Clutching at the recovery straws

"A specialty of martial arts is to see that which is far away closely and to see that which is nearby from a distance." wrote Miyamoto Musashi in The Book of Five Rings. That statement aptly applies to fields as distant from martial arts as economics and politics. More so now that we are enmeshed in conflicting signals about the global economy so much so we can't make head or tail about which way the economy is heading. The confusion stems from the absence of a guiding pattern as reflected in our anxiety for any indicative news on the economy. There's no way to strategise when your only beacon is the unfolding news.

A typical confusion is exemplified by none other than two well known professors, both having divergent views on how the economy will turn out. In one corner is Niall Ferguson, an economic historian at Harvard whose contention is that the money printing by Bernanke will lead to rampant inflation and consequently high interest rates. In the other is Paul Krugman, an economics professor at Princeton and a Nobel Prize winner to boot. Krugman believes that Obama's deficit will lead to recovery and any rise in interest rates is an indication of funds moving to stocks and investments.

How these two icons of erudition in economics could go wrong is easy to see. They both rely on analytical inquiry; with one or two steps you can plausibly argue out your position. Instead, we should use a different approach, that is, pattern recognition. This approach takes five or more steps in one thinking cycle. For example, using the investment clock as a pattern (see Ticking towards midnight), it's safe to predict that cash will be precious in this depression because of its scarcity. The likelihood of high nominal interest rates is low but because of falling general prices, real rates will be high. We will see major debt write-offs and financial sector deleveraging (loans being called in as banks' capitals get eroded from debt write-offs). Now it appears that cash is aplenty with Bernanke furiously printing money. But don't be so sure that this can continue indefinitely.

We first need to understand the reasons for the temporary growth spurt and why this is just an aberration in a secular downsliding global economy. The refrain about the coming recovery stems from the actions of three men: Bernanke, Obama and Hu Jintao. I will tackle each in turn and debunk their claims to reversing the depression. But first, an overview of the common structural weakness of their actions.

Their failing lies in their inability to perceive the cause of the depression as more than just a liquidity crisis. If it were so, it would have been easily solved by Ben Bernanke's money printing. The fact that it hasn't proves that it's more than merely a liquidity issue.

In my earlier post, I've argued that this depression is actually a capacity crisis (see It's capacity, not liquidity, stupid). Actually, it's more than that; to find out, we need to take a step back. The real reason is the absence of a new growth driver, not only to propel growth but also to creatively destruct the present growth engine. The alternative is annihilative destruction as exemplified by Hitler's WW2 legacies in Europe. The mind can't even contemplate such a nightmare scenario.

The term 'creative destruction' was coined by Joseph Schumpeter of the Austrian school of economics. This school has been disdained by mainstream economists because of the Austrian school's eschewal of mathematical models. The Austrian school has a valid reason since human behaviours are too complex to avail themselves to modelling.

The purpose of creative destruction is to keep the wealth moving from those who have succeeded under the present growth paradigm to those who will succeed under the new growth paradigm. Without this changeover, whatever deficits and money printed will benefit only those who prosper under the existing growth paradigm. Within the context of the global economy, the higher the budget deficits of the US government, the more will be the US current account deficits as China and the oil exporting countries siphon off the surpluses. And for any national economy, the sizes and debts of almost all governments keep burgeoning to meet the demands of their populace until they collapse under their own and their debts' weights. Take Japan, while its public debt has exceeded 200 percent of GDP (second only to Zimbabwe), its household financial assets amount to US$16 trillion (second only to the US).

Ancient societies had ways of dealing with this imbalance through debt cancellation in times of crisis and famine. Our inability to recognise this unsustainable imbalance condemns us to tackling the symptoms while the real problem remains misunderstood. It seems despite our technological advances, we are way behind the ancients in the understanding of social and economic issues.

A similar ineptitude afflicts our three key decision makers. I have written an earlier post on Bernanke (see Bernanke vs The Market), so what's described here are additional comments on his perverted beliefs. Ben Bernanke has earned the nickname Helicopter Ben for his remark that he would drop dollar notes from a helicopter in order to keep the economy going. If only it were that easy. Ben is in need more of a helicopter view to overcome his myopic sight than a helicopter ride. Actually, he has to call upon Obama and Congress to drop money because only they can authorise the spending budget. What Bernanke or the Fed can do is to swap the printed money with existing debts, not willy nilly throwing away money.

