Another high speed crash on the way

The collision of two Chinese bullet trains on 23 July 2011 has elicited public outrage on its microblogging services. The crash caused by a lightning strike that stalled a train was not totally unexpected as China has been expanding its high speed rail network at breakneck speed. Still this is nothing compared to the disaster that will be visited upon China when another of its fast speeding contrivances, that is, its economy, starts to hit the skids.

China has been copying and modifying imported rail technology in order to breach the speed limit. Its meddling with its trains is akin to its tinkering with its economy writ small.

A picture tells a thousand words. The two charts from The Financial Times on the left demonstrate that China is dangerously breaking the economic speed limit.

The most revealing information from these charts is that China's net exports, much ballyhooed as the driver of China's GDP is not what it was made out to be. Instead it's its gross fixed asset investment or gross fixed capital formation, i.e., before depreciation, that's the real engine of growth.

Compared to Japan's fixed asset investment in its bubble years, which topped out at 35 percent of GDP, China's figure is now approaching 50 percent of GDP. Even the US registers only 20 percent.

China's investment, mostly debt financed, has gone past diminishing returns, swinging into negative territory. Its rail accident may be due to its failure to grasp the need for the rail signalling software to keep pace with advances in the hardware. Similarly, its breakneck economic growth would be incomplete without a corresponding growth in debt financing. Rushing headlong into capitalism just after ditching communism is hazardous for a nation that hasn't grasped the dark side of capitalism.

The final chart from The New York Times is more alarming. The difference between this chart and the above is that the fixed asset investment includes expenditure on land and inventories which the gross fixed capital formation excludes. This chart shows that China's GDP closely tracks its fixed asset investment. The investment, at a staggering 70% of GDP, is unprecedented in economic history.

One Chinese microblogger perfectly summed up the bleak situation that is dawning over China: "China today is a train travelling through a thunderstorm. None of us are spectators; we are all passengers." The two colliding high-speed trains with 1,400 passengers registered only 39 fatalities. Its economic train with 1.3 billion passengers however won't be so lucky.

Weak hypothesis on a great empire

History is an open subject; every historian has hisstory or herstory. In fact, you also can posit your own theory of the rise and fall of past societies. Now a new one has been made by a historian, Elin Whitney-Smith. Essentially, she hypothesises that great economic shifts have been precipitated by changes in the way information is managed. By her assertion, she has reduced the underlying pattern to a single cause, going too far in the direction of simplicity. This violates Einstein's dictum that "Everything should be made as simple as possible, but not simpler." Anyway, her information-revolutions.com website contains nuggets of interesting facts and her in-progress book would appeal to any history buff.

We can use her take on the collapse of Ancient Rome, specifically its western half, to test the tenability of her contention that information is key to understanding momentous changes in human history. She argues that the collapse of Ancient Rome was prompted by information overload. Rome was too big to be effectively governed, so it had to split into two: the Western and Eastern Roman empires. To reduce the overload, both Emperors Diocletian (reigned 284-305) and Constantinople (r. 313-324) turned to autocracy and mandated one state religion, the former promoting paganism and the latter Christianity.

As usual, Whitney-Smith has fallen into the single lever trap. The proponents of this approach try to discover one single overarching theme that can explain all monumental shifts in history. Then they tailor their findings to suit their hypothesis, ignoring all evidence that contradicts it. With enough materials assembled, voila, a new theory has been discovered. As history is subjective, everybody is entitled to his opinion. So their new theory is accepted as one of the many causes of great historical shifts. What history ends up is a mass of erroneous inferences which no one has taken the trouble to contradict, correct and reassemble. To do so, we need to bring up the big picture for which the various inferences can be fitted in so that the real story can emerge.

As a rule, history can never be reduced to a single lever theme. It takes several major causes, at its simplest not less than four, to explain great transformations. The four are encompassed in the 4C framework or model comprising Capacity, Communication, Consumption and Capacity. Whitney-Smith's information theme is only one aspect, i.e., the communication, of the 4C. That means she has missed out on more than three quarters of the causes. With the 4C as a reference, picking holes in any historian's arguments is a cinch.

Let's look back at the narrative on Ancient Rome so that we can fully understand why it collapsed. It will provide lessons on the coming collapse of nation-states. Ancient Rome reached its greatest territorial extent under Emperor Trajan (r. 98-117). Administering it was very costly because Trajan had overextended. However his successor, Emperor Hadrian (r. 117-138) undid his mistake by withdrawing from Mesopotamia and Armenia.

