A Crescendo of Crisis - Explained?

Even though I have a hectic schedule at the moment, I could not resist the urge to post. I opened up Reddit, and several news sources, and it was interesting to see the brewing of so much potential crisis. For the sake of ease, and a sample of the point, I will use the Daily Telegraph to illustrate the point. The headlines and quotes are as follows:

Euro Reaches its Eleventh Hour

The German chancellor and the French president were barraged with pleas from political and financial leaders to reach agreement on bailing out Greece – or risk the collapse of the single currency.

The leaders have been told that today's crucial summit in Brussels was the "last chance saloon" for the euro project.

Wall Street Paralysed by US Debt Talks

The White House and Republicans and Democrats in Congress have 10 days to raise America's $14.3trillion debt ceiling. Failure to do so would see the government default on its debts, which Federal Reserve chairman Ben Bernanke has warned would be a catastrophe.

Investors' confidence that politicians would avoid that outcome has dwindled as the deadline approaches.

And for the UK, we have a commentary titled 'Britain's deleveraging nightmare threatens its triple A rating'. This is a quote from this commentary, and a chart from the same article follows:

Yet a substantial part of the Chancellor’s plans for eradicating the deficit rely on quite brave assumptions about the scope for future economic growth. With nine months of economic flatlining now under our belts, these assumptions are looking ever less credible. The Office for Budget Responsibility will almost certainly have to trim its forecast of 1.7pc growth for this year in its next update, and many will begin seriously to doubt its independence if it doesn’t adjust longer term forecasts down too.

In other words, the whole economic strategy hangs on a quite slender thread which could easily break and plunge the UK into the same vicious cycle of one austerity programme after another that has been forced on the European periphery. Now look at the graphic below, from a recent update to the McKinsey Global Institute’s study into the economic consequences of the credit bubble.

It is really not difficult to see the commonalities in these stories, all of which are about the problems of sovereign debt. The most interesting point in the story above is that the author, Jeremy Warner, recognises the real problem; that paying off the debt has hardly begun (in fact all the countries in question are still running up more debt).

In the wake of the so-called 'financial crisis', governments and central banks have sought to borrow money and flood the world with money as their respective solutions to the problems that they saw developing as a result of the crisis. These were the magic bullets that would pull the world back from the brink of another great depression. Lined up behind both policies was a mainstream economics profession that sought to justify these actions, with argument isolated to the extent, breadth and detail of the policy. There were, of course, some exceptions, notably the Austrian economists, who railed against the policy solutions and were largely ignored by policy makers.

What we have seen since is a roller coaster ride. As the policymakers pulled their macroeconomic levers, they would promise salvation and that they would 'fix' the world economy. The same theoretical models that failed to see the oncoming problems would now fix the world economy. Well, I have a question for these titans of economic theory; does it look like it is working, or are the scale of the problems just getting larger and larger? The most extraordinary thing about the mainstream economics profession is that they simply refuse (as an economics professor described to me) 'to look out of the window at the world around them'. They are firmly fixated upon models which have already failed, and continue to fail as even as they keep on using them.

At the heart of the problem is that they have forgotten what economics is supposed to represent, which is the exchange of labour (however subjectively that labour might be valued). If person A uses their labour and makes item X, and person B wants item X, person B must offer something from their own labour which person A wants in exchange. Whilst it is quite possible that person A will give item X on credit, at some point person B must start giving person A something that they want. If not, it is likely that person A will no longer give person B credit (unless they are a charity or a fool). It is really not that difficult to understand.

If we scale up these simple principles, it is apparent why the macroeconomic levers are causing more harm than good.

Lets say that person A is making item X and they are willing to exchange two of item X for one of item Y made by person B. When they exchange two of item X for one item Y, all is well and good. However, if we see that person A is regularly exchanging three of item X for one of item Y but ask that in the future person B will give additional item Ys, then they are giving credit. This is all ok, as long as person B is able to return the additional item Y in the future. The problem arises when this is the situation:

• Person B is buying 12 item X per year.
• Person B can make 5 item Y per year for exchange, unless they reduce their own consumption of item Y (4 per year).

What we see is a shortfall in the capacity to ever return the owed item Ys - unless of course the following take place:

• They reduce or forgoe their consumption of item Y
• They reduce of forgoe their consumption of item X
  

Now, it is quite possible that person A will provide item X on credit for a good long while. However, unless person B is able to dramatically increase their output of item Y, there is a point at which they must reduce their consumption of item X or Y. When credit is offered, it is done so on the basis that it will be repaid at some time in the future (+with interest). This is completely obvious.

