Thursday, September 29, 2011

The 'Greeks' hold the answers to the euro crisis

The problems besetting the global economy can be boiled down to two, one solvable and the other intractable. The immediately solvable part is the debt crisis while the unyielding one is the capacity crisis, or consumption crisis, viewed from the other side of the coin. The capacity crisis is tied to technology and as long as the existing technology prevails, wealth generation and accumulation will be increasingly skewed in favour of the efficient. This pattern which underlies all Kondratieff Waves is depicted below.





Only the rise of a totally new revolutionary technology that displaces the existing technology will stop the maddening accumulation of wealth. However this does not mean that the old order will be reestablished. The new order that will emerge may instead upend society, as is typical of any upheaval that follows in the wake of a revolution.

But the debt crisis is unlike the capacity/consumption crisis. It can be solved, only that it takes a lot of guts and an iron spine. The policymakers are evading this task in kicking the can down the road. They are extending more debts so that the borrowers can repay old debts. You can imagine what this will lead to: a debt bubble that will eventually burst with catastrophic consequences. If only they had heeded the advice of Philip Gibbs (1877-1962), an English journalist and novelist, "It's better to give than to lend, and it costs about the same", they would have forgiven a greater chunk of the outstanding debts. But nobody has the statesman-like character to push through such a measure.

It has been recently reported on Bloomberg.com that the first sovereign default was committed by the Greeks in the 4th century BC when 10 municipalities defaulted on their debts to the temple of Delos. Another version has it that of the 13 states that borrowed from the temple in 377-373 BC, only two fully repaid. The resulting bad debts amounted to four fifths of the sum borrowed. As fate would have it, the most pressing credit problem now is with modern Greece. It seems that debt and credit are not Greek to the Greeks. So to the ancient Greeks we defer, to learn how to solve the seemingly tough debt crisis.

Ancient Athens or Attica, one of the Greek city-states, encountered a major crisis of wealth imbalance at the beginning of the 6th century BC. The Athenian society then was on the verge of collapse because of the huge amount of debts owed to the wealthy creditors. But it had the good fortune of having Solon, a legislator and statesman, to handle the crisis. Solon was appointed chief magistrate in 594 BC for a temporary period, giving him tyrannical power though he wielded it in an enlightened way. He devalued the drachma by a quarter, or as another account has it, by 40 percent. Citizenship was granted to skilled immigrants. He also had to convince the rich that debt write-offs were in their best interest. Had the society collapsed, even the rich would have been devastated. The rich relented but it wasn't without a price. Solon reserved for them the appointment as administrative officials. In addition, they were given the right to speak and vote in the assembly while the poor could only vote. This was the forerunner to the full democracy which was to be established in 508 BC.

It was also to preserve the phalanx fighting arrangement that Solon carried out the debt forgiveness, thus restoring the small farmers to their land and abolishing debt slavery. Its phalanx fighting formation entailed every hoplite infantryman fighting side by side as equals, suppressing differences in social status. Democracy was a logical extension of this. This was further buttressed by the pattern of its economic activities. Most Athenian peasant farmers grew their olive or wine crop on a 10-acre plot with the help of one or two slaves. They thus worked independently unlike the Chinese who required a central organisation to manage water for the efficient growing of rice.

Any account of ancient Greek history, especially its two major powers, ancient Athens and Macedonia, wouldn't be complete without any mention of silver. Athens rose on the back of Mt. Laurium silver while Macedonia that of Mt. Pangeios in Thrace. Athenian silver mine discovered in 483 BC was used to finance the building of a fleet of triremes that enabled Athens to project its power over the Aegean Sea, a major trade conduit for the Greek city-states. More important was safeguarding its grain supply which had to be shipped from the northern shore of the Black Sea through the choke points of Hellespont and Bosphorus. Being a hegemonic power, it was able to exact tributes from other city-states seeking protection against Sparta, a rival power.

