The Origins and Development of the Economic Crisis

I thought it might be time for a review of the big picture. How we got to where we are, and the underlying problems in the world economy. For regular readers, much of what I will discuss will be familiar material, but some may also be new. However, this post is primarily aimed at the newer readers of the blog and the aim is to offer a framework that explains why my analysis is such as it is.

To start at the beginning, I wrote an article called 'A Funny View of Wealth', in which I identified a fundamental flaw in the UK economy (and which might apply to many other economies such as the US). I wrote it before the financial crisis, and my approach was to review each potentially wealth creating sector of the UK economy. On reviewing each of the sectors, I realised that there was no sector that could possibly explain the apparent increase in wealth in the UK in the 10 years preceding the essay. Instead, what I saw as the only explanation was that there had been a massive growth in personal debt, alongside some growth in government debt (if I recall correctly, I think I included the off balance sheet liabilities). I was very worried, and it turned out, rightly so.

As the banking crisis emerged upon a startled world, I became increasingly horrified at the actions of governments in response to the crisis. I argued strongly that the response to the crisis would eventually backfire on sovereign states, and we are watching this process now unfolding. My analysis of the situation has always been different from every economist, analyst and commentator, and I still hold with my view that the banking crisis was a symptom of an economic crisis, not the cause of an economic crisis. As time has passed, the analyses of the problems have largely been dominated by one, or a combination of, the following:

1. It was de-regulation of the banks that caused the problem
2. It was greedy short-termism of the markets
3. It was the central banks running lax monetary policy
4. It was the housing bubble
5. It was the credit bubble
6. It is an imbalance in world trade
7. It is a corrupt stitch up by the banks in conjunction with government
8. It is the inevitable result of a fiat money system

I may have missed a few, but these are the explanations that come most readily to mind. Having presented these explanations, I have given some of the common ideas of the cause of the current crisis, but these do not really explain the problems of the world economy. Instead, my argument is that these causes are contributory, not the main cause. As such, it seems that I should explain the underlying problem.

I first began to formulate my ideas in a post called the 'Cigarette Lighter Problem'. I asked the question of why an identical lighter, sold through an identical distribution system, might cost nine times more in a Western country than in China. The differential in the cost was fundamentally inexplicable (if you read the article, you will see why). I came to the conclusion that part of the additional cost was actually developed in the accumulation of debt in the economy overall.

As I thought about this problem, I started to think about the cost of labour in the world, and how it was determined. As part of this process the explanation of the economic crisis became clear. In the build up to the crisis, it was possible to see a massive expansion of the global labour supply. Even China by itself represented a massive expansion, but when you add India and the other emerging markets, the labour with access to markets/technology/capital must have at least doubled.

This of itself would not necessarily cause the crisis. As fast as the new labour entered the markets, they might have in turn become consumers, and thereby expanded output for everyone. However, there was a problem. Whilst the labour supply was increasing, the other inputs into wealth creation were not increasing as fast, or were not increasing fast enough to accommodate the massive infrastructure needed to built (from a very, very low starting point) in the emerging economies. If we just think of oil, output barely expanded as the emerging economies emerged, and that means with an increase in the size of the labour force, there was not going to be sufficient oil available for both the West to maintain their standard of living and to see the emerging economies continuing to improve their standard of living. Something was going to have to 'give'. The following is from my article on Huliq, but I suggest that you read the original for the full picture:

I have already identified that the world labour force has roughly doubled in the last ten years. At the same time, there has not been the doubling of the other inputs into the world economy. In crude terms, what this means is that the amount of inputs available to each worker to undertake economic activity has been reduced per capita.

If we take the example of oil, in 1997 output was around 75 million bpd, and output had only climbed to about 85 million bpd in 2007 (a chart here shows the output - not a good source but the chart is usefully clear and conforms to charts from better sources). What we can see from 1997-2007 is an approximate doubling of the labour force, and only a tiny increase in the output of another key component of economic activity.

This quite literally means that the availability of oil per worker has seen a significant decline. In such a situation, there must be a consequence. If a worker in country A increases their utilisation of oil, then a worker in country B will have less oil available.

With regards to other commodities, it might be argued that the output has risen to meet the new demand from the expanded labour force. For example, copper has seen high growth in output from around 11 million tons to 16 million tons, and iron ore output nearly doubled. The problem with such expansion is that it is growth in a period of rapid development of the emerging economies, in which the demands on resources are particularly high. Think of the massive expansion of highways, tower blocks, apartments, airports and factories in China, and it is apparent where such increases might be absorbed.