Land transport in those days was 60 times more expensive than water transport. As a result the Roman territories could not extend more than 75 miles from the coasts or navigable rivers. The map below, taken from the companion website of the Civilization in the West textbook, shows that the dominion of Ancient Rome was limited to accessible waterways, comprising maritime and riverine routes. Even now rail movement, the cheapest land transport, costs four times the cost of moving goods on a large ship.

The beginning of the split between West and East occurred around the time of Emperor Diocletian (r. AD 284-305). That's more than 165 years after Trajan's death. Mind you, the age of the US in its largely present form is less than that. California and New Mexico were annexed into the US only in 1848. Alaska was purchased in 1867 and Hawaii, the last state, added in 1898. Certainly information overload wouldn't have been an issue for the Romans. If it had been, the empire wouldn't have extended that far in the first place. In fact, communication between the two halves of the empire was cheap. Look at the map and immediately you'll notice the Mediterranean Sea, the main communication artery that fused the empire together. But extending beyond the 75-mile coastal and riverine limits was not possible as costs would have exceeded benefits.

In terms of capacity, the Roman empire's fortune moved downhill the moment it couldn't extend its land acquisition. In contrast to the modern-day superpower which must keep on acquiring new technologies to remain dominant, ancient Rome must keep on acquiring territories. New territories furnished Rome with new slaves and economic goods especially agricultural produce. Once Rome stopped expanding, economic growth stagnated though eventual downfall in those days took some time since events moved at a glacial pace.

Rome itself initially was a centre for the production of wine and olive oil. However other Italian regions began eroding Rome's competitive advantage. Eventually its colonies, Spain and Gaul (modern France), cornered this production leaving Rome a hollow core economically. Meanwhile, gold and silver flowed out to China and India to balance the trade deficits arising from silk and spice imports. The only economic activity left in Rome was building works as this could not be traded across borders. It also served to provide jobs for the unemployed. Sounds familiar?

The troubled times with chronic usurpations of power occurred around the 50 years after the death of Severus Alexander (r. 222-235). This chaotic period was characterised by rapid inflation, the combined result of decreased food production and coin debasement. Coin debasement took two forms: reduction of silver content and when this had reached its limit, changing the denominations to higher amounts.

As the western half of Ancient Rome was subjected to constant harassment by the barbarians on its borders, maintaining it cost more than the benefits it generated. It was therefore inevitable that for the empire to survive, it had to size itself down. This move began under the rule of Diocletian (r. 284-305) who divided the rule into two halves by nominating Maximian as the western co-emperor. He also appointed two junior caesars, in the process of which the two senior emperors were elevated to augusti. This Tetrarchy system secured his rule from the chronic usurpations of power as powerful army commanders now had more opportunities to be emperors. In actual fact, it solved the problem in his time but the problem reappeared later because more openings led to more contenders for power. The root cause had always been economics, not politics.

Diocletian managed to bring back some stability to the empire. But in an empire that had been on a natural decline, it was a temporary fix and the cost was immense. Inflation was rampant and this could be attributed to the fall in agricultural production as a result of his ruthless taxation. When the monetary system had broken down following hyperinflation, Diocletian instituted taxation-in-kind. As powerful landowners received exemptions from taxation, the burden of taxation fell on the small landowners. To avoid the oppressive tax, the small landowners left their farms deserted to become tenants or slaves to the big landowners. Notice that even now, the big corporations and the rich know how to find tax loopholes in order to avoid paying tax. This deceit would in turn hasten the breakdown of society.

The increased tax revenue allowed Diocletian to increase the hitherto declining Roman army by one third to 435,000 thus providing the needed stability. Bureaucracy was also expanded. He tried to reform the currency by issuing non-debased full-weight coins but his fixing of the new coin denominations at the same value as the debased ones resulted in the new coins being hoarded and taken out of circulation. Bad money drove out good money. Though politically astute, till his retirement economic issues proved elusive to him.

Emperor Constantine (r. 306-337) was able to consolidate the emperorship into one in 324 after spending the early part of his rule usurping power from fellow emperors and contenders. His rule was the last in which Rome regained its supremacy prior to its official split into east and west. Again the price was costly and it was just a short spurt in a secular decline. Constantine increased slightly the size of the Roman army to 450,000. Also like Diocletian, he used religion to strengthen the state but whereas Diocletian embraced paganism and turned against Christianity, Constantine was intensely sympathetic to the Christians. Turning to religion provides a ruler an alternative instrument of control when the economics crutch can no longer be relied upon.

Constantine initially ruled the western half of the Roman empire. However after uniting the two halves, he moved the capital to Byzantium, which he renamed Constantinople. It was a strategic location as it sat astride the east-west trade route. It could live off trade. This move marked the end of Rome. Sucked hollow economically and besieged by the barbarians militarily, Rome would permanently lose its preeminence. The official split between east and west took place in 395. Long before the western half collapsed in 476, its capital had moved from Rome to Ravenna in 402.

