The Crisis is Steadily Moving Towards Denouement

First of all, apologies for the lack of posts recently. I have simply not had the time to post.

Are others seeing that there is a slow and steady unwinding of the economic situation? There now appear to be signs of substantial cracks the edifice of the illusion economy. A review of the news sees several apparently unrelated stories, but nevertheless they cumulatively represent the underlying flaws in the attempts to hold back the underlying reality of the world economy.

First of all, there is the ongoing saga of Dubai, the exemplar of the worst excesses of property speculation:

Fresh fears about Dubai's ability to resolve its huge debt mountain returned to global stock markets today as shares across America, London and Europe tumbled.

In America, the leading Dow Jones industrial index fell 111.63 points to 10,278.48 at 3.40pm in New York.

Earlier today, Abdulrahman al-Saleh, Dubai's finance minister, admitted that six months may not be enough to restructure Dubai World, the state-owned conglomerate which owns Nakheel, the property developer.

It later emerged that Nakheel made first half losses of $3.65 billion, according to Bloomberg, after taking a huge writedown on the value of its land and developments. Two weeks ago, the Dubai Government asked creditors to grant Dubai World a six-month standstill on its repayments of nearly $60 billion of debt. Dubai World then announced plans to restructure $26 billion of its liabilities.

Likewise, there are the ongoing problems of Greece, perhaps an outrider for the larger Western economies. Greece presents another crack in the edifice of confidence in government debt:

The agency placed the country on credit watch negative, meaning it is likely to lose its A- rating within months. The country already has the lowest credit rating in the eurozone, but has come under greater scrutiny amid fears that its newly-elected government may avoid imposing significant cuts on the public finances

[and]

Following the recent crisis in Dubai, investors have become doubly sensitive to the risks of sovereign debt crises, with others warning that the UK is similarly exposed.

S&P also revised its outlook on Portugal’s sovereign-credit rating to “negative” from “stable”, blaming a deterioration in public finances.

As I have previously argued, if the UK falls, the US will soon follow. In the meantime, President Obama is reacting to a swathe of bad news with yet more 'stimulus' spending, at a time when the creditors to the US are already very nervous:

WASHINGTON – President Barack Obama called for a major new burst of federal spending Tuesday, aiming to jolt the wobbly economy into a stronger recovery and reduce painfully persistent double-digit unemployment.

Despite Republican criticism concerning record federal deficits, Obama said the U.S. must continue to "spend our way out of this recession" as long as so many people are out of work. More than 7 million Americans have lost their jobs since the recession began two years ago, and the jobless rate stands at 10 percent, a statistic Obama called "staggering."

Congressional approval would be required for the new spending, the amount unspecified but sure to be at least tens of billions of dollars.

This new stimulus comes on top of the news that the fiscal situation in the US is already in an absolutely appalling state:

In October and November, the government spent $292 billion more than it took in, the nonpartisan Congressional Budget Office said.

That was even worse than the same period last year, when the government was on its way to posting a record $1.4 trillion deficit for the fiscal year that ended Sept. 30.

The federal budget has been battered by the worst economic downturn since the Great Depression of the 1930s, as tax revenues have plunged and spending on safety-net programs like unemployment insurance have skyrocketed.

What we are seeing is the ongoing unwinding of the many bubbles, and that the forecasts and announcements of the end of the crisis are indeed premature (which has long been my argument). Even Bernanke is admitting that there are ongoing and deep problems, and the $US continues to decline:

The dollar resumed its slide against the yen, euro and other currencies after climbing in recent days amid hopes the US might stage a quicker-than-expected rebound.

On Monday, however, Fed Chairman Ben Bernanke said the world's largest economy was facing "formidable headwinds" — including a weak job market, cautious consumers and tight credit — that would limit the pace of recovery.

Obama expressed shock at the relentless rise in unemployment, but around the world a dire situation continues to deteriorate. This is just one example from the Times:

London traders were also unnerved by new data on industrial production, revealing flat output in October, signalling that Britain, which is still in recession, has made a weak start to the fourth quarter. The CBI also published its industrial trends survey, which showed factories expect output to fall in the coming months.

