Thursday, July 31, 2008

Can the Economics of the Past be used to Predict the Economic Future?

I have had several comments on my posts and, time allowing, I will try to respond to them. One interesting question was:
'I suppose we are used to economic cycles, with booms and busts of varying degrees. Are you saying that this time it's going to be very different? Has anything similar happened in history before?'
I would hope that it is apparent from my many posts that this time it will be 'different', at least in the sense that it will be different from the economic cycles that we have been used to. The point of my posts is to say that something has changed profoundly, in particular there has been an economic shock in terms of too much labour in relation to the available commodities. In particular the amount of labour has increased without the commensurate increase in commodities necessary to make all of the labour productive. In this case, until commodities catch up, there will be a redistribution of wealth. Whilst capacity constraints in commodities are nothing new, the unique factor here is the massive input of available labour. Globalisation has allowed capital to move freely, and this has allowed a large amount of new labour to become potentially productive. This has created an oversupply shock.

It is worth noting at this point that I have predicted that oil prices will fall back. How can I square this with what I have said with regards to commodities and labour? The answer is that, until the point is reached where the economies are sufficiently rebalanced, there will be turmoil in the world economy. One of the elements that has unbalanced the world economy has been the supply of finance into Western consumption. This had led to a poor allocation of capital into the West, and the world economy will fall back until the damage done by the credit bubble is corrected. In the interim, commodities will fall back as the West contracts, but demand will again pick up as the East continues growth in a couple of years time. However, as the East grows again, the West will stagnate, for the reasons set out in 'The Root of the Problem'. As the East continues expanding it is likely that the world supply of commodities will continue to bump up against the metaphoric brick wall of supply constraints, with supply continuing to lag growth. All of this assumes that there will be stability in the world trading system, which is not guaranteed. There is a real possibility of a retreat into protectionism in the next few years.

There is a further question asked in the comment as follows:
'In our current situation are these experts' views valid in any way, shape or form?'
This question relates to the use by experts of previous bear markets to predict the current market. My answer is that my opinion is just one of many. If you are looking for investment advice, the majority view would be that you should listen to these experts. On the other hand, you may wish to take my views into consideration. I do not think that the state of the world economy is comparable with the past, and therefore the 'expert' predictions are built on foundations of sand. All prediction is based upon past experience, but I believe that past experience is only a guide to current situations, and needs to be tempered in light of the fundamental differences of the current situation. To date I have not seen any acknowledgement of the shock of the oversupply of labour, so I am very dubious about most predictions. The oversupply of labour into the world market is (in my mind) what has really changed, and changes the entire dynamic of the world economy. Until the experts grasp this, they are missing a vital element in appraising the economic situation.

I have also had a question from another person who has posted anonymously. The question was regarding the prospects of Thailand, China and Brazil. I have discussed China elsewhere and have admitted that there are many question marks over the future. In particular, if China suffers a drop in exports (very likely) then will it be able to maintain social stability? Has it reached the point at which it can grow without export led growth? There are also possibly imbalances in the Chinese economy to factor in, but otherwise there is no reason why China will not continue to grow, and grow fast (with maybe a blip in growth in the next couple of years). As for Brazil, I will have to confess insufficient knowledge to have a strong opinion on the future. For Thailand, there is no reason for it not to continue to grow but, in Thailand, the real constraint is political risk. It is basically a very unstable country, and therefore the consideration is primarily political risk.

This brings me to the subject of political risk which I have alluded to throughout this post. Globalisation has had an astounding effect on the world. One of those effects is that a huge number of people have been raised out of poverty. Few would argue that this is not a good thing. The problem that has arisen as a result of this, however, is that there are now imbalances in the world economy. We are now in a situation where politicians, in particular in the West, will need to address these imbalances. As the West is pressured by the competition of the emerging economies, there is a real likelihood of demands for protectionism. If this happens, the turmoil will increase further. The problem that really arises is that we are entering into a period of world instability. As much as we would like to think otherwise, economics is the great driver of events.

If a situation of economic turmoil arises (as I have predicted), then political turmoil will surely follow. I have already mentioned this in relation to China. However, this political turmoil is likely to become more pronounced over the next couple of years, and everywhere will be effected. The question in my mind is to ask how politicians around the world will deal with the problems that are arising. It is here that the problems start, as this largely depends on the nature of leadership, and how the leaders will deal with crises. It is very difficult to say how they will react, but I am rather gloomy about the situation.

The basic point that I am making is that the problems of the world economy are now set in place. There is no reversing them and, one way or another, they will now permanently change the structure of the world economy. However, there is no way of telling what the final change will be, as this is now in the hands of individuals. We can sketch out general scenarios, but can not make predictions.

One scenario is that the trading system remains open, and that the rich world responds to the entry of the emerging economies by reforming and meeting the challenge. Another scenario is that the rich world retreats into protectionism, and that the world economy sinks back. Yet another scenario is that the turmoil will create social unrest, and the response will be conflict. All of this depends on how individuals respond to the challenges that are arising. There are more scenarios that can be proposed but I hope these illustrate the potential for varied outcomes.

In such a situation, I would be very cautious about predicting whether China, Brazil or Thailand are good bets. The only certainty is that counties such as China now have a large part to play in the world economy, but whether that is a stable rise or a chaotic rise is a matter that can not be predicted.

You may gather from this post, that I find the current situation very worrying. This would be to understate my concern. Returning to the first questions (using the past to predict the future), we do have worrying precedents to the current situation of economic instability. The situation today is unique, but the idea that economic instability creates political instability can be carried forward as a general principle.

The shape of the world has changed, and is continuing to change. At present the majority of economists and politicians have not fully grasped the nature of the change and that is a dangerous situation. As the current economic crisis unfolds, I will do my best to give a view on how it will impact on the world economy, and what I believe should be done to ameliorate the crisis. However, the situation is going to get ever more complex in the coming years.

Wednesday, July 30, 2008

Recessions are Hard to Predict? Post Number 2

I have just been looking through some of my posts on The Guardian Comment is Free section (I was looking for a quote for something else I was writing elsewhere), and found some predictions that I was making a year ago, nearly to the day (August, 2007). As you will notice from this post title, I am posting these comments to make a point, following on from my previous article on predicting recessions. Also, my credibility rests largely on the accuracy of the predictions I made for the economy. I had forgotten that I had posted on the subject before writing 'A Funny View of Wealth' in November (an essay that explains in detail what has gone wrong...). As such, I have posted here just to re-emphasise that all of this mess of today was apparent and could be seen as inevitable a long time ago. .

The article, including the posts can be found here (you will need to click on the link to view all comments to find mine). I have only posted my comments below rather than the whole thread. I'm afraid I am replying to the points made by others in the forum, but I hope that the posts still make sense.
An addition to my original post. I found some earlier (May, 2007) posts where I commented on articles in the Guardian, and have added these directly below (original article here):
Comment 1

May 06 07, 4:58am

A very good article. I first became concerned about overheating in the housing market as long ago as 2000/2001.

The reason for my concern was that I was buying a house after returning from overseas. I saw one house which I missed due to the sale of my own house falling through at �115,000. 3 months later I saw a house in the same road, same type, slightly better condition but further away from the centre, and it was selling for �139,000, and achieved this price. This was the state of inflation at that time generally.

Whilst this example was in 'Silicon Fen', as it became known, it was still an unjustifiable rise from any rational economic point of view. I have been waiting for a crash ever since.

Fast forward to now.. Why did the crash not happen. In part there have been several factors that have been in play.

World Macroeconomics

- the introduction of China (& India to a lesser extent)into the world market has introduced a huge reserve of labour, which has helped to restrain wage inflation. - As above - but the introduction of Chinese manufacturing has helped to push down prices of many goods, holding down inflation. - The massive foreign reserves held by China and Japan have provided a supply of cheap money, helping to keep interest rates down. I describe this as a conveyor, where US (the most important consumers but also the UK et al)purchases goods from China, this creates foreign reserves in China, and this is then fed back on the return conveyor into 'cheap' money which is then lent so that households can continue to buy things. - In normal circumstance the exchange rate would rebalance this trading system, with the RMB appreciating , but the RMB is not a free currency.

UK Macro

- The UK has had a massive expansion in the population due to immigration. This is a sensitive subject with many people politicking about the numbers. As such to keep the focus on the economics here lets all just agree that it is 'a lot' by which I mean enough to influence supply and demand of housing - pushing prices up.

- In addition there has been the speculative buy to let market, changes in the lending criteria for mortgages etc. pushing house prices up.

- The immigrants are here, in part, in response to the 'success' of the UK economy which provides plentiful jobs. The UK economy is, in part, successful due to the massive expansion in the money supply created through the record growth in consumer credit, and also through increased mortgage borrowing that is the result of record levels of equity withdrawal, which is the result of house price increases. This in turn allows people to spend on home improvements, goods, services etc. thereby holding up employment, thereby encouraging immigration, and pushing house prices up.

