Thursday, April 30, 2009

Optimism and Economics

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

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

Perhaps the best summary of the optimism can be found in the Independent, with the headline 'US Recovery Hopes Grow Even as Economy Contracts 6.1%'. The article goes on to say:
US economic output contracted at an annualised rate of 6.1 per cent in the first quarter, almost as bad as the minus 6.3 per cent GDP figure for the final three months of last year, when consumers and businesses were reeling from the collapse of Lehman Brothers.
The report went on to say:
Other "green shoots" in the report included a surprisingly strong uptick in consumer spending, which contributed 1.5 percentage points to GDP, where it had been a net negative for the two previous quarters. Information on the price of goods and services helped to ease the fear of deflation taking hold. And economists also dismissed an unexpected drop in government spending as temporary.
However, we have this from the New York Times:
A day earlier, the government released figures showing an unexpected increase in consumer spending in the first quarter, offering one of the few bright spots in an otherwise dreary accounting of the country’s overall economic output. But the monthly report released Thursday showed that while consumer spending rose sharply in January, its gains tapered off in February and reversed themselves in March, declining by a larger-than-expected 0.2 percent.
So what exactly is this optimism all about? Perhaps the best expression of the depth of the ongoing problems can be found in the actions of the Federal Reserve. In particular, the Fed is currently printing $1.2 trillion and using the money to buy mortgage backed securities and treasuries. Does this action look like an expression of confidence in a recovery?

The most odd part of the so-called 'green shoots' of recovery is the sudden surge in bank profits. An article in the Economic Times sums up the reality of the situation:
The first quarter results of US banks mean little. In early April, the US accounting regulator tweaked mark-to-market rules for bank assets in order to help banks show lower losses on these assets. These modified rules were applied with effect from March 15, allowing banks to show better than expected results for the first quarter.

The idea that banks can work their way back to good health simply by making profits hereafter is absurd. US bank losses are huge — the IMF’s latest estimate of US bank losses is $1.6 trillion. US banks have raised an additional $400 billion in capital so far, which means they need another $1.2 trillion to get back to normal health. For banks to cover this amount through profits would take years. Until then, banks will not be in a position to provide adequate credit.
Quite simply, common sense should tell us that there is no realistic way in which the US banks can be returning to profitability. All of the US banks have massive exposures to the US economy, and every part of the US economy is heading in a downwards trajectory. How an earth can banks be making profits when real estate is falling, consumer spending is falling, insolvencies are up, unemployment is up and so forth...

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

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

In the case of the UK, it is even more mysterious. The UK budget in particular painted an appalling picture of the state of the UK economy. In my post on the subject, I suggested that it would be interesting times for gilts and the £GB. However, the most recent gilt auction proved to be a success, albeit in a gilt that is part of the Bank of England's money printing purchase scheme. Meanwhile the £GB has gone through a roller-coaster ride:
Sterling fell against a broadly recovering dollar on Thursday after rising to a two-week high as initial optimism about the global economy petered out, even as share prices gained.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Saturday, April 25, 2009

Finally, The Mainstream Media 'Get it'....

I have already published two posts recently, but could not resist a further post. I have been reading the Sunday editions and it has become apparent that the mainstream media is finally waking up. The Darling budget has finally persuaded the commentariat of the profound difficulty with which the UK is confronted.

Regular readers can now see many of the views I have long been expressing starting to be mirrored in the press - and it does not make happy reading. Despite this, I read the views with a grim satisfaction. It is not the satisfaction of seeing others coming to share my views, but the satisfaction that the first step in fixing the economy is the recognition of the nature and severity of the problem. With the mainstream media finally confronting the reality of the situation it is quite possible that the politicians will have to start to respond with real plans to address the underlying problems.

One example comes from Ambrose Evans-Pritchard in the Telegraph. He is recognising the impossibility of the funding of so many huge government deficits around the world. He points out that many of the previous supporters of Western debt are now turning off the taps, and that the level of debt raising was in any case increasingly impossible. Perhaps the most interesting comment he makes is as follows:
Traders already whisper that some governments are buying their own debt through proxies at bond auctions to keep up illusions – not to be confused with transparent buying by central banks under quantitative easing. This cannot continue for long.
I have long suspected that this has been a part of how the debt has continued to be purchased. When I pressed the Bank of England on the subject of quantitative easing, one of the questions I asked was for them to confirm that they would not be using proxies to purchase bonds in debt auctions (they confirmed that they would not). However, the impossibility of funding such massive debt has kept me questioning how the government might be intervening, and I have recently been trying to find sources for who is buying the gilts at the moment (to no avail). If Ambrose is correct, the government is intervening in the auctions, and my guess that the government is using banks effectively under state control to buy the debt may well be correct.

Perhaps the most vocal in the criticism is another Telegraph commentator, Liam Halligan. His latest article is almost a mirror of my posting on the budget. For example, he notes that the budget does not acknowledge the many forms of off-balance sheet borrowing, and also adds that the bank bailouts are not included:

Remember, also, the hundreds of billions of pounds of off-balance sheet liabilities – not least the bill for public-sector pensions and the utterly dishonest private finance initiative.

For all these reasons, even Darling's outlandish borrowing totals are just the start of the Government's extra debts. Oh – and by the way, much of the cost of the massive bank rescues isn't in these numbers either. The Budget fine print claims officials "haven't yet been able to calculate their impact […] on public sector net debt".

So these borrowing estimates can only rise – as they have after every Labour Budget since 2001. Already, debt service is the fourth biggest item on the Government's balance sheet. Soon we'll be spending more public money on interest payments than on schools and universities combined.

As a final example from the Telegraph, Tracy Corrigan, details the retreat of investors from the UK gilts market:

At least the recently introduced policy of quantitative easing, designed to boost the economy, is helping to support gilt prices. But for how long? The scale of the Bank of England's purchase of gilts under this programme – it is buying £75bn and could return for the same again, if it decides the economic case merits it – is having a powerful effect on the market. But that will be, by definition, relatively short-lived, and at some point that spending, too, will have to be financed.

For the moment, the Bank of England's bulk buying is covering up another unpalatable truth. Other investors are not quite so keen to get involved.

Although UK pension funds hold gilts, they aren't buying much at the moment. Overall, UK fund managers were net sellers last year, and the recession causing lower dividend income this year means they will have less new money to invest anyway. Banks have been buyers, partly to meet new requirements to hold liquid assets, but they now largely have what they need.

Of course, the elephant in the room in regards to the quantitative easing is that, at some point, the gilts being purchased by the Bank of England must be sold back into the market. This will need to be done at a time when investor confidence is diminishing (or disappeared), and the issuance of new debt by the government is exploding. From the FT, there is a leading article which expresses cautious concern over whether the government can continue to finance debt:

Which, of course, is the trick. At the moment, the UK government has little trouble finding lenders, but this can stop on short notice. If gilt investors began to doubt its commitment or ability to close the deficit, the market’s willingness to refinance UK sovereign debt could come to a sudden halt. The government must pre-empt perilously self-fulfilling doubts before it is too late.

