Sunday, 8 March 2009

Things Fall Apart?

No-one has a clue where the world economy is heading, do they? It will probably get worse (and feel worse) before things get better (or feel better), but apart from that, whose to say? I think all that money- obscene amounts- that Governments and international institutions have thrown into the global economy will have some sort of effect in mitigating the worst consequences of the 'downturn' (it's a euphemism), at least in the short-term, but no-one knows how it will finally pan out. As Keynes said, in the long-term we are all dead.

Instead of making predictions, I'll just post two articles that have caught my eye in recent days. This one by Larry Elliott will appear in tomorrow's Guardian:

Never give a sucker's rally an even break
Larry Elliott,, Sunday 8 March 2009

Even when times are really hard, stock­­­­markets never go down in a straight line. There are periods – often lasting months – when prices rally amid hopes that recovery is under way. Then the selling resumes and the market takes another downward lurch. Dealers call it a sucker's rally.

Bear this phrase in mind, because it is not only financial markets that can have false dawns. In the late 1970s, for example, the UK economy appeared to bounce back from the recession of 1974‑75 and the sterling crisis of 1976 only to be plunged into an even deeper slump in 1980-81.

The chances of a sucker's rally over the next couple of years are high. Hard though it is to envisage during these dark days, there will be a resumption of growth – and probably sooner than the financial markets envisage. Policy was so heavily geared to expansion – even before the Bank of England announced that it was to start creating money – that it would be a miracle if green shoots did not soon start to appear.

Just consider: six months ago, anyone with a £150,000 tracker mortgage was paying more than £600 a month to finance their home loan. They are now paying about £60 – a colossal increase in spending power that is bound to affect behaviour, despite the fear of unemployment. Falling inflation means those in work are seeing increases in real income, and that tends to be a key determinant of consumer spending. Add lower taxes to the mix and it is a heady cocktail that, in normal times, would be enough to generate a wild boom.

Clearly, though, these are not normal times. In normal times, the Bank of England likes to keep the bank rate at about 5% rather than 0.5%, and it would not be pursuing monetary policies more normally associated with banana republics. One City financier has what he calls a Gono index, which charts how far the UK is along the road travelled by Robert Mugabe's central bank governor. He estimates that we are halfway there.

Normally, Alistair Darling would be preparing a budget next month of such austerity that it would put Sir Stafford Cripps to shame. But the chancellor is considering an expansionary package that will lead to a further increase in the budget deficit. On some estimates, the Treasury may need to borrow £180bn next year to balance the books – 12% of GDP and unprecedented in peacetime (and probably wartime, for that matter).

The justification for all this is that the banking system has been rendered dysfunctional by the credit crunch. That is true up to a point. Homeowners and businesses are finding capital harder to come by, but the supply of loans did not entirely dry up even when the financial pressure on the banks was at its most intense last autumn.

Consider what the financial system was like before the crash: the Icelandic banks and specialist lenders filling the gap between domestic savings and demand for loans; mortgage providers gaily handing out home loans worth 125% of the value of the property. We have merely gone from one form of dysfunctionality to another.

Be that as it may, the re-capitalisation of the banks, the insurance scheme for their toxic loans and now quantitative easing should increase the supply of credit in the coming months. To make a difference, of course, there has to be a matching demand for credit, and the question is whether the impact of the policy stimulus will outweigh the negative effects of falling house prices, a bombed-out stockmarket, rising unemployment and weak global trade.

It will, not least because Mervyn King says the Bank will continue to print money until the policy has the desired effect. When will this happen? No one knows but after a horrendous start to the year and a poor second quarter the economy could begin to bottom out in summer. My guess is that there will be evidence of modest growth by autumn, at which point – sucker's rally or not – Gordon Brown will claim vindication for his handling of the economy.

There are, however, reasons to treat any recovery with caution. One is that the causes of the original problem – an economy heavily dependent on property speculation, easy credit and debt – have not been addressed and, indeed, will not be until Brown admits that the economy he presided over as chancellor was nowhere near as strong as he thought it to be.

