The Great 'Shift' - China and the West

We are living through one of the times in history when a major and irrevocable shift is taking place. It will be a time that will be the subject of controversy amongst historians and, no doubt, there will be arguments about causation, about what set off a chain reaction of change. They will perhaps ponder and wonder that so many people were so blind to what was actually taking place before their eyes.

The shift that we are witnessing is the move of economic power from the West to the East. It is a well worn theme on Cynicus Economicus, that we are seeing the rise of China, and the fall of the US, and the process is now accelerating. Alongside the fall of the US, we are also seeing further declines in countries like the UK.

When I first arrived to work in China in 1997, I could see the emergence of an economic juggernaut. Sure, there were huge problems, and I encountered the legacy of communism in a generation of senior managers who were next to hopeless. Despite that, when I finally left China, I could see that the future was going to be Chinese. I could see a generation of hard nosed business people emerging.

The experience in China shaped my thinking on economics. On the ground in China I could see the massive investment from the West shaping a new and dynamic China. The Chinese welcomed us with open arms and, when I first arrived, were still somewhat in awe of the success of Western business. However, as time progressed, I also saw that Westerners were seen as a soft touch, who would overpay on everything.

The establishment of joint ventures was just one example of the many ways in which the Chinese would extract great deals. When I first arrived in China, all of the consultants were urging investments in joint ventures, and would prattle about notions such as 'guanxi', without any real knowledge of what they were talking about. The Western companies would send out a senior executive with orders to arrange a joint venture. When they arrived in China, they would be presented with four or five prospective joint venture partners, all of whom would have opaque business operations.

In the end, with all of the partners similarly opaque, the Western executive would settle on the least ugly partner. The documentation would then be drawn up, and the business would commence. It was at that point that the Western company would find out that they were supporting a whole raft of pensioners and other commitments in the joint venture. As part of the deal, the Western company would introduce new technology and process, train the management and the workforce. The trouble is that they were training the people ready for a new company to be established by their joint venture partner, and the new company would take all the technology, process and training, and open a competitor company. The competitor would be free of all of the social commitments and other costs.

Then there were the deals where, in order to win a contract, China would insist on technology transfers. I remember a GE power station turbine deal with technology strings attached, or the opening of an assembly plant by Airbus in order to secure deals in China. In so many cases, the price of doing business in China was risking the very thing that made the Western companies such a success; transfer of technology and process.

Then there is 'outsourcing', the rush to China to cut costs at the price of de-skilling the Western work force. It is not just the factory workers, but the designers and engineers who end up de-skilling. A good designer or engineer will understand the process of manufacture. Whilst there may be a legacy of good designers, as time goes by, the great design will emerge in the location of the manufacturer, and that will mean China. It will take time, but it will happen. The other trouble with outsourcing is that, as the manufacturers undertake the work, they will gain scale and experience, and will one day seek to move up the value chain. They will be in a position where all they need know is how to market and distribute their products. Outsourcing may make profit in the short term, but often at the cost of the future of the company doing the outsourcing.

Alongside this, there has been the artificial manipulation of currency by China, and no respect for intellectual property rights. The countries of the West have allowed this to take place, and now appear powerless to stop such practices.

There is a reason why I have returned to the subject of China. I have long argued that the ascent of China will progress far faster than most analysts and commentators suggest. I have long argued that China will emerge as the winner from this crisis, and have argued that their currency will be the new reserve currency in the future. Over many, many posts, I have tracked their steady process of internationalisation of the RMB, and consistently argued that the $US is so weak that it must collapse. I have returned to the subject as the mainstream media are finally really starting to understand what is taking place. Amongst the many articles, it is this article from Ambrose Evans-Pritchard that inspired me to return to the subject:

Beijing does not need to raise money abroad since it has $2 trillion (£1.26 trillion) in reserves. The sole purpose is to prepare the way for the emergence of the yuan as a full-fledged global currency.

"It's the tolling of the bell," said Michael Power from Investec Asset Management. "We are only beginning to grasp the enormity and historical significance of what has happened."

[and]

"Everybody in the world is massively overweight the US dollar," said David Bloom, currency chief at HSBC. "As they invest a little here and little there in other currencies, or gold, it slowly erodes the dollar. It is like sterling after World War One. Everybody can see it's happening."

"In the US they have near zero rates, external deficits, and public debt sky-rocketing to 100pc of GDP, and on top of that they are printing money. It is the perfect storm for the dollar," he said.

