This is a long piece - probably too long to be read easily in a blog post. A pdf of the article is available here. Might be a good idea. . .
Recently, investors have asked me repeatedly whether we are staring at the ‘End of Days’. After some thought, my answer is ‘Yes’. This longish piece is an attempt to explain and elaborate what I mean by it, why I think it is upon us, and where we go from here.
First, what do I mean by it? I mean that the assumptions and policy reactions underpinning economic policy, and generating outcomes both for the economy and for financial markets, are exhausted. Rather than solving problems, the default conventional wisdom is now compounding problems. As a result, the incentive structures within which we think and work, currently are more likely to result in bad choices rather than good ones. Our attempts to project a future based on those familiar stimuli and familiar assumptions, are likely to be either ineffective or, at worst, actively mislead us.
If this seems a baffling or obscure way of explaining what I mean by something as apocalyptic as End of Days, I can perhaps make things clearer by explaining what it was like last time we entered such a phase (of economic policy, of financial markets, of economic wisdom). I was born in 1961, and for better or more probably for worse, I have been trying to understand economics, and why economies go wrong, since I was about 12 years old. (Yes, I was that tiresome and precocious child.) I was initiated into this by the constant struggle with which my father attempted to keep the family textile firm alive. By the mid-1970s, as he explained the way various demand and supply-side forces affected his business, it was just abundantly clear that the bastardized late-period ‘Keynesian’* policies of government intervention were no longer capable of addressing the problems they had fostered. Indeed, they were observably doing more harm than good, even as he was paid subsidies to maintain his payrolls.
Nonetheless, all public commentary was framed within that ‘Keynesian consensus’, and, when people started teaching me ‘economics’, first at school and then at Oxford, it was that framework which still crowded out the syllabus.
But I got lucky: in the late 1970s, whilst I was still at school, I was bought Hayek’s 1975 book of essays. With its emphasis on how the microeconomics of firms’ production could be distorted into inefficiency by transitory inflationary demand, its account of the damage done to investment patterns by ‘Keynesian inflation’, and, most of all, its insistence that the whole justification for markets was their ability to discover information which was discoverable in no other way, it was a revelation. I cannot tell you how exciting it was to figure out just how things could go wrong even when marginal revenue equalled marginal cost!. It was a revelatory because it allowed me to understand how and why the current understanding of economics had become damaging. And, almost literally, I could see its truth written on the worry-lines of my father’s face.
Whatever one may think of his legacy, Hayek had correctly identified the End of Days.
Ultimately, though, the test was not whether Hayek was right in all his analysis and policy prescriptions. The test was that the answer to the question ‘if we carry on with the policies we’ve always used,, will things get better’ had become obviously and emphatically ‘No’.
It took a few years of compounding misery (aka ‘the ‘70s’) before the End of Days was recognized in the election of Margaret Thatcher’s Conservatives in 1979, and more years still before the collection of assumptions, attitudes, errors, indulgences and blind-alleys which resulted hardened into the sort of settled consensus which the Keynesian consensus had been before it.
It is in this sense that I think we have reached another End of Days. If we ask ‘will the policy defaults, underpinned by economic assumptions, which have guided us over the last few decades, solve the problems currently facing our economies?’, then I think the answer is emphatically ‘No.’ Doubling down on the globalization of the economy, global financialization (by which I mean that the major recipient of global credit creation turns out to be the financial industry itself), global ‘free trade’ and ‘flexible labour markets’ at this stage is likely to compound current miseries, not relieve them.
At this stage, I need to ask for your patience and indulgence: of course I understand that these descriptions are imprecise and perhaps even contentious. That is partly a pretty inescapable product of some of the conceptual and practical errors obfuscated in the language generally in play in economic and financial discussions. Things may get more precise as the argument develops. In fact they must, because some of those errors concealed in the obfuscatory language turn out to be important.