For the moment I would like to present a different scenario to what actually took place in response to this problem, and we can see how the economic crisis developed. For the sake of ease I will just use the examples of the US and China to illustrate a general point. If we jump back in time, to about 10-15 years ago, the Chinese economic miracle was in full swing. New factories were pouring goods out of China, and the US consumers were busily expanding their purchase of Chinese goods. As they did so, many US industries were moving offshore, as it became ever more necessary for companies to compete in world markets through lowering their costs. At this point, what should have happened was that there should have been increasing unemployment as the demand for labour fell in the US. With that rise in unemployment, living standards in the US should have started to fall, and at the same time, Chinese living standards should have risen. After all, America was losing in competition to China, and China was winning in competition with America.

As we know, this did not appear to happen. The Chinese appeared to be growing wealthier, but not as wealthy as their prodigious growth might have suggested. This returns to the cigarette lighter problem. If we look at China, the entire economy appears to be low cost. Wages and costs in general are surprisingly low in relation to the increasingly impressive output of goods and services. This is in part because they have still not pulled their entire labour force into the 'modern' economy. It is also partly a result of the value of the RMB, whose value has been held down through the purchase of treasuries. This has meant that, for an ordinary Chinese worker, they are not paid in wages that reflect the true value of their labour. Imported goods are artificially expensive.

What the Chinese have been doing is, as fast as their productive capacity has expanded, and their exports to the US have grown, is lend that missing labour value into the US economy. That missing value turned up in the US economy, and is why the US standard of living did not decline as it should have done in relation to China. All of this gave the illusion that nothing had really changed.

It seemed like China would just get richer, that the US would just get richer, and all was well in the world. However, without an increase in the other key inputs to wealth, the commodities, this could never work in the long run. For example, ten divided by ten equals one, 10 divided by 20 equals a half. If the additional ten lend you their halves, then it can appear that everything is okay, and that you still have one. Of course, in this example, I am being simplistic, as the amount of commodities did increase, but they did not increase fast enough, and China did not lend all of their output. However, I hope that this nevertheless illustrates how the illusion of wealth can be maintained, even as wealth generating capacity is slowly melting away.

What we have is the situation in which a low cost economy is rapidly expanding, endlessly increasing the labour force in the world, consuming more and more resource, and lending a significant portion of their output to another country. At the same time, they are making their already competitive position even stronger. They are adding a further lever to their low cost advantage, and decimating industries and competitors as a result, through holding down the value of their currency. In purchasing US treasuries, they increased the demand for $US, and the increased demand raises the value of the $US, and they also allowed the illusion of wealth in the US to continue through their lending.

However, this is not the whole story. As well as countries such as China lending their value of labour to the US, there are plenty of other actors within this scenario. For example, Japan's export machine kept on chugging onwards, along with the Japanese acquisition of US debt. Then there are the commodity countries, such as the petro-states, or other primary commodity countries. All of these benefited from the increased demand, which itself was a result of the expanding pool of labour. We can think, for example, of a major oil producer in this global picture. In real terms, they are lending oil in the expectation of a return in goods and services. If we go back to the American example, they are literally borrowing oil from the petro-states, and one day they must actually pay for the oil.

Oil is an interesting example of what took place, as it is so central to the functioning of modern economies. We can be buried in the complexities of currency rates, interest rates and so forth. However, when Saudi Arabia lends the US oil, they expect to get something in return.
For example, if the Saudis wanted cheese in return, they might lend their oil based upon the exchange relations for cheese and oil, however abstracted those relations might be. Central to their expectation is that if 1 litre of oil = 1kg of cheese, they will expect that in the future they will be repaid roughly on this rate, with interest added (e.g. repaid 1.3 kgs of cheese per litre of oil). If we look at US cheese output, there may be a nationwide output of 100 units, with 80 units going to the domestic market, and 20 for export. If we imagine that Saudi Arabia starts calling in their oil debt in cheese, we might see the 100 units reapportioned to 30 for export and 70 for domestic use.

What we are seeing is the inflationary impact of debt accumulation. The cost of cheese in the US is going to go up. There is less cheese in relation to domestic demand and, barring a cheese manufacturing productivity miracle, prices must go up. It might be that, with the rise in prices, the US farmer will devote more to dairy, and cheese output will increase, but they would do so by not doing some other kind of farming. The only way to avoid inflation is more farms, or greater productivity from the existing farms, or a combination of both.

Within this simplistic example, we see the principle that issuance of debt eventually creates a call on future output. When is does so, unless there is a productivity miracle, or an increase in the resource devoted to any industry, there will be less output for the domestic market. This means that goods and services will be relatively scarce. For the example of output of cheese, just replace cheese with the total potential output of the economy. You then see the problem with debt accumulation from overseas lending, and why it is inherently inflationary.

