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

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

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

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

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

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

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

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

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

Prestowitz goes on to say the following:

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

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

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

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

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

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

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

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

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

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

So where has this led us?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Reforming Energy Policy

I am writing this post as part of a much delayed, often promised, attempt to deal with the problem of reform of regulation in the economy. One of the reasons why I am starting with energy is that I recently needed to give a presentation to a forum on energy policy, or more specifically whether New Zealand should consider nuclear power. The only reason why I was in any way qualified to talk about the subject was because I have been trained in nuclear reactor engineering, physics, operations and so forth. As such, in many respects, I came to the subject with a relatively open mind on the economics of each of the options, with some suspicions about the economics of certain energy sources.

Energy policy is actually a matter of some importance in the consideration of economics, as it has such a substantial input to so many parts of the economy. The best way to understand how significant it can be is to imagine a situation in which, for example, the UK had access to unlimited free electricity. If we think of this idea, it is becomes apparent how much competitive advantage this would confer. Such an idea is sadly impossible, but it illustrates how important energy actually is.

The most interesting thing about energy policy is how much it is rooted in ideology, and many of the people making the presentations acknowledged this. I found a very good academic paper (1) on the subject, which made the point in reference to the whole way that New Zealand energy policy is framed. It makes worthwhile reading if you believe that energy policy can be anything but rooted in ideology so I have given the reference at the end of the article.

It is impossible for example to extricate any discussion from the consideration of the Man Made Global Warming (MMGW) debate. I am aware that there are some people out there who consider that the science is 'settled', and that anyone who questions the MMGW argument are 'flat earthers'. In all cases the words 'scientific consensus' appears, along with implications that anyone who has a different perspective is 'ignorant'. For all of those that might respond to this post with such arguments, might I suggest that, before you post, you take some trouble to read some philosophy of science. However, this post is not about MMGW, but about reform of the energy provision. The reason why MMGW needs to be dealt with is that it is necessary to accept that there are two arguments, both of which are legitimate, and also that there are debates within the MMGW camp as to how severe the problem actually is, and what should be done about MMGW (e.g. Bjorn Lomborg's arguments against the Kyoto protocol).

My argument about energy reform upsets those who are passionate about MMGW for the reason that my solution does not enforce behaviour, but leaves it to individual discretion. I make no claims fore either side of the argument, but to some individuals, even acknowledging that the debate is not settled is enough reason for condemnation as a heretic.

It is necessary to deal with ideology, for the simple reason that it intrudes so heavily in energy policy, and is creating significant distortions in the role of energy supply. I made this point in the case of New Zealand, where there has just been an election. At first glance, New Zealand appears to have a relatively liberalised market. However, with the change of government, a new energy policy will be implemented, and this will mean that the structure and economics of energy are about to change. If the Conservative Party wins the next election, the same will happen in the UK. Why does this matter?

The simple reason is that, for generating companies, there is no certainty in their long term planning of energy. In particular, whatever the flavour of government, they will implement their own mix of subsidy, cross-subsidisation, planning biases and so forth. In such circumstances, with many energy projects as long term investments, it is quite impossible to plan. As such, I will later address this problem.

Returning to the economics of different energy sources, one of the other presenters looked at the question of nuclear generation in light of the experience in the UK. He pointed out that, whilst the UK government is suggesting that there will be no subsidies for nuclear power, there will in fact be subsidies. I do not have the quotes to hand, but he simply quoted government statements in which the government would make statements such as the nuclear power companies would take their 'share' in the disposal of nuclear waste. As the speaker quite rightly pointed out, who would be taking the rest of the share? One of the interesting points of agreement amongst all of the presenters was that the economics of nuclear power are completely opaque, and that the actual cost of nuclear power is an unknown. Whilst we could all find academic papers, figures from various organisations, there is considerable debate about how to put a real cost on nuclear power generation.

I am hoping that you are starting to see where I am going with this. However, having pointed out that subsidies are hidden in nuclear power provision, it may be worthwhile looking at another example where the costs are buried in cross subsidy. It is impossible not to have noticed the massive expansion in wind power in the UK and, once again, there is considerable debate on what the cost of wind power actually is. My reading on this subject provided some fascinating insights.

