Prospects for 2010 world economy

As we near the end of the year, I'd like to make an overview of my current views of where we might find ourselves next year. This is an aggregation of much of recurring themes in this blog plus some additional points made by similarly-oriented blogs in recent weeks. First the set-up:

The US is a consumption and finance and investment-oriented economy. The US has already ceded most of its production and manufacturing industries abroad, and has recently been outsourcing most of its service industries. The economy has hollowed out and the only way the economy managed to hum along in the last few years is by people continuing to consume and to make financial investments. Because people were losing income due to outsourcing activities of companies, they managed to continue their consumption activities by getting into more debt. They were able to secure debt because they were able to borrow against the increasing values of heir homes and investments. This increasing value was only possible for as long as more people were chasing into houses as an appreciating asset, but had to stop when many people can no longer realistically afford the increasing prices. This was an unsustainable source of growth for the economy and unsustainable source of consumption funds for the people. Everything started to unravel last year.

But since the US remains a hollowed out economy, the only way for the government and the Fed to keep the economy afloat was to support the continuing of investment activities. Financial institutions that stand to lose a lot due to loan delinquencies are being kept afloat because the fed is buying all their assets and providing them with liquidity. This is resulting in an increase in money supply, and has been supporting the rally in equities in the US. It is also supporting a massive dollar carry trade that has resulted in rallies in emerging economies, commodities, and emerging economy currencies.

This is again unsustainable. The only reason that the US economy has not imploded is because it has managed to export its loose monetary policies abroad.

China is the largest holder of US debt. Since it has been the largest surplus nation that benefited from US trade deficits, it ended up with the most US denominated IOUs. China is a production oriented economy. It is managing its currency by pegging it to the US dollar. This has kept its exports to the US competitively priced. Now that the dollar has been depreciating, both because of the US recession, and more so because of the loose US monetary policy, the yuan has followed it in debasement. China keeps the currency peg so that its can continue its exporting activities. It needs to do so because it needs to provide employment for millions of rural Chinese people migrating to the urban areas looking for work. If they do not find work, the government is concerned they will rebel against the Communist government. So as an integral part of its stimulus during the current global economic downturn, much stimulus money has gone into investing for more factory production capacity. This is in the hope that a recovery will result in exports rising again, leading to more employment for rural migrants.

But because the US recovery policy has only benefited capitalistic investors and financial institutions, many Americans still do not have the stable income to buy goods from China. For this reason, economists are worried that China will export its excess capacity. In other words, it will flood the world with its goods which it will likely sell below cost.

This will be the final nail in the coffin for many manufacturing industries world wide and will result in more job losses. This means less people able to buy goods, further feeding the bad feedback loop.

So we see the deflation coming very soon in manufactured goods that will lead to many losses to companies involved in the production economy. But we also see inflation coming in investment assets due to the US exporting its loose policy.

Some economists are worried that China will stop buying US Treasuries because the US is debasing its currency. A debased currency helps a debtor because the value of the debt goes down. If the US cannot earn enough to pay for its debt it simply prints more money. If China stops buying US Treasuries as a result, the dollar will go down in value steeply.

But there is now a growing sentiment that China cannot do it without hurting itself more. This is like the saying “Owe the bank $100 and the banks owns you. Owe the bank $100 Million and you own the bank”. There is also the belief that if China will suddenly sell its dollar holdings in the market, the US will simply resort to capital controls. That means the US will stop buying its own currency, and hence no nation will want to buy China’s dollar holdings.

But China has slowly been getting rid of its US dollars, by using it to buy into global commodities, global companies, and even global companies producing commodities. This is further leading to the global inflation in commodities .

This will increase the cost of the most basic inputs of production, so that even more businesses will suffer and probably close. The poorest economies of the world will bear the strongest brunt of this commodity inflation. Food will become too expensive for the poorest people.