Overseas debt is a call on the total output of your economy in the future, and the greater the debt, the greater the proportion of future output needed to service the debt, and the less goods and services available within your economy for domestic use, and the greater the inflation in the economy. Unless there is a productivity miracle, or debt default, then something has to give. There are simply less goods and services available in the economy. Imports can not substitute, as you are already using your output to exchange for past borrowing, meaning you have less output to exchange for imports. As for the example of the US, we can add many other debtor nations to the list of those facing this problem, with similar consequences.

Having explained the danger in the accumulation of debt from overseas, we can start to see the problem. Now, before I go on, there is an important point. Instead of consuming, for example, the oil being lent from Saudi Arabia, lets say that we used this resource for investment in new capacity. Building a new factory, for example, is an energy intensive activity. If we were to use the oil for this purpose, we would actually see a return on that borrowed oil. We have increased our overall capacity to produce goods. Alternatively, imagine an executive used a portion of that oil in a flight overseas to sell a consultancy service. Whilst the oil is consumed, in both cases it is going to generate goods and services that we might sell overseas to repay our overseas loans.

However, this is not what took place, and there is a very good reason for this. The first relates to manufacturing. In the face of low cost competition, investment into manufacturing was shifting rapidly to the emerging economies. In the case of services, the story of India needs no retelling, and again we can see that there was a considerable expansion of competition in many services. However, the money nevertheless was pouring into many Western countries. Where was the money going?

We can only now see the impact of the traditional reasons given for the financial crisis. What we have is a situation where the actual output of goods and services in the economy appear to be increasing. In fact, during a period in which intense competition in goods and services are appearing over the world, there is a strange thing going on. In face of this massive competition, the people in countries like the US appear to be consuming ever more output, even whilst this fierce competition is arising. Not only that, inflation appears muted, and GDP is steadily and apparently rising at a healthy rate.

What we are seeing are two deeply flawed measures. In the case of GDP, it is measuring all of the activity that flows from the resources being lent into the country, in addition to the productive output of the country itself. When we see inflation, it is not capturing the inflation in asset prices. What we have is the miraculous service economy. The money is pouring in from overseas, and that is used to import resources, and these resources are being consumed at an astonishing rate, fuelling profits in companies, and increasing activity around the economy. If we return to the oil example, we can think of Saudi Arabia lending oil to the US, and how that oil might allow for an increase in activity around the economy.

The interesting point about all of the traditional factors for the current crisis is that I would agree that they are all contributory factors in the debacle that we are now witnessing. The one point I would argue with is that it was a result of de-regulation, as I do not accept that there was deregulation, but rather there was misguided regulation. I have emphasised the role of the Basel I and II banking regulation frameworks in contributing to the crisis. There are plenty of easy targets to pick on - for example the Basel II entrenchment of the ratings agencies in the determination of capital adequacy ratios.

As I have long argued, it has been apparent that the regulators have long been of the view that they (and presumably the rating agencies) have some mystical power to see where future risk might be found. Amongst their amazingly prescient determination of future risk, they allocated OECD government debt as being almost completely without risk. Apparently, at this moment in time, banks all over Europe are sitting on piles of absolutely safe Greek government debt, and this debt is a key component in what determined their safe level of capital. The more I dug into Basel I and II, the more silly the provisions seemed.

I even found an article on the Bank of England website that innocently noted that Basel I had been a driver of the market trend to securitisation, the very instruments that later exploded onto the world with the banking crisis. The paper was published pre-crisis, and I wonder if anyone in the central banks would now published, as it is firmly points (with hindsight) an accusatory finger at the role of the regulators. Happily, for the central bankers, the article is now forgotten and gathering dust.

Returning to the question of government bonds being given a zero risk rating, what we see is a regulatory framework that positively encourages banks into buying government debt. A long time ago (I forget which post) I wrote about how, when modern banking was being developed in Renaissance Italy, the city states would grant banking licenses in return for preferential interest rates on their borrowing. What we see now is the same cosy relationship between the central bankers, the banks and the politicians. I scratch your back......

The problem is that, although most people accept government borrowing as if it is some kind of force of nature that is unavoidable, I have yet to see a convincing argument for government borrowing for a developed country, short of war or natural disaster. If governments want to spend more, then just tax more. They have a massive base from which to fund government, so why are they borrowing at all?

Returning to the central point, regulation has played a large part in the lead up to the financial crisis, and has also encouraged states into their current indebtedness. You will note that, as the crisis progressed, central banks and regulators have demanded greater levels of capital to be held by banks - and that is a way of telling banks to hold more government debt - exactly at the time that governments have been increasing debt. The banks are now stacked up with debt which was formerly considered safe, and (in the case of many European banks at present) they are faced with a potential implosion of their balance sheets if there are sovereign defaults.

