It is truism that the world economy now stands at the crossroads, with a system that brought much prosperity to most parts of the world in the past two decades, namely the combination of laissez faire capitalism and globalization, being blamed for a bulk of the world’s ills.
Socialists and communists are churning out volume after volume of indictments on the capitalist system, essentially using the first opportunity in two decades to vent all of their pent-up frustrations at being marginalized into obscure think-tanks and regular professorial salaries.
A few weeks ago, when I wrote Deaf frogs and the pied piper (Asia Times Online, September 30, 2008), I intended the article as much a defense of capitalism as a criticism of market intervention by sundry participants ranging from Asian central banks to credit rating agencies. My end-of-year article Ask not for whom the bells toll (Asia Times Online, December, 25, 2008) took a look at the startling similarities between the runts of the global markets, namely developing countries, and the apparent safe-haven investments, namely the developed Group of Seven leading industrialized nations.
In the weeks since then, calls for regulatory and government intervention into free markets have only intensified; whether related to the bailout of the US auto industry, Germany’s fiscal package aimed at boosting its economy or the events surrounding the scandal at an Indian computer services company. Socialists have used these events to triumph the failures of capitalism and the need for Keynesian intervention in the modern economy.
Paul Krugman at the New York Times goes so far as to use the events of the current crisis to cast aspersions on the entire Chicago school of economics and its most notable exponent, namely Milton Friedman. In a recent article he wrote:
Milton Friedman, in particular, persuaded many economists that the Federal Reserve could have stopped the Depression in its tracks simply by providing banks with more liquidity, which would have prevented a sharp fall in the money supply. Ben Bernanke, the Federal Reserve chairman, famously apologized to Friedman on his institution’s behalf: “You’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”
It turns out, however, that preventing depressions isn’t that easy after all. Under Mr. Bernanke’s leadership, the Fed has been supplying liquidity like an engine crew trying to put out a five-alarm fire, and the money supply has been rising rapidly. Yet credit remains scarce, and the economy is still in free fall.
This is gross misstatement of facts. Credit is very much being made available by banks to viable corporate entities and individuals whether in the US, Britain or Japan. However, on a net basis after taking into account companies and individuals declaring bankruptcy, credit formation is negative; exactly what you would expect when an economy slides into recession.
People like Krugman criticize the banks for taking government money in the form of bailouts (which I oppose in any event but that’s besides the point in the current discussion) and then not lending the funds to citizens of that country. That line of thinking highlights the intellectual pitfalls of these economists, who fail to understand the difference between the concept of cash as defined by the money in your pocket and funds as defined by the accounting or book entry transfers between institutions.
The key factor in the translation of funds to cash is the velocity of money in the banking system; which declines in a recession. Thus, if an economy has a velocity of 10x in normal times and has a billion of cash, total fund flows are 10 billion; however, as a recession bites and velocity goes to 3x, then even a doubling of cash available will not improve the overall monetary situation. What the US Fed and others have been trying to do is to make good the funds situation of the banks as the velocity of money drops and leaves various financial arrangements stranded; this is by no means a way to make cash available to companies and individuals directly.
You could only count a monetary stimulus when the total utilization of funds in the economy is higher than previously; this is impossible for the US and other G-7 economies now, as I argued in various articles over the course of 2008, as they confront a balance sheet recession. In two articles towards the end of last year Party’s Over (Asia Times Online, November 14, 2008) and Party’s Beginning (Asia Times Online, November 15, 2008), I laid out my arguments for the G-7 countries to spend their fiscal stimulus on the parts of the world with profit potential aligned with demographic realities; namely developing countries starting with the big Asian nations, such as China.
Far from being a call to Keynesian spending, my argument remains that G-7 governments can actually address their goals of broad economic improvements and make a profit in the bargain by supporting the consumption ethic in developing countries. In any event, any activity that is likely to produce a profit eventually is hardly Keynesian, almost by definition.
Europe in dire straits
Intellectual sophistry of the kind displayed by Krugman will meet its come-uppance over the course of this year when Europe as a combined entity falls flat on its face. Much like the most open countries in the continent – Iceland, Britain and Switzerland – all slid into crisis mode over the course of 2008, this year will bring the decline of the main euro-bloc countries.
In a series of ratings announcements since last week, the much-maligned agencies have made it clear that a whole raft of European countries – Ireland, Greece, Spain and Portugal – will likely be downgraded over the next few months. Others such as Italy are living on borrowed time in any event; leaving for the moment only Germany and France as stable members of the trading bloc. On Wednesday (January 14), Ireland announced that a continued worsening of the economy would push it to call the International Monetary Fund for assistance: the country nationalized its banking system last year and faces a significant downturn as its tax-efficient Dublin financial center is hollowed out by investment losses.
Even Germany and France appear imperiled by the decline in their banking systems; as well as the first shots of economic stimulus – Germany declared a 50 billion euro (US$66 billion) stimulus package last weekend – are applied to counteract the scary economic decline. French President Nicolas Sarkozy was apparently too busy playing geopolitics over the course of 2008 and will now have to rush various stimulus efforts.
If the interventionist European system was all that superior to laissez faire, as Sarkozy suggested last year, why then are all these countries in as much if not more trouble than the United States? My own current state of disenchantment with the US stems from its apparent abandoning of capitalist principles for the short-term succor that is offered (but unlikely to be actually delivered) by socialist intervention.
The effects of this upcoming mess in European finances are visible across the markets already. Standard & Poor’s downgraded Greece by one notch on Wednesday (January 14) and signified more pain to come in the next few months. Meanwhile, the first few auctions of government debt in Europe last week proved quite difficult to sell; indeed, Germany had the dubious distinction of opening the year with a failed bund auction, when its 6 billion euros (US$8 billion) in debt offering attracted only around 4 billion euros of demand.