This is going to be most problematic for countries that have been mirroring the US’ loose monetary policy. Canada has been mirroring the loose policy because it needs to have a competitive currency because the US is its biggest trade partner. But the medium-term effect of this currency debasement is to make the local currencies lose value vs the global prices of these rising commodities.

Since many people are losing income, the government is losing tax revenue. And more people are turning to government safety nets (if there are any) to support themselves. Thus, government finances are deteriorating. Many countries that have to borrow in US dollars are going to have problems down the road, and the only way the government will manage to stay afloat is to raise taxes.

The US government is lucky in that it is able to borrow in its own currency. Also, because it is a global standard currency, it can just print more money to finance its deficits. A problem with that is the debasement of its currency, and the fact that it exports its debasement to countries that mirror the US moves.

Local governments in the US, which cannot print money but can only tax its constituents, are now feeling the pain. Many are already going bankrupt, and California is the leading state going down this road. To raise money, it will need to raise taxes. But if it raises taxes, people will just move out of California, confounding the tax revenue losses.

3 things seem likely to happen next year:
1. Deflation in manufactured goods
2. Inflation in investment assets, most especially commodities
3. Increase in government taxes

The only way to halt this imbalance getting worse is to halt globalization, halt international money flows, halt international trade, and halt the international movement of people.

Nobody knows if the US dollar will be winner in the long-term or a loser, and people are hedging with gold. But gold is already too high. If inflation becomes too high, people will still likely not be paying purchases with gold anyway. Bartering may come into vogue.

If populist sentiment in the US increases, it will probably nationalize the too big to fail banks because they already have national guarantees anyway, and their market making activities are deemed too important (sounding more and more like a social utility rather than a for-profit function). It will therefore likely be safe to put your money as deposits in them but unsafe to invest in their stocks or bonds.

I think countries will retreat into national groupings at the most. So businesses in Asia will focus on regional blocs like the ASEAN, while companies here will have NAFTA all to themselves.

Global Rebalancing and sustainable recovery

Let me just momentarily dip back into the blogosphere with this link to Edward Hugh’s post…… The G20 and Why Export Dependency And Global Imbalances Matter

Edward touches up on several recurring themes here in my blog, many of which I touched as I tried to figure out what was going on with the global economy. Edward links them all up – changing demographics, global financial and investment flows, developed country investment managers’ quest for yield that took them to the most speculative areas of the world. His main point – many of what we see are symptoms of major demographic change. He comes to the same conclusions –the need for a rebalancing of the global economy, and the taking up of the consumption slack by the developing world.

This is what we need to see for green shoots to truly sprout. Otherwise, we will only keep coming back to the same old issues over and over.

But in order to have permanently sustainable development, emerging countries need to learn to get their acts together. Getting them to do so successfully would be the next worthwhile arena of discussion.

Auf weider sehen

A year into my blog, I find a need to break. What a year it has been covering world economics. From the threat of inflation to its wild swing into deflation, events have led to a point where no economic doctrine was safe from intense scrutiny and questioning. It was a year to think unconventionally, yet it was also a year to remember what may have been conventional but recently forgotten.

How will I look back to these writings a year or two from today? Who knows? I haven't been shy with the projections and semi-predictions. Some have come to pass, many may yet prove erroneous, some I believe will yet come about as I expect.

Perhaps I will get back after a year's absence. But for now, I wish you all well in your endeavors.

Ironies in economic behaviour

I listed the following economic truisms last year. I repost them here, as a reminder to both individuals in regulating their future behaviour, and to policymakers designing tweaks in the economic system.

1. Quest for everything at the cheapest cost. Not only has this led to the occasional substandard or dangerous product, this has also led to global wages standardizing down instead of up. Do the math.

2. Quest for maximum utility. When it comes to scarce resources, every additional utility we squeeze for the present, we are taking away an equal utility from the future. Do the math.

3. Quest for the riskless reward. The recent derivative innovations has only led people take even bigger risks, while at the same time diversifying the risk onto everybody else.

