Friday, November 25, 2011

Tripped by the Phillips curve

The link between unemployment and inflation once used to move according to a predictable relationship as mapped on what is known as the Phillips curve (PC) (see chart on the left). The curve was named after Bill Phillips (1914-1975), a New Zealand economics professor, who had observed wage inflation and unemployment rates in Britain in earlier decades. The negative sloping curve reflects the inverse relationship between inflation and unemployment: a rise in one is accompanied by a fall in the other.  This relationship held out in the 1960s.

By 1970, the relationship started to give in (see the left-hand  panel of the chart below). Even Milton Friedman came up with his own hypothesis on unemployment, which is the straight line Long Range Phillips Curve (LRPC), as seen in the above chart. By the subsequent decades, the relationship went haywire (see right-hand panel below). The Economist even devoted an article, "Heroes of the zeroes", whence I've sourced the charts in this post, on the Phillips curve.



Another way of presenting the relationship between inflation and unemployment is the Misery Index chart from Bloomberg (see below). Looked from this perspective, it is obvious that there's no relationship whatsoever between the two even as early as the 1920s and 1930s.  Most economists are good at rationalising events which would have been easily disproved had they been more discerning with their observations.


Bill Phillips's observations either were flawed or he had restricted them to those years which had conformed to his hypothesis. Those were the days when globalisation and technological change were minimal. Once these conditions were gone, the politicians would in time lose control of the economy. One thing leads to another. It's no wonder that they are now losing control of politics. Once the horse has bolted, closing the gate now is useless. It's time for the politicians themselves to bolt because the public has no more trust in them. Those crafty enough have seduced the technocrats to stick their necks out in order to save the politicians' necks.

Sunday, November 13, 2011

Clinton's ingenious disingenuity

Mark Twain used to quip, "It is better to keep your mouth shut and appear stupid than to open it and remove all doubt." Bill Clinton however has refused to do so. He has been bragging about his four years of budget surpluses in his new book, "Back to Work: Why We Need Smart Government for a Strong Economy", that also dishes out nostrums for reviving the economy. He certainly has credibility based on the US economic performance, as reflected by the decreasing rates of inflation and unemployment, while he was in office (see chart below from Bloomberg).


That is true only if you believe that the economy depends solely on the decisions and actions of the President and his administration. But the economy is much more than that. Many variables are in play, all of which are best explained by the 4C framework. We can pick just two of those variables, that is, capacity and communication, to provide the basis for the improving economy under Clinton's watch. And both of them had nothing to do with what Clinton did during his administration. Instead, they were predictable aspects of the fourth Kondratieff Wave.

The capacity of that wave can be attributed to the computer, especially the microprocessor. But capacity alone won't unleash investment unless that capacity can be communicated to a wider group of users and producers. The internet, which started to come into widespread use in the 1990s, provides the answer to that missing variable. So Clinton, being lucky enough to be in the right place at the right time, reaped the rewards of the wave's technological progress.

As the wave was on the rise, it was natural for business investment to roll along, in a too bullish fashion, eventually ending in the dotcom bust in March, 2000. Consequently prior to the bust, that is, throughout the latter half of the 1990s, the debt of the financial, business and household sectors was briskly expanding (see left chart from The Economist). The period under Clinton's watch is marked red on the chart.  The expansion enabled the government to pare down its debt resulting in four years of consecutive budget surpluses. The US government could save because the others borrowed. Yet the total debt was on the rise. Now should Clinton shoulder the blame for not controlling the debt growth? Certainly but looking at the chart, the biggest offenders were Reagan and Bush, Jr.

Another chart, on the left, also from The Economist provides the reason for the continuing credit expansion during the second Bush administration. Under Clinton's watch, the fed funds rate never dropped below 4% except at the beginning of his administration when the economy was still recovering from the 1990-91 recession. Because of the bullish sentiment following the internet technological revolution, credit expansion was not constrained by the relatively high interest rates. The expectation of better economic prospects deluded businesses into investing in ventures that had no hopes of economic returns.

After the dotcom bust, the Fed lowered the interest rate in the hope of continuing the economic growth. This time, however, the credit expansion was undertaken by the households who borrowed for capital gains and equity drawdown. Again, without any hope of matching returns from rental income, the situation turned from a housing bubble into a debacle.

Clinton's pontification on how to turn around the economy should thus be taken with a pinch of salt. If he doesn't understand the factors that contributed to his budget surpluses, you shouldn't expect him to comprehend the real causes of the current recession. If you really want to get to the root of the current crisis, read up economic history rather than the policy nostrums of a self-deceived ex-president.

Wednesday, November 9, 2011

Rise by the oil, fall by the oil (Part 2)

The first phase of Thatcher's administration (1979-1983) succeeded in subduing inflation even though total debt, i.e., money, grew. Inflation thus is not only a function of monetary growth but also of energy costs, primarily, oil. However the inflation fight was at the expense of the unemployment rate (see chart below from Paul Maunders blog) which remained stubbornly high.

Thatcher had to get the unemployment rate down to provide evidence of success for her economic policies. The easiest way to achieve growth was to unleash credit but first, Friedman's monetarism theory of stable monetary growth had to be permanently ended. The Bank of England did its part by officially abandoning monetarism in 1986. The US government had already turned on the monetary tap in 1984, thus securing Reagan his second term.

