30 September 2013

National Output and Disintegration For Mummies

1. Mummified and Buried with debt
2. National Output for Mummies 101
3. Europeaness and the Bubble-gum card
4. Bleak House
Recent economic news seems to justify optimism.  The summer saw well-behaved sovereign interest-rate spreads, a strengthened euro and a recovery in equity markets. Very superficial.  
Part one: - mummified and buried with debt for the afterlife:
The underlying crisis in the euro-zone is still there and very real. Many economies in the Euro-zone face very poor growth prospects. Debt overhang and balanced-book repression still haunts investment - private 'capital' that could go to productive investment remains 'flighty'.

Euro-zone's self-inflicted macroeconomic disequilibrium will persist - a cycle of internal trading imbalances, bubbles, financial repression, deflation and uneasy peace (global upturns and elections). Press one button to restore a member's import-export trading balance and create internal imbalance. Press the other to restore its internal balance and create an external trade imbalance.

Without growth prospects, unfortunate economies are mummified and entombed. A one trillion euro Pyramid (that give liquidity to banks to buy government bonds) to ensure a safe journey to the afterlife (in 2020) is not enough.  Euro tribes may still revolt and seek a new promised land.

Solving the euro-zone trading imbalances (caused by misspecified fixed 'terms of trade') by destroying trade (depression) is (fiscal compact) madness. There is still no flexible mechanism to adjust a members' terms of trade to the constantly changing conditions of global trade. Instead, adjustment is by sluggish corruptible unfair structural reforms and population movements that (works in the USA but) destabilizes euro member's political systems.

The resolution to this very European economic disequilibrium (reoccurring internal trading imbalances and more potential 'debt overhang') is politically unfeasible.  It doesn't take much to stir up a new crisis.  Successful monetary unions follow political unions, not the other way around.

But "We are all Europeans. I'm European. You're European"
"We're all mad here. I'm mad. You're mad."  How do you know I'm mad?" said Alice.  "You must be," said the Cat, "otherwise you wouldn't have come here."  Alice-in-Wonderland
Germany elected a Mummy ('Mutti' Merkel ), trusted by her voters to handle Euro crises. The 'Home' and "Mummy knows best" comes first. But why should Germans care about Greeks more than Germans?  How can European policies not be dominated by national media and prejudices?  How can voters not worry more about their own economy and livelihoods than elsewhere?  How can voters, suffering years of economic repression, not worry about their livelihoods, not resist and not change policies and not create another Euro-zone crisis?  Does Greece having a primary budget surplus make it bolder, more independent and freer ... to do what?

Debt repayments:  "Two Tens for a Five"

Greece still needs a real restructuring of its debt, including deep write-offs. To do this in any real meaningful way, Greece will still face a stand-off with the creditors and will again be threatened by euro exit. Without real debt relief and sustained economic recovery, a choice becomes even more clearer to voters. Either leave your country (and move to other increasingly xenophobic countries) or make it leave (euro exit).

Debt Overhang
Greece's debts is currently higher than it was in 2010. Its economy has collapsed by 25% and its debt to GDP approaches 180%. It is maddening ratio that stubbornly refuses to go down.  On the other hand, policies that reduce a denominator to (pay and) reduce a numerator (Debt / GDP) will do exactly what to the actual size of the ratio?

Unmanageable debt burden compromises economic growth. It is a ghost that haunts any Euro-zone country finding itself on the wrong side of the trading balance. It distorts and crowds out investment, with an economy's funds increasingly managed by feudalistic principles rather than by economic returns.  "Debt overhang" (debt is so large that it threatens ability to repay its past loans) scares off potential investors who will need to deal with the unpredictable actions of a government prioritizing impossible debt-servicing obligations.  The returns from investing in the economy are effectively "taxed away" by the repression imposed by existing creditors who had over-lent.  Bad investments, that are not allowed to fail, drives out good investment. When investors do appear, projects with quick returns rather than for long term projects that make growth sustainable are more likely to be chosen.

Debt per se is not a 'bad'. The addition of debt can finance and enhance the country's capital stock and productive capacity and restore a country's competitiveness. In Greece, the additions of debt to maintain (rather than write off) bad debts perpetuates 'bad' lending and a rotting system. It attracts vulture funds more than real investors. Debts should have been written off back in 2010 to restore the confidence of investors in the real economy - not the confidence of 'failed' lenders to a failed system. It was bad capitalism not to write off bad debt and to disable the reboot button.

