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.