The potent mix of narcissism and nihilism

We've seen how recessions can be categorised as epidemic or pandemic. But those experiencing recessions have to undergo several emotional stages that will tax their resolves to the limit. This is true at the individual as well as at the macro level.

Such stages are similar for those being depressed at the loss of their livelihoods as those facing terminal illnesses. The stages have been well documented in the form of the grief model by Dr. Elisabeth Kubler-Ross in 1969, in her book On Death and Dying.

The model shown here essentially contains five stages though this chart - taken from Booz & Co's Strategy & Business website - shows eight. The five key stages are: denial, anger, bargaining, depression and acceptance.

As I've argued earlier, this recession is a pandemic recession or more correctly, a Grand Depression, much worse than the Great Depression of the 1930s. Most people still are convinced that the worst is now over. This is not surprising since they are mostly still at the denial stage. If you look at the chart, moving from the denial to the next stage, anger, is very difficult. The emotional response climbs from a low steady state to an agitated level. It's certainly a big hurdle to pass.

This refusal to face reality prolongs the recession. In fact, if we look back to the Dow Jones Industrial Average (DJIA) during the depression years 1929-1933 (see chart below from Bloomberg), we can notice that there are several rallies, seven as counted by some commentators, on its way to the bottom. The pattern is also obvious, everytime it went down, it tried to move up but every upward movement had less momentum than the preceding one. But one thing is clear, each year it closed lower than the bottom of the previous year. At its peak on September 3 1929, the DJIA topped out at 381.17. Within three years, it slumped to 41.22, just over 10% of its peak closing.

In the spring of 1931, they were also talking about green shoots. But these shoots wilted when the Austrian bank, Creditanstalt, then the largest bank in Central and Eastern Europe, collapsed in May 1931. Creditanstalt was not a run-of-the mill bank; it was controlled by the Rothschilds. The collapse triggered a global meltdown. Before that, it was thought the economic crisis was confined only to the US.

Likewise, today the widely held view is that the crisis is caused by the US subprime loans. That's just the early symptom; the real crisis is global excess capacity. No country will be spared. It's a matter of when. Its severity will be certainly very grim.

This crisis will over time disconnect the leaders of many countries from the led, each with diametrically opposing views of themselves and on the future economic outlook. The leaders and policymakers are imbued with narcissism, smug and confident that they have the means to end the recession. In the Kubler-Ross diagram, they are at the denial state.

If they manage to hang on to office, in due course they will cross the anger state. At this point, their politics of consensus and inclusion gives way to one of polarisation. Fortunately, during the last wave, the anger could be directed to the war in Europe. Now the US is too powerful for any nation-state to pick a fight. The anger has to be dealt with internally. The next two stages, depression and acceptance, are beyond the reach of the leaders because they would have been booted out at the anger stage. We would be witnessing frequent changes of leadership as voters become more dismissive of their leaders.

The man in the street buffeted by prolonged unemployment and weighed down by heavy debts, can no longer be reasoned to. He has reached the point of nihilism, a result of their anger, rejecting everything just for rejection's sake. President Obama will have tremendous obstacles pushing new initiatives, be they healthcare or defence buildup in Afghanistan. The odds are stacked against him succeeding.

With no recovery in sight, the mood of the unemployed will grow angry and, for those that have progressed to the advanced state, depressive. Anger fuels increased crime and violence. The depressed may succumb to suicide. The internal breakdown of the American society will be on a much larger scale than that wrought on Iraq and Afghanistan. The government needs to provide support for volunteering and self-help work that provide outlets for the unemployed to occupy their time and utilise their energy. This encourages their move to the acceptance stage.

Everyone must accept the reality that in an environment of excess capacity, there are simply no more new jobs. Only then can we move quickly to the acceptance stage. But we know that this is not going to be; instead, anger and depression - the state of both the mind and the economy - will be the order of the day.

The plague of recession

While leaders and policymakers have been trumpeting the end of the recession, are we really on the cusp of recovery? Knowing at which stage of the recession we are in is critical because we are dealing with millions of livelihoods throughout the world. A wrong judgment may mean the difference between getting on with or giving up on lives.

Recessions have much in common with plagues. Both create uncertainty and fear; uncertainty of being hit and fear of the severity of the affliction. A lot has been written on the history of plagues. But the one highly regarded is by the eminent historian, William H. McNeill.

Plagues can be categorised into several phases: epidemic, pandemic and endemic (note that by the time a disease is endemic, it's no longer a plague). To begin with, an explanation of the terms is helpful.