Most of his swaps (or purchases, to be exact) comprise treasury bills and mortgage backed securities (MBS). There are limits to both. In the case of T-bills, his holding has exceeded US$700 billion. Any further increase depends on the US government getting deeper into deficits or the holders of existing T-bills continue selling to the Fed. The first is getting tougher as Obama has come under increasing pressure to balance the US government budget. The latter option can only be made at increasing prices as supply of T-bills gets scarcer with greater Fed purchases.

As for the MBS, for which the Fed now holds more than US$800 billion, more purchases of it exposes the Fed to higher risks as following the law of diminishing returns, incremental debts tend to carry greater risks of default, more so in times of deflating prices.

Bernanke's artificial suppressing of interest rates through his flooding of liquidity is not helping the economy either. The sloshing liquidity is sending wrong signals, such as higher commodity prices. Commodity producers are encouraged to increase capacity at a time when the commodity prices are going to collapse as they eventually will when their supplies overwhelm the shrinking demand. The only time when the money floodgate should be opened is during a panic and that moment passed in March 2009. Now is the time to allow the liquidity to gradually decline.

The next decision maker, Pres. Barack Obama is facing many critical issues: economic depression, unemployment, health care, global warming, Afghan and Iraq; all of which offer no easy solutions. To tackle them he must first acknowledge that the US is no longer a hegemon especially when the survival of the nation-state itself is precarious. His priority is to the American voters. He can thus safely ignore global warming, Afghan and Iraq.

Global warming, even if it really is caused by carbon emissions, cannot be solved by government edicts and regulations. Only technology can address it. Furthermore, in a severe depression, it will eventually be relegated to the back burner. Iraq is a goner when oil prices crash. The reason the Iraq surge succeeded was because it was accompanied by cash bribes to the Sunni tribal chiefs who then rallied the Sunni tribes against Al-Qaeda. This lesson has been lost on the American generals who still believe that it was the surge alone that turned the tide. American intelligence in preventing attacks in its homeland has improved tremendously that the US doesn't need to be present in Afghanistan. It should allow Taliban to rule Afghanistan and use the threat of the missiles to get them to put on their best behaviour. Israel's experience with Hamas after Hamas's rule of Gaza is instructive. For invisible enemies, the key is to make them visible so that they can be contained.

Health care, the last pocket of inefficiencies in the private sector, is a secondary issue in a downturn. The way health care is administered now, with practitioners operating autonomously within a hospital, engenders perverse incentives and is predatory on the consumers. The US should look into certain revolutionary health care practices, especially in India where salaried doctors using factory line style procedures focusing on volumes, have improved quality and lowered costs.

The economic depression is a given as the moment Obama reduces the US deficits, if not balances its budget, the global economy will keel over once again. That leaves unemployment as the critical issue that Obama should redirect his attention to. To solve this, he must first institute trade barriers and capital controls. It's no point incurring massive deficits if the money eventually flows out. Of course, these measures are economically inefficient.

But look at the factory floor, you can only be very efficient in only one area of your choosing; it's either labour, machine or space. Similarly, if you want cheap quality goods, you must tolerate continual deficits and high unemployment. It's Linear Programming 101: you can only maximise efficiency in only one area, but subject to the constraints or minimum thresholds that you have specified for the others. In the case of the US economy, it's maximising goods production efficiency without regard to any constraints on the level of unemployment nor on the deficits.

Finally, Hu Jintao who is the President of China, a country living on borrowed time. China is probably the last in a series of countries ranging from Japan to the East Asians and South East Asians that have been or about to be humbled by the deflationary plague. The Tibetan and Uighur riots in 2008 and 2009 were just mild foretastes of worse things to come. The riots were easily quelled because they were initiated by minorities. When the turn of the Han Chinese comes, not even the biggest army in the world can subdue it. Even Suharto, politically once the strongest man in Asia had to shamefully step down in 1998 after 30 years of iron rule when the whole region was steeped in economic turmoil.

China survives for the moment because of its US$586 billion stimulus and the US$1.2 trillion in additional bank credits. These packages are being used to increase capacity when it is least needed. Soon abandoned factories and real properties will dot China's landscape. The cost in terms of massive bank failures and lost jobs will be closely followed by a social breakdown of immense proportion.

