Below are three comments about the banking industry made by three individuals. Identify the one that is most prescient and the individual who is the least famous, if not totally unknown, among the three.
Comment 1
“I believe that the tools available to the banking agencies, including the ability to require adequate capital and an effective banking receivership process, are sufficient to allow the agencies to minimize the systemic risk associated with large banks. Moreover, the agencies have made clear that no bank is too big to fail. So that bank management, shareholders, and uninsured debt holders understand that they will not escape the consequences of excessive risk taking. In short, although vigilance is necessary, I believe the systemic risk inherent in the banking system is well managed and well controlled.”
Ben Bernanke, Federal Reserve Chairman and a former Princeton University professor
In an answer to a Senate Banking Commitee question on his first confirmation hearing in 2005
Comment 2
"[G]iven 1990 levels of capital, both Fannie Mae and Freddie Mac had sufficient capital to survive." even when tested against "the financial and economic conditions of the Great Depression." And "on the basis of historical experience, the risk to the government from a potential default on GSE debt is effectively zero."
Joseph Stiglitz, former Chief Economist of the World Bank and a Columbia University professor
In a paper written in 2002 titled "Implications of the New Fannie Mae and Freddie Mac Risk-Based Capital Standard."
Comment 3
"Running a bank is like piloting a warplane. If you alter the steering even a little bit, you end up in a completely different position."
Coskun Ulusoy, a former banker and the CEO of OYAK, Turkey's Armed Forces Pension Fund
On the rationale for selling OYAK's own bank to ING for USD2.7b in 2007
In terms of grey matter, academic credentials and widespread recognition, Bernanke and Stiglitz are far ahead of Ulusoy. But Ulusoy has one essential trait ― the ability to correctly size up the situation and then to use it to discern the key underlying patterns ― that separates those who can rise above the trivia and see the obvious from those blinded by the mass of details. In this, Ulusoy is one of the brilliant few that possess such insight. Certainly getting out of the global banking mess in the nick of time is one thing but to offload a future muck onto ING at a good price deserves acclaim.
While Bernanke and Stiglitz are muddling through one step at a time with the apparent solution at each step being overwhelmed by unintended side-effects, Ulusoy has already leaped five steps ahead knowing fully well the adverse consequences of the slow plodding. Bernanke and Stiglitz do conduct serious analyses and researches but these are all done to confirm their already firmly held beliefs, not to challenge them. This is the fundamental flaw of smart people ― a refusal to admit that they could go wrong.
The whole banking industry has a basic failing which is only evident during a depression ― its high gearing. This weakness is unique only to the banking industry. Practically all bankers except the enlightened few, such as Ulusoy still believe that it's their asset quality that matters. However, in a depression characterised by deflating prices, asset prices will definitely collapse. No amount of money printing can stave off this collapse because such money will be sucked by the black hole of loan write-offs and bank deleveraging. Money printing works only to stem a panic, not to avoid a decreasing money supply which should be allowed to take its natural course.
How does a bank's gearing choke the bank to death? Let's start with the bank's balance sheet. A bank's capital is typically about 8 to 10 percent of its total assets which comprise loans issued out to borrowers. To support the huge asset base, a bank raises the other 90 percent externally in the form of outside liabilities. These consist of money from depositors and inter-bank borrowings. Banks are classic cases of an entrepreneur's dream – use of other people's money (OPM) – that are extremely dangerous in tight liquidity situations. In a depression, asset prices can fall by more than 30 percent and at the extreme can surpass 50 percent whereas the liabilities remain fixed.
How are property prices holding up in the US? For commercial properties, prices have fallen by 44 percent from their peak in October 2007, a fate similarly shared by those in the UK. The median existing house price for the US has fallen by 25 percent from its peak in the 4th Quarter, 2005 with another 10 percent fall forecast for 2010. The Case-Shiller index covering houses in 20 cities in the US reveals a decrease of 33 percent from its peak in July 2006 to its trough in April 2009. Prices then rose for the next five months because of the Obama stimulus before stalling in October 2009. Karl Case, the eponymous co-founder of the index has predicted that prices will fall by another 15 percent. All in all, it won't be surprising if the price collapse exceeds 50 percent, posing fatal threats to the banks' existence.
Because of a bank's gearing, typically from 10:1 to 12:1, it takes only a 10 percent fall in its asset values to compeletely wipe clean the bank's capital. The bank's assets comprising mostly loans are secured against collaterals which can be real properties or other assets, such as machinery financed by those loans. In a deflation, the values of these collaterals will be dragged down with the falling economy. It doesn't take a mathematical genius to figure out that even with loans amounting to only 80 percent of the collateral values, it needs only a 30 percent fall in the collateral values to drag the bank's assets down by 10 percent. The actual situation is much worse because at the peak of the subprime mania in 2006, the loan-to-value (LTV) ratio even exceeded 95 percent. With their collaterals worth less than their loans, the borrowers will simply walk away from their obligations leaving the bank, devoid of capital, holding on to fast depreciating assets.
The severity of such a scenario can only be felt by looking at the impact of the Great Depression in the 1930s. In 1921, the number of banks in the US peaked at 30,456. Thenceforth, the number gradually diminished but the rapid decline occurred between 1929 and 1933, in the midst of the Great Depression, in which 43 percent or about 10,800 of the banks went bust. Even the relatively mild Savings and Loan crisis of the late 1980s and early 1990s led to the closure of more than 1,600 Savings and Loan institutions.
How do the current bank closures stack up against those of the Great Depression? Actually, we haven't scratched the surface. From 2000 to 2008, the US had only 53 bank closures, including two years, 2005 and 2006, the only time in the history of US banking without any closure. In 2009, the pace started picking up with 140 closures. The US now has about 8,000 odd commercial banks. The coming depression which I call the Grand Depression is definitely many orders of magnitude worse than the Great Depression. The credit expansion was many times bigger and, in a regression to the mean, the credit contraction would need to be equally huge. We can expect more than 3,000 banks to shutter for good within the next few years. These zombie banks are still walking because of the foreclosure moratorium which puts on hold the writedowns of their toxic assets to market value.
Would Islamic banking and sukuk bonds be immune to this catastrophe as bragged about by their proponents? In truth, there's no difference between Islamic and conventional banking. They share the same chink in their armour – high gearing. An economic depression doesn't differentiate between Muslims and non-Muslims. Even any other businesses with high gearing will incur the wrath of the depression. And this crisis in banking won't be restricted to the US; it is spreading globally in line with falling commodity and real estate prices. We only have to wait for the other shoe to drop in the US banking crisis to trigger a chain of falling dominoes in other countries.
Monday, December 28, 2009
Saturday, December 5, 2009
Clutching at the recovery straws
"A specialty of martial arts is to see that which is far away closely and to see that which is nearby from a distance." wrote Miyamoto Musashi in The Book of Five Rings. That statement aptly applies to fields as distant from martial arts as economics and politics. More so now that we are enmeshed in conflicting signals about the global economy so much so we can't make head or tail about which way the economy is heading. The confusion stems from the absence of a guiding pattern as reflected in our anxiety for any indicative news on the economy. There's no way to strategise when your only beacon is the unfolding news.
A typical confusion is exemplified by none other than two well known professors, both having divergent views on how the economy will turn out. In one corner is Niall Ferguson, an economic historian at Harvard whose contention is that the money printing by Bernanke will lead to rampant inflation and consequently high interest rates. In the other is Paul Krugman, an economics professor at Princeton and a Nobel Prize winner to boot. Krugman believes that Obama's deficit will lead to recovery and any rise in interest rates is an indication of funds moving to stocks and investments.
How these two icons of erudition in economics could go wrong is easy to see. They both rely on analytical inquiry; with one or two steps you can plausibly argue out your position. Instead, we should use a different approach, that is, pattern recognition. This approach takes five or more steps in one thinking cycle. For example, using the investment clock as a pattern (see Ticking towards midnight), it's safe to predict that cash will be precious in this depression because of its scarcity. The likelihood of high nominal interest rates is low but because of falling general prices, real rates will be high. We will see major debt write-offs and financial sector deleveraging (loans being called in as banks' capitals get eroded from debt write-offs). Now it appears that cash is aplenty with Bernanke furiously printing money. But don't be so sure that this can continue indefinitely.
We first need to understand the reasons for the temporary growth spurt and why this is just an aberration in a secular downsliding global economy. The refrain about the coming recovery stems from the actions of three men: Bernanke, Obama and Hu Jintao. I will tackle each in turn and debunk their claims to reversing the depression. But first, an overview of the common structural weakness of their actions.
Their failing lies in their inability to perceive the cause of the depression as more than just a liquidity crisis. If it were so, it would have been easily solved by Ben Bernanke's money printing. The fact that it hasn't proves that it's more than merely a liquidity issue.
In my earlier post, I've argued that this depression is actually a capacity crisis (see It's capacity, not liquidity, stupid). Actually, it's more than that; to find out, we need to take a step back. The real reason is the absence of a new growth driver, not only to propel growth but also to creatively destruct the present growth engine. The alternative is annihilative destruction as exemplified by Hitler's WW2 legacies in Europe. The mind can't even contemplate such a nightmare scenario.
The term 'creative destruction' was coined by Joseph Schumpeter of the Austrian school of economics. This school has been disdained by mainstream economists because of the Austrian school's eschewal of mathematical models. The Austrian school has a valid reason since human behaviours are too complex to avail themselves to modelling.
The purpose of creative destruction is to keep the wealth moving from those who have succeeded under the present growth paradigm to those who will succeed under the new growth paradigm. Without this changeover, whatever deficits and money printed will benefit only those who prosper under the existing growth paradigm. Within the context of the global economy, the higher the budget deficits of the US government, the more will be the US current account deficits as China and the oil exporting countries siphon off the surpluses. And for any national economy, the sizes and debts of almost all governments keep burgeoning to meet the demands of their populace until they collapse under their own and their debts' weights. Take Japan, while its public debt has exceeded 200 percent of GDP (second only to Zimbabwe), its household financial assets amount to US$16 trillion (second only to the US).
Ancient societies had ways of dealing with this imbalance through debt cancellation in times of crisis and famine. Our inability to recognise this unsustainable imbalance condemns us to tackling the symptoms while the real problem remains misunderstood. It seems despite our technological advances, we are way behind the ancients in the understanding of social and economic issues.
A similar ineptitude afflicts our three key decision makers. I have written an earlier post on Bernanke (see Bernanke vs The Market), so what's described here are additional comments on his perverted beliefs. Ben Bernanke has earned the nickname Helicopter Ben for his remark that he would drop dollar notes from a helicopter in order to keep the economy going. If only it were that easy. Ben is in need more of a helicopter view to overcome his myopic sight than a helicopter ride. Actually, he has to call upon Obama and Congress to drop money because only they can authorise the spending budget. What Bernanke or the Fed can do is to swap the printed money with existing debts, not willy nilly throwing away money.
Most of his swaps (or purchases, to be exact) comprise treasury bills and mortgage backed securities (MBS). There are limits to both. In the case of T-bills, his holding has exceeded US$700 billion. Any further increase depends on the US government getting deeper into deficits or the holders of existing T-bills continue selling to the Fed. The first is getting tougher as Obama has come under increasing pressure to balance the US government budget. The latter option can only be made at increasing prices as supply of T-bills gets scarcer with greater Fed purchases.
As for the MBS, for which the Fed now holds more than US$800 billion, more purchases of it exposes the Fed to higher risks as following the law of diminishing returns, incremental debts tend to carry greater risks of default, more so in times of deflating prices.
Bernanke's artificial suppressing of interest rates through his flooding of liquidity is not helping the economy either. The sloshing liquidity is sending wrong signals, such as higher commodity prices. Commodity producers are encouraged to increase capacity at a time when the commodity prices are going to collapse as they eventually will when their supplies overwhelm the shrinking demand. The only time when the money floodgate should be opened is during a panic and that moment passed in March 2009. Now is the time to allow the liquidity to gradually decline.
The next decision maker, Pres. Barack Obama is facing many critical issues: economic depression, unemployment, health care, global warming, Afghan and Iraq; all of which offer no easy solutions. To tackle them he must first acknowledge that the US is no longer a hegemon especially when the survival of the nation-state itself is precarious. His priority is to the American voters. He can thus safely ignore global warming, Afghan and Iraq.
A typical confusion is exemplified by none other than two well known professors, both having divergent views on how the economy will turn out. In one corner is Niall Ferguson, an economic historian at Harvard whose contention is that the money printing by Bernanke will lead to rampant inflation and consequently high interest rates. In the other is Paul Krugman, an economics professor at Princeton and a Nobel Prize winner to boot. Krugman believes that Obama's deficit will lead to recovery and any rise in interest rates is an indication of funds moving to stocks and investments.
How these two icons of erudition in economics could go wrong is easy to see. They both rely on analytical inquiry; with one or two steps you can plausibly argue out your position. Instead, we should use a different approach, that is, pattern recognition. This approach takes five or more steps in one thinking cycle. For example, using the investment clock as a pattern (see Ticking towards midnight), it's safe to predict that cash will be precious in this depression because of its scarcity. The likelihood of high nominal interest rates is low but because of falling general prices, real rates will be high. We will see major debt write-offs and financial sector deleveraging (loans being called in as banks' capitals get eroded from debt write-offs). Now it appears that cash is aplenty with Bernanke furiously printing money. But don't be so sure that this can continue indefinitely.
We first need to understand the reasons for the temporary growth spurt and why this is just an aberration in a secular downsliding global economy. The refrain about the coming recovery stems from the actions of three men: Bernanke, Obama and Hu Jintao. I will tackle each in turn and debunk their claims to reversing the depression. But first, an overview of the common structural weakness of their actions.
Their failing lies in their inability to perceive the cause of the depression as more than just a liquidity crisis. If it were so, it would have been easily solved by Ben Bernanke's money printing. The fact that it hasn't proves that it's more than merely a liquidity issue.
In my earlier post, I've argued that this depression is actually a capacity crisis (see It's capacity, not liquidity, stupid). Actually, it's more than that; to find out, we need to take a step back. The real reason is the absence of a new growth driver, not only to propel growth but also to creatively destruct the present growth engine. The alternative is annihilative destruction as exemplified by Hitler's WW2 legacies in Europe. The mind can't even contemplate such a nightmare scenario.
The term 'creative destruction' was coined by Joseph Schumpeter of the Austrian school of economics. This school has been disdained by mainstream economists because of the Austrian school's eschewal of mathematical models. The Austrian school has a valid reason since human behaviours are too complex to avail themselves to modelling.
The purpose of creative destruction is to keep the wealth moving from those who have succeeded under the present growth paradigm to those who will succeed under the new growth paradigm. Without this changeover, whatever deficits and money printed will benefit only those who prosper under the existing growth paradigm. Within the context of the global economy, the higher the budget deficits of the US government, the more will be the US current account deficits as China and the oil exporting countries siphon off the surpluses. And for any national economy, the sizes and debts of almost all governments keep burgeoning to meet the demands of their populace until they collapse under their own and their debts' weights. Take Japan, while its public debt has exceeded 200 percent of GDP (second only to Zimbabwe), its household financial assets amount to US$16 trillion (second only to the US).
Ancient societies had ways of dealing with this imbalance through debt cancellation in times of crisis and famine. Our inability to recognise this unsustainable imbalance condemns us to tackling the symptoms while the real problem remains misunderstood. It seems despite our technological advances, we are way behind the ancients in the understanding of social and economic issues.
