Saturday, January 5, 2008

The Phoney Recession

World War II officially started when the Nazis invaded Poland in September 1939, forcing France and Britain to declare war on Germany. French and British troops manned the Maginot Line, Germans faced them from their own Siegfried Line and ... nothing much happened - until the cataclysmic attack on France in May 1940. This intervening period was dubbed the Phoney War.

The unfolding global economic crisis started back in early 2007 with a warning shot from US sub-prime mortgages. Viewed as an isolated event, this first crisis quickly quieted down - only to flare up again in the fall, engulfing the financial sector and sending money markets reeling. Still, the global economy was deemed healthy because BRICs were at full speed, US consumers kept spending and jobs were plentiful. In addition, rate cuts and liquidity injections provided by the Fed and ECB worked to reassure equity markets, soothing otherwise frayed nerves. The majority of economists and market analysts were sceptical, but not unduly alarmed. The truth is, however, that they have been lulled into complacency by a "phoney economy".

In the past two weeks the armies of the Global Recession have finally attacked the main front, the US economy. Holiday shopping was flat, housing and manufacturing weakened further, private employment dropped - Americans are reeling from high debt, rising fuel and food prices, low incomes, negative saving and dropping house prices. The blitzkrieg is in full blast now and the center of the defensive line is rapidly caving. In this election cycle no fiscal policy reinforcements can be expected, either (e.g. tax cuts). The Bush administration is politically bankrupt and may only manage a retreat. Given its past record of incompetency, from the Iraq war to New Orleans, chances are it will botch even this badly.

With the center gone, the wings made up of European and Asian auxiliaries are not going to be able to withstand by themselves the full force of the global recession. Decoupling is an illusion, another myth of the phoney economy that will prove as effective as the static Maginot Line was against Guderian's tanks and the Luftwaffe. The main reason is that at the core of decoupling stands, once again, the US consumer - a force that has now crumbled from within.

Oh, decoupling happened, all right: production moved abroad, but consumption - fuelled by easy vendor credit - stayed home. A simple statistic: minimum wage is $5.85 in the US and 55 cents in China. Even ignoring the fact that more Chinese make minimum wage and save more of it than Americans, it is obvious that China simply cannot consume more than a fraction of what it produces.

Let's look at those "wings" more closely. Europe is as much dependent on artificial growth boosts as the US: Club Med (Spain and Greece) fed on the familiar recipe of zooming household debt and real estate bubbles, newer EU members also borrowed with abandon (in yen and Swiss francs, no less), Russia is a hollowed-out economy entirely reliant on oil and gas and Britain, anchored as it is on the City's financial industry, is already reeling from the American disease. Germany, France and Italy are stalling at 1.6%-1.8% GDP growth; the strong euro is killing their exports. Inflation at 3.1% is far above the ECB's 2% target, and this only because the euro is somewhat cushioning the damage from imported oil and Chinese goods.

In Asia, Japan is similarly dependent on exports for whatever growth it can eke out. Its goods are almost entirely focused on affluent consumers (i.e. the US and Europe) and cannot be marketed to China and India; likewise for South Korea and Taiwan. The second (or third, depending on counting methodology) largest economy in the world is thus a basket case, growth-wise. China is growing on capital spending/investment steroids (around 50% of GDP), mostly because it is building factories and infrastructure to support exports going to America and Europe (readers may remember an older post titled China Kettle, Dryer and Scale, Inc.). The confluence of lower export demand and PBoC's tighter monetary policy are going to reduce growth much faster than people think, in my opinion.

India doesn't really "belong" to the BRIC bloc, except for a small percentage of its otherwise agrarian and backward economy, located in a couple of big cities and tech service enclaves. Australia, Canada, Brazil and the Gulf Arab economies are in a class by themselves. They are essentially pure commodity plays, one or two dominoes further removed from faltering US and EU consumers.

