False Assumption, Ponzi, and the Developed World

We are now heading towards 2013, and it very, very striking that the world is still mired in an economic crisis. It is very easy for people to be caught up in the 'events' that comprise the daily news stories in the media; the events appear as more real than the abstractions that are the explanations that sit under the events. The explanations of 'events' is 'events'. Thus we have an event such as a government announcement A, leading to event B. It is wonderfully tempting and seductive to take this view, as the correlations between events can be easily determined, easily seen, and easily explained. However, the event A does not take place in a vacuum, and the event B that follows likewise does not take place in a vacuum. Instead, what is really happening is the events sit in a messy context of broader drivers, the beliefs and perceptions of innumerable actors, contesting interests, and sometimes just plain irrationality.

For example, take the belief that seems to be common in the developed world that relatively high levels of wealth are a given, a natural state of affairs. Would anyone contest that this belief is firmly entrenched? Whilst some might argue about the distribution of the wealth, for example arguing that true wealth should see more even distribution, they would still proceed from an assumption that there is and will be a relatively high level of wealth for distribution. I have now been blogging for several years, and have been thinking about economics for longer, and have not found any examples which do not proceed from an assumption that the developed world should just somehow be more wealthy. Even when articles bemoan the rise of China, they do so on the basis that, somehow, it is a natural place/position/state of affairs that the developed country should, well...... just be more wealthy.

The articles that worry about the sliding position of the developed world are the most interesting. They have a sense that 'something must be done', and often they will offer their policy prescriptions to fix the problem. It does not matter whether the author is left or right leaning, the aim is to maintain the relatively high levels of wealth in the country under discussion. With the right tweak of policy here, tweak there, all will be fixed. They assume that the natural position of relative wealth might be maintained, if only we could just do x, y or z.

Most of the readers of this blog seem to be well informed about economics. As such, I ask you to think about the many articles you read, and the assumptions that underpin them. You will find an assumption that the developed world not only is naturally more wealthy than the rest of the world, but also should be more wealthy than the rest of the world. There are some exceptions, in particular on the left, that the developed world is somehow sinful for being wealthier, and that the developed world should actively redistribute its wealth to the poorer parts of the world. Even here, we see an assumption of natural wealth.

The problems with the assumption of natural wealth, and that the developed world should be more wealthy is that it is just that; an assumption. It is treated like a natural force, and a right that is dictated by some kind of natural law. The problems is that there is no natural law, and no right that can be supported or defended in any way whatsoever. When a less well developed country pulls itself up by its metaphorical boot straps, sees rapid economic development, and contests for a position in the top tier of wealthy countries, there is no natural force that might stop them, or reverse the ascent. Instead, there are the complexities of the trillions of individual purchase decisions, the choices of individuals in economic entities such as firms, regulators, and policy makers.These are the real forces at work in economics, rather than some unseen and non-existent forces and rights.

I too have been guilty of the assumption that the developed world should be more wealthy. Like many others, I have argued that the developed world should act to defend its position as 'wealthy', including offering my own solutions. In some respects it is wrong-headed. There is no real reason why any particular country should be more wealthy than its neighbours, if the people of each country are equally as hard working and innovative. It seems that, in this situation, there can be no justification for one country being wealthier than another. There are, of course, situations where a particular country is just blessed, as in the examples of the oil resources available to countries in the Middle East. Putting it crudely, they just do not have to work as hard as others. Resenting such good fortune is, of course, pointless and sometimes such blessings also turn out to be a curse.

However, the world is not so simple as I paint it here. It assumes a world of competition between economic entities, based upon hard work and innovation. However, there is another competition at work, and that is the competition of systems; systems of how society is ordered. At one extreme we have what might be described as a something like a fascist state; China. All ideas that are imported into the country are subject to 'sinification', so China's system is uniquely Chinese. I use the word fascist therefore in a very loose way as the nearest equivalent. It would then be tempting to say that, on the other side, we have liberal, democratic and free market countries of the developed world. It would be a neat narrative of black versus white, but it does not hold.

However, the latter categorization is nevertheless partially true. With differing degrees of dysfunction, the developed world is democratic, and to different degrees 'liberal'. I say dysfunctional, because democracy is not working well. The system is failing. There are certain types of dysfunction that I will put to one side here, such as the shocking amount of money that is necessary to compete for the US presidency (albeit that such problems also relate to my area of concern). My concern is rather with the dysfunction of the electorate.

A significant economic challenge has developed, and that challenge is very real. We have seen a significant shift in the economic structure of the world. It has been assumed that what we are witnessing is a game of 'catch-up', in which countries such as China are seeking to chase after the on-going growth of wealth in the developed world. The idea that 'surpass' might take place is only in aggregate, not at the level of individual wealth. However, the developed world is not growing in wealth, but seeing a diminishment of wealth. The developed world is on a down escalator, even whilst the developing world is on the up escalator. As I have pointed out recently, those on the up escalator now face their own problems, but to assume that they will not continue upwards and the developed world downwards would be complacent.

It is here that I return to the dysfunction of the electorate and the question of liberal democratic and free market. In the developed world, the electorate have been seduced by the idea of the natural right to wealth in their own country. They know that there are now challengers to their position of wealth. They cannot avoid seeing this reality. Even those with the most passing interest in economics will be aware that the world has changed. Faced with the challenges of a new economic structure, instead of facing the new competition, electorates have demanded that the world remains unchanged. However, demanding that the world remains unchanged does not make the world unchanged. All that has happened in response to this demand, is that the politicians have responded to the demand by developing a pretense that the world is unchanged. Happy days are just around the corner. But the corner continues to be elusive. So what is the pretense?

The pretense is that we still operate in a world of free markets and that the world has not changed. Of course, it has never been the case that markets have ever been truly free, so we are talking about degrees of freedom. The point is that, since the economic crisis came into view, the marketplace has come to be dominated not by market signals, but monetary and fiscal policy of governments. Governments have always had a role in the marketplace, but underlying market signals could still (mostly) be discerned from the noise created by government. This is no longer true. More pertinently, it is now being recognised, even in conservative organisations like the Boston Consulting Group, that current policy is simply impossible to sustain.  They are blunt; they call current policy in the developed world a 'ponzi scheme'. This is just one extract from the report, and the content will be no surprise to regular readers of this blog:

Intensifying International Competition and Rising Inequality. Globalization has brought the promise of economic prosperity to billions of people around the world. But it has also contributed to tougher international competition and the creation of new inequalities of wealth and income in the developed world. The growth in the global labor force continues to put pressure on labor costs in developed economies. At the same time, globalization is leading to increasing inequalities in income and wealth within countries, as some groups (such as investors) benefit more from increased globalization than others (such as manufacturing workers).

Income statistics highlight this development: between 1979 and 2007, the income of the average U.S. household grew by 62 percent. Over the same period, the income of the top 1 percent of households grew by an extraordinary 275 percent and the income of the rest of the top 20 percent grew by a slightly above-average 65 percent, while the income of the remaining U.S. households grew by less than 40 percent. The incomes of the lowest quintile grew by only 18 percent.

Inequality increases the risk of social unrest and declining support for capitalism and a free society. As University of Chicago economist and former IMF chief economist Raghuram Rajan points out, “Ultimately, a capitalist system that does not enjoy popular support loses any vestige of either democracy or free enterprise.”

In the last passage, they capture the problem of democracy, and why it is that the response of governments is to pander to demands. All of the new workers who have entered the global workforce are not going to go away. The advantage of capital over labour will not disappear for a long time. This is the reality and no amount of propping up of demand, printing of money or borrow and spend will make this reality disappear. Demanding a standard of living will not make it so.

