The Curse of being a Creditor Export Nation

"Germany was one of the leading borrowers on the American market during the boom. Germany was undoubtedly short of capital, bereft as she was by the war and then by her ruinous inflation, culminating in late 1923. However, the German bonds floated in the United States did not, as most people thought, rebuild German capital. For these loans were largely extended to German local and state governments, and not to private German business. The loans made capital even scarcer in Germany, for the local governments were now able to compete even more strongly with private business for factors of production."
Murray Rothbard, Americas Great Depression

The recent GDP figures in relation to the German economy were dreadful. The economy was reported to have shrunk 3.8% in the first quarter. Later in the week Japans figures came out, again the numbers were once again nauseating. This time a contraction of 3.5% for the quarter along with a collapse in exports. Meanwhile millions in China are being made redundant. Despite the massaged figures that the Communist party reports, China is heading for a hard landing. Many commentators have begun warning the Asian bloc of nations that their export based economic model is flawed, signaling they need to buy our bonds to avert a further collapse in their own economies. Ambrose Evans Pritchard has stated that Asia will author its own destruction if they stop buying US governments bonds, meanwhile Anatole Kaletsky claims that Germans need to abandon their rigid monetary stance and deploy a looser fiscal policy in order to save itself and the Eurozone. Why is it that prudent nations, who saved, lived within their means, who were running trade surpluses during the boom are having a harder time of late than nations such as the UK or US, who did the exact opposite? I mentioned that this should occur back in February, and it is perfectly logical. It is always the prudent that face a worse punishment than the reckless, this is the way it always works.

Think of a hypothetical situation in which Person A works, saves, lives within his means and always seeks to improve his working skills. Person B on the other hand, works as little as he can, doesn't save, borrows as much money as he can and has no interest in bettering himself. Person A has so much saving that he doesn't know what to do with it all, therefore lends it to Person B to fund his lifestyle. It seems like a good idea, as both benefit, one gets interest on his loans, the other is able to live beyond his means. Person B comes to a point where he has simply borrowed too much, but insists that Person A must continue to lend him money just until he gets back on his feet, otherwise he would default on his loans. Person A initially agrees, but as time goes on Person B has still not changed his ways, still threatening that he needs more money as both would be in real trouble if the current agreement stopped. At some point, Person A decides enough is enough and decides to cut his loses. Person B realises he can no longer pay back the money so defaults.

In the above Person A has to go through a lot more pain, as he has essentially just worked and saved for no reason, as Person B defaulted on his loans. He has lost all his capital and doesn't know what to with his future earnings. Person B however has had a pleasant lifestyle and at this point has gained greatly. He hasn't taken the short term hit. Yet despite this, over the long term Person B needs to develop his skill set to pay for his lifestyle he was previously used to and needs to learn once more how to live within his means. Person A meanwhile has the above already and has a head start on person B. Over the long term he is in far more beneficial position as he re saves his money, continues working and has learnt a lesson not to take excessive risk by lending to individuals such as Person B.

The above is an extreme and simplified situation but illustrates the global issues we are now seeing. Despite all the empty threats Hilary Clinton sends to China to continue buying US government debt, as soon as creditor nations decide to cut their losses the better they will be in the long term. This is the decoupling commentators such as Peter Schiff mention. The initial stages will be very painful for the creditor export based nations, but over time they will write off these losses and move forward consuming more of what they produce, rather than shipping it to others who can't pay.

The globe was at a similar junction during the Great Depression. Back then America was the creditor export nation of the world, making loans to Europe and assisting with the inflationary program Britain was pursuing as she tried (and failed) to keep the pound artificially high. During the 1920's Europe was a economic fiasco. Germany witnessed the collapse of the Mark, Austria nearly had a similar fate, France was weak, Britain was struggling with her empire and Russia had cut itself off as it succumbed to Communism, embarking on the road towards impoverishing her people. When the phrase 'roaring twenties' is used, it never applied to Europe, America was the creditor of the world producing and exporting some of the most innovative products of its day. With this surplus she helped nations in Europe, even into the depression;

"The New York Federal Reserve loaned, in 1931, $125 million to the Bank of England, $25 million to the German Reichsbank, and smaller amounts to Hungary and Austria. As a result, much frozen assets were shifted, to become burdens to the United States. The Federal Reserve also renewed foreign loans when borrowers failed to pay at maturity."
Murray Rothbard, Americas Great Depression

Economists always like to mention the fact that European nations never had as bad depression as America, such as the BBC's commentator Stephanie Flanders, however comments like this miss the whole economic perspective and analysis. Europe never had a boom, therefore it didn't have as hard a time as the US, instead during the 1920's many of the continents nations experienced high inflation to erode the value of debts obtained during the First World War. Over the long term America, as history showed, bounced back and became the economic superpower. During the 1950's and 1960's American products were practically unbeatable and she also assisted with Europe's Reconstruction after WW2 with the Marshall Plan.

