Economic recovery or false dawn?

Which came first? The chicken or the egg? In the context of Keynesian economic wisdom the answer may be "Neither". Both had to come at the same time...well, at least about the same time.

This is how contemporary economic analysis works. It's all about establishing a balance; and equilibrium.

Going by economic news in the recent fortnight economic data suggests positive results in China and Western Europe. Going by the stock markets, even Bursa Malaysia, investors are regaining a sustained confidence that the worst is over.

But, then, if we go by that great contrarian, Nouriel Roubini, what we are seeing is the be upward climb of what he expects to be a "double-dip" recovery or a "W". In a sense, he's in good company with many economists. The caution given by Chinese Premier Wen Jiabao is also consistent with this line of sentiment.

Reasons for the "false dawn" caution
Almost every government in the world has, in the course of 2008-2009, implemented stimulus packages. Every government budget is in deficit. Now deficit spending in and, of itself, is not unusual since the conventional Keynesian wisdom is that if the private sector is hesitant, the government puts in investments so that an economy will equilibrate at a higher level than before. This is called economic growth.

Stimulus spending is quite different from the garden-variety deficit spending. A stimulus requires excessive investment that is designed to prevent an economic contraction.

To finance this type of deficit-stimulus spending, governments the world over have created large amounts of sovereign debt. These are Treasury bills, government bonds or, whatever they are called. It means that the government is borrowing money to spend. The idea is to spend so much money that the nervous citizens become convinced that they need no longer be nervous and, they should start spending again with great aplomb and confidence. This is called consumption.

Now, let's take a look at the Chinese economy in this context.

Many economies, including Malaysia, are looking to China as a panacea that may reduce significantly or, remove completely, the global economic malaise.

Private consumption is running at about 36 percent of GDP in China right now. That is half of the US consumption rate, and it’s about two-thirds of the consumption rate of Europe.

Bolstered by a $586 billion government stimulus program and a surge in lending by state-owned banks, many expect China to be the first major economy to bounce back from the global recession.

But, many economists realise that the composition of China’s growth remains unbalanced. Aggressive increases in government spending and investment by state-owned enterprises has cushioned the impact of weak exports. But the increased government spending have not been matched by comparable increases in private consumption.

It is a fact that spending by Chinese households as a percentage of GDP is only half the US consumption ratio and remains significantly below private spending levels in Europe and Japan. Worse still, despite rising sales of items such as automobiles and household appliances, the ratio of private spending to GDP in China today has actually fallen relative to Chinese spending levels of a decade ago. Clearly the Chinese households are being very guarded.

Social safety nets and consumption
China has some similarities with Malaysia in that both countries have relied on the so-called investment-export model of economic planning.

The other similarity may be the absence of significant social safety nets.

China doesn’t have a complete social-security system. As at 2007, only one-third of the urban population was covered by the social-security system. And for rural residents, most of them don’t have social security. And also in past years, the cost for education, for medication, for housing has increased quite rapidly—much more rapidly than GDP growth and income growth. The same may also be said of Malaysia.

One of the main obstacle to boosting private consumption in China is to persuade a large generation of Chinese workers and families who have been displaced under the guise of state-owned enterprise reform—who have lost the sort of cradle-to-grave support, the so-called iron rice bowl, the safety net that had been in place in the prior state-owned enterprise regime—to convince them that it’s okay to begin to draw down the excesses of precautionary saving.

Income-gap and consumption
Some economists have observed that income distribution has a significant impact on consumption and, that, therefore, the Chinese government needs to make some adjustments to reallocate income distribution—how much goes to citizens, how much to governments, and how much to enterprises. This is a macroeconomic adjustment that can be achieved with new fiscal policies, including changes in tax policy.

In Malaysia's case, income disparity is also widening. This means that the tax-base remains narrow which has an impact on the government's ability to fund its budget deficit.

Social safety net financing and impact on consumption
Increased spending on social security may not necessarily lead to increased private consumption. The key issue may be how social security is financed. This goes back to the matter of deficit spending.

A case in point is the rural health insurance in China, which is subsidized by the government. The presence of this type of subsidy prevents the phenomenon of crowding out. The rural Chinese are not required to spend a lot to purchase health insurance. This created enough disposable income such that consumption increased.

The bottom line is, if people feel that there is a social safety net, they will have greater confidence to apply their disposable income to consumption. Otherwise, the instinct is to save.

Consuming our way out of an economic debacle?