When starting this blog, I was largely a lone voice. The economic crisis was called a financial crisis, with a suggestion that, with bailouts, and some largess from central banks, the problems would disappear. They have not. They have simply been magnified. I argued for the idea that the world had entered a world of 'hyper-competition' and that is still where we stand. I am no longer a lone voice in this, and the BCG report is just one of the more 'conventional' sources that has finally recognised the changes that have taken place. The problem was not, as I have always argued, some isolated financial crisis, but a shocking change to the world economy - to the very structure of the world economy. Globalization was more than a word, but was a description of an accelerating revolution. On my bookshelf, I have a long unopened book on globalization; even when I read it several years ago, it appeared fanciful and arrogant. It now seems positively quaint. So here we are now in a world of hyper-competition. I will highlight a quote from the BCG report:

Fortunately, there is still time to act. But leaders from all social sectors—government, business, organized labor, environmental and other stakeholder groups—need to act decisively and quickly in order to secure future economic prosperity, social cohesion, and political stability. It is in the nature of Ponzi schemes to collapse suddenly, without warning. No one knows what event may send the developed world and the global economy as a whole back into crisis.

They get what I did not get when I first started writing this blog. The absurdity of a ponzi scheme continues till it doesn't. The magic of a ponzi scheme is that they can sustain themselves for so long, before the weight of the fraud finally topples them. I thought that people would see through it much earlier because, in reality, it has always been in plain sight. People just had to choose to see it. And that is the problem. When confronted with reality, we (the electorates, the policy makers, the economists, the politicians) choose to look away. A while ago, I saw a film about the Madoff ponzi scheme (sorry, I forget the name), and the most striking point in the film was the stubborn refusal to see what was in plain sight. It is the same situation in the developed world economies. After all, it can run a little longer, and we will be ok, won't we?

Note: I did think about posting this after Christmas. It is not full of festive spirit, after all. However, when is the best time for bad news? I am not sure. So, I end here by wishing that you all enjoy Christmas, and only give thought to economics after enjoying Christmas with your families. On Christmas day, I will raise a glass of appreciation to all the regular readers of the blog, as it your interest that keeps me posting. Thank you, and have a great Christmas.

The Price of Unskilled Labour

Bearing in mind the ongoing chaos in Europe, and other major stories, I am guessing that this post might appear a little odd. It relates to a single story, which is the problem of recruiting labour for farm work in Alabama. I do not know the agricultural sector well, let alone the sector in the US, and I therefore add this as a caveat for my discussion and my conclusions. However, I think it is worthwhile plunging on as (even if there are specifics that might confound my case) I think the principles still apply. I will quote the start of the story at some length:

Alabama farmers are facing a labor crisis because of the state's new immigration law as both legal and undocumented migrant workers have fled the state since the strict new rules went into effect last month.
So far, piecemeal efforts to match the unemployed or work release inmates to farm jobs are not panning out, and farmers are asking state lawmakers to do something before the spring planting season.

Farmer Guiseppe Peturis has a small operation — growing mostly vegetables on his family's 20-acre farm in Belforest, Ala. — and selling them on the corner in front of his house. His retail business has suffered since he appeared on the local news saying Alabamians don't want to do hard farm work.

Peturis says he's a Republican, but is no fan of Republican Gov. Robert Bentley's plan to get jobs for out-of-work Alabamians by passing the nation's toughest immigration law. Among other things, it calls for police to detain suspects if there's reasonable suspicion they are in the country illegally.


Peturis says he's tried to hire through the state unemployment office before, but didn't have much success.
"Two of them left in 30 minutes; didn't even tell us they [were] going to leave," Peturis says. "One worked an hour and says it was too hard on his back."

There are many ways to approach this simple story. One approach would be to note that the local workers are simply too lazy to do hard work, despite horrendous levels of unemployment in the US. From this, we could present a story of lazy rich country workers who think that the world owes them a living, who are not willing to get on with work, but would choose living on hand-outs rather than doing hard work. It is a tempting approach, and was my first reaction to the story.

However, I then thought back to a time when I finished my degree and had some time to fill between starting my first job. I needed money to tide me over and worked for a little while as a building labourer. I discovered the meaning of hard physical work. I can safely assume that working as a labourer on building sites remains just as hard. I also note that there is not the same kind of discussion of the necessity for immigrant labour to allow the building trade to continue. I also remember that, when I chose the labouring job, I chose it because it paid considerably more than, for example, bar work.

When I thought about this story, it occurred to me that perhaps the real problem is that the pay being offered is simply too low for the level of hard physical work that is required. The farmers have become used to being able to pay low wages to immigrant workers, and have not accepted that they must simply pay more for local workers. This means that the farmers costs must go up, and that means higher food prices. However, set against that, the demand for government hand outs would be reduced with the resultant drop in unemployment and there would be more tax paid to the government.

Nevertheless, there is an element of the first approach to the story that remains. It is that presumably unemployed people are choosing hand outs over working for low wages which they do not think compensate them for the demands of the work.

Although this story at first seems to be straightforward, it is actually discussing some of the complexities of trying to understand the real operation of an economy. The availability of migrant labour has seemingly allowed farmers to pay lower wages than local people would accept. This in turn has impacted upon the cost structure of agriculture, such that the expectations for the prices asked by farmers are, in part, determined by this cost structure. I do not know the details of the Alabama law that is referred to in the story, but it seems that Alabama has 'gone it alone' with regards to cracking down on migrant labour. This in turn leaves the Alabama farmers with a problem with their costs in relation to the competition.

The real problem therefore is not that Alabama has restricted access to migrant workers, but that it has acted alone. I suggested earlier that Alabama farmers had not accepted that they must pay more, but it is probably a case of them being unable to pay more without making a loss. The real question is to ask what would happen if migrant labour were to disappear across the whole of the US? If this were undertaken, if migrant labour was unavailable, the story from Alabama suggests that the wages for agricultural labour would have to rise to compensate for the hard work involved. This would lead to inflation in food prices, and therefore lead to a rise in the broad measure of inflation, and a fall in unemployment.

However, there are other potential consequences that might confound this scenario. For some kinds of produce, there is the potential for competition from other countries. Would the increase in costs in the US agricultural sector then lead to an increase in imports of produce? If so, it might be that, in paying higher wages to the local workers, the farmers would still face competition and might lose in that competition.

The real question here is about the cost of labour in the US. The problem is that, where there is potential for competition for imports, the cost of labour really matters. The problem is that, if labour is a large element of the input of a good or service, then the low cost countries are likely to win in competition. The agricultural sector has survived competition by importing relatively low cost labour i.e. labour that is willing to work for lower wages than local labour. The result of this is that there is cheaper food, but higher unemployment. Remove the immigrant labour, and agricultural wages will rise, and unemployment will be reduced. However, this might take place at the cost of certain sectors of agriculture going out of business, with a negative impact upon the balance of trade, and possibly a negative impact upon unemployment to offset the positive gains. 

As I said, this appears to be a simple story, and simple narratives could be wrapped around the story. However, it illustrates some of the problems in a world economy where there is greater competition between unskilled labour, even if it is not always obvious that the competition exists. There are some elements in this story which much of economic theory does not really capture, such as the idea that people think that there is a fair price for hard physical labour, rather than a market price determined by supply and demand. The supply of unskilled labour is large, with any unemployed person who is not disabled able to do the work. Nevertheless, it seems that this labour has a sense of a 'fair' price for this kind of hard physical labour so that, even though there is an oversupply of labour, the price of that labour must rise in order to access that pool of labour. Supply and demand does not explain this.


What appears to sit underneath the entire story is the cost of labour. I have made a case in this blog that the massive input of labour into the world economy has created what I have termed hyper-competition.  However, it appears that the story about the Alabama farmers appears to be an illustration of how the oversupply of labour is creating a situation of hyper-competition, at least in some agricultural sectors. The curiosity is the response of the unemployed US people, who simply think it is unfair to be paid so little for such hard work. As much as it would be nice to be paid higher wages, is it possible/realistic? Is it confronting the reality of the situation of hyper-competition? Can the US afford to keep people so many people unemployed? If my take on this story is correct (and again I highlight the caveat), then the story is a hard illustration of the problems that have come with the growth in the world labour force.

Banking Crisis - What is REALLY Going On?

Note: Published in September

It is very easy in the current circumstances to focus on the crisis that is engulfing the financial system or the unfolding drama of the US bailout. However, this is not the real story, just an expression of the symptoms of the real story.

As I have mentioned before, the idea of a 'credit crunch' has taken root, and sometimes it appears to be a force with a malevolent intent. In other words it has become an animistic entity on which we can easily lump blame, and pretend that there is not real causation behind the crisis. The reality is that there is a real force out there, which is market sentiment. This is not, however, something with a life of its own, but rather the thoughts and feelings of real people with real concerns. Collectively they constitute market sentiment, but we should not forget that market sentiment comes from somewhere.

