From emerging to submerging

Much excitement has been generated by the emerging markets because this is where economic growth is at a time when other markets are in doldrums. Can these markets avoid the problems of a world facing a synchronised economic depression?

The Wall Street Journal has produced several charts (see below) that compare the debt growth of selected advanced economies with those of emerging economies. For the advanced economies, their debt as a percentage of their GDP is declining while that of emerging economies is still growing. This disparity accounts for the seemingly sanguine prospects of the emerging economies.















But take a deeper look into the debt growth and you can discern a clear pattern. The advanced economies have moved further along the debt growth S-curves. The emerging economies are lagging behind but they are all approaching turning points of their respective S-curves. Don't be lulled by the low government debts of these emerging economies. Their precarious situations lie in their private debts. Most of these debts are being used to finance property booms since their export machines have faltered in the face of global excess capacity and falling consumption.

The next chart (from The Financial Times) compares the current situations of the emerging countries with that prior to the 1997 Asian financial crisis. Some of these countries are facing debt situations that are worse than those in 1997. Yet the picture is still incomplete since it doesn't incorporate bond and shadow banking debts. In 1997, they were rescued by the US economy which pumped increasing credit to generate the consumption that offloaded the exports of these struggling emerging economies. Now the US economy itself is under considerable strain. There's no saviour this time around. Instead of emerging prosperity, it's emerging  calamity that is staring in the face of these countries.

How a balance leads to imbalances

The notion that the leadership baton of the global economy will pass from the US to China or the EU is just wishful thinking. Instead, it is the baton of economic followership that the other big economic players have grabbed. The US economic leadership is immutable and should it eventually give, which it eventually will during the 5th Kondratieff Wave, the current global order will crumble.

Neither China, Japan nor the EU, specifically Germany, is in a position to assume the mantle of global leadership because they are all current-account (CA) surplus countries. The bigger their economies become, the more problems they create for the rest of the world. Take Germany, the economic problems of the southern European countries can be traced to Germany's preoccupation with maintaining continual current account surpluses since the formation of the eurozone on 1st January 1999 (see The Economist chart at left). Notice that prior to the eurozone, most of the other euro countries were having CA surpluses.

An updated chart from the recent issue of The Economist shows that Germany is still fixated with these damaging CA surpluses. The others can't match Germany's economic prowess because their labour productivity is inferior. This can't be redressed without an adjustment in exchange rates or drastic salary cuts. For example, Spain and Italy are expected to turn their deficits into a surplus this year but at the expense of substantial cutbacks in consumption. What's the purpose of saving when starving is the price paid?

As long as the euro exists, it will drive the EU into the ground. Germany can't get rid of its CA surpluses because its 2009 constitutional amendment requires the federal and state governments to maintain balanced budgets. Even its soccer clubs has a licensing system that ensures their fiscal prudence.

Germany is perplexed that others can't emulate its financial discipline, so through its economic clout, it is imposing this discipline on others. But by doing so it's tightening its own noose. Its CA surpluses will soon diminish once other EU nations have to reduce their CA deficits. Without the benefits of the CA surpluses, Germany's balanced budget restraint will unravel but that can't be undone without flouting its constitution. So expect Germany to face a long slog to an uncertain future.

Why Obama deserves impeachment

Despite the almost daily record notching feats of the US stock indices, things are not going smooth with the US economy. Otherwise Obama wouldn't be facing possible impeachment hearings. The Benghazi and IRS scandals are only the beginning. If those fail to unseat Obama, more will come. Don't think about the US leading the world in the coming years as it itself will be in perpetual crisis mode.

The main failing of Obama is not his failure to manage crisis, though he's certainly lacking in this bit. Instead it's his inability to read the future based on a reading of the money supply movement. Obama should have known that the money supply, that is not the conventional definition by the economists but the total credit in the economy, would be in severe trouble once the sequestration kicked in on 1st March, 2013. And by correlation, so would be his position. All along throughout the Great Recession, itself a misnomer since it actually is a Grand Depression, government spending had been the driver of credit growth. Without it, credit growth would've stumbled, pulling the economy down with it.

