Let’s try a thought experiment.? Divide the would into two camps.
1) Countries that are importing more than they export, and are increasing debt levels.
2) Countries that are exporting more than they import, and are acquiring debt claims that will provide future goods and services.
Simple enough.? But now look at the two groups.
Group 1 is the developed world with its common problems:
- Bad demographics affects public and private pension systems.? Both systems underfund, rather than tax/pay/borrow to fully fund.
- Sloppy, easy monetary policy in the last 25 years has led to an overage of debt finance which is now difficult to service.
- Governments were too aggressive in trying to service needs that the tax base and electorate would not validate, leading to more borrowing.
My summary for group 1 is that they became less competitive over time, and tried to maintain expanding living standards for their nations via borrowing, and encouraging borrowing.? Central banks became less willing to sponsor harder downturns that would force the liquidation of bad investments.? Much of that stemmed from a fear that liquidations would cascade, leading to another depression, and so, the central banks provided liquidity to support asset prices but not goods prices.
Group 2 is OPEC and the developing world.? This group is more heterogeneous, and has a different set of problems:
- They have populations that are generally younger than the developed world, with some notable exceptions, e.g., China.
- Their laborers are generally less productive than those in the developed world, largely because there has not been the same level of capital investment.
- They are trying to develop industry, and trying more broadly to create societies that resemble the prosperity that the developed nations have.
- There are limits in some nations as to what freedoms will be tolerated.? For some nations, the ideal is a creative, clever workforce, that is highly productive, and has no aspirations apart from their jobs.? Call their representative “the new capitalist man,” willing to sacrifice himself for those above him in the economic hierarchy.
While writing at RealMoney, I would often bring up the problem of neomercantilism.? Given what I have already described, the problem is that Group 2 favors their exporters and producers, and sell cheaply to consumers in Group 1.? Who loses?? Consumers in Group 2, and producers in Group 1.? In any case, in aggregate, nations in Group 2 build up financial claims against nations in Group 1.
And there is the problem.? These nations are overly indebted already, and the ability for them to make good on all of their obligations is speculative, regardless of what their bond rating is.? Few of the nations in Group 1 are doing well right now, unless their economies have a large natural resource extraction component to them, such as Norway, Australia, and Canada.? They look at their economies and say, “Loosen monetary policy!? What do you mean we can’t loosen further?? Run deficits!? What do you mean our ability to do that is limited?!”
When governments are overly indebted, and the demographic profile says that things will only get worse if current policy maintains, there is a pressure to head for austerity.? Keynesians will argue against this, but when you can’t easily borrow more, Keynesian remedies die.? “In the long run, we are all dead.”? Well, guess what, the long run has arrived, and those of us living now have to deal with the accumulated debts, malinvestments, and low interest rates that discourage saving.
It is not as if deficit spending really stimulates.? It may shift money from taxpayers to some government employees, but unless that spending somehow increases the economic capacity of the economy, it is a waste.? We would be better off giving money evenly to all of society, than letting the government figure out what to do with it.? They will reward cronies, anyway.
As it stands, the nations of Group 1 are heading into a scenario like that of Japan.? Don’t liquidate.? Don’t take losses.? Refinance them at low rates, and expand the monetary base to do so.? Coddle the unproductive to save jobs.? Turn the credit of the nation into a safety net for politically-connected industries that have grown bigger than is useful for society.
But what the markets are saying to Group 1 is simple.? “You are living beyond your means.? There is no way that you can fund the retirements/healthcare of so many.? Beyond that, your governments spend too much in areas that are worthless.? Fix that.”
The future for Group 1 is a diminution of living standards, or at least a slowdown in their growth, should financing remain available.? That diminution could happen in several ways: increased inflation, bad debt liquidation, currency revaluation, unemployment with lower wages, or a combination thereof.? It is not a happy future, but happiness is often having expectations set properly.? Time to move expectations down.? Time to start liquidating bad debts.
Group 2 is another matter.? A lot depends on how much their financial systems rely on full payment in current purchasing power terms from Group 1.? Defaults from Group 1 are not impossible; does your financial system rely on full repayment?? It is a mistake to lend too much to anyone, particularly if it is sizable relative to your capital.
Remember the Mercantilist era.? The mercantilists sourced gold dearly, and never got the full good of their investment.? The same is true today of those relying on US Dollar-based investments. You are relying on the kindness of strangers.? Under pressure, do you really think that the US will favor foreign creditors over domestic needs?? Some things do change over time: the ethical generation that fought World War II has been replaced by a bunch of sybarites.
So Where Does This Leave Us?
It leaves Group 1? in a Japanese-style scenario, where it stagnates.? It leaves Group 2 reliant on what will likely prove to be bad assets from Group 1, either from default or inflation.? There are? no easy ways out; Group 1 must accept lower living standards, but shows little inclination to do so.? Group 2 needs to rely less on export-led growth, and should try to deepen their internal markets, and accept imports.? Neither fits with the political goals of each group’s leaders.? Thus the problems we face today.