Epidemic, formed from two Greek root words, epi and demos meaning above and people, refers to an outbreak of a disease that spreads quickly to a large group of people within a specific location and within a specific time frame. Pandemic - pan for all - on the other hand, is far more virulent as the disease disperses over a very wide area, which now is synonymous with a global diffusion, and thus affects many, many more people.

Endemic - en for in - is the stage where the disease and host have adapted to one another. The disease, now less virulent, is commonly found among the people and aside from causing discomfort, is no longer fatal to the host. They have evolved towards a stable pattern of co-existence.

To better understand the cause of the present economic crisis, we have to undertake a forensic pathology on economic recessions in recent times. But first, a lesson in economic recession. An economic recession can be of two varieties: an inflationary one caused by a rapid increase in money supply unmatched by a corresponding increase in goods production, and a deflationary one caused by surplus goods production in an environment of rapid money contraction.

How can money appear and disappear in vast amount in so short a time? For this, we have to thank two modern innovations: credit banking, the major player, and the printing press which plays a supporting role. In our modern economy, credit represents more than 90 percent of the money in circulation with paper making up the balance. So it's very easy to inflate or deflate the money supply. Our familiar paper money doesn't suffer that much from this disappearing illusion, only the virtual money.

The other leg of the equation, goods production, has been playing an increasing role since the start of the Industrial Revolution. Actually, the technology waves triggered by the Industrial Revolution have unleashed the energy stored over millions of years in the form of coal and oil fossil fuel. This translates into a massive leap in goods production. Helping to wipe up these additional goods are the innovations in transportation and communication that move goods cheaply or make comparisons about prices widely available.

Generally such advances are synonymous with capitalism since they require substantial capital. More savings are channeled into investment capital further raising goods production. Eventually too much of a good thing turns harmful. Production exceeds consumption generating negative returns on the invested capital. In time the capital will be written off. This is the scenario of a deflationary recession.

What about inflationary recession? This occurs at the early phase of a technology wave. Demand is growing but production lags behind. The banks lend more to meet the need for more money to buy goods but production still can't catch up. More money translates into higher prices. Solving this is easy; you raise the price of money, that is the interest rate. Money supply reduces and things return to normal. Over time production rises to meet the increasing demand. The recession happens when the money supply is crimped. Jobs are lost as businesses retrench.

Of the two, deflationary is the more malign because reducing supply is much harder than increasing it. Businesses will continue running at a loss until many go bust. Recovery takes a long time.

To demonstrate that inflation prevails during the run-up to the crest of the technology wave while deflation as the wave matures, the US inflation for the years 1914 to 2007 taken from the Wikipedia site, shown below, would be instructive. The third wave ended around 1950 after cresting in 1920 (The story of the whole five waves will appear in a future post). You can observe that from the 1920s to the 1930s, the period was wrapped in deflation. In the 1940s, it would have been deflation had not the Second World War diverted the production capacity to arms production. Indeed traces of deflation still reared its ugly head at the end of the war.

After the war, the need for housing to house the American families in the suburbs fueled the demand growth. Highway construction was carried out on a grand scale and automobile sales correspondingly rose. A baby boom in the 1950s to the 1960s rounded off the demand growth story.

After 1950, the upsurge in demand raced ahead of supply until it reached the turning point in 1990. My future post will describe why inflation nowadays can only become an epidemic and a tempered one at that but deflation can transcend from epidemic to pandemic and eventually becomes endemic. Like its disease counterpart, the epidemic spreads from countries to countries while the pandemic comes in waves.

A yen for wisdom

An expert may have all the knowledge on any subject at his fingertips yet he may not have the wisdom. As a guide to tell a wise person and an expert apart, I've chosen an article, Japan's control on the yen, which appeared in the Think Asian column of the Malaysian newspaper, The Star on August 29, 2009. The author is Andrew Sheng, Adjunct Professor at the University of Malaya and Tsinghua University as well as a Director of Khazanah Nasional Berhad. He also sits on various prominent high-powered councils and boards. He sure is a heavyweight on his subject but his article is full of irrelevant arguments, or the proverbial trees instead of the insightful forest.

Let me summarise the pertinent points in his article. The article discusses why the Japanese yen fails to become a reserve currency. Several arguments, the trees, are advanced to support that contention. Among them are its volatility (unstable value), the low yield on yen denominated financial and real assets, and, lastly, the rise of the euro which adds another competing alternative to the yen.

Now, let's rise above the trees to see the forest. One point is enough to puncture holes in all of Mr. Sheng's arguments. For a currency to be a reserve currency, the currency's country must have a tremendous amount of current account deficits, i.e., it must be a global debtor, not just a debtor like most sub-Saharan countries. Only one country qualifies and it is the United States of America.

