The Marxhall Theory of Economic Growth and Decline

A person's view of the economy is coloured by the economic conditions prevailing during his lifetime. Even the great economic philosophers of the past could not escape the clutches of their economic environments. For that reason, we should always note the years of their births and deaths to establish how their great ideas came about. There are three peculiarities about these philosophers that conditioned their thoughts and philosophy and made them stood out from the crowd. The first is that they were keen observers of human lives and interactions.

The second is that they lived in the days of consumption always exceeding capacity mainly because of ever increasing population growth rate though there were periods, during the economic decline phase, when consumption failed. But a slowing population growth rate or, worse, a declining population was never the contributory factor. So to rely on their ideas for a solution to the current global economic crisis, which has been exacerbated by a falling population growth rate, won't get us anywhere. Theirs were valid only for their times.

As for technology, the progress was already evident in Adam Smith's time. Although the Industrial Revolution was in its early days, the fruits of the Agricultural Revolution, which actually was a precondition for the Industrial Revolution, had been evident. Factory production had also been established though still powered by water — steam powered factory machinery was only made feasible when James Watt produced a rotary-motion steam engine in 1781. Technology therefore was not a differentiating factor between then and now.

Therefore Adam Smith (1723-1790) with his Theory of Absolute Advantage and David Ricardo (1772-1823) with his Theory of Comparative Advantage were strong advocates of free trade. The British economy then was the world's leading economy, so it was to its advantage that trade was free. Also Adam Smith was, first and foremost, a moral philosopher who was more concerned with maximisation of employment rather than profit. As free trade created a bigger market for Britain's produce while enabling its workers to buy cheaper food imports, its benefits were in accord with Smith's stance. Had he lived today, he would have railed against free trade and would have certainly disowned its modern-day champions.

In military-speak, the supporters of free trade are still fighting a second generation war (2GW) in which mass bombardment is the order of the day. Now warfare is in its fourth generation (4GW), characterised by the entry of a large number of non-state combatants. If a nation-state still uses 2GW strategy to fight 4GW opponents, it's a war that the nation-state is condemned to lose, as is unfolding in Afghanistan.

Although capacity was the constraining factor then while now it's consumption, the Nikolai Kondratieff's (1892-1938) cycle of economic growth and decline was equally valid then as now. Kondratieff's argument was that overinvestment (growth phase) led to overcapacity and layoffs which reduced demand (decline phase). In this, he was roughly but not precisely right. Much better was Karl Marx (1818-1883) who was spot on but only in regards to the decline phase.

If the decline phase had been just a case of overcapacity, the climb out of the depths would've been easy because an across-the-board cut in capacity would've restored the pre-decline situation. But what makes a recovery intractable is the extreme imbalance in the suffering. Any supposed solution — deficit spending, tax on the rich, pay cut, inflation — is only a palliative measure because the extreme imbalance won't be redressed. As long as the technology remains as is, whatever money spent goes back to the rich. The only cure comes from technological progress. Joseph Schumpeter (1883-1950) coined a euphemistic term, 'creative destruction', for it. The right term is wealth destruction; old wealth must be destroyed through the introduction of new technologies so that the generation of new wealth could proceed unabated.

However, before even both Kondratieff and Schumpeter identified the technology driven solution to an economic decline, Alfred Marshall (1842-1924) had already cottoned on to this idea. The key difference between Marshall and Marx was that Marshall observed what was going in the factories. Marx never stepped foot into one. What he observed was the conditions in the Manchester slums. Had he done so, we'd have been toasting the Marxist system now.

In the first three Kondratieff waves, every time a technology solution arose, the population was ever ready to grow to absorb the increased production. Now the Fourth Kondratieff wave has again unleashed massive production capacity but this time the constraint to be unclogged is no longer  technology. Instead, it's biology, to be exact, the human fertility rate. Technology cannot solve this. But technology is adapting itself to address this drastically changed paradigm. The Fifth Kondratieff wave is ushering in technologies that provide pinpoint answers to human needs. Need a component? Worry not, a 3D printer will print it, one unit only, no more no less, on the spot. Need chemotherapy? Instead of chemotherapy, molecular target therapy can precisely target the cancerous tissue without affecting others surrounding it.

Finally, the last common factor that bind these philosophers together is that they never substituted mathematics for their keen observations unlike the current generation of economists who put mathematics at the forefront of their thought process, akin to putting the cart before the horse. No wonder no great economic ideas have of late percolated from their blinkered minds. To be sure, some of the great philosophers did resort to mathematical rigours to test their ideas but mathematics was always kept in the background. Here's how, as written in Wikipedia, Alfred Marshall described his use of mathematics to support his economic ideas:

1. Use mathematics as shorthand language, rather than as an engine of enquiry.
2. Keep to them till you have done.
3. Translate into English.
4. Then illustrate by examples that are important in real life.
5. Burn the mathematics.
6. If you can't succeed in (4), burn (3). This I do often.

As Marshall was Keynes's economics teacher, now we know why Keynes eschewed mathematics in his economics writings though he might have resorted to mathematics in conceptualising his ideas.

We can do one better than Marshall. Instead of using mathematics, we can resort to the plethora of patterns in the real world to illustrate the mechanics of an economic wave. For example, its 4C underpinning is based on an observation of product movements on the factory shop floor while the skewing of wealth towards the end of an economic wave is gleaned from the Monopoly board game.

Regardless, Marx and Marshall deserve the the credit for being the first to get it right, albeit each getting half right, in describing the growth and decline of an economic wave. Marx also has the last word, if not the last laugh at seeing the eventual collapse of capitalism, since he was the one who coined the label 'capitalism'.

Seize money before money seizes up

We've been used to the notion that money was essentially credit. But after observing how credit moved over the past few months, our usual definition of money now stands corrected. Money now should be defined as spent credit or moneyspend. The reasoning is very simple. You can have $1 trillion dollars but if you sit on it, that money doesn't affect the economy one whit. It's dead money. It must be spent to qualify as real money.

Paul Krugman, always lost in the trees because of too much thinking about the forest, has recently come out with another of his naive statements: "Remember, the US government can't run out of cash (it prints the stuff)." Now if you consider moneyspend as the real money, you can see why Krugman's talking with his sleep mask on. Surely, the US government can't run out of cold hard cash (dead money) but it has limits on how much it can spend (real money).

Another more confused person, Ben Bernanke, is pushing the Fed's holdings of Treasury bonds and Mortgage Backed Securities (MBS) to US$4 trillion from the current US$2.86 trillion. In return he'd be dishing out more deposits to banks and other financial institutions. We've been through this before and we know where this would lead to. Ben mistakenly believes that deposits (another dead money) can be conjured into spending (real money).

There's another money conjuring trick carried out lately by non-financial business corporations. We know that equities are also money but they are safe money because their value move in tandem with the credit quantity. So there's no point in monitoring them. Debts in contrast are toxic money, that is, when economic conditions deteriorate. In current conditions, you must get rid of debts by all means regardless of how cheap they can be. But because of Ben Bernanke's manipulation of the interest rates, the business corporations have been lured by the siren song of cheap interest rates to raise bonds in order to buy back equities.

Bond interest costs are now dirt cheap (see chart at left) while equity returns are expensive. In swapping equities for bonds, the business corporations are pushing equity prices higher despite the gloomy earnings forecasts. But the financial risk of bonds increases as the depression looms nearer. If you're thinking of putting your money into equities or corporate bonds, don't. No matter how profitable a business is right now, its income will plummet with the collapsing credit. Only the rare few will continue registering profits. CEOs will soon realise that the external environment will overwhelm them regardless of their business savvy.