At least Japan were rich when they were hit by the crisis in 1990 while the East Asians and South East Asians were partially saved by the devaluation in 1998. China may be the world's second biggest economy but its per capita GDP is still low. The devaluation option is no longer available as, given its economic impact, all eyes are watching its actions. As the negative forces of unsustainable debts, falling asset prices, rising unemployment and shrinking exports close in on their quarry, China, we can only watch with trepidation the strangulation of a would-be superpower. How fortunes change ― from greatness to wretchedness, from prosperity to calamity, from mastery to misery, from predator to prey, all it takes is a spin of the economic wheel.

Oiled for turmoil

Oil is getting scarcer but demand is increasing at an alarming rate. Peak oil has already been reached, production will soon decline. Ergo the high oil prices. Certainly a grim narrative for oil consumers. Except that it's untrue. The bleak outlook will instead redound on the oil producers.

Actually, the oil business is turning into a sunset industry. New technologies are discovering new vast reserves faster than can be consumed. As for old and plugged fields, they can now be brought back to production with new recovery techniques squeezing more oil that heretofore remains unrecoverable.

Capitalism leaves in its wake a history of broken constraints. In the case of oil, there are two ways in which oil supply constraints can be smashed. Both involve the use of new technologies. One will enhance the prospect of discovering new fields and recovering more oil from the fields, including those that have been long abandoned. The other, part of the final technology wave, will make oil obsolete and redundant.

On the surface, although oil prices appear as the product of supply and demand, things are not that straight forward. Looking back at the history of oil prices since October 1973, when OPEC started flexing its muscles, oil prices have usually been a product of the interplay between global liquidity and the follies of the oil producers. On the way up and down, they move in tandem, continually reinforcing each other. The wild swings in oil prices are the inevitable outcome of the commodity nature of oil. It doesn't take much to tip the scales in favour of either the consumers or producers; the marginal price sets the price for the entire market since the market is not segmented. Worse, both supply and demand are not that elastic over the short term.

In the immediate term, even without factoring the new technologies, the outlook for oil prices is downward. Because bringing new oil fields to production takes time, anywhere from 7 to 10 years, these fields, the planning of which began in 2003 when oil prices inched upwards, will start producing by 2010. Foreign Affairs Nov/Dec 2009, disclosed that Saudi's production capacity would rise from 9.5 million barrels a day in 2002 to 12.5 mbd in 2010, with an extra 1.0 mbd on standby. By then, total OPEC production capacity will grow to 37 mbd, giving a spare capacity of 6 to 7 mbd over current production level. All this is happening in the face of a massive global economic slowdown.

Twice in the past, as narrated by Foreign Affairs Mar/Apr 2002, Saudi used its spare capacity to discipline wayward oil rivals. In 1985/86, Saudi intentionally engineered a price war to regain its market share from interlopers. More than ten years later, in 1998, again it purposely added another 1.0 mbd to its production to punish Venezuela for displacing it as the prime supplier to the US. But the authors of that piece ignored the events leading to the two price collapses that had taken place a few years earlier. The chart shown here from The Economist is enlightening.

Prior to the Arab Israeli War in 1973, the oil spare capacity had been on a secular fall while production - and, by inference, consumption - had been rising, Surely, such opposing trends would have signalled a price increase in the near future. On the other side of the globe, another war had been draining the US of substantial funds that by August 1971, Nixon had to de-peg the US dollar from the gold standard. Free from its leash, the total debt level (money supply) in the US leaped. The 1973-74 oil shock, wrongly attributed by many to the Arab oil embargo, wouldn't have been a shock had the policymakers been aware of the rapidly declining spare capacity as well as the depreciating value of the US dollars. The sudden jump in oil prices from US$3 a barrel to US$12 was an otherwise predictable event. In the 1967 Arab Israeli War, the Arab countries also imposed an embargo but it came to nought. Why? Because spare capacity was still high; even the US then was a net oil exporter.