That is the crux of my argument. The detailed bits follow.

Of course, not every country can be a global debtor. For it to be a global debtor, it must be credible, not only economically but also militarily. In other words, it must earn its stripes. It is not an easy process because a country has to go through the mill. It must first be a creditor country, accumulating current account surpluses over the years. In fact, only in the 1980s did the US become a debtor nation. Thenceforth, its foreign debts could only move one way, that is upwards.

Since Japan is not a debtor country, there's not enough yen floating around for it to be adopted as a reserve currency. You may argue you can easily buy yen. True but for you to hold yen, you must give the Japanese something in exchange. The Japanese don't want your Malaysian ringgit or any other exotic currencies because they are not tradeable outside the countries' borders. They prefer the US dollar. Same goes for the EU. The more yen or euro you want to keep, the more US dollars the Japanese and Europeans must hold in return.

As for the volatility of the Japanese yen, it's not Japan's fault. Since many countries trade mostly with the US, they stabilise their currencies' exchange rates only with respect to the US dollar. Should there be a major fluctuation of these currencies vis-a-vis the US dollar, it's primarily due to a drop or a rise in their economic competitiveness relative to other countries exporting to the US. For example, the 1997 Asian financial crisis was precipitated by the rise of China which made all other East Asian countries non-competitive. Only when they devalued their currencies could they recover. George Soros wasn't the cause nor were capital controls a remedy.

The US does not have the luxury of setting its own exchange rate. It has to take whatever exchange rates set by the monetary authorities of other countries. When the Japanese ran huge trade surpluses with US in the early 1980s, the US had to bear on the Japanese through the 1985 Plaza Accord to get them to appreciate the yen vis-a-vis the US dollar. The yen doubled its value within three years. Gradually, the Japanese became non-competitive. Whatever it can produce, the Koreans and, eventually, the Chinese also can at much lower costs because of their cheaper currencies. With a population that's both declining and ageing faster than those of its competitors, Japan will be an economic basket case.

Since other countries do not target a specific exchange rate vis-a-vis the yen, the yen is bound to fluctuate (or more likely, appreciate) relative to their currencies. There is no benefit at all in borrowing money in yen even if no interest is charged; the borrowers will be hit by the increasing exchange rate.

The low yield on the Japanese assets are also beyond their control. Japan's economy has been in the rut ever since their bubaru keizai (bubble economy) burst in 1991. They tried various measures including zero interest rate policy but to no avail. Till today, policymakers can't figure out why Japan remains mired in a gloomy mindset for such a long time. Even when they had economic growth, the outlook wasn't cheerful. Actually, this phenomenon is a pernicious effect of globalisation. Similar situations can be found in resource rich countries, such as the major oil exporting countries. As it requires a lengthy explanation, I'll elaborate on this in a future post.

Finally, can the euro displace the yen? Actually, such a notion is implausible because neither can be reserve currencies. The euro's claim to reserve currency status is as much tied to Germany's current surplus as the yen is to Japan's. However both are only claims, not real entitlements. Neither has been a superpower and ever won't they be.

These arguments countering Mr. Sheng's assertions are intended to demonstrate how an eminent expert can suffer from blind spots. Being wise is not difficult; you need to build patterns in your thinking. Patterns include enduring laws which are simple yet escape the attention of experts. For example, one highly pertinent law is that the interest rate for a country cannot exceed its economic growth rate. Applying this to the Japanese case, we can naturally deduce that returns on yen denominated assets would be very low since Japan has been in recessionary mode for the past twenty years despite having intermittent growth. So to advise Japan to increase the yield on the yen denominated assets is indeed silly.

An expert may know all the tools of the trade but to know what tool to use and where to use it require wisdom.

Free-falling into the Grand Depression (1)

"We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand." No, this is not a case of an incompetent flight crew fumbling with the flight controls. It is what John Maynard Keynes wrote in his essay titled "The Great Slump of 1930" published in December of the same year. His observation refers more to economists bungling with the fiscal and monetary controls of the economy.

As plane crashes have sometimes been caused by pilots' errors in the handling of their aircraft in emergencies, economic crises are similarly worsened by economists' faults in their diagnoses of the crises and prescriptions for the recovery.

The failings of the economists can be understood using the recent fatal plane crashes as analogies in unearthing relevant patterns. Both crashes had no survivors; all perished. The first involves a Continental Airlines flight 3407 that went down in Buffalo, New York on February 12, 2009. The second is Air France flight 447 that dived into the Atlantic on May 31, 2009.