For example, there is a report (2) from DENA, a German energy agency, that raises some rather difficult questions about the economics of wind farms. A diagram from the report is provided below:


















The green part of the diagram is the projected capacity of new wind farms in Germany, where wind power has become an increasingly important source of energy generation. I will quote from the report as follows:

'In the year 2015 the conventional power station pool can be reduced by 2,300 MW. This is 6% of the installed wind power capacity of 36,000 MW.'

They go on to say that energy storage systems are needed and that there would need to be enlargement of grid connections between regions to ameliorate the problems. However, there is no escaping the fact that wind energy requires the back up of a source of power that is not subject to the same variability of provision. With a figure of only a 6% capacity credit, there is a substantial problem that to guarantee supply, every MW of wind energy virtually requires a MW elsewhere, and thereby means that the capital expenditure for each MW of capacity needs to be made twice.

As if this were not bad enough, there are substantial problems with how wind power might be integrated into grids. For example, when the wind is blowing, what happens to the capacity in thermal plants? A report from the Irish Grid (3) looked at the economics of what happens to thermal capacity in a situation where it is necessary to adapt to the swings in provision from wind power. They point out that, if thermal plants are run on low loadings they become very inefficient, if they are shut down that increases maintenance costs, as well as being very expensive to start and stop and so forth. Equally, a consortium of energy providers in Germany have written a report (4) in which they point out that switching off capital intensive plants makes the cost effectiveness of these plants very poor (obvious really). Finally there is the cost of attaching these widely distributed plants to the grid, which requires substantial investment, with problems of the economics further hindered by the variability of the units generated versus the capital cost and maintenance of the infrastructure.

As one of these reports pointed out, some of these problems can be ameliorated, but the amelioration involves even greater investments, so does not rectify the substantial additional costs of wind power. All of these problems apply to other variable sources such as wave power and solar power. It becomes apparent that the power generated from these sources is just very, very, very expensive. It is also apparent that the only way that these sources of energy can be viable is through government diktat, direct subsidy and cross-subsidy.

In other words, the introduction of these energy sources is without any economic merit whatsoever. It is here that the MMGW debate enters the picture. For example, the argument is that the true cost of thermal energy is not accounted for, as it does not include the environmental harm that is caused by emissions of CO2. The same argument is being deployed in support of nuclear energy. This has seen the introduction of carbon trading schemes, but carbon trading schemes are actually just another way of implementing a cross-subsidy. It quite literally means that one energy source will provide money to another energy source that generates electricity at a higher cost. Whether there is a real cost to CO2 is a matter of debate, and as I have pointed out earlier there are various arguments even within the MMGW camp as to how much damage CO2 is actually doing. As such, even if accepting the MMGW argument, how can a price be fairly put on CO2 emissions?

There is an even more fundamental problem with the MMGW argument. This is quite simply that raising the cost of conventional power will just serve to further displace economic activity to countries like China. If you are a company that uses a large amount of energy, you will simply move operations to where the power is cheaper, which means countries with no CO2 emissions costs. The oft quoted point that China is building a new coal fired power station every two weeks expresses the problem.

I am hoping that I have now framed the problem. We have a situation in which ideology has seen the introduction of costly sources of energy, thereby driving up the overall costs in the Western economies. The most likely result of this increase in energy costs is the acceleration of the displacement of energy intensive economic activity to countries that have lower cost energy supplies and are likely to see many of the emissions gains offset by displacement. Furthermore, the overall increase in the cost of power will impact on every part of the economy, making almost all activity within the economy more costly. This overall will leave the economy less competitive, and will contribute further to the displacement of economic activity more broadly, such that in the long term the overall distribution of usage of energy will be further displaced to countries like China.

From this perspective, I can now discuss energy policy. The first and most important point that emerges from this discussion is that government needs to get out of the business of determining the energy mix. The solution that I am proposing is quite simple in principle, but would take some deeper consideration to implement in practice.