Are you starting to see the circularity here? However, I have digressed a little from my central theme, which is to set the context of the current parlous state of the world economy.

A key element is the financial services industry. We need to this in the context of a massive shift in the productive output in the world, with inflation in commodity prices. Rather than directly exchanging the profits from these shifts directly into purchase of goods and services, the countries in question have chosen to lend their growing wealth into countries like the US. They do so with great confidence, as they see the OECD countries as more reliable and safe place to lend their money. Alongside this, they see what appears to be healthy and growing economies. What could go wrong?

The problem is that, a wall of money is entering into these debtor economies, and yet there are very limited numbers of investment opportunities, outside of redistribution of the borrowed money into consumption based activity. In particular, if you are investing in the provision of new goods and services for the global market, much of the smart money is going into the emerging economies. So, the banks have a wall of money to lend out, and few opportunities to invest it in places where it might eventually create opportunity for export of goods and services. What to do with the money?

As we now know, the money went into higher and higher risk consumer lending. One result of this was that the money available for lending into mortgages started to outstrip the increase in the number of houses available to soak up the new money. This is, of course, a situation in which more money is chasing a particular good, which means that the price of the good will increase. Thus the housing boom was born. We can see the increase in the money supply into the market with the many highly dubious methods of lending that appeared in the run up to the financial melt-down. What we now see is where the financial crisis comes from.

The bankers were aware that, if you start lending to bad credit risks, then you are eventually going to make some losses. They could hardly sit on the money and do nothing with it, and here we have the incentive for the development of the instruments of mass destruction that were to explode in the financial crisis. The lending was increasingly risky so, within the Basel frameworks, they did everything they could to bury the extent of the risk such that it was out of sight.

The CDOs were rated as investment grade, as per the requirement of the Basel regulations, which had already encouraged securitisation, SIVs, and a host of other practices that were to be seen as precursors to the financial crisis. As a result, it seemed that the banks were making miraculous profits, bankers achieved their amazing bonuses, all at the same time as they were loading up on thinly disguised and regulator approved risk. Remember, the regulators and ratings agencies apparently had a privileged and magical insight into where risk will occur in the future.

We then move onto the role of the central banks, and their contributory role in the mess that we are all now in. Their role was one of astounding stupidity. They were the people paying attention to their metrics of GDP and inflation, all the time having absolutely no idea of what these actually measure. All they could see was the mass of activity in the economy, and did not realise that a large portion of that activity was simply the use of resources borrowed from other countries to move around and distribute borrowed resources lent by other countries. They imagined that all of the activity was from internal resources generated by their own countries output. The really mad part was that, the more that was borrowed from overseas, the greater the activity in redistribution, and the more they believed that the country was getting wealthier.

As a result, with low inflation, and steady GDP growth, they kept interest rates low, and poured more fuel onto the fire with expansionary monetary policy. All this despite asset prices going up at a rate that was disproportionate to the actual underlying state of the economy....

And then there is government. Like the central banks, they were equally as deluded by their use of inflation and GDP figures. Perhaps the worst example is Gordon Brown in the UK, who absolutely convinced himself and nearly everyone else that an economic miracle was taking place. Everyone was becoming richer. In these same countries with the miraculous service economies, governments started letting go of any sense of fiscal caution, in the belief that the good times would not end. They expanded or started new government programs, benefits and entitlements, creating ever more structural government costs, on the basis that their economies seemed to be endlessly expanding. In reality, it was only indebtedness that was expanding, as their economies were in reality stagnant or perhaps even contracting in some cases.

What we were seeing was an illusion of success in many economies, and all the while they were sowing the seeds of future destruction. The increase in debt in economies like the UK and US was simply hiding the structural change that had taken place in the world economy, the emergence of the emerging markets, and the competition for a finite amount of resources amongst an ever increasing labour force. The illusion of the service economy was simply the distribution and consumption of the borrowed output of labour of overseas countries. Houses became ATMs, new shopping malls were built, and new services were developed to consume all of this apparent wealth.

The financial crisis was the shock to break the illusion; or rather it should have been the shock to break the illusion. The madness of consuming future output now was laid bare. However, rather than break the illusion, the choice of governments and central banks was to try, as hard as they could, to continue the illusion.

In the period since the financial crisis, there has been no action to address or recognise the problem. Instead, the reaction has been a host of measures to try to restore a situation that was, of itself, a delusion.

