Wednesday, April 27, 2011

An Occasional Return

My last post on this blog was a 'goodbye' post but, as was expressed in a recent comment, a lot has happened in the last 8 months. Another comment suggested that we are on the edge of a seismic shift in the world economy. I am not sure how often I will post, but will see how much time allows. For this post, naturally enough, I will just cover some of the 'events' that have taken place since my last post. As such, it will be a little rambling, and more sparsely referenced than readers might be used to. I will try to link the course of events with the themes that I have covered in the blog before, or at least as much as possible.

The UK

I started this blog with a strong focus on the UK economy, but it was apparent that the problems of the UK economy were part of a wider shift in the world economy. My underlying idea, pre-financial crisis, was that the UK economy only appeared to have been growing, and that analysts had mistaken growth in debt for growth in wealth. As a result of this analysis, I suggested that the UK (as a whole) was poorer than people imagined. It seems that this reality is now official, with the Office of Budget Responsibility predicting a fall in the standard of living. The reason given for this is the rise in inflation, coupled with low wage growth. Below are the National Statistics Inflation figures:

The UK inflation genie has long been out of the bag and, as I pointed out a long, long time ago, the underlying driver is the devaluation of the currency. If you are a net importer, then a devaluation of the currency must push up prices. The mythical spare capacity in the economy was never going to hold down inflation, it was only ever going to hold down wages. It is worth reiterating why this spare capacity is mythical. If the UK economy is built around services, with a consumer debt led economy, then there will be large numbers of individuals who are trained and employed in sectors to support debt led consumption. These individuals, in a range of industries, can not suddenly shift into new areas of work. Using a crude example, a shop worker will not suddenly be able to transfer their skills to an engineering company. Below is a chart from National Statistics, which shows the decline in debt accumulation:

The Bank of England meanwhile seems to have quietly abandoned the remit set for inflation, and seems to wilfully ignore the ongoing rise in inflation, maintaining low interest rates under an implicit new remit to look after the health of the economy overall. In particular, they appear to be aiming to offset future reduction in the rate of increase of government borrowing. This is a far wider remit than targeting inflation, and nobody who is grounded in the real world should believe that the Bank of England is now trying to keep inflation within the agreed targets.

However, this is only part of the picture, as there is also the question of government debt. Again, from National Statistics, the government debt situation is below. Note on the percentage of GDP that this excludes 'interventions' which are apparently not to be counted, though there is no good reason for why this should be the case.

The simple fact of the matter is that, despite talk of austerity, the UK government continues upon its binge of borrowing and spending. This extract from a Telegraph article seems to tell the overall story rather well:

Mervyn King, the Governor of the Bank of England, has said that the January VAT rise and other inflationary pressures meant that prices would likely outstrip pay again this year, leaving real wages no higher than they were six years ago. Not since the Depression-hit 1920s has a fall of such scale taken place, said the central banker.

The ONS said that public sector net borrowing totalled £10.3bn in February, up from £8.12bn for the same month in 2010 and well above economists' median forecasts of £8bn.

So much for austerity. The UK economy is still sitting upon the life support of government borrowing, and has yet to face what might happen when the borrowing stops, and repayment starts. Even with the linked inflation and currency devaluation, the UK debt position remains in a dire position. The government and Bank of England are playing a very, very dangerous game. They are treading a fine line which is largely reliant on gestures, rather than substantive changes to the UK economy.

Throughout this blog, I have argued that there needs to be substantial reform of the UK government. The kind of reform necessary to make the UK economy more viable is nowhere in sight. A recent article in the Economist discussed the problems of state spending, and the growth of the state more broadly. I rather liked the following statistics:

Although there appear to be moments of reform, the trend is clear. The state surely and steadily gets larger, and larger. This growth in the state has been affordable, as long as no competitors had a significantly smaller state. The trouble is that, over the last two decades, these competitors have emerged. This is not to say that the size of the state is the only determinant of economic health; there are many other elements that feed into the success of an economy, such as the structure of the private sector, education system, the culture of the country and any number of other variables. However, the size of and nature of the state intervention within an economy are undoubtedly significant factors in the health of one economy compared to another.

