack of logic in the current situation must come to an end. There is no way that the creditors to the West can be happy to be supporting the Western economies, with little prospect of ever gaining any return. At some point, it just must come to an end.

I am sorry for such a gloomy post, but my aim has always been to try to analyse situations in as realistic way as possible. For new readers, there are many points in here that require deeper explanation, such as the role of commodity supply in the world economy. You may want to take a look here to understand why the situation is as I say it is. You may also want to take a look at the other posts that I link to at the top left side of the blog. This all may sound like an extreme take on the situation, but there is a disturbing logic in this analysis to be found throughout this blog. Even as I write this, it is a sunny day, and the world outside appears normal and unchanged. The best way to understand how deceptive this calm might be is to imagine the tourists sunbathing on the beaches of Phuket, just before the Tsunami struck. In a matter of minutes, their world was turned upside down.

Note 1:

Ishmael asked the following question:

'My question was in regards to the system of fractional reserve banking and the criticisms that have been made in a few documentaries especially "money as debt" and "zeitgeist" and "zeitgeist addendum"

This article can explain the debate better than I.
http://en.wikipedia.org/wiki/Criticism_of_fractional-reserve_banking

I was wondering on your opinion on this matter as my financial knowledge is a little basic, Is a crash inevitable or is there another mechanism at play that mitigates the effect of exponential debt plus interest?'

I have not seen either of these documentaries, but I do discuss fractional reserve banking and my post on the subject can be found here. It is a rather unusual perspective, but if you stick with it, I hope that you will find it interesting. My article on government borrowing and interest rates may be of interest as well.

Note 2: An anonymous poster has mentioned how easy it is to make fake coins, in reference to my cynicism about the Amero conspiracy theories. Thanks, for the contribution, which is helpful.

Note 3: I have the following from an anonymous poster (edited):

'I know the idea is to get the banks and mortgage providers lending again, but they cannot go back to lending to people who will never be able to repay the loan.(sub prime)

With the economy about to take a dive, (and I suspect never to recover to pre crash levels) what sort of an economy will follow?

The only exponential growth in the Western world is people, Britain (and America's) populations are rocketing and it is my guess this is where the growth is to be conjured, as I suspect it has for the past eleven years. '

The answer to this is relatively simple and also terribly complex. The one certainty is that the economy of Western countries will be considerably smaller. As to what kind of economy, that is the complex question. Increasingly socialised, protectionist, or lean and mean and ready to face the competition in the world? That, to a large extent, is in the hands of the politicians and where democracy is in play, that is in part in the hands of each individual with a vote. Will the voters look to the state to 'fix' the problems through protection, endless state interventions, or will they decide that they want to regain their place in the world? This ceases to be a question of economics, but becomes a question of politics.

Note 4: A very late reply to Phil (apologies)

I’d like to offer a further point of reflection: while in the West we continue the “Debt Economy Delusion”, what the biggest producer of real wealth - China - will do?
12 October, BBC News website had an article, “China agrees land reform package”.
The article quotes Xinhua news agency:
"The Communist Party of China Central Committee on Sunday approved a decision on major issues concerning rural reform and development," Xinhua said.
Its commentary added: "The global credit crisis freezing up the world's finances may be a blessing in disguise for China as it aims to modify its economic structure after three decades of breakneck growth."
My take is that, as the global crisis will restrict external demand for Chinese goods, China will expand its internal market, the biggest single market of the world.
And what will happen then, monetary speaking? Will the Yuan increase its (now artificially lowered) value?
And, as we are at it, what will happen to major world currencies?

This is a very interesting comment. The RMB will certainly have to significantly increase in value, at some stage or another. I tried to keep my own money in RMB for that reason, but holding money in China is problematic. There are many possible drivers for a large upward revaluation, including threats of protectionism, and it is difficult to say when the CCP will allow a major revaluation. Add into this mix the questions about internal stability, and what might happen if China falls into recession, and life gets more complicated.