This is not to say that every country is solely dependent on the state of the American and European consumerist economies. But unlike recent decades, when the capitalist and free market system affected directly only a minority of the global population, globalization has today exposed the entire world to the vagaries of the business cycle. Dominoes falling in New York and London are once again affecting Moscow, Shanghai and Mumbai even more than they did during the glory days of laissez faire in the 19th century. Communism and interventionist statism certainly created a lot of dead weight, but it also provided inertia that attenuated the ups and downs of the global cycle.

I fear the phoney recession period is ending and the main attack of the Global Recession is about to commence.


  1. People will argue about whether we are in a recession for months. Krugman's blog (http://krugman.blogs.
    has a figure showing the employment-population ratio. The E-P graph shows a decline from 64.5% in '99 to 63% at the end of '06.

    All it would take to give up the slight gains of the '03 to '06 period is a period of zero-growth in total debt. If history is a guide, debt deflation is not a necessary condition to resume the downward trend.

  2. So when China Kettle, Dryer & Scale goes belly up along with a large number of its competitors what does the Party do about it? It's not like they can send all those workers back to the farm. There is nothing more capitalist than ruinous calamity that "no one could have predicted." The Chinese have a long history of such disasters, but they tend to bring down the dynasty of the day.

  3. To stay in cash, then, what is the realistic alternative to the euro or USD?
    Confused in Pittsburgh

  4. B-B-But the decider will just send everyone a check so we can continue consuming.

    I remember the term "unsustainable" became a catch-phrase a few years back. It was as if people knew instinctively our present path couldn't continue. The only question was when the unwinding would commence, and with them internets communications the acceleration could be breathtaking.

    The Shrub's the perfect nitwit to have in charge for this collapse. A privileged, non-productive twit that firmly believes in cronyism as an organization model, and against any sort of evil "regalations." This'll be over before he can say "Brownie you're doin a heck of a job."

    What's the matter with Kansas? I don't know but we're all going to pay for this foolishness.

  5. A joke from Krugman's Google talk is worth repeating.

    Herb Stein is famously known for saying that if something can't continue forever, it will end. James Glassman is best known for finding reasons why something will continue forever if it can't.

    Our policy makers subscribe heavily in the Glassman theory.

  6. I don't like the comment that Americans don't save; regardless of other +/- savings we save 12.4% of our salaries (6.2% of lost wages). That money is obviously mismanaged in SS, but it was saved.

    Perhaps the typical American could save a bit more if interest rates weren't adjusted downward at any fluctuation in the market. I'm in the unfortunate position of saving to buy a house in the affordable NY area (and looking on in sick glee with turmoil; come on, is a 10% correction in home prices really a disaster after a 250% increase). How could the housing situation improve when, after each and every rate cut, interest rates for saving/mm's decrease, while mortgage rates remain static?

    By the way, I really love this blog. Find it very well-written, compelling, and best of all entertaining and informative. Thanks.

  7. Hellasious:
    “Australia, Canada, Brazil and the Gulf Arab economies are in a class by themselves. They are essentially pure commodity plays, one or two dominoes further removed from faltering US and EU consumers.”
    I got just an inkling, just a hint, of something in those two sentences I’ve been searching in vain for both in yours and similar blogs for months now. Being that I am back and forth between Oz and the U.K. frequently and away for months at a time dealing with property interests in and around Perth, W.A.. Blog-wise it’s kind of like we’re getting the cold shoulder. The old saw: ‘Australia—everybody knows where it is but nobody wants to go there.’
    What I’m looking for is a: ‘what’s gonna happen’ scenario in this S.E. Asian continent where everybody, in typical Australian fashion, seems to be sleep walking their way into the 21st century with (re: the subprime debacle and the consequent fallout) the ‘It ain’t gonna happen here mate.’ mantra. The same mentality which has sustained them through one of the biggest property and consumer booms in living memory. Perth (pop. 2 million) is a boom town. A gold rush town where property ‘values’ have soared to astronomical heights. Where the life style is solid Southern California and the mentality typically Texas. Incidentally the population of Australia is roughly that of Texas. I don’t think anybody climbing the ladder of affluence down here has missed a step since the start of the millennium.
    Apparently the great white hope for continued growth in the Australian GDP is tied to the vast northern mineral deposits which the Chinese are scooping up by the mega tonne on a daily basis. And that is just about it. Perth itself, like most Australian cities, produces little more than an army of pen pushers up to their eyes in real estate and insurance sales. Something like 70% of these populations produce a mere 12% of the GDP.
    So—in future postings could you try to shed more light on the future of the economy for us ‘down under’? All us Aussies and Poms would sure appreciate it.
    Good on ya mate.