The first point is that there should be no subsidy, no priority, no cross subsidy of any form of energy generation as a result of government policy. The introduction of wind power, and the covert subsidy of nuclear energy explains why this is necessary. Instead of this, the government should have a role in the following:

1. Stability of supply
2. Free and fair competition (no cartels etc.)
   
3. Immediate environmental impacts
4. Ensuring freedom of choice in source of energy purchase
5. Creating a consistent classification of energy source across providers
6. Some special considerations for nuclear power
   

The energy mix itself should be left to individual consumers. At its most basic this is a system in which energy sources are classified into broad groups. For example nuclear, geo-thermal, wind, coal etc. The government then has a role to ensure that no company uses any form of cross-subsidy from one energy source to another. This is about free and fair competition.

The result should then be that every individual and business has a clear choice about what energy sources they are willing to pay for at what price. When presented with an energy contract, they will need to given the energy source options, the cost per unit of energy from that source, and then they select which source and then prioritise their selections. e.g. If a person is a Green Party member, they may wish to pay for wind energy, and set this as their number one priority but, because of the variability of supply, they may wish to also select hydro as their second selection and so forth. Likewise a steel manufacturer might want to choose coal, with their only concern being cost effective power. A poorer family might also be concerned with price as their priority, and their concern for the economic well being of their family their greatest concern.

As each selection is made, the trading companies will then be committed to using the payments (once they are received) to purchase energy from their first priority where sufficient supply is available, and by their descending priorities. The role of government in this part of the system is to ensure that the companies purchase according to allocations, and prioritise planning for energy generation methods where there is a shortfall in meeting priorities.

This has several advantages. The first is that, unlike having government determining the energy mix, the choices of individuals and businesses are more likely to be be relatively consistent. The exception to this is energy sources which have high volatility in prices, such as oil. As regular readers will be aware, oil has been something of a roller coaster in terms of price over the last year. However, if an energy company wishes to take risks and invest in and offer this kind of energy provision, the risk is their own. For example, if the price of oil rises above their expectations, then presumably very few people will select oil as a source, which would mean that it would be likely that their capacity would become underutilised, and therefore unprofitable.

In my presentation, I did suggest energy security as being within the remit of government. However, I think that, without cross-subsidy, the energy companies would in any case take this into consideration. This is a question mark, and one which I have not fully resolved in my own mind.

With regards to stability of supply, I do think that government does have a role. By stability, I mean reliably delivering energy through the grid to individuals and business without interruption. In particular, there is a role for ensuring that the overall capacity of generation is measured accurately. I have already pointed out the problems with wind, but there has also been a history of problems with nuclear power, for example 'derating' and failure to deliver on expected capacity. This presents stability of supply problems, in particular with regards to the long time frames from a decision to the actual point where a nuclear power station becomes available as an energy source.

This also returns me to the particular role of nuclear energy that does require direct government attention. There are several points that need to be addressed.

The first of these is the problem of waste. In both the UK and US there has been endless wrangling on the subject of waste storage. Until such time that these arguments are resolved, no more nuclear power should be added. In particular, without a finalised solution to the problems of storage, it is not possible to provide a cost for storage. Furthermore, such storage is over such long time periods that there needs to be some very clever arrangements to work out how to continue payments for site maintenance (a very interesting illustration of this is that there has been considerable discussion of the signage needed such that future generations will still be aware of the dangers in the storage place).

A related problem is the cost of decommissioning. This is a very costly business, and there are still significant question marks over how much it might cost. If the cost exceeds provisions made for the decommissioning, one way or another, the taxpayer will foot the bill. It is not possible to just leave a nuclear power station to rot away. The solutions to date have been to allocate revenue to the eventual clean up. However, the costs of decommissioning have generally been poorly estimated. This raises a more fundamental question; what happens if the investment is made, but the energy becomes relatively expensive. In this situation not enough revenue will have been put aside for the cost of the decommissioning. The example of Italy provides a telling case study of how the costs of abandoning nuclear power can be very high indeed. In short, until someone can come up with a way of guaranteeing these costs can be met, it does not seem that nuclear power can be seen as a viable option. You will note here that I am not against nuclear power, but I am against un-costed nuclear power. It is simply a case that, at the moment, governments are having to sign a blank cheque.

