Round 2?

The underlying and fundamental problems in the world economy are once again bubbling into view, and the headlines are filled with panic. Stock markets have fallen around the world, and it might be that the slide will continue on Monday. Or perhaps not. I am not sure whether this is the start of the final act of the economic crisis at this stage, but it certainly has the potential to be so. In particular, there is a growing sense that the so-called recovery is nothing more than an illusion. There is a growing sense that the central banks and politicians cannot fix the problems, and have not fixed the problems. There is growing sense that the macro economists do not know what they are doing. In other words, there is a growing loss of confidence in those who think that they control the economy.

Somewhat predictably, Krugman takes a partisan stand, and calls for more government intervention. According to Krugman, government can just make new jobs, and all will be well:

Well, it’s time for all that to stop. Those plunging interest rates and stock prices say that the markets aren’t worried about either U.S. solvency or inflation. They’re worried about U.S. lack of growth. And they’re right, even if on Wednesday the White House press secretary chose, inexplicably, to declare that there’s no threat of a double-dip recession.

Earlier this week, the word was that the Obama administration would “pivot” to jobs now that the debt ceiling has been raised. But what that pivot would mean, as far as I can tell, was proposing some minor measures that would be more symbolic than substantive. And, at this point, that kind of proposal would just make President Obama look ridiculous.

The point is that it’s now time — long past time — to get serious about the real crisis the economy faces. The Fed needs to stop making excuses, while the president needs to come up with real job-creation proposals. And if Republicans block those proposals, he needs to make a Harry Truman-style campaign against the do-nothing G.O.P.

As is usual with Krugman, it is the evil republicans blocking more spending and, if only money was spent on job creation, the economy would grow. More government action is the solution, not the problem. Similar arguments are appearing from less heavyweight commentators, for example Polly Toynbee in the Guardian:

Faced with a new crisis, it stretches credibility to imagine Osborne invoking the spirit of Roosevelt's New Deal, but that's what's needed, with a job guarantee for every young person. That investment would be every bit as cashable for the future as roads or railways, since the great social debt now accumulating will be more burdensome for future generations than mere financial debt. No one is counting the social deficit, the costly damage done to this generation of young people, though the evidence shows that a workless youth does life-long harm, some never finding their feet again, becoming the workless parents of the next generation.

Today's Guardian editorial suggests that:

But even in the US and the UK, governments have all but removed their stimulus policies – with the result that both economies are now stuttering. The result may look like a financial crisis; but it is really a failure of government.

Apparently, the crisis is due to a lack of stimuli. However, in both the UK and the US, governments are continuing to borrow and spend at a shocking rate. Even if it were true that the US debt deal were really going to deal with the monstrous deficit (which it will not), this has had no impact yet. However, even the prospect of some fiscal tightening is being blamed for a new crisis. If this is the start of the final act, the actuality of ongoing massive spending and borrowing will be forgotten by the economics profession, and the economic crisis will be turned into a narrative of simultaneous tightening causing an economic crisis. The mantra will be, 'if only the governments had not simultaneously undertaken austerity measures....'

However, even Krugman has got something right:

It’s not just that the threat of a double-dip recession has become very real. It’s now impossible to deny the obvious, which is that we are not now and have never been on the road to recovery.

For two years, officials at the Federal Reserve, international organizations and, sad to say, within the Obama administration have insisted that the economy was on the mend. Every setback was attributed to temporary factors — It’s the Greeks! It’s the tsunami! — that would soon fade away. And the focus of policy turned from jobs and growth to the supposedly urgent issue of deficit reduction.

Regular readers of this blog will already know that there has never been any kind of real recovery, just lots of chatter - lots of optimism that is continually dashed with reality. All the policy and chatter did was to paper over the cracks, whilst the problems of the foundations saw the cracks widening even as new paper was being added to hide the consequences. In the mainstream media, it is becoming apparent that some commentators are starting to realise that there is a real very fundamental problem. This from a Telegraph editorial:

It is equally vital, as the pressures grow, that the world stays true to the free market principles which have been the cornerstones of post-war prosperity. The crisis of the last four years is not the fault of free markets as such, but of the way they have been distorted and corrupted by public policy and the unchecked excesses of finance.

In the search for the underlying causes of today’s rolling series of debt crises, it is hard to ignore the extreme trade and financial imbalances which have grown between countries, fed both by the mercantilism of China’s dash for growth and the absurdities of the single currency. The resulting build‑up of external indebtedness among deficit nations is now tearing the world economy apart.

Yet the pretence continues that somehow or other, we can just carry on as we are. Political leaders must find the courage to tell the truth about the fix we are in, and the painful choices that must be made to deliver a sustainable future.

They are groping towards the reality that has been the theme of this blog. They have still not fully grasped the nature of the change in the world economy; that the joining of China and India and other (so-called) emerging economies into the world economy had dropped a massive pool of new labour into world markets. The resulting hyper-competition is driving the current crisis, and the response of much of the Western world is denial of this reality and the consequences and impacts of this massive economic shift.

The answer of the Krugmans of the world is for greater government borrowing, printing more money. How these will address the problem of hyper-competition is never discussed, because the actuality of the hyper-competition is never acknowledged. They think that the massive disruption of the massive input of new labour into world markets is not the cause of this crisis, but rather it is a financial crisis caused by irresponsible banks. It is impossible to deny that the banks played a role, but as I have argued elsewhere, the banking crisis was a symptom of an underlying cause:

The summary of the situation is that the emerging economies lent their new found wealth from their increasingly large workforce into the West, and in doing so allowed the emergence of the so called 'service economy', or 'post-industrial economy'. The lending was built on an unfounded belief that, because the West had been economically dominant for so long, it would always be in a position to pay back the lending. The problem with the lending was that there were no productive wealth creating opportunities to soak up the money, (e.g. investment in manufacturing was being directed towards the emerging economies themselves) such that the money pouring into countries like the UK and US was directed into asset price inflation (real estate), consumption and consumer credit, and excessive government borrowing.

In the post, I argue that the world economy was being constrained by the limits of resources. With emerging economies soaking up huge amount of resources for infrastructure, and with supply constraints on commodities such as oil, the world economy was sharing a limited supply of resources over an ever increasing number of workers. In an earlier post, I presented an analogy. I described commodities as a moving brick wall to growth, with the world economy running behind this wall of constraint. As the economy runs forwards, it hits the wall and tumbles backwards. The world economy then gets back on its feet, and once again runs towards the wall only to eventually bounce back again. Below is a chart of oil production and consumption from the Economist and a chart of oil prices that tells the story.

China alone has increased oil consumption by over 4m barrels per day in the last decade. It is a picture of the brick wall. Note the upwards spike in 2007, and the upwards spike leading up to the current crisis. I have to emphasise, that other commodities have seen greater increases in output, but that the infrastructure demands of the emerging economies is a countervailing force, such that prices are reflecting the high demand.