Even now an increasing proportion of investment-grade new bond issues are those with credit ratings at the low end of the investment grade (see charts below).

The business corporations' switch to bonds for their funding has been received with open arms by the investment funds who lap up the corporate bonds in the erroneous belief of their low risk (see charts at left). Actually the better bet is the government bonds of the strong national economies, such as the US and Germany but their available supply is getting less and less as central banks mop them up through their quantitative easing. Furthermore, the austerity drives undertaken by many governments limit the supply of new government bonds.

Equally troubling is the dubious safety of the MBS purchased by the Fed. Of its US$1 trillion new quantitative easing, US$620 billion will be for MBS and US$500 billion for Treasuries. As house prices are expected to begin their decline soon, the MBS is as safe as the flimsy guarantees of Fannie Mae and Freddie Mac. To put it simply, the US government will need to widen its deficits in the near future to rescue both institutions so as not to drag the Fed down with them.

Bernanke's cheap money for the time being is creating an illusion of an economy on the mend by shoring up the stock indices but in the final analysis is deferring massive problems to the future. The stress has not been relieved but continues to build up and when it finally bursts, Bernanke's effort will be laid bare as a hopeless patch-up job.

The futility of this effort can be  viewed in the Q3 2012 US total credit picture (left chart), in which the businesses appeared to have increased their credit growth. Under normal conditions, this would be favourable to the economy. But as explained earlier, the increase in credit was offset by a decrease in equities. So there was no impact to spending. If we exclude this growth, there was no credit growth by all sectors except that contributed by the US federal government. Extending this trend ahead, the credit outlook for Q4 2012 and for future years would appear bleak indeed.

As a percentage of GDP (left chart), the picture is worse still. Even the government debt is flagging. indicating that we have reached a turning point.

The 0.2% improvement in the latest unemployment rate is meaningless as the labour force participation rate in the same survey shows a retrogression of a similar percentage, down from 63.8% to 63.6%.

With the slow but relentless fall in credit quantity, money will be hard to come by. For the immediate term, the most secure investment is the US treasuries but over the medium term, real physical cash is king. There's no risk of loss in value. For the long-term, that is 50 years from now, only precious metals serve as the only means of wealth accumulation as nation-states start crumbling and national paper money will disappear along with its issuing nations. However an economy is not about wealth accumulation, rather it is more about wealth generation and consumption and in this sense, locally issued paper money serving the local community and circulating only within it would ensure that wealth gets produced and consumed within that self-contained community.

The farcical cliff

Ben Bernanke seems to have a way with coining terms that can leave everybody in utter confusion. First, it's quantitative easing and now it's fiscal cliff. As the fiscal cliff looms ahead, we are being led to believe that failure to overcome the cliff will land us in recession. The cliffhanger is the showdown between the Democrats and Republicans. Both have different views on how the fiscal cliff should be handled. To reduce the deficits, the Republicans want to cut entitlement spending while the Democrats want to increase taxes. However these are all distractions serving to demonstrate that the politicians' primary job is to spin no-brainer issues into newsworthy material.

It's easy to figure out the Western thought process because it tends to be binary: either black or white, always insisting upon a solution and with little tolerance for grey areas. Since both parties are adamant that they're on the right track, both will not budge from their entrenched positions, more so when one side is still smarting from the recent election defeat.

Even without this fiscal cliff, Obama's ability to throw money at the economic problems will be severely crimped given that his administration's $1 trillion odd deficits in each of the last 4 years have not yielded any long-lasting recovery. That isn't surprising considering that we're in the second half of the Fourth Kondratieff Wave.

If you are presented with this situation, how should you approach it? To tackle this seemingly tough problem, you need a pattern as a guide. For this there is no better pattern than the Monopoly board game. The other thing that we need to know is where we are in the Kondratieff Wave cycle. There are 2 actually, the uptrend first half and the downtrend second half. With just these, you can foretell, like no economist can, how events will unfold.

The first half of the wave is when you start playing the Monopoly game. This is the most exciting part because everybody is eager to grab properties. So when the banker pours money into the game, it will keep circulating in the game as assets are being purchased and sold. But when you reach the second half, the excitement starts dwindling down. There are no more properties up for grabs. If you're losing, you'd rather be in jail since every move you make costs money. Any money poured by the banker will end up with the sole winner.

What has this got to do with our present predicament? Almost everything, in fact. All the current economic difficulties can be easily explained by the Monopoly game. So any deficit spending now will ultimately end up with the few winners. As the government will eventually be weakened by continual deficits, it must start getting the money from the winners, the rich, that is, to fund its spending. But the rich with their footloose wealth can run rings around the taxman. Ask Mitt Romney how. One is to park their financial wealth in offshore tax havens with ultra low tax rates. The other is to recast their incomes as capital gains which also attract a much lower tax rate. As long as capital controls are absent and tax law is riddled with loopholes, the ability of political leaders to control the national economy and by extension the national politics is tenuous.

What about the Republicans' proposal to cut entitlement spending while maintaining the current tax rates? Without increased spending, the economy will quickly go into a tailspin. The Republicans' contention is that the lower tax rates will encourage the rich to invest and create jobs. That's a load of bull. Again we seek the help of our Monopoly pattern. When the game has settled down to a predictable pattern, the winner will just collect rentals. He has no need to build new hotels. After all, with the present investment, he's already winning. The proof is in the statistics. Another of the various income imbalance charts that I've been plugging just to highlight the real cause of the depression is shown above (this one from The Financial Times).

If the government doesn't wrest the wealth from the rich, there's no new spending to perk up the economy. The rich fail to grasp that whatever spending the government makes, be it on entitlement, military or whatever, will ultimately end up in their bank accounts. So it is in their interest to pay more tax. They can play the Monopoly game much longer, and keep winning while at it.

Both groups of politicians can't comprehend this simple concept. As a result, they both agree that the deficits have to be reduced. For comparison, the 2012 US Federal deficit was estimated at US$1,089 billion. The fiscal cliff, if not addressed, will reduce the deficits by US$535 billion. The fiscal cliff is not the issue. The real issue is the amount of the deficits. The amount that they can agree will be substantially less than US$1 trillion. So fiscal cliff or not, it's highly conceivable that the US economy will slump in 2013.

Recriminations between the two parties will intensify with the worsening state of the economy, causing them to dig their heels deeper. One will insist that entitlement spending discourages people from working while the other will claim that reduced taxes do not trickle to the economy at large. This is an exercise in futility as the solution is not to be found in the Fourth Kondratieff Wave. Future economic growth has been forecast to be anaemic, meaning that the economy cannot outgrow the debt. To artificially boost growth, the economy really needs bigger spending but there's no longer any economic sector that can bear ever increasing spending. All have been squeezed dry, that is, except the rich.

As an aside, I can't help taking a dig at the housing bulls, especially The Financial Times which came up with the following headline in its 28 November 2012 issue: "US growth hopes lifted by housing data", just after the Case-Shiller index for September 2012 had been published. Now I've updated it in my own chart above. As you can see, the pattern of housing price increase still remains. But the increase was very marginal in September 2012 and if you project it to the next month, prices will start dropping. If an eminent financial newspaper can betray its economic ignorance with such a premature headline, what can you expect of economic pundits and talking heads who are much less endowed in their cognitive faculties?

Consumptivity, not productivity

Economic growth worldwide is on a decline. Economists have been attributing this to the declining productivity which itself is a reflection of the much reduced impact of the new economy's technological advancement as compared to that of the earlier technology waves. Robert J. Gordon, an economics professor from Northwestern University, has produced a paper tracing the economic growth since 1300 (the two charts on the left below, reproduced by The Financial Times) as well as evidence of the declining US productivity (the two charts on the right).

