Optimism and Economics

I recently wrote about the surge of optimism in the press regarding the world economy and the Economist magazine has recently detailed the number of press mentions of 'green shoots of recovery'. The Economist chart shows a steady rise of the use of the term in March, and an explosion in April.

In my post on the subject of this optimism, I highlighted that all of the indicators were negative, and wondered what might justify such optimism. For example, in the UK, there was a slight uptick in house prices, but I suggested that this was a false dawn. Since I wrote the post, house prices have continued their downward trajectory, though the rate of decline in prices is reported as slowing. Likewise in the UK there has been an improvement in consumer confidence, albeit from abysmal levels.

Perhaps the best summary of the optimism can be found in the Independent, with the headline 'US Recovery Hopes Grow Even as Economy Contracts 6.1%'. The article goes on to say:

US economic output contracted at an annualised rate of 6.1 per cent in the first quarter, almost as bad as the minus 6.3 per cent GDP figure for the final three months of last year, when consumers and businesses were reeling from the collapse of Lehman Brothers.

The report went on to say:

Other "green shoots" in the report included a surprisingly strong uptick in consumer spending, which contributed 1.5 percentage points to GDP, where it had been a net negative for the two previous quarters. Information on the price of goods and services helped to ease the fear of deflation taking hold. And economists also dismissed an unexpected drop in government spending as temporary.

However, we have this from the New York Times:

A day earlier, the government released figures showing an unexpected increase in consumer spending in the first quarter, offering one of the few bright spots in an otherwise dreary accounting of the country’s overall economic output. But the monthly report released Thursday showed that while consumer spending rose sharply in January, its gains tapered off in February and reversed themselves in March, declining by a larger-than-expected 0.2 percent.

So what exactly is this optimism all about? Perhaps the best expression of the depth of the ongoing problems can be found in the actions of the Federal Reserve. In particular, the Fed is currently printing $1.2 trillion and using the money to buy mortgage backed securities and treasuries. Does this action look like an expression of confidence in a recovery?

The most odd part of the so-called 'green shoots' of recovery is the sudden surge in bank profits. An article in the Economic Times sums up the reality of the situation:

The first quarter results of US banks mean little. In early April, the US accounting regulator tweaked mark-to-market rules for bank assets in order to help banks show lower losses on these assets. These modified rules were applied with effect from March 15, allowing banks to show better than expected results for the first quarter.

The idea that banks can work their way back to good health simply by making profits hereafter is absurd. US bank losses are huge — the IMF’s latest estimate of US bank losses is $1.6 trillion. US banks have raised an additional $400 billion in capital so far, which means they need another $1.2 trillion to get back to normal health. For banks to cover this amount through profits would take years. Until then, banks will not be in a position to provide adequate credit.

Quite simply, common sense should tell us that there is no realistic way in which the US banks can be returning to profitability. All of the US banks have massive exposures to the US economy, and every part of the US economy is heading in a downwards trajectory. How an earth can banks be making profits when real estate is falling, consumer spending is falling, insolvencies are up, unemployment is up and so forth...

I am increasingly of the view that we are departing ever further from reality. We are now living in a world in which insolvent banks that are living on life support from the government are apparently making profits.

I will freely admit that I have been increasingly puzzled by the optimism that is emerging. I have always accepted that commentators, analysts and markets can be somewhat irrational, but have always insisted that reality must at some point intrude. I still believe that reality will catch up with delusions, but have had trouble understanding the level of self-delusion that is taking place. I keep on wondering just what will it take for the underlying reality to sink in.

In the case of the UK, it is even more mysterious. The UK budget in particular painted an appalling picture of the state of the UK economy. In my post on the subject, I suggested that it would be interesting times for gilts and the £GB. However, the most recent gilt auction proved to be a success, albeit in a gilt that is part of the Bank of England's money printing purchase scheme. Meanwhile the £GB has gone through a roller-coaster ride:

Sterling fell against a broadly recovering dollar on Thursday after rising to a two-week high as initial optimism about the global economy petered out, even as share prices gained.

An improvement in British consumer confidence had pushed the pound sharply higher, but news that U.S. automaker Chrysler would file for bankruptcy later in the day and data showing a fall in UK house prices weighed on the pound.

I am starting to take the view that one of the problems must be that the paradigms being used in the markets is one in which the only reality is a belief in the inevitability of recovery. I suspect that, with no experience of a long term and sustained decline many people simply refuse to believe that such an eventuality is possible. Instead of asking the simple questions as I do, such as asking where the real wealth is generated, the markets hang on to figures which have no bearing on the broader reality. In this world an uptick in consumer confidence is a herald of recovery, a bank's profits are real even if they are simply an illusion. It is increasingly looking like drowning men clinging to anything that floats, even as the sharks circle round them.