The worrying part is that economies such as China are still going through the process of integration of their labour into the world economy. The process is not yet complete, and the problem is that the bounce backs will therefore continue, and the competition will become even more intense. For example, China is engaged in a process of seeking surety of supply of key resources around the world. This is a chart from Foreign Policy, representing 2005-9:

It is a trend that has been accelerating. Somebody in China seems to know the nature of the game that is being played out in the world economy. The Chinese development of a blue water navy also tells the story. In the end, economics is about recovery of resources and application of labour to add value to resources. With constraints on the volume of resources and massive increases in the volume of labour, this must lead to hyper-competition. It is really not that complex.

When thinking of the Krugmans of the world, we see no discussion of this simple idea. If you increase the workforce by 10% but only increase the resource by 5% then something is going to happen to the distribution of resources. Government spending on 'creating' jobs, or money printing, they claim can make a difference, but it does not address the underlying and substantive problem. More government action is the solution proposed.

Another problem with the commentary I am reading is the belief that this is a crisis of capitalism. Today's Guardian has a picture of an evil capitalist monster, and it is a view that is gaining currency. However, the real reason for this crisis is not capitalism, but the actions of communist and socialist governments before they started the process of opening their economies. They created barriers to the integration of their labour force into the productive and enriching capitalist world economy, and then suddenly started 'dropping' the labour into the world economy at a rate that the capitalist system could not absorb. It is why we see the increasing divide in incomes between the rich and the rest. It is not the evils of capitalism, but rather the last terrible contribution of years of rejection of capitalism in countries like China and India. They created a flood of new labour into the world economy, and the result is that labour has been devalued.

What we have in so much commentary is policy that is blind to the causes of this crisis, and solutions which replicate in varying degrees the fundamental causes of the problems; government constraints and interference with free market capitalism. Whatever anyone does, short of cutting of the supply of new labour, the situation cannot go back to the old 'normal'. The only way to deal with the crisis is to accept and embrace the hyper-competition, and that means addressing the structure of economies. When competition was less fierce, it was possible to have many luxuries in economic structures; for example, cradle to grave welfare or expending resources on any number of unproductive activities. The question that needs to asked is what can each economy really afford based upon their real productivity (i.e. not borrowed money). What are the real priorities within the constraints of the actual competitive position of the economy? Each economy must address this question, and address the question reflecting upon the hyper-competition that now characterises the world economy, and their relative strengths and weaknesses.

I do not know if this is the start of the final phase of the economic crisis; the moment when the reality that borrowing and spending and printing money are part of the problem not the solution. I hope that this is the moment, as the longer the denial of reality continues, the worse the problem will get. The crisis should have taken place a long time ago but, against my expectations, governments and central banks have buried the problem for longer than I ever thought was possible. Perhaps they have some last measures that they might yet deploy to 'save' the situation (but which will just create an even bigger problem in the future)? At this stage, I do not know, but we will see how events develop over the coming months.

Capitalism and Consumption

I am aware that, in the current climate, a defence of capitalism and consumption will not go down well with everyone. An interesting question on the subject was added to my last post by Lemming, a regular commentator. I will quote his question, as others are asking similar questions, such as whether there is enough resource for endless growth:

Can you design a system of capitalism which doesn't rely on economic growth to function? (Or is this simply a contradiction in terms?)

There is a fundamental problem in capitalism with respect to endless growth. Regular readers will know that I am somewhat cynical about the modern environmental movement, but I accept that there is a real problem in the medium to long term with resources. In the short term there is also a problem, but rather this is a matter of output rather than absolute limits on resource. In light of this, Lemming is asking a very pertinent question with wider implications. However, for the purposes of this post, I will ignore the longer term issue of resource, as this is a question that is too complex to cover in this post.

Another problem associated with economic growth is the relentless growth of advertising and media representation of society, in particular the lifestyle advertising that seems to encourage so much consumption. It is a matter of controversy how much advertising is a reflection of society, and how much it might 'make' society, and again I will not address this question here due to the complexity of the subject.

On the other hand Lemming's question does raise a more fundamental question. If endless economic growth is a problem it would imply that, at some point, economic growth should be frozen. This is a difficult idea, as it raises the question as to when exactly, or at what stage of development, growth should be stopped.

If we can think back to the world twenty years ago, would that have been an appropriate time to have frozen growth, or should we say that we should freeze further growth now? It is only when we ask such questions that the nature of the problem becomes clear. If we were to imagine that the world had frozen in terms of economic growth twenty years ago, then we must accept what the world would be like today without such growth (we will ignore the current economic mess for the sake of illustration - as the crisis is not a result of economic growth but the way in which the growth has taken place).

A simple example to illustrate the question is to ask whether we think that we should have foregone the development of fMRI equipment - which have allowed considerable improvements in our understanding of the brain, as well as being used to treat a range of medical problems. As soon as the innovation was introduced, it would have been a spur to economic growth, as it created a whole new industry and no doubt many offshoots. It might be argued that this is a very narrow and selective example but, if it were not for the massive advances in computing (for example), then the fMRI process would never have been possible.

The point in this example is that it is very difficult to separate out 'good' economic growth from 'bad' economic growth. For example, the boom in consumer purchases of computers has no doubt created significant economies of scale in the computer industry, as well as being an ongoing spur for continued innovation. The economies of scale and innovations that resulted from this ongoing consumption will have fed into many areas, even possibly fMRI scanning (e.g. cheap displays or processing power) and it is difficult to propose that such improvements do not have 'worthy' outcomes. As such, the boom in consumption of computers will have indirectly contributed to the development of fMRI, as well as many other innovations.

On the other hand there is a general backlash against the relentless consumption of goods by ordinary people, a sense that this neither makes us happy or really better off. Like many people, I am somewhat cynical about this almost mindless consumption, and do have doubts about what it might (of itself) really achieve. There seem to be ever more articles in which this consumption culture is being challenged, and the articles are sometimes linked to wider problems of the capitalist system (or quasi-capitalist systems might be a more accurate description).

As another example of consumption, once again we can return back in time to twenty years ago. At that point in time, for example, the Internet was relatively new, and only later emerged into ordinary life - alongside a burst in consumption. As a blogger, I inevitably see great value in the Internet - I see it as a great tool of freedom of speech, and would not like to see a world without it. The trouble is that, in order to see this development I have to consume huge amounts of resources individually, and many other people and organisations must consume resources to create the necessary infrastructure. All of this represents economic development and growth.

Once again, in my own consumption, I can point to what appears to be a 'worthy' reason for why this consumption can be justified. What if there is no such 'worthy' justification? We might take for example the endless cycles of consumption that are associated with home redecoration, or the purchase of (the much used example of) a plasma television. Surely there is no 'worthy' way to justify such consumption?

It is very easy to sympathise with a view that relentless economic growth driven by consumption is somehow unacceptable. However, there appears to be a curious 'moralism' that frames the arguments about consumption.

Astute readers may, at this point, see that in some respects I may be setting up a straw man. I am starting to try to link consumption with a notion of worthiness. However, in linking the examples of consumption here to worthiness, I am hopefully illustrating a point. The point is that it is actually very difficult to regulate/control what is acceptable consumption. For example, a person may travel to far away places and offer the justification that they are learning about other cultures and people. That such an activity consumes massive resources might be considered acceptable by the person who undertakes such travel. On the other hand, another person might claim that this is an unacceptable use of resource.

