A Recovery in the UK?

A recent comment on the blog suggested that perhaps there was not much to write about, as the UK economy appears to be recovering. Bearing in mind that such stories are now appearing in the press, it is not surprising to see that this point of view is gaining some traction. For example, we have this from the Telegraph, reporting on the National Institute for Economic and Social Research (NIESR):

NIESR’s optimism was echoed by the Royal Institute of Chartered Surveyors (RICS), which expects house prices to rise this year, in a startling reversal of its forecast that prices would plunge 10pc to 15pc in 2009.

A slew of positive economic data and an upbeat trading update from Carpetright – often seen as a bellwether for the economy – prompted analysts to predict the UK could emerge from the recession as early as the third quarter.

From David Wighton, of the Times, we have the following:

Still more convincing, the purchasing managers’ survey of services, the most timely and respected gauge of the economy’s most vital sector, shows expansion for a third month, and at the fastest pace since February last year.

The equivalent manufacturing survey shows that industry is rebounding too, and the fightback is affirmed by official data, with the biggest monthly output jump since October 2007.

Markets seem convinced — the FTSE 100 is up by a third from its lows plumbed at the start of March.

It all appears to be compelling evidence of recovery, does it not?

The truth is that we are witnessing a mirage. My first article for this blog was entitled 'A Funny View of Wealth', and I return in this post to the theme in this (very long) essay. The essay was written before the economic crisis struck in full force and, in the essay, I tried to find the apparent source of wealth in the UK, but found that there was no explanation except for a massive expansion in credit. Output of commodities were in decline, manufacturing output had remained static for many years, and export of services provided no explanation for the massive 'growth' that had apparently taken place in the economy. The remaining explanation was that the UK's growth had been built upon borrowing, and in particular borrowing from overseas.

We can now fast forward two years in time, and I can ask the same questions. Exactly what is the source of the current 'recovery'? Which sector is producing the growth in wealth creation to justify the 'recovery'. Let's start with manufacturing:

The chart above is the production index from the Office of National Statistics (ONS). It seems that, even with an uptick now, we are now producing significantly less than ten years ago. This is what the index of production covers:

The Index of Production (IoP) measures the volume of production of the manufacturing, mining and quarrying, and energy supply industries, which covered 17.2 per cent of the UK economy in 2005.

How the word 'recovery' might be applied to this is very puzzling. With regards to productivity, the picture is as bad, with this from the ONS.



As can be seen here, the UK is not in the midst of any kind of productivity miracle that might explain the sudden recovery.

The other potential source of real growth in an economy is in the exports of services. In the essay at the start of the blog, it was apparent that financial services were at the heart of the growth in services export, and the decline of the sector has been reflected in recent services export figures, with a negative trend appearing in the figures (raw data taken from the ONS here - series IKBB & IKBC & IKBD). Curiously, 2008 did see a moment of increase in the positive balance (in part as a result of an expansion in financial services exports! - see data here), but quarter 1 2009 reversed this. Overall, the picture is one of a continuing positive balance in the export of services, but still with nothing that might offer an explanation of the current 'recovery'. On the latest figures from the ONS, which takes us to Quarter 1 of 2009, there is no explanation for the recovery.

Then there is the overall trade balance, which has seen a shrinking of the deficit, but still an ongoing deficit. This from TradingEconomics:

The trade deficit continues, despite a substantial devaluation of the £GB since the crisis began, such as the decline against the $US (apologies for the poor chart). Devaluation has the effect, for example, of reducing the purchasing power of consumers within a country, and is therefore a real reduction in wealth of the individuals whose income is derived in the currency.



However, it is when we see the current account that the scale of the problem becomes really apparent, with the following chart from TradingEconomics:


If taken together, what we are seeing here is no growth in output from manufacturing that might explain a 'recovery', no growth in the export of services, and an ongoing current account deficit. It is hardly a picture of a 'recovery'. To this happy picture of 'recovery', we can add unemployment, with this from the ONS:


It is worth thinking about the underlying meaning in this chart. The proportion of working age people in employment is falling off a cliff. If people are not working, where is the output in the economy coming from? We know that there is no productivity miracle, so how exactly can an ongoing decline in working people explain a recovery? Where can real increases in output in the economy come from except from either a growth in productivity or a growth of the numbers in the workforce actually in work?

