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The Effects of Government Fiddling |
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Written by Martin Hutchinson
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Monday, 19 July 2010 19:16 |
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The British government's announcement that it intends to force a change in indexing of private sector pensions from the Retail Price Index to the Consumer Price Index (CPI), thereby making British pension schemes sounder while depriving aged pensioners of 25% of their expected income is typical of an unpleasant recent trend. Governments are manipulating official statistics and their uses to make themselves look better and in some cases renege on previous promises to their electorates. Apart from its ethical unpleasantness, this process carries an additional danger: governments, seeking to deceive their electorates, may end by deceiving themselves and dangerously distorting markets.
The first major instances of this unhappy trend were in the United States and related to the consumer price index. In 1980, Carter administration policymakers were annoyed that rapidly rising house prices were playing a major role in reported "headline" inflation. They therefore removed house prices from the index and substituted "owners' equivalent rent." This did not do much for the inflation rate in the short term, since housing almost immediately went into one of its periodic slumps. It however made the CPI unduly optimistic as a barometer of inflation in the late 1980s. Since the Fed was following published rather than true inflation rates, this made monetary policy excessively loose in 1986-89, when the reported CPI rises were artificially low and unduly restrictive in 1991-92, when the housing bubble had burst and the CPI was correspondingly overstating inflation.
The distortion became greater in the housing bubble of 2002-06. During this period, the Fed constantly assured the country that inflation was low and controlled, and indeed that deflation was a major potential problem. In reality, inflation in some years during the period soared above 10% when housing costs were accounted for properly. Thus the Fed's interest rate policy, which had already become excessively stimulative during the stock market bubble years of 1995-99, became hopelessly so in 2002-06. The debacle of 2008 should thus have come as no surprise.
The effect of statistical fiddling in the U.S. price index was exacerbated by two further changes made during the 1990s. First, instead of the CPI representing an arithmetically weighted fixed basket of goods, geometric weighting was introduced, so that a sharp increase in the price of particular goods would be minimized. Goods whose price continuously declined, such as those in the tech sector, would have an artificially large impact on the indices.
Then, following the report of a commission headed by Michael Boskin and with the enthusiastic support of Fed chairman Alan Greenspan, the Bureau of Labor Statistics introduced the concept of "hedonic pricing," under which quality improvements would supposedly be taken into account in calculating price statistics. In its application, there were two major flaws in hedonic pricing. First, the Moore's Law doubling of computer processing power every two years was taken as a linear improvement in quality, whereas in practice each doubling in processor power produces nothing like a doubling in functionality. Indeed the Law of Diminishing Marginal Returns set in many years ago with respect to processing power, so that the improvements produced with recent doublings of processor power have been derisory. Nevertheless, combined with geometric pricing this change has produced a marked downward bias on the CPI, reflecting no decrease in costs paid by any consumers in the real world. Second, equally perniciously, the hedonic pricing system takes no account of extra costs imposed on consumers by such Satanic innovations as automated telephone answering systems, robocalls and spam – in other words the hedonic pricing system is dishonestly used only in one direction.
In the last couple of years, the two effects of housing distortion and hedonic pricing have approximately cancelled out in the United States. In 2006-09, the U.S. inflation rate was truly low as the grossly distorted housing market collapsed, restoring consumer purchasing power in the housing sector. Since the housing market stabilized in early 2009, the inflation rate has once again been understated, and Fed policy has been correspondingly too loose. In general, in a reasonably free housing market (albeit with excessive and growing subsidies) like that of the United States, the housing price distortion should be nearly neutral over the long run, while the hedonic adjustment will consistently cause inflation to be understated.
In Britain, the government in 2003 made a change in Britain's price statistics similar to that of the 1980 U.S. change—Britain has not yet experimented with the joys of hedonic pricing. In times of rising house prices—endemic in Britain with its land shortage, overpopulation and socialist planning system—the post-2003 Consumer Price Index understates true inflation substantially. In the latest month of June 2010 the CPI was 3.2% up over the past year, whereas the old Retail Price Index was up 5.0%.
