The Perpetual Economic Growth Machine

When first starting this blog, I had a thesis; that debt growth was the underlying cause of 'economic growth'. As the blog progressed, along with the breadth and depth of my analysis, I came up with the idea that the economic crisis had an underlying cause; a labour supply shock in conjunction with a lack of commensurate increase in commodity supply. It was an idea that I then used to develop the idea of hyper-competition. In light of this theory, I thought that the outcome would be clear. The Western economies were uncompetitive, and they would lose out in the face of the competition from the emerging economies. It seemed so screamingly obvious that I wrote a post in 2009, predicting that it was the year of the fall of the West (Japan was counted in the West, which I know is a little odd). It was a post in which I made a poor assumption; I thought that, one way or another, the underlying and obvious problems of the Western economies MUST be recognised.

The crash I predicted failed to take place, and I took a hit to my credibility.

When the predicted crash failed to materialise, I was heavily criticised by commentators on Reddit. I responded by saying that at least I was willing to put a date on the turning point, whilst others lack confidence in their theories and refuse to predict outcomes. I should have added that a theory needs to be tested by evidence; can it predict? If it cannot predict, then it fails. Most of what you read does not offer the confidence to predict outcomes, or leaves the timings of outcomes open. The authors shroud their thesis in ambiguity, and nothing they say can be held accountable.

My mistake at the time I wrote of the Downfall of the West was that I failed to see that there was plenty of extremes to which policy makers were willing to resort. In addition, I failed to see how entrenched views of the world were; the West was the heartbeat of the world economy, and NOTHING would ever change that. It a question of government action acting to support and shore up a world view that is resilient the the underlying facts. We would return to the status quo of the West living high on the hog, whilst those poor countries tried to catch up. The world economy would return to the natural order, once we just sorted out the fallout from the 'financial crisis'. It was just a problem in the financial system, and some policy action here and there would return all back to 'normal'.

If you have contrary evidence to your theory, you need to ask why you got it wrong. Perhaps, in the explanation I have given above, I am making excuses. I am highly self-critical, and do not believe these are excuses. In fact, as time has progressed, I have come to the view that I was right all along. Not right that there would be a terrific crash, but right in my underlying thesis. I expected drama, not the steady and relentless decline that has taken place. I argued that the West is 'poorer than we think' and we are steadily recognising this in the decline of the standard of living in many Western countries. We are slowly but surely seeing the middle classes being hollowed out, declining real incomes, growing unemployment (or underemployment). This is taking place against the backdrop of crazy levels of sovereign borrowing, money printing, and the related issue of extraordinarily low interest rates. None of this extreme policy seems able to lift the economies of the West.

Instead, whilst governments rack up debts, and money is pouring forth from central banks, we are just getting poorer. I have to emphasise the point that governments are creating mountains of debt, and we are still in day-to-day terms, getting poorer. We are already poorer, but how much poorer will we be when (assuming we actually pay it) we start to bear the load of the debt being accumulated now. Tax must rise at some stage to pay for it. The opposite view is that economies will return to major growth, and this will cover the debts. It is a promise that has been made for a long time. However, even as governments borrow, as money is printed, there is no real growth. There is only the anaemic growth that is following profligate borrow and spend policy.

It has never been complicated. If I borrow money, and use that money to pay for consumption, it generates activity in the economy. The borrowed money circulating through the economy creates activity, and that reflects in the GDP figures. Take away the borrowing, and GDP falls. We see this in Greece and Spain, and start to see what takes place when an economy reliant on borrowing stops borrowing. The evidence is there in plain sight. Nevertheless, there are many who argue that the problems of overly in-debt countries is to borrow more, and they convince many people. Borrow 1 billion, and it will produce 3 billion of activity in the economy, and the tax income from that activity will allow the economic growth to pay back the debt through increased tax revenue.

Just think about this. A country borrows money to produce revenue to pay back the borrowing. The problem is simple; resources are being consumed along the way. The view that borrowing more is going to solve problems is based upon the idea of a perpetual motion machine. There is no loss of energy, or in this case no loss through the consumption of resource. Borrow and spend is a perpetual motion machine. Borrowed money comes in, generates revenue to pay back the borrowing, and revenue then pays the borrowing. Nothing is lost. No resource is consumed. It is the perfect system. Except that it is impossible.

The perpetual borrow and spend, create revenue, repay borrowing machine is a truly unique idea. It is unique in that so many people have persuaded themselves of its possibility. We laugh at the perpetual motion machine, but many view this perpetual economic growth machine as possible. No loss. Just gain. Here is how it can work. Every year, we can increase our borrowing, and increase the activity in the economy. As the activity increases, we can increase our revenue, and that increases our ability to service our debts. In fact, we are not borrowing enough. If we accelerate our borrowing, we will increase our revenue, and we will be in an even better position to repay our borrowing. The more you borrow, the better you are able to pay back the borrowing. No loss, just growth in revenue, as nothing is apparently being consumed in the process.

If only the perpetual economic machine were true. We could forget having to compete and just borrow our way to prosperity.

I now return to my failed prediction of the 'downfall of the West'. We are growing poorer. And we are consuming based upon growing debt. Real resource is being consumed through debt accumulation. All would be good if there were a perpetual economic growth machine, but it is a fantasy. Nevertheless, that fantasy has real currency in the real world. It has prevented a crash, but we are nevertheless getting poorer. My error of thought was to believe that illogic would be uncovered. Instead, debate and discussion takes place, and the perpetual economic machine is the winning argument that drives belief.  Policy will make the economies of the West return to their natural and rightful position. If in doubt, just keep borrowing towards wealth.

The exceptions, the Spain and Portugal examples, just need to abandon austerity, and they will return to growth. The perpetual economic growth machine will deliver. It WILL deliver, because it MUST deliver. It is a costless machine. Nothing is consumed.

Update just after publication: Just a little note as I left my  thread of thought behind as I wrote (yet again). I missed making a key point. How could anyone predict that people might believe in a perpetual economic growth machine? But people do..... this was a crucial fault in my prediction. Sorry, but I was distracted from the point I was trying to make. I could not accept that the perpetual economic growth machine could be a foundation of belief, and the belief therefore might avoid the crash which I predicted. What we are looking at in the world economy is the contradiction between the perpetual economic growth machine as a belief, and the reality that it cannot and does not work (barring the exceptions such as Spain where we can see the idea collapsing). Reality and belief are bumping together, and reality is slowly winning out.

2nd Update just after publication: Long term readers will have seen my prediction, but still come back. I have always left it in place as I think my record of what I have got wrong is as important as what I have been right about (notwithstanding that I argue here that I was not so wrong). I do not believe that bloggers should 'airbrush' their record, and have left all of my posts as live.  I encourage new readers to dig into the archives. See where I have been right and wrong. Make a judgement on  whether I have something interesting to say based upon my record. I am obviously biased, but I think my record overall puts me in a strong position.....despite my admission/s that I have got things wrong (there is one case where I presented a detailed analysis of an economic forum, only to have an astute reader point out that I was a year out of date; I was analysing the meeting and output of the previsous year, but the post and apology is still online).

The World Economy: The State of Play

First of all, I would like to apologise for the lack of posting for so long. I have several times sat down to start to post, but was somewhat at a loss as to where to start. I had a quite a long period in which all I had time for was a major project, and returning to posting has been difficult in the face of an ever more 'odd' world economic situation. Too much cries out for attention, and this is the problem; each of the many stories that are ripe for discussion do not make sense in isolation. As such, I will try to give a selective overview, and do so in the context of my underlying thesis of the causes of the world economic crisis.

[Note: as I have pressed forward in the post, I have limited references/links, and also digressed from my original purposes for the post. I hope that it still remains a coherent view.]

First of all, I will briefly outline my explanation of the crisis in the world economy. One of my discussions of the underlying cause can be found on Huliq, and I recommend reading this if you are new to the blog (there is a more detailed version somewhere, with more figures, but I forget where it is). The short version is that, with the entry of economies such as India into the world economy, there was a huge supply shock. The labour available to the world economy (by which I mean with capital and connected into the world economy) has approximately doubled. Even whilst this was taking place, the supply of many commodities failed to keep pace with the expansion of the labour force and, for other commodities that did expand in supply, the demands of building new infrastructure in places like China saw demand explode to a degree that commodity supplies still struggled to keep pace with demand.

The result of the labour supply shock, in conjunction with the problems of commodity supply, saw what I term hyper-competition. I dispute the idea that the 'financial crisis' was the cause of the economic crisis, but argue that it was instead a symptom of the supply shock (see the Huliq article for why). The economic crisis is resultant from hyper-competition, and the shift of limited resources towards the 'emerging' economies. From this underlying thesis, I have argued that the result will be that there will be a re-balancing of wealth around the world. Contra to the argument that the emerging economies would grow in wealth whilst the developed world continued to be wealthy, I have argued that the world economy would grow overall in wealth, but that the growth in wealth of the emerging economies would, due to redistribution of limited resource, come at a cost to the developed world. Whilst the emerging economies grew in wealth, the developed economies would generally see an erosion of wealth.

In the Huliq article, I link to my early posts on this thesis in 2008. Time has now passed, and we can start to see the outcome of the labour supply shock. An interesting example can be found in the many stories coming out of the US describing the shrinking of (and often described as the the 'death of') the American middle class.There are questions about what people might call the middle classes, but there is a clear picture in which median incomes and the quality of life of 'the middle' in the US is moving in the wrong direction. At the same time, stories abound about the 'rich getting richer', along with rafts of figures supporting this point. That this is taking place is unsurprising; if there is a massive increase in supply of one of the factors of production, then it should be expected that the price of the factor will go down. As labour prices have gone down, this in turn increases the potential for those with capital to make greater profits and those with capital reap the benefits of cheaper labour.

A similar story can be found in the UK, where incomes have been described as being 'squeezed' by the Governor of the Bank of England (sorry, no link) and reports of ongoing declines:

People in the UK saw their incomes squeezed in 2010-11, despite a modest recovery in the wider economy, according to a new report.

Data collated by the Institute for Fiscal Studies (IFS) has revealed that median household income fell by 3.1 per cent after accounting for inflation during this period, wiping out five years of minor growth within 12 months and setting income levels back to those seen in 2004-05.
This represented the largest single-year decline in income levels since 1981, with earnings falling across all parts of society.

According to the IFS, these figures can be attributed to rising inflation and the delayed effect of trends seen during 2008-10 at the height of the recession.