The recent idea that a nation who consumes too much is doing nations that live within their means a favour is absurd. Its much easier for one to consume than to produce. Generally once a nation becomes a debtor for consumption purposes it becomes very hard to break the cycle, as increasing amounts of money is used for further short term consumption or paying interest on the existing debt. Many Eastern European states borrowed heavily from the West for such means while they were still within the unproductive Iron curtain. Nations such as Poland, who in 1970 were 1.1B in debt, increased these overseas debts to 25B ten years later. This money was not used wisely as it was just used to consume goods rather than to increase productive capacity. Many such nations experienced mass inflation with the economies being effectively Dollarised (foreign visitors were quite frequently asked by the locals to pay for goods or services in Dollars rather than the local currencies).

Many commentators justify Americas recent borrowing stating that America borrowed hugely from European countries such as Britain and Germany in Europe during the 19th Century, but again they miss the point. Back then this money was used for production, not consumption. Countries like China recently have borrowed huge amounts of money from the West, however they have used this money for production purposes or investing in human capital. There is nothing wrong with borrowing money - it's what you do with it that matters.

America up until the eighties was a creditor nation, it was during Reaganomics that it chose to become the worlds largest debtor in history. Once travelling along this path it becomes very hard to stop or reverse. Tough choices have to made by politicians and the countries citizens, all of which are avoided until it is too late.

Don't get me wrong, there are issues with many of the worlds creditor nations. The Saudis are ruled under a despotic regime, Russia still suffers from decades of Communist decay, China has too much bureaucracy, Germany has a rigid labor force and Japan has huge amounts of Government debt, increasing as the crisis deepens. In short I think the whole world has issues.

Keynesian economics always tells people what they want to hear, mainly it is an economic framework that provides individuals with the notion of a free lunch. As Milton Friedman said "There is no free lunch", every action has a cost. Consumption, Debtor nations will have to pay more for their situation than the export and creditor nations in the long run. There is no curse for being an export creditor nation. The curse is a Keynesian myth, the economic school that once again gets the wrong end of the stick. The curse lies with debtor consumption nations. It always has and always will.

Beware of the Sage

"'If we elected a Congress with intestinal fortitude, it would stop the spending all right!' ... I went to Washington with exactly that hope and belief. But I have had to discard it as unrealistic. Why? Because an economy Congressman under our printing press money system is in the position of a fireman running into a burning building with a hose that is not connected with the water plug. His courage may be commendable, but he is not hooked up right at the other end of the line. So it is now with a Congressman working for economy. There is no sustained hookup with the taxpayers to give him strength."
Howard Buffett, U.S. Congressman 1948

Businessman and Politician Howard Buffett was the father to one of the world's most successful investors in history, Warren Buffett, who would grow up to be the richest man on the planet by earning his wealth purely by investing in companies. From an early age Warren was exposed to the business that would become his passion. Howard worked as a local stock broker which captured the younger Warrens imagination. While other children were playing games, Warren was more interested in business activities, so much so that he would never have attended University had it not been for his fathers influence. He began as an Investment salesman, but as time went by the "Sage of Obamha" amassed billions and become a household name.

However, since the credit crunch began brand Buffett has taken a hit of late. He has lost some of his wealth during the financial turbulence and Bill Gates has resumed pole position as the richest person in the world. His Investment fund, Berkshire Hathway, has made its first loss since 2001 and in the process lost its triple A rating. Despite setbacks, Warren continues to reassure his legions of followers that over the long term all is well and stocks will always do well. It would take a brave person to write off the Sage, but there are signs that Warren is out of step with the times.

There seems to be a contradiction between his advice and his actions. He is famed for calling financial derivatives as "weapons of mass destruction" but recently bought up a pile of such instruments to hold in his investment company. He states that governments are carrying out the correct policies to help the economy through the current crisis, yet openly admits that government bonds are a bubble. Through 2006 and 2007 he warned that many stocks were overvalued along with various other issues that the world would face, yet bought many stocks, including Conoco Phillips, at their peak. The above seems to illustrate a person in touch with global affairs, yet going against his own advice. At the age of 78 has Warren embarked on a personal crusade to save the U.S. and world economy from further collapse, carrying forth his philanthropist work into his investment decisions?

His father was a strong believer in Libertarianism, with a strong distrust of Government. To Howard, Government was always the root of the problem - not the solution. The policies and deficits being proposed today would deeply worry Howard who never lived to see the world monetary system we operate under today. Under a pure fiat system Howard would have quite different investment decisions to his son, as he was always weary of how governments could confiscate the public's wealth through inflation. Gold was his preferred monetary basis and he would no doubt be telling his son about its properties during the times we find ourselves in now. Warren by contrast, views Gold in a somewhat different light, a barbarous relic, which does no good for society unlike stocks. He is no doubt correct on the fact of what both assets do for society, but is he willing to put his own and his clients wealth at risk for the good of humanity?