Constantine raised his funds in other ways aside from taxation. The pagan temples that he destroyed yielded a lot of gold and treasures. In addition he regularly received gifts, which were actually tributes, from Roman cities and provinces in the form of gold and silver on the many special occasions. With his new found sources of wealth, Constantine was able to issue a new type of gold coins known as the solidus. The solidus which eventually became the tribute objects, was to be produced over the next 700 years, the longest time any currency was ever used. Of course, Constantine relied on wealth transfer to mint his solidus but subsequent eastern Roman emperors assiduously cultivated its current account to ensure that it always generated surpluses.

After the split, Justinian (r. 527-565), the eastern emperor attempted to resurrect the old Roman empire by invading the Italian peninsula. He succeeded in 554 (see map below) but it was an expensive affair, costing him 300,000 pounds of gold with no significant economic returns. By 568, three years after his death, the new territories had to be relinquished. As usual the defining yardstick has always been the 4C, this time the conquest not yielding any new capacity that would have compensated for the cost of the expedition. Using information as the sole criterion does not do justice to the events surrounding the downfall of the Roman empire.

The economic and political evolution of the Roman Republic

The no-enigma trilemma

It is common nowadays to hear self-proclaimed pundits extolling the benefits of a strong currency, one that is tied to gold, commonly known as the gold standard, just so to prevent the erosion of its value by irresponsible politicians. Most people will be swayed by the seductiveness of this assertion without realising the misfortune that it will wreak on the many in order to benefit the few.

Still, can we resurrect the gold standard? It's easy to decide if you're Joe Public. The thought that your savings won't be stealthily diminished by the government's money printing shenanigans is good enough reason to revert to the gold standard. But how sure are you that you're going to have savings in the first place? That's the issue that should've been addressed. Those pundits manage funds in the billions of dollars and their advice surely has a self serving agenda. Instead the best counsel to understanding the appropriateness of a monetary or currency system is of course economic history especially the evolution of our modern-day currencies over the last 100 years.

The theoretical underpinning that superbly explains the currency evolution is none other than the Mundell-Fleming trilemma (see diagram from The Telegraph below). This economic model was formulated independently by economists Robert Mundell and Marcus Fleming.

Under this monetary policy trilemma, you can only pick two out of three choices. Actually, the word 'can' is misleading as you'll soon realise that you can't decide; the choices have been predetermined. If you choose all three, the trilemma will penalise you for this transgression and put you in a worse off position than before. A political leader's role thus is to move with the ebb and flow of economic waves.

This trilemma won't be explained here in detail since you can google its many articles on the web. Instead this post will demonstrate that the trilemma doesn't justify its name because picking up which two of the three options is a no-brainer.

The three choices available in the trilemma are fixed exchange rates, capital mobility and independent monetary policy. In chronological order, our modern-day currencies, that is, over the last 100 years, began with the gold standard which lasted until 1914, the start of World War I when it was suspended. In any crisis or panic such as war, everybody wants to switch to gold which can lead to a severe run on a country's gold reserves. To preempt that, you have to suspend gold convertibility.

During the heyday of the pre-1914 gold standard, capital was mobile and exchange rates were fixed but no country had control over its monetary policy, i.e., it could not set its interest rates nor money supply. But the world then had minimal borrowings. Government deficits were unknown except in times of war; in the first half of 1910s the US government debt was less than 4.0 percent of its GDP. Governments derived their incomes from import tariffs. The US government only reestablished its income tax in 1913 after the earlier one, necessitated by the Civil War, had been abolished in 1872. Consumer credit was small and only used for the purchase of furniture and sewing machines; credit for consumer durables was introduced only after World War I.

In those days, the population was largely rural, so money was not crucial for the low-volume economic transactions which in most cases were carried out through barter. The farmers upon harvesting would deliver enough supply of flour, after it had been ground by the miller, to the grocer in exchange for one year's supply of groceries. Sometimes, it entailed a system of credit to be settled upon harvesting. In rural areas such a system worked because everybody knew one another; running away from your obligation wasn't an option. In present-day cities where everyone is a stranger, barter is impracticable. Without money, life in cities would collapse. But in the beginning of the last century, there was little need for financial savings. You could rely on your next of kin and neighbours should any misfortune befall you. If all else failed, death was just around the corner. Life expectancy in the 1910s was in the early 50s, that is, you worked until you fell dead. So you didn't have to save for old age.