Bearing this in mind, we have to ask what is really scaring each of those individuals that constitute the market. Is it just an irrational fear, or is there some justification for the fear?

It is here that we must realise that these are panicked but mostly rational people. The panic stems from the realisation that they have been buying fools gold for many years. Yes, it looked like the real thing, but they have now had the material analysed, and the reality has dawned upon them. The big question is whether the financial crisis is driving events, or whether events are driving the financial crisis.

The truth is that there is an element of both. One is feeding off the other in an inevitable downward spiral. When I predicted this crisis in 'A Funny View of Wealth', I pointed to the idea that one negative factor would reinforce another, in what might be poetically called a 'death spiral'. This was not a prediction based upon an abstract entity called the 'credit crunch', but was based upon the fundamental problems in the economy of the UK. Many aspects of the essay equally apply to the US (and other OECD economies to a lesser extent). One of the central points of the essay was that the growth in GDP (at least) over the last ten years was an illusion. It was growth built upon asset prices inflation and a boom in credit. This is now widely accepted as the reality of the situation, but the 'commentariat' have still not grasped the reality of what this means. They are so busy charting the day to day crisis development that they are losing sight of the idea that something substantive must underlie the crisis.

In light of this I thought I would try to pull some of the strands of my thinking together and try to put the jigsaw together. In some respects I will be repeating ideas in my previous posts, but the aim is to try to integrate the ideas into a large picture. For those that have followed the blog from when it started (people to whom I am grateful, as their reading and comments encouraged me to continue), none of this will be new.

The first element to consider is that of the entry of the emerging markets into the world economy. I have dealt with this in the posts 'Why Do Economists Get it so Wrong?' and 'The Root of the Problem'. The argument, at its most basic, is that there has been a massive input of new labour into the world. The labour was always there, but the key difference is that the emergence of these economies has seen capital and technology, and access to markets, become available to this previously underutilised workforce. The result of this change has seen the available labour force available in the world roughly double in the last 10-20 years. This is nothing short of a revolution in the world economy, but few economists have understood what it really means. This is best expressed in simple terms of an example (using made up figures but referencing the real events) to make the point clear.

If we imagine that (to pick an arbitrary date) in 1990 there were 100 units of labour and 100 units of commodity utilised by that labour, and an available 120 units of commodity capacity (not all utilised), we can see a benign situation. It is a situation in which the commodity supply exceeds demands. We can see this, for example, in the long period in which oil prices were so low for so long. Now, if we jump to 2008, we see the oil prices spiking. This is because, whilst the supply of commodities such as oil has been increasing, they have not been increasing at the same rate as the available supply of labour. Let's call the supply of units of commodity in 2008 a total of 140, to pluck a number out of the air. At the same time we now have 200 units of available labour. At this point, it is apparent that there is a mismatch. The question arises as to why it is that the problem did not hit at the point where labour first exceeded the supply of commodity. This is because the labour entering the market was not as efficient at utilising the resource as the original labour. It is the catching up, the increase in both the efficiency of the new labour, and the increase in the use of the output of their own labour that has tipped the world into the current situation.

This is one element that explains the current situation, but it still does not seem to match the reality on the ground. For the last ten years, countries such as the US and UK have been booming, have been apparently successful. Logic says that, if we input a massive amount of new resource (in this case labour) such that supply is always exceeding demand, the price of labour should have fallen. This has not happened, and it seems that the Western world became ever richer, with rising salaries, ever expanding wealth. How can this be so? One of the key elements in this is that these new workers were relatively very cost effective, and therefore generated significant profit surpluses, which was then funneled back into the western economies, thus creating the boom in credit. Huge trade imbalances, massive government deficits, and a stunning growth in consumer debt was the result of a wall of money entering into the western economies.

The borrowed money was entering the western economies in ever greater amounts, all of it looking for investment opportunities. The problem is, what happens when the supply of good investment opportunities is used up? The money that is entering the economies must be utilised somehow. It is at this point that the money starts to be utilised in ever more risky ways. It is here that the origins of the bad lending lie. The money had to be utilised but could not be invested in productive assets, such as manufacturing, as the growth in manufacturing was focused on the more cost effective emerging markets. If you wanted to build a new manufacturing facility, then increasingly the logic dictated that you looked to the East. This left a huge surplus of money sitting around, and the end result was cheap and easy credit for consumers and governments alike.

Now, in normal circumstances, such a massive oversupply of money would lead to inflation, and then governments would seek to dampen down the inevitable expansion in activity in the economy in order to combat inflation. This did not happen, as the measures of inflation did not account for the reduction in the cost of manufacturing resulting from the massive input of labour into the world economy. Prices for all kinds of goods just kept falling. Furthermore, wage growth was not as inflationary as it might have been, due to the ongoing threat that manufacturing would move their operations to the emerging markets. The governments of the West failed to understand that these factors were muting the signals that would normally prompt them to reign in their too fast expanding economies. Instead, they deluded themselves that all was well. The worst aspect of their measures of inflation was that they failed to take into account the inflation of asset prices, in particular housing.

One of the justifications for this was that the cost of servicing the housing debt was apparently not rising. To justify this people looked at the amount that individuals were using for repayments, pointing out that interest rates were low, thus making higher prices affordable. However, they failed to see that inflation and interest rates together the make up the actual cost of a house over the lifetime. High interest rates coincide with high inflation, and low interest rates coincide low inflation. High inflation compensates for higher interest rates by eroding the value of the debt owed, such that the two factors balance out. The problem was that everyone apparently forgot this, and therefore people committed ever greater portions of their lifetime earnings to buying their houses. This in turn inflated the prices of housing, as ever greater amounts of money was entering the market. In any market, if you increase the supply of money available for purchase of a finite number of assets then there will be inflation.

This inflation of asset prices, due to an ever expanding supply of money, apparently supported by collateral, led to a belief that the money was being lent wisely. It was not, because the necessary increase in wealth needed to justify the increase in prices was not occurring. What was occurring was the debt merry-go-round.

This was a situation in which more and more money was entering the financial markets to support house purchase, and providing ever more easy credit. The 'service economy' was born, the massive expansion in retail and leisure activities for consumers. The new expensive restaurants, the shiny shopping malls, the crystal healers, personal trainers and so forth. At the same time, governments were borrowing more and more money, and creating ever more new government activities, more government jobs, and so forth. It is here that we come to the multiplier effect.

Each £1 or $1 entering an economy has a multiplier effect. When we go to a restaurant and buy a meal, we do not only support the success of that restaurant, but also the suppliers of the restaurant, the supplier of the supplier, and so forth. This means that a service economy can generate what appears to be huge amount of productive economic activity. All of the money going into purchasing the services trickles through the economy, supporting more and more activity. This keeps employment high and, as services expand, the economy appears to grow.

The problem here is that all seems well but, if the spending on the services is built upon growth in debt, then what is happening is not actually growth in the economy at all, but actually temporary growth at the cost of future growth. When we borrow money for consumption (not investment), we are foregoing future wealth. In short, the credit boom was a massive boom in forgoing future wealth. The most dangerous part of all of this boom was that, for reasons which still baffle me, the economists who were measuring economic growth included this foregoing of future wealth as economic growth, which is why we saw ongoing rises in GDP. Occasionally there were concerns expressed about the way in which manufacturing shrank as a percentage of the economy every year, but this was all answered with twittering about 'post-industrial' economies. No one seemed to ever ask where the real source of the ever expanding wealth came from. This was the purpose of my original essay, 'A Funny View of Wealth'. In that essay, I looked at all of the potential sources of real growth in wealth, and found that there were none. I also found that the GDP growth was rising in line with the growth in debt.

The most curious part of this is that the lending to the West has continued for so long. In some recent posts, I have pointed out that this is largely due to confidence. It is the belief by those that financed the boom that the West had always been rich, that the West would always be rich, and was therefore a good credit risk, and a good investment. Just as the Western economists were pointing to 'growth' in the Western economies, so could those doing the lending, all the time not realising that their lending was going into the consumption that was actually the source of the growth. In other words they were financing the luxury lifestyle of the West in the belief that the West was an ongoing economic success, without realising that the success was entirely illusory.

