The future job sector is self employment

The employment statistics for August 2012 were released last Friday. As usual, the statistical measure that interests us is not the unemployment rate but the Labour Force Participation Rate (LFPR) (see chart from the Bureau of Labor Statistics below). The LFPR enables us to derive a long-term  pattern which is shown as the blue trend line on the chart.

The August 2012 LFPR of 63.5% is the lowest since September 1981. But the LFPR in 1981 was on an upward trend, a reflection of the mass entry of women into the workforce which had started in a big way during World War II when the menfolk was on the frontlines of war (chart below).

This economic dividend is now gone. Both genders are now hard hit by the LFPR reversal as businesses make do with fewer employees, a consequence of technological progress and outsourcing.  All the rules that used to govern the relationship between unemployment and GDP (Okun's Law), inflation (Phillips Curve), and job vacancy (Beveridge Curve) are now rendered obsolete. But by squeezing their labour force, the businesses are tightening the noose around their own neck. As employees are increasingly retrenched, their ability to consume goods and services would be progressively reduced. The big businesses will soon be caught in a vicious circle of continually reduced demand feeding on continually reduced income.

In the third world countries, it's been observed that there are proportionately more entrepreneurs than in the developed world. However this doesn't mean that they are more commercially driven; it's just that salaried jobs are hard to come by. So survival comes from being petty traders or doing odd jobs.

Now retrenched workers in the developed world will face the same problem. The Fifth Kondratieff Wave is unlikely to create the kind of jobs that uplifted the lot of the workers on such a large scale as in the Third and Fourth waves. Everybody has to be on their own, probably trading, producing goods or services, or even growing food; blurring the lines between services, manufacturing and agriculture. In short, back to the days when every community is self-sufficient ... the days of feudalism.

All hype, no bite

Mario Draghi is about to unleash another round of 'money printing' through massive bond purchases in order to stave off the collapse of the euro. He has pledged to do whatever it takes to save the euro. If his pledge is indicative of the future of the euro, then the dissolution of the euro is nigh.

To appease the Germans, who for unfathomable reasons have a morbid fear of inflation, he will sterilise whatever 'money printed' by taking in an equivalent amount in deposits from banks. This clearly shows that Draghi doesn't understand how central banking works. Central bankers actually have no power to create money! Whatever bonds or loans that they purchase must be funded by somebody. Only if central banks can issue their own bonds, can they create money but they don't have such authority. As a result, they must borrow from the banks by taking in their deposits.

Therefore whether Draghi will sterilise or not isn't his choice because whatever Draghi, Bernanke or Bank of England's King does will always be sterilised. Their bazookas can only fire blanks. When truth will out, they will be derided as the Three Stooges of central banking.

Warren Buffett has cautioned us to be fearful when others are greedy. No, we should be fearless instead. As suckers rush in to load up on equities upon hearing of Draghi's pledge, now's the time to unload all your equities. Or if you miss this one, you can wait for Bernanke's pronouncement which should be due anytime soon.

All the obstacles to delaying the depression are now being removed. The Eurozone is still trapped in its balanced budget ludicrousness. Germany is finding itself dragged into the vortex of the Southern European downward spiral towards economic and political oblivion. The Catalans and Basques are clamouring for separate statehood from Spain. Pretty soon, many supposedly homogeneous states will find that they actually have many ethnicities.

The US is being entertained by two presidential contenders, both fraudulently promising the voters of their ability to revive the economy when the powers to do so are in nobody's hands. Of the two, Romney would hasten the collapse of the US economy since he would run the economy as he did Bain Capital. The traits needed for a successful businessman are incompatible with those of a great statesman. You run a business to make profits but you can't run a nation to avoid deficits unless your nation is a city-state that derives the bulk of its GDP from exports. Only if the state suffers a deficit can the households save and the businesses profit. If the state also wants to reap a surplus, then misery will be the lot of the households and businesses.

In the East, Japan is making a turnabout towards almost zero deficit after 20 years of continuous deficits, not realising that it is those deficits that have prevented its economy from keeling over. China will need to awaken Mao Zedong from his deep slumber in order to keep the country as one.