"The dollar rallied last year because we had a global liquidity crisis, but we think the rules have changed and that it will be very different this time [if there is another market sell-off]" he said.

The self-correcting mechanism in the global currency system has been jammed until now because China and other Asian powers have been holding down their currencies to promote exports. The Gulf oil states are mostly pegged to the dollar, for different reasons.

This strategy has become untenable. It is causing them to import a US monetary policy that is too loose for their economies and likely to fuel unstable bubbles as the global economy recovers.

The article was a response to news (since denied) that China, France, Japan, Russia, and the Gulf states were planning to abandon the $US for pricing of commodities. Ambrose Evans-Pritchard argues that the currency of pricing commodities is of no importance, but this is something with which I disagree. This is what I had to say on the subject of the emergence of the RMB as a reserve currency in April:

However, the real key to reserve status is when trade is more broadly conducted in the RMB, such as move to trading oil in RMB. Perhaps Venezuela will offer such an opportunity? An article here suggests that Venezuela may need to turn to China for financial support, and this may well present an opportunity for China to start this process:

In Latin America, the external funding situation remains relatively stable but in the case of further deterioration of capital flows, the solid economies would be able to tap the IMF or the Inter-American Development Bank (IADB) for non-conditional lines of credit, while the economies with less sound macroeconomic frameworks such as Ecuador, Argentina and Venezuela would most likely only be able to obtain funds through more formal conditionality or by turning to lenders like China.

Returning to the question of whether it is possible, I see no reason to prevent the RMB from taking on this role. There has been talk about the RMB not being 'liquid' enough, the lack of depth of their financial markets. However, I take a fairly simplistic view, which is to ask whether a currency has the underlying strength of being able to be used to purchase goods and services. The answer to this question is, of course, 'yes'.

It appears that ambitions for pricing of oil in RMB are far more ambitious than I first thought. Whilst the story has been denied, there is an underlying logic to the story that belies the later denials. It is only a matter of time before we see commodities priced in RMB.

In order for the RMB to succeed the $US as the reserve currency, it was always going to be necessary for the $US to collapse. The US has undertaken policy that will ensure such a collapse, and it is simply for the reason that the US is fiscally incontinent, printing money, and pouring the wealth of the future into zombie banks. When the $US falls, the US will finally see the forces of inflation unleashed, as the massive imports of commodities, goods and services surge in price. It is at this point that the underlying reality of where real economic power lies will finally become clearly visible. It is at this point that the real wealth generating capacity of the world will emerge into the light.

When the US is no longer able to borrow, when it is reliant upon what it actually produces, rather than borrows, it will be apparent how bad the situation has become. The same will be true of several other economies, such as the UK. For many years, these economies have been subsidised by the economies to the East and, without any further subsidy, they will find life is far harsher than they have ever imagined.

The rise of China is no mystery but, no doubt, the historians will manage to find controversy, manage to bury all of this under complexity. The economists will meanwhile suggest that the transfer of economic power emerged out of the banking crisis. The reality is far simpler.

The Western world was complacent, arrogant, and bloated. Collectively, the West allowed the emergence of a new competitor who used mercantilist policies to accumulate the modern equivalent of bullion, they allowed the export of all that had made their economies such a success and, when confronted with reality buried their heads in the collective sand of borrowing and money printing. Whatever happened, once China opened to the world, a new economic challenge was inevitable. However, the way that the West met the challenge has ensured that China will emerge as the great economic power.

As we move towards the end of 2009, we are entering into a new world, a new economic structure. We are witnessing a change in the world that will be viewed in hindsight as one of the defining moments of the 21st century.

Note 1: I have not referenced as many points as usual. However, many of the points made are consolidating the points made in previous posts, and these provide support for the case that I am making. I have listed some previous articles on China and the $US, if you are interested in seeing my case in greater detail, and the evolution of my thoughts on China's rise:

1. July 2008, China - What Future?
2. August 2008, China Propping up the $US
3. January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
4. January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency
5. February 2009, China's Pivotal Role in the Next Step for the World Economy
6. Fenruary 2009, China and the US - Fighting on the Edge of a Cliff
   
7. March 2009, Economics and Power, the Loss of US Power
8. March 2009, China, Gold and the $US
9. April 2009, China as the World Economic Power?
10. April 2009, The RMB as the Reserve Currency
11. May 2009, China, the RMB and the $US
    
12. July 2009, The RMB as the Reserve Currency - an Update
13. September 2009, The Rise and Rise of China
    

Note 2: Am I repeating myself here, or does this post add to past posts? Comments welcomed. If readers feel I should move off this subject for a while, I will do so.