What I am in fact doing is dramatically shifting my view of the world. I am finding myself in a position where I must accept a new reality. That new reality is that self-delusion is a fundamental part of the human condition and that rationality is a very rare commodity indeed. I am currently ploughing my way through several books that deal with economics and psychology, as it is clear that my model of the economy is incomplete.

I have already found one interesting insight, which can be found in 'Predictably Irrational', by Dan Ariely. He points out that when making a valuation of something, we develop what he calls an anchor price. Through a series of experiments he shows that the first price that we see for an item becomes an anchor for valuations, and that it is very hard for us to adjust to a new reality, to adjust our perceptions of price. Interestingly, for some of his research he used bankers as his experimental subjects, though the principles he establishes have wider relevance. In particular it is possible to stretch his insight, and see that we might have made a broad brush evaluation of whole economies, so that we have a fixed view of the Western economies. We have anchored our valuation of the economy to a certain level, such that it is very hard for us to adjust to a new valuation.

Whilst this is stretching the findings, I do not believe it is over-stretching them. He is reporting an underlying factor in human thinking, and there is no reason to think that his examples of decisions about individual valuation might not apply to a broader valuation. As a non-experimental illustration he cites the example of a DVD player, which starts out very expensive, thereby creating an anchor price that is high. When we later buy a DVD player, when the price has fallen, we believe that we are buying a bargain. However, as we know with these kinds of goods, our bargain of today will still look expensive tomorrow. Perhaps what we are seeing in markets now is this kind of process?

Essentially, what we must take from these examples is that there is a reluctance to adapt ourselves to new underlying realities, and that our sense of value is 'sticky'. This in part may explain the stock market rallies of late, and similar rallies that took place in the great depression. However, as in the DVD case, there is no reason why valuation and therefore price will not eventually move, even if our perception of value is sticky. The question that this does not answer is exactly how that shift might finally come about.

On that subject, I am increasingly wary of making predictions....

Note 1: I only have a brief moment to reply to some of the interesting comments on the last post. As such, apologies if I do not reply to your comments.

Escaping Eastwards: You raise an interesting question which I will try to address in a future post.

Anonymous (who posted a massive comment): I hope that you take note of the comments of other commentators, and try to format your comments in a way that will better express your point of view. I publish all comments, but was not happy to publish your comment simply because of the format problem. However, I published anyway on principle. I will echo Lord Sidcup, and suggest that perhaps you might start your own blog? Gina, thanks for a great job of 'translation' on the comment. I would like to answer the comment, but it is rather a large subject for a simple reply.....

Lord Keynes: I am glad that you use the term 'neo-liberalism' rather than liberalism for the record of Labour. Liberal would not be an accurate description.

Chas H: In answer to your question, the problem for the future of the UK economy in the medium to long term is that we simply do not know what the politicians are going to do. As such, it is impossible to guess at outcomes. For example, it is always possible for a 'great' leader to emerge, who might lead the country back to economic strength. Alternatively, it is just as possible that a populist demagogue might emerge. As for the social consequences, I will leave that to other commentators, except to say that my view is that there will be serious problems.

Lemming: Maybe the 'reset' will be the default and collapse of the £GB? As I have discussed before, such a reset has a price....

Acrobat_747: The problem with your thesis is that you are looking at debt in absolute terms rather than relative terms. It is possible for a country to rack up debts if they have prospects of growth, or rather there is a perception that a country has prospects for growth. The problems arise when there is no apparent method for that future growth, and when the markets realise this. In the case of the UK, there is no such prospect for growth. My question has always been 'where will the growth come from?' On one occasion I asked this question on the Guardian's CiF forum, and nobody was able to come up with an answer. I have, to date, still not seen any explanation of where the growth might come from. If you have an answer, you might wish to add it in a comment. When I asked this question, I was asking for specific sectors, rather than answers that amounted to 'it will just happen'.

At the moment, the best case for growth I have seen is growth based upon a falling currency. This is not real growth but a process of adjusting to relative impoverishment. Whilst this may make the UK more competitive, it is done at the cost of reducing the cost of UK labour, and therefore reducing the standard of living of everyone in the UK. It is also not a form of 'growth' that would please holders of UK debt that is denominated in £GB. Under such circumstances, would you invest in the UK or in government debt?

This is why the level of debt is relative. The growth in debt in the UK can not be paid back, as there is no growth that can provide a route out of debt, or to continue to service debt. The UK is structurally unable to service debt without incurring more debt. This is a scenario of ever expanding debt, with no means of payment in sight. Quite simply the output of the UK economy can not pay for the consumption within the UK economy, and there is no prospect of this situation changing (unless you believe Alastair Darling). As Lemming said in a comment; 'I have to ask, are we really serious about getting out of debt?'

As a note, there is no reason why the UK might create a new technology or process and achieve substantial growth in this way. However, this is highly speculative. Why might the UK come up with such innovations? It has the same prospects as other developed economies, but no particular advantage over and above them. I am not sure that creditors would invest on the basis of such a 'hope'.