One of the interesting things about an artificially low currency is that drives economic growth through export led growth, but at the cost of the relative wealth of all the individuals in that country. To give an example, a Gucci bag may be significantly more expensive than it otherwise might be with a balanced exchange rate. That differential means that, in real terms, the potential purchaser of that bad in China is poorer. In short, the people in the country do not get a 'fair' price for the imports that they buy. If you look at it this way, China could overnight become significantly more wealthy, just by revaluation. However, in doing so, could they maintain their economic growth? It is not certain at the moment that this is, in any event, possible. It really is a very complex point. How much of China's success is due to the artificial currency rate? I am not sure on this, but think that it is significant a factor. However, the cost of this approach is now coming at them through the back door, through the damage that the undervaluation has helped create (unbalancing the world economy).

As you can see, a very involved answer, and one that illustrates the inter-connectedness of the world economy. I think I have already answered the questions on currencies in the main post, so will not answer that question further.

Note 5: Another anonymous poster asked this:

This whole business has led to a potential cataclysmic political sea change.

Is neo Liberalism dead in the water?

The ramifications to the answer to this question is mind boggling.

If the answer is yes - What next?

I have answered one of the questions in the main post. Neo liberalism dead? Another one for the politicians, I believe.

Note 6: Hilly asks the following:

'Is the extent and volume of the losses incurred internationally (100s of billions of $) simply due to this over-lending, over-valueing, over-selling etc.. not just in housing (which does incur the losses) but in the levels of borrowings bothprivate & commercial that are being defaulted currently or are anticipated to be so, plus governmental overspending of future incomes?'

I am not sure I grasp your underlying question here, but if you can clarify it, I will try to answer it (time allowing).

Note 7: In reply to a question below:

It's just occurred to me. (I'm not the sharpest tool in the shed) Are we, (West) in the absurd position of being lent money by China to enable us to buy their goods?

It's a sort of merry-go-round that could continue for ever.

This is something I have discussed previously in this blog. You are absolutely right, except about the ability for this to go on forever. The lending will only go on as long as the lending creates a return. As soon as the returns diminish, the merry-go-round stops. It was an unsustainable economid model and part of what we are seeing is the collapse of this model. It was not just China, but all of the creditor nations who have funded the West to buy their products. It sounds mad when you think about it, but this is why I make the Aristocrat analogy. Think of the situation where the aristrocrat buying his tailoring on credit.

Note 7: More questions (see below). I only have a little time so I will just answer a couple of those raised (all too briefly). Answers are in italics.

'The economic backdrop to the 21st. century is the mantra of ever increasing growth in a world of diminishing supplies of raw materials. (is this the same as your commodities?) The production of raw materials (commodities) relative to demand are decreasing even though output in absolute terms has increased. See post here.

Where has all the money gone? Has it been consumed on trips to Disneyland, McMansions, SUV's, snowmobiles, second homes, etc.etc. The short answer here is yes. Much of the money has gone into consumption, and therefore has been spending now at the cost of foregoing future wealth.

With the present arrangement of China having become the workshop of the world, they have amassed shed-loads of dollars amounting to hundreds of billions, what are they supposed to do with this mountain of money? Not hundred of billions but fast heading towards $2 trillion. That is one of the problems that they face (and other creditors are facing). The West is not producing enough of what they want to buy at a price they are willing to pay. That means that the value of the currency must devalue. Once it is no longer used to fund Western borrowing, then there is no demand for the currency, and the value of the currency falls.

The only thing they can do with it is lend it back to the West or buy up Western assets as investments. Yes, see above. But they will no longer want to lend it, as their little prospect of the ability of the West to repay. We are not making enough goods that they want etc. (see above answers). This is one of the points in the above post, so I think I will need to rewrite it, to better explain this.