The statistics-fiddling becomes more serious when real contracts involving real money are based on the figures. British index-linked gilts, instituted in 1981, are based on the Retail Price Index, so they provide a true protection against inflation. Conversely, U.S. Treasury Inflation Protected Securities, instituted in 1997, are indexed only to the hedonically adjusted CPI, so they trail true inflation by some unknown but significant amount. In 2008, before the market collapsed TIPS yielded about 0.8%-1% more than index-linked gilts, indicating the market estimate of the U.S. fiddle was about 0.80%-1% per year. To me, given both the housing and hedonic fiddles, that looks like a market underestimate of the true distortion. The website Shadow Government Statistics (http://www.shadowstats.com) suggests the true distortion is as high as 6-7%. That appears to me to involve some double-counting but I'd be surprised if the distortion averaged less than 2.5-3%.
Since the market collapse, both index-linked gilts and TIPS have benefited from the "flight to quality" in different degrees, so the differential between their yields has fluctuated. Now the British wish not only to link pension contracts to the CPI rather than the RPI (ripping off pensioners by denying them the benefits to which they are contractually entitled) but also to issue index-linked gilts based on the CPI, thus providing two securities trading simultaneously, a truly indexed one and a falsely indexed one.
Meanwhile in the United States, Social Security payments are already linked to the CPI, so they already swindle social security holders by the amount of "hedonic pricing" plus any shortfall in housing inflation. However in this case no contract is being violated, only a government promise—notoriously unreliable at the best of times.
Even more dangerous than statistical fiddling to make their budgets balance or eliminate actuarial deficits is the effect of fiddled statistics on monetary and fiscal policy. Alan Greenspan's enthusiastic support for the gross distortions of U.S. inflation statistics in the 1990s appears to have been predicated on the idea that he could avoid the high inflation and painful monetary remedies of the 1970s and 1980s by the simple expedient of making sure that the consumer price index figures never reported high inflation, whatever the reality.
Ben Bernanke has continued and even intensified this approach, also making sure that monetary economists were also unable to criticize his policy through the simple expedient of ceasing to report broad M3 money supply in February 2006. M3 is acknowledged by the European Central Bank, the Bank of England and most other authorities to be the best measure of monetary sloppiness, and has increased about 40% more rapidly than money GDP in the period since 1995. Thus its abolition has given the Fed even more undesirable policy flexibility than it already had.
Fiscally, we saw in Britain the attempt to push long-term borrowings off the government balance sheet through the private finance initiative. In the United States the entire Fannie Mae and Freddie Mac saga has been a consistent and very expensive attempt by government to avoid owning up to its policy misdeeds. Budget hawks are wrong when they claim U.S. Federal obligations to be some figure such as $75 trillion, five times GDP, because that figure includes 75 years' inflation in medical costs without consideration of the longevity effect that those medical advances would bring. However the budgetary shenanigans of the Bush and Obama administrations, together with their stooges in the Fed, have truly eaten the seedcorn from future generations. The polite fiction by which Social Security payments were invested in phantom Treasury bonds and the net surplus counted against the budget deficit has reached its sell-by date in 2010, seven years earlier than expected, as the Social Security trust fund swung into deficit.
There were signs at its formation that the British Coalition government would put an end to the self-delusions of fiddled statistics, and run the public sector on the basis of straightforwardness and honesty. However the change in the pension indexation is a very bad sign indeed; it suggests that within two months of taking office, the feeble fiscal integrity of the Coalition has broken, and that shenanigans similar to those of New Labour and the Clinton, Bush and Obama administrations will now continue in full force. In the United States, no relief from deception is in sight; there would need to be a complete turnover in all three economic branches of government, Congress, the Administration and the Fed, before such relief could be imagined, let alone implemented.
Needless to say, policies of self-deception are in the end very painful, albeit more for the populace as a whole than the mandarins who implement them. One need only look at Argentina, among the world's richest countries in 1910, in 2010 a serial bankrupt with an impoverished populace reduced to mortgaging its future to China in order to repair its decrepit railroad network, to see the damage that can eventually occur.
No short-term relief can be expected in the United States, but one can at least hope that in Britain the government realizes the mistake it is making and reverses its attempt to subvert the economy through mis-measurement. Economies cannot be successfully managed through such deception and illusion; in the end it is necessary to deal with objective reality.
The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of "sell" recommendations put out by Wall Street houses remains far below that of "buy" recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) – details can be found on the Web site www.greatconservatives.com and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley – 2010). Details forthcoming.
Views are as of July 19, 2010, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
The Consumer Price Index (CPI), also called the cost-of-living index, is an inflationary indicator published monthly that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation.
