Green Shoots of Reality

As time moves forwards, it is possible to see that the mainstream media eventually catches up with the underlying realities of the current economic situation. It is interesting to watch how they take cautious steps, with a few commentators daring to speak the unspeakable, before eventually the rest of the 'herd' follows suit.

We are once again at a point where this process is accelerating, and the realities are starting to finally sink in. In this particular case, the solvency of the US and UK are now finally being questioned in a trickle of articles, hyper-inflation is being considered seriously, along with the end of the $US as a reserve currency.

The first article that is of particular interest was passed on in a comment on my last post by 'anon82', and is an article by Willem Buiter. I have highlighted this article as the author is part of the financial establishment, and therefore his opinion might be considered to carry a considerable weight. Throughout this crisis, he has veered a fine line between the delusions of conventional economic wisdom, and the heresy of accepting economic reality. In his latest article, he discusses the state of the UK economy, and is effectively accepting that the UK is structurally bankrupt. I strongly recommend the full article, as the excerpt below does not do the article justice:

As the government deficit explodes over the next few years, the actual primary surplus is likely to be primary deficit of around 8 or 9 percent of GDP. As the economy recovers, tax receipts will rise and cyclical public expenditure will decline, but the rest of the public expenditure programme (health, education, pensions) will keep on rising in real terms and as a share of GDP. It is easily conceivable that when the output gap is closed again, in 4 or 5 years time, there will still be a primary deficit of five or six percent of GDP. That means that a permanent reduction in the primary deficit will be is required of between 6.5 and 7.5 percent of GDP.

Essentially, Buiter has realised that the government is simply spending more than it can ever repay, and is accepting that the only realistic way out of the problem is to inflate away the debts. However, even with such an analysis, he is still not fully understanding the severity of the structural problems, as he still overestimates the underlying position of UK GDP. He is not accounting for the fact that, even now, GDP is being flattered by the activity that follows from the government's ongoing massive borrowing. As regular readers will know, GDP measures economic activity, which includes the activity created by debt based consumption (if this is new to you, you may want to read this post from October 2008).

I first wrote of the UK being structurally bankrupt in July 2008, and expected that the market would quickly realise that this was the case (I thought it would take six months). The point I was making in my article was that government deficits were going to balloon. I realised at that time that, as the downward economic spiral took place, revenues would collapse and expenses would explode. This would combine with a structural deficit, and plunge the UK economy into a deep crisis as creditors to the UK took fright.

At the time I wrote the article, I had not imagined the extreme policy that government would take in reaction to the crisis, and now believe that the final outcome will be worse even than I envisaged at that time. However, the important point about Buiter's article is that he is starting to recognise the structural nature of the problem. He is starting to see that this is not a short term economic crisis but rather a crisis in the very structure of the economy.

Buiter is not alone in starting to question economic assumptions. I have long been highlighting the similar points about the US economy as for the UK economy. Ever more analysts are likewise starting to question the sustainability of the US economic policy, and this questioning is emerging in the mainstream. In particular, the bland acceptance of the reserve status of the $US is finally being questioned, which has been a theme of this blog. In January of this year, I devoted an article to the subject - a response to reading on so many occasions that the reserve status of the $US would save it from collapse. It is not a post that is amenable to a short quote or summary so, if you have not read it, you may wish to read it now (see here - it is a long post!).

Since writing the post I have been tracking the moves of China to replace the $US with the RMB as a reserve currency (e.g. here). The latest news is that that Russia is again proposing development of a new reserve currency (SDRs - see here) to the BRIC economies (Brazil, Russia, India, China). The $US was immediately hit by the talk, indicating the inherent weakness of the $US.

The important point here is that there is now an acceptance that the reserve status of the $US is not a fixed feature of economic reality. Reserve status needs to be rooted in underlying economic strength if it is to be maintained, and more and more questions are being raised about the nature of the US economy. For example, there is a recent article in the Wall Street Journal that asks 'Is Your Portfolio Ready for Hyper-Inflation?', and in another article by CNBC, the many risks in the US economy are laid bare. In other words, the talk of hyper-inflation is seeping into the media, along with the increasingly dire prospects for the US economy (I have long been discussing the potential for hyper-inflation e.g. December 2008).

