The Greek Crisis

I don't know about the readers of this blog, but I am now at a stage of simply being overwhelmed by the ongoing and endless rescues of the Euro. Every day the news pours out on the latest initiative, the latest plan, the latest crisis meeting/summit, the latest bad news......In light of this, it was a pleasure to read the latest take on the story from Spiegel Online, which cuts through much of the fluff on Greece. The headline and sub-head offer a great summary:

European Politicians in Denial as Greece Unravels


Europe's politicians are losing touch with reality. Greece is broke, and yet Brussels wants to send the country billions in new loans, to which there is growing opposition within the coalition government in Berlin. Rescue efforts are hopelessly bogged down by bickering over who will ultimately step up.

This was the part that I really liked:

The Greek economy is not productive enough to generate growth. Aside from olive oil, textiles and a few chemicals, there are hardly any Greek products suitable for export. On the contrary, Greece is dependent on food imports to feed its population.

"Greece has been living beyond its means for years," an unpublished study by the German Institute for Economic Research (DIW) concludes. "The consumption of goods has exceeded economic output by far."

Especially devastating is the assessment that the DIW experts make about the condition of an industry that is generally seen as a potential engine for growth: tourism. According to the DIW study, the Greek tourism industry concentrates on the summer months, with almost nothing happening throughout the rest of the year. There is almost no tourism in the cities, which translates into low overall capacity utilization and high costs for hotel operators. By contrast, capacity utilization in the hotel sector is much more uniform in other Mediterranean countries.

I have long argued that this is one of the fundamental problems that sits beneath the economic crisis. It is the fantasy that a country can just continue to endlessly consume more than it produces. Whilst Greece may be an extreme case, it is very apparent that Greece is not alone. I am going to quote at length from the first post of this blog, which is from an essay I wrote in 2007:

I am going to start by looking at the world from the point of view of many modern economists. Whilst none of the economists would accept that what I am about to portray is their belief, when you look hard, you will find that this must be their basic belief. If not, then they have no justification for their pronouncements of success for the UK economy.

Imagine a family living in the UK, not an atypical family, not a typical family, but an ordinary middle class family. We will call them the Wilsons. The father has a job in management for a chain of retailers, and earns £30,000 per year. The mother has a good job in a local hotel where she is the marketing manager and earns £30,000 per year. They therefore have an income of £60,000 a year. They have two children at the local school.

The Wilsons have purchased a home, which cost them £300,000, which is five times their combined income, using a 95% mortgage. The house has increased in value by £30,000 a year, in each of the three years since they purchased it. They are very pleased to see their house growing in value, as it is like having another earner in the house, except this earner pays virtually no tax on the income, making it an even better earner than themselves.

The Wilsons have a relatively large mortgage, but interest rates are low. Despite this, they struggle to balance the quality of life that they enjoy against their income. As such, they make use of credit cards to occasionally purchase items. Each year, for three years, they have added £6000 to the family debts through overspending on the ‘little luxuries’ in life, such as holidays, and new goods for the house. At the end of the second year in the house, Mr. Wilson decided that he would fulfil his dream of owning a Mercedes, and re-mortgaged the house to realise £20,000 of the increase in value of this asset. He used this as the down payment on the car, and took a loan for £20,000 to pay for the remainder.

Overall, the Wilsons non-mortgage debt stands at £18,000 for the credit cards, and £15,000 remains of the loan for the car. They are starting to find the payments on these debts are stretching them, and they seem to be using the credit cards a bit more often than before.

Next door to the Wilsons live the Jones family. The Jones family know and respect their next door neighbours. They can see how successful they are. They are always doing something to the house, making improvements, and they seem to be living the good life. Only recently the Wilsons bought a new Mercedes and Mr. Jones feels a little jealous, as he would love a Mercedes too.

The Jones family, have less income than the Wilsons, but every year they save a few thousand pounds. They have no debt except for their mortgage, and only spend what they earn. They purchased their house at the same time as the Wilsons, and are steadily paying their mortgage. Their belts are tight, but they get by, and look forward to better days ahead.