The Dire Position of the US Economy

Yes, cheer up everyone, the 'Great Recession' has come to an end. Or so says the New York Times, in yet another positive article:

Even as evidence mounts that the Great Recession has finally released its chokehold on the American economy, experts worry that the recovery may be weak, stymied by consumers’ reluctance to spend.

Here we go again. The 'mounting evidence' that all is well in the world after all. The problem is that, having told us that all is well, the article goes on to say the following:

Given that consumer spending has in recent years accounted for 70 percent of the nation’s economic activity, a marginal shrinking could significantly depress demand for goods and services, discouraging businesses from hiring more workers.

Millions of Americans spent years tapping credit cards, stock portfolios and once-rising home values to spend in excess of their incomes and now lack the wherewithal to carry on. Those who still have the means feel pressure to conserve, fearful about layoffs, the stock market and real estate prices.

So what of the recovery? With consumers quite reasonably digging in their heels and refusing to spend, and consumer spending having been 70% of economic activity, where exactly is the recovery coming from? The basic contradiction between the opening of the article and the content is completely lost on this author. He even highlights one of the artificial props to the so-called recovery, writing:

In recent weeks, spending has risen slightly because of exuberant car buying, fueled by the cash-for-clunkers program. On Friday, the Commerce Department said spending rose 0.2 percent in July from the previous month. But most economists see this activity as short-lived, pointing out that incomes did not rise.

If this is a recovery, then I would really like to see how they might define a bad economic situation. As such, a brief review of some of the highlights of the US economy....

Let's start with the banking system. It is all tickety boo, is it not? The first problem is that, at the commanding heights of banking, there are the zombie banks with portfolios filled with toxic waste. Whilst the world appears to be sunny, this is largely down to the accounting fiddle of FASB 157 (Financial Accounting Standards Board), in which the standard of Mark-to-Market standard 'fair value' of assets was watered down. What this means in plain English is that the valuation of assets has been moved from being what they can actually be sold for in the open market, to what they might be able to make if the world was a wonderful place again.

The excuse for this change to the rules was that there was no market for the assets, due to a collapse in banking liquidity...but even at the time of the change, there was a massive pool of liquidity 'out there', for example in sovereign wealth funds (who are estimated to have over $US 3trillion in assets). If the toxic waste on the bank balance sheets were of any value, then there were plenty of potential buyers out there, so there has always been a market for these assets in principle. The problem is that they are junk, and the change to the accounting rules has simply hidden this.

As if this were not bad enough, the meltdown of retail mortgages is now going into the new phase, which is the rise of prime mortgage defaults:

The percentage of loans on which foreclosure actions were started was 1.36 percent, down from 1.37 percent in the first quarter, driven by the decline in subprime loans. New foreclosures on prime loans increased to 1.01 percent from 0.94 percent, while subprime loans dropped to 4.13 percent from 4.65 percent, Brinkmann said.

The delinquency rate for prime loans rose to 6.41 percent from 6.06 percent, and the share of prime loans in foreclosure increased to 3 percent from 2.49 percent.

To add to the misery to come, we have this from the Economist magazine (the chart referred to shows the growth in resets):

Just as worrying is the possible recurrence of “payment shock” as interest rates on adjustable-rate mortgages reset higher. Resets on subprime loans have mostly taken place, but the worst is yet to come for some other loans, especially the “Alt-A” category between prime and subprime and a nasty type of mortgage called an “option ARM” (see chart 3). The impact may be muted, but only if the Fed can keep short-term rates very low for the next couple of years—or if the borrowers can refinance as the reset approaches.

As a final addition to the nasty state of retail mortgages, there are new problems being stored up for the future, with Ginnie Mae racking up new dodgy loans:

This extraordinary resilience reflects the widespread political lust in America for subsidising housing. Anyone who doubts this should look at Ginnie Mae, another fully state-owned agency which guarantees and bundles mortgages, usually of below-average quality, that are insured by the government. Fannie and Freddie are now being conservative about writing new business, but Ginnie is enjoying its own bull market, issuing guarantees at a furious rate. It is expected to have a trillion dollars outstanding by next year. “We are seeing a gravitation of the subprime universe from Fannie and Freddie to Ginnie”, says Mr Setia. It will be a miracle if taxpayers get their money back from Fannie and Freddie. Worse, there is a chance the disaster will be repeated.

