Friday, February 12, 2010

Eyes are starting to open and see the world as it is

One of the long running themes of this blog is that people have chosen an illusionary vision of the world rather than confronting reality. My argument has always been that, in the end, reality would confront the illusions and blow them away.

When I wrote my first essay on economics, 'A Funny View of Wealth' in November 2007, I wrote of the illusion of wealth in the UK, pointing out how the underlying basis for the apparent wealth of the UK economy was actually just the accumulation of debt. I described how, when the debt fuelled growth disappeared, the economy would spiral downwards, as unemployment rose, as the 'service' economy contracted. This is what I said in my conclusion:
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 the government is forced to cut back, many of the new state sponsored jobs that have been developed over the last ten years will start to disappear. This will not impact immediately, where funds have already been allocated, and contracts remain, but the process will accelerate over time. Some regions, such as the North East, will be hit very hard, as their economies are largely dependent on the state sector.

The situation overall will be a massive contraction in the UK economy, a contraction that will see the UK step back in time in terms of economic development. The contraction will need to be deep and severe enough to reverse the illusory gains of the previous ten years (or even longer), and will require that the UK restructures its economy from top to bottom. It will, in effect, be the most significant crisis to hit the UK since the World War II. The only way out of the crisis will be to alter the fundamentals of the UK economy back to producing more goods and services for export led growth, and away from debt based growth in services. It will be a long, and very painful adjustment that will see the UK lose its place as one of the worlds’ leading economies, and recovery from the crisis will take many years.


It would be nice to end this conclusion with a sunny and positive note for the future, and to say that the UK economy will bounce back. However, this would require major changes in the structure of the UK, changes that will be hard to make. I worry that the politicians will not have the courage to lead the people of the UK through such changes, and therefore wonder whether the bounce back is possible.
When writing this, I was just focusing on the UK economy, but much of what I said might have been applied to economies such as the US. At the time of writing the diagnosis of the problem was radical, and there was still a widespread belief that all was well with the economy of the UK. In the years since writing this, I have seen how the analysis of the situation has gradually and steadily moved into the mainstream. The idea that the pre-crisis boom was built upon a bubble is now accepted, and one illusion has been partially blown away.

In May 2008 I wrote an update, and suggested that sub-prime would just be the start of the financial crisis, that the situation would only get worse. A short while later, in a fit of frustration, I commenced my critique of the idea that GDP represents anything other than an illusion. It is a theme of this blog that GDP is a useless metric, and I expressed my frustration as follows in June 2008 (for the UK):

I have since refined this basic point, and continue to express my frustration. Despite this, I still see economists and analysts talking of economic growth in the economy, when what they are really referring to is debt based growth in activity. It is an illusion that has yet to be punctured. We can still see celebrations of 'return to growth' which is based upon nothing more than activity stimulated by government borrowing. At some point, this metric, so beloved of policymakers, will finally be recognised for the delusion that it really is.

A short while before writing of the problems of GDP, I wrote of the 'Cigarette Lighter Problem'. The problem I identified was determing why a cigarette lighter purchased in a developed country conveninece store might cost nine times the price of an identical lighter purchased in a similar Chinese convenience store. Somewhere in the developed economy, some sector of the economy must be adding massive amounts of value to justify such a differential. The problem that arose was to understand where so much added value might be found, for example in comparison with a fast modernising China. The answer to the problem is that, in part, the price of the lighter is founded in an economy that is awash with debt.

My experience of living and working in China has had a profound effect on the way that I have viewed the economic crisis. It presented a reality check, a perspective on the way that the world economy has been reshaped by the massive input of labour into the world economy. I will not rework a post that I have recently made, in which I have reiterated my underlying explanation of the economic crisis as a massive supply shock from the increase in the world labour force. I suggest you read the most recent post on the subject here for an outline of the argument (though the argument was first presented in the blog in July 2008).

What I will emphasise is the consequence of the change in the structure of the world economy. We have entered a period of hyper-competition, and the developed world is losing to the emerging economies. What we are seeing is a massive shift in the distribution of wealth from the 'developed world' to the 'emerging economies'. This is the foundation of my thinking and views on the economy, and the argument is the foundation for my complete rejection of every response that has been made by policymakers to the economic crisis. Whatever happened, if you drop a massive surplus of labour into the world economy, competition would inevitably intensify, and the only response is to become more competitive.

In an article for TFR magazine, I used the example of the Tata Nano and SUVs to represent the fundamental shift in the world economy. Whilst the Tata Nano has order books that it can not meet, the sale of SUVs have shrunk. For the latter, the SUV represents a concentration of debt fuelled consumption, and could not be sustained, and for the former it represents the rising middle class of the developing world and the redistribution of wealth towards the developing world. The process has seen a move of the world market, in which the middle is progressively moving down and broadening, with emerging middle classes taking a greater proportion of global wealth.

