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.


  1. Thanks for a very informative post.

    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?

    Most economic commentators seem to draw on past events for their predictions. A specific example is here:


    "Shares fall by 35 per cent on average during a bear market, which tend to last for around a year. This means that a further fall of 15 per cent in the market's value could be to come before it bounces back.

    Alan Steel, founder of Alan Steel Asset Management, said: "I started my career in 1973. That was a proper downturn.

    "These things come in cycles and bear markets don't last nearly as long as bull markets."

    He added that anyone coming up to retirement should defer buying an annuity. "The rules allow you to wait until you are 75 before you have to take an annuity. I have no doubt that in three years' time the value of your pension fund will be much higher than today."

    In our current situation are these experts' views valid in any way, shape or form?

  2. Just one more question:

    You give the examples of Richtown, Poortown and Commoditytown. What if we had Richtown A and Richtown B? Could one of them have adopted policies which would have left it "better placed to weather the storm"?

    If so, until the crisis struck, would these policies have *appeared* to make the town a poor performer compared to the other?

  3. I’m thinking about one of the BRIC countries from theUK, China or Brazil, or maybe even Thailand. How do you see their prospects over the next decade?

  4. Rather than making a general post, I will answer the second question from Lemming briefly here.

    Yes, if we had 2 Richtowns then, there would be the possibility of very different outcomes for each, and that is the situation that has arisen. However, there are some common problems to all 'Richtowns', and these have been recognised by none of them.

    Yes, some of these policies might have made a 'Richtown' appear to be a poor performer in comparison with others. The less the country binged on credit, the less healthy their economy would have appeared. However, they would be better placed to weather the storm, and manage the period of transition.

  5. A very lucid (as usual on this blog) analysis of a problem, which the mainstream economists, blinded by their dogma (e.g Ricardo's "law" of comparative advantage) cannot even conceptualize, while our civilization is committing collective suicide.

    I'm particularly interested in your thoughts on Japan and its Richtown B strategy. I came across an interesting article (from 2004) which is quite at odds with received "wisdom" about that country, and seems to be close to my (admittedly limited) personal observations of that country and its people:


    Best regards

  6. Both in Tory and Labour times they all fall for it and fail to regulate the economy, so that the problems can get nipped in the buds early-Instead they do nothing until its far to late and then panic with even more riskier schemes. House prices need to come down 80% and held down at that level and Mortgages should not be a loan of no more than 3.5 x times income. This must be checked and the business audited to ensure fraudulent activities are not taking place.

  7. My understanding of financial matters is infinitesmal, however, I do seem to have developed a 'gut feeling' for things over the years. In the past weeks I have been soaking up all that has been said and I am forced to the conclusion that it is too late. We have blown it! thombo.

  8. A very nice and well written parable.

    I'm slightly unclear as to why 'Commodityworld' is a separate world. Things like factories and money exist in Richworld and Poorworld, so why do commodities need their own world, with their own implied citizens, within the structure of the analogy to account for things like scarcity? In reality, first world and developing world and all in between all produce their own commodities.

    It seems from your analysis that Poorworld will end up as rich or richer than Richworld. In the real world, that would be alright: if globalisation can't after all provide prosperity for all, better in my book that we all end up not being able to own two cars or go on holiday every year, if it means less people are dying of preventable causes.

    My query is, though, that if it's mainly been Poorworld lending to Richworld, then surely it's Poorworld that's going to be hit when it finds that money has now disappeared, since Richworld consumers and businesses are defaulting. In effect, they have been buying their own products and giving them to Richworld consumers, in return for future payment which is now at risk of never coming into existence. It resides, perhaps, in Debtworld, the equivalent of the afterlife, in which many believed but which may turn out to have been an illusion.

    If so, does that mean Poorworld is in fact as f*cked as the rest of us?

    Apologies if that didn't really make much sense.


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