It's not that anybody can reverse this trend. Credit will definitely contract, sequestration or not, because the consumption leg of the 4C is floundering. It had been propped up only by the grace of Obama's deficits. Even Mitt Romney, if he had been elected, would've been coming up against similar intractable situations as Obama is now facing. Probably not Benghazi or IRS since those could be blamed on his predecessor but others would in time rise to the surface.

How do we know that federal debt is being constrained given that the Fed Funds Flow statement for Q1 2013 would only appear early next month while that for the current quarter in September 2013? Easy, just look at the budget deficit. This year's deficit has been projected at US$642 billion. That's half a trillion less than last year's.

The Republicans just need a few more Senate seats in the 2014 mid-term elections to give Obama the boot. Or they may succeed earlier provided the total credit in the system declines for a couple of quarters before making their impeachment move. See how powerful is the soulless credit market in determining one's fortunes.

Debt in a time of decline

Carmen Reinhart and Kenneth Rogoff, the authors of a famous 2010 study, 'Growth in a Time of Debt' have been assailed after it was discovered that their conclusion that economic growth would falter once public debt levels reached 90% had incorporated an error in their Excel spreadsheet.

A reworking of the code by Thomas Herndon, a University of Massachusetts student, and his two professors shows that growth only declines slightly instead of contracting (see The Economist chart at left).

Those in the stimulus camp have been rejoicing at the debunking of Reinhart and Rogoff's flawed findings. However both the austerity and stimulus proponents have not been able to put their fingers on the real issue. Again this reflects their data-driven infatuation that has prevented them from seeing the real pattern.

Actually the pattern is simple. What do you do if you're out of job? You'd do anything – beg, steal or rob – to survive but if someone is willing to lend you money, you'd surely borrow before choosing the other less well-meaning options. Similarly, if you take the analogy of the Monopoly board game, how can you make the game last longer when only one player is winning? There is surely no other way than borrowing from the winning player or from the banker. Of course, you can never repay because your borrowed money eventually ends up with the winning player.

The same goes for our real life economy. In the maturity phase of a Kondratieff Wave, we have no choice other than to increase debt (chalk one up for the stimulus camp). But increasing debt doesn't revive growth, it merely buys time, delaying the inevitable contraction, now made worse by the increased debt load (chalk one up for the austerity camp). Like that of the Monopoly game, the losers do not have the slightest chance of winning. Their only hope of winning is to start a new Monopoly game (or in real life, a new Kondratieff Wave).

The chart below (also from The Economist) depicts the economic growth pattern for the advanced, middle-income and low-income countries. We can see that the advanced economy has finally succumbed to the inevitable decline phase of the Kondratieff Wave. Notice that the cycle for the middle-income lags that of the advanced but leads that of the low-income. So as wealth inequality rises for the advanced economy, it is falling for the low-income, for now. The final outcome would still be a rising one as the low-income eventually catches up with the rest, not in terms of GDP per capita but in terms of hitting the economic growth wall. So the main defect of Reinhart and Rogoff's argument is their confusing cause and effect; growth is not a consequence of debt but debt is a consequence of an economic super-cycle.

The other critical defect in the Reinhart and Rogoff's study is that it covers only public debt whereas for the purpose of the real economy, all debt components  – public, businesses, households and financials must be counted. There are times when public debt falls but total debt increases. Relying solely on public debt generates a false picture on the amount of money in the economy.

For two renowned Harvard professors to commit a simple Excel error, that is forgivable but for the whole economics profession's failure to see a crystal-clear pattern, that would be damning evidence of its wretched state.

Which comes first, economics or politics?

Many of the political problems plaguing many nations now stem from the fact that their political systems are no longer consistent with their economic systems. Because of the widespread growth of democracy and its natural complement, human rights, every nation is pressured to adopt the democratic process although the result of doing so increasingly will be at odds with the evolution of its economic system.

The evolution of an economy is easy to foresee because, as long as wealth accumulation is allowed to go to extremes, it always takes the path of the Monopoly board game. If you analyse the past history of ancient Greece or Rome right down to the present time, you'll be amazed that the same pattern echoes through the ages. The following Financial Times op-ed piece titled A wealth of inequalities bodes ill by Merryn Somerset Webb which came out last week, has a fascinating take on how wealth flowed among the citizens of the Italian city-states in the middle ages. Read on:

I am reading a book by historians Charles Foster and Eric Jones on this very subject (The Fabric of Society and How it Creates Wealth, Arley Hall Press). Foster and Jones traced the social and economic conditions in four societies that manufactured cotton cloth between 1100 and 1780 – northern Italy, Germany, Lancashire and Holland and looked at how and why these particular areas were so successful at generating wealth. There appears to be a clear answer. 

