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.

Which Way is Down?

Our Prime Minister has been talking about social distancing being necessary for months to come. He’s probably right. The objective is to keep people from getting what has been called the Chinese Flu*, but it seems to me that without getting it, we will be at risk for it until a vaccine is developed. And when is that?  Maybe early next year we are told. So even when we think we have the virus beat because social distancing is preventing new cases from developing, how long before it comes around again after we start getting close to people?  Realistically, we need to maintain the distance until a vaccine is developed and distributed.

That’s a long time. My hair, which unlike the PM’s and Bill Morneau’s, is still growing, and I do not like the look that is developing. I could ask a household member to do something with it, but I have to decide for what look I am aiming --- Larry, Moe, or Curly? 

Hair aside, let’s consider the economy. If this lockdown is over in 3 or 4 months, a lot of businesses will have been hurt, but mainly they will still be intact and able to resume activities. Many of them would ramp up to make up for the lost production. Their essential energy would still be alive.  But let’s say it is several months, maybe 6 or 8 months before the doors can be thrown open. A lot of businesses would no longer be around, and many who still are would find that consumption habits have changed: people have found out they really can do without a lot of stuff and still be happy, or at least no unhappier than they were with the stuff. Now let’s say that we are locked down until the elusive vaccine is actuated. It’s hard to envision anything pretty about that economy.

The longer the disruption of the economy occurs, the more likely it is that supply chains will break. Many inventories are low by design (just-in-time inventory management), so the system is easily disrupted. We all depend on vendors for something, and they make it from stuff they got from other suppliers (or they resell). And those suppliers also depend on yet other components. Purchases have ancestors. You have two parents, four grandparents, eight great-grandparents, and so on until you go back enough generations and you have descended from a very wide portion of the population.  So, to give one example, Peru, Chile, and Argentina have all shut down their silver mines. That's 25% of the world's production. And in other silver producing nations, some of the mines will be closed. What will remain open are the mines that are very remote and not easily accessible so that the companies running them can control who gets in and out. There will be severe disruption in the supply of silver, a metal essential to many processes. That is just one mineral. Others will also be in short supply. Products made with and from the missing minerals are used in the production of still others, and so on.  It's very complex.

The government knows the problem is grave. Their answer? Throw money into the system. The trouble is that money is not wealth. Real property, goods, and services constitute wealth.  When people are not working they are not producing wealth, but they are consuming it. The overall wealth reduces. The new money, which is not wealth, is a claim on wealth, and we have more and more money laying claim to the ever-shrinking wealth. So prices are bid up, and we have price inflation to match the monetary inflation. That’s what a lot of people expect.

There is a problem with the foregoing view. Money is not a claim on wealth if it is sitting idle, and it does not bid prices up. The velocity of money --- the frequency with which money changes hands --- is every bit as important as the amount of money there is. We are in a time of fear, and I expect velocity to slow down in a big way as people decide against spending. I expect prices will fall and that we will be in a deflationary depression similar to North America in the 1930s. Cash will be king as people elect not to spend, choosing instead to keep their powder dry. Eventually, they will resume spending, as they gain confidence, and then cash will be trash as money velocity increases markedly. 

Governments traditionally have lowered interest rates to urge the economy along. That won’t work this time. Interest rates are practically at zero. That bullet was fired in response to the 2008 crisis, and rates did not climb appreciably after that. Now some are urging negative interest rates, the belief being that if it costs you to hang onto your money, you will spend it to buy something of lasting value. I doubt it. I think you’ll simply stash your cash somewhere in your home. No wonder governments seem bent on outlawing banknotes. With many businesses now not accepting cash, contrary to legal tender legislation it seems to me, governments may want to keep it that way after the crisis is over. With money being only electronic, negative interest rates could be forced on you, not to mention the surveillance of your activities and spending habits that could take place as a result of watching your cashflow.

We sure are in a mess.

* It looks to me as though the Corona 19 virus is descended from a bat virus that was altered in a laboratory in Wuhan. I understand that a portion of the gene sequence is not found in nature, and that Wuhan is where the Chinese have their biological weapons lab.

Hoarding in a Free Market

A phenomenon that has been noticed in connection with the current goods shortages connected with the virus scare is resale of hoarded items. People have gone to Costco, for example, and bought all hand sanitizer and then resold on Amazon at huge mark-ups.

While such actions are viewed with disgust and greeted with calls for interdiction, I disagree. The free market is too important to the welfare of society to impede it because of such concerns. To have a free market, you need property rights, voluntary transactions, a price system, and a profit system. It helps to have division of labor too. Preservation of such rights and functions aid overall prosperity.

