Sunday, May 6, 2012

End This Delusion Now!

The signs of a capitulating economy are percolating. The Occupy movement is restarting its protest occupation. Professor Paul Krugman, who has recently criticised Ben Bernanke for not doing more to reinvigorate the economy, has just come out with his new book "End This Depression Now!"

At last a figure of high regard in the economics profession now admits that we're about to enter a depression.  But Krugman himself still doesn't completely grasp the issue. With Bernanke still blind to the scary situation that's progressively unfolding, Krugman is the one-eyed man in the land of blind economists, meaning he gets only 50% right.

Krugman claims that Bernanke isn't aggresive enough while Bernanke counters that Krugman's inflation promoting suggestion is reckless. At the end of this civilised spat, both remain none the wiser simply because one is nebulous and the other clueless. At the root of the issue is the belief that there is a solution to the crisis. We had three Kondratieff Waves in the past, and their curtain calls were all marked by three depressions.

We might as well beseech God to put a stop to tsunami waves. When the calamity is inevitable, you don't attempt to find a solution; you adapt to the problem. If you knew when a tsunami would strike, you would have put the ships out to sea and moved the residents to higher grounds. Unfortunately, we have yet to discover the means for triggering advance warnings of tsunamis though we can roughly estimate their timing based on a 70- to 100-year cycle. This lack of tsunami early warning indicators is the main reason that many are always caught unprepared.

A Kondratieff Wave is different. We have all the past patterns needed to sense its timing. The symptoms are evident years before disaster strikes. The timing is almost perfectly regular. Now what should we be doing to minimise, mind you, not avert, the impact of the depression? First we need to identify the distinguishing features of an economic depression. Then we'll walk through the depression to see how it reaches its natural conclusion so that we can anticipate the succeeding moves. Our aim is to have minimal surprises. For this post, we'll focus on why the depression is unavoidable and why there's no solution, but only adaptation.

The problems of this depression are essentially two-fold: a drastic fall in money supply and a skewing of wealth distribution. These also happen to indirectly relate to the dual mandate of the Fed, that is, price stability and maximum employment. Contrary to received wisdom, the fall in money supply is merely a symptom, not a cause, of the depression. The true cause of the depression is however the maturing technology drivers of the Kondratieff Wave in which a few producers have cornered the productive capacity. Towards the end of the wave, wealth accumulation is highly skewed resulting in an extreme imbalance between creditors and debtors (see The Wall Street Journal chart above). Even if the first problem is resolved, it will recur as long as we are stuck in the same Kondratieff Wave.

In any case, the symptom must be addressed before all else in order to unfreeze the economy. Even this the policymakers can't even grasp. Tackling the symptom is easy, if only the policymakers had the authoritarian powers to bulldoze the corrective measures through. First they need to understand that the money supply has to fall. Any measures to prop it up will not last long, much like the Japanese sea-walls that were destroyed by the 13-metre sea waves. What we have now is the excess money created during the credit boom years trying to downsize itself so as to be commensurate with the size of the economy.

The intellectually bankrupt policymakers are preventing this fall by creating money in baby steps. With every step forward, they are taking two steps back. There are two solutions but both are unpalatable and therefore, without authoritarian powers, unimplementable. One is to quicken the pace of the money winding down by the forceful large scale write-off of debts. Those with financial savings will terribly suffer. The other is to increase the income level and asset prices superficially by unleashing inflation √† outrance, not the 4% suggested by Krugman. With this the underwater loans will refloat and debts can be wiped out. Again the same group of people will suffer but the main beneficiaries in both cases will be the debtors. Without either of these two options, the suffering will be long and excruciating.

Both Bernanke's and Krugman's failing lies in their inability to apprehend the money supply. As money is 98%  credit, Bernanke cannot create money regardless of how much he prints. Bernanke only swaps one form of credit, deposits by the banks with the Fed, with another, treasury bonds and mortgage backed securities (MBS). Even if Bernanke were to print trillions worth of paper money for the banks and forbid them from placing it with the Fed, inflation would still be flat. Why? The banks will sit on the paper money and guard it with Fort Knox-like security. The cost is cheaper than losing money from lending in times of  low repayment prospects. No lending, so no new money, thus minimal inflation.

Bernanke doesn't want to print more money out of his misguided fear that this may lead to runaway inflation. And Krugman is accentuating the confusion by castigating Bernanke for being timid. The funny thing is that both believe high inflation will be the outcome of Krugman's suggestion. Are they teaching voodoo economics at Princeton?