- In addition to this the government is also spending more money - resulting in borrowing increasing. Of particular note is that PFIs do not appear on the 'balance sheet' and are therefore a massive form of hidden borrowing. This is a big injection of money into the economy.

If you take out the low inflation and interest rates that would not have occurred if China had not entered the world economy, the current boom would have disappeared long ago, as a rise in inflation and interest rate rises would have occurred. As it is we have now created a monstrous bubble, that will have to burst. I do not think people have yet to grasp how bad it will be.

In particular if there is a downturn in the housing market/the economy (this is the classic chicken/egg story) - there will effectively be a loss of confidence. In each case house prices will fall/have fallen. Once they fall - they will collapse, as the equity withdrawal and 'feelgood' factor will disappear, and with it spending on goods, services etc. Banks will tighten credit in response, further pushing spending down. This will hit employment, further ratcheting the economy down. As unemployment increases some (or many) of the immigrants will start to go home, ratcheting down the house prices by reducing demand (One curious feature I discussed with an economist at Oxford University was that the immigrants will take their accumulated savings with them, which will be the equivalent of importing goods - you may wish to think about this point and realise that it makes sense - a further negative effect on the economy during a period when it will already be in trouble, and where typically the outflow of money will reduce with the tightening of spending).

Sorry, a gloomy picture. However, in the UK the belief for a while is that borrowing is the same as earnings. This is not so and the lesson will be hard. We have had a 'strong' economy due to record borrowing. As we all know, pay back time must come with all borrowing. This develops a new question, aside from the City of London - have we any new earnings to show for the last ten years?? Is the growth of the City enough to support the UK on its own? I'll leave these questions open.

Comment 2: May 06 07, 7:03am

Waltz: House prices at six times average incomes.....

As I mentioned earlier house price inflation is one of the keys to the so called �success� of the UK economy. The problems in the UK economy will become visible when finally confidence/the bubble bursts. This bursting can come through many causes, including just a change of mood on housing. At this point this is where the economic outcome gets scary. As I have pointed out there has been a self perpetuating spiral, but without the usual bubble bursting mechanisms in place. Add in the final factor of immigration and what should have burst 3-4 years ago has managed to survive. The scary part is to ask the question which is; �At what point did housing overtake the normal growth in house prices�. If you take the measure of the trend for house prices as a ratio to income we start going back a several years � back to 2001 if I remember correctly. It is also worth mentioning that asset prices typically undershoot when a bubble bursts......

(note: this does not mean that prices will drop back to 2001 prices - inflation and salary increases are real drivers)

Comment 3:

May 06 07, 8:33am


Sandstorm: I am 100% in agreement with you over the idea of expanding the land that can be built on, though not in response to the current problems, which may turn out to be a short term problem. I'll leave my reasons to one side however, as they are not relevant to this debate.

I have to agree that the lunacy of the banks is astounding. In particular their insistence that the current interest rates make houses more 'affordable'.

A simple way to illustrate this is to jump back in time. This was when interest rates were quite high and inflation was quite high. Do you remember how it was then, for a couple who purchased their first home? At this time it was still 3 times income allowed as a multiple + deposit. Typically the couple would save up for a deposit, scrimp and save, and take on their first home. The first few years would be very tough, as the interest rate was high. They would struggle. However, every year they would find things became easier as the high inflation economy was eating away the value of their debt. After a few years life got easier. Their incomes would increase in line with inflation + real growth and life quickly got better.

Today on the other hand we have had(or rather had till the last few months) low inflation and low interest. Instead of the scenario above, we have a different form repayments. This point is best expressed in an imaginary world world where, like in the past, everyone is still allowed 3 times income multiples and still need a deposit . In this case what would happen is that the person who buys the new home would appear to be much better off than their counterpart in the past.Their initial payments, as a percentage of their income would be much less, as interest rates are relatively low. But...and here is the big but....they will not benefit from inflation eroding their debts. In light of this their total ***real*** repayments are going to be similar.

The point here is that is that the amount paid back in real terms is similar, but the timing of the payments have changed. In the earlier example you have greater pain at the start of the mortgage, in the second example the pain is spread out over a longer period.

(Note: inflation and interest rates do not move in perfect tandem, but over time there is a strong relationship - e.g. if inflation goes up now the Bank of England will **probably** increase interest rates)

Now you may have noticed that, to illustrate the point, I imagined a modern world where we were still on 3 times multiples of income + deposits. Now we all know that this is no longer the case. What does this mean? Well I suggest you return to my previous paragraphs it will be obvious.

The answer is, of course, that when the banks say that low interest rates make housing more affordable then they are not telling the truth. They have persuaded people (and perhaps themselves) that offering a 6 times multiple makes sense due to the low interest rates. However, in doing so they ignore the impact of inflation.

So - what we now have is people offering huge amounts of borrowing on the basis that housing is more 'affordable' due to low interest rates. People buy into this and overpay for their house as they can now 'afford' it. However, they struggle for the first few years and then on struggling. This is because their proportion of their income they are paying towards housing has actually seen a real increase over the lifetime of the mortgage. In short it takes a long while before the proportion of income going to mortgages drops, whereas in the high inflation past on 3 times multiples this was relatively quick and painless.

Perhaps this has been one of the reasons for the sense of malaise in the UK? Perhaps this is why the loading up with consumer debt? These last comments are obviously just speculation but I've thrown them in anyway.

Comment 4:

May 06 07, 9:46am


You are right that there are foreign investors in the UK market. However, they are in the market for gain and will, if they get the jitters, get out pretty fast.

With regards to housing benefit, yes, it does support some of the market but that is nothing new. I am not sure why this is different from the past, except that there is greater availability of properties for rent.

As for your 'elite banking families' - who are these people. Nearly all of the UK banks are PLCs. I can not say this is true or not true for the rest of the world but the UK banks are most active in the UK mortgage market with foreign banks at best playing a minor role, and UK those banks are mostly public companies or building societies.

I am also very interested to know what these non-existent banking families 'long term plans' might be. Reading this expression I feel you are talking about Ming the Merciless here - not about a bunch of rather boring bankers? Perhaps I have got it wrong and I will understand once you reveal what you believe these 'long term plans' might be? Maybe you just mean the plan to make money for their shareholders? However, I am not sure who these people with plans are in the context of the mortgage market.....

As to the banks giving away mortgages at a loss because they will all win in the long term..... I think that there is currently an element of desperation in the action of the banks in loosening the lending criteria. However, I think this is more about desperately trying to maintain impossible growth rates that have been promised to their shareholders. I am not sure it has anything to do with any conspiracy but more to do with the more mundane and far less interesting fact of incompetence. I think that another poster rightly pointed this out earlier.

Comment 5: May 06 07, 10:37am


I read your post with interest. I have a few questions as follows:

How much social housing is enough?

How do you decide who is deserving of social housing? What fair criteria is there for giving people high quality housing subsidised by the rest of society? Or would you argue for poor quality housing?

Social housing is very expensive in terms of investment and maintenance, and subsidy. How would this be paid for? Would you use a PFI for raising the finance or borrow more directly or tax more and buy later? What other services would you cut in order to pay for the expansion in cost of social housing? How much additional expenditure would be enough to satisfy the costs as per your answer to the 'How much social housing is enough?' question?

I hope these are not too many questions and look forward to your answer.


You are right that we can not blame the banks alone for the mess that we are in. However, they are playing their part as are consumers, 'buy to leters', the government and the media. It is not really about 'blame' but trying to figure out the how and what should those who are thinking about buying do.


Your description of what caused so many problems in the last crash is perfectly fair. I would not argue for a comparison with the past though, but rather predict the bust on the basis that classical economics always wins in the end - however many people on however many occasions tell everyone that it is different this time. I was wrong for 3-4 years (albeit ** possibly ** due not knowing about the levels of immigration). I could still be wrong and misguided to think that old fashioned economic theory will work in the end. The last time it was 'different this time' was the new economy, with a 'wall of money' chasing shares with not enough supply of shares to meet demand, and therefore a long term upwards revaluation of shares.....ooooops. Didn't quite work out though....

And my comments on the Guardian in August.......


Aug 11 07, 5:39am

I'm not sure that there is a full and frank acknowledgement of how bad things are yet. This is not an incident, but the start of a serious collapse. The idea that central banks can halt it is absurd.

CDOs and the other derivatives that have oiled the wheels of the Anglo-Saxon economies are just the start. It is not just sub-prime that is the problem - it is far deeper.

Think of the UK as a single household. Two of the people in the house are working and earning money and they have a total combined income of £40,000 per year. However, they also live in London and own a semi-detached house. This is increasing in value by £15,000 a year - which is the same as the earnings of one of the people.

The £40,000 is enough to live a comfortable life, but the household wants better than comfortable. They want better cars, holidays and everything else money can buy. So they borrow £5000 a year using the increase in the value of their house as collateral. This is still not enough though, so they borrow on credit cards and bank loans. Another £5000 per year.