The problem for person B is that their lifestyle has been based upon consumption that can not be sustained in the long term. In fact, they must reach a point at which their overall consumption equals their total output of Y minus the number of Ys owed to person A (according to how the repayment is structured). Prior to this, their consumption was total output of Y + the credited amount of Xs. If we think on this a little, we can see that the move from taking credit to repayment of credit is problematic for the quality of life of person B. They either have to reduce consumption, or increase the amount of labour that they do in order to continue to consume as much as they did when they were taking credit. The only other possibility is that person B manages to find a new technology or process which will allow them to make item Y faster, or a new item which, relative to person B's total input of labour, is valued more highly by person A.

In absence of the last option, there is no escaping the fact that person B will see their quality of life negatively impacted; either through less consumption or through more labour. In both cases, person B is poorer than they thought that they were.

So how do the macroenomic solution stack up against this fundamental reality of economics?

First of all, let's look at printing more money and other monetary solutions. Do these in any way increase the overall capacity to produce Y, or create a new item which will be valued more highly by person A? The answer is: 'No'. What it does do is to reduce the amount of Ys that are owed to person A, thereby cheating person A (they use the devaluation to reduce person A's capacity to buy item Ys, as the credit is held in abstract monetary units rather than in units of Y). The knock on effect of this will be that other people will see person A being cheated, and will no longer trust person B with credit. In all cases, as person B refuses to give any further credit to person A, there will be less of item X for person A to consume.

However, there is something interesting in this option. In printing money, the value of the medium of exchange between person A and B has shifted. In the real world, person A and B represent a large number of people consuming more variety of goods than X and Y, with money acting as the medium to reduce complexity in transactions. In reducing the value of the money for exchange with persons B, the ability of persons A to individually exchange their Y products for X products is reduced. In this way, they have been made poorer and are less able to consume X products. In the real world, if I am paid in £s and the value of £s reduces in relation to Euros, I am less able to buy as much Belgian beer as I was before - unless the amount of £s that I am paid is increased in relation to the fall in value in relation to the amount of X goods that I buy. For example, in the UK, inflation is eroding spending power, as wages are falling behind inflation.

This is a way of adjusting the consumption of X goods by individuals, and reducing the amount of debt growth as a result of reducing consumption of X goods. It is simply another mechanism to reduce the quality of life of person Bs, but doing so in a way that is less directly obvious.

How about borrowing more? This appears ok in the short term but is just making the problem worse in the long term. For a while longer, it is possible for person B to consume as much item X and item Y as before, but only at the cost of greater reductions later. I think that there is no need at this stage to point out the obvious dangers in this approach. However, it is worth noting that the borrowing takes place without the explicit expression of the future cost to quality of life. This is the way that politicians buy votes of voters now, at the cost of quality of life in the future. It is simply dishonest. The voters will have a poorer quality of life in the future - unless person A who is giving credit is cheated (see earlier discussion). In either case, the politicians are not telling the truth.

Whilst it is possible that somehow Person B will find some way to increase output/create a new item to exchange at higher value, this is (at best) a gamble. Also, if this outcome were achieved, without the overhang of debt, everyone would be better off in proportion to the improvements in output that this represents. This improvement in quality of life will be diminished by the necessity to repay past debts + interest.

I really do not think that any of this very complicated. There are complexities in the systems that are operational in economies, but the underlying principles upon which those systems rest are relatively simple. The complexities of the operations simply serve to hide/obscure the very simple principles. In the case of the mainstream macroeconomists, they are buried in the complexity, and never seem to pause to think about what sits underneath the complexity. This is why their solutions are so fundamentally wrong. They simply do not understand what they are looking at, and never look out of the window at the world.

Note: This is a hurried post, and I hope that the logic follow, and more importantly is expressed in such a way that my intended meaning is conveyed. Please feel free to point out errors in logic/expression where you find them. Also, if you disagree, as ever, feel free to point out why.

We are poorer than we think....

I will start this post by jumping back in time. In June of 2008 I wrote a post called 'The Cigarette Lighter Problem' and a sharp commentator argued that we (in the UK) were not poorer than we thought. I responded to the comment as follows:

You correctly identify that exchange rates are out of line with PPP. In this case I could change £1 and buy several lighters if I took that money into a Chinese shop.

This has been one of the consistent arguments of this blog. Exchange rates are going to have to shift.

You suggest that is that there is not much difference in the value created by our cheap labour and that of China, so we will not be poorer in the future. However, it is evident from your own argument that our purchasing power is being significantly subsidised by China (and I would add - many others).

The imbalance in the exchange rates means that we have not been paying the full value for the goods that we purchase. We have had our purchasing subsidised by China.

If we take away that subsidy (exchange rate corrects), then our purchasing power will diminish significantly. This, by any reasonable definition, means that we will be poorer. At its most simple, the lighter we bought for 59p will go up in price.