There are two pictures of the world economy. In one picture, in the mind of policy makers and many economists, there is a belief that the SUV economy still exists or might exist. Their responses to the economic crisis is to try to recreate the SUV economy, and to reject the notion of the Tata Nano economy. It is the most grand of all the illusions. It is the belief that the real state of the world economy has not shifted. It is the belief that if we can only return to the consumption levels represented by SUVs, all will once again be well.

The problems of such an illusory picture of the world economy is best expressed by the obsession with consumer spending, and the price of housing. As an example, even as Greece spirals downwards, the worry is that, if Greece implements the austerity necessary to start to live within its actual wealth generating capacity, it will see a downwards spiral as unemployment increases, activity decreases, and revenues for the government slump. What this actually means is that, if borrowed money is removed from the Greek economy, we will actually see the real level of wealth creation in the Greek economy, and it will not be a pretty sight.

As for Greece, the same might be said of countries like the UK and US. The massive borrowing in both countries are an attempt to maintain the illusions of the SUV economy. It works like this; if you borrow money, the money lands in the pockets of consumers who spend, creating more activity, and they then pay taxes from that borrowed money, thereby increasing government revenues and increasing GDP.

The problem is that part of the money that is returned to the government is actually rooted in the borrowing of the government in the first place. The government gives out borrowed money, only to have a portion consumed before some of the government borrowed money is returned in taxation. The more governments borrow, the more money that appears in the economy, and the more money, the greater the activity, and the greater the activity, the greater the tax revenues.

It is all so neat, except that the increase in revenues is the result of borrowed money in the first place. The government is just indulging in a borrowed money merry-go-round, with each round of activity simply resulting in the consumption of a proportion of the borrowed money. All the time this takes place, ever more unsustainable deficits are accumulating.

If we look at Greece, we are simply seeing the potential for the underlying reality of the Greek economy to be revealed. The Greek people are expected to react with anger to the austerity that they are facing. The problem is that their government has, in effect been feeding them an illusion that they are wealthier than they actually are. The Greek people, it seems, simply do not want to accept that they are much poorer than they believe. They are no different to the people in countries such as the UK or US. In all cases, people just want the credit taps held open, and want to believe that they can continue to live beyond the means of their real collective output of wealth.

The problem is that Greece is simply the first in a line of countries that must finally accept that they are really much poorer than they think. This returns me to exactly where I started in my essay 'A Funny View of Wealth'. It is the idea that the consumption of borrowed money is the same as wealth creation. It is the fundamental illusion of the economists and policymakers. It is the illusion upon which so many other illusions are built. It is the foundation of government policy, economic analysts, and much of the commentariat.

However, as we are now seeing with Greece, and the threat of sovereign debt default contagion around the world, reality must one day intrude on the delusions of the SUV economy. In the Greek crisis, we finally are seeing the opening of eyes. The aggregate output of each individual that comprises the output of the Greek economy simply does not create enough added value to support the aggregate consumption of each individual. The reality is that, if a Greek individual is earning Euro 20,000 per year, the government is also borrowing over 2000 Euro's on his behalf and using that money to support the activity of the individual, and other individuals, within the economy. It is a self-reinforcing loop of delusion.

This is economics. The economics of illusion. And reality is starting to shine a painful and illuminating light on the illusion. Maybe, just maybe, the policy makers can just deflect the light of reality a little longer. A bailout of Greece might delay the illumination, but nothing will alter the reality that Greece, Spain, Portugal, Ireland, the UK, the US, are all in the same illusionary world as Greece. Many more might be added to the list.

All these countries share the same problem that can be summed up as; they have 'a funny view of wealth'.

Note 1:

A few of the latest headlines suggest that the Greek problem is spreading, with gilt yields already rising. Meanwhile, the EU support for Greece remains opaque, leaving the situation unresolved at the time of writing. It also is notable that an increasing number of writers are expressing concern about the lack of credible plans in the UK to tame the government deficit. In many cases these are the same authors who supported the massive intervention in the banks, and supported the fiscal deficits. Regular readers will know that I would have seen no such interventions, and would have allowed the very painful adjustments needed in the UK to take place sooner rather than later. The policies of the UK government and central banks have now just made the scale of the underlying problems even greater.