However at US$12-US$14, there was no much incentive to develop new oil fields. Oil spare capacity was still hovering around 5 percent of production. It needed the Iranian revolution and the subsequent Iran-Iraq war to secure a production fall of more than 3 mbd and thus jolted the prices to US$38 a barrel by end 1979. At this new price, consumption dropped through energy efficiency measures but not in an appreciable manner. More momentous was the spike in spare capacity as all producers ramped it up to capitalise on the high prices. Gradually, the prices dropped to US$26 by 1985. Saudi, being the swing producer had to cut production from 10 mbd to less than 4 mbd in order to stabilise prices. Seeing that others were profiting at its expense, it suddenly surged production to 5 mbd in early 1986. Within a year, prices slumped by more than 50 percent, dropping to as low as US$11.

Spare capacity dropped steadily all the way to 1990. Because of the long lead time in the development of crude oil production, spare capacity cannot jump or slump suddenly. Not however actual oil production . When Iraq sparked the first Gulf War by invading Kuwait on 02 Aug 1990, oil prices bounced back to US$38 but this was shortlived as Saudi jacked up production from 5 mbd to 8 mbd to appease the coalition countries which expelled the Iraqis.

The prices moved within a price band of US$15-US$23 from 1991 to 1997. Spare capacity was subdued at 5 percent. This was a period when supply and demand reached a stable accommodation. From now onwards, the oil producing countries no longer maintained spare capacity as a matter of policy. Any increase in spare capacity will be a result of a consumption slowdown. When the financial crisis hit East Asia in 1997-1998, global oil consumption for 1998 stagnated and spare capacity increased. Venezuela increased its shipments to the US to dethrone Saudi as the biggest OPEC supplier but Saudi retaliated by jacking up production by 1 mbd. Prices collapsed to US$9 by end 1998 and early 1999.

The 2000 dotcom boom pushed prices to over US$30 but they fell back to US$16 the following year with the dotcom crash. The spare capacity yo-yoed from 1998 to 2001 because of these economic crises. Beginning 2002, Greenspan and Bush participated in the biggest US credit creation that ended in 2008. Prices peaked at US$143 by June 2008 but dropped to US$34 by winter. Spare capacity was dangerously low. Obama's public stimulus (the biggest in US history), Bernanke's money printing and Chinese easy credit revived the prices to US$80 by late 2009. These not only benefit oil exporters but also countries, such as Australia, Brazil and Indonesia that depend on other extracted commodities including coal. Their economic growth is by no means a reflection of their management of the economy.

As the world approaches 2010, these band-aid measures will start to wear off. And spare capacity for OPEC itself will exceed 10 percent. In 2008-2009, two years in a row oil consumption fell, the first time since 1982-1983. In 2010, it's likely to fall unless the US institute another trillion dollar budget deficit. The outlook for oil certainly looks very gloomy.

Will oil production drop in order to prevent price collapse? Possible but highly unlikely. The producers are caught in a trap of their own doing. Almost all the major exporters have populace that is dangerously dependent on oil largesse through government jobs and spending. This is a fixed cost that cannot be crimped without severely exposing the governments to social instability and political upheaval. As prices drop, they will rev up production to keep revenue steady. Soon, this vicious circle feeds on itself until the country itself succumbs to economic and political collapse. Although oil will be cheap, it's not oil but blood that will be spilled in the streets.

Remember the Eastern European communism collapse and Soviet withdrawal from Afghanistan in 1989, and Russian financial crisis and Suharto's fall from grace in 1998. Their root causes lay in the oil price collapse. Take Indonesia. Like the other South East Asian countries, it suffered from an overvalued currency then but buffeted at the same time by low oil prices and El Nino-induced rice crop failure, the ensuing carnage was total. Even now the rupiah exchange rate tracks the oil price movement.

As an aside to the main topic, certain commentators, some of whom are economists, have attributed the present recession to the high energy costs, specifically those based on oil. Yet more ridiculous are those who blame the expected declining oil production as a leading cause for the recession. These conjectures reflect a flawed reasoning arising from confusing cause with effect.

If you recall the investment clock (see Ticking towards midnight), high commodity prices immediately precede the deflationary crash. Inferring that A causes B just because A precedes B is a flawed reasoning known as post hoc (after this) reasoning. A fitting analogy is a rooster's crow at the break of dawn which in no way causes the sun to appear. Actually high commodity prices is symptomatic of massive credit creation and when this credit is later written off because the borrowers cannot repay, the whole economy collapses.