Warren can afford to be careless. He has an inexpensive lifestyle and has no interest in money, it seems he just relishes the challenge of picking stocks. He has built an almost religious following, but beware, all people are fallible. Throughout history great captains of finance have lost their way. The Rothschilds, Rockefellers and Morgans to name a few. All bounced back, but lost considerable influence and dominance that they once had. Could we be seeing a similar point in history with Warren Buffett? I have no doubt that he has an eye for picking stocks and certainly knows his domain, but what if there are no fundamentals for the asset class in question? When government embarks on a policy of preventing liquidation and printing money by increasing government spending, this does not create the conditions required for a strong equity market. Japan tried this and their market index is still under half its measure from 20 years ago. During the seventies the US stocks went no where for 15 years, in inflation adjusted terms you would have lost money.

Despite Warren seeing inflation down the road, he seems to quietly ignore this damaging effect on business behaviour, choosing to believe in the fact that Coca Cola or whoever will be able to rise above it. Howard would see something different in the climate we are in. He would see the government in the process of hampering the private sectors ability to function along with the government confiscating the public's wealth through inflationist policies. He would also worry about the current monetary system we find ourselves in. He never lived to see a full global fiat system, but he understood the history of it. As he once said;

"But first let me clear away a bit of underbrush. I will not take time to review the history of paper money experiments. So far as I can discover, paper money systems have always wound up with collapse and economic chaos."

Could we be facing further dislocations to come, or are we through the worst as many are suggesting? We have not even begun in this recession even as many proclaim that a recovery is within sight, as the clutching at straws begins. There is much more chaos to come and we are due a currency crisis. The dollar is a bubble along with other currencies. The Yen trade still has huge amounts of money overseas and as further losses accumulate, these will no doubt have to be covered putting further downward pressures on already weak currencies. Whether we see the end to the current monetary system or a transition to an alternative is another question. The authorities can only buy time, they can't fix the system and as the quotes sixty years ago suggest, paper money can never survive indefinitely. As for the question on whose view to take, Howard or Warren, Howard clearly understood economic theory and history better than his son. Investors beware, Warren may have a generous heart in attempting to save the world but many of his followers will not have as deep pockets.

Failed Policy

Ron Paul is one of the few politicians I have seen that understands economics. Here he is talking about credit and capital. Capital is vital for any nation to prosper. Savings, in which people forgo current consumption in order to invest in productive future endeavours, is how nations build wealth. Excess credit in the boom years caused the issues we are now seeing take hold on our economies. The market is currently attempting to unwind all this artificial credit as it was never based on prior savings, it was created out of thin air by fractional reserve banking operating in concert with the central banks. It created an artificial prosperity, in fact it actually has impoverished us. We are witnessing this market adjustment by certain lines in our production structure that seemed to be profitable during the boom being liquidated, releasing labor (unemployment). This process can not be stopped nor can it be 'softened' or corrected. When institutions try and stop this process all it does is make this lack of real savings worse and prevents the cure. It keeps discouraging savings and investments. It erodes the value of the capital that currently exists.

As I have said throughout the blog the idea that people should keep consuming just doesn't make sense, even when you don't know economic theory. If people just consumed and never saved to invest in productivity then how would we improve our material well being? Savings are the basis of human prosperity along with technology. They can not be created out of thin air by government and there is no shortcut to this process, it requires self sacrifice and hard work. I will post on a later date about the fallacies of savings, as savings are the way out of this mess along with the unwinding of this current credit bubble.

Political Capital

"Politicians are like diapers. They both need changing regularly and for the same reason."
Unknown Author

It's been a week Gordon Brown would like to forget. Hazel Blears has questioned his leadership over the weekend, stating the party needs to connect with people and show a more 'human' side. A humiliating mid-week defeat in the commons over the Gurkha's gave his opponents an opportune moment to pose in front of a just cause. With this defeat displaying dissent within the party ranks, Brown didn't risk carrying forward the recent politicians expenses bill instead backing down on these proposals. On his travels he managed to get a bashing from the Poles and the Chileans, regarding government spending restraint and building up money during the good years. Those 'Tory' Boom and Bust remarks are also coming back to haunt him as unemployment climbs, entailing hardship worse than when Gordon as a young backbench MP lamented the government on the lack of jobs. Contrast this with Obama in the US, and we can see quite different fortunes. Here Barack Obama can do no wrong. The recent G20 meeting exemplified this as the worlds leaders clambered to be seen with the charismatic leader. Political Capital - the credibility and perceived vision of a person - is all important in the world of politics.