The situation in Europe is complicated by the Euro crisis, with the crisis an additional factor that is influencing the wealth of individual countries throughout the European Union. Nevertheless, the picture is one in which, for much of the EU, the economic situation can only be characterised as dire. The Euro crisis just complicates the picture. Perhaps the most interesting example in relation to my thesis are Australia and Sweden, which have largely been immune from the economic crisis that has been felt in the rest of the developed world.

Unlike Britain, it is sometimes said, Australia and Sweden are advanced economies that have managed to get their public policy agenda broadly right, and as a consequence now reap the rewards.

Both economies sailed through the credit crunch pretty much unscathed, unemployment is at or close to an all-time low, and unlike so many other ''rich'' nations, public debt is under control.

But while inspired policymaking has no doubt played its part, much more important is that both Australia and, to a lesser extent, Sweden are rich in natural resources. Sweden also has an abundance of relatively cheap hydroelectric power.

The blessings of nature, not the brilliance of policymakers, offer the better explanation as to why these countries have done so well.

Similar stories can be told for other commodity rich economies such as Brazil and Russia. The success of these commodity rich economies are exactly what might be expected in the era of hyper-competition. I have also argued that the world economy would be dominated by commodity supply and prices, saying that: 

In an earlier post, I presented an analogy. I described commodities as a moving brick wall to growth, with the world economy running behind this wall of constraint. As the economy runs forwards, it hits the wall and tumbles backwards. The world economy then gets back on its feet, and once again runs towards the wall only to eventually bounce back again. [sorry, I forget where I first wrote about this].

This has been the pattern that has emerged since the world economy fell into crisis. But, it may be that the situation may be about to change. The first element that needs to be considered is the energy revolution that has resulted from 'fracking', which has allowed an explosion in natural gas output. It is not a direct substitute for oil, with more limited uses, but it has changed the overall picture of energy supply. This is not to say that the constraints of oil supply  have been removed but they have been ameliorated. However, this is nothing compared with the potential for the Chinese economy to impact on the commodity situation:

Sharma is heard with respect when he gives an opinion on something concerning emerging economies. At the same time, the commodity supercycle standing for a very long-term surge in prices may or may not have run out of all its steam. Unarguably, bulk commodities and metals subject to stagnation in the two decades preceding 2000, subsequently started experiencing regular spikes in prices on the back of unprecedented demand growth in emerging markets.

If China stood out for its ravenous appetite for raw materials, a big market opened up for their suppliers, benefiting emerging economies, like Brazil and Russia. In the beginning of the cycle, demand for raw materials was ahead of supply and buyers in China and India (for coking coal) were constrained to pay ever rising premium prices. Raw material price spikes left huge surpluses with the mining groups leading them to invest heavily in capacity expansion to take care of the world hunger for minerals. This is bringing about a balance in demand and supply and as a result, a southward push to prices of raw materials and collaterally to metals.

Unlike Sharma, many others argue that rises and falls in commodity prices happen in waves lasting 20 years. If it is to be accepted that a supercycle has a life of 20 years, then there is no running away from the fact that halfway, the market is taking a hard look at slowdown in all emerging economies from where the bulls in the first place drew inspiration. The Chinese double digit growth rate is in the past and as the world’s second largest economy is aiming at a soft landing, it grew at 7.6 per cent in the second quarter of this year. China has now lowered its 2012 growth target to 7.5 per cent from the earlier eight per cent.

As for India, Moody’s says the combination of a sharp and broad-based slowdown, a poor monsoon and a government that has “badly lost its way” will restrict the country’s growth at 5.5 per cent this year and six per cent in 2013. Growth deceleration in the two BRIC (Brazil, Russia, India and China) nations will set off a chain reaction. Fall in China’s raw materials import growth rates in particular will be hurtful for resource-rich and export-dependent Brazil and Russia. Australia, a major supplier of a host of minerals to the world, is taking a hit because of a downturn in commodity prices. Retreat by bulls is also due to discouraging industrial output data from Euro zone countries. Their main concern is Europe’s manufacturing hub Germany, which after sustaining growth through the European debt crisis is now feeling the impact of the Euro zone storm. No wonder the German manufacturing PMI in July was at its lowest for more than three years. Bulls are further disheartened by the Bank of England warning the UK economy would grind to a complete standstill and the US Federal Reserve and European Central Bank refusing to introduce new stimulus packages.

For a long time, I argued that China was playing its cards superbly. They played the developed world players off against each other, stole intellectual property, and used their currency in support of mercantilism trading policy. From the ravages of Maoism, when China commenced opening up to the world economy, the massive investments in infrastructure were easy 'hits' for creating infrastructure with significant economic returns. However, even in my early posts, back in July 2008 I said the following:

The first point is that it is quite possible that China has a construction bubble. Whilst I was in China I noted that there were lots of apartment blocks being built, and that it was very popular for these to be purchased by investors. In many cases the investors were leaving the apartments empty (Chinese people like to buy property brand new, once it has been lived in the value falls), and they were holding on to the apartments in an expectation of increases in value. In addition to this there has been a boom in the construction of shopping malls, and I noted that they were already (back in January) starting to exceed demand. If the Chinese economy is pulled back due to world demand for exports dropping, it is likely that such investments will lead to a bust. It is also worth considering the state of the Chinese banks. If they are lending into construction in this way, will there be a repeat of the previous Chinese bad lending problems of a few years ago? What other bad lending is buried in their books?

Set against this is that the finances of the Chinese government are very healthy, as are the levels of savings in China. The real question with China is how much their continued growth is reliant on exports, and how much growth can be sustained within China. I will readily admit that I am not sure on this at all. I am not sure that anyone is. My best guess is that China will also hurt, and hurt badly, with a significant potential for civil unrest as a result.

The final paragraph; I was wrong, and China did pull through and in part because of the spending binge of the developed economy governments maintaining demand. However, it is now four years later, and the situation I described with housing and other real estate was indeed taking place, but no bust took place. Analysts have recognised what I saw on the ground all those years ago, and have similarly been predicting a bust in the last couple of years. That bust may, or may not be in motion now, but the curious question is why it was that the bust has been evaded so long. The answer is simple; the Chinese have nowhere else to put their money, except for the casino Chinese stock market, in state bank accounts with pitiful returns, or in places like Wenzhou in very dubious private corporate lending.

With regards to the finances of the Chinese government, they still remain relatively healthy, but only if you discount the provincial and local government. A combination of corruption and ineptitude has seen large investments being made in construction projects, in preferred state companies, and real estate. The result is massive investments in capital projects, including dubious infrastructure projects and real estate. As time has moved forwards, the easy investment 'hits' have diminished, and the result increasingly dubious investments. These investments are, in turn, linked into the state banking system, which will undoubtedly be sitting on low grade debt that will sour at some point in the future. In a previous post, I have detailed the cities being built with no people to live there, and this is just a very visible tip of a large iceberg.

The Chinese government sought to engineer a soft landing from the real estate boom, restricted credit, and the result may be a hard landing. I mentioned Wenzhou earlier, as it is the exemplar of how this tightening of credit led to a big bust in the private 'grey' credit markets; the limited access to credit in the state banks fed into a bust for many of the unregulated private lenders, often with horrendous results for small investors. However, in the face of dramatic drops in growth, the restraints on credit have been pulled, and a new round of large capital investments has been unleashed. The problem is that the re-loosening of the credit taps will see more malinvestment. It may (or may not) be too late to reverse a bust. The problems that are taking place in China are likely to be exacerbated by the problems of the EU economies weakening demand for goods, and the so-called 'fiscal cliff' in the US:

Congress is moving to quash the threat of a government shutdown, but the prospect of a one-two punch of tax increases and slashing, automatic spending cuts will still confront lawmakers when they return to Washington after Election Day.

The House on Thursday passed a six-month stopgap spending bill to keep federal agencies running past the end of the budget year, the elections and into the spring. It effectively scratched a major item off of Congress' to-do list heading into a potentially brutal postelection, lame duck session.

The bipartisan 329-91 House vote for the measure sent it to the Senate, which is expected to clear it next week for President Barack Obama's signature, capping a year of futility and gridlock on the budget despite a hard-fought spending and deficit-reduction deal last summer.

Nobody can predict at this stage how the 'fiscal cliff' will play out. If it does kick in, the US economy is likely to be hit hard, and this may explain the feds renewed bout of printing money; it is front-running the potential fallout from the fiscal cliff. In the meantime, the mess of the Euro continues to stagger forwards with compromise and delay, but with no real resolution. It is a crisis that simply refuses any resolution. It is almost becoming dull to watch the back and forth between crisis, and temporary bouts of market relief. As time goes forwards, it becomes ever more apparent that we are watching King Canute seeking to turn back the tide. We are just left with the hanging question of when and how the tide might finally overwhelm the desire that it be held back.

The problem is that, if China really does go into reverse, this will have knock on effects in the countries that have been sheltered from the economic crisis through the commodities super-cycle. The new bout of investment may just lift the Chinese economy enough to keep the economy from a bust, but it is far from certain in the face of wider economic headwinds.

There are some things which remain resolutely unchanged. The global 'too big to fail' banks still sit like time bombs within the global financial system, but post-crisis are even more 'too big to fail'. Although there have been vague and weak attempts to address some of the problems of these banks, central banks continue to support bust banks, and do whatever is needed to shore up the banking system. As I have discussed in previous posts, parts of the EU bailouts have been directed towards shoring up insolvent banks, and in return the insolvent banks have propped up insolvent governments. It is the same story I have discussed previously; banks are magic entities which are the foundations of economies. Somewhere along the way, the regulators and politicians lost sight of the purpose of banks as a support for the rest of the economy, and now the rest of the economy is a support for the banks.

Then there is the government borrowing. In the developed economies, the debts of governments just keep on growing. Whether financed through the printing presses, or financed through dubious credit lines of central banks, developed world governments just keep on borrowing and spending. The poster boy for the borrowing and spending approach is, in my view, the UK; they proclaim austerity whilst continuing to borrow and spend at astonishing levels. I am not going to discuss this subject in detail, as the blog is replete with discussions of individual economies, and general principles.

However, I will re-emphasise that this is a prolonging of the problems of the developed world. The shift in the world economy represented by the labour supply shock was hidden by huge expansion in credit. This allowed the diminishing levels of wealth in the developed world to be hidden for a while. Even though less wealth was being generated, lifestyles were maintained as if wealth generation was increasing. The 'financial crisis' was simply the 'bust' of this paradigm, and the developed world governments replaced the private credit growth with government credit growth. What the governments failed to recognise was that the private credit growth had restructured their economies to service credit growth, and that they are retaining that structure through the use of government borrowing. In the end, credit growth cannot be sustained forever, and any structure built upon ongoing credit growth must eventually collapse.

