Sunday, May 23, 2010

The Origins and Development of the Economic Crisis

I thought it might be time for a review of the big picture. How we got to where we are, and the underlying problems in the world economy. For regular readers, much of what I will discuss will be familiar material, but some may also be new. However, this post is primarily aimed at the newer readers of the blog and the aim is to offer a framework that explains why my analysis is such as it is.

To start at the beginning, I wrote an article called 'A Funny View of Wealth', in which I identified a fundamental flaw in the UK economy (and which might apply to many other economies such as the US). I wrote it before the financial crisis, and my approach was to review each potentially wealth creating sector of the UK economy. On reviewing each of the sectors, I realised that there was no sector that could possibly explain the apparent increase in wealth in the UK in the 10 years preceding the essay. Instead, what I saw as the only explanation was that there had been a massive growth in personal debt, alongside some growth in government debt (if I recall correctly, I think I included the off balance sheet liabilities). I was very worried, and it turned out, rightly so.

As the banking crisis emerged upon a startled world, I became increasingly horrified at the actions of governments in response to the crisis. I argued strongly that the response to the crisis would eventually backfire on sovereign states, and we are watching this process now unfolding. My analysis of the situation has always been different from every economist, analyst and commentator, and I still hold with my view that the banking crisis was a symptom of an economic crisis, not the cause of an economic crisis. As time has passed, the analyses of the problems have largely been dominated by one, or a combination of, the following:

  1. It was de-regulation of the banks that caused the problem
  2. It was greedy short-termism of the markets
  3. It was the central banks running lax monetary policy
  4. It was the housing bubble
  5. It was the credit bubble
  6. It is an imbalance in world trade
  7. It is a corrupt stitch up by the banks in conjunction with government
  8. It is the inevitable result of a fiat money system
I may have missed a few, but these are the explanations that come most readily to mind. Having presented these explanations, I have given some of the common ideas of the cause of the current crisis, but these do not really explain the problems of the world economy. Instead, my argument is that these causes are contributory, not the main cause. As such, it seems that I should explain the underlying problem.

I first began to formulate my ideas in a post called the 'Cigarette Lighter Problem'. I asked the question of why an identical lighter, sold through an identical distribution system, might cost nine times more in a Western country than in China. The differential in the cost was fundamentally inexplicable (if you read the article, you will see why). I came to the conclusion that part of the additional cost was actually developed in the accumulation of debt in the economy overall.

As I thought about this problem, I started to think about the cost of labour in the world, and how it was determined. As part of this process the explanation of the economic crisis became clear. In the build up to the crisis, it was possible to see a massive expansion of the global labour supply. Even China by itself represented a massive expansion, but when you add India and the other emerging markets, the labour with access to markets/technology/capital must have at least doubled.

This of itself would not necessarily cause the crisis. As fast as the new labour entered the markets, they might have in turn become consumers, and thereby expanded output for everyone. However, there was a problem. Whilst the labour supply was increasing, the other inputs into wealth creation were not increasing as fast, or were not increasing fast enough to accommodate the massive infrastructure needed to built (from a very, very low starting point) in the emerging economies. If we just think of oil, output barely expanded as the emerging economies emerged, and that means with an increase in the size of the labour force, there was not going to be sufficient oil available for both the West to maintain their standard of living and to see the emerging economies continuing to improve their standard of living. Something was going to have to 'give'. The following is from my article on Huliq, but I suggest that you read the original for the full picture:

I have already identified that the world labour force has roughly doubled in the last ten years. At the same time, there has not been the doubling of the other inputs into the world economy. In crude terms, what this means is that the amount of inputs available to each worker to undertake economic activity has been reduced per capita.

If we take the example of oil, 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). What we can see from 1997-2007 is an approximate doubling of the labour force, and only a tiny increase in the output of another key component of economic activity.

This quite literally means that the availability of oil per worker has seen a significant decline. In such a situation, there must be a consequence. If a worker in country A increases their utilisation of oil, then a worker in country B will have less oil available.

With regards to other commodities, it might be argued that the output has risen to meet the new demand from the expanded labour force. For example, copper has seen high growth in output from around 11 million tons to 16 million tons, and iron ore output nearly doubled. The problem with such expansion is that it is growth in a period of rapid development of the emerging economies, in which the demands on resources are particularly high. Think of the massive expansion of highways, tower blocks, apartments, airports and factories in China, and it is apparent where such increases might be absorbed.
For the moment I would like to present a different scenario to what actually took place in response to this problem, and we can see how the economic crisis developed. For the sake of ease I will just use the examples of the US and China to illustrate a general point. If we jump back in time, to about 10-15 years ago, the Chinese economic miracle was in full swing. New factories were pouring goods out of China, and the US consumers were busily expanding their purchase of Chinese goods. As they did so, many US industries were moving offshore, as it became ever more necessary for companies to compete in world markets through lowering their costs. At this point, what should have happened was that there should have been increasing unemployment as the demand for labour fell in the US. With that rise in unemployment, living standards in the US should have started to fall, and at the same time, Chinese living standards should have risen. After all, America was losing in competition to China, and China was winning in competition with America.

As we know, this did not appear to happen. The Chinese appeared to be growing wealthier, but not as wealthy as their prodigious growth might have suggested. This returns to the cigarette lighter problem. If we look at China, the entire economy appears to be low cost. Wages and costs in general are surprisingly low in relation to the increasingly impressive output of goods and services. This is in part because they have still not pulled their entire labour force into the 'modern' economy. It is also partly a result of the value of the RMB, whose value has been held down through the purchase of treasuries. This has meant that, for an ordinary Chinese worker, they are not paid in wages that reflect the true value of their labour. Imported goods are artificially expensive.

What the Chinese have been doing is, as fast as their productive capacity has expanded, and their exports to the US have grown, is lend that missing labour value into the US economy. That missing value turned up in the US economy, and is why the US standard of living did not decline as it should have done in relation to China. All of this gave the illusion that nothing had really changed.

It seemed like China would just get richer, that the US would just get richer, and all was well in the world. However, without an increase in the other key inputs to wealth, the commodities, this could never work in the long run. For example, ten divided by ten equals one, 10 divided by 20 equals a half. If the additional ten lend you their halves, then it can appear that everything is okay, and that you still have one. Of course, in this example, I am being simplistic, as the amount of commodities did increase, but they did not increase fast enough, and China did not lend all of their output. However, I hope that this nevertheless illustrates how the illusion of wealth can be maintained, even as wealth generating capacity is slowly melting away.

What we have is the situation in which a low cost economy is rapidly expanding, endlessly increasing the labour force in the world, consuming more and more resource, and lending a significant portion of their output to another country. At the same time, they are making their already competitive position even stronger. They are adding a further lever to their low cost advantage, and decimating industries and competitors as a result, through holding down the value of their currency. In purchasing US treasuries, they increased the demand for $US, and the increased demand raises the value of the $US, and they also allowed the illusion of wealth in the US to continue through their lending.

However, this is not the whole story. As well as countries such as China lending their value of labour to the US, there are plenty of other actors within this scenario. For example, Japan's export machine kept on chugging onwards, along with the Japanese acquisition of US debt. Then there are the commodity countries, such as the petro-states, or other primary commodity countries. All of these benefited from the increased demand, which itself was a result of the expanding pool of labour. We can think, for example, of a major oil producer in this global picture. In real terms, they are lending oil in the expectation of a return in goods and services. If we go back to the American example, they are literally borrowing oil from the petro-states, and one day they must actually pay for the oil.

Oil is an interesting example of what took place, as it is so central to the functioning of modern economies. We can be buried in the complexities of currency rates, interest rates and so forth. However, when Saudi Arabia lends the US oil, they expect to get something in return.
For example, if the Saudis wanted cheese in return, they might lend their oil based upon the exchange relations for cheese and oil, however abstracted those relations might be. Central to their expectation is that if 1 litre of oil = 1kg of cheese, they will expect that in the future they will be repaid roughly on this rate, with interest added (e.g. repaid 1.3 kgs of cheese per litre of oil). If we look at US cheese output, there may be a nationwide output of 100 units, with 80 units going to the domestic market, and 20 for export. If we imagine that Saudi Arabia starts calling in their oil debt in cheese, we might see the 100 units reapportioned to 30 for export and 70 for domestic use.