The fact is all governments are running out of bullets. With their ability to stomach further deficits stretched thin, this last line of defence is about to give in.

Nowhere to hide

With the depression slowly engulfing more and more European nations, should you place your bets on Asia? It's easy to assess the growth of Asia since most of these countries are export hogs. Their GDP numbers, though correct, can mislead us into thinking that they have the answer to the crisis. Actually, they are all borrowing their way to growth, either through government debt or household debt or a combustible mix of both. Instead, a better indicator of their economic health is the level of their forex reserves (chart at left from The Financial Times).

With the US current account deficits already slowing down, no country can expect to increase its forex reserves. Now the three major South-east Asian economies of Indonesia, Thailand and Malaysia have started running down their reserves while Asia's two major powers, China and India are seeing their reserves increasing at a slower pace. China is the worst of the lot, with all sectors of the economy heavily in debt.

China's latest balance of payments (chart at left from The Economist) confirms that even its forex reserves have started to decline mainly because of capital flight, a problem you'd usually associate with Greece or Spain. Do the rich Chinese know something which the China bulls are still in denial of?

If you think that you can sleep soundly after moving your investment to these countries, you'd better put on a pair of good earmuffs. There are still many shoes waiting to drop.

The last of the financials

Why has the financial sector grown so big in so short a period, that is, in less than 30 years? In fact, before the recent housing bubble bust, the financial sector was the employer of choice for most of the MBA graduates from the top business schools in the US.

Looking at the longest recorded stretch of the credit picture in the US (see chart from The Financial Times below), dating back to 1870 but with the debt components tracked only from 1929, it's evident that debts prior to the 1930s never amounted to twice the GDP. Even though we don't have the breakdown of the debt components prior to 1929, we can reasonably infer that they were stable throughout that period because total debt grew at a measured pace. And the financial sector borrowings, i.e., excluding the customer deposits placed with it, had always remained relatively small even during the Great Depression of the 1930s. So generally banks then financed themselves using equity.

As can be seen in the above chart, the main financing during the 1930s was raised directly by the non-financial corporations in the form of bonds. The corporations lent the money to brokers who relent it as 90% margin loans to their clients who ultimately speculated on the stock market. The failure of these loans however was only a secondary cause of the 1930s Great Depression — the primary cause of all economic depressions has always been excess capacity. Since then, the non-financial corporations have learned their lesson by keeping their debt leverage to reasonable levels.

During the Great Depression, as the non-financial corporations raised bonds directly, the banks, deprived of their traditional loan business to corporations, bought the corporations' bonds. They also wrote loans with only 10% margin requirements to buyers of stocks. About 40% of their loans went to financing stock speculation.  Not content with that, they also speculated directly in stocks. Their participation in this speculation and its financing eventually led to the failure of 10,800 banks. Because of their leverage, the banks are the first to fail — and they fail big — in any economic depression, that is, a condition characterised by a substantial collapse in money supply.

Up until the turn of the 20th century, the banks' leverage was much lower. Their capital ratio was never less than 20% (see chart at left from The Economist depicting the percentage of book equity to book assets, this approximating the capital ratio). However a high capital ratio means a bank has to use more of its own capital which is not as rewarding as using other people's money (OPM) — mainly customer deposits — because the cost of OPM is much lower. A low capital ratio therefore translates into more profits for the bank shareholders, provided the money supply keeps growing at a healthy pace.

But one thing obvious from the above chart is that the banks' capital ratio during the Great Depression was much higher that at any time since. Therefore insisting on the banks to increase their capital ratio wouldn't necessarily shield them from future crises though it may lower the risk of failure, albeit only marginally. However banks in the 1930s were not as big as they are now though there were many, about 25,000. With low capital requirements then, setting up a bank was easy.

There are two intriguing questions here. One is why the finance sector only becomes big now. The other is why the current depression unfolds over a prolonged period rather than like the quick bust of the Great Depression. Remember that the start of this depression can be traced to the collapse of the Japanese stock market towards the end of 1989. For the US, the Dotcom bust in 2001 is the  the starting point. For this post, we'll answer the first question. The second will follow in the next post.