Athens also used the silver to mint standardised coins called the tetradrachm. One tetradrachm was equivalent to four drachmae. The vast availability of the tetradrachm, famously known as the owl silver coins, smoothed the flow of trade. With the tetradrachm, Athens could bear trade deficits which reinforced the coins' role as the standard medium of exchange for the Aegean sea trade. Actually the riches from its silver mines allowed the Athenians to afford the time to debate and vote in the assembly. The silver paid for the slaves who carried out most of its economic activities. There were a high number of slaves in its silver mines, quarries, maritime galleys (as rowers), pottery workshops and farms (especially those owned by the rich).

However Athens's riches sowed the seeds of its downfall. It was locked in the long running Pelopponesian war with Sparta from 431 to 404 BC. The war consumed most of its silver wealth. So it had to impose high taxes on its farmers. Many of the small scale farmers had to abandon their farms which in turn were acquired and consolidated by the aristocrats who used slaves to work the farms. As fields worked by slaves were inefficient, higher tax was levied forcing more small farmers off the land. Athens eventually lost the Pelopponesian war but it was spared destruction by Sparta. It even managed to reinstate democracy in 403 BC.

Meanwhile in the northeast of the Greek peninsula, another power, financed by silver, was rising with the ascension of Philip II. One of the things that Philip II of Macedonia, the father of Alexander the Great, did to cut into Athens's commercial dominance was to flood the market with his own silver tetradrachm coin. He could afford it as he had his own bigger silver mine at Mt. Pangeios in Thrace. This brought down the price of Athenian owl coins, leaving Philip II's tetradrachm as the medium of exchange for Aegean commerce. Macedonia eventually defeated Athens in the Battle of Chaeronea in 338 BC. Imposing dominion over the Greek city-states was one thing but subjugating other empires needed a lot of wealth. The wealth in the form of gold and silver came from the Persian war booty. The silver made its way into the commerce of the Greek city-states as well as the newly conquered areas, inflating prices but also increasing trade. However war booty had its limits because it could only come from the Persian ruler who had hoarded wealth instead of releasing it into the economy. Had Alexander lived long, he'd have a hard time keeping his empire intact. Soon after Alexander's death, his vast empire split into four regions, each ruled by one of his generals.

As for Athens, by the 2nd century BC as its aristocratic farms grew to thousands of acres, the Athenian society went down a death spiral.

Certainly there are many lessons that can be gleaned, particularly:

  • the need for debt write-offs in times of crisis,
  • the use of currency devaluation to regain competitiveness for inefficient states,
  • the importance of releasing instead of hoarding wealth for commerce, the price of which the powerful state has to suffer continual trade deficits,
  • the usefulness of money in stimulating trade, and even with credit, the need for physical money remains,
  • the tendency for wealth to excessively accumulate over time to a small number of affluent group, leaving the rest impoverished,
  • the need for wealth for keeping a large empire intact,
  • the use of economic warfare by flooding wealth to sap the financial strength of your adversary (the US could easily flood the US dollars to wipe out the vast forex holdings of the other countries),
  • the significance of having an enlightened tyrant during a severe crisis to replace democratically elected leaders who, ever mindful of approval ratings, aren't capable of taking the needed radical and drastic steps.

  • If only the modern Greeks had the farsightedness and sagacity of their forebears, they certainly wouldn't have chosen their current path to perdition. Instead of listening to the EU politicians and ideologues, it's time for the Greeks to dust off the annals of their forebears and escape the mindless grip of fiscal austerity.

    Monday, September 19, 2011

    Money 101 for the Fed

    We can imagine how discomfited Ben Bernanke must be now seeing that his QEs failing to lift the US economy out of its doldrums. His frustration is a consequence of his own doing. He is under the illusion that the Fed finally has the power to vanquish the business cycle with its money printing press. When reality doesn't bear him out, instead of changing course, he is sticking to his guns, albeit very much subdued as his much anticipated QE3 may have to be scaled down to Operation Twist. Bernanke is forced to take such a course in light of the resistance from other members of the Fed Open Market Committee (FOMC) who remain ignorant on the actual causes of inflation.