What we are seeing is the inflationary impact of debt accumulation. The cost of cheese in the US is going to go up. There is less cheese in relation to domestic demand and, barring a cheese manufacturing productivity miracle, prices must go up. It might be that, with the rise in prices, the US farmer will devote more to dairy, and cheese output will increase, but they would do so by not doing some other kind of farming. The only way to avoid inflation is more farms, or greater productivity from the existing farms, or a combination of both.

Within this simplistic example, we see the principle that issuance of debt eventually creates a call on future output. When is does so, unless there is a productivity miracle, or an increase in the resource devoted to any industry, there will be less output for the domestic market. This means that goods and services will be relatively scarce. For the example of output of cheese, just replace cheese with the total potential output of the economy. You then see the problem with debt accumulation from overseas lending, and why it is inherently inflationary.

Overseas debt is a call on the total output of your economy in the future, and the greater the debt, the greater the proportion of future output needed to service the debt, and the less goods and services available within your economy for domestic use, and the greater the inflation in the economy. Unless there is a productivity miracle, or debt default, then something has to give. There are simply less goods and services available in the economy. Imports can not substitute, as you are already using your output to exchange for past borrowing, meaning you have less output to exchange for imports. As for the example of the US, we can add many other debtor nations to the list of those facing this problem, with similar consequences.

Having explained the danger in the accumulation of debt from overseas, we can start to see the problem. Now, before I go on, there is an important point. Instead of consuming, for example, the oil being lent from Saudi Arabia, lets say that we used this resource for investment in new capacity. Building a new factory, for example, is an energy intensive activity. If we were to use the oil for this purpose, we would actually see a return on that borrowed oil. We have increased our overall capacity to produce goods. Alternatively, imagine an executive used a portion of that oil in a flight overseas to sell a consultancy service. Whilst the oil is consumed, in both cases it is going to generate goods and services that we might sell overseas to repay our overseas loans.

However, this is not what took place, and there is a very good reason for this. The first relates to manufacturing. In the face of low cost competition, investment into manufacturing was shifting rapidly to the emerging economies. In the case of services, the story of India needs no retelling, and again we can see that there was a considerable expansion of competition in many services. However, the money nevertheless was pouring into many Western countries. Where was the money going?

We can only now see the impact of the traditional reasons given for the financial crisis. What we have is a situation where the actual output of goods and services in the economy appear to be increasing. In fact, during a period in which intense competition in goods and services are appearing over the world, there is a strange thing going on. In face of this massive competition, the people in countries like the US appear to be consuming ever more output, even whilst this fierce competition is arising. Not only that, inflation appears muted, and GDP is steadily and apparently rising at a healthy rate.

What we are seeing are two deeply flawed measures. In the case of GDP, it is measuring all of the activity that flows from the resources being lent into the country, in addition to the productive output of the country itself. When we see inflation, it is not capturing the inflation in asset prices. What we have is the miraculous service economy. The money is pouring in from overseas, and that is used to import resources, and these resources are being consumed at an astonishing rate, fuelling profits in companies, and increasing activity around the economy. If we return to the oil example, we can think of Saudi Arabia lending oil to the US, and how that oil might allow for an increase in activity around the economy.

The interesting point about all of the traditional factors for the current crisis is that I would agree that they are all contributory factors in the debacle that we are now witnessing. The one point I would argue with is that it was a result of de-regulation, as I do not accept that there was deregulation, but rather there was misguided regulation. I have emphasised the role of the Basel I and II banking regulation frameworks in contributing to the crisis. There are plenty of easy targets to pick on - for example the Basel II entrenchment of the ratings agencies in the determination of capital adequacy ratios.

As I have long argued, it has been apparent that the regulators have long been of the view that they (and presumably the rating agencies) have some mystical power to see where future risk might be found. Amongst their amazingly prescient determination of future risk, they allocated OECD government debt as being almost completely without risk. Apparently, at this moment in time, banks all over Europe are sitting on piles of absolutely safe Greek government debt, and this debt is a key component in what determined their safe level of capital. The more I dug into Basel I and II, the more silly the provisions seemed.

I even found an article on the Bank of England website that innocently noted that Basel I had been a driver of the market trend to securitisation, the very instruments that later exploded onto the world with the banking crisis. The paper was published pre-crisis, and I wonder if anyone in the central banks would now published, as it is firmly points (with hindsight) an accusatory finger at the role of the regulators. Happily, for the central bankers, the article is now forgotten and gathering dust.

Returning to the question of government bonds being given a zero risk rating, what we see is a regulatory framework that positively encourages banks into buying government debt. A long time ago (I forget which post) I wrote about how, when modern banking was being developed in Renaissance Italy, the city states would grant banking licenses in return for preferential interest rates on their borrowing. What we see now is the same cosy relationship between the central bankers, the banks and the politicians. I scratch your back......

The problem is that, although most people accept government borrowing as if it is some kind of force of nature that is unavoidable, I have yet to see a convincing argument for government borrowing for a developed country, short of war or natural disaster. If governments want to spend more, then just tax more. They have a massive base from which to fund government, so why are they borrowing at all?

Returning to the central point, regulation has played a large part in the lead up to the financial crisis, and has also encouraged states into their current indebtedness. You will note that, as the crisis progressed, central banks and regulators have demanded greater levels of capital to be held by banks - and that is a way of telling banks to hold more government debt - exactly at the time that governments have been increasing debt. The banks are now stacked up with debt which was formerly considered safe, and (in the case of many European banks at present) they are faced with a potential implosion of their balance sheets if there are sovereign defaults.

Are you starting to see the circularity here? However, I have digressed a little from my central theme, which is to set the context of the current parlous state of the world economy.

A key element is the financial services industry. We need to this in the context of a massive shift in the productive output in the world, with inflation in commodity prices. Rather than directly exchanging the profits from these shifts directly into purchase of goods and services, the countries in question have chosen to lend their growing wealth into countries like the US. They do so with great confidence, as they see the OECD countries as more reliable and safe place to lend their money. Alongside this, they see what appears to be healthy and growing economies. What could go wrong?

The problem is that, a wall of money is entering into these debtor economies, and yet there are very limited numbers of investment opportunities, outside of redistribution of the borrowed money into consumption based activity. In particular, if you are investing in the provision of new goods and services for the global market, much of the smart money is going into the emerging economies. So, the banks have a wall of money to lend out, and few opportunities to invest it in places where it might eventually create opportunity for export of goods and services. What to do with the money?

As we now know, the money went into higher and higher risk consumer lending. One result of this was that the money available for lending into mortgages started to outstrip the increase in the number of houses available to soak up the new money. This is, of course, a situation in which more money is chasing a particular good, which means that the price of the good will increase. Thus the housing boom was born. We can see the increase in the money supply into the market with the many highly dubious methods of lending that appeared in the run up to the financial melt-down. What we now see is where the financial crisis comes from.

The bankers were aware that, if you start lending to bad credit risks, then you are eventually going to make some losses. They could hardly sit on the money and do nothing with it, and here we have the incentive for the development of the instruments of mass destruction that were to explode in the financial crisis. The lending was increasingly risky so, within the Basel frameworks, they did everything they could to bury the extent of the risk such that it was out of sight.

The CDOs were rated as investment grade, as per the requirement of the Basel regulations, which had already encouraged securitisation, SIVs, and a host of other practices that were to be seen as precursors to the financial crisis. As a result, it seemed that the banks were making miraculous profits, bankers achieved their amazing bonuses, all at the same time as they were loading up on thinly disguised and regulator approved risk. Remember, the regulators and ratings agencies apparently had a privileged and magical insight into where risk will occur in the future.

We then move onto the role of the central banks, and their contributory role in the mess that we are all now in. Their role was one of astounding stupidity. They were the people paying attention to their metrics of GDP and inflation, all the time having absolutely no idea of what these actually measure. All they could see was the mass of activity in the economy, and did not realise that a large portion of that activity was simply the use of resources borrowed from other countries to move around and distribute borrowed resources lent by other countries. They imagined that all of the activity was from internal resources generated by their own countries output. The really mad part was that, the more that was borrowed from overseas, the greater the activity in redistribution, and the more they believed that the country was getting wealthier.

As a result, with low inflation, and steady GDP growth, they kept interest rates low, and poured more fuel onto the fire with expansionary monetary policy. All this despite asset prices going up at a rate that was disproportionate to the actual underlying state of the economy....

