Friday, April 27, 2012

Positives and Gloom

Please accept my apologies for the long time since my last post. As ever, the choice of subjects for discussion is overwhelming. As such, I thought I would write briefly on several subjects.

Richard Duncan's Presentation

A commentator recently left a link to a talk by Richard Duncan, and it proved to be very interesting. I strongly recommend it, and this section will only make sense if you have watched it (start at the 10 minute mark to save watching a dull introduction). The most interesting point about the talk is the dispassionate approach to the current and future situation. He simply accepts that, in a few years time, the world economy will have a horrendous crash, that states are now fully in the driving seat of the world economy, and most importantly that investment choices should now be based upon state action rather than market drivers. In simplistic terms, whenever a government prints money, his answer is buy, buy, buy!

The talk has been weighing on my mind since I saw it. I am not sure about his timescales, but much of his analysis is very good. However, what has been weighing on my mind is his call to enjoy the investment opportunities in the lead up to the big crash, alongside his advice on how to not lose everything when the crash comes. Put another way, you can make pots of money now, and later on you can hold on to a large proportion of what you made, and protect yourself from the various and different terrible potential outcomes that will follow from state action. It is a hard and cynical approach. The reason it has weighed on my mind is that I wonder if what he is saying explicitly is what many others in the financial industry believe. Certainly, there are many analysts in the financial industry who have expressed concern with state policy, but there is a strong incentive for the financial services industry to play along with the current 'game', with individuals ensuring that they are buffered against the eventual crash. As long as they get the timing correct, they can play the markets based upon state action, and can still come out at the end significantly richer (albeit they will lose some proportion of their gains).

In short, the longer that states continue their current policy, the greater the damage in the future. However, fFor those who understand the nature of the game, the longer the game continues, the more time they have to secure wealth to insulate against the inevitable crash. It is a worrying thought, as the financial industry has an out-sized influence on government policy.

A Positive Note

Longstanding readers of the blog will know my thesis that one of the factors underlying the economic crisis was the growth in the world labour force in relation to a lack of commensurate growth in the supply of commodities (see here for a fuller explanation). This, I argued, led to an emergence of what I termed as 'hyper-competion' for the limited supply of resources.

One of the examples I have used to highlight the problem was the lack of sufficient growth in the supply of oil during the entry into the world of the (then) emerging economies such as China. For a while now, I have been reading about and watching the results of the shale gas revolution. The US has embraced this new source of energy and it has resulted in an astonishing drop in natural gas prices, as shale gas extraction has increased. Although it is not a substitute for oil, it does provide a source of cheap and plentiful energy, and this increase in the input of energy into the world economy is a major positive. However, there is a lot of 'politics' surrounding the process of extracting the shale gas, and this means that it has yet to be exploited everywhere. If the political questions can be resolved, shale gas has the potential to make a major positive impact on the world economy by increasing the supply of energy into the world market. I would not go as far as saying that it will resolve all the problems of energy, but it certainly ameliorates the problems.

Another problem I identified was that, even though some commodities did increase significantly during the period of 'economic emergence', one of the problems was that the emerging economies (and in particular China) growth was infrastructure intensive. Building of new highways, factories, rail lines, cities and so forth, all created a massive demand for basic commodities requiring a larger increase in supply than actually took place. In the case of China, many analysts have noted that the infrastructure heavy growth of China may be coming to an end, or at least will slow down significantly (Richard Duncan discusses this in relation to industry if I recall correctly). The result of slowing infrastructure development should start to ease the pressure on the supply of many commodities, and this in turn may see some reduction in commodity prices. Much depends on government policy, in particular in China where the desire for social stability may see ongoing investment in infrastructure (whether needed or not) to maintain employment and social stability. However, if there is a reduction in intensity of infrastructure development, this is also good news for the world economy.

If demand for resources reduces, and supply of other resources such as energy, are now starting to move in a positive direction, the outlook for the world economy should (in principle) improve. The 'hyper-competition' should return towards 'competition' and that would be major a positive. The only problem with this idea is that, since the economic crisis became visible, states have now taken ever greater and ever more risky policy decisions. We are now saddled with the consequences of these decisions, and the interventions are ongoing and will create ever greater problems going forwards. As such, despite the possibility of the underlying causes of the crisis starting to be ameliorated, the actions of states in response to the crisis will have to be paid for regardless of these positive developments. In other words, what should be a bright outlook remains bleak, albeit slightly less bleak than before. 