The problem with being big is that once you've tasted bigness, you're loath to scale down since size has its own benefits. But in an economic depression, size doesn't guarantee safety. It just makes the fall that much more catastrophic. The government has to step in to rescue no matter what.

The case of Lehman Brothers is instructive. When Lehman failed exactly four years ago, it had $660 billion worth of assets at book value, making it the biggest corporate bankruptcy in history. Because banks cross-lent to one another extensively, the US Treasury's decision to let Lehman fall soon led to to the seizure of the money market. Market participants pulled back their lending, scared that the counter-parties might go belly up. Only a $9 trillion guarantee and overnight loans by the Fed restored market normalcy. This rescue was never made public; only the much smaller $700 billion TARP rescue fund was. Helped by Obama's four straight years of annual deficits exceeding $1 trillion each, the banks have managed to regain ground and the Fed its money.

We can be sure that the next time around, the Fed won't let another Lehman fall. But by letting the banks grow, the Fed is in thrall to the big banks. However with the depressed state of the economy even four years after the Lehman collapse, the politicians and the Fed have squandered whatever political capital they have left. So it's arguable whether the public can stomach another Lehman-type rescue by the Fed though it's in its interest that the Fed does so.

The debt picture doesn't tell how exactly has the financial sector grown because it looks only from the credit side. We need to see the obverse of debt, that is, the asset or debit side. The chart below from The Economist shows that the financial sector's assets started their relentless increase beginning in the mid 1980s. Now if you look at the debt chart above, you'd notice the similarity in the movements. Bear in mind that both charts reflect the amount as a percentage of GDP. So any movement above 100% means that the assets or debts increase at a faster pace than that of the GDP. The assets are however greater than the debts. This can be easily accounted for by equities which are the only financial assets that are not debts.



















Technically, equities perform the same function as money except that they are safe money unlike debts which are toxic money, that is, in conditions of declining money supply. In the lead to a depression, the value of equities will fall but debts retain their value until the moment it becomes unsustainable and snaps. That's why the values of all financial assets and commodities can suddenly plunge.

To be sure, the banks began their growth after the 1973 oil crisis when the US started to suffer increasing trade deficits. The wealth generated by those deficits went to the oil producers who deposited them back with the US banks. But the 1970s were the days of high inflation, so the debt value as a percentage of GDP was contained.

However by 1981, the inflation was brought down by Paul Volcker's harsh interest rate regime. Unknown to many, more influential was the extra capacity brought on by the oil producers who by then had substantially increased both oil production and spare capacity. Essentially since then inflation has been much subdued because technology and globalisation have both been unleashing limitless capacity. Even when commodity prices have gone up, inflation has never reared its ugly head. But inflation did appear in short and sharp bursts particularly for those countries that suffered severe debt crises, such as Korea, the South-east Asians, Sweden and more recently Iceland. Their inflation came stealthily through currency devaluation which was a one-off event, after which price levels stabilised.

It is this low inflation environment that has accommodated the big increase in credit supply and on its heels, the burgeoning financial sector. In an inflationary environment, holding on to financial assets can be detrimental because they may lose value faster than real assets. In contrast, a low inflationary or, worse, deflationary environment favours creditors since their debts hold value even when prices are crashing everywhere. This tremendous debt increase has enabled all sorts of financial outfits — ABS pools, hedge funds, pension funds, and many others — to proliferate and some to grow big.

How will the financial sector evolve once the money supply settles to its natural level? The most vulnerable will be the big banks. When the Fed provided financial assistance during the 2008 financial crisis, it should have been made conditional upon the banks eventually splitting themselves, if for no other reason than facilitating the banks to be shuttered when money supply plummets. The investment banks are already planning to reduce their assets by $1 trillion and costs by $10 billion over the next two years. Whether such reductions are sufficient remain to be seen.