I believe I wrote to you before on this.
Now, instead of whole countries consider any two trading entities.
The increasing disparity between rich and poor in our own societies has led to the mirror image of unbelievable wealth on the one side and over indebtedness on the other.
A similar phenomenon was observed in the run up to the 1930’s funnily enough and might just be a feature of our monetary system hitting the limits of imbalance between trading entities.
The balance must be restored to health. Allowing the rich to ‘hoard’ (i.e. not trade in balance with those on the other side) and avoid the re-balancing mechanisms of taxes or default or inflation is no longer an option.
David,
A sobering yet realistic assessment of the state of the world today, thanks for writing it. One of the “the devil is in the details” aspects of the globalized economy is that many of the central banks in Group 2 have taken on enormous currency mismatches, with liabilities in their own currency but assets denominated in the US dollar and other Group 1 currencies. In Group 1, certain central banks have taken on enormous credit and duration risks, to the extent that some of these banks woulod be insolvent if that term could be applied to a central bank with the power to create fiat money. These accumulations add another layer of instability and risk to the global economy.
It would be enlightening to hear your further thoughts on the commodity nations in Group 1 that you mentioned. Should we consider Canada, Australia and Norway for example to offer potential financial safe havens as the global economy lurches from one future crisis to the next? Or are these economies subject to other issues that negate this possibility?
i think group 2 is making the progress in deepening internal market, but that takes time. group 1 is hopeless, they are like drug addict that cant change behavior unless capital market force them (ex Greece). Obama (this ponzi guy) will get USA into deeper debt hole.
While an individual can save for their retirement, a society cannot. Most of what retirees consume must be produced by those working then. Savings is only a means of apportioning consumption between them. The best they can do is save up in the form of foreign assets that they can liquidate and hope they will be worth something. We will soon be moving into a time of negative returns where we can save but what we save will be worth less in the future. Instead of adding to capital we will be liquidating it. We will just have to adapt.
first line, typo : would => world.
I think this is too simplistic. I can name two refutations of your premise: Germany an India.
Germany has a huge trade surplus, horrible demographics and a larger debt-to-GDP ratio than we do.
India has great demographics and a trade deficit.
The post is very useful. I want to note just one point:
“Bad demographics affects public and private pension systems. Both systems underfund, rather than tax/pay/borrow to fully fund.”
This is a political problem, and we are capable of solving it. What we need is a plan that begins with a set of recognized goals for govt support, and then the putting in place the most efficient plan for realizing those goals. Fortunately, there is such a plan:
Milton Friedman A Monetary and Fiscal Framework for Economic Stability
If you criticize me, be gentle, since I’m about to buy a book. Here’s the book:
The Company of Strangers: A Natural History of Economic Life (Revised Edition)by Paul Seabright
On Monday, that is. My ‘no advertising day’ is Saturday. Please enjoy yours, today. Don
You can remove the EU from your model world, as the EU has a neutral current account (only the interior is very unequal and the reverse of what you are describing). This leave the US of A (plus the former British empire?) vs. the world ex Europe. Curiously Japan is also a third world country. Mhh. Now that I write this down the simplification is too contradictory. But you have good points.
In particular “A lot depends on how much their financial systems rely on full payment in current purchasing power terms from Group 1.” I think this captures the essence of the problem of US vs. China. With a savings rate of 50 percent plus do the Chinese really need all this money back? Even if they lost half of it, that would still be a high effective savings rate of 25 percent.
For Germany vs. Eastern Europe I think Germany will depend on at least partial repayment as well (they are used to giving money away as reparation, to East Germany and the EU, but can’t afford to write off everything). Alternatively a lot of reeducation of its citizens is needed to accept poverty as a way of life. You can’t accuse Angie and the libertarians of not at least trying…
1)Eh…the long run really hasn’t arrived yet. We also have a lot of human capital you seem to dismiss and there is plenty of economic flexibility within the US.
2) I read here quite a bit and do enjoy most posts, but I’m very skeptical of the moralist argument – “harder downturns to liquidate mal-investment.” Prognosticating on what investments are and are not good seems to leave you in the position of determining just how we can decide at all whether they are good or not – whether or not they should have survived.
Austrian economists have left us even fewer tools to deal with downturns than todays modern macroeconomists (who have left us virtually nothing as well). Keynes and Minsky have really been the only men to answer the question of what to do. You can tell us to liquidate our bad investments, but once again, how do we determine if they are bad? Should we simply be at the whim of dumb luck?
Frank: “You can tell us to liquidate our bad investments, but once again, how do we determine if they are bad? Should we simply be at the whim of dumb luck?”
Yep… good point… to make matters worse, the free market is very irrational during stressful periods. So the notion of what is a bad asset and a good asset is virtually impossible to determine in the thick of the crisis.