They spend all of this money on foreign holidays (moving money out of the UK), buy an expensive German car (moving money out of the UK), and the latest gadgets and gizmos (moving money out of the UK). They also spend money at bars, restaurants, on home improvements (employing builders etc.) and buy designer clothes.

Is this household richer or poorer? They have a rising asset that covers the cost of their debt so perhaps they are richer? On the other hand an asset may go down in value as well as up. Are they really richer?

According to the statistics the UK economy has shown a strong trend of GDP growth. The question to ask is where the growth has come from. Is it from asset prices? It seems to be.

The point is that, just as in the case of the household, the GDP growth measure includes debt growth as if it is income. As such, in the household analogy, they appear to be earning £50,000 per year - rather than the £40,000 that they actually earn from their work. The borrowing appears as income. In a similar way the GDP growth that the UK appears to generate is not based upon actual income, but is income plus borrowing.

The real problem arises when you try to liquidate an asset, and the asset value is not what was expected. The apparent increase in wealth is ephemeral. Instead of wealth, you have generated debt.

The reason why you should all be worrying is that the UK economic growth is built on asset price inflation and debt. This in turn has fuelled growth (?) in the economy which has also fuelled the growth in the service sector - all those smart new restaurants, shopping malls, bars, taxis, night clubs, as well as the plumbers, electricians, bricklayers, gardeners who work on your home. This increase in economic activity has also increased confidence, which in turn has increased asset prices and borrowing.

Then there is the immigration boom, itself built on a booming service sector and economy, and that in turn has put pressure on housing stocks - thereby pushing asset inflation higher, thereby fuelling more borrowing.......

Which will unwind first

- house prices? - Credit squeeze - Further stock market falls? - Household spending as jitters about the economy multiply pulling down spending? - the immigrants returning home with remittances in their hands (£5000 per year - when they take the money home it is the equivalent of importing a small car)?

Whatever unwinds first, it makes no difference - as each of the elements is related to the other elements - and each will unwind the other in time.

I'm sorry to spoil your Saturday, but the UK is entering the worst economic downturn since the Great Depression. I knew that it was coming, but the final when and how evaded me. It has now arrived, and it is only a question of how quick it bites.

Note: I hope that the above makes sense. I have tried to put some very complex ideas into a very short space. Sorry, if it is not so clear - or a bit simplistic.

Comment 2:

Aug 11 07, 6:46am

Sorry - a correction to my own post. The £5000 is an estimate only for illustration. No one knows the actual levels of remittances.

Also, a question. How will Brown respond to the crisis? Can he give a Keynesian boost to the economy, and would he want to? I am not sure on either of these questions but, if he is capable of doing this, and does so....then the real pain may be delayed for a while.

Also - Perhaps an early election for Brown is more likely now? Get back in before the wheels fall off?

Comment 3


Point taken - but sadly this is just the start.......I think things will be far worse this time. As I said this is just the start, or the opening shots.


Yes - Brown IS the most irresponsible chancellor.

I came to the same conclusion about the Tories in power some time ago, and agree that, were they to win an election, they would destroy themselves. I have long held the view that the Tory party should not want to win the next election. The problems of today have been visible for a long time. The economy is a mess, however pretty it may have looked, and if the Tories win, they will take the 'rap' for the foolishness of Brown. Prudent - I think not. I do not know Brown but suspect that he will want power for the sake of power. As such he will call an election to win the election - not lose. I suspect that he actually believes in himself (though who knows what will happen in his head in the dark hours of night).


I think you have it. Can you imagine the person who says 'but this is crazy - who would want to lend to people who can not pay.....'. Can you imagine that his views would be welcome whilst everyone appears to be winning? With regards to the salary of these bankers - 100% in agreement (except for the fact that it may not just be the banks that hold the CDOs and CLOs. If you can sell a high risk loan on to another organisation - e.g hedge funds -, removing the risk from your own organisation, then that makes you a very smart snake oil salesman, and not so dumb).

Comment 4


Why do you believe the EU is going to help? What can the EU do to rectify the situation. As for being at the mercy of the U.S. I am not even sure what this means. Basel II did not help (originated in Europe though not strictly an EU initiative), the ECB can not magic away the CDOs that have been purchased (such as those bought by IKB ). The regulatory system has failed everywhere. Why is the EU any better? As one poster has already mentioned, bail outs just create moral hazard encouraging greater risk taking and greater crises (Basel II has been criticised for a similar reason, a criticism that is starting to appear to be prescient).

I am puzzled? I am not sure what your point is. How exactly is the EU helpful here?


Take a read of Adam Smith. You will find most of what was said by Smith holds up. His ideas have (largely) proved themselves over 100s of years.


I have no idea where to put your money. This is a period of extreme risk and uncertainty. Debt collection agencies might be one place (not serious). However, a general rule is to think about what people will spend money on during tougher times. Taxis, restaurants, holidays etc. are discretionary spending and are the first to go when budgets tighten. Food shopping, and other 'essentials' will be more resilient. If Brown takes a Keynesian approach providers of services/products to the public sector are possibilities. However, all this is speculation.


The worst case scenario is that a trade war starts with China, and that China starts to sell the dollar reserves it holds. If this happens the US economy will really pay a price. You can thank your wonderful president for this gift to the US nation.

Comment 5

Aug 11 07, 12:09pm


First of all excuse me for paraphrasing but....

Democracy is the worst system - except for all the rest Capitalism is the worst system - except for all the rest

It may be imperfect but the history has shown the results.


I agree 100%. If we bail them out this time, what is to stop them taking the same risks in the future. As I mentioned earlier - moral hazard.


You are both right and wrong. Yes, banks do need to make loans, but they also should only make loans with a reasonable expectation of profit on the loans. The problem which led to today's situation is that the issuer of the loan often does not hold the risk. The banks do not have to make so many loans to survive as you think. The trouble is that the capital adequacy ratio allows them to make loans far in excess of their deposits, provided that (under the Basel rules) their overall portfolio meets certain risk thresholds. They *choose* to leverage their deposits to higher levels to make greater profits. The derivatives that have caused the credit bubble have been rated wrongly for risk - which appears to be the result of the corruption of the rating agencies seeking greater profits (or maybe they really did not understand what they were rating).


What you are describing is quasi-mercantilism - not free markets. One of the great ironies of history is that Marx never managed to grasp that mercantilism and free markets are not the same. In a free market the banks would go under and the 'insurance' provided by states would evaporate. The banks would then need to take greater care - no bail outs - more risk averse.

Keynes: You say;

"The bankers" have got us all by the short and curlies. Your income after tax will go down a long way if Brown or the Fed don't "bail them out". In fact its the free-spending that has ensured what is left of the economy still survives.

But the government can only spend tax income or debt. They are not helping the economy to survive by pumping in more money, but storing up future debt. This is hardly the recipe for economic survival. Debt must be paid, and it is generally expensive. It is a short term expedient, with a political motivation.

With regards to tax going to the rich in landlord payments - what of council housing. Council houses were very prevalent during the Keynesian heyday. In this time tax went to the government - not the rich. What is tax anyway? Isn't is just government rent seeking - legalised extortion? If you don't pay - you pay big time. That aside, I'm not sure I fully understood your point here. I'd appreciate an explanation.

Comment 6

Just a quick note to let you know that a lot of UK debt is off the balance sheet. It is called PFI. It's a very effective way of hiding debt. I would find a link for you but, sorry, I am short of time now. (PFI = Private Finance Initiative)


End of the posts. I hope that the point is clear.......

Tuesday, July 29, 2008

The Root of The Problem

I was talking with someone yesterday, and was trying to explain why there are so many problems in the world economy at the moment, and gave a simple explanation that seemed to make sense. It is far from being a perfect explanation, but it does make the problem very clear. In this case I am trying to turn a two way conversation into a written explanation, so I hope it makes sense and accept my apologies where I mix metaphors. What I did was compare the world to 3 towns; Poortown, Richtown and Commoditytown.

Poortown is, like its name, very poor and has a population of 10,000. For some reason, they had followed mad policy, and had inadvertently made everyone poor in the process. Richtown also had 10,000 people and, by contrast, had got the basics of economics right and had flourished. Most people in this town were doing pretty well, and they could enjoy many good things in life. Commoditytown did ok, but had suffered booms and busts, and never seemed to manage stability.

For some reason, Poortown finally decided that they would give up on their crazy policies and would follow the same policies as Richtown, and try to become richer. After all, if policy worked for Richtown, why not them? Now, before Poortown could do anything, they needed to learn how Richtown had succeeded. Their problem was that they did not even have a way of travelling to Richtown to find out, so they built a path through the mountains that separated the two towns and invited some of the people from Richtown to come over and take a look at Poortown.

A few brave individuals from Richtown, decided to take a look, but were nervous about going, as Poortown was famously unfriendly. However, when they arrived, they were welcomed with open arms. The place was pretty poor, but it was very friendly. Poortown suggested to the visitors that everything was different now, and that they planned to get as rich as Richtown. A few brave individuals decided that there was an opportunity, and decided to take a risk and start businesses in Poortown. They noticed that there were lots of opportunities to cut their costs and increase profit because the poor people of Poortown did not want much pay. Just as importantly, there were lots of people in Poortown, and they imagined selling their products to them, and having new markets for their goods.