It is for this reason that what should have happened, did not happen. As competition from the emerging economies became ever more effective, the logical outcome was that the West should have seen their economies adapt to the new competition. As the trade balances were turning negative, there should have been a drop in the value of the Western currencies, and this would have created a re-balancing of the world economy. Instead, the flood of money pouring into government and consumer debt, meant that there was high demand for the currencies, so that the currency could then be lent back to the consumers and governments of the Western countries. For a long time ever more money pouring into the Western economies actually continued to generate returns, but the generation of those returns was in turn reliant on an ever exapanding source of finance into credit for the Western economies. In other words, the returns were reliant on more and more borrowing, such that the returns were actually coming from more borrowed money. A debt pyramid, if you will.

We can now add in some rather unusual factors for both the UK and US. In both cases they saw a massive increase in immigration, for the former the immigration of Central European workers, for the latter Mexican workers. In addition to these workers also helping to hold down wage inflation (in addition to competition from emerging economies), they also created even greater activity levels in the destination economies, adding even more growth to the GDP and also accelerating demand for housing. They came in large numbers due to the boom in the service economy, which in turn was built upon the boom in credit. In other words, the mass immigration was an upward lever on the economies, on the bubbles that were forming. The trouble is that immigrant workers are, in most cases, a negative impact on an economy, in particular if they are temporary. Each immigrant worker who comes on a temporary basis intends to return home with a cash sum. When they return home, they are therefore taking real wealth out of the economy. Furthermore, if they return home in large numbers, one of the props for the housing market price rises is removed, as demand will go down.

It is now that we come to what I call 'The Cigarette Lighter Problem'. It is not of itself a problem, but the expression of a more fundamental problem. In the post I detail how a lighter in a Western economy costs about nine time the price paid in China. In paying this price for an identical product, delivered in an identical way to the way it was delivered in China, I point out that there must be some part of the economy generating huge amounts of added value to support such a price. At the same time I consider the economy of China, which increasingly has the same infrastructure, the same technologies (at least in the cities), increasing productivity, and so forth. In such circumstances, how can the price differential be maintained? Can such a large differential be justified?

The answer to the cigarette lighter problem is actually the answer to the problems that the West is now facing. The differential is built upon the flood of money that has entered the economies of the Western world, such that it is the lending that is actually the root of much of the difference in the price. There is no part of the economy that can explain such a massive differential, and we can only conclude that a large part of the price differential is that the emerging economies are paying for a large part of the differential. I am aware that this is a difficult concept to grasp. It is the idea that when we enter a shop and do something as simple as buying a lighter, we are paying for it in part with money that was actually borrowed from other countries.

So now we return to the problems that we are seeing today. The first point of note is that commodity prices are now falling back (notwithstanding the irrational pouring of money into commodities out of panic). The reason for this is that, now that the flow of money into the Western economies is drying up as the debt spigot is switched off, the economies of the West are contracting, with a commensurate contraction in those who were exporting to them. In other words, demand is fast contracting and contracting back to a level where supply once against exceeds demand. I like the analogy here where world demand was a person racing forward, only to hit a wall, and bounce back before once again commencing progress. What will happen is that, having bounced back, the running forward will again occur at breakneck speed in the future, only for the runner to bounce back once again. All the time, the wall is moving forwarded, but never fast enough for the speed of the runner who will keep running forward and bouncing back.

It is here that we see the underlying problem for the Western economies. As I have discussed, there are many new workers in the world and, in order for them to be productive, they will need to have access to resource, to commodities. The situation is now one in which the runner has bounced back, and there is an excess of supply of commodities relative to demand. However, if we remember, the amount of commodities available to the world economy has not increased in a way commensurate with the supply of labour. As such, until such a time, not everyone will be able to have the same share of the available resource that was utilised by the West. It will not be possible, until that time, for the emerging economies to 'rise up' to the standard of living of the Western world. There is simply not enough available resource for this to be possible.

Many economists claim that international trade is not a zero sum game. They claim that everyone can benefit, as trade will help everyone get richer. This is absolutely true, but only if there is not competition for limited resource. In such circumstances of competition, the situation today, there are winners and losers. The big question that this raises is one of who will win and who will lose?

My argument is that the West is not well placed to win in this new competition. Our economies are bloated with fat, and due to the excesses of the credit boom, loaded down with debt. Our governments are inefficient and complacent, our advantages in education are diminishing as our education systems fall victim to faddish dumbing down, our technology is being exported wholesale to the emerging markets, we carry the weight of welfare systems that are unsustainable, and we tie up our businesses with regulation, and tie the hands of business behind their backs by ethical laws, so called 'green' policy, and demands for abstract notions such as 'corporate responsibility'. On top of this, you can see a culture of expectation, that government has the answers, that we have a right to wealth, and a culture or complacent expectation. Compare this with the hard working emerging economies, in particular in Asia, who revere education, who will do anything to secure the betterment of their family position, whose governments are hungry for success, and determined to find their place in the world (I am really talking of China here), and who are pursuing aggressive mercantilism policy.

In such a situation, I have to ask how we can win? It is the reason for this blog, and the reason why I have written about structural reform. However, these are the least read and least commented part of the blog. I suspect that, on the one hand, we can accept intellectually the arguments that I am putting forward, but not actually accept the reality of the inevitable consequences. Those consequences are that we must adapt to being poorer. Whilst the world overall is getting richer, a greater share of that wealth is going to move to the emerging economies, and it will happen at the expense of the West (or OECD if you prefer). The way that the wealth is redistributed will not be even. Some countries will fare better than others. I have always argued that the UK is going to be one of those hardest hit, and everything that I have seen in the last few years, and more recently confirms this. On the other hand, I used to believe that the US would hurt, but the flexibility and dynamism of the US culture and economy would pull it through (such that there would be pain, but not as bad as for example the UK). However, events of the last week appear to suggest that the path being taken is to try to magic away the problems with ever more borrowing. I am now very pessimistic.

As I said at the start of this very long post, the crisis in the financial system is actually based upon an element of rationality. It is not some strange force, but a reflection of the underlying economic problems, and the shock of the intrusion of reality into the delusions that have been held by so many. I have said many times that what we are witnessing is the inevitable rebalancing of the world economy. Everyone will hurt in the process and we will enter a period of economic chaos, with possible political chaos flowing from the pain.

Pure and simple, the world economy is a mess. The reactions to date are not encouraging. It seems that nobody has yet accepted that the errors of the past can not be fixed overnight, that the gross misallocation of capital in the Western world must have consequences, and that the West must come out of this poorer than it started, and considerably so.

In this post I have not done full justice to all of the points that have been made in previous posts. I have just sat down at my computer and churned this out without any plan or structure, so I hope that it makes sense to you. In places I have oversimplified, and not accounted for the many inter-connections that have driven all of this disaster. I have not referenced much of the post. I apologise for all of these faults, but I am (as ever) constrained by the demands of my 'real life'. I hope that you will understand.

If you do find that the argument put forward here makes sense to you, then I would suggest that you take time to look through the blog, as there is far more in depth explanations and discussions. I have given links at the top of the post, which take you to some key posts. However, do not neglect the archives. I had myself forgotten some of my previous posts, and on occasion have been pleasantly surprised to find some of my own explanations that I had forgotten, but which helped me make sense of the current situation.

Note for Regular Readers: I will not be posting as often as in recent times as my 'real life' will be very busy for the next month and a half. Also, I want to avoid getting sucked into 'punditry' and would rather focus on the wider issues. As such I will continue to post, but will try to restrict my posts to implications as the crisis unfolds.

Note added 28th September:

I have just posted a comment in a forum, which may be worth adding here:

The justification for the bailout is to avoid a repeat of the Great Depression. However, the world is not in the 1930s, so why would an imagined solution to a 1930s problem fit the circumstances of 2008. . There is no evidence that it would have worked then, and even if had worked then, would that suggest that this would solve the different crisis that is occuring today?

As I have detailed above, the crisis actually stems from some very particular circumstances.