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The Changing Face of Emergence |
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Written by Martin Hutchinson
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Monday, 12 July 2010 15:55 |
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There's a new acronym for favored emerging markets – CIVETS. Coined again by Goldman Sachs' Chief Economist Jim O'Neill (who invented the BRIC acronym for Brazil, Russia, India and China in 2001) it stands for Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa. However the new acronym's enthusiasts may have missed out on one thing: the face of emergence is changing. A different set of skills and factor endowments is needed today to achieve the takeoff into rapid growth than was needed a decade ago.
The traditional emerging market used its ample reserves of hard-working and increasingly skilled labor to rise up the income scale. By saving huge portions of their income, its inhabitants both educated their children and provided for their own retirement, while making available to the economy the seed capital for innumerable future businesses, with their attendant economic growth. That formula worked for Japan in the 1950s and 1960s, for Singapore in the 1960s and 1970s, for Taiwan and Korea in the 1980s, and above all for China in the 1990s and 2000s.
Alternative economic models, driven by socialism or dependent on natural resources, failed miserably. In the Middle East, a few countries were so rich in oil income that they were able to enrich their people without effort, but none of those countries have built a genuinely viable economy for their inhabitants to enjoy when the oil runs out. In Latin America, repeated attempts to build viable economies on the basis of government funded infrastructure and high tariffs failed, even when as in Brazil the local economies had large endowments of natural resources. In Africa, in spite of the resources, the surplus of labor and in some places a decent education system, nothing worked – largely because that continent's rulers were not only kleptocrats but London School of Economics-educated socialist kleptocrats.
Since 2000, there have been signs that the emerging market formula may be changing. Vietnam is a traditional east Asian emerging market – oodles of cheap labor, hard-working people, a high savings rate and a manufacturing orientation with lower labor costs than neighboring China. However other non-traditional emerging markets look a little different. Brazil seems finally to have broken out of its decades-long stagnation. Colombia and Chile both benefit from resources rather than cheap labor, yet have managed to preserve a free-market orientation and a commitment to improving their inhabitants' quality of life. Even in Africa, there have been some modest success stories, and the overall record of the continent has been better than at any time since the 1950s. As the recovery from the 2007-09 recession begins, signs are that the move away from the traditional pattern of emerging markets may be intensifying.
There would appear to be two reasons for this, both connected to the Internet-fueled economic emergence of China and India, which between them represent around a third of the world's population.
The first reason for the changing pattern is the obvious one, discussed here before: the effect of 2.5 billion consumers, newly lifted above subsistence level, on natural resources markets. Until 2000, resources markets were both highly cyclical and downwardly biased in price, as improved extraction techniques and new sources of supply allowed commodity users to benefit at the expense of producers. Thus even low-cost commodity producers, such as Brazil, found their income sources continually eroded and their huge investments in production capacity continually less profitable.
From 2000, this has changed. The emergence of major markets in China and India has potentially quadrupled the demand for basic commodity-heavy, energy-intensive consumer goods such as automobiles, washing machines, refrigerators, central heating and air conditioning. While wealthy consumers, whose economies are expanding less rapidly, diversify their demand toward high-tech gadgetry, and many poorer consumers also demand low-feature cell phones and PCs, the markets for most commodities and energy is driven by the emerging newly middle class consumers' thirst for products that wealthy country consumers acquired in the 1950s through the 1980s. Consequently the long-term bias in commodity and energy prices is now upward rather than downward, at least for the foreseeable future.
The emergence of China and India has however had a second effect, which is to block off at least partially the previous golden road to riches through manufacturing labor. Manufacturers such as Foxconn, with huge facilities in China (Foxconn employs 300,000 people) have until recently been able to ramp up production without raising wages simply by importing workers from China's vast domestic hinterland. That has suppressed inflation in the west, in the same way as did the opening of the railroads and refrigeration in the 1880s. Less noticed, it has also suppressed growth in other countries that had previously been able to rely on competing through manufacturing cost advantages. Thailand and Malaysia, for example, both of which had risen into middle income status by the middle 1990s and appeared likely to become wealthy in another decade or two, have found their progress halted by China and India's emergence. In Thailand's case this has destroyed the country's hard-won political stability.
The pool of low-cost labor in China and India is nowhere near exhausted; the hinterlands of those countries will be opened up by infrastructure and educational development, resulting in a glut of low-cost labor for the world economy as a whole. That means other countries that had hoped to emulate the typical east Asian route to wealth will find it much more difficult to do so. Their wage costs will be capped by the wage costs available in the less costly parts of China and India, countries in which most major foreign investors are already used to operating. Growth for low wage manufacturing countries will remain possible, but will be limited by the overhang from the enormous Chinese and Indian competition.