We can see this kind of measure of 'worthiness' of consumption in the example of 4x4 cars, which have become a symbol of relentless consumption and environmental harm. Amongst some people, such consumption leads to the attribution of social pariah status for the consumers. The problem is that, with the exception of a small minority, most of those who heap such a status on others will themselves be involved in some kind of 'unnecessary' consumption. Even amongst the minority who do significantly restrict their consumption, they will often be using the resources and enjoying many of the benefits that are resultant from the system of consumption that the 4x4 represents.

The idea that consumption is somehow immoral is nothing new. We can see it in history in the sumptuary laws, as in the case of Renaissance Italy. It is a long while since I studied this history, but I recall laws such as restrictions on the use of feathers in hats. In this case the laws were dictated by the church, but who might dictate the laws to restrict consumption today? Who is going to determine which form of consumption is worthy, and which is not? How do we measure a holiday to learn about Chinese culture against the purchase of a 4x4, or redecoration of a house against a connection to the Internet? There seem to be many people who seem to think that they know the answer, but I find it difficult to see how they might make the distinction.

There is another area of consumption 'culture' which is clearly a problem. This is the encouragement of indebtedness of consumers. I do not believe that there should be restrictions on borrowing for consumption, as that is a matter for individual people to determine. For example, some people might claim that borrowing to buy a house is 'good' borrowing, whilst borrowing to buy a plasma T.V. is not. Once again, I find it difficult to determine a way in which we can determine what is 'good' and 'bad'. Is a £200,000 mortgage debt a better thing than a debt of £1500 for a plasma TV? How might we determine what is 'good' and 'bad'?

However, there is a problem in the modern system of credit. One of the first points is that there is a system in which it is very complicated to work out how much debt we are really taking on. For example, cost of credit is often presented in terms of monthly repayments, rather than absolute cost. 'Interest free' credit is promoted to such an extent that it becomes irrational not to accept the credit. However, it is not interest free, as the interest is loaded on the goods upfront, thereby disadvantaging the cash buyers. This then encourages the use of credit.

These problems can be addressed through legislation. For example, information can be better presented, with an emphasis on the actual real cost of the credit. Consumer credit law might be devised such that retailers can not charge less for credit than they themselves are paying for the cost of the money that they are lending (though this might be complicated to administer). Teaser rates, variable interest rates, and a whole host of other methods for potentially leading consumers into debts that they can not repay are also amongst the subjects that should be addressed. For example, how can a consumer know what their debt obligations might be on a variable rate of interest, when even an economist is unable to make that prediction? All of these solutions would likely see a shrinkage in consumer credit, but would not restrict the freedom of an individual to access credit. The central point is that the system should be transparent and allow people to make well informed decisions.

This does not mean that individuals will not get themselves into financial problems. As with many of my posts, the emphasis is on provision of good and clear information such that individuals are making informed decisions. The government just sets out a framework in which costs are clear and transparent. For example, as there is no such thing as 'interest free credit', it is a fraud and should be exposed as such. It is not the role of government to protect fools, but to help individuals understand what the risks are in their behaviour.

I therefore accept a role of government, but only in making the role and nature of credit transparent.

In one respect, I do not accept the role of government, and perhaps this goes to address part of the problem that Lemming raises in his question. This is the problem of government manipulation of the money supply and interest rates in order to actively encourage consumers into consumption. At its most extreme, governments have recently been guaranteeing the lending of financial institutions in order to encourage yet more consumer debt accumulation. The real problem here is that 'economic growth' has been tied too closely to debt driven consumption.

Even as I am writing, it is possible to find in many government policy statements, and policy proposals, an ambition to 'get credit flowing'. What they mean when they suggest this is that consumers should resume borrowing to buy housing, borrowing to buy cars, borrowing to buy consumer goods. They see this as a 'good thing'. At the same time, they have lowered interest rates, thereby creating disincentives for individuals to take the more responsible route of saving money to fund their purchases.

This is the point that I suspect that underlies the question that Lemming has raised. I am guessing that he is looking around at friends and family who have 'binged' on credit, paid too much for their homes, and sunk themselves in a quagmire of debt. We can all see the painful results around us, and this has been encouraged by endless inflationary policy, and manipulation of the money supply in order to keep the economy 'booming'. All the time that governments have encouraged the boom, politicians like Gordon Brown were infamously promising that the 'good times' could last.

This is the growth of economies built on the foundations of endless expansion in credit. The role of the government in this process is that, as soon as credit growth shrinks, they seek to inflate the money supply in order to encourage yet more lending to consumers by the financial institutions. I would not claim that this is only the result of individual governments, as this problem has arisen through the actions of many governments. For example, I have detailed how the Japanese government expanded money, and how this money flooded into the West through the 'Carry Trade'. This money in turn inflated house prices, and provided 'cheap' money for lending to consumers.

Whilst the government is not holding a gun to the heads of consumers to make them borrow, they have sought to structure their economies to encourage such borrowing. This has come at the cost of a culture of relentless consumption, unsustainable growth, and the abandonment of thrift and saving. The result is that there has been economic growth based upon a boom in credit derived consumption, and this was both wasteful and unsustainable. As a clear example of the waste, we can now see swathes of new housing developments being abandoned in the US, and the system was unsustainable because there would always be a limit to such credit expansion.

Whilst it would be foolish to heap all of the blame for the model of economic growth based upon credit expansion, there can be little doubt that governments have contributed significantly to the problem.

The answer to Lemming's question, and perhaps the questions of others, is that there is no basic problem in economic growth, and no real problem in a system built around consumption. The benefit of capitalism is the provision of goods and services to meet the needs and wants of individuals, and it has consistently delivered on that promise, and provided the many innovations that arise from such a system that benefit us in a myriad of ways. Whilst some point to over-consumption as a bad thing, it is hard to separate out what is good, and what is bad consumption, what is good growth, and what is bad growth. On the other hand the encouragement of consumption built upon the encouragement of debt is certainly not good for individuals, or for the wider economy. This illusion of economic growth should not be confused with economic growth built upon using savings or income for purchase of goods and services.

In other words, the underlying system works. There are broader questions about how we might sustain such economic growth in the face of finite resources, and how the marketing of goods and services might ignite a desire to consume more than we would otherwise do. However, the problem arises as to how we might restrict consumption without making moralistic judgements, and how such consumption might be restricted in a way that is fair or just. If I wish to use money for all of the consumption necessary to use the Internet, then I would feel aggrieved if someone told me that this was unacceptable. Twenty years ago, the majority of us would not have even owned a computer, but we now all accept them as items we want, and which are useful to us.

This is the reality of economic growth. We are all tied into it and, as much as we may protest otherwise, we all reap the benefits.

Note 1: I would like to apologise for not posting for a while, and am very grateful for the comments and lively debate after my last post. In particular MattinShanghai has presented an interesting post which seemed to stimulate lots of debate, and many interesting follow on comments. I am hoping to post again on the weekend, as there are several interesting points in the news, such as the G20, the struggle to sell bonds, and the issue of inflation figures. It will be tough to choose which, so I may try to do a broad brush post.