Starting Point: The Hinge of the Global Economy
The logical place to start in describing the exhaustion of the current model of globalization/financialization is in recognizing the central dynamic relationship which dominates current global production and investment. The central hinge upon which the global economy turns is the relationship, very broadly, between Western demand and Asian production. This relationship between global supply and global demand determines not only global current and capital flows, but is also inescapably a major factor in determining domestic financial activity (saving, borrowing, investment) on both sides of the equation. Although there have been periodic attempts to believe that NE Asia is decoupling out of this relationship, the evidence suggests, if anything, that the relationship has become tighter over time. The link can be illustrated by comparing changes in G3 import demand and NE Asia export performance.
If, in fact, we are facing the End of Days, we need to ask if this applies at both ends of this central relationship, or whether the breakdown is confined to either the Western Demand end of the model, whilst the East Asian Supply model remains vigorous and viable?
The Supply Side Issue
It is easiest to start at East Asian Supply side of the equation, because the central actor here is China, and it has been obvious to all - and not least to China’s leadership - that the model which drove China’s historically-unprecedented rise has been pressing against its limits. More specifically, it was starting to generate problems which were genuinely threatening to its continued viability.
China has been the largest ever practicing exponent of exogenous growth theory. Whittled down to its core, this theory asserts that a major reason why one country is poorer than another is because its productivity is lower, which in turn is a function of the amount of capital each worker brings to the task. Hence, rapid growth and rapid productivity growth can be generated by a policy of financial repression to discourage consumption and provide a plentiful flow of cheap savings for investment. At the early stage of the model, rapid accumulation of surplus savings to fund capital accumulation is what matters above all, certainly more than concerns about return on that capital. With domestic consumption restricted and relatively indiscriminate capital stock growth accelerated, the country will inevitably produce more than it can consume. The surplus production, then, is exported, with the assumption being that there will always be sufficient exogenous demand to soak up the surplus production. Note that excessive trade surpluses are not the aim of the policy, but rather its inevitable and logical outcome.
The model ultimately develops several problems. First, when the economy approaches its ‘technological barrier’ then, in association with the law of diminishing returns, it becomes more and more expensive to generate addition output. This is a complex area which is not fully avoided by simply discovering access to the latest technology, or even by ensuring the workforce is sufficiently educated to deploy that technology. For ‘technological barriers’ will also tend to include a series of institutional factors, including the predictability of the legal system and legal protections for both physical and intellectual property.
Second, as the technological barrier is approached, and further relative progress becomes more and more expensive, so the hazards of neglecting return on capital begin to be discovered. At first this can be seen simply as an ever-rising demand for leverage in response to falling returns. If this demand is always indulged, it must eventually morph into systemic bad-debt problems and systemic financial weakness as banks discover not only have they a load of bad loans on their books, but that the pricing of other financial assets has also been wrong.
And third, owing simply to China’s size relative to the rest of the world, the assumption that all surplus production can be painlessly exported will come into question. The limits can be expected to be discovered sector by sector,
After decades of unprecedented success, it is clear that China is coming up against its technological barrier, and that the long-term problems inherent in the exogenous growth model have arrived. The evidence surfaces in a number of areas, and tells the story consistently.
At the crudest level, my return on capital directional indicator, which expresses nominal GDP as a flow of income from a stock of fixed capital, has shown two separate periods of decline. The first period of decline showed up in the later 1990s, and although this decline was arrested throughout the mid-2000s, the second decline set in in the aftermath of China’s credit-splurge in came in 2009/10.
More directly, we can measure how securing market share of Northeast Asia’s exports became more and more expensive in terms of accumulating capital stock. The following chart compares the relative build-up of China’s capital stock and its share of Northeast Asia’s exports. Between 1990 and the early 2000s, the equation was fairly simple: build capital stock in part by encouraging industrial relocation out of Japan, S Korea and Taiwan, and export market share was gained accordingly. However, by the later 2000s, the numbers were already showing that it was becoming increasing expensive to ‘buy’ market share simply by raising relative capital stock.
As the second chart shows, the gains became more difficult to sustain after around 2005, and after the financial crisis China has had to throw more capital stock into the competitive battle than the rest of NE Asia in order to win or even sustain market share of exports. That decline has not yet stabilized.