And then there is government. Like the central banks, they were equally as deluded by their use of inflation and GDP figures. Perhaps the worst example is Gordon Brown in the UK, who absolutely convinced himself and nearly everyone else that an economic miracle was taking place. Everyone was becoming richer. In these same countries with the miraculous service economies, governments started letting go of any sense of fiscal caution, in the belief that the good times would not end. They expanded or started new government programs, benefits and entitlements, creating ever more structural government costs, on the basis that their economies seemed to be endlessly expanding. In reality, it was only indebtedness that was expanding, as their economies were in reality stagnant or perhaps even contracting in some cases.

What we were seeing was an illusion of success in many economies, and all the while they were sowing the seeds of future destruction. The increase in debt in economies like the UK and US was simply hiding the structural change that had taken place in the world economy, the emergence of the emerging markets, and the competition for a finite amount of resources amongst an ever increasing labour force. The illusion of the service economy was simply the distribution and consumption of the borrowed output of labour of overseas countries. Houses became ATMs, new shopping malls were built, and new services were developed to consume all of this apparent wealth.

The financial crisis was the shock to break the illusion; or rather it should have been the shock to break the illusion. The madness of consuming future output now was laid bare. However, rather than break the illusion, the choice of governments and central banks was to try, as hard as they could, to continue the illusion.

In the period since the financial crisis, there has been no action to address or recognise the problem. Instead, the reaction has been a host of measures to try to restore a situation that was, of itself, a delusion.

Front and centre were the bank bailouts. The process was not only one in which government money was poured into the banking system, but also a process of allowing the banks to hide their underlying insolvency. Governments have also borrowed to support the existing economic structure, which is an attempt to maintain employment and activity, which is itself an attempt to support (for example) real estate prices, which in turn supports the value of bank assets, which in turn supports the viability of the financial system. It is all circular, with one element supporting the other, with overseas borrowing the foundation of the system. It is impossible to tease apart the circular relationships. Governments must keep on borrowing more and more, or the whole edifice falls apart.

Effectively, when consumers stopped borrowing, government stepped in to fill the vacuum. The problem is that, in doing so, they are supporting the unsupportable. I have previously laid out the contradictory nature of this process in my last post. We have a process as follows:

  1. A government borrows money from overseas
  2. The money is spent by the government and this increases activity in the economy
  3. Individuals who would otherwise be unemployed are able to buy houses, pay back loans, service mortgages, buy goods and services
  4. Individuals and businesses pay more taxes
  5. Government revenues are supported
  6. GDP is supported by all of the activity, either preventing a dramatic fall or slowing of GDP growth
  7. The relatively good health of the economy reassures investors (e.g. some investors actually believe that the US is recovering)
  8. Investors are willing to extend further credit
It all looks to be highly sustainable, except for the fact that governments are accumulating debt which is being used to finance consumption. For example, in the case of tax revenues being supported, the money that is returned in taxation to the government is being supported by the borrowing, such that the revenue from taxation is a case of the government eating its own tail. It borrows, a portion of that borrowing is consumed, and the returned tax revenue is therefore the borrowing minus the intermediate consumption process. It simply means that a small amount of the borrowed money is returned to the government, whilst the total amount of borrowed money increases.

The other result of borrowing more is that more borrowed money supports the level of GDP, which means that the more a government borrows, the higher the GDP. All the borrowed money supports activity within the economy, and this gives the appearance of a healthy economy. This allows for a better debt to GDP ratio, which is, of course circular.

For example, if a government were to double their overseas borrowing overnight, then they would be able to massively increase activity in the economy. GDP would climb rapidly, and the result would be that the GDP to debt ratio would look much better. What you have done is pulled a massive amount of future activity into the present, and this would flatter the size of the economy. However, the GDP outcome does not represent your own generation of activity, but consumption of the output of others, at a cost of committing your own future output. In other words at the cost of a future shrinkage in your own activity. Unless you just keep borrowing more and more.

And here is the problem. Unless you keep borrowing more and more, there is no way to sustain your GDP level, and no way to keep the GDP to debt ratio looking positive. As soon as you stop borrowing from overseas, you are then in a position of repaying the debt that you have already accumulated, and also doing this when your economy is fragile. It is fragile because the structure of the economy has still not managed the adjustment to the new competition from the emerging economies. Government has borrowed to consume to support the structure of an economy that was already built on excessive borrowing from overseas. There is still a period of adjustment to the real structure of the world economy to take place. This can only be achieved through seeing the destruction of the swathes of the economy that were supported through the distribution and consumption of resources that were generated from overseas.

This returns me to the example of the US economy, in which I showed that 17% of US GDP may be accounted for by activity in the distribution and consumption of resources borrowed from overseas. As yet, nobody has contested this figure, though it is certainly open to challenge (see here for the original post). Even if I am roughly right, we can see what happens if the growth in debt halts. We would see a massive contraction in the US economy, and the debt to GDP ratio would deteriorate in a shocking way. It is similar to what we are seeing in Greece. Businesses will close, unemployment will explode, government revenues will fall, asset prices will fall, banks will go bust, and the economy will fall off the edge of a cliff. As this happens, it will become increasingly impossible for governments, businesses and individuals to service the debts that have been accumulated as part of an economic structure built on foundations of sand.

The really horrific part of this is that it is not just the US that is in this terrible position. This is a widespread problem. Furthermore, the structures that have been built to protect failing sovereign states is built upon credit coming from many of the states that are now at risk. One interesting development is that the US is now questioning their role in the IMF bailout of Greece, and is recognising that the credit it would supply would fall into a black hole, and that it can no longer afford to bail out other countries. After all, the US finances are themselves flashing red warning lights. I pointed out in a previous post that, in reality, although the US appears to be a major funder of the IMF, it is in reality the creditors to the US that are really funding the IMF. If the US were not able to borrow more money, would they be able to finance the IMF as they have traditionally done in the past?

Where is the money for IMF bailouts going to come from in the future? It is a question I asked at the start of writing this blog, and it only now that it is apparent to the world that there is a problem. When both the 'bailees' and 'bailouters' are broke, what happens then?

In Europe, it is possible to see the increasing queasiness at having to bail out their fellow European states. The fact that the bailing out of another state means borrowing more, and taking the sovereign debt risk of other countries onto already stretched balance sheets, means that the bailouts can only go so far. The problems do not stop there. For example, if Greece defaults on its debt, this will impact Germany through, for example, their banking sector's exposure to Greek debt. If Greece falls, it may take elements of the German financial system with it. Such is the complexity of the edifice of debt that has been created around the world, and the complexity in the linkages in the destiny of sovereign states.

Niall Ferguson famously coined the phrase Chimerica to express the interdependent relationship between China and the US. The US used Chinese credit to purchase Chinese goods, and then plays a major role in the support of China's export sector. The two countries are inextricably tied in dysfunctional relationship. If either side blinks, they both plunge. However, the contradictions of a developing country (China is still relatively poor) supporting the rich lifestyle of the US must be a finite arrangement. Both sides need to extricate themselves from the relationship, but neither side seems to know how.

In recent news, China has recommenced the purchase of US treasuries, and Chimerica is once again in full swing. This means that, for the moment, the US might continue to finance their dizzying deficits. I think that we are safe in assuming that China is restarting the relationship because they can no longer see any clear alternative. However, as they have hinted at in various statements, China knows that Chimerica is unsustainable, and the US appears to realise this too. In both cases, it is possible to sense that they both hope that something will turn up. In the meantime, the scale of the problems for the future grows and grows.

The only way to describe the trading relationships across the world is 'dysfunctional'. They are relationships built upon a foundation as follows: country 'x' provides country 'y' with credit, and country 'y' uses that credit to buy goods and services from country 'x' and country 'z'. Country 'x' builds an export market in country 'y', and therefore needs country 'y' to keep buying their goods, in order for them to maintain employment and growth. Japan needs the US, Germany needs Spain, China needs the US and so forth. The recipient countries must keep buying, but increasingly have less and less capability to repay the money they are borrowing. The country 'x's reach a point where they are confronted with the reality that they are, in effect, almost giving their goods and services away, as they will never be paid for them. However, if they stop, their own industries will collapse, as they are structured towards servicing these debtor markets.