Returning to the UK, despite talk of 'austerity' and hysteria in the left leaning media, the state is not set to see any real depth of reform or any depth of fiscal consolidation. It would be easy to blame the government, whether Labour, Conservative or Liberal. However, the problem is that the people of the UK have yet to grasp the severity of the problems that they are facing. Even as their living standards slide, the big state trundles forward largely unchanged. In fact, the state is setting out to hobble any hope of the manufacturing renaissance that is necessary to move the UK forwards. As just one example, the UK's energy policy is leading towards ever higher energy costs, and the possibility of energy shortages in the future ( a few lonely voices are raising the alarm). And then there is the legislation and regulation, whether from the UK government, or from the EU. And the ever more complex tax systems.

In other words, despite talk of austerity, and reform, there is no real appetite for change. As long as the government can keep borrowing and spending, nothing will really change. The problem is that this cannot go on forever, and something must eventually change. The question is to ask what might force the change. The decline in living standards might be just such a driver, but it is just as likely that the decline will prompt ever louder voices for ever more state intervention, ever more state borrowing and ever greater debt accumulation. It is the idea that something must be done to halt the decline, and that the state that has been behind the problem might now solve the problem. The other possibility is that the UK goes down the same road as Greece, Portugal and Spain i.e. the county loses the trust of lenders.

The BRIC Economies

Regular readers of the blog will know that I have an obsession with the rise of China. I discuss China for two reasons. The first is that China is rising at such an astounding rate, and the second is that I have lived and worked in China, and therefore have first hand experience of the economy. This is not to diminish the impact of the other BRIC economies (Brazil, Russia and India), but rather to highlight the importance of China. From a very early stage in the development of this blog, I concentrated on the rise of China. I had seen how the Chinese economy developed, and the amazing way in which manufacturing clusters grew on the back of exports to the West. For example, near to a city in which I lived, a small town emerged which did nothing but specialise in the manufacture of lighting. And there was the dogged determination of individual Chinese people to better their situation, and more pertinently the drive to better the situation of their children.

In a way, what I observed in China was an absence. An absence of complacency. China and the Chinese people have pursued the goal of economic development with an amazing will. They have done so through both fair means and foul. The foul are the theft of intellectual property, loading the dice within their own domestic economy against international firms, and the use of their currency and subsidies to flatten competition. The fair is their willingness to adapt, and their sheer determination and hard work.

It is worth discussing the issue of Chinese currency manipulation. I have often argued that this is a mercantilist practice, and that it distorts the world trading system. However, to apportion all of the blame to China would be wrong. In order for China to manipulate their currency, they first need to have assets to buy with that currency, and the US has provided them with unlimited assets through the massive issuance of treasuries. Take away the issuance of treasuries, and what might the Chinese buy to hold down their currency against the $US? Without the unlimited supply of treasuries to buy, the Chinese would be forced to buy either real estate or stocks within the US, and the scale of the purchases would have served to alarm the ordinary people of the US, just as happened with Japanese purchases in the 1980s. However, in buying treasuries, in some respects, they are achieving the same ends, as those assets (and personal taxation) will in the end provide the tax revenues necessary to service the debt. China is, in other words, indirectly buying up a large chunk of the US economy. It is doing so in a way that is just less obvious than direct purchase of assets such as real estate.

It has long been apparent to me that China has a broader agenda. That agenda is the diminishing (if not the complete ending) of the $US as a reserve currency, and the use of the RMB as a new (or replacement) reserve currency. When I first suggested this, many people commented on how unrealistic this was, that it would be years before such a change took place, that the Chinese bond market was not liquid enough, and so forth. I persisted with this view in the face of the criticism, as my argument was simple. Which currency would you chose as a reserve currency, if the $US was not already a reserve currency? An economy overburdened with growing debts and massive trade deficits, or a currency that was supported by massive foreign exchange reserves, a huge balance of trade surplus, and a story of phenomenal economic growth. To me, the answer is obvious, but there are still many people who will argue the point.

In the interim, since I first proposed the RMB as a reserve currency, the situation has been rapidly shifting, and the shift is supportive of my argument. This is a report on a recent BRIC conference:

As such, it is interesting the BRICs just signed an agreement to grant one another loans in their national currencies, not in dollars. The mighty Chinese Development Bank has now formally offered 10bn yuan loans to other BRIC members, expected to focus on large oil and gas projects.

Russia and China are now trading oil in rubles, rather than dollars. A Sino-Russia oil pipeline recently opened, almost ignored by the Western media, which will eventually pump 1bn barrels a year from Siberia to the People’s Republic. It will soon be joined by a gas pipeline too. These developments undermine the dollar’s role of global petro-currency, the bedrock of its reserve currency status. They are of huge geostrategic importance.