The natural result is that the efficiency of finance has deteriorated sharply. Even taking into account the recession of 2000/2001 in the five years to 2005, an extra Rmb 1bn in bank lending to the economy was associated with approximately Rmb 1bn of extra nominal GDP. Subsequently, that relationship has soured dramatically, and despite attempts to discipline bank lending, in the five years to 2018, Rmb 1 bn in extra lending was associated with only Rmb 480 mn in extra nominal GDP.
The good news is that China’s authorities are extremely clear-eyed about the problem, having fretted about it, and laid plans to deal with it, for at least a decade. The bad news is that making the change from this sort of exogenous growth model to one which is driven by consumer demand and return on capital is about the trickiest traverse in economic governance. Doing it successfully whilst avoiding a major financial crisis is rare. Nevertheless, this is what China is trying to do.
This is recognition that at least one side of the global economic model - the China supply-side - has reached its limits.
But merely laying out how China’s growth model is running up against its inevitable limits actually misses the whole point of the exercise: the model has been fantastically good at lifting hundreds of millions of Chinese out of grinding poverty and into material decency, and even affluence. I suspect that no such mass alleviation of poverty has been achieved ever in the history of mankind. It is a genuinely stunning achievement.
And yet,this success is also being challenged and to some extent undermined by a problem which is also undermining the demand side of the picture: rising inequality. Taking data from the Standardized World Income Inequality Database (https://fsolt.org.swiid/), the rise in China’s Gini coefficient has been dramatic. This measure of income inequality pitches china as having the most dramatic inequality of any significantly industrialized economy: more unequal than Singapore (where the Gini coefficient runs at 38.6) and only slightly less unequal than Hong Kong (Gini coefficient of 41).
Below I shall argue that there are economic costs to widening inequality, particularly if profits are to any major extent dependent on domestic demand. I cannot honestly claim to know how this inequality is experienced in China, or to what extent it has become a significant factor depressing the potential for generating profits from domestic demand. I simply do not have the necessary data.
However, it is said that the unofficial neologism ‘qiou’ has has been dubbed the word of the year for 2018. It is a mashup between three characters - 'qiong', meaning poor, 'chou', meaning ugly, and 'tu', meaning earth. Taken together, the character essentially means "poor as dirt and ugly." ‘Dirt poor’ - the word of the year in China.
Western Demand: Profits & Wages
The symptoms of the exhaustion of China’s exogenous growth model are easy to understand, easy to illustrate, and not controversial. What about the other side of the supply and demand equation: Western demand? Here the problem is more difficult to articulate and demonstrate. However, an initial stab at the locating the problem is to recognized that China’s production has been satisfying Western demand which previously would have been met by Western production. To some extent it is true, then, that elements of Western production have been idled as capacity has relocated to China.
So what? After all, the argument goes, if China offers cheaper goods than domestically-produced ones, then the consumer gets a better deal, releasing more spending power for other areas of economic activity. Everyone benefits from discovering and exercising comparative advantages in free trade. And if globalization results in rising profits for domestic companies, those profits will be recycled back into the economy via the financial system - Say’s Law after all ensures it. Eventually, globalization drives up outcomes for everyone.
If that argument is correct, then talk of the End of Days is mere panic-mongering. But the problem with Say’s law is that as inequality rises, so its smooth operation becomes increasingly dependent on an effective and efficient financial sector being able to re-allocate the savings surpluses of the rich in a way which compensates for the demand shortfall of the poor. And here we already find two problems: first, that the financial systems of the West have tended to re-allocate the savings of the rich around the globe, rather than in the domestic economy. Second, the GFC demonstrated quite effectively that the West simply doesn’t have an effective and efficient financial sector.
