The other problem is the sheer volume of views and opinions on what is taking place. As Ambrose Evans-Pritchard of the Telegraphs says, it is time to rip up the textbooks. He is talking about the ongoing and partially hidden crash in US housing, and the underlying unemployment rate of just over 17%, and makes comparisons with the Great Depression. In my case, I long ago ripped up the economics textbooks, as they never made any sense, but it is interesting how many mainstream commentators are now taking this view.
What we saw in 2009 was the final and last gasps of the enactment of the textbook economic theory that has dominated policy over the last few years. The economists and policymakers have now shot most of their monetary and fiscal bolts. In other words, the politicians, the economists, and the central bankers have continued pulling and pushing on the levers of the economy in the hope that reality might be forced back into its box. We have seen fiscal stimuli, and a flood of printed money into the world, and this has been used to finance record government deficits. We have seen bailouts, guarantees of toxic assets, the concentration of the banking systems into ever fewer too big to fail players.
However, in 2009, whilst everything appeared to change, very little has really changed. Whilst many of the 'rich world' countries have fallen into deep recession (if not depression), there has been no change in the underlying reality of the world economy. On the surface, we can see all of the activity of governments to 'save' their economies, but the changes are restricted to appearances, not to the actual way in which their economies are really structured.
What do I mean by this?
It is very simple. Whilst governments intervene in ever greater swathes of the economy, nothing has changed in the underlying competitive position of the 'rich world' economies that are in such deep troubles. Except for the devaluation of currencies.
It is the lever of last resort. If you can not compete, do whatever you can to devalue the currency, and then your workforce will be cheaper relative to the work force of your competition. It is a strategy that directly reduces the standard of living of every person paid in that currency. It punishes the savers, punishes the investors, but if it is taken far enough, eventually the economy will once again be 'competitive'. It is an economic policy of impoverishment, however it may be dressed up.
However, even with such devaluations, all is still not as it should be. The imbalance at the heart of the world economy has not gone away. Even as the $US falls, the RMB falls with it, making the Chinese economy ever more competitive, and ensuring that Chinese goods and serviced continue to win on the back of mercantilism policy. Nothing has changed, as no country yet has the resolve to face down Chinese mercantilism, even as the policy of China slowly but surely destroys swathes of industry around the world. Even in the depths of recession, the pre-crisis current account deficits persist in many countries.
In the latest mercantilist move, China is now talking of restricting the export of rare earth metals, over which they have a virtual monopoly. These metals are vital commodities in the manufacture of a huge number of goods:
Worldwide, the industries reliant on REEs [rare earth metals], which produce anything from fibre-optic cables to missile guidance systems, are estimated to be worth £3 trillion, or 5 per cent of global GDP.If you want to manufacture using these materials, best you have a base of supply and manufacture in China. Even the possibility of a freeze on exports will result in industries moving to China. And the response to this latest mercantilism policy? Nothing. No threats of trade sanctions, no action whatsoever. As before, China just continues its economic power grab, and the reaction is nothing of any substance. As I have said, nothing has really changed. Wealth creation will continue its inexorable shift to the East.
Then there is the structure of trade that is associated with the shift of wealth. Nothing has changed there either. Just as before, much of the 'rich world' continues to consume more than it produces. Sure, consumers are no longer the primary drivers of the debt binge economy, with the government seeking to fill the holes created by the retraction of consumer borrowing, but the essential reality of consuming more than is created continues. Nothing has really changed though because, in the end, government borrowing is consumer borrowing, as consumers will eventually pick up the bill.
There is one change that results from the debt binge of governments. The belief in the wealth of the 'rich world' is eroding, and the ability for the rich world to raise finance is eroding with this belief. It brings us full circle to the problem of printing money to pay the government's bills. If ever there were an exemplar of the underlying reality that this is a means to finance government profligacy, the Bank of England should metaphorically step forward. Tasked with maintenance of steady CPI inflation, the Bank of England claimed that the policy of printing money was to stave off deflation. Even as CPI inflation threatens to climb upwards, the original purpose of the policy is de-emphasised, and the policy continues.
For a while, the massive government borrowing of countries like the US and UK appeared to be possible. It seemed that the world accepted that all would be well, that the rich countries would continue to be rich, and were good for their debt. It seemed that countries could even 'get away with' printing money to finance government spending. I for one, never believed that such a situation could be possible, and was certain that it would all rapidly end in tears. However, throughout 2009 governments 'got away with it'.
As we enter into 2010, this looks unsustainable. More and more cracks are appearing in the edifice. Whilst each crack appears to be meaningless of itself, cumulatively they are destroying the integrity of the structure. There are the bilateral deals by China to trade outside of $US, the emergence of a petro-currency, the withdrawal of PIMCO from US and UK bonds, the shift of money into commodities, the carry trade of the $US and so many other small cracks....
The big question is this. Who is going to continue to finance the debt binge of the deficit countries in the coming year?
