Eurocalamity

I have been reading many views from an endless number of commentators on the potential roll on effects of a Euro break-up; a new language has sprung up around the Euro crisis, such as the now widely used Grexit, and even less pleasant sounding Spexit (which does not seem to have caught on). What to make of all these scenarios that are being trotted out?

My answer makes this a relatively (and unusually) short post; the answer is that nobody really has any idea at all, and if they say they do, then they are genuinely geniuses, have an outstanding set of tarot cards, or they are just plain guessing. The reason why I argue this is very straightforward. As I argued in my last post, we are entering a special set of circumstances. In particular, the drivers of the world economy long ago ceased to be about market fundamentals, and is instead dominated by state action; whether fiscal or monetary policy. This is largely the result of what I termed as extreme policy making setting up a dynamic in which the extreme policy enacted in economy x, sends ripples out into the markets, leading to a further extreme policy response from country y, which in turn washes back onto economy x, which reacts with further extreme policy.....and so it continues with all of the major economies now acting with increasingly extreme policy to a point where markets are now 'nationalised'.

There are therefore some very basic reasons why it is not possible to predict the roll on effects of a Grexit, or any other exit, from the Eurozone. The only certainty is that, as and when these events take place, the economic policymakers will not stand back, but will again intervene in an even more dramatic fashion, in an attempt to 'save' the world economy. Here I am assuming that the coming Euro-calamity will actually take place in the coming month/s. Quite suprisingly, I am in rare agreement with Paul Krugman that there is currently no plausible avenue out of the current path to crisis in Europe. However, I put a small caveat that there just might be a new action from policymakers, and not just those in Europe, and these might still hold back the tide a little longer.

Like many commentators, I am tempted to hazard a guess at possible outcomes, but keep on trying to grab hold of any scenario which is driven by clear principles, theory or the market. However, as I argued in my last post, any theory or generalisation from past events has been torn up along with the economic textbooks.

Instead of finding any clear scenario, I simply finding myself contemplating what will be done as a large ditch attempt to turn back the tide, and how this will set up even more unpredictable outcomes. One obvious answer will be that the printing presses will roll, and not just in Europe. We might even see concerted and coordinated central bank responses, including the Euro area, Japan, China, the US and the UK. In all events, the central banks will continue to at least try to stand behind the banks, perhaps producing something like an LTRO on steroids.

Perhaps the most interesing question will be the timing of action. At what point will policymakers act; before Grexit, during Grexit, or once the consequences of Grexit are apparent. Also, although Grexit is often seen as the forthcoming trigger for crisis, it may be that the trigger will emerge in one of the larger Euro economies, with Spain, Italy, Portugal, Ireland, and even France, all looking fragile. There is a real risk of events overtaking the current 'magic' date of the Greek elections.

Regardless of the 'trigger', if my guess is right, and that there will be a coordinated response, there will likely be a positive spike upwards, as relief grips the market. Commodities and stocks will likely briefly soar in so-called safe haven markets. As with previous state interventions, eventually the markets will fall back down, or even crash. Alternatively, if policy is uncoordinated, then there is likely to be a series of small market rallies, which will extinguish themselves as quickly as they started. This might encourage yet further extreme policy responses. Running to gold is another possibility, as gold in some respects is entirely irrational and that very irrationality is also gold's strength. It just feels safe when all else feels unsafe*.

Nevertheless, this is all speculation, and the only certainty in the policy response is that there absolutely will be a policy response, and it will almost certainly be extreme. As such, the ripples of the actions of each of the policymakers will ripple out and interact in the global economy, and will likely further swamp any market signals that might remain. It is for this reason that I emphasise that my commentary is nothing more than speculation; I am guessing.

As such, we are now in the uncomfortable position that, come what may, the world economy now no longer sits in the hands of markets, firms, banks and individual actions of economic actors. Instead, we now wait upon the action of states to determine the next steps in this economic crisis. The track record of states at managing the crisis is not encouraging. They have tugged and heaved on both fiscal and monetary policy levers, and still the situation in the world economy swings back towards negative outcomes. With each swing back to negative from each policy response, the stakes are being raised ever further. Again, in my last post, I discussed how the LTRO has compounded the problems in Spain, albeit giving both the Spanish banks and state a very, very brief reprieve.