A similar ineptitude afflicts our three key decision makers. I have written an earlier post on Bernanke (see Bernanke vs The Market), so what's described here are additional comments on his perverted beliefs. Ben Bernanke has earned the nickname Helicopter Ben for his remark that he would drop dollar notes from a helicopter in order to keep the economy going. If only it were that easy. Ben is in need more of a helicopter view to overcome his myopic sight than a helicopter ride. Actually, he has to call upon Obama and Congress to drop money because only they can authorise the spending budget. What Bernanke or the Fed can do is to swap the printed money with existing debts, not willy nilly throwing away money.
Most of his swaps (or purchases, to be exact) comprise treasury bills and mortgage backed securities (MBS). There are limits to both. In the case of T-bills, his holding has exceeded US$700 billion. Any further increase depends on the US government getting deeper into deficits or the holders of existing T-bills continue selling to the Fed. The first is getting tougher as Obama has come under increasing pressure to balance the US government budget. The latter option can only be made at increasing prices as supply of T-bills gets scarcer with greater Fed purchases.
As for the MBS, for which the Fed now holds more than US$800 billion, more purchases of it exposes the Fed to higher risks as following the law of diminishing returns, incremental debts tend to carry greater risks of default, more so in times of deflating prices.
Bernanke's artificial suppressing of interest rates through his flooding of liquidity is not helping the economy either. The sloshing liquidity is sending wrong signals, such as higher commodity prices. Commodity producers are encouraged to increase capacity at a time when the commodity prices are going to collapse as they eventually will when their supplies overwhelm the shrinking demand. The only time when the money floodgate should be opened is during a panic and that moment passed in March 2009. Now is the time to allow the liquidity to gradually decline.
The next decision maker, Pres. Barack Obama is facing many critical issues: economic depression, unemployment, health care, global warming, Afghan and Iraq; all of which offer no easy solutions. To tackle them he must first acknowledge that the US is no longer a hegemon especially when the survival of the nation-state itself is precarious. His priority is to the American voters. He can thus safely ignore global warming, Afghan and Iraq.
Global warming, even if it really is caused by carbon emissions, cannot be solved by government edicts and regulations. Only technology can address it. Furthermore, in a severe depression, it will eventually be relegated to the back burner. Iraq is a goner when oil prices crash. The reason the Iraq surge succeeded was because it was accompanied by cash bribes to the Sunni tribal chiefs who then rallied the Sunni tribes against Al-Qaeda. This lesson has been lost on the American generals who still believe that it was the surge alone that turned the tide. American intelligence in preventing attacks in its homeland has improved tremendously that the US doesn't need to be present in Afghanistan. It should allow Taliban to rule Afghanistan and use the threat of the missiles to get them to put on their best behaviour. Israel's experience with Hamas after Hamas's rule of Gaza is instructive. For invisible enemies, the key is to make them visible so that they can be contained.
Health care, the last pocket of inefficiencies in the private sector, is a secondary issue in a downturn. The way health care is administered now, with practitioners operating autonomously within a hospital, engenders perverse incentives and is predatory on the consumers. The US should look into certain revolutionary health care practices, especially in India where salaried doctors using factory line style procedures focusing on volumes, have improved quality and lowered costs.
The economic depression is a given as the moment Obama reduces the US deficits, if not balances its budget, the global economy will keel over once again. That leaves unemployment as the critical issue that Obama should redirect his attention to. To solve this, he must first institute trade barriers and capital controls. It's no point incurring massive deficits if the money eventually flows out. Of course, these measures are economically inefficient.
But look at the factory floor, you can only be very efficient in only one area of your choosing; it's either labour, machine or space. Similarly, if you want cheap quality goods, you must tolerate continual deficits and high unemployment. It's Linear Programming 101: you can only maximise efficiency in only one area, but subject to the constraints or minimum thresholds that you have specified for the others. In the case of the US economy, it's maximising goods production efficiency without regard to any constraints on the level of unemployment nor on the deficits.
Finally, Hu Jintao who is the President of China, a country living on borrowed time. China is probably the last in a series of countries ranging from Japan to the East Asians and South East Asians that have been or about to be humbled by the deflationary plague. The Tibetan and Uighur riots in 2008 and 2009 were just mild foretastes of worse things to come. The riots were easily quelled because they were initiated by minorities. When the turn of the Han Chinese comes, not even the biggest army in the world can subdue it. Even Suharto, politically once the strongest man in Asia had to shamefully step down in 1998 after 30 years of iron rule when the whole region was steeped in economic turmoil.
China survives for the moment because of its US$586 billion stimulus and the US$1.2 trillion in additional bank credits. These packages are being used to increase capacity when it is least needed. Soon abandoned factories and real properties will dot China's landscape. The cost in terms of massive bank failures and lost jobs will be closely followed by a social breakdown of immense proportion.
At least Japan were rich when they were hit by the crisis in 1990 while the East Asians and South East Asians were partially saved by the devaluation in 1998. China may be the world's second biggest economy but its per capita GDP is still low. The devaluation option is no longer available as, given its economic impact, all eyes are watching its actions. As the negative forces of unsustainable debts, falling asset prices, rising unemployment and shrinking exports close in on their quarry, China, we can only watch with trepidation the strangulation of a would-be superpower. How fortunes change ― from greatness to wretchedness, from prosperity to calamity, from mastery to misery, from predator to prey, all it takes is a spin of the economic wheel.
Monday, November 16, 2009
Oiled for turmoil
Oil is getting scarcer but demand is increasing at an alarming rate. Peak oil has already been reached, production will soon decline. Ergo the high oil prices. Certainly a grim narrative for oil consumers. Except that it's untrue. The bleak outlook will instead redound on the oil producers.
Actually, the oil business is turning into a sunset industry. New technologies are discovering new vast reserves faster than can be consumed. As for old and plugged fields, they can now be brought back to production with new recovery techniques squeezing more oil that heretofore remains unrecoverable.
Capitalism leaves in its wake a history of broken constraints. In the case of oil, there are two ways in which oil supply constraints can be smashed. Both involve the use of new technologies. One will enhance the prospect of discovering new fields and recovering more oil from the fields, including those that have been long abandoned. The other, part of the final technology wave, will make oil obsolete and redundant.
On the surface, although oil prices appear as the product of supply and demand, things are not that straight forward. Looking back at the history of oil prices since October 1973, when OPEC started flexing its muscles, oil prices have usually been a product of the interplay between global liquidity and the follies of the oil producers. On the way up and down, they move in tandem, continually reinforcing each other. The wild swings in oil prices are the inevitable outcome of the commodity nature of oil. It doesn't take much to tip the scales in favour of either the consumers or producers; the marginal price sets the price for the entire market since the market is not segmented. Worse, both supply and demand are not that elastic over the short term.
In the immediate term, even without factoring the new technologies, the outlook for oil prices is downward. Because bringing new oil fields to production takes time, anywhere from 7 to 10 years, these fields, the planning of which began in 2003 when oil prices inched upwards, will start producing by 2010. Foreign Affairs Nov/Dec 2009, disclosed that Saudi's production capacity would rise from 9.5 million barrels a day in 2002 to 12.5 mbd in 2010, with an extra 1.0 mbd on standby. By then, total OPEC production capacity will grow to 37 mbd, giving a spare capacity of 6 to 7 mbd over current production level. All this is happening in the face of a massive global economic slowdown.
Twice in the past, as narrated by Foreign Affairs Mar/Apr 2002, Saudi used its spare capacity to discipline wayward oil rivals. In 1985/86, Saudi intentionally engineered a price war to regain its market share from interlopers. More than ten years later, in 1998, again it purposely added another 1.0 mbd to its production to punish Venezuela for displacing it as the prime supplier to the US. But the authors of that piece ignored the events leading to the two price collapses that had taken place a few years earlier. The chart shown here from The Economist is enlightening.
Prior to the Arab Israeli War in 1973, the oil spare capacity had been on a secular fall while production - and, by inference, consumption - had been rising, Surely, such opposing trends would have signalled a price increase in the near future. On the other side of the globe, another war had been draining the US of substantial funds that by August 1971, Nixon had to de-peg the US dollar from the gold standard. Free from its leash, the total debt level (money supply) in the US leaped. The 1973-74 oil shock, wrongly attributed by many to the Arab oil embargo, wouldn't have been a shock had the policymakers been aware of the rapidly declining spare capacity as well as the depreciating value of the US dollars. The sudden jump in oil prices from US$3 a barrel to US$12 was an otherwise predictable event. In the 1967 Arab Israeli War, the Arab countries also imposed an embargo but it came to nought. Why? Because spare capacity was still high; even the US then was a net oil exporter.
However at US$12-US$14, there was no much incentive to develop new oil fields. Oil spare capacity was still hovering around 5 percent of production. It needed the Iranian revolution and the subsequent Iran-Iraq war to secure a production fall of more than 3 mbd and thus jolted the prices to US$38 a barrel by end 1979. At this new price, consumption dropped through energy efficiency measures but not in an appreciable manner. More momentous was the spike in spare capacity as all producers ramped it up to capitalise on the high prices. Gradually, the prices dropped to US$26 by 1985. Saudi, being the swing producer had to cut production from 10 mbd to less than 4 mbd in order to stabilise prices. Seeing that others were profiting at its expense, it suddenly surged production to 5 mbd in early 1986. Within a year, prices slumped by more than 50 percent, dropping to as low as US$11.
Spare capacity dropped steadily all the way to 1990. Because of the long lead time in the development of crude oil production, spare capacity cannot jump or slump suddenly. Not however actual oil production . When Iraq sparked the first Gulf War by invading Kuwait on 02 Aug 1990, oil prices bounced back to US$38 but this was shortlived as Saudi jacked up production from 5 mbd to 8 mbd to appease the coalition countries which expelled the Iraqis.
The prices moved within a price band of US$15-US$23 from 1991 to 1997. Spare capacity was subdued at 5 percent. This was a period when supply and demand reached a stable accommodation. From now onwards, the oil producing countries no longer maintained spare capacity as a matter of policy. Any increase in spare capacity will be a result of a consumption slowdown. When the financial crisis hit East Asia in 1997-1998, global oil consumption for 1998 stagnated and spare capacity increased. Venezuela increased its shipments to the US to dethrone Saudi as the biggest OPEC supplier but Saudi retaliated by jacking up production by 1 mbd. Prices collapsed to US$9 by end 1998 and early 1999.
The 2000 dotcom boom pushed prices to over US$30 but they fell back to US$16 the following year with the dotcom crash. The spare capacity yo-yoed from 1998 to 2001 because of these economic crises. Beginning 2002, Greenspan and Bush participated in the biggest US credit creation that ended in 2008. Prices peaked at US$143 by June 2008 but dropped to US$34 by winter. Spare capacity was dangerously low. Obama's public stimulus (the biggest in US history), Bernanke's money printing and Chinese easy credit revived the prices to US$80 by late 2009. These not only benefit oil exporters but also countries, such as Australia, Brazil and Indonesia that depend on other extracted commodities including coal. Their economic growth is by no means a reflection of their management of the economy.
As the world approaches 2010, these band-aid measures will start to wear off. And spare capacity for OPEC itself will exceed 10 percent. In 2008-2009, two years in a row oil consumption fell, the first time since 1982-1983. In 2010, it's likely to fall unless the US institute another trillion dollar budget deficit. The outlook for oil certainly looks very gloomy.
Will oil production drop in order to prevent price collapse? Possible but highly unlikely. The producers are caught in a trap of their own doing. Almost all the major exporters have populace that is dangerously dependent on oil largesse through government jobs and spending. This is a fixed cost that cannot be crimped without severely exposing the governments to social instability and political upheaval. As prices drop, they will rev up production to keep revenue steady. Soon, this vicious circle feeds on itself until the country itself succumbs to economic and political collapse. Although oil will be cheap, it's not oil but blood that will be spilled in the streets.
Remember the Eastern European communism collapse and Soviet withdrawal from Afghanistan in 1989, and Russian financial crisis and Suharto's fall from grace in 1998. Their root causes lay in the oil price collapse. Take Indonesia. Like the other South East Asian countries, it suffered from an overvalued currency then but buffeted at the same time by low oil prices and El Nino-induced rice crop failure, the ensuing carnage was total. Even now the rupiah exchange rate tracks the oil price movement.
As an aside to the main topic, certain commentators, some of whom are economists, have attributed the present recession to the high energy costs, specifically those based on oil. Yet more ridiculous are those who blame the expected declining oil production as a leading cause for the recession. These conjectures reflect a flawed reasoning arising from confusing cause with effect.
If you recall the investment clock (see Ticking towards midnight), high commodity prices immediately precede the deflationary crash. Inferring that A causes B just because A precedes B is a flawed reasoning known as post hoc (after this) reasoning. A fitting analogy is a rooster's crow at the break of dawn which in no way causes the sun to appear. Actually high commodity prices is symptomatic of massive credit creation and when this credit is later written off because the borrowers cannot repay, the whole economy collapses.
As for the declining oil production Chicken Littles, they should read Scientific American October 2009. The magazine describes the new technologies that will extract more oil from the fields. Right now, only 35-40 percent of the oil in the average field is recovered; the rest remains unrecovered. New recovery techniques using heat, chemicals and microbes allow us to go after this buried wealth. Moreover, for new fields, only one third of the world's sedimentary basins - geologic formations that may contain oil reserves - have been thoroughly explored using modern technologies.
A recent example in the natural gas reserves is instructive. Hydraulic fracturing, a new technology that injects water and chemicals at high pressure to break shale rocks that trap natural gas, has been attributed to a 35 percent jump in the US gas reserves in two years. A similar thing is happening to oil reserves. The fact is more oil is still untapped and peak oil is rather more of our psychological fear than of physical reality.
Actually, the oil business is turning into a sunset industry. New technologies are discovering new vast reserves faster than can be consumed. As for old and plugged fields, they can now be brought back to production with new recovery techniques squeezing more oil that heretofore remains unrecoverable.
Capitalism leaves in its wake a history of broken constraints. In the case of oil, there are two ways in which oil supply constraints can be smashed. Both involve the use of new technologies. One will enhance the prospect of discovering new fields and recovering more oil from the fields, including those that have been long abandoned. The other, part of the final technology wave, will make oil obsolete and redundant.
On the surface, although oil prices appear as the product of supply and demand, things are not that straight forward. Looking back at the history of oil prices since October 1973, when OPEC started flexing its muscles, oil prices have usually been a product of the interplay between global liquidity and the follies of the oil producers. On the way up and down, they move in tandem, continually reinforcing each other. The wild swings in oil prices are the inevitable outcome of the commodity nature of oil. It doesn't take much to tip the scales in favour of either the consumers or producers; the marginal price sets the price for the entire market since the market is not segmented. Worse, both supply and demand are not that elastic over the short term.
In the immediate term, even without factoring the new technologies, the outlook for oil prices is downward. Because bringing new oil fields to production takes time, anywhere from 7 to 10 years, these fields, the planning of which began in 2003 when oil prices inched upwards, will start producing by 2010. Foreign Affairs Nov/Dec 2009, disclosed that Saudi's production capacity would rise from 9.5 million barrels a day in 2002 to 12.5 mbd in 2010, with an extra 1.0 mbd on standby. By then, total OPEC production capacity will grow to 37 mbd, giving a spare capacity of 6 to 7 mbd over current production level. All this is happening in the face of a massive global economic slowdown.
