The World is Changed - We are Starting to see How...

One of the themes of this blog has long been that there is a fundamental shift in the world economy. I had expected the shift to become visible a couple of months ago, predicting a £GB and $US collapse, and have paid my penance for calling this event too soon. However, my central thesis, that 2009 is the year of the fall of the West appears to be coming true - only the process of change appears to be happening in slow time.

In a recent post, I sought to understand why I had called the collapse too soon, and suggested that perhaps the mechanism was anchor prices, an idea proposed by Dan Ariely. Essentially, this is the idea that the first price we see anchors our price expectations, and I extended the idea to the value of economies. In one example, if I recall correctly, Dan Ariely identifies how DVD players started off very expensive, and how, as the price reduced, we had a sense that they were bargain prices - even though all DVDs were less expensive. We were still fixated on the original price, not the price now.

I raise this example as, one way or another, despite our natural tendency to anchor, prices do indeed fall. In the case of the Western economies, we are starting to see the shift in the perception of the value of the economies, though the 'stickiness' of the anchor is still there.

This brings me on to the news, which indicates that S&P have put the UK's rating to a negative outlook, a move that is often a precursor to a sovereign downgrade. I have long been waiting for the markets to 'get it', and have long been puzzled that it has taken them so long. However, this is not necessarily a reason to conclude that the 'end' is now nigh. A metaphor might express the situation, which is to see the anchored valuation of the UK economy as a dam, and this is an additional crack in the structure of the dam. Just as with a dam slowly developing cracks, with the structural integrity weakening with each new crack, it is hard to say which crack will finally result in the deluge.

In my discussion of the climax of the crash, I speculated that the £GB would be the first to fall, and that the $US would follow after. In saying this, I recognised the inherent stickiness in our valuations of economies, and saw a necessity of the £GB falling in order to create enough of a crack in the dam to see the $US fall:

From my point of view, it will be the collapse of the UK economy that will be needed to shatter the belief in the US economy, and will be the final impetus to push the $US over the edge. Such a collapse might even see a brief run to safety into the $US, before the realisation hits that it is a run into danger

We have this quote from the Times, in which the latest US bank insolvency is discussed:

Investors were also concerned that the US may be next in the firing line after Standard & Poor’s sounded a warning about Britain’s AAA credit rating.

What is happening is that doubts about the sustainability of both monetary and fiscal policy in the UK and US are steadily leaving ever more, and ever deeper, cracks in the dam. However, the belief that the US must come through this economic crisis remains, and therefore I still believe that only a £GB rout will finally destroy the $US. However, as the dam analogy makes clear, this is at best only a guess, as there are many other cracks that are appearing, and they might cumulatively be enough to burst the dam.

When I first started to suggest a $US collapse, I was probably seen by many as being a lunatic out on the fringe. The view of the fragility of the $US is increasingly spreading into mainstream thinking. I flicked through the headlines and conveniently found this article in the Financial Post:

The U.S. dollar's day of reckoning may be inching closer as its status as a safe-haven currency fades with every uptick in stocks and commodities and its potential risks - debt and inflation - are brought under a harsher spotlight.

Ashraf Laidi, chief market strategist at CMC Markets, said Wednesday a "serious case of dollar damage" was underway.

"We long warned about the day of reckoning for the dollar emerging at the next economic recovery," Mr. Laidi said in a note.

Mr. Laidi said economic recovery would weigh on the greenback as real demand for commodities, coupled with improved risk appetite, caused investors to seek higher yields in emerging markets and commodity currencies. This would draw investment away from the U.S. dollar, which was dragged down by growing debt and the risk quantitative easing would eventually spark a surge in inflation.

The nature of the fragility of the $US is not, however, as simple as it might first appear. Another article perceptively highlights one of the underlying problems with the idea of a $US collapse, by pointing out that all of the major currencies are looking very 'ugly' at the moment:

The British pound has been a beneficiary, rising on May 21 to a high against the dollar this year of $1.58. But a downgrade of the UK's outlook by Standard & Poor's has just taken the wind out of the pound's sails. The rating agency's assessment is a timely reminder that it is not just the US which is running a double-digit government deficit, doubling its debt in the space of a few years and praying that money printing - £125bn in the UK's case - will generate economic recovery.