For regular readers, they will be aware of my cynicism about what GDP figures actually show, as they include activity from debt based consumption (see here for a full explanation). However, even this indicator, which potentially massively overstates the positive in an economy, looks like this:


So exactly what is the source of this recovery? Here is a summary of where we are at:

1. There is no productivity improvement but a decline
2. The number of workers in the workforce is in rapid decline
3. Production is below the levels of 1998
4. The trade balance of goods and services is negative, the trade in services remains positive but with no growth, and the current account balance is negative. On balance, we are still consuming more than we produce.
5. GDP growth, a poor measure that exagerates the positive, is still negative. Even if it were to move to the positive, how much of the activity recorded comes from growth in debt?
   

Altogether, this simply shows that there is no sustainable recovery. A shrinking UK workforce is still consuming more than it produces, and productivity and output are still in negative territory.

So where exactly is the recovery? The indicators given as evidence of recovery are the slight uptick in manufacturing, which I have already dealt with, house price recovery, and the stock market recovery. The recovery proposed appears to the return to price inflation of two asset classes, but with no underlying economic justification for these that might be seen as sustainable.

So where is this 'recovery' coming from? Once again, I return to the theme outlined in 'A Funny View of Wealth'. The only real reason for any signs of 'recovery' is that there is yet another increase in debt. The only real difference this time is that the source of the borrowing is primarily the government, and that borrowing is expanding at a record rate. Again, from the ONS:



And how is the government funding that borrowing? By the Bank of England printing money, which is then used to purchase gilts (UK government bonds). The Bank of England has just announced yet another expansion of the so called 'quantitative easing' (QE - printing money) programme, which is primarily being used to purchase government debt. I have previously shown that the QE purchase of debt is propping up the UK bond market, and that it is the monetization of government debt.

What we are looking at is simply more delusion, more hiding from the underlying dire state of the UK economy. The 'recovery' is founded on printing money and more debt. I will quote myself from an earlier blog post, which in turn quoted an even earlier blog post. It is shocking that nothing has actually changed:

Quite simply, aside from the fact that a failure to fund the deficit would be catastrophic, what kind of 'recovery' is it, if it is being financed by borrowing 13% of GDP?

A long time ago, I made an analogy with a household to explain the absurdity of this notion. A household has been racking up huge debts due to too much expenditure on the 'good things in life', but continues spending. All the time the family's debt is increasing, and then the bad news comes. The wife's job is under threat, and the husband's working hours are being reduced. Their income is declining, but the cost and size of the debt is increasing. They are in deep financial trouble, and are borrowing more and more money in order to keep their lifestyle and also to make payments on previous debt.

It looks like the household is in crisis, and they will soon go bankrupt if they continue their profligate spending. Fortunately, so it seems to our irresponsible family, a visitor comes to their house from 'Dodgy Loan Corporation' and offers them a further and much bigger new loan. They look at the figures, and it appears that, if they accept the loan, the family will be able to continue to live the same lifestyle as they had before. A massive weight lifts off their shoulders, and they live happily ever after.....

We can all (I hope) see the problem in the happy ending. I have not mentioned the prospects for the family's income increasing in the future, and without a massive increase in income, bankruptcy will just be delayed. Sadly, for the family, there is no identifiable prospect of such a massive increase in income in the future, and they are just hoping that 'something will turn up'.

I keep wondering how long this can continue. How long can we delude ourselves that all will be ok if we just keep on borrowing more and more, even as our income declines. I keep on asking myself, 'when will we wake up to reality?'

The Underlying Problems in World Trade

Regular readers will know that I am very cynical about the talk of recovery in the Western economies. I recently posted on the optimism for the US economy, and pointed out the many indicators that suggested that the economy is a long way from recovery. Similar arguments may be made for the UK economy. However, for this post, I thought I would return to the underlying nature of the economic situation, and there are a few factors that I would like to highlight.

The first of these is that the balance of trade, and current account balances of the UK and US are still in negative territory. Rather than detail the situation as it stands, I will try to illustrate the profound problem this represents through a gross simplification. I hope I will be forgiven this method.