As for the declining oil production Chicken Littles, they should read Scientific American October 2009. The magazine describes the new technologies that will extract more oil from the fields. Right now, only 35-40 percent of the oil in the average field is recovered; the rest remains unrecovered. New recovery techniques using heat, chemicals and microbes allow us to go after this buried wealth. Moreover, for new fields, only one third of the world's sedimentary basins - geologic formations that may contain oil reserves - have been thoroughly explored using modern technologies.

A recent example in the natural gas reserves is instructive. Hydraulic fracturing, a new technology that injects water and chemicals at high pressure to break shale rocks that trap natural gas, has been attributed to a 35 percent jump in the US gas reserves in two years. A similar thing is happening to oil reserves. The fact is more oil is still untapped and peak oil is rather more of our psychological fear than of physical reality.

Ticking towards midnight

Financial markets throughout the world are effectively tightly woven together as a result of the free cross border movement of capital. Likewise the global economy is closely integrated because of the increasing trend towards free trade.

These are indeed dangerous times for political leaders. Any upheaval in a major financial centre or economy can spread like wildfire to other centres or economies. Since political stability of a country very much depends on the state of its economy, each country must start building its own firewall. This means restricting the free flow of capital and goods. Hoarding US dollars as foreign reserves is not enough.

It's not that the free movement of capital and goods are bad; it's just that there are times when they are appropriate as well as times when they should be abandoned. It all depends on the stage of the investment and economic cycle we are at.

Savvy financial investors are aware of the investment clock which identifies the type of investments appropriate at any moment in the economic cycle. The usual clock depicts business slowdowns as occurring between 3 o'clock and 6 o'clock. However, I prefer the one used by Baring Securities, itself long subsumed by another entity. Its investment clock shown here, appeared in The Economist, Nov 1994. Instead of 3 o'clock, the slowdown in Baring's clock begins in the final sector, numbered 6, i.e., from 10 o'clock to 12 o'clock.

The clock can help us reestablish our bearing, more so in current conditions where the signs are pointing towards a depression yet policymakers still insisting on growth being in the offing.

The clock starts at noon, where the mood is still bearish as the economy exits the previous downturn. The preferred investment at this stage is bonds because interest rate at the end of a recession is high but is trending lower with increasing liquidity. This makes for a rising bond price. A $1,000 bond with 10% coupon that matures in 5 years' time can rise in price to $1,216 if the prevailing interest rate falls to 5% from 10%.

By 4 o'clock, bonds have lost their lustre as not much capital gain can be had by holding on to them. The interest rate will stop falling. As the economy expands, more money enters circulation. Inflation is still low and holding steady since the economy still has spare capacity. Equities go up in prices in tandem with increasing profits from greater sales. Occasionally, the money supply races ahead of economic output and inflation follows but this is easily put right by slamming the brakes on the money supply. However generally the inflation is subdued. These two factors - rising profits and stable monetary value - are what make equities attractive. The good times for equities are between 2 o'clock and 8 o'clock but an orderly retreat should be made from 6 o'clock forward.

As the economy keeps expanding, it will hit constraints in certain sectors, such as commodities and real estate because the supply of these goods takes time to keep up with the increasing demand. The money supply meanwhile keeps on increasing as the production of other economic goods has to be sustained with many more producers entering the fray. But these producers' margins are razor thin because on the cost side, they have to pay more for the commodities while on the revenue side, they have no pricing power with most markets being over supplied with competing products.

The commodity supplies bottleneck are only a temporary setback. Their high prices are a reflection of the surplus money flooding the market. As new mines and fields are discovered and opened, the prices will come down to earth. If not for the surplus liquidity, the economy would have fallen into recession much earlier. The liquidity has deferred the collapse but at the risk of magnifying and prolonging the eventual debacle. The commodities ascendancy starts at 6 o'clock and ends at 10 o'clock. Right now, it has expired.

We are now in cash territory. The investments in equities, real properties and commodities turn sour as their returns become out of sync with their inflated prices. Income from these investments can no longer support the loans used to finance their purchases. Increasing loan write-offs start spooking the banks. Banks stop lending and begin hoarding cash.