The euro, too, has been winning admirers. Yet its previous chaste appeal - in the form of German opposition to money printing - has been tarnished a little by the European Central Bank's decision to buy E60bn of covered bonds. The ECB considered buying more than twice that, according to Bloomberg. That is hardly surprising given the eurozone's slump is so shockingly deep. The German economy shrank 6.7pc in the first quarter from a year before. The comparable dip in the US was 2.6pc. Now which currency is the ugliest of them all? [emphasis added]

If we put ourselves in the mind of a scared investor, it is increasingly difficult to see where exactly we might want to place our wealth, such that it can be secured in these turbulent times. All of the major economies are in free fall, whether Europe, Japan, the UK or the US......What the investor is left with is the 'emerging market' economies, and these have traditionally been seen as the markets with the greatest risk.

On the one hand we have the high anchor valuation of the traditional leading economies, and on the other we have the risks associated with the emerging markets. It is no wonder that the signals from financial markets are so confused.

Added into this mix, we must also factor in the extraordinary actions of the Western governments, in particular the policy of Quantitative Easing (QE, or printing money). The UK and US are both embarked upon this policy, both countries are using the policy to support their bond markets, and both countries are steadily expanding the policy. The major overseas purchasers of the bonds are now becoming increasingly restless, and suspicious that the policy is going to lead to an inflationary default on debt, as is highlighted in a recent article:

For now, the dollar doesn't appear to have anything going for it. The US Federal Reserve has cut its benchmark interest rate virtually to zero. Worse, it is printing money and using the freshly minted cash to buy US Treasuries. The Chinese, the US's biggest foreign creditor, have made it quite clear that they take a dim view of this "policy mistake", as China's central bank put it. Undeterred by eastern frowns, some Fed governors have been gunning for even more money creation to buy bonds, according to the minutes of the last Federal Reserve meeting.

Just to add to the toxic mix of Western policy, the EU has also started down the road of QE, though as yet they are not buying EU government debt with their freshly printed money. However, for the UK and US, overseas creditors are increasingly worried about the credit worthiness of the countries. The negative report from S&P is an indicator of the worries for the UK, but the signs are also not positive for the US. Russia is now shifting reserves into Euros, The Democratic Party in Japan is threatening to only purchase US debt denominated in Yen (making funding of US debt a Japanese election issue), and China is shifting its mass of $US debt into short term instruments out of fear of US inflationary policy.

However, the policy of QE, rock bottom interest rates, and massive government borrowing and spending might be enough to prevent the real collapse in the economies in the very short term. As I have often pointed out, this is a short term fix with very high long term costs. As such, for domestic purposes these policies may serve the politicians in the short term, but only at the price of destabilising their ability to raise finance in the future, and even greater general economic damage later. This is at the heart of the worries of overseas creditors.

One of the arguments that has, in the past, been provided for the stability of the $US was the reserve status of the currency. Even this foundation for the $US is increasingly being questioned, and I have long been writing about the many activities of China in which they are gradually positioning the RMB as the replacement reserve currency. A search on Google news produced a flood of articles on the subject, of which the following is just one example:

May 15 (Bloomberg) -- The yuan may gain as much as 5 percent against the dollar this year as China promotes wider use of the currency, according to Bosera Asset Management Co., the nation’s second-largest fund company.

China has signed 650 billion yuan ($95 billion) of foreign- exchange swap agreements in the past six months with countries including South Korea, Argentina and Belarus and plans to promote the use of the currency in cross-border trade. The renminbi may become one of the world’s three major currencies within 30 years, joining the dollar and the euro, Li Quan, executive vice president of Bosera, said in a telephone interview yesterday.

“Demand for yuan-denominated assets will grow as China is trying to make the yuan a global currency,” said Shenzhen-based Li, whose firm oversees 178 billon yuan of assets. “At the same time, concern about dollar devaluation will prompt investors to inject more capital into emerging markets, especially China.”

Once again, my early posts on the subject might have been seen as the ravings of a lunatic, but nevertheless the idea of an RMB reserve currency is gaining increasing credibility. The only difference now between myself and many commentators is that they see the shift as being long term, whereas I see it as a rapidly accelerating process. I suspect that the difference lies in the fact that they are not recognising the vulnerability of the $US, and that if the $US does collapse, it will not be able to retain reserve status. In other words, they are focusing too much on the RMB's growing strength, rather than the inherent weakness in the $US.