Right from the commencement of the blog, I have made similar arguments, and proposed that the UK will see a fall in the general standard of living as illusory forms of wealth disappear, in particular illusory wealth founded in debt accumulation. Over the last year, the illusion of wealth has finally started to fade in the most visible way - through inflation outstripping earnings:


For the regular readers of this blog, this inflation rate will only surprise in that it is not much higher. However, expectations of further rises in inflation are coupling with severe declines in consumer confidence. If you would like to see the reason for the fall in confidence, it is apparent in the following chart:



Interestingly, the rate of personal insolvency and house repossession has ameliorated, but it seems to be reasonable to question whether this might continue.



The reason for why we can expect these trends to reverse are explained in the Wall Street Journal:

U.K. households' disposable income fell for the second consecutive quarter in the first three months of 2011, forcing consumers to eat into their savings to maintain their lifestyles, official data showed Tuesday.

The weakness of consumer spending is one of the major headwinds facing the U.K. economy and reduces the likelihood the Bank of England will raise its key interest rate in the near term.

In its final reading of the economy's first-quarter performance, the Office for National Statistics said gross domestic product grew an unrevised 0.5% between January and March after shrinking 0.5% in the fourth quarter. However, the ONS lowered estimated GDP growth on an annual basis to 1.6% from 1.8% due to a revisions in previous quarters of 2010.

The ONS said household real disposable income fell by 0.8% in the first quarter after a fall of 0.9% in the fourth quarter of last year. The drop in real disposable income is a result of households being squeezed between inflation of 4.5%—more than twice the Bank of England's 2% target—and stagnant wage growth.

The household savings ratio fell to 4.6% in the first quarter from 5.1% in the fourth quarter. The drop in savings came despite an increase in wages—which grew by 0.9% in the first quarter compared with a 0.5% increase in the previous quarter—indicating that consumers are having to dip into their savings to maintain their lifestyles due to high inflation.

It seems that the answer to the reduction in real income is to pull out the credit cards and supplement income with debt. From the Bank of England (here), they chart the growth in consumer borrowing, and it is notable that whilst growth rates for credit card debt declined for a while, there is a new upwards trend. Of particular interest is that other forms of unsecured lending seem to be increasing even more dramatically, and also secured lending is on the increase. Some of this might be explained by higher university fees, but I do not have the statistics to hand to see the impact of this factor. As a note, for those who look at the figures at the BOE, note that this is changes in growth of borrowing. Needless to say, the savings rate is also in decline.

Overall, what we are seeing is a real decline in the ability of people to live to the standard of living to which they are used, and the response is to use borrowing as crutch for their standard of living. What should be happening is the opposite. With ongoing uncertainty, consumers should be rebuilding their balance sheets, and preparing and adapting to tougher times. The problem is that this is all taking place in an environment of astoundingly low interest rates and an ongoing massive government fiscal deficit. This from Liam Halligan in the Telegraph:

Yes, I know the entire political debate has shifted and the Conservatives seem to have won reasonably wide support for their “austerity” programme. This doesn’t surprise me. Some of us argued for years that if the Tories abandoned their misguided pledge to “match Gordon Brown’s spending plans” and actually admitted that UK borrowing was far too high under Labour, and Government expenditure out of control, then they would win popular support.

What does surprise me, though, is that despite the broad support the Tories have received since taking office, and despite endless rhetoric about “living within our means”, UK fiscal policy is actually becoming more profligate. Far from insulating ourselves from systemic dangers, we are making the UK even weaker.

During April and May, the first two months of this fiscal year, the Government borrowed £27.4bn according to figures released last week, up from £25.9bn during the same months in 2010. That’s right, we’re borrowing more – despite all the Treasury’s tough talk.

These borrowing rises happened despite higher tax receipts in April and May – up around 8pc on last year. But spending was also higher, not only on benefits and social services, but debt interest too. Interest payments, in fact, were up a staggering 18pc on last year, even though gilt yields have been kept artificially low by so-called “quantitative easing” – that is, creating money from thin air in order to buy your own government bonds, an activity the UK has practised to a greater extent than any other major economy on earth.

In addition to the 2011 borrowing increase, a further borrowing rise was also sneaked through last week, when the 2010 total borrowing figure was revised upwards from £139.4bn to £143.2bn.

Add to this that the UK is still in trouble with the current account balance (which is just not as bad as before), and we have a picture of an economy that is sliding to further ruin. The government and Bank of England are both trying to lift the economy out of the doldrums, but the only result is an ongoing slide in real standard of living. Has it not occurred to either the government or the BoE that they seem to be, at best, holding the country on the brink, but doing so at such an astounding cost? Surely, this must lead to some change in thinking? The situation is not improving, and there are still external shocks still to be fully felt. For example, the Euro-Greek crisis still has yet to really bite.