Unfortunately I've not been able to find the chart that plots the 1986 credit increase for the UK. The best that I've got is the earlier chart shown in Part 1 of this story which ends in 1985. Its follow-up chart (see below, also McKinsey's) however begins from 1987, leaving a gap for 1986. Regardless we can interpolate to find out what transpired in 1986. The UK's total credit as at end 1985 was slightly below 150% of GDP while that for (probably end) 1987 was 189 percent. So within two years, credit as a percentage of GDP grew by around 40 percent. That is a blistering pace that would have rocket-propelled any economy. The other thing about the chart that strikes the eye  is the relentless growth in credit up until the onset of the current crisis. That strongly explains why Tony Blair, like Thatcher, also managed to hang on to three terms. One thing for sure, the successive British governments have been running the country into the ground as the price for keeping up with the major powers. The mess has now dropped into David Cameron's lap who is certain to be overwhelmed by the sheer scale of the total debt level.


Back to Thatcher, in her second term, she accomplished several noteworthy achievements. First she managed to break the back of the trade unions when the coal miners' union gave up their strike in March 1985. She also carried out large scale privatisation of nationalised industries. Estimates of the privatisation proceeds have ranged from £19 billion to £29 billion.

However in 1986 the monetary value of Britain's oil production collapsed following Saudi's price war to spite the non-OPEC interlopers. Without the backing of the oil wealth, Thatcher had nothing to show for all the hardships of monetarism induced inflationary busting. So something had to be done not only fast but fast enough to bear fruit before the next election. The base interest rate was the tool: from a high of 14% in January 1985, it bottomed out at 7.5% by May 1988 (see chart above from www.houseweb.co.uk).

Her earlier privatisation of the nationalised industries and enfeeblement of the trade unions were expected to boost productivity which would unleash the goods supply to match the increased credit supply. This would also reduce unemployment just in time for the next election. Theoretically, that was how it should work but in reality, Britain's goods production had been severely impaired through neglect that the only growth for the economy was in the financial services and non-tradable real estate sectors. The eclipse of manufacturing was not entirely due to Thatcher's earlier contractionary monetary policy; the British firms had failed to invest at the same pace as Germany's or Japan's. Furthermore, Britain's petro economy had fostered a strong currency that remained so until early 1985, making exports non-competitive for its manufactured goods.

The credit growth that lasted from 1986 to 1990 was emblematic of Thatcher's trial-and-error experiment with the British economy. Her accomplice in this scheming was her Chancellor, Nigel Lawson who dismantled all financial barriers and regulations with the 1986 Big Bang. Lawson also brought down the basic tax rate from 30% in 1986 to 25% by 1988 and the top rate from 60% to 40%.

Thatcher and Lawson opened the gate for the foreign banks to set up shop in London much as the developing countries wooed the goods producers from the developed world to establish factories on their soil. It was hoped that financial services would take over from manufacturing as the country's biggest economic driver and turn London into a global financial centre. However, financial services could never replace the goods exports lost to the new manufacturing upstarts from Asia. The above chart from www.economicshelp.org proves that Britain has never been able to regain her manufacturing competitiveness that was lost way back in the early 1980s.  It was estimated then that financial services exports would have to increase by 10% to make up for a 1% drop in manufactured goods exports.

Banking unlike manufacturing however is a very dangerous game. In manufacturing, during a recession, a major producer that packs up and closes shop will disrupt only the local supply chain and employment. In financial services, because of the widespread lending between financial institutions, a failure of a major bank can pull down the others unless the government steps in to take over the debts. This wholesale crash will cause the money supply to collapse and seize up the economy.

It is true that currently a large share of the assets, i.e., loans disbursed, of the British banks not only are made abroad but are also supported by borrowings from abroad: Table 9D of the Bank of International Settlement statistics as of 30 June 2011 shows that foreign banks' claims on UK borrowers amounted to US$3.06 trillion (second only to the US) while British banks' claims on foreign borrowers totalled US$4.18 trillion (biggest in the world). Regardless, the aphorism, attributed to J. Paul Getty, that when you borrow small, the problem is yours, but when you borrow big, the problem is the bank's, rings true for Britain's debt situation. Given this disproportionate dependency of the British economy on financial services (see how much the yawning current account goods deficit gap was closed by financial services in the above chart), Thatcher's promotion of financial services will in time come home to roost in the coming Grand Depression.

But Thatcher herself didn't have to wait for the coming Grand Depression. The quick-fix boost to the economy enabled Thatcher to be elected for a third term in 1987. Britain's house ownership at around 70% ranked among the world's highest, making the public eager voters for Thatcher's Conservative party. However the good times would soon be over, marking her third term as her downfall phase. The easy money had resulted in a capacity constraint that was followed by a surge in Britain's current account deficits and higher inflation (see chart above). To subdue inflation, the base rate was doubled from 7.5% in May 1988 to 15% by October 1989, bursting the housing bubble. Unemployment crept up to its pre-boom level. However inflation took two years after the peak of the interest rate hike, to be contained. Worse, with the oil prices still in the doldrums, Thatcher no longer had the luxury of oil wealth to appease the public with increased social security and unemployment benefits.

The trap had been set for Thatcher to stumble into. It just needed only a trigger. She survived the poll tax riots in March 1990. But the general unfavourable economic conditions made it tougher for her to ride roughshod over her Tory colleagues without creating deep animosity. They needed a bone to pick with her. Her strident stand against increasing European encroachment on Britain's sovereignty became their cause.  Feeling that she might lose the second round of a leadership challenge, she voluntarily resigned her premiership in November 1990. What an ignominious exit, three consecutive wins at the polls, only to be stabbed in the back by party colleagues.

Had Thatcher restricted herself to two terms, like Reagan, she would have stepped down with her reputation held in high esteem. The British public would be now yearning for her leadership although in reality, she benefited largely from factors beyond her control, especially the oil wealth. Without its crutch, her downfall was predictably swift.