The King Canute Economy

I have had a good day in browsing through the economic news, as I found three very interesting articles which together represent a consistent theme (although I say lucky, I mean only in the finding but not the implications of the content). The first of these comes from Ambrose Evans-Pritchard, the second Peter Schiff, and the last Liam Halligan. For the former, Ambrose Evans-Pritchard, I often disagree with his analysis, but can not dispute that he often identifies some fascinating stories on the economy. Today, I came across an article which is of particular interest, and some highlights are given below:

In a report entitled "Worst-case debt scenario", the bank's [Societe Generale] asset team said state rescue packages over the last year have merely transferred private liabilities onto sagging sovereign shoulders, creating a fresh set of problems. [this was exactly my argument at the time the first bailouts were being undertaken]

[and]

Governments have already shot their fiscal bolts. Even without fresh spending, public debt would explode within two years to 105pc of GDP in the UK, 125pc in the US and the eurozone, and 270pc in Japan. Worldwide state debt would reach $45 trillion, up two-and-a-half times in a decade.

[and]

Inflating debt away might be seen by some governments as a lesser of evils.

If so, gold would go "up, and up, and up" as the only safe haven from fiat paper money. Private debt is also crippling. Even if the US savings rate stabilises at 7pc, and all of it is used to pay down debt, it will still take nine years for households to reduce debt/income ratios to the safe levels of the 1980s

I strongly recommend reading the article in full. All in all, this is not far from the kind of scenario that has long been painted on this blog. Shifting debt from the private sector onto the public sector, at exactly the time that the public sector would be starved for revenues, was always going to be a disaster.

In another article Peter Schiff, a long term bear, touches on another theme of this blog - the role of China in the world economy, and the artificial low level of the RMB in relation to the $US. The SocGen report and Schiff's report are actually just looking at two sides of the same equation. If we put the two reports side by side, it is apparent that both of the reports are actually discussing exactly the same problem - which is that governments have sought to replace private debt with government debt, and that the only route out of the debt is eventual currency devaluation. In replacing private debt with public debt, the imbalances in the world economy will be maintained. This is an extract from Schiff's article:

While the peg certainly is responsible for much of the world's problems, its abandonment would cause severe hardship in the United States. In fact, for the U.S., de-pegging would cause the economic equivalent of cardiac arrest. Our economy is currently on life support provided by an endless flow of debt financing from China. These purchases are the means by which China maintains the relative value of its currency against the dollar. As the dollar comes under even more downward pressure, China's purchases must increase to keep the renminbi from rising. By maintaining the peg, China enables our politicians and citizens to continue spending more than they have and avoiding the hard choices necessary to restore our long-term economic health.

[and]

As demand falls for both dollars and Treasuries, prices and interest rates in the United States will rise. Rising rates will restrict the flow of credit that is currently financing government and consumer spending. This change will finally force a long overdue decline in borrowing. So, not only will Americans lose access to the consumer credit that funds their current spending, but the things they buy will also get more expensive.

Our short-term loss will be in sharp contrast to the gain felt by foreigners, who will be rewarded with falling consumer prices and a more abundant supply of investment capital. In other words, the American standard of living will fall while that of our trading partners will rise.

As for Liam Halligan's article, he reports on a report from the OECD as follows:

Less prominent was the admission that: "The upturn in the major non-OECD countries, especially in Asia and particularly in China, is now a well-established source of strength for the more feeble OECD recovery". So the Western world is relying on the emerging markets – the far-flung economies of the East – to pull them out of this slump.

The West's debt-soaked consumers, firms and governments badly need to "de-leverage" – which channels resources into interest and repayment costs, rather than expansion. The likes of Brazil, China, India and the others, meanwhile, have far, far lower debts than their Western rivals, so can spend the next few years "levering-up" – taking on more credit, in turn fuelling growth even more.

All of these articles relate to and article I wrote a long time, explaining the underlying change in the world economy, and which explained the economic crisis as the shift in wealth generation from West to East. In particular, the opening of the East saw a sudden massive expansion of the labour force (labour meaning with access to capital, markets and technology).

My argument was that the massive credit and housing bubbles were simply masking the underlying change in the world economy that flowed from the supply shock of new labour into the world economy. I have written several versions of the article, but my version on Huliq is a short version and can be found here (note: there is an error - zero sum 'gain' should be 'game'), or a fuller discussion can be found here.

What we are seeing in the reports and the analysis of the three articles cited here, is the process of governments seeking to hold back and resist the fundamental change that has taken place. The change that I am referring to is that there is a massive redistribution of wealth, and that there is now a situation of hyper competition throughout the world. In an article for Trade and Forfaiting Review magazine, I explain this in simple terms by making a comparison between the fortunes of SUV car manufacturers and the Tata Nano car:

While the US and, to a lesser extent, Europe are seeing catastrophic contractions in their car markets, the Tata Nano has a massive waiting list among Indian car buyers, keen to upgrade from two wheels to four. The contrast between the old industry, perhaps best exemplified by General Motors, and this innovative upstart illustrates the new shape of the real-world economy.