Note 2: I know that the environmental question is a major factor in the discussion above, and no doubt some people will comment to that effect. However, I have yet to see anything on the table that can realistically solve the problem of resources. With regards to man made global warming and the Kyoto protocol, I would point people to Bjorn Lomberg, as he offers an interesting perspective. However, I do not want to get into the rather muddy waters of this debate, as it will distract too far from the main point of the blog - the current economic crisis and the immediate impacts. The purpose in this post was really to put a simple (perhaps simplistic) case forward for continued economic growth. It is a huge subject in reality, and the post was always going to be limited in scope.

Note 3: Lord Sidcup - yes, the $US is still hanging on in there. It defies logic, but somehow it just withstands whatever is thrown at it, including QE. With regards to the Schiff book, I am afraid I have not read it. I was disappointed you did not like the Ascent of Money - I liked his discussion of bubbles, and I broadly agree with his Chimerica thesis, though disagree with his views on the resolution of this situation. I don't recall the economic hitman point in the book, so can not comment on that point. Like many books it has strengths and weaknesses, but for me the strengths outshone the weaknesses.

Note 4: Lemming - some good questions, and sorry I can not answer all the points.

Note 5: I have noted that there are some commentators on the blog who appear to be white supremacists. I will always publish the comments, as I follow John Stuart Mill's 'On Liberty'. However, I might mention that I do not accept/ agree with any such views, as they simply do not relate to any reality I have ever seen. I note that other commentators are addressing the points that are being made, which is good.

Note 6: Some excellent links are being placed in the comments section. As ever, these are appreciated. Some interesting posts alongside these, and it is interesting to note that there is more contemplation of war appearing. One of my ongoing worries with the current situation is that it will be easy for the situation to lead to various forms of conflict, though I do not believe that China is in any kind of position to risk a 'hot' war. I have noted ever more news of Chinese assertiveness, and note that China has just done a deal with Argentina to use the RMB for settlement of trade. The march towards the RMB as a reserve currency marches on....whilst talk of IMF SDRs as a new reserve currency seems to be keeping everyone distracted.

The Crisis of 2009 - the Fault of Markets or Governments?

This post started out as an attempt to address the many interesting and often enlightening comments that have been made against the posts. However, in attempting to address two comments in particular I found that the responses led me onto a completely different track. This is one of the benefits of having having so many intelligent and incisive commentators on the blog. They spur new ideas and considerations.

In this case, I found that my rather meandering answers to their questions somehow morphed into something entirely new, a defence of free market economics. There are ever more calls for interventions in every market, more regulation, more controls, and all this adds up to is ever more government interventions. However, as I wrote my answers, it seems that everything that has gone wrong in the world economy can be directly, or indirectly, traced to government interventions. Despite this, the blame for this crisis is being laid at the door of the free market?

A good place to start is actually to look at the root cause of the problems, which I have detailed throughout this blog (e.g. here). This is the massive input of labour into the world economy, which has happened as a result of both India and China entering into world markets. This has led to the effective doubling of the available global labour force in a period of about ten years. It can not be emphasised enough here, that the massive dumping of labour into the market is not the fault of free markets, but is the result of a correction of government intervention in China and India. Both of these countries were artificially holding their labour back from the market until recent times. It is the sudden reversal of a government managed market distortion that has caused the shock to the world system. Governments in countries like China held back their labour force in a way analogous to a dam, only to let the dam open as a flood. Thus we have a massive imbalance in the available labour as a sudden shock to the global economy.

The real surprise in this distortion is that the free market system has managed to integrate such a massive input of labour as effectively as it has. However, the free market system is quite simply incapable of adjusting quickly enough to absorb this level of input flooding in. Whilst the system is flexible, it is simply not able to adapt quickly enough.

Another element at the root of the curren crisis is also the result of government intervention. In conjunction with dropping a massive labour supply into the world market, there has been an ongoing distortion in the world market.

As is pointed out by Lord Keynes (a commentator - not the original Keynes), we do not live in the perfect world of free trade, of genuine open competition. Lord Keynes points to the myriad ways in which competition is distorted, and quotes the quasi-mercantilist approach of China as detailed by Clyde Prestowitz:

Today, China is already the largest market in the world for steel, mobile phones, cement, aluminum, and electronic components. Within 20 years, it will likely be the largest market in the world for just about everything. If you are a manufacturer, you will pretty much have to succeed in the China market to have a chance of surviving anywhere else. In theory, you can serve the China market by exporting, but there are some good reasons why you might not. Because Chinese labor is inexpensive, production processes that are capital-intensive in the advanced countries can be “dumbed down” and made much less capital-intensive in China. As a manufacturer, you cut both your wage and your investment costs. On top of that, the Chinese government at local, provincial, and national levels will offer substantial investment incentives -- such as long tax holidays, capital grants, free land, low utility rates, worker training, and other benefits -- to companies willing to put plants and research-and-development facilities in China.

These investment incentives confound free-trade theory. They are, in fact, distortions of the market, and therefore of questionable legitimacy under the rules of the World Trade Organization. This has never been challenged because other countries have investment subsidies, too. (American states offer tax deals to induce companies to invest.) China, however, subsidizes investment strategically to capture new industries at higher levels than anyone else.

Prestowitz goes on to say the following:

Nor are there government policies to maintain U.S. advantage; it is assumed that American genius and free markets will automatically result in U.S. leadership.

Prestowitz is making a perfectly valid argument that China is following a beggar-thy-neighbour approach, and that the approach is nothing to do with free and fair trade. However, he also makes the point that the West has used its own variants of such policies, just with less aggressive mercantilist intentions. As Pretowitz points out, there is a belief that US brilliance will suffice.

I have long argued that China has been using unfair trade to gain unfair advantage, and that the US should have long ago confronted this problem. The posts can be found here and here, and I detail many of the unfair trade practices, as well as a threat by the Chinese government to destroy the $US.

However, the picture painted by Prestowitz, whilst perfectly valid, does not emphasise enough one of the real keys to the success of China. That key is the drive and determination to succeed at every level of Chinese society. I have lived in China for several years, and I was trying to think of an illustration of that drive. I then remembered a little street food restaurant that I used to use for my breakfast. It was open seven days a week from six in the morning until 11 at night, and every day, every hour, it was manned by the married couple who owned the business, with their daughter occasionally helping out.

Not all Chinese people are so hard working, but it is hard to see many cases of such complete single minded dedication to work in the Western world. The business was small, not very well run, but they were going to succeed, whatever it took from them. Knowing Chinese culture, their motivation was almost certainly to secure their daughter's future. Can anyone in the Western world deny that people such as these deserve their place in the sun, deserve the opportunity to secure the future of their daughter? We hear so much about the poor wages of Chinese workers, but we do not hear of these hard working people working to secure the future of their family.

There is generally considerable talk of 'slave wages' making the difference in China. However, low wages are only one part of the equation. I have seen a side by side comparison for an identical product made in a French factory and in a Chinese factory. The wage differential made the difference of a few percent, but it was in all of the other elements of the cost that the real differential lay. It is for this reason that I have emphasised that the solution is about restructuring of the Western economies. Whilst, for high labour input goods, labour cost will be a significant factor in competitive advantage, it is not the case for many products.