If we were to imagine a world in which there were only two trading countries, that their trade was confined to two products, and that their trade was undertaken as barter, we can strip out the complexities of currency, and see the underlying problem. For the example, we will imagine that one country exports packs of pharmaceutical pills, and the other country toys. In country A, they manufacture 100 packs of pills per day, with 100 workers manufacturing 1 packet of pills each per day. In country B, they manufacture 100 toys per day, with 200 workers producing half a toy each per day. The workers in country B are willing to exchange 1 toy for 1 packet of pills in barter exchange. As such, the productivity of country A is twice that of country B, implying that country A is by far the wealthier country.

The problem that then arises is as follows; Country A is consuming 80 packets of pills per day, but also consumes 40 toys per day. Furthermore, Country A is saving nothing, whilst Country B is saving some. In the table below, it is possible to see how, after five years of this arrangement, Country A owes country B a whole years labour per worker. I make no pretense that these are real figures, but they serve to illustrate principles ( I hope the table is clear, as Blogger shrinks the images down, which is very annoying). As a note the exchange value is 1 toy for one pack of pills, such that each represents 1 unit of output.



What we are looking at in this table is a country B with large numbers of workers, with low productivity, but relatively small consumption levels and a high savings rate overall. I have put a separate column for savings in the table, but the debt owed by country A is (of course) representative of savings. The point in having a separate column is just to emphasise that the individual consumers in country B are very thrifty and cautious, and they therefore hold back from committing all of their stored wealth as credit to Country A. In other words they keep a store of toys (money) ready for exchange in the event of emergency. The model only shows the export trading part of the economy, and this store of toys is there for the exchange of goods and services, but still represents stored value.

The purpose of the table is to show what happens when one country over-consumes, and another under-consumes. Despite the high productivity of Country A, they are still in deep, deep trouble. By seeing the trade in terms of barter rather than currency, it is apparent that it is labour that is being exchanged.

Typically, what we see is such ideas hidden under mountains of economic theory, and obscured by many complicating factors. However, if we look at trade in these simple terms, it is possible to see how, in the end, one worker ends up owing another worker a huge amount of their labour. In this scenario, each Country A worker owes country B an entire years worth of labour. When considering this, it is necessary to also factor in to the equation that no individual is able to actually give a year of their labour to repay debt, so this labour must be repaid over time. As such, of course, the labour that is providing the credit in goods would (and does) demand interest for foregoing the consumption that they might achieve now for future consumption.

The table does not therefore fully express the severity of the situation for country A.

If we apply such a principle to the real world, thinking of the US (like Country A) and China (like Country B) as obvious examples, it is possible to see that something, somehow, absolutely has to 'give'. If we remove the complications of currency, it is possible to see that there is huge amount of labour owed by the US to China. It is also possible to see that China has the savings that will allow it to ride through the current downturn. For real current account balance figures, the US can be found here, and China here.

Inevitably, life is not as neat as the illustrative example, but the principles are what really underpin the nature of trade. It is the exchange of labour between two countries, not the exchange of money. Money is just an intermediary that represents the equivalent of toys and packets of pills.

If we think of the world in terms of this underlying exchange of labour, then it becomes clear that the previous current account deficits of the US has put the economy very, very deep in debt. If we then view the ongoing current account deficits, then we can see that the problem is just getting worse, albeit at a slower rate. The US is confronted with choices, none of which are very palatable. The first choice is to accept the reality of the debts, and therefore do what is absolutely necessary. This is to live in a frugal way until the labour owed to China is repaid. This means, in practical terms, a significant decline in living standards, with a massive decline in consumption, as more of the value of labour is switched to exports. For China, this means that they would not have to work so hard to achieve the same living standard, or they might still work as hard and have a far higher living standard.

After all, if the US starts to use its labour to repay debts, then the value of that labour will flow into China in the form of goods and services.

It is at this point, that life gets somewhat more complicated. It is the question of how this might be achieved.

The simplified model ignored currency in order to illustrate the underlying principles of what has taken place in the world economy. However, the reality of the world is that it does have a currency system. The underlying problem that the US must confront is that, at current valuation of the $US (albeit it has fallen back recently), it can not compete with Chinese labour in many sectors (thus the ongoing deficits). This is a very curious situation.

What we currently have is a belief that the ongoing deficits and the existing debt of owed labour do not matter when considering the value of the $US. It is the only explanation of why the $US might be valued in the way that it is. In part, this is a result of a false confidence in the productive capacity of US workers and the US economy as a whole. Another part of the problem is that China has a nasty choice. The only way that they might be repaid for the labour owed by the US is to accept that part of the existing debt of labour owed be wiped off the slate. I will try to explain this difficult concept...