The flaws in the Euro system are still there.  There is still no flexible mechanism to replace the role of exchange rates - instantaneous adjustments to a country's competitiveness. Recovery and short to medium term attempts to stimulate the European economy will regenerate new, if not old, trading imbalances.  As for long run solutions, Europe does not seem able to coordinate any 'agreed' and meaningful  policy. An adjustment (in the absence of internal exchange rates) of economies by population movements or depopulation leads to more political uncertainty, economic and regional inequality and nationalism and political extremism.  Poorer regions will lose more of its taxpayers and human capital whilst at the same time be faced with an aging population and rising health and welfare costs.  

Government budgets crisis, even if it is enshrined as the 11th commandment "thou shall not overspend",  will not go away

Part Two: National Output for Mummies 101 (you may want to jump to Part 3)

Or you might read Credit Writedown's  Why can’t people understand national accounting?
"the whole framing of the problem presented in the media is wrong because it gets cause and effect totally backwards. The question the media asks is "how can government cut the government deficit?" The real question is "why are deficits high to begin with and what should we do about it?" And it’s this question that gets people into trouble."
An economy's output cannot simply be measured by adding the monetary value of each producer's output -  the output of one (wheat) is another's input (baker) - but it can be measured by adding the differences between the value of output (bread sales) and inputs (wheat purchases) - "Value Added",

If a producer's balance sheet profits appear as:
Profits  =  Sales  - Purchases From others  -  Depreciation  - Wages  -  Interests
then a producer's "Value Added" is
(Sales - Purchases from others )  =  Depreciation  +  Wages   +  Interest  +  Profits
 'Value Added"  =   (S - PF)    =         DP        +      W      +      IN      +      P
and the "Value Added" for all producers is:
GNP at factor cost  = Σ (S - PF)  = Σ (DP + W + IN + P)

Allowing for depreciation, the monetary value of an economy's output (Net National Product NNP)
NNP = GNP - Σ DP  = Σ (W + IN + P)
is equal to all the possible ways of earning income - National Income (Y).
NNP  =  Y 
Output, including imports, goes to consumption (C), investment (I), government (G) or is exported (X)
IM + NNP  = C + I + G + X
Available resources  =  Resource use
NNP  =  C + I + G + (X - IM)
Incomes (wages, profits/interest and rents) are used to pay taxes (T), saved (S) or spent (C)
 Y = C + S + T
Savings is postponed consumption, stored under a mattress, bank account or as "financial investments" (stocks and bonds) with various degrees of liquidity or risk, that lay claim to income from future production. 

The national income accounting identity (NNP = Y) gives
C + I + G + (X - IM)  = C + S + T
I + G + (X - IM)  = S + T
(X - IM) = (S - I) + (T - G)
Current Account (Trade) balance  = Private sector net savings + Government budget account

This [ (X-IM) = (S-I) + (T-G) ] is the Euro-zone default line

Persistent trading deficits (X - IM) < 0 will always be accompanied by accumulating (private or public) debts ie
 (S - I) + (T - G) < 0. 

The trade imbalances (X - IM) do not easily clear, as there is no simple mechanism to adjust relative prices (domestic to foreign prices). There is no exchange rate, nor domestic currencies, to do this job.  The impact of these surpluses and deficits (and a political 'tragedy of the common' euro debts), has distorted the European investment mechanism
I = S  -  (G - T)   -   (X -  IM)
net investments =  private savings +  govt budget  +  trade account

In Spain this manifested itself  in a construction property bubble.; in Greece, net imports was offset by government deficit; and in Ireland the government debt replaced banking debts.  

It is the current account balance which drives the flow of wealth and employment within the Euro-zone. The tail that wags the government doggy budget deficits.  Even if the EU's Fiscal Compact works (T- G = 0), trading deficit will be accompanied by private sector debts as
(X - IM) = (S - I)
This could be resolved by either exchange rate or by efficient financial markets on the other side of the above equation. Euro-zone has neither:  no internal exchange rates, a financial system (that allows the 'bad' not to fail) and, in turn, an inefficient or corrupt investment mechanism. Using internal devaluation to adjust domestic to foreign prices (international competitiveness) fails when the internal markets are themselves monopolistic. Getting a corrupt system to reform itself doesn't get the intended results.

