The Underlying Size of the US Economy

I would like to start this post with a hypothetical item of government spending, such as building an extension to a government building, and track some of the money that might be spent. The example uses the US, but the principles apply to any country. The reason for this example will become apparent later, and may be a little disturbing.

As soon as the money for the extension is approved, there will be a surge in economic activity. Project management groups will be formed, an architect firm hired, contractors will be tendering, and medical suppliers will be preparing for large orders. In this case, I will just track some of the spending as it passes to the firm of architects. Depending on the nature of the contract, money will eventually start being passed to the architect firm, and that money will arrive in the firm's bank account. Once in the account, the money will be used for a range of purposes, such as the cost of operations, cost of office space, and legal and other services. All of these economic activities will be partially supported by the government expenditure. For the next movement of the money, I will concentrate on the salary paid to the workers in the firm, and in particular one of the architects.

Let us imagine that one of the the less senior architects is a man who works on the project for 6 months, and all of his pay is therefore coming from the hospital extension project. We might imagine that the architect is an average type of individual in a professional occupation, and that he is married with a young family and earns $100,000 per year. We can therefore imagine his spending, with his income covering a mortgage, payment on a car loan, and fairly large expenditure on consumer items, and consumption of services like trips to restaurants. All of these will be paid with government money. If we just consider the example of expenditure on consumer items, we might think of a toy purchase for one of the architects. He will visit a store, and we can imagine that he spends $50 on a toy for his daughter's birthday.

The $50 originates in government money for the extension, and it now lands in the till of the retailer selling the toys. The retailer then banks the money, and the money will then be utilised for a range of purposes. If we imagine that the toy has a $25 mark-up, then $25 of the money will be used to reorder the toy. The toy is made by a company based in the US, but with manufacturing overseas in China. As such, some of the money will be used to pay for the manufacturing in China, and we will just imagine that $10 covers the cost of manufacturing a replacement. That means that £15 will go to the US company, and will pay for the operations of the company and profit, with $10 'leaking out' of the US economy into the Chinese economy.

As with the architect firm, the $15 that goes arrives in the US toy company will contribute to staff salaries, pay for the costs of the office, pay for business expenses and so forth. If we imagine one of the office staff, part of the pay of the person will come from the sale of the toy, and that money has come from the architect, and that money has come from the building project, and that money has come from government expenditure. The money for the building extension is rippling through the economy creating activity....Whilst the headline amount of the money diminishes at each level, the money is utilised many times over in multiple transactions.

What I am (I hope) showing, is the way in which the money spent by government generates economic activity way beyond the headline figure of the actual expenditure. Each of the activities that the money generates, as the money use multiplies throughout the economy, is recorded in the GDP figures. It is a very complex process to track, and economists have great difficulty in trying to work out how much government spending increases activity throughout the economy. For example, one review of academic literature (see note 1) identifies that different fiscal expenditure in different situations and countries can lead to multipliers of between zero and four.

It is actually quite easy to see why the multiplier effects of government spending are so difficult to calculate. For example, the spending of government money on infrastructure such as a steel bridge might have very different effects according to the individual economy. If the economy has a strong steel industry, then the multiplier will likely be much greater, as otherwise a large portion of the expenditure will rapidly 'leak out' of the economy to pay for the purchase of the steel from overseas suppliers.

What we are therefore left with is a big question mark over how much activity each $1 of government expenditure might generate within the US economy. In light of the estimates of between zero and four, I will proceed on the basis of a multiplier of three, as the study cited suggests higher multipliers occur in larger economies. Furthermore, a large proportion of the US economy is based upon services, which again suggests a high multiplier. This means that the US might even have a multiplier of four, but I will stay with three as a more conservative estimate.

Having come this far, you may be wondering what all of this means, and why I am discussing this in so much detail. The reason is relatively straightforward. I want to give a (very, very) rough estimate of the real size of the US economy - the size if there were no borrowing from overseas. When we see that way that government spending multiplies in the economy, it is apparent that borrowing money from overseas (translated into government spending) will inflate the GDP figures more than the headline borrowing figures suggest.

