Debt in a time of decline

Carmen Reinhart and Kenneth Rogoff, the authors of a famous 2010 study, 'Growth in a Time of Debt' have been assailed after it was discovered that their conclusion that economic growth would falter once public debt levels reached 90% had incorporated an error in their Excel spreadsheet.

A reworking of the code by Thomas Herndon, a University of Massachusetts student, and his two professors shows that growth only declines slightly instead of contracting (see The Economist chart at left).

Those in the stimulus camp have been rejoicing at the debunking of Reinhart and Rogoff's flawed findings. However both the austerity and stimulus proponents have not been able to put their fingers on the real issue. Again this reflects their data-driven infatuation that has prevented them from seeing the real pattern.

Actually the pattern is simple. What do you do if you're out of job? You'd do anything – beg, steal or rob – to survive but if someone is willing to lend you money, you'd surely borrow before choosing the other less well-meaning options. Similarly, if you take the analogy of the Monopoly board game, how can you make the game last longer when only one player is winning? There is surely no other way than borrowing from the winning player or from the banker. Of course, you can never repay because your borrowed money eventually ends up with the winning player.

The same goes for our real life economy. In the maturity phase of a Kondratieff Wave, we have no choice other than to increase debt (chalk one up for the stimulus camp). But increasing debt doesn't revive growth, it merely buys time, delaying the inevitable contraction, now made worse by the increased debt load (chalk one up for the austerity camp). Like that of the Monopoly game, the losers do not have the slightest chance of winning. Their only hope of winning is to start a new Monopoly game (or in real life, a new Kondratieff Wave).

The chart below (also from The Economist) depicts the economic growth pattern for the advanced, middle-income and low-income countries. We can see that the advanced economy has finally succumbed to the inevitable decline phase of the Kondratieff Wave. Notice that the cycle for the middle-income lags that of the advanced but leads that of the low-income. So as wealth inequality rises for the advanced economy, it is falling for the low-income, for now. The final outcome would still be a rising one as the low-income eventually catches up with the rest, not in terms of GDP per capita but in terms of hitting the economic growth wall. So the main defect of Reinhart and Rogoff's argument is their confusing cause and effect; growth is not a consequence of debt but debt is a consequence of an economic super-cycle.

The other critical defect in the Reinhart and Rogoff's study is that it covers only public debt whereas for the purpose of the real economy, all debt components  – public, businesses, households and financials must be counted. There are times when public debt falls but total debt increases. Relying solely on public debt generates a false picture on the amount of money in the economy.

For two renowned Harvard professors to commit a simple Excel error, that is forgivable but for the whole economics profession's failure to see a crystal-clear pattern, that would be damning evidence of its wretched state.

Which comes first, economics or politics?

Many of the political problems plaguing many nations now stem from the fact that their political systems are no longer consistent with their economic systems. Because of the widespread growth of democracy and its natural complement, human rights, every nation is pressured to adopt the democratic process although the result of doing so increasingly will be at odds with the evolution of its economic system.

The evolution of an economy is easy to foresee because, as long as wealth accumulation is allowed to go to extremes, it always takes the path of the Monopoly board game. If you analyse the past history of ancient Greece or Rome right down to the present time, you'll be amazed that the same pattern echoes through the ages. The following Financial Times op-ed piece titled A wealth of inequalities bodes ill by Merryn Somerset Webb which came out last week, has a fascinating take on how wealth flowed among the citizens of the Italian city-states in the middle ages. Read on:

I am reading a book by historians Charles Foster and Eric Jones on this very subject (The Fabric of Society and How it Creates Wealth, Arley Hall Press). Foster and Jones traced the social and economic conditions in four societies that manufactured cotton cloth between 1100 and 1780 – northern Italy, Germany, Lancashire and Holland and looked at how and why these particular areas were so successful at generating wealth. There appears to be a clear answer. 

In each country a society emerged where a large number of families owned a small amount of capital – “wealth was fairly widely distributed” (perhaps as a result of having plural political institutions). “Vigorous technical and social innovation then occurred” which created rising wealth across the board – probably because “many families had enough wealth to permit innovators to experiment and establish their new ideas.”

In the end, however, some families worked it so that they ended up economically and politically more successful than most others, wealth became concentrated in a few hands and that was that: plural government turned to oligarchy, innovation declined and “these societies ceased to be able to generate increasing wealth for their citizens”. 

A quick look at one village in northern Italy in 1243 – Piuvica. Records (amazing that there are any, isn’t it?) show that there were 238 resident householders in the village and that the top 50 per cent controlled 80 per cent of the wealth. 

You might think that sounds a lot, but in the great scheme of history it suggests an astonishingly equal distribution. 