Note 2:

I wanted to write a post about China, but have been distracted by the Grrek crisis. I noted some interesting stories which seem to confirm my worries about China's role in the world economy. For example, I have previoulsy highlighted how China has used $US reserves to threaten the US before. In the early example I cited over a year ago, they used a proxy to make the threat during a period of trade sensitivity. They have done so again, this time using the military to make the threat. This method allows the government to deny the threat, whilst still having it 'out there'.

Another story reports of UK companies seeking to leave China due to the way that they suffer at the hands of the Chinese government's mercantilist policy. Again, it touches on a theme I made in earlier posts in which I described the way that the Chinese government would seek to diminish overseas companies in China.

I have long suggested that the RMB is being positioned as a replacement for the $US, with many suggesting that this is fantasy. However, the idea is steadily moving into the mainstream, as in this quote: 'The Chinese are very interested in the yuan becoming more important internationally'. It is hardly an endorsement of my thesis, but it is the baby steps towards it, and I have noted that this kind of view is gaining currency. With more time, I could have dug out similar views, and views closer to my own views (e.g. Roubini).

Another article that grabbed my interest is one which doubts the Chinese economic miracle is sustainable. I frequently include caveats in the discussion of the rise of China, and believe that there is potential for China's trajectory to turn. In particular, if the economic crisis does accelerate, I am not sure whether China will be able to manage to pull itself through unscathed, in particular if there is a serious challenge to China's currency manipulation from both Europe and the US. However, in the meantime, China looks to be well placed, and in a position to continue shopping for resources and new technology to help ensure the ongoing rise.

All of these points really need expanding, but time allows a brief summary only.

Note 3:

I will be away for a couple of days, so may take a while to publish your comments.

Sunday, February 7, 2010

The Greek Problem

A storm has slowly been brewing in the press over recent weeks in regards to the state of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). According to some analysts, the Euro area itself might be at risk of break up.

Before going further, it is worth mentioning that the dangers that we are now seeing are hardly unforeseen. I trawled through my own blog and found several of my own references to the problem (but probably missed many others), such as the following in a post from 2008:
Also, an interesting comment from VKP who suggests that the UK and Greece have many similarities. I am not as familiar with the details of the economy of Greece as I would like, but am aware that they are running very large deficits. I have mentioned the possibility of the abandonment of the Euro, and the state of the finances of Greece is one factor in that consideration. I am not sure how much longer Germany will play ball....
And a little later, at the start of 2009:
As an aside, I long ago suggested that the cohesion of the Euro might be strained as the economic crisis progressed, and there have been an increasing number of articles recently mirroring this view. I still believe that the Euro may not come through this crisis, and think the likelihood of either a partial falling apart, or complete abandonment of the Euro is possible. We could yet see the return of the mighty Deutsche Mark. As such, if you hold any Euros, make sure that they are held in a German bank in Germany....
More recently, I described the problems of Greece as an 'outrider' for larger economies - as a foretaste of the coming problems. I have not been alone in these early concerns for the Euro in the economic crisis, but have no references for those that were sharing them (apologies). However, the view that I shared with such Euro pessimists was that it was not possible to have a stable currency with the huge variations in individual government policy and economic structures. It was the tragedy of the commons writ large, with the Southern European states acting as free riders. With no method of effectively enforcing discipline and rules, it was possible to free ride in the system. The economic crisis would just bring these problems to the surface (though I had not imagined in such a dramatic way).

Despite this, the Euro enthusiasts have a counter argument. In a recent outing to a bar, I was speaking with a German on the subject of the risk to the Euro, arguing that Germany would not tolerate bailing out Southern Europe when confronted with its own problems. His response was to highlight the position of Germans as 'good Europeans' (including mention of Germany's troubled history) and that Germany would therefore support the integrity of the Euro area. I expressed my doubts about this, suggesting that Germany would not support profligate spending.

The attitude in Germany is of particular interest due to the economic weight in Europe, such that their agreement is essential for any bailout to proceed. This is from Die Welt:

"The EU has given Greece a long leash for far too long. Now Brussels has no choice. All that is left is the weak instrument of budgetary surveillance and a vague hope that, somehow, everything will go well. Sanctions, such as the freezing of EU subsidies, penalties to the tune of billions of euros or exclusion from the monetary zone are not feasible. Any such step would plunge the Greeks even further into the abyss and weaken confidence in the euro even more."

"Brussels is backing strict austerity measures. That is correct, but also wrought with dangers. The planned massive spending cuts and tax increases could stifle the economy of Greece and lead to deflation -- causing a vicious circle. The Greek drama is far from finished. It may well be that a few euro countries like Germany will soon have to jump in as a savior, offering billions in bilateral aid. That would be bitter pill to swallow."

Variations on these themes can be seen from other news outlets in Germany. I strongly recommend the summary contained in Spiegel Online if you would like to understand the direction of German sentiment.