My final guess is to suggest that, at the very least, the economic ride of the coming months will be a turbulent one. In this, I think I am in agreement with everyone. For the rest, and my own comments, treat is all with a big pinch of salt.

* I do not believe that gold is some kind of 'special' form of 'money', but its history as money is what I believe gives it the feeling of safety. 

Note: For my next post, I will try to get away from the Euro crisis and instead take a more analytical look at China or the US going forwards. The European crisis is not the only issue of interest. However, for all my good intention, I keep being distracted by Europe and, for obvious reasons, may be pulled back to Europe. If I do return to the European situation, rather than a very general post such as this one, I will try to focus on some of the detail of the situation (country/market/institution etc.).

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 Economic Shift in the World Economy

I have started this post without a title, as I'm still trying to sort out which might be the best subject for a post. The slow motion car crash of the Euro is always tempting. Then there is the current state of China, which increasingly appears to be in trouble. Then there is the US 'recovery' or the latest discussions at Davos.

For the last point, an interesting perspective was aired at the forum in Davos, and it may be that it can tie together some of the many stories that are being discussed. This from Jeremy Warner of the Telegraph:

The contrast between Western gloom and Eastern optimism is again striking this year, and it is something that goes beyond the immediate challenges of the eurozone crisis.

According to forecasts aired by Indonesia's minister for creative industries, the total size of the world's middle class will more than double to 4.9bn by 2030, with 85pc of the growth occurring in the developing world. By then, some 65pc of this middle class will be in Asia.

Long term predictions of this sort are always going to be suspect, but few would disagree with the thrust of what the Indonesian minister is saying.

The article mirrors something that I wrote in 2009, in which I discussed the emergence of the Asian middle class, in contrast to the Western middle class whose spending power was in decline. I used the Tata Nano (perhaps a poor choice with hindsight) and SUVs as an example to illustrate the point. Whilst SUV sales were falling the Nano was the coming thing. The shift represented the move from wealth being concentrated in Western middle classes (the SUV), to a dispersion of the wealth to the East (the Nano), and with the Western middle classes moving down to meet the rising Eastern middle classes in the middle.

Another of the stories that I had kept in mind for a future post ties into the story of the decline of the middle classes in the West. It comes from the New York Times, and is an explanation of why the Apple iPhone is not made in the US (there is also a visual presentation of the argument here). It is a long article, but there are some points that are clearly made. The first is that it pops the fantasy that gripped the Western world; that the East would do all the clever work and that the East would simply be the cheap labour. Again, it has been a theme of this blog that this was just not going to happen. I have argued that all of the key services would, in the end, follow manufacturing.

The most interesting thing about the Apple story is that Apple still does have the design knowledge and experience, and this is still undertaken in the US. The problem is that there are so few jobs that this creates. Instead, the article argues persuasively that it no longer about the availability of cheap labour, but the flexibility of Chinese companies, and also the proximity to all key suppliers that makes manufacturing in China a compelling case. In addition, China has an army of engineers and technically trained staff, skilled manufacturing employees and so forth. The result is that Apple has a compelling case for manufacture in China. It is the underlying reason for why the middle classes of the US are being hollowed out. Those skilled jobs are going to China, for example the solidly middle class engineering jobs, and the skills of the US workforce must inevitably decline over time in relation to countries such as China.

It then just becomes a matter of time before the most highly paid jobs, such as those in design and marketing, likewise commence the move Eastwards, as the Chinese workers 'upskill', as Asian markets grow in relation to Western markets, and as the key skills to 'make stuff' become ever more concentrated in the emerging markets.The worrying element of this is that China has created a virtuous spiral. The more manufacturing it undertakes, the more compelling the case for manufacturing in China.

All of this appears, then, as a done deal. But is it?

To date, all of the massive growth in China has taken place in the context of 'state capitalism', in which China has carefully guided the rise in its economy with a combination of massive investment in state companies, and measures to ensure a competitive currency, and a policy of obtaining technology from the West through demands for technology transfers and outright technology theft. It is a story that is told in a recent Economist special report. But it is not just China that is following a state capitalism model, but as the report details, state capitalism is increasingly being endorsed around the world.

After all, who can argue that China's model has been a success to date? The real question is one of how long it might continue?