I do not often post now, so I must by necessity be broad in my approach. As such, I will end the post with a single point. We have now watched governments managing to keep plates spinning, and prevent an all out collapse of the economy. They have expended all their ammunition, and do not have anything left in their dubious armoury. I did not believe that they could possibly keep the plates spinning this long, but they have done so. However, as much as they try to magic the ongoing crisis away, it just keeps coming back. And the longer they delay, the more they tinker and seek to direct the economy, the greater the accumulation of problems. The one thing that nobody wants to do is to acknowledge that the world has changed.

The world that was taken for granted by countries like the UK started to evaporate a decade ago. The world is now one of hyper-competition, and it is a competition for a finite supply of resource. The economic fight is over the distribution of the finite resources. There is only one solution in such a situation, and that is to reform and make your economy lean and efficient. That is the one thing that is barely addressed....and no amount of expenditure of magic bullets will fix this.

The European Situation

I thought I would make a brief return again, as I have been watching the slide of Europe into a morass with that feeling of watching a slow motion car crash. I am writing this as a very general post, without referring to the specifics of individual countries, but highlighting the principles of why the European financial crisis just will not go away. There are differences in detail and circumstance, but I think that the general principles will hold. As a light introduction, I just saw an amusing Youtube clip, which seems (in a simlistic but effective way) to sum up the madness that is facing the EU.




Since the alarm bells about the debt of Greece, Ireland, Italy, Portugal and Spain were first rung, there have been a series of deals, bailouts, negotiations, austerity measures, and on and on...but still the crisis pops back into life. The problem is something I have long discussed, which is that you cannot easily reverse the direction of an economy. In all of the above cases, the economies were living on too much borrowed money, and that borrowed money shaped the structure of the economies. The direction of that money was into consumption, and the consumption beyond the actual income was unsustainable. However, a county that has lived on borrowed money has developed an economic structure to support the consumption of the wealth creation of other countries.

In simplistic terms, this translates into the means of importing and distributing goods and services paid for by the wealth creation of other countries. In practical terms this means the over-development of retail, the restaurant and entertainment sectors, the government services, and all of the infrastructure that supports these. In a madly self-destructive cycle, the more the country borrowed, the more the activity in the economy, the higher the employment and the higher the reports of GDP, and the greater the confidence of lenders to keep on lending. The problem with the cycle is that it keeps feeding on itself right up to the point that it does not. It does not even matter what finally triggers the loss of confidence by creditors, as at some point there must be a moment of realisation of the inherent unsustainability of the cycle.

The problem with the policy actions of all of the parties seeking to save Europe from the crisis is that, once the cycle breaks, the real underlying economy emerges. As the flood of borrowed money diminishes, all of the activities that were supported by borrowed money go into reverse, unemployment rises, GDP sinks, and government revenues fall. The debt to GDP ratio starts spiralling, and fresh borrowing comes at an ever greater cost as the weakness of the economy becomes apparent. The ability to service existing debt dimimishes, and the crisis emerges once again in full force, as the downward spiral continues. Even as bailouts are calculated and handed over, the ability for the country in question to support the existing debt (let alone the new debt) is diminishing. The bailouts are chasing a downwards moving target.

In the end, the only answer is austerity. Somehow, it is necessary for consumption within a crisis country to come back into balance with the wealth creating capacity of the country. The problem is that, the deeper and longer the debt accumulation, the more the structure of the economy will have been distorted towards the consumption of debt. The real income per capita, without the addition of debt into the economy, is much, much lower than people had come to believe. It is as if the entire country has been spending their salary X, but were unkowingly supplementing their income with a slowly rising credit card debt of Y.

When the credit stops flowing into the country, and the supplement of the borrowing disappears, it is apparent what the actual income is. It is far lower than everyone thought. As it is, there are large numbers of people who are actually supplementing their income with debt, but they were unaware of how much additional debt they were personally liable for when their government borrowed. They were also unaware of how much of the whole economy was reliant on the continual debt accumulation, and can not understand why their job has evaporated. And that of their neighbour. And their brother. It is no surprise that they feel angy. They just did not realise that the promises made by their governments were not built upon sound foundations, and that the shiny new businesses making so much money were reliant upon borrowing for their survival. That is, the aggregate borrowing over the whole economy was supporting so many businesses, so much employment.

It is quite understandable that people were deceived. When all around you, you see the signs of growing wealth, it seems only natural that it must be built upon real wealth creation. It is the great illusion that debt equals wealth. The reality is that debt for consumption equals a higher quality of life, right up to the point that the debt becomes due. Then, as has always been the case, ruin follows. What we are watching in the ongoing European crisis is the slow and painful emergence of the real size of the economies in question. The problem is that, when looking at many of the non-crisis economies, they also look to be troublingly reliant upon debt.