Mid-Fourth Quarter Blog Review:

Latin & Hellas On The Global And US Economies
– Swimming In the Mud

So far, since its inception in January-February 2006, the writer of this blog has focused on globalization, the US economy, and the economies of the early industrialized countries in general, in the context of the globalization of the industrialized economy. Building on previous posts, here we will review 1) the basic historical framework for globalization, the current situation, and likely developments, 2) the global financial system and the debate over the fiat currency system vs gold, and 3) current economic policy in the US, mainly from the viewpoint the central bankers, and the quest for a soft landing which, I argue, is more like swimming in the mud, possible but dirty.

I. Basic Historical Framework For Globalization

In the essay Diffusion and Darkness (posted July 28, 2006), we mentioned the thousand-years spread of agriculture across the globe as humans emerged from hunting and gathering. As Douglass North pointed out in one of his books, the political history of the pre-industrial world is humans’ working out the social implications of that shift in economics: agriculture was practiced over the centuries under any number of political structures and regimes, from isolated subsistence farmsteads to extensive monarchical empires, based on religious ideologies, spanning land and sea, complete with transport and monetary systems based on metal coinage.

In their public speeches, US central bankers often address the topic of globalization. In a recent speech (August 25, 2006), current Federal Reserve Chairman Bernanke even offered a brief outline of the history globalization, citing the Roman Empire as the premier example of the achievement of globalization in the ancient world.

Another culminating moment in the history of globalization was the European “discoveries” period, led first by the Portuguese and Spanish, and later the British, Dutch and French (roughly 1500 to 1750), spurred by advances in European shipping technology and navigation, leading to the globalization of trade, not to mention colonization.

Industrialization, which began in the United Kingdom and spread to certain parts of Europe, North America and certain other European colonies during roughly the 1750-1914 period, was the most important revolution in human economic history since the shift from hunting and gathering to agriculture, and political history since then is humans’ working out the social implications of that shift in economics: spawned under the auspices of the Western liberal revolution, representative democracy and market economics, industrialization over the span of some two-hundred fifty years has spread across the face of the globe, complete with transport, financial, and information & telecommunications systems, and today it is practiced under various political structures and regimes ranging in size from city- and island-states to empires spanning land, sea, and air, from various types of dictatorships to various types of semi-anarchy.

The current situation

Most of us are aware that organizers of a consumption-driven, market-based industrialized economy perceive the need to expand the scope of production, consumption, markets, and the supply of energy.

In the essay Musings On The Global Economy (posted February 21, 2006), we noted that, in political economy terms, globalization today means that big power groups – mainly national governments and multinational enterprises – can organize a truly global division of labor, allocation of capital, and consumption in a system largely driven by market prices mixed with government intervention.

Following the energy crises of the 1970s, the US reacted in the 1980s and early 1990s with policy reforms, while at the same time introducing new technologies to implement them on a global scale.

First, in terms of policy reform, the US overhauled its domestic tax and financial systems, then led the drive towards international capital market openness and free trade and travel policies, stimulating also Europe’s drive toward a single market and political union, openness and restructuring in eastern Europe and Russia after the end of the cold war, openness and industrial development in China and India and other emerging countries of east Asia, the “Washington consensus” policies in Latin America, greater involvement of especially energy-rich sub-Saharan African countries, while relations with Islamic countries remained complicated and uncertain, and, most recently, migration of low-cost workers, especially toward the countries of early industrialization.

In terms of technology, generally speaking the early industrialized countries learned how to use energy for transport and especially power generation for industry and services more efficiently. But the application of information & telecommunications (ITC) technology on a global level and scale, coupled with improvements in management techniques and more flexible labor and capital markets leading to productivity gains, especially in the US, has been the culminating point so far in the process towards the globalization of the industrialized economy whose social, political, and economic implications are still being played out.

Technological and economic change brings about social change. Study of human history shows that, speaking of big power groups (governments and big business), any change in territorial relations due to any combination of technological, economic, social, and political change also gives rise to the challenge of how to manage potential and real social changes that result within the territories of the respective big power groups. In other words, the policy, technological and economic changes that are the driving forces behind the globalization of the industrialized economy are posing challenges to domestic social models organized and managed by respective big power groups, on the one hand, and relations among big power groups on a global level and scale, on the other, and they are in turn mutually influencing each other’s domestic models, on friendly and unfriendly terms as the case may be.