Which of these two families is the more wealthy family?

The answer largely depends on whether you are an economist who has been a cheerleader for the boom of the last ten years, or whether you are a person grounded in the real world. The Wilsons have been the motor of growth in the Anglo-Saxon economies. Apparently we have gone through a period of sustained growth and, in moments of hubris (Gordon Brown in the UK being a wonderful example), we promote the ‘success’ of the Western economies to the rest of the world. The trouble arises when we ask a simple question; ‘Where is this growth?’

The Greeks are the Wilsons. Yes, they have lived a good life. But the bills have simply grown to the point where they do not have enough income to repay them. This aspect of economics has never been complicated. If you are continually borrowing to pay for consumption, you will indeed have a high standard of living - for a while. Unless your income growth is outstripping the rate of debt accumulation, it is only a question of time before the credit becomes too much to service. It is not a case of 'if', but 'when'.

It is very curious how much effort and time goes into denying this simple formulation. The answer to the problems of too much debt is apparently to just borrow more....We see it endlessly from economists, politicians and commentators. Austerity is self-defeating. The answer is to borrow more. 'Yes', when borrowing more, the economy will appear to grow. Just like the Wilsons, there will be an illusion of wealth for a little longer. However, like the Wilsons, it can not change their actual real income; it cannot change the ability to create real wealth.

The Spiegel article gets to exactly this point with Greece. Greece simply does not have the ability to continue to have the high standard of living that it has previously enjoyed. That standard of living was supported by unsustainable debt accumulation. They just do not create enough wealth to either continue to live as they have done, or pay back the debts accumulated in giving them an illusion of wealth.

I just do not understand how it is that this simple and evident reality can be ignored by so many. In the case of Greece, it is plain to see. And just as it is plain to see in the case of Greece, it is also plain to see in the cases of other economies. They may not be as dramatic as Greece, but the same principle applies.It really is very simple.

Austerity in the UK

I know I bang on about Krugman, but his pronouncements become ever more silly, and I would like to relate his latest silliness to the post above. This is his commentary on austerity in the UK:

Britain, in particular, was supposed to be a showcase for “expansionary austerity,” the notion that instead of increasing government spending to fight recessions, you should slash spending instead — and that this would lead to faster economic growth. “Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong,” declared David Cameron, Britain’s prime minister. “You cannot put off the first in order to promote the second.”

[and later]

And we may get tipped in the wrong direction by Continental Europe, where austerity policies are having the same effect as in Britain, with many signs pointing to recession this year. 

The infuriating thing about this tragedy is that it was completely unnecessary. Half a century ago, any economist — or for that matter any undergraduate who had read Paul Samuelson’s textbook “Economics” — could have told you that austerity in the face of depression was a very bad idea. But policy makers, pundits and, I’m sorry to say, many economists decided, largely for political reasons, to forget what they used to know. And millions of workers are paying the price for their willful amnesia.

There is one very fundamental problem with his use of the exemplar of the UK for the evils of austerity; there is no 'austerity' in the UK, just talk of it. It is a point made very well in a post in the Money Illusion:

But I am seeing article after article claiming that the coming recession is due to fiscal tightening.  I was curious to see just how tight British fiscal policy actually is, so I checked the “Economic and Financial indicators” section at the back of a recent issue of The Economist. They list indicators for 44 countries, including virtually all of the important economies in the world.  Here are the three biggest budget deficits of 2011:
1.  Egypt  10% of GDP
2.  Greece:  9.5% of GDP
3.  Britain:   8.8% of GDP
Egypt was thrown into turmoil by a revolution in early 2011.  Greece is, well, we all know about Greece.  And then there’s Great Britain, third biggest deficit in the world.

There is absolutely nothing that can be described as 'austere' about the rate of borrowing in the UK. Quite the opposite - it is shockingly profligate. In reality, the UK is doing exactly what Krugman has long argued for, and has now been doing it for a long time. The UK is borrowing and spending with abandon. The really shocking thing about the UK economy is that, despite following this reckless path, it is still seeing shrinkage of the economy.