When German workers wince at the Greek bailout, this is the logical conclusion of the dysfunctional relationship. German credit has allowed German exports to Greece (of course, this is not a one to one relationship, but I use this case for simplifying some complexity). If Greece defaults on their debt, German creditors will take a haircut. If Greece is bailed out, the German government will, through the tax system, make the German worker pay for the Greek bailout. In either case, Germany will have, in real terms, been providing goods and services to Greece at massively subsidised cost, or in extreme circumstance free of charge. In all cases excepting full repayment of debt from Greece, Greek consumption is being subsidised through the labour and efforts of overseas workers. It does not matter which of these many creditor/debtor nations we can look at, the relationship is basically the same.

In each case, in each of these relationships, the dysfunctional accumulation of debt continues, and always with the hope that 'something will turn up', that the debtor nation will miraculously turn around, and start earning more than they consume.

However, the debtor nations have become credit addicts, and become ever more dependent upon the credit to sustain the structure of their economy, which is itself structured around debt. The more credit they get, the more their economic structure will be shaped to utilise the credit. The population of each country is unaware of the source of their apparent wealth, which is too abstract to understand, and they then resist any reform which might mean that they have to accept their real level of wealth. The politicians cave in, and hope that something will indeed turn up (or that they are lucky enough to be out of office when the contradictions of the situation are forced to resolution).

In the end, the creditor nations must blink. They will only support the profligate so far. Like the debtor nations, the people of the creditor countries are unaware that they are in effect, giving away a portion, or all of their labour, to other nations. When it becomes apparent, as with Greece and Germany, that this is the reality of the situation, they are understandably resentful. However, they do not realise that, if the situation halts, then many workers will find that their particular industry, their individual job, is pointing at a market that was entirely reliant on the credit that they have been providing. When their own country turns off the credit taps, the markets for their goods and services will evaporate. They have been pointing their industry and labour to the wrong markets, to markets that were never really going to pay for their goods and services, because they do not have enough output that they are willing to return.

In practice, what happens is that all the savings of individual workers are exposed to the losses that will follow the non-payment of debt. When a person invests in a pension fund, puts their savings in a bank, they are deferring their own consumption. In principle, their money should be channelled into new investments which will produce a future return. Instead, through whichever conduit, their savings have been used to support consumption in the debtor nations. If Greece defaults on debt, and German banks take a hit, this is not abstract money, but the accumulated savings of individuals aggregated and lent into the Greek economy.

I hasten to add that, as they currently operate, the markets are not all relatively ‘benign’ movements of savings and investments. The infamous speculators do exist. However, I have no problem with these people risking their money, for example betting against the Euro. What I do object to is naked credit default swaps, and any of the many other practices that border on the fraudulent, or the way that government backstops the risk, or the way in which governments have entrenched and supported an elite of bankers.

Returning to the central point, the deferred consumption of German workers has instead been consumed by Greek workers, and they are not going to return that consumption with goods or services for the German workers to consume. The deferred consumption has been forever consumed.

The point that I am trying to make here is that this is not as abstract a situation as many analysts and commentators try to make it. It is about the basics of person 'A' manufacturing good 'B' or providing service 'C' to person 'D'. This is the core of economics. It is not mountains of abstract data, but about how this process works in practice. At the heart of the system is that the savings of person 'A', their deferred consumption, is aggregated and offered to others in the belief that it will be returned one day in goods and services for their own consumption.
The expectation of each worker who defers their consumption is that, at least, their savings will be returned in an a way that gives them access to an equivalent amount of goods and services to those they might have consumed at the time of the investment. This is a reasonable expectation, and is the source of potential for sustainable economic growth.

The problem arises when the systems for the allocation of those aggregated savings go wrong. This is the dysfunctional trading relationships between countries. Those in government, in the financial services industry, the analysts and economists, all misunderstood what they saw. They made false assumptions as follows:

  1. Just because a country has always been wealthy, it will always be wealthy
  2. Just because a country has a good credit record, any amount of credit might be given to that country
  3. GDP = Wealth creation
  4. Inflation measures are meaningful, even when asset prices are inflating outside of the recorded figures
  5. Trade imbalances might be eternally sustainable where the cause of the imbalance is in consumption activity of one actor of the goods and services of another actor
I am not sure that this covers all of the assumptions, but it is certainly a starting point. At the heart of all of the above is a question of credit risk. What we are seeing are assumptions that underpin how investors have determined the risks in the provision of credit. At the heart of the economic crisis is that various metrics and assumptions led to a false set of beliefs about the relative creditworthiness of individuals, businesses and states.

These assumptions were built upon a world that no longer existed. The entry of the emerging markets, and the newly intensified competition for a finite amount of resource changed the game and the structure of the world economy. As the emerging markets emerged, we entered a period of hyper-competition.

Instead of confronting the competition, much of the developed world simply borrowed and pretended that nothing had changed. The assumption was that the rich world would get richer, and the developing world would get richer. It never occurred to any of the economists, politicians, analysts, and financiers, that with finite increases in resources, we had entered a situation similar, albeit not the same as, a zero sum game. While the pie of resources was getting larger, the number of actors eating the pie was increasing faster still. Just because some of them were lending some of their share of the pie, did not alter the problem that the share of the pie was changing.

So it is that we come to the situation today, with a world economy in which false dawns, endings of the 'financial' crisis, come and go. New solutions are tried, more illusionary gains are achieved, only to see the underlying and unaddressed problems bubble back to the surface. We can see that, despite the efforts of government, many of the rich world countries are indeed getting poorer. The austerity program proposed in the UK may just be an example of this process in action, and we can only hope that austerity can resolve the problems gradually. However, the actions of having tried to prevent change make a gradual rebalancing the least likely outcome, though not impossible.

It is never pleasant to be relentlessly gloomy. I have offered consistent pessimism. I do so because, I believe, I have identified the underlying causes of the economic crisis. In doing so, I believe that the actions to try to turn back the clock are wrong. The only way to move forwards is to resolve the imbalances, and take the pain sooner than later. In accruing ever more debt, in seeking to prop up systems that can not be supported, it may delay the pain, but at a greater cost later. At each stage of the economic crisis, I have repeated the same message.

The only way to resolve the crisis is in the structural reform of economies, and to face the fact that, with a finite pie, and more actors seeking a share of the pie, the only solution is to win the greatest share of the pie possible through efficient development of industry and innovation, and having lean and effective economies. This means that we must trim the fat from our economies. We simply do not have the resource to maintain the lifestyles to which we have become accustomed.

We also have to face up to the imbalances in the world economy, and accept that these are finally unsupportable. Country ‘x’ can not and will not provide goods and services to country ‘y’ at subsidised rates forever. In particular, now that the inability to repay is being highlighted, the real choices for the creditor nations are becoming clear. The reality of the imbalances is now showing the underlying choice – continuation of giving something and getting very little in return, or a painful period of restructuring of their own economies to reflect the real distribution of wealth creation and resource.

I also accept that, in this hyper-competitive world, we are unlikely to win as great share of the pie as before. In an ideal world, the resource pie might expand infinitely, but this is an unlikely outcome at our current position in history (a debate I will leave aside for the moment), and we might have to accept a period of hyper-competition for a long while. After all, there is plenty of labour out there that is still yet to be connected with technology, capital and markets.

It is not an easy message to digest. However, if we wish to address a problem, we have to face up to the actual causes of the problem. As long as the policymakers seek to ignore the real problem, we will continue down the wrong path. It does seem that, with the emergence of the problems of Greece, there are the first signs of accepting that the situation can not continue as it has done. Greece is a warning, and we are collectively starting to take heed. Whether this translates into effective action, and above all acceptance of the reality of the situation, is still uncertain. I can only hope that it does, and that it is not too late.

Within this perspective on the world economy is a further worry. I blithely suggest that we need to adjust, but I also identify that the people of the creditor and debtor nations have not, and probably will not, fully grasp how this mess arose. We see this in the riots in Greece, and the growing anger at the politicians in Germany. The adjustment is going to be very, very painful, and this presents significant dangers. In order for the adjustments to be made, both debtor and creditor countries will suffer painful adjustments. The whole world economy will go through a painful adjustment. In such circumstances, with unemployment growing, and complex and difficult to explain causations, it is a period in which social and political instability will rise.

It is a time in which some people will offer easy solutions, will blame group ‘x’ or group ‘y’ for all of the ills, who will grab the popular anger, and will use that anger for their own ends.

The situation I have outlined in this post, the causes of the economic crisis, are not down to any individual country, or any single group. The bankers were greedy, the regulators were idiots, the Chinese were mercantilist, the Western politicians acquiesced to the Chinese mercantilism, when the politicians promised something for nothing, the press acceded, and the people with them. I could go on. In the end, we all played a role in building this mess.