But there is a third problem with assuming that Say’s law will alleviate the problems of the displaced West. For it assumes that the problem to be solved is essentially one of maturity mismatch, in which the savings of the rich can be lent to the recently displaced who are suffering an unexpected but essentially temporary disappointment in their income. But if the problem is not cyclical or temporary but is essentially the result of cyclical change, lending to the displaced sector of the Western economy is no answer. Rather, the accumulating household debt accelerates the underlying pauperisation of those displaced by ‘globalization.’
There are also terrible problems with the ‘comparative advantage’ assumptions, which are commonly heard to justify the ‘short-term displacements’ of productive activity from the West to the East. The argument of comparative advantage upon which the doctrine of the benefits of free trade is based is among the most elegant in economic theory. It is hugely appealing. But in a world in which capital, knowledge, technology and skilled labour are all globally mobile, these arguments simply fail. In fact, given the proper incentive structures and sufficient provision of capital, almost any ‘national comparative advantage’ can be bought and constructed. This is, after all, the assumption at the very heart of ‘exogenous growth theory’.
Moreover, to the extent that these days ‘comparative advantage’ is found mainly the economic benefits generated by industrial clusters, there’s a likelihood that competitive advantage can and will be bought outright.
The alarming implication is that right now ‘free trade’ does not necessarily grant the win-win result for both economies as is commonly assumed. Indeed, it is quite likely to result in a win-loss result.
For both these reasons - the likely absence of Says Law, and the breakdown of free trade arguments - this is the right time to acknowledge a crucial part of the evidence which tends to be overlooked in our neck of the woods. It is time to think about the rise in income inequality.
The Global Rise of Income Inequality
A starting point here is to acknowledge the rise in the Gini coefficient, which tracks the cumulative proportions of the population against cumulative proportions of income they receive. Perfect income equality results in a score of zero, perfect income inequality (ie, one person receiving all the income) results in a score of 100.
Everywhere, Gini coefficients have risen since 1980, with the rises being particularly sharp in China, Japan and the US, and relatively muted in the Eurozone (proxied here by the average of Germany, France, Italy and Spain). In China and the UK, and perhaps in Japan also, there are signs that the coefficient has peaked. In the UK at least, this decline since 1999 is almost certainly a reflection of the total rise in the rate of employment, from an average of 72% in 1999 to 75.5% in the latest 12m.
However, it may be that broad measure of the Gini coefficient is not capturing the structural change and challenge of inequality. For the problems associated with rising inequality, and the political repercussions it is bringing, may be accentuated by new patterns which are fundamentally regional, rather than simply ‘class’ based. This is certainly suggested by the geographic fissures expressed in the current wave of Western political discontent, seen in the rebellions in the US (the Trump presidency), France (the gilet jaunes protests), Germany (the rise of the AfD) and Italy (etc).
But this is not easy to demonstrate. However, data from the UK provides one way of illustrating the way in which rising regional inequality is breaking down the cohesion and coherence of the ‘national’ economy. In a ‘coherent sample’ of regional income distribution in a single economy one would expect to see a basically Zipfian distribution pattern, with a tight and predictable relationship between the size of income and its relative frequency, albeit with exceptions at the top and bottom ends of the distribution. The UK has produced annual surveys of average household income broken down into 179 regions since 1997. The 1997 survey expressed a basic Zipfian distribution pattern reasonably well.
(See this piece.)
This coherence was maintained over the next decade. But by the 2016 survey, the relationship was looking extremely ragged. Indeed, I suspect if you put an AI engine to work on the data, it would suggest at least two different relationships emerging here.
If rising regional inequality is undermining the assumption that the UK is, economically, a ‘coherent sample’ it has profound implications both for politics and rational economic policy-making. The political implications are obvious: the web of commercial and financial relationships by which a society is bound together is coming apart. Or to put it bluntly, what happens in, say, Weybridge no longer has economic implications for, say, Leicester. (My apologies for picking on Leicester: it features here because its citizens have a gross disposable household income of less than £13,000 pa). And this has two further implications: first, what is spent in Weybridge may have no implications for demand in Leicester. And second, the assumption that economic, monetary and fiscal policies set at national level can be expected to ‘deal with’ problems in Leicester is undermined.