This is typical of an economics professor pontificating from on high. There's actually nothing wrong with the rate of technological progress.  We know that productivity is the ratio of output to input. Economists can't explain why output declines or increases for the same level of input. To them, the link between input and output is a black box. But implicit in that link is the little known assumption that whatever can be produced will be consumed.

If only the economists had worked in a manufacturing setup, they would learn that a factory's main problem was not producing but selling. No production planner would produce goods that cannot be sold. He may produce for inventory but that can only be sustained up to a certain level, determined by the availability of his cash or credit. Beyond that, it's economic suicide.

If you come across anything inscrutable as the economist's productivity black box, the right way to address the issue is not to ignore it but to view it from another angle. The fact that the black box is termed 'productivity' is itself a cause of the confusion. Because of that, production output has always been the sole measure. Whether the factors of production are not producing because of something else doesn't count. Since we know that for a manufacturing setup, getting the goods out the door to the consumers is the main challenge, consumption is thus a better measure than production. Now if we instead label the black box 'consumptivity', then a whole new vista opens up. The problem is no longer solely production but extends to consumption.

But how do we prove that the problem lies with consumption? In this regard, we can rely on two plausible explanations. One is population growth and the other is falling income as a result of technological progress and globalisation. We can show two population charts, the movements of which mirror those of the two leftmost charts above.

The first is the rate of population growth (left chart from Wikipedia). The shape is similar to that of the GDP growth rate. Even though the GDP growth chart tracks the growth of the UK GDP (for the First Kondratieff Wave) and the US GDP (for subsequent Kondratieff Waves), the impact of that growth has trickled to the whole world as reflected in the global population growth rate.

If you observe this population chart carefully, you'll notice two kinks. The first, between 1900 and 1950, is the result of the two major wars in which more than 16 million and 60 million deaths were recorded for WW1 and WW2. The second reveals the folly of China's Great Leap Forward, which lasted from 1958 to 1961. Upwards of 30 million lives were believed to have perished by famine. However these kinks did not alter the secular trend of the pattern. It goes to show that long-term trend can be easily foretold years in advance. Even now, we can foresee the future outlook of economic growth just by looking at the population growth rate. Neither sixth sense nor fancy forecasting tool is needed. Also with patterns, we won't be blindsided by any black swan, which anyway is a lame excuse offered by those who fail to recognise obvious patterns.

The next chart maps the global population since 0 CE (Common Era). It corresponds to the GDP per capita chart above, that is, the second chart from the left. Even if you use total GDP instead of per capita, the same pattern would appear as the populations of the UK and the US have always been on the rise. These two charts are strong enough proofs of the close link between economic growth and population growth. It's not just a case of one causing the other; it's more of  a mutually reinforcing relationship. But now the population growth is starting to give in as a result of lower fertility rates; the opportunity cost of raising a kid is a main contributing factor.

Next we need to explain the productivity behaviour in the two right panels of the top charts. For this we have to rely on our 4C. The first C of this Fourth Kondratieff Wave, that is, the capacity driver  is the computer. It's fitting therefore to label this wave as the Intellectual Revolution. But on its own, it cannot power economic growth in a big way.

We thus need the second C, the internet, to act as the communication driver. We all know that the internet started becoming common in the mid-1990s. That's when the productivity measure began to improve. But how was this improvement possible when the population growth rate for the US and the whole world was slowing? To counter this headwind, we need the third C, the currency as represented by the debt increase. Notice that the first wave of debt increase on the left chart was initiated by President Reagan through government borrowings but the second wave was kicked off by President Clinton through private sector debt, both towards the end of their first terms in 1983 and 1995 — that's how both got reelected. However the impact of this debt increase on productivity could last until 2004 as productivity began declining from 2004 onwards, as indicated by the second panel from the right of the top charts above.

The technological  improvements of this Kondratieff Wave turn out to be more vicious than virtuous. Now we don't need as many workers as before. Work that used to require simple logical decisions by the workers can now be handled by microprocessor powered sensors, remotely controlled using SCADA systems. At most, only one person is needed to supervise the running of the SCADA system. For work requiring an army of workers, outsourcing and globalisation have sent the jobs to other corners of the world.

Productivity has actually tremendously increased, if only all the potential output can be consumed. But this was not happening as from 2001 to 2004, the labour force participation rate (left chart from the BLS) started declining. This pattern continues to this day.

Business corporations are caught in this vicious circle of lower consumption yielding lower income which again leads to lower consumption as workers spend less and less. The productivity slackens as workers remain on the payroll but not producing to their full extent because there are limited takers for their output. To improve productivity, the corporations retrench more workers which further worsens their buying power. Those still working end up in the low paying and low productivity service sector.

Such is the fate of mankind. In its quest for progress, it finds the answer but one that puts itself in a state worse off than before.

Realty Distortion Field

In an economic depression, weird and eerie things transform into the new normals. Zombies — banks which should have been dead and buried long ago — continue straggling and threatening to pull the world economy into the grave. Madmen — fund managers always in search of abnormal returns — keep switching huge amount of funds between investment assets, only to discover that normal now means negative returns while abnormal means bigger negative returns.

Steve Jobs was famous not only for his creativity but also of prevailing upon his team members that the unreal could be real. He distorted reality to bend people to his will but you cannot fault him because he delivered what he had boastfully promised. This reality distortion feat has also become the new normal, none more obvious than the supposed recovery in the US housing market at a time when prices should be dropping with the ebbing credit quantity.

Housing or real estate is one economic sector that has generated a distorting effect on the true direction of the economy. Because house prices will always climb to stratospheric heights just preceding an economic depression, post-crisis house price drops exceeding more than 50% are typical. It's easy to see why house prices steeply climb in the first place. In the mad search for abnormal returns, housing is the last bastion offering such returns primarily because it's sheltered from foreign competition. Furthermore, most buyers steadfastly hold on to the view that land and buildings, like precious metals, are assets that won't depreciate in value. As a Mark Twain quote oft-used by real estate agents has it, "Buy land, they're not making it anymore."

Events over the last four years have disproved that belief. Many countries were hard hit, especially those that had relied on real estate to drive their GDPs (see The Economist chart at left). In the US, house prices climbed 83% from 1997 to 2006. However, among countries that had property booms, the US property boom was relatively mild. That doesn't mean that the price correction will be more subdued than those experienced by other countries. So far, only Ireland appears to be the hardest hit. But Spain, with the most overbuilt homes in Europe — 675,000 homes built annually between 1997 and 2006 — has seen prices dropping by 32.4% from their peak in December 2007 to the end of 2nd quarter 2012. With more than 2 million unsold homes and housing debts in the balance, housing price drops will continue to bedevil the Spanish economy.

As for the US, the chart at left from the 2012 Economic Report of the President, shows that the current housing bust is worse than that of the 1930s Great Depression. Even the Case-Shiller index is not above distorting the numbers as any depression related declines would usually exceed 50% of the housing peak values. The nominal price drop from 1925 to 1933 as registered by the Case-Shiller index was 30.4% but because the economy was also suffering from deflating prices, the real drop was 12.6%. Both numbers don't seem plausible given the drastic plunge in credit quantity then.

One finance blog argues that the Case-Shiller home prices during the Great Depression are not actual sales data, but hypothesised. In fact, a study of home prices in Manhattan during the Great Depression found that prices dropped by 67%.

