Five minutes to midnight

Behind the credit crunch lies a complex web of self-interest and delusion that will hit the UK economy especially hard.

At the time of writing this article, the Governor of the Bank of England is just putting his final flourishes to a letter to the Prime Minister outlining why interest rates must be cut and why the time is now right for ‘quantitative easing’. This, of course, if the practice of increasing the money supply by repurchasing government gilts and bonds with freshly issued currency – printing money by any other name.

If the UK does so, it will be following the US example, once again. Just two years ago, the prospect of such action would have been met with derision and howls of outrage. Today, it is seriously considered by otherwise sober economists as a reasonable way of avoiding the spectre of deflation – a reflection, perhaps, of how far standards have sunk.

However, this is the situation as it now stands. As the economic crisis engulfs the world, there has been considerable discussion about the cause of the crisis, with a consensus forming that poor regulation of the financial system was to blame.

While this goes some way towards explaining the causes, it does not get to the real root of the problem. Indeed, something quite extraordinary has changed in the world economy and the surprising part of this change is that its place in the crisis has been overlooked. The real root of the economic crisis does not lie in the financial institutions, which were simply the mechanisms of transmission, but can be found in one of the greatest supply shocks in economic history.

New labour
The shock in question is an approximate doubling of the global labour force in a period of just ten years.

At this point, the expression ‘labour force’ should be clarified – when I use the term, I use it in a very specific way, and mean ‘workers with access to capital, technology and markets’. The source of this massive supply of fresh labour is largely due to the entry of both China and India into the world economy.

While it might be argued that both countries entered world markets much earlier, in practical terms it is only in about the past ten years that their impact has really started to be felt. Such a massive change in one of the key inputs into the global economy was inevitably going to have profound implications.

However, this is not the whole story.

Even though the impact of this massive labour input might be enough, in itself, to shake the foundations of the global economy, there is another element to the story that needs to be accounted for. This is the role of the supply of commodities in relation to the supply of labour.

It has long been said that not everyone in the world could enjoy the same standard of living, with the consumption of raw materials that implies, that people in the US or Western Europe enjoy. Indeed, it was recognised many years ago that it would not be possible even for the average Chinese to consume as much paper per head as the average American, let alone other commodities.

The potential implications of such conundrums were quietly forgotten all the while low-cost Chinese labour was delivering ever-cheaper goods, lower global inflation and achieving record rates of GDP growth for China.

But most economists failed to ask the important question of how such growth might be resourced and accommodated; that in order for India and China to rise towards the standards of living of the West, there would have to be a commensurate rise in the supply of commodities to satisfy the legitimate, rising demands of the 2.5 billion people of China and India.

However, such big increases in the supply of commodities are not so easy to achieve in the real world. Take oil, for example. Between 1998 and 2007, output increased from about 75 million barrels per day (bpd) to about 85 million – a modest rise of around 13% over ten years.

Similar real-world scenarios for the output of many other important commodities can be found. But the central point is this: the supply of commodities cannot increase fast enough to satisfy everyone’s rising aspirations. In other words, while markets are flexible, they cannot accommodate the sheer scale and speed of the increase in the supply of labour in the past ten years.

This can cause bottlenecks in all sorts of unusual and unexpected places. A couple of years ago, for example, there were reports of shortages of tyres for the mammoth earth diggers used in mining.

This shortage was constraining expansion of output in mining. With such surges in demand, such bottlenecks become inevitable. As a result, shortages will lead to insufficient resources for all labour to be productive, in turn leading to what might be called ‘hyper-competition’.

This may go a long way to explaining the roots of the current economic crisis. While the most visible cause might have been the spike in commodity prices, because producers were unable to expand output fast enough to meet demand, there were many other inter-related factors that intensified the impact of the crisis.

The first factor is no secret – the opportunities to lower costs by transferring operations to countries in the emerging markets. This created a major shift in manufacturing out of the UK and other developed economies, as well as considerable outsourcing of services. This story has been told many times before and requires no retelling now.