How History will View the Economic Crisis.

In recent posts, I have discussed the criticism of so-called austerity. In particular, I have highlighted how ongoing borrowing is being used to support the repayment of previous government borrowing, creating an unsustainable cycle of needing to borrow ever more. The logic of those who argue for more and more state borrowing appears sound until you examine what they really mean. If you would like to grasp the problems, you may wish to look at the post here, and also take a look at the insightful comments at the end.

The reason I talk about how history will view the economic crisis is because the economists who are calling for ever more borrowing (Krugman comes to mind as an exemplar) will argue that the depression that is here/about to arrive (depending on your reading of the current situation), was the fault of 'austerity'. If only governments had borrowed and spent more......all would have been well. The interesting thing about this is that, if you read the analysis of the causes of the Great Depression, there is a similar retrospective analysis. This then guides economic analysis of the current situation, as the aim of the borrow and spend economists is to use policy to avoid another Great Depression. However, just as in the future the analysis of the borrow and spend economists will be wrong, so is much analysis of the Great Depression that now guides their policy advice. Nevertheless, these economists have influence, with Bernanke for example being a 'scholar' of the Great Depression.

If the analysis of the Great Depression is as wrong (and I would argue that it is) as some economic analysis of the current situation, then their policy advice commences on flawed foundations. Furthermore, the current situation is very, very different from the period of the lead up to the Great Depression, such that using it as a guide is in any case questionable. For example, the rapid entry of the emerging economies into the world economy is a quite unique event. This is not to say that nothing can be learned from this period, but it must be remembered that the circumstances today are very different. Overall, it is therefore worrying that much of the policy advice today is founded on analysis of the Great Depression, and that analysis of the Great Depression will one day determining the analysis of the current crisis, and the analysis of the current crisis will then be used to support the previous analysis of the Great Depression. I am not sure I am making my point as well as I might, but I hope that you get the gist of it.

Tuesday, April 10, 2012

Has Anything Changed?

I it now seems a long time since the Lehman crisis revealed the underlying problems in the world economy. The post title asks the question of whether anything has changed since that time; the obvious answer is that, yes, there have been changes. The situation has been revealed to be very poor indeed. The response is even poorer. Unlike most of my posts, this will probably be relatively free of links and references. I thought it might be a good time for an overview.

The response to the Lehman crisis, and the financial crisis that surrounding the collapse of Lehman's, was to dismiss the problem as being a problem in the banking sector. The name for the problem became 'financial crisis', rather than the more appropriate 'economic crisi's. As I have argued elsewhere in the blog, the nature of the world economy had shifted; the joining of countries such as China and India into the world economy joined a massive supply of labour into the world economy, and effectively flooded the world with new labour capacity that could not be readily absorbed. In particular, the 'emergence' of these economies was infrastructure intensive, and they presented new demands on the supply of the basic commodities that sit underneath economic growth. Whilst the supply of commodities have expanded, the supply is continually being stretched to meet ongoing increases in demand (with the ups and downs of the Western economies sometimes masking the underlying pressure on supply). As a result, there has been the development of what I term 'hyper-competition', in which limits in the growth of commodity supply means that a finite supply of commodities generates a zero sum game (for those new to the blog, read a more comprehensive explanation here).

Alongside the problem outlined above, there was a flood of money entering into western markets from the petro-states, from the emerging economies, and from Japan (partly as a result of their policy of printing money). This is the root of the financial crisis. Whilst money flooded into the banking system, the opportunities to invest in new productive capacity was limited. The smart money for such investment was going to the emerging economies. With limited capacity to invest the money in productive investments, the money was instead moved into consumer lending, presenting the consumer credit markets with a flood of money. The result was the housing boom and bust, and consumers gorging on the credit. This consumer debt driven boom hid the underlying changes in the world economy and the emergence of hyper-competition. Even as the emerging economies were growing more wealthy, their wealth was recycled into consumer credit, and much of the Western world appeared to be in rude economic health, as the wealth of others was consumed in the Western economies. The Lehman crisis simply highlighted that much of Western growth was built upon the foundations of sand of a credit bubble (sorry to mix metaphors here).