4. Quest for overspecialization/division of labor. This has led to people putting ever greater focus on ever more specific tasks and objectives, each time leading to greater over-all loss of sight of how real value is created.

5. Quest for the person who will take the first step during uncertain situations. This has led to longer and deeper recessions than necessary, and also to lack of innovation during times when it is needed the most.

6. Quest for someone else to pay your liabilities. This has led to the proliferation of all sorts of insurance and health management firms that either end up in bankruptcy, or taking money from people while avoiding paying claims at all costs.

7. Quest for the greater fool. This has led to momentum investing in the stock market and in all other financial markets. Everybody hopes that there will always be that someone else who will bail him out after he makes that one last bold move at the “peak” of the market.

Rise of the dragon currency

Nouriel Roibini is warning how financial power is currently transferring at a rapid pace towards China, as a result of US need to fund its deficit.

China is a creditor country with large current account surpluses, a small budget deficit, much lower public debt as a share of G.D.P. than the United States, and solid growth. And it is already taking steps toward challenging the supremacy of the dollar. Beijing has called for a new international reserve currency in the form of the International Monetary Fund’s special drawing rights (a basket of dollars, euros, pounds and yen). China will soon want to see its own currency included in the basket, as well as the renminbi used as a means of payment in bilateral trade.

Brad Setser explains why China will want to do so.

China’s basic problem is not that it is running a large current account surplus and accumulating financial claims on the world. Rather, its problem is that those financial claims are denominated in dollars and euros rather than in China’s own currency. If China was lending to the US – and Europe – in renminbi, China could continue to run large current account surpluses without taking on as much financial risk as it is now. If the US was required to pay China RMB, not dollars, China wouldn’t need to worry about about of inflation in the US that led the dollar to depreciate – or for that matter a dollar depreciation that wasn’t the product of a rise in US inflation.

Roubini further warns.. Now, imagine a world in which China could borrow and lend internationally in its own currency. The renminbi, rather than the dollar, could eventually become a means of payment in trade and a unit of account in pricing imports and exports, as well as a store of value for wealth by international investors. Americans would pay the price. We would have to shell out more for imported goods, and interest rates on both private and public debt would rise. The higher private cost of borrowing could lead to weaker consumption and investment, and slower growth.

We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports.

Brad again: The problem of course is that is that China’s own choices more than anything else constrain the renminbi’s ability to serve as a global reserve currency. China’s currency isn’t freely convertible and its capital account is heavily managed. And China’s government doesn’t exactly welcome foreign inflows of any sort — and it certainly doesn’t want to increase its dollar holdings to allow other countries to increase their stock of renminbi denominated reserves. Letting other central banks hold RMB means letting other central banks speculate on RMB appreciation …

The US shouldn’t welcome a world where Asian countries try to maintain undervalued currencies – and thus run large, sustained external surpluses – while minimizing their risk by running up renminbi and yen denominated claims on the US, Europe and potentially a host of emerging economies.

China should allow its currency to appreciate, offset the drag from slower growth of exports with aggressive policies to stimulate domestic demand (including the rapid implementation of a broad social safety net, even if this produces sustained budget deficits) and bring its current account surplus down. China’s government would no longer steadily accumulate large quantities of dollar reserves. More balanced trade flows would allow the RMB to eventually float – allowing China to direct domestic monetary policy toward stabilizing China’s own economy rather than stabilizing its exchange rate.

But for as long as the US will remains a debtor without choice, and China its primary creditor, how could this alternative be possible?

* Both articles are must-reads to understand the dynamics of the possible China-US currency standoff.

Where to look for green shoots of recovery

In a regular business recession, businesses that over-expanded whittle down their excess inventory, and reinvest capital in more profitable lines. Once inventories are at a more sustainable level and capital redeployed to more appropriate endeavors, growth should come back.