What all of this amounts to is that the shift in the shape of the world economy is slowly becoming visible in financial markets.

However, this is not the whole story.

One of the other points that I have previously discussed in the blog is that the world economy is pointing in the wrong direction, which is towards illusory wealth of Western consumers. I have suggested that, in order for recovery to take place, account must be made for the shift in wealth around the world. In a recent article for the Trade and Forfaiting Review, I used the Tata Nano and the US car industry as an illustration of how the movement of wealth will shift economic structures:

The important point about the Tata Nano is that it is meeting a new demand from a rising middle class in emerging economies. In the interim, the credit-fuelled demand for SUVs, the mainstay of US car industry profits (until recently), is collapsing. On the one side there is a car that rests upon an unsustainable credit-fuelled consumption boom, a car that flattered the aspirations of the indebted, and on the other there is a car that meets the rising aspirations of the world’s new wealth generators.

Since writing the article, I saw another article in which the shift in the structure of the world economy is already becoming apparent:

General Electric yesterday became the latest big manufacturer forced to change course and make cheaper and simpler products to cope with the decline in purchasing power around the world.

The US engineering and financial conglomerate, which makes medical scanners, joins companies such as Sony and Unilever in seeking to develop less complex, better value products that will tempt customers in the face of the global recession. The shift away from cutting-edge technology and premium brands towards value for money is affecting a broad swath of businesses, from medical diagnostic equipment to soap powder.

GE is moving billions of dollars in research funds away from developing high-specification medical equipment towards lower-cost technology. Over the next six years GE Healthcare will devote half its $1 billion R&D budget towards low-cost products designed for use in emerging markets and remote areas, up from only 15 per cent today, John Rice, GE’s vice-president, said.

I have long argued that the financial crisis is a symptom, not the cause of the underlying economic crisis, and it becomes ever more apparent that this is the case. The boom in house prices and credit bubbles simply masked a more profound underlying change, whilst magnifying the consequences. Whatever happened, the wealth was shifting to countries like China, but the indebtedness of the Western economies has made the change more devastating, and also has hobbled the ability of the West to recover.

In the meantime, the governments of the Western world are seeking to sustain an economic 'shape' that was itself a product of an illusion. The change in the shape of the world economy has already taken place, and is just now become clear to see. As the illusion is dissipating, the world, the markets and individuals are starting to see the underlying reality. It is primarily the governments of the West that still seek to persuade us that we are in the illusory world that has already passed from existence, and seek to persuade us that it is still within reach. It is an illusion that flatters our dreams and aspirations, and is therefore an illusion that is aimed at a receptive audience. It is pushing at an open door.....we want to believe....

An interesting comparison again comes from Dan Ariely in a lecture that he gave recently (see video here). He shows a picture of two tables, where the length of the tables is an optical illusion in which one looks longer than the other - but they are in reality both the same length. Even having demonstrated that the tables are the same length, we can not help but still see one table as longer than the other. If you see the image below, it is possible to see the illusion in action. I can tell you that the tables are the same length, but still they appear to be different (image from here)












We have a resistance to seeing reality.

Even when we are told something is real, we can not help but hold on to our original perceptions. Whether the length of the tables, or our anchor valuation of the economy, we are sometimes resistant to abandoning our previous perceptions.

As we look on at the shift in the world economy, it is possible to see how enduring the illusions are. Even as ever more evidence mounts to suggest that we are witnessing a different shape, still we cling to the illusory world of old. We are still insistent upon the illusion that the West is still wealthy, that one way or another, it simply must be. Every day another measure tells us that the size of the economy is an illusion, but still our perceptions revert back to the illusory size.

The problem is that reality is still reality. Just as we must accept the reality that the tables are the same size, so must we accept the real size of our economies. It is this wilful disregard of reality that is, in part, driving us ever deeper into the ditch. I suspect that many in government have started to grasp the reality, but they are clinging on to and promoting the illusion, if only for their own selfish ends.

