From Notting Hill Editions
Tom Kremer, founder of Notting Hill Editions, explains that the soundness of an economy is measured by how far expectations exceed the value of assets.
When will the recession finish? When will the economy be back on track? The implied image is one of something moving happily along, accidentally falling into a hole, with only a matter of time before that something resumes its natural course. The problem is, that there is nothing like a god-given, pothole-free, regular track designed for a normal economy.
The post-WWII world, especially its Western part, experienced a more or less continuous rise in its standard of living. This brought with it a general culture of expectations, now deeply embedded in the psyche of three generations. We all believe that tomorrow has to be better than the yesterday. Many of us do not just expect it; we feel entitled to it. The economy is constituted by just two ingredients: assets and expectations. The distance between them determines the state of the economy. If the gap is narrow, producing a risk-averse society with little ambition, the economy is sluggish. If the gap is too wide, with expectations far in excess of practical realization, there is always the danger of economic contraction. Right now, the gap is an abyss engulfing the economy, in the worst crisis since the great depression. So, in the first instance, the answer to the oversimplified question is straightforward: the recession will end when the gap between expectations and reality is brought back to manageable proportions.
There has been, as far as I know, no quantitative formula for measuring the size of the gap on a national, let alone the global scale. Every household, every enterprise, is able to assess the odds of realizing its expectation. This is because they can estimate the value of their assets and the extent of their expectations. To quantify national assets and expectations in relation to each other is considerably more problematic. Even so, an analytical tool to define this ratio is critical for a meaningful assessment of the state of any economy. It is critical, because the key measure universally employed to do this is not only inadequate; it is dangerously misleading. Gross Domestic Product, or GDP, is strictly a measure of volume. It recognises no distinction between income and expenditure, between asset creation and asset use, between profit and loss. It would be a useful tool if, as its inventor intended, it was employed in conjunction with other tools, measuring the quality of the economy.
Recession is officially acknowledged when two consecutive quarters show a negative GDP. No doubt, the recession will be officially declared over, when a similar period shows a growth in GDP. This figure includes virtually every activity under the sun, from collecting rubbish to building aircraft carriers, from manufacturing goods to dispensing health, from servicing washing machines to administering justice. Some of these activities are revenue-producing for the national economy and some are depleting its resources. Disregarding this distinction, you may bask in the glow of growing GDP figures while the economy is sinking quietly below the horizon. You will only notice that something is radically wrong when credit dries up, enterprises go bust, the budget deficit balloons, and the government swings into manufacturing money. This is not a theoretical possibility; it is what is happening now, after many decades of virtually continuous GDP growth.
Realizing that something is radically wrong when the crisis is already upon us is a little too late. To anticipate grave imbalances, and to redress them in time, we must abandon GDP as our principal measure. It has to be replaced by a qualitative analytical tool capable of more meaningfully assessing the state of the economy. My candidate for such a tool is the Net Domestic Product, as set out in some detail in a previous Journal essay. The envisaged NDP segments economic activity, grading it in terms of degrees of contribution to, or depletion of, the national asset base. In the broadest of outlines, making things, material or digital, is a net contributor; the public sector, including the bulk of the welfare state, is a net spender; the service sector does support, in part, the production process and so could be considered part contributor and part spender; education, although a major expense, does supply the human resource and thus should qualify, in part, as an investment into the economy, not just an expenditure.
The NPD, or something like it, is crucial for delineating assets and expectations in relation to each other. There are few absolute assets and not many baseless expectations. Nevertheless, it is useful to think of assets as primarily residing in NDP whilst the rest of GDP is made up of expectations. In other words, the NDP/GDP ratio will tell you how much of your economy is real and how much is hostage to future fortune. Applying these figures to national economies, you will see at once why we are in a crisis, how individual economies vary and, most significantly, what it will take to bring them into some sort of balance.