Similar figures exist for what was the city state of Orvieto. This was the period in which business development surged in northern Italy, when the quality of cloth (silk, cotton and wool) surged and when great innovation appeared in accounting and banking. But with wealth came greed. And after 1300 or so committees of citizens gave way to chief magistrates who often succeeded in making the position hereditary to their families. They became Signori. 

Next came rising budgets and taxes and the armies of officials needed to administer them. By 1427 you could see the changes in the records from the city of Florence: 8 per cent of the households held 80 per cent of the wealth. 

This came with some good (just as the concentration of wealth in the UK post-industrial revolution gave us 150 ornamental lakes designed by Capability Brown, the Italian concentration gave us the artwork of the Italian Renaissance) but it might also have had something to do with the fact that by 1700 “an exporting textile industry in Italy barely existed and the country was no longer rich”. 

You’ll be wondering what my point is. It is this. Wealth inequality may be, as Ridley suggested, falling across the globe, but in the west it is rising to uncomfortable levels. 

In the US the top 1 per cent of the population own more than 35 per cent of the nation’s wealth while the top 20 per cent own not far off 90 per cent. The bottom 80 per cent, between all of them own a mere 7 per cent. 

The UK looks pretty rubbish when it comes to wealth distribution as well. The top 1 per cent have something in the region of 20 per cent of the wealth and the top 10 per cent hold 50 per cent. And, as I write, a good 150 ex-hedge fund managers, chief executives or retired politicians-turned consultants are probably in the process of designing new lakes for their estates or, as Foster puts it when he refers to the UK rich after the industrial revolution, “expending their talents on trivial pursuits”.

The article doesn't explain why the Italian textile industry disappeared. Essentially the Italian city-states generated more wealth from the East-West spice trade, that is, when the trade had to pass through the overland routes. But the Dutch cut this off when they rounded the Cape of Good Hope. As always, water transport beats land transport hands down. Of course, the Portuguese pioneered the route but they missed out because they lacked credit or currency—another critical component of the 4C—to finance bigger and frequent voyages. To put the final nail in the coffin, the Dutch in the 17th century flooded the Mediterannean with cheap pepper, effectively putting the Italians out of business. And with no wealth, all other industries were similarly busted.

The main point however is not about the spice trade but the way wealth over time gets concentrated in the hands of the successful few. The only difference is that in the past, things moved at a leisurely pace. Now, 60 years is the length of one cycle of wealth growth and decline. Luckily we have been through 4 such cycles in the space of almost of a quarter of a millennium. But with every wave, the government grows bigger until eventually a large proportion of wealth creation centres on the government mainly through government deficits leading ultimately to the implosion of the government itself.

With only one cycle left, we'd better be prepared for a new of style of politics. Democracy is already passe with a growing number of hung parliaments unable to govern. Oligarchy should be revived, no matter how unpleasant it may be. Next would be fractured oligarchy as states begin breaking down. Else we can welcome anarchy, Syrian style.

Abenomics, the latest in a series of muddle-nomics

The new Japanese prime minister must be feeling smug now that the Nikkei index has jumped by leaps and bounds at a time when other stock indices are sluggish. Has Shinzo Abe at last discovered the solution to the deflationary crisis which has plagued the nation since 1990? It's still early days. But Prime Minister Abe has delivered nothing other than bluff and bluster. Reality has to yet to sink in but if past precedents — the most famous being Reaganomics and Thatchernomics — of such word blending are any guide, then the Japanese people have been promised nothing but snake oil.

The Japanese economy is in the doldrums for more than 20 years that any glimmer of hope is quickly seized upon lest it soon vanishes. Abe is taking the deflation bull by its horns when he promises to end deflation through massive deficit spending, money printing and deregulation. Many economists have applauded him for taking such a stance, in the hope that his success will prod the EU leaders to end their austerity programme.

Abe's immediate apparent success as reflected in a 20% drop in the yen exchange rate and a 40% rise in the Nikkei index since assuming the premiership has given credence to his mission of trumping deflation. Abe is salivating at this prospect but reality will disappoint him. Abe was once an average prime minister who stepped down voluntarily. So why should he be different this time around? Of course he can avoid the musical-chair fate of his predecessors if he continues to strike a hardened attitude towards his similarly economically troubled neighbours over the disputed islands as a diversion from economic issues.

We can pick holes in Abe's deflationary busting strategy but we will start by setting the record straight on the large fall in the yen exchange rate. Exchange rates are a puzzle to many simple because they're unpredictable. However ignoring the short-term fluctuations which are the outcome of speculative manipulations, exchange rates move in line with a country's current account balance. If a country's current account is increasingly in deficit, its exchange rates will soon drop unless that the deficit is sustained on increased foreign debt. Even then, in the long run its exchange rate will plunge if the current account remains persistently negative. The only exception is the US as it still is an economic and military superpower.