    It's very pathetic that the eggheads running the monetary policy of the world's biggest economy don't understand the essence of money. Something is seriously wrong with the whole economics profession and education. Time to clear the murk that's been clouding our understanding of what money really is.

    We'll start with the Fed's financial statement, specifically its balance sheet over the last five years which I've tabulated below in a simplified form.
    The major items, with values exceeding US$300b, are penned in red boxes. By focusing on these items, we can clearly see the Fed's strategy. At the beginning of the current crisis, the Fed embarked on QE1 in December 2008. It went on a lending spree, to both private and other central banks (see the 2008 Assets column) to stem the panic. When the crisis had subsided, it switched its investments to Treasury bills and GSE mortgage backed securities (MBS) (Assets columns 2009-2011). From US$500b of Treasuries in 2008, it increased them to $2.2 trillion of Treasuries and MBS by end 2010. Seeing that the economic recovery was still tepid, it launched QE2 in November 2010 with the purpose of lending another US$600b. The latest available figures show a combined Treasuries and MBS total of US$2.6 trillion.

    Can Bernanke's QEs be considered successful? Yes on only one measure: it has managed to bring down the interest rate to almost zero. In others, it hasn't made a dent. Let's see where the Fed has sourced the funding for its investments. The 2011 Liabilities column shows that currency notes have increased to almost US$1 trillion with the balance US$1.6 trillion in the form of bank reserves placed with the Fed, earning a paltry 0.25%. In fact, from end 2008 till now, currency notes have increased by almost 6% annually while bank reserves more than 25%. In monetary measures parlance, currency notes are denoted by M0 while both currency and bank reserves with the Fed are termed monetary base. However bank reserves do not form any of the usual money measures, be they M1, M2 or the discontinued M3. The bottom line is the Fed has done nothing to boost the money supply (that is, lending); whatever increase has been due to Obama's deficit spending. Yet the talking heads have been lambasting Bernanke for money printing. Sure, the currency notes have increased by US$150 billion but this is not even a drop in the US$52 trillion credit ocean.

    What has actually happened from end 2007 till now is that the Fed's holding of Treasuries and MBS has increased by $1.9 trillion. This increase has been funded by banks ($1.6 trillion), currency notes ($0.2 trillion) and others ($0.1 trillion). Now when the banks fund the Fed, that money is taken from funding elsewhere, notably Treasuries and MBS. So effectively, there's no new credit which means no new money.

    The Fed's lowering of interest rate through its massive Treasury and MBS purchase is supposed to spark lending but the banks don't lend solely on interest rate consideration. More important is the risk of non-repayment which is real when demand has faltered. There's no point building factories or houses when there are no takers for the goods produced or houses built. The point is demand is zilch at the end cycle of a Kondratieff wave because wealth generation and accumulation have skewed to a narrow group of successful businesses, wherever they may be all over the globe.

    Now let's see what the usual monetary measures are showing. The chart on the left from shadowstats.com plots the M1, M2 and M3 since 2003. Note that the official M3 from the Fed ceased being published from March 2006 (red line). It's being tracked as the blue line by shadowstats.com. It was Bernanke who stopped the publishing of the M3 (the Fed's broadest measure of money) in March 2006 after he had been appointed the Fed Chairman the previous month. So Bernanke is left with M0, M1 and M2. However we can safely ignore all these measures, including the unofficial M3 as there is a better measure of the total money in the system, that is, the total credit market amount which is all encompassing. The credit market size is US$52.7 trillion while M3 is US$15.0 trillion and M2 US$9.5 trillion. Bernanke is using a metric that's less than one fifth of the real money supply measure.

    Remember that all money is credit, even the currency notes. Look at the Fed's balance sheet. The currency notes appear as liabilities though the Fed is never obliged to pay out anything since they are never redeemed.