Take our UK economy as an example. The last Chancellor never tires of claiming ten years of steady growth under his personal guidance. He is, of course, referring to GDP figures, but he was strangely oblivious as to what exactly grew. We know very well that it was services, property prices, paper profits in the City, together with the public sector, the welfare state and government expenditure that grew. And we also know that the asset base of the economy did not grow, or at least not at a rate anywhere near enough to keep pace with the increasing GDP. As a direct consequence, the NDP/GDP ratio deteriorated, the gap between reality and expectations stretched to a breaking point and we were in a crisis. Whatever else happened in the world, whatever triggered the collapse, these are the hard local facts.
If you have any doubts about my common sense analysis, you may be reassured by the view of Robert Chote, the director of the influential Institute for Fiscal Studies. In a recently published study, he reaches the same conclusions, albeit described in somewhat different, more academic, terms.
It is true that something similar happened on a worldwide scale, but not uniformly to the same degree. Comparative NDP/GDP ratios show significantly diverging patterns. The scenarios in Canada, Norway and Poland, for example, look not nearly as sombre as those in Hungary, Spain, Italy and the UK. America, for multiple reasons, is a case apart, seemingly able to withstand the laws of economic gravity. However, its imported consumer bias, trade and budget deficits, and its declining manufacture base, all indicate a massive volume of over-expectation. Given the variations in the gravity and form of the recession, it is obvious that the end of the crisis and its aftermath will also vary from country to country. The recession may be global; economic recovery will be highly specific.
Since the need for qualitative assessment of economies is elementary, how come we ended up worshipping at the altar of GDP growth? After all, we have household budgets, profit and loss accounts and balance sheets of companies, so why not subject national economies to the same discipline? The answer is simple: almost everyone has a vested interest in cultivating expectations.
We feel entitled to state benefits in terms of health, education, justice, internal and external security, consumer protection and the provision of an array of equalities. Businesses are geared to deal in products that create demand. The financial industry is wholly built on expectations. Governments, at least in Western democracies, come into being and survive by raising expectations. And then there is a culture, fostered since the industrial revolution, that tomorrow has to be better than the past.
Against such forces, what are the chances of NDP being taken seriously? After all, in an affluent, morally sophisticated society, mundane considerations of cost, debt, affordability and value are only ever paid lip service. What matters that the principle of prolonging life in virtually all circumstances takes many billions from the exchequer? What matters that vast amounts of moneys are spent on protecting people from falling off ladders or falling off moving trains when they are foolish enough to open unlocked carriage doors? Any small series of shocking incidents may generate prolonged official inquiries and bring forth a plethora of sensible recommendations, new laws and multiple regulations that may, or may not, turn out to be helpful. But no one cares to calculate the total financial parameters.
Bernard Shaw puts words into the mouth of Doolittle that have a particular bearing on this matter. Eliza's father, a dustman, tells Professor Higgins that it is all very well for the middle classes to have morals but he cannot afford them. Class distinctions are less relevant today but the point remains valid: all principles have a price.
I am sure that the social aspirations of our society are noble, but I am not sure that we can afford them all at the same time. When a household is in financial trouble, it can moderate its lifestyle. When a business is overstretched, it can downsize. When a government gets into difficulties with an overblown budget deficit, it can tighten the financial screws. But when the national economy, as a whole, is massively out of balance, we are in deep, deep trouble. This is why, despite overwhelming resistance, the concept of NDP will have to come to the forefront of the economic debate.
What happens now depends on three factors: the gap between expectation and reality; the form and extent of government intervention, and the native enterprise and resilience of the people. As all these factors differ significantly from economy to economy, the duration of the recession and its aftermath will vary too.
That said, certain features, to a greater or lesser extent, are common to most Western economies. Judging by NDP/GDP ratios, public sector commitments, overall indebtedness, and the inflated valuation of assets, the critical gap is at an historic high. This means a radical restructuring of the economy is in the offing. Left to itself, any economy would eventually redress its own imbalance simply because, at the end of the day, it is always the hard facts that determine the outcome.