Even George Soros last year returned his investors all their money, foreseeing that there was no money to be made when money itself would disappear. But big funds such as the pension retirement funds are putting more of their assets into hedge funds hoping the hedge funds could outfox the market. The right thing to do should have been to close down the retirement funds and distribute the capital to the retirees, letting them manage their own money. These retirement funds are at risk of being wiped out in the coming money disappearing act.

When these giant financials are gone, there is very little likelihood that they will make a comeback in the Fifth Kondratieff Wave. The new investment of this final wave no longer favours the accumulation of large capital. In future big production facilities will be passe when 3D printing can produce items economically in units of one. Mineral commodities except gold and silver will best be left underground as nanomaterials with better material properties enter commercial use and renewable energy takes centre stage.

As this depression progresses, bid farewell to the financial giants; we'll never see the likes of them again.

Downsize or doze off

Banks are being chastised from all and sundry for their misdeeds and blunders. Now even Sandy Weill, the person credited for creating the Citigroup behemoth, has been calling for banks to split their commercial arm from their investment trading arm. The common justification put forward for the split is the different cultural attributes of a bank's investment and commercial arms.

Actually, the split or the sizing down of banks should not be precipitated by the huge trading losses or the Libor rigging scandal. Warren Buffett has observed that, "Only when the tide goes do you discover who's been swimming naked." Indeed an op-ed piece in the Financial Times confirms that the banks have been rigging the Libor for more than 20 years. Bob Diamond and his ilk, the regulators and the central bankers have known this all along. The parliamentary committee hearing was a sham to provide cover for everybody's ass. The reason this scandal wasn't exposed earlier is because the tide was still up. As the tide recedes, all the skeletons will start walking out of the closet

As for the differing cultures, they can be easily managed by having separate organisational setups that don't mix the two. The only reason that compels a bank to downsize is much deeper than these specious arguments. To understand why, we must delve into the bank's ecophysiology, not philosophy since there's nothing philosophical about overly paid bankers making money from borrowing cheap and lending dear, or betting on market movements.

Like any living things, a bank grows big if its food is aplenty. Similarly, if food is scarce, it must start scaling itself down. Sizing down entails shrinking a bank's loan asset base by recalling loan assets that pose great risks. Income will fall but in these depressing times, growth and income are the least of a bank's priorities; survival is the most pressing.

It's been observed in evolution that mammals above the size of rabbits living on islands would diminish in size (see The Island Rule). To remain big and active in times of scarcity is an invitation for disaster. A bank's food is the money supply, the best measure of which is total credit. If you look at the total credit picture for the US, the picture appears bleak, more so with the recent second quarter 2012 GDP growth turning south.

Obama's deficit spending only manages to slow down the slide and the resulting bank failures (see right table). But as its impact will soon start to wear off with the declining deficits, the descent will resume its previously steep decline. The eurozone total credit has crumbled in Italy, Spain and Greece with more states joining in. Whenever total credit crashes, banks will be the first to be hit because of their gearing.

We also should be aware by now that Bernanke's QE won't work. If only someone would sock it to Bernanke that his QE actually means quantitative exchange, that is, a swapping of debts on the scale of trillions of dollars, maybe he'll wise up to the fact that QE doesn't print money. QE works only to stem a panic, that is, when a bank is in imminent danger of collapse. The bank can swap its less liquid assets for liquid money from the central bank. But if the bank has assets that have hugely lost their value, there's nothing to prevent its collapse except by a takeover by the state. And if the state itself is in a wreck, the mess multiplies severalfold. Now, this latter scenario is going to haunt the banks as round two of the economic depression starts to unfold.

The other alternative to sizing down for a bank is powering down its thermal engine through hibernation. A bank can power down by switching its loan assets to low-return Treasury bonds and bills and aggressively paring its operating costs through salary and bonus cuts. After all you don't require smart people in banking; banking is best served by staid and conservative characters. No matter how pristine the quality of a bank's loan assets is now, it will be tarnished once total credit resumes its downward slide. By then it'll be too late to unload the assets at good prices as all banks will be rushing for the exit. The sight of panic, naked bankers is not something you'd want to behold.