When Chinese labour was exchanged for promissory notes from the US, there was a belief that the US would eventually exchange the labour for the full value of the notes. The problem arises that, if the US were to make this exchange on the original terms, then US labour would be unable to exchange their labour for the products of Chinese labour. Quite simply, they owe too much of their labour, and repayment would mean that they are living in relative poverty. In short, their consumption would fall back to a degree where they would by buying very, very few goods and services. The Chinese economy is largely centred around provision of their labour to provide goods and services to the US economy, and the halting of the consumption in the US would leave many companies without a market.

Now if we return to the table example, it is apparent that the Chinese are very productive, but consume very little. They are cautious consumers. In order for the situation to be rectified, they need to consume more of their own output. In other words they need to live more wealthy lives. The trouble is that, for cultural and systemic reasons, they are cautious, and would rather not use their acquired wealth for immediate consumption. If they were to consume more of their output, then they would be in a position of living relatively wealthy lives, and this would be further bolstered by the repayment of the labour owed to China by the US.

The problem then arises as to what will happen to all the factories that have, in effect, been lending the labour to the US? If the US economy collapses, then there is no market for their goods. If they demand that the US repays the debt of labour owed (on the original terms) the US will be very poor, and will be unable to afford to buy any of the products of Chinese labour.

The Chinese are now in an uncomfortable position. It is apparent that the US would struggle to have its workers repay debt, and this would be a political nightmare to enact. Nobody likes to move from apparent wealth to actual relative poverty. As such, instead of accepting the underlying reality that is represented in the current account deficits, both the US and China are doing the equivalent of sticking their fingers in their ears and singing 'la, la, la, la!' at the top of their voices.

The real problem, however, is what the US is doing to try to rectify the problem. It is apparent that US labour has been doing the same as the country A workers in the table. They have been consuming more than they produce, and now owe significant amounts of their labour to China. Now that they are confronted with repayment of their debts, they simply do not want to pay. Furthermore, they are demanding that their ability to consume more than their output is continued.

The US government, rather than telling them the hard reality that it is repayment time, is telling them that they can, in fact, continue to consume more than they produce. In order to allow this to happen, they are using several rather dishonest measures. The first of these is that they are attempting (and currently succeeding) in persuading many countries, organisations and people, that the US is in a position to one day repay the debt of labour owed, and that the US has sufficient future output to repay even more debt to the labour of others in the future. The curious part of this is that, up to this point in time, they have offered no explanation of how the US might actually achieve such (increasingly massive) debt repayments.

The second measure that they are enacting is the policy of printing money, and the eventual devaluation of the $US. This is a measure to allow the US to default on the debts of the past. In the table, the barter exchange rate is 1 toy = 1 packet of pills. However, in the real world currency is an intermediary, and devaluation of the currency is a way of post hoc arranging that 1 toy = something like 0.6 packets of pills. In other words, they are reneging on their debt, and breaking their promise to pay.

Whilst this may resolve past debts through dishonest means, it still leaves the US with an underlying problem. The apparent wealth that they have enjoyed is, in part, due to living on the labour of others. However, if they do not repay their past debts, that labour will be withdrawn (e.g. if they devalue their currency, China will no longer lend their labour). At the time that the labour is withdrawn, the US will find that it is reliant upon the output of its own labour, and that labour is insufficient to support the standard of living that was possible with the labour input of countries like China. They will find that they are very much poorer than they imagined, and that is a painful situation to confront.

Perhaps this is too simplistic. I would welcome comments on the situation, and how the underlying premise might be wrong.

Having said all of this, it might appear that I am painting China as an innocent party in the current problems. However, as I have emphasised in the past, China has manipulated its currency in a policy of mercantilism. In so doing they have systemically under priced the value of their labour, and used this to ensure positive trade balances. The cost of this has been borne by Chinese workers, whose purchasing power of imported goods has been diminished, and whose earnings have not properly reflected the market value of their labour. For example, by holding the value of the RMB at an artificially low level, the cost of imported goods has been held high, meaning that each worker is relatively poorer than they might otherwise be. This has also had the effect of overpricing US labour, such that it is not competitive.