Front and centre were the bank bailouts. The process was not only one in which government money was poured into the banking system, but also a process of allowing the banks to hide their underlying insolvency. Governments have also borrowed to support the existing economic structure, which is an attempt to maintain employment and activity, which is itself an attempt to support (for example) real estate prices, which in turn supports the value of bank assets, which in turn supports the viability of the financial system. It is all circular, with one element supporting the other, with overseas borrowing the foundation of the system. It is impossible to tease apart the circular relationships. Governments must keep on borrowing more and more, or the whole edifice falls apart.

Effectively, when consumers stopped borrowing, government stepped in to fill the vacuum. The problem is that, in doing so, they are supporting the unsupportable. I have previously laid out the contradictory nature of this process in my last post. We have a process as follows:

1. A government borrows money from overseas
2. The money is spent by the government and this increases activity in the economy
3. Individuals who would otherwise be unemployed are able to buy houses, pay back loans, service mortgages, buy goods and services
4. Individuals and businesses pay more taxes
5. Government revenues are supported
6. GDP is supported by all of the activity, either preventing a dramatic fall or slowing of GDP growth
7. The relatively good health of the economy reassures investors (e.g. some investors actually believe that the US is recovering)
8. Investors are willing to extend further credit

It all looks to be highly sustainable, except for the fact that governments are accumulating debt which is being used to finance consumption. For example, in the case of tax revenues being supported, the money that is returned in taxation to the government is being supported by the borrowing, such that the revenue from taxation is a case of the government eating its own tail. It borrows, a portion of that borrowing is consumed, and the returned tax revenue is therefore the borrowing minus the intermediate consumption process. It simply means that a small amount of the borrowed money is returned to the government, whilst the total amount of borrowed money increases.

The other result of borrowing more is that more borrowed money supports the level of GDP, which means that the more a government borrows, the higher the GDP. All the borrowed money supports activity within the economy, and this gives the appearance of a healthy economy. This allows for a better debt to GDP ratio, which is, of course circular.

For example, if a government were to double their overseas borrowing overnight, then they would be able to massively increase activity in the economy. GDP would climb rapidly, and the result would be that the GDP to debt ratio would look much better. What you have done is pulled a massive amount of future activity into the present, and this would flatter the size of the economy. However, the GDP outcome does not represent your own generation of activity, but consumption of the output of others, at a cost of committing your own future output. In other words at the cost of a future shrinkage in your own activity. Unless you just keep borrowing more and more.

And here is the problem. Unless you keep borrowing more and more, there is no way to sustain your GDP level, and no way to keep the GDP to debt ratio looking positive. As soon as you stop borrowing from overseas, you are then in a position of repaying the debt that you have already accumulated, and also doing this when your economy is fragile. It is fragile because the structure of the economy has still not managed the adjustment to the new competition from the emerging economies. Government has borrowed to consume to support the structure of an economy that was already built on excessive borrowing from overseas. There is still a period of adjustment to the real structure of the world economy to take place. This can only be achieved through seeing the destruction of the swathes of the economy that were supported through the distribution and consumption of resources that were generated from overseas.

This returns me to the example of the US economy, in which I showed that 17% of US GDP may be accounted for by activity in the distribution and consumption of resources borrowed from overseas. As yet, nobody has contested this figure, though it is certainly open to challenge (see here for the original post). Even if I am roughly right, we can see what happens if the growth in debt halts. We would see a massive contraction in the US economy, and the debt to GDP ratio would deteriorate in a shocking way. It is similar to what we are seeing in Greece. Businesses will close, unemployment will explode, government revenues will fall, asset prices will fall, banks will go bust, and the economy will fall off the edge of a cliff. As this happens, it will become increasingly impossible for governments, businesses and individuals to service the debts that have been accumulated as part of an economic structure built on foundations of sand.

The really horrific part of this is that it is not just the US that is in this terrible position. This is a widespread problem. Furthermore, the structures that have been built to protect failing sovereign states is built upon credit coming from many of the states that are now at risk. One interesting development is that the US is now questioning their role in the IMF bailout of Greece, and is recognising that the credit it would supply would fall into a black hole, and that it can no longer afford to bail out other countries. After all, the US finances are themselves flashing red warning lights. I pointed out in a previous post that, in reality, although the US appears to be a major funder of the IMF, it is in reality the creditors to the US that are really funding the IMF. If the US were not able to borrow more money, would they be able to finance the IMF as they have traditionally done in the past?

Where is the money for IMF bailouts going to come from in the future? It is a question I asked at the start of writing this blog, and it only now that it is apparent to the world that there is a problem. When both the 'bailees' and 'bailouters' are broke, what happens then?