Now, as a rule, established power groups do not want to lose control, and this stage of transformation of the global economy is no exception. Generally, big power groups exercise political and social power through control of the energy supply and of strategic commodities, control of military force, control of the money supply (the means of exchange, unit of account, and store of material value), and control of ideology and mass media.

The will of the current main big power groups is that there be no fundamental changes in the matrices of the current social political models, based on the cultural ideology of consumerist materialism as a result of the mere global extension of the industrial economic model organized through a combination of free markets and government intervention. For example, through domination of international capital markets and organizations such as the IMF and the World Bank, the countries of early industrialization have, so far, maintained control of the global money supply.

Nevertheless, social models are changing – in the countries of early industrialization, in Islamic countries, in east Asia, in Latin America, etc. – and several political conflicts, economic imbalances, and social structure problems have emerged as a result.

One economic imbalance, for example, is energy: demand has increased because of the need to fuel the growing number of factories in countries such as China, for example, and the need to transport all this merchandise to the centers of consumption over mountains and oceans, throughout sprawling suburbs, while supply has not kept apace. Here a political conflict arises: still the most efficient sources of energy (oil & natural gas) are found for the most part inside or around countries where major groups aspiring for power, with another ideology, want to increase and legitimize their power, and so to achieve this objective they make war, through whatever means available to them, where the stakes are the price of energy, to whom to sell it, and how to redistribute the income so generated. Here, of course, I am referring to the conflict between the Islamists and the countries of early industrialization (including here Russia), with countries like China and India lurking in the background.

The wave of change in social models also probably explains the current conflict with North Korea, a regime trying desperately cling to an old social model that is clearly obsolete – not even the Chinese subscribe to it any longer (Cuba is a special case, not discussed here) – and to obtain nuclear weapons to defend itself.

Another example of a change in social model is in the United States and Europe: the union, welfare and pension systems developed towards the end of the 1800s and during the 1900s in the countries of early industrialization that upheld the majority of the working population in the middle class clearly cannot be sustained going forward because of cost competition elsewhere: the golden age of a restricted and protected middle class in the US and Europe is just about over and the gains of industrialization are now being dispersed over a greater number of people throughout the world.

Likely developments

Most likely, through trade, direct investment, immigration and war too, we will all become a little bit more like each other: demographically-challenged US, Europe, and Japan are accounting for an increasingly lower proportion of global output, and probably within the next two or three decades the average Chinese and other east Asian, Indian, Latin American, Arab, and African and so on will have non-agricultural jobs, have access to money to purchase basic consumer goods through wages and credit, as well as access to some kind of healthcare, education and a pension, and the quality of the consumer goods, wages, healthcare, education, and pension will reflect the average quality of the masses of both the older centers of industrialization and the new, for better or worse – those of the masses that survive the global social shift and the energy wars.

II. The Global Financial System

In two articles, i) The Finances Of The Nation-State And The Global Foreign Exchange System and ii) Reform The International Monetary System Or Reform The Nation-State System?, both posted February 23, 2006, but written in April 1995 in the wake of the collapse of the European Monetary System in 1992 and the North American currency crisis of 1994-1995, during a period featuring high budget deficits in the countries of early industrialization, we argued that tinkering with the international monetary system may have some tangible effects in a series of short-runs, but that the underlying cause of chronic macroeconomic disequilibria is fiscal imbalance. In the ensuing years, fiscal balance was restored in the United States and improved in Europe in the run-up to the introduction of the single currency.

The expanding global credit bubble since 2001 spawned by historically low interest rates in attempts to revive or maintain consumption, the return in the US to budget deficits and the expanding trade deficit as well as consumer debt, persistent budget deficits and now a trade deficit and burgeoning consumer debt in Europe, and high energy and commodity prices, have all been associated with the rising price of gold in the past several years, sparking a debate, among other things, over the future of the fiat currency system, even as some central banks have begun to replenish their stocks of gold.

In the past eight months, we have contributed to this debate with three articles – The Global Financial System: To Plough Into Gold Or To Plough Seed (published April 24, 2006), Erosion Of The US Dollar? (published May 16, 2006), and More On Gold And The Global Economy (published July 17, 2006).

In these three articles, the focus of the analysis shifts to relative productivity which, however, is not unrelated to fiscal imbalances, debt, and inflation. Briefly tracing the history of the US dollar’s value against the JPY and the DEM (and now the EUR), we pointed out that in the early 1970s, amidst a relative rise in productivity in countries like Japan and Germany, leading to an erosion of the US dollar among other phenomena like inflation and an oil crisis, the gold standard and fixed-exchange rate regime came to an end.