The guy that hoards and later releases goods into the market has performed a valuable function. In a free market, prices signal demand. The higher the price, the more acute the need that the price reflects. The guy that hoards by buying a product at a relatively low price and later sells at a seemingly outrageous price has in effect saved goods from consumption until the time they are most needed. He has performed a valuable service, and the profit he makes is his reward and incentive for doing so.

The Lay of the Land Today

We have all been treated to the real life drama of the CV-19 epidemic. And now that Italy and some other nations with honest data reporting have made their stats available on a daily basis, we see how an epidemic really works. Not like the fictional data from China.

I don’t mean to imply that we know the number of infections in Italy and elsewhere. We only know the results shown by testing. What about the silent majority who have not been tested? Mrs. Trudeau, wife of Canada’s Prime Minister, has recently, just like the wife of Spain’s Prime Minister, tested positive for the virus. Her infection has been attributed to her brief visit to London for a speaking engagement. So, there she was in a country where officially one in a hundred thousand people have the virus. What is the likelihood that Madame Trudeau encountered even one infected person on her trip? Even if she was with two meters of 10,000 people, the likelihood of her being infected would have been very low IF only one in 100,000 people in the UK have the virus. Statistically, her infection indicates that a much higher proportion of the population is infected than what the tests show. It makes sense because most people don’t get tested. What’s even the point of testing if there is no cure? If you have symptoms, keep away from other people. You don’t need testing to know that.

The virus scare plus the oil price collapse have served as two pins to burst the asset price bubble that has been with us for a long time. The bubble was bound to burst; it was just a matter of finding the straw to break the camel’s back. 2007 to 2009 should have done the job of reallocating assets from the inefficient to the efficient and grounded the economy on a stronger foundation, but our frightened governments kicked the can further down the road with their bailouts. Well, guess what…?  We seem to have arrived at where the can landed. The trouble is that we are a lot more tired and the can is a lot bigger now. I doubt we can kick it out of the way again. I laughed yesterday when I heard that interest rates had been cut to zero, like that will do anything. You can’t stimulate an economy with interest rate cuts when the rate is already very low. Part of the drawn-out delay in coming to grips with the economic dislocations of 12 years ago has involved the low interest rates. Had they been allowed to rise, then today there would be some wiggle room.

There is another aspect to the problem: the notion that reduction in interest rates will give businesses a chance to borrow money to tide them over until they can pay it back. The businesses that need the cash don't have the credit rating to gain access to the cash. Interest rates are not the problem. Liquidity is. Soon, more and more businesses will not be able to keep their workers working.

Many people around the world are no longer working; they are avoiding other people. Prosperity in an economy depends on the production of goods and services and distribution of them. When people are not working, they are not producing or distributing. A depression will be the natural outcome of the current state of things unless people get back to work before the start of our northern summer methinks.

The fear that is toppling markets is seen in the strengthening of the U.S. dollar. Even gold and silver prices are collapsing. The Japanese Yen is one of the few major assets holding its value in dollar terms, not unusual in times like today.

Cash is becoming king again. Hang onto it. Keep your powder dry and wait for prices to come to you rather than chasing them. Prices are dropping and will drop more.

Growing Global Social Unheaval

We are seeing a disturbing trend in the spread of social disruption around the world. We had the Arab Spring several years ago, which I think was primarily triggered by economic difficulties of the masses. Food prices had gotten very high, seemingly in response to USA economic policy.

This was followed by some years of relative social peace until Venezuela imploded. Now we see Chile, once considered an oasis of South American prosperity and peaceful stability, erupting in unrest that has destroyed numerous supermarkets and injured thousands of people, while other thousands have been arrested.

We’ve had recent riots in Iraq and in Lebanon which seem like delayed Arab Spring phenomena. South Africa is experiencing unrest born of people’s frustration with government corruption and rolling power blackouts. France is experiencing demonstrations, and so is Ecuador. Even Alberta seems to be in the beginnings of such social turmoil.

None of the foregoing have the potential for damage as does what is going on in Hong Kong. China, as I keep saying in this blog, has a major economic problem. China was able to grow capital simply by forcing people to work, but its workers have aged and its population pyramid no longer looks like a pyramid. It is more like a fire hydrant with the big bulge of 50s, and a smaller bulge of millennials. Gen X, born at the start of the one child policy, and Gen Z, born during the latter years of that foolishness, are a small percentage of the population. A workforce like that is limited by age related infirmities from providing the kind of brute production it once did. Chinese economic growth can only continue by working smarter instead of harder. This requites innovation. It is hard to induce innovation in a centrally planned economy where people labor yields fruit to be taken by the government. I think China may be in for some major social upheaval, and if so, it will likely be very bloody.