    On the left is the chart that plots the annual total credit market growth from the first quarter 2006 to the second quarter 2011. This chart is more revealing than all the conventional M measures. As early as 2006, we should have known that this all encompassing money metric had reached a plateaued growth. From 2008, the growth has slowed considerably bottoming out in Q1 2010, a pattern similar to that of the M3. Now the most interesting bit: the growth for Q2 2011 has slowed whereas the M measures are still registering increasing growth. With Obama restrained by Congress from further spending increase and Bernanke still toying with his impotent tool, figure out yourself how the future will unfold.

    Tuesday, September 13, 2011

    The five generations of warfare

    Advances in warfare usually are a result of a confluence of changes unfolding in economics, politics, technology and society. However the impact of warfare is more obvious because of its brutal nature while those of the other fields are more insidious. This is due to the pressing need to bring any warfare to a quick resolution resulting in intense and accelerated development and introduction of new weapons, strategies and tactics by all sides to the conflicts. Hence changes in the other fields can be foretold by looking at developments on the battlefields.

    Since the Peace of Westphalia in 1648 that ended the 30-year religious war between the Catholics and the Protestants, warfare took on a new dimension. After 1648, wars were being fought out by nation-states instead of tribes and cities.

    The root cause for the Thirty Years' War can be traced to the invention of printing in 1450 which in turn had been made feasible by the introduction of cheap paper. We have come full circle since then with the invention of the social media, allowing every one of us to broadcast our points of view to the whole world. Social media have also empowered protesters bent on bringing down governments. Much as the impact of the hard media was to lead to the rise of nation-states, the soft media's impact would herald the demise of nation-states.

    This trend towards disintegration of nation-states is also being felt in warfare. Warfare has its own cycles which closely mirrors those of the Kondratieff waves. It has been accepted by military writers and strategists that there are four cycles to-date. The evolution from one cycle to another usually involves a radical change in the manner in which it is fought, as summarised below:
        1GW - massed manpower
        2GW - massed firepower
        3GW - mechanisation
        4GW - non-state actors (groups)

    You can view the detailed explanations on the above modes or generations of warfare at Security XXI and Antiwar.com.   Our main interest however is in finding out how warfare will emerge post-4GW, i.e., the 5GW, since this will also presage how the 5th Kondratieff wave will unfold. Our useful guide in this respect is a pattern that's been used for stock market trading, the Elliott Wave, which in turn is based on the Fibonacci numbers. The Fibonacci sequence of numbers is prevalent in the natural world where behind nature's seeming randomness, you can discover order and structure based on the Fibonacci numbers.

    The Elliott Wave consists of 5 motive or impulse waves (coloured green on the left chart from StockCharts.com) and 3 corrective waves (coloured red). The motive waves drive man's progress in productive capacity. The first 3 green waves drive the pattern upward while the last 2 downward. Mapping this pattern onto the warfare pattern, we can deduce that the 1st 3 waves mark the growth of nation-states while the last 2 herald their demise.

    From 1 GW to 3GW, warfare was defined by state combatants. However after the fall of communism, states have retreated from wars between themselves because of the disappearance of one of the two major backers. But mankind's propensity towards conflict remains. Wars continue on a small scale with non-state actors, in the form of guerrilla bands fighting small wars against states. To be sure, guerrilla warfare has a long history; in fact as long as the history of mankind. But post-commmunism, non-state actors have been empowered in new ways, enabling them to capitalise on the weaknesses of state combatants. Moreover, in the past guerrilla movements relied on a plan issued from central command; nowadays they operate in cellular mode needing only a recipe instead of a plan.