Twice in the past, as narrated by Foreign Affairs Mar/Apr 2002, Saudi used its spare capacity to discipline wayward oil rivals. In 1985/86, Saudi intentionally engineered a price war to regain its market share from interlopers. More than ten years later, in 1998, again it purposely added another 1.0 mbd to its production to punish Venezuela for displacing it as the prime supplier to the US. But the authors of that piece ignored the events leading to the two price collapses that had taken place a few years earlier. The chart shown here from The Economist is enlightening.Prior to the Arab Israeli War in 1973, the oil spare capacity had been on a secular fall while production - and, by inference, consumption - had been rising, Surely, such opposing trends would have signalled a price increase in the near future. On the other side of the globe, another war had been draining the US of substantial funds that by August 1971, Nixon had to de-peg the US dollar from the gold standard. Free from its leash, the total debt level (money supply) in the US leaped. The 1973-74 oil shock, wrongly attributed by many to the Arab oil embargo, wouldn't have been a shock had the policymakers been aware of the rapidly declining spare capacity as well as the depreciating value of the US dollars. The sudden jump in oil prices from US$3 a barrel to US$12 was an otherwise predictable event. In the 1967 Arab Israeli War, the Arab countries also imposed an embargo but it came to nought. Why? Because spare capacity was still high; even the US then was a net oil exporter.
However at US$12-US$14, there was no much incentive to develop new oil fields. Oil spare capacity was still hovering around 5 percent of production. It needed the Iranian revolution and the subsequent Iran-Iraq war to secure a production fall of more than 3 mbd and thus jolted the prices to US$38 a barrel by end 1979. At this new price, consumption dropped through energy efficiency measures but not in an appreciable manner. More momentous was the spike in spare capacity as all producers ramped it up to capitalise on the high prices. Gradually, the prices dropped to US$26 by 1985. Saudi, being the swing producer had to cut production from 10 mbd to less than 4 mbd in order to stabilise prices. Seeing that others were profiting at its expense, it suddenly surged production to 5 mbd in early 1986. Within a year, prices slumped by more than 50 percent, dropping to as low as US$11.
Spare capacity dropped steadily all the way to 1990. Because of the long lead time in the development of crude oil production, spare capacity cannot jump or slump suddenly. Not however actual oil production . When Iraq sparked the first Gulf War by invading Kuwait on 02 Aug 1990, oil prices bounced back to US$38 but this was shortlived as Saudi jacked up production from 5 mbd to 8 mbd to appease the coalition countries which expelled the Iraqis.
The prices moved within a price band of US$15-US$23 from 1991 to 1997. Spare capacity was subdued at 5 percent. This was a period when supply and demand reached a stable accommodation. From now onwards, the oil producing countries no longer maintained spare capacity as a matter of policy. Any increase in spare capacity will be a result of a consumption slowdown. When the financial crisis hit East Asia in 1997-1998, global oil consumption for 1998 stagnated and spare capacity increased. Venezuela increased its shipments to the US to dethrone Saudi as the biggest OPEC supplier but Saudi retaliated by jacking up production by 1 mbd. Prices collapsed to US$9 by end 1998 and early 1999.
The 2000 dotcom boom pushed prices to over US$30 but they fell back to US$16 the following year with the dotcom crash. The spare capacity yo-yoed from 1998 to 2001 because of these economic crises. Beginning 2002, Greenspan and Bush participated in the biggest US credit creation that ended in 2008. Prices peaked at US$143 by June 2008 but dropped to US$34 by winter. Spare capacity was dangerously low. Obama's public stimulus (the biggest in US history), Bernanke's money printing and Chinese easy credit revived the prices to US$80 by late 2009. These not only benefit oil exporters but also countries, such as Australia, Brazil and Indonesia that depend on other extracted commodities including coal. Their economic growth is by no means a reflection of their management of the economy.
As the world approaches 2010, these band-aid measures will start to wear off. And spare capacity for OPEC itself will exceed 10 percent. In 2008-2009, two years in a row oil consumption fell, the first time since 1982-1983. In 2010, it's likely to fall unless the US institute another trillion dollar budget deficit. The outlook for oil certainly looks very gloomy.
Will oil production drop in order to prevent price collapse? Possible but highly unlikely. The producers are caught in a trap of their own doing. Almost all the major exporters have populace that is dangerously dependent on oil largesse through government jobs and spending. This is a fixed cost that cannot be crimped without severely exposing the governments to social instability and political upheaval. As prices drop, they will rev up production to keep revenue steady. Soon, this vicious circle feeds on itself until the country itself succumbs to economic and political collapse. Although oil will be cheap, it's not oil but blood that will be spilled in the streets.
Remember the Eastern European communism collapse and Soviet withdrawal from Afghanistan in 1989, and Russian financial crisis and Suharto's fall from grace in 1998. Their root causes lay in the oil price collapse. Take Indonesia. Like the other South East Asian countries, it suffered from an overvalued currency then but buffeted at the same time by low oil prices and El Nino-induced rice crop failure, the ensuing carnage was total. Even now the rupiah exchange rate tracks the oil price movement.
As an aside to the main topic, certain commentators, some of whom are economists, have attributed the present recession to the high energy costs, specifically those based on oil. Yet more ridiculous are those who blame the expected declining oil production as a leading cause for the recession. These conjectures reflect a flawed reasoning arising from confusing cause with effect.
If you recall the investment clock (see Ticking towards midnight), high commodity prices immediately precede the deflationary crash. Inferring that A causes B just because A precedes B is a flawed reasoning known as post hoc (after this) reasoning. A fitting analogy is a rooster's crow at the break of dawn which in no way causes the sun to appear. Actually high commodity prices is symptomatic of massive credit creation and when this credit is later written off because the borrowers cannot repay, the whole economy collapses.
As for the declining oil production Chicken Littles, they should read Scientific American October 2009. The magazine describes the new technologies that will extract more oil from the fields. Right now, only 35-40 percent of the oil in the average field is recovered; the rest remains unrecovered. New recovery techniques using heat, chemicals and microbes allow us to go after this buried wealth. Moreover, for new fields, only one third of the world's sedimentary basins - geologic formations that may contain oil reserves - have been thoroughly explored using modern technologies.
A recent example in the natural gas reserves is instructive. Hydraulic fracturing, a new technology that injects water and chemicals at high pressure to break shale rocks that trap natural gas, has been attributed to a 35 percent jump in the US gas reserves in two years. A similar thing is happening to oil reserves. The fact is more oil is still untapped and peak oil is rather more of our psychological fear than of physical reality.
Sunday, November 8, 2009
Ticking towards midnight
Financial markets throughout the world are effectively tightly woven together as a result of the free cross border movement of capital. Likewise the global economy is closely integrated because of the increasing trend towards free trade.
These are indeed dangerous times for political leaders. Any upheaval in a major financial centre or economy can spread like wildfire to other centres or economies. Since political stability of a country very much depends on the state of its economy, each country must start building its own firewall. This means restricting the free flow of capital and goods. Hoarding US dollars as foreign reserves is not enough.
It's not that the free movement of capital and goods are bad; it's just that there are times when they are appropriate as well as times when they should be abandoned. It all depends on the stage of the investment and economic cycle we are at.
Savvy financial investors are aware of the investment clock which identifies the type of investments appropriate at any moment in the economic cycle. The usual clock depicts business slowdowns as occurring between 3 o'clock and 6 o'clock. However, I prefer the one used by Baring Securities, itself long subsumed by another entity. Its investment clock shown here, appeared in The Economist, Nov 1994. Instead of 3 o'clock, the slowdown in Baring's clock begins in the final sector, numbered 6, i.e., from 10 o'clock to 12 o'clock.
The clock can help us reestablish our bearing, more so in current conditions where the signs are pointing towards a depression yet policymakers still insisting on growth being in the offing.
The clock starts at noon, where the mood is still bearish as the economy exits the previous downturn. The preferred investment at this stage is bonds because interest rate at the end of a recession is high but is trending lower with increasing liquidity. This makes for a rising bond price. A $1,000 bond with 10% coupon that matures in 5 years' time can rise in price to $1,216 if the prevailing interest rate falls to 5% from 10%.
By 4 o'clock, bonds have lost their lustre as not much capital gain can be had by holding on to them. The interest rate will stop falling. As the economy expands, more money enters circulation. Inflation is still low and holding steady since the economy still has spare capacity. Equities go up in prices in tandem with increasing profits from greater sales. Occasionally, the money supply races ahead of economic output and inflation follows but this is easily put right by slamming the brakes on the money supply. However generally the inflation is subdued. These two factors - rising profits and stable monetary value - are what make equities attractive. The good times for equities are between 2 o'clock and 8 o'clock but an orderly retreat should be made from 6 o'clock forward.
As the economy keeps expanding, it will hit constraints in certain sectors, such as commodities and real estate because the supply of these goods takes time to keep up with the increasing demand. The money supply meanwhile keeps on increasing as the production of other economic goods has to be sustained with many more producers entering the fray. But these producers' margins are razor thin because on the cost side, they have to pay more for the commodities while on the revenue side, they have no pricing power with most markets being over supplied with competing products.
The commodity supplies bottleneck are only a temporary setback. Their high prices are a reflection of the surplus money flooding the market. As new mines and fields are discovered and opened, the prices will come down to earth. If not for the surplus liquidity, the economy would have fallen into recession much earlier. The liquidity has deferred the collapse but at the risk of magnifying and prolonging the eventual debacle. The commodities ascendancy starts at 6 o'clock and ends at 10 o'clock. Right now, it has expired.
We are now in cash territory. The investments in equities, real properties and commodities turn sour as their returns become out of sync with their inflated prices. Income from these investments can no longer support the loans used to finance their purchases. Increasing loan write-offs start spooking the banks. Banks stop lending and begin hoarding cash.
Every time a loan is written-off, the money supply shrivels. Loans on the debit side of a bank's balance sheet are matched by deposits on the credit side. But loan write-offs are magnified by the bank's leverage. One dollar of loan write-off hits the bank's capital by that amount but because of the capital asset ratio, the bank has to reduce its loan portfolio by 10 dollars. The impact on the money supply is therefore 10 times.
From 10 o'clock to 12 o'clock, the increasing debt defaults push up the real interest rates in order to account for the high risk. Still, the banks will not lend at any price. Citibank's cash and deposits balance as at 30 September 2009 stood at US$244.4 billion, the largest in its history. Even though the Fed and other central banks are fixing their lending rates at record low levels, the banks refuse to disburse new loans. Only investment banks, such as Goldman Sachs and JP Morgan can still chalk up huge profits as a result not of lending but of trading in stocks, bonds and foreign currencies.
The shrivelling money supply triggers declining general prices. Nominal interest rates may be low but the falling prices make the real rates high. The likelihood of businesses going bust grows. Falling prices and failing businesses feed on each other in a vicious circle.
The Fed's quantitative easing or money printing won't solve the problem as it's not increasing the total money supply. It's just converting an illiquid money (bonds and other debts) into a more liquid one (cash and deposits). This has resulted in the liquid money being used not for lending but for trading in stocks and commodities. So we are now having a short-lived aberrant hike in stock and commodity prices.
To make up for the vanishing money, it's up to Obama to rack up humongous deficits year after year without fail. His recent US$787 billion stimulus has provided a limited GDP growth in the third quarter. But the stimulus will taper off in 2010 and 2011. To sustain this growth, the US needs no less than US$1 trillion budget deficit each year. That unfortunately appears more difficult with each approaching year as the House and Senate look set to admit more Republican congressmen in the midterm elections next year.
The gloomy mood will not only pervade sector 6 of the chart but will continue to sectors 1 and 2. Only in sectors 3, 4 and 5 will the social mood be cheerful again. For the political leaders and policymakers who have been proclaiming that recovery is just around the corner, don't bet on it. They suffer from extreme bouts of amnesia and even if they don't, they won't be around long enough to answer for their careless remarks.
These are indeed dangerous times for political leaders. Any upheaval in a major financial centre or economy can spread like wildfire to other centres or economies. Since political stability of a country very much depends on the state of its economy, each country must start building its own firewall. This means restricting the free flow of capital and goods. Hoarding US dollars as foreign reserves is not enough.
It's not that the free movement of capital and goods are bad; it's just that there are times when they are appropriate as well as times when they should be abandoned. It all depends on the stage of the investment and economic cycle we are at.
Savvy financial investors are aware of the investment clock which identifies the type of investments appropriate at any moment in the economic cycle. The usual clock depicts business slowdowns as occurring between 3 o'clock and 6 o'clock. However, I prefer the one used by Baring Securities, itself long subsumed by another entity. Its investment clock shown here, appeared in The Economist, Nov 1994. Instead of 3 o'clock, the slowdown in Baring's clock begins in the final sector, numbered 6, i.e., from 10 o'clock to 12 o'clock.The clock can help us reestablish our bearing, more so in current conditions where the signs are pointing towards a depression yet policymakers still insisting on growth being in the offing.
The clock starts at noon, where the mood is still bearish as the economy exits the previous downturn. The preferred investment at this stage is bonds because interest rate at the end of a recession is high but is trending lower with increasing liquidity. This makes for a rising bond price. A $1,000 bond with 10% coupon that matures in 5 years' time can rise in price to $1,216 if the prevailing interest rate falls to 5% from 10%.
By 4 o'clock, bonds have lost their lustre as not much capital gain can be had by holding on to them. The interest rate will stop falling. As the economy expands, more money enters circulation. Inflation is still low and holding steady since the economy still has spare capacity. Equities go up in prices in tandem with increasing profits from greater sales. Occasionally, the money supply races ahead of economic output and inflation follows but this is easily put right by slamming the brakes on the money supply. However generally the inflation is subdued. These two factors - rising profits and stable monetary value - are what make equities attractive. The good times for equities are between 2 o'clock and 8 o'clock but an orderly retreat should be made from 6 o'clock forward.
As the economy keeps expanding, it will hit constraints in certain sectors, such as commodities and real estate because the supply of these goods takes time to keep up with the increasing demand. The money supply meanwhile keeps on increasing as the production of other economic goods has to be sustained with many more producers entering the fray. But these producers' margins are razor thin because on the cost side, they have to pay more for the commodities while on the revenue side, they have no pricing power with most markets being over supplied with competing products.
The commodity supplies bottleneck are only a temporary setback. Their high prices are a reflection of the surplus money flooding the market. As new mines and fields are discovered and opened, the prices will come down to earth. If not for the surplus liquidity, the economy would have fallen into recession much earlier. The liquidity has deferred the collapse but at the risk of magnifying and prolonging the eventual debacle. The commodities ascendancy starts at 6 o'clock and ends at 10 o'clock. Right now, it has expired.
We are now in cash territory. The investments in equities, real properties and commodities turn sour as their returns become out of sync with their inflated prices. Income from these investments can no longer support the loans used to finance their purchases. Increasing loan write-offs start spooking the banks. Banks stop lending and begin hoarding cash.
Every time a loan is written-off, the money supply shrivels. Loans on the debit side of a bank's balance sheet are matched by deposits on the credit side. But loan write-offs are magnified by the bank's leverage. One dollar of loan write-off hits the bank's capital by that amount but because of the capital asset ratio, the bank has to reduce its loan portfolio by 10 dollars. The impact on the money supply is therefore 10 times.
From 10 o'clock to 12 o'clock, the increasing debt defaults push up the real interest rates in order to account for the high risk. Still, the banks will not lend at any price. Citibank's cash and deposits balance as at 30 September 2009 stood at US$244.4 billion, the largest in its history. Even though the Fed and other central banks are fixing their lending rates at record low levels, the banks refuse to disburse new loans. Only investment banks, such as Goldman Sachs and JP Morgan can still chalk up huge profits as a result not of lending but of trading in stocks, bonds and foreign currencies.
The shrivelling money supply triggers declining general prices. Nominal interest rates may be low but the falling prices make the real rates high. The likelihood of businesses going bust grows. Falling prices and failing businesses feed on each other in a vicious circle.
The Fed's quantitative easing or money printing won't solve the problem as it's not increasing the total money supply. It's just converting an illiquid money (bonds and other debts) into a more liquid one (cash and deposits). This has resulted in the liquid money being used not for lending but for trading in stocks and commodities. So we are now having a short-lived aberrant hike in stock and commodity prices.