This big drop is more credible given the features of the mortgage at that time. Back then all mortgages were of short duration, from 5 to 10 years. A mortgage required a down-payment of one-third of the purchase price. Interest was paid every 6 months while the principal was paid in one lump sum, known as the balloon payment, at the end of the loan period. Usually instead of the balloon payment, the mortgage was rolled over into a new one at the prevailing interest rate. The banks also had a call provision inserted into the mortgage, so that they could at any time demand immediate payment. A severe credit crunch caused the banks to trigger that provision in the depths of the Great Depression, fostering the sharp descent in home prices.

To counter the lack of financing facilities, President Roosevelt, as part of his New Deal, created the Home Owners' Loan Corporation in 1933 to provide financing that stretched to 25 years. Another agency, the Federal Housing Administration, was set up the following year to guarantee loans made by the private sector for up to 30 years. That was how the present mortgage loans came to being. It doesn't mean that the new type of mortgage financing is resilient to any credit crisis. What it means is that instead of a sharp, sudden credit shock, you now get a long-drawn-out credit crisis that continues to hang in mid-air. Instead of a heart attack or a stroke, we now get cancer. The final outcome never differs.

Let's review the current Case-Shiller index (chart at left). I've drawn the vertical axis in such a way that tracks the % decline since the index's peak in July 2006. My target for the eventual bottom is a 50% drop from the peak. This is done by extending a red projection line linking the past troughs all the way to the 50% mark. At the rate the index is snaking, it's expected to reach the 50% mark only by the end of 2017. That's still a long, long way before we see any sign of a real recovery. However with the impending cutbacks in federal deficits, we can be certain that Obama will accelerate the process somewhat.

What about the latest apparent recovery in the housing market with the uptick in the number of housing starts and home prices? Look carefully at the chart above. The curve is about to reach its peak and turn the corner for the worse. If you're still skeptical, see another chart at left, this time depicting the month-to-month change in home prices. Now the pattern is as clear as crystal. In every single year since 2008, we have had a dead cat bounce. In normal times, it is said that a cat has nine lives. But in times of depression, even a dead cat has nine lives. The last presidential election should have been Romney's for the taking given the state of the economy. But alas, the economy was in a minor bull market as seen on the chart above. Give another two months and you'll see Obama's ratings dropping precipitously.

About the Mark Twain quote that I mentioned earlier, there's a need to shed some light on Mark Twain, the person. Mark Twain was well-known for peppering his writings and quotes with satire. He lost a large share of his book profits, about $150,000 or $4 million in today's dollars, not on land deals but on the Paige Compositor, an automatic typesetting machine. I guess it would be amiss if I didn't include this quote of his: "Get your facts first, and then you can distort them as you please." Well, he never said that we should buy land because the price would keep on rising.

Imbalance Sheet

Situations that appear serene and balanced on the surface can hide a deep undercurrent of suppressed tension and imbalance. In most instances, the state of imbalance however doesn't emerge suddenly but develops over time. If we're conscious of the unfolding pattern, we'd have spotted the eventual outcome long before it transpires.

A losing business can continue operating provided it has enough cash or, more likely, credit to sustain itself. It's only when banks and creditors refuse to extend further credit that leads to its collapse. That usually occurs when its debt to capital leverage has reached a dangerous level. The root cause of the collapse however is not the extreme level of its indebtedness but its loss-making operation.

A glimpse of a firm's accounting balance sheet, that is, its statement of assets and liabilities, can reveal a distressing situation if most of its capital assets are financed by external short-term borrowings. Likewise, for a national economy, a similar account of its assets and liabilities can also disclose a worrying condition if the assets are held by a small, prosperous group that's totally detached from the bigger but wretched group bearing the liabilities.

Other types of imbalance also exist in a national economy. For example, the exchange rate can become too expensive leaving the populace unable to produce and dependent on imported goods. Also, the power of technology can hasten the decline in middle class income, leaving a small minority at the top able to afford spending. These imbalances are the reason why an economy stops producing. By the time an imbalance makes itself felt, the economy would've already been in serious trouble.

Politicians and policymakers are naively exhorting their countrymen to be more productive as if this economic crisis is all about failing to compete. Improving productivity is a slow process that's ill-suited as a crisis solution. Moreover, it usually calls for major investment that's unlikely to be forthcoming when investors are fleeing the country. Any turnaround effort must therefore first rectify the debt imbalance through debt write-offs. If the debts are owed between residents of the country, a high inflation rate performs the same function as debt write-offs. An exchange rate imbalance can be addressed through a currency devaluation. The last imbalance, the technological edge, has no fix except for a new Kondratieff wave that will obsolete the existing technology. Because of this, the first two imbalances will keep on recurring even after they have been snuffed out. It also explains why an economic depression is inevitable.

How do we spot an imbalance in a country's balance sheet? First, we need to understand the assets and liabilities that need to be monitored. What we mean by assets are financial assets, the numbers in virtual bits and bytes stored digitally on the servers of financial institutions. They are not the tangible, physical assets that can be touched and seen, the values of which are unimportant since they move in sync with the ups and downs in the credit quantity.

Liabilities, on the other hand, are always financial. In modern times, you don't owe others in terms of physical things. Even if you do, they'll be translated into financial terms. As assets and liabilities are just opposite sides of the same coin, we only need to monitor one, which in this case is liabilities, being the more convenient because the Fed publishes complete data on credit in its quarterly Flow of Funds Accounts.

If you recall the cash flow of a national economy in an earlier post, the cash flow is actually the debt movement of the economy. The balance sheet on the other hand is a snapshot status of liabilities and assets. As on the cash flow, we're interested only in debts on the balance sheet. So in effect, with the GDP — this being the economy's income statement — and the debt flow, you can assess the strength and portend the future of any economy. These are the speedometer and tachometer of the economy. Extending the car meter analogy further, you can add the house price index and the labour force participation rate (LFPR) charts to represent the temperature and fuel gauges. Unlike a car which breaks down from overheating, the global economy is grinding to a halt because of overcooling. The world economy doesn't have much problem with overheating because mankind's ingenuity will see to the expansion of capacity to meet any excess demand.

Let's bring on the latest charts to see how much further the world economy would have to struggle before succumbing to the forces of the economic depression. We begin with the US GDP which has just declared its third quarter figures for 2012. There's only one driver of growth: personal consumption. Both government spending and investment haven't shown any improvement. In fact, investment spending would have sagged had not residential investment, again incurred by consumers, risen. Regardless, home prices have much further to fall, despite the recent price uptick. In the lead to an economic depression, you'll come across many instances of the dead cat bounce.

The GDP growth since the 2009 recession also has been wriggling within a narrow band (blue line) with no sign of breaking out. With no more trillion dollar deficit in the pipeline, we can be sure where the GDP growth is headed in the coming quarters.

It appears from the first chart that the consumers are the driver of the GDP growth but the GDP components as computed aren't a true reflection of the real driver of growth because a significant proportion of government spending and business spending would end up as personal spending. In addition, the GDP records only spending and ignores any wealth destruction, such as loan write-offs — every time a loan is written-off, an equivalent amount of financial asset disappears.

To get the true picture, we need the debt chart, at left, updated only up to the second quarter 2012. A different picture now emerges. The government debt is on a relentless increase because of Obama deficits. But the household debt  is trending south together with that of the financials. Aside from the massive government spending, the major reason for the escalation of government debt is that it cannot be written off whereas household debt is still suffering from write-offs with much more expected in the future.