A few brave souls set up manufacturing in poor town, and had many problems at the start. The workers were not very good, and there were many problems to overcome. However, the local government of Poortown was determined to make everything work so that, over time, life got easier and they started to make money. They noticed that the workers were quick to learn, and that the people of Poortown were very determined to get rich. It seemed that, for many years, they had been secretly envious of the wealth of Richtown.

The individuals setting up business in Poortown started making profits, and more and more individuals started visiting Poortown to set up their own businesses. Poortown responded by widening the road through the mountains between the two towns, and trade between the two started to boom. Everything was fine for many years. The growth in trade meant that there were many things that suddenly became cheaper in Richtown, and everyone was making a profit. Poortown was getting richer faster with several thousand of their people getting better jobs, and Richtown enjoyed cheaper goods.

The trouble started when the business owners in Richtown started to move their factories to Poortown in ever larger numbers. It was just much cheaper to do business in Poortown and, as the workers of Poortown got better and better at business, they became ever more attractive as workers. Some of the people of Poortown were even setting up their own businesses as they had quickly learnt from the Richtown businesses. This led to a situation in which the people of Richtown started to buy more and more things from Poortown, and less and less from Richtown. Poortown started to use the money earned from the people from Richtown to accelerate their growth to riches by investing in more and more factories.

Meanwhile, in Richtown, businesses were starting to shut down as they could not compete with Poortown. Everyone thought that this was not a problem though, as all the cheap goods from Poortown led to a boom in shopping. Moreover, Poortown was lending a large amount of the money they were making from Richtown back to Richtown. After all, Richtown was a good place to put money as it had always been rich. Everything looked fine.

All the while this was going on, Commoditytown seemed to be doing pretty well. As Poortown grew, they found that boom was back. However, they were more cautious than they had been in the past. Several times they had seen booms, but each time they invested to meet the boom, they had found that they ended up making less money, as they started taking too much material out of the ground, with no place to sell it. So they expanded slowly. Each year a bit more expansion. The trouble was that they were not keeping up with the increase in demand, and many of their commodities were reaching capacity. They then faced this problem but, whilst they were trying to increase capacity, they found that they just could not do it fast enough. They needed to build new mines, and needed lots of machinery, and they just could not do it fast enough. On the upside, prices were going up and up and up. They were getting rich, and were getting even richer by lending their big profits to Richtown.

Everywhere was booming. Richtown was flooded with money, Poortown made more and more goods, and Commoditytown was selling more and more commodities at high prices.

It is at this point that everyone started to notice something. All the while that Poortown grew, it had been so poor before, that it had huge numbers of willing and cheap workers. All of these workers wanted to be as rich as the Richtown workers. Meanwhile in Richtown, less and less workers were working in factories, because all the factories were going to Poortown. In fact, it was hard to see that Richtown was producing very much of anything compared with before. They had started with a hundred factories, but thirty had already shut down and moved to Poortown. More were planning to move. Thousands of the Richtown workers were moving into new jobs to support the massive expansion in consumption. More and more people were spending more money, but nobody asked where the money came from to spend on consumption. The trouble was that they were borrowing all that money.

Then it happened. Commoditytown had orders that it just could not meet. Prices went ever higher, as everyone fought for the commodities that were available

The problem was that there were more workers all competing to be the ones who would use the commodities to make things. There were more workers wanting to make things than there were commodities to supply everyone. The commodity cake was only so big, and the question arose to who would be able to buy how much of the commodity cake. Richtown looked on aghast. Poortown looked on and suggested that it was best placed to take the commodities, as it could turn out goods from the commodities cheaper than Richtown. Only so many goods could be made from the commodities available, and so someone was going to lose out.

Meanwhile there were more workers in Poortown as it built roads to the outlying villages, which meant ever less commodities per worker. Poortown had 10,000 workers, and still they were only using a few thousand. As fast as Poortown grew, there seemed to be no end to the supply of new workers available for work.

The situation was arising that the commodity cake needed to be shared out amongst the workers in Richtown and Poortown. Although the commodity cake was getting bigger, there were more and more people trying to share it. It was a competition to see who would get how much of the cake. It was at this point that it started to dawn on Richtown that they were no longer in a position to win the cake. Doing business in Richtown was expensive. Doing business in Poortown was cheap. With only so many commodities to be shared out, they were going to lose out.

However, the situation was much worse than Richtown had realised. All the while Poortown had been booming, they had been lending lots of money to Richtown. The people of Richtown had used a lot of that money to buy the products of Poortown. They had not used the money wisely, and had not invested it. They had spent it. They now not only owed large amounts of money to Poortown, but also to Commoditytown.

It was suddenly occurring to a few people in Richtown that they owed a lot of money, and that they had no way of paying it back. Not only that, but they were still finding that they were losing factories to Poortown, which was still a much cheaper place to do business. Their ability to pay back the money was getting worse, not better. All the while this was happening, there was a state of denial in Richtown. They kept pretending that Richtown was really very rich and that, one way or another, they would always be rich. Curiously, Poortown and Commoditytown still believed this too.

What no one had thought about, was that the commodity cake would have to keep growing as fast as the number of workers, or one day the amount of cake available would not be enough to go around. At that point, the worker who was most cost effective would get the commodities. This would mean that the Poortown workers would get more, at the cost of Richtown workers as, for many products, they were more cost effective. Richtown would get poorer, whilst Poortown would get richer. At least until more commodities became available.

End of the analogy.

The point at the heart of this analogy is that there has been the fundamental change in the world economy. The world has changed dramatically. Give the same capital and technology to a worker in a country with lower costs of doing business, and wealth will move to that country. With more and more workers becoming available, the amount of commodities available per person is dropping. In short, there is a massive oversupply of labour versus commodities. Not all of the workers can be utilised in productive ways. In principle, everyone could get richer, and the emerging economies could just catch up with the rich economies. However, in order for this to happen, there needs to be the availability of both capital and materials for everyone. In the case of not having enough material (supply bottlenecks) there will be competition for the available resources. In this situation, there will be winners and losers. At the moment the world has bottlenecks, and the resources available for consumption are now being redistributed. The winners will be those who can make the most cost effective use of the available resources and, in many cases, that is not the rich world (as we currently know it).

The speed of the rebalancing will, in part, be determined by how quickly the emerging economies catch up with the rich economies in infrastructure, management and technology. It will also depend on how quickly supply of commodities catch up with demand. For the moment the imbalances will cause turmoil, due to the poor allocation of capital into rich world consumption, rather than investment into productive output. This has meant that the available resources have been directed towards consumer led growth, rather than the necessary expansion of commodities to support the growth in the output of the world economy. The competition for the limited output, and allocation of, the limited supply of commodities has now started. The process will see a levelling up of the emerging economies, and a levelling down of the rich economies.

I am not sure that this is as clear as it could be, so feedback and comments are welcomed. I am aware that it does not paint a pretty picture, but it is not possible to have a massive expansion in labour without a massive expansion in the materials necessary to make the labour productive. That is the simple point I am trying to make.....

Note Added After the Original Post:

I have not really accounted for Japan in this post, as it does not quite 'fit'. I have been meaning to post on the subject of Japan for some time, and hope I will have time soon.

Sunday, July 27, 2008

Isn't all Growth built on Debt?

I have had a comment on the question of debt, and consumer debt in economic growth, from a regular commentator 'Lemming' (whose questions become ever more perceptive and interesting):

'I'm still a bit baffled, and this section seems to fit quite neatly with my question on fractional reserve banking. If money is created only when someone takes out a loan, then by definition isn't all economic growth really a growth in debt? And as the debt is taken on in order to spend the money, isn't that growth going to be driven, in large part, by consumer spending?

I was thinking of this when I asked my earlier question. If I understand the UK's 'FRB' system correctly, it appears that someone, at some point, decided that the best way to regulate the growth of the economy is to base it on the man-in-the-street's judgement, as measured by his requests for loans.'

The poster, for example, describes the irresponsible person buying a plasma TV for every room in his house, relying on debt to fund this purchase. The poster suggested that the growth of such debt was the driver for growth of finance overall, and that this the driver for the economy in the hands of 'stupid people' (ordinary consumers, though I think Lemming means financially illiterate here) .

In order to lend the money to the individual, the bank must first borrow money in order to lend money, with for example central banks providing the initial liquidity. This initial liquidity is then fed through the banking system, and appears to multiply many times over, due to fractional reserve banking (see here for and explanation of this). At the end of the chain is the bank lending money to consumers.

These consumers are then borrowing money, which then flows from the banking system into consumption - in this case a plasma T.V. At each stage of the lending chain, one organisation is guaranteeing, repayment to another, all the way up the lending chain. In other words, each bank is often reliant on many banks all making repayments.

Is the consumer in the driving seat, and driving the economy by driving demand for finance? This is a very interesting question. Is demand for finance creating a debt laden economy?

