lørdag den 22. november 2008

Rethinking Macro Economics ?

As the crisis that started in August with the market for US sub prime loan collapsing now has gathered a momentum that hasn’t been seen for many decades, a lot of observers and experts have expressed a multitude of suggestions and remedies while financial leaders, regulators and politicians have been working around the clock to try to stem the harsh tides. (See: The Fuel that fed the Subprime Meltdown)

And as the traces have now spread to almost all countries and sectors of the economy it is obvious that new approaches, indeed more than a New Deal is needed. As all major European and Western economies are now more or less in recession, the price of oil has dropped to as low as one third of the price during July, the Bloomberg’s Metals Index likewise down to 1/3 of July, prices for food have dropped to 50% of an all-time high. Stock value of most of the Worlds leading companies down to 50% or below, with a threatening overcapacity in industries like transportation, tourism and an automotive industry on the verge of collapsing, it is about time to stop and wonder how this could happen so fast and with an impact of this enormous magnitude.

There are some obvious and some maybe more hidden reasons why this could happen:
Firstly, the Globalization is the direct reason for the rapid spread of the problems; the first wave due to the Financial derivatives being traded on a World Wide basis much alike re-insurance made the sub-prime loans felt in almost all major financial institutions. (See: Gambling on Derivatives)
Secondly, most of the financial regulatory system – especially, but not only the US ‘Greenspan’ system – has been based on a long, steady period of growth, and has not been geared to any kind of massive drop in values and stock prices; this meant for instance that because of rules on Pension Funds protecting their core capital, they had to sell off bonds or stock in the beginning of the downturn, putting additional pressure on the market.
Thirdly the Globalization now means that all major industries spread the value chain across the continents leading to direct and fast reactions in supplier markets.
Add to this the inefficiency of supra national regulatory and supporting systems. We have seen the G7 gather quickly, but before their decisions, some countries were already trying to implement their own strategies, and even if a somewhat concerted effort was indeed agreed upon, it was still implemented in lots of different ways. And then you could argue, that as OECD has pointed out that only 20% of the Global Economic Growth from 2005 to 2009 comes from the advanced economies, G7 should have been enlarged to, well G20 (See declaration on G20 meeting in Nov. 2008), with lots of negotiation power plus obligations put on the BRIC-countries and developing economies, that still has a promise of positive economic growth in the next couple of years. Looking at the IMF, this institution has only once during the last 10 years being called upon by a Western Country – namely Iceland. So IMF and it’s traditional mission, remedies and requirements before putting any substantial credits on the table, it is hardly a toolbox that is fitted to the complicated advanced economies, that are now suffering.
And likewise, the World Bank has other objectives, to help developing countries.

(Figure: IMF: Real Economic Growth by Market Type, 1997-2013 %)

So what is really wrong and why doesn’t the funds but to the disposal of the financial institutions do the trick? Why isn’t the drop of interest rates in most countries helping us?
One of the reasons I expect is imbedded in the psychology of the intervention packages: As Government officers are now being put in charge of banking operations, we are coming from a situation with lots of risky business with lots of willingness in the financial market to finance risk by spreading it around to a situation now where absolutely NO risk is tolerated; it may be that basic international trading business and associated payments are financed, but funding for new start-ups are likely to disappear completely. The next phase of the downturn will be that Government tax revenue will start to drop as income drops and the unemployment starts to rise.

Going back to Economic history the situation looks almost like described in Karl Marx ‘Das Capital’. His prediction that as the competition between the capitalists is bringing down the ‘value add’, the lack of profit will lead to mass bankruptcies, take over and mergers so that the strong will get even stronger – and finally leading to the collapse of the capitalist system. Only this time we put Government officials on top of the Capitalists – but how can they become efficient bankers? Let alone efficient car makers? Is it a take over by the Proletars? Or will it just lead to more bankruptcies?