Starting with the basics, the US economy for 2009 will produce about $14 trillion of GDP, the federal deficit is expected to be something like 12% of GDP for 2009 overall, and according to the Congressional Budget Office the deficit for the fiscal year (just ended)was $1.4 trillion. In order to isolate the effects of overseas borrowing, it is necessary to find out how much debt has been sold overseas. I naively thought that I might find these figures relatively easily, but this has proved to be problematic (see note 2). For example, I searched the Treasury website, and only found an 'estimate' of the overseas holdings of US government debt. Likewise, the St. Louis Federal Reserve (an excellent resource normally) only offers the following chart, for overseas federal debt holdings:



According to the chart, overseas holdings of federal debt have increased in the first six months of 2009 by $305.3 billion, making an annualised rate of overseas accumulation of US debt of around $600 billion (assuming that overseas investors continued to buy US debt at the same rate). It might be noted that the fiscal year in the US does not match the calendar year, so there is some more fudge in the numbers. However, we might make an approximation on the total amount of GDP that is actually due to the multiplier effect, by multiplying the figure by 3, which gives us $1.8 trillion.

Now at this stage, it would be normal to then minus the $1.8 trillion from the overall size of the economy ($US 14 trillion). The first problem is that some of the borrowed money will be servicing interest payments on previous borrowing ($182 billion), such that it will not create activity. The second problem is that there is the question of how much private borrowing is sourced from overseas lenders, in particular consumer borrowing. I have tried to identify how much of this borrowing originates from overseas, but have been unable to come up with any firm figures. I will therefore just take a guess at the impacts of these two factors and raise the overall total to $2 billion, implying something like $127 billion of consumer credit provided by overseas lenders (remember the multiplier of 3), an extremely conservative guess.

With the current figure of $14 trillion, the correction to remove the activity resultant from overseas borrowing would mean that the real size of the economy is just $12 trillion. In other words, something like 17% of the US economy is funded by overseas borrowing. You may note that there is a large amount of 'fudge factor' in all of this, and comments and critiques are therefore welcomed (especially from those who are more numerate than myself - which is most people).

What does this mean?

As I have frequently pointed out, measurement of GDP is flawed in any economy that has a net accumulation of debt, for the very reason that the activity in the economy includes debt activity derived from overseas borrowing. The problem becomes particularly acute when measuring the ratio of debt to GDP, as the activity from debt is included in GDP. Even more curious is the idea of GDP growth, when a country is accumulating debt, but nevertheless economists are predicting 'growth' for 2010.

The real concern is the question of what would happen if the overseas lenders were to stop lending. In this event, the US economy would quickly revert to its real size, and that would be significantly smaller than today. The results of any halt in credit provision for the US are extremely worrying, as support for a large percentage of the economy would disappear. The result would be that unemployment would explode upwards, government could not operate at current levels, and the shock would likely precipitate a broader collapse in the economy.

The problem that is faced by the government is that for the years preceding the economic crisis, the economy was also being flattered by a combination of overseas borrowing for government expenditure, but in combination with consumer borrowing that originated in overseas credit. I am guessing that, if it were possible to strip out the effect of borrowing for the three years preceding the crisis, the same kind of results would emerge. In other words, I believe the problem is structural, meaning the current level of the economy can not be sustained. As such that there is no possibility in the near term of achieving anything near pre-crisis economic conditions unless creditors continue to fund the US at current levels.

This is improbable.

One reason is that the printing of money by the Federal Reserve and size of deficits are already alarming creditors such as China, with China giving implicit threats to stop lending. A devaluation of the $US might provide a solution to the problems by eventually return the US economy to its true size and wealth relative to other countries. However, ongoing $US devaluation will just accelerate the point at which overseas creditors refuse further lending. In other words, it will precipitate a crisis before the adjustment is completed. In the event of no further credit, the US would face the prospect of rapidly transitioning to the real size of the economy.

The only solution that I can see is for the US to first freeze the growth in borrowing, and to then implement a clear and binding plan to reduce borrowing aggressively over the short to medium term, with a clear plan for a return to surplus in five years time. This plan would give confidence to overseas creditors, and allow a more orderly transition to the real size of the economy. Such a plan would be very, very painful, as the economy would still shrink dramatically. However, it would be less painful than the sudden collapse that might take place if overseas lenders were to stop lending.