It wasn't always like this for Gordon Brown. When he became the unelected Prime Minister, Labour did gain in popularity as Tony Blair's political capital had slowly ebbed away. As the financial events have evolved, fortunes have changed and since Brown was involved in the economic decisions of the past decade it has consequently meant his creditability with the public is in many ways non-existent. Similar to Jim Callaghan thirty years ago, both were former chancellors who became prime minister, both became the tallest PM in each of their eras and both inherited a domestic economy in turmoil, in part their own doing. A successful politician can obtain their capital in two ways, by circumstantial chance, or by genuine integrity.

Nelson Mandela is an iconic figure, a universal political and diplomatic celebrity. People with no interest in politics instantly recognise him. He is a classic example of political capital that he built up by himself for his integrity and devotion for the apartheid cause. As the leader of the militant wing of the ANC, Spear of a Nation, Mandela was involved in various guerrilla warfare operations, sabotaging many government installations (he was influenced by the readings of Che Guevara, Fidel Castro and Mao Zedong). It was on these acts of sabotage he was charged, which he admitted to and was sentenced to serve time on robben island. During this he was offered various offers to renounce the armed struggles of the anti-apartheid movement in exchange for his freedom, all of which he declined. These half measures would not be enough as he sought complete equality. With International apartheid economic sanctions further crippling the South African economy along with growing unrest, secret talks were opened with Mandela and the National Party Government to allow free democratic elections for all.

There would not be many political leaders who would endure the above, and many would have resentment towards the current government, but not Mandela. He realised South Africa needed the whites, as they were the educated ones who would be required for the new knowledge economy. He also realised that fiscal and government restraint were the solutions towards wealth - not increased government, or generous welfare programs for the Black public who would be his main supporters.

It was these tough decisions that Mandela was prepared to make, at the risk of unpopularity. Yet his political capital shone through. The ANC were voted in, with large sections of the White population voting for him as they realised change was needed. The recent South African elections still show how much mass appeal Mandela has, as the ANC wheeled him out in order to gain further support for a new generation of ANC leaders, whose capital is no where near as large. Nelson Mandela is a classic example of political capital built through integrity, principles and self sacrifice.

There is another type of political capital, that of just being plain lucky. Tony Blair gained the leadership of the Labour party back in 1994. A recession, a government that had been in power for nearly two decades which was mired in scandal after scandal, Blair was the right guy in the right place. An opportunist, who as Home Secretary copied his Tory counterpart, tough on crime tough on the causes of crime, and continued the imitation of the opposition when he led the party. The 1997 election proved to be a landslide. For the next 10 years Blair would be at the helm as everything fell into place. The rise of Asia as a low cost labor destination, the explosion of telecommunications that enabled further off shoring of office operations to such destinations. Record low Oil prices, which allowed the industrialised countries of the west to further grow along with Asia. The peaking production of North Sea Oil and Gas providing a nice tax stream for the Treasury along with the distortion the pounds value and the balance of payments. The British population coming into the prime of their working age, as many of the boomers were in their 30's, 40's and 50's, putting institutions such as education and the NHS under less fiscal pressures. The ending of 'The Troubles' as Northern Ireland looked for peace after a generation of conflict who had just had enough. Thatchers reforms during the eighties that got rid of industries that Britain had become uncompetitive in and moving into other jobs. The rise of London as a giant hedge fund that created wealth out of nothing, or so it would seem at the time. The accession of Eastern European nations such as Poland into the EU provided limitless cheap low and high skilled labor, doing jobs British people didn't want to do or couldn't do.

All of this provided Tony Blair with the perfect political platform, that gave him capital and leverage that he could do as he pleased, with little dissent. Tony Blair told middle England what they wanted to hear. He promised social justice with no intention of raising income taxes, so middle England could feel better about themselves rather than the guilt they had felt under Thatcher. He could give them everything, when in reality he did nothing. All the events detailed above did the real work. Blair would later admit as much.

So can Brown survive and can he regain his political capital? Once politicians begin to lose their political capital it becomes very hard to recapture it. Ted Heath's clashes with the Miners which resulted in the three day week, or Anthony Eden's moment with the Suez crisis, each lost them vital political capital and they never regained it back. There is only one way Brown and Labour can regain political capital. If the opposition implodes, but this seems highly unlikely. The other is a leadership challenge, to try and get some fresh capital back. There has been discussions of this for a while and I feel we are still too early from the general election. The local elections to be held in June will provide valuable insight into the immediate damage that has been inflicted. A devastating defeat and members of the party may get restless, with a leadership challenge likely. Political capital, either from timing or integrity, is vital in politics. Neither of which Gordon Brown has.