The good ol’ macro economic model for aggregate demand will have to be looked at a mega-economic level, as the best idea in the mid term run will be to stimulate demand:

D = C + I + G + (X-M)

(Demand equals Private Consumption plus Investment plus Government Expenditures + Export minus import). The sinister scenario goes like this:

Consumption: Consumers expect prices to fall and keep their money in the pocket, disposable income may come down due to lay offs, consumer credit is being stopped by risk-adverse banks, and as housing values are coming down, there is no easy way to obtain a mortgage credit to finance major items like cars, washing machines etc.
Investment: Probably only most necessary re-investment programs will survive, capital equipment will begin to be worn down, and banks are not allowed to finance any kind of innovative new start ups or new development, unless the needed capital is generated by the companies themselves.
Government expenditure: If Governments are facing cut in tax revenues and rising unemployment and social costs, this will create a short term deficit, but only major investment programs, new infrastructure projects (Going green? Public Transportation instead of cars?) would help.
Exports are likely to drop, particularly exports to the mature western economies. It does help of course, that Import will most likely drop as well.
If we take all of these factors together, we have the classical remedies for a depression spiral.

So indeed the task that the Governments are facing is enormous, the international institutions not fitted for the magnitude of the problem, the need for collaboration and mutual adjustment is immense, and the risk for potential social unrest is looming.

The dynamics of the model is based on expectation; the more likely it is that prices will fall, the more the aggregate demand will be reduced leading to a very vicious spiral. Only short term remedy could be a marked, temporary and international cut in VAT to kick consumers to go out and buy.
It may only be a short term advantage, but it definitely need to be accepted internationally to avoid problems with the balance of trade in some countries.

So where is the hope for a more long range type of solution?
On the institutional side we need to create a supranational regulatory body with power enough to call for collaborative funding and with benevolence enough not to strangle the countries they are helping.
We also need a ‘Bretton Woods’ type of agreement on common rules and regulations for criteria to have solid banks, with well-defined products, have efficient pension fund regulations, establish a transparent market for dealing with and handling risks and international investments, trying to harmonize mortgage systems around the World - and we need to speed up the Doha round to ensure free trade and break down what may remain of restrictions and local subsidies – to food, cars, anything. We need to have an international agreement beyond Sarbanes-Oxley to ensure public insight into all sorts of major businesses, and we need some sort of international court system for fraud committed by international organisations and companies, much like the Haag International Criminal Court.

But all this require transparency and easy access to information. My point is that the more we speed up the velocity of adequate information related to international trade and finance, the more we will be able to expand commerce and trade. If you remember the old quantitative model:

M x V = P x Q

Saying that is a proportionality between the supply of Money times the velocity of Money circulation and the general Price level P times the aggregate production index, Q.
The theory was in various disguises used by Milton Friedman, suggesting that in case of inflation the volume of Money in circulation should be brought down. But maybe we could reformulate this to:

(M x V(m)) x V(i) = k x (P x Q)

Suggesting that the volume of Money multiplied by the Velocity of Money multiplied by the velocity of information in a transparent economy could be stated to be proportional to P x Q, which again is a pseudonym for the National Product. The idea is that the faster the flow of information needed to exchange info business, transfer financial transactions, exchange freight and customs documents, the more transactions will be performed, and the more transactions can actually be funded by the available amount of money. In other words: Speed AND transparency.
This calls for investment in updating management of value chains, updating flow of information between suppliers, manufacturers, consumers and financial institutions. It also calls for fast introduction of open standards for cross national and cross agency communication (See the EU’s Interoperability Framework!) – and first and foremost it calls for transparent semantics on all aspects of trade and finance. UN EDIFACT was just a beginning.

If we accept this, our supra national regulatory body and it’s steering committee (New role for G20?) should as it’s first task to finance a new global infrastructure look at financing a network, a structure and a set of standards and stewardship rules for ensuring transparency along the ideas described above.

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