Governments were totally oblivious to the crisis that was taking place. They mistook growth founded upon unsustainable increases in debt as underlying economic growth. A raft of economists gave explanations for this fantasy of economic growth and provided comfort; the West would do all the added value whilst the rest of the world did the messy business of making things, the service economy was the new paradigm, boom and bust had been ended, the great moderation was taking place. One of the factors that was so important was the apparent growth in GDP whilst inflation remained subdued. That this was the result of the lowing of labour and other costs in the emerging economies was ignored. Central banks, and the banking regulators were no better. They likewise considered that all was well. They devised rules and regulatory systems which were based upon fantasies that they could uniquely see risk in the future. If you do doubt this, look at the Basel banking accords. As just one example, Basel I regulated OECD sovereign debt and OECD banks as safe investments in relation to banking stability. Apparently, they knew what was safe and what was not. Their rules and regulations were fantasy.

The Lehman crisis revealed to the world that all was not well. Much of the banking system was insolvent after recklessly lending into to the consumer boom. They had hidden the risk in a multitude of ways, creating an illusion of stability. Lehman's was not alone, but was just an exemplar of an insolvent system. The response to the banking crisis was to pour every resource possible into the banking system. Governments provided direct financial support, and central banks poured even more support into the banking system in less transparent bailouts, whilst accounting rules were relaxed to hide bank insolvency. The idea of 'too big to fail' was discussed, and used as an excuse to save insolvent banks. The result was ever more concentration of the banking system, making the potential failure of one of the major banks ever more dangerous. Supporting the massive bank bailouts was a massive allocation of resource from the government, which saw government debt increased to support the banking system. Somewhere, the politicians and economists had forgotten, or were ignoring, the function of banks.

The function of banks is to allocate resources into productive investments. They are a service provider to the economy providing support for economic growth. Instead, the rest of the economy is supporting the banking system. The bailouts represent the rest of the economy paying for the banking system's failures. Banks have ceased to be a support to economic growth, and are now a drain on economic growth. The productive parts of economies, one way or another, are paying for the support of the banking system. After all, resource must come from somewhere productive. To add insult to injury, the salvation of the insolvent banks has seen the banks return to 'profit', and the re-emergence of the big bonus culture. Whilst the rest of the economy is still paying for the failures of the banks, those running the banks have emerged from the crisis as wealthy as ever, and as powerful as before (if not more so).

Has anything changed with the banking system? The answer is yes and no. In Europe, the European Central Bank (ECB) is busy in the task of bailing out the European banking system. They are flooding the banks with easy money, with one wag (I forget who) suggesting that the ECB will take a bus ticket as collateral for loans. When the federal reserve supplies liquidity into Europe, the federal reserve is concerned about US bank exposure to Europe's banks. The EU crisis is not only about sovereign insolvency, but about the potential damage to the banks exposed to sovereign default. And this is one of the changes. The banking system is not only exposed to bad consumer credit, but also to bad sovereign credit. Again, their recklessness is backstopped. The banking system remains outsized in relation to the rest of the economy, and the risk taking continues unabated, with the too big to fail banks larger than before. Yes, there have been regulatory tweaks, but the problems remain. The major banks have simply learned that whatever happens, they will be rescued. Heads they win, and tails they win. Someone is paying for their bets, and that can only mean the productive parts of economies.

It is argued by many economists that the bailouts were regrettable, but they saved the Western world from depression. In doing so, they assume that the West has been saved from depression, and that conclusion is premature. The response to the economic crisis in most countries was for government to replace the consumers as the engine of credit driven economics. Many governments have gone on a debt fuelled spending spree. As growth in consumer credit driven consumption abated, governments stepped into the breach, and grew the rate of their own debt accumulation. Some countries are now starting to address the problems of the growth in government debt, but much of it is too little, too late and too timid.

