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

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.