Getting the Chinese to increase their consumption cannot be the solution to global economic recovery. China's economic is only one-third the size of the U.S. economy. Moreover, the consumption behaviour of the Chinese consumer is so markedly different from that of the U.S. consumer. Hence Premier Wen Jiabao's caution.

And, we do have to wonder whether this use of the Keynesian paradigm to examine economic issues is still valid? It probably is, but, we will do well to constantly ask this question albeit at a philosophical level. See my posts on conspicuous consumption.

The reason for the issue of consumption to be raised is that consumption is one of the elements of the Keynesian economic model. In the desire to equilibrate, many economic thinkers and planners are looking to boost the "C" component to match the "G" and "I". For a recap on this last bit, please check the post I made earlier, Stimulating the G-spot.

Re-visiting Veblen

Some time ago I wrote about Thorsten Veblen and his thesis on conspicuous consumption. In almost all economic news of late, the overt intention of most governments is to implement stimulus packages that are intended to stimulate consumer demand.

What kind of consumption is are governments talking about?
Do governments want consumers to consume anything and everything that they can afford? Or, do they mean basic necessities? Basic necessities have to consumed anyway to provide humans with a comfortable living.

Do the governments also hope that consumers will also consume luxury goods also? That would appear to be the case. Consume. Consume. Consume.

Maslow's hierarchy of needs
Abraham Maslow was quite a guy. You can read about his theory on the hierarchy of needs here. This basic construct of the psychology of consumption has influenced generations of management and marketing people.


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Where are your needs within this hierarchy? In our modern society, unless you are poverty-ridden, we head straight for the top. We always perceive ourselves at the level of self-actualisation.

Beyond the brief language of the pictogram above, modern corporations have adopted a detailed understanding of the need for Esteem and Self-actualisation even more than we can imagine.

Advertising stimulates conspicuous consumption
Maslow's pyramid is the foundation upon which the entire advertising industry frames their marketing and promotional campaigns for corporations.

The idea is to tell the consumer that he or she will have better self-esteem if they are seen to own and consume certain luxury products. Thus, a Perodua Aviva is different from a Toyota Camry. Thus, a Poh Kong diamond is different from a Lazarre diamond.

The idea is to tell the consumer that he or she is seen to have arrived at the peak of the socio-economic ladder, self-actualisation, when they are are seen to own and consume even more expensive products. Thus, a Toyota Camry is different from a Mercedes S320. Thus, a Lazarre diamond is different from a Tiffany diamond.

The production trap
The role played by advertising to stimulate desire and, therefore consumption and demand is only one aspect. This is where I will try to get to what I believe to be the structural problem with modern capitalism, the production trap.

This expression, production trap is an expression that I hope to have just coined. And, if some great economist has coined it earlier I will immediately offer my apologies.

What do I mean by production trap? Briefly, I want to draw your attention to the ridiculous situation where almost every product undergoes model and design changes within very short periods of time.

Just staying with the car analogy. I seem to recall that prior to the 1980s, a new car model launched will stay the same for at least four to five years with some very minor modifications. Since the 1990s, car models are changing every two years.

Even if you don't have any inkling of production costing, you will know that when the shape of the car model changes, when the dashboard changes, when the headlights and rear lights change, all these mean that a lot more money is being spent on industrial design, production of new parts and even more advertising and promotion.

The basis for this trend of quickening model changes is competition.

This leads to ever more rapid consumption and discarding of old models. Multiply this phenomenon a billion-fold to every single product (other than meat and vegetables) and you will get the picture of the production trap i.e. the reckless and continuous production of similar goods and services in the name of capitalistic competition to meet the redundant wants of consumers whose needs have been more than fulfilled.

The RM64 billion question (it used to a RM64 question but, now got hyper-inflation) is, how does modern humankind get off this careening and bumpy wagon?

Now, THAT would be a thesis that is worthy of a Nobel prize.

Market turmoil: How the s*** hits the fan

Call me old-fashioned, I don't care. I've never believed in financial instruments, especially the genre they call derivatives. No, not for me these sexy tools that financiers and stockbrokers use to manage risk. My feeling was always that the guys who created these instruments were just trying to make a fast buck (via handling commission) at the expense of greedy (and hapless) investors.

But, of course, I simplify. And, why not? It would seem that the entire financial edifice that has been created since the late 1980s is built upon two basic principles; profit and hedging risk.

Let's look at each of these twin pillars, shall we?