The BRICs are all creditors to the US – with the Chinese, in particular, holding vast swathes of American Treasury bills. So they won’t make any sudden moves in terms of dislodging the dollar as “top dog”, as that would harm the value of their T-bill holdings. They are, though, pushing for the IMF to overhaul the role of Special Drawing Rights, the international unit of account comprising the dollar, euro, yen and sterling.

Were the yuan and possibly the ruble to be included, the BRICs say, then the SDR could ultimately replace the dollar. That would be anathema to Washington, formally ending America’s global hegemony and forcing it to address its massive overseas debts. It was a message the BRICs wanted to emphasise in Hainan, just in time for this weekend’s spring meetings of the World Bank and the IMF in Washington.

In a post I made a long time ago, I suggested that a key moment to the emergence of the RMB as a reserve currency would be the use of the RMB for pricing oil (and also other commodities, but with oil as the key). This report is not isolated. I have in previous posts detailed the many other bilateral deals that China has been introducing to 'internationalise' the RMB, and there have been other reports in the last 8 months which I do not have time to cover. The Chinese are not only major creditors to Western nations, but also to other emerging economies. In other words, as an increasingly important creditor, China is developing the heft to make the shift to reserve currency status. In the interim, the $US continues to slide in value:

A complacent perspective would be to suggest that, as the $US has dropped before, there is no need to worry. In some respects, this is true. It may be that there will be a flood back to the $US as a 'safe haven', perhaps in response to another crisis. However, if this takes place, it is simply a habit, rather than a reaction to anything fundamentally positive in the US economy. After all, the Federal Reserve is printing money at astonishing rates, and the debt of the US economy just climbs and climbs, and with no real answer as to how the spending and borrowing might be restrained. The latest figures for US federal borrowing make the point:

The U.S. budget deficit in the first six months of the current fiscal year totaled $830 billion, $113 billion more than the shortfall for the same period last year, the nonpartisan Congressional Budget Office said on Thursday.

The red ink stretches into an eternity, and nothing substantive is being done to rectify the situation. A brief overview of the trade and current account balances of China and the US just serves to highlight the natural winner of the best candidate for a reserve currency:

The subject of the G20's recent meeting was ''global imbalances''. According to the communique issued by the group, the meeting focused on developing a procedure for identifying which G20 countries have ''persistently large imbalances'' and why they have them. This delicate analytical task was assigned to the International Monetary Fund, which is to complete its work before the ministers' next meeting in October.

It hardly takes a team of IMF economists to answer these questions. Anyone who has taken a first-year undergraduate course in economics would have no difficulty in identifying the countries with the largest trade surpluses and deficits. The United States wins first prize with a trade deficit of more than $650 billion in the most recent 12 months. No other country comes close enough to be awarded second prize.

The broader current-account indicator (including trade in services and net investment income) confirms America's leading role - its external deficit is nearly $500 billion. No other country has more than a $100 billion current-account deficit.

Even if we look at current-account deficits relative to GDP, America's 3.3 per cent ratio exceeds that of almost every other economy. The three countries with larger deficit-to-GDP ratios have a combined deficit of less than $70 billion - not enough to warrant the G20's attention.

The country with the largest current-account surplus is, no surprise, China, with a positive balance of more than $300 billion. Japan and Germany are the only other countries whose current-account surpluses exceed $100 billion.
The problem is that, when examining the $US and RMB without the $US being an 'incumbent', the RMB looks like the natural reserve currency.

None of this is to say that China's place in the sun is assured. The opacity of China makes any analysis difficult, and there are warning signs within the Chinese economy. When first writing this blog, I had only recently left China. Whilst in China I had noticed how many new apartment blocks had been unoccupied, and the lack of customers in the brand new malls, and commented that it was possible that there was a real estate bubble in China. In the years that followed, ever more alarming reports have emerged which confirm my anecdotal suspicions. In addition to having something like 60 million vacant properties, China has built so called 'ghost cities' where there are almost no inhabitants. China's growth model has been infrastructure dependent, and there is talk about massive growth in excess capacity over the whole economy. This is from Nouriel Roubini:

China has grown for the last few decades on the back of export-led industrialization and a weak currency, which have resulted in high corporate and household savings rates and reliance on net exports and fixed investment (infrastructure, real estate, and industrial capacity for import-competing and export sectors). When net exports collapsed in 2008-2009 from 11% of GDP to 5%, China's leader reacted by further increasing the fixed-investment share of GDP from 42% to 47%.