How do you explain the inconsistency between the household debt on the debt chart and personal consumption on the GDP chart? There can be only one plausible explanation: two groups of consumers are experiencing two diverging patterns, one flourishing from government spending spillovers and the other languishing under the burden of debts. Technological progress and globalisation also reward the former but assail the latter. Bloomberg has a revealing chart below that sums up the fortunes and misfortunes of the two groups. The pattern fits the 80:20 rule, the top 20% enjoying and the bottom 80% suffering. This pattern is spreading worldwide to any country that exposes itself to the ravages of globalisation.

This increasingly lopsided sharing of wealth is reflected in the worsening Gini coefficient, a measure of inequality, as shown on the The Economist chart below. But more ominous is China's Gini coefficient which has deteriorated at the fastest pace since 1980. Heralded by many as the next engine of growth, doesn't China look more likely to be a drag on global economic growth?

The view from the top

The maxim, "What gets measured gets done", is the root of many blinkered views in the business world. Only an enlightened maxim can trump this malign one. What better aphorism can you get than one from Einstein: "Not everything that can be counted counts, and not everything that counts can be counted."

In real life, there are many things that cannot be measured and of those that can be measured, the brain can only keep track of only a few. Take the analogy of driving a car. Of all the various gauges on the dashboard, only two are prominent — the speedometer and tachometer. Our eyes though should not be fixated on those meters but on the road ahead and the surrounding situation. Of course we can also use the analogy of the plane with its many gauges and the need to keep our eyes on them but if there were as many planes in the sky as cars on the road, flying would've been very frightening.

With the economy, we also need only a minimum of metrics. Our focus however should be on the unfolding situation which we can always glean by observing, and talking to people in business and on the street. That's why Jack Welch couldn't stomach the latest unemployment number because it doesn't jibe with the input that he's getting from other sources.

The metrics for an economy are quite similar to those of a business. We've gone through the cash flow. Now it's the turn of the income statement, to be followed in the next post by the balance sheet. How do you derive an economy's income? Actually we don't need to. When you're at the micro level, that is, at the level of business, you can't see what's happening outside your business boundaries. But as you go up, that is, at the level of the national economy, you'll find that the economy is a closed system. Certainly, foreign trade exists but for most countries, the net impact — export less import — is relatively small.

In a closed system, someone's income is another's expense. Or one's profit is another's loss. So there's no point in looking solely at profit as a bigger profit could mean a bigger loss elsewhere. But you hardly hear losses elsewhere because only businesses post profits or losses. Take the profits of the US corporate businesses (see chart at left from The Economist). They continue to register ever increasing profits in the midst of a depression. But this good fortune would soon peter out once Obama runs out of deficit fire power. Well, it turns out that they are about to report pessimistic third quarter results. We can thus dispense with business income or profits since this is indicative of only one sector of the economy.

For the economy, the GDP which really is the total output of the economy is the best indicator. We only need to dissect its components. For a typical country, that is, not a city-state, the relevant components are personal consumption, government spending and private domestic investment. The exports and imports, although each may be sizeable, are small when offset against each other. For example, the imports less exports of the US over the years tend to range between 3 and 6 percent of GDP. If the number sways beyond this range, the drop in exchange rate will set it back. The problem with the southern euro countries is that, with no possibility of currency devaluation, they have straitjacketed themselves into a progressively worsening situation with no avenue of redress.

The chart at left shows the three main components of the GDP in real terms using 2005 dollars. I've  used two vertical axes because personal consumption is several times the size of the other components, this being the result of a quirk in categorisation. By using two axes, we can place the three components close together and magnify their movements. Though both axes start at different amounts, their vertical increments are identical. I've also chosen 2001 as the beginning year since this is the beginning of the depression in the US with the dotcom bubble burst.

With this magnification, we can see clear patterns. The steep increases in both debt-financed personal consumption and investment prior to the subprime crisis were never sustainable. This led to the crash in 2009. Government spending took up the slack in 2009 but it has been on a gentle decline since 2010. Investment, of which only a quarter is undertaken by households on residential properties, the rest by businesses, appears to have stalled in 2012. Only personal consumption by households still mindlessly climbs upwards. But households eventually depend on income from government spending and business spending to drive personal consumption spending. Now, the quirk in GDP computation that I mentioned earlier is the non-inclusion of business non-investment spending, the bulk of which is on payroll, for reasons of double counting. But similar spending by the government is included. That's why the GDP component spending is disproportionately skewed towards personal consumption.

Be that as it is, we can infer from the investment spending, three quarters of which is by businesses, the pattern of business non-investment spending since both would have moved more or less in a similar fashion. As investment is now stalling, shouldn't non-investment spending also flag? The third quarter results of major US corporations which are expected to be subdued portend dark clouds on the horizon for business non-investment spending and, by extension, household income.

The relative size of the GDP components for the US economy is typical of most other mature economies. Developing economies however have a different component profile. Their investment spending is proportionately much higher. The US investment spending as a percentage of the GDP is usually in the teens.

Not so for China. I've included two pertinent graphics, the first from The Economist and the other its sister publication, The Financial Times, to demonstrate how insanely weird is China's economy. This concerns its investment spending. Never in the history of mankind has economic growth been powered primarily by investment spending that's now touching 50 percent of GDP. China is fuelling its growth by adding more capacity. In the early days of the Kondratieff Wave, this may have been acceptable though still excessive. But we are in its waning days in which capacity would be least needed. If this were a car tachometer, China is in the redline zone with the engine about to seize. It would've been safer for China to heed Keynes's advice that the government should instead pay people to dig holes in the ground and then fill them up. At least there won't be deserted apartments and malls, and underutilised roads and railway tracks that would've been costly to maintain or demolish.

China's relentless drive for growth at all costs is the price being paid for the mistake that Deng Xiaoping made more than 30 years ago. In an interview then, Deng was asked whether wealth accumulation  contradicted socialism's doctrine. Deng assured the interviewer that China's wealth accumulation was unique because its wealth would be shared by all. Deng might have been politically astute but economically he was a neophyte. Once you allow wealth accumulation, you must be prepared to live with extreme inequality. Probably only the Scandinavians have found a way to equalise wealth with massive government transfers.

Mao Zedong was thought to have been a madman for carrying out the bloody purges of the Cultural Revolution. But let us reflect on the wise words of Kenneth Boulding, an American economist who was cofounder of the General Systems Theory: "Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist." Now, Mao doesn't seem that mad after all.

Thinking in circles

A country's economy should be viewed from a circular perspective. This doesn't seem natural to most of us because we are used to viewing things from a linear perspective. There's a starting point and an exit point. Take any business. It generates profit for itself and jobs for the community. In the process of making as much profit, the business also helps the community and, if you extend the logic ad infinitum, the whole world. This is the line of thought that Adam Smith put up in the Wealth of Nations and has been a strong influence on all free market advocates ever since. Even the communists in China and Vietnam have ditched their old ideology and embraced capitalism.

But can this profit-making motivation be extended ad infinitum? Let's analyse this process step by step. Profit entails an increase in assets which can take the form of property, inventory, debt owed by others or money. Now, I usually use the island thought-experiment to see how far this process could go on. Imagine two persons stranded on an island. Each specialises in producing only one type of item. Initially they would exchange their surplus produce to the mutual benefit of both. They could go on forever and if they put a lower price on their cost and a higher price on their sale, they would be making greater and greater profit.

However reality is not that benign. There'll always be one person that is more efficient than the other. In the past when technology use was still low, this person would keep on accumulating the factors of production and communication, be they land, slaves, or transport carts or ships. Nowadays, he will acquire modern production and transportation or communication technology. Because modern technology massively magnifies competitive advantage, a small number of successful sellers or producers could corner the market for the whole world. This is no fantasy: Apple with more than $100 billion in cash reserves, and Samsung are extreme examples of winners-take-all in the smartphone market.