So where does this leave China in the world trade system?

On the one hand, they have an economic structure that is highly supportive of a competitive position, and where there is a strong argument for their success being deserved. On the other hand we have aggressive mercantilist policy, such as the control and fixing of the currency, no enforcement of intellectual property, and so forth. I have long argued that the US in particular should confront China over the latter problems, but have also recognised that the US is in no position to confront China, as China has the ability to destroy the $US (read the posts I linked to earlier for details of this). However, the lack of action, under the Chinese threat to the $US is just allowing China to build ever more leverage and exacerbates the problem. Better to face the pain for the $US now than later, when there is even less left of the manufacturing base.

What we are seeing is a world trade system that is anything but free, open and fair, and where the strong advantages of China are being rammed home with unfair trade practices. However, as has been pointed out, the problem is that to different degrees other countries are using unfair practices. It is the fact that these practices are entrenched to different degrees that makes it so difficult to deal with the particularly effective form of quasi-mercantilism practiced by China. For example, during the Asian financial crisis, there was universal acclaim for China for not devaluing its currency in line with the fall of other Asian currencies. It was apparently right to fix their currency at that time, when it suited Western interests, but not now that it no longer suits Western interests.

What you have here is a situation of 'pick 'n' mix' on the question of free and fair trade. Everyone can agree with everything, as long as it protects their own interests. This pick n mix approach offers legitimacy to Chinese unfair trade practice, and leaves complaints struggling to reach the moral high ground.

So where has this led us?

At its most basic, when a Western manufacturer tries to sell into the Chinese market they will often struggle to sell their product, as the Chinese government has held their currency at an artificially low level, and provided subsidy and incentives for manufacturers within their borders. In fact the Western company has trouble selling into any market in which they compete with any China based company. The Chinese government in following this policy has developed what can only be described as a powerful form of investment. In holding down the currency, the Chinese government makes every individual in China poorer in the short term (the investment - foregone income), as they do not have access to the same amount of goods as if they had a stronger currency, but the upside is that this relative poverty now is an investment that destroys the competitors who are unable to compete on these unfair terms (the return). It is a policy for long term success at the cost of short term wealth. It is a very effective investment, but one which is completely unfair in an open trading system and a system that creates imbalances in the world economy.

In the traditional definition of mercantilism the aim is the accumulation of bullion but, in this modern form, it is the accumulation of foreign exchange reserves. As has already been pointed out, the accumulation of such reserves has seen a transfer of power into China, which now has the power to run a steam-roller over currency markets. With that threat, they are in a position where they can face down demands for fair trade, and all the while their supply of foreign currency grows strengthening their ability to destroy currencies at whim.

In the picture painted by Prestowitz, the implication is that China has won through following this policy. It is now increasingly evident that they may have actually set in motion their own catastrophe.

The simple truth is that, as countries like China use unfair trade measures to gain advantage, imbalances build up as a result, and the world system goes out of kilter, requiring ever more government interventions to stave off disaster, but creating the foundations of the next round of disaster. China has built up a massive trade imbalance, but in doing so has sowed the seeds of their own downfall, because they have quite literally destroyed the wealth of the market on which their own growth in wealth was dependent.

Instead of allowing their currency to float, they hold it down, and hope to support their own economy by exporting into the west, thereby pushing the West further into the ground. All the time, they are destroying their customers, and doing so at the cost of holding their own people in relative poverty. As a simple example, allowing the RMB to float freely and rise would dramatically pull down the cost of Western medical equipment, and allow for cheaper and better health care. One of the key reasons for Chinese people saving so much is the cost of health care as this is largely provided on a cash payment basis. That very high savings rate holds back the growth of their internal consumption of their own production, as well as the products from other countries. The result of the RMB rate is an artificially high cost of medical equipment and medicine. This in turn feeds into the cost of medical care, and this feeds into higher savings rates, and this feeds into less domestic consumption. In other words we can find just one small impact of the artificial currency level and see that it is just one of the many small distortions that ripple through markets as the result of government interventions, leading to its own problems, its own imbalances.

The implication of writers like Prestowitz is that China is winning in this great game of beggar-thy-neighbour. However, as we view the slide of the Chinese economy, it does not look much like a winner. It will not be long before the trade barriers start to go up in retaliation, or the collapse of their export markets sucks them down. In either case, they can not win in the long term, and the cost for China may be very high indeed. It might be that they see the kind of instability that leads to bloody war and revolution. Returning to the little ripple caused by health care costs, the switch to internal consumption in the Chinese market is, in part, held up by the very distortions that have led to the rapid economic expansion. As their exports collapse, they need that switch to the internal market, but one of the reasons for consumers keeping their wallets closed is the cost of health care, and that is partly the result of the mercantilist policy on currency.

I have just chosen one example of the problems that the Chinese government intervention in the exchange rate creates, the cost of health care. However, it is if we imagine a full float of their currency that we see the extent of their difficulties. If they float the RMB, China will likely collapse. With so much accumulation of foreign reserves, such a strong balance of trade they are in a position where any float would see the RMB soar to astronomic levels. The result of such a change would be to wreak destruction on their export machine, and create a massive inrush of imports. Whilst they might retain a strong balance of payments position, they would see large sectors of their export industry wiped out overnight, as well as seeing foreign companies suddenly emerging as effective competitors within their own markets. Quite simply, the artificial exchange rate has insulated their business from tough competition.

In short, they have accumulated this massive reserve of power and wealth, the massive accumulation of foreign reserves, at the cost of trapping themselves. They must keep exporting as a large part of their economy is structured towards this goal but, in doing so, they are impoverishing and destroying their customers. The only way they can save their customers is through a move to fair trade, but the destruction to their economy of such a move would see their country likely collapse into chaos. If they keep going as they are, their customers will go bust, and they will eventually collapse with them, and if they abandon the policy that is destroying their customers, they will also collapse. If their customers call time on their unfair trade, they threaten to sink the $US, but in doing so China will destroy the massive reserves they have accumulated, along with their customers. They could try to manage the rise in their currency, but they would still need to make the rise in the RMB fast enough to prevent a trade war, and to prevent the destruction of their customer base. The shock would still be too great.

In other words, their quasi-mercantilist policy allowed them to grow at a rapid rate, but the rate of growth has turned out to be an illusion. One way or another, they sink or swim with those upon whom they directed their mercantilist policy. A balanced and fair trade policy might not have offered such astounding rates of growth, but the rate of growth might have been sustainable and solid.

In one of the posts on China that I linked to, I suggested that China was balanced on a knife edge, that as the Western economies crumbled, maybe China had the capability to soak up the losses with growth in internal consumption. However, their mercantilist export policy meant that this was never going to be possible. They could have allowed their reserves, for example, to be used to pay for the building of a system of health insurance, or a basic social security net. Such a move would have allowed for their people to have the confidence to spend some of their huge reserve of savings. They need not have followed the expensive and overly complex state models of the West, but come up with at least some form of security for their people. Now it is too late. They can not change the savings culture of their people overnight, and can not therefore stimulate internal demand. They can not overnight structure their economy from their reliance on exports to the West.

