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.


  1. As always, an excellent synthesis CE, thank you.

    I am firmly of the view that much modern economic theory and analysis ignores a central and undeniable fact. Everything is paid for out of the pockets of people.

    Corporations are a useful legal device to allow business to be conducted efficiently but they do not really own anything or pay anything themselves. When they make profits, people receive money; when they go bust people lose money. Shareholders in Lehmann Brothers were often corporations such as pension funds, when it hit the wall the result was smaller sums available from which those pension funds could pay people. Lehmann Brothers lost nothing because Lehmann Brothers was just a legal construct, it was a file of papers in the US equivalent of Companies House. Only individuals can ever make profits or losses.

    Similarly government debt is not really government debt, it is a debt owed by the people the government governs. Even if it is repaid out of corporation tax, the result is corporations having less money to pay wages and dividends to individuals.

    Governments throughout the developed world lost sight of this reality and worshipped the god known as GDP because it made them look good. They claimed everyone was richer because GDP rose, people fell for it and voted for them. It follows that falls in GDP are seen as a disaster and cost votes.

    I believe the core problem, certainly in the UK, is political rather than economic. Can we ever expect a government to tell the people that the whole country (namely, the individuals in the country) can only afford about 75% of what it is currently enjoying?

    The core economic argument is as simple as simple can be - if you spend more than you generate in income you have two problems: (i) you lose money every year paying interest on borrowed money and (ii) the day will come when you have to repay your debts. That means you will have less cash to spend in the future than you have now. Yet now you have the joys of a huge and very thin television, a fridge with two doors, holidays in Las Vegas, a BMW and the rest of it and they are a normal part of life. How can politicians expect to win votes by telling people they must have less in the future than they have now?

    Some politicians are brave enough to do so. Sadly, they are not in government.

  2. "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."

    A mortgage isn`t an investment for a person. The principle, in the long run, is a storage of value. The interest replaces rent. As the debt is repayed the bank devalues the currency. I would class a mortgage in the same categary as gold and silver, which are real money. Building a house is an investment.

  3. http://cfapodcast.smartpros.com/web/live_events/Duncan/index.html

    I found this talk by Richard Duncan very interesting , along with his timeline for the US's implosion and his suggested solution.

    (It begins with 10 mins of boring intros and waffle)

  4. Great post but I am regularly confused by the attack on mainstream economists. While many are certainly paid shills, there are many who are well aware of the points you have made here.

    I would be interested to hear CE's view on the work of mainstream economists Stiglitz, Sen, Argawal, Arrow and many others on the fallacy of GDP=prosperity.

    It was commissioned by mainstream politician in Sarkozy. Conclisions include:

    "there often seems to be a marked distance between standard measures of important socio economic variables like economic growth, inflation, unemployment, etc. and widespread perceptions. The standard measures may suggest, for instance that there is less inflation or more growth than individuals perceive to be the case, and the gap is so large and so universal that it cannot be explained by reference to money illusion or to human psychology. In some countries, this gap has undermined confidence in official
    statistics (for example, in France and in the United Kingdom. only one third of citizens trust official figures, and these countries are not exceptions), with a clear impact on the way in which public discourse about the conditions of the economy and necessary policies takes place."


    1. The RPI and CPI are pretty useless. Take for example a packet of biscuits may rise in price 3%. The packet might be reduced in size. Also, they may use cheaper ingredients that are inferior. Is that not a reduction in spending power? A reduction in wealth?

      Another example prices may go up 3%, wages might go up 3%. However the workforce may increase. Does the standard of living on average rise? Does it stay the same? The money supply(credit) could rise. Productivity could rise or fall.Unless productivity rises more than credit then credit is inflationary(reducing peoples standard of living on average)

  5. The politician who tells the Western world that the party is over will be mocked, resisted, excoriated, burnt at the stake and compared to Hitler.

    Who would be a martyr when you can comfortably get voted into office for telling the same happy lies as the rest of the financial-political class?

    It'll all be fine, just trust your betters.

  6. What started as a financial crisis showed that the banks had no clothes. The State stepped in and saved the banks, and now we are seeing that the State has no clothes either.