Conversely, while the manufacturing labor route to wealth is becoming blocked, the resources route to wealth is being opened up in a way it had not been since the late nineteenth century. Before 1900, countries such as Australia, Canada, Argentina and Mexico were able to increase rapidly in wealth, approaching and in some case surpassing the European manufacturing economies, on their basis of their commodity resources, of which they encouraged the exploitation. Other countries, notably Britain, France, the Netherlands and Belgium, increased domestic living standards further by colonial exploitation of other countries' resources. With resources prices trending upwards long-term, this route to wealth will reopen as the manufacturing route closes.
The closing of the manufacturing route to wealth has severe implications for middle income emerging markets. The richest manufacturing-oriented countries, such as Korea, Taiwan and Germany, will continue to thrive (as will Japan and France if they sort out their public sectors) as they have already developed world-beating technological and research capabilities that China and India cannot easily match. However the poorest countries that had hoped to develop through manufacturing prowess, such as Pakistan and Bangladesh, will find they no longer have cost advantages sufficient to tempt investors to desert China and India for their more difficult environments. Middle-income countries such as Thailand, Malaysia and the Philippines that depend substantially on manufacturing for their emergence will find themselves particularly badly affected (though Malaysia and the Philippines have substantial commodities exports that offset this).
More adverse still will be the effect on those middle income countries with heavy government burdens, poor governance or excessively activist labor unions that prevent efficiencies from being achieved. Mexico is the archetypal case of these. Not particularly well endowed with commodities (or rather, with a commodities endowment that has been reduced in value by inefficient exploitation and economically diluted by excessive population growth), Mexico was expected to benefit hugely after the 1994 signing of the NAFTA agreement from manufacturing relocated from its wealthy northern neighbor. This expectation has not been fulfilled. Manufacturing has been outsourced to China and India rather than Mexico, as costs there are lower and operating difficulties no more extreme. Even Monterrey, Mexico's wealthiest city, expected to be a pole of economic development, has now become infested with drug violence as poor employment growth produced an underclass of potential criminals.
In today's world Mexico will not be able to compete with China and India unless it drastically reforms its governance. The same is true with two of O'Neill's other CIVETS, Egypt and South Africa, in both of which corruption is extremely high, and workforce discipline poor, although in South Africa's case mineral resources may alleviate the problem if the government allows them to be developed on a modern free-market basis. Vietnam, a third CIVETS, we have discussed; it is probably OK, though it will find the road to wealth much more difficult than for its 1950s-1980s Asian predecessors. Turkey could go either way. It is not very well endowed with natural resources, but its labor markets are relatively efficient and free-market-oriented. If it plays its cards right, it will get a favorable association agreement with the EU (though not membership) that will allow foreign investors to use it as a cheap labor source inside the EU tariff and non-tariff barrier regime. Turning too enthusiastically towards its Middle Eastern basket case neighbors, conversely, would be economically suicidal.
The remaining two CIVETS, Colombia and Indonesia have much better prospects, because they benefit from the other side of the commodities/labor see-saw, being relatively well provided with commodities and energy resources. Colombia now has a free-market oriented government and a huge endowment of commodities and energy for its relatively modest population. Consequently it could experience development in which manufacturing for the U.S. market (if the Colombia /U.S. free trade agreement is ratified) and providing domestic services relating to the extractive industries could supplement resource extraction to provide a rapidly increasing standard of living. Indonesia is a more difficult case because of its much larger population, but its favorable location close to the major Asian economies, with which it should tighten its free trade agreements, should allow it to develop in a similar manner to Colombia.
Outside the CIVETS, Africa will for the first time have a clear road towards greater wealth by playing off Western, Indian and Chinese resource seekers against each other, provided it improves its governance. In Latin America, Chile is the example to follow and Venezuela and Argentina the examples to avoid; the latter two could be enjoying rapid increases in living standards today were they not so abominably run. Finally in Eurasia, badly run manufacturing countries like Romania, Bulgaria and Ukraine will find their positions slipping, while the resource-rich Kazakhstan, no better run, moves forward. (Russia will find its fate depends crucially on its choice of regime, but its resources endowment will provide it with major advantages that it did not in the 1990s.)