I emphasise the press reactions, as the basic question that arises from the Greek crisis is not a question of economics. The EU has always rested upon compromise, upon politicians measuring their national interest against the 'great European project'. Such compromises have always been hard to sell to domestic audiences, but the problems of the Southern European states are a scale of a different order. It is very tough indeed to justify, when you have your own problems, why you might wish to bail out those whose problems are largely of their own making. Having said this, the elites within Europe have often managed to their goals in the face of opposition. Might they manage this in the face of crisis? I am really not sure.

The point I am trying to make here is that the Euro is more a political confection than it is an economic unit. The same may be said about all currency, but the existence of the Euro relies upon a continuing process of compromise and tolerance. The indications are that Germany are increasingly unwilling to bail out Greece, despite the potential for a broad crisis for the Euro itself. A search against 'Euro' and 'Greece' paints the picture of the sense of crisis for the Euro. One headline says it all, with the Sydney Morning Herald suggesting that 'Greece Trips, Euro Could Fall'.

The crisis in Europe has profound implications. I have long argued that the continuance of the massive accumulation of government debt in the 'rich world' rests upon a flimsy premise. This premise is that delusion that the Western world (and now Japan) have always been rich, and will always be rich. Iceland could be dismissed as exceptional, Dubai was still not the 'West', but the fall of Greece risks a spreading crisis that will undermine the belief in the 'rich world'. This is a Euro economy, and whatever the particular peculiarities of the Greek situation, the cracks in the edifice of belief will enlarge. As I have also long argued, the deficits of the major debtor economies are structural, and will not disappear. The cracks in belief will refocus minds on this underlying reality, and the closer the reality is examined, the greater the cracks will grow.

Will the crisis in Greece be enough to herald the denouement to the lax and unsustainable fiscal and monetary policies that have supported countries like the UK and US? Much hangs on the response to the crisis, but a response of a bailout will only serve as a delaying mechanism. Furthermore, a bailout might further stretch the economies of those that come to the rescue of the PIIGS, with Ambrose Evans-Pritchard of the Telegraph comparing the potential damage to the absorption of HBOS by Lloyds.

Chickens are coming home to roost. And for those who say that countries who have control of their own currency are in a different situation, the answer is very simple. The only way those with control of their own currency can avoid the same crisis as Greece is if they inflate away debts. However, doing so whilst raising record amounts of debt on international markets looks to be implausible. The US might get a benefit of 'flight to safety', but only for a short while. At some point, investors will realise that they have fled the bear only to hide in the bear's cave. It is an analogy I have used before, as the US is no haven of safety.

The position now is; 'wait and see'. A cobbled compromise might serve to delay the final act of the economic crisis. However, it is possible that the economic crisis is entering the last act. If Greece topples, who will follow?

Note: I have included Ireland in the PIIGS acronym, and Ireland is certainly at risk. However, Ireland is facing the fiscal problems head on, and should really be in a different category. I am not saying that it should be considered and treated as safe, but that it should be viewed as less of a risk than the other PIIGS. I have great respect for the efforts of the Irish government to reign in the deficits, and therefore will be sorry to see that their efforts might have come too late (or the crisis too early???).

Friday, February 5, 2010

Why the Risk of Sovereign Debt Crisis?

The subject of this post will be familiar to long term readers of the blog, but I will nevertheless plunge on with newer readers in mind. I have just read a column by Jeremy Warner in the Telegraph, in which he describes how he sees the progression of the economic crisis. It is an analysis with which most analysts, politicians and commentators would broadly agree. The problem is that it is wrong.

The interesting thing about the analysis is that it is made in the context of the sovereign debt worries about the PIIGS (Portugal, Ireland, Italy, Greece Spain), and the broader worries about the AAA rated larger economies such as the US and UK. His view is that this is a new potentially damaging phase in the crisis. This is how he describes the first two phases:
The first was a fairly conventional, if extreme, banking crisis where a cyclical overexpansion of credit and lending suddenly, and violently, corrects itself in a great outpouring of risk aversion.

In the second phase, governments and central banks attempt to counter the economic consequences of this crunch with unprecedented levels of fiscal and monetary support. Temporarily, at least, it seemed to work.

The reason that this is wrong is that the first phase is not actually the first phase at all. Something else entirely caused the current economic mess, and the risk of sovereign default naturally flows from the real first phase (it is a long post, but if you stick with it, it will be clear why the sovereign debt crises are inevitable). I first discussed the real causes of the economic crisis in a series of posts that steadily built a picture of what was going wrong in the world economy. The posts tracked my evolving thinking on the problem, up to the point where I identified the real cause of the current economic crisis (some of the key posts in the development of the ideas are here, here, here, and here).