The cracks in the edifice of belief in the inevitability of the 'rich world' being rich mean that the supply of endless credit may well be coming to an end. In many countries, and I think of the US and UK in particular, though there are many others, there is the belief that the current structure of their economies might, somehow, be maintained. There is a lack of understanding that, in the end, that structure is built upon the credit provided by other countries, and without that credit, the structure can not be sustained. Even as the structure is crumbling before our eyes, there are many commentators, analysts and politicians claiming that this is a temporary aberration, and that all will one day return to normal. There are even claims that the economic crisis is coming to an end.
The analysts and commentators point to their indices, and say that, 'yes, things are looking up'. GDP is growing, or house prices rising once more, or industrial output has ticked up. The indicators are trotted out to suggest that all will be fine once again. The magic of governments and central banks pulling on their levers has worked. That the only explanation for such upticks is due to the largess of government, and that the largess of government is built upon overseas credit, is ignored. Strip out that overseas credit, and the situation looks very, very different.
Then there is the stability of the financial system. The banks appear to be making hay again, with business as normal having resumed. Meanwhile, in the background, do we really know what is going on? How much of that business as normal is resultant from the support of government and central banks? How much of this has been the socialisation of losses, the manipulation of accounting rules, the propping up of the house market through guarantees, and all of the other levers being pulled in the background. How much of the financial system sits upon the implicit guarantees of government, and how much risk is being transferred to the state?
What happens if the implicit guarantees of the state can no longer guarantee the financial system, because the states themselves are no longer seen as a guarantee? This is circular, as the more guarantees provided by the state, the greater the liabilities of the state, and the less the guarantee of the state might be seen as a guarantee.
I am not sure that anyone can actually pull apart the increasingly tangled knots between the financial system and the state. They appear to be mutually dependent, with the state providing guarantees, and the financial system funding the state with financial support through bond purchases to shore up their capital ratios, and so forth. How convenient that bank capital adequacy encourages the holding of government debt. Going back to Renaissance Italy, bankers were granted licenses and monopolies if they were willing to lend to the state on preferential terms. Nothing has changed.
But that supposedly rock solid capital that the banks are accumulating in the form of government bonds might, itself, be less solid than it is supposed to be. The same framework on capital adequacy that says that such bonds are safe is the same framework that said that lending to an OECD bank was safe - even though this proved not to be the case. Except....except, the lending to other OECD banks did prove to be safe, as governments and central banks stepped in and socialised the losses. The difference this time is that, if government debt goes sour, who might step in and socialise the losses?
Ambrose Evans-Pritchard is right when he suggests that we should rip up the economics textbooks. What we are seeing is a grand experiment, in which economists and policymakers are attempting to structure wealth in economies by fiat. As each lever is pulled, as each policy is enacted, there are ripples through the world economy. Flooding $US into the markets whilst holding interest rates low sees the export of $US popping up and creating bubbles elsewhere. Backstopping the mortgage market sees foreclosures reduced, but at the risk of calling into question (contributing to doubts about) the financial viability of the state. Holding the value of the RMB down leads to greater trade imbalances. Each policy has a consequence, and each policy interacts with the policy pursued by every other government.
In other words, as each lever is pulled, the consequences defeat the intention of the lever puller. For example, if the trade imbalances destroy the economic stability of the destination of Chinese exports, where will this leave the Chinese economy? The more each state pulls on the levers, the greater the turbulence between each of the economies. The world economy is a dynamic system, such that policy in one country impacts on the economy of another country, which then reacts with its own policy provisions, which then impact upon other countries. It is an endless cycle of reactivity, with each reaction driving further reaction, and developing an increasingly unstable system as each country enacts ever more dramatic policy to counter or ameliorate the effects of the policies of other countries.
A simple example is the relatively recent Japanese policy of printing money to stave off deflation. With rock bottom interest rates, the newly printed money was simply exported into other countries in the so called 'carry trade'. Within Japan, deflation persisted, whilst the newly printed Japanese money appeared in other countries, contributing to the process of asset price inflation in the countries that were the destination of the carry trade. The policy levers were pulled, but the consequences were far from those that were intended.
What textbook might be able to predict the outcome of such a dynamic system? Despite this, we see the policymakers pulling on their levers, and offering confidence that they know what they are doing. Apparently, the masters of the universe are in control.
I simply do not believe it.
As I said, nothing has really changed. The policymakers continue pulling their levers, continue to react, continue to seek to 'control' their respective economies. The only thing that has changed is the scale and scope and intensity of the policy. As they pull harder on ever more levers, the imbalances grow, the risks grow, and the consequences become ever less predictable. I was worried in 2009, but somehow governments succeeded in shoving reality back into its box. Can the masters of the universe continue to do so in 2010?
I am not convinced. Welcome to 2010.
Note: Thanks to Lemming who posted the link to the rare earth metals story, and thanks in general for the many interesting comments.