The unbearable reality

A striking but unremarked phenomenon of our times is the paucity of portfolio investment into emerging markets. The fact that the mature stock markets of the developed world are weak is only the most immediate of the reasons to invest in emerging markets. The populations of Western Europe, North America and Japan are also aging and must live off dividends and interest, not salaries and wages. Emerging markets, on the other hand, are full of young people and unmet needs. The senescent rich of the northern hemisphere should be living off returns to capital and labor in emerging markets that are, in the cases of China and India at least, four or five times what can be earned in the developed world. It is not as if there is a shortage of emerging market funds in which to invest, or direct or proxy stocks offering exposure to the superior rates of growth in emerging markets, yet this apparently obvious opportunity is showing up in neither stock nor fund market returns in the developed world. Of course, savings have doubtless gone into wrong-headed investments, emerging market authorities do not always make it easy to invest, domestic interest groups resist foreign competition and a wide variety of nefarious practices make it impossible for foreign companies to succeed. But there is also something far more discomfiting at work, which has much to tell us of how the great commercial civilizations of the Atlantic have colluded in their own euthanasia.One symptom of this is immigration. If markets were working properly, the capital of Europe and North America would be investing in the developing world. Instead, the labor of the developing world is coming to Europe and North America. A second curiosity is even more contrary. Far from the savings of the developed world flowing to the emerging markets, capital is actually moving in the opposite direction. The United States in particular is devouring the savings of China, Russia and the Middle East to fund its budget and current account deficits. This year, the budget deficit of the United States is expected to hit $1.5 trillion. The Institute of International Finance estimates that total net private sector capital flows to all emerging markets last year totaled $825 billion, or just over half the amount the United States government will borrow this year from savers at home and, increasingly, abroad. If the foreign exchange reserves held by emerging market central banks are offset against those private sector flows, a substantial net flow of capital from the emerging markets to the developed world is visible. Of the emerging market foreign exchange reserves whose currency the IMF can identify, nearly 60% ($1.5 trillion, as it happens) are denominated in US dollars. Most of the remainder is denominated in euros, sterling and yen.Governments, in the United States and several of the major nation-states of Western Europe, are now equivalent to timeshare salesmen, their choices devoid of any moral or political content. Every question reduces to an issue of financing. It helps that their counterparts in the emerging markets are happy to play the role of latter-day Colbertists, piling up dollars as greedily as Rumpelstiltskin spun gold. Even Germany and Japan, the two developed economies that run large current account surpluses, have not invested much in emerging markets. The result is a world turned upside down. Instead of the aging inhabitants of the developed economies as the rentiers of the world, living off the higher returns of the emerging markets, the emerging market state has become the patron of the United States and the European Union. The overwhelming majority of developed economy assets held by emerging market investors are not equities or direct investment, but government debt. And the overwhelming majority of the holders of those assets are not individuals or families or fund managers or companies but state entities such as central banks and sovereign wealth funds. What is happening to the flows of capital around the world is not a market process at all but a horrible symbiosis between the degraded democratic politics of the northern hemisphere and the despotic politics of China, Russia and the Middle East. It is not a bargain that encourages good behavior by either party. Illiberal governments ensure that wealth, which could be put to much more productive use in private hands, accumulates in the hands of gangsters sympathetic to the incumbent regime or state-controlled institutions that can divert it to the pursuit of dangerous ideological or geopolitical ends. For elected politicians, on the other hand, borrowing is spending without taxation. It is of course no more than deferred taxation, but a tax deferred is a vote gained. In fact, the current scapegoating of bankers and the sustained legislative and regulatory assault on the financial markets by elected politicians is a more than usually disgusting variety of political hypocrisy. It is impossible to disentangle the development of modern democratic government from the growth of sophisticated financial markets in which elected governments can borrow. A century ago public spending accounted for just 13% of GDP in Britain and Germany, then the prototypical welfare states. In France the state ate just 9% of the national income, and in the United States it consumed a mere 8%. The