My cause for the crisis does not originate with the financial crisis, but with shifts in the world market for labour. In particular, I track the economic crisis to the massive expansion in the world labour market that commenced with the full entry of China and India into the world economy (as well as a more broad expansion e.g. Vietnam, but these are the two major factors). It might be noted that the labour was already in place in these markets, but the key difference was that there was a change such that these labour markets were connected with world markets, capital and technology. It is impossible to pick a specific date when they started to impact upon the world economy, but I consider the late 90s as an approximate starting point.

If we want to understand the degree of impact of such a change, we just have to think of labour as a factor of production. The greater the supply, the lower the cost of the supply. Both in China and India there are vast pools of labour that is still not fully connected into the labour force, but with potential to be connected. The migration of lower value manufacturing to the West of China is an example of how partially connected labour is continuing to be brought into the world economic system.

What this amounts to is a massive expansion of availability of one of the key factors of production, such that there is an oversupply of labour. However, in order to make this labour productive, it is necessary that the labour has access to the other factors of production, such that the labour might be utilised. These other factors commence with the supply of commodities. I will try to illustrate the point with a simple illustration.

If the world standard of productivity is such that each unit of labour can process 1 unit of commodity, and there are 100 units of labour, the available commodity supply must exceed or equal 100 units for the labour to be fully utilised. If the commodity supply is less than 100, then there will be unemployment/underemployment until the supply of commodities catches up with the supply of labour.

We know that life is not that simple, with variable levels of productivity, but the underlying principle nevertheless applies. In order for labour to be productive, it needs to have a supply of commodity that matches demand according to the potential productivity of the time commensurate with the available supply of the input factor of labour.

What we have seen with the entry of emerging economies is a massive labour supply shock, which is a supply shock that might be regarded as unprecedented in world history (perhaps new world silver supply expansion might be comparable?). The important point about the supply shock is how the supply of the other key input factor responded - the supply of commodities. I will quote from a previous post rather than rewriting the section.
The best example of the problem can be found in oil, as it is still so central to economic activity. In 1997 output was around 75 million bpd, and output had only climbed to about 85 million bpd in 2007 (a chart here shows the output - not a good source but the chart is usefully clear and conforms to charts from better sources). Copper has seen higher growth in output from around 11 million tons to 16 million tons over the same period, but this would still suggest that the growth is still probably not matching growth in labour.

However, not all of the commodities have seen a similar pattern to these examples, with iron ore output nearly doubling over the same period. Whilst this might suggest that there is no problem, it is necessary to remember that countries such as China have been growing infrastructure at an astounding rate, such that their demand for steel will be exceptionally high in comparison with a 'developed' economy (take a look the pictures of Pudong in Shanghai, or Chongqing and you will get a visual sense of one source of demand).
The point here is that there has been a major bottle neck in the supply of one of the key inputs to production, and that the supply of other commodities has not fully reflected the extraordinary demands created by emerging economies. The increase in the supply of labour in the world economy was not accompanied by a commensurate increase in supply of materials for labour to process, and for the extraordinary infrastructure development of the emerging economies.

The other side of this coin is, of course, that the final output of commodities and labour is consumption of the value created by labour in conjunction with commodities. As fast as new labour enters the market, there is a demand for supply of commodities to process, but also increase in demand for consumption of the output of the factors of labour and commodities. Again, a simple illustration will make the point.

If an average Western consumer is consuming one unit of commodities per year, and there are 100 consumers and 100 units of available commodity, it is possible for the one unit of commodity consumption to be sustained. However, if we add 20 consumers per year, and then add only 10 units of commodity per year, it is possible to see that the world average of consumption per person is falling. This, of course, does not make sense. In particular, countries such as China have grown richer, such that the Chinese consumer now has the means to buy more goods and services than before. The point here is that countries like China were so poor, they barely registered per unit as consumers, just as they did not register as labour in the world economy. What is really taking place is a reduction per person of available commodity, alongside a redistribution of this lower per person supply.

In essence, the supply of commodities has increased, but not in a way sufficient for each person to utilise the same amount of commodity as a pre-economic crisis developed world consumer. As such the proportion of available commodities available to places like China is increasing in proportion to the developed world, at the cost of the availability of those commodities in the developed world. The available resources of the world are steadily transferring to countries like China, and the only way for the developed world to maintain the current standards of living is if there is a massive expansion in the supply of commodities.

The big question is how this relates to the sovereign debt crises that are looming. I am afraid this requires more explanation.