The process of self-balancing is painful, with the sacrifice of treasured enterprises, destruction of 'secure' wealth and personal deprivation on a disturbing scale. For any government to appear to be idle amidst such devastation is politically unacceptable. It is not going to happen. So instead we have frenzied initiatives and a substantial supply of international paper resolutions. What remains to be seen is how helpful government intervention proves to be in narrowing the expectation gap, which is what really matters.
So far, what governments have done is to safeguard the existing banking system and stimulate economies by pumping them up with astronomic quantities of borrowed or manufactured money. The question is, at what price and what is the continuation? The price was on a scale of billions or trillions, ranging from Iceland to the States. However measured, the sums are massive in relation to the size of the economies. As the rescue acts were accomplished by borrowed or manufactured money, the expectation gap must have widened considerably everywhere.
In the follow-up, an army of regulations is lying in wait at the door of the financial industry. Regulations are seldom conducive to the creation of wealth and those currently prepared, in a mood of general hostility towards money men, may do more harm than good. Rather than a raft of legislation encompassing the whole sector, it would make sense, in the interest of cost and transparency, to paint the doors of the financial institutions with three different colours: green for retail banks, residing in the High Street, amber for the corporate sector, and red for the more adventurous activities of investment banks, hedge funds and inventors of sophisticated financial instruments.
Walking through the green door, depositors would receive modest returns but have peace of mind. Their money would always be guaranteed by the government. The amber door would signify higher returns but also higher risks, with moneys invested in the material economy solely at the bank's discretion. A relatively simple set of regulations would suffice here. A red door would offer wonderful prospects, as well as the distinct possibility of complete financial wipe-out. Just like in any gambling joint, you pick your horse, or lucky number, and take your chances. As transactions here are between two private entities, there is no room for any government intervention beyond the existing civil and criminal laws.
Such an attempt at simplifying the financial world is bound to be met with serious objections. As an example, we will be told that short selling, conducted privately behind red doors, could damage perfectly sound commercial enterprises, hence the need for regulations. The damaging aspect of short selling is not in dispute. But fighting money with bigger money is more effective than fighting it with regulations. Each stock exchange, the DAX, the CAC, the LSE, and the NYSE, could establish a fighting fund, with relatively small contributions from all its quoted companies. So every co-ordinated shorting attack would face a possible counter attack by the fighting fund at a time of its own choosing. A few resounding defeats, with corresponding losses would see off unjustified shorting permanently. This is not such a far-fetched idea. The Chinese are already thinking of doing something very similar.
The whole trouble with the banking world is a virus so far officially unclassified. The name of the virus is marbleitis. Its origins go back at least to the 18th century, when every bank on the European continent was dressed in marble from the entrance steps upwards. The importance of marble cannot be exaggerated. It embodied wealth, durability, smoothness and class. It created an aura of awe so that ordinary members of the public shrunk to half their size and were lulled into a deep sense of false security.
Bankers always understood the impact of marbleitis and so have carefully cultivated it to the present day. The European Bank of Reconstruction and Development (EBRD) was established in the City of London in 1991. Its mission has been to foster the private sector in the backwaters of the continent. The newly appointed president of the bank, Jacques Attali, a pure product of the French elite and former adviser to the French President Mitterrand, had scarcely stepped foot in the splendid new building before setting out his priorities. The rather ordinary marble was ripped out and replaced throughout by specially selected, extremely expensive, Carrera marble imported from Italy. Here was a true banker who really knew what mattered in the banking world.