The result of such a policy is that China has protected its domestic manufacturers in the home market, and subsidised their exports through underpricing their labour. In so doing, they are making an investment in the future of China, as the result of the underpricing is that they are able to compete unfairly, by undercutting US companies and putting them out of business. I remember reading an article in the Economist a long while ago that suggested that a country in receipt of subsidised goods should be grateful that they are able to consume the products at a discounted rate. However, the result of such subsidy is to destroy businesses that might otherwise compete with such products.

What we can now see in the relationship between China and the US is a very messy situation. The US owes a huge amount of labour to China, and is unable to pay this debt without a massive retrenchment in consumption. That the US is not facing up to debt, and is increasing debt, is a problem that will simply not go away. Whilst US consumers are now starting the painful process of debt repayment, the government is increasing its debt to attempt to maintain living standards in the US. However, in doing so, the overall debt in labour owed to other countries is still increasing. This despite the fact that the US is both unwilling and unable to service existing debts as their economy is currently structured.

Meanwhile, China continues to under price its labour, and therefore continues to undercut the labour of the US, such that it continues the process of hollowing out US capacity to ever repay the debt. In doing so, it drives the US ever further into a ditch.

Quite simply, when we remove the complications of currency, and think of the debts owed by one country to another in terms of labour owed, the madness of the current situation becomes apparent. It is also possible to see that the actions of governments are quite simply making a very bad situation worse, and that the final outcome - or denouement of the situation - will be ever more extreme.

Note 1: I hope that all of this makes sense. I showed the post to another person before publication to see whether there were any errors in my thinking, and the response was very positive. I am aware that many readers of this blog are very astute, so I will also look to you to identify any problems in my thinking. My concern is that, when expressed this way, the gravity of the situation becomes so profoundly obvious, that I simply must be missing something. I look forward to the comments.

Note 2: I have had some interesting links that are pointing to increasingly negative sentiment for the $US. The link provided by Don Keyes is a good summary of the situation. Is this the start of the $US collapse? Quite possibly...but I have predicted the collapse before and been wrong. Like any sane person, I do not want to see a $US collapse. However, set against this, better sooner than later....the longer the US government and Federal Reserve follow their mad policy, the greater the long term damage to the US and world economy.

Economic Crisis - A Torrent of Bad News

I thought I would write a quick post, as there have been some items in the news which are interesting.

The first of these is a report from the IMF, which said the following:

'In its bleakest assessment yet of rapidly worsening global prospects, the International Monetary Fund predicted that industrial economies as a whole will shrink through next year by 0.3 per cent, in the worst such slump of the postwar era.

The IMF said that the toll imposed by the downturn across the West would sap the strength of the world economy and cut global growth next year to an anaemic 2.2 per cent. That is down 0.8 points from its last forecast, made only a month ago, and is below the 2.5 per cent threshold at which the world economy is judged to be in the grip of global recession'

It might be noted that the IMF reports are progressively becoming more downbeat. The reaction from stock markets was predictably negative, in yet another case of a rally of optimism being dented by economic reality.

Meanwhile the Bank of England has slashed interest rates in an attempt to turn around the economy. For regular readers, they will be aware of my lack of support for central banks setting interest rates, but I have argued that, if they must, they should have cut rates a long time ago. For those that are unaware of the mechanism by which interest rates are 'set' (targeted), I have copied an explanation of this from an earlier post:

'interest rates are set (as a target) to govern the money supply in the economy (through open market operations in the UK primarily through the London Interbank Offered Rate). The control of the money supply is managed by either buying or selling securities such as second hand government debt (e.g. bonds), or by lending to or borrowing money from banks.'

The trouble is that the banks are not playing ball, and are holding interest rates higher than the rate targeted by the Bank of England. The real problem here is that the same article details that the banks are now being pressurised to accept lower interest rates in their lending. This is what the article had to say:

'John McFall, chairman of the Commons Treasury Committee, told The Times:“These guys came in with some pretty big begging bowls asking for taxpayers’ money. They are displaying an alarming lack of social conscience. They should pass on the cuts in full.”

Yvette Cooper, Chief Secretary to the Treasury, said that ministers expected banks to pass on the cuts as fast as possible. “The Government has stepped in to make the banking system safe, to support the banks,” she said. “It is right now that the banks do their bit to support everybody else.”'