The point is this; the great labour supply shock has taken place. It is there in front of our eyes. It is not possible for the entire world economy to become richer if the rate of labour entry exceeds the increase in the rate of available commodities. It is a situation further complicated by the resource intensive growth in infrastructure needed to grow a developing economy, but it is a simple and logical formulation. If 10 people share access to 10 litres of oil, each can have a litre. If the number of people increases to 15, and the available oil only increases to 12 litres, it is not possible for each person to have a litre. What then happens is that those who want a litre of oil, as they had before, must compete intensively with the newcomers if they want to keep their oil. The newcomers, unsurprisingly, would also like to have a litre of oil. Welcome to hyper-competition.

It is a situation which is now being recognised. This from a conservative commentator in the Telegraph:

In his seminal study of business cycles, the Austro-Hungarian economist, Joseph Schumpeter, explained these long – or Kondratieff – cycles as the natural result of particularly high periods of technological innovation. This seems plausible, even though the latest phase of innovation is of course mainly about communications, little if any of which originated in China.

Modern communications has none the less reduced Western advantage in many commodity industries to virtually zero. The major beneficiary has so far been China, where dissemination of Western technology and globalisation of trade has driven a remarkable economic transformation.

Western economies have in a sense shot themselves in the foot. Their own innovation has made them relatively less competitive and therefore less well off than they used to be. One of the manifestations of this shift is that we have to pay a lot more for our commodities – be it food, oil or metals – than we used to. Speculation, Western money printing and ultra low interest rates have turbo-charged the bubble.

But even assuming that China avoids the much feared hard landing, there is good reason for believing the present super-cycle may already have peaked. The iron ore price has fallen nearly 40pc in the past year alone.

As in 2008-09, the fall may be a blip, but equally, it may a presage a much-needed shift in the composition of Chinese economic growth away from commodity intensive investment and capital accumulation to consumption. China’s investment and export orientated model is proving just as unsustainable as the West’s consumption driven approach to growth. China knows it must change if it is to keep growing. There’s no relief to be had from once buoyant Western export markets.

People are starting to get it. It was never a financial crisis for the developed world - it was a fundamental economic crisis - a shock that was buried in a credit make-believe. All the actions of policymakers and governments, including politicians and central banks in particular, has been a pretense that 12 divided by 15 can equal 1. The response has been to hide from the reality that the figures just do not add up.

We have seen the Chinese economic miracle, and to a lesser extent the other emerging economies, dominate the shape of the world economy. Rather than confront the challenge that was represented by this new challenge, the answer was to pretend that all could go on as before. Rather than adapt to the new and emerging reality, the answer was to preserve the structures of another time, even though they were increasingly impossible to maintain. In trying to preserve the existing economic structure, the policy response has been to create a new world in which governments are now in the driving seat of markets, are now taking an ever larger role in the economic activity of the world, and consuming ever greater proportions of the available resources. This action is supposed to 'save' the world economy.

But is is not. In the developed world, most people are getting poorer and poorer. Even as governments grow their debts ever larger and larger, people are still getting poorer. And those debts must one day be repaid. Then there is the money printing, and the market sugar rush that follows each bout of printing money. I reported on an analyst's view of this some time ago. His advice; invest when money is printed, and get out before the effects wear off. In other words, the markets are no longer about underlying economic drivers, but are responses to policy actions alone. It is hardly a basis for future economic growth. The same analyst gave five years of this paradigm before it all collapses horribly. And then there are the banks. Protected at all costs, wealth flows from the rest of the economy into the banks. Every bout of money printing helps them; they get access to capital for the carry trade. So far, they remain as the winners, albeit with some ups and downs. In the new paradigm, they are protected at the cost of everyone else. The economy now services the interest of the banks, not the banks servicing the interests of the economy.

For me, this is how I see the world economy. In some respects, it is a rambling discourse. However, there is a theme running through. Something changed, and there was a failure to respond. Something is changing now. The miracle of China is running its course, and there is a turning point. I am not predicting an immediate economic bust but rather that the corruption and ineptitude of the Chinese system is now starting to overwhelm the raw potential that was unleashed with the reforms of Deng Xiao Ping. This might have been an opportunity for a resurgence of the developed economies. However, when looking at the state of the developed economies resultant from the policies of the last few years, it is not clear that there is the foundation for a resurgence. That is the tragedy of the last few years. We are now at an inflection point, and the developed economies may be too weak to respond.

Note Added 16/09/12: The first comment has my thesis 'smashed' - I suggest for those who doubt the thesis, take a look at oil output over the last ten years, and consider this in the context of the growth of emerging economies. The idea that commodity prices are all controlled by speculation is a myth; it is possible to play markets for a while....but in the end the values are driven by demand for the actual product (with some obvious exceptions such as gold). I have no doubt that some will not accept this, whatever is suggested. 

Note Added 18 Sept, 2012: I have just published a comment below, but it nearly went in the delete pile. You will guess which one. Whilst robust comment is good, please refrain from personal attacks and insults.

Nationalisation of Markets

Every once in a while, the Economist magazine gets it right. In this case, the point is made in the Buttonwood column, titled 'The Nationalisation of Markets':

EACH step taken by the authorities over the past five years has been designed to prop up the economy and save the financial system. But the cumulative effect has been the creeping nationalisation of markets. Central banks are the biggest players in many rich-world government-bond markets. Equity markets seem to perk up only when central banks are expanding the money supply. And banking systems are incredibly reliant on implicit or explicit government support.

It is a very worrying point, and reflects the discussion of Richard Duncan that I considered in a post a while ago. I summarised his position as follows:

The most interesting point about the talk is the dispassionate approach to the current and future situation. He simply accepts that, in a few years time, the world economy will have a horrendous crash, that states are now fully in the driving seat of the world economy, and most importantly that investment choices should now be based upon state action rather than market drivers. In simplistic terms, whenever a government prints money, his answer is buy, buy, buy!

When listening to Richard Duncan, some might suggest that his view is an outlier, or even outlandish. However, we know that, when the Economist reports the same thing (albeit in a column rather than an editorial), there has been a shift in broader perceptions about what is going on in the global economy. For regular readers of the blog, the idea that states are in the driving seats is nothing new. For example, in January 2010 I had the following to say, in a post titled 'Masters of the Universe':

I am not sure that anyone can actually pull apart the increasingly tangled knots between the financial system and the state. They appear to be mutually dependent, with the state providing guarantees, and the financial system funding the state with financial support through bond purchases to shore up their capital ratios, and so forth. How convenient that bank capital adequacy encourages the holding of government debt. Going back to Renaissance Italy, bankers were granted licenses and monopolies if they were willing to lend to the state on preferential terms. Nothing has changed. 

I described how governments were intervening in ever wider areas of their economies. I went on to say the following:

Ambrose Evans-Pritchard is right when he suggests that we should rip up the economics textbooks. What we are seeing is a grand experiment, in which economists and policymakers are attempting to structure wealth in economies by fiat. As each lever is pulled, as each policy is enacted, there are ripples through the world economy. Flooding $US into the markets whilst holding interest rates low sees the export of $US popping up and creating bubbles elsewhere. Backstopping the mortgage market sees foreclosures reduced, but at the risk of calling into question (contributing to doubts about) the financial viability of the state. Holding the value of the RMB down leads to greater trade imbalances. Each policy has a consequence, and each policy interacts with the policy pursued by every other government.

In other words, as each lever is pulled, the consequences defeat the intention of the lever puller. For example, if the trade imbalances destroy the economic stability of the destination of Chinese exports, where will this leave the Chinese economy? The more each state pulls on the levers, the greater the turbulence between each of the economies. The world economy is a dynamic system, such that policy in one country impacts on the economy of another country, which then reacts with its own policy provisions, which then impact upon other countries. It is an endless cycle of reactivity, with each reaction driving further reaction, and developing an increasingly unstable system as each country enacts ever more dramatic policy to counter or ameliorate the effects of the policies of other countries.

A simple example is the relatively recent Japanese policy of printing money to stave off deflation. With rock bottom interest rates, the newly printed money was simply exported into other countries in the so called 'carry trade'. Within Japan, deflation persisted, whilst the newly printed Japanese money appeared in other countries, contributing to the process of asset price inflation in the countries that were the destination of the carry trade. The policy levers were pulled, but the consequences were far from those that were intended.

What textbook might be able to predict the outcome of such a dynamic system? Despite this, we see the policymakers pulling on their levers, and offering confidence that they know what they are doing. Apparently, the masters of the universe are in control.

I wrote this a long while ago, and we can now see that states are now firmly in the driving seats of global markets. The problem that I long ago identified is now playing out on the world stage. The 'masters of the universe' kept pulling on their policy levers, the ripples radiated out, interacted with the ripples of other policy levers being pulled, and the result is ever more pulling on policy levers. That we are now in a position in which governments are driving markets is unsurprising, and was the inevitable result of the dynamic that states set into action.

The fundamental problem is that, as the world situation deteriorates, the policy actions are becoming ever more extreme. The LTRO was but one example of the escalation, and there is surely more to come. The worrying part of these actions is that those who are pulling the levers are doing so in the belief that they are taking actions to correct problems in their economies, when the reality is that they are now fundamentally in the driving seats of their economies, and the problems that they seek to resolve are problems that they, and their colleagues in other countries, are creating. The markets are now resting on government policy actions, and they created the situation where this was the case. It did not happen by magic, but specifically because the extremes of policy interventions were overtaking 'normal' market signals.

At this point, the sane response would be to pull back. However, as the 'masters of the universe', policy makers are simply too arrogant. They think that they know what they are doing. They cannot see that the current parlous situation is being derived from their own policy responses. They are dealing with a system of such huge complexity that each action that they take can never have a predictable response.  This has always been true to some degree, but the extremes of current policy have changed the degree of the outcomes, and the intensity and the complexity of the feedback from each policy provision. A very simple illustration can be found in the LTRO, as I discussed a short while ago:

The problem is simple. No external investors believe that there is any real commitment to policy that might allow borrowers to pay back their debts. The only way any sane person will purchase the debt is if it sold at fire-sale prices, which means big losses for current holder of 'periphery' European debt. Instead, the only way forwards is for the European Central Bank (ECB) to continue its backdoor bailouts, by continuing to lend to bankrupt European banks so that they can buy their home country sovereign debt, and thereby expose themselves to ever more bad debt.

Having bought so much euro zone debt, banks in the periphery are now major holders of their governments’ liabilities and will be sitting on losses, given recent selling of peripheral debt, according to Das.