Tiberius: An interesting point of view. It is interesting to see such diverse perspectives on the blog.

Gone: You mention that people will continue to buy bonds as long as they believe that they can sell it on. That is a matter of confidence, and that in turn is a matter of belief in the stability and sustainability of an economy. Just because there are buyers now does not mean there will be buyers tomorrow. Even though the government is still having success in selling their debt, confidence is waning, and this can be seen in the rising CDS premiums.

I am afraid I have run out of time, and apologies for rushed responses.

Free Trade, 'Yes' - Mercantilism, 'No' - Why China Should be Shut Out

I have had several comments on the subject of free trade and protectionism, and thought the best way to answer this would be to dedicate a post to the subject. Much of the discussion revolved around some of the points that I made around the subject of China in the world trading system in recent posts, such as the notes at the end of my post on 'UK Bank Bailout - Round 2 Begins?'

The best way to start is to highlight my underlying principle, which is that free and fair trade is a good thing, and that such free and fair trade offers considerable benefits to all.

When I discuss fair trade, I would like to highlight that this is not the fair trade of 'fair trade coffee' and other such causes. I actually believe that such so called fair trade is grossly unfair and serves to create market distortion.

In the case of the coffee market, the reason for the fair trade movement was the collapse in coffee prices that was resultant from the decision by the government of Vietnam to expand the coffee business (yes another government distortion in the free market causing problems - see post here for an argument for free markets). The resultant glut in the coffee market caused considerable difficulties for other producers:

Apart from oversupply, there are two types of paradigm shifts underlying the current situation:

1. A structural change in the nature of supply, particularly increases in both the quantity and quality of Brazil and Vietnamese coffees.
2. Structural changes in demand, comprising increasing demand for high-end, differentiated products, new technology allowing greater flexibility in blending, and geographic-generational shifts in the appeal of different types of coffee products.

There are dramatic changes in the nature of this new supply. Of particular note is that global supply has become more concentrated. During the previous period of low prices in 1992, USDA data shows Colombia, Brazil, and Vietnam produced 44 percent of world production. In 2002-2003, 60 percent of world supply came from these three producers, and this figure is likely to increase unless production in other countries significantly reverses its decline. For some roasters, these three suppliers can provide almost everything they need, leaving them to buy only small amounts of coffee from other countries. (1)

The response to this shift in supply was to create the 'fair trade' coffee movement. At the heart of the movement were arguments about the immorality of the high prices charged for coffee in the West (Starbucks would often figure in these discussions), and the low prices achieved by farmers. This was apparently 'unfair'.

The result was that the fair trade movement instigated a system of guaranteed minimum wages for coffee farmers in particular regions, on a selective basis. In doing so, they offered prices for coffee that the market would not otherwise stand. This has created one central problem. If there is a glut in supply, and you guarantee prices, guarantee a living wage, you create a situation where a) you encourage otherwise inefficient producers to remain in the coffee market b) encourage new entrants into the market. In doing so, you are just prolonging the problem of oversupply in the market. Furthermore, on what basis do you award the guarantee to whom? Is it fair that farmer x gains a guarantee, even if he is an inefficient producer, but deny the same to farmer y, an efficient producer? What would be a fair basis to offer this guarantee? If farmer y is very hard working, very efficient, why would it be fair that he must compete in a market in which an artificial glut is maintained through price support for inefficient producers?

In this respect it is unfair trade. On the other hand, if we view it as a marketing tool, it is perfectly fair trade. If a company can persuade people to buy coffee on the basis of benefits to their sense of moral righteousness, then that is a good marketing ploy, and conveys a competitive advantage. They are no longer just selling coffee but a 'feel good', emotional benefit. However, that this is a genuinely moral activity is at the very least dubious. It is fair trade in the sense that a point of differentiation is created, but it is certainly not fair trade in the sense conveyed by the supporters of the fair trade movement.

The case of coffee illustrates my point of real fair trade perfectly. Real fair trade is about removing distortions from the market, but the coffee market has seen considerable distortions, including international agreements on quotas and all kinds of interventions (from the same report as above):

At the domestic level, state-managed governing bodies, such as the coffee boards, were often inefficient,and, under the ICO programs, their management of the export quotas gave them opportunities for rent seeking (Bohman and Jarvis 1999). When this rent seeking was combined with the inefficiencies, the marketing boards induced in their markets, it served to divert a significant share of the export value of these crops away from the producer toward either governments, the marketing boards themselves, or the export sector. even if they managed to smooth market signals and responses which most likely contributed to lower domestic volatility (Giovannucci, et al. 2002a). It was not surprising that, in many cases, the end of the ICO quota schemes led to both a dismantling of the coffee boards and a rise in the producers share of the export price.