The problem is that, at present, there are no such plans. Instead, deficits stretch to the horizon, overseas creditors express their doubts, and the $US is steadily sinking. In other words, my very rough estimates may be put to the test.

Note 1: Spilimbergo, A., Symansky, S., Blanchard, O., Cottarelli, C., & Hall, W. (2009) 'Fiscal policy for the crisis', Centre for Economic Policy Research, Paper No. 7130, January 2009.

Note 2: I used the Treasury website here, and downloaded the document titled 'Ownership of Federal Securites'. Actually getting firm numbers on actual sales of new debt is very difficult, and news reports, for example, seem to focus on debt type and/or sales to particular countries. A fairly tpical example is the following report:

WASHINGTON (MarketWatch) -- Net foreign purchases of long-term securities increased to $28.6 billion in August from $15.3 billion in July, the Treasury Department said Friday. Net foreign purchases of long-term U.S. securities were $ 32.9 billion. Of this, private investors purchased $21.3 billion and foreign official institutions bought $11.6 billion. U.S. residents purchased a net $4.3 billion of long-term foreign securities. China's holdings of Treasurys slipped $3.4 billion to $797.1 billion in August. So far in 2009, China has increased its holdings of Treasurys by $57.5 billion

If you have a definitive source of sales to overseas, a link would be appreciated, or more accurate figures. I am surprised that this data is so hard to find....perhaps I am looking in the wrong places..

The Economic Policy of the Next UK Government

At this moment in time, it appears that (barring any major blunders) the UK will elect Conservative government at the next election. Several readers have asked me to discuss Conservative economic policy, so this post is a response to those requests. Before starting, I should emphasise that I do not have any particular loyalty/affiliation/position which predisposes me to any of the contenders in the election. In particular, regular readers will be aware that I have a libertarian 'lite' point of view, and none of the UK political parties come close to such a perspective. I am therefore looking at policy from the point of view of which party has the least negative approach.

The problem in making the comparison is that any comparison with the Labour Party will flatter the party with which the comparison is made. It would be difficult to do much worse than the current government. In particular, as regular readers will know, there is the ongoing problem with current policy of printing money and fiscal incontinence in conjunction with previous fiscal profligacy. The debt in the UK is soaring, and the only thing propping up the issuance of debt is the Bank of England's purchase of gilts through the weasel worded quantitative easing (printing money).

It might be noted that the Conservative party were unwilling to challenge the fiscal profligacy in the past, with their formulation of 'sharing the proceeds of growth'. As such, their past policy was to follow Labour into a fiscal black hole, by promising to match and continue the policy of growth of government expenditure. It now seems that the Conservatives have accepted that the current levels of government expenditure are unsustainable, and are starting the process of adapting their policy according to this point of view. For the most part, I will be using the Conservative policy document on the economy (available for download from the Conservative website here) as this is a clearer statement of their intent than speeches or the opinions of commentators. It is written by David Cameron and George Osborne, and is therefore a good indicator of policy.

However, before examining the policy document, there is one piece of news that I find very encouraging. David Cameron, the Conservative leader, has spoken out against the current practice of printing money:

Without mentioning the central bank, Cameron told his party’s conference in Manchester that he opposed creating money, saying “sometime soon that will have to stop, because in the end, printing money leads to inflation.”

As a result, he has been subjected to criticism, in particular from David Blanchflower, who recently left the Bank of England Monetary Policy Committee:

David Blanchflower, who left the bank’s Monetary Policy Committee in May, said Cameron’s speech yesterday was “bizarre” and if put into practice may tip the U.K. into a “depression.” Shamik Dhar, a former Bank of England economist, said “at best this is wrong and at worst downright dangerous.”

Regular readers will know that I have been firmly against printing money from the outset of the policy, and I therefore see the discussion of an end of the policy as a very encouraging point. However, it is highly unlikely that the policy can continue up to the point of the next election, so this is a moot point. This is also a wider problem in the consideration of Conservative policy. Whilst they are currently offering policy considerations (as they must), it is not entirely clear what kind of economy they might inherit. For the moment, I will put this to one side, and look at their policy as if it might be implemented now.