As for the wealthy West, it will find itself under pressure. Its commodities and energy purchases will continually increase in price, while all but the most talented in its workforce will find their living standards threatened as outsourcing advances up the value chain.
In 1900, you would have done better economically as a worker in Melbourne, Vancouver or Buenos Aires than in Paris, Berlin or Manchester. In 2000, the wealthy and sophisticated West and Japan were the places to be. By 2050, we may have reverted largely to the 1900 pattern.
The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of "sell" recommendations put out by Wall Street houses remains far below that of "buy" recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) – details can be found on the Web site www.greatconservatives.com and co-author with Professor Kevin Dowd of "Alchemists of Loss" (Wiley – 2010). Details forthcoming.
Views are as of July 12, 2010, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
Federated Equity Management Company of Pennsylvania
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Written by Martin Hutchinson
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Monday, 28 June 2010 14:48 |
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For the past three months, markets have been worrying about the future of countries in the European Union, and more particularly within the zone that uses the euro. The euro has fallen consistently against the dollar and euro-denominated bond yields of southern European countries have risen to heights at which financing- budget deficits becomes painfully expensive. Yet as policy responses on both sides of the Atlantic have evolved, one thing has become clear: Europe is not the problem markets think it is, and the U.S. economy looks much shakier than markets currently believe.
U.S. commentators, at least from the conservative side of the aisle, have always tended to sneer at the European Union. Undoubtedly, its bureaucracy is even more irresponsible and unaccountable than that in Washington, D.C., and the constitutional barriers against that bureaucracy's self-aggrandizement instincts are much too weak. When I dealt with it fifteen years ago it was also significantly more corrupt than its U.S. counterpart, although I have the impression that U.S. standards have since deteriorated to equalize matters.
As for the European economies themselves, they generally involve about 10% more of GDP than in the United States being absorbed by the government, partly in better (and more efficient) healthcare provision, but also in a greater degree of income redistribution and an overgrown welfare state. There is a certain offset from lower European defense spending, but overall government's drag on the economy is significantly greater in Europe.
Nevertheless, in certain respects the European system works better. This is notably the case in monetary policy, where the constitution of the European Central Bank and its links to the German Bundesbank make it more immune to meddling than the over-politicized Fed. Europe's expansion of money supply was less during the bubble than the Fed's, its interest rate floor has been 1%, rather than zero, and it has been notably less enthusiastic than the Fed in buying rubbish when trouble intervened, attempting to sterilize its purchases through repurchase agreements rather than simply running out and buying mortgage-backed junk in trillion-dollar lots.
At June 18, the ECB's balance sheet totaled 2.12 trillion euros ($2.54 trillion) compared with the Fed's $2.39 trillion in an economy which at $1.20 = 1 euro is just about the same size. That comparison shows nothing; however of the ECB's balance sheet 1.25 trillion euros ($1.5 trillion) represented lending to Eurozone banks and government securities, considerably less than the Fed's equivalent figure of $2.07 trillion. Since the Eurozone is currently in mid-crisis whereas the U.S. banking crisis is a year in the past, the ECB has thus been notably more conservative than the Fed in the use of its balance sheet as well as in its monetary policy.
However the most notable economic policy area in which the EU differs from the U.S. is its attitude to fiscal "stimulus" and budget deficits. Even at the height of the 2008 banking crisis, when some EU countries such as Britain under its Labor government were widening their budget deficits, the social democrat German finance minister Peer Steinbruck referred to the stimulus policy as "crass Keynesianism." Unlike in previous economic crises like the 1930s, when electorates tended to turn towards big government, this time in Europe they have turned away from it, with both Germany and Britain electing center-right coalitions within the past year.
The result of recent electoral changes and of the Greek crisis has been a big move in Europe towards fiscal austerity. Greece, Portugal and Spain were more or less forced to cut their budget deficits. However Germany, which introduced a deficit reduction package last week and France, which increased its state sector retirement age to 60, were in little danger of a market "run" on their government bonds, so their move to fiscal austerity has been largely voluntary. Now Britain has introduced the largest budget cuts in a generation, aiming to get close to balancing the government's budget by 2015. All these countries have taken an axe to their public sectors in terms of employment levels, pay and pensions, reducing state-sector entitlements that had become bloated by a decade of moderate economic expansion and fiscal laxity.