In addition, the situation is not one in which there will be any painless fixes. We have collectively spent years building an illusionary economic structure. As that structure adjusts, and it must adjust, there is no way to do so without pain for everyone. How we might deal with the adjustment is a matter of debate, but there is no way in which it can be done without pain being felt by ordinary people. However, there will be those who will offer ‘clever’ solutions. They will ‘magic’ away the problems. How this might take place, when the problem is the structure of the world economy, is a mystery. However, they will dress up their magic with plausible and complex argumentation, and in the end avoid accepting that there must be some kind of pain.

In the scenario I have painted, it is apparent that there must be pain that comes with the restructuring. I do not hide this. For governments, the key is not to try to halt the restructuring, but to seek to ameliorate the worst of the effects. It is a fine balance between restructuring and, in the case of the ‘rich world’ getting poorer, and maintaining social cohesion. The danger lies in the pretence that no restructuring is necessary, and that pain might be avoided. The danger lies in governments squandering their resources, as they already have done, in propping up a system that is inherently unsustainable and inherently unstable.

In a very long essay, I have suggested a system that might prevent these problems happening again (it can not ‘fix’ the current problems, but might accelerate their resolution). It is not a perfect solution. No system, for example, might have fully absorbed the labour supply shock that the world has seen. However, the system I have proposed would have prevented the imbalances that followed the supply shock. It is a system which is largely self-regulating, bubble resistant, and imbalance resistant. However, I suspect that such a system is only a dream, as it removes power from those who would like to hold on to their power. I therefore offer it as a solution, but also as a solution that is unlikely to be adopted.

Note 1: When first posting this solution, my use of the concept of value of labour led one commentator to suggest that it was Marxist. The concept of value of labour used is very different from that of Marx, and the solution is in no way Marxist. Also, a regular critical commentator on the blog, commenting under the name ‘Lord Keynes’ has recently said the following:

“Cynicus’ variant on the labour theory of value, in which he believes that value is both caused by subjective factors and by labour is logically inconsistent.Value cannot be subjective and also caused by labour.”
It is entirely consistent to say that we subjectively value labour, which is my explicit central point. I see no inconsistency in this. Lord Keynes simply misrepresented my argument to create an inconsistency. From this commentator, there will no doubt be essays in response to this reply. I would therefore ask you to read the original.

Note 2: As ever, please feel free to comment on any aspect of the post. Even in a post as long as this, in order to cover breadth I have had to sacrifice depth. If any point is unclear, I have expansions on each of the points littered throughout the blog. Also, in trying to compress many arguments, I hope that the arguments are not weakened or might appear inconsistent. Finally, there is the sin of ommission. For example, I do not include the many additional mercantilist Chinese practices that I have included elsewhere in the blog, or the dangers in quantitative easing (printing money), or many other key points. In short, an overview can only be an overview.

Note 3: Thanks for the interesting comments on the last post. I recently found that I had missed following one of your links on a previous post, which was to a You Tube video of the Modern Mystic. An amusing distraction....many thanks.


  1. Having re-read the post, I noted several small errors. Please accept my apologies for these.

  2. Comments 2

    We can think, for example, of a major oil producer in this global picture. In real terms, they are lending oil in the expectation of a return in goods and services. If we go back to the American example, they are literally borrowing oil from the petro-states, and one day they must actually pay for the oil.

    Oil states do not “lend” oil to the US. They have sold it to the US. They get US dollars in return. The American people have paid for the oil already. The oil states can – and do – use these dollars to purchase anything they want on world markets (either in the US or in other countries). The US dollar is the world’s reserve currency.

    But, in real terms, the oil states have so much money they simply do not want to spend it all on goods or services. If they did, they would do so. Instead, what they want is a low risk financial asset: US Treasuries.
    They get that from the US. And their holding of US dollars does not mean this is simply a claim on US output. It could be a claim on EU output, or Australian output, or China’s output.

    For example, if the Saudis wanted cheese in return, they might lend their oil based upon the exchange relations for cheese and oil, etc. .... What we are seeing is the inflationary impact of debt accumulation. The cost of cheese in the US is going to go up.

    The US dollar is the world’s reserve currency. If oil producers want to accumulate another commodity like cheese in exchange for oil they can buy it from other countries in US dollars (e.g., Switzerland). Why do you assume that they would only demand it from the US?

    Overseas debt is a call on the total output of your economy in the future, and the greater the debt, the greater the proportion of future output needed to service the debt, and the less goods and services available within your economy for domestic use, and the greater the inflation in the economy

    I have just shown how the US just doesn’t conform to this idea. The US dollar is the world’s reserve currency. If a country A accumulates US dollars, it does not mean that country A wants all of these US dollars from US output at all.

    When you come to other countries, then overseas debt can be a call on your output. However, if you have abundant resources to sell (say, minerals or primary commodities) then this is necessarily a problem. Far from being inflationary, it might simply increase employment and raise exports lowering your current account deficit.

  3. Great Video in note 3!

    On a more serious note:

    What we have is the situation in which a low cost economy is rapidly expanding, endlessly increasing the labour force in the world, consuming more and more resources, and lending a significant portion of their output to another country.

    China does not “lend” its output to other countries. The EU in fact is a bigger export market for China than the US:

    Even though the EU has a huge bilateral trade deficit with China, the EU as a whole tends to have a trade surplus because of Germany. In what sense is China “lending” goods to the EU?

    In purchasing US treasuries, [China] increased the demand for $US, and the increased demand raises the value of the $US, and they also allowed the illusion of wealth in the US to continue through their lending.

    There is something wrong with this argument.
    According to this argument, the US dollar should have risen in value, especially after China’s huge trade surpluses developed in the period 1998-2008. Note that it was only in about 1998 that US trade deficits with China started to explode:

    But the massive purchases of US Treasuries by China did not increase the value of the US dollar. On the contrary, after 2001 the US dollar fell sharply:

  4. The one point I would argue with is that it was a result of de-regulation, as I do not accept that there was deregulation, but rather there was misguided regulation. I have emphasised the role of the Basel I and II banking regulation frameworks in contributing to the crisis

    The financial crisis was the result of a fundamentally flawed regulatory environment, in which deregulation was certainly a part of it, as I have shown here:

    I even found an article on the Bank of England website that innocently noted that Basel I had been a driver of the market trend to securitisation, the very instruments that later exploded onto the world with the banking crisis.

    That Basel I was a badly designed regulatory system only strengthens the thesis that a fundamentally flawed regulatory environment was a fundamental cause of the financial crisis. Its role may be exaggerated, however. See below.

    The problem is that, a wall of money is entering into these debtor economies, and yet there are very limited numbers of investment opportunities .... What to do with the money? .... As we now know, the money went into higher and higher risk consumer lending.

    The West was hit by a wall of money in the 1970s comparable to the recycling of money by China in the 2000s. Yet no massive financial collapse happened. Why? Because of effective financial regulation, as I have shown here:

    Effective financial regulation was precisely what was needed to channel money into productive lines of investment, or prevent it from being used to create asset bubbles in the absence of such investments. The idea that you let banks do anything they want is precisely the problem.

    The Canada Problem

    One major confirmation of the effectiveness of financial regulation is the state of Canada’s banking system. In 2008, the World Economic Forum ranked Canada's banking system as the soundest in the world. The US system was ranked at number 40, and Germany and Britain ranked 39 and 44. Canada’s banks required no direct government bailouts.

    You blame Basel I and II as a cause of the financial collapse.

    But if Basel I and II cause asset bubbles and financial collapse, then why has this not occurred in Canada?

    The answer is fairly simple: Canada, unlike many other Western countries, still has tight and effective banking regulation.

    That the role of Basel I and II in the present crisis is exaggerated is suggested by the fact that

    “Canadian banks were the first in the world to adopt risk-management approaches under the new international Basel II capital framework, which sets out rigorous requirements to ensure a bank holds adequate capital reserves appropriate to the risk it is exposed to through its lending and investment practices.

    Furthermore, neither investment banks nor hedge funds (essentially the shadow banking sector) were really subject to Basel rules, yet these were the sectors of the financial system where the crisis originated: thus it was the investment banks Bear Stearns and Lehman Brothers that first collapsed in 2008. Furthermore, even commercial banks could evade Basel by creating SIVs, which were not subject to Basel I and II capital regulations.