Had their currency been free floating, they might not now have their reserves, but there might also have been a better balance of growth between export and internal growth. The massive growth in their industry might have still been export oriented, but not so fatally so. Furthermore, with a free floating exchange rate, their rise would have been more measured, and not led to the destruction of the customers that provided for that growth.

As it is they now own the massive reserves of currency, but the question arises as to how those reserves might be deployed without destroying the value of those reserves. In order to utilise those reserves, they need to start buying things from the US, with most of their reserves held in $US. However, their mercantilist policy has left the US in a position where they have less and less to sell to the East. What does China want from the US, that is does not now manufacture at home? Yes, there will be some things, but they will be relatively expensive because they have trapped themselves in their own currency game. The only way that China will be able to use those reserves will be to sell large amounts of the reserves and, in doing so, destroy the value of those reserves. Their massive reserves are, in other words, valueless paper.

I hope that this is becoming clear. Whatever China does now, the imbalances that it created have left it with no options for riding out this crisis. If they float their currency they fall into chaos. If they fix the rate at which they maintain their exports, they will suffer retaliation, or simply proceed to economically destroy their customers. Yes, they will accumulate yet more reserves of yet more useless paper...but to what end?

Their mercantilist policy once looked to be a very clever road to success, and has given them economic power. The trouble is that the economic power they have gained as a result is as illusory as the apparent economic success in the West over the last ten years. It is the economic power, to borrow a phrase from the cold war, of Mutually Assured Destruction. They can not escape the fact that their economic fate is entwined with the West, and they are now locked into a morbid lover's embrace with the West, even as the west plunges over the cliff edge.

Is this a case of free market failure? I think that it would be hard to pin the blame on the free market under such circumstances. One of the great balances of trade, the rate of exchange of currency, was allowed to be manipulated. This manipulation caused imbalances that a floating currency would long ago resolved.

However, there is another guilty party in all of this, and that is the US. In this respect, I agree with the analysis of Prestowitz. The US has issued useless paper on a scale that is quite simply astounding. As Prestwitz says, the attitude has been:

If the Chinese are foolish enough to exchange low-priced consumer goods for cheap U.S. paper, let the party continue.

So the Chinese exchanged their hard earned currency for what is now evidently useless paper. And the exchange was one in which the Chinese exchanged their hard earned labour by lending to the consumers who would then buy their goods, and would repay that debt with ever more paper with ever less value.

The US has used its position in the world currency system, has abused its position, to pour ever more paper into the world markets to fund their own boom in consumption. The same argument, to a lesser degree, can be made of many other Western countries, such as the UK. However, whilst they followed a similar route, none could manage the scale of the US, where the strength of their status as a reserve currency gives them so much more potential to get away with it over such a long period of time. I have said it before, and will say it again, the $US is the biggest bubble that the world has ever known.

However, the issuance of the useless paper is not a great money for nothing scheme that will hurt the Chinese. The US may have got huge amount of product in exchange for useless paper, but it will eventually hurt the US too, as it will eventually bounce back to the US as a horrendous devaluation of the currency which will destroy the wealth of the American people.

Once again, the bubble is not the result of a free market failure, but is the result of government central banks being able to issue fiat currency. If they were constrained by ensuring that the money had some underlying contractual value, such issuance of money would never have been possible.

Once again, this is not the failure of markets, but the manipulation of markets, of debasing the value of the very thing upon which markets are built - money. In one sense, yes, there has been a market failure. The US should have been punished for the irresponsibility of its actions a long time ago. However, once again, the markets have been distorted, with governments around the world, again with China as a good example, following mercantilist approach such that they have followed policy of actively seeking to accumulate $US reserves. This is not demand to support trade between countries, but a modern misguided attempt at the accumulation of 'bullion'. The market did not create demand for this bullion, but government policy. If there were just the purchase of $US for trade between countries, then the bubble would never have grown as it has done. If it were trade alone that determined the value of the $US, it would have sunk long ago, as the $US just does not produce enough that others want to buy. Quite simply, there is relatively very little demand for the $US to allow trading with the US.

So we have a debased $US.....

.....and if you thought that the manipulation of money already detailed were not enought, Jeremy, a commentor, posted a link to a Youtube clip in which experts on gold discuss the interventions of central banks in the gold markets. One of the most important points of the discussion (I believe) was the consideration that gold is a competitor to fiat currency. In particular, there has been a significant move of individuals into private holdings of gold. I have discussed at some length that fiat currency is built entirely on confidence, and the move into gold is indicative of the erosion of that confidence. Again, I recomend this clip, as it is very illuminating. One of the points that is raised is that central banks have been shown to be regularly intervening in the gold markets. The interviewees debate why on earth central banks, issuing fiat currency, might have any interest in the gold market. As is identified at the start, gold is still a competitor to fiat money, so the only explanation for the interventions that makes sense is to hold the value of gold down, to make it unattractive in relation to the fiat money. Again, there is government intervention in markets, and in this case in support of their own increasingly debased fiat currencies.

Then we come to the other market distortions that have allowed the US to continue to borrow and issue useless money. One of the greatest distortions can be found in the Basel accords, in particular Basel I. As I have detailed in my previous post on the banking system, the accords actively encouraged banks to buy up issuances of government debt. OECD sovereign debt is a key constituent of the capital adequacy ratios of banks. It is quite extraordinary that banks have been actively encouraged to lend to governments. The idea that governments should borrow at all is in any case quite absurd, but that rules for the financial system should be implemented to actively encourage lending into governments just heightens the absurdity. As I pointed out a long, long time ago, such lending pulls money away from the private sector and only serves to increase the cost of capital for the private sector, which has to compete with the ever growing government deficits by attracting higher interest rates.

For the sake of convenience, I will quote my post on Government borrowing:

Another reason why government borrowing is influential is best illustrated by a simplification. I am an individual investor and wish (for whatever reason) to make an investment in £GB. I will be faced with a range of choices for where I might to wish to put my money. For example, I may wish to lend into the consumer markets (e.g. putting my money into a building society account where it will be used to provide mortgages), or invest in companies (e.g. stock market), or I can lend to the government (e.g. bonds) and so forth. In each case I must make an assessment of risk and reward. If we take the example of lending of money to the government through the purchase of bonds, these kinds of bonds are considered to be 'no-risk' (a misnomer - as they do have risk) and therefore are highly competitive in the respect that they are relatively very safe investments (in some cases they even allow for inflation). By comparison non-government lending looks pretty risky.

In this situation, my investment decision would, if all investments were offering the same yield, be to go for the government bonds. Why take a risk on putting my money into unsafe instruments such as consumer lending. As such, non-government competitors must offer me a premium over lending to the government in order to give me an incentive to invest my money in their asset. As such the government becomes a formidable competitor in the market for where I invest my money, and set a benchmark on the minimum yield I will accept. In doing so, they are distorting the markets, and setting an effective minimum interest rate in the market.