Or:

Stabilization funds suffer from a number of structural weaknesses. As discussed above, the tendency of commodity prices to have short spikes and long troughs means that stabilization funds have a tendency to run out of money before a recovery can occur. In the case of Papua New Guinea, this led to the fund having to borrow from the government—loans that later had to be forgiven. There is also an assumption that the stabilization fund managers can better invest the levies received during periods of high prices than can individuals, and producer support for stabilization funds may, therefore, be indicative of a problem of lack of access to financial services.

I can not reproduce the entire paper here, but what you see is not a market of free and fair trade, but a market in which there are endless interventions both internationally and at national government level. If we just take the example of Papua New Guinea, the intervention meant that their coffee producers were given an unfair advantage in the market of a subsidy. Someone, somewhere, will lose from this subsidy because they will be faced with less efficient producers than themselves who are still in the market place due to subsidy. It is a classic case of 'beggar-thy-neighbour' policy. The end result of such policies is that everyone tries to manipulate the market, the gluts continue, and the problem of excess supply never goes away.

The end result of such distortions is that there is a lot of land devoted to producing a commodity that nobody really wants, and that means that potentially productive resource is actually not producing anything of value. At the local level, it is easy to make a case for intervention, but each intervention ripples through the market eventually hurting someone else.

As such, if you want true fair trade, then you need to make the markets as free and as fair as possible, which means that the most efficient producers survive, and the inefficient get out of the business. The problem with such a solution is that it meets with resistance in each of the countries that are unable to compete.

The coffee market is world trade writ large as, for some reason, farmers appear to have greater emotive appeal than, for example, a worker in a widget factory. For some reason a farmer going bust has greater emotive appeal than a widget factory worker being made redundant. In both cases they might be thrown into poverty, but for some reason the farmer's poverty counts for more. As such the distorting effects of intervention are particularly more apparent in markets such as coffee.

It is at this point it is worthwhile opening up the discussion of free trade to a broader frame of reference. No doubt, all of the readers will be aware of the bailout of the US automotive industry, and that similar bailouts are being proposed elsewhere (e.g. the UK). Even before the contraction of the world economy that we are now seeing, there has long been a glut in the supply capacity of cars, and the current contraction should have seen the end of the US automotive industry (or at least the end of one of the big three, possible two). Just as with the coffee market, we have a situation in which a government subsidy will create the same beggar-thy-neighbour effect as the intervention of Papua New Gunea in the coffee market. Someone else somewhere will pay the price of this intervention.

In the meantime, there is another problem. In intervening to prop up inefficient industry, it may appear that this is a good thing for the intervening country, but in some respects it will only cause them long term harm. In this case, the money for the car industry is being provided by central government, and that (one way or another) will be paid for elsewhere in the economy. There are several ways that this might cause hurt.

One is that, if it is funded out of borrowing, that money will need to be repaid, and that means that the efficient parts of the economy will have to pay for the inefficient parts of the economy, thereby removing capital from those efficient parts, and therefore constraining their growth potential. If the bailout is paid for by printing money, then it is paid for by a general tax on the economy as a whole, as the value of the existing money is transferred onto the printed money (the tax), and then transferred to the inefficient industry. In both cases, the efficient parts of the economy will be taxed to pay for the inefficient.

From this perspective, all seems very clear. Subsidy, it appears, hurts yourself. However, I have emphasised that it also has a beggar-thy-neighbour impact. The point here is that, if you subsidise an industry sufficiently, you have the potential to destroy the same industry in your neighbour. Having destroyed that industry, you remove the glut, and your inefficiently run industry can then achieve a position of profitability and market domination.

It is for this reason that governments intervene to support their industries. It is very rarely ever discussed in these terms, but the central idea behind subsidy is that of supporting an industry until it is the 'last man standing'. I do not mean this in the literal sense, as it is unlikely in most cases that it will be the last man standing, but rather if there are not many men left standing, then the industry can achieve profitability. I recently read an essay in a book (2) in which they discussed the 'rule of threes'. This is the idea that, over time, industries will whittle down to three major players, and that in an increasingly globalised system this is starting to apply internationally. Whilst not agreeing with their entire argument, the principle is roughly right. In such circumstances, whilst having some negative effects on your own economy, subsidy can pay.

From this starting point, we now come on to China. I have consistently argued that there are two fundamental problems with the rise of China. In particular the theft of intellectual property, and aggressive trading practices such as currency manipulation. I had the following to say in an earlier post on China (it is a little clearer in the original context, but the central point is clear enough);

I have suggested in a previous post that the world trading system needs to get tough with China. I did not have the time to dig up the articles that I had read, which caused me so much concern, so have previously not outlined this point of view. However, on reading the latest attempt by the Chinese government to manipulate trade, it seemed a good point in time to outline this problem. I am at heart a free trade advocate, but I also believe that trade should be free and use reciprocal rules should be binding and enforced. It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.