Now, in the mid-2000s, in the face of rising inflation and debt, especially in the US and to a lesser extent in Europe (asset-price inflation – equities and real estate – and in non-exportable services like healthcare and education, coupled with consumer and government debt and trade deficits), leading to an erosion of, and constant pressure on, the US dollar, a debate has arisen whether gold is a speculative ploy or emerging once again as a store of value.

But we argued that the real question is, from the US or European or even Japanese perspective, to what extent do we believe in our own ability to maintain productive enterprises on our own soil, to discover and/or invent new forms of energy, renewable energy, and protect that technology from those that would do us harm? Gold is as much a fiat measure of value as paper currencies or as electronic accounting systems: it is valuable because people view it as valuable; there is no “intrinsic” value in gold or in anything for that matter. The global industrial system can only go so far as the real economic cost of energy for production and transportation. Perhaps we should design our “monetary” system based on units of energy.

As for the practical matter of the dollar exchange rate going forward, in short, we argued that the US economy is operating on an unsustainable consumption and energy model, a significant contributor to the several imbalances in the global economy and tension in the global political community. On the other hand, the eurozone economies and its satellites in eastern Europe are beset with their own structural problems (see also A Foursome On European Monetary Union published July 28) and, though certainly the Chinese and Indian economies have become relatively more productive than the US and eurozone economies, at least over the past three or four years, arguing in favor of a stronger Chinese and perhaps other Asian currencies, nonetheless the competitiveness of US manufacturing, both in high-tech fields and possibly also in the lower rungs of the technology chain once again in the future (see massive inflow of low-cost immigrants), as well as the overall productive potential of the US economy, the dollar cannot be easily dismissed.

Overall, then, we expect the dollar to remain under pressure against the euro and the other major currencies, especially while the yuan remains, what many perceive to be, artificially low. However, there are enough countervailing factors that argue in favor of further see-saw movements rather than some kind of dollar meltdown and, even more remotely, a return to the gold standard. Therefore, the speculative play on gold, and on commodities in general for that matter, is not a one way bet going forward.

III. Current Monetary Policy And The Search For A Soft Landing: Swimming In The Mud

In a series of four articles – i) Inflation, Interest Rates, And Short-Term Market View (posted May 25, 2006), ii) After The June Hikes, What Next? (posted July 5, 2006), iii) Governor Kohn Indicates Higher Interest Rates, Lower Real Estate Prices (post July 6, 2006), and iv) More Fed Watching, The Dilemma Of August 8 (posted July 29, 2006), we focused on the US economy, some of its structural imbalances as reflected in debt, deficits, asset prices, and inflation, financial market performance, and the monetary policy response, all against the backdrop of globalization.

Led by the corporate sector, the US still has the most productive, or at least the most efficient, economic system in the world in terms of the production and distribution of goods and services. It is even the top exporting nation in dollar volume terms. Though the manufacturing sector has lost nearly five million net jobs over the last 25 years or so, the number of high-skill manufacturing jobs has risen by 1.2 million, and the sector as a whole still accounts for 20% of total output. In short, the US manufacturing workforce in now smaller but more skilled and highly productive in such sectors as transportation equipment, aerospace, steel, forestry, and of course information and telecommunications technology. It is also among the world’s top agricultural producers and exporters, and the US economy as a whole makes the most efficient use of energy as measured by GDP per barrel of oil consumed.

Yet, if the US trade and budget deficits are any indication, it is clear that, on the aggregate, economic participants in the US consume more than they produce. While productivity is concentrated in the corporate sector, the household sector and the government are heavily indebted. In this context, in order to maintain sustainability, it is not surprising that US monetary policy-makers focus heavily on two main variables, debt and productivity. Closely related to these variables are inflation, reported and real, and interest rates and credit standards, the main policy tools of the Fed and the credit system.

To a large extent as a result of relationships with countries like China and India, reported US consumer price inflation and interest rates are low. But the imbalance between consumption and production and the concentration of surpluses in the corporate sector show up in other areas of the economy, such as asset price inflation (lately the real estate market) and prices for non-exportable and to a large extent captive services for most US residents, such as healthcare and education, the fact that headline inflation is reported with energy stripped out when on the rise but with energy included when on the decline, and that real wage growth has not kept up with even reported inflation and is way behind real inflation, hence easy credit and high levels of household debt. A similar dynamic is at play also in Europe. All these are indicators of the real relative decline of the middle class in the countries of early industrialization, though consumption continues, abetted by easy credit.