The important point about the Tata Nano is that it is meeting a new demand from a rising middle class in emerging economies. In the interim, the credit-fuelled demand for SUVs, the mainstay of US car industry profits (until recently), is collapsing. On the one side there is a car that rests upon an unsustainable credit-fuelled consumption boom, a car that flattered the aspirations of the indebted and, on the other, there is a car that meets the rising aspirations of the world’s new wealth generators.

The point is that SUVs represent a concentration of car-owning wealth in the hands of the few, and the Nano is the shift of that car-owning wealth into the hands of the many. It is representative of the underlying shift in real wealth, which is redistributing towards the East, and levelling down the West in the process.

It is a crude characterisation of the change in the world economy, but many large companies such as GE are already changing their product lines to meet these changes. The middle of the market has shifted down whilst broadening. The problem is that these changes are real, and are taking place now. Governments are seeking to withstand the reality of the changed circumstances of the world. The trouble is that, as much as any government might resist the change, it is unstoppable. Nobody is going to put the 100s of millions of new workers back in a box - and there are still large reserves of labour ready to enter the market.

It is only when the economy is seen in this light that we can truly see the madness of government policies - whether the policy of China, the US or the UK. Each country is seeking to maintain an equlibrium that never actually existed. The credit and housing bubbles in the West flattered the underlying condition of economies such as the UK and US, and the world economy was misdirected to feed the illusion of wealth in the West. The overall structure of the underlying economy is the Tata Nano economy, but all governments are seeking to maintain the SUV economy. In doing so, the imbalances are becoming ever larger, as ever more is owed by the current account deficit countries to the surplus countries. The growth in the imbalances is simply going to make the final adjustment ever harder.

I call this the 'King Canute Economy'.

In the legend of King Canute on the sea shore, it is popularly represented that King Canute was so arrogant that he actually sought to hold back the tides. However, King Canute was actually demonstrating that, for all his power, there were some forces which he could not overcome. As we contemplate the actions of governments around the world, it is possible to wonder whether they have ever heard King Canute's story.

In the case of King Canute, he ended up with wet feet. In the case of the world economy, the consequences might not be so mild.

The $US - Some Musings...

I made an error just under a year ago, in predicting an early collapse of the $US; I predicted a collapse by April of this year. When the collapse failed to materialise I was forced to look at my model of the world, and explain why I had been wrong. Up to that point, my model had been reliable, and had managed to explain what was taking place in the world economy. Having been wrong before, I will this time discuss the $US in terms of 'musings' on the future.

My conclusion on reflection of the erroneous prediction was not that I was wrong about the underlying weakness of the $US, but that I had been wrong about difficult it would be to shift perceptions about the $US in world markets. I had written an article titled "The Myth of the Eternal Status of the $US as 'the' Reserve Currency", and still stand by the discussion laid out in this article. Reserve status can only protect a currency for so long when the fundamental poor state of the economy is apparent.

As an explanation for the error of the prediction for the collapse, I adapted Dan Ariely's anchor price theory, and therefore accepted that it would be difficult to shake the 'faith' in the $US. Putting the argument in simplistic terms, the belief is that because the US economy has always been a success, it is difficult to shift market perceptions to see the US economy as it is now. Quite simply, markets are valuing the $US on past performance of the US economy, not on the performance now. People have blind faith that somehow the US must recover the economic crown that it has worn for so long.

The US government is now intent on testing that faith to the limits, and the cracks are starting to appear in the faith. The bond markets are now appearing to shift:

Figures released by the Treasury Department this week indicated that China reduced its holdings of Treasury securities by $25 billion in June, the most China had ever sold in a month.

Monthly figures can be volatile, and can be revised, so it is risky to draw conclusions from one month’s data. In May, China increased its holdings by $38 billion, according to the Treasury figures.

Nonetheless, the decline highlighted a fact shown in the accompanying graphics: Asia’s appetite for Treasury securities is not growing as fast as it once did. That means the United States will have to turn to other buyers, including American citizens, who are now saving as they did not do during the boom years, to finance the deficits.

The article is right to point out that one month's figures are not enough to be meaningful, but the figures will no doubt spook the market to some degree. The worry about the Federal Reserve's purchase of treasuries with printed money is already raising concerns, and the possibility of a $US rout is being discussed in the mainstream media:

Mr. Buffett worries that U.S. policy makers will fail to move decisively to curtail the nation's ballooning net debt, expected by some to rise to more than 75% of annual economic output by 2013. Instead, policy makers might tolerate higher inflation, which makes existing debt more manageable but would hurt the U.S.'s creditors, including China and Japan. In this scenario, investors would demand much higher interest when lending to the U.S. government, raising its borrowing costs and making further budget deficits harder to finance, at a time when an aging population will sharply boost the costs of Social Security and government-sponsored health care.