In another post I concluded the following:

China poses a real and ongoing threat to the world economic order, and will continue to grow at the expense of the West, unless the West responds by restructuring of their economies through (real) improvements in education, lowering their cost base, and taking an aggressive approach to intellectual property and fair trade (for why, see here).

And in yet another post:

One of the key elements in the rise of the Chinese economy has been their very lax attitude to Intellectual Property, which is stolen at a rate that is truly astounding. For example, it is nearly impossible in most Chinese cities to buy genuine computer software for individuals, excepting that which is preloaded on new computers. If we just took the example of Microsoft Windows, we can take a reasonable guess that, at least, 100 million computers are running on the software, and the majority of these are illegal copies. At something like $100 retail per unit for Windows, it is not difficult to grasp the scale of the theft. This is just one example. Multiply this across all of the software, and the numbers start to look truly shocking.

I later go on to say the following:

Another problem has been the exchange rate in China. It has been fixed, then moved to a basket with a partial floating rate. In a free trade situation, this is unacceptable. However, the West congratulated China on holding firm on its exchange rate during the Asian financial crisis, thereby hobbling the ability to complain about the problem of the exchange rate later. Had the exchange rate been free, the RMB would have strengthened, making Chinese exports more expensive, and thereby avoided the degree of imbalance that has occurred.

What I am therefore saying is that there was always going to be some pain for the Western economies, but the foolishness/weakness of Western leaders contributed to the scale of the current problems. China always had the potential to grow, but the rise was boosted by two practices which might be described as 'unfair' trade practices. These have accelerated the growth and have contributed mightily to the degree of imbalance that we now see.

As you will note, my stance on free trade has been pretty consistent, and in particular with regards to China. My argument has always been that China has enough advantage without any subsidy, whether that is through the export subsidy and protectionism implicit in exchange rates or through the theft of intellectual property. I believe that, as a result of the implicit subsidy in the exchange rate, in conjunction with intellectual property theft, China has been in a position where it has been effectively been allowed to destroy industries in its competitors. The worst part of this is that China has always had the potential for strong growth without such measures. I have always believed that China deserves its place in the sun, but only on free and fair trade terms.

I should qualify this slightly, as I think that all countries indulge in some unfair practices to some degree or another. This is not to condone any such practices, but at least they should be minimal. The difference with China is that it has practiced two policies which have such a massive impact on the trading position of the country.

The real question in all of this is why the world trading system has not responded, and this is a difficult question. One part of the equation was detailed in one of the posts I have already cited as follows:

On a related subject, in an article a while ago the Telegraph, it was reported that senior Chinese officials were willing to use dollar sales as a way of exerting power over the US. In short, the Chinese have the power to destroy the $US by selling the currency, and therefore have huge economic power over the US. The Chinese government later denied the policy, but those familiar with Chinese culture will know that using such methods of presenting a threat is not unusual.

Another factor which is somewhat harder to summarise has been a divide and conquer, carrot and stick approach, in which the two major trading partners of China, the US and Europe, have been played off, one against the other. It has appeared to me that the Chinese government have long played this game, but it is hard to support such an allegation. The carrot has always been the access for each country's companies to the lucrative engineering and infrastructure projects, ease of access to the Chinese market and so forth. The stick is getting unfavourable treatment within the Chinese market. All the time there will be pressure from business on governments to keep China 'sweet', in order to secure the access.

In other words, what has been lacking is a unified stand against the unfair trade practices of China. I believe that, as the severity of the impact of the speed of growth of China's impact on US manufacturing gathered pace, the US would have acted, were it not for threat that China could destroy the $US. By the time the US woke up to the impact of China, it was too late to act, as they had already ceded economic power to China by allowing the massive accumulation of $US reserves.

My argument has always been that it is better to take the risk of economic damage now (the damage to the $US), rather than later. The longer it is left, the greater the accumulation of $US reserves by China, the greater the numbers of industries permanently destroyed, and the greater the long term pain. In other words, the longer that the confrontation with China is delayed, the less able the rest of the world will be to withstand the consequences. When I first wrote about this, the full impact of the economic crisis was just in my imagination, was just a prediction. Now that it is here, the weakness of the economies of West is such that the leverage of China is that much greater. I have long predicted the collapse of the $US, and mainstream thinking such as Willem Buiter, are coming around to the idea. In the situation of an already vulnerable currency......

At the end of this post, I can only conclude that it is time to face up to the mercantilism of China, and finally address the problems that are being caused by such practices. I do not, and will not agree with protectionism, but I do believe that, where a country is systemically mercantalist, then action should be taken, including raising trade barriers and tariffs. I would even countenance a complete embargo on trade.