If we jump back in time to, for example, the entry of Chinese labour into the world market in relation to the US economy. We see that the Chinese were savers and the US were debtors. It is no secret now that China has been playing a large part in funding the US government deficit and that there have been ongoing negative current account balances in the US. Whilst the US has remained an industrial power house, in aggregate the country has been consuming more than it produces. If we think of the real shift in the balance of resources that has taken place, what we can see is that the Chinese share of the available resources has been increasing, and that it has taken a proportion of that increased resource, and handed it back to the US as credit. This has hidden the real shift in the balance of resource allocation.

In the US, the lending of that proportion of Chinese resource has allowed consumption to continue as if the rebalancing did not take place. In China, it has hidden the real increase in wealth of the Chinese. In the short term, it has appeared that the US is wealthier than it is, and that China is less wealthy than it is. However, the reality is that it is the lending of one country's resource share to another country, and needs to be repaid. If the US does pay, then China will start to increasingly appear as it really is - a far more wealthy country than is presently apparent.

At this stage, you will note that I have not mentioned the financial crisis at all. This despite the fact that nearly every analyst points to the idea that the current crisis was all due to irresponsible lending by the banks. How does this fit into the cause of the crisis that I have discussed here?

There are a multitude of factors that contributed to the crisis, such as the nature of financial regulation, the role of central banks, and the role of government policy more broadly. However, the real root of the financial crisis lay in the provision of ever greater levels of credit to consumers. The source of that credit was from many sources, such as the petro-economies who benefited from rising prices of oil, which in turn reflected the lack of supply matching the increasing demand from the increase in labour. Then there was the supply of credit, exemplified by Chinese lending into the US. Finally, there was central bank policy, best exemplified by the Japanese carry trade, which flooded the rest of the world with Japanese credit, fresh from the Japanese bank's printing press (takes some explanation, see here).

The overall net effect of this was a flood of money into the developed industrial economies. When a bank is offered money, it is highly unlikely to turn it down, and will seek to profit from utilising that money in pursuit of profit for itself and the originator. The problem that arose in this situation of the flood of money is the question of where it might go. If there is a huge supply of money, the first tranche is likely to go into investments in which the risks are well balanced, the second tranche is likely to go into a slightly higher risk investment, and so forth. At any given moment, there are only so many good investment opportunities, and problems arise if there is more available money for investment than good opportunities. However, if there are a dearth of opportunities, then the bank will still find opportunities, even if these are higher risk.

Thus was the consumer boom born, and the service economy built on asset price inflation and debt. This 'new economy' was (in most analysts' minds) different from previous booms, as a virtuous cycle of increasing asset prices supported increased credit, which supported increased service activity and consumption, which increased employment and so forth. The trouble was that, it was not different, but was a massive expansion in credit fuelled by the lending of resource from the rest of the world that needed repayment. The wall of money that was being introduced into the developed world economy was not being invested, but being consumed. If you wanted to invest in productive output, long term investment with a return in wealth generation, all the 'action' was in the emerging economies.

Sure, there were investments in many sectors of the developed world economies, but these investments were largely made in support of the boom in consumption. That consumption was achieved by a combination of internally generated resource, but also with the loaned share of the resource of the overseas creditor. Large sectors of economies were, in the long term, unsustainable.

The financial crisis was simply the unwinding of the many mal-investments as the unsustainable nature of the credit boom became apparent. As the banks made losses, the overseas creditors turned off the taps to the banks. As fast as governments poured money into the financial system, the money flooded out the back door to repay the losses of overseas creditors. If we think about it, as the government bailed out bank A, if the problem was internal creditors, the money would have reappeared in bank B as new credit for lending. Instead, as fast as governments poured in money, it appeared to vanish. The only way that governments could keep the whole system up in the air was to use quantitative easing and massive purchases of distressed assets. In doing so, the losses of the banks, and the losses of overseas creditors appeared on (in the broadest terms) government balance sheets.

Effectively, the overseas credit spigots were turned off, and the only way that credit could be obtained was through the government. The direct credit from overseas lending was simply rechanneled through the government, and thence again appeared in the banking system or as direct spending in the economy. The government had become the debt fuelled consumer of last resort, in an attempt to hide the fact that the economy no longer had the underlying wealth of the past.

If we return to the point about resources in relation to labour, it is very clear that, if the emerging economies were utilising a greater share of a diminishing per person availability of resource, someone somewhere was, by definition, poorer. I was in China in 1997, as a boom in television manufacture took place, along with a boom in the consumption of this good within China. Each television that was consumed in China represented a redistribution of the allocation of the resource of the world into the hands of Chinese consumption, and a move of resource into the hands of Chinese labour. Had the world increased the supply of resources, or commodities, commensurate to the growing supply of labour, this would have presented no problem.