If you recall the 4C circle, reproduced at left, any skewing of productive capacity will unbalance the circle (for a more detailed reading on the 4C curve, see Reality in 4C). Capacity exceeds production because technology allows the few producers to make do with fewer workers. As more and more of the inefficent green/blue nodes are knocked out of the game, their consumption becomes less and less. The few surviving green/blue nodes keep on producing but how do you keep the circle flowing when there are many busted green/blue nodes? You see there's one more C, that is, the currency leg that can be artificially manipulated to resurrect the dead green/blue nodes as zombies.

To understand how this is done, we need to view the currency circle. Currency as we all should know by now is 98% debt. So when all else fail, the state can always resort to debt to drive the economy. The debt flow (see graphic at left) is actually the flow of cash in the economy. The blue upper half represents cash inflow while the green lower half, cash outflow. There are actually four economic sectors that are responsible for the inflow and outflow but on this graphic, I've combined business together with finance because business no longer drives cash outflow. Nowadays business debt leverage is prudently managed unlike in the 1930s Great Depression when businesses were responsible for aggravating the debt deflation.

On the left side of the graphic are the foreign exchange transactions reflecting inflow from and outflow to foreign countries. This graphic depicts a utopian state in which each economic sector earns approximately what it spends, as reflected in the same thickness of the curved line. Technically, if the flow is balanced, it can go on forever. But as always, reality is never perfect.

Where does the central bank fit in the debt circle? Nowhere. Its role is only to lower the price of money so that the households and businesses can pile on more debts. But this is hardly panning out in a situation of excess capacity. The banks are not lending when the borrowers have no income to repay. As for the businesses, with $2 trillion in cash reserves, they have no need for new loans.

One reason for the prolonged delay in the liquidation of debt is that the debt bubble keeps being passed from one player to another. We can go back to the Clinton administration (1993-2001) to see the movement of the debt bubble. The following charts (from The New York Times) provide a trail of debt growth among the various economic sectors.



To discern the pattern better, I've fitted them in the debt circle graphic below. The thicker line points to the main driver of debt growth. Now, we can clearly see that each administration is not free from fault. Clinton was assisted by the financial sector, Bush by the households, and Obama with all other sectors moribund is left only with the government sector. So naturally he has to spend more than $1 trillion annually to keep the economy on life support. Mitt Romney got it all wrong when he said that 47% of the American public depended on the government. Actually, if you dig back to the root cause, almost everybody in the US and the whole world is feeding at the US government trough.



To be sure, under the Bush administration, the financials were also guilty of racking up debts but as I want to bring out the pattern, I've highlighted only the most guilty party. With this, we can predict the next scenario of this debt circle.

How would the future pan out? There's no way that the financials and households could make a comeback as the former is shrinking to oblivion and the latter is still stuck with a plethora of debts made worse by a diminishing stream of income. The businesses are more likely to hold on tighter to their money as the economy tanks. When the government sector finally succumbs, as is unfolding in many other countries, all the debt lines will wither presaging a collapse in society, politics and world trade.

Understanding the economy from a cash flow perspective is much easier than the GDP circular flow. In the next post, we'll view the economy from the perspective of the income statement.

Creative thinking is oxymoronic

To many people, creativity seems elusive. The East Asian policymakers, especially, worried about the rote learning of their kids, are desperately scrambling to imbue them with creative thinking techniques. Would creative thinking be the solution to their economic malaise? Maybe, but the way creative thinking is taught is fundamentally wrong. You can improve your thinking skills by going through Edward de Bono's thinking course but that in no way enhances your creative thinking.

The fault with the common perception about creative thinking is that most people believe that you just need to think differently. No, you can't teach creative thinking because creativity doesn't come from a lot of thinking. Creativity comes from putting together seemingly disparate but distantly related patterns. When they click, you'll get that Eureka moment when the anterior Superior Temporal Gyrus (aSTG), a small region on the surface of the right hemisphere of the brain lights up. Creativity therefore presupposes that you have a repository of patterns within yourself. The thinking part is merely linking these bits of patterns together. The bigger chunk of creativity is observing which takes years while the thinking part is very minor.

So to force creative thinking onto someone with limited observational past is an effort in futility. Steve Jobs, famous for his insanely great creativity, claimed that the best inventors sought out diverse experiences, which years later became the raw material for their creativity. Jobs didn't seek experience solely in computing; in fact, he never coded a single programming line. But he had diverse experiences: dabbling in Hinduism and Buddhism, hanging out with friends in different fields, experimenting with psychedelic drug, to name a few. Recognising the value of diversity, he designed Pixar's headquarters such that all the bathrooms were placed in an atrium, increasing the likelihood of writers and programmers bouncing into one another to facilitate the sharing and cross-fertilising of ideas. If all lifelong, one has been specialising in only one field, there's very little chance of he/she having great creativity.

The essential elements necessary for creativity are thus:

Varied experiences

Musing about those experiences

Another advice from Steve Jobs: "You can't connect the dots looking forward; you can only connect them looking backwards." So, to dream up the future, always look back and piece the past with the present, to wit, what's unfolding right now. This association of random patterns doesn't come about when you're focused on the problem but when you're not thinking seriously about it, that is, when you're daydreaming. Under normal conditions, the brain inhibits blood flow to the aSTG. Only when the brain is relaxed will this inhibition ease.

The beauty about storing patterns is that you can easily recall them. Here we can bring up Edward de Bono's insight. He wrote: "Once a pattern has been formed then the mind no longer has to analyse or sort information. All that is required is enough information to trigger the pattern. The mind then follows along the pattern automatically in the same way as a driver follows a familiar road." Certainly, we can be misled by the wrong pattern. But we can always empirically test its suitability by going back to the past, not just a few years but thousands of years. If reality unfolded according to the selected pattern, then our pattern is the right one. We can also go forward by checking the predictive power of the pattern.

The power of pattern recognition and creativity can be seen in the massive role reversal in the smartphone market. Consider Nokia, it outspent Apple and Google on R&D but just couldn't translate the spending into game-changing products. Apple was fortunate to have Steve Jobs. Whether it can continue unleashing a never ending stream of transformative products is an open question. But by the look of the recent iPhone 5, it seems that Apple has settled down on the incrementalism treadmill despite iPhone 5's record breaking sales. Its mojo has gone with the passing of Steve Jobs.

To illustrate a simple use of cross-applying a familiar pattern to a supposedly complex issue, I'll demonstrate in the next post, how using a pattern from the accounting profession, we can size up the economy much better than the economist with their econometric tools. We only need the Income Statement, the Balance Sheet and the Cash Flow. The next time an economist bores you about how great China's GDP is, you can enlighten him/her on why that country is going the opposite way.

The future job sector is self employment

The employment statistics for August 2012 were released last Friday. As usual, the statistical measure that interests us is not the unemployment rate but the Labour Force Participation Rate (LFPR) (see chart from the Bureau of Labor Statistics below). The LFPR enables us to derive a long-term  pattern which is shown as the blue trend line on the chart.

The August 2012 LFPR of 63.5% is the lowest since September 1981. But the LFPR in 1981 was on an upward trend, a reflection of the mass entry of women into the workforce which had started in a big way during World War II when the menfolk was on the frontlines of war (chart below).