Keynesians are now arguing that Europe's austerity packages will plunge the continent back into recession. President Obama penned an official letter to this effect prior to this weekend's meeting of the G20 leaders of the world's major economies, and was reinforced by Larry Summers and Treasury Secretary Tim Geithner in a Wall Street Journal op-ed. Obama is right to be worried. If the Keynesians are right, Europe's budget cutters, by pushing the United States' largest market back into recession, will damage the United States' embryonic recovery. If however the Keynesians are wrong, and Europe does not plunge back into recession, then the United States with its titanic budget deficit will become an isolated example of fiscal laxity, damaging its credit rating. Since the United States makes an excellent return on seignorage from the dollars it provides to the world economy and to fearful Chinese central banks, causing the world's bankers to focus on the dollar's problems could push the country even further into downturn.
My vote would be for the Keynesians being wrong, and being proved so pretty quickly, partly because of the markets' dinging of the euro in recent months. For the southern European countries in real trouble, reducing their deficits will increase the availability of capital to their economies, as markets come to have confidence in their long term viability (that may not apply to Greece, the worst of the miscreants, but there an EU bailout will have a similar effect—free money always helps matters.) For Britain and France, fiscal retrenchment will also increase the amount of capital available to those countries' business sectors, at a time when banks' natural preference is to invest only in government bonds, funding those purchases with short-term deposits and picking up large returns from the universal steep yield curves.
For Germany, the benefits of immediate reduction the fiscal deficit are less, because Germany is in fine shape economically, with a recovery that is already on track. However for Germany and for all the other EU countries, the reduction in the value of the euro will provide a very welcome boost to exports. Countries like Spain, which have become uncompetitive with their Eurozone partners, will benefit least, but Germany should benefit most of all because its export sectors are already highly competitive and should gain market share. If the ECB and the Bank of England begin to raise interest rates, as seems very possible, the yield curve attractions of government bond investment will disappear, banks will once more be forced into the difficult business of lending to small companies and European consumers will further rebuild their personal balance sheets through saving.
The main laggards in the race to rebalance budgets are thus the United States and Japan (apart from India, something of a special case and still a relatively small economy.) In Japan, the new prime minister Naoto Kan has made noises about moving towards fiscal balance, but appears to wish to do so by raising consumption taxes rather than by trimming back Japan's excessive government expenditure. If he follows this preference, the positive effect on the private sector will be less marked than from spending cuts, since money released by lower borrowing will be reabsorbed through extra tax. Increasing the consumption tax in order to reduce the deficit failed in Japan in 1997; it is unlikely to be very successful today, although reducing investor anxiety over Japan's gigantic debt burden will certainly provide long-term benefits.
As for the United States, President Obama and the current Congress appear committed to continuing their Keynesian "stimulus" polices. These have already failed in their ostensible purpose of increasing employment—the damaging effect of the huge deficits on bank lending to the small-business private sector appears to have negated any benefit from preserving public sector union jobs. With the dollar strengthening against the euro and interest rates far below the rate of inflation, the balance of payments deficit and savings dearth have both worsened, returning towards their unsustainable levels of 2007. Now housing appears to be weakening once more, with the ending at the end of March of the Fed purchases of mortgage backed debt and at the end of April of the $8,000 subsidy to homebuyers. There must thus be a substantial risk of a double dip recession, not in the world as a whole, but in the United States, where both fiscal and monetary policies have for several years been hopelessly misguided.
No doubt the other G20 leaders attempted to explain this problem to President Obama at their meeting. On past form, they are unlikely to have succeeded in doing so. Meanwhile it is the United States and to a lesser extent Japan, not Europe, that have the greatest economic problems currently. With the help of some draconian and courageous budget management, Europe is recovering just fine.
The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of "sell" recommendations put out by Wall Street houses remains far below that of "buy" recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) – details can be found on the Web site www.greatconservatives.com and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley – 2010). Details forthcoming.
Views are as of June 28, 2010, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
Gross Domestic Product (GDP) is a broad gauge of the economy that measures the retail value of goods and services produced in a country.
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Last Updated on Wednesday, 30 June 2010 14:21 |
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Back to the Kaiser's World |
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Written by Martin Hutchinson
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Monday, 21 June 2010 15:09 |
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As anyone who has played "Diplomacy" knows, the economic and political world from 1871 to 1914 was one of Manichean struggle: Countries attempted to establish spheres of influence behind high tariff barriers, and multiple power centers between which war was by no means impossible. As the mildly social democrat Nirvana of the 1990s recedes into history, it is becoming increasingly clear that weak U.S. leadership and poorly designed policies have led us back into a similarly unpleasant economic environment.