What this means is that there is an ongoing attempt to reflate, or at least stabilise the housing market, and the US taxpayer will be on the hook for the fallout. Without such irresponsible lending, the crisis in the housing market would no doubt be even worse, but the future liabilities are undoubtedly racking up.

Then there is the commercial real estate meltdown that is finally arriving. I have spoken about this in the past, but it has taken longer than expected:

Defaults of multifamily and commercial real estate loans from banks climbed to their highest rate since at least 2003, as lenders gave up hope of being repaid in full, according to a report by research firm Real Estate Econometrics.

The default rate of bank loans for shopping centers, office buildings, warehouses and hotels rose to 2.88 percent in the second quarter, up 0.63 percentage points from the prior quarter, according to the report released on Monday.

The default rate for apartment buildings rose 0.68 percentage points in the second quarter to 3.13 percent.

The results of these ongoing crises is an endless stream of bank failures, with many more to come yet. The Federal Deposit Insurance Corporation's (FDIC) latest report makes ugly reading, and there is widespread speculation that the solvent banks will shortly be tapped for huge sums of money to fund the depositor insurance for the failing banks.

Bove said the FDIC will likely levy special assessments against banks in the fourth quarter of this year and second quarter of 2010.

He said these assessments could total $11 billion in 2010, on top of the same amount of regular assessments. "FDIC premiums could be 25 percent of the industry's pretax income," he wrote.

It appears that all is not so tickety boo in the world of finance. In fact, the crisis is just being buried away. We then have the problems of rising unemployment, which is further feeding into the downwards spiral of the US economy. Whilst there have been a few slightly positive signs of late, the trend is still firmly downwards:

The government announced that the jobless rate had fallen one-tenth of a point to 9.4 percent in July on narrowing job losses but analysts say the rate could soar to about 10 percent by year end even with an improving economy.

Perhaps the most worrying aspect is that there is no expectation of recovery in jobs in manufacturing. This from the President of the Atlanta Federal Reserve:

'Unfortunately, time may not return manufacturing employment to pre-recession levels,' he added. Between 1965 and 2000, manufacturing employment generally fluctuated between 16.5 and 19.5 mln jobs. But in the first years of this decade, the number of manufacturing jobs have fallen to just over 14 million and have continued to drift downward, Lockhart said. 'The harsh financial constraints of this recession appear to have accelerated this secular decline.'

The picture already looks pretty bleak, but the real unemployment rate is considered by many to be far higher than the headline figures suggest, according to the Economic Policy Institute:

The real unemployment rate nationally is nearly 17 percent, instead of the official 9.4 percent, when discouraged workers and part-timers who want full-time employment are factored in. Other workers have seen their hours cut or been forced to take furloughs.

Meanwhile, the number of Americans out of a job for six months or more is at a 70-year high.

The result is a huge labor glut at a time when net job gains are scarce or nonexistent. Observers celebrated when the national economy lost only 247,000 jobs in July. (Washington state even added 4,000 new jobs in July.) The U.S. number would be a catastrophe in most circumstances, but was better than the more than 700,000 lost in January. Yet the American economy must add 127,000 jobs a month just to keep up with natural population growth.

At this stage I will halt with the state of the real economy. For each harbinger of recovery touted by the media, there is a mass of data that suggests the real depth of the underlying problems. Furthermore, even where there are upticks, what we are viewing is the artificial life support being provided by the government, such as the 'cash for clunkers', the absurd lending of Ginnie Mae, or the so-called federal stimulus. That this comes at huge future cost is simply forgotten by the cheerleaders for the view that the economic crisis is at an end.

Perhaps the surest indication of the scale of the underlying problem can be found in how those outside of the US view the state of the economy. The chart below shows net capital inflows into the US, and that there is now the start of a dramatic outflow of capital.



It seems that overseas investors are not too impressed with the recovery, or the prospects for the US economy. It is no wonder really that they are reacting this way, with fiscal deficits climbing to shocking levels, monetization of government debt through money printing by the federal reserve, and an economy still in free fall. The overseas creditors can clearly see that there is no sustainability in the US economy.