What is finally happening is that the mainstream media are starting to accept that the current activity of government and central banks will, in the end, have negative consequences. It is no longer a few lone voices - bloggers, conspiracy theorists, and the occasional maverick - but mainstream commentators, nation states, politicians and economists who are increasingly questioning the sustainability of the Western economies.

I have previously written about the mainstream 'getting it', in the follow on from the UK budget. However, the endless talk of 'green shoots' drowned out the cynicism. What we are once again seeing is the 'green shoots' of acceptance of reality. I suspect that this time the momentum, and the withering of the green shoots of recovery, will carry the acceptance of reality further forwards into the mainstream.

I have just completed an article for Huliq and a further article of Trade and Forfaiting Review (both submitted today for publication, so not yet available). The two articles take very different approaches, but both emphasise that something profound has taken place in the world economy. That profound change has been the theme of this blog.

Whilst it is positive to see that the mainstream are now finally accepting that the situation, and the responses of government, are leading towards disaster, the problem remains that they are still fixated on the wrong explanations for the economic crisis. In particular, they still actually believe that the financial crisis caused the economic crisis, rather than seeing that an underlying economic crisis caused the financial crisis.

This is a matter of ongoing concern. Without an accurate understanding of what went wrong, of the underlying causation, a recognition of the severity of the situation will still not necessarily lead to solutions that might resolve the crisis. In particular, there is a need to recognise that the entry of China and India into the world economy has seen the world labour force double, and that such an input of new labour (one of the key inputs of economic activity) is at the heart of the crisis. As I have explained elsewhere in this blog (e.g. my most recent discussion can be found here, or an earlier discussion here), this has created an era of hyper-competition, and the traditionally wealthy countries have yet to adapt to this situation.

As such, whilst it is encouraging to see that there is a greater acceptance of reality, there is still a risk of continuing to pursue solutions that fail to address the underlying problems. In particular, the only long term solution is to adapt the economies of countries like the UK and US to meet the challenges of hyper-competition. The only way that might be achieved is through deep structural reform of the economies. As Buiter recognises in his article, there will be strong resistance to such reforms, but without such reforms there can be no eventual recovery.

In short, the recognition of the depth of the crisis is a start, but there is still a long way to go before we might start to see solutions that might make a real difference. My worry is that it will take the full severity of the crisis arriving before the world finally addresses such solutions. I further worry that, at that time, it will be too late.....

Are the cynics 'Doomsters'?

I have had another interesting comment to one of my posts, and I will reproduce the key parts below:
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'I have recently been discussing the economy with a friend of mine and I find it quite frustrating that whatever I say about the problems we face, he is of the view that the economy will be back to normal in a couple of years. I suppose what I particularly don't like is:

(a) It implies that he has some wisdom that I don't have. I'm just responding to the 'doomsters'.
(b) He sees nothing peculiar about ordinary people earning more money from their house than they do from their job, and that this is perfectly sustainable.
(c) He does not share my wonder at just how lucky we are (were) here in the West.'
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I like this comment because those of us who are cynical about the UK economy have probably had similar conversations.

Dealing with point (a) first, this is the idea that, somehow, the so called 'doomsters' are just bleating on about nothing. The root of such thinking is the complacency that comes from the attitude that, just because we have been doing well in the past, we will do well in the future. The UK has had a successful economy, and has been very successful, so there is nothing to argue with on this point. However, the question to ask of such people, making such assumptions, is on what basis would past performance guarantee future performance? The key part of this approach is to ask what it was in the past that created such economic success.

It is at this point that our friend may start to scratch his/her metaphorical head. It is actually not a simple question. If we start to examine it, we will start to consider at what point our economy did become a success, and need to ask why this happened, and why it continued to be such a success. The question gets really complicated.

One virtual certainty in the foundation of the success of the UK economy was that we led the industrial revolution. The trouble is that the reasons for why the industrial revolution took place is still a matter of some debate. If we then start to ask the question of why we continued to be such a success, the question becomes even more complicated. What does it take to make a country an economic success?

