Tuesday, July 22, 2014

Be wary of high GDP growth and the central bank

Once again the looming depression is beginning to rear its ugly head while the world is buoyed by positive news of various economic indicators, such as the global manufacturing PMI, the stock indices and the unemployment rate. Such positive news are at odds with the economic conditions experienced by the common man. Even the Bank for International Settlements in its latest annual report is puzzled by the disconnect between financial markets' buoyancy and the global underlying economic developments.

Some emerging market (EM) countries are still reporting strong GDP growth, exceeding 5% on an annual basis. Economists would approve of such commendable economic performance in the belief that the EM would shore up the global economy. Under normal conditions, that would be the logical thing but during the closing phase of the Kondratieff Wave, the EM is courting disaster. This does not mean that countries should aim for low GDP growth either. It's just that unless countries address the extreme wealth disparity, whatever choice made is irrelevant. The outcome is between later more awful misery and immediate slow death, a choice opted by France.

In the Monopoly board game, when the game is winding down, most of the players have dropped out. You can continue playing provided the winner doesn't bankrupt the losers but accept IOUs from them instead. Before that happens, the bank, which in the real world is represented by the government, would have issued IOUs to the players as the Monopoly money is never enough to last till the end. That's why in the real world, credit, not gold, bitcoin or hard cash, is the real money.

A country's GDP can also be compared to the revenue of a business. When economic conditions have taken a turn for the worse, sales will inevitably stagnate, if not fall. You can only increase sales if you make credit sales to customers with poor credit history. Of course, you'll never see your money but by then you'd have flogged the business to suckers to deal with the receivables mess.

The political leaders of countries that are taking a similar course are tempting fate, only that in this case they themselves will end up being suckers. Towards the end of a Kondratieff Wave, government is the only economic sector that can spend using borrowed money. Government borrowings never decrease in absolute terms; they do so only in relative terms, that is, as a percentage of GDP. So the GDP growth must outpace government debt growth but at the end of the Kondratieff Wave, this possibility is closed given the dwindling economic activity. This means that the government must double down its spending just to keep the economy on an even keel. Like in the Monopoly game, the bank, even if it pays $1,000 to the losers upon passing Go, may find it not enough to keep the game going because every time the losers traverse round the board, the punishing rents will suck more than what they earn from the bank .

A snapshot of a country's finances and its revenue can be seen from the movements in its debt and GDP. The chart at left shows that after the 2009 recession, the US economic growth outpaced the debt growth but that ended in late 2012. Since then, it's been the reverse and the further ahead we project into the future, the greater will be the divergence unless Obama plans to set himself up for impeachment. You'd also notice in the chart that the GDP growth for the 1st quarter 2014 is a positive 1.5% using the more meaningful YoY computation instead of the widely reported negative 2.9% annualised QoQ number.

Delving into the GDP components would give us a better picture of the GDP sluggishness. For this, you don't have to rely on the personal consumption expenditures (PCE) despite its 69% contribution to the GDP numbers. It's not only because of the lopsided weight attached to it but also the PCE, which has been growing consistently around 2% YoY since mid 2011, doesn't carry much predictive ability.

Instead, the more critical components of the GDP are investment and government spending. The investment spending reflects business and household confidence in the future prospects of the economy. If business prospects are sanguine, businesses will invest in plants and machinery. Likewise, households will invest their money in homes if they expect their incomes to rise. Still, government spending as explained earlier is the most consequential. Unlike other components, government has the power to create money — by this, I mean deficit spending, not money printing which has confused most economists — but excessive deficit spending has weakened government so much that the edifice of nation-state is beginning to crumble.

Now, the Q1 2014 US economic reality is shown on the GDP chart at left. Residential investment growth YoY has plunged to 2.7% while business investment growth has been sluggish since early 2013 snaking between 2.4% and 3.5%. The slowing investment is in accord with the Monopoly game pattern at the ending when with the losers all gone, it's pointless to put up new buildings. Meanwhile, government spending has been crimped since mid-2010.

Next, look at the credit charts below. The left panel shows the movement in absolute amount while the right panel is the relative YoY growth. You'll notice only two debt components that are still growing, to wit, government and non-financial businesses. Though the growth rate for government debt is on the decline, it's still higher than the GDP growth rate.



How do you reconcile government spending in the GDP which is decreasing and the government debt which is still growing? It simply means that even though government has been cutting spending, its revenue is still insufficient to cover the reduced spending. The more pertinent question is what is really driving GDP growth: the household PCE spending or the government debt that fuelled that spending. The GDP chart wouldn't give the credit to the government but the debt chart would.