The first section of their document is titled 'Fiscal Responsibility', which is an encouraging start, and they appear to be serious about the idea in principle. In particular, they are proposing the establishment of an independent oversight body, similar to the US Congressional Budget Office (CBO), which will report on the fiscal sustainability of government fiscal policy. As a statement of intent, this is a positive, and inclusion of private finance initiatives on the government balance sheet are all well and good. However, it might be noted that the US is still firmly on a path of fiscal profligacy despite the CBO. Also, whilst this is a positive, the UK already has independent oversight in the form of the Institute of Fiscal Studies, which is genuinely independent.

More worrying is that the remit of the organisation will be to look at fiscal policy and consider the sustainability of the policy 'adjusted for the cycle', and a proposal that there is 'a balanced current budget adjusted for the cycle'. It is in this statement that the major concern arises. Whilst the policy discusses the consideration of uncertain forecasts, it still allows for governments to borrow money based upon assumptions of some kind of knowledge of where the economy might be in the 'cycle'. It therefore ignores the fundamental solution to fiscal responsibility, which is that, barring disaster such as war, government should have no need to borrow.

After all, the government has a massive tax base, and should therefore be able to fund activity out of current income. In particular, if the government wishes to instigate a counter cyclical policy, it should save for a rainy day, a phrase that is included in the policy document. However, their policy implies that a government can save for a rainy day, and still borrow when the rainy day arrives. Why not simply save during the good times, and spend the saved money when the rainy day arrives? There is no need for government to borrow, except in times of war or disaster. It might be noted that, as a result of past borrowing, it will be a long, long time before a government is able to actually save money for a rainy day, as they will have a long period of paying down current debt.

Section 2 of the document is also headed with an encouraging title, which in this case is 'Financial Responsibility'. However, within the document are many worrying ideas. Perhaps the most worrying aspect is that the policy sees a transfer of considerable responsibility to the Bank of England for financial stability. As I have pointed out in previous posts (e.g. here - a long post), the regulatory framework and monetary policy of central banks made a significant contribution to the financial crisis, and giving them more power appears to be a perverse solution to future financial stability.

One of the cornerstones of the policy is that the Bank of England will have responsibility for spotting market-wide risks. This sounds very appealing in light of the disaster that has overtaken the financial system, but assumes that the Bank of England can actually see the risks in advance. As I have endlessly pointed out in past posts, the Basel rules (the foundation of bank regulation) included provisions such as very low capital adequacy ratios for lending into OECD banks, and for lending to OECD governments. With regards to the former, the OECD banks were the ones that were found to be insolvent, and the non-OECD banks were the ones that came out of the crisis relatively unscathed. In other words, the understanding of risk in the financial system was 100% wrong. Furthermore, there are now question marks over the sustainability of OECD government debts, which are still treated as zero risk.

The question here is very simple. If the central banks and regulations based upon their view of risk were so wrong in the past, why on earth should they get it right in the future?

On a more positive note, the policy discusses giving the Bank of England new powers to deal with banks when they are failing. However, there is no mention of the real problem, which is the so called 'too big to fail banks'. I have largely argued against regulation, but do believe that regulation should deal with the problem of 'too big to fail' banks, and that means breaking up 'too big to fail' banks, and ensuring that no bank is of a scale that it might create a systemic risk. The one lesson of the financial crisis that cries out for new regulation is the one area that is ignored.

Instead of dealing with the underlying problem, the Conservative policy instead moves into the emotive area of 'Tackling Reckless Bonus Structures'. If the policy were to address the issue of 'too big to fail', there would be no need to tackle reckless bonus structures, as excessive risk by a bank would result in insolvency, and the insolvencies would act as a warning to other banks. The point here is that banks must be small enough such that governments feel no need to ever rescue them when they fail.

Another problem that is not addressed is the ongoing ability of banks to pay organisations to rate their standing and rate their products. Again, the Basel rules encouraged this practice by having the ratings provided by the bank paid ratings agencies used as the basis of capital adequacy. The simple solution is that financial institutions should not be allowed to pay any organisation to rate anything. Ratings should be paid for by the purchaser of the product, not the seller. In allowing the banks to pay for ratings, the development of a market for independent ratings is throttled. Again, with an encouragement of genuinely independent ratings agencies, there would be no need for regulatory interference in banking bonuses. Excessive risk would be punished by independent ratings.