    Several reasons can account for the rise of the non-state actors. First, the internet has allowed them to bypass the states' hold on information dissemination. The ability of each group to broadcast, or rather narrowcast, to its target audience makes for a fractured society. Second, state combatants have costs attached; every US soldier in Afghanistan costs $1m a year to maintain while that of the non-state group runs on a very minimal budget. Third, the failure of communism has provided room for the rise of religion and ethnicity as alternatives to capitalism, turning the clash from a conflict over ideology into a more passionate conflict over faith and culture. This is worsened by the recession which is morphing into a depression; the economy instead of being the glue that holds nation-states together will be the force that pulls them apart. Even homogeneous societies, such as the Arabs of Tunisia, Egypt, Yemen and Libya are sliding into turmoil mainly because of lack of jobs to keep their youths off the streets.

    The weakening of nation-states also will be somewhat hastened by the progress of the 5th Kondratieff wave. The advances expected of that wave will be in biotechnology and nanotechnology. The outcome will be cheap energy, materials and food, all produced by consumers for their own consumption, destroying the wealth accumulated in big manufacturing facilities. Design for the products will be available as open source blueprints the way open source codes are currently available for software. Nation-states also are no longer needed to provide the infrastructure and security for the distribution or circulation of such goods. Money which used to be the means of accumulating wealth may have passed its usefulness, making barter or precious metals as the medium of exchange. By the way, not much needs to be exchanged if you can produce your own goods and energy. Without exchange, nation-states won't be able to assess incomes for taxation.

    Weapons of destruction will come in new forms. As biotechnology advances, the cost of creating new types of viruses drops, easing the way for the development of biological weapons. Similarly, nanotechnology can facilitate the development of nano-sized toxic materials that can be easily dispersed in public places. With such ease, individuals can now act alone, dispensing with the need for group organisations to unleash chaos. A mild foretaste of this danger was demonstrated in the anthrax attacks in the US that began just one week after the 9/11 attacks. In the present 4th Kondratieff wave, we've also witnessed how Lulzsec and Anonymous mounted cyber attacks, all without the need for a formal organisation or central command. Each hacker knew what to do and had the tools to do it. That however was virtual yet the financial losses were immense, what more if the attacks were physical. 5GW therefore will emerge as warfare conducted by non-state actors most likely working as lone wolves. That'll be the ultimate combatant, reduced to one.

    To be sure, nation-states with their resources have made much progress in mechanising warfare through miniaturisation. In order to fight the non-state actors, war has to be cheapened by replacing humans with machines, such as unmanned vehicles and drones. Their prices have substantially declined as machines get miniaturised; the new $56,000 Raven drone price tag pales in comparison with the $5m Predator. Future drones can even be as small as bugs. A drone printed out by a 3D nylon laser sintering printer, has also successfully flown. However, such progress can turn against the innovators. There's nothing to stop any malicious individual from inventing his own drone to stake out his conspicuous opponents.

    Indeed the power doesn't lie in technology but in size as in future technology can be easily procured. A small size on the other hand confers stealthiness. The invisible has become invincible while the visible has turned vulnerable. Future battles no longer favour the big and strong but the small and weak. The world is changing too, the sooner the nation-states adapt to it, the less resources wasted on maintaining the status quo.

    Monday, September 5, 2011

    The errors of the neo-Keynesians

    The importance of observing events cannot be emphasized enough as demonstrated by the erroneous diagnoses and prognoses of the global economy by the self-proclaimed experts. So let's tease out the reasons behind their errors which typically stem from incorrect observations.

    For this post, we'll deal with the neo-Keynesians since they have quite an influence on the economic thinking of most governments, especially those bent to the left. The neo-Keynesians seek to fuse the thoughts of John M. Keynes (1883-1946) with those of classical economists. They have introduced mathematical models, something which Keynes never used, to provide a semblance of rigorous veracity. As always the case, the legitimacy of models depend on the assumptions and in this the neo-Keynesians fall far short of reality.