What Krugman means is that the UK government should increase the rate of debt accumulation to even higher levels. It is his solution to all ills. Just borrow more, or print more money. He cannot even see that the UK is already doing exactly what he recommends, that it has been doing so for a long time, and that it has not worked. Quite the opposite. For all the debt accumulation, the UK economy is still shrinking.

As regular readers know, I do not argue the case of expansionary austerity. I can at least agree with Krugman on this point. Real austerity will be a hard and painful path. If the UK were to balance the government budget tomorrow, the UK economy will nosedive. However, as I argue above, in the end, there is no real choice but to see the economy nosedive at some point. It is not 'if', it is 'when'. Again, as argued above, Krugman's solution will keep the illusion going for a while, assuming that bond markets play ball, but it will only prolong an illusion.

In the post above, I talked of the way that modern economists might see the two families. At the time of writing I was not familiar with Krugman. However, he is exactly the kind of economist who would propose that the Wilsons are the wealthier of the two families. He seems to really believe this......it is shocking. It is why his pronouncements are so very, very wrong.

The Economic Shift in the World Economy

I have started this post without a title, as I'm still trying to sort out which might be the best subject for a post. The slow motion car crash of the Euro is always tempting. Then there is the current state of China, which increasingly appears to be in trouble. Then there is the US 'recovery' or the latest discussions at Davos.

For the last point, an interesting perspective was aired at the forum in Davos, and it may be that it can tie together some of the many stories that are being discussed. This from Jeremy Warner of the Telegraph:

The contrast between Western gloom and Eastern optimism is again striking this year, and it is something that goes beyond the immediate challenges of the eurozone crisis.

According to forecasts aired by Indonesia's minister for creative industries, the total size of the world's middle class will more than double to 4.9bn by 2030, with 85pc of the growth occurring in the developing world. By then, some 65pc of this middle class will be in Asia.

Long term predictions of this sort are always going to be suspect, but few would disagree with the thrust of what the Indonesian minister is saying.

The article mirrors something that I wrote in 2009, in which I discussed the emergence of the Asian middle class, in contrast to the Western middle class whose spending power was in decline. I used the Tata Nano (perhaps a poor choice with hindsight) and SUVs as an example to illustrate the point. Whilst SUV sales were falling the Nano was the coming thing. The shift represented the move from wealth being concentrated in Western middle classes (the SUV), to a dispersion of the wealth to the East (the Nano), and with the Western middle classes moving down to meet the rising Eastern middle classes in the middle.

Another of the stories that I had kept in mind for a future post ties into the story of the decline of the middle classes in the West. It comes from the New York Times, and is an explanation of why the Apple iPhone is not made in the US (there is also a visual presentation of the argument here). It is a long article, but there are some points that are clearly made. The first is that it pops the fantasy that gripped the Western world; that the East would do all the clever work and that the East would simply be the cheap labour. Again, it has been a theme of this blog that this was just not going to happen. I have argued that all of the key services would, in the end, follow manufacturing.

The most interesting thing about the Apple story is that Apple still does have the design knowledge and experience, and this is still undertaken in the US. The problem is that there are so few jobs that this creates. Instead, the article argues persuasively that it no longer about the availability of cheap labour, but the flexibility of Chinese companies, and also the proximity to all key suppliers that makes manufacturing in China a compelling case. In addition, China has an army of engineers and technically trained staff, skilled manufacturing employees and so forth. The result is that Apple has a compelling case for manufacture in China. It is the underlying reason for why the middle classes of the US are being hollowed out. Those skilled jobs are going to China, for example the solidly middle class engineering jobs, and the skills of the US workforce must inevitably decline over time in relation to countries such as China.

It then just becomes a matter of time before the most highly paid jobs, such as those in design and marketing, likewise commence the move Eastwards, as the Chinese workers 'upskill', as Asian markets grow in relation to Western markets, and as the key skills to 'make stuff' become ever more concentrated in the emerging markets.The worrying element of this is that China has created a virtuous spiral. The more manufacturing it undertakes, the more compelling the case for manufacturing in China.

All of this appears, then, as a done deal. But is it?