Note 2, added 28th September:

One comment on this article accepted the principles of what was said in the post as saying

'Absolutely wonderful post. Although I am somewhat more optimistic than you that people in OECD countries can bounce back and become competitive when they are under greater competitive pressure'

Whilst my posts are unremittingly gloomy, I also believe that the OECD (Western) economies can bounce back. However, the first step is the recognition of the reality of the changed world, and it is the lack of recognition that concerns me. Another comment noted that there was a problem of arrogance in the US, and this is perhaps a related point to the one I am making here.

Another poster has added a comment against 'A Funny View of Wealth' asking:

'What will be the effect(s) of continued mass unskilled imigration from third world countries?'

My answer to this is that I suspect that, as the economy turns down, the borders will probably close to any significant immigration (Central European immigration notwithstanding). However, this is a matter of politicians making choices, so it can only be a guess. However, if the borders remain relatively open, it is likely that numbers will diminish as the Western economies will start to look less attractive. Whilst the West will still be relatively wealthy comapred with many countries, economic migration probably needs fairly strong motivation, and the prospect of arriving in a country with surging unemployment is probably not going to help with that motivation.

Lemming (a regular commentator), asks a perceptive question as follows:

'The brave, clever and perceptive thing to have done would have been to stifle 'growth' (debt) with the future in mind. But at what point would such a suggestion stray into the realms of 'socialism'?'

This raises the question of how much intervention governments should undertake in markets. My argument has consistently been that the problem actually arose as a result of government regulation (see 'The Market and the Crash') which caused a false sense of security. I have also been critical of the very idea of government borrowing and the setting of interest rates by central banks (see 'Government Borrowing and Interest Rates'). Removing regulation, and the ability of central banks to set interest rates would probably have avoided this crisis. In particular, without the regulation the activities of the banks would have caused alarm much sooner than was the case when they met regulatory requirments (implying that they were 'sound') and would have also prevented the need for off-balance sheet structures, CDOs and all of the other problematic activities.

Lemming goes on to ask:

'Did any government in the world conspicuously do the right thing over the last decade?'

I can think of no example. However, I am a market purist, where I believe that the only role of government is in the prevention of market concentration and monopoly, fraud, insider trading and so forth. This serves to remind me that I still need to finish my post on regulation, which will discuss such issues in more depth. Hopefully this will answer your question as this is too big a subject for a quick comment.

Can the Economics of the Past be used to Predict the Economic Future?

I have had several comments on my posts and, time allowing, I will try to respond to them. One interesting question was:

'I suppose we are used to economic cycles, with booms and busts of varying degrees. Are you saying that this time it's going to be very different? Has anything similar happened in history before?'

I would hope that it is apparent from my many posts that this time it will be 'different', at least in the sense that it will be different from the economic cycles that we have been used to. The point of my posts is to say that something has changed profoundly, in particular there has been an economic shock in terms of too much labour in relation to the available commodities. In particular the amount of labour has increased without the commensurate increase in commodities necessary to make all of the labour productive. In this case, until commodities catch up, there will be a redistribution of wealth. Whilst capacity constraints in commodities are nothing new, the unique factor here is the massive input of available labour. Globalisation has allowed capital to move freely, and this has allowed a large amount of new labour to become potentially productive. This has created an oversupply shock.

It is worth noting at this point that I have predicted that oil prices will fall back. How can I square this with what I have said with regards to commodities and labour? The answer is that, until the point is reached where the economies are sufficiently rebalanced, there will be turmoil in the world economy. One of the elements that has unbalanced the world economy has been the supply of finance into Western consumption. This had led to a poor allocation of capital into the West, and the world economy will fall back until the damage done by the credit bubble is corrected. In the interim, commodities will fall back as the West contracts, but demand will again pick up as the East continues growth in a couple of years time. However, as the East grows again, the West will stagnate, for the reasons set out in 'The Root of the Problem'. As the East continues expanding it is likely that the world supply of commodities will continue to bump up against the metaphoric brick wall of supply constraints, with supply continuing to lag growth. All of this assumes that there will be stability in the world trading system, which is not guaranteed. There is a real possibility of a retreat into protectionism in the next few years.

There is a further question asked in the comment as follows:

'In our current situation are these experts' views valid in any way, shape or form?'

This question relates to the use by experts of previous bear markets to predict the current market. My answer is that my opinion is just one of many. If you are looking for investment advice, the majority view would be that you should listen to these experts. On the other hand, you may wish to take my views into consideration. I do not think that the state of the world economy is comparable with the past, and therefore the 'expert' predictions are built on foundations of sand. All prediction is based upon past experience, but I believe that past experience is only a guide to current situations, and needs to be tempered in light of the fundamental differences of the current situation. To date I have not seen any acknowledgement of the shock of the oversupply of labour, so I am very dubious about most predictions. The oversupply of labour into the world market is (in my mind) what has really changed, and changes the entire dynamic of the world economy. Until the experts grasp this, they are missing a vital element in appraising the economic situation.

I have also had a question from another person who has posted anonymously. The question was regarding the prospects of Thailand, China and Brazil. I have discussed China elsewhere and have admitted that there are many question marks over the future. In particular, if China suffers a drop in exports (very likely) then will it be able to maintain social stability? Has it reached the point at which it can grow without export led growth? There are also possibly imbalances in the Chinese economy to factor in, but otherwise there is no reason why China will not continue to grow, and grow fast (with maybe a blip in growth in the next couple of years). As for Brazil, I will have to confess insufficient knowledge to have a strong opinion on the future. For Thailand, there is no reason for it not to continue to grow but, in Thailand, the real constraint is political risk. It is basically a very unstable country, and therefore the consideration is primarily political risk.

This brings me to the subject of political risk which I have alluded to throughout this post. Globalisation has had an astounding effect on the world. One of those effects is that a huge number of people have been raised out of poverty. Few would argue that this is not a good thing. The problem that has arisen as a result of this, however, is that there are now imbalances in the world economy. We are now in a situation where politicians, in particular in the West, will need to address these imbalances. As the West is pressured by the competition of the emerging economies, there is a real likelihood of demands for protectionism. If this happens, the turmoil will increase further. The problem that really arises is that we are entering into a period of world instability. As much as we would like to think otherwise, economics is the great driver of events.

If a situation of economic turmoil arises (as I have predicted), then political turmoil will surely follow. I have already mentioned this in relation to China. However, this political turmoil is likely to become more pronounced over the next couple of years, and everywhere will be effected. The question in my mind is to ask how politicians around the world will deal with the problems that are arising. It is here that the problems start, as this largely depends on the nature of leadership, and how the leaders will deal with crises. It is very difficult to say how they will react, but I am rather gloomy about the situation.

The basic point that I am making is that the problems of the world economy are now set in place. There is no reversing them and, one way or another, they will now permanently change the structure of the world economy. However, there is no way of telling what the final change will be, as this is now in the hands of individuals. We can sketch out general scenarios, but can not make predictions.

One scenario is that the trading system remains open, and that the rich world responds to the entry of the emerging economies by reforming and meeting the challenge. Another scenario is that the rich world retreats into protectionism, and that the world economy sinks back. Yet another scenario is that the turmoil will create social unrest, and the response will be conflict. All of this depends on how individuals respond to the challenges that are arising. There are more scenarios that can be proposed but I hope these illustrate the potential for varied outcomes.

In such a situation, I would be very cautious about predicting whether China, Brazil or Thailand are good bets. The only certainty is that counties such as China now have a large part to play in the world economy, but whether that is a stable rise or a chaotic rise is a matter that can not be predicted.

You may gather from this post, that I find the current situation very worrying. This would be to understate my concern. Returning to the first questions (using the past to predict the future), we do have worrying precedents to the current situation of economic instability. The situation today is unique, but the idea that economic instability creates political instability can be carried forward as a general principle.

The shape of the world has changed, and is continuing to change. At present the majority of economists and politicians have not fully grasped the nature of the change and that is a dangerous situation. As the current economic crisis unfolds, I will do my best to give a view on how it will impact on the world economy, and what I believe should be done to ameliorate the crisis. However, the situation is going to get ever more complex in the coming years.