  5. On the “subjective” labour theory of value

    It is entirely consistent to say that we subjectively value labour, which is my explicit central point. I see no inconsistency in this. Lord Keynes simply misrepresented my argument to create an inconsistency.

    But the point is that, when people buy commodities, they don’t all “subjectively value labour.” The subjective decision to buy something could be based on one, two, or many factors that have nothing whatsoever to do with the subjective value of the underlying labour.

    My position is laid out here:

    The assertion that all purchases of commodities involve people “subjectively valuing labour” is simply untrue.

    If you find even one instance of someone buying a commodity where his or her subjective decision had no role for a subjective valuing of labour, the theory you describe wouldn’t work.

    And, of course, in reality, many people do consume commodities without the slightest interest in the subjective value of the underlying labour.

    If a purchase a pearl at a market, I do so because I find the pearl aesthetically pleasing. I have no interest in the subjective value of the labour it took to bring the pearl to market, which is utterly irrelevant to the question whether I find it aesthetically pleasing or not.

    Your position requires the previous belief that all value must come from labour, which is simply untrue.

    By definition, if value is subjective, it cannot simply come from one factor like labour, but could come from many factors.

  6. Mistake in Comments 2

    A the end I meant to write

    However, if you have abundant resources to sell (say, minerals or primary commodities) then this is not necessarily a problem.

  7. You say: "for an ordinary Chinese worker, they are not paid in wages that reflect the true value of their labour". I find that a difficult concept because I cannot see how there can be a single "true value".

    Mr Chinaman might be paid US$40 a week to do a job Mr American would only do for US$400 a week, Mr Italian might charge US$250 and Mr Kiwi US$300. (Mr Greek might charge US$200 but is too busy rioting.)

    Each takes the job because he either cannot get anything paying more or he prefers to do that job rather than earn more elsewhere.

    Each rate of pay represents the true value within the circumstances prevailing in each country. If it did not, people would not take the work for that money except under duress.

    One cannot say Mr Chinaman is underpaid where his only other option is the back-breaking paddy field for US$10 a week and one cannot say Mr American is overpaid if no American can be employed to do the work for less than US$400. Every manufacturer has to decide whether the price it can achieve for its product is more than the costs of production - of which labour is only one element. If it can and the given wage has to be paid to attract staff, then that is the true value of the job in each country (or in each state / county / town).

    Whenever we measure something in monetary terms we cannot avoid the fact that monetary values are relative not absolute and they are local not universal.

  8. Thanks, that was a very good summary. On Neo Keynesians,Kipling’s: “Twisted by knaves to make a trap for fools” comes to mind.

    Tmm thrashes about a bit, but when he does nail it, it stays nailed. Well worth looking at his videos.

  9. Interesting post. One question:

    "If Greece defaults on debt, and German banks take a hit, this is not abstract money, but the accumulated savings of individuals aggregated and lent into the Greek economy."

    Is this consistent with how banking works? Don't banks create credit out of nothing, simply by expanding their balance sheets? Isn't this precisely why there is far more debt in the world than actual savings?

  10. Lord Keynes,

    you state that many people do consume commodities without the slightest interest in the subjective value of the underlying labour. which conciously may be the case but underlying this is the indisputable fact that any individual doing work will place a value on the work they have done and will pass this on to the next person in the chain. Of course, there may come a time when market forces dictate that a persons subjective assessment of the value of their work doesn't meet the market price (possibly due to over supply or lack of demand) at which time the individual must decide whether to jack it all in or improve their processes to a level where they are happy with the subjective value applied to their work.

    Taking your pearl purchase example, assume that there are two pearl stalls at the market with identical looking pearls with identical properties (shine, hardness etc) yet one stall is 80% cheaper than the other because these pearls have been farmed and not plucked from the depths of the ocean by a risk taking free-diver. The fact that the free-diver charges 5 times more than the stall next door is due to his own subjective value of his own underlying labour, similarly for the farmed pearls.

    Which pearls will you buy? Regardless of which stall you choose your answer will, in some manner, be influenced by the subjective value of labour required to bring those pearls to market, even if it never crosses your mind personally.

  11. Sir

    I do not think you are gloomy, but a realist who is appraising the situation from an impartial perspective. That type of analysis has been overlooked in the past 20 years throughout the economy, with the results we see today. Too much ego, not enough rationality.

    I'm glad you mentioned oil, but its importance is underestimated. The guys sitting in Goldmans need electricity to run their computers, and their sandwich boy needs petrol for his sandwich truck. Making a derivative on a computer screen doesn't produce petrol for sandwiches to be delivered. We need a new raw material to generate real, tangible wealth, not collapsing empire wealth, denominated in pixels on a screen.

    This is the big distinction to make, Raw materials = wealth. If your material of choice is getting very expensive and stops your growth, you either stop or move on to a cheaper alternative - Hemp Oil.

  12. One potential problem with your argument (wrt foreign borrowing/money in-outflow) is that it seems so amazingly unlikely that, with all the extra money floating around through these very advanced economies, (certainly compared to 2nd/3rd world nations that experience(d) massive inflation due to foreign investments) there still weren't enough workers who used this money to create new exportable products with.. I can see how this would apply to, say, the UK, with its gutted industrial/manu sector, or the US, but your argument seems to entail that most of the Eurozone (excepting NL, DE, and.. which other countries?) never managed to use that money to its advantage.
    Now, while I'm more than willing to accept the charge that most of this extra money was put in useless places (like housing prices), it's just surreal that this would be the case. (Similarly for recent eastern European economic growth.)
    Certainly part of this will be explainable via the argument that the difference in labor cost is just too big to offset the productivity difference given the enormously expanded labor market, and I realize the answer to this 'question' of mine would likely be a very empirical, computational one, that cannot really be answered, but still.. It boggles the mind.
    Also, it saddens the heart that the economics curriculum really is this complacent and ideological.

  13. Taking your pearl purchase example, assume that there are two pearl stalls at the market with identical looking pearls with identical properties (shine, hardness etc) yet one stall is 80% cheaper than the other because these pearls have been farmed and not plucked from the depths of the ocean by a risk taking free-diver. .... Which pearls will you buy?

    Again, you are talking about price, not value.
    The causes of price are the costs of factors of production – labour is only one of them. For instance, the pearl diver may have rented capital goods (e.g., boat, diver suit etc) which he must also pay for by raising the price of the pearls.
    That you have found an instance (and no doubt there are many of them) where a buyer’s subjective decision to buy something was influenced by cost (which in turn was related to underlying labour) in no way refutes my point above that there are also numerous other cases where the buyer has no interest at all in a subjective valuation of the underlying labour that produced a commodity.

    Again: If I purchase a particular pearl at a market, I do so because I find the pearl aesthetically pleasing. I have no interest in the subjective value of the labour it took to bring the pearl to market, which is utterly irrelevant to the question whether I find it aesthetically pleasing or not.

  14. Reply to Ginger tosser

    but underlying this is the indisputable fact that any individual doing work will place a value on the work they have done and will pass this on to the next person in the chain.

    In which case you are talking about price, which is different concept from value.

    In fact this discussion would benefit from people defining their terms:

    (1) In Neoclassical Economics:
    Use value is purely subjective. Utility is the satisfaction or pleasure derived by an economic agent (a person or a firm) from consuming a good. Utility is the measure of value. This stems from a subjective valuation of the worth of the good by an economic agent. Thus the value placed on any good can, and often does, vary from person to person. Two people can derive completely different utilities from a good that costs them the same price. Also, utility can influence the price of a commodity.
    Exchange value is the price that a good or service commands in the marketplace, although the price can also be affected by supply and demand. The utility of the good (and the individual subjective valuation of that good) can directly influence the price, particularly when aesthetic judgements are involved. In modern microeconomic analysis, price theory is the study of how prices are determined in individual markets. There are two main factors affecting the price of a good: the demand side and the supply side. The demand side is essentially consumer behaviour involving individuals maximizing utility. The number of individuals who place a subjective value on a particular good can cause demand, and along with supply, this influences the price of the good. Furthermore, the long-run or average price of a particular commodity is also caused by the costs of the factors of production (labour, however, is only one of these factors).

    (2) In Marxist Economics
    Use value is the objective usefulness of a good and depends on the way in which the good is used by the buyer.
    Exchange value is the power that something has in obtaining other goods in exchange, and it is completely independent of the use value.