Another policy outlined in the policy document is closely related to this problem. The Conservatives are proposing tighter regulation of consumer credit. Some of their proposals, such as greater provision of information, and a cooling off period for store credit cards are very good. However, they fail to tackle one of the central problems of the provision of financial information, which is that the providers of the information are often working on commission from the financial institutions. Once again, the financial institutions are paying for ratings of their products, and this should be made illegal.

Another problem they fail to tackle is the provision of so-called interest free credit. I describe this as so-called, as it is an impossibility. The only way that interest free credit might be offered is if the cost of the credit is loaded onto the selling price of the item. Under such circumstances cash buyers are subsidising the credit of others, and this is an encouragement of indebtedness. It is a fraud to describe any retail credit as interest free, as all credit has a cost (even if a cash rich retailer offers this, there is an opportunity cost). The same might be said of teaser rates, and a whole host of methods that encourage consumers into excessive debt through provision of distorted information and downright fraud (e.g. self-cert mortgages in the hands of commissioned advisers).

With regards to taxation, the picture is more encouraging. As I identified in a previous post, the taxation system is far too complicated at every level. The Conservative policy recognises this and proposes the establishment of an Office of Tax Simplification which will be tasked with the simplification of the whole tax system. Of particular note is that there will be significant oversight of the taxation system, including a commitment to preventing 'stealth' taxation. This is a worthy aim, and it just remains to be seen whether the new organisation can actually deliver on the ambition inherent in the office's name.

A more problematic area is the discussion of tax reduction. Whilst there may be arguments for and against any level of taxation, the discussion of tax reduction is a purely academic debate. In the current fiscal situation, it is unlikely that any reduction in the overall level of taxation might take place. As such, the discussion of tax reductions looks to be disingenuous. For example, they discuss a reduction in corporation taxes, but also propose a raft of so-called green taxes. In doing so, they will likely give with one hand, only to take away with another.

The instigation of the 'green' taxes also has potential to add to the complexity and cost of the management of taxation, thereby potentially undermining the stated aim of tax simplification. The real answer to the problem of taxation is genuine simplification, and I outline how this might be achieved in a post here (I have since come up with ideas as to how the proposed system could be streamlined, and will post on this at some time in the future).

The final section of the policy document again has an appealing title, which is 'A More Balanced Economy'. The analysis of the problem is very sound, as they identify that most of the 'growth' in the economy has been related to government, housing and retail/wholesale and related activities, and note that manufacturing has 'flatlined'. They do not however note that the 'growth' that these describe is actually resultant from borrowed money, so not real growth at all, but rather foregoing of future growth. It is the great myth of GDP growth, which does not represent real growth at all (see here for why).

As a solution to the unbalanced growth, they look at the essential infrastructure of the UK, including diverse policy areas such as education, welfare reform, and road building. As such, their proposals are that reform in the infrastructure will encourage improvements in the balance of the UK economy. This is a difficult proposal to evaluate without an evaluation of each individual policy and, even then, it would still be difficult to determine cause and effect in terms of the re-balancing of the economy.

One point that they do not discuss is the UK economy in terms of the world economy. In particular, there is no discussion of the mercantilism practices of countries such as China, which actively result in unfair competition in manufacturing, and also in the theft of intellectual property. Whilst the emerging economies will, in all cases, be tough competitors, the mercantilism policies utilised undermine the potential for re-balancing the UK economy. This is perhaps the single most important area of policy, how to deal with mercantilism, but it is not addressed in any form.

There is one area of the policy document that will actively work against the redevelopment of manufacturing, which is the implementation of so-called green policies. These appear throughout the entire policy document, and are largely focused on the issue of carbon dioxide emissions in relation to the idea of man made global warming. At this point, I should mention that I am a man made global warming skeptic, so you may wish to bear this in mind. However, even if believing that global warming is man made, there is a fundamental problem in the implementation of 'green' policy; it will fall hardest on manufacturers who are large energy users. These companies will be faced with increasing costs due to the green policies, and this will undermine their competitive position. This will result in outcomes that will work against the re-balancing towards manufacturing.