Doubts about the dollar are building while investors are growing comfortable with the idea of emerging economies like China, Russia, and Brazil playing a bigger role in shaping international finance. Some analysts, including Pimco portfolio manager Curtis Mewbourne, say emerging economies have an opportunity to use the crisis to reduce their reliance on the U.S. dollar, which tends to account for most of their foreign-exchange reserves.

It now appears that, with a rising savings rate in the US, the individual US investors are starting to take up some of the slack. This might be seen as a positive but, whatever happens, there still needs to be an influx of money from outside the US economy, if the US economy is to continue on the current path. In particular, the US is still running a current account deficit, and the only way to fund such a deficit is through overseas borrowing or further printing of money. Furthermore, the question remains as to whether the US savers have the resource to step into the breach in the event of an overseas exit, and whether they will continue to fund the deficits if the $US starts a dramatic fall.

Then there is the matter of yields. In the event of a shortfall in overseas purchase of US debt, can savers step up to the plate to an extent that they might hold yields down, or will they demand risk premia based upon a declining $US?

Whichever way you look, the prospects for the $US do not look good. Most importantly, the printing of money by the Federal Reserve to purchase treasuries is setting up a feedback loop; the higher the volume of purchases, the less the confidence in treasuries, and the more that the Federal Reserve must buy. It is very difficult to see how it might be possible to climb off the quantitative easing treadmill once the process has been started, in particular in the case where the policy is used to monetize government debt. Then there is the question of political influence.....with governments on a spending spree, with promises of sunny days in the future, no plan for deficit reduction, the pressure on the Fed to continue purchases will be high.

I learned my lesson before about naming a date for the $US to collapse. I am also not so sure now that a sudden collapse will be the outcome, but this is still possible/likely. It seems possible that the process might be a more steady decline, including moments of recovery, but with a declining trend. In all cases, the $US must, one way or another, decline in value relative to other currencies.

However, having said this, which currencies might the $US decline against? For example, the fundamentals underpinning sterling are perhaps weaker than the $US. The Euro area has its troubles, as does Japan. I argued before in TFR magazine that there would be a period of volatility, as investors flee in and out of different risks. I will admit that I have no clear answer to this question, and it is head spinning material trying to work out how a $US decline might play out globally. As simple example, what of the petro economies? How might a $US decline impact upon these states, and how will that impact upon oil prices. The $US remains so central to the world economic system, it is impossible to untangle how it might decline relative to other currencies, with further complications being caused by the state of the economic situation in the other major currencies.

Quite simply, the question that arises is how the world economy might pull itself out from the domination of the $US? It is a question on which fortunes will be lost, and fortunes will be made. It is a question of timing and a question of process, but the underlying problems will eventually make themselves felt, in one way or another. The $US is on the slide, and it is unlikely that the slide might now be reversed....the doubts are now cracking the walls of belief and, without 'belief', the $US has little left to support it.

Government Borrowing - How exactly will it be repaid?

In amongst all of the headlines, and all of the chatter about the economic crisis, there is a question that does not seem to appear. It is the most fundamental question when considering the question of what is, and what is not, the right thing to do in the current crisis.

I have spoken about this before, but I think the subject needs a post that directly addresses the question, and that question is as follows:

Exactly what will be the source of economic growth that will pay back the huge borrowing that is being undertaken by governments?

I have just posted on the Guardian newspaper's 'Comment is Free' forum, asking this question (you can find it here - I post under the name MarkinChina). It is the second time that I have asked the question. The first time, nobody responded to the question. So far, at this early stage, I have had the following response, which inadvertently points out the problem:

MarkinChina - I fear your question - while well-meaning - is a crass one. We are now painfully aware of the problem you succinctly outline - what we want is some sorta answer to get us out of the mess the idiots got us into. Just to rephase the problem as you have done is too easy.

For the record I believe the debt will almost certainly be repaid off by massive inflation a few years down the line.

Meantime - while our money is still worth something - borrowing more to give us a better future is probably the least bad solution.

I will not criticise this person for this response, as what they are actually doing is recognising that the price of the profligacy of today will be paid tomorrow. At least in this case, the poster recognises that borrowing without any way of paying it back will have unpleasant prospects down the line.

