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.

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.

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