What is true of Britain is also true globally. The problem in the boom years was that one half of the world spent too much and the other half saved too much, thus creating a fatal imbalance between creditor and debtor nations. One of the great fallacies of the bubble years was that the surpluses from the export booms in China, Japan and Germany could be recycled to finance the trade deficits in the United States, Britain and Spain.

What actually happened was that the flows of hot money into London and New York drove up the pound and the dollar, making exports dearer, and the higher exchange rate bore down on inflation and put downward pressure on interest rates. That kept consumer spending high, sucked in more imports, which in turn made the surplus nations even more dependent on exports.

Ironically, the recession is hitting the big exporters – Japan and Germany especially – harder than those that were living beyond their means. The exporters will enjoy their own sucker's rally on the back of the pick-up in demand in the US (and, to a lesser extent, Britain) but for a lasting recovery, the surplus countries have to increase their domestic demand and the debtor countries have to save more. There is no evidence that this is going to happen on the scale needed.

Even so, tentative signs of recovery will put pressure on policymakers to apply the brakes. Here, we are back to the dilemma Alan Greenspan had after the dotcom bubble in the early years of this decade. The then Fed chairman ensured the recession was short and shallow by cutting interest rates to 1% and leaving them there until he was absolutely certain that the economy was recovering. But monetary policy works with a time lag, and by the time Greenspan started to jack up interest rates it was too late and he then had to tighten aggressively to prick the housing bubble.

This is now Groundhog Day. Policy has been loosened to compensate for the tightening in mid-decade, which in turn was to compensate for overly lax policy at the start of the decade. Policymakers now have a choice: they can move early, anticipating recovery, but with a risk that they will move too soon – as Roosevelt did with his fiscal tightening in 1936 – and push the economy back into recession. Or they can do what Greenspan did and risk the build-up of inflationary pressures and a new bubble, this time in the bond market.

Policymakers are more comfortable dealing with inflation, a problem they feel equipped to solve, than with a slump only Japan has experienced. They will do what they always do: increase borrowing costs, raise taxes and cut public spending. Unless they get it spot on, which they have conspicuously failed to do previously, the sucker's rally will be followed by sluggish growth or a double-dip recession.

The other simply shows that things must have got bad economically when mainstream economic pundits, such as HSBC Group's Chief Economist, have to admit that Karl Marx may have had more than a point:

As capitalism stares into the abyss, was Marx right all along?: We may avoid a 1930s Depression but the best we can hope for may be a 1990s Japan
Stephen King, The Independent, Monday, 2 March 2009

Karl Lego!

"Modern bourgeois society ... a society that has conjured up such gigantic means of production and of exchange, is like the sorcerer who is no longer able to control the powers of the nether world whom he has called up by his spells."

Those of you with revolutionary zeal will immediately recognise these words. Penned by Karl Marx in 1848, they form part of the Communist Manifesto. Marx, like Adam Smith before him, had a historical view of society's development. Capitalism, with its bourgeoisie, had replaced feudalism, but capitalism, according to Marx, would be replaced by communism. Capitalism was inherently unstable, as Marx noted later in the same paragraph:

".....the commercial crises... by their periodical return, put the existence of the entire bourgeois society on its trial, each time more threateningly. In these crises, a great part not only of the existing products, but also of the previously created productive forces, are periodically destroyed. In these crises, there breaks out an epidemic that, in all earlier epochs, would have seemed an absurdity – the epidemic of over-production."

Whatever else one thinks of Marx, he certainly knew a thing or two about the business cycle. Were he alive now, he would surely claim his theories were being vindicated. We are, after all, witnessing the most remarkable collapse in economic activity around the world. Take Japan. In November, industrial production fell 8 per cent. That was bad enough. In December, production dropped another 9 per cent. That was even more remarkable. January's production figures, though, are simply eye-wateringly awful, showing a further 10 per cent decline. Production, then, is down almost 30 per cent in just three months, a pace of decline unprecedented in Japanese post-war economic history.

Or how about the US, where we discovered last week that national income contracted in the final quarter of last year at an annual rate of more than 6 per cent, the biggest drop since the early 1980s. Then there's Taiwan, where exports have been in freefall in recent months. Not to mention dear old Blighty, where the economy might end up shrinking by approaching 4 per cent this year.