What the US has now is a capitalist recession. In this particular recession, investor/capitalists over-invested in speculative assets and mostly funded these purchases with massive debt. Before growth will come back, debt levels will have to be paid down. But how can debt be paid down if the investment was in non-income generating assets that have, at best, now come down in value, or at worst, unsellable?

To recover from debt, capitalists have had to hoard capital and cut down private consumption. Ditto their lenders, who also have had to swallow massive writedowns, now also hoarding capital and cutting private consumption.

So viable businesses, if there are any left, starve from a lack of capital, while most barely survive from the loss of consumers. This leads to more hoarding and clampdown on consumption. So where can “green shoots” of recovery come from?

Certainly not from the economy in capitalist recession. As we’ve mentioned many times before, you will have to look to those economies that have not been profligate with spending and borrowing - economies who have merely had a business recession.

Once inventories in these economies have come down to more sustainable levels (given the lowered demand) and capital redeployed to more appropriate endeavors (businesses that stimulate domestic consumption), growth should come back. Not just to these economies, but eventually, to economies in capitalist recession.

Look for these green shoots in the emerging markets. But be patient. It will take years for these shoots to become noticeable.

Now, it is possible for the US, being a hothouse for technology, to sprout green shoots by solving current problems in health care, alternative energy, and environmental care. But given the capital hoarding going on there, the capital will have to come from Asia.

The curse of the big, publicly-held company

The bigger the company, the more lavish its executive perks. And the bigger the company, the more likely it will be a publicly-held company.

Just about every corporate malfeasance seems to have been committed by those at the top of the publicly-held toy company, Mattel over the years – accounting fraud, lavish entitlements, golden parachutes given despite disastrous management reigns, corporate property theft, and endless litigations. These and other ‘dirty laundry’ are aired in the book, “Toy Monster, the big, bad world of Mattel” by Jerry Oppenheimer.

Now, the book is mostly about the personal backbiting and internal politicking that went on at Mattel, and as such, are not the main concerns of this site. But since I have read it (and it’s an interesting read for those of you who like reading about insider dramas at big corporations), I want to raise the human interest themes of the book to a more macro-level question: Just how much better governed are public companies than privately owned ones?

We know that going public tends to bring in more professional management, who should be bringing in best practices, to a company. But once you have management who are company insiders but are divorced from the fiduciary duties coming from true personal ownership of the firm, and who are in a position to negotiate for themselves better returns (whether in the form of salaries, wages, or stock options) than its small, passive shareowners, are we at all surprised that these things constantly happen at the large public companies?

Stock options were supposed to have better aligned company management interest with the interest of the small shareowner. But still, this didn’t prevent unscrupulous executives from writing for themselves backdated options, options with low exercise prices, or instituted other methods that ensured their options were never ‘out of the money’, regardless of what happened to the stock in the long-run (meaning in the years after they have left the company).

Now, just because a company is public doesn’t mean it automatically gets the best executives who can bring in the best practices. In reality, being a public company actually meant the company can now afford to participate in bidding wars to lure ‘rock star’ CEOs, those who are best at promoting their agenda and in keeping themselves in the limelight.

Are we then surprised that as companies got bigger, more politicking and backbiting went on, and those who managed to get to the top often are those who really are the most narcissistic, opportunistic go-getters? It’s the shareholders who end up paying more, to get these people - who end up driving the company to the ground.

And who is to keep the CEO from looting the company, usually by negotiating lavish perks and a golden parachute for himself? Is it the Board of Directors? Not if they are cronies who also profit from giving these concessions to the CEO. We see a bit of that also in the Mattel story.

So you ask me, where do I think the real wealth creation will come from in the years to come? As far as 'public wealth creation' is concerned, without a doubt, my answer is, from the smaller companies, as they always have been ever since companies started becoming public. Who should we be looking out for in terms of providing better economic incentives? I don’t have to repeat myself on that.