Retaining market confidence calls for plausibility: this government must shed its reputation for overly optimistic forecasts. It must also try to avoid the need to roll over a large amount of debt at any one time. The plan to complement auctions with organised syndicates of lenders is a good one. So is the substitution of medium-term bonds for the shortest maturities in sovereign debt issuance. Puzzlingly, however, the government has not increased the share of the longest maturities, despite pension fund demand for more such paper.

These steps, although sensible, do not guarantee safety. Like its biblical namesake, economic original sin differs from ordinary sins: whether you are guilty of it is largely outside your control. Nonetheless, the UK government’s only hope is to stick to the straight and narrow
Willem Buiter likewise expresses concerns in his blog at the FT, although he is broadly positive about the budget:
If the necessary fiscal tightening is not forthcoming because different groups and vested interests are engaged in a war of attrition aimed at shifting the fiscal burden to the other guy, markets could easily panic and Britain could face an emerging market-style “sudden stop”, with the rest of the world withholding financing from its public and private sectors.

To forestall the occurrence of a triple crisis (banking, sterling and sovereign debt), it would behove the UK to apply for an IMF Flexible Credit Line (FCL). Unfortunately, the criteria for qualifying for an FCL arrangement include “ . . . (iv) a reserve position that is relatively comfortable . . . ; (v) sound public finances, including a sustainable public debt position; . . . (vii) the absence of bank solvency problems that pose an immediate threat of a systemic banking crisis; (viii) effective financial sector supervision.” It is questionable whether criteria (iv) and (v) are met. Criteria (vii) and (viii) are obviously not met. In addition, with a £175bn annual borrowing requirement for the next couple of years, the measly $240bn or so the IMF currently has at its disposal is unlikely to make much of a difference.

One of the interesting points is that the IMF is no longer seen as an option to bail out the UK. Quite simply, the demands of the UK are seen as too great for IMF funding, and the possibility of the IMF being a safety net looks increasingly dubious. As it is, the IMF is already confronting problems in raising cash to fund its operations.....

Meanwhile the Wall Street Journal is also expressing the view that there are increasing concerns in markets over the ability of the government to finance their borrowing:
The plunge [in output] raised fresh concerns about the U.K.'s ability to handle the mounting costs of its financial and economic bailouts. Compared with a year earlier, the U.K. economy shrank by 4.1%. That cast doubt on an official projection this week that the economy will contract by only 3.5% in 2009 and rebound quickly enough to help the government get its stretched finances under control.
Even the Times is now accepting that we might have reached the limits, and that a funding crisis looms. I have highlighted the point that is tucked away in their leading article today:
For the people of Britain, the consequences of that imprudence will be with us for many years. It will take nearly a decade to get public borrowing to acceptable levels – if the markets allow us that long – and until the 2030s to get government debt back to the 40% “ceiling”. Whoever wins the general election, we can look forward to years of austerity and tax rises.
From the Independent we have another allusion to the problems of financing the government's profligacy (I have again highlighted the point):
There are fundamental questions that all our political leaders – at least those with serious designs on power – need to answer. What services do we want the state to provide? And what can Britain, as a nation reliant on the confidence of international investors, afford?
One of the exceptions to the increasingly gloomy views on the UK Economy is the Guardian, which still sees relatively upbeat commentary. As one example, Ashley Seager has the following to say:

So where is the economy especially weak? Everywhere, it seems. Manufacturing suffered its biggest quarterly fall since records began in 1948, driven by a 50% annual drop in car output, while the much bigger services sector saw the biggest drop since 1979.

Still, there was one bright spot in separate data from the Office for National Statistics that showed an unexpected rise in retail sales in March, driven by higher clothing and food sales. Is that enough to help pull us out of recession? No chance.

At some point, though, the Bank of England's record interest rate cuts, its £75bn of new money for the economy, combined with Darling's recent tax cuts and the big fall in sterling should put the economy back on an even keel. Today's GDP figures, though, suggest that the battle is far from won.

It seems that he actually believes that it is possible to turn the problems around with interest rates and printing money, but such delusions are increasingly on the retreat. Another similar positive outlook comes from Krugman at the New York Times, who is also positive about the policy of printing money:
So I’m actually fairly hopeful about Britain; right now, the fact that it’s not on the euro is serving it well.
Despite the remaining optimists, there can be little doubt that there is a growing perception amongst the mainstream media that the UK is in very, very serious trouble, and increasing concerns about whether the UK can actually continue to support the proposed levels of borrowing and spending.

I think that, over the coming weeks, there will be considerable interest in gilt auctions, and I would guess that many analysts will looking for cracks in the government financing of debt or the possibility of a gilt strike. Alongside this, there will also be major question marks over the value of the £GB.....

Interesting days are ahead, and increasingly worrying times.

Friday, April 24, 2009

China as the World Economic Power?

When I first wrote a post on this blog devoted to China in July of last year, I emphasised how opaque China was as an economy. For example, I suggested that the housing construction boom might be a bubble (which proved to be the case), but could offer no solid backing for it. As such, my thoughts on the future of China were cautious:
The Chinese economy may, or may not be, at a point where internal growth within China has the potential to take up the slack. Has it yet reached that point? It is very difficult to say. It is a finely balanced point, but the economic growth of the coastal areas is now being replicated in the interior. Can the growth in the interior maintain the momentum of the coastal cities? The Chinese government has huge reserves to draw upon should the economy falter, and may seek to use those funds to further develop the interior of the country. There is also an ongoing and dramatic process of infrastructure investment which may help carry China through the bad times.

Furthermore, China has being making ever stronger inroads into markets such as Africa, and South America. Whilst these can not replace the US and European markets, they may serve to ameliorate the effects of a downturn.

As you will note, there are many question marks here. There are many 'experts' in China trying to wade through the piles of figures trying to see what will happen with China. The trouble is that many of the statistics are either opaque or suspect. In this situation, it is just as well to rely on intuition.
In a later post I emphasised the mercanilist approach of the Chinese government, and have followed that theme through many of my subsequent posts. However, the major question mark over the future of China has remained, and my posts have tried to balance the potential for huge economic success with the risks to the Chinese economy from the world economic crisis.

As China's importance in the world economy has become ever more apparent, there has been growing interest in the state of the Chinese economy. I have recently seen some reports which consider the future of China and there are mixed views. For example the D&B Riskline report for April rates China as a 'slight risk' with the trend 'deteriorating'. with very little economic growth for this year and the next. By contrast, the Economist magazine is painting a picture of strong growth on the back of the Chinese government stimulus:
At first sight, the GDP figures published on April 16th were disappointing. China’s growth rate fell to 6.1% in the year to the first quarter, less than half its pace in mid-2007. On closer inspection, however, the economy is starting to perk up. Comparing the first quarter with the previous three months, GDP rose at an estimated annualised rate of around 6%, after nearly stalling in the fourth quarter (see chart). By March the economy was gaining more speed, with the year-on-year increase in industrial production rising to 8.3% from an average of 3.8% in the previous two months. Retail sales were 16% higher in real terms than a year ago, and fixed investment has soared by 30%, signalling that the government’s infrastructure-led stimulus is starting to work.
What we have here are two very different perspectives on the Chinese economy, which appears to be the norm for analysis of the Chinese economy. To give a perspective on the opacity of the Chinese economy, analysts often use proxy measures such as electricity output to try to understand what is really going on. Understanding the Chinese economy is no easy matter.