respective proportions today are 50%, 45%, 55% and 41%. Public expenditure now averages 44% across the OECD. In the United States, the net financial liabilities of the government currently total 75% of the national income, more than twice the level of a decade ago. Across the euro area, the equivalent figure is 60%. There is no better measure of how democratic government fosters the illusion that budgetary constraints can be escaped, and so ultimately comes to rest upon it. In tracing the linkages between this fiscal incontinence and the monetary incontinence that was the ultimate cause of the financial crisis of 2007-09 it is hard to distinguish cause and effect. There is now universal agreement that interest rates in the United States and Europe remained too low for monetary conditions from 2001 to 2007. But the fact that deficits could be funded at lower rates of interest was obviously material to decision-making by the government as well as the private sector. Cheap money encouraged borrowing by making senseless investments look viable, and fueled asset price booms in housing and stock markets. But the credit boom could not have been put into effect without state control of the central bank and state underwriting of the banking system. Far from acknowledging this truth, and their own direct responsibility for the disaster, the central banks of the world present themselves as the principal victims of the behavior of the commercial banks, and the saviors of the world from an even greater disaster.If ever there was a demonstration of the impossibility of centralized control of changes in the demand for money, it occurred over the last full economic cycle between 2001 and 2009. Only a special brand of shamelessness has freed the same central banks that completely misjudged monetary conditions in the boom to use exactly the same tools to fix the crisis as those that caused it in the first place. They have again manipulated the rate of interest to punish savers and reward spenders, and they have embarked on a massive inflation of the money supply. Both are designed to restart the credit cycle, not least by stoking a revival of the stock market. Whether the inflation of the money supply is a measure of the recklessness of central bankers or the desperateness of the situation scarcely matters, but it is certainly lavish. In April 2000, when the dot-com bubble imploded, the monetary base of the United States stood at $578.5 billion. By the time the financial crisis began in earnest in June 2007 it was up by more than two-fifths to $826.5 billion. Four years later, it stands at $2.65 trillion. In other words, the United States has "printed" an additional $1.8 trillion in the last four years alone, a sum equivalent to three times the entire monetary base just a decade ago. Similar "quantitative easing" programs are in place in the United Kingdom and Continental Europe.A drunk would call this a hair-of-the-dog-that-bit-you. There are more sophisticated explanations of why it makes sense to cure the after-effects of a speculative bubble by reflating the bubble with increases in the supply of money, which in turn encourages companies and consumers to borrow from banks at low rates of interest. But, like drinking to cure a hangover, they testify to an unwillingness to address the underlying structural problems of western capitalism in general, and Anglo-Saxon capitalism in particular. The belief that artificial expansions of money and credit offer a shortcut to growth, enabling whole economies to bypass the sacrifice of saving for investment and the discipline of work, is so entrenched that its critics are treated by mainstream economics as bumpkins and imbeciles. Nobody now considers it extraordinary that almost any European or American adult with a job can buy a new house or motorcar as soon as he or she wants it, paying for it not out of savings or even current earnings but by borrowing from future earnings. Yet it was impossible as recently as the 1960s. Even the extraordinary prospect of impoverished workers in developed economies making the necessary sacrifices of time and money to fund debt-financed consumption by wealthy consumers in developed economies can be explained by policymakers and mainstream commentators as if it were a problem of shallow causation and recent provenance, susceptible to remedy by a handful of obvious policy changes. The usual term employed is "global imbalances." It implies that, if only the Chinese government would allow the renminbi to find its true value, or the oil-producing nations would not restrict the production of gasoline, these imbalances would disappear. There is even a view that the law of comparative advantage is at work in this process. In other words, that the overgrown financial services industries of Western Europe and North America are a symptom not of politico-economic corruption, but a reflection of the labor cost advantage of less developed economies. There is no sense of any structural or historical or moral dimension to what is happening at all. Yet what is happening is that the developed economies are losing their capacity to create wealth. Repeated revolutions of the credit cycle destroy real wealth as well as paper wealth and gradually erode the productive potential of an economy. Most obviously, they do this through the arbitrary transfer of wealth from