The weak data was released ahead of the Pre-Budget Report tomorrow when the Chancellor is widely expected to reduce his forecast for Britain's economic growth this year from a decline of 3.5 per cent to 4.75 per cent.

Meanwhile, European markets were unsettled by Fitch’s decision to cut Greece’s sovereign debt rating to BBB+ from A- with a negative outlook - the first time in 10 years a major ratings agency has put Greece, the eurozone's weakest economy, below an A grade. Fitch cited fiscal deterioration as the reason.

Also weighing on European stock markets was worse-than-expected German industrial production data. German industrial output fell 1.8 per cent in October, largely as a result of weaker production of machinery and cars, against expectations of 1.1 per cent growth.

As ever, the nervousness about the situation continues to be seen in the price of gold:

GOLD soared through US$1,200 (S$1,657) as investors and speculators feared renewed US dollar weakness following President Barack Obama's decision to substantially boost the war effort in Afghanistan.

Other factors that have boosted the demand are worries about quantitative easing, that is, money printing in the US and UK, punitively low interest rates for savers seeking a home, fears of renewed inflation and persistent turmoil in the Middle East.

Uncertainty in Dubai with expectations of bailouts and a general rise in oil and other commodity prices are other reasons.

There are some curiosities in the news, such as the ongoing rise in house prices in the UK. One just has to ask why house prices might be rising in a sinking economy to know that this is yet another illusion. After all, with unemployment rising, where is the money coming from? One article suggests that it is a lack of supply of houses for sale as the driver, but it is certain that the rise in prices does not reflect the real economy.

Essentially, any review of the news shows that the attempts to reflate economies with printed money and massive government borrowing are simply not working. The cash for clunkers, the massive spending on 'make work' projects are a dead end. Printing money with no economic foundation will simply not work.

The one thing that might work, the reforming of the economic structure of the troubled economies, is the one thing that is never considered. In the early days of the blog, I wrote some examples of how the UK economy might be reformed. I am not sure that the UK will be able to even afford to support the reformed economy that I proposed. It is too late. Instead of using credit to manage the transition to a more lean and competitive economy, credit has been used to try to hide the reality of the economic situation. The same might be said of other economies, such as the US.

I keep on asking how long can this continue? How long before the illusions shatter? I am amazed that it has lasted this long.

Note 1:

In an early post during the bailouts, I mentioned that all of the money given to support the UK banks was not to protect little old ladies' savings, but to support overseas creditors. This is what I had to say in a post titled 'The UK and the Silent Bank Run' (written March 2009, but I think I argued this point at the outset of the bailouts, but can not find the article):

If we think of the numbers that we are looking at, it becomes self-evident why the endless bailouts by the government are falling into a black hole. The government is having to bail out the banks to repay these overseas investors such that, as fast as the money is pumped in, it is pumped straight back out to meet the demands of overseas depositors. With the banks sitting on mountains of toxic debt, with no market left for the sales of these toxic assets, there is nowhere to turn except to the government.

It is as I have long suspected. I have always been of the view that this is not really just about bailing out little old ladies with their savings held by RBS, but also about bailing out all of the overseas investors who stand to lose so much money.

This is an article in the Telegraph:

British taxpayers stand behind more than £167bn of toxic assets in the US, Ireland, the Middle East and beyond, it has emerged as the Treasury disclosed details of what Royal Bank of Scotland has dumped in the state insurance scheme for bad debts.

Most of the £281.9bn of assets RBS has placed under taxpayer protection are based outside the UK, with loans secured against everything from negative equity properties in Dublin to hedge fund assets in Caribbean tax havens and container ships docked in ports around the world.

I suspect that this is just the tip of a very large iceberg, and the same will be found for the US. What we have witnessed is the salvation of the banks to protect overseas creditors. These were the same creditors who flooded the economies of countries like the UK and US with money, which in turn created the asset price bubbles and credit bubbles. In the case of the banking industry, it is heads I win, tails I win. It was never about protecting the small domestic depositors, but bailing out overseas investors.