Of course, the above is massively simplified, as there are often a multiplicity of interdependencies and relationships between different banks, and financial institutions. I do not want to give a more complex explanation than this, as the key question in such a system, is whether all growth is built upon debt. Is it possible to have the capitalist system without growth in debt?

The issue here is what the debt is being used for. If the generation of debt is being used to finance a productive asset, then few people would argue that this will benefit the economy in general and therefore consumers indirectly. On the other hand, if there is a massive expansion in the money supply being fed into credit based consumption, then this creates a situation in which consumers will just be foregoing future wealth. The trouble arising from such a scenario is when the supply of money expands such that there is an oversupply of money, and this money is then allocated poorly (the current situation). In this situation there is a ballooning of debt, which must one day be paid, and finance becomes so cheap/available that it gives consumers incentives/capacity to be 'stupid' (to use Lemming's expression). In so doing the banks fuel what appears to be expansion through consumer led growth, such that the economy appears to be performing well, which in turn maintains an illusion that the consumers will be able to continue paying debt.

So which causes which? Is it growth in the money supply that creates the debt, or is it demand from the consumers which produces debt. It is actually a combination of the two. Without the expansion in the money supply, debt would not be offered to consumers who are relatively high risk, but the consumers still need to take on the debt in order for the money to be allocated to consumer debt. What we have is a feedback loop in which one encourages the other.

The result of such a self-reinforcing system is that the increase in money supply is built on confidence in the economy, on the ability of consumers to continue to service their debt, which is built upon an assumption of continued employment. If the growth in employment is built upon foundations of growth in consumption, then we have the makings of a bubble. Debt pays for consumption, consumption drives employment, and employment drives further lending. One factor reinforces the other. All the time the overall amount of lending and debt is building. Right up to the point where consumption stops, and then the credit bubble bursts, leaving banks and consumers in trouble, and a wreck of an economy.

As an answer then, we can say that, in part, the economy is being driven by 'stupid' consumers. However, we can also say that the economy (in this case) is also being driven by 'stupid' bankers, whose economists have not grasped that consumer credit led growth is a bubble. Had the economists asked where the future repayments of their lending was going to come from, then they might have suggested that their lending was irresponsible. The trouble is that, whilst the economy continued to expand, they ignored the warning signs (increase in values of housing), and chose to imagine that the new 'service' economy was sustainable long term. As such they continued to lend into an already saturated market. At some time, it was inevitable that an increasing number of consumers would be unable to service their debt, leading to a shrinkage in consumption, and a bursting of the credit bubble.

In this case we have the complication of house prices, which enjoyed price rises due (in part) to an increase in the availability of finance on ever more relaxed terms (poor/higher risk allocation of money). This generated a boom in house prices, such that the banks could point to illusory security on their debt, and for consumers to have the illusion of growing wealth in assets to justify their irresponsible borrowing. Without the factor of house price rises, the credit bubble would have burst much sooner. The illusion of security for both parties kept the credit bubble inflating. If you then throw in the unusual factor of migrants coming into an apparently booming economy, increasing the population, and thereby increasing demand for housing, thereby creating further upward leverage on house prices, you have the mess that we are in today.

I am simplifying here and pretending, for the sake of argument, that the UK is a closed economy, ignoring government borrowing etc. The complication in all of this is that external confidence in the UK economy has also been a factor. However, I hope that this goes some way to answering the question. It is not just the consumer that has driven the debt bubble, but also the banks, who have misunderstood the risks inherent in a consumer credit based economy.

A note for Dan, who made a comment on another post.

Dan suggested the idea that he should be able to opt out of certain benefits provided by the government, such as unemployment benefit, with a subsequent reduction in his individual tax rate. This is a perfectly fine idea, as long as he is able to continue in employment. However, if he were to lose employment, what would then happen? Looking at the case of unemployment benefits, there are some problems.

In the case of Dan becoming unemployed it is likely that he would then become completely destitute and would therefore potentially starve to death, or become a beggar (I am assuming that he is not wealthy enough to have a very large amount of savings for the sake of argument). Both outcomes would be unacceptable to society. The only option would be for charity to help out, but would charity be inclined to help in the situation that he actively opted out of the protection of the state in order to benefit from the savings on taxation whilst he was in employment? The answer is probably 'no'.

Modern society does not accept begging or starvation, and therefore society would still (in some way) have to offer some support. As such, an opt out system would not work, on the basis that as a society we would not accept such an extreme level of destitution. Dan's concern is presumably that he feels that taxation is too high. The only option is to either completely abandon, or reform, benefits for everyone to reduce the overall demand on taxation. At some time in the future I hope to look at these questions, and hope that I can propose a solution that would be acceptable to Dan, and to society as a whole.

Friday, July 25, 2008

Recessions are Hard to Predict?

An interesting article has appeared in The Telegraph in which they discuss the difficulty of predicting recessions.

The interesting part of the article is as follows:
'Meanwhile, growth in consumer spending, which has been the engine for UK growth for most of the past decade, slowed appreciably - though the precise data on this will not be available until next month.'
In writing this, they neatly sum up why economists were unable to predict the current slide into recession and depression. Once again, they are conflating consumer spending with economic growth, without actually considering where the consumer spending originates. In doing so, they are making the fundamental error of mistaking growth in debt with economic growth. This was one of the central themes of 'A Funny View of Wealth' and I still look on in wonder as I watch how mainstream economists continue to make this fundamental error in the face of the looming economic crisis.

At what point will they finally understand that measuring economic growth on the basis of consumer activity is a recipe for economic disaster?

The Telegraph goes on to say the following:
'Such a suspicion is confirmed by the ONS numbers, although there were a few surprises. Most notably, the services sector, which accounts for around three quarters of UK economic growth, expanded slightly faster than in the first quarter.

However, a closer look shows that this was largely thanks to a surge in transport and communication - perhaps in part due to higher petrol prices boosting profits.

The National Institute for Economic and Social Research said in its latest quarterly report that Britain faces three years of anaemic economic growth, though it will avoid a recession.

I happen to believe that it is too optimistic. With UK consumers and companies more indebted than any of their counterparts overseas the scale of the economic slowdown facing us will be significant.

Don't forget that only a few months ago a variety of economists (and the Council of Mortgage Lenders comes to mind here) were confidently predicting that house prices would not fall this year.

They could not have been more completely, utterly wrong. Economists find it hard to forecast recessions.'

The really curious part is that the author of this article 'sort of gets it', but just does not quite manage to grasp the central point. There is the recognition of the debt problem but no connection is made with the illusory growth that was created by the debt.

I get the feeling that mainstream economists are finally on the cusp of discovery, and am now waiting patiently for the reality to sink in. At that point, no doubt, everyone will become wise with hindsight, and discover what readers of this blog have known for a long time:

Consumer spending does not mean economic growth.

The Banking System - Synthetic Economics

Note: If you are a new visitor to this blog, this may not be the kind of post that you were expecting, as it touches on some very specific economic theory. If so then you may want to skip to some of the other posts which are easier to follow ( I would recommend 'A Funny View of Wealth' as a starting point - it is long, but hopefully interesting). Alternatively, if you want to have your head spin, then read on....

I have had another interesting question from Lemming, and one which takes me out of my 'comfort zone'. The question is as follows:
'One thing I have yet to resolve, is the role of 'fractional reserve banking' in the operation of the markets. Why do we use it? Is it fundamental to capitalism? Is the idea that it is simply an efficient self-regulating mechanism? Or is it a system bankers have devised make themselves very rich? '
There is an excellent introduction to this subject on Wikipedia that can be found here. You will need to read this in order for what I write later to make sense. I'm afraid that it is not particularly easy reading, but I hope that when combined with what I am writing later, it will make some sense. I guess that this is a question that has been raised following my discussion of banking regulation. The whole idea of fractional reserve banking can sometimes get your head spinning. How can you create money from nothing?

Instead of giving a long discussion of how it works, which is any case covered in the Wikipedia article, I would like to describe a very weird idea that helps illuminate the Alice in Wonderland of what I might describe as synthetic economics.

Right now there is a virtual/synthetic world called 'Second Life' (the website is here). This synthetic world allows people to have a 'second life' using avatars (computer generated representations of people). The curious thing about this is that they have an economy in this virtual world, and people are even earning their living there. People design and sell virtual clothing for people to use for their avatars, design buildings and so forth. The most curious part is that they have their own currency, the Linden Dollar.

So how does this economy work? The starting point for the economy is that the company that owns Second Life, Linden Lab, makes money through the sale of virtual land in their world. In order to buy land, you need Linden dollars. As such, if you are new to Linden Lab, you need to exchange 'real currency' for Linden dollars. Alternatively, you can go to work and design and sell something within this world for Linden Dollars. Second Life is not the only virtual world that has a virtual economy.

What I will now do, is paste in something I wrote on this subject a while ago. I'm afraid that the relevant part is towards the end, but this part will only make sense if you read the rest. It is rather academic, but stick with it. It will explain something very important about the question of fractional reserve banking.