The trouble is that, as I pointed out in a previous post, China has now placed itself in a position where too large a proportion of the economy is geared towards export. It is destroying the very customers that are supporting its economic growth. If the West were now to act to discipline China, it is a very dangerous proposition. In particular it will wreak even greater damage on the Chinese economy, which is already suffering from the contraction of its major markets. Regardless of the rights and wrongs of the situation, China will cry 'foul', and will proceed to stir up nationalist fervour within China. This will see attacks and boycotts on Western and foreign owned businesses. It will see even greater unrest in China, which is already seeing unrest as a result of world economic contraction, and the situation will potentially become explosive. In letting the nationalist genie out of the bottle, with legitimacy of the Chinese government founded on economic growth and nationalism, we have the makings of a heady cocktail. Where such a heady cocktail might lead can only be a matter of supposition, but it will certainly not be a good direction.

The real answer is that the question of the rise of China should have been dealt with long ago. However, the situation as it stands does need to be confronted. Saying that it should have been dealt with long ago is not very helpful. The trouble is that, because it was not dealt with, a situation has arisen in which the costs of dealing with China have exploded. One commentator mentioned that it seemed that the world trading system appears to be fragile, if China's rise can have so much impact. It is only fragile because the impact was not addressed earlier, at a time when the impact of China could have been the emergence of a strong economy in a (in very loose terms) free trade world.

In short, we have a very, very serious problem at the heart of the world trade system. Not only that, but it is a problem whose resolution can only be painful. However, the problem must be resolved, one way or another.


(1) Lewin, Bryan, Giovannucci, Daniele and Varangis, Panos,Coffee Markets: New Paradigms in Global Supply and Demand(March 2004). World Bank Agriculture and Rural Development Discussion Paper No. 3 .

(2) Sheth, Uslay C, and Sisodia, R, (2008) The Globalisation of Markets and the Rule of Three, in Marketing Metaphors and Metamorphosis, ed Kitchen, P

The Economic Crisis - The Bailout and Other News

Yesterday, before I read the latest news on the bailout, I made my regular visit the various financial sections on the online news services. I was struck by one of the finance home pages, in this case the Telegraph. I would link to the page, but the page changes daily. Why would this page be of interest. Fortunately I left the page open, and here are a selection of the headlines:

'Mortgage Lending Plunges 95pc as market "Decimated"'
'UK high street banks may benefit from US bailout'
'City has B&B concerns'
'Airbus Launches in China'

Today, in the same paper, the headlines are as follows:

'US Markets in Freefall as Bailout Rejected'
'Banking crash hits Europe as ECB loses traction'
'Banks to absorb B&B losses'
'Benelux states part nationalise Fortis bank'

Why am I giving this list of headlines? The reason quite simply is that, within these headlines are expressions of the roots of the problem. As I viewed the above headlines I came across a quote from Gerard Barker of the Times as follows:

'If Congress wouldn't listen to Bush and Paulson it might at least listen to the markets'

It is a fascinating quote in light of the above headlines, because there is a fundamental disconnect in the thought. Gerard Barker is assuming that the real market is what is happening in Wall Street and the City. He is missing the point entirely. The real market is the market of the day to day decisions and activity of billions of consumers, and endless millions of companies supplying goods and services, and the choice of where real wealth creating capital is allocated. It is they that drive the markets, not Wall Street, and certainly not governments.

The City and Wall Street are just a reflection of the reality of the situation on the ground. The banks are not failing because of the lack of a bailout, but failing because of the damage in the wider economy. Even before the current crisis, the CBI survey of financial institutions in the UK found that the banks were suffering from plunging profits. This is the reality of the crisis, that both consumers and businesses were hurting, and that the result was that the banks were looking at ever more pain as a result. With consumers not borrowing, banks not lending, consumers not spending, and therefore businesses suffering, the banks are in trouble. What that actually means is that, on the ground, away from the world of finance, there are real problems. It is the downward spiral that occurs when the credit ATM shuts down. I have said it before, but the bank balance sheets will be looking ever more ugly as each day goes by, as consumers increase defaults on both mortgage and personal debt, and as commercial debt goes sour.

In other words, there is not some mystical force in Wall Street or the City driving all of this, but fundamental and deep economic problems. If the fundamentals of the economy were good, there would be no banking crisis. Companies would be generating profits, and consumers would not be defaulting on their loans, and the house market would be buoyant.

If we return to the above headlines we can see an illustration of one of the problems in the article that details the opening of an assembly plant in China by Airbus. Such an action would have been encouraged by the Chinese government, as a way of ensuring access to the growing market for aircraft in China. Airbus, in opening such an assembly operation, will ensure that China will emerge as a competitor in aviation in 10 years time. Once embedded in China, the process of sourcing components and parts locally will commence, and local Chinese companies will be taught how to serve the aviation market and, once they have learnt, will expand into broader international markets. As more and more suppliers are able to meet the high standards and technology required to build modern aircraft, the infrastructure will be put in place for a Chinese competitor to emerge. This process has been going on for many years, in many sectors. It is the combination of capital, access to markets, access to technology that I have discussed in my previous posts in the abstract.