  8. The phony war metaphor is beautiful, but the overall feeling is of general, hazy gloom and doom.

    Unless we are on the verge of another Great Depression surely there should be something positive somewhere in the world (as far as economists are concerned).
    I am not an economist and my hometown Detroit is hardly a paradise now, but gosh, when reading this it seems that the world is going to end.

    The way I see it - if the people who control the world's economy are smart, we will see 4 or 5 years of slower world economic growth and a recession in USA. Seems to me that since the Internet bubble everyone is still waiting for the end of the world.


  9. Hellioius you write an interesting blog. But are you not falling into a trap by thinking China is soley dependant on American consumption?

    China artifically subidises its prices other than what they would normally be, by exporting its savings and supporting a current account deficit - a subsidy to the US consumer, while the west deskills as production moves abroad.

    There is nothing to stop china moving from producing goods concentrating on exports to consuming them internally when it stops exporting its domestic savings back.

  10. hellasious,

    Thanks for emphasizing that "what happens in the US won't stay in the US."

    What most market analyst and commentators fail to realize is that the same massive debt and credit problems being experienced in the US are present in Europe, Canada and Asia as well.

    Financial institutions and hedge funds throughout the world, abetted by spineless central bankers, have been competing with each other to see who could come up with the most ludicrous and reckless lending policies and "investment" strategies imaginable.

    The question remains what type of fiscal stimulus package the Bush administration is going to unveil at the end of this month during his State of the Union address. My gut feeling is that whatever is proposed, consisting primarily of extending tax cuts to the very rich, will be insufficient to make up for the impending shortfall in consumer demand.

    I use to believe that the PTB actually had some idea of what they were doing and were simply pursuing a hidden agenda. But instead it is now becoming abundantly clear they haven't the foggiest idea regarding the extent of the economic and soon to be political mess they have made.

    It is amateur hour among the current crop of would be empire builders and world improvers. What is truly scary is that these guys actually believe the nonsense that is spewing out of their mouths. The level of denial among these policy wonks as they march into the trash bin of history is astounding. When all this is over Bernanke will rue the day that he fulfilled his lifelong ambition to be at the nexus of power brokering between Wall Street and Washington DC. Talk about the wrong place at the wrong time. He along with the rest of Bush and crew are destined to go down as some of biggest boobs in US history. Not an easy feat.

  11. trampjuice; it would help to recognize that the majority of Chinese goods exports derive from the transnational sector within China. That is, E. Asia has been restructured in a manner which places China at the end point of a transnational production process controlled by transnational, not Chinese, firms. Which is also to say that there can be no simple switch from export dependency to a still weakly developed internal market.

    Even confiscation/nationalization of these firms would not suffice since it would merely be an appropriation of segments of the larger global production and sales chains.

    As Asia scholars Martin Hart-Landsberg and Paul Burkett noted in 2006, it is:
    'not surprising that the share of East-Asian trade that is intra-regional has grown significantly. But, rather than reflecting a growing regional independence and balance...this trade activity is tied to a regionally structured accumulation process that is anchored in China and ever more dependent on final sales outside the region, especially to the US and the EU.'

    IOW, China and rest of Asia will be severly impacted. I've no idea of where the unreal notion of a 'decoupled' world came from unless the become archaic yet firmly held beliefs in national economies merely trading with one another, other than in theory a long superceded condition.