To make up for the vanishing money, it's up to Obama to rack up humongous deficits year after year without fail. His recent US$787 billion stimulus has provided a limited GDP growth in the third quarter. But the stimulus will taper off in 2010 and 2011. To sustain this growth, the US needs no less than US$1 trillion budget deficit each year. That unfortunately appears more difficult with each approaching year as the House and Senate look set to admit more Republican congressmen in the midterm elections next year.
The gloomy mood will not only pervade sector 6 of the chart but will continue to sectors 1 and 2. Only in sectors 3, 4 and 5 will the social mood be cheerful again. For the political leaders and policymakers who have been proclaiming that recovery is just around the corner, don't bet on it. They suffer from extreme bouts of amnesia and even if they don't, they won't be around long enough to answer for their careless remarks.
Tuesday, November 3, 2009
It's capacity, not liquidity, stupid
Economic issues are best left to the economists, right? Wrong. They've got them wrong most of the time. Most economists, including well known pop economist Paul Krugman, can't predict economic events, not even anything remotely approximating the eventual outcome. They can only do so when the event is coming close to hand by which time the outcome is fairly obvious. Even their reasoning on the causation of the event is suspect.
The problem is that they are blinkered from the big picture by their eagerness to fall back on their mathematical formulas to model reality. Unlike the physical sciences which are amenable to formulas, social sciences, which include economics, have to account for human behaviours, cultures and emotions; factors not easily translated into mathematical variables.
The distinguished economic historian, the late Charles P. Kindleberger was dismissive of mathematical models because the models could never incorporate the myriad variables extant in the real world. Aside from the human quirks, we have to contend with war, politics, demographics and technologies, just to name a few. Yet Kindleberger had good predictive ability. Those of his breed are first and foremost economic historians. Historians look for patterns, not fancy formulas. Like war generals, they think subjectively. If war can be boiled down to formulas, everybody can be a general but war would have been unnecessary because the outcome can be deduced from the formulas before the first shot is fired. Good historians, like good generals, must have a keen sense of observation in order to root out the relevant from the irrelevant.
The present Grand Depression is the latest example of how brilliant economists are getting it wrong on the real cause of the crisis. It's not at all surprising since economists are schooled in the art of the monetary flow and not in the field of technologies. So the first conclusion that they have agreed on is that the crisis has been brought about by the abundant liquidity splurging in the monetary system. I have no argument with this except that abundant liquidity is merely a second order cause.
The real mastermind culprit is still out there on the loose; what they have caught is just his accomplice. Several narratives blaming the overflowing liquidity as the cause of the recession (most economists mistakenly regard this crisis as just a worse-off recession) have been or are about to written. This is a grave mistake, one that will later cast serious doubts on the credibility of its many authors.
The publication on the Great Depression of the 1930s authored by Milton Friedman and Anna Schwartz titled, A Monetary History of the United States, 1867-1960, equally blamed the lack of liquidity for the depression. Big mistake. Poor Ben Bernanke, in a speech in 2002 honouring Friedman's 90th birthday, he apologised on behalf of the Fed for its monetary policy error in the 1930s. He shouldn't have to; instead, he should have ticked off Friedman and Schwartz for misleading policymakers for almost 40 years and still continuing to do so.
Let's get back to nailing our main culprit. If we look at the chart of global economic growth (see below) from 1600 to 2003, we can see that beginning 1820, the per capita GDP started breaking away from the static zero growth line that had characterised the global economy since AD 1, that is, the time of the Roman Empire.
The shift in the global per capita growth coincides with the start of the Industrial Revolution. It also marks the beginning of a volatile era typified by periodic boom and bust cycles. The main cause is the lagged effect of mobilising and demobilising of production resources. In the early part of the cycle, demand races ahead of supply because it takes time to set up plants or mines. Prices rise but gradually as supply catches up, everything stabilises. After some time, as production resources multiply, supply capacity outstrips demand.
To make matters worse, the production resources cannot be easily decommissioned since much capital has been invested in them. Prices start falling. To sustain demand in order to absorb the excess supply, policymakers increase the money supply by easing on the credit. Most of this money however goes towards speculating on assets, such as houses, and commodities, such as oil. Eventually, the whole charade can no longer be prolonged and gives way. Prices collapse ensues and businesses with high gearing, particularly banks begin falling like dominoes.
From the narrative, it is obvious that the liquidity surge kicks in later in order to pick up the demand slack. Policymakers are inclined towards easing liquidity since that's what society demands of them. Otherwise they'll be criticised for constraining growth.
The real culprit triggering the meltdown is actually surplus production capacity. Technological advances create the conditions for supply to increase tremendously yet using lesser number of people. It's not strange that the US jobless are fast becoming the hard-core unemployed. They have no chance of getting a job, ever. Once you globalise, the wages have to converge. For the American workers, it means they have to let their wages match those of the Chinese. This is very unlikely.
Also, in the past three technology cycles, the demographics were favourable to absorb the increased supply. However, the demographics, the growth of which closely tracks the per capita GDP line above, are reaching the end of its S-curve. The world's maximum population is expected to peak at 9 billion by 2050. Moreover, the last time around, we had Hitler, who despite his many evil deeds, managed to slip in one good deed of a massive destruction of the production resources of Western Europe which set the stage for their major rebuilding.
Therefore despite protestations to the contrary by leaders and policymakers, the current crisis is indeed a Grand Depression, the likes of which we have not undergone and probably the future generations will never experience. Its shape is neither V nor W but more of a staircase going all the way downhill.
The problem is that they are blinkered from the big picture by their eagerness to fall back on their mathematical formulas to model reality. Unlike the physical sciences which are amenable to formulas, social sciences, which include economics, have to account for human behaviours, cultures and emotions; factors not easily translated into mathematical variables.
The distinguished economic historian, the late Charles P. Kindleberger was dismissive of mathematical models because the models could never incorporate the myriad variables extant in the real world. Aside from the human quirks, we have to contend with war, politics, demographics and technologies, just to name a few. Yet Kindleberger had good predictive ability. Those of his breed are first and foremost economic historians. Historians look for patterns, not fancy formulas. Like war generals, they think subjectively. If war can be boiled down to formulas, everybody can be a general but war would have been unnecessary because the outcome can be deduced from the formulas before the first shot is fired. Good historians, like good generals, must have a keen sense of observation in order to root out the relevant from the irrelevant.
The present Grand Depression is the latest example of how brilliant economists are getting it wrong on the real cause of the crisis. It's not at all surprising since economists are schooled in the art of the monetary flow and not in the field of technologies. So the first conclusion that they have agreed on is that the crisis has been brought about by the abundant liquidity splurging in the monetary system. I have no argument with this except that abundant liquidity is merely a second order cause.
The real mastermind culprit is still out there on the loose; what they have caught is just his accomplice. Several narratives blaming the overflowing liquidity as the cause of the recession (most economists mistakenly regard this crisis as just a worse-off recession) have been or are about to written. This is a grave mistake, one that will later cast serious doubts on the credibility of its many authors.
The publication on the Great Depression of the 1930s authored by Milton Friedman and Anna Schwartz titled, A Monetary History of the United States, 1867-1960, equally blamed the lack of liquidity for the depression. Big mistake. Poor Ben Bernanke, in a speech in 2002 honouring Friedman's 90th birthday, he apologised on behalf of the Fed for its monetary policy error in the 1930s. He shouldn't have to; instead, he should have ticked off Friedman and Schwartz for misleading policymakers for almost 40 years and still continuing to do so.
Let's get back to nailing our main culprit. If we look at the chart of global economic growth (see below) from 1600 to 2003, we can see that beginning 1820, the per capita GDP started breaking away from the static zero growth line that had characterised the global economy since AD 1, that is, the time of the Roman Empire.
The shift in the global per capita growth coincides with the start of the Industrial Revolution. It also marks the beginning of a volatile era typified by periodic boom and bust cycles. The main cause is the lagged effect of mobilising and demobilising of production resources. In the early part of the cycle, demand races ahead of supply because it takes time to set up plants or mines. Prices rise but gradually as supply catches up, everything stabilises. After some time, as production resources multiply, supply capacity outstrips demand.
To make matters worse, the production resources cannot be easily decommissioned since much capital has been invested in them. Prices start falling. To sustain demand in order to absorb the excess supply, policymakers increase the money supply by easing on the credit. Most of this money however goes towards speculating on assets, such as houses, and commodities, such as oil. Eventually, the whole charade can no longer be prolonged and gives way. Prices collapse ensues and businesses with high gearing, particularly banks begin falling like dominoes.
From the narrative, it is obvious that the liquidity surge kicks in later in order to pick up the demand slack. Policymakers are inclined towards easing liquidity since that's what society demands of them. Otherwise they'll be criticised for constraining growth.
The real culprit triggering the meltdown is actually surplus production capacity. Technological advances create the conditions for supply to increase tremendously yet using lesser number of people. It's not strange that the US jobless are fast becoming the hard-core unemployed. They have no chance of getting a job, ever. Once you globalise, the wages have to converge. For the American workers, it means they have to let their wages match those of the Chinese. This is very unlikely.
Also, in the past three technology cycles, the demographics were favourable to absorb the increased supply. However, the demographics, the growth of which closely tracks the per capita GDP line above, are reaching the end of its S-curve. The world's maximum population is expected to peak at 9 billion by 2050. Moreover, the last time around, we had Hitler, who despite his many evil deeds, managed to slip in one good deed of a massive destruction of the production resources of Western Europe which set the stage for their major rebuilding.
Therefore despite protestations to the contrary by leaders and policymakers, the current crisis is indeed a Grand Depression, the likes of which we have not undergone and probably the future generations will never experience. Its shape is neither V nor W but more of a staircase going all the way downhill.
Friday, October 30, 2009
The economic and political evolution of the Roman Republic
To some, history may be a dull subject. But if you approach it with the objective of uncovering patterns, it offers the most fascinating of lessons. Particularly if it is about the Roman history because written historical records and physical artefacts abound for many writers to posit their own perspectives about the Romans.
From the Romans, many useful lessons can be gleaned, especially on economics and politics. Economics however is the more important of the two since in statecraft, economics underpins politics.
The Roman history consists of three periods of governance: monarchy, Republic and Empire. The rule of kings lasted 250 years while the other two roughly 500 years each. For this post, we focus on the Republic because Rome's rise occurred during this period. The Roman Empire will be the subject of my future post. Although Rome's territorial conquest peaked during the time of the Empire, specifically under Emperor Hadrian, the new territories were no longer prime territories and holding on to them proved to be more costly than leaving them outside the borders.
Political leaders during the Republic were initially composed of senators. Although there were elections, it was a rule by aristocracy not democracy because only patricians (the land owning nobility) could be elected to the senate. Gradually the plebeians (commoners) who had grown rich through trade were allowed into the senate.
In ancient Greece and early Roman Republic, only the propertied class and the aristocrats had the right to vote. Even in the West in the 19th century, when voting was first introduced, only those with landed property were allowed to vote. Then, as now, democracy has always been biased towards those with wealth. Over time, this requirement was relaxed. The Roman electorate citizens eventually numbered more than a million. Rome was the first to introduce the secret balloting process. After the Republic faded away, it took 1,900 years for male universal suffrage to reappear in Western Europe.
The economic wealth of the Romans was derived from agriculture, trade and conquests. Conquests brought new lands (including metals mined therefrom) and increased tax revenue to the state coffers. Trade also rose because the security provided by the Roman rule encouraged exchange of produce between distant lands.
As is commonly the case with unchecked movement of goods and labour, in the long term, the impact on the social patterns and structure can be disruptive. Arising from the conquests, thousands of prisoners-of-war were sold as slaves. Only the wealthy aristocrats could afford them and their use on the large farms outdid the yields of the peasant farms. Unable to compete, the peasants sold their farms to the aristocrats.
Cheap grain imports from Sicily and North Africa also made the small peasant farms uneconomic. Gradually wealth tended to accumulate with the aristocrats and the merchant class. It's not surprising that in modern societies, as the economy prospers, the wealth concentration as reflected by the Gini coefficient gets more polarised.
The peasants flocked to Rome and the big towns where they survived on the assistance of the wealthy citizens. Later, the state took up this responsibility and also, to keep them from getting restless, the task of providing entertainment in the form of gladiator games, chariot races and theatre plays. Modern day political leaders are well advised to dish out subsistence assistance and cheap forms of entertainment to ease the pain of economic hardships and forestall social instability.
In the provision of public services, the Republic contracted them out to private parties, known as publicani. The contracts were auctioned off: for revenue collection to the highest bidders while for the expenditure on services and goods to the lowest. Even for military duties, there was no standing army. The army was conscripted from citizens of working age who had to pay for their own armour. The wages paid to them were barely enough.
With a growing citizenship and, consequently, electorate in line with Rome's territorial expansion, the stability of the leadership could no longer be guaranteed. New citizen voters could upset the balance of votes. In 27 BC, Augustus made himself emperor and thus ended the era of the Republic to be replaced by the Empire.
Under the Empire, the state bureaucracy expanded and the public services that had been carried by private contractors were now conducted by the state. The citizen army also turned into a standing one as pre-emptive defence replaced the former strategy of post-invasion counterstrike. As with any bureaucracy, once started, it could only enlarge even though the income of the state stagnated or receded. Even in modern times, increasing budget deficits are the logical evolution of governments moving towards the end-state of their life cycles. Any attempt to minimise deficits through balanced budgets unnecessarily hastens the demise of the governments.
The Romans had no significant technology wave. As described earlier, their growth mainly came from territorial conquests which also increased trade and agriculture. Such conquests also allowed Rome to transplant its idle people to the newly conquered areas. Whatever energy technology they had was based on the muscle power of humans and animals. The main contributor of that power was captured slaves. The water mills were far and few between.
The other critical leg of any technological progress, communication, was manifested in the Roman roads - running 85,000 km across the Empire - and the Mediterranean Sea, which after the defeat of Carthage, became mare nostrum (our sea or the Roman Lake.) Beyond these, the absence of further technological advance condemned Rome to a secular decline.
In contrast, the prosperity that we are now enjoying is the fruits of the Industrial Revolution that began in the 1780's. And it's not one cycle of progress. In fact, it has been renewed four times. We are now past the midpoint of the fourth wave and there is only one wave left to power us before our civilisation sputters like that of the Roman. These waves have enabled us to be liberal with human rights, giving political freedom that heretofore can't even be imagined.
Nowadays, champions of freedom and human rights are ignorant of the fact that such rights can be conferred only if the economic needs of the populace are well taken care of. Democratisation of wealth precedes the democratisation of politics. As the world nears the end of the technological progress, the incompatibility of liberalism with an economy in its last gasps is a sure-fire recipe for political turmoil.
It is also telling that in times of crisis, the Senate of the Roman Republic elected a dictator who had absolute power for a period of six months. Later, when the Roman Republic turned into an Empire, it was partly due to a lack of opportunities for economic growth. The need for stability entailed the firm rule of emperors. Even then, usurpations of power became common reflecting the hard times that prevailed in latter day Roman Empire.
Iron rule is not the answer but merely a predictable response to tough economic times. The eventual outcome would be pluralism, a fracturing of society into self-contained units last seen in Western Europe during the Middle Ages, also known as the Medieval period. In modern times, we are witnessing the shift towards pluralism in Somalia and Afghanistan. Waiting on the sidelines are many others: Pakistan, Iraq and most of the Sub-Saharan African countries. The world's refusal to face this reality means more bloodshed ahead without affecting the final destiny one whit.