The Economics of Synthetic Worlds

The importance of the economics of activity in synthetic worlds first became apparent in a paper by Castronova (2001), an economist, who detailed a virtual economy with very real impacts on the real economy. His study showed that the synthetic world of Norrath, as part of the ‘Everquest’ game had created a currency with a $US exchange rate that exceeded the rate of the lira and Yen, and that Norrath’s GNP per capita exceeded that of India and China. One recent paper (Chein, 2006) gave the aggregated value of trading in property in synthetic worlds as being worth hundreds of millions of dollars annually, and it is likely that such trade will have grown since the paper was written (at least in line with the growth of participant numbers - ‘at least’ is used on the basis that, as more people become aware of the potential to use synthetic worlds to earn money, and greater the likelihood that individuals will be using synthetic worlds in this way).

Lederman (2007) explores why it is that such games have such an economic basis. For worlds, such as ‘World of Warcraft’, she points to the utility of the items in achieving the quests that are a major part of the game, and their utility in helping to achieve higher levels for their characters (to this explanation, Lederman should also add that high value items also confer status on the holder, on the basis that they are (in this case false) representations of accomplishment). Whilst this appears to contradict the purpose of the game, where enjoyment is derived in part from ‘achievement’ in the game, she points out that there are circumstances in which individual players might want to speed the process, such as keeping up with more friends who are more accomplished players. By contrast some synthetic worlds, such as ‘Second Life’, offer an environment that is explicitly commercial, such that many of the activities in the world explicitly require money, whether generated within the world or from without. In this circumstance it is inevitable that the world will develop an economic base.

One of the researchers who have started to consider the economics of synthetic worlds is Malaby (2006). He details the case of a person who developed a game called Tringo, within the environment of ‘Second Life’, which then became a sensation within the world. He points out that this has created a situation where a virtual person created a virtual game that was then sold to virtual people. However, rather than being startling, this is the very foundation of the ‘Second Life’ experience. The logical outcome of this idea of virtual items being virtually made and sold is detailed by Chin (2007), who notes that one individual had achieved $US millionaire status through becoming the ‘Virtual Donald Trump’ (p 1306). Other participants are giving up their ‘real’ world jobs and making ‘Second Life’ the home of a second career. In 2005 there were already ten individuals who were earning over $US 250,000 salaries from ‘Second Life’, and the ‘Second Life’ world hosted at least 7000 profitable businesses. There have already been several reports of real world businesses that are exploiting the economics of synthetic worlds, such as an individual who established a company in the real world, in which Chinese artists and engineers have been employed to build new virtual objects within ‘Second Life’, and more recently ‘Entropia’ (Hendaoui et al, 2008).

It is not only individuals that are undertaking commercial activity within ‘Second Life’, but also corporations, notable examples of which are Nissan, who purchased and island in ‘Second Life’ to create a driving course, and created a car ‘vending machine’ as a promotion. Other companies experimenting with ‘Second Life’ as a promotional channel are Nike, Reebok, Amazon and American Apparel (New York Times, 2006). Whilst initial forays into ‘Second Life’ by real world businesses have had mixed results, it is likely that, with experience, companies will find ways to successfully exploit this new commercial space, at which time the economic importance of synthetic worlds will further increase.

Malaby has considered some of the implications of such economic developments. He notes, for example, that commodity value is transformed in Synthetic Worlds. Once the code for an item, or service, is developed, then everything has the potential to be a commodity. The way in which morpegs have tried to overcome this is through control, in this case by maintaining scarcity through governance of the synthetic worlds. In addition to scarcity, another key part of the value of marketable items in such worlds also lies in the utility of use value of the items, such as their provision of social capital, which in turn often requires scarcity. To illustrate this point Malaby uses the real world example of a baseball card, where the value is culturally derived and the value is further defined by relative scarcity.

Castronova (2007) also asks some interesting questions about the economics of synthetic worlds. He takes the example of an individual who is building products within Second Life, and earning $US convertible money from doing so. As such he proposes that the individual’s activity in Second Life should also be regarded as a part of the ‘real’ economy and be included in GDP, asking the question of whether activity in the synthetic worlds should be taxed. Inevitably, this question raises further questions, such as the question of whether a person who builds themselves a house in ‘Second Life’ for their own use should be taxed on the property. Has the individual generated an asset? If the house appreciates in value, should it be liable for capital gains tax, or other duties. The house has a potential real $US value so the building of the house represents productive activity. How do the ‘real world’ institutions such as law and government deal with such a situation?

Lederman attempts to answer some of these questions, taking up the issue of taxation of synthetic worlds in her paper ‘”Stranger than Fiction”: Taxing Virtual Worlds’ (2007). She points out that, in the US, the Internal Revenue Service is already aware of the potential for taxation of earnings in synthetic worlds. She examines the US tax code in relation to synthetic worlds, choosing to analyse environments like ‘World of Warcraft’ and ‘Second Life’ as separate (but related) cases.

For the former, she considers the case of ‘loot drops’, which are the primary source of ‘earning’ items of value. Having dismissed the status of the End User Licence Agreements and accepted that the participants ‘own’ their synthetic world property, she goes on to consider whether these loot drops are liable for taxation. She commences by firmly dismissing the idea that loot drops might be imputed income (which is that they are market-price equivalents of non-market activity - an example being a home made table), arguing that they are not self generated, but require the activity of a third party (the world developer). Another possible source of taxation she proposes is that the loot drop might have equivalence to a windfall, which are winnings or found items (she cites game show prizes as one example), all of which are subject to taxation. However, she argues that loot drops should not be treated as a windfall, as participants must invest substantial time and effort to attain them. Instead, she argues, the loot should be treated as a ‘taken’ item (an analogy being a fish caught by a professional fisherman), as it is neither a windfall, but neither is it a self-made item (it is made by the game). In this case, Lerman argues that such items are counted as inventory, and do not constitute income until disposed of.

There appear to be some problems with Lederman’s argument. First of all, a windfall such as a game show prize might require substantial effort, for example preparing for a quiz. As such, in both cases, equivalence can be shown. Both are described as games and both required prior effort to achieve the winnings. Another problem occurs with her idea that the item is ‘taken’ and is therefore counted as inventory. Normally, when loot is gained by a participant, they will quickly use it in one of three ways. Either it will be used by the player to continue playing, in which case it might be regarded as using retained earnings as investment capital (and therefore becomes accountable in tax considerations), or the player will exchange the loot for other items in the game (selling it to a merchant or making an exchange with another player) which would constitute barter (taxable under US law), or they will sell the item/s for real world currency to another player. In all three cases the player utilises the items, and does not retain them as inventory.

It appears that Lederman is ignoring the fact that what is being produced in these ‘games’, is no more or less real than a piece of software, a book, a movie, a personal shopper service, or even a package holiday. As an example, if an individual were to start to manufacture knitted jumpers, and used a system of barter to exchange them, then they would be liable for taxation. How would working towards earning a piece of armour in ‘World of Warcraft’, differ from producing goods for barter? In both cases the individuals have used tools to develop the item (note, the idea that you pay to use some synthetic worlds has an equivalence in this situation to leasing a machine for the knitting). As soon as the armour is exchanged in any way but as a gift, the person who has worked to gain the item has either engaged in barter, or engaged in trade. Lederman accepts this principle in player to player trade, but fails to recognise the other potential avenues for trade, such as with a Non-Player Character, or the fact that the item is a tool to further advance in the world, thereby creating opportunity for further ‘loot’.

Another problem with Lederman’s argument is her view that the income can not be viewed as imputed income. One way of looking at the question would be to view the synthetic world as facilitating software, as equivalent to Microsoft Word. If a consultant types a report in Word, there is no question that the output would be taxable when the consultant is paid for their service, as the software is not treated as a third party but as a tool. In both cases software facilitates the realisation of the item, and in both cases the item has real value that is earned by the user. This renders the argument that the drop is not imputed income to be false, as it relies on the idea that the developers are a third party, rather than the reality that their software facilitates the earning. As a note, as Lederman points out, one of the primary problems in taxing imputed income is that it is so hard to identify and value. In the case of synthetic worlds, such items can be readily traced, and the market value can be relatively easily ascertained.

In the case of ‘Second Life’ Lederman takes a different approach. In doing so, she manages to tie herself in some knots. She correctly acknowledges that in ‘Second Life’ property is recognised (albeit in an unclear way) by the developer, implying (in the way that her argument is structured) that this creates a distinction between worlds such as ‘Second Life’ and ‘World of Warcraft’. However, this is irrelevant, as her previous arguments were based upon the assumption of property rights in the other synthetic worlds. She commences her analysis of ‘Second Life’ with a problematic argument, suggesting that exchange of property for Linden Dollars constitutes an ‘exchange’, even though the seller obtained no cash [by which she means ‘real’ cash]. In this case she sees that the transaction can be counted as barter, which is a perfectly reasonable position. However, in making this argument, the problem arises as to how Linden Dollars differ from Gold, Silver, and Copper pieces in ‘World of Warcraft’. In ‘World of Warcraft’ it is a normal part of the game to visit a merchant (NPC) and exchange items for this local currency. As such, as suggested earlier, barter has taken place, and it is not clear how Lederman can make any distinction between the two situations.