The problem that this presents is significant. There are two very different futures that might arise depending on the growth in the Chinese economy. One scenario is of a collapse into disorder, and the other is to increasing dominance in the world economy.

As I have mentioned in previous posts, there is a belief that China needs to maintain a growth rate of 6% in order to maintain social stability. This is needed to soak up the ever expanding labour force, and failure to do so is supposed to create significant risks. In particular, the legitimacy of the Communist government rests on the pillars of economic growth and nationalism, so that any major drop back in growth might see a significant rise in discontent. An earlier report in the Economist highlighted the problems that students are having in obtaining employment after graduation, and pointed out the risks in such a situation:
Campus stability has long been a worry to China’s government. Students took a leading role in several outbreaks of pro-democracy unrest in the 1980s, including the Tiananmen Square protests of 1989. Student demands for political change have been rare since then, thanks largely to an improvement in career prospects brought about by the economic take-off and the freeing of state controls. (In the 1980s, graduates had to accept the jobs they were assigned by government.)
On the one hand, therefore, we have a scenario in which, if the economy slows significantly, there is a major risk to the stability of China overall. On the other hand there is the possibility that China will continue to grow, and the consequences of such ongoing growth might lead to a very different outcome for China.

If we assume that the growth scenario is correct, the position of China in the world economy becomes ever more important. It appears that China is currently making the opening bids to establish the RMB as a reserve currency, and I have posted on this subject several times. For example, in a recent post, I pointed out the many moves that China is making to achieve this goal:
In other words, China is now actively positioning itself as (at the least) a major issuer of reserve currency, but is doing so in a way in which - if their attempt were to meet resistance or fail - they can step back and point out that it was never their intention. They can therefore proceed with an official position of support for SDR, whilst acting to develop the RMB as a reserve, whilst never risking losing face. It is a very effective way of operating.
The post details a series of actions by the Chinese government to establish the RMB as an international reserve currency, along with some consideration and speculation about the Chinese government's thinking. You may wish to read the post before continuing. In another post (again, you may wish to read it before continuing), I made an even more speculative consideration of what the Chinese government may be aiming to achieve, and how they might achieve it. In essence, I speculated on how China might take advantage of the economic crisis to become the world economic power.

Within the speculation, I suggested that China would discreetly start to dump treasuries, and would move their reserves into a broad based portfolio of assets. Whilst China has promoted the IMF SDRs as an alternative reserve currency, I proposed that this was a red herring which would allow China to undermine the $US without actually promoting the RMB as a replacement. However, the SDR approach is being taken seriously by some:

But in recent weeks, China has begun to address each of these dollar-forever arguments head-on, taking baby steps on the long road toward diversifying away from the U.S. dollar and moving instead toward the establishment of an alternative world reserve currency.

The signs began to emerge in mid-March, when Chinese Prime Minister Wen Jiabao publicly announced that he was "worried" about China's exposure to the dollar. Shortly thereafter, Zhou Xiaochuan, the governor of the Chinese central bank, released a policy paper suggesting the creation of a "super-sovereign reserve currency" to replace the dollar as a reserve currency over the long run. Specifically, he suggested the creation of a fund, managed by the International Monetary Fund, through which dollars could be exchanged for Special Drawing Rights (SDRs), an IMF-created international reserve asset whose value is fixed by a basket comprised 44 percent of U.S. dollar, 34 percent of euro, and 11 percent of each pound and yen.

However, it is now apparent that China has made significant moves towards gold, and this was one of the moves that I suggested in the post. This would help bolster the RMB as a reserve currency. We now have the following from the FT:
China revealed on Friday that it built up its gold reserves by three quarters since 2003, making it the world’s fifth largest holder of bullion.


Hou Huimin, vice general secretary of the China Gold Association, said China should build its reserves to 5,000 tonnes.

“It’s not a matter of a few hundred, or 1,000 tonnes. China should hold more because of its new international status, and because of the financial crisis,” he said. “The financial crisis means the US dollar’s value is changing fast, and it may retreat from being the international reserve currency. If that happens, whoever holds gold will be at an advantage.”

In addition to this, China is also building up stocks of other metals such as copper. In the D&B report, this is viewed as a move towards supporting government infrastructure investments. An alternative view comes from Ambrose Evans-Pritchard in the Telegraph:
China's State Reserves Bureau (SRB) has instead been buying copper and other industrial metals over recent months on a scale that appears to go beyond the usual rebuilding of stocks for commercial reasons.


The beauty of recycling China's surplus into metals instead of US bonds is that it kills so many birds with one stone: it stops the yuan rising, without provoking complaints of currency manipulation by Washington; metals are easily stored in warehouses, unlike oil; the holdings are likely to rise in value over time since the earth's crust is gradually depleting its accessible ores. Above all, such a policy safeguards China's industrial revolution, while the West may one day face a supply crisis.

Beijing may yet buy gold as well, although it has not done so yet. The gold share of reserves has fallen to 1pc, far below the historic norm in Asia. But if a metal-based currency ever emerges to end the reign of fiat paper, it is just as likely to be a "Copper Standard" as a "Gold Standard".

The moves of the Chinese government are increasingly fitting with my speculations on a move by China to rapidly achieve economic dominance. However, it is necessary to consider the other side of this coin, which is that China is also quite vulnerable to social unrest.

The key question that keeps nagging at me is which way will China go in the coming year? Will it be a slide into disorder, or a successful bid for economic dominance? Are there other middle paths, and what might they be? Are they really making a bid for economic dominance - to be the new economic power?

With such an opaque system, it is not possible to be sure of anything. However, all the indications appear to point to an ongoing strategy from the Chinese government of placing China at the centre of the world economy. Whilst all the recent moves of China might be coincidence - responses to changing circumstances - there does seem to be an emerging pattern in their actions. If it is more than coincidence, we may be witnessing one of the most dramatic peacetime shifts in power in modern history. It could well be that China is returning to its traditional position as the preeminent country in the world.

Only time will tell......

Thursday, April 23, 2009

2009 Budget Madness....

I have a curious streak of optimism that somehow the economic policy insanity will be ended. At some point, I keep thinking, the politicians will 'get it', then knuckle down and face the reality of of the task that confronts them. In my foolish optimism I held out some hope that the budget might see some kind of return to sanity. Instead, what we have is a work of complete fantasy, and a work that will plunge the UK ever deeper into an economic hole.