The problem with the gold standard was that the money supply was restricted to the amount of gold held as reserves. With the annual global gold supply increasing at only 1.5 percent, there was always the risk that money supply would be outpaced by goods and services production, which was increasing at 2.6 percent annually from 1900 to 1925. A situation of falling prices or deflation would soon follow. Of course, policymakers could issue bank notes not supported by gold reserves but they'd be courting the serious danger of inadequate reserves should there be a run on gold.

As long as credit was minimal, the gold standard could persist because the likelihood of a financial panic was small. Under the gold standard, the policymakers couldn't pump up the money supply to replace money withdrawn from the system unless they could come up with enough gold reserves. And money could only disappear if a substantial part of it was in the form of credit (if you've been following my earlier posts, by now, you should know how money vanishes). World War I upended this calm scenario. To finance the war, the countries resorted to deficit spending by printing money. The US on the other hand benefited from the overseas demand for war materials. From being the largest debtor in 1914, it transformed into the largest creditor in 1918. Its capital surplus was then invested in Europe.

The Europeans however were suffering from high inflation as a result of money printing to finance their deficits; Germany especially suffered terribly from hyperinflation from 1921 to 1923. To dampen the inflation, Germany revived the gold standard in 1924 followed by Britain the next year. Because of the high value originally set for the pound, Britain suffered an economic contraction that by 1931 it had to dump the gold standard following which it enjoyed a five-year mini boom. Japan which had gone on gold standard in 1930 went off it within one year. Only the US and France were happily sequestering gold reserves because they had set their currencies at values lower than their real worth.

Germany's stable currency had attracted funds from the US but the US stock market boom in 1928-1929 reversed the flow. Germany found itself short of money made worse by its uncompetitive economy because of the high value originally fixed for the German mark. Soon after getting out of hyperinflation, Germany was facing hyperdeflation. The resulting banking crisis and depression forced it to junk the gold standard in 1932 but it was too late to prevent Hitler from becoming chancellor in 1933. As they say, the rest is history. In fact, if you go back to the root cause, it could be argued that it was the US who sowed the seeds of World War II. By moving huge amount of funds in and out of Germany, it destabilised Germany's economic and financial conditions, facilitating Hitler's rise.

Actually there's a way to cope with the shrinking money under the gold standard. It's by reducing prices, including wages, across the board. However powerful unions prevented such a move. Even now, nobody would tolerate having his pay cut. The only available alternative thus was to drop the gold standard and devalue the currency. That was how the gold standard met its fate. Moreover you can never have fixed exchange rates if you allow unrestricted international trade while maintaining inflexible prices and wages since some countries will always try to benefit at the expense of the others. Free trade is never fair.

After Word War II, the US economy was at its greatest relative to that of the world: its share of world economic output was about 30 percent in 1945. It also had strong trade surplus and held two thirds of the world gold stock. As a result the US dollar was chosen as the reserve currency under the 1944 Bretton Woods agreement, a new currency arrangement to replace the gold standard. The British pound was also selected as another reserve currency but this was more to placate the British than for any other economic reason since Britain was no longer the superpower that it once had been.

Under Bretton Woods, the politicians adopted a system that swapped capital mobility for independent monetary policy in order to escape the misery under the gold standard. This boded well for politicians since they now controlled the money supply. Thus it appeared that they could regulate the economy though the reality has always been the other way round. Under Bretton Woods, the dollar was pegged to gold and the other currencies in turn anchored to the dollar. Although the dollar was no longer convertible to gold, sovereign nations could still exchange with the Federal Reserve their dollar holdings for gold bullion. It was a gold standard of sorts.

The key flaw with this arrangement is that with the dollar being the anchor currency, it restricted the US from adjusting its currency whenever it suffered current account deficits whereas the others could do so. As expected, what actually unfolded was that uncompetitive countries would adjust their currencies downwards while competitive ones, like Japan and Germany, would prevent any upward revision or did so at less than what should have been their appropriate values. The US bore the brunt of Bretton Woods. As long as the US was enjoying current account surpluses, this arrangement would last.

Beginning in the mid 1950s, Germany and Japan were having persistent balance of payments (BOP) surpluses financed by the US BOP deficits. Actually the US current account was in surplus for most of the 1950s and 1960s. Its capital account on the other hand was in deficit because of foreign direct investments (FDI) by the US multinationals in Europe. The net impact overall however was still deficit because the negative balance of the capital account outweighed the current account's positive balance. The growth of the US multinationals can be traced to this propitious period. The industrialised economies of the West benefited greatly from the US FDIs. As the dollar flowed into Europe, by the late 1950s the European countries were confident enough to relax their exchange controls, flouting a fundamental rule of the trilemma. This capital mobility was to eventually kill Bretton Woods.