The fallacy of endless profit
I call it a fallacy because wise men know that everything and, I mean, EVERYTHING, follows the laws of Nature, particularly physics. What goes up WILL come down.

Everything has life-cycles. Every single living thing. And, companies and their products are no different. They are introduced to the market. Initial popularity brings in revenues. Forecasts of revenues go up and up. Grand announcements are made to improve the product. Worst of all, plans are made and implemented, to raise money from investors and banks to finance expansion. Then, Lo! and Behold!, the demand for the product falters. The product's life cycle is waning. Revenues fall. The company gets into financial distress. Investors cry foul. Banks commence legal action.

Conspicuous consumption
The term conspicuous consumption was introduced by the economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. Veblen used the term to depict the behavioral characteristic of the nouveau riche, a class emerging in the 19th century as a result of the accumulation of wealth. Veblen's brilliant insight is still relevant today.

Just open any glossy magazine and you are inundated with must-haves; cars, clothes, jewellery, mansions. The expression keeping up with the Joneses is an understatement. In this era it is more like shove it up the Joneses faces.

This wannabe phenomenon is pertinent to what I'm saying, because how does one finance an aspirational lifestyle? The drudgery of one's day job is just enough to pay the mortgage on the house and car and, household expenses. But, to get the extra edge you have to put your money to work. EPF annual interests is hardly enough for one roti canai a day, or so many think.

So, this impetus forms the base the world over. Pension funds are under pressure to put the money to work. Insurance giants, like AIG, are under pressure to put money to work. Banks are under pressure to put money to work.

Putting money to work
At this stage, the money is called investment funds. Somehow, by the stroke of a financial wizard's wand (or pen or PC, whatever metaphor you wish), one's hard-earned savings becomes available to the financial wizards (but, are they really wizards or, like Mickey Mouse, they are merely wizards' apprentices?).

In its most basic form, money can work for us when we buy property to rent out or, arrange for fixed deposits that yield a periodic return. For more excitement, one will trade in ordinary shares of publicly listed companies. Here one can receive a paltry dividend and, possibly capital gains from rising share prices. That is the upside. The downside is that share prices can fall, too. But enough of this. This is not a story about small investors.

How do banks and investment funds put our money to work? Yes, it is the money from deposits and pension contributions. And, they put the money to work everywhere. They buy shares of publicly listed companies. They invest the money in debt securities like bonds and derivatives.

But, these young boys and girls who work in banks and investment funds are smart kids. They realise that with their money being invested all over the place there is this thing called risk.

Managing risk
I'm no financial or mathematical expert. I was very far, far away from being even remotely competent in my Additional Maths in school. But, like you, I do know how to grasp, in a very loose sense, some concepts, like risk. Basically, its a cool word for the idiom, don't put all your eggs in one basket but at a higher order of thinking, of course.

As far as I understand the evolution of the financial instruments called derivatives, it arose when investment bankers and funds realised that there is a value to being able to calculate differences between the yield from one instrument in one place with another instrument in another place. These differentials, as it turns out, can be turned into new financial products and be traded. There was money to be made from trading on these financial products that had very minimal links to the real world. These financial products were derived from real products like bank loans, bonds or shares and stocks, hence the moniker, derivatives.

So, new products kept being conceived by bright, young mathematically-minded, economics or business-trained hotshots.

To borrow a hackneyed Chinese expression, this is a classic case of using money to make money. Except that it is more like, using money to make money to use the money made to make more money (I told you it is abstract).

Losing track of risk
This is why the subprime mortgage crisis that has created the financial maelstrom in the U.S. is so ironic. It is a case of risk-management-type financial products being poorly or negligently risk-weighted so that risky instruments were placed in the same basket as low-risk instruments and given a triple-A rating by the rating agencies. That is what you get for leaving billion- and trillion Dollar decisions with young boys and girls.

Obviously no one had a clue or, risk algorithm that could calculate the downside risks of the CDO instruments. Note the anguish and indignance in Bill Saporito's words in his Time magazine article on this phenomenon:

Then there's the nonsense that ratings agencies shoveled out about the risk levels of collaterized debt obligations (CDOs), how this new bit of financial wizardry deserved AAA and AA designations even though it rested partly on a foundation of subprime mortgages. It was all justified by super-sophisticated models — way too sophisticated for "you" to understand — that looked back at real estate pricing and foreclosures and couldn't conjure a scenario in which the holders of the most senior parts of these tranches wouldn't get paid.