“As with the sovereigns, the LTRO does not solve the longer term problems of the solvency or funding of the banks, which now remain heavily dependent on the largesse of the central banks,” said Das, who fears deep recession. “It is a government-sponsored Ponzi scheme where weak banks are supporting weak sovereigns, who in turn are standing behind the banks — a process which can be described as two drowning people clinging to each other for mutual support.”

The analogy in the quote is quite apt. For those that have not read about it, the LTRO (Long-Term Refinancing Operation) is the ECB's complete abandonment of Germanic prudence, whereby bankrupt European banks are being bailed out by the ECB. As one wag put it, the ECB is accepting bus tickets as security for the lending at below market rates. The really stunning part of this is that it is possible to find commentators and analysts who support this lunacy. I mean really, bankrupt sovereigns supported by bankrupt banks, which in turn are supported by bankrupt sovereigns? And this is a good idea?

A good idea? Pour money into banks in countries like Spain, encourage the banks to buy their own sovereign debt and this will fix both the states and the banks. The result of this madness can be seen emerging into the financial headlines. When we read those headlines, we absolutely must remember that someone in a meeting/presentation actually said this was a good idea. This person was one of the self-selected 'masters of the universe', undoubtedly supported their good idea with reams of economic theory, but nevertheless was unable to foresee that their actions have left, for example in Spain, governments and banks in worse condition than before they started.

And here is the rub. As the situation continues downhill, there will likely be another policy response. It will now, as a matter of necessity, have to be even more extreme response than the last policy response. The problem has grown larger, not smaller, and the only 'solution' to the ever growing crisis will be a larger and more extreme policy responses. The illusion of control of the situation continues, but those who think they are in control just do not have any idea (or acceptance) that they are the problem, not the solution.

The Price of Unskilled Labour

Bearing in mind the ongoing chaos in Europe, and other major stories, I am guessing that this post might appear a little odd. It relates to a single story, which is the problem of recruiting labour for farm work in Alabama. I do not know the agricultural sector well, let alone the sector in the US, and I therefore add this as a caveat for my discussion and my conclusions. However, I think it is worthwhile plunging on as (even if there are specifics that might confound my case) I think the principles still apply. I will quote the start of the story at some length:

Alabama farmers are facing a labor crisis because of the state's new immigration law as both legal and undocumented migrant workers have fled the state since the strict new rules went into effect last month.
So far, piecemeal efforts to match the unemployed or work release inmates to farm jobs are not panning out, and farmers are asking state lawmakers to do something before the spring planting season.

Farmer Guiseppe Peturis has a small operation — growing mostly vegetables on his family's 20-acre farm in Belforest, Ala. — and selling them on the corner in front of his house. His retail business has suffered since he appeared on the local news saying Alabamians don't want to do hard farm work.

Peturis says he's a Republican, but is no fan of Republican Gov. Robert Bentley's plan to get jobs for out-of-work Alabamians by passing the nation's toughest immigration law. Among other things, it calls for police to detain suspects if there's reasonable suspicion they are in the country illegally.


Peturis says he's tried to hire through the state unemployment office before, but didn't have much success.
"Two of them left in 30 minutes; didn't even tell us they [were] going to leave," Peturis says. "One worked an hour and says it was too hard on his back."

There are many ways to approach this simple story. One approach would be to note that the local workers are simply too lazy to do hard work, despite horrendous levels of unemployment in the US. From this, we could present a story of lazy rich country workers who think that the world owes them a living, who are not willing to get on with work, but would choose living on hand-outs rather than doing hard work. It is a tempting approach, and was my first reaction to the story.

However, I then thought back to a time when I finished my degree and had some time to fill between starting my first job. I needed money to tide me over and worked for a little while as a building labourer. I discovered the meaning of hard physical work. I can safely assume that working as a labourer on building sites remains just as hard. I also note that there is not the same kind of discussion of the necessity for immigrant labour to allow the building trade to continue. I also remember that, when I chose the labouring job, I chose it because it paid considerably more than, for example, bar work.

When I thought about this story, it occurred to me that perhaps the real problem is that the pay being offered is simply too low for the level of hard physical work that is required. The farmers have become used to being able to pay low wages to immigrant workers, and have not accepted that they must simply pay more for local workers. This means that the farmers costs must go up, and that means higher food prices. However, set against that, the demand for government hand outs would be reduced with the resultant drop in unemployment and there would be more tax paid to the government.

Nevertheless, there is an element of the first approach to the story that remains. It is that presumably unemployed people are choosing hand outs over working for low wages which they do not think compensate them for the demands of the work.

Although this story at first seems to be straightforward, it is actually discussing some of the complexities of trying to understand the real operation of an economy. The availability of migrant labour has seemingly allowed farmers to pay lower wages than local people would accept. This in turn has impacted upon the cost structure of agriculture, such that the expectations for the prices asked by farmers are, in part, determined by this cost structure. I do not know the details of the Alabama law that is referred to in the story, but it seems that Alabama has 'gone it alone' with regards to cracking down on migrant labour. This in turn leaves the Alabama farmers with a problem with their costs in relation to the competition.

The real problem therefore is not that Alabama has restricted access to migrant workers, but that it has acted alone. I suggested earlier that Alabama farmers had not accepted that they must pay more, but it is probably a case of them being unable to pay more without making a loss. The real question is to ask what would happen if migrant labour were to disappear across the whole of the US? If this were undertaken, if migrant labour was unavailable, the story from Alabama suggests that the wages for agricultural labour would have to rise to compensate for the hard work involved. This would lead to inflation in food prices, and therefore lead to a rise in the broad measure of inflation, and a fall in unemployment.

However, there are other potential consequences that might confound this scenario. For some kinds of produce, there is the potential for competition from other countries. Would the increase in costs in the US agricultural sector then lead to an increase in imports of produce? If so, it might be that, in paying higher wages to the local workers, the farmers would still face competition and might lose in that competition.

The real question here is about the cost of labour in the US. The problem is that, where there is potential for competition for imports, the cost of labour really matters. The problem is that, if labour is a large element of the input of a good or service, then the low cost countries are likely to win in competition. The agricultural sector has survived competition by importing relatively low cost labour i.e. labour that is willing to work for lower wages than local labour. The result of this is that there is cheaper food, but higher unemployment. Remove the immigrant labour, and agricultural wages will rise, and unemployment will be reduced. However, this might take place at the cost of certain sectors of agriculture going out of business, with a negative impact upon the balance of trade, and possibly a negative impact upon unemployment to offset the positive gains. 

As I said, this appears to be a simple story, and simple narratives could be wrapped around the story. However, it illustrates some of the problems in a world economy where there is greater competition between unskilled labour, even if it is not always obvious that the competition exists. There are some elements in this story which much of economic theory does not really capture, such as the idea that people think that there is a fair price for hard physical labour, rather than a market price determined by supply and demand. The supply of unskilled labour is large, with any unemployed person who is not disabled able to do the work. Nevertheless, it seems that this labour has a sense of a 'fair' price for this kind of hard physical labour so that, even though there is an oversupply of labour, the price of that labour must rise in order to access that pool of labour. Supply and demand does not explain this.


What appears to sit underneath the entire story is the cost of labour. I have made a case in this blog that the massive input of labour into the world economy has created what I have termed hyper-competition.  However, it appears that the story about the Alabama farmers appears to be an illustration of how the oversupply of labour is creating a situation of hyper-competition, at least in some agricultural sectors. The curiosity is the response of the unemployed US people, who simply think it is unfair to be paid so little for such hard work. As much as it would be nice to be paid higher wages, is it possible/realistic? Is it confronting the reality of the situation of hyper-competition? Can the US afford to keep people so many people unemployed? If my take on this story is correct (and again I highlight the caveat), then the story is a hard illustration of the problems that have come with the growth in the world labour force.

Round 2?

The underlying and fundamental problems in the world economy are once again bubbling into view, and the headlines are filled with panic. Stock markets have fallen around the world, and it might be that the slide will continue on Monday. Or perhaps not. I am not sure whether this is the start of the final act of the economic crisis at this stage, but it certainly has the potential to be so. In particular, there is a growing sense that the so-called recovery is nothing more than an illusion. There is a growing sense that the central banks and politicians cannot fix the problems, and have not fixed the problems. There is growing sense that the macro economists do not know what they are doing. In other words, there is a growing loss of confidence in those who think that they control the economy.

Somewhat predictably, Krugman takes a partisan stand, and calls for more government intervention. According to Krugman, government can just make new jobs, and all will be well:

Well, it’s time for all that to stop. Those plunging interest rates and stock prices say that the markets aren’t worried about either U.S. solvency or inflation. They’re worried about U.S. lack of growth. And they’re right, even if on Wednesday the White House press secretary chose, inexplicably, to declare that there’s no threat of a double-dip recession.

Earlier this week, the word was that the Obama administration would “pivot” to jobs now that the debt ceiling has been raised. But what that pivot would mean, as far as I can tell, was proposing some minor measures that would be more symbolic than substantive. And, at this point, that kind of proposal would just make President Obama look ridiculous.

The point is that it’s now time — long past time — to get serious about the real crisis the economy faces. The Fed needs to stop making excuses, while the president needs to come up with real job-creation proposals. And if Republicans block those proposals, he needs to make a Harry Truman-style campaign against the do-nothing G.O.P.

As is usual with Krugman, it is the evil republicans blocking more spending and, if only money was spent on job creation, the economy would grow. More government action is the solution, not the problem. Similar arguments are appearing from less heavyweight commentators, for example Polly Toynbee in the Guardian:

Faced with a new crisis, it stretches credibility to imagine Osborne invoking the spirit of Roosevelt's New Deal, but that's what's needed, with a job guarantee for every young person. That investment would be every bit as cashable for the future as roads or railways, since the great social debt now accumulating will be more burdensome for future generations than mere financial debt. No one is counting the social deficit, the costly damage done to this generation of young people, though the evidence shows that a workless youth does life-long harm, some never finding their feet again, becoming the workless parents of the next generation.

Today's Guardian editorial suggests that:

But even in the US and the UK, governments have all but removed their stimulus policies – with the result that both economies are now stuttering. The result may look like a financial crisis; but it is really a failure of government.

Apparently, the crisis is due to a lack of stimuli. However, in both the UK and the US, governments are continuing to borrow and spend at a shocking rate. Even if it were true that the US debt deal were really going to deal with the monstrous deficit (which it will not), this has had no impact yet. However, even the prospect of some fiscal tightening is being blamed for a new crisis. If this is the start of the final act, the actuality of ongoing massive spending and borrowing will be forgotten by the economics profession, and the economic crisis will be turned into a narrative of simultaneous tightening causing an economic crisis. The mantra will be, 'if only the governments had not simultaneously undertaken austerity measures....'