The reasons for these outcomes are very simple; not all countries are going to follow the same level of 'green' policy, and those that implement the strongest policy will provide competitive advantage to those that follow the weakest policy. In such a situation, all that will happen is that the carbon dioxide emissions will simply be displaced from the 'green' country to the competitors with less 'green' policy. In many cases, this will lead to higher emissions, with countries like China being less efficient in their energy utilisation. In other words, without binding standards across every country, 'green' policy will simply shift manufacturing overseas, and will likely increase overall output of carbon dioxide overall. Unless there are universal standards, this is simply a policy to encourage further declines in manufacturing.

In this analysis, I have outlined a broad brush view of the proposals of the economic policy of the Conservative Party. However, I have only covered a fraction of the detail, and have been selective in what I have examined. I would therefore suggest that you read their document in full, to see the many points and detail that I have not included. It should also be noted that some of the details have yet to be filled in by the Conservative Party.

With regards to my overall assessment, I view their approach as a positive in comparison with current policy, but that is an assessment that commences from a low benchmark. Overall, I see the policy as tinkering with the current system, with a few improvements here and there, and some profoundly negative policy, such as the 'green' elements of the policy. The most encouraging idea is the simplification of taxation, which is a long overdue reform, but I have reservations about whether this will not see new complications enacted in, for example, the implementation of 'green' policy.

Altogether, what is really lacking is a radical rethinking of the underlying principles of what government, and government institutions, are actually there for. I have discussed several reforms which address these fundamental issues (such as the post linked to earlier on taxation). I am not proposing that the posts that I have presented on reform are the only answers, or that they are the best answers, but in each post I have asked what the underlying purpose of the government is for the area under discussion.

What is lacking in the conservative policy is this questioning. What are education, welfare policy, tax policy supposed to do, and how might they be achieved? Instead, the Conservative policy document commences with an assumption that, somehow, what is policy today is the starting point, rather than starting thinking from the principles of what policy in each area needs to finally achieve. It is policy built upon the legacy of what has gone before, rather than asking what the policy should deliver, and then proposing how that delivery might be achieved. It is the reason for the tinkering approach, rather than a root and branch examination built upon the underlying purpose in the policy.

As I have emphasised throughout the blog, the world is changing fast, and is becoming a far more competitive place. There are many good points in the UK system (from my point of view), such as the universal access to healthcare. In order to be able to afford such benefits, the rest of the system must be addressed, as well as how those benefits are delivered. I have, for example, linked to the post on tax reform. One of the aims of this reform is to free up huge amounts of potentially productive labour that is currently tied up in the complexity of managing the tax system. It is only if these root and branch reforms are made that the UK will be able to continue to afford to continue in the provision of state funded healthcare. I have also posted on reform of the health service, the provision of unemployment benefits, and education.

In a tougher world, these kind of deep rooted reforms, with likely better proposals than mine, are the only way that government might actually be able to afford to continue with the many benefits that the UK has formerly provided. In some respects, the Conservative policy is going in the right direction, but I suspect that, by the time they reach government, their policy will need to face up to a much harder reality, a reality imposed by a tougher world. The UK is not as wealthy as it still appears, and is still living on overseas borrowing. At some point, that borrowing must stop, and only radical reform will allow for the UK to continue with a good lifestyle when exposed to the real level of wealth in the economy. Quite simply, there will be no room for fat.

There remains in the Conservative policy a belief that the UK is wealthier than it actually is. They are confusing the living standard that has been supported by debt with the living standard that will be imposed when the debt stops. This is perhaps the reason for their timidity. It is this failure to face up to the underlying reality of the UK economy that really leaves me unconvinced. However, perhaps by the time they reach government the reality may be so plain, that they will indeed adapt? On this I can only speculate.

The Great 'Shift' - China and the West

We are living through one of the times in history when a major and irrevocable shift is taking place. It will be a time that will be the subject of controversy amongst historians and, no doubt, there will be arguments about causation, about what set off a chain reaction of change. They will perhaps ponder and wonder that so many people were so blind to what was actually taking place before their eyes.

The shift that we are witnessing is the move of economic power from the West to the East. It is a well worn theme on Cynicus Economicus, that we are seeing the rise of China, and the fall of the US, and the process is now accelerating. Alongside the fall of the US, we are also seeing further declines in countries like the UK.