Thus, China did not suffer a severe recession - as occurred in Japan, Germany, and elsewhere in emerging Asia in 2009 - only because fixed investment exploded. And the fixed-investment share of GDP has increased further in 2010-2011, to almost 50%.

The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

China's approach of 'build it and they will come' can only take the country so far, and there are substantial risks accumulating in the economy. There is also the looming problem of how China might extract itself from Chimerica, the importance of ongoing US consumption in the support of the Chinese export sector. The growth in trade between so-called emerging markets might ameliorate a decline in trade with the US, which must eventually take place, but how far is an open question at this stage. As I have always emphasised, there is potential for social unrest in China if the growth should stop. A debt crisis, and significant decline in trade, might just be enough for China to tumble over.

The United States

I have already covered some of the problems within the US economy. The borrowing is, in any reasonable perspective, out of control and with no end in sight. On top of this, the borrowing is largely being funded by the printing press of the federal reserve. As if that were not enough, the US faces the prospect of another financial crisis.

For all the time I have been away from posting, I have been taking occasional time out to watch the developing mortgage crisis in the US. I will try to cut a long story short. The problem is related to mortgage backed securities (MBS). It turns out that, in the rush to develop these products, a legal requirement was overlooked. The essence of the problem is that, when transferring a mortgage from one entity to another, there is a necessity for documentation to record the transfer. The banking industry chose to ignore the legal requirements, and instead replaced this requirement with an entity called MERS. This was supposed to take on the task of ensuring a record of transfers took place, but unfortunately was a system that was outside of the legal process. The problem that is emerging is that the result of this new extra-legal system is that the standing to foreclose on propery with mortgage arrears is now surrounded by legal questions. This has, in turn, resulted in dirty tricks being played by the banks, in the establishment of foreclosure mills, which are legal services being used to hide the fact that the legal documentation for foreclosures does not exist.

I am unsure how it will turn out. For a summary of some of the implications, Zero Hedge offers a neat speculative summary. There are several concerns. If the legal fiasco is not resolved it is possible that the US real estate market will grind to a halt, as title over property becomes the subject of dispute. In particular, if property title insurers get the jitters, the problem could blow up in a very nasty way. Furthermore, if those who have purchased MBSs decide that the MBS is not backed by a legal mortgage, they would be justified in demanding the issuer repurchase the securities. This will mean big losses. The issue has only recently made it into the major media outlets, and it is still a problem bubbling under the surface. This is the latest from the Atlantic:

It may be time to ready those orange jumpsuits after all. Although a settlement is already being worked out between banks and state attorneys general over the institutions' failures to follow proper procedures in processing foreclosures, money and concessions might not be enough. A recent segment on 60 Minutes certainly makes the case that some bank officers should serve some jail time.

The show's segment revealed some pretty amazing stuff. One of the most incredible parts includes reports from former "robo-signers." One was paid $10 per hour to pretend to be a bank executive with a made up name to sign off on foreclosures.

The basic question here is whether the failure to follow due legal process might be given a retrospective reprieve. Although deals might be made, will the judges accept one law for financial institutions, and another for ordinary citizens? I am not sure I have the answer. A ticking time-bomb, or something that will glossed over behind the scenes?

Moving on from this potential hazard, how is the US economy doing overall? As I have mentioned, the trade balance and current account balance are both in the red. There have been positive sounding noises on employment in the US, but there are convincing arguments that this an artifact of the way that the statistics are collected. Leo Hindery is gaining an increasingly high profile for challenging the statistics, and gives a figure of over 17% for unemployment. The important difference is that he includes discouraged workers and those working part-time but wanting full time employment. In other words, there are many more unemployed if you count those that have given up looking and also those who are unable to find full time work. As for the arguments over the federal budget, they are arguing over pennies, and there is no prospect of real retrenchment.

As time is running short, I will leave the post here before finishing a full review. My belief is that, since I last posted, the US economy is in no better state than at that time. The US economy is in a very, very poor shape and would be in a dire situation without the ongoing government borrowing and money printing. For the moment, it seems that the situation is bad, but not that bad. However, the cost of the current approach is accumulating.

There is much more that could be said on any of these subjects, but this is a (long) short catch up. One point I hoped to cover was the rise and rise of commodity prices. Perhaps in a future post...