Every time a loan is written-off, the money supply shrivels. Loans on the debit side of a bank's balance sheet are matched by deposits on the credit side. But loan write-offs are magnified by the bank's leverage. One dollar of loan write-off hits the bank's capital by that amount but because of the capital asset ratio, the bank has to reduce its loan portfolio by 10 dollars. The impact on the money supply is therefore 10 times.

From 10 o'clock to 12 o'clock, the increasing debt defaults push up the real interest rates in order to account for the high risk. Still, the banks will not lend at any price. Citibank's cash and deposits balance as at 30 September 2009 stood at US$244.4 billion, the largest in its history. Even though the Fed and other central banks are fixing their lending rates at record low levels, the banks refuse to disburse new loans. Only investment banks, such as Goldman Sachs and JP Morgan can still chalk up huge profits as a result not of lending but of trading in stocks, bonds and foreign currencies.

The shrivelling money supply triggers declining general prices. Nominal interest rates may be low but the falling prices make the real rates high. The likelihood of businesses going bust grows. Falling prices and failing businesses feed on each other in a vicious circle.

The Fed's quantitative easing or money printing won't solve the problem as it's not increasing the total money supply. It's just converting an illiquid money (bonds and other debts) into a more liquid one (cash and deposits). This has resulted in the liquid money being used not for lending but for trading in stocks and commodities. So we are now having a short-lived aberrant hike in stock and commodity prices.

To make up for the vanishing money, it's up to Obama to rack up humongous deficits year after year without fail. His recent US$787 billion stimulus has provided a limited GDP growth in the third quarter. But the stimulus will taper off in 2010 and 2011. To sustain this growth, the US needs no less than US$1 trillion budget deficit each year. That unfortunately appears more difficult with each approaching year as the House and Senate look set to admit more Republican congressmen in the midterm elections next year.

The gloomy mood will not only pervade sector 6 of the chart but will continue to sectors 1 and 2. Only in sectors 3, 4 and 5 will the social mood be cheerful again. For the political leaders and policymakers who have been proclaiming that recovery is just around the corner, don't bet on it. They suffer from extreme bouts of amnesia and even if they don't, they won't be around long enough to answer for their careless remarks.

It's capacity, not liquidity, stupid

Economic issues are best left to the economists, right? Wrong. They've got them wrong most of the time. Most economists, including well known pop economist Paul Krugman, can't predict economic events, not even anything remotely approximating the eventual outcome. They can only do so when the event is coming close to hand by which time the outcome is fairly obvious. Even their reasoning on the causation of the event is suspect.

The problem is that they are blinkered from the big picture by their eagerness to fall back on their mathematical formulas to model reality. Unlike the physical sciences which are amenable to formulas, social sciences, which include economics, have to account for human behaviours, cultures and emotions; factors not easily translated into mathematical variables.

The distinguished economic historian, the late Charles P. Kindleberger was dismissive of mathematical models because the models could never incorporate the myriad variables extant in the real world. Aside from the human quirks, we have to contend with war, politics, demographics and technologies, just to name a few. Yet Kindleberger had good predictive ability. Those of his breed are first and foremost economic historians. Historians look for patterns, not fancy formulas. Like war generals, they think subjectively. If war can be boiled down to formulas, everybody can be a general but war would have been unnecessary because the outcome can be deduced from the formulas before the first shot is fired. Good historians, like good generals, must have a keen sense of observation in order to root out the relevant from the irrelevant.

The present Grand Depression is the latest example of how brilliant economists are getting it wrong on the real cause of the crisis. It's not at all surprising since economists are schooled in the art of the monetary flow and not in the field of technologies. So the first conclusion that they have agreed on is that the crisis has been brought about by the abundant liquidity splurging in the monetary system. I have no argument with this except that abundant liquidity is merely a second order cause.

The real mastermind culprit is still out there on the loose; what they have caught is just his accomplice. Several narratives blaming the overflowing liquidity as the cause of the recession (most economists mistakenly regard this crisis as just a worse-off recession) have been or are about to written. This is a grave mistake, one that will later cast serious doubts on the credibility of its many authors.

The publication on the Great Depression of the 1930s authored by Milton Friedman and Anna Schwartz titled, A Monetary History of the United States, 1867-1960, equally blamed the lack of liquidity for the depression. Big mistake. Poor Ben Bernanke, in a speech in 2002 honouring Friedman's 90th birthday, he apologised on behalf of the Fed for its monetary policy error in the 1930s. He shouldn't have to; instead, he should have ticked off Friedman and Schwartz for misleading policymakers for almost 40 years and still continuing to do so.