I do not know how many banks are still marbled, from head to foot, on the continent. But this no longer matters; the virus is firmly ensconced in the universal psyche. It is particularly infectious in the upper circles of the Bank of England, the Financial Services Authority and the Treasury. If not for marbleitis, how else do you explain the financial collapse and the absence of penetrating supervision? Or the 17 million pounds pension pot taken by the departing chairman of the failed Royal Bank of Scotland, Fred Goodwin, with government blessing? The attack on tax havens, too, is a popular move because it is seen as a punishment of the devious rich. Unfortunately, it does nothing to improve the situation. Insofar as it is successful, it merely transfers funds from private investors to governments who are less skilled, and less interested, in distinguishing between wealth-creating opportunities and popular projects that consume resources.
But it is the artificial, indiscriminate stimulation of the economy that matters most in distorting the shape of the recession and its aftermath. It is easy to applaud moves to help mortgage defaulters keep their homes, to rescue hard-hit industries, to reduce the number of jobless, to shield public services. They all help improving GDP figures, creating an atmosphere of confidence. This is supposed to re-animate economic activity and lift market sentiment, creating enough momentum to pull us out of the recession.
On the face of it, such an approach may appear reasonable. But it rather depends on the starting point and the NDP/GDP ratio of each individual economy. In developed Western economies, ignoring differences, the expectation gap is substantial, the NDP/GDP ratio is unfavourable, and the financial resources needed have to be borrowed or printed. All this makes for a lethal mix. Injecting resources you do not have widens a yawning gap still further. By going indiscriminately after growth, the balance between the asset positive and asset negative will deteriorate. Since we're in hard times, the instinct is to support those who suffer most, not the ones who are most productive.
So, in the final analysis, paradoxically, the more GDP figures improve, the deeper we sink into recession. I realize that this conclusion will be met with universal incredulity. It flies in the face of everything that is being said and done by those who guide our destinies. Nevertheless, the conclusion is the final logical step in the analysis that leads up to it. If there is a fundamental imbalance in any structure, the fault line will grow with its expansion. This is just common sense.
Taking Britain as a European example, the likely outcome is this: somewhere in 2010, the economic downturn will moderate, to be followed by hope of a significant and sharp rebound. This hope will be dashed because the improvement in GDP figures simply is no indicator of a true economic recovery. In a great measure, it reflects growth in government-financed activity, in the retail and service sectors that make up 75% of the rest, leaving little room to account for any change in the asset-bearing, productive part of the British economy.
The Government's cumulative borrowings will have exceeded the total borrowed over the last 300 years. So, from 2010 on, the government will be in no position to inject any resources into the economy. In fact, it will be under tremendous pressure to find the money to just maintain the built expectations of our society. As for the retail and service sectors, they piggy-back on the productive economy and live off the disposable income of individuals and corporate appetites. So no relief here.
The future prospects of other European economies are no less bleak. Although Germany and France might have better NDP/GDP ratios and are less burdened by the weight of government borrowing, they have difficulties of their own. Germany is forced to rethink its entire post-WWII model of economic success based on export-led growth, while France is saddled with a huge, unwieldy public sector, gobbling up more and more resources. The game is largely about cutting back expectations; and neither political establishment had any significant success in reforming labour laws, pension entitlements, and levels of over-all taxation in their countries.
In addition, the German economy is the principal support pillar of the European Union, and the financial backbone of the entire Eurozone. Without raking over the European map, it is fair to mention some exceptions to the dismal scene. Some of the central European countries, such as Poland and the Czech Republic, for example, are in a stronger financial position, having undergone painful reforms over the last one and half decades. They certainly feature fewer built-in expectations, with their people actually interested in working, not just securing better working rights.
China presents a contrasting picture to the European scenario. Even taking the official statistics with the proverbial grain of salt, for many decades now, the net revenues of the economy seem to have far exceeded national expenditure, be they public or private. Expectations, in terms of state provisions to the individual, have increased at a slower rate than the rate of growth of the productive, asset-oriented, economy. As an obvious consequence, the gap between expectations and reality in China is much narrower than almost anywhere else in the world. The evidence is there for all to see: the recession there meant a reduction of GDP from a 12% annual increase to a mere 6%; at the start of the slowdown, China had adequate reserves and resources to support its economy on a large scale without having recourse to borrowing or manufacturing money; at 67.7 percent, the NDP/GDP ratio continues to be far superior to that of the West.