With the World's dwindling resources I cannot see manufacturing returning to the West, which again prompts the question, where is the wealth generation to come from? Please do not buy peak oil and the rest of the scare stories out there. oil must peak at some point, but there is no firm uncontested evidence that resources are dwindling, and peak oil has been predicted since the 1930s. It could be now, or it could be later. I was posting months ago that oil would drop to $60 when the peak oil believers were predicting $200. Last time I checked it was at $75. Overall demand has outstripped the ability for suppliers to meet the demand, but demand is now falling back as the Western economies contract. Again, see post here. The main problem is bottlenecks, not the amount of material (a curious example is the inability to produce the huge tyres for the monster trucks used in open mining)

As an aside, how can the West (Britain) embark on an economy of manufacturing when the have just announced another round of cuts on carbon emissions? Expect 101 ways for this to be quietly abandoned in the coming years. I think that you will find hard times will diminish the enthusiasm for action which damages economic prospects.

Naive question perhaps, what is the difference between borrowing money and the government printing its own? In other words why borrow when you can print it? This one is not a short answer, so I will (time allowing), try to address is another time. The simplest answer...Both options are bad, but printing money is worse.Not a naive question, but a very good one deserving a proper reply.

I am afraid that time has run out (explaining the rushed responses above). I will try to put more time to answering questions but must balance my limited time against the general posts. As such I will do my best to keep answering as many comments as possible.

Economic Crisis - Conspiracy and the New World Order?

I have had some comments that have suggested that the crisis is all a big conspiracy for a new world order. As regular readers will be aware, I am more inclined towards the principle of foolishness and stupidity. I followed a link to the Daily Kos, and had a quick look through an article to get a feel for a feel of how these theories are being presented. I remain unconvinced that this is all the result of a plot, but do have concerns at the power that might be taken by government resultant from nationalisations, and the cosying up of world leaders to 'fix' the problems. The latter brings to mind a quote from Adam Smith:

"People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices." (1)

Whilst not entirely apt, I think that the idea carries over to this well. This leads neatly into the current state of the panic that is driving countries to act in unison. There is this from the IMF Chief Economist, reported in the Times:

'“Intensifying solvency concerns about a number of the largest US-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.” Countries would need to take further measures, including interest rate cuts and steps to bolster the banks. '

And the result of this panic can be found in another Times article:

'THE government will launch the biggest rescue of Britain’s high-street banks tomorrow when the UK’s four biggest institutions ask for a £35 billion financial lifeline. The unprecedented move will make the government the biggest shareholder in at least two banks'

As the conspiracy theorists have correctly identified, there is the G7 agreement that there will coordinated action, and it is looking ever more likely that the action of the UK government will be a template for the actions of other governments. I will not rehash all the latest news on the crisis from around the world, as I think the IMF Chief Economist has neatly summarised the situation, and the rest is a matter of detail. Meanwhile, one of the interesting outcomes is that several commentators have noted that this crisis and the international grandstanding have been helpful for Gordon Brown. In the US, the lame duck presidency of Gerorge Bush is now probably beyond any such boost.

The question is whether any of this supports the idea that all of this was a conspiracy? If we view the records of those who would have to be 'in' on the conspiracy the records do not inspire much confidence in their ability to manage something so complex (and fiendish?). However, a more valid point to make is that, if we trace the underlying causes of the current crisis, as I have done on this blog (see here for an introduction) it is apparent that nobody in their right mind would have engineered this crisis. In particular, in the case of the Western world, they would have had to not only have planned the financial crisis, but also accepted as a price the loss of power and long term economic decline for the West. This is not a scenario that would appeal to conspirators, who I am guessing would seek to enhance their power overall. After all, far better to have control over an uber-powerful state than a diminished one. If they were that 'cunning' and powerful, I am sure they would have engineered a far better outcome.

Whilst it is always very exciting to imagine smoke filled rooms (think of the X-Files), filled with old guys plotting an planning their evil schemes, there really is no need for such a scenario. Stupidity, wishful thinking, herd thinking, and all of the other foibles and weaknesses to which humans are so prone are more than sufficient to explain the origins of this crisis. For the conspiracy theorists out there, sorry to disappoint, and I am sure that I will lose readers for saying this, but there has been no conspiracy. The only exception in all of this may well be China, which I believe has deliberately sought to gain economic power through whatever means, fair or foul (see post here which discusses the subject).