The Root of The Problem

I was talking with someone yesterday, and was trying to explain why there are so many problems in the world economy at the moment, and gave a simple explanation that seemed to make sense. It is far from being a perfect explanation, but it does make the problem very clear. In this case I am trying to turn a two way conversation into a written explanation, so I hope it makes sense and accept my apologies where I mix metaphors. What I did was compare the world to 3 towns; Poortown, Richtown and Commoditytown.

Poortown is, like its name, very poor and has a population of 10,000. For some reason, they had followed mad policy, and had inadvertently made everyone poor in the process. Richtown also had 10,000 people and, by contrast, had got the basics of economics right and had flourished. Most people in this town were doing pretty well, and they could enjoy many good things in life. Commoditytown did ok, but had suffered booms and busts, and never seemed to manage stability.

For some reason, Poortown finally decided that they would give up on their crazy policies and would follow the same policies as Richtown, and try to become richer. After all, if policy worked for Richtown, why not them? Now, before Poortown could do anything, they needed to learn how Richtown had succeeded. Their problem was that they did not even have a way of travelling to Richtown to find out, so they built a path through the mountains that separated the two towns and invited some of the people from Richtown to come over and take a look at Poortown.

A few brave individuals from Richtown, decided to take a look, but were nervous about going, as Poortown was famously unfriendly. However, when they arrived, they were welcomed with open arms. The place was pretty poor, but it was very friendly. Poortown suggested to the visitors that everything was different now, and that they planned to get as rich as Richtown. A few brave individuals decided that there was an opportunity, and decided to take a risk and start businesses in Poortown. They noticed that there were lots of opportunities to cut their costs and increase profit because the poor people of Poortown did not want much pay. Just as importantly, there were lots of people in Poortown, and they imagined selling their products to them, and having new markets for their goods.

A few brave souls set up manufacturing in poor town, and had many problems at the start. The workers were not very good, and there were many problems to overcome. However, the local government of Poortown was determined to make everything work so that, over time, life got easier and they started to make money. They noticed that the workers were quick to learn, and that the people of Poortown were very determined to get rich. It seemed that, for many years, they had been secretly envious of the wealth of Richtown.

The individuals setting up business in Poortown started making profits, and more and more individuals started visiting Poortown to set up their own businesses. Poortown responded by widening the road through the mountains between the two towns, and trade between the two started to boom. Everything was fine for many years. The growth in trade meant that there were many things that suddenly became cheaper in Richtown, and everyone was making a profit. Poortown was getting richer faster with several thousand of their people getting better jobs, and Richtown enjoyed cheaper goods.

The trouble started when the business owners in Richtown started to move their factories to Poortown in ever larger numbers. It was just much cheaper to do business in Poortown and, as the workers of Poortown got better and better at business, they became ever more attractive as workers. Some of the people of Poortown were even setting up their own businesses as they had quickly learnt from the Richtown businesses. This led to a situation in which the people of Richtown started to buy more and more things from Poortown, and less and less from Richtown. Poortown started to use the money earned from the people from Richtown to accelerate their growth to riches by investing in more and more factories.

Meanwhile, in Richtown, businesses were starting to shut down as they could not compete with Poortown. Everyone thought that this was not a problem though, as all the cheap goods from Poortown led to a boom in shopping. Moreover, Poortown was lending a large amount of the money they were making from Richtown back to Richtown. After all, Richtown was a good place to put money as it had always been rich. Everything looked fine.

All the while this was going on, Commoditytown seemed to be doing pretty well. As Poortown grew, they found that boom was back. However, they were more cautious than they had been in the past. Several times they had seen booms, but each time they invested to meet the boom, they had found that they ended up making less money, as they started taking too much material out of the ground, with no place to sell it. So they expanded slowly. Each year a bit more expansion. The trouble was that they were not keeping up with the increase in demand, and many of their commodities were reaching capacity. They then faced this problem but, whilst they were trying to increase capacity, they found that they just could not do it fast enough. They needed to build new mines, and needed lots of machinery, and they just could not do it fast enough. On the upside, prices were going up and up and up. They were getting rich, and were getting even richer by lending their big profits to Richtown.

Everywhere was booming. Richtown was flooded with money, Poortown made more and more goods, and Commoditytown was selling more and more commodities at high prices.

It is at this point that everyone started to notice something. All the while that Poortown grew, it had been so poor before, that it had huge numbers of willing and cheap workers. All of these workers wanted to be as rich as the Richtown workers. Meanwhile in Richtown, less and less workers were working in factories, because all the factories were going to Poortown. In fact, it was hard to see that Richtown was producing very much of anything compared with before. They had started with a hundred factories, but thirty had already shut down and moved to Poortown. More were planning to move. Thousands of the Richtown workers were moving into new jobs to support the massive expansion in consumption. More and more people were spending more money, but nobody asked where the money came from to spend on consumption. The trouble was that they were borrowing all that money.

Then it happened. Commoditytown had orders that it just could not meet. Prices went ever higher, as everyone fought for the commodities that were available

The problem was that there were more workers all competing to be the ones who would use the commodities to make things. There were more workers wanting to make things than there were commodities to supply everyone. The commodity cake was only so big, and the question arose to who would be able to buy how much of the commodity cake. Richtown looked on aghast. Poortown looked on and suggested that it was best placed to take the commodities, as it could turn out goods from the commodities cheaper than Richtown. Only so many goods could be made from the commodities available, and so someone was going to lose out.

Meanwhile there were more workers in Poortown as it built roads to the outlying villages, which meant ever less commodities per worker. Poortown had 10,000 workers, and still they were only using a few thousand. As fast as Poortown grew, there seemed to be no end to the supply of new workers available for work.

The situation was arising that the commodity cake needed to be shared out amongst the workers in Richtown and Poortown. Although the commodity cake was getting bigger, there were more and more people trying to share it. It was a competition to see who would get how much of the cake. It was at this point that it started to dawn on Richtown that they were no longer in a position to win the cake. Doing business in Richtown was expensive. Doing business in Poortown was cheap. With only so many commodities to be shared out, they were going to lose out.

However, the situation was much worse than Richtown had realised. All the while Poortown had been booming, they had been lending lots of money to Richtown. The people of Richtown had used a lot of that money to buy the products of Poortown. They had not used the money wisely, and had not invested it. They had spent it. They now not only owed large amounts of money to Poortown, but also to Commoditytown.

It was suddenly occurring to a few people in Richtown that they owed a lot of money, and that they had no way of paying it back. Not only that, but they were still finding that they were losing factories to Poortown, which was still a much cheaper place to do business. Their ability to pay back the money was getting worse, not better. All the while this was happening, there was a state of denial in Richtown. They kept pretending that Richtown was really very rich and that, one way or another, they would always be rich. Curiously, Poortown and Commoditytown still believed this too.

What no one had thought about, was that the commodity cake would have to keep growing as fast as the number of workers, or one day the amount of cake available would not be enough to go around. At that point, the worker who was most cost effective would get the commodities. This would mean that the Poortown workers would get more, at the cost of Richtown workers as, for many products, they were more cost effective. Richtown would get poorer, whilst Poortown would get richer. At least until more commodities became available.

End of the analogy.

The point at the heart of this analogy is that there has been the fundamental change in the world economy. The world has changed dramatically. Give the same capital and technology to a worker in a country with lower costs of doing business, and wealth will move to that country. With more and more workers becoming available, the amount of commodities available per person is dropping. In short, there is a massive oversupply of labour versus commodities. Not all of the workers can be utilised in productive ways. In principle, everyone could get richer, and the emerging economies could just catch up with the rich economies. However, in order for this to happen, there needs to be the availability of both capital and materials for everyone. In the case of not having enough material (supply bottlenecks) there will be competition for the available resources. In this situation, there will be winners and losers. At the moment the world has bottlenecks, and the resources available for consumption are now being redistributed. The winners will be those who can make the most cost effective use of the available resources and, in many cases, that is not the rich world (as we currently know it).