    Financial markets are funny things. Things that obviously can't continue the way they are going (I remember a serious article in the UK press c.2006 about house prices that discussed the likelihood of the £500K average house price come 2020) will nevertheless continue a lot further than one would have thought before crashing and burning. And when realisation hits the results are far worse than they need have been. A problem that could have been solved by a small amount of pain 10 years ago becomes a massive crisis of a whole society.

    So where are we today? The debts of the Western nations (UK, USA, France, Italy, Spain etc etc, plus Japan) will not be repaid. Not in an orderly fashion anyway. Possibly in currency that is worthless, but not in the manner the lenders would have expected. They cannot be repaid because the ability to do so is not there. The countries cannot grow themselves out of the debt as their economies are aligned for debt fuelled consumption, not investment and production. And even if they were, who would be doing the buying? Their populations have become accustomed to the State providing for them whatever the situation, and will not countenance reductions in State spending. They are also (certainly in the European cases) highly taxed already so there is little room for tax rises.

    The political and economic elites will attempt to keep the plates spinning for as long as possible, but eventually one will fall, somewhere, for some trivial reason. And the knock on effects will bring the whole edifice down. When, where, how, why cannot be predicted, but it WILL happen. And the consequences will be unimaginable, to our molly-coddled Western way of life. 90% of the world's population will view it merely as a reduction to a standard of living they would still aspire to. To us it will feel like the end of the world.

  7. I used to believe what Jim has articulately written, but now having watched the economy, house prices, financial markets for too many years, I have changed my mind.

    With hindsight, I believe Governments did exactly the right think to bail out the banks and effectively stop the financial system from unravelling. The problem is, that having stopped a catastrophe, they have done nothing to start unwinding the problem - the show goes on.

    As long as the flow of credit keeps circulating then everything will carry on, pretty much as it is. If the credit is switched off, then we would go into meltdown pretty quickly - it is for this very reason that the flow of credit won't be switched off.

    What I think will probably happen is that the supply of credit gets squeezed over a long time - probably in excess of 25 years. Over this time period the clever rich folk can unwind their positions into something that is more sustainable and less risky. The poor folk just struggle on.

    If the adjustment is slow, then people will adapt and change with it. Ultimately, the problem might just manage its self away.

    The collapse of the Euro is a classic example of a disaster that should happen but doesn't. Eventually, when the clever rich folk have managed away most of their exposure to disaster, then slowly the Euro will get wound down, country by country. I'd be very suprised to see a disorderly exit from the Euro, despite what any short term headlines may choose to say.


  8. Very nice piece of analysis ! It is a real failing of the political mindset to ignore Time Preference Theory which is the essence of Capitalism, that some Consumption is deferred to finance Investment in Production and that Bankers were the allocators of Deferred Consumption to Productive Capacity.

    Politicians moved in countries like Britain in the 1950s from a Rationing Society caused by War to a Mass-Consumer Society apeing the USA by the late-1950s. The introduction of PAYE tax deduction at source made Workers oblivious to their Forced Deferral of Consumption and Saving in favour of Government.

    Thus the Rationing of Physical Goods had turned into the forced Re-allocation of Income before receipt - to the Government which exhibited no Time Preference beyond the immediate Electoral Cycle which overlaid the Credit Cycle.

    I pick Britain because it is the centre of an Offshore Banking Empire trading on lax regulation to attract New York Capital and the fact that London has become an Offshore Island City State circulating trillions of dollars of asset/liabilites globally outside the regulatory and tax framework and destabilising national economic policy.

    In no other country does Finance have a lobbyist sitting behind The Speaker's Chair in Parliament as does The City Remembrancer. Britain is run for Offshore interests and now the Offshore liabilities have been loaded onto the UK taxpayer as RBS - the global behemoth collapsed followed by smaller fry such as HBOS and Northern Rock and Lloyds.

    Britain is the epicentre of this storm living way beyond its means since 1955

  9. Does the topic has to do with your professional status or perhaps is it more about your leisure and free time?


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