This economic dividend is now gone. Both genders are now hard hit by the LFPR reversal as businesses make do with fewer employees, a consequence of technological progress and outsourcing.  All the rules that used to govern the relationship between unemployment and GDP (Okun's Law), inflation (Phillips Curve), and job vacancy (Beveridge Curve) are now rendered obsolete. But by squeezing their labour force, the businesses are tightening the noose around their own neck. As employees are increasingly retrenched, their ability to consume goods and services would be progressively reduced. The big businesses will soon be caught in a vicious circle of continually reduced demand feeding on continually reduced income.

In the third world countries, it's been observed that there are proportionately more entrepreneurs than in the developed world. However this doesn't mean that they are more commercially driven; it's just that salaried jobs are hard to come by. So survival comes from being petty traders or doing odd jobs.

Now retrenched workers in the developed world will face the same problem. The Fifth Kondratieff Wave is unlikely to create the kind of jobs that uplifted the lot of the workers on such a large scale as in the Third and Fourth waves. Everybody has to be on their own, probably trading, producing goods or services, or even growing food; blurring the lines between services, manufacturing and agriculture. In short, back to the days when every community is self-sufficient ... the days of feudalism.

All hype, no bite

Mario Draghi is about to unleash another round of 'money printing' through massive bond purchases in order to stave off the collapse of the euro. He has pledged to do whatever it takes to save the euro. If his pledge is indicative of the future of the euro, then the dissolution of the euro is nigh.

To appease the Germans, who for unfathomable reasons have a morbid fear of inflation, he will sterilise whatever 'money printed' by taking in an equivalent amount in deposits from banks. This clearly shows that Draghi doesn't understand how central banking works. Central bankers actually have no power to create money! Whatever bonds or loans that they purchase must be funded by somebody. Only if central banks can issue their own bonds, can they create money but they don't have such authority. As a result, they must borrow from the banks by taking in their deposits.

Therefore whether Draghi will sterilise or not isn't his choice because whatever Draghi, Bernanke or Bank of England's King does will always be sterilised. Their bazookas can only fire blanks. When truth will out, they will be derided as the Three Stooges of central banking.

Warren Buffett has cautioned us to be fearful when others are greedy. No, we should be fearless instead. As suckers rush in to load up on equities upon hearing of Draghi's pledge, now's the time to unload all your equities. Or if you miss this one, you can wait for Bernanke's pronouncement which should be due anytime soon.

All the obstacles to delaying the depression are now being removed. The Eurozone is still trapped in its balanced budget ludicrousness. Germany is finding itself dragged into the vortex of the Southern European downward spiral towards economic and political oblivion. The Catalans and Basques are clamouring for separate statehood from Spain. Pretty soon, many supposedly homogeneous states will find that they actually have many ethnicities.

The US is being entertained by two presidential contenders, both fraudulently promising the voters of their ability to revive the economy when the powers to do so are in nobody's hands. Of the two, Romney would hasten the collapse of the US economy since he would run the economy as he did Bain Capital. The traits needed for a successful businessman are incompatible with those of a great statesman. You run a business to make profits but you can't run a nation to avoid deficits unless your nation is a city-state that derives the bulk of its GDP from exports. Only if the state suffers a deficit can the households save and the businesses profit. If the state also wants to reap a surplus, then misery will be the lot of the households and businesses.

In the East, Japan is making a turnabout towards almost zero deficit after 20 years of continuous deficits, not realising that it is those deficits that have prevented its economy from keeling over. China will need to awaken Mao Zedong from his deep slumber in order to keep the country as one.

The fact is all governments are running out of bullets. With their ability to stomach further deficits stretched thin, this last line of defence is about to give in.

Nowhere to hide

With the depression slowly engulfing more and more European nations, should you place your bets on Asia? It's easy to assess the growth of Asia since most of these countries are export hogs. Their GDP numbers, though correct, can mislead us into thinking that they have the answer to the crisis. Actually, they are all borrowing their way to growth, either through government debt or household debt or a combustible mix of both. Instead, a better indicator of their economic health is the level of their forex reserves (chart at left from The Financial Times).

With the US current account deficits already slowing down, no country can expect to increase its forex reserves. Now the three major South-east Asian economies of Indonesia, Thailand and Malaysia have started running down their reserves while Asia's two major powers, China and India are seeing their reserves increasing at a slower pace. China is the worst of the lot, with all sectors of the economy heavily in debt.

China's latest balance of payments (chart at left from The Economist) confirms that even its forex reserves have started to decline mainly because of capital flight, a problem you'd usually associate with Greece or Spain. Do the rich Chinese know something which the China bulls are still in denial of?

If you think that you can sleep soundly after moving your investment to these countries, you'd better put on a pair of good earmuffs. There are still many shoes waiting to drop.

The last of the financials

Why has the financial sector grown so big in so short a period, that is, in less than 30 years? In fact, before the recent housing bubble bust, the financial sector was the employer of choice for most of the MBA graduates from the top business schools in the US.

Looking at the longest recorded stretch of the credit picture in the US (see chart from The Financial Times below), dating back to 1870 but with the debt components tracked only from 1929, it's evident that debts prior to the 1930s never amounted to twice the GDP. Even though we don't have the breakdown of the debt components prior to 1929, we can reasonably infer that they were stable throughout that period because total debt grew at a measured pace. And the financial sector borrowings, i.e., excluding the customer deposits placed with it, had always remained relatively small even during the Great Depression of the 1930s. So generally banks then financed themselves using equity.

As can be seen in the above chart, the main financing during the 1930s was raised directly by the non-financial corporations in the form of bonds. The corporations lent the money to brokers who relent it as 90% margin loans to their clients who ultimately speculated on the stock market. The failure of these loans however was only a secondary cause of the 1930s Great Depression — the primary cause of all economic depressions has always been excess capacity. Since then, the non-financial corporations have learned their lesson by keeping their debt leverage to reasonable levels.

During the Great Depression, as the non-financial corporations raised bonds directly, the banks, deprived of their traditional loan business to corporations, bought the corporations' bonds. They also wrote loans with only 10% margin requirements to buyers of stocks. About 40% of their loans went to financing stock speculation.  Not content with that, they also speculated directly in stocks. Their participation in this speculation and its financing eventually led to the failure of 10,800 banks. Because of their leverage, the banks are the first to fail — and they fail big — in any economic depression, that is, a condition characterised by a substantial collapse in money supply.

Up until the turn of the 20th century, the banks' leverage was much lower. Their capital ratio was never less than 20% (see chart at left from The Economist depicting the percentage of book equity to book assets, this approximating the capital ratio). However a high capital ratio means a bank has to use more of its own capital which is not as rewarding as using other people's money (OPM) — mainly customer deposits — because the cost of OPM is much lower. A low capital ratio therefore translates into more profits for the bank shareholders, provided the money supply keeps growing at a healthy pace.

But one thing obvious from the above chart is that the banks' capital ratio during the Great Depression was much higher that at any time since. Therefore insisting on the banks to increase their capital ratio wouldn't necessarily shield them from future crises though it may lower the risk of failure, albeit only marginally. However banks in the 1930s were not as big as they are now though there were many, about 25,000. With low capital requirements then, setting up a bank was easy.

There are two intriguing questions here. One is why the finance sector only becomes big now. The other is why the current depression unfolds over a prolonged period rather than like the quick bust of the Great Depression. Remember that the start of this depression can be traced to the collapse of the Japanese stock market towards the end of 1989. For the US, the Dotcom bust in 2001 is the  the starting point. For this post, we'll answer the first question. The second will follow in the next post.

The problem with being big is that once you've tasted bigness, you're loath to scale down since size has its own benefits. But in an economic depression, size doesn't guarantee safety. It just makes the fall that much more catastrophic. The government has to step in to rescue no matter what.