In Europe, it is possible to see the increasing queasiness at having to bail out their fellow European states. The fact that the bailing out of another state means borrowing more, and taking the sovereign debt risk of other countries onto already stretched balance sheets, means that the bailouts can only go so far. The problems do not stop there. For example, if Greece defaults on its debt, this will impact Germany through, for example, their banking sector's exposure to Greek debt. If Greece falls, it may take elements of the German financial system with it. Such is the complexity of the edifice of debt that has been created around the world, and the complexity in the linkages in the destiny of sovereign states.

Niall Ferguson famously coined the phrase Chimerica to express the interdependent relationship between China and the US. The US used Chinese credit to purchase Chinese goods, and then plays a major role in the support of China's export sector. The two countries are inextricably tied in dysfunctional relationship. If either side blinks, they both plunge. However, the contradictions of a developing country (China is still relatively poor) supporting the rich lifestyle of the US must be a finite arrangement. Both sides need to extricate themselves from the relationship, but neither side seems to know how.

In recent news, China has recommenced the purchase of US treasuries, and Chimerica is once again in full swing. This means that, for the moment, the US might continue to finance their dizzying deficits. I think that we are safe in assuming that China is restarting the relationship because they can no longer see any clear alternative. However, as they have hinted at in various statements, China knows that Chimerica is unsustainable, and the US appears to realise this too. In both cases, it is possible to sense that they both hope that something will turn up. In the meantime, the scale of the problems for the future grows and grows.

The only way to describe the trading relationships across the world is 'dysfunctional'. They are relationships built upon a foundation as follows: country 'x' provides country 'y' with credit, and country 'y' uses that credit to buy goods and services from country 'x' and country 'z'. Country 'x' builds an export market in country 'y', and therefore needs country 'y' to keep buying their goods, in order for them to maintain employment and growth. Japan needs the US, Germany needs Spain, China needs the US and so forth. The recipient countries must keep buying, but increasingly have less and less capability to repay the money they are borrowing. The country 'x's reach a point where they are confronted with the reality that they are, in effect, almost giving their goods and services away, as they will never be paid for them. However, if they stop, their own industries will collapse, as they are structured towards servicing these debtor markets.

When German workers wince at the Greek bailout, this is the logical conclusion of the dysfunctional relationship. German credit has allowed German exports to Greece (of course, this is not a one to one relationship, but I use this case for simplifying some complexity). If Greece defaults on their debt, German creditors will take a haircut. If Greece is bailed out, the German government will, through the tax system, make the German worker pay for the Greek bailout. In either case, Germany will have, in real terms, been providing goods and services to Greece at massively subsidised cost, or in extreme circumstance free of charge. In all cases excepting full repayment of debt from Greece, Greek consumption is being subsidised through the labour and efforts of overseas workers. It does not matter which of these many creditor/debtor nations we can look at, the relationship is basically the same.

In each case, in each of these relationships, the dysfunctional accumulation of debt continues, and always with the hope that 'something will turn up', that the debtor nation will miraculously turn around, and start earning more than they consume.

However, the debtor nations have become credit addicts, and become ever more dependent upon the credit to sustain the structure of their economy, which is itself structured around debt. The more credit they get, the more their economic structure will be shaped to utilise the credit. The population of each country is unaware of the source of their apparent wealth, which is too abstract to understand, and they then resist any reform which might mean that they have to accept their real level of wealth. The politicians cave in, and hope that something will indeed turn up (or that they are lucky enough to be out of office when the contradictions of the situation are forced to resolution).

In the end, the creditor nations must blink. They will only support the profligate so far. Like the debtor nations, the people of the creditor countries are unaware that they are in effect, giving away a portion, or all of their labour, to other nations. When it becomes apparent, as with Greece and Germany, that this is the reality of the situation, they are understandably resentful. However, they do not realise that, if the situation halts, then many workers will find that their particular industry, their individual job, is pointing at a market that was entirely reliant on the credit that they have been providing. When their own country turns off the credit taps, the markets for their goods and services will evaporate. They have been pointing their industry and labour to the wrong markets, to markets that were never really going to pay for their goods and services, because they do not have enough output that they are willing to return.

In practice, what happens is that all the savings of individual workers are exposed to the losses that will follow the non-payment of debt. When a person invests in a pension fund, puts their savings in a bank, they are deferring their own consumption. In principle, their money should be channelled into new investments which will produce a future return. Instead, through whichever conduit, their savings have been used to support consumption in the debtor nations. If Greece defaults on debt, and German banks take a hit, this is not abstract money, but the accumulated savings of individuals aggregated and lent into the Greek economy.

I hasten to add that, as they currently operate, the markets are not all relatively ‘benign’ movements of savings and investments. The infamous speculators do exist. However, I have no problem with these people risking their money, for example betting against the Euro. What I do object to is naked credit default swaps, and any of the many other practices that border on the fraudulent, or the way that government backstops the risk, or the way in which governments have entrenched and supported an elite of bankers.