    When you talk about “value”, which one are you talking about?
    If you are talking about use value in the neoclassical sense, then the utility of a commodity subjectively assessed by a person has no necessary connection to its underlying labour.
    There are plenty of instances where neoclassical use value in this sense does not derive from labour. Therefore a “subjective” labour theory of value will not work.
    If you are talking about exchange value in the neoclassical sense, then the costs of the factors of production are a major cause of long-run or average price. You can’t say that price is just simply caused by a subjective valuing of labour either.

  15. Thanks for the many interesting comments. With regards to Lord Keynes' contributions, they are as ever voluminous, so I thought I would just respond to one point where he is partially right. On the value of the $US, Lord Keynes makes a fair point in the detail, as I should have written it as 'supporting the value' of the $US, instead of 'raising the value' of the $US. The latter was my intended meaning, and the point still stands on that basis.

    Some of the comments offer valid points on the basis of the post as it stands. For example, I make some rather large generalisation, and these are picked up by ospinBoson. I would reiterate that, in order to compress this much, I have to sacrifice depth. In doing so I have offered broad brush principles rather than detail.

    For example, I agree that it is certainly the case that some of the borrowed money went into productive investments, and each country will have a different profile as to how the credit might have been utilised. As I said, in presenting a broad brush, such detail is lost.

    Many thanks for all the comments, whether critical or supportive.

  16. Lord Keynes,

    I understand the confusion that has arisen through the use of the word "value" when in fact "price" is what was meant - fair point, I'm an engineer, not an economist.

    Maybe it is because I am an engineer that I am still failing to understand your point about the fact that a buyer can have no interest at all in a subjective valuation of the underlying labour that produced a commodity. The decision to purchase a product because there is a subjective value/worth assigned to it from the buyers point of view still boils down to the fact that the buyer must pay with cold hard cash at the price set by the seller. If the buyer feels that this price is above the value of the product to him then it is highly probable that the thought processes of the buyer are going something like this - "I worked hard to earn all that money, is this something that is really worth x days wages?" at which point a value of labour has been assigned to the product.

  17. I think that was your best post so far, CE. Capturing all that's gone before and creating an instant summary while adding some interesting new observations and examples.

    I certainly can't fault your logic, though the sort of "economic miracles" which could "turn up" as governments hope, while unlikely, do sometimes happen. Its not impossible.

    Further, since all developed nations are caught up in the problem in one way or another it may be possibly to gradually extract everybody through a careful reversal. It will mean less "bling" for the Western world, no doubt. But maybe this will lead to the obvious substitute for "Must have" commodities - community.

    Sometimes terrible situations lead to positive outcomes. Let's work towards that.

  18. You have missed a key point. A country might be borrowing from overseas (ie selling its debt overseas), but it is selling that debt *in a currency it is sovereign in*. That moves the power from the lender to the borrower, since it can simple print the dollars, euros, pounds, etc to settle both the interest and the debt.

    In other words the loss risk sits with the foreigner.

    Its when a country borrows in a foreign currency (which with the Greeks is of course the Euro) that the problems really arise.

  19. A Real Black PersonMay 26, 2010 at 4:07 PM

    Cynicus, once again you have laid out your case. However, you I think the notion of connecting additional labor to markets and capital makes as being inevitable may not be so inveitable. If economies worldwide are to get leaner and meaner, doing more with the same or less amount of resources, while new labor is being added, that will mean at some threshold there will be more and more unemployment because each additional worker would have to be more and more productive. It's not clear if that's currently possible. In some sectors, adding more labor would actually depress the morale of workers because because additional labor would cause the lowering of wages due to increased supply. In other words, no matter how productive and useful a vocation title is, if the vocation's wages don't justify the effort needed to enter that vocation, innovation slows down. Quality suffers even though labor costs are cut to the bone. I'm not saything this will happen in engineering, but other sectors that are less glamorous, less prestigious but still socially valuable will suffer. The global economy cannot keep adding workers without each additional worker adding an increasing amount of added value. The only "rebalancing" I can see is some level of retrenchment from global trade. This may mean that global consumption of resources will fall below what is produced but I agree that the larger slice of pie will be going to emerging economies. If productivity rises, it probably won't be in every country's best interest to export their wealth. What sense will it make for China to keep exchanging its output for government bonds when it can use it internally to keep people happy and not demanding a say in their government? Indebted countries such as the developed countries countries may end exporting raw resources,(Canada and Russia are in this position) rather than processed goods to places that are barren --where the native people there cannot grow enough food to feed themselves but lead in science and technology sectors. Developed countries, and third world countries will be forced to have governments that are protetionist because they will not be able to compete. Those of you who share Steve Tierney's sentiment might welcome this development if it happens. Everyone knows that misery loves company and that there's no better way to strengthen social ties than reducing prosperity.The only alternative to some kind of protectionism, is as Cynicus, hinted social unrest. I'd say the only alternative is war. Cynicus, I think you need to keep in mind that World War I and World War II were solutions to what you're calling hyper-competition. Other solutions to what you're calling hyper-competition, were colonialism and the cheapest of cheap labor--slavery. Slavery and colonialism were not sustainable because hyper-competition discourages sustainable competetive advantages.( War was the final solution because it destroyed extra capacity and eliminated competition. I 've purposely left out technological innovation because it seemed to proceed at a universal pace until World War II. In the future, it's unlikely that technological breakthroughs will be confined to the regions they were developed in. The computing revolution didn't stay in Silicon Valley , did it? Biotech is done around the world.R&D is global. I don't see developed countries capturing the bulk of future r&d capital right now. They're just not competitive.

  20. To Ginger Tosser
    "I worked hard to earn all that money, is this something that is really worth x days wages?"

    This question goes through my head every time I make a purchase. It also goes through my head every time I see a politician. Which brings me to wonder what on earth goes through the minds of the politicians....

  21. Excellently simplified and succinctly potted precis of precisly why we are where we are Mister Cynicus.

    The underlying mantra that repeatedly supports its deliberately blunt message is unwittingly reinforced by some of the disapproving and disbelieving comments routinely found in the follow up comments section.

    They merely serve to obfuscate the clarity of the article and attempt to justify the unjustifiable like so many others have done, for a long long time, despite in most cases, their obvious powers of thought!

    Maybe they think too much.

    Oh that we could read such pieces in the 'Sun Says' section and put to good use their obvious if inexplicable popularity.

    'Just Say NO' is the title of a competition I'm trying to launch on ThisisMoney website, outrageously plaguerised from the anti-drugs campaign I know but seems appropriate in the circumstances.

    Dave O'Carroll - Romford

  22. As a regular read of your column I though it was about time I left a reply. Firstly to say thanks for this blog. I have found it very interesting and a general good read. And then to add some views on how I see things.For some reason I’ve been reading blogs on economics since 2000 (Dot Com debacle) and have preferred the sceptical ones. Plenty of people from 2005 onwards were warning of the property bubble and CDO’s etc, however I guess they were not people of influence. In the UK I would chat with a few friends about how the UK growth just appeared to based on debt and that housing was getting crazy, but as the mainstream media and politicians just gave the impression that housing was always going to go up (end of boom and bust) must people ignored there gut feelings and got stuck in before they feared they would be priced out.
    The one thing that has surprised I think a lot of people, including the people that perceived a rescession/depression/credtit crunch was in the way was the it has not ended in calamity for banks and countries (yet). No one seemed to realise the extraordinary measures governments would take around the world to try and solve the problem. Who would have predicted a year ago that within a year bankers would be receiving record bonuses again and house prices in London would be increasing again? We seem to be left in a situation where people are now saying that the debt has been passed from private to public hands and ultimately the next thing to expect is government default. On paper I believe that banks and governments are technically insolvent in many western countries. However economics is not controlled by the laws of nature, it appears bankers and politicians can change the laws and rules as they go along. From a logical perspective it is easy to see a path of how this crisis is going to lead to an insolvent Europe and US and many economists/bloggers are taking this logical path with outcomes ranging from Armageddon to the slow and orderly continuation of the transfer of wealth to the East.
    However I think logical thinking and applying the existing rule and laws is not relevant when it comes to economics and world politics. It appears as soon as the existing rules and laws do not suit anymore they will be massaged/changed to ensure they do suit again.
    The banks have been insolvent in the past (Asia Crisis/Latin American debt crisis) and the rules were changed to ensure they did not all go bust. Maybe one or two of the big boys are allowed disappear but the majority are saved.
    Logically we can see how the east is going to overtake the west, massive surpluses of cash, lower wages, motivated and increasingly well educated workforce, theft of western intellectual property and technology, surely this can only lead them to becoming top dog.
    However are we really taking into account how random and irrational people are? I think if you want to try and predict how the game is going to proceed in the next few years you need to have an illogical outlook. We know the governments are in massive debt and insolvent, how are they going to make sure they don’t go bust?
    How could they change the rules back into their favour without causing ultimately a War?
    Ultimately to me it seems the world is far to complex and run by a bunch of shisters. Many people seem to have forgotten that human beings are simply animals and as such don’t expect to much from the ones that make it to the top of pecking order (politicians etc). Capitalism to me does not appear to be governed by any natural irreversible laws for those at the top. Of course for average man on the street rules do apply (fall behind on your mortgage repayments, have a zero reading on your current account) and no one is going to magically change the rules of your mortgage or magically make your balance go back up a few thousand pounds/dollars etc. For the elite however we have to apply illogical thinking and come up with totally irrational ideas of how they will keep the party going, because they will most likely come up with something. Matt London