How much more at risk is the assumption that policies designed to promote ‘globalization’ are likely to help Leicester. Note, in fact, that in all likelihood the flaws in ‘globalization’, with its likely structural interruption of Say’s Law and its blindness to the failure of comparative advantage, are likely to be contributing directly to Leicester’s plight.
To which one possible answer is: ‘So what? End of days for Leicester, perhaps, but hardly a reason to involve the rest of us.’
Inequality and Profits - Cyclical and Structural
The answer is twofold. First, of course, is that the Leicesters of the Western world are already in revolt, and some sort of policy response to that revolt is inevitable. Pressing on with the policy-assumptions which have produced that revolt only make it more likely that the eventual policy responses will tend to be destructive rather than constructive.
The second answer is that eventually inequality can not only torpedo the business cycle, but undermine profits over both tactical and strategic time-frames. These outcomes are not immediately obvious, and consequently do not feature in most current economic analysis. I have, however, written about them recently in this piece.
‘The signal I am watching is the fluctuating relationship between profits and wages. At some level of description it must be true that there is a relationship between how much profit companies can make and the amount of money they pay their employees. If so, then when the balance between the two reaches a local extreme, it is likely to beckon a recession.
‘In inflationary times, this is easily understood: when labour markets become extremely tight (for whatever reason, crucially including the incentives embedded in the economy's political structure) and wages rise, a combination of rising inflation and declining profits can undermine return on capital, investment spending, with obvious cyclical consequences. The crucial signal, in this regime, is when wages peak relative to profits.
‘In disinflationary times, the situation is less easy to understand and spot for at least two reasons. First, since the crucial signal we need to watch is the when profits are peaking relative to wages, by definition it occurs at a time when profits are booming. Second, whereas the inflationary impact of sharply rising wages is obvious and invites a monetary tightening response from central banks; the disinflationary opposite shows itself as an otherwise inexplicable inanition of demand, which can at least initially be offset precisely by increased consumer leverage, which delays the onset of recession and disguises its underlying motivation. But notice this: if consumer leverage is used to delay or offset the imbalance, the result would be a build-up of consumer debt which over time will tend to tighten the relationship. Leverage initially disguises the pauperisation of the middle class, but eventually confirms it.’
For the track record of the relationships between the peaks and troughs of this relationship, and the onset of recessions, please check out the full piece.
At present, the relationship between wages and profits has been sliding since around 1980, and fell to the lowest level since 1929 in 2014. After a distinctly feeble rally, it began to fall again in 2018.
My earlier piece suggested: ‘If we are looking for a disequilibrium which gets its resolution through a recession, then perhaps this is it. Perhaps the slow-acting pauperisation of the middle class generates a profits recession by sheer financial inanition.’
Profits Have Peaked Already
That remains a mere suggestion. But what is already observable fact is that by 2018, in most economies, profits had already peaked, and in most cases were in retreat. The analysis which shows this is the Kaleckian profits equation, in which changes in profits are exhaustively determined by:
Changes in household savings positions
Changes in government savings positions
Changes in the net savings position of the rest of the world with the domestic economy.
The great attraction of this Kaleckian insight is that it has the logical force of a straightforward accounting identity, whilst at the same time granting an insight into the ‘source’ of profits at a macroeconomic level, rather than a company level. If Dupont analysis is the definitive key to understanding changes in a corporate’s return on equity, Kaleckian profits analysis is the definitive key to understanding changes in profits at a macroeconomic level.
Here’s what the Kaleckian profits calculations are showing in the 12m to Sept 2018:
US: +8.9% yoy 12ma
UK :+2.9% yoy 12ma
Eurozone: Down 1.9% yoy 12m
Germany: Down 7.5% yoy 12ma
Japan: Down 12% yoy 12ma
S Korea:: Down 14.1% yoy 12ma
Taiwan: Down 4.5% yoy 12ma
In every major economy I track except the US and the UK, profits are falling. And even in the US, it is not entirely clear that profits have not already peaked: on a 12m basis, there was no growth between the 2Q and 3Q.