Returning to the central point, the deferred consumption of German workers has instead been consumed by Greek workers, and they are not going to return that consumption with goods or services for the German workers to consume. The deferred consumption has been forever consumed.

The point that I am trying to make here is that this is not as abstract a situation as many analysts and commentators try to make it. It is about the basics of person 'A' manufacturing good 'B' or providing service 'C' to person 'D'. This is the core of economics. It is not mountains of abstract data, but about how this process works in practice. At the heart of the system is that the savings of person 'A', their deferred consumption, is aggregated and offered to others in the belief that it will be returned one day in goods and services for their own consumption.
The expectation of each worker who defers their consumption is that, at least, their savings will be returned in an a way that gives them access to an equivalent amount of goods and services to those they might have consumed at the time of the investment. This is a reasonable expectation, and is the source of potential for sustainable economic growth.

The problem arises when the systems for the allocation of those aggregated savings go wrong. This is the dysfunctional trading relationships between countries. Those in government, in the financial services industry, the analysts and economists, all misunderstood what they saw. They made false assumptions as follows:

1. Just because a country has always been wealthy, it will always be wealthy
2. Just because a country has a good credit record, any amount of credit might be given to that country
3. GDP = Wealth creation
4. Inflation measures are meaningful, even when asset prices are inflating outside of the recorded figures
5. Trade imbalances might be eternally sustainable where the cause of the imbalance is in consumption activity of one actor of the goods and services of another actor

I am not sure that this covers all of the assumptions, but it is certainly a starting point. At the heart of all of the above is a question of credit risk. What we are seeing are assumptions that underpin how investors have determined the risks in the provision of credit. At the heart of the economic crisis is that various metrics and assumptions led to a false set of beliefs about the relative creditworthiness of individuals, businesses and states.

These assumptions were built upon a world that no longer existed. The entry of the emerging markets, and the newly intensified competition for a finite amount of resource changed the game and the structure of the world economy. As the emerging markets emerged, we entered a period of hyper-competition.

Instead of confronting the competition, much of the developed world simply borrowed and pretended that nothing had changed. The assumption was that the rich world would get richer, and the developing world would get richer. It never occurred to any of the economists, politicians, analysts, and financiers, that with finite increases in resources, we had entered a situation similar, albeit not the same as, a zero sum game. While the pie of resources was getting larger, the number of actors eating the pie was increasing faster still. Just because some of them were lending some of their share of the pie, did not alter the problem that the share of the pie was changing.

So it is that we come to the situation today, with a world economy in which false dawns, endings of the 'financial' crisis, come and go. New solutions are tried, more illusionary gains are achieved, only to see the underlying and unaddressed problems bubble back to the surface. We can see that, despite the efforts of government, many of the rich world countries are indeed getting poorer. The austerity program proposed in the UK may just be an example of this process in action, and we can only hope that austerity can resolve the problems gradually. However, the actions of having tried to prevent change make a gradual rebalancing the least likely outcome, though not impossible.

It is never pleasant to be relentlessly gloomy. I have offered consistent pessimism. I do so because, I believe, I have identified the underlying causes of the economic crisis. In doing so, I believe that the actions to try to turn back the clock are wrong. The only way to move forwards is to resolve the imbalances, and take the pain sooner than later. In accruing ever more debt, in seeking to prop up systems that can not be supported, it may delay the pain, but at a greater cost later. At each stage of the economic crisis, I have repeated the same message.

The only way to resolve the crisis is in the structural reform of economies, and to face the fact that, with a finite pie, and more actors seeking a share of the pie, the only solution is to win the greatest share of the pie possible through efficient development of industry and innovation, and having lean and effective economies. This means that we must trim the fat from our economies. We simply do not have the resource to maintain the lifestyles to which we have become accustomed.

We also have to face up to the imbalances in the world economy, and accept that these are finally unsupportable. Country ‘x’ can not and will not provide goods and services to country ‘y’ at subsidised rates forever. In particular, now that the inability to repay is being highlighted, the real choices for the creditor nations are becoming clear. The reality of the imbalances is now showing the underlying choice – continuation of giving something and getting very little in return, or a painful period of restructuring of their own economies to reflect the real distribution of wealth creation and resource.

I also accept that, in this hyper-competitive world, we are unlikely to win as great share of the pie as before. In an ideal world, the resource pie might expand infinitely, but this is an unlikely outcome at our current position in history (a debate I will leave aside for the moment), and we might have to accept a period of hyper-competition for a long while. After all, there is plenty of labour out there that is still yet to be connected with technology, capital and markets.