I am certainly having my doubts that it is a model that can be sustained. I recently used an analogy to explain to friend why I thought the Chinese model might now be in some trouble. When China first 'opened for business', the country was in a parlous state following the years of chaos characterised by Maoism. The first advantage was that China could almost do no worse. The second advantage that flowed from this is that, in terms of state capitalism, China could safely invest in infrastructure and almost guarantee a return. My analogy was that it was like throwing a dart at a dartboard from one foot away from the board, with the bulls eye dominating most of the board. As time has moved forwards, the person throwing the darts is moving steadily further away from the board, and the bulls eye is shrinking back to its normal size. It now takes skill to hit the bulls eye, and there are more misses than hits. Just one example of this in action is the case of cities being built but remaining unoccupied.

The second problem with the Chinese model is that it requires the acquiescence of trading partners. The special report points out the increasing queasiness of key trading partners when faced with effectively subsidised state giants entering into international markets. The Economist article is perhaps an exemplar of a growing backlash against the state capitalist model. For example, it points to the spreading influence of the model, and the more the model spreads, the more problematic it becomes. The more companies that face competition from these state supported enterprises, the more there will be complaints to policy makers of unfair competition. There are two approaches to such complaints. One is restriction of trade, and the other is to respond in kind. In either case, the model will start to break down. The former is (I hope) self-explanatory, but response in kind will just lead to a fight that neither side will win.

I am reminded of a long while ago. I remember commenting on another Economist article (sorry, I cannot find it now) that argued that the cheap products being manufactured in China should be seen as a wonderful benefit for the West. The article argued how this kept down inflation, and provided a better standard of living to the West. They mentioned the problem of currency keeping prices as low, but thought that the benefits derived from this were positive (this is my best recollection of a long, long while ago). I do remember that I argued at the time that this subsidy of Chinese goods might appear to provide benefits, but at the cost of hollowing out their competitors in the West. I see the state capitalist model is going to raise the same issues, but this time with China's trading partners increasingly jaded about China, and with a growing sense of frustration as the impacts of the emerging market growth becomes ever more plain to see.

I am not sure that the acquiescence can continue for much longer.

Another side of the story is that of Chimerica. The funding of Western states in order to continue trade imbalances is coming to an end. It has not ended, but the limits of the model are becoming apparent. Also, the costs of the model are becoming apparent. This leaves a tough period of transition. For example, the problems of the Euro area will eventually land on the doorstep of China and the other emerging markets. This is going to take place at a time which, in the case of China, will be when the problems of the state capitalist model are starting to make themselves felt. China's property bubble is bursting, and there are signs that the Chinese economy is rapidly slowing. This from Ambrose Evans-Pritchard, who discusses proxies for the state of the Chinese economy before saying:

So how did China pull off an economic growth rate of 8.9pc in the fourth quarter?

Beats me.

I strongly suspect that the trade and power data reveal the true state of China’s economy.
There clearly was a pick up in early January but I stick to my view that China has inflated its credit bubble beyond the limits of safety – an increase of 100pc of GDP in five years, or twice US credit growth from 2002-2007 – and that Beijing cannot continue to gain much traction with this sort of artificial stimulus.

Indeed, the extra boost to GDP from each extra yuan of credit has collapsed, according to Fitch Ratings.

There are several points that can be taken from the discussion that I have presented. The first is that, as was predictable, a major shift has taken place in the world economy, and the price of the shift has been the diminishing of the Western middle classes, and the rise of the middle classes in the emerging economies. This is being noticed, and it is finally being understood. The success of the model has relied on the acquiescence of the Western world, but the continuing acquiescence is doubtful. Set against this, the stage of development of China in particular, has seen a virtuous spiral develop. However, that virtuous spiral might be upset by the consequences of the gross mis-allocation of resources that are becoming apparent. Whether the over investment in real estate by banks and provincial and city governments, or ever more questionable infrastructure investment and investment in more and more industrial capacity, this has potential to be a drain on the Chinese economy.

It is a complex situation. It is difficult to predict how it might unwind. However, the one certainty is that some kind of change is on the horizon. The pain being felt by the middle classes of the Western world will be addressed by politicians, and there is no sure way to know how they will finally respond. Of one thing, I am increasingly certain. The acquiescence of the West to a system that is destroying the wealth of the West is coming to an end.

Note: I have used the expression emerging economies but they have, in most senses already emerged. Please excuse my use of this convenience. Also, as ever, my focus is perhaps too much on China, which is simply because it is one of the countries I watch most closely.