The original exchange control restriction was in respect of both the capital and current account convertibility, terms which you hardly hear nowadays. Capital account convertibility refers to the conversion of one currency into another for the purpose of investments or loans while current account pertains to trade related currency movement, for example, payment for imports and receipts for exports. The current account convertibility was liberalised first at the end of the 1950s followed by the capital account in the 1960s. Actually in those days, aside from the US, only Canada and Switzerland, countries spared the ravages of World War II, were countries that had no exchange controls,

As for the Bretton Woods reserve currencies, the British pound, being the weaker of the two was the first to lose the status. It had to devalue by 14 percent in 1967 after suffering a string of large current account deficits. In those days, a billion pound was a huge sum. Like oil wealth, possession of a reserve currency was a curse. Because other countries were accumulating dollar and pound reserves, the US and Britain would eventually suffer current account deficits which could not be redressed except through a devaluation.

The gradual decline of the US current account began in 1968 with higher government spending following President Lyndon Johnson's Great Society programmes and increasing involvement in the Vietnam war. However, Nixon drastically reduced the deficits in his first two years as President but by 1971 the Vietnam spending took its toll. By August 1971, the dollar convertibility to gold was halted after it could no longer be defended against sustained withdrawals by other nations. That signaled the end of Bretton Woods. The US and Europe attempted to resurrect Bretton Woods in December 1971 through the Smithsonian Agreement but it was stillborn as the price of gold kept moving upwards. The trilemma could not entertain fixed exchange rates with free movement of capital.

In the same year the US suffered its first current account deficit, of $1.4 billion followed by $5.8 billion the next year. Meanwhile the oil embargo following the October 1973 Arab Israeli war pushed the oil price from $3 to $12. The Arab states began accumulating petrodollars which they parked with the US banks which in turn relent them to the Latin Americans and the US private sector. Once the banks realised how easy it was to make profits from other people's money, they never looked back, forgetting their fiduciary duty to prudently manage the nation's money supply. The chart above (from The Economist) shows that the growth of the US financial sector began around this time. The high inflation, beginning in 1973, was initially caused by these recycled petrodollars, not money printing by the government though later the government also fanned it through its increasing budget deficits. Had the US crimped the money supply by increasing the banks' reserve requirement, the inflation wouldn't have ensued although a severe contraction would have been the outcome.

As a result of these actions, from 1973 to 1981, the US money supply was boosted on average 6.5 percent annually. In consequence, the other major currencies appreciated against the dollar and the US current account turned positive from 1973 to 1976. But the other nations soon learned the trick, which was to tag their currencies after the dollar. They lowered their currency values through money creation. The US current account surpluses switched to deficits from 1977 to 1980. However, this concerted money creation effort unleashed inflation on a global scale.

To suppress inflation, President Carter appointed Paul Volcker as the Fed chairman in August 1979. His solution was simply to increase the federal funds rate to 20 percent by mid 1981. The dollar became a stable currency, better in fact than gold because aside from credibility, it now had liquidity. Rarely in economic history would a currency possess both qualities.

President Reagan capitalised on the strength of the dollar to unleash deficit spending on a scale unheard of before. The resultant massive current account deficits transformed the US from a creditor to a debtor by the mid 1980s (see left chart from The Economist). This time around, inflation didn't rear its ugly head as the global capacity was ready to unleash the supply to match the demand let loose by the monetary flood. The trilemma seemed to have been vanquished. But not quite. Just as the Europeans had been the beneficiaries in the 1960s and the petro states and the Latin Americans in the 1970s, the 1980s belonged to the Japanese.

Intoxicated with dollar reserves, the Japanese kept suppressing the yen exchange rate by creating massive amount of yen through increased bank loans. The money ended up inflating stock and real estate prices. The spectacular collapse of these prices at the end of 1989 marked the twilight of Japan. Soon the 1990s was the turn of the Asian tigers. Again the same Japanese scheme was hatched and the same ruinous fate met in 1997. The Chinese latched onto similar machinations in the 2000s but this time on a much grander scale. This time is different, they gloat. A new global power is staking its rightful claim. Indeed, it is. Highways, bridges, tunnels and railroads, all to nowhere; buildings and factories, all for no one. Going by the reckoning of the past, China's chapter should have closed by the late 2000s. Trying to delay destiny into the 2010s is certainly a heavy price to pay just to prove that the trilemma can be subdued.

As go borrowings, so go savings

Debts are bad and savings are good. Any homily on good moral values wouldn't have missed this out. Your parents and grandparents would have impressed this on you since your childhood days. But let's see what happens if everybody saves and none borrows. In modern times, this probably doesn't matter because you can always save. Whether others borrow is none of your business and you probably couldn't care less.