The underlying purpose of this blog has been quite simple. I have sought at every stage to paint a picture of the underlying reality of our economic situation. In doing so, at many stages, I am sure that I have been seen as raving, of being an 'end is nigh' doomster. The trouble that arises is that, as the economic crisis progresses through each stage, the scale of the disaster is becoming increasingly evident. What might have been viewed as ravings of a doomster eventually creep into the mainstream. Whilst getting some points wrong, the general thrust of the thesis of the blog appears to be correct.

The thesis is that the West is not, and will not be, as wealthy as it thought. A major change has taken place, and there is no prospect of reversing that change. Western governments, with their profligate interventions, are simply denying the world that sits before them. In denying reality, they are simply pushing the decline ever further, and to a point where any recovery of our former wealth becomes ever more impossible.

As with any other commentator on the economy, perhaps I am also subject to illusions, and might be perceiving an illusory world. The trouble is that, as time has progressed forwards, the world looks ever closer to the one in my perceptions. It is not a heartening thought.....

Note 1:

Some responses to comments on the last post.....

Jonny, in response to your question about how the Bank of England might cause deflation in the RPI, perhaps the BoE February inflation report will clarify. I hope this is the right report, but they point to lower interest rates impacting upon the RPI. I was going to quote from the report, but my Internet connection has gone into a tailspin, such that it is very slow today (rather frustrating...). Apologies for not being able to offer up the quote (assuming I have the right publication and date).

Anon82, I think that you will find that my post on the US economy may shatter any illusions of any significant recovery. Many of the points might apply to the UK economy.

Gingellenator, I have discussed the inflationary default for a long time across many posts. I would like to provide you with a link, but this is an argument that has evolved through several posts. As such, time allowing, I might pull the thoughts together at a later date.

Sobers, you are quite right to question how QE might be reversed. You might note that there are no credible or serious plans for this, just vague assurances. It is hardly comforting.....

Anonymous, on the subject of the Bloomberg house price article. I am very impressed with your dilligence, and am unsuprised to find that yet another positive indicator is not at all positive.....For curious readers, you may want to compare and contrast the following two articles:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aS5rTdLCIWR8&refer=home

http://miranda.hemscott.com/static/cms/5/2/8/2/binary/0058649286/2118458.pdf

Adam, thanks for the Austrian view on inflation, which is an interesting contribution, in particular as it is so relevant to the post.

Clauswitz, thank you for your kind comments.

Kecske, thanks for the link to the article on hyper-inflation. I had picked this one up on Reddit. It is certainly interesting, but I have some reservations. I would like to discuss these, and may come back to it in the next post that is relevant.

Anonymous and Anonymous82, many thanks for the links on the S&P downgrade....very useful.

Optimism and Economics

I recently wrote about the surge of optimism in the press regarding the world economy and the Economist magazine has recently detailed the number of press mentions of 'green shoots of recovery'. The Economist chart shows a steady rise of the use of the term in March, and an explosion in April.

In my post on the subject of this optimism, I highlighted that all of the indicators were negative, and wondered what might justify such optimism. For example, in the UK, there was a slight uptick in house prices, but I suggested that this was a false dawn. Since I wrote the post, house prices have continued their downward trajectory, though the rate of decline in prices is reported as slowing. Likewise in the UK there has been an improvement in consumer confidence, albeit from abysmal levels.

Perhaps the best summary of the optimism can be found in the Independent, with the headline 'US Recovery Hopes Grow Even as Economy Contracts 6.1%'. The article goes on to say:

US economic output contracted at an annualised rate of 6.1 per cent in the first quarter, almost as bad as the minus 6.3 per cent GDP figure for the final three months of last year, when consumers and businesses were reeling from the collapse of Lehman Brothers.

The report went on to say:

Other "green shoots" in the report included a surprisingly strong uptick in consumer spending, which contributed 1.5 percentage points to GDP, where it had been a net negative for the two previous quarters. Information on the price of goods and services helped to ease the fear of deflation taking hold. And economists also dismissed an unexpected drop in government spending as temporary.

However, we have this from the New York Times:

A day earlier, the government released figures showing an unexpected increase in consumer spending in the first quarter, offering one of the few bright spots in an otherwise dreary accounting of the country’s overall economic output. But the monthly report released Thursday showed that while consumer spending rose sharply in January, its gains tapered off in February and reversed themselves in March, declining by a larger-than-expected 0.2 percent.