The bottom line is this. Trying to borrow yourself out of a recession caused by too much borrowing is just plain silly. It would be laughable, were it not such a tragedy. The actions of the US government are attempts to turn back time. They are trying to support an economy that was always unsupportable. Consuming more than you produce is just unsustainable, and no matter how many economists line up to tell you otherwise, it is the underlying reality that must be addressed.

Perhaps the most shocking part is that the borrowing binge is not even managing to support the economy. All of the costly measures are still not enough to brake the US economy from a downward spiral. This begs the question as to how bad the US economy really is. I am guessing, and it is no more than a guess, that the answer might start becoming apparent towards the end of the year. At some point, the great unwinding must take place, and then it is time to reach for your hard hats. The ride has only just started, and it is going to get very bumpy.

Obama's Budget - From where will the money come?

The news at the moment might be described as worrying. Today, we have the story of the 'Obama' budget, which is simply quite staggering. The link I have provided will take you to the Times version with plenty of detail, but I rather like this from the Telegraph, which illustrates the scale of the spending:

If the $3.552 billion budget is divided between all 138,893,908 American taxpayers – the 2007 US Internal Revenue System figure, the latest available – then it will each one $25, 573.48.

The Republicans are up in arms (despite their own prior fiscal incontinence), with their concerns ranging across many areas. However, their focus appears to be on taxation, rather than the idea of deficit spending (Ron Paul is a notable exception).

Inevitably - the promised return to shrinking deficits is apparently going to happen at some point in the future. In order to achieve this, there is very little detail:

Mr. Obama’s first budget was light on proposals to cut spending, despite his statement at the White House on Thursday that the government would be “cutting what we don’t need to pay for what we do.” (NY Times)

Of particular interest as illustration of the lack of clarity is that one of the ways proposed for balancing the budget is to increase taxation on higher earners. This raises a question of how many higher earners there will be, and how much they will be earning, as the economic shake-out progresses. The news reports do not give the details of how calculations have been made, but I would guess that such 'details' have not been considered. For example, this is from the NY Times:

He says he would shrink annual deficits, now at levels not seen in six decades, mostly through higher revenue from rich individuals and polluting industries, by reducing war costs and by assuming a rate of economic growth by 2010 that private forecasters and even some White House advisers consider overly rosy. [italics added]

In other words, the return to fiscal continence looks rather improbable. Perhaps the most worrying part in all of it is the proposals to tax business and increase business costs:

He would remake the energy sector to reduce reliance on foreign oil and address global warming, by requiring industries to buy permits to emit the heat-trapping gases that contribute to global warming. The revenue would pay to develop alternative energy sources and to provide tax relief for Americans facing higher prices from utilities and industries passing on their permit costs. (NY Times)

At a time when the US is on its metaphorical economic knees, this is a proposal to increase the costs of businesses that provide employment. Whatever your views on man made global warming, such action will have an impact on those industries, and will see their competitive position erode, and the businesses that rely on such industries erode in many cases (e.g. if US energy costs increase, so will the cost of steel produced in the US).

Above all else, on top of all the other borrowing and activity that has been undertaken, there is an assumption that the money will be available for borrowing. The US has managed to continue to fund its borrowing due to the 'flight to safety' towards the $US, but Hilary Clinton's visit to China with a begging bowl clutched in her hands illustrates the fragility of the situation.

Regular readers will know that my belief is that a situation of the world (and in particular China) continuing to fund US deficits looks ever more improbable. What we now have is the US attempting to raise $US trillions to finance government, the same in the UK, the same across Europe, the same in many places in the world. Governments across the OECD are going on a binge of borrowing and spending. If we then think of the creditor countries, the countries that potentially have the savings to fund such borrowing, we see that their priorities are to deal with their own troubles.

China and Japan are both in a situation in which the rapid contraction in exports are hitting them hard, and they need to rapidly act to restructure/transition their own economies away from exports. As an article in the Economist points out, there is severe pain in the Chinese industrial heartlands, and a Chinese government fearing social disorder. This is a government that must use their own resources for their own needs, not use the resource for further lending into collapsing world economies. At this point I will digress slightly, as I have seen a contrary view from an individual whose views I respect. Niall Ferguson has the following to say:

The line is very clear from China. They've consistently made their position clear. They want the status quo. They do not want this thing to break down. They were kind of appalled when Geithner said the ‘m' word. And they took full advantage of Hillary Clinton's visit to smooth ruffled feathers and restate their commitment. It's a very good bilateral relation. That bilateral will is important here. The Chinese believe in Chimerica maybe even more than Americans do.