In fact you should. A hypothetical situation would shed some light. Imagine a situation on an isolated island with only two inhabitants, A and B. Each has some cash, say, $10 each. Although they are preoccupied with finding food to survive, let's also assume that both wish to settle their mutual transactions in economic terms. Suppose A is more productive in finding food for his own needs and then some, leaving B free to tinker with his contraption. A can sell the excess to B. In next to no time B will exhaust his cash reserve.

If B wants to continue consuming he has to issue IOUs to A. If not, the economic exchange breaks down. A can no longer save and B consume. To A, the $20 cash and the IOUs are his savings whereas to B the IOU s are debts. So the IOUs are actually money that supplements the $20 hard cash. In fact in the real world, there are more IOUs than physical cash. If B keeps on issuing IOUs with hardly any hope of ever redeeming them, A will realise one day that B's IOUs are as good as his worthless promise. The IOUs will lose their value overnight. It's the collapse of the IOUs or credit that is the cause of economic depression.

However, if suddenly, B could garner more food with his contraption than A with his muscle power, B's IOUs would retain their value. The money now moves in reverse provided A stops going about his usual food gathering business, using that opportunity to do other things instead. A and B's mini economy starts humming again until A's credit is fully stretched. If both parties come to their senses, they should specialise, say with one growing cereals and the other catching fish. They would trade their surpluses in such a way that no one excessively owes the other. In the real world of technological progress, this is very unlikely because one party can always outmanoeuvre the other with the help of technology.

We can now surmise that what an economy needs to continue operating indefinitely are continuing economic growth and a change in the fortune of the players. This presupposes the arrival of a new technology that will step up economic growth and redistribute economic wealth but a deliberation on this topic deserves its own separate posting. Alternatively, when economic growth has run its course, the players could attain a stable relationship among themselves by producing just enough for their own needs, precluding the accumulation of disproportionate savings.

The other important lesson, which actually is the subject of this post, is that savings and borrowings are indeed a zero-sum game. To be able to save, someone else must borrow. The proof for this assertion is the following diagram of a nation's GDP, taken from The Levy Economics Institute of Bard College site. On the left side of the top equation is national output or rather spending, commonly referred to as GDP while national income or GNI represents the right side. Making up the difference between a country's spending and its income is either net exports (income more than spending) or net imports (the other way round).

Although the diagram appears self-explanatory, a little explanation would help. Net exports as you'll notice sits on the left side of the top equation. You may think that exports are income but that's incorrect. Exports are actually foreigners' spending on goods and services while the corresponding domestic equivalents are household (consumption and property investment), business (capital expenditure) and government spending. The income from that spending is on the right. If net imports were to appear, the item would be offset against the domestic spending on the left. Business operating expenditure doesn't appear as it has been accounted for in computing business gross profits.

After some shuffling, the equation finally boils down to that of the last line. In the above diagram, the aim is to highlight business profits; the term Gross Profits actually means profits before depreciation since depreciation is a non-cash item. A modified Powerpoint page version of the above image can be downloaded for you to tinker with; you can change the flag to that of your preferred country. This version which puts government deficits on the left draws attention to the fact that in the present deflationary conditions, government's deficits is key to increased household savings and business profits. For other scenarios, you can move the icons around but make sure when you move icons from right to left or vice versa, the mathematical signs (+/-) are reversed.

Right now, for most economies, the other contributors to savings are anaemic. Investments in the form of business capex are moribund because of excess capacity and falling prices. Investments in real property are reaching its end game that would inflict a catastrophic blow on those who haven't exited. Exports are out of the question when all countries are winding down their spending. That leaves only government spending but after years of mega deficits, the governments' backs are about to be broken.

The increase in government deficits started during Reagan's days, towards the end of his first term (see chart below, taken from Morgan Stanley website). Now you know why Reagan was so popular. Clinton and Bush, Jr. continued this reckless practice with the non-government players (banks, corporates and households) doing the politicians' bidding. However these non-government players have been stretched to the limits of their borrowing ability after more than 15 years of continual credit growth. The US government took back the lead role in 2009 but after three years of more than a trillion dollar annual deficits, its critics are getting restless and demanding that the deficits be curtailed.

What those critics fail to realise is that government deficits can never be tamed. Only the relative quantum, in this case reckoned against the GDP (see chart above) can be reduced. However, the absolute amount always increase year after year except when the households or corporates go on a borrowing binge, even then for short periods. For a big country like the US, the government can only go into surplus if the corporates and households are willing to endure increased borrowings. Only small countries can climb out of government deficits through exports.