In this post we will deal with with the Continental Airlines plane. The aircraft was a new Bombardier Dash 8-Q400. The crash was solely due to the pilot's incompetency. Both the pilot and co-pilot were suffering from sleep-deprived fatigue. To make matters worse, on the landing approach, they were engaged in nonessential conversation, something not allowed under the aviation rules. As a result, they didn't notice that the air speed had dropped exposing the aircraft to a dangerous stall. The control yoke (analogous to the car steering wheel) was shaking, pointing to a stall. The plane's automatic system tried to push the nose down in order to gain air speed and prevent stall. However, probably in panic, the pilot pulled back the control yoke in order to bring the nose back up. But his action worsened the stall, thus dooming the lives of 49 onboard and 1 on the ground.

Many lessons for the current economic crisis can be gleaned from the accident. The crisis was precipitated by the loose monetary policy which was evident from the phenomenal credit growth. The central bankers however were focused on the inflation rate indicator rather than the credit growth indicator to guide their actions. The inflation indicator was not moving because of the excess supply capacity created by the entry of China onto the global economic stage. The boom in commodity and asset (real property) prices didn't translate into high consumer prices except at a very late stage.

The commercial banks' books were also clean as they had been using off balance sheet vehicles to hide the loan growth. Securitisation of the loans was another method that shielded the loans from being reported. The loans appeared on the books of foreign banks and non-bank players: portfolio managers, pension funds, and insurance companies. Like the doomed Continental Airlines plane, the critical indicator was vibrating but the central bankers chose to ignore it, fixing their eyes on the wrong ones instead.

Another useful lesson is the wrong remedy prescribed to cure the ills brought about by the crisis. Just because the plane was stalling shouldn't mean that the pilot must point the nose upwards. The right move would have been to point it lower in order to gain speed and get out of the stall. Similarly, because the crisis was caused by too much money, some economists are recommending cutting spending and constricting money supply. The sure outcome will be an economy in a death spiral, politically bringing down with it a crumbling nation-state. Don't worry about inflation. The money supply is not even stalling, it's collapsing. At this critical juncture, you need plenty of money. Don't even think of inflation; deflation is the killer.

Regardless, printing money and massive government spending provide only a temporary respite. This depression is a foregone conclusion; there's no way out. We have to endure it before the game changer of the next technology wave allows the economy to recover slightly.

Finally, the most important lesson is the incomplete training of most economists. To be really competent, a professional must go through the rigours of crises. Pilots experience them in simulator rides. They have to because hundreds of lives depend on one pilot. In fact, the pilot of the ill-fated Continental Airlines plane was actually not qualified to fly because he had failed 3 simulator tests, known as check rides.

Economists, on the other hand, do not have the luxury of going through the stress tests. Yet they are responsible for the lives of millions of people. Indeed, we are in the midst of being led by those who have, in the words of Keynes, blundered in the control of a delicate machine. The coming economic crash may yet turn out to be very nasty.

Part 2: The Crash of Air France

Worry not global warming but fear globalisation

Globalisation and global warming have little in common. Or so you might think. Ecologists are as varied in their opinions as economists are among themselves. For example, global warming has been such a controversial issue even among ecologists so much so that we don't know whether the earth is warming up or is going into an Ice Age. Ecologists sit on both sides of the political fence and so their beliefs depend on their political inclinations. Same goes for the economists.

To be sure, global warming has no relevance to economics while globalisation has been much touted by economists of all stripes as a driver of economic growth. Can we learn anything about globalisation from patterns in the field of ecology? Definitely, but we must go back to 250 million years ago towards the end of the Permian period when all major areas of the continental crust coalesced into a single land mass called Pangea, meaning 'all land' in Greek.

The biggest extinction in earth's history occurred during this time. What caused 95 percent of the species to go extinct? As usual, we are wont to ascribe a single cause to any problem. But in life, most dramatic and drastic occurrences are a result of a confluence of factors. The Permian massive upheavals were more likely caused by a multitude of causes. In this case, they all can be boiled down to two: global warming and globalisation. Hence the juxtaposition of both in this post.

Global warming arose during the late Permian because of two geologic activities which took place over thousands of years. The first happened when coal bearing deposits in southern Pangea were uplifted to the surface. The other arose in the Siberian Traps region where volcanic eruption of CO2 and methane released massive quantity of greenhouse gases into the atmosphere.

The outcome of these events resulted in the atmospheric CO2 shooting up to 3,000 parts per million (ppm). In contrast, our present CO2 stands at 390 ppm. It will continue to climb until 2200. Thenceforth the level will slowly drop as we will have depleted out the fossil-fuel carbon.