From the above example, it seems that there is a fundamental problem in Lederman’s perceptions. One problem is that it appears that she is unable to overcome the idea that it is possible to obtain income from pleasurable pursuits (despite the evidence of professional sportspeople, for example). This can be seen in the difference in the treatment of different synthetic world currencies. The other problem appears to be that she is unable to grasp the idea that virtual items really are equivalent to real items, despite her assertion to the contrary early on in her paper. Again, this is illustrated in her failure to understand the nature of the currencies of synthetic worlds.

Whilst it is tempting to view these currencies as part of the play, even as a gimmick, and not as ‘serious’ currencies, Malaby (2007) makes an interesting comparison. He points out that the Euro was a purely virtual currency before it became a physical currency (i.e. before it became notes and coins that could be utilised in day to day commerce). The whole purpose of this virtual rollout was to establish trust in the currency before it was made a physical currency. Equally, since the abolition of the Gold Standard modern currencies can not be redeemed against fixed specie of a commodity. Therefore, if we view any currency in the modern world, there is no way to give a real value to a currency except through purely subjective belief in what the value might be (an idea amply illustrated in the recent devaluations of the $US). On this basis, there is no reason to view the $Linden in a different light, as it is no more or less virtual, and the value of the currency is determined subjectively by similar sentiments to a ‘real’ currency.

The idea of synthetic world currencies also raises some interesting questions over and above the question of equivalence with real world currency. Malaby raises the question of what institution is underwriting the currencies of synthetic worlds, though unfortunately fails to address this question. At the time of his writing, he was probably unaware of the run on a virtual bank in Second Life, inspired in part by financial troubles in the real world (Economist, August 2007).

In the case of ‘Second Life’ the obvious answer to the underwriting question is that Linden Lab, as the owner and equivalent of the government of ‘Second Life’, is the underwriter of the currency. If this is accepted then it becomes clear that Linden Lab has taken a significant financial and governance responsibility. For example, opening too many islands too fast would precipitate a dramatic fall in property prices. Also, if they were to allow ‘pirating’ of virtual goods, destruction of goods, or general lawlessness, then all of these would have an impact on the trust in the $Linden, and the currency would be at risk of devaluation or collapse. In effect the primary role of Linden Labs in their governance is the protection of property rights within ‘Second Life’, a role with obvious parallels to real world government. However, they also need to ensure the maintenance of scarcity, in the context of virtually zero marginal cost for reproduction of all commodities and resources, a unique feature of synthetic worlds, creating very strong obligations to protect intellectual property rights.

Linden Lab appears to be aware of the importance in their role of currency stabilisation, and ‘uses a set of monetary instruments, allowing it to inject or mop up liquidity. It also intervenes on […] LindeX, which even features circuit breakers if trading gets too frantic’ (Economist, August 2007).

Once it is accepted that virtual property has real value, a greater question is ‘what happens if ‘Linden Lab’ or any other developer, ends their world whilst there are still assets inside the world? For example, what would happen to the Australian investor who purchased an island in ‘Project Entropia’ for GB£13,700 (Chein, 2006), or to the ‘Donald Trump’ of ‘Second Life’ in the event that servers for their respective worlds were switched off? In this event the losses to the individuals is very real, and would undoubtedly lead to real world litigation.

This idea of maintaining scarcity may not be the only necessity in the governance of synthetic world economies; there is also arguably a need for maintenance of synthetic world stability. Bartle gives a hypothetical example of a game where there is a special sword which a person has purchased for $US500. If the developers decide that the sword is too powerful, and is unbalancing the game, they would (under current practice) be likely to lower the power of the sword to restore balance to the game. In doing so the player who purchased the sword would be disadvantaged. Bartle makes the point that nearly all changes within a game have the potential to advantage or disadvantage each of the participants. However, in this case the individual would have, through no fault of his own, and through no fault of the seller, overpaid for the now reduced power sword. As such the participant might feel a need to seek legal means for restitution from the developer.

Bartle, who has the perspective of a game developer, points out that allowing such restitution would be a bad thing for the game/world, as it would remove the freedom of the designer to alter the game. Referring to the potential to seek legal recourse, he argues that, even were it to be left to judges to decide on the reasonableness of a change, it would not be possible to do so, any more than asking a judge to measure the ‘reasonableness’ of a portrait. This view implies that the developers are in the position of benevolent dictatorship, or as Chein (2006 expresses it; ‘the administrators of games are necessarily “God” for all practical purposes, able to control every aspect of the game world to the point of deleting avatars in order to maintain a balanced play area’ (p1066).

The inspiration for this view could be lifted straight from ‘Leviathan’, in which Hobbes proposes that effective governance requires absolute authority. The view of Bartle highlights the fundamental problem that developers have in understanding exactly what they have created. The worlds that they develop cease to be only under their own governance, once the players enter the world. As is discussed in the section on synthetic world law, once a player enters a game, they also bring the law and expectations derived from the real world with them. As another example, Mnookin (1996) discusses law in LamdaMOO, noting that, in disputes between participants, individuals would often introduce legal principles from the real world into the debate, despite the community having its own system of ‘law’. As such, individuals will expected to be treated fairly within the world based upon external norms, and having your sword devalued by a ‘government’ with no compensation, however benign the government may claim to be, will not be considered fair treatment by the individuals, and possibly by the synthetic world community. It will clearly be a dilemma for developers to balance overall game play against the (often originally unintended) economic nature of their creations, a point understood by Chein (2006) in his thought experiment on theft of virtual property.

This brief review only touches on some of the economic questions that are being raised by the development of synthetic worlds. A brief review of a small part of the literature reveals that people are still struggling with many of the implications of virtual economics, in particular in the recognition that virtual property has equivalence to real property. A simple illustration of this confusion would be that it would be a very curious point of view to differentiate between an individual who, as a ‘labour of love’, writes an electronic book and a person labouring towards achieving a character at level 50 in a morpeg. However, in the first case few would argue that the sales of the book should be viewed as a part of the normal economy, but few would suggest that the labour of the individual creating the character is part of the normal economy (despite the real value that is created). There appears to be no rational reason for this and it is therefore unlikely that the differentiation will be allowed to persist.

At the moment the economies of synthetic worlds are still developing but the interest of the US tax authorities’ interest is indicative of their potential importance. Within the context of the rapid and dramatic expansion of the numbers of people using synthetic worlds, and the amount of time that they are spending inside them, the virtual economy will soon be having some profound effects on the real economy. Furthermore, it is likely that hybrids between types of games will emerge, games which will merge the ideas of ‘Second Life’ with the ideas to be found in games such as ‘Everquest’. If this occurs, not only will the boundaries between the real and synthetic economic worlds have blurred, but also the boundaries between work and play. This blurring will potentially serve to heighten confusion over what constitutes the ‘real’ economy.


An apology - I do not have the references to hand that I have made in the text above.

The reason that I have included this is that it illustrates something that is vital to grasp. The Linden Dollar is absolutely no different from the $US or the £GB. In all cases their value rests entirely on confidence. In other words, this is a very long winded way of demonstrating that the modern economy is built on nothing more than confidence. It is no more real than the world of Second Life, and that includes money.

If we look at fractional reserve banking, we see the same thing. The entire system is built on confidence. It is the belief that we can redeem our money, if we so wish. It is built on the belief that, when we do redeem our money, it will have retained at least most of its value for exchange with goods or services. More than that, it assumes that it has a value at all. Just as with the Linden Dollar, there is nothing really there to back it up except our collective belief that £1 will be able to be exchanged for something which we value. The person who accepts our £1 must also believe that it has value.

If we were to imagine that Linden Labs suddenly made available large amounts of land, they would undermine the confidence in their currency, and there would be a run on the currency as everyone rushed to convert it to another currency that would retain its value. This is because the value of the currency is tied to scarcity, in this case scarcity controlled by Linden Lab.

If you have read the Wikipedia article, I think you will grasp what I am pointing at here.

Returning to the original question, is fractional reserve banking a good thing? That depends largely on whether you believe that it is possible to maintain confidence in the system. My argument would be that this confidence is currently being tested. There has already been a bank run in the UK with Northern Rock, and a run on IndyMac in the USA (see here for the story). The whole system relies on confidence. That confidence relies on the belief that the banks have invested the money that they hold wisely, and that the value of the assets that they hold has retained sufficient value for the money deposited to be returned.

The good side of the system is that it allows for rapid economic expansion, but the downside is that there is a fragility, and that the fragility is built upon the foundations of the system - confidence. The whole system is no more real than the confidence in the Linden Dollar, and the economy of the world is no more real than the economy of Second Life. It is all built upon belief in the value of currencies that have no real value, except what we subjectively give them.