However, even Krugman has got something right:

It’s not just that the threat of a double-dip recession has become very real. It’s now impossible to deny the obvious, which is that we are not now and have never been on the road to recovery.

For two years, officials at the Federal Reserve, international organizations and, sad to say, within the Obama administration have insisted that the economy was on the mend. Every setback was attributed to temporary factors — It’s the Greeks! It’s the tsunami! — that would soon fade away. And the focus of policy turned from jobs and growth to the supposedly urgent issue of deficit reduction.

Regular readers of this blog will already know that there has never been any kind of real recovery, just lots of chatter - lots of optimism that is continually dashed with reality. All the policy and chatter did was to paper over the cracks, whilst the problems of the foundations saw the cracks widening even as new paper was being added to hide the consequences. In the mainstream media, it is becoming apparent that some commentators are starting to realise that there is a real very fundamental problem. This from a Telegraph editorial:

It is equally vital, as the pressures grow, that the world stays true to the free market principles which have been the cornerstones of post-war prosperity. The crisis of the last four years is not the fault of free markets as such, but of the way they have been distorted and corrupted by public policy and the unchecked excesses of finance.

In the search for the underlying causes of today’s rolling series of debt crises, it is hard to ignore the extreme trade and financial imbalances which have grown between countries, fed both by the mercantilism of China’s dash for growth and the absurdities of the single currency. The resulting build‑up of external indebtedness among deficit nations is now tearing the world economy apart.

Yet the pretence continues that somehow or other, we can just carry on as we are. Political leaders must find the courage to tell the truth about the fix we are in, and the painful choices that must be made to deliver a sustainable future.

They are groping towards the reality that has been the theme of this blog. They have still not fully grasped the nature of the change in the world economy; that the joining of China and India and other (so-called) emerging economies into the world economy had dropped a massive pool of new labour into world markets. The resulting hyper-competition is driving the current crisis, and the response of much of the Western world is denial of this reality and the consequences and impacts of this massive economic shift.

The answer of the Krugmans of the world is for greater government borrowing, printing more money. How these will address the problem of hyper-competition is never discussed, because the actuality of the hyper-competition is never acknowledged. They think that the massive disruption of the massive input of new labour into world markets is not the cause of this crisis, but rather it is a financial crisis caused by irresponsible banks. It is impossible to deny that the banks played a role, but as I have argued elsewhere, the banking crisis was a symptom of an underlying cause:

The summary of the situation is that the emerging economies lent their new found wealth from their increasingly large workforce into the West, and in doing so allowed the emergence of the so called 'service economy', or 'post-industrial economy'. The lending was built on an unfounded belief that, because the West had been economically dominant for so long, it would always be in a position to pay back the lending. The problem with the lending was that there were no productive wealth creating opportunities to soak up the money, (e.g. investment in manufacturing was being directed towards the emerging economies themselves) such that the money pouring into countries like the UK and US was directed into asset price inflation (real estate), consumption and consumer credit, and excessive government borrowing.

In the post, I argue that the world economy was being constrained by the limits of resources. With emerging economies soaking up huge amount of resources for infrastructure, and with supply constraints on commodities such as oil, the world economy was sharing a limited supply of resources over an ever increasing number of workers. In an earlier post, I presented an analogy. I described commodities as a moving brick wall to growth, with the world economy running behind this wall of constraint. As the economy runs forwards, it hits the wall and tumbles backwards. The world economy then gets back on its feet, and once again runs towards the wall only to eventually bounce back again. Below is a chart of oil production and consumption from the Economist and a chart of oil prices that tells the story.

China alone has increased oil consumption by over 4m barrels per day in the last decade. It is a picture of the brick wall. Note the upwards spike in 2007, and the upwards spike leading up to the current crisis. I have to emphasise, that other commodities have seen greater increases in output, but that the infrastructure demands of the emerging economies is a countervailing force, such that prices are reflecting the high demand.

The worrying part is that economies such as China are still going through the process of integration of their labour into the world economy. The process is not yet complete, and the problem is that the bounce backs will therefore continue, and the competition will become even more intense. For example, China is engaged in a process of seeking surety of supply of key resources around the world. This is a chart from Foreign Policy, representing 2005-9:

It is a trend that has been accelerating. Somebody in China seems to know the nature of the game that is being played out in the world economy. The Chinese development of a blue water navy also tells the story. In the end, economics is about recovery of resources and application of labour to add value to resources. With constraints on the volume of resources and massive increases in the volume of labour, this must lead to hyper-competition. It is really not that complex.

When thinking of the Krugmans of the world, we see no discussion of this simple idea. If you increase the workforce by 10% but only increase the resource by 5% then something is going to happen to the distribution of resources. Government spending on 'creating' jobs, or money printing, they claim can make a difference, but it does not address the underlying and substantive problem. More government action is the solution proposed.

Another problem with the commentary I am reading is the belief that this is a crisis of capitalism. Today's Guardian has a picture of an evil capitalist monster, and it is a view that is gaining currency. However, the real reason for this crisis is not capitalism, but the actions of communist and socialist governments before they started the process of opening their economies. They created barriers to the integration of their labour force into the productive and enriching capitalist world economy, and then suddenly started 'dropping' the labour into the world economy at a rate that the capitalist system could not absorb. It is why we see the increasing divide in incomes between the rich and the rest. It is not the evils of capitalism, but rather the last terrible contribution of years of rejection of capitalism in countries like China and India. They created a flood of new labour into the world economy, and the result is that labour has been devalued.

What we have in so much commentary is policy that is blind to the causes of this crisis, and solutions which replicate in varying degrees the fundamental causes of the problems; government constraints and interference with free market capitalism. Whatever anyone does, short of cutting of the supply of new labour, the situation cannot go back to the old 'normal'. The only way to deal with the crisis is to accept and embrace the hyper-competition, and that means addressing the structure of economies. When competition was less fierce, it was possible to have many luxuries in economic structures; for example, cradle to grave welfare or expending resources on any number of unproductive activities. The question that needs to asked is what can each economy really afford based upon their real productivity (i.e. not borrowed money). What are the real priorities within the constraints of the actual competitive position of the economy? Each economy must address this question, and address the question reflecting upon the hyper-competition that now characterises the world economy, and their relative strengths and weaknesses.

I do not know if this is the start of the final phase of the economic crisis; the moment when the reality that borrowing and spending and printing money are part of the problem not the solution. I hope that this is the moment, as the longer the denial of reality continues, the worse the problem will get. The crisis should have taken place a long time ago but, against my expectations, governments and central banks have buried the problem for longer than I ever thought was possible. Perhaps they have some last measures that they might yet deploy to 'save' the situation (but which will just create an even bigger problem in the future)? At this stage, I do not know, but we will see how events develop over the coming months.

The Origins and Development of the Economic Crisis

I thought it might be time for a review of the big picture. How we got to where we are, and the underlying problems in the world economy. For regular readers, much of what I will discuss will be familiar material, but some may also be new. However, this post is primarily aimed at the newer readers of the blog and the aim is to offer a framework that explains why my analysis is such as it is.

To start at the beginning, I wrote an article called 'A Funny View of Wealth', in which I identified a fundamental flaw in the UK economy (and which might apply to many other economies such as the US). I wrote it before the financial crisis, and my approach was to review each potentially wealth creating sector of the UK economy. On reviewing each of the sectors, I realised that there was no sector that could possibly explain the apparent increase in wealth in the UK in the 10 years preceding the essay. Instead, what I saw as the only explanation was that there had been a massive growth in personal debt, alongside some growth in government debt (if I recall correctly, I think I included the off balance sheet liabilities). I was very worried, and it turned out, rightly so.

As the banking crisis emerged upon a startled world, I became increasingly horrified at the actions of governments in response to the crisis. I argued strongly that the response to the crisis would eventually backfire on sovereign states, and we are watching this process now unfolding. My analysis of the situation has always been different from every economist, analyst and commentator, and I still hold with my view that the banking crisis was a symptom of an economic crisis, not the cause of an economic crisis. As time has passed, the analyses of the problems have largely been dominated by one, or a combination of, the following:

1. It was de-regulation of the banks that caused the problem
2. It was greedy short-termism of the markets
3. It was the central banks running lax monetary policy
4. It was the housing bubble
5. It was the credit bubble
6. It is an imbalance in world trade
7. It is a corrupt stitch up by the banks in conjunction with government
8. It is the inevitable result of a fiat money system

I may have missed a few, but these are the explanations that come most readily to mind. Having presented these explanations, I have given some of the common ideas of the cause of the current crisis, but these do not really explain the problems of the world economy. Instead, my argument is that these causes are contributory, not the main cause. As such, it seems that I should explain the underlying problem.

I first began to formulate my ideas in a post called the 'Cigarette Lighter Problem'. I asked the question of why an identical lighter, sold through an identical distribution system, might cost nine times more in a Western country than in China. The differential in the cost was fundamentally inexplicable (if you read the article, you will see why). I came to the conclusion that part of the additional cost was actually developed in the accumulation of debt in the economy overall.

As I thought about this problem, I started to think about the cost of labour in the world, and how it was determined. As part of this process the explanation of the economic crisis became clear. In the build up to the crisis, it was possible to see a massive expansion of the global labour supply. Even China by itself represented a massive expansion, but when you add India and the other emerging markets, the labour with access to markets/technology/capital must have at least doubled.

This of itself would not necessarily cause the crisis. As fast as the new labour entered the markets, they might have in turn become consumers, and thereby expanded output for everyone. However, there was a problem. Whilst the labour supply was increasing, the other inputs into wealth creation were not increasing as fast, or were not increasing fast enough to accommodate the massive infrastructure needed to built (from a very, very low starting point) in the emerging economies. If we just think of oil, output barely expanded as the emerging economies emerged, and that means with an increase in the size of the labour force, there was not going to be sufficient oil available for both the West to maintain their standard of living and to see the emerging economies continuing to improve their standard of living. Something was going to have to 'give'. The following is from my article on Huliq, but I suggest that you read the original for the full picture:

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.

For the moment I would like to present a different scenario to what actually took place in response to this problem, and we can see how the economic crisis developed. For the sake of ease I will just use the examples of the US and China to illustrate a general point. If we jump back in time, to about 10-15 years ago, the Chinese economic miracle was in full swing. New factories were pouring goods out of China, and the US consumers were busily expanding their purchase of Chinese goods. As they did so, many US industries were moving offshore, as it became ever more necessary for companies to compete in world markets through lowering their costs. At this point, what should have happened was that there should have been increasing unemployment as the demand for labour fell in the US. With that rise in unemployment, living standards in the US should have started to fall, and at the same time, Chinese living standards should have risen. After all, America was losing in competition to China, and China was winning in competition with America.