It is not an easy message to digest. However, if we wish to address a problem, we have to face up to the actual causes of the problem. As long as the policymakers seek to ignore the real problem, we will continue down the wrong path. It does seem that, with the emergence of the problems of Greece, there are the first signs of accepting that the situation can not continue as it has done. Greece is a warning, and we are collectively starting to take heed. Whether this translates into effective action, and above all acceptance of the reality of the situation, is still uncertain. I can only hope that it does, and that it is not too late.

Within this perspective on the world economy is a further worry. I blithely suggest that we need to adjust, but I also identify that the people of the creditor and debtor nations have not, and probably will not, fully grasp how this mess arose. We see this in the riots in Greece, and the growing anger at the politicians in Germany. The adjustment is going to be very, very painful, and this presents significant dangers. In order for the adjustments to be made, both debtor and creditor countries will suffer painful adjustments. The whole world economy will go through a painful adjustment. In such circumstances, with unemployment growing, and complex and difficult to explain causations, it is a period in which social and political instability will rise.

It is a time in which some people will offer easy solutions, will blame group ‘x’ or group ‘y’ for all of the ills, who will grab the popular anger, and will use that anger for their own ends.

The situation I have outlined in this post, the causes of the economic crisis, are not down to any individual country, or any single group. The bankers were greedy, the regulators were idiots, the Chinese were mercantilist, the Western politicians acquiesced to the Chinese mercantilism, when the politicians promised something for nothing, the press acceded, and the people with them. I could go on. In the end, we all played a role in building this mess.

In addition, the situation is not one in which there will be any painless fixes. We have collectively spent years building an illusionary economic structure. As that structure adjusts, and it must adjust, there is no way to do so without pain for everyone. How we might deal with the adjustment is a matter of debate, but there is no way in which it can be done without pain being felt by ordinary people. However, there will be those who will offer ‘clever’ solutions. They will ‘magic’ away the problems. How this might take place, when the problem is the structure of the world economy, is a mystery. However, they will dress up their magic with plausible and complex argumentation, and in the end avoid accepting that there must be some kind of pain.

In the scenario I have painted, it is apparent that there must be pain that comes with the restructuring. I do not hide this. For governments, the key is not to try to halt the restructuring, but to seek to ameliorate the worst of the effects. It is a fine balance between restructuring and, in the case of the ‘rich world’ getting poorer, and maintaining social cohesion. The danger lies in the pretence that no restructuring is necessary, and that pain might be avoided. The danger lies in governments squandering their resources, as they already have done, in propping up a system that is inherently unsustainable and inherently unstable.

In a very long essay, I have suggested a system that might prevent these problems happening again (it can not ‘fix’ the current problems, but might accelerate their resolution). It is not a perfect solution. No system, for example, might have fully absorbed the labour supply shock that the world has seen. However, the system I have proposed would have prevented the imbalances that followed the supply shock. It is a system which is largely self-regulating, bubble resistant, and imbalance resistant. However, I suspect that such a system is only a dream, as it removes power from those who would like to hold on to their power. I therefore offer it as a solution, but also as a solution that is unlikely to be adopted.

Note 1: When first posting this solution, my use of the concept of value of labour led one commentator to suggest that it was Marxist. The concept of value of labour used is very different from that of Marx, and the solution is in no way Marxist. Also, a regular critical commentator on the blog, commenting under the name ‘Lord Keynes’ has recently said the following:

“Cynicus’ variant on the labour theory of value, in which he believes that value is both caused by subjective factors and by labour is logically inconsistent.Value cannot be subjective and also caused by labour.”

It is entirely consistent to say that we subjectively value labour, which is my explicit central point. I see no inconsistency in this. Lord Keynes simply misrepresented my argument to create an inconsistency. From this commentator, there will no doubt be essays in response to this reply. I would therefore ask you to read the original.

Note 2: As ever, please feel free to comment on any aspect of the post. Even in a post as long as this, in order to cover breadth I have had to sacrifice depth. If any point is unclear, I have expansions on each of the points littered throughout the blog. Also, in trying to compress many arguments, I hope that the arguments are not weakened or might appear inconsistent. Finally, there is the sin of ommission. For example, I do not include the many additional mercantilist Chinese practices that I have included elsewhere in the blog, or the dangers in quantitative easing (printing money), or many other key points. In short, an overview can only be an overview.

Note 3: Thanks for the interesting comments on the last post. I recently found that I had missed following one of your links on a previous post, which was to a You Tube video of the Modern Mystic. An amusing distraction....many thanks.

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'.

Economic Crisis - A Torrent of Bad News

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Lemming goes on to say the following:

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

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

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

DZ followed up Lemming's comment with this:

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

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

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

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

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

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

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

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

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