Scary, huh? Is your head spinning? The foundation of modern economies is our subjective belief that the bank which holds our money will safeguard the value of that money, and that the money will retain a similar value in exchange tomorrow as it does today. In other words the foundations of a modern economy is entirely in each and every one of us, in our heads. This is the foundation of fractional reserve banking.

I hope that I have helped answer your question, albeit in a very circuitous way.

Thursday, July 24, 2008

Oil Prices and Retail Consumption

There has been some interesting news published, which seems to further reinforce my predictions for the future of the state of the UK economy. A while back, there were some positive figures for retail sales and these were questioned by myself (and others) as to their accuracy. On the one hand all of the reports from retailers were negative, but government statistics showed growth. My response was that this was likely to be a statistical error, and my suggestion was to 'wait and see'. Whilst conceding that there was a possibility that the government figures might be right, they simply did not make sense.

The Times has just published an article in which the government figures show the most dramatic decline in retail sales in 20 years, with a 3.9% decline. The article deals with the disputed May figures, but in a fairly inconclusive way. As such, it is still not clear whether May was a statistical anomaly or a last 'huzzah' of consumers. My view remains that is was the former.

I also recently predicted that oil prices would fall in an article written at the start of July:
'Having said that demand for commodities will fall, as the world economy slows, a counter-effect will be the ongoing readjustment of the U.S, economy, with continued pressure on the dollar for some time. Whether the increase in supply will outstrip any further weakening of the dollar becomes the question. My own view is that the increase in supply will see oil falling back in price in about six month’s time. My best guess, and it is no more than that, is that in two year’s time, oil will be back to about $US60-70 a barrel. This is based upon the provision of a small increase in capacity, a drop in demand, set against a further weakening of the dollar. Lots of ‘ifs’ - which is why it is a best guess.'
At the time that I wrote this, there were widespread predictions of ongoing rises, including talk of $200 per barrel. Such increases just did not make any sense, and I was very puzzled at the time that 'experts' could have believed this.

My only surprise is the speed with which oil prices have started to fall. I thought it would take a while for the level of demand to fall back enough to pull prices down. The speed of the fall suggests that the contraction in the world economy is far more dramatic than I had considered to be likely.

So what will the effects of a declining oil price be? There is no denying that it is a positive factor, as it will eventually feed through to consumers. In broader terms, will it effect the slide of the UK economy into depression? The simple answer is 'no', as oil prices were never a major factor in the slide in the UK economy. It was just an additional factor that pushed the slide downwards faster. On a more positive side, it may finally hasten the Bank of England to lower interest rates, which is desperately needed in a period of economic contraction. We can just hope that the bank responds sooner rather than later.

Wednesday, July 23, 2008

Market Domination

I just thought that I would write a quick note in response to a comment on my post on 'The Market and the Crash'.

The comment was as follows:
'Yes, but I can still imagine the ultimate free marketeer. He would be the businessman who finally managed to 'own' everything: all the land, all the houses, all the water, all the fuel. The people would have to do whatever he required in order to survive. Isn't that the logical conclusion of an unregulated free market?'
The quick reply to this comment is that I did not suggest no regulation, but light regulation. This is the kind of regulation such as competition regulation (such that no organisation can dominate a market), such as laws against insider trading, and laws on disclosure, false advertising (making fraudulent claims) and so forth . In short, regulation to ensure that markets are competitive and open - regulation to ensure that individuals have as much exposure to information as possible, and that there is a competitive market in analysis and presentation of information.

The alternative is what we currently see. Too much regulation creating a false sense of security. As I mentioned before, we need to return to 'buyer beware', as the best regulator of markets. After all, the mass of current regulation did not protect people from the housing bubble (this was one of the complaints of the person commenting). The current housing bubble was, in part, built upon an oversupply of finance into the mortgage market, and that oversupply was (in large part) the direct result of regulation and government interference in markets, as I mentioned in my previous post.

As a note, I would like to thank the anonymous poster, who prompted me to clarify the issue of regulation somewhat.

The Market and the Crash

I have been reading several articles, and comments, over the last couple of months in which 'the market' is being blamed for the mess that the world economy has fallen into. There are calls from every direction for more regulation of markets in general, and the banking system in particular.

The first problem with such calls is that they start from false assumptions. For example, many people suggest that the current problems originate in the sub-prime crisis in the USA. The interesting thing here is that the US market for mortgages is not a free market at all. As anyone reading the unfolding Fannie Mae and Freddie Mac story will know, these two US mortgage giants have benefited from an implicit government guarantee of their security. In particular that guarantee has allowed them to raise money in the market place at cheaper rates, as well as allowing them to operate with levels of capital that would otherwise have rung alarm bells.

One interesting part of this story, which I have not yet read in any of the commentary, is that the presence of these two state guaranteed mortgage lenders may be one of the reasons for the sub-prime crisis. The interesting thing is that the market for non sub-prime markets was dominated by these two institutions due to their ability to raise finance cheaply. Financial institutions that wanted to compete with these two institutions could not raise money as cheaply, and would therefore find it difficult to compete in this market. In this situation, the only mortgage market that was open to genuine competition was the sub-prime market. For financial institutions wishing to enter the mortgage market, the only place to go was therefore markets that were not dominated by these institutions - sub-prime (the story is complicated by the fact that Fannie Mae and Freddie Mac were also indirectly buying into the sub-prime market, but that is not the issue here).

The important point to note is that there was no free market in mortgages in the United States, and that the presence of Fannie Mae and Freddie Mac may have indirectly been a push for lending into sub-prime.

What of the banking crisis in broad terms? Surely this is a case of the free market getting it wrong?

Once again, if we look at the current crisis we see that it has taken place in a time when the banking system has been highly regulated. It is not a free market, but a highly regulated market. All of the current problems have taken place under the regulatory environment created by the Basel Accords, which required banks to meet capital adequacy ratios. These accords were inspired by a bank failure, and were supposed to make the banking system safer. They were all about regulation of risk, and the calculation of capital adequacy, which was supposed to prevent banks getting into trouble.

So how is it, in the most stringent regulatory regime in history, that there is now a banking crisis unfolding? The first problem is that the regulations were, in part, responsible for the emergence of SPVs, SIVs and CDOs, which were very useful ways for the banking system to take high risk positions, whilst still meeting the capital adequacy ratios. In other words, the regulatory regime was one of the main reasons for the emergence of new methods, which were actively used to bypass the regulations, and led to the current crisis.

There is a fundamental problem with regulation. It is always going to be an unequal battle. On the one hand you have the banks able to recruit and finance the best and brightest, and on the other you have the regulators endlessly trying to keep up with (and regulate) the innovations of these agile and clever banks. Whatever regulations are created, there will always be ways around them. Furthermore, there is also a fundamental problem with regulation in any event. How do you value assets and risk? Two years ago, property was a safe investment. Today it is not. Who decides what is safe and unsafe? And how?

The trouble with regulation is that it creates a false sense of security, and this false sense of security encourages complacency. If a bank meets the regulators requirements, then it must be sound, right?.....right up to the point where it falls over....

The fundamental problem is that, whatever system is created, someone will find ways to game the system. The more secure that everyone feels, the less everyone looks at the fundamentals of the activity. In such a system, there is more likely to be a major crisis, as everyone believes that the system is under control.

There have always been bad investments, such as the 'Tulip Mania' or the 'South Sea Bubble'. The single defining commonality of bubbles is 'money for nothing', 'no risk' and old fashioned greed. As long as their is a lust for money for nothing and greed, nothing will ever stop such bubbles occurring. Any capitalist system will allow bubbles to form in some way or another. There is always someone out there finding new ways to exploit greed, offering high returns for 'no risk'. Regulation offers banks the opportunity of suggesting that they are safe, and 'no risk' institutions, and that false confidence has allowed the banks to reach the current point of crisis.

Today, rather than accepting that regulation does not work, there are now cries for more regulation. However, if we look at the history of regulation, we find that for each crisis, there are proposals for more regulation. Despite this, crises continue to occur.

At what point will there be sufficient regulation for the avoidance of another crisis? How many new and complex rules will it take?

This is not to say that a light regulatory regime will avoid crises. The difference is that, in a light regulatory regime, people are more likely to heed the ancient advice of 'buyer beware', and scrutinise their investments more carefully. Whilst, inevitably, there will still be crises, they are more likely to be found sooner, rather than later. The crises will be more frequent but of less severity. Each small crisis would be a reminder that there is no such thing as 'risk free' investment.

If we look at the current problems, it is not the free market that has created the problems, but rather it is the regulation that has largely caused the problems. The underlying greed that always causes problems is a factor, but the degree of this particular crisis has been magnified by the false confidence of regulation.

This idea can be summarised as follows:

The more free the market, the less the likelihood of systemic risk.

Note: Much more could be said on this subject but, as ever, I am forced into a short post due to time constraints. If you doubt what I am saying, then take a look at the history of Basel, and regulation in general, and just keep asking yourself why it is that we keep on having crises when there is more and more regulation. In other words, if regulation stops crises, then why do they keep on occurring?