From the Romans, many useful lessons can be gleaned, especially on economics and politics. Economics however is the more important of the two since in statecraft, economics underpins politics.
The Roman history consists of three periods of governance: monarchy, Republic and Empire. The rule of kings lasted 250 years while the other two roughly 500 years each. For this post, we focus on the Republic because Rome's rise occurred during this period. The Roman Empire will be the subject of my future post. Although Rome's territorial conquest peaked during the time of the Empire, specifically under Emperor Hadrian, the new territories were no longer prime territories and holding on to them proved to be more costly than leaving them outside the borders.
Political leaders during the Republic were initially composed of senators. Although there were elections, it was a rule by aristocracy not democracy because only patricians (the land owning nobility) could be elected to the senate. Gradually the plebeians (commoners) who had grown rich through trade were allowed into the senate.
In ancient Greece and early Roman Republic, only the propertied class and the aristocrats had the right to vote. Even in the West in the 19th century, when voting was first introduced, only those with landed property were allowed to vote. Then, as now, democracy has always been biased towards those with wealth. Over time, this requirement was relaxed. The Roman electorate citizens eventually numbered more than a million. Rome was the first to introduce the secret balloting process. After the Republic faded away, it took 1,900 years for male universal suffrage to reappear in Western Europe.
The economic wealth of the Romans was derived from agriculture, trade and conquests. Conquests brought new lands (including metals mined therefrom) and increased tax revenue to the state coffers. Trade also rose because the security provided by the Roman rule encouraged exchange of produce between distant lands.
As is commonly the case with unchecked movement of goods and labour, in the long term, the impact on the social patterns and structure can be disruptive. Arising from the conquests, thousands of prisoners-of-war were sold as slaves. Only the wealthy aristocrats could afford them and their use on the large farms outdid the yields of the peasant farms. Unable to compete, the peasants sold their farms to the aristocrats.
Cheap grain imports from Sicily and North Africa also made the small peasant farms uneconomic. Gradually wealth tended to accumulate with the aristocrats and the merchant class. It's not surprising that in modern societies, as the economy prospers, the wealth concentration as reflected by the Gini coefficient gets more polarised.
The peasants flocked to Rome and the big towns where they survived on the assistance of the wealthy citizens. Later, the state took up this responsibility and also, to keep them from getting restless, the task of providing entertainment in the form of gladiator games, chariot races and theatre plays. Modern day political leaders are well advised to dish out subsistence assistance and cheap forms of entertainment to ease the pain of economic hardships and forestall social instability.
In the provision of public services, the Republic contracted them out to private parties, known as publicani. The contracts were auctioned off: for revenue collection to the highest bidders while for the expenditure on services and goods to the lowest. Even for military duties, there was no standing army. The army was conscripted from citizens of working age who had to pay for their own armour. The wages paid to them were barely enough.
With a growing citizenship and, consequently, electorate in line with Rome's territorial expansion, the stability of the leadership could no longer be guaranteed. New citizen voters could upset the balance of votes. In 27 BC, Augustus made himself emperor and thus ended the era of the Republic to be replaced by the Empire.
Under the Empire, the state bureaucracy expanded and the public services that had been carried by private contractors were now conducted by the state. The citizen army also turned into a standing one as pre-emptive defence replaced the former strategy of post-invasion counterstrike. As with any bureaucracy, once started, it could only enlarge even though the income of the state stagnated or receded. Even in modern times, increasing budget deficits are the logical evolution of governments moving towards the end-state of their life cycles. Any attempt to minimise deficits through balanced budgets unnecessarily hastens the demise of the governments.
The Romans had no significant technology wave. As described earlier, their growth mainly came from territorial conquests which also increased trade and agriculture. Such conquests also allowed Rome to transplant its idle people to the newly conquered areas. Whatever energy technology they had was based on the muscle power of humans and animals. The main contributor of that power was captured slaves. The water mills were far and few between.
The other critical leg of any technological progress, communication, was manifested in the Roman roads - running 85,000 km across the Empire - and the Mediterranean Sea, which after the defeat of Carthage, became mare nostrum (our sea or the Roman Lake.) Beyond these, the absence of further technological advance condemned Rome to a secular decline.
In contrast, the prosperity that we are now enjoying is the fruits of the Industrial Revolution that began in the 1780's. And it's not one cycle of progress. In fact, it has been renewed four times. We are now past the midpoint of the fourth wave and there is only one wave left to power us before our civilisation sputters like that of the Roman. These waves have enabled us to be liberal with human rights, giving political freedom that heretofore can't even be imagined.
Nowadays, champions of freedom and human rights are ignorant of the fact that such rights can be conferred only if the economic needs of the populace are well taken care of. Democratisation of wealth precedes the democratisation of politics. As the world nears the end of the technological progress, the incompatibility of liberalism with an economy in its last gasps is a sure-fire recipe for political turmoil.
It is also telling that in times of crisis, the Senate of the Roman Republic elected a dictator who had absolute power for a period of six months. Later, when the Roman Republic turned into an Empire, it was partly due to a lack of opportunities for economic growth. The need for stability entailed the firm rule of emperors. Even then, usurpations of power became common reflecting the hard times that prevailed in latter day Roman Empire.
Iron rule is not the answer but merely a predictable response to tough economic times. The eventual outcome would be pluralism, a fracturing of society into self-contained units last seen in Western Europe during the Middle Ages, also known as the Medieval period. In modern times, we are witnessing the shift towards pluralism in Somalia and Afghanistan. Waiting on the sidelines are many others: Pakistan, Iraq and most of the Sub-Saharan African countries. The world's refusal to face this reality means more bloodshed ahead without affecting the final destiny one whit.
Sunday, October 18, 2009
From Nixon to Bush: The debt financing of American politics
If one were to designate the most prosperous post-WW2 decade in America, without question, it would have been the 1960s. The economy was growing. Neither inflation nor deflation was evident. The American households were still saving and America was still a creditor nation. But as is always the norm, good things never last.The 1970s heralded the start of a tumultuous era for the American economy. Thenceforth America's growth was to be financed by ever increasing amount of debt. The chart above shows the yawning gap between America's debt and its GDP. It is as if debt grows geometrically but GDP arithmetically.
A detailed examination of the debt growth from 1971 provides an instructive view of how the US gradually surrendered control of its economy to outsiders, all the while without realising so. Why 1971? Because 1971 is full of connotations.
First, it marks the year the debt first outpaced the GDP since WW2, growing by more than 10 percent. Another momentous milestone, on 15 August 1971, occurred when Pres. Nixon severed the link between the US dollars and gold in order to stem the flow of gold to other countries, notably France. It paved the way for debt (and its corollary, the money supply) to start its relentless growth. If the gold link were in place, the gold reserve would have constrained any debt increase and the consequent GDP growth.
As the money supply rose, so was the pressure on commodity prices, simply because their supplies could not be hastily bumped up. Even now, it still takes 7 to 10 years for new supplies to come onstream. The 1973 Arab-Israeli War snapped the suppressed oil prices because by then the pressure for an increase had been 2 years in the offing. The trigger was the war but the root cause was the debt (or money supply).
The debt also fueled the inflation past the 10 percent mark in 1974 as the debt growth outpaced the slowing GDP. The oil price surge upended the economy with increased oil expenditure constraining spending in other areas. Stock market and property collapsed as debts growth slowed. Nixon sought to reduce the federal deficit, slashing it to $6.1 billion by 1974. The fed funds rate was raised to almost 13 percent by July 1974. The resulting recession in 1974 cost Nixon the presidency. He had to resign during his second term to avoid impeachment. Nixon wanted to control the debt but in the end the debt got him.
Gerald Ford who replaced him for the remainder of his term was beset by persistent inflation and high unemployment, a phenomenon known as stagflation. Actually towards the end of his term, inflation dropped to as low as 4.9 percent but the high unemployment killed his reelection hopes.
The debt again rose as Carter took up the presidency in 1977, corporate financial and non-financial debts being the main cause. Towards the end of his term, he sought to rein in the debt. Again the economy slipped into recession in 1980 as inflation crested at 13.5 percent. Like how it brought down Nixon, the debt showed no mercy to Carter. Out he went.
When Reagan came into office in 1981, Paul Volcker, the Fed Chairman, attacked inflation with a vengeance. He jacked up the fed funds rate to 20 percent. Inflation tumbled to 3.2 percent by the end of 1983. As debt growth slowed to 10 percent, the wrath of the public was heaped on Volcker instead of Reagan. Without the inflation debasement, the US dollars became a stable currency, much sought after by foreign exporters.
At the same time, the Japanese had made inroads into the US market and they were happy to be paid in US Treasury bonds. Reagan soon discovered that America could borrow to the hilt without the pain of inflation. The supply capacity constraint was broken by the opening of the Japanese manufacturing spigot. So America went on a debt and import spree. Sure enough, Reagan got his second term. Aside from the Volcker induced recession at the beginning of his presidency, Reagan never had to endure another recession. In short, the American public could have its cake and eat it too.
Bush, the elder, was elected in 1988 on the coattails of Reagan's popularity. But he was alarmed by the state of the government budget. He raised taxes in departure to his election promise of no new taxes. Despite this, he actually increased the budget deficits throughout his presidential term. Yet the debt growth slowed down to 5 percent turning the US into a net exporter by 1991. The cause was the Savings & Loan Crisis which had started in 1987 following the rapid debt growth during the Reagan years. The consequent deceleration in private sector borrowings contributed to the 1990-1991 recession and sealed Bush's fate. Like Carter, Bush was shown the door after just one term.
Clinton was elected in 1991 on the strength of his slogan, "It's the economy, stupid!" Of course, he did focus on the economy, that is on enlarging the debt. That contributed to his successful second term bid. Towards the end of that term, the dotcom boom kicked in. Businesses and financial institutions piled on increasing amount of debts deluded by their optimistic view of the future. Clinton disingenuously claimed credit for the government budget surplus, after continual deficits of more than 30 years. That feat was only possible because of the private sector's tremendous debt build-up.
The dotcom boom fizzled out and a short recession ensued in 2001 as Bush, the younger, came into office. But the debt kept its relentless growth, this time powered by the households and financial institutions. The new debts were related to mortgage financing. Bush saw to the growth of these debts throughout the eight years of his tenure. These massive debts however could never be repaid. Their unwinding falls on Obama's lap. How the process will unfold is the subject of another post, "Bernanke vs. The Market."
Tuesday, October 13, 2009
Bernanke vs. The Market
Stock indices all over the world have recovered from their lows in March 2009. Similarly, commodities have rebounded from their nadir at the beginning of the year. Everybody is quick to point to a recovery from recession. Not so fast. Indices and prices that move with a high volatility cannot be explained simply by fluctuations in supply and demand. Something with a more powerful force could have accounted for the movement.
If you travel in a moving object, things outside the object will fleetingly pass you by. Only a fool would imagine that the world is moving while he is sitting still. In like manner, if you believe that the volatility in the stock markets and commodity prices are due to demand and supply, then you've been taken for a ride.
First, we need a primer on demand and supply. Our common understanding of demand and supply is that price is the mechanism that matches demand and supply. If demand exceeds supply, price rises and vice versa. But this law overlooks one crucial element: the medium for the price. Nowadays it is fiat money, a currency with no precious metal backing. The value is decided by the authorities. Demand and supply can remain the same but if the currency volume is increased, the price will follow suit.
This is where Ben Bernanke comes into the picture because he's in control of the one tool that significantly affects stock markets and commodity prices: money printing or also known by its current euphemism, quantitative easing (QE). Herein lies the problem with Bernanke. Abraham Maslow's quote, "If you only have a hammer, you tend to see every problem as a nail", aptly fits him. Bernanke is using his hammer to maximum effect. He keeps pounding on all economic problems regardless of whether his hammering will bring the house down.
To understand the danger of Ben's knocking, let's have some basics on modern day money supply in the US. Why the US? Because the US is the primary locomotive of the global economy that even other large economies, such as China, Japan and Germany largely depend on its growth to drive their own progress. A good indicator of the money supply in the US is not the money supply computed by the US Fed. It's actually the total debt in the US. The official money supply reflects only the debts or loans made by the US banks (debts or loans appear on the asset side of the banks' balance sheets while the liability side is made up of deposits and checking accounts, i.e., the money supply). Not only is the banks' money supply incomplete, it has also been muddled by securitisation and the banks' hiving off the loans to off-balance sheet vehicles.
As debt plays an increasingly important role in the economy, it's useful to study the chart below from the NY Times. It plots the US debt growth from 1953 to 2009. The period 1971 to 2008 marks the growth of debt that surpassed the GDP growth. This period is described in detail in another post, "From Nixon to Bush: The debt financing of America."
Another chart below shows the ratio between the total debt and the GDP. What is interesting about these two charts is not the extremities to which they are heading. Since the future is more exciting than the past, we want to identify the patterns that will unfold. After all, anybody can rationalise the past regardless of how flawed their arguments are.
Looking at the first chart, you can can see a faint outline of a bell curve while the second clearly marks the shape of a developing S-curve. Now you know the relationship between the bell curve and the S-curve. For the mathematically inclined, the bell curve is a derivative of the S-curve. Both are laws of nature from which there is no escape. You can deviate but the laws will pull you back to their predestined paths.
Both curves indicate that the American debt explosion has run its course. The debt is already past its prime. The S-curve is plateauing and probably drooping over the coming years. The bell curve shows a major correction, a big downward shift after Bush's aberrant move upward. This shift spells disaster presaging a rating plunge for Obama.
His damage control, in the face of slumping debt positions of all other sectors, is naturally to accelerate deficit spending. The just released 2009 federal fiscal (year ending 30/09/09) deficit was $1,417 billion, amounting to 10 percent of US GDP. But how does this stack against the big picture? This chart from Forbes 02/11/09 shows Obama's deficit couldn't even cover the collapse in the finance sector debts. The total debt movement may go into negative territory this year.
So now we are left with Ben Bernanke's frantic bungling in the debt market. Bernanke thinks that the problem is liquidity. Because that's what Milton Friedman and Anna Schwartz identified as the cause of the 1930s Great Depression. They couldn't have been more wrong. The real cause for the Great Depression and the present one is not liquidity but capacity (see It's capacity, not liquidity, stupid).
Because of his misguided view of the cause of the crisis, Bernanke has pumped more than $1 trillion buying all sorts of debts, from Treasury bonds to asset backed mortgages to corporate papers. Before the crisis, Fed's holding of debts was $870 billion. Now it's $2.1 trillion. He thought that with more liquidity, the credit market would start moving. But surprise, surprise, it's not budging. The extra liquidity is being used not to create more debts but to speculate in stocks, commodities and bonds. Since this is a capacity crisis, nobody would want to borrow for investment because all over the world, there's surplus capacity. Only fools believing the rising stock prices as a portent of an improving economy will rush to invest. The wise use this opportunity to reduce their debts, cut expenses and sell off surplus capacity.
Bernanke will come to realise that when confronting the laws of nature, there are limits to what the Fed can muster. And for Obama, he will come to rue his appointment as President and be sensible enough to stop harping on his predecessor's legacy. The past presidents had to do what had to be done; they were under the yoke of the debt. Obama's job is to manage the debt transition from its growth phase to the maturity phase. There are no two ways about it; the laws of nature dictate so.
If you travel in a moving object, things outside the object will fleetingly pass you by. Only a fool would imagine that the world is moving while he is sitting still. In like manner, if you believe that the volatility in the stock markets and commodity prices are due to demand and supply, then you've been taken for a ride.