Net investment (I) in the national accounts may increase but, in a macroeconomic disequilibrium, this can be an illusion. There are three main components of net aggregate investment: 1)  'real' economic investment (additions to the stock of capital - machinery and equipment) with returns from future output),  (2) construction (factories, offices AND residential ) AND (3) inventories (intentional or not eg unsold goods).  

When the system fails, this mix can become very toxic. Real economic investment (1) is overwhelmed by (2) construction and property bubbles that eventual show up as (3) unsold goods and stocks.

Part Three:  'Europeaness' and the original Bubble-gum card 

Bubbles are shared fantasies, pricked by reality. Scrams are getting enough people to believe in the fantasy to pay for it. Euro-zone convergence was myth.  The euro crisis has been a story of more and more dealings in government debt, insider trading, bribes to politicians, and debts backed debts to spend on purchasing more debts.

The trade benefits of convergence turn out to be as mythical as the South American Trade benefits were to South Sea Company (UK early 1700s).  The company's stock rose (S. American trade was under Spanish control) with more and more dealings in government debt fueled by insider trading, bribes to politicians, and loans backed by those same shares to spend on purchasing more shares. The renewal of war with Spain in 1718 did not prevent its collapse in 1720.  
The South Sea Bubble Card - 1720 
The South Sea Company was created as a public-private partnership to reduce the cost of national debt under the disguise of a monopoly of South American trade (which was under Spanish control).  In 1718 war broke out with Spain. The bubble burst in 1720. The only real trade that occurred was in people (slaves)

Effective financial markets ought to mean that the returns to investment (future profits and output) are related to borrowing costs (debts) where the risk of failures sold and brought in derivative markets. A rise in net investment ought to indicate an increase in the productive capacity with profit-taking accruing from wealth creation. The risk of returns failing to meet lending/borrowing costs ought to be dealt with by the secondary markets (buying and selling of risk, insurances and the pooling of risk etc). When profit-taking, risk-taking and borrowing costs become increasingly disconnected from the economy's actual returns and risk, increases in aggregate investment are illusory.

Net investment (and GDP) in the euro zone periphery flowed into bond, construction, real estate and asset bubbles. Trading surpluses were fed into a slot of a bubble-gum vending machine that fed deficit countries forced to operate on 'bad' Terms of Trade. Like Gresham's Law, a debased currency of circulating debts leads bad investment (debts) driving out good investment (debt).  

Once the bubbles burst, trading deficits (X- IM) fall by the private sector (S-I) imploding - investments, output, consumption (and hence imports) and savings and investors run for cover.  The trading deficit economy, is then subject to a viscous circle of underdevelopment, buried by the weight of accumulating debts that become increasing larger in real terms as its future income and GDP falls.  

The Abbott & Costello Multiplier 

The result is a macroeconomic disequilibrium where consumption, savings, investment, government expenditure and tax plans will collapse upon each other. The economy does not grow but shrinks its way out of financial crises.  

Part four: Bleak House
"Suffer any wrong that can be done you rather than come here!"
Jarndyce v Jarndyce  a large inheritance entrapped in a case dragging on for many generations that is finally resolved by the legal costs devouring the entire estate. (Charles Dickens' Bleak House)
Europe is threatened with long-run stagnation. Its investment engine over-flooded with toxicity, the funds of trading surplus economies' channeled into poor investments and pyramid schemes whilst deficit economies are asset-stripped of their human capital.  A flawed monetary union adjusts by population adjustments (emigration, lower quality of life, lower birth rates, lower life expectancy etc).  The periphery's young migrate to the core keeping its wages costs low and its relative competitive advantage. Human capital (education, healthcare, etc) that was paid for in the periphery yields its returns to the core. Left behind is an increasingly unskilled, aging and unhealthy population tied to debt repayments struggling on third world wages to meet European food prices (distorted by a flaw Common Agriculture Policy). 

You cannot have the holy trinity of stable current accounts, sustainable debts and balance government budgets.  They could be sustained by a permanent system of European-wide transfers. Something like the original Marshall Plan, that laid the foundations to the original European Community, would do. But this would imply a degree of "European-ness" that does not exit.

Without debt forgiveness and real investments, a small indebted country should keep a euro-exit card up its sleeve and not be afraid to play it.
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