The part that is most shocking about the budget is the fantasy projections for the future of the economy, and many commentators have already seized upon this. For example, Liam Halligan of the Telegraph has the following to say:

One reason is that Darling’s has made some extremely rosy assumptions about future UK growth. While he admitted our economy will contract by 3.5pc this year, the Chancellor foresees a return to growth of 1.25pc in 2010, with the economy booming once more soon after, expanding by 3.25pc in 2011.

These estimates are pie-in-the-sky. Most economists think the UK will contract next year too. And I know not a single forecaster outside the Treasury betting on growth above 3pc the year after.

Even the optimist in chief amongst the economics columnists, Anatole Kaletsky, had the following to say:

Just as the Treasury, along with the IMF and the OECD and all the other supposedly expert institutions, have revised their forecasts out of all recognition in the space of just four or five months, the numbers published in yesterday’s Budget will be overtaken by events in the next few months.

Quite simply, nobody in their right mind will see the Darling figures for growth in the UK economy as anything but fantasy. The reality at the moment is that the UK has a long way to go before it reaches bottom. We have only gone through the initial stages of the economic crisis, and there is much more bad news to come.

For example, there is the forthcoming meltdown in commercial property, which will send the banking system into a new tailspin. This from the Telegraph this April:

Meanwhile restructuring experts have warned that the quarterly rent bill could be the tipping point that would force a significant number of retailers into administration. Malcolm Cohen, a partner at BDO Stoy Hayward said: "Retailers are already struggling for survival and have been further impacted by consumers reining in on their discretionary spending

This is just the retail sector, but there is likely to be a similar continuing decline in the broader commercial property market as the economy contracts. The bottom line here is that, with consumer spending contracting, the retail sectors absolutely must continue to contract. Meanwhile, despite some optimism in the residential housing market, the trend is still predicted to be downwards for a long time yet.

Another element in the ongoing banking crisis will be continually climbing numbers of defaults on consumer debt and mortgages. Even whilst consumers are paying back debt, due to concerns about the state of the economy and unemployment rising at 2000 people per day, there must be ongoing losses at all the major financial institutions, though figures for this are very hard to come by. A good indication of the problems are the ongoing problems being confronted by building societies, exemplified by the dire state of Dunfermline Building Society (which also made significant losses on commercial property). Meanwhile, consumer confidence remains very low indeed.....

Added to this gloomy picture, there is the massive decline in manufacturing output. The Times had this to say:

Manufacturing output tumbled in the past quarter, with 53 per cent more companies cutting their output than increasing - the lowest level since 1975.

Exports, which have performed more strongly in recent months as the pound has weakened, declined more rapidly in the last quarter than businesses had hoped, with a balance of -39 per cent which is far below the expected -27 per cent and the weakest figure since October 1998.

Companies expect export orders to fall again next quarter, but at a more moderate pace.

The same report also highlighted a continued trend of laying off workers. Inevitably, UK GDP is falling at an astounding pace:

Economists were expecting GDP to have contracted by 1.5pc in the final quarter of last year – in line with the preliminary estimate – but the Office of National Statistics had to revise the figure downwards to 1.6pc.

It is the biggest quarterly fall in GDP since 1980 and the biggest annual fall since the last recession in 1991.

The contraction was aggravated by a sharp revision of the fall in construction output from 1.1pc to 4.9pc in the last quarter, falling consumer spend and businesses cutting back their inventories.

It should be remembered in considering GDP that it measures activity, not actual creation of wealth. As such, large percentages of the activity will be funded through government borrowing, meaning that activity now will have to be paid for by a decline in activity at some future point in time.

Under these circumstances, with just about every sector of the economy reporting bad news, the idea that a genuine recovery will start next year is just pure fantasy. Even the IMF forecast for the UK stands as a sharp contradiction of Darling's forecast, with a 0.4% contraction next year. Within this context, the borrowing forecast being offered by Alastair Darling is pure fantasy, but is nevertheless still alarming. With an ongoing contraction of the economy, the need for greater than forecast borrowing is a foregone conclusion. As the forecast stands, borrowing is predicted to rise as follows:

According to projections in the Budget, public sector net debt, the accumulated stock of outstanding Government borrowing, will reach £1,370 billion in 2013/14.

It should be remembered that, in addition to this, there are many liabilities that are buried. For example, Private Finance Initiatives are not included, but significantly adds to the government's real level of debt. Added to this are the unfunded pension liabilities for the public sector which are believed to be double the official estimate at £1 trillion +, and the underlying problem that the first of the baby boomer generation are now retiring. This will mean less workers are going to be available to fund government activity, whilst healthcare and pension costs are set to soar:

Such high national debt is not without consequences: it leads to more expensive interest payments while the flood of new British gilts into the bond market will crowd out investment that might otherwise have gone into the private sector. Meanwhile, Britain's ageing population heralds a mass of new pension contributions, further obligations to public funds that the government probably does not want to think about right now.

Under such circumstances it is no wonder that many commentators are now questioning whether the government will be able to continue to fund such extravagant borrowing. For example, and article in the Wall Street Journal is pointing out the significant risks in the UK fiscal position, with concerns about quantitative easing (printing money) and the massive expansion in debt:

But a big expansion in quantitative easing -- already huge at 5% of GDP -- carries risks. It stores up trouble for the future, increasing bank sector reserves that will eventually need to be mopped up before they trigger an inflationary surge while adding to the BOE's stock of gilts that will one day need to be sold.

More importantly, it would fuel suspicions the BOE is simply monetizing the government's debt, further undermining the U.K.'s credibility -- and potentially precipitating the BOE's nightmare scenario.

That leaves the BOE in an invidious position. Its own credibility is all that stands between the U.K. and a full-blown financial crisis. Yet thanks to the government's refusal to spell out a credible plan to reduce government borrowing, the BOE finds itself at the mercy of foreign investors, who by the end of last year held 35% of gilts.

It wouldn't take much -- a further collapse in the public finances, another bank bailout or signs of a surge in inflation -- to undermine sterling and prompt the showdown the BOE fears.

The government could yet be forced to deliver a proper budget before the year is out.

The possibilities of a gilt strike, a refusal of markets to continue funding UK government debt is becoming an ever greater possibility. The risk of sovereign rating downgrade is looming, and there have been ongoing problems at gilt auctions - even before the budget:

The scale of the Treasury's borrowing plans -- and continued fears about the UK's ability to recover from the slump and repay its debts -- have raised the prospect that investors may simply refuse to buy all the bonds the Government issues.

The Treasury was last month hit by an "uncovered auction" when investors refused to buy all the gilts ministers wanted to sell.

Also, even before the budget, the £GB has been under pressure, and this can only serve to raise anxiety about the massive issuance of gilts:

There is evidence to support the view that sterling may have moved to a permanently lower level, reflecting a preference shift away from what the UK does best, namely financial services. But the results suggest that around 60pc, of sterling's decline since mid-2007 can be accounted for by a rise in the risk premium associated with holding sterling.

In plain English, overseas investors fear that the UK may no longer be capable of delivering the stability that it was once thought to have enshrined. And given the extent of the government's borrowing, they see a significant risk of inflation ahead. And who can blame them, sterling has form.