This is not what happened.

We can make an analogy of the resources as a pie. Even as the resource pie is growing, you are confronted with a zero sum game. The number of people sharing the pie is outstripping the growth of the pie, and somebody therefore has to lose. If we want to understand why sovereign defaults are inevitable, we just have to see the actions of governments for what they are. They are pretending that the share of the pie has not moved, and are borrowing the share of pie of others in order to convince their electorates that nothing has changed. The problem is that, even as they borrow a proportion of that pie from others, there is an expectation that it will be returned in the future. Even as the developed world governments borrow, their relative share of the pie continues to diminish, leaving them in a situation where they are committing an ever greater share of a diminishing share of the pie to the creditors.

It is all unsustainable, and no amount of monetary tinkering will change the reality. As labour entered the world economy at a faster pace than resource growth, somebody was going to lose. Monetary tinkering and borrowing will not be able to change this reality, which must somehow emerge.

Note: I have not discussed why the emerging markets have won a greater share of the resources, as the post was already very long. Apologies for this, as it is an important component of the argument, but I am sure there will be many suggestions provided in the comments. There is a great deal more detail that could be added, but I wanted to keep the arguments as simple as I could. I hope that it is clear, and that I have made no significant errors (sometimes it is hard to summarise these kinds of ideas).

Thursday, February 4, 2010

The Pause in Quantitative Easing

Finally, the Bank of England has ended the policy of Quantitative Easing (QE), albeit that they are describing it as a pause:
The Committee will continue to monitor the appropriate scale of the asset purchase programme and further purchases would be made should the outlook warrant them.
The weasel worded technical name has never hidden the underlying reality of QE; that it is identical to the running of a physical printing press to print money. The vast majority of that money has gone into the purchase of government debt, and the cumulative purchases have been enough to have funded much of the unprecedented peacetime debt racked up by the government:
The amount spent by the Bank of England on its asset-buying program since March is almost 89 percent of the 225.1 billion pounds of bond sales planned by the Debt Management Office for the current fiscal year.
The fig leaf used to justify QE was the prospect of CPI deflation, and with CPI inflation moving higher, the initial justification for QE has disappeared. The bank must now leave the UK government to sell its debt to private investors and overseas central banks. The timing of the ending of QE has both positives and negatives.

On the positive side, there is a looming general election, and the possibility of a new government that might make real cuts to the size of the government deficit. The Conservative Party still looks the likely winner of the election, and have expressed greater concern about the deficit than the Labour Party, but still with no real concrete plans for tackling the monumental scale of the deficit. Despite this, some investors might suspect that, fearing electoral damage, the Conservatives are hiding the scale of the cuts that they will undertake. The success of the issuance of government debt may well hinge upon such a weak foundation for some time yet, but the fragility of such a foundation leaves a very real possibility of a failed debt auction. Then there is the point that the Bank of England has not ruled out restarting the printing presses, which analysts believe has weighed down on the £GB.

The concerns over sovereign debt extends further, with the ongoing saga of the PIGS (Portugal, Italy, Greece and Spain):
The Spanish and Portuguese markets led the declines as investors' fears focused on whether government plans to cut their deficits are tough enough. By late afternoon, Spain's main market, the IBEX, was down more than 5pc and Portugal's benchmark, the PSI-20, was off a similar amount.

The prospect of a sovereign debt crisis has been seen as one of the biggest risks facing the global economy this year as the downturn catches up with heavily indebted countries. Attention so far this year has been on embattled Greece, where the Government's debts have jumped to 12.7pc of gross domestic product, but appear to be switching to Spain and Portugal.

Then there is also increasing concern over the size of the US deficit, with many analysts and commentators worried about a sea of red ink stretching out to the horizon. Obama's freezing of sections of spending has done nothing to dent the fears that the US deficit is unsustainable, as the freeze covers such a small portion of total expenditure. Obama's expressions of concern over the deficit mean nothing if action does not follow the words. The result is the prospect of a downgrade of US debt:
The credit ratings agency cautioned that if the US were to grow at slower pace levels than expected, the largest economy in the world’s already-extended finances could be over-stretched, in turn damaging its AAA credit rating.
This might again be seen as a positive for the UK, but the position of the ratings agencies on the UK is equally as concerned, and preceded the worries about the US. Moreover, this is a comparison of a bad situation with a bad situation, and does not detract from the underlying reality that both countries are looking increasingly risky places to invest money. It is a bit like comparing a man with broken arms and a man with broken legs, and trying to decide who is in the worse situation.