  23. might be of interest (john Mauldin, with a more or less comparable message to yours)

  24. After seeing someone mention his name I found an interesting talk by Michel Chossudovsky givne in Jan 2009:

  25. Hyperinflation Myth: US Broad Money Supply M3 Falls

    The US M3 money supply … has been posting big declines in past months that have been accelerating to a pace that mirrors that of the Great Depression … The M3 fell 9.6%, from $14.2 trillion to $13.6 trillion

    Meanwhile, the US is basically experiencing disinflation (with a slight spike in March):

    US Inflation Rate
    Jan. 2.63%
    Feb. 2.14%
    March 2.31%
    April 2.24%

    The mythical hyperinflation threat is as far away as ever, so it seems.

    Remember this sort of prediction last year:

    Marc Faber says Hyperinflation in The United States 100% Certainty

    So it was 100% certain last year!!

    One wonders whether these hapless Austrian school commentators like Marc Faber are feeling embarrassed now.

  26. Lord Keynes:

    Faber says hyperinflation is a certainty whilst Schiff said very high inflation is.

    But they did not give a timeframe to their prediction.

    Time will tell if they are correct.

  27. Also, have you seen ?
    "The administration has made economic policy as if it believes that once financial institutions and financial markets are restored, credit will start flowing and growth will follow. This would be in keeping with its analysis of our economic problems, but ignores the deeper roots of the crisis, which lay not so much in the incapacity of financial institutions to lend, as in the overcapacity that has long gripped the global economy."

    Author highlights a few historical points that may be of interest (suggesting Greenspan was cleverer than he seems to have been), and commits a few post hoc fallacies along the way, but his overall story is not dissimilar.

  28. Lord Keynes,

    You still don't get it that hyper-inflation is a sudden event in a currency crisis, and does evolve from demand economy high inflation. To see how history shows that hyper-inflation follows deflation, see

    Keep believing that printing money out of nothing and via debt issuance is the answer to and not the cause of our problems. My children and I would love it if you are correct and I am wrong, but....

  29. Reply to George

    You still don't get it that hyper-inflation is a sudden event in a currency crisis

    It’s not always a sudden event – it is usually started by accelerating inflation.

    The table in the article you link to shows Weimer hyperinflation was not sudden at all, by the way.

    Moreover, the article is, frankly, quite ignorant.

    Most instances of hyperinflation also require severe supply shocks or massive crises like wars.

    The idea that deflation is some kind of good predictor of hyperinflation is ridiculous. The US had severe deflation from 1929-1933, and then large deficits - no hyperinflation ever resulted.
    Japan was mired in deflation from about 2000-2004, so where is the hyperinflation in Japan now?

    Keep believing that printing money out of nothing and via debt issuance is the answer to and not the cause of our problems.

    You obviously haven’t read most of my comments on this blog. I don’t think QE is the solution frankly. The very fact that QE has failed to stimulate lending is proof that it is not that successful.
    Financial regulation, trade and industrial policies and deficit spending are the cure for the current crisis.

  30. An equally good post on QE in Japan and inflation myths:

  31. Cnyicus, once again you mention that if that all all the economic activity generated by borrowing were to be removed from the American economy, it would shrink only by 17 % . I find this percentage to be somewhat optimistic given the fact that approximetly sixty percent of the United States' GDP is comprised of consumer spending. When you came up with that 17 percent figure, did you figure out an average for what portion of that 60 % was fueled by pure credit over the last 20 years?
    In short, how much mathematical rigor is behind that 17% figure?

  32. Lord Keynes,

    We all know those CPI figures you quoted are meaningless, such is the extent to which the US govt goes out of its way to hide real inflation, which I suspect is closer to 8%.

    Japan shows clearly that Keynesian fiscal stimulus packages and excessively loose monetary policy simply don't work. The very fact that Japan did not experience hyperinflation (or just high inflation) despite the BOJ attempting to cultivate inflation shows how strong deflationary forces actually were. Japan would be a lot better off now had those price actions been allowed to play out.

    By intervening to try to maintain the existing structure of production the Japanese govt simply prevented the necessary market processes from working to correct the artificial boom's malinvestments. This is essentially what we are seeing in the UK/US, the difference being that our economies are fundamentally far less sound than Japan's was. This, naturally, does not bode well.

  33. A Real Black Person:

    Thank you for your comment, and an interesting question. For the 17% I am just looking at overseas borrowing but there is, of course, a wider problem. With regards to the rigour of my calculation, you will see in my original post that there are some approximations in the figures.

    With regards to your point about the 60%, this is the point of my first ever blog post, in which I tried to work out where the apparent wealth came from in the UK. With no reasonable explanation for where the source of this wealth might be, I came to a conclusion that at least the last ten years of GDP 'growth' were due to borrowing.

    My assumption is that the US would present a similar picture, but I have not done the analysis for the US in particular.

  34. On thalidomide and regulation

    Off topic, but on the issue of the need for regulation:

    Thalidomide first entered the German market in 1957 as an over-the-counter remedy, based on the maker’s safety claims ... Around this time, Australian obstetrician Dr. William McBride discovered that the drug also alleviated morning sickness ... In 1961, McBride began to associate this so-called harmless compound with severe birth defects in the babies he delivered. The drug interfered with the babies' normal development, causing many of them to be born with phocomelia, resulting in shortened, absent, or flipper-like limbs. ... In July of 1962, president John F. Kennedy and the American press began praising their heroine, FDA inspector Frances Kelsey, who prevented the drug’s approval within the United States despite pressure from the pharmaceutical company and FDA supervisors. Kelsey felt the application for thalidomide contained incomplete and insufficient data on its safety and effectiveness. Among her concerns was the lack of data indicating whether the drug could cross the placenta, which provides nourishment to a developing fetus.

    Far from being an 'outlier' ("outlying observation, or outlier, is one that appears to deviate markedly from other members of the sample in which it occurs"), the Thalidomide disaster was the result of simply believing the claims made by a drug manufacturer - without careful trials and study.

    The FDA prevented it from being used in the US - an obvious example of the success of regulation.

  35. We all know those CPI figures you quoted are meaningless, such is the extent to which the US govt goes out of its way to hide real inflation

    The CPI figures are not meaningless, just underestimated, if you prefer to believe the Shadowstats figures are more accurate:

    Even if you accept the Shadostats figures there has been very clear disinflation since 2008 (precisely as I said), with a slight spike at the end of 2009 and then disinflation again now (precisely as I said).

    There is no sign of hyperinflation.

    Japan shows clearly that Keynesian fiscal stimulus packages and excessively loose monetary policy simply don't work.

    On the contrary the fact that they had no depression is sign of the effectiveness of fiscal policy.

    By intervening to try to maintain the existing structure of production the Japanese govt simply prevented the necessary market processes from working to correct the artificial boom's malinvestments.

    The existing structure of production was not the major problem in Japan: it was dysfunctional banks and not enough domestic demand.

    By intervening to try to maintain the existing structure of production the Japanese govt simply prevented the necessary market processes from working to correct the artificial boom's malinvestments.

    No, they didn’t. The cleaned their banks up in the late 1990s – the malinvestment was corrected.
    The malinvestments anyway were largely bad real estate loans made in the 1980s and ealy 1990s, because of a a real estate bubble and financial deregulation.

    Hans Rosling here tells another part of your story (growth/catchup of china/india)


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