people who bought at the top of the cycle to people who sold at the top of the cycle. Less obviously, the spectacular returns available in financial markets diverted real resources of land, labor and capital into speculative housing and stock market investments. Now, by refusing to allow the market to flush its system of misguided investments by injecting more money and credit into the system, the central banks risk turning the economies of Europe and North America into western hemisphere versions of Japan: places where a prolonged credit boom is followed by nothing but a prolonged period of stagnation in the real economy as the authorities refuse to acknowledge the consequences of their own handiwork. Indeed, it can plausibly be argued that they are Japan already. The average annual rate of growth of the economy of the United States in the long golden era that lasted from 1950 to the first oil crisis in 1974 was 2.45%. In the years that followed, down to the end of the dot-com bubble, it was 1.86%. The equivalent figures for Germany are 5.02% and 1.58%; for France, 4.04% and 1.72%; for the United Kingdom 2.42% and 1.93%; for Europe as a whole, 3.92% and 1.77%. In other words, most of these economies are growing at a third to a half of the rate they managed in the 1950s and 1960s. These apparently small differences actually matter a great deal. If the national income of the United States grows at 1.86% instead of 2.45% for the next ten years, Americans will be $1 trillion worse off in 2021. Yet real economic growth in the United States over the last ten years has averaged only 2.2%. In the same period, Germany and France have managed just 0.9% a year, and the United Kingdom 1.4%. Much of the growth that did occur measured only the power of oceans of credit to sustain housing and consumption booms. It is no secret that the average American or European has scarcely gained at all from the economic "growth" that has occurred since the 1990s. The system has successfully concealed this reality from them through a vast expansion of credit. Nowhere was this more true than the United States, where the value of all personal, commercial and public sector debt increased 32-fold between 1970 and 2007, with no sector increasing faster than financial services, where the impact of increased leverage was most direct. That leverage created an extraordinary level of risk, but an equally extraordinary degree of profitability in the financial markets, all of which was reversed in the crisis. Not that this is completely understood, for not all of that reversal is apparent yet. This is because much of the misguided investment can still be financed, even if only at the central bank. When the crisis began in August 2007, the total assets of the Federal Reserve stood at $869 billion. They now stand at well over $2 trillion. In the same period, the balance sheet of the Eurosystem has inflated from EUR1.25 trillion to EUR2 trillion, and that of the Bank of England from GBP81 billion to GBP237 billion. The dirty secret of the financial services industry is that the banks are still sitting on trillions of assets whose valuations rely on nothing but their own mark-to-market models and the willingness of the central banks to fund them. In a world in which emerging markets save more than they spend, but developed economies spend more than they save, and economies are not growing fast enough to create new wealth, what has happened to the balance sheets of the central banks is a microcosm of what is happening to the world. Even worthless assets can be financed for a remarkably long time, but wealth must in the end be transferred from borrowers to lenders, or borrowers must default. This has happened and is happening already to banks, fund managers, investment banks, consumers and pensioners that borrowed heavily against rising asset values in the boom. It serves as a sharp reminder that credit is never wealth, only a claim on wealth. Borrowing to invest in the hope that value of the assets will always stay ahead of the value of the principal is not just a risky substitute for acquiring real savings by deferring gratification, investing them in more productive technologies and working hard. Credit is a drug that draws a veil across the reality that resources are scarce and, if we have more of one thing, we cannot have more of another. Ultimately, the only source of wealth is productivity, or getting more output from the same amount of input. Productivity is created by the steady interaction of physical technologies (the wheel, the steam engine, the internal combustion engine, the microchip) with the social technology economists call the division of labor. In the 40 years that have elapsed since the end of the golden era in the early 1970s, credit, and the asset price inflation it creates, has served to obscure this tiresome reality from the inhabitants of the developed economies of the world. Their creditors in the emerging markets may or may not be about to foreclose on them, but it is hard to ignore the growing body of evidence that an overgrown financial services sector is not after all a measure of success, or even of failure, but simply a symptom of a mass retreat from reality by the citizens of the west, orchestrated by their governments and facilitated by their central banks.

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