In each country a society emerged where a large number of families owned a small amount of capital – “wealth was fairly widely distributed” (perhaps as a result of having plural political institutions). “Vigorous technical and social innovation then occurred” which created rising wealth across the board – probably because “many families had enough wealth to permit innovators to experiment and establish their new ideas.”

In the end, however, some families worked it so that they ended up economically and politically more successful than most others, wealth became concentrated in a few hands and that was that: plural government turned to oligarchy, innovation declined and “these societies ceased to be able to generate increasing wealth for their citizens”. 

A quick look at one village in northern Italy in 1243 – Piuvica. Records (amazing that there are any, isn’t it?) show that there were 238 resident householders in the village and that the top 50 per cent controlled 80 per cent of the wealth. 

You might think that sounds a lot, but in the great scheme of history it suggests an astonishingly equal distribution. 

Similar figures exist for what was the city state of Orvieto. This was the period in which business development surged in northern Italy, when the quality of cloth (silk, cotton and wool) surged and when great innovation appeared in accounting and banking. But with wealth came greed. And after 1300 or so committees of citizens gave way to chief magistrates who often succeeded in making the position hereditary to their families. They became Signori. 

Next came rising budgets and taxes and the armies of officials needed to administer them. By 1427 you could see the changes in the records from the city of Florence: 8 per cent of the households held 80 per cent of the wealth. 

This came with some good (just as the concentration of wealth in the UK post-industrial revolution gave us 150 ornamental lakes designed by Capability Brown, the Italian concentration gave us the artwork of the Italian Renaissance) but it might also have had something to do with the fact that by 1700 “an exporting textile industry in Italy barely existed and the country was no longer rich”. 

You’ll be wondering what my point is. It is this. Wealth inequality may be, as Ridley suggested, falling across the globe, but in the west it is rising to uncomfortable levels. 

In the US the top 1 per cent of the population own more than 35 per cent of the nation’s wealth while the top 20 per cent own not far off 90 per cent. The bottom 80 per cent, between all of them own a mere 7 per cent. 

The UK looks pretty rubbish when it comes to wealth distribution as well. The top 1 per cent have something in the region of 20 per cent of the wealth and the top 10 per cent hold 50 per cent. And, as I write, a good 150 ex-hedge fund managers, chief executives or retired politicians-turned consultants are probably in the process of designing new lakes for their estates or, as Foster puts it when he refers to the UK rich after the industrial revolution, “expending their talents on trivial pursuits”.

The article doesn't explain why the Italian textile industry disappeared. Essentially the Italian city-states generated more wealth from the East-West spice trade, that is, when the trade had to pass through the overland routes. But the Dutch cut this off when they rounded the Cape of Good Hope. As always, water transport beats land transport hands down. Of course, the Portuguese pioneered the route but they missed out because they lacked credit or currency—another critical component of the 4C—to finance bigger and frequent voyages. To put the final nail in the coffin, the Dutch in the 17th century flooded the Mediterannean with cheap pepper, effectively putting the Italians out of business. And with no wealth, all other industries were similarly busted.

The main point however is not about the spice trade but the way wealth over time gets concentrated in the hands of the successful few. The only difference is that in the past, things moved at a leisurely pace. Now, 60 years is the length of one cycle of wealth growth and decline. Luckily we have been through 4 such cycles in the space of almost of a quarter of a millennium. But with every wave, the government grows bigger until eventually a large proportion of wealth creation centres on the government mainly through government deficits leading ultimately to the implosion of the government itself.

With only one cycle left, we'd better be prepared for a new of style of politics. Democracy is already passe with a growing number of hung parliaments unable to govern. Oligarchy should be revived, no matter how unpleasant it may be. Next would be fractured oligarchy as states begin breaking down. Else we can welcome anarchy, Syrian style.