The speed of the rebalancing will, in part, be determined by how quickly the emerging economies catch up with the rich economies in infrastructure, management and technology. It will also depend on how quickly supply of commodities catch up with demand. For the moment the imbalances will cause turmoil, due to the poor allocation of capital into rich world consumption, rather than investment into productive output. This has meant that the available resources have been directed towards consumer led growth, rather than the necessary expansion of commodities to support the growth in the output of the world economy. The competition for the limited output, and allocation of, the limited supply of commodities has now started. The process will see a levelling up of the emerging economies, and a levelling down of the rich economies.

I am not sure that this is as clear as it could be, so feedback and comments are welcomed. I am aware that it does not paint a pretty picture, but it is not possible to have a massive expansion in labour without a massive expansion in the materials necessary to make the labour productive. That is the simple point I am trying to make.....

Note Added After the Original Post:

I have not really accounted for Japan in this post, as it does not quite 'fit'. I have been meaning to post on the subject of Japan for some time, and hope I will have time soon.

Are the cynics 'Doomsters'?

I have had another interesting comment to one of my posts, and I will reproduce the key parts below:
-------
'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.'
---------

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.

So what is to be done?

So what is to be done to fix the UK economy? A perfectly fair question, you might think.

However, the problem is that it is too late to fix the problems that are now occurring. There is no magical legislative wand that can magic away the structural problems in the UK economy. It is the idea that such a magic wand exists that is part of the problem. What can be done is to put in place the infrastructure to allow a recovery in the future. The problem is that such infrastructure would require politics and politicians with great bravery, and such politicians do not seem to exist. Instead of facing the reality of the world that we are now in, they pretend that nothing has changed. Such an approach is reassuring in the same way that rushing towards a cliff in a car with no brakes is reassuring. Whilst the driver claims that there is no cliff, that does not make it so.

The first step in reforming the UK economy is to recognise that the world has changed. During the period that we built the current infrastructure the level of competition in the world was far less than it is now. Even the entry of Japan into the world trading system can not be compared with the entry of the so called BRIC economies (Brazil, India and China). The entry of these countries into the system of world trade has created a huge surplus of cheap labour, and the western world has to accept that these economies can not be ignored.

It is not just their cheap labour that creates the threat. It is also the relative freedom of their businesses from regulation and interference from government. A few years ago, I saw the cost model for a range of products with a direct comparison of costs in China and France. In China the products were significantly cheaper but labour costs only constituted about 5% of the cost differential. The rest of the cost difference was built into the entire structure of the economy.

The answer that is commonly provided to solve this problem is that the western economies need to move up the value chain. We can provide the services that support the BRIC manufacturing base. We can do the product design. We can offer our skills in marketing, or consultancy and so on.

This is the great dream that ignores the reality. As the BRIC countries go on expanding their manufacturing, the services that support such wealth creation will naturally move to be nearer to their customers. That means the banks, the legal services, the designers, the marketers and so forth. They will not reside in the UK, the US, or France. They will follow where the money leads. For example, if we take the idea that design can be done in UK and manufacturing done in China it is completely unrealistic in the long term. Good design needs to include an understanding of the manufacturing process, to maximise the resources and technology available. If manufacturing is moved to China, over time, that knowledge will be lost in the UK, but will be gained in China. It is a recipe for long term decline. The same can be said of many of the ideas for moving up the value chain, whether it is consultancy, accounting or any of the other 'strengths' in the Western economies.

However you look at it, for any medium to large sized country, you need a base in manufacturing. Without such a base it will be impossible to remain a competitive economy.

So how do you encourage and maintain a manufacturing base? Here is where the real problem resides. The question to ask is why is so much manufacturing moving to the BRIC economies. As I have already mentioned, it is not just cheap labour, although that is a part.

The real key is that governments have piled huge amounts of legislation on top of companies, such that they are hobbled and no longer able to compete from a base in the UK. A crude example of this is the minimum wage, which tells an employer that they have to pay a wage that may be uncompetitive if they wish to manufacture in the UK. As a result, jobs and wealth are lost to the UK, and instead of productive people the UK has a huge roll of unemployed (and often unemployable) individuals. This adds cost to the government who have to pay for the unemployed, and that cost is passed onto the companies in the form of taxation. How can this make sense? No doubt, some economists will reel out statistics to say 'it ain't so', but simple reason would tell you that, whatever anyone says, if you are competing on labour cost, a minimum wage hobbles the ability to compete.

What of all of the other employment legislation? I worked on a project that was looking at the cost of the European Working Time directive for road transport companies. This crazy piece of legislation had a shocking effect on the costs of companies. The cost of recording and managing the information was quite startling. Furthermore, the rules did not allow drivers to work as they wanted to work, but restricted their freedom, and thereby restricted the flexibility of the businesses. It seems that the European Union knew better how much they needed to earn than the drivers did (it should be noted that safety was already protected through other legislation).

This example is just one example of interfering legislation that both removes the flexibility of labour, as well as imposing costs. The question is; for what? It is not entirely clear what this legislation achieved, except in generating huge costs for all those required to implement it, and to restrict the earning potential of drivers.

Another labour cost is one that is outlined in my essay 'A Funny View of Wealth'. This is the idea that the welfare system already creates an alternate minimum wage. I have quoted a section of the essay below:

'As mentioned before, all things in the UK are not equal due to the minimum wage, but also because the UK employer needs to compete for labour with the UK benefits system (which is an indirect minimum wage that applies to anyone entitled to social welfare benefits). This system allows an individual to remain economically inactive, or to choose an option of accepting a low paid job for very little real remuneration despite a major increase in the expenditure of their labour. In such cases the value of the labour expended is far below the minimum wage as it needs to be calculated as the weekly pay minus the benefits, to give an actual wage for the work done. The rational person in this situation might reasonably ask whether the loss of their free time to work is worthwhile for what will often be little financial incentive as, in this situation, the UK worker is often working for extremely low wages'

I will not address this subject further here, as it is a subject that requires a more detailed review which I will deal with on another occasion. What is worth noting is that the welfare state has now become the 'burden state'. It is no longer a safety net, but an alternative to productive activity.

For the moment, I am just addressing a couple of the problems in the structure of the UK economy. I am very aware, as I write, that this is not a subject that can be covered in a single, off the cuff, post.

As such I will call a halt here, and start addressing some of the concerns in a series of posts over the coming weeks or months. For the next post, I will take a detour, and give an example of where government money is being spent to 'help business'. I think that you will agree that it is a sad and rather pathetic tale, and I hope that you will agree that it highlights the stupidity and waste of government.

The Cigarette Lighter Problem

I have mainly been talking about the UK economy, but for a moment I would like to talk about the 'cigarette lighter problem'. It is a rather unusual way of looking at the underlying functioning of economies that I came up with when discussing economics with some friends.

The starting point is my purchase of a disposable lighter in China for approximately $NZ 0.19. I purchased an equivalent lighter in New Zealand for $NZ 1.80. In both cases I purchased the lighter in small shops. In both cases the lighters were equivalent products, and the convenience of the shops were identical, and the service provided identical. In both cases the lighters were manufactured in China.

The problem arises as to why the prices were so different.

At this point it is very tempting to get into discussions about purchasing power parity, but I am going to put that to one side and consider the real implications. The problem here is that, for some reason, the lighter in New Zealand is about 9 times more expensive.

Before continuing it is necessary to remove one factor in the consideration of the price; the cost of transport of the lighter from China to New Zealand. When we think of the size of lighter, and the cost of shipping, it will be apparent that the cost of shipping is going to add virtually nothing to the cost of the lighter.

So where does this additional cost come from? It is first necessary to track the journey of a lighter through the distribution systems until it reaches my hand.

In both cases, once the lighter has been manufactured, the journey of the lighter to a corner shop will start in a warehouse. Someone will be selling the lighter to wholesale. When the wholesaler purchases the lighter it will be transported from this warehouse to the wholesalers warehouse. The wholesaler will be providing an aggregation service to small shops, providing a range of products to service the small shop sector. The small shop will then purchase the lighter, along with other lighters and other products stocked by the wholesaler. There are then 2 options here. One is that the wholesaler will deliver, or the other is that the purchaser will be purchasing from a 'Cash and Carry' type wholesaler, such that the owners transport the lighter to the shop themselves. Using either method, there should be no significant cost differential. In both cases the shop owner took the lighter out of the packaging and onto a shelf. In both cases the shop owner took the lighter off the shelf and placed it in my hand, before accepting my payment.