This is the reality behind the financial crisis, the emergence of competitors who are taking ever larger shares of world trade. They are producing goods and services in competition with the OECD countries, and they are doing so ever more effectively. For those who still insist that it is just cheap labour, I would suggest that you listen to the following from an Economist report on globalisation (Economist Print Edition, September 20th-26th, 2008, p 12):

'Being Willing to match India's low-cost model was essential, but Mr. Cannon-Brookes insists that IBM's enthusiasm for emerging markets is no longer chiefly about cheap labour [...] Perhaps a bigger attraction now, according to IBM, are the highly skilled people it can find in emerging markets'

The reality of the markets is that we in the West have deluded ourselves that we have the better people, the better technology, the better infrastructure. Perhaps we still do, one of the points made in the Economist article, but the speed with which such advantages are diminishing is shocking, and in any case the advantages pertain to an ever smaller part of the market (the part of the market that requires only the highest levels of technology, process and know-how such as aircraft manufacture). In other words, globalisation is setting about a complete restructuring of world markets, and that restructuring is about moving business to any place where there might be any competitive advantage. This again, is the reality of the market.

Every time that a consumer enters a shop to purchase something, they are the drivers of the real market. Every time a business seeks a supplier of a component or service, they are the real market. Every time a company allocates capital, this is the driver of the real market. The financial institutions of Wall Street and the City may imagine they are in the driving seat, but the reality is that they are just responding to each of those tiny market signals. This is not to say that they have no influence, as they allocate the capital that is available, and have allocated it very poorly, leaving insufficient capital for investment in productive activity in the OECD (real wealth generation), but they still are driven by the activities of the real market.

In the current situation, the problem is that they lent to the wrong places, consumer and mortgage debt. They miscalculated, they failed to realise the real source of wealth is in manufacturing products and supplying services to support that wealth generation. They thought that debt = wealth, the fundamental point in 'A Funny View of Wealth'.

The purpose underlying this post is to reiterate that, for all of the excitement about the state of Wall Street and the City, they are really not what matters. If the underlying economy were healthy, then all of the lending to consumers that is driving the banks to bankruptcy would not be going sour. It is the underlying weaknesses, the lack of wealth generation, that means that the debt is going sour.

When we view the world as it is, instead of through the delusional filters with which we have viewed the world, it becomes apparent that the bailouts would never have worked and would just be another burden on economies that were in any case less and less fit to compete. The question that needed to be asked about the bailout is whether it could actually change the underlying reality of the economies that really drive the financial system. In other words, would the bailout do anything to create wealth? At some point wealth must be created to pay back the debt, and the bailout was just transferring debt from one place to another. It was not solving any real problem, but just shifting the problem to another place. The only solution to the real problem is for the OECD countries to respond to the real market, and that market is one in which tough competitors have emerged, and who are fast moving up the value chain.

It is for this reason that in a previous post I call the bailout a 'magic wand'. It is for this reason that I have opposed the bailout. It is just a way of pretending that the real problem is not there, of pretending that the world has not changed. It is just a continuation of the delusion.

No doubt, some readers would have expected me to discuss the events of the last few days. I hope that, having read this, you will see why I have not discussed the blow by blow saga of B&B or Fortis, or the failed bailout. They are events, they are important in their own way, but they are just a reflection of something more important. The market is readjusting, and the banks are just following the 'real' market (or at least the real drivers of the market - individual choices in the selection of goods and services) in the readjustment, albeit accepting that they are one part of that market.

I have had a comment from 'Souza', which questions some of the ideas that I have put forward. I will quote Souza in full, as he puts forward some interesting points:

'Having immigrated from an "emerging economy" to a "rich country" I experienced this phenomenon first-hand, but the explanation always seemed obvious to me: rich countries are rich because of currency imbalances. Much of the wealth of rich countries is founded upon (and funded by) artificial exchange rates. The answer to the "cigarette lighter problem" is that the New Zealand dollar is overvalued against the Chinese yuan by a factor close to the ratio between the prices of the lighter in both countries.

The fundamental question is not "why the lighter costs more in New Zealand", but rather "why the income of workers in different countries is not commensurate with their productivity". I don't know the exact figures, but I'm quite sure that a convenience store clerk in New Zealand earns at least 10 times more than one in China, despite the fact that the productivity of both workers is roughly the same. As I said, I experienced this first-hand when I moved from one country to another and saw my salary instantly multiplied by 4, despite the fact that I have not become any more productive.

So when you say that "something is very wrong and unbalanced in the world economy", I say "it's the exchange rate, stupid!". (I hope you recognize the "stupid" as an allusion to a commonly used phrase, not an insult). And even though I'm sure there is a lack of balance, I'm not sure it's necessarily wrong, for the simple reason I don't fully understand where it comes from.