So what exactly is this optimism all about? Perhaps the best expression of the depth of the ongoing problems can be found in the actions of the Federal Reserve. In particular, the Fed is currently printing $1.2 trillion and using the money to buy mortgage backed securities and treasuries. Does this action look like an expression of confidence in a recovery?

The most odd part of the so-called 'green shoots' of recovery is the sudden surge in bank profits. An article in the Economic Times sums up the reality of the situation:

The first quarter results of US banks mean little. In early April, the US accounting regulator tweaked mark-to-market rules for bank assets in order to help banks show lower losses on these assets. These modified rules were applied with effect from March 15, allowing banks to show better than expected results for the first quarter.

The idea that banks can work their way back to good health simply by making profits hereafter is absurd. US bank losses are huge — the IMF’s latest estimate of US bank losses is $1.6 trillion. US banks have raised an additional $400 billion in capital so far, which means they need another $1.2 trillion to get back to normal health. For banks to cover this amount through profits would take years. Until then, banks will not be in a position to provide adequate credit.

Quite simply, common sense should tell us that there is no realistic way in which the US banks can be returning to profitability. All of the US banks have massive exposures to the US economy, and every part of the US economy is heading in a downwards trajectory. How an earth can banks be making profits when real estate is falling, consumer spending is falling, insolvencies are up, unemployment is up and so forth...

I am increasingly of the view that we are departing ever further from reality. We are now living in a world in which insolvent banks that are living on life support from the government are apparently making profits.

I will freely admit that I have been increasingly puzzled by the optimism that is emerging. I have always accepted that commentators, analysts and markets can be somewhat irrational, but have always insisted that reality must at some point intrude. I still believe that reality will catch up with delusions, but have had trouble understanding the level of self-delusion that is taking place. I keep on wondering just what will it take for the underlying reality to sink in.

In the case of the UK, it is even more mysterious. The UK budget in particular painted an appalling picture of the state of the UK economy. In my post on the subject, I suggested that it would be interesting times for gilts and the £GB. However, the most recent gilt auction proved to be a success, albeit in a gilt that is part of the Bank of England's money printing purchase scheme. Meanwhile the £GB has gone through a roller-coaster ride:

Sterling fell against a broadly recovering dollar on Thursday after rising to a two-week high as initial optimism about the global economy petered out, even as share prices gained.

An improvement in British consumer confidence had pushed the pound sharply higher, but news that U.S. automaker Chrysler would file for bankruptcy later in the day and data showing a fall in UK house prices weighed on the pound.

I am starting to take the view that one of the problems must be that the paradigms being used in the markets is one in which the only reality is a belief in the inevitability of recovery. I suspect that, with no experience of a long term and sustained decline many people simply refuse to believe that such an eventuality is possible. Instead of asking the simple questions as I do, such as asking where the real wealth is generated, the markets hang on to figures which have no bearing on the broader reality. In this world an uptick in consumer confidence is a herald of recovery, a bank's profits are real even if they are simply an illusion. It is increasingly looking like drowning men clinging to anything that floats, even as the sharks circle round them.

What I am in fact doing is dramatically shifting my view of the world. I am finding myself in a position where I must accept a new reality. That new reality is that self-delusion is a fundamental part of the human condition and that rationality is a very rare commodity indeed. I am currently ploughing my way through several books that deal with economics and psychology, as it is clear that my model of the economy is incomplete.

I have already found one interesting insight, which can be found in 'Predictably Irrational', by Dan Ariely. He points out that when making a valuation of something, we develop what he calls an anchor price. Through a series of experiments he shows that the first price that we see for an item becomes an anchor for valuations, and that it is very hard for us to adjust to a new reality, to adjust our perceptions of price. Interestingly, for some of his research he used bankers as his experimental subjects, though the principles he establishes have wider relevance. In particular it is possible to stretch his insight, and see that we might have made a broad brush evaluation of whole economies, so that we have a fixed view of the Western economies. We have anchored our valuation of the economy to a certain level, such that it is very hard for us to adjust to a new valuation.

Whilst this is stretching the findings, I do not believe it is over-stretching them. He is reporting an underlying factor in human thinking, and there is no reason to think that his examples of decisions about individual valuation might not apply to a broader valuation. As a non-experimental illustration he cites the example of a DVD player, which starts out very expensive, thereby creating an anchor price that is high. When we later buy a DVD player, when the price has fallen, we believe that we are buying a bargain. However, as we know with these kinds of goods, our bargain of today will still look expensive tomorrow. Perhaps what we are seeing in markets now is this kind of process?