When I first arrived to work in China in 1997, I could see the emergence of an economic juggernaut. Sure, there were huge problems, and I encountered the legacy of communism in a generation of senior managers who were next to hopeless. Despite that, when I finally left China, I could see that the future was going to be Chinese. I could see a generation of hard nosed business people emerging.

The experience in China shaped my thinking on economics. On the ground in China I could see the massive investment from the West shaping a new and dynamic China. The Chinese welcomed us with open arms and, when I first arrived, were still somewhat in awe of the success of Western business. However, as time progressed, I also saw that Westerners were seen as a soft touch, who would overpay on everything.

The establishment of joint ventures was just one example of the many ways in which the Chinese would extract great deals. When I first arrived in China, all of the consultants were urging investments in joint ventures, and would prattle about notions such as 'guanxi', without any real knowledge of what they were talking about. The Western companies would send out a senior executive with orders to arrange a joint venture. When they arrived in China, they would be presented with four or five prospective joint venture partners, all of whom would have opaque business operations.

In the end, with all of the partners similarly opaque, the Western executive would settle on the least ugly partner. The documentation would then be drawn up, and the business would commence. It was at that point that the Western company would find out that they were supporting a whole raft of pensioners and other commitments in the joint venture. As part of the deal, the Western company would introduce new technology and process, train the management and the workforce. The trouble is that they were training the people ready for a new company to be established by their joint venture partner, and the new company would take all the technology, process and training, and open a competitor company. The competitor would be free of all of the social commitments and other costs.

Then there were the deals where, in order to win a contract, China would insist on technology transfers. I remember a GE power station turbine deal with technology strings attached, or the opening of an assembly plant by Airbus in order to secure deals in China. In so many cases, the price of doing business in China was risking the very thing that made the Western companies such a success; transfer of technology and process.

Then there is 'outsourcing', the rush to China to cut costs at the price of de-skilling the Western work force. It is not just the factory workers, but the designers and engineers who end up de-skilling. A good designer or engineer will understand the process of manufacture. Whilst there may be a legacy of good designers, as time goes by, the great design will emerge in the location of the manufacturer, and that will mean China. It will take time, but it will happen. The other trouble with outsourcing is that, as the manufacturers undertake the work, they will gain scale and experience, and will one day seek to move up the value chain. They will be in a position where all they need know is how to market and distribute their products. Outsourcing may make profit in the short term, but often at the cost of the future of the company doing the outsourcing.

Alongside this, there has been the artificial manipulation of currency by China, and no respect for intellectual property rights. The countries of the West have allowed this to take place, and now appear powerless to stop such practices.

There is a reason why I have returned to the subject of China. I have long argued that the ascent of China will progress far faster than most analysts and commentators suggest. I have long argued that China will emerge as the winner from this crisis, and have argued that their currency will be the new reserve currency in the future. Over many, many posts, I have tracked their steady process of internationalisation of the RMB, and consistently argued that the $US is so weak that it must collapse. I have returned to the subject as the mainstream media are finally really starting to understand what is taking place. Amongst the many articles, it is this article from Ambrose Evans-Pritchard that inspired me to return to the subject:

Beijing does not need to raise money abroad since it has $2 trillion (£1.26 trillion) in reserves. The sole purpose is to prepare the way for the emergence of the yuan as a full-fledged global currency.

"It's the tolling of the bell," said Michael Power from Investec Asset Management. "We are only beginning to grasp the enormity and historical significance of what has happened."

[and]

"Everybody in the world is massively overweight the US dollar," said David Bloom, currency chief at HSBC. "As they invest a little here and little there in other currencies, or gold, it slowly erodes the dollar. It is like sterling after World War One. Everybody can see it's happening."

"In the US they have near zero rates, external deficits, and public debt sky-rocketing to 100pc of GDP, and on top of that they are printing money. It is the perfect storm for the dollar," he said.

"The dollar rallied last year because we had a global liquidity crisis, but we think the rules have changed and that it will be very different this time [if there is another market sell-off]" he said.

The self-correcting mechanism in the global currency system has been jammed until now because China and other Asian powers have been holding down their currencies to promote exports. The Gulf oil states are mostly pegged to the dollar, for different reasons.