The absurdity of this position is that the reason for the banking crisis was the mis-pricing of risk, which has led to huge losses for the banks. Having been scathing about the banks for doing this, now that the banks are (rightly) being cautious, the government is now using its newly acquired whip hand to force the banks to return to mis-pricing of risk. This is exactly one of the many problems that I predicted would arise as a part of the government bailout of the banks. It also sows the seeds of further troubles for the banks in the future.

The reason for such pressure is the belief that banks need to start lending again, as there is still a fundamental belief that everything can be solved through borrowing. This attitude is implicit in many commentaries, and just one example can be found in a commentary on the problems being faced by Barack Obama:

'America is looking to its new president for a string of answers: how to stop the US economy shrinking at its fastest rate for seven years; how to stop unemployment, already at a five-year high of over 6pc, rising even further next year; how to rebuild consumer confidence, which suffered its steepest drop in October since records began in 1952; how to kick-start consumer spending, which represents two thirds of the US economy and fell in September for the first time in many years.'

It is the last part that is most telling. The key to the revival of the economy apparently lies in getting consumers spending again. Note that there is no mention of increasing wealth generating business and activity, but instead the answer lies in consumers going shopping. The question of shopping with what is not discussed, but the reality is that what they really mean is shopping with borrowed money. That is why governments are urging the banks to cut interest rates and pressuring them to lend. Whatever way you look at it, it is increasingly clear that governments view the solution to all the problems is increased consumer spending, and they do not care whether that spending is generated through increased consumer debt. Even were such a solution to succeed (which it will not), at what point would the unsustainability of such a proposition become evident? How much debt can consumers actually shoulder? In this foolish conception of economics, apparently consumers can go on borrowing for eternity.

This does make me wonder whether governments have any idea of what they are really saying. Surely, even when dressed up with economic jargon and euphemisms, the thrust of what they are suggesting must be apparent to them.

Note 1: There have been some very interesting and insightful commentaries on the blog, starting with Lemming, who says the following:

'Mark, I'm still thinking along the lines of a comment I made a few months back in which I asked whether the financial system is so broken, that only some sort of 'reset' can get things back on track. It seems to me that nothing has gone greatly wrong with the world's ability to produce sufficient 'stuff' for most people to live adequately, but that capitalism has tied itself into such knots that it cannot be untangled without destroying society in the process. Can we continue with capitalism in its present form?'

The idea of a reset makes sense in some respects. The trouble with such an idea is that it would be a very bitter pill for the creditors to accept, as they would have to write off large tracts of wealth as unrecoverable. In writing off such wealth, it would then cause a complete loss of confidence in all kinds of investment, as investment is built on the trust that there are rules that support a return on investment. If the rules can simply be torn up when it is no longer convenient, and the defaulter suffers no adverse consequences, then on what basis would anyone invest? Would you give an individual, £1000 to open a shop if you were told that he could do anything with the money that he liked, for example using to throw a party, and that if he never repaid the money, then there was nothing you could do about it. You might notice that he owns a house, and a car, but you would have no claim on these things if he failed to repay. You would just be told, 'tough luck'. Would you ever lend again under these circumstances?

What you have in a reset, is an 'unfair' situation and game theory has tested this. In an experiment they sit two people at a table, and say that if the two sides can agree on a division of money, then they will both get the money according to the split that they agree to. In other words they both will win if they agree. Universally, people will not agree if they think that the division of the money is unfair. In these circumstances, they would rather get nothing, rather than get an unfair share. In a reset situation, both sides would benefit, but would benefit unfairly. Game theory shows that the inclination is to not allow an unfair outcome, even at cost to oneself.

Lemming goes on to say the following:

'I think in previous posts you have described how the world economy expanded to such a degree that bottlenecks in the supply of essential raw materials, like oil, caused the expansion to halt, thereby causing an inevitable crash (the economy must expand constantly to keep paying off the interest on loans..?) If a requirement of capitalism is to constantly expand the amount of economic activity towards infinite size (and it sounds as though it is) then the bottlenecks you describe are unavoidable, and no degree of ingenuity can get around them, whatever Adam Smith says. Isn't capitalism just a giant pyramid scheme which collapses as soon as a bottleneck in the supply of energy or raw materials or cheap labour is reached? And like all pyramid schemes can't you point to persuasive evidence that 'it works' right up until it collapses?'