As we know, this did not appear to happen. The Chinese appeared to be growing wealthier, but not as wealthy as their prodigious growth might have suggested. This returns to the cigarette lighter problem. If we look at China, the entire economy appears to be low cost. Wages and costs in general are surprisingly low in relation to the increasingly impressive output of goods and services. This is in part because they have still not pulled their entire labour force into the 'modern' economy. It is also partly a result of the value of the RMB, whose value has been held down through the purchase of treasuries. This has meant that, for an ordinary Chinese worker, they are not paid in wages that reflect the true value of their labour. Imported goods are artificially expensive.

What the Chinese have been doing is, as fast as their productive capacity has expanded, and their exports to the US have grown, is lend that missing labour value into the US economy. That missing value turned up in the US economy, and is why the US standard of living did not decline as it should have done in relation to China. All of this gave the illusion that nothing had really changed.

It seemed like China would just get richer, that the US would just get richer, and all was well in the world. However, without an increase in the other key inputs to wealth, the commodities, this could never work in the long run. For example, ten divided by ten equals one, 10 divided by 20 equals a half. If the additional ten lend you their halves, then it can appear that everything is okay, and that you still have one. Of course, in this example, I am being simplistic, as the amount of commodities did increase, but they did not increase fast enough, and China did not lend all of their output. However, I hope that this nevertheless illustrates how the illusion of wealth can be maintained, even as wealth generating capacity is slowly melting away.

What we have is the situation in which a low cost economy is rapidly expanding, endlessly increasing the labour force in the world, consuming more and more resource, and lending a significant portion of their output to another country. At the same time, they are making their already competitive position even stronger. They are adding a further lever to their low cost advantage, and decimating industries and competitors as a result, through holding down the value of their currency. In purchasing US treasuries, they increased the demand for $US, and the increased demand raises the value of the $US, and they also allowed the illusion of wealth in the US to continue through their lending.

However, this is not the whole story. As well as countries such as China lending their value of labour to the US, there are plenty of other actors within this scenario. For example, Japan's export machine kept on chugging onwards, along with the Japanese acquisition of US debt. Then there are the commodity countries, such as the petro-states, or other primary commodity countries. All of these benefited from the increased demand, which itself was a result of the expanding pool of labour. We can think, for example, of a major oil producer in this global picture. In real terms, they are lending oil in the expectation of a return in goods and services. If we go back to the American example, they are literally borrowing oil from the petro-states, and one day they must actually pay for the oil.

Oil is an interesting example of what took place, as it is so central to the functioning of modern economies. We can be buried in the complexities of currency rates, interest rates and so forth. However, when Saudi Arabia lends the US oil, they expect to get something in return.
For example, if the Saudis wanted cheese in return, they might lend their oil based upon the exchange relations for cheese and oil, however abstracted those relations might be. Central to their expectation is that if 1 litre of oil = 1kg of cheese, they will expect that in the future they will be repaid roughly on this rate, with interest added (e.g. repaid 1.3 kgs of cheese per litre of oil). If we look at US cheese output, there may be a nationwide output of 100 units, with 80 units going to the domestic market, and 20 for export. If we imagine that Saudi Arabia starts calling in their oil debt in cheese, we might see the 100 units reapportioned to 30 for export and 70 for domestic use.

What we are seeing is the inflationary impact of debt accumulation. The cost of cheese in the US is going to go up. There is less cheese in relation to domestic demand and, barring a cheese manufacturing productivity miracle, prices must go up. It might be that, with the rise in prices, the US farmer will devote more to dairy, and cheese output will increase, but they would do so by not doing some other kind of farming. The only way to avoid inflation is more farms, or greater productivity from the existing farms, or a combination of both.

Within this simplistic example, we see the principle that issuance of debt eventually creates a call on future output. When is does so, unless there is a productivity miracle, or an increase in the resource devoted to any industry, there will be less output for the domestic market. This means that goods and services will be relatively scarce. For the example of output of cheese, just replace cheese with the total potential output of the economy. You then see the problem with debt accumulation from overseas lending, and why it is inherently inflationary.

Overseas debt is a call on the total output of your economy in the future, and the greater the debt, the greater the proportion of future output needed to service the debt, and the less goods and services available within your economy for domestic use, and the greater the inflation in the economy. Unless there is a productivity miracle, or debt default, then something has to give. There are simply less goods and services available in the economy. Imports can not substitute, as you are already using your output to exchange for past borrowing, meaning you have less output to exchange for imports. As for the example of the US, we can add many other debtor nations to the list of those facing this problem, with similar consequences.

Having explained the danger in the accumulation of debt from overseas, we can start to see the problem. Now, before I go on, there is an important point. Instead of consuming, for example, the oil being lent from Saudi Arabia, lets say that we used this resource for investment in new capacity. Building a new factory, for example, is an energy intensive activity. If we were to use the oil for this purpose, we would actually see a return on that borrowed oil. We have increased our overall capacity to produce goods. Alternatively, imagine an executive used a portion of that oil in a flight overseas to sell a consultancy service. Whilst the oil is consumed, in both cases it is going to generate goods and services that we might sell overseas to repay our overseas loans.

However, this is not what took place, and there is a very good reason for this. The first relates to manufacturing. In the face of low cost competition, investment into manufacturing was shifting rapidly to the emerging economies. In the case of services, the story of India needs no retelling, and again we can see that there was a considerable expansion of competition in many services. However, the money nevertheless was pouring into many Western countries. Where was the money going?

We can only now see the impact of the traditional reasons given for the financial crisis. What we have is a situation where the actual output of goods and services in the economy appear to be increasing. In fact, during a period in which intense competition in goods and services are appearing over the world, there is a strange thing going on. In face of this massive competition, the people in countries like the US appear to be consuming ever more output, even whilst this fierce competition is arising. Not only that, inflation appears muted, and GDP is steadily and apparently rising at a healthy rate.

What we are seeing are two deeply flawed measures. In the case of GDP, it is measuring all of the activity that flows from the resources being lent into the country, in addition to the productive output of the country itself. When we see inflation, it is not capturing the inflation in asset prices. What we have is the miraculous service economy. The money is pouring in from overseas, and that is used to import resources, and these resources are being consumed at an astonishing rate, fuelling profits in companies, and increasing activity around the economy. If we return to the oil example, we can think of Saudi Arabia lending oil to the US, and how that oil might allow for an increase in activity around the economy.

The interesting point about all of the traditional factors for the current crisis is that I would agree that they are all contributory factors in the debacle that we are now witnessing. The one point I would argue with is that it was a result of de-regulation, as I do not accept that there was deregulation, but rather there was misguided regulation. I have emphasised the role of the Basel I and II banking regulation frameworks in contributing to the crisis. There are plenty of easy targets to pick on - for example the Basel II entrenchment of the ratings agencies in the determination of capital adequacy ratios.

As I have long argued, it has been apparent that the regulators have long been of the view that they (and presumably the rating agencies) have some mystical power to see where future risk might be found. Amongst their amazingly prescient determination of future risk, they allocated OECD government debt as being almost completely without risk. Apparently, at this moment in time, banks all over Europe are sitting on piles of absolutely safe Greek government debt, and this debt is a key component in what determined their safe level of capital. The more I dug into Basel I and II, the more silly the provisions seemed.

I even found an article on the Bank of England website that innocently noted that Basel I had been a driver of the market trend to securitisation, the very instruments that later exploded onto the world with the banking crisis. The paper was published pre-crisis, and I wonder if anyone in the central banks would now published, as it is firmly points (with hindsight) an accusatory finger at the role of the regulators. Happily, for the central bankers, the article is now forgotten and gathering dust.

Returning to the question of government bonds being given a zero risk rating, what we see is a regulatory framework that positively encourages banks into buying government debt. A long time ago (I forget which post) I wrote about how, when modern banking was being developed in Renaissance Italy, the city states would grant banking licenses in return for preferential interest rates on their borrowing. What we see now is the same cosy relationship between the central bankers, the banks and the politicians. I scratch your back......

The problem is that, although most people accept government borrowing as if it is some kind of force of nature that is unavoidable, I have yet to see a convincing argument for government borrowing for a developed country, short of war or natural disaster. If governments want to spend more, then just tax more. They have a massive base from which to fund government, so why are they borrowing at all?

Returning to the central point, regulation has played a large part in the lead up to the financial crisis, and has also encouraged states into their current indebtedness. You will note that, as the crisis progressed, central banks and regulators have demanded greater levels of capital to be held by banks - and that is a way of telling banks to hold more government debt - exactly at the time that governments have been increasing debt. The banks are now stacked up with debt which was formerly considered safe, and (in the case of many European banks at present) they are faced with a potential implosion of their balance sheets if there are sovereign defaults.

Are you starting to see the circularity here? However, I have digressed a little from my central theme, which is to set the context of the current parlous state of the world economy.

A key element is the financial services industry. We need to this in the context of a massive shift in the productive output in the world, with inflation in commodity prices. Rather than directly exchanging the profits from these shifts directly into purchase of goods and services, the countries in question have chosen to lend their growing wealth into countries like the US. They do so with great confidence, as they see the OECD countries as more reliable and safe place to lend their money. Alongside this, they see what appears to be healthy and growing economies. What could go wrong?

The problem is that, a wall of money is entering into these debtor economies, and yet there are very limited numbers of investment opportunities, outside of redistribution of the borrowed money into consumption based activity. In particular, if you are investing in the provision of new goods and services for the global market, much of the smart money is going into the emerging economies. So, the banks have a wall of money to lend out, and few opportunities to invest it in places where it might eventually create opportunity for export of goods and services. What to do with the money?

As we now know, the money went into higher and higher risk consumer lending. One result of this was that the money available for lending into mortgages started to outstrip the increase in the number of houses available to soak up the new money. This is, of course, a situation in which more money is chasing a particular good, which means that the price of the good will increase. Thus the housing boom was born. We can see the increase in the money supply into the market with the many highly dubious methods of lending that appeared in the run up to the financial melt-down. What we now see is where the financial crisis comes from.

The bankers were aware that, if you start lending to bad credit risks, then you are eventually going to make some losses. They could hardly sit on the money and do nothing with it, and here we have the incentive for the development of the instruments of mass destruction that were to explode in the financial crisis. The lending was increasingly risky so, within the Basel frameworks, they did everything they could to bury the extent of the risk such that it was out of sight.

