Wednesday, July 20, 2011

A Crescendo of Crisis - Explained?

Even though I have a hectic schedule at the moment, I could not resist the urge to post. I opened up Reddit, and several news sources, and it was interesting to see the brewing of so much potential crisis. For the sake of ease, and a sample of the point, I will use the Daily Telegraph to illustrate the point. The headlines and quotes are as follows:

Euro Reaches its Eleventh Hour

The German chancellor and the French president were barraged with pleas from political and financial leaders to reach agreement on bailing out Greece – or risk the collapse of the single currency.

The leaders have been told that today's crucial summit in Brussels was the "last chance saloon" for the euro project.

Wall Street Paralysed by US Debt Talks

The White House and Republicans and Democrats in Congress have 10 days to raise America's $14.3trillion debt ceiling. Failure to do so would see the government default on its debts, which Federal Reserve chairman Ben Bernanke has warned would be a catastrophe.

Investors' confidence that politicians would avoid that outcome has dwindled as the deadline approaches.

And for the UK, we have a commentary titled 'Britain's deleveraging nightmare threatens its triple A rating'. This is a quote from this commentary, and a chart from the same article follows:

Yet a substantial part of the Chancellor’s plans for eradicating the deficit rely on quite brave assumptions about the scope for future economic growth. With nine months of economic flatlining now under our belts, these assumptions are looking ever less credible. The Office for Budget Responsibility will almost certainly have to trim its forecast of 1.7pc growth for this year in its next update, and many will begin seriously to doubt its independence if it doesn’t adjust longer term forecasts down too.

In other words, the whole economic strategy hangs on a quite slender thread which could easily break and plunge the UK into the same vicious cycle of one austerity programme after another that has been forced on the European periphery. Now look at the graphic below, from a recent update to the McKinsey Global Institute’s study into the economic consequences of the credit bubble.
It is really not difficult to see the commonalities in these stories, all of which are about the problems of sovereign debt. The most interesting point in the story above is that the author, Jeremy Warner, recognises the real problem; that paying off the debt has hardly begun (in fact all the countries in question are still running up more debt).

In the wake of the so-called 'financial crisis', governments and central banks have sought to borrow money and flood the world with money as their respective solutions to the problems that they saw developing as a result of the crisis. These were the magic bullets that would pull the world back from the brink of another great depression. Lined up behind both policies was a mainstream economics profession that sought to justify these actions, with argument isolated to the extent, breadth and detail of the policy. There were, of course, some exceptions, notably the Austrian economists, who railed against the policy solutions and were largely ignored by policy makers.

What we have seen since is a roller coaster ride. As the policymakers pulled their macroeconomic levers, they would promise salvation and that they would 'fix' the world economy. The same theoretical models that failed to see the oncoming problems would now fix the world economy. Well, I have a question for these titans of economic theory; does it look like it is working, or are the scale of the problems just getting larger and larger? The most extraordinary thing about the mainstream economics profession is that they simply refuse (as an economics professor described to me) 'to look out of the window at the world around them'. They are firmly fixated upon models which have already failed, and continue to fail as even as they keep on using them.

At the heart of the problem is that they have forgotten what economics is supposed to represent, which is the exchange of labour (however subjectively that labour might be valued). If person A uses their labour and makes item X, and person B wants item X, person B must offer something from their own labour which person A wants in exchange. Whilst it is quite possible that person A will give item X on credit, at some point person B must start giving person A something that they want. If not, it is likely that person A will no longer give person B credit (unless they are a charity or a fool). It is really not that difficult to understand.

If we scale up these simple principles, it is apparent why the macroeconomic levers are causing more harm than good.

Lets say that person A is making item X and they are willing to exchange two of item X for one of item Y made by person B. When they exchange two of item X for one item Y, all is well and good. However, if we see that person A is regularly exchanging three of item X for one of item Y but ask that in the future person B will give additional item Ys, then they are giving credit. This is all ok, as long as person B is able to return the additional item Y in the future. The problem arises when this is the situation:

  • Person B is buying 12 item X per year.
  • Person B can make 5 item Y per year for exchange, unless they reduce their own consumption of item Y (4 per year).
What we see is a shortfall in the capacity to ever return the owed item Ys - unless of course the following take place:

  • They reduce or forgoe their consumption of item Y
  • They reduce of forgoe their consumption of item X
Now, it is quite possible that person A will provide item X on credit for a good long while. However, unless person B is able to dramatically increase their output of item Y, there is a point at which they must reduce their consumption of item X or Y. When credit is offered, it is done so on the basis that it will be repaid at some time in the future (+with interest). This is completely obvious.