    The neo-Keynesians  argue that government intervention is needed for continual economic growth as capitalism, left to its own devices, can dislocate itself by going unnecessarily to extremes. Therefore the guiding hand of the state is needed to ensure full employment and price stability. Whereas Keynes counselled intervention during a crisis, the neo-Keynesians support intervention on a continuing basis. Keynes also stated that an economy's output in the short run was determined by the aggregate demand, that is, the total spending of households, businesses and government. So Keynes's advice for the government to spend heavily during the Great Depression of the 1930s was right but it was only right for that time and under the conditions prevailing then.

    It's easy to see where the neo-Keynesians have misunderstood Keynes. They have placed demand as the solution to recessions and economic slowdowns for all times. Now if we weigh this against the 4C framework, it is obvious that the neo-Keynesians have ignored both Capacity and Communication, and placed little importance on Currency. Their obsession has always been with Consumption. Till today, Paul Krugman, the popular public face of the neo-Keynesians, stubbornly insists on major government deficit spending to stave off the depression, not realising that such a move only buys time. It's a counter-measure, not a solution since there is no solution.

    Now let's tackle their theoretical underpinning, that is, the IS-LM (Investment Saving - Liquidity Preference Money Supply) model (see left charts from The Economist). This model works only in a closed economy and as low cost producers started to compete with American goods in the 1970s, the model began to give way.

    The model has two curves, the IS and the LM. The IS charts the different combinations of output and  interest rates at which demand equals supply (or saving equals investment). It marks the real (goods and services production) part of the economy and therefore used as the basis for fiscal policy. It is negatively sloped because as interest rate goes down, output (synonymous with income or demand) increases. The neo-Keynesians believe government can shift this curve to the left (by reducing spending) or the right (by increasing spending), thus reducing or increasing income. With an open economy, a shift to the right may not result in increased income if the income is siphoned off by the foreigners. The other failing is that with increasing technology use, the income is not shared by all as a few producers become very efficient leaving many others without jobs and income.

    The LM curve on the other hand charts the different combinations of output and interest rates at which the demand for non-interest bearing money equals its supply. It is positively sloped because as output increases, the demand for holding money increases thus pushing up interest rate. It forms the basis for monetary policy. The government, it is thought by the neo-Keynesians, can shift this curve to the right (by printing money) or the left (by issuing bonds to mop up the money). The intersection between the IS and LM curves represent the equilibrium point for goods production and money holding. In reality, it's doubtful whether there is such a state.

    The events post 1973 rendered the IS-LM  irrelevant. As oil prices began to rise after 1973, the recycled petrodollars from the inflating oil prices pushed money supply up through bank lending. The Fed had to jack up the fed funds rate to almost 13 percent in 1974 to suppress inflation. Although inflation did indeed fall briefly to 4.9 percent in 1976, it was achieved at the cost of high unemployment. Energy had become a constraint on capacity as new oil fields, now explored as a result of the high prices, took some time to enter production. Only by the mid 1980s, did oil prices fall. Consequently much of the late 1970s and early 1980s was characterised by high inflation and high unemployment, a phenomenon known as stagflation.

    As the neo-Keynesians were baffled by this turn of events, Milton Friedman of the monetarist school came up with his NAIRU (non-accelerating inflation rate of unemployment) which posits that there's a natural rate of unemployment below which inflation will rise.

    We can now prove that both schools are wrong. The neo-Keynesians and the monetarists have been using the unemployment rate as the yardstick for measuring capacity utilisation. High unemployment, in the neo-Keynesians' views, reflect high slack capacity and therefore the economy could do with some monetary expansion to increase output with no impact on inflation. However had they studied the 4C's Capacity, they would have realised that capacity is much more than unemployment; energy, materials and technology play a much bigger role. With so much automation in the factory even as far back as the 1970s, labour was no longer a key factor in determining the economy's capacity utilisation. Actually unemployment now has no relations to capacity utilisation as we now have surplus capacity but high unemployment. As for Milton Friedman, his views were always naive but the fact that he could influence so many policymakers to this day is a reflection of the low acumen of those to whom we surrender our fate.