On the other hand I do believe that the new concentrations of power going to the state are a matter for genuine concern, as is the idea of world leaders and central bankers trying to co-ordinate the world economy. For the former, it will certainly give the state too much power, and for the latter, it should be remembered that these are largely the people that presided over the build up to this mess. However, all of the grand plans for the nationalisation of financial systems rest on the idea that the Western economies are going to be able to continue to borrow their way out of trouble, and I have often expressed my reservations about how long this can continue. There have been stories circulating in the news of other organisations going cap in hand to governments for bailouts, and it is impossible to see how governments can, through borrowing, support this level of damage.

Overall, my largest concern is that government intervention in the markets is a large part of the cause of this crisis. In regulating the banks, they allowed everyone to become complacent about the operations of the banks. For those who are not regular readers, and have been hearing endlessly about lax regulation, you will need to read my post here. Essentially, in trying to regulate away the risk of bank failure, governments have set up a system in which failure is likely to be catastrophic. An occasional bank failure serves to remind us all that the banking system needs careful attention. On top of this the poor measures of GDP, the misuse of interest rates, and many other factors suggest that governments are a large part of the problem (I discuss some of these problems here)

As such, based on the record of governments, my worry has consistently been that governments will do more harm than good, and governments acting in concert is therefore an even more worrying development.

I think that I will leave it there for the moment. It will be interesting to see what events the start of the week will bring. How will the concerted action be enacted, and will it create a momentary calm, or will the storm continue unabated? If it is calm, it will simply be the eye of the hurricane, and the full force of the storm will resume in time.....

(1) Adam Smith., The Wealth of Nations, Book V, Chapter I, Part III, Article III

As a note, have others seen the conspiracy theory predicting the 'Amero' (I think) as a replacement for the $US. I have seen it referenced a couple of times, but would like to get a good reference on what it is all about. It is more than likely as unfounded as the other conspiracy theories, but I try to keep an open mind. As such, if you have one, I would appreciate you posting a link in the comments.

Note 2: For some reason something went wrong with the formatting on the blog - thus the changes. For a little while, about an hour or two, the home page was not showing correctly. Apologies if you found it with this problem.....

Note 3: I have had a long comment from an anonymous poster (see below). He apologises for a long comment. However, there is no need to apologise as I welcome all comments. Another poster comments that they had problem leaving a comment. I am not sure why this would be the case, but my editorial policy on comments are that they are all posted, provided that they do not use abusive language or spam the blog. To date (happily) I have not encountered either of these problems, so have published all comments. As such, I am not sure what prevented the publishing of the first post from the commentator, but would assure those who wish to comment and disagree with me that their comments will be published (within the limitations I have just mentioned). In the meantime (for the commentator who had a problem) please accept my apologies that you had a problem in getting your comment published, and I hope that you will accept my assurance that this was not due to my editing it out. As a final note, one commentator posted a link which was somehow chopped. The link is as below:

http://disclose.tv/action/viewvideo/9899/NAU__Hal_Turner_Shows_New_AMERO_Currency/

Note 4: Yet more glitches here. I have just noted that the home page is showing zero comments on the post, despite there being several comments. However, if you click on the comments link below, the comments are there. I have also checked in other parts of the blog, and the comments are fine. Please accept my apologies for all of these problems, and I will try to work out what is going on. I am hoping that the problems are just with this post (though I can see no reason why this would be the case).

Note 5: I have viewed the link provided on the Amero, and dug around a little bit, including viewing the blog of Hal Turner. The first point of note is that the only evidence provided is a coin which he claims is the Amero (having a coin made I would guess is not very difficult). No other evidence. The next point is that he is a white supremecist, and that gives me cause to doubt his motivations. I followed some of the links, and none of it was backed by evidence. However, the one thing that I believe is correct is that there is likely to be a $US collapse, but that is a different thing from saying that the 'Amero conspiracy' is real, or something that has been planned. In short, I have seen nothing to persuade me of a plot. As such, I invite any hard evidence (leaked documents verified as genuine by a reputable source etc.) to support the Amero conspiracy.