The great advantage of Pax Americana, as of Pax Britannica between 1815 and about 1870, was that a single hegemonic power was able to enforce trading rules and prevent a descent into economically damaging protectionism. In the early 19th century, once Britain's economic position had been righted by the Liverpool ministry from the excessive debts incurred in the Napoleonic wars, the move toward free trade was steady. The Corn Laws were reduced in 1828 and abolished in 1846, while further tariff reductions culminating in the Cobden-Chevalier Treaty of 1860 minimized British tariff barriers.
Most of those tariff reductions were unilateral, but the 1860 Treaty pushed France also in the direction of free trade. Meanwhile U.S. tariffs remained moderate until the Civil War, as the South had the ability to veto tariff increases by the protectionist North, with a final tariff reduction under the much maligned President James Buchanan in 1857 reducing U.S. tariff rates to an average 18%. Germany was divided between protectionist Prussia and the free trading Rhineland, while Austria-Hungary and Russia retained high tariffs both internal and external. Nevertheless, until the 1860s it appeared that the world was moving gradually towards free trade, as economists were already recommending.
After 1870 Britain was no longer economically hegemonic – partly because of the damage done to her economy by her unilateral tariff disarmament in 1846-1860 while other countries retained protection – and tariffs began to rise. The U.S. Lincoln administration raised tariffs twice, in 1861 and 1862 and further tariff increases were enacted regularly, culminating in the ultra-protectionist McKinley tariff of 1890, with a 50% average rate, enthusiastically supported by Andrew Carnegie seeking to protect his steel business from British and now German competition. Germany, united in 1871, increased its tariffs sharply in 1879. Thereafter it pursued a policy of protectionism, seeking to draw smaller countries into its sphere of influence, which was to continue through the Nazi economic order of the late 1930s. France also increased her tariffs after her defeat of 1871, passing a particularly protectionist tariff law in 1892.
Thus while 1870-1914 saw the apogee of free international finance, it saw marked backsliding in the area of free trade. By 1900, all the major powers except the luckless Britain were thoroughly protectionist and industries such as steel and automobiles grew up along nationalist lines. World War I intensified this trend, the Smoot-Hawley Tariff of 1930 carried it to its absurd destructive extreme, and it was only after World War II, when a new hegemon emerged, that tariffs once more began to decline.
The rise of tariff protection after 1870 also changed the relations between states. Before 1870 small states, for example those of Western Germany, had been able to prosper by forming global trade relationships, perhaps with limited free trade areas between themselves such as the German Zollverein. After 1870 this was no longer possible. Germany and Italy were formed as economically and politically powerful states and smaller states such as those in the Balkans prospered only by attaching themselves to a major power. Outside Europe, the period after the 1870s was the apogee of Imperialism with countries in Africa and Asia that had remained independent in spite of their technological backwardness becoming increasingly dominated by one or more European powers or in some cases, such as China, the subject of diplomatic and occasionally military conflict between them. It was not an accident that Japan felt the necessity in 1868 of modernizing itself in order not to fall victim to one of the Europeans; no such modernization had appeared necessary in 1820.
Kaiser Wilhelm II, to his contemporaries a bogeyman, to modern eyes a figure of fun overshadowed by his dreadful successor, both epitomized the 1870-1914 period of protectionism and, together with his mentor Otto von Bismarck, was its most successful protagonist. He believed in a German sphere of influence including Austria, much of the Balkans, the crumbling Ottoman Empire and, he hoped, eventually the oil-rich Middle East, held together by the Imperial Berlin-Baghdad Railway project. Germany's tariffs sufficed to fund a gigantic army, social security provisions that were generous by the standards of the time, rapidly improving living conditions and, after 1900 an embryonic navy that was regarded as serious threat by British governments.
Kaiser Wilhelm II's worldview was to modern eyes thoroughly unpleasant – witness his speech to troops departing to fight the 1900 Boxer Rebellion "When you come upon the enemy, smite him. Pardon will not be given. Prisoners will not be taken. Whoever falls into your hands is forfeit. Once, a thousand years ago, the Huns under their King Attila made a name for themselves, one still potent in legend and tradition. May you in this way make the name German remembered in China for a thousand years so that no Chinaman will ever again dare to even squint at a German." It was a long way from the civilized waltzing of the 1815 Congress of Vienna, and protectionism and the lack of a hegemon had caused the change.