To date, all of the massive growth in China has taken place in the context of 'state capitalism', in which China has carefully guided the rise in its economy with a combination of massive investment in state companies, and measures to ensure a competitive currency, and a policy of obtaining technology from the West through demands for technology transfers and outright technology theft. It is a story that is told in a recent Economist special report. But it is not just China that is following a state capitalism model, but as the report details, state capitalism is increasingly being endorsed around the world.

After all, who can argue that China's model has been a success to date? The real question is one of how long it might continue?

I am certainly having my doubts that it is a model that can be sustained. I recently used an analogy to explain to friend why I thought the Chinese model might now be in some trouble. When China first 'opened for business', the country was in a parlous state following the years of chaos characterised by Maoism. The first advantage was that China could almost do no worse. The second advantage that flowed from this is that, in terms of state capitalism, China could safely invest in infrastructure and almost guarantee a return. My analogy was that it was like throwing a dart at a dartboard from one foot away from the board, with the bulls eye dominating most of the board. As time has moved forwards, the person throwing the darts is moving steadily further away from the board, and the bulls eye is shrinking back to its normal size. It now takes skill to hit the bulls eye, and there are more misses than hits. Just one example of this in action is the case of cities being built but remaining unoccupied.

The second problem with the Chinese model is that it requires the acquiescence of trading partners. The special report points out the increasing queasiness of key trading partners when faced with effectively subsidised state giants entering into international markets. The Economist article is perhaps an exemplar of a growing backlash against the state capitalist model. For example, it points to the spreading influence of the model, and the more the model spreads, the more problematic it becomes. The more companies that face competition from these state supported enterprises, the more there will be complaints to policy makers of unfair competition. There are two approaches to such complaints. One is restriction of trade, and the other is to respond in kind. In either case, the model will start to break down. The former is (I hope) self-explanatory, but response in kind will just lead to a fight that neither side will win.

I am reminded of a long while ago. I remember commenting on another Economist article (sorry, I cannot find it now) that argued that the cheap products being manufactured in China should be seen as a wonderful benefit for the West. The article argued how this kept down inflation, and provided a better standard of living to the West. They mentioned the problem of currency keeping prices as low, but thought that the benefits derived from this were positive (this is my best recollection of a long, long while ago). I do remember that I argued at the time that this subsidy of Chinese goods might appear to provide benefits, but at the cost of hollowing out their competitors in the West. I see the state capitalist model is going to raise the same issues, but this time with China's trading partners increasingly jaded about China, and with a growing sense of frustration as the impacts of the emerging market growth becomes ever more plain to see.

I am not sure that the acquiescence can continue for much longer.

Another side of the story is that of Chimerica. The funding of Western states in order to continue trade imbalances is coming to an end. It has not ended, but the limits of the model are becoming apparent. Also, the costs of the model are becoming apparent. This leaves a tough period of transition. For example, the problems of the Euro area will eventually land on the doorstep of China and the other emerging markets. This is going to take place at a time which, in the case of China, will be when the problems of the state capitalist model are starting to make themselves felt. China's property bubble is bursting, and there are signs that the Chinese economy is rapidly slowing. This from Ambrose Evans-Pritchard, who discusses proxies for the state of the Chinese economy before saying:

So how did China pull off an economic growth rate of 8.9pc in the fourth quarter?

Beats me.

I strongly suspect that the trade and power data reveal the true state of China’s economy.
There clearly was a pick up in early January but I stick to my view that China has inflated its credit bubble beyond the limits of safety – an increase of 100pc of GDP in five years, or twice US credit growth from 2002-2007 – and that Beijing cannot continue to gain much traction with this sort of artificial stimulus.

Indeed, the extra boost to GDP from each extra yuan of credit has collapsed, according to Fitch Ratings.