Going forward, various other countries including Spain and Italy are likely to face investor resistance when they attempt to borrow excessively in the European bond markets. Even as the European Central Bank pushes interest rates to zero, we could well see borrowing costs for European governments rising sharply over the course of this year.
With all the talk of stimulus and intervention, the bald facts are that taxpayers in the G-7 have neither the current income nor the expectation of sufficient future income to actually repay all of the new debt being raised to pay for government intervention. There is unlikely to be adequate profit generation from these activities to broaden the economic slate or even generate extra cash flow that can be used later on to repay debt.
Auto industry example
Another favorite talking point of the left wing is the case for intervening in the auto industry. The argument is that a government that sends a couple of trillion dollars towards Wall Street can certainly afford a $100 billion bailout of Detroit. As evidence, these interventionists point to the auto industries of Europe and Japan, which continue to survive due to heavy government subsidization and intervention.
Once again though, they have mistaken cause with effect. The travails of American automakers can be laid at their own doors rather than at those of the governments in Europe and Japan; which is not to suggest that the latter group is blameless but that the former group did not function as capitalists should.
An industry rife with overcapacity is most likely to have significant share-price discounts applied on its valuations even as credit spreads remain at broadly elevated levels signifying omnipresent default threats. Overcapacity simply means that the balance of power lies with buyers of products rather than sellers; in turn meaning that every new product launch is fraught with risk of failure.
To understand the makings of a profitable future for the auto industry, we need to look no further than the computer industry of the 1950s and 1960s. Despite a number of players, or rather because of them, the marginal costs of owning a computer were prohibitively high in that period. This in turn kept overall demand at an extremely low level, which further increased the risks of capital expenditure being incurred by the industry on every new product.
In the 1970s, when the industry went into a demand turmoil, two events shook it: firstly the launch of a dedicated personal computer by Apple and secondly the emergence of the Windows-Intel duopoly (dubbed Wintel). The standardization of operating systems and interface as well as the main processor chip meant that the old norm of “IBM-compatible” gave way to a large number of parts suppliers who specialized in making as well as improving standardized components.
That took the bulk of capital expenditure away from the computer makers to the parts makers, in turn rendering the former as assemblers and service-providers from their previous role across the entire value chain.
In this kernel lies the future of the global auto industry. There is no reason why a Nano made by Tata in India cannot have the same gearbox as what is used on the smallest models made by Hyundai, General Motors, Renault or even industry leader Toyota. Similarly, various other modules ranging from engines, transmissions and even axles can be standardized.
This would rebalance the risks of design and interface; while pushing marginal costs substantially lower. The vehicle makers of today would then become designers and assemblers of products, much like the computer makers.
The inflection point for the computer industry came from the bankruptcies of various manufacturers in the 1970s that pushed out parts manufacturing to specialist start-ups. By saving the likes of GM and Ford, the American government stands exactly in the way of true progress for the industry, which can only come when the balance of risks is changed between parts makers and the auto majors.
In effect, by denying the Schumpeter process of creative destruction, the US government is effectively retaining the crisis mode of the industry; perpetuating the very inefficiencies foisted on it by the Japanese and European governments. Much like very few makers of computers survive in Japan or Europe today because of their failure to embrace the American model, a change of industry dynamics would similarly shift the balance of power from integrated carmakers to the assemblers.
The last and certainly not the least story in this series that has elicited much chest-thumping from socialists pertains to Satyam, an erstwhile star in the Indian computer software firmament that has been laid low by a scandal involving misstated cash balances that were somehow certified for many years by a global accounting firm. What is essentially a corporate scandal has somehow been twisted as evidence of the continued failures of global capitalism, as the story came on the heels of the Bernard Madoff affair in the US.
For many years, the Indian computer software industry has been a thorn for the country’s socialists as well as the left-controlled media; as in its success lay the greatest argument for doing away with the fads imposed by the country’s socialist leaders. Thus, any failure in the sector would automatically lead to calls for greater government involvement, as if that were a panacea of any kind.
A similar outpouring of scorn for capitalists was visible in China on the heels of the Gome Electrical Appliances affair last year (see Going, going, GOME, Asia Times Online, December 6, 2008), when the richest person in China, the company’s chairman, was arrested for suspected irregularities and market manipulation.
Yet socialists have done greater damage in both China and India than capitalists could ever imagine. In the case of the former, Exhibit A is the country’s commercial banks, which benefited from some US$100 billion in government assistance over the past five years as they serially wiped out their capital bases on bad loans and corrupt transactions. In a country growing at over 10% annually, these levels of losses at large banks are virtually unheard of in a capitalist context; leaving us to judge them purely as failures of socialism.
In the case of India, any visitor to the country would immediately highlight the first example of the pitfalls of government intervention in the corporate sector: the “national” airline, Air India, which stands as the perfect combination of abysmal service and a terrifying safety record; its monopolistic market share was wiped out when the government opened up the sector to private sector entrants.
Over the course of 2009, we will have much cause to revisit the questions raised in this article as the lurch towards Keynes and socialism produces a series of unintended consequences for the global economy. In game theory terms, the global economy will approach a “Nash equilibrium” this year as every player accepts and executes a sub-optimal outcome because they simply cannot trust anyone else to do better.
That in turn spells greater trouble for the global economy as it confronts the true costs of a recession. Every step the socialists take will bring a great depression closer to reality for a bulk of the world’s population.