There is an element of truth in this. However, the current circumstances are unique, and that is why the current crisis is unique. It is the scale and speed of the introduction of productive labour into the system, with the emergence of countries like China, that is the problem that makes the bottlenecks so devastating. For example, in China, it is not an inherent fault in capitalism, but a knock on effect that arises from communism. The communist system restricted the productive potential of workers, whilst providing just sufficient resource to keep the numbers of workers expanding. When the communist system was abandoned, the workers were allowed to start reaching their productive potential, and the speed of this development reflected the strength of the capitalist system. It demonstrated the actual potential of the workers. However, in doing so, it provided a supply shock that has only recently become apparent in the evident lack of commodity to supply their new found productivity. As such, the shock is not the result of capitalism, but the removal of a distortion caused by communism. Whilst the capitalist system is flexible, this has stretched the flexibility to a literal breaking point.

The shock is evident in the current crisis, and as I described before, the world has run towards the commodity brick wall, bounced back, and will in due course start running at the wall again. Whilst the wall is moving forwards too, the runner will keep catching up and bouncing back. In other words the capitalist system is responding, but it can not respond fast enough.

DZ followed up Lemming's comment with this:

'If a society deals with interest, then like lemming said, we have to assume infinite growth. However the world is not full of infinite resources. So it becomes a pyramid scheme with the initial lenders gaining the lion share of resources and the guys at the bottom working to pay of ever increasing debt until they give up, which cause market crashes to reset things.

However, take away the "interest on loans" concept away and you are left with trade. Trade is all about dealing in resources so you will have winners and losers but the economic system then doesn't depend upon infinite growth. Instead we rely on increasing productivity to maximise usage of finite resources.'

DZ is right that there are not infinite resources, at least not for everything. However, at the moment resources are still there to meet growth, they have just not yet been harnessed. In principle there is potential for the world to rise up to an overall higher standard of living by better harnessing and extraction of resource. For example, huge areas of Russia are not fully exploited for agriculture (I read about this in the Economist some time ago, but must apologise that I do not have time to find the article). The availability of resources such as oil is more questionable, but the dominance of oil is in part due to its availability. There are arguments that when oil starts to run down that the economic incentives to develop alternatives will be compelling and will therefore spur alternative solutions/structures. This is all debateable, but I personally buy this argument.

With regards to charging interest, what happens if you are a productive person and generate a surplus. Without an incentive to utilise that surplus, why would you use it in any way? Interest allows you to use that surplus to improve the economic activities/performance of other individuals. It also allows people to lend into consumption, which is not always obviously beneficial. However, that comes down to a point of view of whether you believe individuals should be free to accumulate debt. For example, although housing has been confused with investment, for owner occupiers it is also a form of consumption (consumption of a mode of shelter, as well as social status, comfort and so forth). Would it therefore be acceptable to restrict borrowing for this kind of consumption? If this is acceptable then it is hard to find a reason to restrict other borrowing towards consumption.

I hope that I have addressed the points in the comments. There were some other comments I would like to have addressed, but I have run out of time. As a general point, it is really good to see such thought provoking comments on the blog.

Note 2: I have just made one of my regular visits to the New York Times and it makes bleak reading. Retailers are reporting shcocking falls in sales, another report tells of stock market falls inspired by negative news such as General Motors struggling to keep its head above water, and poor figures on unemployment. The 'Obama bounce' is rapidly disappearing, as the hard economic news onces again bites optimism.

Perhaps the greatest concern is that the Chinese economy is also showing signs of strain. Regular readers will be aware that I have always had mixed views on what would happen to the Chinese economy in this crisis, but erred towards the possibility that the economy would hurt, but not as badly as others. This is becoming less and less certain. We have yet to see how the Chinese government might deploy the substantial reserves to support the economy, but the negative side of that for the Western countries is that there is less and less chance of China using the reserves to prop up the world economy. There is also the problem that, if China draws on the reserves, in particular the $US reserves, this will also bring about a collapse in the value of the $US and thereby destroy some of the value of the reserves. It is a very tangled web.

The real worry is that, if the Chinese economy slows sharply enough to bring about hardship, the potential for unrest in China remains high. There have been many reports over recent months of simmering discontent with the government, and my own sources within China are suggesting that there is some anger over government behaviour in general. The consequences of unrest in China are very, very disturbing, so we should all hope that China can ride out the problems without too much damage.

Note 3: I have not posted this link for a while, but for new readers, I would recommend that you read this post if you would like to understand why we are really going through the current financial crisis.