As for my views on the situation, Niall Ferguson believes that China and the US are locked in a perverse economic embrace. However, we differ in the belief that the embrace can be maintained. My reason for disagreement is that, even if China pours more money into the US, an insufficient amount of that lending will be returned to the US through consumer purchasing of Chinese goods, as the wallets of US consumers are snapping shut. In addition the US is printing money, and the possibility of repaying debt in anything other than more useless paper looks increasingly improbable. In such a situation, China is giving large amounts of output for free, and that will in any case be unsustainable.

With regards to Japan, I find the country quite a puzzle to understand. Whilst familiar with Asian culture, and Japanese business, I find the country as a whole a genuinely difficult one to understand. I promised an article on Japan long ago, but never managed to have enough confidence to plunge into the muddy waters of this subject. Some things we do know, which is that the Japanese export machine is grinding to a rapid halt, the economy is falling off a very big cliff, and the only salvation for Japan is in the huge savings of the Japanese individuals. I have read somewhere (sorry no reference) that the Japanese have started to eat into those savings to fund their day-to-day expenses. Again, in such a situation, it is hard to imagine that Japan will ride to the rescue of the West.

The big oil producers are returning to the hard realities of life in an environment of cheap oil. Even in December 2008, there were reports of problems in the finances of Saudi Arabia (although their problems might be considered slight when viewed against the problems of the West), and reports of diversification of petro money away from US treasuries in November of 2008. I believe that I have also given some further examples of an increasing cynicism towards Western investment in the last few months in several articles. As a source of finance, the petro economies look unlikely to be willing to dip into their deep pockets.

For Germany, it has its own problems due to falling exports, and is faced with the potential for disaster in the Eastern and Central European countries turning into massive losses across Europe, as well as the troubles in the evocatively named PIIGS countries (Portugal, Ireland, Italy, Greece, Spain). As a result, the future of the Euro is starting to look threatened (something I discussed as a possibility long ago), and Germany will be focusing resources into their own troubles as a priority, and the Euro area troubles as a second priority.

The essential problem is this. All around the world, economies are in free fall, and resources directed to problems at home will be the absolute priority of each country. In such circumstances, the possibility of countries being able to finance their deficits through overseas borrowing looks to be so unlikely that it remains close to impossibility. In the case of the US and China, the Ferguson thesis looks to be the best explanation for how lending might occur, but the insanity and unsustainable nature of the imbalance must be apparent to China. I just do not believe that they will continue to finance US profligacy in return for increasingly worthless pieces of paper. However, I can offer no clear evidence for this, though I have previously posted articles in which China has been hinting at their unwillingness to do so.

Regular readers will have noted my continuing campaign for clarity on the Bank of England's policy on quantitative easing (QE, printing money), and my suspicion that the Bank will be using this to directly fund government operations. I have not, as yet, looked as closely at the situation in the US, and will look at this in the future. However, bearing in mind that there just does not appear to be the money 'out there' to borrow, my suspicions that the US government is doing a 'Zimbabwe' is very strong indeed. Further discussion to follow....

Note 1: I had a comment from 'Red' pointing out that I am putting flies in the ointment in my requests for clarity on the BoE policy on QE. As one anonymous poster put it, better to get the truth out sooner than later, before the real damage is done. Another commentator suggested that I am fear mongering. To this I would respond by saying that, rather than fear mongering with no justification, I have sought to gain a clear understanding of what the BoE is up to. As such, I am giving them the opportunity to assuage my fears, and hopefully the fears of those who share my concerns. Their evasion to date suggests that they have something to hide. I have today sent an email asking them to acknowledge my email, and am still awaiting any replies to my questions. We will see...

Note 2: ChasH has sent a letter to his local Conservative MP, and received a reply. The reply really says very little at all, and as ChasH points out, it looks remarkably like a 'form' letter. The letter can be found at the bottom of this post in the comments section, and I would be interested to hear if others have had similar replies. It is a little worrying that the reply appears to be so complacent and could be summarised as 'wait and see'. As I have stressed, this may be the most radical economic policy every undertaken, and we have no idea about any details of the policy....

Note 3: I have had some interesting comments on my article on deflation, and can not reply to them all. However, I would like to some points.