Perhaps no one figured that subprime mortgage holders were 10 times as likely to enter into foreclosure as people who made downpayments and could document their ability to pay. "This poor performance in the subprime market calls into question the capabilities of lenders, securitizers and investors to reliably estimate peak charge-off rates," warned Joshua Rosner, managing director of Graham Fisher & Co. and Joseph R. Mason, a finance professor at Drexel University in a paper in early 2007. When all the indicators went bad — delinquencies and interest rates up, home prices down — the agencies started yanking the ratings on CDOs by the carload. As the number of subprime delinquencies started to climb, and the magic mark-to-model accounting that the investment houses used to value their AAA and AA CDOs got market-tested — as in, "What will you give me for this piece of paper?" — the game was over.

Fundamental questions about the profit paradigm
We can blame the investment banks that cobbled together the CDOs. We can blame the ratings agencies. We can blame pension and investment funds for demanding growth in profits year-on-year. But, we can also blame contemporary society for lionising and lauding individuals who has the most wealth. We read Forbes and Malaysian Business to see the annual tally of the richest. And, we wannabe like them.

This is what happens when we put money to work in the hands of others. If our money was invested in a business that we manage and operate ourselves we wouldn't care a hoot whether this year's profits is higher than last year's, especially in economically uncertain times like these. We would be happy to maintain a profit similar to last year's. I wrote about this in Flat is the new up.

I'm not saying that we should all be business people or, put our savings under the bed. But, each of us, in aggregate, form the human society. Just as the environmentalists tell us to start the conservation effort from our homes first and, foremost, we have each got to realise that putting our money to work by putting our money in the hands of the financial boys and girls may not always be the best risk option.

Conspicuous consumption

Thorsten Veblen. Now, that's a name not many people know of outside socio-economic academia. For many years I have found Veblen's views remarkably resonant even though the book that he wrote, Theory of the Leisure Class was written in 1899 and, it was about the emerging American middle-class and their habits as consumers.

Veblen coined the phrase conspicuous consumption.
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Whereas neoclassical economics defines humans as rational, utility-seeking people who try to maximize their pleasure, Veblen recast them as completely irrational creatures who chase after social status without much regard to their own happiness.

He used the term emulation to describe these actions. For example, people attempt to mimic the more respected members of their group in order to gain more status for themselves. Now we call this wannabe behaviour. It means the same thing.

As an example from modern-day life, certain brands and stores are considered more high-class than others, and people may shop at them, despite the fact that they cannot afford to do so, and even though cheaper alternatives would ease their financial situation and the goods available may be of equal utility.

Following this line of reasoning, Veblen also concluded that businessmen were simply the latest manifestation of the leisure class.

Veblen noted that businessmen do not produce goods and services, but simply shift them around whilst taking a profit.

He thus argued that the modern businessman is no different from a barbarian, in that he uses prowess and competitive skills to make money from others, and then lives off the spoils of conquests rather than producing things himself.

Doesn't all this sound familiar? Veblen was certainly a visionary.

I highlight Veblen and his theses because I believe that despite the economic turmoil and, even in its aftermath, the basic values that drive modern economies will not change. The classic words uttered by the fictional character of Gordon Gecko (played by Michael Douglas) in the seminal movie, Wall Street, "Greed is good" still underlines all modern economies and, I do mean ALL modern economies.
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The effect of this value system is the benchmarking of what constitutes success. Veblen was like many Taoist sages in identifying happiness as the key indicator. But, this was a cry in the wilderness. Everyone preferred to have money, money, money. This is the Faustian pact that most of us have signed on.

The profit and growth paradigm
If the desire for money is the root cause, then the demand for profits and continuous growth must be its effect.

We put our money in banks expecting an interest yield. We buy shares and equities of publicly listed companies expecting dividend yields but, mainly we look for capital gains. What do you expect fund managers to do? What do you expect corporate bosses to do? There is a desperate need to expand and grow and grow. That is when bad judgments and mistakes are made under great stress.

I have no grand solutions. I only highlight this phenomenon to create awareness of why many of us do the things that we do, sometimes without knowing why we do them. And, maybe it is this spark of awareness that will create a groundswell against the wild chase for money.

If we recall Asian history and, even Athenian history, we will learn that in enlightened societies it is the scholar that is on top of the social hierarchy. Pericles was the scholar-statesman of the Golden Age of Athens. In the old China, it was the scholars who went through rigorous examinations processes that formed the top quartile of Chinese society and, became the ruling class.
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But in this day and age, it is the businessman that tops the social pile. What does that say about the current state of play?