Don't Use a Financial Fix for an Economic Problem

There is a lot of confusion, it seems to me, over what the economy really is. A good working definition is the production and distribution of goods and services. Prosperity occurs when there is a high level of production and distribution of goods and services that people want. In a free market, the price system sends a clear signal as to what people want. When governments interfere, by quotas, or by subsidies, or even by point of sale taxes, prices can get distorted and send the wrong signal. I well remember my introduction to shopping behind the Iron Curtain many years ago. It was at a department store in Bratislava. There was a skimpy selection of basics, but an abundance of fur coats. Rows and rows of them. Without a free market pricing system to send out the signals, manufacturers had no reliable measure of the market. They didn’t know what to make.

A similar confusion appears in government response to the current economic downturn. In Canada, our governments are flooding the country with cash. Our problem is a sharp decrease in the production of goods and services; the distribution systems are still working more or less. Throwing cash at the problem isn’t going to resolve it. Although more energetic, this is the same tactic used about 11 years ago in response to the then collapsing financial and manufacturing industries. But back then, the problem was a balance sheet problem. It was liquidity. Part of it was rising current liabilities versus current assets. In other words, depleted and negative working capital. Another problem was that many assets had lost significant value: loans that had been made to debtors who became insolvent, real estate that had lost much of its value, and financial derivatives that had evaporated into money heaven. In short, equity had disappeared. Pumping cash into impaired balance sheets helped.

Today, the problem is primarily an income statement problem, not a balance sheet one.  Revenues are down because people aren’t working to produce and people aren’t buying. Giving those businesses money helps them stay in business a little longer, but is just an exercise in kicking the can down the road. People are not inclined to spend the money if they don’t have to. I think we will look back to 2020 and see that government largesse rapidly inflated the M1 money supply, but did not stem the declining velocity of money. And it is the velocity that is more important. I think we are seeing a financial fix being applied to an economic problem, and it will not work.

Changing Patterns in World Trade

We are all wondering what the post-Covid-19 world will be like. Perhaps new habits will have been built. Perhaps people will decide that they can work at home, and employers may decide they don’t really need to rent as much space as they have been. Perhaps people will like not having to fill their cars more than once every several weeks. I don’t know the probability of such outcomes.

I do have a stronger opinion about macro-economic consequences. One thing the pandemic has done is to help Americans realize more than ever that they prefer short supply lines. Why manufacture in Asia?  Which is cheaper --- having 3000 laborers weaving textiles in a shop in India, or building a robotic based factory in Indiana run by 3 people and weaving more cloth more consistently? After the capital cost is incurred, it is much cheaper manufacturing in America, and there are lower distribution costs and more secure distribution channels.

Franklin Roosevelt, shortly before he died, invited representatives from 44 Allied nations to a conference at a resort in New Hampshire called Bretton Woods. There a trade deal was sold. America would now use its mighty navy to keep the seas safe for shipping, removing much of the risk. In the not so distant past, the lay of the land was that empires coalesced around major powers who just took what they wanted. A country needed to be in an empire to have a market and military support. Bretton Woods changed that. 

Shortly thereafter, a strange thing happened. Roosevelt, who along with his wife was a friend to the Soviets, seeing them as allies and realizing that is was mainly the Soviets who were beating back Germany, was replaced by Harry Truman. Right from the start, Truman seemed hostile to the Soviets. It was like he expected them to be enemies, and soon they were. The Bretton Woods arrangement now was for countries that were not allied with the USSR, and the world prospered. America gave free military protection to ensure safe trade, except for the price that the recipient was not to side with the USSR.

Close to 50 years later, the USSR disintegrated. The reason behind Bretton Woods was no longer relevant. America began to lose interest in international networking. Clinton was a domestic president with almost zero interest in foreign affairs. He would cram from notes before a meeting with a representative from another country, pass the meeting with flying colors, and then forget about it. Bush II, Obama and Trump have not been much better. There has been no reason to be. America is a self-contained economy whose exports are well under 10% of its GDP. She is resource rich and doesn’t need to import much. So the USA is paying the cost of keeping sea lanes safe for what? It had been to encourage beneficiary nations to stay out of the Soviet camp, but the USSR folded up. So what has the reason been these last three decades? I don’t think Americans know. Donald Trump is wondering the same thing. His America First policy is euphemism for withdrawing America into a continental economy that is not dependant on the rest of the world.