The work ethos inspired by Confucianism and collective life just as deeply inhabits the industrial and commercial China of today. Worker output and worker entitlement are nowhere near those on an Occidental scale. Provisions in the field of housing, health, social welfare, pensions and justice are relatively modest and likely to remain so in the foreseeable future. Being still a half-way command economy, government intervention can be targeted to the productive economy and is likely to be far more effective since the money finds its way there with relatively little leakage to the banks. If the government decides to build 3 million new homes, the land, money and materials will be at the disposal of the contractors, and the houses will be occupied promptly on completion, by tenants paying rents within their government-ensured means.
For these reasons, the outcome of the global recession should be very different in China than elsewhere. Although their consumer-related export industries have suffered heavy blows and domestic demand is seriously underdeveloped, the country has the will and the means to restructure its economy. It will turn inwards, moving to a greater degree of self-sufficiency while still maintaining an impressive momentum.
Can we be as optimistic about the USA? The simple answer is 'no'. The fault line in its economy closely resembles European weakness. Over the last 40 years, the country moved backwards from world dominance built on a strong, well-balanced economy with ample financial reserves, a stable currency, substantial budget and trade surpluses, to a shadow of what it once was. The dollar, still the only true world reserve currency, is no longer stable. The nation has become predominantly a consuming, not a producing, society. This has got to such an extent that the national economy can no longer fund its own consumption, but has to rely instead on foreign countries that primarily use America as a receptive market for their own ever-improving, highly competitive products. The result is a dismal catalogue of self-inflicted woes: burgeoning budget and trade deficits; a collapsing property market; failing industries; steeply rising unemployment; a whole economy that has to
be bailed out with many trillions of dollars the US just does not possess.
It is true that America has huge natural, technological, military and human resources, far superior to those of Europe. In a world of lightning changes, such resources, well fostered and intelligently deployed, could make all the difference. But for this to happen, the entire culture of the economy would have to change. But such a radical change is made possible only by a great shock to the whole system.
Human beings, sadly, learn mostly through pain and this applies with equal force to their economy. Deep recessions are not the product of a banking tsunami. The misery they bring are warning symptoms of things being radically wrong. Missing the symptoms or mistaking them for the root causes of the illness is much more damaging than the initial recession itself. By widening the expectation gap even more, the leaders of the West will have, in the medium term, deepened the crisis. But, even worse, they will have missed the great benefits wrought by every major shock to the system. Only when the crisis bites really hard, is it possible to reassess the profound economic imbalances and redress the expectation gap. The problems of unrealistic state pensions in France, of stifling labour laws in Germany, of an insatiable welfare state in Britain, of an ungovernable Italy, and of unsustainable financial governance in the US, could become at a stroke less intractable. People across the West would have to lower their material expectations simply because the money would have run out.
Among the worst offenders in this regard are the politicians and officials of the European Union who continue, in their habitual way, to pile on admirable regulations irrespective of attendant costs, setting the EU and the entire Eurozone on a course to economic irrelevancy. Yet the recession offers a once in a lifetime opportunity to substantially reform the Union and save it from a painful disintegration.
It is highly unlikely that, at this late stage of the recession, Western leaders will change tack. It is safer to assume then that they will continue to use all their financial means to boost confidence, relying on GDP growth. This means, of course, raising the bar of expectations even higher without developing the corresponding asset base . In the aftermath of the crisis, the global economic centre of gravity is bound to shift from West to East, from the relatively affluent, spoilt societies of the European and North American continents, to a more industrious and more hardened China and its satellite countries in South East Asia. When this tectonic movement, with all its implications, becomes apparent, historians will record the current crisis as a convenient point of reference.
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