First, we need a primer on demand and supply. Our common understanding of demand and supply is that price is the mechanism that matches demand and supply. If demand exceeds supply, price rises and vice versa. But this law overlooks one crucial element: the medium for the price. Nowadays it is fiat money, a currency with no precious metal backing. The value is decided by the authorities. Demand and supply can remain the same but if the currency volume is increased, the price will follow suit.
This is where Ben Bernanke comes into the picture because he's in control of the one tool that significantly affects stock markets and commodity prices: money printing or also known by its current euphemism, quantitative easing (QE). Herein lies the problem with Bernanke. Abraham Maslow's quote, "If you only have a hammer, you tend to see every problem as a nail", aptly fits him. Bernanke is using his hammer to maximum effect. He keeps pounding on all economic problems regardless of whether his hammering will bring the house down.
To understand the danger of Ben's knocking, let's have some basics on modern day money supply in the US. Why the US? Because the US is the primary locomotive of the global economy that even other large economies, such as China, Japan and Germany largely depend on its growth to drive their own progress. A good indicator of the money supply in the US is not the money supply computed by the US Fed. It's actually the total debt in the US. The official money supply reflects only the debts or loans made by the US banks (debts or loans appear on the asset side of the banks' balance sheets while the liability side is made up of deposits and checking accounts, i.e., the money supply). Not only is the banks' money supply incomplete, it has also been muddled by securitisation and the banks' hiving off the loans to off-balance sheet vehicles.
As debt plays an increasingly important role in the economy, it's useful to study the chart below from the NY Times. It plots the US debt growth from 1953 to 2009. The period 1971 to 2008 marks the growth of debt that surpassed the GDP growth. This period is described in detail in another post, "From Nixon to Bush: The debt financing of America."
Both curves indicate that the American debt explosion has run its course. The debt is already past its prime. The S-curve is plateauing and probably drooping over the coming years. The bell curve shows a major correction, a big downward shift after Bush's aberrant move upward. This shift spells disaster presaging a rating plunge for Obama.
His damage control, in the face of slumping debt positions of all other sectors, is naturally to accelerate deficit spending. The just released 2009 federal fiscal (year ending 30/09/09) deficit was $1,417 billion, amounting to 10 percent of US GDP. But how does this stack against the big picture? This chart from Forbes 02/11/09 shows Obama's deficit couldn't even cover the collapse in the finance sector debts. The total debt movement may go into negative territory this year.So now we are left with Ben Bernanke's frantic bungling in the debt market. Bernanke thinks that the problem is liquidity. Because that's what Milton Friedman and Anna Schwartz identified as the cause of the 1930s Great Depression. They couldn't have been more wrong. The real cause for the Great Depression and the present one is not liquidity but capacity (see It's capacity, not liquidity, stupid).
Because of his misguided view of the cause of the crisis, Bernanke has pumped more than $1 trillion buying all sorts of debts, from Treasury bonds to asset backed mortgages to corporate papers. Before the crisis, Fed's holding of debts was $870 billion. Now it's $2.1 trillion. He thought that with more liquidity, the credit market would start moving. But surprise, surprise, it's not budging. The extra liquidity is being used not to create more debts but to speculate in stocks, commodities and bonds. Since this is a capacity crisis, nobody would want to borrow for investment because all over the world, there's surplus capacity. Only fools believing the rising stock prices as a portent of an improving economy will rush to invest. The wise use this opportunity to reduce their debts, cut expenses and sell off surplus capacity.
Bernanke will come to realise that when confronting the laws of nature, there are limits to what the Fed can muster. And for Obama, he will come to rue his appointment as President and be sensible enough to stop harping on his predecessor's legacy. The past presidents had to do what had to be done; they were under the yoke of the debt. Obama's job is to manage the debt transition from its growth phase to the maturity phase. There are no two ways about it; the laws of nature dictate so.
Tuesday, September 8, 2009
The potent mix of narcissism and nihilism
We've seen how recessions can be categorised as epidemic or pandemic. But those experiencing recessions have to undergo several emotional stages that will tax their resolves to the limit. This is true at the individual as well as at the macro level.
Such stages are similar for those being depressed at the loss of their livelihoods as those facing terminal illnesses. The stages have been well documented in the form of the grief model by Dr. Elisabeth Kubler-Ross in 1969, in her book On Death and Dying.
The model shown here essentially contains five stages though this chart - taken from Booz & Co's Strategy & Business website - shows eight. The five key stages are: denial, anger, bargaining, depression and acceptance.
As I've argued earlier, this recession is a pandemic recession or more correctly, a Grand Depression, much worse than the Great Depression of the 1930s. Most people still are convinced that the worst is now over. This is not surprising since they are mostly still at the denial stage. If you look at the chart, moving from the denial to the next stage, anger, is very difficult. The emotional response climbs from a low steady state to an agitated level. It's certainly a big hurdle to pass.
This refusal to face reality prolongs the recession. In fact, if we look back to the Dow Jones Industrial Average (DJIA) during the depression years 1929-1933 (see chart below from Bloomberg), we can notice that there are several rallies, seven as counted by some commentators, on its way to the bottom. The pattern is also obvious, everytime it went down, it tried to move up but every upward movement had less momentum than the preceding one. But one thing is clear, each year it closed lower than the bottom of the previous year. At its peak on September 3 1929, the DJIA topped out at 381.17. Within three years, it slumped to 41.22, just over 10% of its peak closing.
In the spring of 1931, they were also talking about green shoots. But these shoots wilted when the Austrian bank, Creditanstalt, then the largest bank in Central and Eastern Europe, collapsed in May 1931. Creditanstalt was not a run-of-the mill bank; it was controlled by the Rothschilds. The collapse triggered a global meltdown. Before that, it was thought the economic crisis was confined only to the US.
Likewise, today the widely held view is that the crisis is caused by the US subprime loans. That's just the early symptom; the real crisis is global excess capacity. No country will be spared. It's a matter of when. Its severity will be certainly very grim.
This crisis will over time disconnect the leaders of many countries from the led, each with diametrically opposing views of themselves and on the future economic outlook. The leaders and policymakers are imbued with narcissism, smug and confident that they have the means to end the recession. In the Kubler-Ross diagram, they are at the denial state.
If they manage to hang on to office, in due course they will cross the anger state. At this point, their politics of consensus and inclusion gives way to one of polarisation. Fortunately, during the last wave, the anger could be directed to the war in Europe. Now the US is too powerful for any nation-state to pick a fight. The anger has to be dealt with internally. The next two stages, depression and acceptance, are beyond the reach of the leaders because they would have been booted out at the anger stage. We would be witnessing frequent changes of leadership as voters become more dismissive of their leaders.
The man in the street buffeted by prolonged unemployment and weighed down by heavy debts, can no longer be reasoned to. He has reached the point of nihilism, a result of their anger, rejecting everything just for rejection's sake. President Obama will have tremendous obstacles pushing new initiatives, be they healthcare or defence buildup in Afghanistan. The odds are stacked against him succeeding.
With no recovery in sight, the mood of the unemployed will grow angry and, for those that have progressed to the advanced state, depressive. Anger fuels increased crime and violence. The depressed may succumb to suicide. The internal breakdown of the American society will be on a much larger scale than that wrought on Iraq and Afghanistan. The government needs to provide support for volunteering and self-help work that provide outlets for the unemployed to occupy their time and utilise their energy. This encourages their move to the acceptance stage.
Everyone must accept the reality that in an environment of excess capacity, there are simply no more new jobs. Only then can we move quickly to the acceptance stage. But we know that this is not going to be; instead, anger and depression - the state of both the mind and the economy - will be the order of the day.
Such stages are similar for those being depressed at the loss of their livelihoods as those facing terminal illnesses. The stages have been well documented in the form of the grief model by Dr. Elisabeth Kubler-Ross in 1969, in her book On Death and Dying.
The model shown here essentially contains five stages though this chart - taken from Booz & Co's Strategy & Business website - shows eight. The five key stages are: denial, anger, bargaining, depression and acceptance.As I've argued earlier, this recession is a pandemic recession or more correctly, a Grand Depression, much worse than the Great Depression of the 1930s. Most people still are convinced that the worst is now over. This is not surprising since they are mostly still at the denial stage. If you look at the chart, moving from the denial to the next stage, anger, is very difficult. The emotional response climbs from a low steady state to an agitated level. It's certainly a big hurdle to pass.
This refusal to face reality prolongs the recession. In fact, if we look back to the Dow Jones Industrial Average (DJIA) during the depression years 1929-1933 (see chart below from Bloomberg), we can notice that there are several rallies, seven as counted by some commentators, on its way to the bottom. The pattern is also obvious, everytime it went down, it tried to move up but every upward movement had less momentum than the preceding one. But one thing is clear, each year it closed lower than the bottom of the previous year. At its peak on September 3 1929, the DJIA topped out at 381.17. Within three years, it slumped to 41.22, just over 10% of its peak closing.
In the spring of 1931, they were also talking about green shoots. But these shoots wilted when the Austrian bank, Creditanstalt, then the largest bank in Central and Eastern Europe, collapsed in May 1931. Creditanstalt was not a run-of-the mill bank; it was controlled by the Rothschilds. The collapse triggered a global meltdown. Before that, it was thought the economic crisis was confined only to the US.
Likewise, today the widely held view is that the crisis is caused by the US subprime loans. That's just the early symptom; the real crisis is global excess capacity. No country will be spared. It's a matter of when. Its severity will be certainly very grim.
This crisis will over time disconnect the leaders of many countries from the led, each with diametrically opposing views of themselves and on the future economic outlook. The leaders and policymakers are imbued with narcissism, smug and confident that they have the means to end the recession. In the Kubler-Ross diagram, they are at the denial state.
If they manage to hang on to office, in due course they will cross the anger state. At this point, their politics of consensus and inclusion gives way to one of polarisation. Fortunately, during the last wave, the anger could be directed to the war in Europe. Now the US is too powerful for any nation-state to pick a fight. The anger has to be dealt with internally. The next two stages, depression and acceptance, are beyond the reach of the leaders because they would have been booted out at the anger stage. We would be witnessing frequent changes of leadership as voters become more dismissive of their leaders.
The man in the street buffeted by prolonged unemployment and weighed down by heavy debts, can no longer be reasoned to. He has reached the point of nihilism, a result of their anger, rejecting everything just for rejection's sake. President Obama will have tremendous obstacles pushing new initiatives, be they healthcare or defence buildup in Afghanistan. The odds are stacked against him succeeding.
With no recovery in sight, the mood of the unemployed will grow angry and, for those that have progressed to the advanced state, depressive. Anger fuels increased crime and violence. The depressed may succumb to suicide. The internal breakdown of the American society will be on a much larger scale than that wrought on Iraq and Afghanistan. The government needs to provide support for volunteering and self-help work that provide outlets for the unemployed to occupy their time and utilise their energy. This encourages their move to the acceptance stage.
Everyone must accept the reality that in an environment of excess capacity, there are simply no more new jobs. Only then can we move quickly to the acceptance stage. But we know that this is not going to be; instead, anger and depression - the state of both the mind and the economy - will be the order of the day.
Tuesday, September 1, 2009
The plague of recession
While leaders and policymakers have been trumpeting the end of the recession, are we really on the cusp of recovery? Knowing at which stage of the recession we are in is critical because we are dealing with millions of livelihoods throughout the world. A wrong judgment may mean the difference between getting on with or giving up on lives.
Recessions have much in common with plagues. Both create uncertainty and fear; uncertainty of being hit and fear of the severity of the affliction. A lot has been written on the history of plagues. But the one highly regarded is by the eminent historian, William H. McNeill.
Plagues can be categorised into several phases: epidemic, pandemic and endemic (note that by the time a disease is endemic, it's no longer a plague). To begin with, an explanation of the terms is helpful.
Epidemic, formed from two Greek root words, epi and demos meaning above and people, refers to an outbreak of a disease that spreads quickly to a large group of people within a specific location and within a specific time frame. Pandemic - pan for all - on the other hand, is far more virulent as the disease disperses over a very wide area, which now is synonymous with a global diffusion, and thus affects many, many more people.
Endemic - en for in - is the stage where the disease and host have adapted to one another. The disease, now less virulent, is commonly found among the people and aside from causing discomfort, is no longer fatal to the host. They have evolved towards a stable pattern of co-existence.
To better understand the cause of the present economic crisis, we have to undertake a forensic pathology on economic recessions in recent times. But first, a lesson in economic recession. An economic recession can be of two varieties: an inflationary one caused by a rapid increase in money supply unmatched by a corresponding increase in goods production, and a deflationary one caused by surplus goods production in an environment of rapid money contraction.
How can money appear and disappear in vast amount in so short a time? For this, we have to thank two modern innovations: credit banking, the major player, and the printing press which plays a supporting role. In our modern economy, credit represents more than 90 percent of the money in circulation with paper making up the balance. So it's very easy to inflate or deflate the money supply. Our familiar paper money doesn't suffer that much from this disappearing illusion, only the virtual money.
The other leg of the equation, goods production, has been playing an increasing role since the start of the Industrial Revolution. Actually, the technology waves triggered by the Industrial Revolution have unleashed the energy stored over millions of years in the form of coal and oil fossil fuel. This translates into a massive leap in goods production. Helping to wipe up these additional goods are the innovations in transportation and communication that move goods cheaply or make comparisons about prices widely available.
Generally such advances are synonymous with capitalism since they require substantial capital. More savings are channeled into investment capital further raising goods production. Eventually too much of a good thing turns harmful. Production exceeds consumption generating negative returns on the invested capital. In time the capital will be written off. This is the scenario of a deflationary recession.
What about inflationary recession? This occurs at the early phase of a technology wave. Demand is growing but production lags behind. The banks lend more to meet the need for more money to buy goods but production still can't catch up. More money translates into higher prices. Solving this is easy; you raise the price of money, that is the interest rate. Money supply reduces and things return to normal. Over time production rises to meet the increasing demand. The recession happens when the money supply is crimped. Jobs are lost as businesses retrench.
Of the two, deflationary is the more malign because reducing supply is much harder than increasing it. Businesses will continue running at a loss until many go bust. Recovery takes a long time.
To demonstrate that inflation prevails during the run-up to the crest of the technology wave while deflation as the wave matures, the US inflation for the years 1914 to 2007 taken from the Wikipedia site, shown below, would be instructive. The third wave ended around 1950 after cresting in 1920 (The story of the whole five waves will appear in a future post). You can observe that from the 1920s to the 1930s, the period was wrapped in deflation. In the 1940s, it would have been deflation had not the Second World War diverted the production capacity to arms production. Indeed traces of deflation still reared its ugly head at the end of the war.
After the war, the need for housing to house the American families in the suburbs fueled the demand growth. Highway construction was carried out on a grand scale and automobile sales correspondingly rose. A baby boom in the 1950s to the 1960s rounded off the demand growth story.
After 1950, the upsurge in demand raced ahead of supply until it reached the turning point in 1990. My future post will describe why inflation nowadays can only become an epidemic and a tempered one at that but deflation can transcend from epidemic to pandemic and eventually becomes endemic. Like its disease counterpart, the epidemic spreads from countries to countries while the pandemic comes in waves.
Recessions have much in common with plagues. Both create uncertainty and fear; uncertainty of being hit and fear of the severity of the affliction. A lot has been written on the history of plagues. But the one highly regarded is by the eminent historian, William H. McNeill.
Plagues can be categorised into several phases: epidemic, pandemic and endemic (note that by the time a disease is endemic, it's no longer a plague). To begin with, an explanation of the terms is helpful.
Epidemic, formed from two Greek root words, epi and demos meaning above and people, refers to an outbreak of a disease that spreads quickly to a large group of people within a specific location and within a specific time frame. Pandemic - pan for all - on the other hand, is far more virulent as the disease disperses over a very wide area, which now is synonymous with a global diffusion, and thus affects many, many more people.