The pace of decline in global economic output is extraordinary. On virtually any metric, we are seeing the worst global downturn in decades: worse than the aftermath of the first oil shock in the mid-1970s and worse than the early-1980s downswing, when the world economy had to cope with a doubling of the oil price, the tough love of monetarism and the onset of the Latin American debt crisis. Moreover, this time we cannot use the resurgence of inflation as an excuse for lost output: the credit crunch in all its many guises has seen to that. Instead, we have a world of collapsing output combined with falling prices: a world, then, of depression.

For many years, Marxist ideas appeared to be totally irrelevant. The collapse of the Berlin Wall in 1989 brought to an end the era of Marxist-Leninist Communism, while China's decision to join the modern world at the beginning of the 1980s drew a line under its earlier Maoist ideology. In western economies, Marxist ideas were at their most potent after the First Word War when the likes of Rosa Luxemburg could smell revol-ution in the air and as the Roaring Twenties gave way to the Great Depression of the 1930s. I'm not suggesting we're entering revolutionary times. However, it seems increasingly likely that the economic landscape in the years ahead will be fundamentally different from the landscape that has dominated the working lives of people like me who entered the workforce in the 1980s. We've lived through decades of plenty, where incomes have risen rapidly, where credit has been all too easily available and where recessions have been mostly modest affairs. Suddenly, we're facing a collapse in activity on a truly Marxist scale. It's difficult to imagine the world's love affair with free markets being sustained under this onslaught. The extreme nature of this downswing will change our lives for decades to come.

The first change relates to the allocation of capital. Increasingly, policymakers are accepting that market forces, left to their own devices, will lead to a race to the bottom. The dangers are becoming greater by the day. Interest rates are close to zero while prices and wages are in danger of declining. If deflation takes hold, real interest rates on cash will start to rise, creating perverse incentives in capital markets. Why bother to buy equities or corporate bonds if you are nicely rewarded for hanging on to an entirely risk-free piece of paper?

The efforts to stop this vicious circle are increasingly focused on bypassing the banking and financial system. As central banks widen the assets they are prepared to purchase to maintain the flow of credit to the economy at large, they are increasingly getting into the capital allocation game. They, and not the market, will at the margin decide whether companies and households are creditworthy. And as governments increase their spending plans to ward off a catastrophic loss of demand, they, rather than companies, will decide on how our savings should be allocated.

The second change relates to an increased national bias in the allocation of capital. As Nicolas Sarkozy, the French President, pushes to offer government funding to French car companies on condition they don't outsource French jobs abroad, as US Congress signs off a stimulus package with more than a hint of a "Buy American" policy, and as the UK Government pushes to encourage bailed-out banks to lend domestically as opposed to internationally, we appear to be turning our backs on the previous world of heightened cross-border trade and capital flows. While these flows have undoubtedly been volatile, they have nevertheless allowed emerging economies, in particular, to gain a foothold on the development ladder. Are we about to cast these countries asunder in our desperate attempt to fix our domestic problems?

The third change relates to interference in the price mechanism. When it comes to Sir Fred Goodwin's pension, this isn't so surprising, but the price mechanism extends far and wide. At the microeconomic level, we'll enter a world of subsidised loans with murky political undertones. At the macroeconomic level, countries may take the opportunity to manipulate their exchange rates in an attempt either to gain a competitive advantage or to "default" to foreign creditors.

Some of these changes may be absolutely necessary to prevent an outright collapse in global economic activity (although the rise in protectionist pressures is surely a retrograde step). They also suggest, though, that there will be no return to "business as usual" for market forces. The cost of avoiding depression is a heightened level of state intervention on a scale unimaginable for those who believe in the virtues of free markets. While such intervention may help prevent the worst ravages of economic collapse, it will ultimately do little to foster the entrepreneurial spirit and risk-taking behaviour which have, in the past, contributed so much to rising living standards. We may avoid a 1930s Depression but, increasingly, we may find the best we can hope for is a 1990s Japan. Not quite a Marxist revolution, then, but certainly a lasting sea-change in economic performance.

In short, Marx may have got the answers wrong, but he asked the right questions...

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