If the relative government deficits could be trimmed in the 1970s and early 1980s, can we repeat the same feat now? Unlikely because the two critical factors necessary for the reduction are missing. First is economic growth or GDP. Since its highs in the 1960s, decadal economic growth has been decreasing. More crucial is the high inflation experienced during those years. Yes, inflation benefits debtors at the expense of creditors. It doesn't reduce the actual debt amount but relative to the general price level, that is in real terms, your debt gets reduced. However inflation is not likely to make a comeback anytime soon because capacity now outpaces consumption. The policymakers' fixation with snuffing inflation is akin to generals fighting the last war.

Anyway, the US credit expansion actually benefits the world. The chart (from The Economist) on the left shows that US current account deficits began to swell in the 1980s under Reagan's watch, turning the US from a creditor to a debtor nation. Soon after, President Bush, the first, suppressed the government deficits at a time when the Savings and Loan crisis led to a drop in the total credit. Not surprisingly, he didn't get a second term. But his successors continued Reagan's practice. As a result US current account deficits movement is a mirror image of its total credit growth.

But that's not the end of the story. US current account deficits have led to a steep expansion in the global forex

reserves (see left chart, also from The Economist). At present, the US dollars represent about 60 percent of the global forex reserves, down from 70 percent in the early 2000s. But more significant, without that 60 percent, the balance 40 percent wouldn't have existed simply because the other major economies, the EU, Japan and China, are current account surplus or creditor countries. The fact that their currencies are available as reserves is due to their ability to hold on to the dollars in exchange for giving up their currencies.

As the US could no longer expand its credit, the currency leg of the 4C will soon begin its winding down. Prices across the board will start descending. You'll soon watch dumbfounded policymakers arguing over what tools to use to fight deflation just as it appears inflation was the scourge. They haven't learned the most important lesson: when faced with an insurmountable obstacle, like the tsunami, you don't fight, you adapt. They should encourage the cancellation of unpayable debts. Everybody has to take a cut so that life can start anew. Sadly, greed precludes this course of action. If financial savings can't be extinguished, borrowings can't be cancelled. The end result is a breakdown in social cohesiveness that will harshly hit both borrowers and savers.

Reality in 4C

Why have economists been mostly wrong not only in prognosticating future economic outlook but also in rationalising past events? The root cause is the university and college economics curriculum. All over the world we are churning out armies of economists who've been wrongly taught and who in turn are preaching deviant thoughts. To stop accepting their economic nostrums, we must have ready a credible alternative.

To be sure, not all economists are clueless. Some really understood the workings of the economy; among them John Maynard Keynes, Hyman Minsky, Wynne Godley and Charles Kindleberger. Sadly they are all deceased. Outside the mainstream, the Austrian school of economists provides a good alternative viewpoint but in this case restrict yourself to just their view of the business cycle. Nikolai Kondratieff, a Russian economist executed by Stalin in 1938, was another proponent of the business cycle but he did not come out with a persuasive explanation to support his theory. Had he lived longer, he might have come out with one. As a result many successive 'experts' have come out with their own ideas which have no strong theoretical basis either.

What should we resort to? Nikolai Kondratieff's long waves are actually a good starting point. What we need is a sound underpinning in the form of a framework. It can only come after an exhaustive study of ancient as well as the modern post-Industrial Revolution societies. Only if the framework can successfully explain the rise and fall of all these societies, can we accept it as a valid theoretical basis.

No, this framework is not going to contain any mathematical symbol nor algebraic equation. Economics is about people, not numbers which should be restricted to the physical sciences and mathematics. With people, emotion generally trumps reason. The melancholic state of economics nowadays is a result of the field being taken over by the quants who have so much blind faith in mathematics. In finance and banking, they have wreaked havoc. Unknown to many, they also are doing much more serious damage to economics but till today such harm has yet to be exposed. The father of this movement is Paul Samuelson who happened to be the author of the widely used college economics text. Not surprisingly, Ben Bernanke was a student of Samuelson. So now you know why the Federal Reserve still can't get a handle on the US economy.

The framework which is meant to undo this damage has been tested against the economic waxing and waning of the societies of Ancient Greece, Ancient Rome, Charlemagne's pre-medieval Europe, the Dutch Republic, the British Empire and the US Republic. In addition the framework must also be able to prognosticate the future economic outlook. The framework, consisting of four components - Capacity, Communication, Consumption and Currency - abbreviated as the 4C, is depicted below. In reality, the structure is a dense network with many-to-many relationship instead of the circular one-to-one relationship. However, understanding comes through simplification as long as the simplification doesn't change the substance of the subject matter.