From the FT, we have the following:

On Wednesday, for example, the cost of protecting five-year gilts was 95 basis points – meaning it costs £95,000 a year to insure £10m of bonds – up from 18 basis points last summer (albeit down from a peak earlier this year).

But if that is embarrassing enough, the cost of insuring the chocolate giant Cadbury was on Wednesday far lower, around 50bp. A company that peddles chocolate coins, in other words, is currently deemed a better credit bet than the British Treasury itself.

Perhaps the most worrying aspect in all of this is that the markets are still paying attention to GDP as if it were a meaningful figure. As such, they measure the state of the government's debt and the ability to repay are based upon GDP figures. As I have often emphasised in this blog, GDP figures are a fantasy, as they measure activity which includes activity resultant from increase in debt. As such, with the government borrowing soaring, and massively indebted consumers and businesses, current and past GDP figures have been massively inflated by activity resultant from debt. As such, all of the analysts (I assume) are measuring the ratio of debt against a measure which massively inflates the perception of the UK's ability to repay the debt.

I have not covered the details of the budget and have emphasised the big picture of the overall fiscal position. I will not go into the details of the budget, which are quite simply tragi-comedic. However, as an example, I have already pointed out the absurdity of the car scrappage scheme in a previous post. To this we can add the 'green' measures, such as a massive investment in useless wind farms (I have detailed why they are useless in a previous post). As Britain falls ever deeper into a black hole, precious resource is being diverted into schemes which simply can not be afforded. Or there are supposedly going to be measures to trim areas of public spending, about the IFS has the following to say:
“The Government has announced that nearly £6bn of extra efficiency savings will be delivered by the public sector in 2010–11. A large proportion of these savings will be delivered by just two departments: Health and Children, Schools and Families, who have announced new efficiency savings of £2.3bn and £0.7bn respectively – equivalent to 2.2% and 1.3% of their current budgets. As a proportion of their current budgets the biggest savings come from Transport at 3.0% and the Home Office at 2.9%. Local Government and Defence have also identified large efficiency savings, of £0.6bn and £0.45bn respectively, but the Treasury has labelled these as ‘recyclable savings’ –meaning that these departments will not actually have their resources
budgets cut by this amount in 2010–11.”
In fact, as the budget is taken to pieces, it is increasingly being derided from every quarter. Above all else, the commentary on the budget appears to focused not on the details, but on the sheer scale of the profligacy of the government, and how it might be able to finance its massive spending plans. The revised figures for the economy detailed in the budget appear to have created a profound sense of shock to the commentariat, and the reality of how bad the situation is has now begun to sink in.

I have erroneously made a prediction of a run on the £GB, the timescale for which expired recently. Having made the error once, I will not once again put a timescale on such an event. However, this budget, the shocking nature of the soaring debt and plunging revenues, must surely mean that the possibility of a gilt strike and run on the £GB have moved that much closer. Even the most moderate of the commentators are now assuming that, at the very least, the cost of servicing government debt will rise. I had the following to say back in November of 2007, at a time when the crisis had not emerged into the full light of day:
All the while this is happening the government will fall into crisis. With a falling pound, an economy collapsing around them, and an already overstretched borrowing position, they will be faced with ever more expensive borrowing, meaning higher interest rates, or massive cuts in public expenditure. There will be no room to manoeuvre. The only solution will be to cut back on expenditure. Continuing to borrow will be too expensive, and would destroy the value of the pound, as well as creating an even deeper crisis of credibility that the UK government can manage the economy.
As I look at the 2009 budget, the one thing I do not see is the real cutting of expenditure. At the time of writing I could not imagine that the UK could reach this position and still continue to borrow and spend in the way that they are doing. That a government could be so irresponsible was beyond my imagination.

In writing this blog, I have always tried to view the actions of the politicians in a positive light, at least as far as their intentions are concerned. I have seen them as fools, but fools with the right intentions. As I look at the budget and the forecasts provided by Darling, I struggle to maintain such a positive view. I simply can not believe that Darling (and Brown) believes his own forecasts.

If this is the case, and he does not believe his forecast, the only conclusion that can be drawn from this budget is that it is a horribly misguided attempt to create a pre-election bounce in the economy. It is a budget aimed at keeping Labour in power, and is being undertaken at massive risk to the economy in the short, medium and long term.

Quite simply, it looks like the government is willing to risk the entire UK economy in a mad gamble for an electoral advantage. If so, then it is a disgrace.

Note 1: A very lively debate on the last post. As ever, the comments were intelligent and considered, and are one of the most successful aspects of the blog. I increasingly see the comments section as one of the best parts of this blog, and would guess that it is at least as much of a draw for visitors to the blog as the original posts.

Note 2: I would sincerely like to know who might be buying gilts at the moment. If anyone has any information on this, please post a comment or link. The usual source for this information is the DMO, but they will not publish on the current quarter for a long while yet. Are there any other sources that are available now? Thanks in advance for help on this.

Thursday, April 16, 2009

Defeat is in the Air......

I recently wrote about a Time magazine article, in which they gave the delusional argument that the financial crisis is over. I do not have a great deal of respect for Time magazine but, in one respect, they may have value; in the capture of the mood in the US. I recently came across an article in the magazine that makes very bleak reading. A quote which sums up the mood is:
No one wishes for hardship. But as we pick through the economic rubble, we may find that our riches have buried our treasures. Money does not buy happiness; Scripture asserts this, research confirms it. Once you reach the median level of income, roughly $50,000 a year, wealth and contentment go their separate ways, and studies find that a millionaire is no more likely to be happy than someone earning one-twentieth as much. Now a third of people polled say they are spending more time with family and friends, and nearly four times as many people say their relations with their kids have gotten better during this crisis than say they have gotten worse.
The underlying mood of the article, and the personal anecdotes that accompany the article, is one of defeat and resignation. Quite simply, the subtext that underlies much of the piece is that of a belief in a decline that is beyond reversal. A similar mood can be found in another article from Anatole Kaletsky in the Times, discussing the dire state of the UK economy. His answer is simply to continue borrowing and hope:
If, on the other hand, the economy remains paralysed for much longer or experiences only a feeble recovery when growth resumes, then it won't matter what tax or spending measures Mr Darling announces: public borrowing will grow like Topsy and, in the end, the Government's only recourse will be to inflate away its debts by ordering the Bank of England to print money without limit.
He later puts a more positive gloss on the situation, but there is no hiding from the paragraph that is quoted above. As one of the great optimists for government interventions, his contemplation of financial Armageddon comes as a profoundly shocking admission of the fragility of the current situation.

With all of the news of great economic events, it may seem curious to focus in on the mood of the US and UK, but I believe that this is something that we should not ignore. Economics is about more than just numbers, but is also about culture, drive, expectations and many other less tangible factors. The mood that is being expressed belies the recent sprinkling of false optimism, and is a mood of defeat and resignation.