The CDOs were rated as investment grade, as per the requirement of the Basel regulations, which had already encouraged securitisation, SIVs, and a host of other practices that were to be seen as precursors to the financial crisis. As a result, it seemed that the banks were making miraculous profits, bankers achieved their amazing bonuses, all at the same time as they were loading up on thinly disguised and regulator approved risk. Remember, the regulators and ratings agencies apparently had a privileged and magical insight into where risk will occur in the future.

We then move onto the role of the central banks, and their contributory role in the mess that we are all now in. Their role was one of astounding stupidity. They were the people paying attention to their metrics of GDP and inflation, all the time having absolutely no idea of what these actually measure. All they could see was the mass of activity in the economy, and did not realise that a large portion of that activity was simply the use of resources borrowed from other countries to move around and distribute borrowed resources lent by other countries. They imagined that all of the activity was from internal resources generated by their own countries output. The really mad part was that, the more that was borrowed from overseas, the greater the activity in redistribution, and the more they believed that the country was getting wealthier.

As a result, with low inflation, and steady GDP growth, they kept interest rates low, and poured more fuel onto the fire with expansionary monetary policy. All this despite asset prices going up at a rate that was disproportionate to the actual underlying state of the economy....

And then there is government. Like the central banks, they were equally as deluded by their use of inflation and GDP figures. Perhaps the worst example is Gordon Brown in the UK, who absolutely convinced himself and nearly everyone else that an economic miracle was taking place. Everyone was becoming richer. In these same countries with the miraculous service economies, governments started letting go of any sense of fiscal caution, in the belief that the good times would not end. They expanded or started new government programs, benefits and entitlements, creating ever more structural government costs, on the basis that their economies seemed to be endlessly expanding. In reality, it was only indebtedness that was expanding, as their economies were in reality stagnant or perhaps even contracting in some cases.

What we were seeing was an illusion of success in many economies, and all the while they were sowing the seeds of future destruction. The increase in debt in economies like the UK and US was simply hiding the structural change that had taken place in the world economy, the emergence of the emerging markets, and the competition for a finite amount of resources amongst an ever increasing labour force. The illusion of the service economy was simply the distribution and consumption of the borrowed output of labour of overseas countries. Houses became ATMs, new shopping malls were built, and new services were developed to consume all of this apparent wealth.

The financial crisis was the shock to break the illusion; or rather it should have been the shock to break the illusion. The madness of consuming future output now was laid bare. However, rather than break the illusion, the choice of governments and central banks was to try, as hard as they could, to continue the illusion.

In the period since the financial crisis, there has been no action to address or recognise the problem. Instead, the reaction has been a host of measures to try to restore a situation that was, of itself, a delusion.

Front and centre were the bank bailouts. The process was not only one in which government money was poured into the banking system, but also a process of allowing the banks to hide their underlying insolvency. Governments have also borrowed to support the existing economic structure, which is an attempt to maintain employment and activity, which is itself an attempt to support (for example) real estate prices, which in turn supports the value of bank assets, which in turn supports the viability of the financial system. It is all circular, with one element supporting the other, with overseas borrowing the foundation of the system. It is impossible to tease apart the circular relationships. Governments must keep on borrowing more and more, or the whole edifice falls apart.

Effectively, when consumers stopped borrowing, government stepped in to fill the vacuum. The problem is that, in doing so, they are supporting the unsupportable. I have previously laid out the contradictory nature of this process in my last post. We have a process as follows:

1. A government borrows money from overseas
2. The money is spent by the government and this increases activity in the economy
3. Individuals who would otherwise be unemployed are able to buy houses, pay back loans, service mortgages, buy goods and services
4. Individuals and businesses pay more taxes
5. Government revenues are supported
6. GDP is supported by all of the activity, either preventing a dramatic fall or slowing of GDP growth
7. The relatively good health of the economy reassures investors (e.g. some investors actually believe that the US is recovering)
8. Investors are willing to extend further credit

It all looks to be highly sustainable, except for the fact that governments are accumulating debt which is being used to finance consumption. For example, in the case of tax revenues being supported, the money that is returned in taxation to the government is being supported by the borrowing, such that the revenue from taxation is a case of the government eating its own tail. It borrows, a portion of that borrowing is consumed, and the returned tax revenue is therefore the borrowing minus the intermediate consumption process. It simply means that a small amount of the borrowed money is returned to the government, whilst the total amount of borrowed money increases.

The other result of borrowing more is that more borrowed money supports the level of GDP, which means that the more a government borrows, the higher the GDP. All the borrowed money supports activity within the economy, and this gives the appearance of a healthy economy. This allows for a better debt to GDP ratio, which is, of course circular.

For example, if a government were to double their overseas borrowing overnight, then they would be able to massively increase activity in the economy. GDP would climb rapidly, and the result would be that the GDP to debt ratio would look much better. What you have done is pulled a massive amount of future activity into the present, and this would flatter the size of the economy. However, the GDP outcome does not represent your own generation of activity, but consumption of the output of others, at a cost of committing your own future output. In other words at the cost of a future shrinkage in your own activity. Unless you just keep borrowing more and more.

And here is the problem. Unless you keep borrowing more and more, there is no way to sustain your GDP level, and no way to keep the GDP to debt ratio looking positive. As soon as you stop borrowing from overseas, you are then in a position of repaying the debt that you have already accumulated, and also doing this when your economy is fragile. It is fragile because the structure of the economy has still not managed the adjustment to the new competition from the emerging economies. Government has borrowed to consume to support the structure of an economy that was already built on excessive borrowing from overseas. There is still a period of adjustment to the real structure of the world economy to take place. This can only be achieved through seeing the destruction of the swathes of the economy that were supported through the distribution and consumption of resources that were generated from overseas.

This returns me to the example of the US economy, in which I showed that 17% of US GDP may be accounted for by activity in the distribution and consumption of resources borrowed from overseas. As yet, nobody has contested this figure, though it is certainly open to challenge (see here for the original post). Even if I am roughly right, we can see what happens if the growth in debt halts. We would see a massive contraction in the US economy, and the debt to GDP ratio would deteriorate in a shocking way. It is similar to what we are seeing in Greece. Businesses will close, unemployment will explode, government revenues will fall, asset prices will fall, banks will go bust, and the economy will fall off the edge of a cliff. As this happens, it will become increasingly impossible for governments, businesses and individuals to service the debts that have been accumulated as part of an economic structure built on foundations of sand.

The really horrific part of this is that it is not just the US that is in this terrible position. This is a widespread problem. Furthermore, the structures that have been built to protect failing sovereign states is built upon credit coming from many of the states that are now at risk. One interesting development is that the US is now questioning their role in the IMF bailout of Greece, and is recognising that the credit it would supply would fall into a black hole, and that it can no longer afford to bail out other countries. After all, the US finances are themselves flashing red warning lights. I pointed out in a previous post that, in reality, although the US appears to be a major funder of the IMF, it is in reality the creditors to the US that are really funding the IMF. If the US were not able to borrow more money, would they be able to finance the IMF as they have traditionally done in the past?

Where is the money for IMF bailouts going to come from in the future? It is a question I asked at the start of writing this blog, and it only now that it is apparent to the world that there is a problem. When both the 'bailees' and 'bailouters' are broke, what happens then?

In Europe, it is possible to see the increasing queasiness at having to bail out their fellow European states. The fact that the bailing out of another state means borrowing more, and taking the sovereign debt risk of other countries onto already stretched balance sheets, means that the bailouts can only go so far. The problems do not stop there. For example, if Greece defaults on its debt, this will impact Germany through, for example, their banking sector's exposure to Greek debt. If Greece falls, it may take elements of the German financial system with it. Such is the complexity of the edifice of debt that has been created around the world, and the complexity in the linkages in the destiny of sovereign states.

Niall Ferguson famously coined the phrase Chimerica to express the interdependent relationship between China and the US. The US used Chinese credit to purchase Chinese goods, and then plays a major role in the support of China's export sector. The two countries are inextricably tied in dysfunctional relationship. If either side blinks, they both plunge. However, the contradictions of a developing country (China is still relatively poor) supporting the rich lifestyle of the US must be a finite arrangement. Both sides need to extricate themselves from the relationship, but neither side seems to know how.

In recent news, China has recommenced the purchase of US treasuries, and Chimerica is once again in full swing. This means that, for the moment, the US might continue to finance their dizzying deficits. I think that we are safe in assuming that China is restarting the relationship because they can no longer see any clear alternative. However, as they have hinted at in various statements, China knows that Chimerica is unsustainable, and the US appears to realise this too. In both cases, it is possible to sense that they both hope that something will turn up. In the meantime, the scale of the problems for the future grows and grows.

The only way to describe the trading relationships across the world is 'dysfunctional'. They are relationships built upon a foundation as follows: country 'x' provides country 'y' with credit, and country 'y' uses that credit to buy goods and services from country 'x' and country 'z'. Country 'x' builds an export market in country 'y', and therefore needs country 'y' to keep buying their goods, in order for them to maintain employment and growth. Japan needs the US, Germany needs Spain, China needs the US and so forth. The recipient countries must keep buying, but increasingly have less and less capability to repay the money they are borrowing. The country 'x's reach a point where they are confronted with the reality that they are, in effect, almost giving their goods and services away, as they will never be paid for them. However, if they stop, their own industries will collapse, as they are structured towards servicing these debtor markets.

When German workers wince at the Greek bailout, this is the logical conclusion of the dysfunctional relationship. German credit has allowed German exports to Greece (of course, this is not a one to one relationship, but I use this case for simplifying some complexity). If Greece defaults on their debt, German creditors will take a haircut. If Greece is bailed out, the German government will, through the tax system, make the German worker pay for the Greek bailout. In either case, Germany will have, in real terms, been providing goods and services to Greece at massively subsidised cost, or in extreme circumstance free of charge. In all cases excepting full repayment of debt from Greece, Greek consumption is being subsidised through the labour and efforts of overseas workers. It does not matter which of these many creditor/debtor nations we can look at, the relationship is basically the same.

In each case, in each of these relationships, the dysfunctional accumulation of debt continues, and always with the hope that 'something will turn up', that the debtor nation will miraculously turn around, and start earning more than they consume.

However, the debtor nations have become credit addicts, and become ever more dependent upon the credit to sustain the structure of their economy, which is itself structured around debt. The more credit they get, the more their economic structure will be shaped to utilise the credit. The population of each country is unaware of the source of their apparent wealth, which is too abstract to understand, and they then resist any reform which might mean that they have to accept their real level of wealth. The politicians cave in, and hope that something will indeed turn up (or that they are lucky enough to be out of office when the contradictions of the situation are forced to resolution).