The case of Lehman Brothers is instructive. When Lehman failed exactly four years ago, it had $660 billion worth of assets at book value, making it the biggest corporate bankruptcy in history. Because banks cross-lent to one another extensively, the US Treasury's decision to let Lehman fall soon led to to the seizure of the money market. Market participants pulled back their lending, scared that the counter-parties might go belly up. Only a $9 trillion guarantee and overnight loans by the Fed restored market normalcy. This rescue was never made public; only the much smaller $700 billion TARP rescue fund was. Helped by Obama's four straight years of annual deficits exceeding $1 trillion each, the banks have managed to regain ground and the Fed its money.

We can be sure that the next time around, the Fed won't let another Lehman fall. But by letting the banks grow, the Fed is in thrall to the big banks. However with the depressed state of the economy even four years after the Lehman collapse, the politicians and the Fed have squandered whatever political capital they have left. So it's arguable whether the public can stomach another Lehman-type rescue by the Fed though it's in its interest that the Fed does so.

The debt picture doesn't tell how exactly has the financial sector grown because it looks only from the credit side. We need to see the obverse of debt, that is, the asset or debit side. The chart below from The Economist shows that the financial sector's assets started their relentless increase beginning in the mid 1980s. Now if you look at the debt chart above, you'd notice the similarity in the movements. Bear in mind that both charts reflect the amount as a percentage of GDP. So any movement above 100% means that the assets or debts increase at a faster pace than that of the GDP. The assets are however greater than the debts. This can be easily accounted for by equities which are the only financial assets that are not debts.



















Technically, equities perform the same function as money except that they are safe money unlike debts which are toxic money, that is, in conditions of declining money supply. In the lead to a depression, the value of equities will fall but debts retain their value until the moment it becomes unsustainable and snaps. That's why the values of all financial assets and commodities can suddenly plunge.

To be sure, the banks began their growth after the 1973 oil crisis when the US started to suffer increasing trade deficits. The wealth generated by those deficits went to the oil producers who deposited them back with the US banks. But the 1970s were the days of high inflation, so the debt value as a percentage of GDP was contained.

However by 1981, the inflation was brought down by Paul Volcker's harsh interest rate regime. Unknown to many, more influential was the extra capacity brought on by the oil producers who by then had substantially increased both oil production and spare capacity. Essentially since then inflation has been much subdued because technology and globalisation have both been unleashing limitless capacity. Even when commodity prices have gone up, inflation has never reared its ugly head. But inflation did appear in short and sharp bursts particularly for those countries that suffered severe debt crises, such as Korea, the South-east Asians, Sweden and more recently Iceland. Their inflation came stealthily through currency devaluation which was a one-off event, after which price levels stabilised.

It is this low inflation environment that has accommodated the big increase in credit supply and on its heels, the burgeoning financial sector. In an inflationary environment, holding on to financial assets can be detrimental because they may lose value faster than real assets. In contrast, a low inflationary or, worse, deflationary environment favours creditors since their debts hold value even when prices are crashing everywhere. This tremendous debt increase has enabled all sorts of financial outfits — ABS pools, hedge funds, pension funds, and many others — to proliferate and some to grow big.

How will the financial sector evolve once the money supply settles to its natural level? The most vulnerable will be the big banks. When the Fed provided financial assistance during the 2008 financial crisis, it should have been made conditional upon the banks eventually splitting themselves, if for no other reason than facilitating the banks to be shuttered when money supply plummets. The investment banks are already planning to reduce their assets by $1 trillion and costs by $10 billion over the next two years. Whether such reductions are sufficient remain to be seen.

Even George Soros last year returned his investors all their money, foreseeing that there was no money to be made when money itself would disappear. But big funds such as the pension retirement funds are putting more of their assets into hedge funds hoping the hedge funds could outfox the market. The right thing to do should have been to close down the retirement funds and distribute the capital to the retirees, letting them manage their own money. These retirement funds are at risk of being wiped out in the coming money disappearing act.

When these giant financials are gone, there is very little likelihood that they will make a comeback in the Fifth Kondratieff Wave. The new investment of this final wave no longer favours the accumulation of large capital. In future big production facilities will be passe when 3D printing can produce items economically in units of one. Mineral commodities except gold and silver will best be left underground as nanomaterials with better material properties enter commercial use and renewable energy takes centre stage.

As this depression progresses, bid farewell to the financial giants; we'll never see the likes of them again.

Downsize or doze off

Banks are being chastised from all and sundry for their misdeeds and blunders. Now even Sandy Weill, the person credited for creating the Citigroup behemoth, has been calling for banks to split their commercial arm from their investment trading arm. The common justification put forward for the split is the different cultural attributes of a bank's investment and commercial arms.

Actually, the split or the sizing down of banks should not be precipitated by the huge trading losses or the Libor rigging scandal. Warren Buffett has observed that, "Only when the tide goes do you discover who's been swimming naked." Indeed an op-ed piece in the Financial Times confirms that the banks have been rigging the Libor for more than 20 years. Bob Diamond and his ilk, the regulators and the central bankers have known this all along. The parliamentary committee hearing was a sham to provide cover for everybody's ass. The reason this scandal wasn't exposed earlier is because the tide was still up. As the tide recedes, all the skeletons will start walking out of the closet

As for the differing cultures, they can be easily managed by having separate organisational setups that don't mix the two. The only reason that compels a bank to downsize is much deeper than these specious arguments. To understand why, we must delve into the bank's ecophysiology, not philosophy since there's nothing philosophical about overly paid bankers making money from borrowing cheap and lending dear, or betting on market movements.

Like any living things, a bank grows big if its food is aplenty. Similarly, if food is scarce, it must start scaling itself down. Sizing down entails shrinking a bank's loan asset base by recalling loan assets that pose great risks. Income will fall but in these depressing times, growth and income are the least of a bank's priorities; survival is the most pressing.

It's been observed in evolution that mammals above the size of rabbits living on islands would diminish in size (see The Island Rule). To remain big and active in times of scarcity is an invitation for disaster. A bank's food is the money supply, the best measure of which is total credit. If you look at the total credit picture for the US, the picture appears bleak, more so with the recent second quarter 2012 GDP growth turning south.

Obama's deficit spending only manages to slow down the slide and the resulting bank failures (see right table). But as its impact will soon start to wear off with the declining deficits, the descent will resume its previously steep decline. The eurozone total credit has crumbled in Italy, Spain and Greece with more states joining in. Whenever total credit crashes, banks will be the first to be hit because of their gearing.

We also should be aware by now that Bernanke's QE won't work. If only someone would sock it to Bernanke that his QE actually means quantitative exchange, that is, a swapping of debts on the scale of trillions of dollars, maybe he'll wise up to the fact that QE doesn't print money. QE works only to stem a panic, that is, when a bank is in imminent danger of collapse. The bank can swap its less liquid assets for liquid money from the central bank. But if the bank has assets that have hugely lost their value, there's nothing to prevent its collapse except by a takeover by the state. And if the state itself is in a wreck, the mess multiplies severalfold. Now, this latter scenario is going to haunt the banks as round two of the economic depression starts to unfold.

The other alternative to sizing down for a bank is powering down its thermal engine through hibernation. A bank can power down by switching its loan assets to low-return Treasury bonds and bills and aggressively paring its operating costs through salary and bonus cuts. After all you don't require smart people in banking; banking is best served by staid and conservative characters. No matter how pristine the quality of a bank's loan assets is now, it will be tarnished once total credit resumes its downward slide. By then it'll be too late to unload the assets at good prices as all banks will be rushing for the exit. The sight of panic, naked bankers is not something you'd want to behold.