A few people have suggested that division of a unit of currency into smaller units is expanding the money supply. This is a very different process, as you are not changing the number of units of the actual currency. If we were to imagine that we followed the idea of a fixed money supply, and imagined that we froze it at £1000 units of currency (for the sake of illustration), we could have the following:

We start with £1 units of currency with a total of £1000 units as £notes. As deflation occurs, we subdivide the currency into each £1 = 100 pence. In practical terms, if we imagine that £1 at the start buys 1 litre of milk, and as deflation occurs it is not possible to use that £1, because the price of milk is now £0.5. We have a problem. How can we exchange the currency for the milk, if we only want 1 litre? We can now only exchange the £1 for 2 litres.

To overcome the problem, we are not diluting the value of the £1, we are merely allowing it to be chopped up into smaller units, for example coins. If you hold a £1, the £1 will still buy 2 litres at £0.5 each. Alternatively, if you decide to exchange your £1 for 100 pence in coins, the £1 will be replaced by 100 pence. Any holder of £1 is not losing anything, as this has absolutely no effect on the £1 that they hold. The important part is that, as the new units are called upon, each 100 pence issued sees the removal of a £1 note. The money supply remains the same, and is always equal to £1000. At any time in the future, although it would become an increasingly impractical unit, you could return to a bank, and exchange the 100 pence back into a £1 note.

However, if you want to really increase the overall supply of money, you would print £1 notes. In this case, every holder of £1 sees the £1 erode in value, because there are now more than 1000 £1 notes. When the new £1 notes are printed, some of the value of those notes is transferred to the new £1 notes. In this situation, if we start with our £1 litre of milk, and more £1 notes are printed, there are more £1 notes chasing the milk, and the price of milk goes up, thereby reducing the value of each £1 in exchange.

The example I give uses physical notes and coins for ease. However, if we think of this in terms of electronic currency, in terms of accounting, large numbers of pence will still be accounted for as £s. All sub-units of currency are measured against the fixed number of £1000 that were there at the start. That number never changes. Whatever happens the number of 1000 x £1 never changes.

I hope this answers the question? Let me know if not.

On a related issue, I have had comments on the fact that this is another fiat currency. The answer is both yes and no.

It is not fixed against an individual commodity, but is fixed against the total output of an economy. Fiat currencies make this claim, but the ability to increase the units means that they can, and actively do, produce more units of currency than the growth in the value of output. In fixing the units of currency, you fix the value of the currency against actual output of value. If output increases, then the value of the currency increases, and if output decreases the value of the currency decreases.

As such, in the example I have given, each £1 = 1000th of the total output of the economy. In normal fiat systems, each £1 = 1000th of output but we would have to add that it would need the proviso that the value would be a feature of time, such that the value is determined not as fixed, but as measured against time (inflation). In other words, the value will become £1 = 2000th of the value of output at some stage in the future. In the fixed money system, whatever happens, £1 = 1000th of the total value of output.

I hope this is clear...

With regards to commodity currencies, they also have inflationary potential (e.g. new gold source found) but are better than ordinary fiat systems, as they create some kind of constraint on the expansion of money. Moreover, they offer a default value as a contract, such that whatever happens you can exchange this money for x amount of gold. A standard fiat currency simply implies that at some point in the future, it may be exchanged for 'something', including another unit of the same currency. However, as we may be about to find out, it may be useless to exchange for 'things', because the value is destroyed by oversupply of units of money. In the case of the fixed money supply, there is a contractual commitment that (staying with the 1000 unit example) you will be able to exchange the £1 for 1000th of total value of output. That is a strong contractual commitment.

The US Dollar

My post on UK unemployment has received a couple of replies. In one the commentator suggested that the rise of the US dollar was a good thing, and suggested that the US economy was therefore on the right tracks. Another commentator replied to this post with the following:

'Isn't the value of the dollar (and the index you mention) just a relative measure, so it's entirely possible that all non-Chinese economies are collapsing together, with just a bit of jostling to see who can collapse fastest?'

In light of these posts, it might be worth just discussing the recent recovery of the $US. In particular, how is it that it is recovering? A dollar recovery does not fit the script that I have been writing over the last few months.

As it is, the second comment is on the right track. All of the currencies of the rich world economies will almost certainly decline against the currencies of the emerging economies, and the reason for this long term trend is given here. However, with regards to the RMB it is a managed floating exchange rate, such that it can not automatically respond to market conditions. This is a big spanner in the workings of the currency system, and continues to be a partial block to the rebalancing of the world economy.