At its projected peak on a business-as-usual basis, the atmospheric CO2 will rise to 1100 ppm. If measures are taken to reduce the emission rate, the level will crest at 550 ppm. The most likely scenario is that the peak will not exceed the lower estimate given mankind's prodigious capacity for innovation. The two engines driving this energy innovation will be biotechnology and nanotechnology.

How much will the sea level rise with the atmospheric CO2 at 550 ppm? National Geographic, September 2004, estimates that at 478 ppm, the sea level will rise by only 4 inches, and that is taking the 1990 sea level as the base. The areas badly affected will only be the submerged South Sea islands. At 550 ppm, most probably, we can expect a sea level rise of only 1 foot.

There certainly will be other severe impacts as glaciers and ice sheets on three critical land areas - mountain regions, Greenland and Antartica - start melting. Most affected are the mountain regions since these glaciers feed major rivers in the Indian sub-continent and China. We can expect serious water issues in the coming decades. But as regards sea level, it won't present an acute problem. For icebergs, their melting doesn't have any impact since floating ice already displaces water of a weight equal to its own.

Within the next 50 years, we can expect new technologies to address the CO2 emissions. We must allow for the passage of time for this to come about. Hastening this process through forced measures, such as limits on carbon emissions will not work and would be a complete waste of time. Likewise, biodiesel, ethanol, carbon sequestration, and hybrid vehicles are only feel-good efforts that siphon money from more beneficial areas.

It is a common human folly to be doom-mongers worrying about non-existent fears. With respect to energy issues, as far back as the 13th century, 500 years before the Industrial Revolution, there had been shortages of wood as fuel for the ironworks. Then they found coal. Similarly, before they struck oil in 1859, they had also worried about coal being depleted. Now they agonised over oil and global warming. What mankind is apprehensive about usually will turn out to be unfounded fears. Instead, what it glosses over are the issues that will pose the most harm to it.

Going back to the Permian extinction, how did the extreme global warming precipitate the process?

Scientific American, October 2006, explains clearly the unfolding of this catastrophe. To begin with, the unleashed CO2 and methane greenhouse warmed both the atmosphere and the oceans. Conditions were arid and vast searing deserts spread across the land. The warm oceans had limited capacity to absorb oxygen because the ocean currents that kept the oceans oxygenated stopped circulating as they got warmer. As a result, bottom dwelling anaerobic bacteria that generated hydrogen sulphide (H2S) thrived. As H2S concentrations built up, they welled up and diffused into the atmosphere. The massive H2S extinguished both lives in the ocean and on land. It also destroyed the ozone layer that shielded life on earth from the UV radiation.

That's only one-half of the story. The other half, on globalisation, is equally interesting. Complementing the single land mass are one vast ocean, the Panthalassa Ocean, and a huge bay, the Tethys Sea. With a conjoined land mass and ocean, it was a free-for-all for the animals and plants. Now they all could roam the entire land or oceans. The shallow offshore water, a rich habitat for life, dwindled as the length of coastlines shrank.

Such conditions initially benefited some but ultimately produced many losers and virtually no winners. The causes can be attributed to the sudden appearance of new species which preyed on the indigenous animals or disrupted their feeding and breeding habitats. But worst of all when species mixed freely is the easy spread of pathogens to species which had not developed suficient immunity to new diseases.

We do not know whether global warming had a greater impact than globalisation in the Permian extinction. But we do know that CO2 ppm in the next 100 to 200 years won't actually reach one sixth of the Permian level of 3,000 ppm. That even without taking into account the coming energy revolution that will make oil a thing that we can live without. Indeed the current economic crisis has reduced the global CO2 emission for 2009 by 2.6 percent.

Given such a scenario, globalisation which has been promoted by almost all economists as a source of economic growth is the real danger unbeknown to its strident advocates. However among economists it is heretical to criticise it because that goes against the teaching of all economics schools. Because of this perverted belief in the benefits of globalisation, many countries have embraced it without realising of its longer-term harmful effects. The harm comes stealthily because initially it beguiles the populace with its temporary economic benefits. The deluded populace embraces it not realising that over time new countries, such as China, adept at manipulating exchange rates, will eat into other countries' lunches.

If we go back to the theory of comparative advantage first promulgated by David Ricardo in 1817, nowhere is it mentioned the applicability of the theory in conditions of surplus capacity. The theory works as long as the demand can consume whatever is being produced. It breaks down when supply exceeds demand as what the world is suffering from now. So now China can produce while the others sit idly by. Certainly, not a recipe for prosperity but for a catastrophe of major proportion. Thus the current crisis which actually is not initiated by the financial meltdown (which happens to be a consequence) but by the surplus supply capacity.