Endemic - en for in - is the stage where the disease and host have adapted to one another. The disease, now less virulent, is commonly found among the people and aside from causing discomfort, is no longer fatal to the host. They have evolved towards a stable pattern of co-existence.
To better understand the cause of the present economic crisis, we have to undertake a forensic pathology on economic recessions in recent times. But first, a lesson in economic recession. An economic recession can be of two varieties: an inflationary one caused by a rapid increase in money supply unmatched by a corresponding increase in goods production, and a deflationary one caused by surplus goods production in an environment of rapid money contraction.
How can money appear and disappear in vast amount in so short a time? For this, we have to thank two modern innovations: credit banking, the major player, and the printing press which plays a supporting role. In our modern economy, credit represents more than 90 percent of the money in circulation with paper making up the balance. So it's very easy to inflate or deflate the money supply. Our familiar paper money doesn't suffer that much from this disappearing illusion, only the virtual money.
The other leg of the equation, goods production, has been playing an increasing role since the start of the Industrial Revolution. Actually, the technology waves triggered by the Industrial Revolution have unleashed the energy stored over millions of years in the form of coal and oil fossil fuel. This translates into a massive leap in goods production. Helping to wipe up these additional goods are the innovations in transportation and communication that move goods cheaply or make comparisons about prices widely available.
Generally such advances are synonymous with capitalism since they require substantial capital. More savings are channeled into investment capital further raising goods production. Eventually too much of a good thing turns harmful. Production exceeds consumption generating negative returns on the invested capital. In time the capital will be written off. This is the scenario of a deflationary recession.
What about inflationary recession? This occurs at the early phase of a technology wave. Demand is growing but production lags behind. The banks lend more to meet the need for more money to buy goods but production still can't catch up. More money translates into higher prices. Solving this is easy; you raise the price of money, that is the interest rate. Money supply reduces and things return to normal. Over time production rises to meet the increasing demand. The recession happens when the money supply is crimped. Jobs are lost as businesses retrench.
Of the two, deflationary is the more malign because reducing supply is much harder than increasing it. Businesses will continue running at a loss until many go bust. Recovery takes a long time.
To demonstrate that inflation prevails during the run-up to the crest of the technology wave while deflation as the wave matures, the US inflation for the years 1914 to 2007 taken from the Wikipedia site, shown below, would be instructive. The third wave ended around 1950 after cresting in 1920 (The story of the whole five waves will appear in a future post). You can observe that from the 1920s to the 1930s, the period was wrapped in deflation. In the 1940s, it would have been deflation had not the Second World War diverted the production capacity to arms production. Indeed traces of deflation still reared its ugly head at the end of the war.
After the war, the need for housing to house the American families in the suburbs fueled the demand growth. Highway construction was carried out on a grand scale and automobile sales correspondingly rose. A baby boom in the 1950s to the 1960s rounded off the demand growth story.
After 1950, the upsurge in demand raced ahead of supply until it reached the turning point in 1990. My future post will describe why inflation nowadays can only become an epidemic and a tempered one at that but deflation can transcend from epidemic to pandemic and eventually becomes endemic. Like its disease counterpart, the epidemic spreads from countries to countries while the pandemic comes in waves.
Saturday, August 29, 2009
A yen for wisdom
An expert may have all the knowledge on any subject at his fingertips yet he may not have the wisdom. As a guide to tell a wise person and an expert apart, I've chosen an article, Japan's control on the yen, which appeared in the Think Asian column of the Malaysian newspaper, The Star on August 29, 2009. The author is Andrew Sheng, Adjunct Professor at the University of Malaya and Tsinghua University as well as a Director of Khazanah Nasional Berhad. He also sits on various prominent high-powered councils and boards. He sure is a heavyweight on his subject but his article is full of irrelevant arguments, or the proverbial trees instead of the insightful forest.
Let me summarise the pertinent points in his article. The article discusses why the Japanese yen fails to become a reserve currency. Several arguments, the trees, are advanced to support that contention. Among them are its volatility (unstable value), the low yield on yen denominated financial and real assets, and, lastly, the rise of the euro which adds another competing alternative to the yen.
Now, let's rise above the trees to see the forest. One point is enough to puncture holes in all of Mr. Sheng's arguments. For a currency to be a reserve currency, the currency's country must have a tremendous amount of current account deficits, i.e., it must be a global debtor, not just a debtor like most sub-Saharan countries. Only one country qualifies and it is the United States of America.
That is the crux of my argument. The detailed bits follow.
Of course, not every country can be a global debtor. For it to be a global debtor, it must be credible, not only economically but also militarily. In other words, it must earn its stripes. It is not an easy process because a country has to go through the mill. It must first be a creditor country, accumulating current account surpluses over the years. In fact, only in the 1980s did the US become a debtor nation. Thenceforth, its foreign debts could only move one way, that is upwards.
Since Japan is not a debtor country, there's not enough yen floating around for it to be adopted as a reserve currency. You may argue you can easily buy yen. True but for you to hold yen, you must give the Japanese something in exchange. The Japanese don't want your Malaysian ringgit or any other exotic currencies because they are not tradeable outside the countries' borders. They prefer the US dollar. Same goes for the EU. The more yen or euro you want to keep, the more US dollars the Japanese and Europeans must hold in return.
As for the volatility of the Japanese yen, it's not Japan's fault. Since many countries trade mostly with the US, they stabilise their currencies' exchange rates only with respect to the US dollar. Should there be a major fluctuation of these currencies vis-a-vis the US dollar, it's primarily due to a drop or a rise in their economic competitiveness relative to other countries exporting to the US. For example, the 1997 Asian financial crisis was precipitated by the rise of China which made all other East Asian countries non-competitive. Only when they devalued their currencies could they recover. George Soros wasn't the cause nor were capital controls a remedy.
The US does not have the luxury of setting its own exchange rate. It has to take whatever exchange rates set by the monetary authorities of other countries. When the Japanese ran huge trade surpluses with US in the early 1980s, the US had to bear on the Japanese through the 1985 Plaza Accord to get them to appreciate the yen vis-a-vis the US dollar. The yen doubled its value within three years. Gradually, the Japanese became non-competitive. Whatever it can produce, the Koreans and, eventually, the Chinese also can at much lower costs because of their cheaper currencies. With a population that's both declining and ageing faster than those of its competitors, Japan will be an economic basket case.
Since other countries do not target a specific exchange rate vis-a-vis the yen, the yen is bound to fluctuate (or more likely, appreciate) relative to their currencies. There is no benefit at all in borrowing money in yen even if no interest is charged; the borrowers will be hit by the increasing exchange rate.
The low yield on the Japanese assets are also beyond their control. Japan's economy has been in the rut ever since their bubaru keizai (bubble economy) burst in 1991. They tried various measures including zero interest rate policy but to no avail. Till today, policymakers can't figure out why Japan remains mired in a gloomy mindset for such a long time. Even when they had economic growth, the outlook wasn't cheerful. Actually, this phenomenon is a pernicious effect of globalisation. Similar situations can be found in resource rich countries, such as the major oil exporting countries. As it requires a lengthy explanation, I'll elaborate on this in a future post.
Finally, can the euro displace the yen? Actually, such a notion is implausible because neither can be reserve currencies. The euro's claim to reserve currency status is as much tied to Germany's current surplus as the yen is to Japan's. However both are only claims, not real entitlements. Neither has been a superpower and ever won't they be.
These arguments countering Mr. Sheng's assertions are intended to demonstrate how an eminent expert can suffer from blind spots. Being wise is not difficult; you need to build patterns in your thinking. Patterns include enduring laws which are simple yet escape the attention of experts. For example, one highly pertinent law is that the interest rate for a country cannot exceed its economic growth rate. Applying this to the Japanese case, we can naturally deduce that returns on yen denominated assets would be very low since Japan has been in recessionary mode for the past twenty years despite having intermittent growth. So to advise Japan to increase the yield on the yen denominated assets is indeed silly.
An expert may know all the tools of the trade but to know what tool to use and where to use it require wisdom.
Let me summarise the pertinent points in his article. The article discusses why the Japanese yen fails to become a reserve currency. Several arguments, the trees, are advanced to support that contention. Among them are its volatility (unstable value), the low yield on yen denominated financial and real assets, and, lastly, the rise of the euro which adds another competing alternative to the yen.
Now, let's rise above the trees to see the forest. One point is enough to puncture holes in all of Mr. Sheng's arguments. For a currency to be a reserve currency, the currency's country must have a tremendous amount of current account deficits, i.e., it must be a global debtor, not just a debtor like most sub-Saharan countries. Only one country qualifies and it is the United States of America.
That is the crux of my argument. The detailed bits follow.
Of course, not every country can be a global debtor. For it to be a global debtor, it must be credible, not only economically but also militarily. In other words, it must earn its stripes. It is not an easy process because a country has to go through the mill. It must first be a creditor country, accumulating current account surpluses over the years. In fact, only in the 1980s did the US become a debtor nation. Thenceforth, its foreign debts could only move one way, that is upwards.
Since Japan is not a debtor country, there's not enough yen floating around for it to be adopted as a reserve currency. You may argue you can easily buy yen. True but for you to hold yen, you must give the Japanese something in exchange. The Japanese don't want your Malaysian ringgit or any other exotic currencies because they are not tradeable outside the countries' borders. They prefer the US dollar. Same goes for the EU. The more yen or euro you want to keep, the more US dollars the Japanese and Europeans must hold in return.
As for the volatility of the Japanese yen, it's not Japan's fault. Since many countries trade mostly with the US, they stabilise their currencies' exchange rates only with respect to the US dollar. Should there be a major fluctuation of these currencies vis-a-vis the US dollar, it's primarily due to a drop or a rise in their economic competitiveness relative to other countries exporting to the US. For example, the 1997 Asian financial crisis was precipitated by the rise of China which made all other East Asian countries non-competitive. Only when they devalued their currencies could they recover. George Soros wasn't the cause nor were capital controls a remedy.
The US does not have the luxury of setting its own exchange rate. It has to take whatever exchange rates set by the monetary authorities of other countries. When the Japanese ran huge trade surpluses with US in the early 1980s, the US had to bear on the Japanese through the 1985 Plaza Accord to get them to appreciate the yen vis-a-vis the US dollar. The yen doubled its value within three years. Gradually, the Japanese became non-competitive. Whatever it can produce, the Koreans and, eventually, the Chinese also can at much lower costs because of their cheaper currencies. With a population that's both declining and ageing faster than those of its competitors, Japan will be an economic basket case.
Since other countries do not target a specific exchange rate vis-a-vis the yen, the yen is bound to fluctuate (or more likely, appreciate) relative to their currencies. There is no benefit at all in borrowing money in yen even if no interest is charged; the borrowers will be hit by the increasing exchange rate.
The low yield on the Japanese assets are also beyond their control. Japan's economy has been in the rut ever since their bubaru keizai (bubble economy) burst in 1991. They tried various measures including zero interest rate policy but to no avail. Till today, policymakers can't figure out why Japan remains mired in a gloomy mindset for such a long time. Even when they had economic growth, the outlook wasn't cheerful. Actually, this phenomenon is a pernicious effect of globalisation. Similar situations can be found in resource rich countries, such as the major oil exporting countries. As it requires a lengthy explanation, I'll elaborate on this in a future post.
Finally, can the euro displace the yen? Actually, such a notion is implausible because neither can be reserve currencies. The euro's claim to reserve currency status is as much tied to Germany's current surplus as the yen is to Japan's. However both are only claims, not real entitlements. Neither has been a superpower and ever won't they be.
These arguments countering Mr. Sheng's assertions are intended to demonstrate how an eminent expert can suffer from blind spots. Being wise is not difficult; you need to build patterns in your thinking. Patterns include enduring laws which are simple yet escape the attention of experts. For example, one highly pertinent law is that the interest rate for a country cannot exceed its economic growth rate. Applying this to the Japanese case, we can naturally deduce that returns on yen denominated assets would be very low since Japan has been in recessionary mode for the past twenty years despite having intermittent growth. So to advise Japan to increase the yield on the yen denominated assets is indeed silly.
An expert may know all the tools of the trade but to know what tool to use and where to use it require wisdom.
Wednesday, July 8, 2009
Free-falling into the Grand Depression (1)
"We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand." No, this is not a case of an incompetent flight crew fumbling with the flight controls. It is what John Maynard Keynes wrote in his essay titled "The Great Slump of 1930" published in December of the same year. His observation refers more to economists bungling with the fiscal and monetary controls of the economy.
As plane crashes have sometimes been caused by pilots' errors in the handling of their aircraft in emergencies, economic crises are similarly worsened by economists' faults in their diagnoses of the crises and prescriptions for the recovery.
The failings of the economists can be understood using the recent fatal plane crashes as analogies in unearthing relevant patterns. Both crashes had no survivors; all perished. The first involves a Continental Airlines flight 3407 that went down in Buffalo, New York on February 12, 2009. The second is Air France flight 447 that dived into the Atlantic on May 31, 2009.
In this post we will deal with with the Continental Airlines plane. The aircraft was a new Bombardier Dash 8-Q400. The crash was solely due to the pilot's incompetency. Both the pilot and co-pilot were suffering from sleep-deprived fatigue. To make matters worse, on the landing approach, they were engaged in nonessential conversation, something not allowed under the aviation rules. As a result, they didn't notice that the air speed had dropped exposing the aircraft to a dangerous stall. The control yoke (analogous to the car steering wheel) was shaking, pointing to a stall. The plane's automatic system tried to push the nose down in order to gain air speed and prevent stall. However, probably in panic, the pilot pulled back the control yoke in order to bring the nose back up. But his action worsened the stall, thus dooming the lives of 49 onboard and 1 on the ground.
Many lessons for the current economic crisis can be gleaned from the accident. The crisis was precipitated by the loose monetary policy which was evident from the phenomenal credit growth. The central bankers however were focused on the inflation rate indicator rather than the credit growth indicator to guide their actions. The inflation indicator was not moving because of the excess supply capacity created by the entry of China onto the global economic stage. The boom in commodity and asset (real property) prices didn't translate into high consumer prices except at a very late stage.
The commercial banks' books were also clean as they had been using off balance sheet vehicles to hide the loan growth. Securitisation of the loans was another method that shielded the loans from being reported. The loans appeared on the books of foreign banks and non-bank players: portfolio managers, pension funds, and insurance companies. Like the doomed Continental Airlines plane, the critical indicator was vibrating but the central bankers chose to ignore it, fixing their eyes on the wrong ones instead.
Another useful lesson is the wrong remedy prescribed to cure the ills brought about by the crisis. Just because the plane was stalling shouldn't mean that the pilot must point the nose upwards. The right move would have been to point it lower in order to gain speed and get out of the stall. Similarly, because the crisis was caused by too much money, some economists are recommending cutting spending and constricting money supply. The sure outcome will be an economy in a death spiral, politically bringing down with it a crumbling nation-state. Don't worry about inflation. The money supply is not even stalling, it's collapsing. At this critical juncture, you need plenty of money. Don't even think of inflation; deflation is the killer.
Regardless, printing money and massive government spending provide only a temporary respite. This depression is a foregone conclusion; there's no way out. We have to endure it before the game changer of the next technology wave allows the economy to recover slightly.
Finally, the most important lesson is the incomplete training of most economists. To be really competent, a professional must go through the rigours of crises. Pilots experience them in simulator rides. They have to because hundreds of lives depend on one pilot. In fact, the pilot of the ill-fated Continental Airlines plane was actually not qualified to fly because he had failed 3 simulator tests, known as check rides.