Moreover, in every case except the UK and Taiwan, the change in contribution towards profits made by the change in household savings behaviour undershot the overall movement in profits. In all these cases, then, pressure on the household sector resulting in more cautious financial behaviour is undermining profits growth.
H’hold’s contribution to Kalecki Profits:
Eurozone: Down 6.6% yoy
Germany: Down 42% yoy
Japan: Down 14.9%
S Korea: Down 47.2%
There is not a single case in which household sector choices are any longer driving profits growth.
In the US , the proportion as a % of GDP has been essentially unchanged since 2010/2011/, in the UK stable since around 2016;
In the Eurozone it has been in continuous decline since 2010; in Germany it has been in decline since 2006;
In Japan it has been in decline since 2014; in S Korea it has been in decline since 2010/2011; in Taiwan it has been in decline since 2013.
End of Days - Summary & Conclusions
The piece has argued that on both sides of the global supply and demand hinge, the models which have previously driven behaviour have exhausted themselves. On the supply side, China’s exogenous growth model some years ago reached the point of quite dramatically diminishing returns as the country approached its ‘technological barrier’. It is currently engaged in the difficult and financial dangerous attempt to traverse from an exogenous growth model to an endogenous growth model. It is the most difficult traverse in the literature, and has defeated many political systems before now (for example, the USSR).
On the demand side, globalization’s internal logic has undermined the economic advantages expected by ‘comparative advantage’ arguments for ‘free trade’, and at the same time has interrupted the workings of Says Law in domestic economies. Moreover, by mistaking the disruptions and dislocations caused by a radical re-allocation of the global means of production as a temporary/cyclical phenomenon rather than a structural shift, debt dynamics have at first delayed but subsequently asserted the pauperisation of the working and increasingly middle classes. Income inequality has risen everywhere, but the broad totals probably mask even more damaging regional inequalities which threaten to undermine the coherence and inter-connectedness of national and even regional economies.
This has now reached the stage where not only is there widespread concerted political revolt, but in addition, the resulting pressures on the household sector have become a drag on the ability to grow profits. In the short term, it is possible that this is a cyclical phenomenon - although it appears to have become so widespread over the last decade that this seems unlikely. More radically, the relationship between wages paid and profits made has become more strained than at any time since the 1920s, suggesting that, at best, new limits are being explored.
The arguments I have put forward here are, I think, consistent and coherent, although the evidence for each stage of the argument has been drawn from a number of different economies. The main reason for this is the availability of data - this argument has not, after all, drawn on many of the mainstream ideas currently fashionable. Still, such cherry picking may give a misleading impression of uniformity of circumstance, and ascribe a fake universality to the picture I have drawn.
However, set against this caveat, let’s remember that the question that needs to be answered is this: ‘If we carry on doing things as we have been doing, will our problems be solved?’ If we accelerate industrial relocation, accelerate globalization of capital and income flows, accelerate the casualization of a global labour force, and rely upon credit creation to deal with the consequences felt by the Western working and middle classes, will the problems identified get better. I find it hard to imagine the answer is ‘Yes’. If you can’t answer ‘Yes’, then we are drawn to the conclusion that our current model is exhausted, and it is, in fact, the End of Days, 40 years after the last End of Days.
One final thought.There is a vicious cycle in which bad policies make for bad economies, which in turn foster worse policies. It is one of the worst and most depressing ironies that in a number of Western economies (UK, US for example) the political response to current woes is Socialism. In the UK particularly, the sort of bone-headed socialism currently offered to the electorate is a sort of reductio ad absurdam of the vicious cycle. The good news is that it looks quite possible to address the situation without recourse to such self-harm: ultimately what is needed are sets of incentives which encourage firms to retain and invest in their workforce, which in turn encourages workers to re-discover the returns to loyalty, and which recognizes that the social costs of the casualization of the workforce will be recovered from companies whose business model depends upon it. Re-imagining a fiscal system to accomplish this does not seem utopian.