When we look at this process, we have to ask ourselves where exactly is NZ 1.60 (approx.) of added value coming from? When we view this process this way, we see that near identical systems of distribution of exactly the same product and service, result in a massive price differential. Is there any added value in the process whatsoever?

The answer, of course, is 'no'.

So why does this matter? If we then think of any economic activity whatsoever in New Zealand (or any other OECD economy), we have to factor in the fact that, whatever activity occurs, this kind of cost escalation is going to be built into the activity. The result of this is that the overall economic activity of the economy overall must generate massive added value to support such cost escalations. For example, manufacturing of products, and the provision of services must be creating huge amounts of value in order for a system of such cost escalation to be supported.

So why does the lighter cost more in New Zealand? The key difference in the process of distribution of the lighter is not in any added value, but in the cost of wages, and the cost of government through taxes and regulation, the cost of warehousing through higher land costs.

In order to support such additional costs, the economy must have elements that are creating wealth for redistribution on a massive scale.

The question to then ask is; where is such wealth generating capacity in the New Zealand economy. The same question can be asked of the U.S. or the U.K. and so on.... Having asked this question, the size of the problem becomes apparent. In the case of the lighter, the cost of the lighter is nine times the cost in China. How can an economy be generating enough added value to sustain these kind of differentials?

I am aware that a lighter is just one example, and not all products have the same differential. However, the point remains. How can the OECD economies justify, and continue to justify, such massive differentials of cost without creating massive added value in other areas of the economy. When we think of the real economy, and compare this with China, where is such massive added value taking place? China increasingly has similar manufacturing industries, service industries, distribution and so on. Despite this, they are able to sell a lighter nine times cheaper than in New Zealand.

It raises the possibility that something is very wrong and unbalanced in the world economy. The question this raises is how big is the imbalance, and how will it be corrected? My own view is that we are just now starting to see the correction, and are just now starting to see the pain of the correction.

Note added 30 Jan 2009:

I have had a very good comment on this post, which was added to another post. As such, I thought I would add the comment here, along with my response.

This is the comment from Aantonikl:

I'm not convinced that we are "much poorer than we think". Your cigarette lighter argument shows that exchanges rates are out of line with purchasing power parity, but that is unrelated to how poor we are. In china, the minimum monthly wage is in urban areas somewhere about 800 RMB a month http://www.marketwatch.com/news/story/china-raises-minimum-wages-calm/story.aspx?guid={B120D814-3C01-468A-9C11-B7596BCE1A35}
This ignores the rural population. But the rural population do not count towards the increase in global labour. Thus in china, on the minimum wage I can buy (according to your figures) 1150 lighters.

In the uk the monthly median wage is about 2075 pounds (http://www.statistics.gov.uk/cci/nugget.asp?id=285), and the relation between the minimum and median wage is about .45 in the uk (http://stats.oecd.org/wbos/Index.aspx?DataSetCode=MIN2MED)
Thus in the UK, someone on the minimum wage will earn about 900 pounds a month. Lighters are .59 pounds (http://www.sainsburys.com/groceries/index.jsp?bmUID=1233139730826)
So I could buy 1500 lighters.

So, the difference in what labour buys between the UK and China is not so great, especially since I suspect they work longer per month in China than the UK. Our cheap labour is worth about the same. For more expensive labour, the UK can pay more as it is more efficient, re infrastructure, rule of law, etc.

So whilst the world economy is in big trouble, and things are going to change, I'm not convinced the man is the western street is suddenly going to be poorer. He may have to change job, and move to an industry that produces more value, but what his labour will buy him should stay the same.

My response was as follows:

Aantonikl:

Thank you for an excellent and very well thought out response to the 'Cigarette Lighter Problem.'

For other readers, the original post can be found here:

http://cynicuseconomicus.blogspot.com/2008/06/cigarette-lighter-problem.html


Your point about the rural population in China is interesting, but we have an equivalent in the long term unemployed. The difference perhaps is that one group is self-sufficient, the other is not. In fact the latter group in the UK could be described as the minimimum wage?

Your analysis reminds me of something I read recently on measuring salary in terms of Mars bars purchasing power - which showed that there was very little real change in the salary of new graduate starting salary at ICI from (I think) 1950 and now.i.e. you can buy roughly the same number of Mars bars now as then with the salary.

Essentially the Mars bar comparison highlights that the measure of inflation is very dubious.

However, returning to your excellent analysis. I am not sure that you have followed it through to the logical conclusion.

You correctly identify that exchange rates are out of line with PPP. In this case I could change £1 and buy several lighters if I took that money into a Chinese shop.

This has been one of the consistent arguments of this blog. Exchange rates are going to have to shift.

You suggest that is that there is not much difference in the value created by our cheap labour and that of China, so we will not be poorer in the future. However, it is evident from your own argument that our purchasing power is being significantly subsidised by China (and I would add - many others).

The imbalance in the exchange rates means that we have not been paying the full value for the goods that we purchase. We have had our purchasing subsidised by China.

If we take away that subsidy (exchange rate corrects), then our purchasing power will diminish significantly. This, by any reasonable definition, means that we will be poorer. At its most simple, the lighter we bought for 59p will go up in price.

One point of contention. You use the price from a major UK supermarket for a comparison. However, in my comparison I used a New Zealand dairy (corner shop/convenience store) and an equivalent sized shop in China.

I do not remember/know what a lighter would cost in a supermarket in China (e.g. there was a Walmart near where I lived in China), but would guess that the price would be considerably lower than that which you used.

Another point of contention is your assertion that:

'For more expensive labour, the UK can pay more as it is more efficient, re infrastructure, rule of law, etc.'

I think that you are making some very bold assertions here. For example, infrastructure in China (in the cities, but also increasingly so in the countryside) is surprisingly good, whether transport, power, or telecoms. Clean water still leaves a lot to be desired, but that is about it.

Your other example is lack of rule of law, which is true, but the lack of rule of law in China has advantages. For example, they can use our intellectual property without paying for it. The absence of law is also a positive in that regulation is less, and often can be ignored, such that costs of regulatory compliance are lower, and so forth.

The cost of this lack of law is uncertainty and corruption, and lack of incentive to develop intellectual property (IP). However, as soon as the balance is to the advantage to China to enforce IP rights, you can be sure that the rule of law will (as if by magic) be enforced.

I think overall you are making some assumptions in your proposed advantages, at least in the examples you cite. If you were to visit a Chinese city/live in China, you may be very surprised, and the same might be said of many of the towns, in particular in the most developed provinces (e.g. Guangdong).

Finally, there is the most fundamental problem. If we accept that our economy has been supported by borrowing, one of the central themes of this blog, then the problem becomes worrying.

In particular, borrowed money circulates through the economy, pushing up activity, pushing up employment, and so forth. All of this offers a higher standard of living for everyone (in the short term)and this reflects in the cost of everything.

As such, every part of the economy appears to have greater wealth than really is the case. For example, the borrowed money is supporting higher wages through higher employment levels.

As such, if you think about it, just taking the case of wages as an example of a factor, those higher wages impact upon the selling price of that lighter. Many people are involved in finally putting that lighter on the shelf, though their overall % contribution to the price will not be that large.

However, this is just one factor, but another might be the cost of real estate, and so forth...the cumulative impact of the higher costs finally ends up in the lighter.

Returning to wages, the cost of the lighter is higher to support the higher wages, and the higher wages are partly resultant from the artificial boom in the economy. The artificial boom is the result of borrowing.

What we have, therefore, is a situation where a part of the price of the lighter originates in borrowed money. As a purchaser, I am also in part spending borrowed money, even if I am buying it from my wages, for the same reason as I have just explained for the cost of the lighter. In other words, part of the transaction is financed by economy wide borrowing.

This is difficult to grasp, I know, but when I buy a lighter with cash (not borrowing), I am in reality using partly borrowed money to purchase the lighter, and the price of the lighter is higher than it should be because of borrowed money.

However, thank you for an excellent and well thought out comment. At some point I may copy your comment and this reply to the original post.

I will welcome a response to my reply. In particular if you feel that you still disagree with my assertion that we are poorer than we think.

More comments are welcomed.