This is obviously just a very broad context and does not explain the recent rise of the dollar. My own suspicion is that the rise in the dollar is nothing to do with fundamentals but just the result of habit. In times of uncertainty, which I think would be a good summary of the current economic climate, people automatically look to the dollar as a safe haven. The trouble is that the dollar is now no such thing, and is still highly vulnerable. It's a bit like the business saying of 'nobody has ever been sacked for buying IBM', but in this case of the dollar it is flying in the face of reason. The simple question to ask is 'what has changed in the state of the US economy in the last few weeks to justify this appreciation?' As soon as you ask the question the only answer is that there has been no major change. As such, sentiment rather than reason is driving the dollar higher.

The real problem here is that the revaluation of the dollar upwards is just storing up even more trouble for the US economy. The US economy needs to be rebalancing towards export led growth, and this will delay progress towards this end. It is only through the relative impoverishment of the US that is represented by a weaker dollar that the US can regain a competitive position.

As such, the dollar may rally for a while, but in the end it can only last for so long before economic reality trounces market sentiment. At some point there needs to be an economic justification for a stronger dollar, and force of habit is a poor justification.

Comments from MattinShanghai:

I have had a couple of interesting comments from a person who presumably lives in China. I am particularly pleased to have a comment coming out of China, as it is only through seeing China 'on the ground' that the reality of that country's economic development is apparent (with Shanghai as a quite startling example).

One point of note was a link to an article/essay that Matt posted. The article can be found here. It offers a very challenging perspective on Japan, and is worth reading. I keep on meaning to address the subject of Japan, but it is on an ever expanding 'to do' list, so will have to wait a while longer.

For his other comment, I will not try to paraphrase it, but it gives an outline of a historical perspective on my post on Synthetic Economics. As such I would recommend a quick read of the comment. Matt refers to one author and his writing can be found here (I am downloading it now, so can not comment on it yet). However, it sounds like the author has an interesting perspective.

Recession Prediction

I have just been looking through the Sunday papers, and it is interesting to note that the British Chamber of Commerce is now saying that the UK is heading for a recession (article in the Times):

'THE British Chambers of Commerce (BCC) will this week become the first leading business group to predict a recession in Britain.

Its quarterly economic forecast, to be published tomorrow, is expected to say that Britain is heading into a “technical” recession of two or more quarters of declining gross domestic product over the next six to nine months.

It will say that a deep recession, of the kind last experienced by Britain in the early 1990s, remains unlikely, but that the risks to the economy have grown significantly over the past quarter and unemployment is set to climb by up to 300,000.'

On the positive side, at least they are recognising that the situation is bad, but their optimism over the length and severity is completely unjustified. I have looked at their website, and assume the source is the quarterly survey, which is only available with a subscription, so am unable to see how they reasoned their prediction. However, whatever their reasoning, at least the conclusion is positive in that they are pressing the Bank of England to ease interest rates. This is desperately needed in a sinking economy and will help the UK to adjust to the economic imbalances through weakening the £GB.

A good example of the non-argument for raising interest rates is given by Simon Heffer in the Telegraph. He calls for higher interest rates to fight inflation, but as is typical of such commentary, fails to explain (and presumably understand) by what process raising interest rates will prevent inflation. He says:

'A rise in rates, which I believe is necessary to drive the last ravages of inflation out of the system, would be the final humiliation not just for Mr Brown, but for the system of economic management that he has made his own.'

And:

'I know a rise in interest rates will cause more houses to be repossessed, more businesses to fold and more bankruptcies.

Sadly, that is what the economy needs in order to turn itself round. You can't have sustainable "growth" on the back of an economy where people and enterprises are living beyond their means. You can have it only where they are living within their means.'

He may not have noticed, but this is already happening. Regardless of the interest rate, this process is already in train, so how is accelerating it going to help? He suggests that it is better to have the pain now than later. However, an interest rate rise will have the effect of being a prop for the £GB (though will just slow the fall), and this is will only have a negative effect. I give the example of Heffer, because his line of thinking is not isolated. Underlying such thinking is a lack of acceptance of both the severity of the current situation, and the changed reality of the world economy. Britain, along with the rest of the rich world, are going through a crisis, and and this lack of recognition of the crisis is one of the great dangers in the current situation.