For my consideration of this question, I will focus on the UK. For the (many) US readers, I think that you will find that many of my points will apply to the US as much as the UK. The starting point for this question is to return to 'A Funny View of Wealth' and consider what actually might produce wealth. In a Funny View of Wealth, I listed the following:

• Commodities extraction and processing
• Manufacturing
• Agriculture
• Export of services
• Inbound Tourism
• Services (provided that they are not paid for through borrowing)

It is a fairly crude characterisation of the discussion in the original discussion, but will suffice for the moment. When we look at this list, the problems become apparent. Our main source of commodity wealth is North Sea Oil, and this is now in steep decline. Manufacturing has been declining for many years, and there are no new industries or technologies that show any promise of ameliorating that decline, let alone reversing it.

Agriculture is mature, but may see some improvements of output, but only if GM technology is widely adopted. This is controversial and, even were this course to be followed, the improved output would probably not make a significant difference to UK output pverall. With regards to tourism I pointed out that we spent more on outbound tourism than we received on inbound tourism. The relative impoverishment of the UK may serve to reduce that imbalance, but is unlikely to see the sector generate a surplus. Our greatest export of services was in the financial sector, and I think very few people would suggest any growth, even to pre-crisis levels, for a very long time. Finally, for services, this growth is built upon the growth of the others.

None of this is to discount the discovery of a new technology or process. In recent years, Vodaphone emerged on the back of a new technology, and is now a global giant. These kinds of developments are always possible. However, it would require the emergence of many such companies to start to provide the wealth required to pay back the borrowing that is now being undertaken. Perhaps a better example than Vodaphone, in the context of this discussion, is Dyson. The founder of the company famously committed to manufacturing in the UK, only to later move operations to Malaysia. He could simply not remain profitable whilst manufacturing in the UK. As such, there is always the possibility of the emergence of new companies, but how much wealth they will generate in the UK is questionable. The Vodaphone and Dyson stories do not make a case, but do serve to illustrate that whilst growth is possible, it will not be easy. The ongoing decline in manufacturing serves to illustrate the point more clearly.

Whichever way that you look at the UK there is no certain area of growth that can currently offer a way of repaying the borrowing. Whilst we can not discount an amazing Renaissance in business, and the growth of whole new sectors, there is nothing to indicate that these are about to happen. Instead, what we are seeing is the massive contraction in the inflated (bubble) service economy, with no commensurate growth in other sectors. More to the point, we are starting to see a severe contraction in sectors such as manufacturing.

When I first wrote a 'Funny View of Wealth', I was painfully aware that the UK was not providing the new businesses to ensure the long term future for the UK's wealth. Since I wrote the essay, the situation has become worse, rather than better. At the time of writing, the UK already had a major debt problem, but that problem is now becoming huge. None of that increase in debt has gone into the development of wealth creation activity, and the problem is that the borrowing will now be a further constraint on the prospects of economic growth, as the productive sectors of the economy will be required to service the debt. Under such circumstances, the emergence of another Vodaphone becomes less likely, and the probability of another case like Dyson more likely. The weight of servicing the debt, will just be a further weight on the economy as a whole.

It is at this point we return to the commentator on 'Comment is Free'. He is quite right that the only solution to the debt problem would be 'massive inflation', but that is not the future that I believe that he really wishes for. I have posted at some length on this and related subjects in other posts, so will not repeat myself.

I have just returned to the 'Comment is Free' forum, and I find none of those praising the use of borrowing for scheme x, y or z are answering the question of how it will all be paid for. The only other reply that acknowledges the problem of repayment of the debt is as follows:

Markinchina - the reason no-one has answered you is that the answer is rather unpalatable, both for the UK economy and because of our size, the world economy; these debts will never be repaid. Ecomonies with enfeebled manufacturing bases and significant imports of foods and manufactured goods will see their currencies collapse, their standard of living relative to the rest of the world eroded, and the debt inflated away. I think you have to look at Argentina from about 1930 to 2000 to see the way the UK is heading. And they could feed themselves!

Me and my partner will probably leave this country (nothing too adventurous - Oz/NZ or US for us) in the next 2 years and I would advise anyone who can to do the same.

The only person who has thought about the reality of the situation is fleeing the country. There you have it. The rest are the 'buy now, pay later' generation in action. Whilst the forum is in a left leaning paper, I suspect that the wish not to confront the reality is a widespread phenomenon. With such views, how can change ever take place?

Note 1: I published the tax reform post, as promised, but a strange quirk of blogger means that it was not published on the home page. The post can be found here. Apologies for that.

Note 2: The next project on the subject of reform will I guess be a subject of particular interest to many regular readers. I will be taking a look at the central bank system, banking regulation, fractional reserve banking and how the system might be reformed. It may take me a while as I have many commitments at the moments, and it is also a very complex subject. In the meantime I will comment on any particularly developments, provided that they are of broad significance.

Note 3: There have been many interesting comments on the last post I made. I will try to address some of these as soon as I have time.