Perhaps the most telling part is in the stories of individuals and families that can be found in the Time article. The tone and mood tallies with some of the commentators on the blog. There is a rejection of the striving, the desire to make more money, a diminishing sense of ambition. It is a rejection of wealth and the culture of consumption.

I will leave it for others to determine whether this shift is a good thing, but will instead discuss what this might mean in economic terms. I have spoken before about the working culture in China, which I have seen first hand. I believe I once gave the example of a couple working endless hours in a tiny food stall, and how their basic motivation was to provide a future for their children. Their absolute determination and willingness to sacrifice themselves was quite astonishing.

If this example from China is compared with that of the West, it is apparent that there is an alternative to the consumption culture that is currently being rejected in the West. The couple working on the food stall are not working to buy the latest gadgets, or to buy a new car. They are working and saving, with a view to their future security and providing for their children. Whilst a consumption culture is growing in China, saving and security is still dominant.

This is the challenge that is facing the West, and it is not just in China that such values and ambition hold sway. It is the Asian approach, and it provides a driver for their economic development.

When I started the blog, my aim was to not only comment on the current situation, but was also to encourage a view amongst readers that reform was needed to pull the UK (in particular) back from the precipice over which the country is now starting to fall. To this end, I have written several posts on ideas for reform of UK institutions, and these can be found in the links at the left of the blog. When writing the posts on reform, I always kept in mind the reality of the competition from China and the other emerging economies. As such, I sought to balance the best of the existing UK system with a move to greater individual responsibility.

As I look at the shifting of the mood of the UK, and also the US, I see a shift which is still not accepting the reality of the situation (the need for reform), and still not accepting that we must actually face the new competition in the world. For example, Kaletsky's argues that, whatever happens, government deficits will balloon, with or without further stimuli. The one thing he does not contemplate is the deep reform of the systems and structure of the economy. In his mind, whatever happens, the government will still continue to spend money that it does not have and, if recovery does not come soon, whatever happens the government will print money to the destruction of the economy. Kaletsky is not alone. Ambrose Evans-Pritchard has the following to say of the US:
One thing is clear: Beijing suspects that the US Federal Reserve is engineering a covert default on America's debt by printing money.
Whilst attributing the view to China, it is possible to guess that he too is finally accepting that the massive printing of money to purchase debt is simply a default by stealth. Despite this, no complaint is made, and the reality of the default is simply accepted. In the meantime, China's importance in the world economy grows larger by the day, with this from a Telegraph article:
Nevertheless, China remains the strongest economy among the major nations, with the Organization for Economic Cooperation and Development predicting a 6.3pc expansion this year, compared with a 4pc contraction in the U.S. and a 6.6pc decline in Japan. China is likely to shortly overtake Japan as the world's second-largest economy.
Returning to the article of Ambrose Evans-Pritchard, he talks of the purchase of copper by China, and the possibility of a commodity backed reserve currency. By implication, his article is now suggesting the RMB will be the new reserve currency. On the 2nd of March, I had the following to say:
However, the analyst makes a basic error in thinking that China would have to take an all or nothing approach. He does not consider that China might spread their reserves over a wide range of assets, and this is my best guess for the direction of China's policy. If they follow this strategy, and implement it with care, China has the potential to rapidly jump towards becoming the world's most powerful economy.
I went on to say:
The first step is to manage the sale of US treasuries with the greatest of care, such that they gain as much value of the sales as possible before the $US collapses. As they move out of $US they would likely buy as many precious metals as possible without driving the price too high, as well as buying into emerging market, European and Japanese bonds. In doing so, they will be taking risks but with the benefit that they will be positioning the RMB as the next reserve currency. Furthermore, it is no secret that China has been trying to buy into various commodity companies (or natural resource companies), such as the ongoing saga of the Chinalco purchase of Rio Tinto or their wider expansion of investments in this sector.
You may wish to read the original article, as it was a speculative piece about how China might become the economic power in the world. They seem to be following a similar strategy to that which I guessed/proposed that they would follow. In other words, they are on the path to success.

The point in listing all of these articles is that there is increasingly the smell of defeat in the air. China's growth appears to be an accepted fact, with no attempt to address the rise from the West. For example, the US has now backed down on the issue of the manipulation of the RMB:

President Obama repeatedly accused China of outright currency manipulation during the presidential campaign, and Mr. Geithner echoed that opinion during his confirmation proceedings.

But in a new report to Congress, Mr. Geithner not only refrained from such accusations, but praised China for its economic stimulus program and its move toward a more realistic exchange rate for the yuan.

“China has taken steps to enhance exchange rate flexibility,” Mr. Geithner wrote in a statement accompanying the new report.

In all of this, in the articles I have quoted, in the reality of China's expansion on the world economic stage, there is the smell of defeat. Quite simply, the West has given up.

Both the governments and the people of the US and UK are quietly folding their hands, and abandoning the game to China. All the while the US and UK governments rack up greater and greater debts that they can never hope to repay. There is a resignation to the defeat, alongside a terrible denial of the reality of the situation. There is a belief that somehow it is possible to endlessly conjure wealth from thin air, through more borrowing or the printing press. There is a belief that it is possible for governments to still provide, to still offer salvation, even while they set about the process of destroying the economies that might provide such salvation. There is a denial of the reality of China.

A few months ago, I predicted the collapse of the $US and £GB, and the deadline for my prediction is now very close. It looks like my prediction was premature - I was wrong. However, for those who might point out that I was 'wrong', take a look around you.

Do you really believe that we can emerge from this crisis?

From the recent faux optimism, the maneuvering of China into economic supremacy, the unending bailouts and stimuli being made with borrowed or printed money, the dogmatic spending by governments that refuse to reform, it becomes clear that is impossible that it can go on much longer.

We are defeated, because we have given up on the one thing that might pull us from the crisis. That 'thing' is the willingness to accept reality, to wake up, and to earn our place in the world. Instead, we continue to delude ourselves, continue to think that it will be better one day, but make no effort to change the situation. We have given up on our belief that our own situation is in our own hands, and believe that government can rescue us, that China can rescue us, that the world can rescue us.

Somehow, it will all come right in the end.....

My answer to this view is simple. It will not come right. If the $US and £GB survive another month, or another two, or another three, it does not alter their final trajectory. If we sit in an oasis of calm for the moment, it is only at the cost of a greater disruption - greater catastrophe - later. Yes, it appears possible for reality to be delayed, but economics does not work by magic. One way or another, the root of economic success is about the creation of real wealth - not the faux wealth of printed money and borrowing. Printing money and borrowing may delay, but they do not create the wealth that will change reality, they simply destroy that wealth. They may keep the economy moving for a while, but only at the cost of a more painful halt later.

On that very gloomy note, I will end the post.

Note 1: In light of the fact that I have now (probably) called the collapse of the $US wrongly, I was tempted to list all of the things that I have got right. However, I am not sure that this would not just be about flattering my own vanity, so decided against it. Also, as one of the 'big movers' in the world economy, calling the state of the $US wrongly probably eclipses the points that I have been correct about.