Economists, on the other hand, do not have the luxury of going through the stress tests. Yet they are responsible for the lives of millions of people. Indeed, we are in the midst of being led by those who have, in the words of Keynes, blundered in the control of a delicate machine. The coming economic crash may yet turn out to be very nasty.
Part 2: The Crash of Air France
As plane crashes have sometimes been caused by pilots' errors in the handling of their aircraft in emergencies, economic crises are similarly worsened by economists' faults in their diagnoses of the crises and prescriptions for the recovery.
The failings of the economists can be understood using the recent fatal plane crashes as analogies in unearthing relevant patterns. Both crashes had no survivors; all perished. The first involves a Continental Airlines flight 3407 that went down in Buffalo, New York on February 12, 2009. The second is Air France flight 447 that dived into the Atlantic on May 31, 2009.
In this post we will deal with with the Continental Airlines plane. The aircraft was a new Bombardier Dash 8-Q400. The crash was solely due to the pilot's incompetency. Both the pilot and co-pilot were suffering from sleep-deprived fatigue. To make matters worse, on the landing approach, they were engaged in nonessential conversation, something not allowed under the aviation rules. As a result, they didn't notice that the air speed had dropped exposing the aircraft to a dangerous stall. The control yoke (analogous to the car steering wheel) was shaking, pointing to a stall. The plane's automatic system tried to push the nose down in order to gain air speed and prevent stall. However, probably in panic, the pilot pulled back the control yoke in order to bring the nose back up. But his action worsened the stall, thus dooming the lives of 49 onboard and 1 on the ground.
Many lessons for the current economic crisis can be gleaned from the accident. The crisis was precipitated by the loose monetary policy which was evident from the phenomenal credit growth. The central bankers however were focused on the inflation rate indicator rather than the credit growth indicator to guide their actions. The inflation indicator was not moving because of the excess supply capacity created by the entry of China onto the global economic stage. The boom in commodity and asset (real property) prices didn't translate into high consumer prices except at a very late stage.
The commercial banks' books were also clean as they had been using off balance sheet vehicles to hide the loan growth. Securitisation of the loans was another method that shielded the loans from being reported. The loans appeared on the books of foreign banks and non-bank players: portfolio managers, pension funds, and insurance companies. Like the doomed Continental Airlines plane, the critical indicator was vibrating but the central bankers chose to ignore it, fixing their eyes on the wrong ones instead.
Another useful lesson is the wrong remedy prescribed to cure the ills brought about by the crisis. Just because the plane was stalling shouldn't mean that the pilot must point the nose upwards. The right move would have been to point it lower in order to gain speed and get out of the stall. Similarly, because the crisis was caused by too much money, some economists are recommending cutting spending and constricting money supply. The sure outcome will be an economy in a death spiral, politically bringing down with it a crumbling nation-state. Don't worry about inflation. The money supply is not even stalling, it's collapsing. At this critical juncture, you need plenty of money. Don't even think of inflation; deflation is the killer.
Regardless, printing money and massive government spending provide only a temporary respite. This depression is a foregone conclusion; there's no way out. We have to endure it before the game changer of the next technology wave allows the economy to recover slightly.
Finally, the most important lesson is the incomplete training of most economists. To be really competent, a professional must go through the rigours of crises. Pilots experience them in simulator rides. They have to because hundreds of lives depend on one pilot. In fact, the pilot of the ill-fated Continental Airlines plane was actually not qualified to fly because he had failed 3 simulator tests, known as check rides.
Economists, on the other hand, do not have the luxury of going through the stress tests. Yet they are responsible for the lives of millions of people. Indeed, we are in the midst of being led by those who have, in the words of Keynes, blundered in the control of a delicate machine. The coming economic crash may yet turn out to be very nasty.
Part 2: The Crash of Air France
Sunday, July 5, 2009
Worry not global warming but fear globalisation
Globalisation and global warming have little in common. Or so you might think. Ecologists are as varied in their opinions as economists are among themselves. For example, global warming has been such a controversial issue even among ecologists so much so that we don't know whether the earth is warming up or is going into an Ice Age. Ecologists sit on both sides of the political fence and so their beliefs depend on their political inclinations. Same goes for the economists.
To be sure, global warming has no relevance to economics while globalisation has been much touted by economists of all stripes as a driver of economic growth. Can we learn anything about globalisation from patterns in the field of ecology? Definitely, but we must go back to 250 million years ago towards the end of the Permian period when all major areas of the continental crust coalesced into a single land mass called Pangea, meaning 'all land' in Greek.
The biggest extinction in earth's history occurred during this time. What caused 95 percent of the species to go extinct? As usual, we are wont to ascribe a single cause to any problem. But in life, most dramatic and drastic occurrences are a result of a confluence of factors. The Permian massive upheavals were more likely caused by a multitude of causes. In this case, they all can be boiled down to two: global warming and globalisation. Hence the juxtaposition of both in this post.
Global warming arose during the late Permian because of two geologic activities which took place over thousands of years. The first happened when coal bearing deposits in southern Pangea were uplifted to the surface. The other arose in the Siberian Traps region where volcanic eruption of CO2 and methane released massive quantity of greenhouse gases into the atmosphere.
The outcome of these events resulted in the atmospheric CO2 shooting up to 3,000 parts per million (ppm). In contrast, our present CO2 stands at 390 ppm. It will continue to climb until 2200. Thenceforth the level will slowly drop as we will have depleted out the fossil-fuel carbon.
At its projected peak on a business-as-usual basis, the atmospheric CO2 will rise to 1100 ppm. If measures are taken to reduce the emission rate, the level will crest at 550 ppm. The most likely scenario is that the peak will not exceed the lower estimate given mankind's prodigious capacity for innovation. The two engines driving this energy innovation will be biotechnology and nanotechnology.
How much will the sea level rise with the atmospheric CO2 at 550 ppm? National Geographic, September 2004, estimates that at 478 ppm, the sea level will rise by only 4 inches, and that is taking the 1990 sea level as the base. The areas badly affected will only be the submerged South Sea islands. At 550 ppm, most probably, we can expect a sea level rise of only 1 foot.
There certainly will be other severe impacts as glaciers and ice sheets on three critical land areas - mountain regions, Greenland and Antartica - start melting. Most affected are the mountain regions since these glaciers feed major rivers in the Indian sub-continent and China. We can expect serious water issues in the coming decades. But as regards sea level, it won't present an acute problem. For icebergs, their melting doesn't have any impact since floating ice already displaces water of a weight equal to its own.
Within the next 50 years, we can expect new technologies to address the CO2 emissions. We must allow for the passage of time for this to come about. Hastening this process through forced measures, such as limits on carbon emissions will not work and would be a complete waste of time. Likewise, biodiesel, ethanol, carbon sequestration, and hybrid vehicles are only feel-good efforts that siphon money from more beneficial areas.
It is a common human folly to be doom-mongers worrying about non-existent fears. With respect to energy issues, as far back as the 13th century, 500 years before the Industrial Revolution, there had been shortages of wood as fuel for the ironworks. Then they found coal. Similarly, before they struck oil in 1859, they had also worried about coal being depleted. Now they agonised over oil and global warming. What mankind is apprehensive about usually will turn out to be unfounded fears. Instead, what it glosses over are the issues that will pose the most harm to it.
Going back to the Permian extinction, how did the extreme global warming precipitate the process?
Scientific American, October 2006, explains clearly the unfolding of this catastrophe. To begin with, the unleashed CO2 and methane greenhouse warmed both the atmosphere and the oceans. Conditions were arid and vast searing deserts spread across the land. The warm oceans had limited capacity to absorb oxygen because the ocean currents that kept the oceans oxygenated stopped circulating as they got warmer. As a result, bottom dwelling anaerobic bacteria that generated hydrogen sulphide (H2S) thrived. As H2S concentrations built up, they welled up and diffused into the atmosphere. The massive H2S extinguished both lives in the ocean and on land. It also destroyed the ozone layer that shielded life on earth from the UV radiation.
That's only one-half of the story. The other half, on globalisation, is equally interesting. Complementing the single land mass are one vast ocean, the Panthalassa Ocean, and a huge bay, the Tethys Sea. With a conjoined land mass and ocean, it was a free-for-all for the animals and plants. Now they all could roam the entire land or oceans. The shallow offshore water, a rich habitat for life, dwindled as the length of coastlines shrank.
Such conditions initially benefited some but ultimately produced many losers and virtually no winners. The causes can be attributed to the sudden appearance of new species which preyed on the indigenous animals or disrupted their feeding and breeding habitats. But worst of all when species mixed freely is the easy spread of pathogens to species which had not developed suficient immunity to new diseases.
We do not know whether global warming had a greater impact than globalisation in the Permian extinction. But we do know that CO2 ppm in the next 100 to 200 years won't actually reach one sixth of the Permian level of 3,000 ppm. That even without taking into account the coming energy revolution that will make oil a thing that we can live without. Indeed the current economic crisis has reduced the global CO2 emission for 2009 by 2.6 percent.
Given such a scenario, globalisation which has been promoted by almost all economists as a source of economic growth is the real danger unbeknown to its strident advocates. However among economists it is heretical to criticise it because that goes against the teaching of all economics schools. Because of this perverted belief in the benefits of globalisation, many countries have embraced it without realising of its longer-term harmful effects. The harm comes stealthily because initially it beguiles the populace with its temporary economic benefits. The deluded populace embraces it not realising that over time new countries, such as China, adept at manipulating exchange rates, will eat into other countries' lunches.
If we go back to the theory of comparative advantage first promulgated by David Ricardo in 1817, nowhere is it mentioned the applicability of the theory in conditions of surplus capacity. The theory works as long as the demand can consume whatever is being produced. It breaks down when supply exceeds demand as what the world is suffering from now. So now China can produce while the others sit idly by. Certainly, not a recipe for prosperity but for a catastrophe of major proportion. Thus the current crisis which actually is not initiated by the financial meltdown (which happens to be a consequence) but by the surplus supply capacity.
To be sure, global warming has no relevance to economics while globalisation has been much touted by economists of all stripes as a driver of economic growth. Can we learn anything about globalisation from patterns in the field of ecology? Definitely, but we must go back to 250 million years ago towards the end of the Permian period when all major areas of the continental crust coalesced into a single land mass called Pangea, meaning 'all land' in Greek.
The biggest extinction in earth's history occurred during this time. What caused 95 percent of the species to go extinct? As usual, we are wont to ascribe a single cause to any problem. But in life, most dramatic and drastic occurrences are a result of a confluence of factors. The Permian massive upheavals were more likely caused by a multitude of causes. In this case, they all can be boiled down to two: global warming and globalisation. Hence the juxtaposition of both in this post.
Global warming arose during the late Permian because of two geologic activities which took place over thousands of years. The first happened when coal bearing deposits in southern Pangea were uplifted to the surface. The other arose in the Siberian Traps region where volcanic eruption of CO2 and methane released massive quantity of greenhouse gases into the atmosphere.
The outcome of these events resulted in the atmospheric CO2 shooting up to 3,000 parts per million (ppm). In contrast, our present CO2 stands at 390 ppm. It will continue to climb until 2200. Thenceforth the level will slowly drop as we will have depleted out the fossil-fuel carbon.
At its projected peak on a business-as-usual basis, the atmospheric CO2 will rise to 1100 ppm. If measures are taken to reduce the emission rate, the level will crest at 550 ppm. The most likely scenario is that the peak will not exceed the lower estimate given mankind's prodigious capacity for innovation. The two engines driving this energy innovation will be biotechnology and nanotechnology.
How much will the sea level rise with the atmospheric CO2 at 550 ppm? National Geographic, September 2004, estimates that at 478 ppm, the sea level will rise by only 4 inches, and that is taking the 1990 sea level as the base. The areas badly affected will only be the submerged South Sea islands. At 550 ppm, most probably, we can expect a sea level rise of only 1 foot.
There certainly will be other severe impacts as glaciers and ice sheets on three critical land areas - mountain regions, Greenland and Antartica - start melting. Most affected are the mountain regions since these glaciers feed major rivers in the Indian sub-continent and China. We can expect serious water issues in the coming decades. But as regards sea level, it won't present an acute problem. For icebergs, their melting doesn't have any impact since floating ice already displaces water of a weight equal to its own.
Within the next 50 years, we can expect new technologies to address the CO2 emissions. We must allow for the passage of time for this to come about. Hastening this process through forced measures, such as limits on carbon emissions will not work and would be a complete waste of time. Likewise, biodiesel, ethanol, carbon sequestration, and hybrid vehicles are only feel-good efforts that siphon money from more beneficial areas.
It is a common human folly to be doom-mongers worrying about non-existent fears. With respect to energy issues, as far back as the 13th century, 500 years before the Industrial Revolution, there had been shortages of wood as fuel for the ironworks. Then they found coal. Similarly, before they struck oil in 1859, they had also worried about coal being depleted. Now they agonised over oil and global warming. What mankind is apprehensive about usually will turn out to be unfounded fears. Instead, what it glosses over are the issues that will pose the most harm to it.
Going back to the Permian extinction, how did the extreme global warming precipitate the process?
Scientific American, October 2006, explains clearly the unfolding of this catastrophe. To begin with, the unleashed CO2 and methane greenhouse warmed both the atmosphere and the oceans. Conditions were arid and vast searing deserts spread across the land. The warm oceans had limited capacity to absorb oxygen because the ocean currents that kept the oceans oxygenated stopped circulating as they got warmer. As a result, bottom dwelling anaerobic bacteria that generated hydrogen sulphide (H2S) thrived. As H2S concentrations built up, they welled up and diffused into the atmosphere. The massive H2S extinguished both lives in the ocean and on land. It also destroyed the ozone layer that shielded life on earth from the UV radiation.
That's only one-half of the story. The other half, on globalisation, is equally interesting. Complementing the single land mass are one vast ocean, the Panthalassa Ocean, and a huge bay, the Tethys Sea. With a conjoined land mass and ocean, it was a free-for-all for the animals and plants. Now they all could roam the entire land or oceans. The shallow offshore water, a rich habitat for life, dwindled as the length of coastlines shrank.
Such conditions initially benefited some but ultimately produced many losers and virtually no winners. The causes can be attributed to the sudden appearance of new species which preyed on the indigenous animals or disrupted their feeding and breeding habitats. But worst of all when species mixed freely is the easy spread of pathogens to species which had not developed suficient immunity to new diseases.
We do not know whether global warming had a greater impact than globalisation in the Permian extinction. But we do know that CO2 ppm in the next 100 to 200 years won't actually reach one sixth of the Permian level of 3,000 ppm. That even without taking into account the coming energy revolution that will make oil a thing that we can live without. Indeed the current economic crisis has reduced the global CO2 emission for 2009 by 2.6 percent.
Given such a scenario, globalisation which has been promoted by almost all economists as a source of economic growth is the real danger unbeknown to its strident advocates. However among economists it is heretical to criticise it because that goes against the teaching of all economics schools. Because of this perverted belief in the benefits of globalisation, many countries have embraced it without realising of its longer-term harmful effects. The harm comes stealthily because initially it beguiles the populace with its temporary economic benefits. The deluded populace embraces it not realising that over time new countries, such as China, adept at manipulating exchange rates, will eat into other countries' lunches.
If we go back to the theory of comparative advantage first promulgated by David Ricardo in 1817, nowhere is it mentioned the applicability of the theory in conditions of surplus capacity. The theory works as long as the demand can consume whatever is being produced. It breaks down when supply exceeds demand as what the world is suffering from now. So now China can produce while the others sit idly by. Certainly, not a recipe for prosperity but for a catastrophe of major proportion. Thus the current crisis which actually is not initiated by the financial meltdown (which happens to be a consequence) but by the surplus supply capacity.
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