Whether the US, the UK, or the PIGS, there is a concern that there is no solution to what is becoming apparent as structural long term deficits. It is not the deficit today that is the major problem (though that problem is large enough), but the lack of any route out of the deficit spending. In fact, ballooning entitlements from demographic changes present the prospect of enlargement of deficits, and further declines in the tax base.

The solution to the problem that is proposed by governments is that they must ensure that their economies return to growth. When they say growth, they actually mean debt based growth, meaning replicating the ersatz growth that took place before the economic crisis. There is much lofty talk of the resuscitation of growth through new technology, and innovation, but it all sounds like the much vaunted service economy, or post-industrial economy, touted before the crisis hit. Whilst talking of the innovative and growing economy, the governments are simply spending and consuming the future wealth of their countries. As I showed in my last post on the US and UK, the increasing deficits being generated by governments a just a return to pre-crisis levels of consuming more in relation to what is produced.

When looking at sovereign debt, there are risks in every direction. Some analysts argue that Japan is looking high risk, others that the PIGS are ready to topple, and so forth. We can see the volatility and uncertainty in the currency markets, with endless shifting tides on each piece of data from each major economy and each policy response. It is now becoming a waiting game to see which economy will topple first, and set off a domino reaction around the world. In this context, is the UK at greater or lesser risk with the pause in the policy of QE?

There are many factors at play, which is the relative risk of UK debt in relation to other countries, as well as confidence in the overall economy. The UK does have a trump card in the forthcoming election, and the pause in QE may be seen as a positive. An alternative view is that the end of QE will now hasten a failed bond auction, and thus prompt the crisis. However, even if the UK does not lead a crisis, will a contagion from, for example the PIGS, just mean that the UK becomes a follower rather than just a leader? The UK is looking very vulnerable, and therefore is at great risk of contagion. This from Edmund Conway of the Telegraph:
Greece, in other words, is the fiscal Petri dish that reveals in gory detail what could happen in the UK if this Government – or the next – fails to maintain the confidence of investors. It is not merely that those interest rates are already inflicting an awful toll on borrowers in Athens and beyond. It is that they are sending the national government towards a full-blown debt spiral, in which the cost of its annual interest bill becomes so unmanageable that it can hardly afford to supply its citizens with basic services.
I take Edmund Conway's analysis with a very large pinch of salt but, in this case, his analysis is reasonable. Unsustainable borrowing will lead to problems, one way or another. The difference between the two countries is the UK can print its own money, but that of itself does not alter the need to eventually live within your means. It only serves to translate the nature and timing of the crisis (with potential for greater damage). However, will the Bank of England really end QE, or will the prospect of a failed bond auction see the Bank of England cave in, rather than see the crisis that follows such an event?

Perhaps the most curious aspect of the looming risk of sovereign debt crises is that, even as we read of them, we hear talk of economic recovery - albeit with many caveats. One of those caveats that is often mentioned is that governments can not sustain massive deficit spending forever. The problem is this; the 'economic recovery' is not a recovery but a rerun of debt induced growth, and the debt that is producing the growth is the driver of the potential sovereign debt crises.

If governments actually act to reduce their deficits, the so called 'economic growth' will disappear, and with it the confidence that the economies might service their existing debts. Their economies will contract rapidly, and with the contraction the debt to GDP ratios will soar and their currencies plunge. With the plunging of the currency, there will be the onset of rapid inflation, and loss of confidence by overseas creditors. For example, in a previous post, I estimated that, if just the overseas portion of US borrowing were to stop, the economy would contract by about 17%. That is just the impact of the end of overseas borrowing.

In this context, the US and UK policy of QE becomes clearer. Governments are on a debt treadmill - damned if they do, and damned if they do not. However, QE does not alter the underlying reality that an economy is consuming more than it produces, it simply alters the scope and nature of the crisis. It is a last gamble that something will turn up in the meantime to save the economies from the real underlying crisis. If all else fails, printing money to stave off a crisis in government funding looks more attractive to policy makers than the alternative being faced by Greece, on whom austerity measures are being enforced. The discontent within Greece has already started.

The reality is that Greece must now learn to live within its means. This is the reality that is being avoided with QE. Greece can not devalue, can not print money, and must actually accept that it is poorer than it would like to imagine. It literally means a lower standard of living than they have come to expect. In this context, I have to wonder just how permanent the pause in QE in the UK will actually be.


I read the interesting debate on the last post. I did however note some comments that were an attack on the person, rather than on their beliefs/views. I would prefer to see the issues debated, rather than the person, and generally think that the high standard of debate and thought (that contributes so much to the blog) would be better served by this approach. Many thanks, as ever for the links and contributions. I would like to respond to some of the points, but seem to have less and less time to do so, but will try to do so.