There are several points that can be taken from the discussion that I have presented. The first is that, as was predictable, a major shift has taken place in the world economy, and the price of the shift has been the diminishing of the Western middle classes, and the rise of the middle classes in the emerging economies. This is being noticed, and it is finally being understood. The success of the model has relied on the acquiescence of the Western world, but the continuing acquiescence is doubtful. Set against this, the stage of development of China in particular, has seen a virtuous spiral develop. However, that virtuous spiral might be upset by the consequences of the gross mis-allocation of resources that are becoming apparent. Whether the over investment in real estate by banks and provincial and city governments, or ever more questionable infrastructure investment and investment in more and more industrial capacity, this has potential to be a drain on the Chinese economy.

It is a complex situation. It is difficult to predict how it might unwind. However, the one certainty is that some kind of change is on the horizon. The pain being felt by the middle classes of the Western world will be addressed by politicians, and there is no sure way to know how they will finally respond. Of one thing, I am increasingly certain. The acquiescence of the West to a system that is destroying the wealth of the West is coming to an end.

Note: I have used the expression emerging economies but they have, in most senses already emerged. Please excuse my use of this convenience. Also, as ever, my focus is perhaps too much on China, which is simply because it is one of the countries I watch most closely.

Debt and Economic Structure

In my post today, I am going to talk about the principles of structural debt reliance in an economy. It is (I hope) going to illustrate, in principle only, why so-called austerity causes a downwards spiral in an economy, and why denying the need for reductions in government borrowing are a fallacy. It is deliberately simplistic, but I hope that it will nevertheless make the point.

In order to illustrate the point, I will use a notional company that makes office 'widgets'. I choose this type of company as its products have broad applications (as all organisations use office supplies to some extent). We will imagine that our notional company makes 1000 widgets per week, and is a private company. At the starting point of the example, the government is borrowing money, but not excessively. Our widget company is supplying many organisations with their products, and they are a company in reasonable shape. Amongst their many customers are various government organisations, and these organisations purchase on average 200 widgets per week.

The widget company actually likes to supply these government organisations, as they have one particular advantage, and that is that they are government organisations. From this flow many benefits to our widget supplier. They pay on time, and most importantly, they seem to pose no credit risk. This in turn has benefits in, for example, raising finance, as the credit provided to the government is seen as rock solid. Overall, the widget company likes to supply to the government, and even hires a sales specialist who has knowledge of government procurement to help build this area of the business. Our widget maker starts to notice the growth of their business with government organisations, with government spending increasing over time. The money being spent by the government is increasingly funded through borrowing, not through taxation.

Our widget maker sees government sales creeping progressively upwards, moving steadily from 200 widgets a week, up to 300. At the same time, there are steady increases in sales from the other purchasers of widgets. With the ongoing growth in the business, our widget maker makes some new hires, and invests in new plant. The demand for their widgets is growing steadily, and they are struggling to meet the new demand for 1200 widgets per week, and will soon be turning down orders unless they invest. On current growth rates, they feel confident to invest in capacity for 1500 widgets per week. In order to grow their business, they visit their bank, and have a persuasive story of steady growth, reliable customers, and a growing stream of revenue with which to repay the loan for the new capacity. The loan is granted, and our widget company invests in expansion. All the while government borrowing is steadily increasing and the overall size of debt growing.

All is going well for our widget company, and then there appear to be tremors in financial markets. For many years, government debt has been growing, and concerns are starting to be raised about the degree of borrowing by the government. Words such as crisis start being used, and yields on government debt are rising. Raising new debt is becoming more difficult and expensive. There is talk of government cutting borrowing, and cutting services. Our widget maker is concerned, but not that concerned until the cuts to government expenditure start to be implemented. The number of widgets sold to government departments stops growing, and then starts to decline. The government sales specialist explains that the cuts by the government are limiting the spending of departments on new widgets, and that some of the government organisations are disappearing entirely.

Sales to government organisations start to fall back to the original 200 per week. It is a blow, but it is not that big a blow that our widget manufacturer cannot survive. After all, it was not just the orders from the government that were growing, but also the sales to businesses. They may have over-invested in new capacity, and repaying the financing of that capacity will be more difficult but not impossible. Time moves forwards, and the cuts of the government are starting to bite. Our widget maker once again becomes concerned. Whilst the government widget purchases have stabilised at the original 200 per week, the company notes declines in orders from some private customers. Also, some of his private customers are becoming tardy in paying their bills, and this is hitting cash-flow. The company is finding that sales overall are falling back towards the 1000 widgets per week, and they need at least 1100 sales per week to cover their cost of finance.