Essentially, what we must take from these examples is that there is a reluctance to adapt ourselves to new underlying realities, and that our sense of value is 'sticky'. This in part may explain the stock market rallies of late, and similar rallies that took place in the great depression. However, as in the DVD case, there is no reason why valuation and therefore price will not eventually move, even if our perception of value is sticky. The question that this does not answer is exactly how that shift might finally come about.

On that subject, I am increasingly wary of making predictions....

Note 1: I only have a brief moment to reply to some of the interesting comments on the last post. As such, apologies if I do not reply to your comments.

Escaping Eastwards: You raise an interesting question which I will try to address in a future post.

Anonymous (who posted a massive comment): I hope that you take note of the comments of other commentators, and try to format your comments in a way that will better express your point of view. I publish all comments, but was not happy to publish your comment simply because of the format problem. However, I published anyway on principle. I will echo Lord Sidcup, and suggest that perhaps you might start your own blog? Gina, thanks for a great job of 'translation' on the comment. I would like to answer the comment, but it is rather a large subject for a simple reply.....

Lord Keynes: I am glad that you use the term 'neo-liberalism' rather than liberalism for the record of Labour. Liberal would not be an accurate description.

Chas H: In answer to your question, the problem for the future of the UK economy in the medium to long term is that we simply do not know what the politicians are going to do. As such, it is impossible to guess at outcomes. For example, it is always possible for a 'great' leader to emerge, who might lead the country back to economic strength. Alternatively, it is just as possible that a populist demagogue might emerge. As for the social consequences, I will leave that to other commentators, except to say that my view is that there will be serious problems.

Lemming: Maybe the 'reset' will be the default and collapse of the £GB? As I have discussed before, such a reset has a price....

Acrobat_747: The problem with your thesis is that you are looking at debt in absolute terms rather than relative terms. It is possible for a country to rack up debts if they have prospects of growth, or rather there is a perception that a country has prospects for growth. The problems arise when there is no apparent method for that future growth, and when the markets realise this. In the case of the UK, there is no such prospect for growth. My question has always been 'where will the growth come from?' On one occasion I asked this question on the Guardian's CiF forum, and nobody was able to come up with an answer. I have, to date, still not seen any explanation of where the growth might come from. If you have an answer, you might wish to add it in a comment. When I asked this question, I was asking for specific sectors, rather than answers that amounted to 'it will just happen'.

At the moment, the best case for growth I have seen is growth based upon a falling currency. This is not real growth but a process of adjusting to relative impoverishment. Whilst this may make the UK more competitive, it is done at the cost of reducing the cost of UK labour, and therefore reducing the standard of living of everyone in the UK. It is also not a form of 'growth' that would please holders of UK debt that is denominated in £GB. Under such circumstances, would you invest in the UK or in government debt?

This is why the level of debt is relative. The growth in debt in the UK can not be paid back, as there is no growth that can provide a route out of debt, or to continue to service debt. The UK is structurally unable to service debt without incurring more debt. This is a scenario of ever expanding debt, with no means of payment in sight. Quite simply the output of the UK economy can not pay for the consumption within the UK economy, and there is no prospect of this situation changing (unless you believe Alastair Darling). As Lemming said in a comment; 'I have to ask, are we really serious about getting out of debt?'

As a note, there is no reason why the UK might create a new technology or process and achieve substantial growth in this way. However, this is highly speculative. Why might the UK come up with such innovations? It has the same prospects as other developed economies, but no particular advantage over and above them. I am not sure that creditors would invest on the basis of such a 'hope'.

Tiberius: An interesting point of view. It is interesting to see such diverse perspectives on the blog.

Gone: You mention that people will continue to buy bonds as long as they believe that they can sell it on. That is a matter of confidence, and that in turn is a matter of belief in the stability and sustainability of an economy. Just because there are buyers now does not mean there will be buyers tomorrow. Even though the government is still having success in selling their debt, confidence is waning, and this can be seen in the rising CDS premiums.

I am afraid I have run out of time, and apologies for rushed responses.