There was always a fundamental problem, and one that is not recognised by most economists. The structure of economies that enjoyed the consumer credit boom were adapted to service the consumer credit. As a basic illustration, when a person used their housing equity to buy the BMW car that they always dreamed of, this put money in the hands of the BMW dealer, and orders into the BMW factory. This in turn put money in the hands of those businesses, and the workers working in those businesses, and this money then flowed into support other sectors of the economy. This shaped the structure of the debt consumption economies. We can see in Greece what happens when debt derived consumption takes place, by seeing the reversal of debt driven consumption. The real shape of the economy emerges when the credit flow stops, and it is not a pretty sight.

When governments replaced the consumer as the borrower and consumer, they were seeking to support an economic structure built upon endless growth in the accumulation of debt. It was never going to work, as there must come a point in time where the growing mountain of debt can no longer be supported. Whilst the growth in debt provides an illusion of stability, in the end it must stop, and economies must then (like Greece) face the reality of the underlying size of their economies without debt growth. This brings me to the myth of expansionary fiscal austerity. The myth is that, if governments reduce their borrowing (note, not stop), economies can expand as they do so. However, if a government stops borrowing and consuming, parts of the economic structure supported by that borrowing and consuming must contract. Whilst reducing borrowing is absolutely essential, the pretence that this can be achieved without economic contraction is pure fantasy. Again, Greece is an exemplar, but we might also add the examples of the other economies that are seeking to reduce their rate of borrowing.

There are those who argue against reducing the rate of debt growth by governments. They argue that it is 'self-defeating'. In a recent post, I hope I (and some of the commentators on the post) punctured the logic of the self-defeating argument. In short, the logic is one in which debt based consumption creates an illusion of an ability for governments to pay for its existing debt, whilst allowing more debt to be accumulated, which requires more debt to be accumulated to continue to pay for existing and rapidly accumulating new debt. It is not easy to explain in brief, so you may wish to read the post, and some of the further explanation from the commentators here.

And so we come to the situation of the major economies. Let's start with the US, which has again been discussed as being on the road to recovery. However, it is necessary to remember that the US is currently accumulating massive government debts. It would be easy to provide a more detailed account of the current US situation (which I will do another time), but this is sufficient to tell us that the US is in no way close to recovery. The US can only be said to be in a position of recovery when the rate of debt accumulation goes into reverse, and if the economy were to continue to grow. The same applies to the UK, where the word austerity is thrown about, even whilst the levels of government borrowing are at record levels. The situation in Europe is one of ongoing crisis, pretense that the crisis is resolved, before crisis reappears. Expansionary fiscal austerity is being tried and is, of course, failing. The future of the Euro looks ever more questionable, and the fallout of a major sovereign default such as Spain does not bear thinking about. Whilst each rescue plan produces a respite, the crisis continues to pop back into life. I see nothing except some kind of fiscal union that might stem the tide and the idea of a fiscal union is highly improbable.

In the case of Japan, it is also facing problems. They are unusual in that their government debt is funded by Japanese savers, but demographics are working against the government. Those savers are starting to draw down on their savings, and that will start to finally strain the debt mountain accumulated by the Japanese government. Furthermore, as an exporter, Japan is exposed to the travails of the Western world. A similar picture emerges for China with regards to exports. However, in the case of China, there is a different problem. The statist economics that served China well in the early stages of economic development are now showing their limits. In fact, it seems that China has learned some bad lessons from the West in economic management. They have created their very own real estate bubble.

China's statist approach is also seeing broad based malinvestment, and they are now seeing the fruits of this in their banking system. When they first commenced their opening of the economy, it was difficult for investment to be anything but productive as the economy was so backwards. As the economy has grown, the easy opportunities for investment have diminished, and the result is poor state led investment. The cozy relationship between the state banks and local government, alongside corruption that accompanies such a relationship, has seen curiosities such as building cities in which nobody lives, but this is likely just the tip of a very large iceberg. It is quite possible that the combination of this poor state led economics, in conjunction with the problems in Japan and the West, may see the Chinese miracle come to an end. At the very least, it seems probable that growth in the Chinese economy will slow markedly. This may be a problem for stability in China. Again, at the very least, China is unlikely to be the engine of world economic growth that many assumed it would be. This is a change in the world situation. China has emerged from this crisis as a major economic power, but the contradictions/problems of their state led system are starting to show.