And this is just the start of the negative effects of government borrowing. For more detail, you may wish to visit the original post. Once again, we have a massive distortion in the market, a distortion in which governments can set the baseline on the accepted level of return on investments, can draw money away from investment into productive private business, and all on the basis that they have a legal entitlement to extract cash from their populations at some point in the future to pay for their borrowing.

I do not intend to reproduce my post on the banking system here, but the encouragement of lending into governments is not the only distortion that has been caused by banking regulation and the interference of governments into the banking market. What I will do is answer another of the comments that I have received. Chas H offers this point on my proposed reform of banking, which I will quote in full:

Thankyou for another well argued post. I would welcome the kind of explicit presentation of risk that you propose, but I see two obstacles to making it work.

1) We live in a culture which does not understand risk. Thus many people buy lottery tickets with a real belief that that they stand a good chance of winning the jackpot. At the same time many people become neurotically anxious about the miniscule risks to health presented by eating certain types of food.

2) We live in a risk-averse society which is burdened down by absurd legislation and precautions to remove risk.

It is for this reason that there must be bank failures on an ongoing basis, and the regulation of banks to make them 'safe' need to be abolished. There needs to be a regular reminder that risk in investment is real, and this will create caution. Such failures will help prevent systemic risk of the kind that we are witnessing. Yes, individuals will be hurt in such bank failures, but it is a discipline on the business of banking, and reminds us all that risk is real and exists. As for point 2, this is exactly the problem. Individuals are currently in a position where they can take huge risks with their money, and then, if that risk goes bad, they suffer no consequence, as the loss is absorbed by everyone else. That is the nature of the previously implicit/explicit (and now just explicit) government guarantee of the banking system. If we remove the consequences of risk, greater risk can be taken with a sense of impunity, encouraging systemic risk taking.

This leads me to a question from a regular commentator, Lemming, who asks whether capitalism and Fractional Reserve Banking can only survive in a situation of growth. The answer to this is that FRB is a matter of risk. In times of growth, the risk is on the upside, and in times of contraction it is on the downside. Even during these bad times, some investments will continue to make money. The trouble is that people just don't like losing their money or accepting that they are risking their money. It all comes down to explicit acceptance of risk. During contractions, there will be more bank runs and bank failures. As some institutions find that they have utilised their depositors funds unwisely, they will find that depositors will lose confidence in their ability to manage their money and secure returns on their investment. In all such cases they will then be subject to the risk of a bank run, in which their available cash reserves are insufficient to meet depositor demand for cash. This will just serve to ensure that people scrutinise their decisions more carefully.

It can best be summarised this way. If we think of the average person opening a deposit account in a bank, how much care do they ever take over that process? They simply look for the highest rate of interest....without any acknowledgement that their higher rate might come with a greater risk to the capital. Such is the government regulated and implicitly and increasingly explicitly backed banking system.

This is not capitalism. This is a dream of a one way bet. Risk free investment.....It is the heart of the problem that I identified in my banking reform post.

Once again, we are very far from failures caused by the free market, and can see that the root of the problems is in the regulation of markets. I give an example in my post on the banking system that directly links developments in the financial crisis to responses to the Basel Accords, and the example that is given by no less than the Bank of England. They spotlight how growth in securities was directly encouraged as a result of Basel I. Again, this is detailed in the banking post. If you read the post in full, it is evident that market failure was not the cause of the financial crisis, but rather it is the endless interventions of government.

I have given some examples here of some of the root causes of the current financial crisis, and none of them are the result of market failure, and all of them are the direct result of government interference and manipulation in markets. As hard as I look, whenever I look to the roots of the problem, I find not market failure, but rather problems that are the direct or indirect result of government interference, manipulations, and regulation of markets.

A long time ago, I listened to a recorded lecture from the von Mises Institute. I can not reference it here, as I forget the details of where I found it or who the speaker was (apologies). One of the key elements of the lecture was that Marx got it fundamentally wrong when he said that he was describing the capitalist system. He was, in fact, describing a mercantilist system, and the reason why Marx's analysis was so wrong was that he thought he was analysing something that was in fact something else.

As I have written this post, this observation came to mind. People are readily describing the economic crisis of today as a failure of free markets. It is nothing of the kind, but represents the distorting effects of governments on markets. There has been no free market, but rather a series of market interventions. What we are seeing are ripples of chaos that emerge from the many distortions in the markets created from those interventions.

One distortion is the withholding of labour from the market, followed by the sudden release of that labour into the market. Another distortion that followed is the artificial currency exhchange rates that allowed the accumulation of worthless paper, issued because government has been allowed and encouraged to borrow, and allowed to run a policy of endless expansion of money. Meanwhile, the banking system has been regulated into ever more distorted activity, and the regulation offered guarantees of the system, encouraging horrendous risk taking through a promise of an unlimited guarantee of the system.

Mercantilism, government intervention, regulation and distortion of markets. If we wish to find a culprit for all that has happened, it is not the fault of free markets, but it is the fault of the endless interventions in the markets. Quite simply, blame for the mess we are in is being put in the wrong places.

Note 1: My apologies for not answering the many comments but, as you can see, I became somewhat distracted.

Note 2: Mercantilist is not a very good term, but it does appear in the dictionary, and seems more convenient than discussing the subject as an 'ism'.

The Multiplier Effect

I have had a couple of responses to my post 'Government Waste an example...' by two anonymous posters (hereafter 'anonymous1' and 'anonymous2').

The first post I will respond to is provided by Anonymous1, who discusses the multiplier effect, citing Wikipedia (i). The principle of the multiplier effect is explained in Wikipedia as a company building a factory, and how the money then circulates through the economy through, for example, the employment of builders. It is pointed out (correctly) that this will raise output overall in the economy.

Anonymous1 links this idea of the multiplier effect to my article about government waste, asking the following question:

'Can there ever be value in economic activity for its own sake?'

Anonymous1 also (again correctly) links this to the economics of Keynes, who believed that government ameliorate the effects of recession/depression through increased government spending (relying in part on the multiplier effect).

I have talked about the multiplier effect in my essay 'A Funny View of Wealth' (See my posts June 2008, though I do not use the term itself), and point to this effect in the creation of the recent boom. In this case the stimulus was a massive inflow of money in various forms of consumer debt and government debt.

Now to return to the question asked by Anonymous. Can there be value in the kind of economic activity for its own sake (i.e. of the kind that I detailed in my post on government waste). The first point is that, even if we accept the idea of using government spending to ameliorate the effects of recession/depression is a good thing, this kind of spending could not be justified, as it was undertaken during a period of economic boom. It would therefore be an additional stimulus to an already highly stimulated economy (in this case stimulated by growth in consumer/government debt). As such, this kind of spending, regardless of questions of economic philosophy, was just plain wasteful. All of the members of the team on the project almost certainly could have found more productive employment in other sectors of the economy. As such non-productive activity was displacing potential productive activity. Furthermore, the source of finance was from, at least in part, genuinely productive sectors of the economy. For example, it is possible to make a relatively crude argument that some of the finance used to fund the activity might otherwise been used to expand a productive business. Instead it was taken as taxation.