They are in trouble, and their cash flow is starting to be a problem for meeting their bills. They are themselves making late payments. They do not understand what is going on. After all, they had a diversified customer base, and were not reliant only on the growth in government orders to finance their expansion. However, they were unaware that many of their customers, just like themselves, were also supplying the government and like themselves grew (in part) through growth in government orders. And then there were the companies that supplied the companies that were supplying the government. And then there were the companies that supplied the companies that supplied the companies that supplied the government. In each case, they all see a deterioration in their revenue as government cuts bite, and each sees a negative impact upon their business.

The companies that are direct suppliers to the government are hit hardest. They are the ones now being tardy with paying their invoices. This tardiness impacts down the supply chain, with some companies not being paid for their products and services as companies start to fail. Our widget maker is now in trouble and is one of those companies. Their own suppliers are complaining about late payments, and are starting to restrict any new credit to the widget supplier. As credit from suppliers starts to disappear, and with now negative cash flow, our widget supplier is going bust. When the inevitable happens, the workers are laid off, and the bank takes a hit to its balance sheet. The liquidators sell off what remains of the plant and anything that might have value for creditors. The laid off workers look for new work, but with so many companies laying off workers, new work is difficult to find.

The laid off workers are unemployed, and they therefore tighten their belts. There is no money available for many things they had enjoyed before. For example, they would regularly go out to restaurants, but this is now completely unaffordable. It is notable that, whilst many restaurants are still in business, many restaurants are also going bust. It is not just restaurants, but other businesses that are closing the doors, such as shops, and hair dressers. And the shopfitters, and the wholesalers are also being hit. Yes, some businesses are still doing well, but the numbers of bankruptcies over a multitude of sectors are steadily rising. Even where businesses survive, they are often downsizing. Unemployment is climbing fast.

At this point I will stop. It is clear that this is a self-reinforcing downwards spiral. The managers of our widget business were, in all regards, perfectly competent business people and  managed their company in a sensible and responsible way. The market gave them positive signals, and they responded. As business people, they did everything right.

Our widget maker was directly exposed to government cuts, but was also indirectly exposed. As the borrowed money flows through an economy, the structure of the economy shifts to the consumption of that money. In some cases, as in the case of our widget maker, the shift in structure is readily apparent. In other cases, the shift in the structure of the economy is less apparent. For example, the small sandwich shop near the widget maker's factory that is doing good business as a result of the increase in the labour force in the widget maker. For example, extra staff may have been taken on to service the increase in business from the widget factory.

When we imagine the many interlinked ways that an economy restructures to service the debt founded consumption, it does not come as a surprise when we see countries such as Greece slide into a downwards spiral as government cuts borrowing and expenditure. It is the only possible outcome. There are those that propose the opposite course of action, which is to increase borrowing and expenditure, but the logic of this is that the economy will simply structure more deeply into servicing the debt based consumption. It will, undoubtedly, delay the problems, but only at the cost of more pain when the ability to accumulate yet more debt finally comes to an end.

Even if only holding debt accumulation at the current rate, the problem remains that the debt is accumulating, but the structure of the economy will remain the same; it means that the problem of a debt based structure is left unchallenged. One day, the economy must restructure away from the debt accumulation as infinite debt accumulation is not possible. There will always come a point at which the debt burden becomes too much, or where markets finally perceive that it is unsustainable.

When an economy structures around debt accumulation there is no painless fix. It is simply unreal to imagine that a restructuring away from debt accumulation might be undertaken without the period of the downwards self-reinforcing spiral. It absolutely must happen. The only question is to ask how much of the economy is rooted in debt consumption, how fast and deep the cuts will be. There are, of course, some things a government might do during this painful period, such as retraining, and other ideas to try to ameliorate the pain. However, there is no avoiding that the painful restructuring is the only way that the economy can move back onto a sustainable path.