In the end, the real point of this rambling review is to suggest that whilst the situation has changed, it has not changed in some fundamental respects. In particular, the economic theory that saw economists blinded to the reality of the change in the world still holds sway. Behind the policy responses to the economic crisis, the same (or similar) cast of characters are still acting in devising policy based upon economic theory that does not work. Or rather devising economic policy that hides economic reality for a little longer, whilst all the time building ever greater future problems. If you were unwell and visited a doctor, and the doctor told you all was well, you might believe the diagnosis. However, if you later found that you had been suffering from advanced cancer at the time of the visit, you might consider that there was a problem with the doctor. In the case of economics, we are still using the same economists and same economic theory that failed to diagnose the disease. And their prescription for the economy is based upon the same economic theory that failed to diagnose the disease until the results were so apparent that they could not be missed. Continuing the analogy, the economists can see that there is an illness, but their theory is unable to diagnose the disease. As such, they are prescribing economic medicine on a poor diagnosis, and with a poor theory of how the economy works.

The disease in this case is debt driven consumption. Debt is not, of itself, a bad thing. Debt is the foundation of investment. It can produce new products, innovations, new systems of production, new factories, new service industries, and so forth. In moderation, it can help individuals. For example, a mortgage allows a person to eventually own their own home. The problem with debt arises when debt becomes a means to fund consumption now, at the cost of less consumption in the future. When so-called growth is built upon nothing more than ongoing growth in debt levels to fund consumption, unless real productivity growth exceeds the rate of debt growth, there must be a future contraction. The longer the period of debt consumption continues, the greater the eventual contraction; the longer the period, the more the economy is structured to service debt based consumption.

If you doubt that economic theory is fundamentally wrong, think of the widespread use of GDP as a measure of the 'health' of an economy. If country A borrows $1 billion from country B, country A will see growth in GDP as a result. The borrowed money will be used and will create economic activity in the economy. This consumption of the resource of another country will see GDP growth in the borrowing country. Or even more absurd. Hurricane Katrina was a good thing. All the activity needed for rebuilding would result in an increase in economic activity, and therefore a growth in GDP. Nevertheless, just about every economist, all governments, and all policy makers use this measure. It is no wonder that they all misdiagnose the disease. They have a tool for diagnosis that is no better than a doctor trying to diagnose cancer with a telescope. And this is the result; more consumption based debt growth solves the problem of consumption based debt accumulation. 

So my conclusion. The world has changed, the situation has changed. However, the policy devised to meet the crisis is founded upon the same fantasy. The change of the situation is not for the better, but for the worse. It is policy that chases a measure, and that measure is so flawed as to be dangerous. As such, nothing has really changed, as policy is stumbling blindly forwards, ignorant of the flaws in the measure upon which it is based.

Note 1: Many thanks to those who contributed to the last post with very good comments. I am always impressed with the standards of the comments on the blog, which suggests that the blog readership are an impressive group of individuals. The comments, I felt, added significantly to the value of the post. I did suggest that I might publish an explanation that explained my point better. However, in the end (and I am of course biased), I felt that they added to explanation rather than presenting a better explanation.

Note 2: I was tempted to include money printing in the content of the post, but the added complexity that this throws in to the scenario would hinder making the point I wanted to make. For those who read the last post, they might note that it is a follow on from the post, but setting some context around it.

Note3: My posting will continue to be patchy for a while, as I am extremely busy at the moment. My aim is to do a proper review of the US economy next, but that will demand a lot of time. Also, circumstances may sway me in another direction. However, I will try my best to find the time for the review.

Update 13 April, 2012: Ronanpeter (see comments below) has kindly provided a reference to some critiques of GDP by mainstream economists. As I am short of time, I browsed through the shorter narrative section, and it appears that (in places) there is some recognition of the problems that I describe (the section on country balance sheets is a move in the right direction). However, the focus of the paper does not reflect the critique given here. GDP measures are seen as inadequate, rather than being dangerous. Nevertheless, it is a positive to see that this measure is being subjected to some critical scrutiny.

Lord Sidcup has provided a link to a talk in the comments below. It is highly recommended. As per Lord Sidcup's comments, skip the first 10 minutes.