The problem for person B is that their lifestyle has been based upon consumption that can not be sustained in the long term. In fact, they must reach a point at which their overall consumption equals their total output of Y minus the number of Ys owed to person A (according to how the repayment is structured). Prior to this, their consumption was total output of Y + the credited amount of Xs. If we think on this a little, we can see that the move from taking credit to repayment of credit is problematic for the quality of life of person B. They either have to reduce consumption, or increase the amount of labour that they do in order to continue to consume as much as they did when they were taking credit. The only other possibility is that person B manages to find a new technology or process which will allow them to make item Y faster, or a new item which, relative to person B's total input of labour, is valued more highly by person A.

In absence of the last option, there is no escaping the fact that person B will see their quality of life negatively impacted; either through less consumption or through more labour. In both cases, person B is poorer than they thought that they were.

So how do the macroenomic solution stack up against this fundamental reality of economics?

First of all, let's look at printing more money and other monetary solutions. Do these in any way increase the overall capacity to produce Y, or create a new item which will be valued more highly by person A? The answer is: 'No'. What it does do is to reduce the amount of Ys that are owed to person A, thereby cheating person A (they use the devaluation to reduce person A's capacity to buy item Ys, as the credit is held in abstract monetary units rather than in units of Y). The knock on effect of this will be that other people will see person A being cheated, and will no longer trust person B with credit. In all cases, as person B refuses to give any further credit to person A, there will be less of item X for person A to consume.

However, there is something interesting in this option. In printing money, the value of the medium of exchange between person A and B has shifted. In the real world, person A and B represent a large number of people consuming more variety of goods than X and Y, with money acting as the medium to reduce complexity in transactions. In reducing the value of the money for exchange with persons B, the ability of persons A to individually exchange their Y products for X products is reduced. In this way, they have been made poorer and are less able to consume X products. In the real world, if I am paid in £s and the value of £s reduces in relation to Euros, I am less able to buy as much Belgian beer as I was before - unless the amount of £s that I am paid is increased in relation to the fall in value in relation to the amount of X goods that I buy. For example, in the UK, inflation is eroding spending power, as wages are falling behind inflation.

This is a way of adjusting the consumption of X goods by individuals, and reducing the amount of debt growth as a result of reducing consumption of X goods. It is simply another mechanism to reduce the quality of life of person Bs, but doing so in a way that is less directly obvious.

How about borrowing more? This appears ok in the short term but is just making the problem worse in the long term. For a while longer, it is possible for person B to consume as much item X and item Y as before, but only at the cost of greater reductions later. I think that there is no need at this stage to point out the obvious dangers in this approach. However, it is worth noting that the borrowing takes place without the explicit expression of the future cost to quality of life. This is the way that politicians buy votes of voters now, at the cost of quality of life in the future. It is simply dishonest. The voters will have a poorer quality of life in the future - unless person A who is giving credit is cheated (see earlier discussion). In either case, the politicians are not telling the truth.

Whilst it is possible that somehow Person B will find some way to increase output/create a new item to exchange at higher value, this is (at best) a gamble. Also, if this outcome were achieved, without the overhang of debt, everyone would be better off in proportion to the improvements in output that this represents. This improvement in quality of life will be diminished by the necessity to repay past debts + interest.

I really do not think that any of this very complicated. There are complexities in the systems that are operational in economies, but the underlying principles upon which those systems rest are relatively simple. The complexities of the operations simply serve to hide/obscure the very simple principles. In the case of the mainstream macroeconomists, they are buried in the complexity, and never seem to pause to think about what sits underneath the complexity. This is why their solutions are so fundamentally wrong. They simply do not understand what they are looking at, and never look out of the window at the world.

Note: This is a hurried post, and I hope that the logic follow, and more importantly is expressed in such a way that my intended meaning is conveyed. Please feel free to point out errors in logic/expression where you find them. Also, if you disagree, as ever, feel free to point out why.