Of course, if there were a formula, then every country would be following it. As such, just in asking the friend the 'why' questions should, of itself, start to undermine the sense of complacent certainty that he/she holds. If we can not even agree on what made the UK successful in the past, on what basis can we be certain of success in the future.

At this point, it might be worthwhile to point out to the friend that, even if we were to be able to identify the cause of past success, and we could demonstrate that we were doing the same now as we were in the past, would our past approach work in the different world that we live in today?

It is only when these questions are asked that the complacency of such thinking really becomes apparent. Furthermore, when we do consider the changes that are taking place in the world economy, the lack of clarity of thinking of such optimists comes into stark relief. In particular we are now going through a revolution just as profound as the industrial revolution, in this case the IT revolution, and we have still not yet felt the full impact. To understand how such changes can have an impact, a good starting point is the humble clock. This simple piece of technology was a necessary antecedent for the industrial revolution, as time keeping is central to modernity. Just think of a railway timetable, the shift system in a factory and the impact of this taken-for-granted technology becomes clear. As another example, if we think of the introduction of electricity, it took many years before all of the impacts were felt, and many of the impacts were unexpected. For example it became to build single storey factories rather than multi-storey, creating a series of improvements in the cost of building a factory and also offering gains in efficiency in many industries.

On top of the technological changes we also have changes in the shape of the world economy. In the past there was, to put it simply, less competition. We now have new economic challengers in China, India, Russia and Brazil (the BRIC countries - I believe that in one of my last posts I may have missed out Russia - apologies for that), as well as the many other emerging economies. It is argued that the rise of this competition is, in part, due to technological change, a point of view that I will not disagree with. However, whatever the source of this change, the reality of the change is inescapable.

As such, if you have a conversation with a friend who exudes the complacency that it will all be OK just because it was OK in the past, I hope that my suggested line of questioning will give them pause for thought.

As for point (b), a few questions are again called for. If a person is earning more in a year from the increase in the value of their house than from their salary, what is the actual source of this wealth? Where does it come from? What source of growth is generating sufficient wealth to make such a massive increase in the value of an asset? Another way to ask the question is to ask what kind of wealth is the UK producing more of in comparison to the past. Is it manufacturing output or productivity increasing (in the case of productivity, it is increasing enough to justify this increase in wealth), is it an increase in the extraction/processing of commodities, are we selling more services overseas than previously, are we exporting more, are we attracting more tourist money than we spend as tourists ourselves, and so forth.

The answer that you may receive is some muttering about services, or the city. However, if we look at the value of services we have to remember that these are redistribution of wealth (this is too complicated to explain and justify here - see my essay 'A Funny View of Wealth' if you wish to grapple with this complex subject), not creators of wealth (excepting where the services are sold overseas or to tourists). If we look at the city, yes it has grown in wealth and power. This is reflected in the trade statistics that show an uplift in the balance of payments for services. However, on looking at the numbers, it becomes apparent that this is not significant enough to explain this apparent rise in the value of a property.

What all of this translates into is one big question mark over the source of the apparent increase in wealth. In order for an asset to rise in value (in a sustainable way), something must have generated the wealth such that people can afford this. The alternative is that people must be getting poorer as, if the cost of living in a home has increased, without an increase in wealth to support such an increase, then people are having to spend more for the same, at the cost of less wealth to use elsewhere (I would also like to cover the supply and demand issue, but that is again too large a subject for this brief review).

As for the final point (c) I had a similar conversation a few years ago regarding our good fortune. The person reacted very poorly when I suggested that we were the luckiest people in history - to have been born in the late 20th century in the Western world. I was told at the time that this was arrogant. Even now, I am very puzzled at this reaction. In my mind this was a simple statement of fact. We have long life expectancy, healthcare, excellent economic opportunities, security from most external threats, freedom and so on. Even now I find it odd that this would be a contentious point.

However, having said all of this, I am not sure that we can take all of this for granted any more. As I have already suggested, the world has changed and is still changing. The rising power of the East is a fact of life, and the impact of that rise is only now becoming apparent. It is for this reason that I argue against the complacency that seems so prevalent. Just repeating that 'it will all be OK' will not make it so.