Let's get back to nailing our main culprit. If we look at the chart of global economic growth (see below) from 1600 to 2003, we can see that beginning 1820, the per capita GDP started breaking away from the static zero growth line that had characterised the global economy since AD 1, that is, the time of the Roman Empire.


The shift in the global per capita growth coincides with the start of the Industrial Revolution. It also marks the beginning of a volatile era typified by periodic boom and bust cycles. The main cause is the lagged effect of mobilising and demobilising of production resources. In the early part of the cycle, demand races ahead of supply because it takes time to set up plants or mines. Prices rise but gradually as supply catches up, everything stabilises. After some time, as production resources multiply, supply capacity outstrips demand.

To make matters worse, the production resources cannot be easily decommissioned since much capital has been invested in them. Prices start falling. To sustain demand in order to absorb the excess supply, policymakers increase the money supply by easing on the credit. Most of this money however goes towards speculating on assets, such as houses, and commodities, such as oil. Eventually, the whole charade can no longer be prolonged and gives way. Prices collapse ensues and businesses with high gearing, particularly banks begin falling like dominoes.

From the narrative, it is obvious that the liquidity surge kicks in later in order to pick up the demand slack. Policymakers are inclined towards easing liquidity since that's what society demands of them. Otherwise they'll be criticised for constraining growth.

The real culprit triggering the meltdown is actually surplus production capacity. Technological advances create the conditions for supply to increase tremendously yet using lesser number of people. It's not strange that the US jobless are fast becoming the hard-core unemployed. They have no chance of getting a job, ever. Once you globalise, the wages have to converge. For the American workers, it means they have to let their wages match those of the Chinese. This is very unlikely.

Also, in the past three technology cycles, the demographics were favourable to absorb the increased supply. However, the demographics, the growth of which closely tracks the per capita GDP line above, are reaching the end of its S-curve. The world's maximum population is expected to peak at 9 billion by 2050. Moreover, the last time around, we had Hitler, who despite his many evil deeds, managed to slip in one good deed of a massive destruction of the production resources of Western Europe which set the stage for their major rebuilding.

Therefore despite protestations to the contrary by leaders and policymakers, the current crisis is indeed a Grand Depression, the likes of which we have not undergone and probably the future generations will never experience. Its shape is neither V nor W but more of a staircase going all the way downhill.

The economic and political evolution of the Roman Republic

To some, history may be a dull subject. But if you approach it with the objective of uncovering patterns, it offers the most fascinating of lessons. Particularly if it is about the Roman history because written historical records and physical artefacts abound for many writers to posit their own perspectives about the Romans.

From the Romans, many useful lessons can be gleaned, especially on economics and politics. Economics however is the more important of the two since in statecraft, economics underpins politics.

The Roman history consists of three periods of governance: monarchy, Republic and Empire. The rule of kings lasted 250 years while the other two roughly 500 years each. For this post, we focus on the Republic because Rome's rise occurred during this period. The Roman Empire will be the subject of my future post. Although Rome's territorial conquest peaked during the time of the Empire, specifically under Emperor Hadrian, the new territories were no longer prime territories and holding on to them proved to be more costly than leaving them outside the borders.

Political leaders during the Republic were initially composed of senators. Although there were elections, it was a rule by aristocracy not democracy because only patricians (the land owning nobility) could be elected to the senate. Gradually the plebeians (commoners) who had grown rich through trade were allowed into the senate.

In ancient Greece and early Roman Republic, only the propertied class and the aristocrats had the right to vote. Even in the West in the 19th century, when voting was first introduced, only those with landed property were allowed to vote. Then, as now, democracy has always been biased towards those with wealth. Over time, this requirement was relaxed. The Roman electorate citizens eventually numbered more than a million. Rome was the first to introduce the secret balloting process. After the Republic faded away, it took 1,900 years for male universal suffrage to reappear in Western Europe.

The economic wealth of the Romans was derived from agriculture, trade and conquests. Conquests brought new lands (including metals mined therefrom) and increased tax revenue to the state coffers. Trade also rose because the security provided by the Roman rule encouraged exchange of produce between distant lands.

