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.