Note 2: Tiberius - I also read the story about Goldman Sachs going after a blogger. Hopefully my blogs are general enough to avoid such troubles, but I hope I would in any case still publish and be damned if the need arose. However, I do not think that I would attract such attention as things stand.

Note 3: I have read a long report on the state of the commodity markets. It is a report that has been lent to me, such that I can not quote it. However, it outlines a period of stagnation in the metals markets. By contrast, if Ambrose Evans-Pritchard is correct, it is quite possible that there will be some shifts in commodity prices in the coming months, and the trajectory will be upwards.

Note 4: I talked recently about the need for oil to be traded in RMB if the RMB was to become a reserve currency. I suggested that a back door for China to start this process might be Venezuelan oil. This from the NY Times:

In February, China’s vice president, Xi Jinping, traveled to Caracas to meet with President Hugo Chávez. The two men announced that a Chinese-backed development fund based here would grow to $12 billion from $6 billion, giving Venezuela access to hard currency while agreeing to increase oil shipments to China to one million barrels a day from a level of about 380,000 barrels.

Mr. Chávez’s government contends the Chinese aid differs from other multilateral loans because it comes without strings attached, like scrutiny of internal finances. But the Chinese fund has generated criticism among his opponents, who view it as an affront to Venezuela’s sovereignty.

“The fund is a swindle to the nation,” said Luis Díaz, a lawmaker who claims that China locked in low prices for the oil Venezuela is using as repayment.

This could be coincidence, but the article also deals with wider expansion of Chinese influence throughout Latin America. From my perspective, it is simply China positioning itself for the the crisis that will emerge with the collapse of the $US.

Note 5: Retail sales in the UK were up, according to a report in the Telegraph. If I remember correctly, it was in my last post that I mentioned that inflationary impacts might be reported in positive terms, giving the example of renewed asset price growth. It is therefore to the credit of the Telegraph that they reported the rise in sales as follows:
Last month was the first time since May that clothing sales rose. Sales were strongest in women's and childrenswear, as shoppers were attracted by the new spring and summer ranges. The value of food sales also rose, partly driven by inflation.
The important point is at the end of the quote; yes, if inflation is increasing then it is quite possible that there will be an increase in sales in monetary terms, but this is not a cause for celebration. Expect to see more examples of inflation feeding into figures.....I hope to write on inflation figures in the near future (events allowing).

Note 5: I have had a message from a commentator that a comment was not published. I am not sure why this was the case. If anyone else has had similar problems, please let me know. I am not sure what I can do, but if I know it is a widespread problem, perhaps I can find out the possible causes. As such, if you could let me know what you 'did' and what went wrong, it would be a great help.

Sunday, April 12, 2009

Wealth Destruction and Government Policy

I had not planned to post again so soon after publishing two articles in quick succession, but a recent article has been nagging away at me for the last couple of days. The article comes from The Times, and deals with a proposal to pay for the scrapping of cars:
It has been on and off for months, but a key announcement in Alistair Darling’s budget in 10 days’ time looks like being a car “scrappage” scheme. The motor industry is in trouble and thinks the best way to reverse an alarming slide in sales is to give people who trade in old cars for new or nearly-new ones a £2,000 allowance.
At the moment, this is still not UK policy. However, as the same article points out, this is not a completely new policy, as it has already been enacted in other countries:
Eight European Union countries – Austria, France, Germany, Greece, Italy, Spain, Portugal and Romania – have introduced scrappage schemes. The biggest impact has been in Germany, where sales last month were up 40% on a year ago, leading the government to treble its funding for the scheme. In France, with a smaller incentive, sales were up by 8%.
As can be seen here, the way in which the scheme is presented is to suggest that this is good and much needed policy. The article does include some critiques of the policy; that it is not 'green' and that the resultant sales of new cars will not necessarily stimulate the domestic manufacturers. To these obvious problems, it might be added (subject to the detailed final plan) that it will simply create a market in second hand cars to be sold for scrap in the scheme. i.e. cars that would be scrapped anyway will be sold to purchasers of new cars in order for them to qualify for the subsidy.

However, this is not the fundamental flaw with this plan, and no commentary that I have seen does deal with the underlying problem with this idea. This is the problem of what the the plan is doing in principle.

In particular, the principle is the wilful destruction of wealth in order to generate economic activity. Each car that is build represents the utilisation of labour, materials and capital to build the product, and the end product represents a store of that wealth. Whilst the value of a car declines, for every year of its life it still represents a store of the wealth that was created. When a person scraps a car before its 'natural' end of life, they are actively engaging in the destruction of wealth.

At the extreme, this is the equivalent of bombing a city to create activity, but without the drama and the inherent sense of absurdity that this represents. On the same principle, we might see a proposal to purchase toasters to scrap them, or the purchase of beef in order to throw it into landfill. Why not knock down some buildings, rebuild them, knock them down again, then rebuild them again? Why not scrap some bridges coming to the end of their life and rebuild them, as the construction industry need help too. The potential for destruction to create 'activity' is limitless, and might be applied to just about anything.

In all of these cases, there would be a destruction of wealth, and the economy would be 'stimulated'. The difference here, with the idea of scrapping cars, is that they are 'used', such that the principle of what is actually being done is not so evident. If the government were, for example, to purchase toasters and scrap them, there would be an outcry, but the underlying principle is identical to the scrapping of used cars.

As if the wanton encouragement of destruction were not absurd enough, this process is being undertaken with borrowed money. The government is therefore proposing borrowing money in order to destroy wealth. What that means is that, at some point in the future, £ 'x' million will no longer be available to, for example, build a hospital or pay for a school teacher. Alternatively, more taxes will need to be raised to repay the borrowing, meaning that you will have £ 'x' less to buy yourself a new car. It is perhaps in this latter example that we can best see the absurdity of the situation. Your future ability to purchase a new car will be diminished because the government is borrowing money to destroy the wealth that is inherently retained in another person's car.

A few months ago, I highlighted an article in the Economist magazine in which they discussed how Hurricane Katrina would create an uptick in GDP. In the post, I highlighted how the massive destruction of stored wealth represented by Katrina could be seen by Economists as a 'good thing', and how absurd such a notion was. However, this was the destruction of wealth through natural disaster, so perhaps might be excused on the basis of trying to look on the positive side of a bad situation. In the case of car scrapping it is an act of destruction devised and enacted by government.

If ever there were an indication of the absolute bankruptcy of ideas to fight the economic crisis, an indication of the underlying idiocy of government policy, then surely this is it. They are acting to destroy wealth to 'save the economy', and doing so at the expense of the future economy. They are spending future wealth in order to destroy present wealth.

Quite simply, the mind boggles.

Friday, April 10, 2009

Cheer Up! We are Over the Worst! Huh?