There are other particular concerns with nuclear energy that are not too problematic, such as ensuring safe design and operation of reactors. For those who mention Chernobyl, I would point out that the reactor was not designed well, and that the operations that caused the disaster were quite simply foolish. The standards of design in existing Western reactors are far safer, and the generation III reactors even more so. However, all provision of nuclear power would still need to insure themselves against accidents, and without any subsidy.

The last point I have not covered is that of a government role in local environmental impacts. Whatever the form of a utility, having a new utility built is likely to have an impact upon both business and individuals in the locality. In other words, there will be winners and losers. Government does have a role to play in trying to find a compromise between the need to build new energy sources and those who might be losers from such provision. The role should be an alternative to court action, where the parties involved seek government provision of binding arbitration over what the costs might be, and how they are resolved.

I am not sure whether I have argued this as well as I hoped, as there is only so much time I can put into this. The complexity of this issue is such that there is no easy summary, so comments and elaboration are particulalry welcomed (whether positive or negative, excepting those who would like to equate me with a holocaust denier). I mentioned at the start that one of the points in all of this was to highlight the distortions of policy, and also to highlight the element of distortion that is based in ideology.

My main point here is that the effects of these can be ameliorated by opening up the rather opaque business of energy generation to real scrutiny of the costs of each of these sources. In this way, ideological positions can be expressed in real choices. At its most simple, the approach is to delegate choices based upon ideology to the individual. If a person believes that wind power is a 'good thing' they should have the opportunity to support this method. If a person does not support wind power they do not have to subsidise the energy. More to the point, the economy will be able to function better when the real costs of all of these energy sources are explicit. In the case of nuclear power, once the subsidies are removed, it will focus attention on whether this power source really is cost effective. Finally, such a system would hopefully help to stop the displacement of economic activity from countries such as the UK to China. As I have mentioned, all this will do in the long term is move any problems of emmissions to a new place. At the very least, even if you accept MMGW, the problem of displacement needs to be resolved.

I think that, of all of my posts, this will be the most controversial. This is a highly emotive subject, and my request that it be left to individual conscience will not suffice for many. I have also not even started to touch on distribution, which is another area of great complexity. I had hoped to use some work I did on monopoly provision in another sector as a point of comparison, but do not have the time to include this. Above all else, my aim in what I am proposing is to realign energy provision with economic choices, and to remove particular ideological points of view from energy provision policy as a whole, whilst offering people the opportunity to express their ideology if they so please.

Note 1 added 29 November:

A response to the comments on energy reform. I knew, as even as I was writing the post, that it would get some negative comments. As I mentioned it is a very ideologically based subject. With regards to one point, it seems that I did not explain myself very well. I will therefore seek to clarify the point. Lemming commented that wind power just needed subsidy so that the industry could achieve economies of scale. The whole point about my post on these kind of variable sources of power is that they can never be economic, or at least not untill a way is discovered to store their power economically. In light of the fact that this was not understood, I will explain again.

The first point to note is that energy supply is just another form of manufacturing. Instead of manufacturing units of product, it is the manufacture of units of electricity. In both cases something is being converted from one thing into another thing, with (hopefully) more added value in the final product as a result of the conversion process.

I will therefore use the example of ready meals as an analogy, and for the sake of analogy, we will imagine that the ready meals have to be sold to the supermarkets within hours of manufacture (they are delivered hot and genuinely ready). Now, if we have demand for 100 units of ready meals a day, then we will normally build a factory that allows us to manufacture those 100 units per day. However, as we know, demand for products such as ready meals can vary. As such we build storage into the system (warehouses that will keep the product hot), but keep that storage to a minimum, as it increases our costs significantly. We also build a factory that will manufacture with enough of a safety margin sufficient to maintain supply of the ready meals in peaks of demand, perhaps a capacity of 110 units per day.