In the end, the creditor nations must blink. They will only support the profligate so far. Like the debtor nations, the people of the creditor countries are unaware that they are in effect, giving away a portion, or all of their labour, to other nations. When it becomes apparent, as with Greece and Germany, that this is the reality of the situation, they are understandably resentful. However, they do not realise that, if the situation halts, then many workers will find that their particular industry, their individual job, is pointing at a market that was entirely reliant on the credit that they have been providing. When their own country turns off the credit taps, the markets for their goods and services will evaporate. They have been pointing their industry and labour to the wrong markets, to markets that were never really going to pay for their goods and services, because they do not have enough output that they are willing to return.

In practice, what happens is that all the savings of individual workers are exposed to the losses that will follow the non-payment of debt. When a person invests in a pension fund, puts their savings in a bank, they are deferring their own consumption. In principle, their money should be channelled into new investments which will produce a future return. Instead, through whichever conduit, their savings have been used to support consumption in the debtor nations. If Greece defaults on debt, and German banks take a hit, this is not abstract money, but the accumulated savings of individuals aggregated and lent into the Greek economy.

I hasten to add that, as they currently operate, the markets are not all relatively ‘benign’ movements of savings and investments. The infamous speculators do exist. However, I have no problem with these people risking their money, for example betting against the Euro. What I do object to is naked credit default swaps, and any of the many other practices that border on the fraudulent, or the way that government backstops the risk, or the way in which governments have entrenched and supported an elite of bankers.

Returning to the central point, the deferred consumption of German workers has instead been consumed by Greek workers, and they are not going to return that consumption with goods or services for the German workers to consume. The deferred consumption has been forever consumed.

The point that I am trying to make here is that this is not as abstract a situation as many analysts and commentators try to make it. It is about the basics of person 'A' manufacturing good 'B' or providing service 'C' to person 'D'. This is the core of economics. It is not mountains of abstract data, but about how this process works in practice. At the heart of the system is that the savings of person 'A', their deferred consumption, is aggregated and offered to others in the belief that it will be returned one day in goods and services for their own consumption.
The expectation of each worker who defers their consumption is that, at least, their savings will be returned in an a way that gives them access to an equivalent amount of goods and services to those they might have consumed at the time of the investment. This is a reasonable expectation, and is the source of potential for sustainable economic growth.

The problem arises when the systems for the allocation of those aggregated savings go wrong. This is the dysfunctional trading relationships between countries. Those in government, in the financial services industry, the analysts and economists, all misunderstood what they saw. They made false assumptions as follows:

1. Just because a country has always been wealthy, it will always be wealthy
2. Just because a country has a good credit record, any amount of credit might be given to that country
3. GDP = Wealth creation
4. Inflation measures are meaningful, even when asset prices are inflating outside of the recorded figures
5. Trade imbalances might be eternally sustainable where the cause of the imbalance is in consumption activity of one actor of the goods and services of another actor

I am not sure that this covers all of the assumptions, but it is certainly a starting point. At the heart of all of the above is a question of credit risk. What we are seeing are assumptions that underpin how investors have determined the risks in the provision of credit. At the heart of the economic crisis is that various metrics and assumptions led to a false set of beliefs about the relative creditworthiness of individuals, businesses and states.

These assumptions were built upon a world that no longer existed. The entry of the emerging markets, and the newly intensified competition for a finite amount of resource changed the game and the structure of the world economy. As the emerging markets emerged, we entered a period of hyper-competition.

Instead of confronting the competition, much of the developed world simply borrowed and pretended that nothing had changed. The assumption was that the rich world would get richer, and the developing world would get richer. It never occurred to any of the economists, politicians, analysts, and financiers, that with finite increases in resources, we had entered a situation similar, albeit not the same as, a zero sum game. While the pie of resources was getting larger, the number of actors eating the pie was increasing faster still. Just because some of them were lending some of their share of the pie, did not alter the problem that the share of the pie was changing.

So it is that we come to the situation today, with a world economy in which false dawns, endings of the 'financial' crisis, come and go. New solutions are tried, more illusionary gains are achieved, only to see the underlying and unaddressed problems bubble back to the surface. We can see that, despite the efforts of government, many of the rich world countries are indeed getting poorer. The austerity program proposed in the UK may just be an example of this process in action, and we can only hope that austerity can resolve the problems gradually. However, the actions of having tried to prevent change make a gradual rebalancing the least likely outcome, though not impossible.

It is never pleasant to be relentlessly gloomy. I have offered consistent pessimism. I do so because, I believe, I have identified the underlying causes of the economic crisis. In doing so, I believe that the actions to try to turn back the clock are wrong. The only way to move forwards is to resolve the imbalances, and take the pain sooner than later. In accruing ever more debt, in seeking to prop up systems that can not be supported, it may delay the pain, but at a greater cost later. At each stage of the economic crisis, I have repeated the same message.

The only way to resolve the crisis is in the structural reform of economies, and to face the fact that, with a finite pie, and more actors seeking a share of the pie, the only solution is to win the greatest share of the pie possible through efficient development of industry and innovation, and having lean and effective economies. This means that we must trim the fat from our economies. We simply do not have the resource to maintain the lifestyles to which we have become accustomed.

We also have to face up to the imbalances in the world economy, and accept that these are finally unsupportable. Country ‘x’ can not and will not provide goods and services to country ‘y’ at subsidised rates forever. In particular, now that the inability to repay is being highlighted, the real choices for the creditor nations are becoming clear. The reality of the imbalances is now showing the underlying choice – continuation of giving something and getting very little in return, or a painful period of restructuring of their own economies to reflect the real distribution of wealth creation and resource.

I also accept that, in this hyper-competitive world, we are unlikely to win as great share of the pie as before. In an ideal world, the resource pie might expand infinitely, but this is an unlikely outcome at our current position in history (a debate I will leave aside for the moment), and we might have to accept a period of hyper-competition for a long while. After all, there is plenty of labour out there that is still yet to be connected with technology, capital and markets.

It is not an easy message to digest. However, if we wish to address a problem, we have to face up to the actual causes of the problem. As long as the policymakers seek to ignore the real problem, we will continue down the wrong path. It does seem that, with the emergence of the problems of Greece, there are the first signs of accepting that the situation can not continue as it has done. Greece is a warning, and we are collectively starting to take heed. Whether this translates into effective action, and above all acceptance of the reality of the situation, is still uncertain. I can only hope that it does, and that it is not too late.

Within this perspective on the world economy is a further worry. I blithely suggest that we need to adjust, but I also identify that the people of the creditor and debtor nations have not, and probably will not, fully grasp how this mess arose. We see this in the riots in Greece, and the growing anger at the politicians in Germany. The adjustment is going to be very, very painful, and this presents significant dangers. In order for the adjustments to be made, both debtor and creditor countries will suffer painful adjustments. The whole world economy will go through a painful adjustment. In such circumstances, with unemployment growing, and complex and difficult to explain causations, it is a period in which social and political instability will rise.

It is a time in which some people will offer easy solutions, will blame group ‘x’ or group ‘y’ for all of the ills, who will grab the popular anger, and will use that anger for their own ends.

The situation I have outlined in this post, the causes of the economic crisis, are not down to any individual country, or any single group. The bankers were greedy, the regulators were idiots, the Chinese were mercantilist, the Western politicians acquiesced to the Chinese mercantilism, when the politicians promised something for nothing, the press acceded, and the people with them. I could go on. In the end, we all played a role in building this mess.

In addition, the situation is not one in which there will be any painless fixes. We have collectively spent years building an illusionary economic structure. As that structure adjusts, and it must adjust, there is no way to do so without pain for everyone. How we might deal with the adjustment is a matter of debate, but there is no way in which it can be done without pain being felt by ordinary people. However, there will be those who will offer ‘clever’ solutions. They will ‘magic’ away the problems. How this might take place, when the problem is the structure of the world economy, is a mystery. However, they will dress up their magic with plausible and complex argumentation, and in the end avoid accepting that there must be some kind of pain.

In the scenario I have painted, it is apparent that there must be pain that comes with the restructuring. I do not hide this. For governments, the key is not to try to halt the restructuring, but to seek to ameliorate the worst of the effects. It is a fine balance between restructuring and, in the case of the ‘rich world’ getting poorer, and maintaining social cohesion. The danger lies in the pretence that no restructuring is necessary, and that pain might be avoided. The danger lies in governments squandering their resources, as they already have done, in propping up a system that is inherently unsustainable and inherently unstable.

In a very long essay, I have suggested a system that might prevent these problems happening again (it can not ‘fix’ the current problems, but might accelerate their resolution). It is not a perfect solution. No system, for example, might have fully absorbed the labour supply shock that the world has seen. However, the system I have proposed would have prevented the imbalances that followed the supply shock. It is a system which is largely self-regulating, bubble resistant, and imbalance resistant. However, I suspect that such a system is only a dream, as it removes power from those who would like to hold on to their power. I therefore offer it as a solution, but also as a solution that is unlikely to be adopted.

Note 1: When first posting this solution, my use of the concept of value of labour led one commentator to suggest that it was Marxist. The concept of value of labour used is very different from that of Marx, and the solution is in no way Marxist. Also, a regular critical commentator on the blog, commenting under the name ‘Lord Keynes’ has recently said the following:

“Cynicus’ variant on the labour theory of value, in which he believes that value is both caused by subjective factors and by labour is logically inconsistent.Value cannot be subjective and also caused by labour.”

It is entirely consistent to say that we subjectively value labour, which is my explicit central point. I see no inconsistency in this. Lord Keynes simply misrepresented my argument to create an inconsistency. From this commentator, there will no doubt be essays in response to this reply. I would therefore ask you to read the original.

Note 2: As ever, please feel free to comment on any aspect of the post. Even in a post as long as this, in order to cover breadth I have had to sacrifice depth. If any point is unclear, I have expansions on each of the points littered throughout the blog. Also, in trying to compress many arguments, I hope that the arguments are not weakened or might appear inconsistent. Finally, there is the sin of ommission. For example, I do not include the many additional mercantilist Chinese practices that I have included elsewhere in the blog, or the dangers in quantitative easing (printing money), or many other key points. In short, an overview can only be an overview.

Note 3: Thanks for the interesting comments on the last post. I recently found that I had missed following one of your links on a previous post, which was to a You Tube video of the Modern Mystic. An amusing distraction....many thanks.