I have recently been astounded by some reports in the media. It appears that many outlets are collectively starting to call the end of the economic crisis. I am, of course, being very broad brush here and there are dissenting articles, dissenting media, but the trend is clear. Perhaps the most astonishing of the stories is this one from Time Magazine:
But, the great banking crisis of 2008 is over.
My response to this proposition is to ask what exactly would happen to the major banks if governments were to announce next week that they were no longer offering any bailouts, support or guarantees - that the government simply went back to pre-crisis business as usual? Does anyone seriously think that the banks would stand? Or would they be declared insolvent?

When I read an article like the one in Time, I can almost sympathise with the conspiracy theorists, as it is hard to believe that this anyone might write this without some kind of hidden motivation. Alas, I actually believe that the author actually believes this. This is a more scary scenario, as it reveals how completely lost/hopeless the mainstream media can be.

Perhaps the most interesting point in this upturn in optimism is the way that the media are presenting some pretty awful statistics. The method of presentation mirrors that of politicians, such as Barack Obama:
President Obama pointed to a 20pc rise in government-backed loans to small businesses last month and a "very significant" pick-up in mortgage refinancing as evidence that markets are improving. "We feel confident that as we deal with problems in the banking system that we're also fixing the non-banking sector when it came to auto and credit card loans," he said
According to Obama small businesses borrowing money that will only be lent with government guarantees is a good thing? As for mortgage refinancing, the actuality of the situation is:
Fannie Mae, the larger of the two government-sponsored entities that process refinancing requests under Obama's mortgage-relief plan, just began accepting automated applications from mortgage lenders on Monday, a spokeswoman said. As of Thursday, fewer than 1,000 loans had been refinanced under the program, said a Treasury official, though the official noted that the pace is expected to pick up dramatically in the weeks ahead.
So what we have here is a government backed programme, which has achieved a grand total, across the whole of the US, of 1000 loans, and those have been given to fund mortgages that are apparently not in trouble. More troubling is that anyone might think that people accepting government subsidies to make up for lack of equity in their homes might be a signifier of an improved economy.

An example of this kind of thinking in the media comes from Businessweek, who paint a picture of an economy possibly having reached the bottom of the slide. Whilst they add caveats to their discussion, they still paint a positive picture, as in the following section:
Consumers were far less tight-fisted in January and February than they were at the end of 2008. Retail sales excluding autos rose strongly in both months, after declining for five months in a row. And in March, car sales rose to a 9.8 million annual rate, from 9.1 million in February, while weekly store receipts continued to hint at fading weakness.
The point I would like to highlight here is the use of the expressions 'fading weakness' and 'less tight-fisted'. Also, note the use of 'annual rate', in which the figures are extrapolated to a year. I have seen this kind of language/presentation in other articles. A slow down in the rate of increase in unemployment becomes a sign of recovery, an uptick in any indicator from a very negative base becomes a sign of recovery. What these presentations are trying to hide is that the underlying figures are actually dire, but they are presented as positive - as they are less dire than they might have been. There is no reason to propose that these are signs of turning the corner, as they are just as likely a pause for breath in the downward slide, or might be a move to a slower but continuing decline.

One of the optimists in chief is Larry Summers, a White House economic policy aide. His positive remarks have been widely reported, but I like the Reuters reporting for the following passage:
The decorated economist said it remained unclear how long it would take for the economy to return to strong, sustained growth, though he did cite "anecdotal" signs of improvements in credit markets that would allow inventory cycles to return to normal.
In particular, I liked that they clearly point out that his comments are unsubstantiated. I suspect that the view from the White House (excuse the metonymy) is that a dose of 'confidence' will somehow 'magic' the economy back on to the right tracks. However, it is hard to see how confidence can magic the economy back into action when 654,000 people became unemployed in the US in the previous month. Once again, in the article I used for the statistic, there is a positive spin placed upon this abysmal figure by some analysts:
"The good news is that the trend in initial claims isn't worsening. The bad news is that the level of claims still speaks to a very weak labor market," said analysts in a note to clients.
How anything about such massive lay-offs can be 'good news' is simply puzzling. 'Yes', the figures could be worse, but that they are not worse does not represent 'good news'. As for a 'very weak' labour market, the word abysmal is more to the point.

An excellent pricking of the optimism bubble is provided in Canadian Business, which says the following in response to news that new home sales had risen in the US:
Take that housing report. Sales may be up, but median prices for new homes continued to decline, tumbling 18% in February from a year earlier, to US$200,900. As Nicolas Retsinas, director of the Joint Center for Housing Studies at Harvard University, explains, "It's helpful to think of the U.S. housing market as effectively two markets. There's the market in foreclosed properties, where, if prices drop dramatically, it stimulates some economic activity." (That explains the recent uptick in sales in such hard-hit markets as Surprise, Ariz.) However, the rest of the market remains "stalled," Retsinas adds. "It's hard to imagine that market recovering until we see a full economic recovery across the U.S."
What all of this 'good news' represents is that the speed, the rate of acceleration of the decline, may have slowed in some areas for a brief period, or positive spins on negative figures. In all cases the statistics are being measured against horrendous bases, and in all cases there is no signifier of a new upward trend, just isolated statistics.

Having said this, it does occur to me that, at some point, all of the newly printed money being pumped into the world economy must have an effect. I have long discussed the inflationary effects of the surge in money printing, and at some point this must feed into a sustained rise in asset prices. However, this will not be a rise based upon an increase in the value of the assets, but rather a price rise due to the devaluation of money. In the event that this takes place before a $US collapse, expect to see such inflation portrayed as a signifier of recovery. The fact that such a 'recovery' will be a precursor to massive or hyper inflation will, no doubt, pass the optimists by.

I suspect that what we are seeing at the moment is 'bad news fatigue'. The bad news over the last year has been relentless, and I think that what we might be seeing is the start of a reaction against this. Perhaps it is simply a case of, in the broadest sense, people just becoming tired of hearing negative news, and are simply looking for any sign that might be hopeful.

Note 1: Acrobat 747 commented on my article on the RMB as the new reserve currency, suggesting that the Chinese economy is too small. A commentator 'Novice' responded by pointing out the problems of measuring GDP, and I would agree with that point. One of the themes of this blog is that GDP is a flawed measure of the wealth in an economy.

Note 2: Tiberius posted a very interesting link, which describes the US government undertaking economic 'war games'. The following is a quote from the article:
In the end, there was sobering news for the United States – the savviest economic warrior proved to be China, a growing economic power that strengthened its position the most over the course of the war-game.
This 'game' may well have ramifications in US policy making. It is one of those articles that could easily be passed by, but which may have reported something with profound influence on future policy. It is only possible to speculate on how much influence it may have, but it is quite possible that, just by playing out the scenarios, the US may be forced to confront its inherent economic weakness. To quote Tiberius:
Whatever happens, I don't think the US will take it laying down.
I think that he may be right. The US government must now be painfully aware of the vulnerable position of the US economy with respect to China. One way or another, they will have to confront the challenge posed by the rise and rise of China. We can only hope that the response is appropriate, as I can see no other way than directly addressing Chinese quasi-mercantilism directly, and that is a scary path.