All the while this has been happening, the UK and other countries have moved towards what has been described as ‘post-industrial’ economies. Countries such as the UK would provide the finance, design and marketing and so on, and people in the emerging economies could get on with the lower-value parts – making the products or providing the service.

For the past ten years, the UK has laboured under the illusion that this ‘new paradigm’ was working. It is only in the past year or two that this illusion of success has been shattered. The reason why requires explanation.

Real sources of growth
In 2007, I analysed the UK economy with a singular aim: to identify the source of its apparent strong growth, while seemingly stronger competitors were barely growing. Rather than look at GDP growth, I tried to examine what might be called the ‘root’ sources of wealth. By this I mean the

basic work of commodity extraction and processing, manufacturing output, export of services, net tourism receipts and so on. Although services experienced growth and services do create output, internally consumed services are redistributions of wealth, rather than root sources of wealth. The conclusion of this analysis was very worrying, but also confirmed my intuition.

The key discovery in the analysis was that, while there had been an explosion in debt at every level of the economy, none of the root sources of wealth had seen any significant growth, at least not enough to explain the apparent buoyancy of the economy. The only explanation for GDP growth in the UK since the late 1990s lay in the growth of debt. When considering this growth in debt, it is important to understand how borrowed money can affect an economy through the multiplier effect. In crude terms, this is the way in which the same money is used over many occasions in the creation of economic activity.

If a person spends £50 in a restaurant using borrowed money, some of that money will later be used to pay the staff, who will then use that money to buy other items, and that will promote more activity and so forth. The borrowed £50 will therefore generate considerable activity, which can be measured as output. That output provides the measure of GDP.

But GDP measurements make no allowance for the source of the activity in the economy; meaning that debt-fuelled activity is measured as production. As such, GDP not only measures the direct result of wealth creation, but also incorporates the result of a growth in debt. When that debt is fuelling investment in productive assets, it is not a bad thing, but in the UK (and this is equally applicable to the US) debt was largely fuelling consumption. When debt is used to finance consumption, it is the foregoing of future consumption, implying a commensurate future contraction.

Who gets the credit?
The credit that fuelled this activity was rooted in the fundamental changes that have occurred in the world. One of the major sources of finance for government borrowing has been China, which has managed to achieve huge trade surpluses through a combination of low costs and a controlled currency that has been kept undervalued. Meanwhile, the growth of emerging economies has driven increases in commodity prices and this additional income for commodity producing countries provided another source of finance. Finally, the problems of the Japanese economy led to the ‘yen carry-trade’ – in which money fled the country because growth and interest rates were so low – in search of the perceived low risk, yet relatively high interest yield, investments available in economies such as the UK and US. This flood of credit (and it should be noted that much of it was recycled from trade with the West and money-supply expansion – quantitative easing in Japan, which is now being considered in the US) has created two important effects.

One of these is that, in order to lend money from one country to another, it is necessary to buy the currency of that country. It is for this reason that currencies of countries such as the UK did not fall in line with their widening trade deficits, as they should have done. In other words, the value of the pound had been supported, in part, by the purchase of sterling used to provide credit into the UK. Thus, demand for sterling remained strong despite relatively poor demand for UK goods.

There were, of course, additional factors, such as the Basel banking accord, which encouraged lending into OECD banks and governments – because of their perceived safety – as well as confidence and relatively high interest rates. All of these factors added up to an illusion of economic and currency strength that is now fast evaporating. This process still has a long way to go as the UK continues to have large trade deficits and the factors that supported sterling are still unwinding.

The second effect is the result of the inflow of money combined with limited investment opportunities within the UK.

The emergence of economies such as China’s has seen manufacturing chase low costs in newly opened emerging markets, and much of the investment with long-term root wealth generating capacity has therefore been directed to the emerging economies that can offer the lowest production costs.