Unlike China. China has a population pyramid that is fat near the top. A huge portion of its population is moving into their senior years when consumption is typically rather low. So China does not have sufficient domestic demand to consume its production. China has depended on the USA to do that. The USA is getting tired of the sub-standard junk China produces and is pulling back from Sino-American trade.

But there’s a larger issue here. Throughout history, there have been many instances of an aspiring super-power expanding and flexing its wings to the point where the existing super-power feels uncomfortable. I could probably cite about two dozen such cases from the last 3,000 years. These situations have usually resulted in a war between the two. We can start with the alliance of Babylonia and the Media demolishing Assyria, continue to the Medes and Persians conquering Babylon, and so on through many centuries to the first real-world war, the Seven Years War, waged in Europe, North America, and Asia. Then the super-power was France, and Britain and Prussia each aspired to the status and took on France, with whom the empires of Russia, Austria-Hungary, and Sweden allied. We see Prussia challenging France again in the Franco-Prussian War of the 1870s. Japan grew to attack the more predominant Russia in the very early 1900s and America in 1941. Now we see China rising and America getting in the way. The probability, it seems to me, is war between the two. I mean a shooting war.

Such a war would help China hold together. We forget that unity is not the natural way of China. The Mongols forced it on them. So did Mao. But these are historical aberrations. See https://www.youtube.com/watch?v=UWqVzZnwnOk for an interesting several minutes. Add to that the fact that 1.1 billion people in China are in the bottom economic class and require financial help. As the Chinese economy falters and stumbles for lack of markets and from the stress of a relatively small proportion of the population producing most of the goods and services and having to support the majority, there will be a tendency to blame the government. If the Chinese Communist Party learned from the Arab Spring, the leaders will want to avoid a Chinese equivalent. Something will be needed to divert attention. War usually does a good job of that.

Now, maybe the parties will be cool and realize that China would have no hope of defeating the USA. One Nimitz class carrier has more firepower than all the other navies of the world put together, and the USA has 11 of them. China’s navy is mainly short and intermediate-range. And in the air, a typical American fighter pilot would have to be incredibly inept and unlucky and a Chinese pilot just as incredibly lucky for there to be a Chinese win in a confrontation between the two.

Maybe there will just be a cold war. Makes sense. America with a handful of trading partners --- Canada, Mexico, the UK, Australia, New Zealand, Japan, South Korea and select countries in South America --- versus China and a much bigger trading community. We may even see Central American countries cozy with China. China is investing there, as in many other regions. For example, they are planning a super-highway across Costa Rica, from Limon up through Guapiles and on to the Pacific coast. The idea is to ship freight overland rather than paying $500,000 for one freighter to make one pass through the Panama Canal. The oligarchy that are members of Panama’s Union Club will likely want to keep ties with the USA, and America may be motivated by the strategic location of Panama, so Panama may be America’s beacon in Central America.

Another country that stands to be hurt in a major way by shifting trade relationships is Germany. Whereas China is a major exporter of crap with about 20% of its GDP being exported, Germany is a major exporter of high quality, highly functional manufactured goods. Half of Germany’s GDP is exported, so she needs a continued market. The USA, turning inwards now even more so as a result of the current pandemic, is more interested in revitalizing domestic industry and supply chains than in keeping Germany in business. The rest of Europe is not enough of a market. When 50% of your GDP is exports, even a 1/5 decline in exports is a 10% drop in GDP. That’s huge.

With a new order shaping up, plus more and more businesses failing the longer the world is locked down, the chances of a major depression continue to grow. I know there is all this wishful thinking about pent-up demand --- the idea that people will buy with a vengeance once they can again --- but I don’t agree. When this shutdown is done, I am not going out to get three haircuts. 70% of Canada’s GDP is services. Services unrendered are lost revenue.

My apologies for rambling a bit here, but I think we need to be thinking outside the contemporary box, and more in line with the broader background of history. I hope this essay provokes you to think longer and more deeply about the state of the world than you have.