Another point made by Anonymous was as follows:

'And when you consider that the 'real' economy apparently thrives on jobs like mobile phone ringtone development and crystal healing he might have a point. Presumably the jobs people do in the 'real' economy are justified because others are prepared to pay for them, but by any definition, many of them are pointless and wasteful.'

I would not actually say that these jobs are wasteful, as the people who buy such services value them. Whilst they are (by my view) odd ways for people to spend money, they have as much value as a bottle of whisky, or going to see an opera. How people spend their disposable income is not an issue in the overall picture of economic health, excepting the issue of whether the spending retains wealth in the country (whether the purchase is for imported goods or services). What is an issue is whether there is a sustainable source of productive activity that creates sufficient output to allow such discretionary expenditure to take place. There are many ways that such output can be created, and I consider these in some depth in 'A Funny view of Wealth'. However, the idea that such wealth can be sustained through the expansion of borrowing is not included, and my argument is that borrowing has been the source of the UK's apparent (illusory) wealth.

What I am saying is that we can say that crystal healing, however odd it may be, is productive output as long as someone values this service. If the service is provided to the wife of a Russian oligarch, then this odd activity even provides a net contribution to the UK economy as a whole. If it is paid for by a factory worker out of his/her wages, it represents a distribution of the wealth created by the worker's productive activity. If it paid for out of debt accumulation, it becomes a net loss of future wealth for an individual. In all cases the service remains a productive activity in its own right. The real problem lies in the origin of the wealth that is redistributed through the purchase of the service. If we return to the multiplier effect, the question is as to where the wealth is coming from - its real origin. Is it from the loss of future wealth represented from debt, or is it from productive activity? In each individual case, it is nearly impossible to separate out the origin of the wealth that is redistributed. This is why we can have an illusion of economic growth, when the reality is that the economy is becoming poorer - through the loss of future wealth represented by debt accumulation.

The real problem arises when a stimulus is created through debt accumulation, and individuals and government believe this is real wealth creation, rather than loss of future wealth.

I hope the above answers the question posed. Next, a slightly more difficult post provided by Anonymous2.

Anonymous2 points to the difficulty in seeing the reality of the waste for anyone outside of the system, and says:

'Your post suggests that an awful lot of public sector employment is wasteful. I have heard people use the term 'rentier economy' to describe the UK. One characteristic of such a state is a high level of unproductive public sector employment designed to keep much of the population content.

http://en.wikipedia.org/wiki/Rentier_capitalism
http://en.wikipedia.org/wiki/Rentier_state

The thing I don't understand is what the resource is that we would be 'renting out' externally.'

I will do my best to answer some of your comments, though I am not sure I fully understand your intent.

What we are doing in the UK, in many cases, is selling assets such as utilities to non-UK owners, which offers a short term boost of cash in the economy.This is at the cost of these assets becoming a source of 'rent' for the new owners of the assets. As such, whilst such sales of these assets present a short term cash boost for the economy, over the long term they represent a net loss of wealth. After all, if a person buys an asset, their intention is to extract more wealth from the asset than they have invested into the asset. This process comes under the term inward investment, and inward investment is widely seen as a 'good thing'. However, (sorry to mention it again) as is discussed in my essay 'A funny View of Wealth', it is not easy thing to determine which kind of inward investment represents an overall gain for the economy, and which represents a loss. I mention the case of the utilities as an example, because this is an example where it is hard to find any sensible reason for why there might be a gain for the economy. For other inward investments, such as establishing a manufacturing facility, the relative benefits are harder to measure (sorry, but for this discussion to make sense you really need to see 'A funny view of wealth', where I discuss the potential pros and cons in depth). However, it is certain that certain kinds of inward investment will over the long term see a net loss for the UK economy. Some of these investments might plausibly support elements of what Anonymous1 is suggesting (if I have correctly understood the meaning of the comment).

This government, and previous governments, have enjoyed the short term benefits of such (ongoing) sales of assets which helped provide an illusion of a healthy economy. How this works is a complex subject, and is difficult to summarise. A simplistic analogy is to think of a company that has owns a piece of productive machinery. It then sells the machine to a finance company that subsequently leases it back to the company. This gives a short term benefit to the balance sheet of the company, but has the long term negative effect of having to pay back more than the initial short term cash from the sale. It looks good on paper initially but, in the end, the company will have spent money with no productive gain (unless the money from the sale is invested in something else that generates more cash than the cost of servicing the lease).

As for the suggestion that the government is using spending to maintain a content (docile?) population, this is a very cynical view, but does have some merit. The more people that are dependent on government income, the more likely they are to vote for a government, and support a government that promises to continue with the spending. This is all very well, but creates a long term structural problem in the economy due to government spending removing people from productive activity. The government pays for this unproductive activity through taxation of productive activity. In doing so, the government sets in train a process of long term economic decline. The really tragic part is that this creates potential for a vicious circle, where a government will need to create ever more 'make work' jobs in order to retain votes and power. As the productive economy suffers under the burden of wealth extraction, it starts to contract, and the government responds by making further extractions to maintain the economy to a degree where the voters will still continue to vote for the government and, in doing so, makes more people dependent on the government, and so on.

I am simplifying, but I hope that you take the point. This government has seen a marked increases in the numbers of civil servants, as can be seen in the following article:

http://www.telegraph.co.uk/news/uknews/1457104/%27Day-of-the-long-knives%27-for-50%2C000-jobs-in-the-Civil-Service.html

This is a very old article, so the figures are now very much out of date (sorry, I am a bit pushed for time, but it serves to illustrate the point).

In addition, there are many other areas of government spending where there are jobs reliant on government spending and in reality the workers are state employees, but which are not directly recorded as such (e.g. the project that I worked on). Every one of these jobs creates a dependency on continued government spending at a cost to the productive parts of the economy.

The implication in the comment by Anonymous2 is that this dependency is planned. In this respect, I disagree with Anonymous2. I think that there are people out there who genuinely believe that the kind of wastefulness, as I detailed in my original post, is actually of value to the economy, and genuinely believe that an ever expanding state can be maintained alongside a healthy economy. As such, where I would agree that such expansion creates docility in a large part of the electorate, I do not believe that this is part of grand plan. I would accept that there is tactical usage of such government expenditure, but do not (perhaps wrongly) believe that there is any strategic plan. Perhaps I am naive but I think that, even allowing for the petty ambition that drives politics at the micro level, the majority of politicians (and the government) are unaware that the cumulative negative effect that such micro-level activity can create. Each little piece of expansion has its own justification and appears, on the face of it, to be merited.

Note for Anonymous2: I am not sure that I have answered your point fully. If you read my this post and feel that I have not addressed your points, then please feel free to post a follow on, and I will do my best to respond.


(i) There are some people who very critical of Wikipedia, pointing out inaccuracies in various entries. However, an independent study comparing Wikipedia with Encyclopaedia Britannica found that there were less errors on average in Wikipedia. I compared the Wikipedia definition with one in an economics textbook, and concluded that the Wikipedia definition was more intelligible. My experience with Wikipedia is almost all positive. The link given for the citation was:

http://en.wikipedia.org/wiki/Multiplier_effect