As such, the wall of credit entering the more developed countries, such as the UK, could not find a profitable home in wealth-creating business and was therefore channelled into consumer borrowing and consumption. This, in turn, drove the profitability of the service industries – not manufacturing – and thereby created the conditions for the growth of the ‘post-industrial’ service economy. As such, investment into the UK was primarily directed towards investment that supported debt-fuelled consumption, rather than wealth-generating businesses.

This massive wall of money invested into consumer borrowing created a fundamental problem. In simple terms, the first tranche of money invested ought to find the cream of the investment opportunities. However, as more money enters the system, good opportunities become scarcer – but it must still ‘go’ somewhere. In such circumstances, the capital is allocated to ever riskier investments, which explains the rise in popularity of collateralised debt obligations (CDOs) and other, similar financial instruments. These practices were simply a method of burying bad investments, while creating an illusion of continued low risk. Bubble trouble

In such a situation, we can see the roots of the house-price boom in the US, UK, Spain and Ireland (among other places) – a classic asset-price bubble in which there was a massive increase in the supply of money and the money simply chased an asset-base that could not expand as fast as the supply of money.

A boom in land and property prices was inevitable, but the debt boom further hid the underlying poor risks. A virtuous cycle ensued: the boom encouraged more lending, which encouraged consumers to borrow and consume more, which in turn encouraged more lending and so forth.

As an added factor, the boom in assets and credit supply also created a massive inward flow of migrants into the UK to work in the booming service and construction sectors, further lifting GDP figures and also increasing demand for housing. This, in turn, further levered prices upwards, increasing confidence and helping to inflate the bubble still further.

The final point in this rather unhappy cycle moves away from economics and into something more like psychology: It is the question of why this wall of money flooded into the UK.

For the answer to this, I will turn to another analogy. In this case, the analogy is of an 18th century aristocrat, living the endless social whirl of balls and expensive entertainments. Everybody imagines that his lavish lifestyle is an indication of his endless wealth, which has been in the family for generations.

However, while his family have a long history of wealth, he has been neglecting his estate and his income has been slowly falling – such that the income from his estate no longer covers his increasing outgoings. In reality, he is ever more reliant on his creditors to keep him afloat, even to the point where he is borrowing to pay back previous borrowing. Despite this, his creditors believe he is good for the money – after all, his family has always been rich and respected...

Underneath the surface, however, the aristocrat’s situation is not a happy one. If his creditors lose confidence, the whole edifice will crumble. This is the current situation of the UK. The creditors are now starting to turn off the credit and an economy built upon a belief in the endless growth in the supply of credit is now confronted with its basic underlying size. To return to the aristocrat analogy, the UK is now seeing what the estate really produces, and it is a painful discovery.

Not only has the estate shrunk, but the absolute debt level of the estate has increased to the point where there must be real questions about whether the debt can be serviced. It is for this reason that printing money – quantitive easing – is now being suggested.

From the point of view of the Prime Minister and the Governor of the Bank of England, one of the few advantages left open to them is the fact that the UK’s debts – thanks to a past reputation for fiscal probity – are denominated in sterling. Increasing the money supply, ostensibly for the purpose of avoiding deflation, will devalue the pound and reduce the headline size of the debt.

In contrast, Iceland’s debts were denominated in dollars and every fall in value of the Icelandic krona increased the size of the country’s debts. The same is true, to a greater or lesser extent, of most economies that binged on debt in the good times.

Sooner or later – perhaps within a year – the UK’s policy of quantitive easing will increase inflation and devalue the pound even further than it has already done so (although some economists suggest that a degree of such devaluation has been built into the value of the pound already).

It is a similar story in the US and explains the high value of gold. In turbulent times, with inflation of unknown quantity expected around the corner, people seek the certainty of gold that, like most other commodities, is limited in supply – a supply that cannot be magically increased at the flip of a switch at the printing press.

This article was written by Cynicus Economicus, a former trade specialist based in China. He blogs at cynicuseconomicus.blogspot.com and can be contacted by emailing cynicuseconomicus@yahoo.com.