Now instead of this perfectly normal arrangement, how would we think of a proposal that we build our ready meal factory in an out of the way place, where the workforce were an unusual bunch of people who would only turn up to work when it suited them? Whatever you did, even asking them their views on their plans to arrive for work the next day, you could never be sure whether they would come into work, or how long they would stay. Now these rather odd workers are a vital input into to the production process, but you never know how many are going to arrive on any given day. You know that, on average, maybe 30% of the workforce will arrive for work, but some days none arrive at all. The one advantage of these workers is that they are very, very. very cheap. So cheap that they are nearly free of cost.

Another problem is that the location of these very cheap workers is that they live on a mountain top with no road. As such, you will need to build a new road from the mountain top to the valley below so that you can distribute your ready meals.

The problem that arises from all of this is that you have a contract with several large supermarkets to provide them with your ready meals. As part of that contract, you must provide them with as much of your product as is required. If you do not provide your product, they will de-list you as a supplier. In other words, your business relies upon providing the product reliably. How are we going to manage this problem.

The first solution is to build lots of factories to supply our ready meals because, on average, at least one of the factories is likely to have enough workers available. The trouble is that we are then in the position of having to make lots of factories in which we know that there is going to be idle capacity. This makes the cost of capital for our factories very high. Now, the second problem is that all of these factories need a special road. This increases our capital costs significantly, with each factory requiring its own special road. However, because we have to distribute the factories over many locations, we have the problem that each factory is relatively small. Whilst this makes our factories more reliable, it makes the relative cost of the roads even greater.

The company decides that, whatever the problems, the attraction of the cheap workers is enough justification to do build all the factories. After a while however, they notice that the variability of workers coming into the factories is such that they appear to have wild swings in their capacity to make their ready meals. One of ther operations people analyses the problem and concludes that, the probability is that, on a bad day, only 6% of the workforce will show up for work. This poses a problem because, on a bad day, there will only be 7 ready meals made. This is a guarantee that the contract will be lost.

Someone then comes up with a bright idea. In addition to the factories on the mountains, they can keep a normal factory as well. Whilst the workers in this normal factory are quite expensive, they know that they will be coming to work reliably every day. Whilst they have holidays every year to recuperate, they can plan for these. Furthermore, the factory can be built right next to the highways, making distribution of the ready meals very easy and cheap. They go ahead with this solution, and build a factory with the ability to manufacture 103 ready meals per day (110 - 7). They then have a problem. What happens when there is a good day at the many mountain top factories, a day when all of the workers turn up. It makes sense to send the workers home in the normal factory and shut the factory down.

The trouble is that, when they shut the factory down, they have to switch off all of the heaters for the cooking equipment and the equipment takes a while to run up. This causes several problems:

The first is that bringing the heaters up to temparature is expensive and the other machinery needs more maintenance when it stops and starts. The trouble is that, even when the mountain top workers do show up for work, they occasionally get bored and go home anyway. In this event, the normal factory will have to restart production.

The second problem is that, whilst the normal factory is idle, it is still expensive because it utilised so much capital. Whilst the investment in the factory makes sense when it is producing between 90-103 units, if the capacity drops below this it becomes very expensive for each unit produced.

One person suggests a solution that, with the variability of the mountain top workers, it is possible to vary the output of the normal factory. In other words keep it running most of the time, but adjust the output according to the numbers of workers who show up in the mountain factories. The trouble is that, whilst this is possible, the costs of the normal factory go up, as there is less output but all of the heaters for the food, and production lines, consume a similar amount of energy, regardless of the capacity running through the factory, thereby increasing the cost per unit of ready meal.

Another solution is proposed, and that it to build a huge warehouse, which will keep the ready meals hot and ready, and this would create a sufficient buffer for when the mountain top workers failed to show up for work. The trouble is that building this kind of warehouse would cost a huge amount of money, making this a very, very expensive solution.

In the boardroom of our ready meal factory, they are very worried. They have already spent a lot of money on the mountain top factories, having been told about how great it would be to utlise the cheap workers. They have tried it out, and yet they can not make sense of how to use these cheap workers. If only they were reliable, and turned up to work every day, it would be wonderful. Instead, what they find is that they are using more than twice the amount of capital to have the capacity to provide a capacity of 110 ready meals to their supermarket customers.