From the 1970s, it became obvious that the world was moving back to a system of free international finance, similar to that of 1870-1914, but its move to free trade resembled more the middle rather than the tail-end of the nineteenth century. After the fall of Communism in 1989-91 the U.S. became a truly unchallenged hegemon, far more powerful in relative terms than Britain in 1815-1870. International institutions such as the World Bank, the IMF and even the United Nations spread a center-left, mildly statist big-government version of the U.S. worldview, the "Washington Consensus" among the nations of the new emerging markets. Small countries, in particular those emerging from Soviet domination, could hope to prosper on the basis of universal free trade, and the success of the east Asian tigers showed that small size was no barrier to economic success.
Beginning in 2000, and more particularly since the financial crash of 2008 and the Obama presidency, the world has changed again. The U.S. is no longer an unchallenged hegemon, far from it. After one barely successful war in Iraq and another in Afghanistan that seems increasingly likely to end in failure, the United States' ability to project power is greatly diminished, its moral authority even moreso. The Washington Consensus has broken down, being replaced on the left by a reversion to out-and-out statism, on the right by a fierce determination to reassert control over runaway government finances and rent-seeking banking systems.
Small countries are finding the world an increasingly unforgiving place. Of the former Russian satellites, Georgia was invaded by Russia without significant opposition from the U.S., Ukraine has reverted to Russian domination, Kazakhstan has reversed its previous tentative opening to the West and Kyrgyzstan appears to be descending into chaos. In the Middle East Iran is increasingly self-confident, Turkey has turned away from the West, the Iraqi democracy appears likely to be short-lived and Israel is increasingly beleaguered. In Latin America, increasing numbers of countries are falling prey to the followers of the sinister Hugo Chavez. Even in Asia, which had appeared capitalism's most shining monument, Thailand and Sri Lanka are no longer progressing smoothly to a future of democracy and ever-increasing prosperity, while Japan appears less and less an example to follow.
As for free trade, the Doha round of trade talks is dead and buried, and even bilateral agreements with the United States have no chance of being ratified by the current Congress. The economic downturn has produced numerous new trade barriers of one kind or another, even if full 1930s-style protectionism has so far been avoided. The financial services sector is wholly unreformed from its rent-seeking metastisization since the 1980s, and increasing numbers of governments are erecting barriers to its depredations in the form of capital controls of one sort or another.
The U.S. is unlikely ever to enjoy again its hegemony of 1990-2008. Its economy retains the flexibility that had made it so admired, but the burden of state spending has increased by over one-third since 2005 and taxation will inevitably rise in response. Most important, a decade and a half of ultra-low interest rates have de-capitalized the economy, not only leaving American savers without enough savings to finance their old age, but also leaving American business starved of capital for expansion, as ever-increasing percentages of the available finance pool head into the government deficit maw. Going forward, U.S. living standards will inevitably decline, while politically the likely result will be a retreat into isolationism and a refusal to get involved in the intractable problems of the international order. Even if the United States attempts to project its power under some new president, it will find financial constraints prevent it from doing so.
The international order has thus returned to the Kaiser's world of multiple states, high tariff barriers and unfair trade competition. Small countries will have no alternative but to seek protection in the spheres of influence of their larger neighbors. Participants in the protectionist new world order will be a diminished United States, a sclerotic and inward-looking EU, projecting its power no further than the Balkans, one or possibly two left-leaning Latin American blocs led by Brazil and Venezuela (which may or may not combine), a resource-rich and oppressive bloc led by Russia, a highly unstable Middle East dominated by Turkey and Iran, and an impoverished and unstable south Asian bloc led by India. By far the most powerful and successful bloc will be led by China, which will include much of south-east Asia and large parts of Africa. There will remain a few substantial independent states: an isolationist Japan, an unstable Indonesia, perhaps a modestly prosperous Australia. However overall the world will geopolitically look like that of the aggressively competitive 1890s or, if we are unlucky, the haunted 1930s.
And ironically enough, the new Kaiser Wilhelm II will be Chinese.
The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of "sell" recommendations put out by Wall Street houses remains far below that of "buy" recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) – details can be found on the Web site www.greatconservatives.com – and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley – 2010). Details forthcoming.
Views are as of June 21, 2010, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
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Last Updated on Wednesday, 30 June 2010 14:19 |
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