Don't be deceived by the simplicity of the 4C. Remember Albert Einstein's dictum: "Everything should be made as simple as possible, but no simpler." In the 4C's simplicity lies a powerful tool enabling us to understand the past and foresee the future.

Let's walk through the framework. We know that an economy revolves around the exchange of goods or services. This implies that you must first produce goods or services surplus to your own needs. A self-subsistence existence on the other hand has no need for any economic exchange or trade. Capacity to produce surplus is thus the precondition for trade. But having capacity is useless unless the surplus production can be transported to those who want to consume it. Hence the communication and consumption legs. Finally a common measure, i.e., currency is needed to enable the exchange. Barter doesn't cut it because a plethora of prices will emerge to overwhelm the exchange. For example, under a barter system, 10 items will result in 45 prices, that is (10 x 9)/2, the formula being n(n-1)/2, whereas a common currency produces only 10 prices.

Currency doesn't have to be physical. In fact, most of our economic transactions are conducted using credit, the virtual currency that forms more than 90 percent of our money. Those who disparage fiat paper currency should have redirected their denunciation towards credit instead. Ancient and traditional societies with surplus economic goods also resorted to credit simply because there was not enough physical money, be they shells, beads or precious metals, to meet the needs of trade. And the main reason for the collapse of the discredited gold standard was its failure to meet the shortage of money.

In our modern day, the capacity and communication legs of the framework are primarily powered by technological advances. Hence to really understand them you need to have a full grasp of the history of technology. Historically, capacity has come in the form of cheaper and more plentiful energy and materials. Those are two out of the three hallmarks of the Industrial Revolution, the other being the setting of the work pace by machines.

Communication which can be either physical or virtual is the leg that drives stock market booms. The consumption leg on the other hand is tied up with demographic growth. Consequently a history of demography is a must. As population growth used to be highly dependent on food, a history of food is also in order. However in modern times, food and population no longer move in sync as fertility rates rapidly decline in the developed world though in the poor developing nations, high fertility rates and declining food production are storing up future troubles.

Only the currency aspect is within the purview of economists. Guess what do you need to know to master this? A history of economics for sure. Not the theoretical stuff peddled in universities. In effect, economists know only probably 20 percent of the knowledge needed to explain monumental shifts in economic conditions. No wonder their predictions go haywire and their rationalisations of the past fail scrutiny.

In the 4C framework, the circle or cell can represent an individual, a corporation or a state. A cell must be a producer (capacity) as well as a consumer (consumption). The purpose of an economy is to keep the network moving so that everybody produces and consumes; if he stops producing, he also cannot consume. If this happens to be a business enterprise, it can be made bankrupt. But you can't do that to humans or nations. That explains why good CEOs make poor politicians.

To support the flow of goods and services, the communication lines must keep the flow moving and there must be enough currency to lubricate the economic exchanges. Like a production planner on the factory floor, the aim is to balance the load along the network. There's no point in making some cells highly efficient in producing goods that the idled others cannot consume. The resources should have been diverted to the slow producing cells so that they can start producing and thus accumulate the wherewithal to pay for their consumption.

Among the four components of the framework, only the currency leg can be manipulated by policymakers. During the first half of any Kondratieff Wave, they would hike the interest rate in order to reduce credit growth. Because the interest rate is the price of money, the higher it is, the less money is borrowed. Through this means, they control consumption so as to be in line with capacity which is still trying to meet demand. A runaway inflation would be subdued in this manner.

Conversely, during the second half, they would reduce the price of money so as to stimulate demand for money. It works, but in the form of a borrowing and spending binge on real estate, and only for a very short duration. To understand why, you must drag in the capacity and the consumption legs. During this stage, the capacity has become lopsided with a few extremely efficient producers cornering the market. As a result the consumption also fails since many cells have been knocked out of the economic game because of their inefficient productive capacity. If this were a factory, you'd see harried economists confusedly scurrying around trying to fix a production flow that heaped superfluous parts at the wrong work cells while starving others of needed parts. So even at zero price or interest, there are no takers for the money. Nobody can borrow if they have no income to repay the loan. Borrowings plummet and money supply drops. Deflation ensues morphing eventually into a depression. A new beginning takes place only when a new 4C replaces the outmoded 4C.

The real life stories are more interesting and will be posted over time. In fact, with this framework as a guide, history will appear to you as a jigsaw puzzle capable of being solved. You'll spot gaps in the narratives of even noted historians. History will no longer be the boring stuff but a fascinating subject offering many lessons and patterns for the future. But one thing is certain, once you've viewed reality in 4C, you'll never want to go back to 3D.