Even when there is reasonably good day, when a good number of the mountain top workers arrive for work, they are not making the gains they expected, because of the increased costs in the normal factory offset many of those gains. They note that stopping and starting the factory increases maintenance costs, and that the cost of bringing all their heaters up to temparature is surprisingly high. On the other hand, if they leave them on, and run their factory at low capacity, then the cost per unit is painfully high. But they must have the full capacity if they are to stay in business.....it is no good asking the supermarkets to allow for days when there will be few ready meals available. They demand that they are always supplied reliably with the ready meals...

The only conclusion that the board can come to is that, whilst those cheap workers looked so enticing, it is not possible to use them when they are so unreliable. Any savings on worker costs are largely offset by the costs that this loads on the normal factory, and with the high cost of capital, the capital allocation to each ready meal unit has doubled. This is making their ready meals much more expensive per unit, not cheaper. If they could only find a cheap way to store the capacity of mountain top workers, it might just work, but even then the additional capital costs of having so many small factories will still make it questionable as to whether this will be cost effective.

This is exactly the problem facing wind and wave energy, and to a lesser extent solar energy. Whilst hydro and geo-thermal power can offer reliable energy, these other 'green' energy sources are like pouring money into a great big black hole. Tidal power has predictability, but has other problems. In this case it is predictable as an energy source, but it is again of variable strength, at different times. Whilst tidal energy might produce a least a little power at any given time, the efficiency of energy utilisation at low levels of tidal flow magnify the losses. In a few cases, it might be possible to engineer solutions to get around these problems, so tidal energy remains a possible source of 'green' energy. However, whether reliable schemes could be engineered that might supply energy at a reasonable cost is questionable. On this subject, each scheme needs to be evaluated on a case by case basis.

At the heart of all of these problems is that, as yet, no one has come up with a cheap solution to the energy storage problems. This is the only way that these variable generation methods might make sense, but even then there are often the increased capital costs to supply these sources to the grid (wind and wave power in particular). In other words, the problems of energy storage just make these energy sources even more capital intensive, and therefore much more expensive as a source of each unit generated. Whilst such energy storage solutions remove the need for doubling the capital cost of each MW generated, they merely displace the capital cost to energy storage. Either way, the energy cost is absurdly expensive.

One alternative proposed is the use of electric cars, with the electric car batteries acting as reserve of supply. However, until such time as everyone has switched to electric cars, this is speculative, and does not address the problem that wind power capacity is being put in place now, even though it is unusable in any economic or sensible way. I am not sure that this is a 'green' solution either, as batteries have their own negative environmental impacts. However, this is beyond what I want to discuss here, and not something I have looked into.

Essentially, as it stands, wind power is just a 'feel good' solution that offers no real solution at all.
I hope that this goes some way to clarifying my point.

Note 2 added 29 November:

Another point made was to ask how me might know whether supplies of some materials might be subsidised in another country. I have no problem with the idea that another country might want to subsidise the cost of energy in the UK. If they wish to do so it is very foolish of them, but is all well and good, as they are indirectly giving away their wealth to the UK.

Note 3 added 29 November:

A couple of posters made the point that people would vote with their wallets, and would presumably not accept the 'green' solutions. Here we come to the crux of it. For some people, they believe in MMGW, and believe that any price is worth paying to ameliorate the effects. Others are sceptical, and believe that there is no substance behind the claims. For many others, the reality is that they care more for their immediate economic concerns, having a job and so forth. This is, for example, the point made by China as a whole, but equally applies to individuals. If the Chinese government accepted MMGW, they would act in concert with other countries in acting to ameliorate the effects, as it is something that will start to effect them as much as anyone else. However, they are not acting, and presumably just do not accept the case for MMGW. Whilst they make the right noises, their behaviour is not consistent with this. It can not be emphasised enough that they will be effected equally by MMGW if it is correct, and they would not act as they do if it was going to harm themselves.

In other words MMGW is not accepted by everyone, and the cost of the solutions will be real costs upon the economy. As I have pointed out, the real cost of 'green' energy is that manufacturing will move from the countries with high energy costs to those with low energy costs. In other words, as I have emphasised, the high cost of energy in the West will just see further displacement of economic activity to economies such as China.