The Japanese current account balance generally has always been positive (The Economist chart at left). Not shown on the chart are the CA deficits in January 2012 and from November 2012 to January 2013. The deficits were a result of the strong yen. It is therefore natural for the yen to devalue in order to restore the CA balance. In fact in February 2013, the CA account was back to surplus. So we can expect the yen to stabilise in the coming months. Any further devalution can be attributed to speculators expecting to make some quick gain.

If we compare the above chart with the yen real effective exchange rate (left chart compiled from the Bank for International Settlements' data) we can discern two inversely opposed movements. Note that an upward movement on the REER chart denotes an appreciating yen. The contrast may not be exact, at times with lags of 1 or 2 years, but generally the two charts complement one another in their contradiction. So despite what Abe has asserted, the yen exchange rate is outside his control. It was a mere coincidence that his tenure started with a drop in the yen value.

The next question is can Abe engineer a continuing drop in the yen exchange rate and in the process reverse the Japanese deflationary environment? The Bank of Japan is committed to "printing" $1.43 trillion worth of yen. A comparison has been made to the situation that prevailed in 1920s Japan when Japan was under the spectre of severe deflation. A new government assumed office in 1931 and Korekiyo Takahashi was installed as the finance minister. He undertook three steps: depreciated the yen by 50%, cut the official discount rate by 3%, and increased government spending by 5% of GDP. The spending was financed through money printing. The economy recovered but Takahashi was assasinated in 1936 when he tried to rein in military spending because like what Roosevelt went through, both governments had limits on deficit spending. Only WWII saved both governments from hurtling back into depression.

To find out whether a similar prescription would be successful in the current crisis, we will revert to our usual patterns for guidance. We will rely on the 4C framework as well as the economic trilemma in which a country's leader can choose only two options out of three, to wit, a fixed exchange rate, an open capital market and an independent monetary policy. Takahashi chose the first and the last. He imposed capital controls on currency movements. Shinzo Abe and Haruhiko Kuroda, the new BOJ governor, have not chosen any two. They will probably stick with the status quo, thus ensuring that their fate will be at the beck and call of economics.

As for the 4C, the two critical components are capacity and consumption. In respect of capacity, the whole world is suffering from severe excess. But for consumption, it's a case of too little. The chart below from dalmady.blogspot.com shows that in the 1930s, Japan was still experiencing growing consumption from a burgeoning population. But its population peaked in 2005 and has been both declining and growing older ever since. This chronic excess capacity and low consumption means that Japan, and soon many others, cannot avoid the deflation trap. Unlike other variables, you can't reverse population trend on a dime; even now you can predict what'll unfold 50 years hence.

We also can make an educated guess on the impact of Abe's massive spending and money printing. Abe's massive spending, not money printing, mind you, will create money which will circulate in the economy. As Japan has massive capacity, most of the money will most likely go to the local winners of the economic game (remember our Monopoly board game). They will surely not consume the money but invest it in real estate or foreign bonds — though it is arguable whether this is possible when other countries are reducing their CA deficits. The same scenario is unfolding in the US. What Japan will end up with is a real estate bubble or a massive holding of foreign bonds. Inflation if any will be very low. This wealth will be wiped out once the bubble bursts which it will because the assets will not generate any income when wealth remains stuck with the winners.

As for deregulation, the third leg of Abe's planned reform, it'll make wealth accumulation more lop-sided. In deflation, you don't need the economy to be more efficient through free trade and deregulation. Instead you must make it more inefficient, the purpose being to give the losers more opportunity of earning income. It sounds ridiculous but if you take a leaf out of ecology, you'll find that only with isolated niches can species proliferate (see Worry not global warming but fear globalisation).

The only way for Abe to generate high inflation is if the country's capacity is wrecked so that more money through massive deficit spending is not matched by increased goods output, as experienced by Zimbabwe under Robert Mugabe. The yen exchange rate will plunge and nobody would want to touch the yen. But on the positive side, Japan's humongous debt which in 2012 was 233% of GDP will be wiped out. Japan can then rebuild its economy based on the new technology of the Fifth Kondratieff Wave. This is only wishful thinking because absent a major destructive war, such a scenario is unlikely to happen.

More than just prognosticating on the future of Japan, what I'm trying to illustrate with this post is the power of using pattern recognition rather than shallow analytical thinking which is characteristic of the assumptions used in many economic models. I've read through many articles of brilliant economists on Abenomics and they all came to the same conclusion, that is, the yen would significantly depreciate and Japan's economy would thrive. What damage have the mathematical models done to their brains? To prove that mathematics matters little in developing ideas, you should read this interesting Wall Street Journal op-ed piece by E.O. Wilson, the famous biologist.