The one thing I can be quite sure of is that exchange rates are a matter of supply and demand, so the currencies of rich countries can only become overvalued by creating artificial demand for them. And the most obvious way in which I see this happening is through cultural influence. To take but one example, the fact that Coke is so popular in almost every nation on the planet is highly beneficial to the American economy, but such a high demand for a product with little intrinsic value can only be created by cultural influence. Surely if exposed to it without the accompanying marketing machine, most people would find the taste of Coke between trivial and repugnant (it is, after all, nothing more than water, sugar, and CO2)

This is a complex topic and I have no room to expand on it, so I'll finish with my opinion on the future of the wealth of wealthy countries: there is not much to worry about, things won't change much. The current state of the world's economy is a product of politics and culture, not of worker productivity. A "service economy" is perfectly sustainable for as long as there are far more poor countries in the world than rich ones - a situation not likely to change in any foreseeable future. The most visible result of the "service economy" is that it creates a world market for things people in rich countries are no longer willing to manufacture; things such as cigarette lighters.'

He is right to say that the currencies are overvalued. This is a point I have made throughout the posts, and why I predict that the 'rich world' currencies must drop against those of the emerging markets. This represents a real loss of wealth, as the commodities that are purchased will be more expensive, and the goods imported will be more expensive, the holidays that consumers take will be more expensive. A simple and crude way of looking at it is that a consumer will have to work x number of hours more to buy a Japanese branded, manufactured in China, plasma TV than they did before. This is a real loss of wealth. In answer to this point, yes, the currencies will drop, and every individual in the 'rich world' will commensurately poorer. I also agree that currencies are dictated in the long term by supply and demand. A large part of the demand for Western currencies has been driven by demand created by foreign institutions to invest in rich world economies, either to buy companies, or to lend into consumer markets. Now that such demand is falling, there will be ever less demand for the currencies. The currencies will fall. The rich countries (excepting some like Germany) are just not producing enough products that other countries want, and the result is that, without the demand for currencies for (now revealed as foolish) lending into the economies, there is little support for the current value of the currencies.

With regards to the salary differentials, that is the underlying point about the 'Cigarette Lighter Problem'. How can this differential be justified? Somewhere in the economy, there needs to be sectors that are generating huge amounts of wealth to pay for the salary differential between the Chinese shop worker and the New Zealand shop worker. Where is this wealth generation coming from. We can look for it, but it is impossible to find such a massive source of wealth (see 'A Funny View of Wealth' for my attempt to find such sources of wealth in the UK). As such, what is paying for the differential? My argument is that it is debt, lending sourced from outside the country, that is paying for a large proportion of the differential.

The Coke example is an interesting one. Coke has many meanings attached to it, not least of which is the association with the US lifestyle, the US dream and US culture. What happens to Coke when the dream goes sour? Coke is a great marketing company, and therefore will probably adapt their image to the changing circumstances, but their value at present is tied up with the culture and values of the US. There still remain in the West many great companies, but these companies are facing ever more, ever better competition. I remember sitting in front of a Unilever executive telling me about the fierceness of competition from local suppliers. Unilever were holding their own, but the battle was tough. Unilever is an example of the very best of Western companies, so what of the weaker companies?

As for the last point made by Souza, I am hoping that the post overall will have answered the suggestion that as long as there are poor countries, the service economy can be sustained.

Anonymous made the following comment (and question):

'I don't know if you are still in China, but I am! I wonder what it would take for all this to start to 'undermine' the Economy here? Is there some event, some process that is unravelling? Elsewhere people have said this is not a 'Global' crisis, just an OECD and particularly US/UK one. To what level might the Euro/GBP actually fall against the Renminbi? You say that is the easiest of the 5 options to be enacted? But would that actually help..and help who?? '

There are many points here, but I will focus on who the devaluation might help. I would not suggest that the devaluation would 'help' anyone. It is a market process that is inevitable, but is not imbued with any intentionality. It is not happening for a purpose, but because market forces seek (again with no intentionality or purposefulness, despite using a verb that suggests otherwise) an equilibrium. The mis-allocation of capital created an imbalance for so long, but eventually the market had to snap back into a balance. In this case the trace balance was pulled out of shape, and the correction is a rectification of this imbalance through currency changes, and the destruction of the value of the Western currencies is the correction.

I hope that the above is clear, as I am somewhat dissatisfied with my own answer here, and am not sure I have expressed it well. Let me know if it does not make sense.

There is much more that could be said in this post, as well as some other comments I would like to respond to. However, time is short, so I hope the other commentators will forgive my lack of response.

I also hope that this post will go some way to directing your attention away from the minutae of events, and help to focus on the bigger picture, which is what really matters.