This strategy has become untenable. It is causing them to import a US monetary policy that is too loose for their economies and likely to fuel unstable bubbles as the global economy recovers.

The article was a response to news (since denied) that China, France, Japan, Russia, and the Gulf states were planning to abandon the $US for pricing of commodities. Ambrose Evans-Pritchard argues that the currency of pricing commodities is of no importance, but this is something with which I disagree. This is what I had to say on the subject of the emergence of the RMB as a reserve currency in April:

However, the real key to reserve status is when trade is more broadly conducted in the RMB, such as move to trading oil in RMB. Perhaps Venezuela will offer such an opportunity? An article here suggests that Venezuela may need to turn to China for financial support, and this may well present an opportunity for China to start this process:

In Latin America, the external funding situation remains relatively stable but in the case of further deterioration of capital flows, the solid economies would be able to tap the IMF or the Inter-American Development Bank (IADB) for non-conditional lines of credit, while the economies with less sound macroeconomic frameworks such as Ecuador, Argentina and Venezuela would most likely only be able to obtain funds through more formal conditionality or by turning to lenders like China.

Returning to the question of whether it is possible, I see no reason to prevent the RMB from taking on this role. There has been talk about the RMB not being 'liquid' enough, the lack of depth of their financial markets. However, I take a fairly simplistic view, which is to ask whether a currency has the underlying strength of being able to be used to purchase goods and services. The answer to this question is, of course, 'yes'.

It appears that ambitions for pricing of oil in RMB are far more ambitious than I first thought. Whilst the story has been denied, there is an underlying logic to the story that belies the later denials. It is only a matter of time before we see commodities priced in RMB.

In order for the RMB to succeed the $US as the reserve currency, it was always going to be necessary for the $US to collapse. The US has undertaken policy that will ensure such a collapse, and it is simply for the reason that the US is fiscally incontinent, printing money, and pouring the wealth of the future into zombie banks. When the $US falls, the US will finally see the forces of inflation unleashed, as the massive imports of commodities, goods and services surge in price. It is at this point that the underlying reality of where real economic power lies will finally become clearly visible. It is at this point that the real wealth generating capacity of the world will emerge into the light.

When the US is no longer able to borrow, when it is reliant upon what it actually produces, rather than borrows, it will be apparent how bad the situation has become. The same will be true of several other economies, such as the UK. For many years, these economies have been subsidised by the economies to the East and, without any further subsidy, they will find life is far harsher than they have ever imagined.

The rise of China is no mystery but, no doubt, the historians will manage to find controversy, manage to bury all of this under complexity. The economists will meanwhile suggest that the transfer of economic power emerged out of the banking crisis. The reality is far simpler.

The Western world was complacent, arrogant, and bloated. Collectively, the West allowed the emergence of a new competitor who used mercantilist policies to accumulate the modern equivalent of bullion, they allowed the export of all that had made their economies such a success and, when confronted with reality buried their heads in the collective sand of borrowing and money printing. Whatever happened, once China opened to the world, a new economic challenge was inevitable. However, the way that the West met the challenge has ensured that China will emerge as the great economic power.

As we move towards the end of 2009, we are entering into a new world, a new economic structure. We are witnessing a change in the world that will be viewed in hindsight as one of the defining moments of the 21st century.

Note 1: I have not referenced as many points as usual. However, many of the points made are consolidating the points made in previous posts, and these provide support for the case that I am making. I have listed some previous articles on China and the $US, if you are interested in seeing my case in greater detail, and the evolution of my thoughts on China's rise:

1. July 2008, China - What Future?
2. August 2008, China Propping up the $US
3. January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
4. January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency
5. February 2009, China's Pivotal Role in the Next Step for the World Economy
6. Fenruary 2009, China and the US - Fighting on the Edge of a Cliff
   
7. March 2009, Economics and Power, the Loss of US Power
8. March 2009, China, Gold and the $US
9. April 2009, China as the World Economic Power?
10. April 2009, The RMB as the Reserve Currency
11. May 2009, China, the RMB and the $US
    
12. July 2009, The RMB as the Reserve Currency - an Update
13. September 2009, The Rise and Rise of China
    

Note 2: Am I repeating myself here, or does this post add to past posts? Comments welcomed. If readers feel I should move off this subject for a while, I will do so.