The really big users of energy, such as aluminium smelters, will move very quickly to another country if energy prices go up significantly. The only way this can be prevented from doing so is through heavy subsidisation of inefficient methods of energy generation. However, subsidy comes from taxation (or government borrowing in the current poor economic approach) and therefore still makes doing business more expensive, just indirectly. In the case of energy being priced without subsidy, big energy consumers will move to another country. This will be direct and visible, and would cause an outcry. On the other hand, with subsidy, the cost of the subsidy will be more evenly spread accross the economy. This means an increase in costs for every individual and business. This means the overall competitive position is weakened, and creates an aditional incentive for all business to move to the East. The effect will be the same as, for example, as big energy hungry companies moving to the East, but it will just be less visible. As such, subsidy is a more politically acceptable way of displacing jobs and businesses to the East.

In the event that this happens, the gains in reduction of CO2 emmissions will be minimal, but with the commensurate damage to the economy. This brings me back to the point about energy users voting with their wallets. If a business thinks that it can afford 'green' energy, and still stay in business, then they have that option. They might even promote their business as being 'green' for doing so, and gain competitive advantage in doing so. On the other hand, if a company does not believe that they can afford the high costs of 'green' energy, they can continue to use conventional sources of energy.

Equally, in the case of individual choices, for a family who may be on low income, where energy use is a large percentage of their expenditure, they have the choice of where their priorities are. The economics of energy is that high energy costs fall disproportionately on the poorer members of society, as it makes up a greater part of their income. Added to this, the disappearance of manufacturing jobs disproportianately impacts upon the less well educated, so has a greater effect on the less wealthy.

The point I am trying to make here is that expensive energy is a luxury. If one group of people think that their priority is 'green' energy, they should be allowed to pay for it, but if another group does not have that priority, then why should they have to pay for it, and pay for the consequences to the economy. The cost of 'green' energy is fine, as long as it can be afforded. I am simply saying, let individuals and businesses decide whether they can bear that cost. After all, for every increase in the unit cost of power, there will be a percentage increase in displacement of industry and economic activityto the East, meaning the impact of 'green' energy policy will be minimised.

Were the introduction of 'green' energy universal, including places like China, the net effect would be a reduction in output around the world, as energy input costs would go up. However, I would be far more amenable to such a situation, as the cost would not be falling disproportinately upon the Western economies, with the minimal effectiveness caused be the displacement of economic activity that goes with such a scenario.

I am aware that this is a contentious subject, and knew that it would upset some people. However, I would rather that we faced up to the real costs and minimal impacts of adopting expensive energy production. I hope that the blog does not lose readers because of what I am saying but, alas, I try to view the world as it is, not how we would like it to be. I therefore just see 'green' energy as another element that will contribute to the decline of the West relative to the East. Even if accepting MMGW, the 'green' policies of the West will make very little overall impact. And the cost will be high in terms of economic decline.

(1) Gunn, C 1997, 'Energy efficiency vs economic efficiency? : New Zealand electricity sector reform in the context of the national energy policy objective', Energy Policy, vol. 25, no. 2, pp. 241-54.

(2) Tiedemann, A 2006, Grid Integration of Wind Energy - Results of Dena's Gridstudy, IEA Workshop on 'Integration of Renewables into Electiricty Grids'

(3) ESB National Grid 2004, Impact of Wind Power Generation in Ireland on the Operation of Conventional Plant and the Economic Implications

(4) DEWI, E.On, EWI et al (2005), Planning of the Grid Integration of Wind Energy in Germany Onshore and Offshore up to the Year 2020

Note 1: Sorry I have not referenced more, which was my original intention, but the time this has taken is longer than I had hoped. If I have time I may return to this and add some more references. If I do so, I will as always note that I have made changes.

Note 2: Kecske, thanks for the link. I had come accross this outfit through my reading of the Economist but had not looked into the subject further. Very interesting. The link is to a site that has a pragmatic and interesting approach to environmentalism. However, they still accept subsidy and distortions as part of their philosophy.

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.