Prices are indeed falling but most people don't notice them because the CPI doesn't include asset prices, but only goods and services. If you factor in all prices, we're already in deflation mode because money is fast drying up. The flow of money is akin to the water cycle. Water in the ocean is not water in the meaningful sense. Only when it circulates through the water cycle, does it benefit the ecosystem. Likewise, money placed with the Fed or stashed under the pillow is dead money and shouldn't be counted towards the money supply. So you can have lots of money yet having zero impact on the economy. Now what do you need to get this money cycle moving?

Again the water cycle analogy helps. First we need to understand why the Sahara which is a desert today used to be a green region with large lakes about 10,000 years ago. William Ruddiman's book, Plows, Plagues & Petroleum, has a fascinating account of the climatic shifts that led to the radical change in the Saharan environment. The root causes of these climatic shifts are the main drivers of global warming and cooling. Fossil fuel is only a recent and to boot a very minor contributor to global warming. In fact, we should be grateful to fossil fuel for without it we would now probably still be in the Little Ice Age, which began as early as 1250 and lasted until 1900, although some would consider 1550-1850 as the real interval. Regardless, it came to an end with the industrial era warming. The coming Fifth Kondratieff Wave, which will yield cheap energy, will see us struggling to get carbon into the atmosphere in order to prevent earth's cooling.

How big the impact of fossil fuel, it's the variation in the sun radiation that actually contributes far more to global warming and cooling. The radiation varies as a result of three astronomical rhythms: the 22,000-year precession cycle, the 41,000-year tilt cycle and the 100,000-year orbital cycle. Precession is the change in the tilt direction of the earth's spin axis. It's like a spinning top, changing the direction in which it leans, progressively until it traces out a complete circle. Note that precession doesn't change the angle of the tilt, only the direction. The tilt cycle is where the earth's tilt angle changes from a maximum of 24.5° to a minimum of 22.2°. The orbital cycle is the cycle in which earth's orbital path changes from elliptical to cyclical. During its elliptical orbit, the earth's distance from the sun is shorter by 5 million kilometres from its average distance of 155 million kilometres.

Over the last 3 million years, the impact of these cycles has gradually resulted in the earth trending towards a more refrigerated state. Only the very recent greenhouse warming has arrested this progress. But of far more interest is the precession cycle since it's the one that has greatly influenced the Saharan environment. This cycle controls the solar radiation at tropical latitudes, which in turn drives the summer monsoons. The maximum radiation arising from this cycle occurred about 10,000 years ago. It so happened that that was when the Sahara desert was green with grasslands and dotted with lakes. Right now, we're at the minimum radiation state.

It seems strange that minimal radiation is associated with desertification whereas maximal radiation with greenery. But you need a strong Sun to heat the land and the overlying air. When the heated air rises, the low pressure left behind by the rising air is filled by moisture-bearing air from the ocean. This air is in turn also heated but this time the moisture condenses as it reaches the upper atmosphere. Clouds are formed, followed by rains in the afternoons and evenings. If the Sun is not strong, the region is devoid of low pressure and the air is dry, hence the present Sahara desert environment.

The man-made fossil fuel global warming is having a relatively small impact and would be easily reversed in the Fifth Kondratieff Wave driven by advances in nanotechnology and biotechnology. Our attempts to do so prematurely during the present Fourth Kondratieff Wave are costly and wasteful of economic resources.

The same goes for our efforts to subvert the downward phase of the Kondratieff Wave. The Sun equivalent for the Kondratieff Wave consists of the capacity and communication technology drivers which in the present wave are computers and the internet. As we are past the halfway mark, these technology drivers are unleashing capacity instead of driving investments. So fewer people are increasingly needed to produce a given level of output.

So a fall in money supply is to be expected. Instead of allowing money to finds its natural level, policymakers are flogging a dead horse by creating more money through government deficits. This slowing down of money contraction coupled with Bernanke's induced low interest rate environment attracted new house buyers, who thought that house prices had hit bottom, towards the end of 2010. Now these buyers are under water, creating more problems instead of solutions that the original stimulus intended.

To adapt to this depression, we need efforts on a collective scale to channel wealth from the well-off to the needy. That's where the consuming demand lies. We don't need more investment since we have more than enough capacity to meet the needs of the world. The spending from the consumption will flow back to the well-off and thus how the wealth cycle like the water cycle works. But as depression rears its ugly head, fear grips everyone's mind. Generosity takes a back seat to selfishness. And everyone will be the loser.

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