The Fed, along with many other observers, knows that debt-based spending in the United States, both household and government, cannot continue. Some are seriously concerned about the possibility of higher inflation combined with not only a slowdown, but even a recession, perhaps prompted by excessive tightening by the Fed, but more so because of the weight of excess debt. Others argue, on the other hand, that despite the high debt levels, the situation is under control by virtue of the high productivity of the US economy and so the expectation that the debt can be overcome in the medium/long-term through growth, with some slowdown now, followed by renewed acceleration later.

So the Fed must do a tight-rope walk at high altitude, seeking a balance between curbing inflation and maintaining the value of the dollar in the face of high levels of debt supported to a large extent by foreign purchases of treasury securities, on the one hand, and consumption and economic growth on the other, equally in the face of high levels of debt.

One way out, the Fed hopes, as US economic growth slows, in part through a downward correction in real estate prices, is that investment and consumption will pick up in the rest of the world, mainly east Asia (as mentioned, the US and Europe account for an increasingly smaller proportion of global output), allowing US exports to increase, by virtue of the productivity and investment potential (saving) in the corporate sector. Productivity may even rise in the meantime, supporting corporate earnings and so the stock market, helping to offset the reduction in the wealth effect caused by the adjustment in the real estate market, allowing interest rates to rise less than expected before the second quarter GDP report, leaving enough excess liquidity also to support emerging equity markets and international bonds, while foreigners would also agree to keep holding US debt paper, now at more competitive interest rates than eighteen months ago, in the interests of maintaining stability.

In the event, so far, economic growth has slowed to around 2.5%, though reported inflation, at around 2.9%, is still stubbornly higher than the Fed’s comfort zone. On the other hand, oil prices have dropped to below $60 per barrel and other commodity prices have also retreated, while the stock market has reached new highs, to a large extent driven by still high corporate earnings growth rates. But this may be a backwards looking indicator. We still have to gauge to what extent the recent run-up in stock prices is also the result of a switching of credit-induced speculative excesses from the real estate market back into the stock market.

In conclusion, one way to frame the main issue facing the US economy going forward is to ask the following questions. Is excess household and government debt cutting into productivity in the corporate sector? Is the US economy, mainly the government and the household sector, spending productivity gains filtering through the corporate sector at a faster pace than it can actually achieve them? Is the corporate sector side-stepping this dynamic through overseas investment, locking both the government and the household sector out of the profits at a faster pace than tax revenues and real asset-price gains?

On the one hand, US productivity and its manufacturing sector should not be dismissed so easily and it may even make a come-back in lower-level technology industries in the coming decades, as mentioned. But the vaunted high productivity of the US economy – which at some point must be put to the test in the face of high levels of international competition and the ongoing energy war – and interest rate policy alone are not enough to solve its imbalances, particularly its unsustainable consumption and energy model. And we do not believe that fiscal and trade policy is the problem either: low taxes, high levels of production, and free trade seem to produce positive results on the aggregate.

Instead, a rethink of the US domestic credit, community planning and transport policies, for example, and the conduct of the global energy wars is necessary. And, by the way, a change in such policies, in addition to a financial re-organization of the healthcare system and improvement in the quality of primary education, is necessary to stave off the decline of the middle class, if that is sincerely among the intentions of the ruling class.

But, as oft repeated, the art of economic policy is mostly pursued in a series of short-runs. As the US heads for a period of slower growth, stagflation, or recession over the next six to eighteen months – whatever it takes to bring overall economic growth back into line with real productivity growth, and no longer inflated by debt-based spending – the slack in overall global growth will most likely be picked up, if at all, by east Asia which, for the moment, still offers the most competitive conditions for manufacturing, even when adjusted for productivity, while at the same time its domestic markets deepen and domestic demand rises. Japan follows, though it largely depends on east Asia, while Europe in the past two quarters may have already reached its potential growth, mired as it is in its own structural problems, retarding its productivity growth. As for Latin America, the recent retreat in commodity prices may reveal how much the region’s economic growth has been dependent on the commodity price boom and how much on real structural gains, if any. As for the oil-producing Islamic countries, the onset of the slowdown has already led to a retreat in oil prices, possibly leading to a lessening of political tensions and a pause for reflection in the conduct of the energy wars by all parties to the conflict.

It is against this backdrop, then, that the US Federal Reserve attempts to engineer a “soft landing” using the few policy tools at its disposal, and it may even succeed, though not onto an “airport runaway” but rather into a “sea of mud” where the US and global economies will have to sink, in conflict with each other, or swim, in some kind of dirty cooperation, going forward.