Note 2:

A slightly rushed article as I am still pressed for time. However, I hope it provides some evidence that we are a long way from any real or sustainable recovery.

The King Canute Economy

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

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

[and]

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

[and]

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

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

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

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

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

[and]

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

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

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

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

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

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

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

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

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

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

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

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

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

I call this the 'King Canute Economy'.

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

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

Who Might Run Industrial Policy?

It has been a while since I have last written a post, and the choice of subject matter for this post has proven to be a difficult decision. On the one hand, there is the ongoing tremors in the financial system, and on the other there are the global shifts, such as the unsubstantiated suggestion by China that they may allow the RMB to appreciate. Added to this, there is the ongoing ascent of the gold price, as investors and governments move into the asset of last resort, and the progressive decline in value of the $US. This from the Wall Street Times:

"The gold market is kind of surprising here," as it holds on to the psychologically important $1,100 level, said Ralph Preston, senior market analyst with Heritage West Financial.

Watching the dollar's next moves will be crucial, Preston said. "It's going to be interesting whether the dollar is developing a bottoming formation or if it is about to fall off a technical cliff."

I will leave such matters alone for this post, as they are being covered elsewhere. Instead I would like to focus on one of the widely utilised government stimuli; the cash for clunkers schemes. I am focusing on this subject, as the scheme has appeared to give a temporary reprieve in the downwards trajectory of many economies. My inspiration was an article in the Telegraph, in which Jeremy Warner analyses the impact of the stimulus on the UK economy.

The purpose of my post is to highlight the absolute foolishness of such government measures in relation to arguments for more government interventions in economies. A long while ago, in a discussion of GDP measures, I pointed out that Hurricane Katrina would have seen an uptick in US GDP. The destruction of infrastructure, housing and other assets would have led to increased activity in the economy, as business and government sought to replace the assets that were lost. In other words, the destruction of a hurricane would appear to be a positive boon for an economy. On such logic, bombing your own cities would be good for the economy.

As it is, we have seen a natural disaster replaced with a man made disaster. Each of the cars that has been scrapped early is an asset with a real value, and useful life. Just as a bridge being destroyed in a hurricane still has a useful potential lifespan, the same might be said of the cars that have been scrapped. Quite simply, the result is just the same.

In some ways it is an identical process to running a production line with a garbage compactor at the end of the production line. As each unit comes off the production line, the compactor simply crushes the item. The result of such a measure would be that the demand for the item might never be met, and the production line would be kept endlessly busy. Output would be maintained, GDP figures would be positive, and the economy would apparently be doing well as the result of this ongoing activity.

What I am discussing is not particularly original, and many other commentators have made similar observations. On this occasion, I am reiterating the point due to comments on my previous post. One of the regular commentators, writing under the name of Lord Keynes, made a robust defence of government intervention in the economy, proposing that governments develop industrial policy. What followed was a heated debate about the relative merits of government interventions, with both sides of the debate arguing their points vigorously.

In light of this debate, the purpose of this post is very simple. I have outlined the principles of a government policy, adopted in many countries, which is just a process of destroying useful assets - governments destroying something and suggesting that this is good for the economy. These governments include the same people in whom Lord Keynes appears to profess so much faith. These masters of our economic destiny actually think that premature destruction of assets is good for an economy. These are people who would count Hurricane Katrina as having had a positive impact upon an economy. Few would say such a thing directly (though I do recall that the Economist magazine came close to actually saying it), but they would see the positive GDP growth from the activity from Katrina as a 'good thing'.

My question is very simple. How can anyone have faith in these people? It is extraordinary that anyone might have faith in people with such bizarre beliefs. Really, can we trust these people with the widespread interventions in the economy, as proposed by Lord Keynes? The very same people who instigated the cash for clunkers policy would be the same people who would devise 'industrial policy'. Lord Keynes is not alone in having such faith in government interventions, and the worry is that those with his views are gaining ground. The advocates of ever more interventions, ever more shift of resource into government hands, are becoming ever more plentiful. That such beliefs are gaining ground is a real cause for worry.