As is commonly the case with unchecked movement of goods and labour, in the long term, the impact on the social patterns and structure can be disruptive. Arising from the conquests, thousands of prisoners-of-war were sold as slaves. Only the wealthy aristocrats could afford them and their use on the large farms outdid the yields of the peasant farms. Unable to compete, the peasants sold their farms to the aristocrats.

Cheap grain imports from Sicily and North Africa also made the small peasant farms uneconomic. Gradually wealth tended to accumulate with the aristocrats and the merchant class. It's not surprising that in modern societies, as the economy prospers, the wealth concentration as reflected by the Gini coefficient gets more polarised.

The peasants flocked to Rome and the big towns where they survived on the assistance of the wealthy citizens. Later, the state took up this responsibility and also, to keep them from getting restless, the task of providing entertainment in the form of gladiator games, chariot races and theatre plays. Modern day political leaders are well advised to dish out subsistence assistance and cheap forms of entertainment to ease the pain of economic hardships and forestall social instability.

In the provision of public services, the Republic contracted them out to private parties, known as publicani. The contracts were auctioned off: for revenue collection to the highest bidders while for the expenditure on services and goods to the lowest. Even for military duties, there was no standing army. The army was conscripted from citizens of working age who had to pay for their own armour. The wages paid to them were barely enough.

With a growing citizenship and, consequently, electorate in line with Rome's territorial expansion, the stability of the leadership could no longer be guaranteed. New citizen voters could upset the balance of votes. In 27 BC, Augustus made himself emperor and thus ended the era of the Republic to be replaced by the Empire.

Under the Empire, the state bureaucracy expanded and the public services that had been carried by private contractors were now conducted by the state. The citizen army also turned into a standing one as pre-emptive defence replaced the former strategy of post-invasion counterstrike. As with any bureaucracy, once started, it could only enlarge even though the income of the state stagnated or receded. Even in modern times, increasing budget deficits are the logical evolution of governments moving towards the end-state of their life cycles. Any attempt to minimise deficits through balanced budgets unnecessarily hastens the demise of the governments.

The Romans had no significant technology wave. As described earlier, their growth mainly came from territorial conquests which also increased trade and agriculture. Such conquests also allowed Rome to transplant its idle people to the newly conquered areas. Whatever energy technology they had was based on the muscle power of humans and animals. The main contributor of that power was captured slaves. The water mills were far and few between.

The other critical leg of any technological progress, communication, was manifested in the Roman roads - running 85,000 km across the Empire - and the Mediterranean Sea, which after the defeat of Carthage, became mare nostrum (our sea or the Roman Lake.) Beyond these, the absence of further technological advance condemned Rome to a secular decline.

In contrast, the prosperity that we are now enjoying is the fruits of the Industrial Revolution that began in the 1780's. And it's not one cycle of progress. In fact, it has been renewed four times. We are now past the midpoint of the fourth wave and there is only one wave left to power us before our civilisation sputters like that of the Roman. These waves have enabled us to be liberal with human rights, giving political freedom that heretofore can't even be imagined.

Nowadays, champions of freedom and human rights are ignorant of the fact that such rights can be conferred only if the economic needs of the populace are well taken care of. Democratisation of wealth precedes the democratisation of politics. As the world nears the end of the technological progress, the incompatibility of liberalism with an economy in its last gasps is a sure-fire recipe for political turmoil.

It is also telling that in times of crisis, the Senate of the Roman Republic elected a dictator who had absolute power for a period of six months. Later, when the Roman Republic turned into an Empire, it was partly due to a lack of opportunities for economic growth. The need for stability entailed the firm rule of emperors. Even then, usurpations of power became common reflecting the hard times that prevailed in latter day Roman Empire.

Iron rule is not the answer but merely a predictable response to tough economic times. The eventual outcome would be pluralism, a fracturing of society into self-contained units last seen in Western Europe during the Middle Ages, also known as the Medieval period. In modern times, we are witnessing the shift towards pluralism in Somalia and Afghanistan. Waiting on the sidelines are many others: Pakistan, Iraq and most of the Sub-Saharan African countries. The world's refusal to face this reality means more bloodshed ahead without affecting the final destiny one whit.