When the game is drawing to a close, spending falls as most players fall by the wayside. The issue is not failing to generate economic output but a failure to consume goods or services produced by the winner because of the losers' falling incomes. The only income that the losers can earn is the $200 salary paid by the bank upon passing Go. Similarly, in real life, the government is the final mainstay of income support to the losers. The fall in residential investment growth is related to the slowing growth in government deficits. The only way for the losers to maintain their PCE is by slashing their home investments. So it's not the losing households' PCE but the government deficits that ultimately drive GDP growth. The deficits fund the households who in turn prop the PCE.

With this, we can also clear the confusion surrounding the central banks' quantitative easing (QE). The Monopoly game has only one banker but our modern day bureaucracy has grown unwieldy in that the same role is taken up by two agencies: the Treasury and the Fed, both equally ignorant of money creation. Only the Treasury can create money through deficit spending. The Fed's role should've been restricted to regulating the financial institutions to ensure that they don't lend more than they can absorb in losses.

When the Fed is tasked to conduct the nation's monetary policy, a task which it is incapable of fulfilling, it rises to the level of its utmost incompetence. Picture its role in the Monopoly game. At the end stage of the game, there'll be a lot of IOUs owed by the bank (in the real world, bonds issued by the Treasury) to the winner. Enter the Fed. It swaps the Treasury IOUs (bonds) with its own IOUs (deposits placed with it). The winner still owns the same amount of IOUs. It makes no difference to the winner who the counter party to the IOUs is.

How has the Fed managed to convey the impression that its QE did stimulate the economy? The claim is nothing more than an illusion. Coinciding with the Fed's QE, the US government continued its deficit spending, that is, it kept throwing IOUs into the game, so to speak. So in the Monopoly game, it's like the bank continuing to pay the $200 to the players to enable continued play. The Fed's bluff should have been called with the slowing growth in government deficits but the non-financial businesses have thrown the spanner in the works when they started ramping up their borrowings. Where the money from their borrowings has gone to will be addressed in the next post.

A case frequently cited for supporting the Fed intervention is that it'll lead to a reduction in interest rates. This is a delusion that needs to be disabused of. The Fed has set the Fed Funds Rate to almost zero since December 2008. Now, look at the yield at left of 10-year T-bonds. If the Fed Funds Rate had a bearing on the interest rates of other financial instruments, then the T-bond yields wouldn't have fluctuated within the 1.5% to 4% band. Effectively the Fed has no say in the determination of interest rates.

It's the market that decides the prices of money, that is, the interest rates. The prices reflect the market expectations of inflation or deflation. Low prices signal low inflation or, possibly, deflation which arises when most consumers are suffering from stagnating incomes, the conditions that prevail at the closing phase of the Kondratieff Wave. Because the Kondratieff Wave is a global phenomenon, you'll find that falling interest rates are predominant throughout the world as depicted in the left chart.

Calls have been made by economic eggheads that the Fed should increase the interest rate so as to encourage investment. The received wisdom is that higher interest will encourage savings and as savings equal investment, higher investment will soon follow. This logic is flawed because it assumes savings will drive investment.

The decision to invest is made when there are opportunities to earn returns that more than compensate the cost of funds. At the end of the Kondratieff, even at zero cost, there are no returns to be had because the market has disappeared with the falling incomes. If investment is infeasible even with funds at zero cost, how can increasing the cost make it viable?

The interest rate decisions of Sweden's central bank since the 2009 recession reveals the futility of trying to control interest rates. Because of the fiscal deficits sustained by many governments following the 2009 recession, there was a temporary spurt in consumer prices. In order to stem the mild inflation, the central bank raised its policy rates but notice that the central bank actions always lagged the consumer price movements. As demand disappeared, consumer prices dipped. As for the central bank, it had to eat crow by retracting its earlier actions. Had it not manipulated the policy rates, the consumer prices would have ended in the same place it is now.

Finally, the last delusion that we need to counter is the argument that China's continuing growth is sustainable because of its current low urbanisation rate (see left chart from The Financial Times). A comparable developing country rate is 60% while that of the developed world is 80%. A 10% increase in China's urbanisation rate would translate into a migration of 130 million people to the cities. Therefore, large scale investment spending is still needed to cater for the mass migration of its rural population to urban areas.

In reality, China is already late to the Kondratieff Wave party. The world can no longer consume more than what China is currently exporting because all over the world the number of losers dropping out of the game are increasing. Following their dwindling incomes, the productive capacity now available far exceeds the consumption ability. What about China's own internal market which exceeds 1 billion people? That's all the more reason to worry because you now have more than 1 billion problems of falling incomes.

By giving in to globalisation and economic liberalisation, mankind has unleashed unseen forces that are too powerful for it to subdue. With those in power remaining oblivious to the dangers, the biggest risk to us is not knowing how the future will turn out.

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