  12. I don't subscribe to the notion that the rest of the world is largely dependent on US and West Europe as ultimate consumers. I am in Asia and as far as I can see, people are buying huge LCD TVs, new cars, new mobile phone every year or two, upgrading their homes, going for holidays, eating in restaurants etc. There are waves of Chinese and Indians tourists, and they are definitely spending money.

    I think analysts in developed countries ought to take a trip to the rest of the world and see for themselves how big these countries are and how much more prosperous these countries have become over the last 5 to 10 years.

    So what if 300m US residents are going to have a slowdown? There are easily 300m middle-class residents in the China and India alone.

  13. hellasious,
    the decoupling argument will be stress tested very soon.
    I live in Istanbul and believe me price level is not much different than Tokyo. Since Turkey does not produce iPods, a 8% GDP current account deficit is financed by carry trade and transferrıng of nontradable sector assets to the newly rich oil centers.

    Similar Ponzi dynamics are inplay in Eastern Europe well.

    I agree ın fıve years time new south-south trade linkages will fuel new boom in Asia but in the interim Asia will pay the hefty price of US dependency.


  14. anon, I don't think you understand export dependency as a structural feature which, whatever the size of the middle class, cannot simply be reversed. Which is especially the case when the overall production processes are internationally segmented. One link in a chain is not the chain.

  15. That money is obviously mismanaged in SS, but it was saved.

    It was spent by the government -- the reported deficit is of course in addition to the SS funds which are spent as if they were general revenue.

  16. Repectfully to all blog readers,

    Hellasious is right as rain on this. Let's not overthink this. Really what he's saying is simple and basic supply/demand econ 101 stuff. Wall Street and the media just want to keep touting stocks- any stocks.

    For interested players with some risk appetite who want to profit from this wrong-headed idea of decoupling, check out FXP. It is a 2x inverse short on the Shanghai index. So, you are long the fund but the fund is leveraged-short the stocks.

    Just a thought,


  17. Reflecting a little on China and Japan. These are eastern Empires - not western democracies. Both are zenophobic. Both will pull up their respective drawbridges when they are subject to a significant external threat. China may go into a sulk behind it's closed door, but Japan could lash out.

    It is a significant mistake for us 'westies' to try to second-guess peoples like the Chinese and Japanese. Instead we have to look back on their behaviours to get some clearer insights as to how they may deal with a severe economic threat.

    Think like Zhu and Musashi, not like Bernanke and King.

    Brian P

  18. I don't want to second guess the Asian mind, but I will never forget my first trip to Hong Kong. It was the early 80's and my husband and I went to Macao for a couple of days. We like to visit places off the beaten track and ended up in a gambling hall away from the tourista areas.

    I don't like to gamble, so I spent the hours watching and listening. We were the only 2 Westerners in the joint and based on my observations the Asian stock markets could get ugly and soon. Since many are "investing" in the stock market, if there is any event whatsoever, the lemmings will fall off the cliff.

  19. "I don't subscribe to the notion that the rest of the world is largely dependent on US and West Europe as ultimate consumers."

    In fact the world depends mostly on Us consumption.

    "Mr Roach said the US was the world's biggest consumer economy at $US9.5 trillion, compared to China at $1 trillion and India at $650 billion."

    So US consumption is nearly six -6) times China + India.

  20. Very interesting the different views in this blog. A colleague of mine who is fairly high up in one of world's biggest mining companies, said they don't see much of a slow down in demand from China for their product even if the US enters a recession and stops consuming China's goods. They believe that China's demand for imports goes to infrastructure projects and that the Government has little choice but to continue with this for political reasons (and that it has the reserves to continue to do so).

    I'm not so sure. If China loses significant income from its exports one would think that internal spending must contract in sympathy. This 'China' question seems to me to be critical to determining the effect on various economies worldwide (like Mr Spyware above, I'm from Australia too and I believe our current economic success is soley due to China demand for our mineral resources. What happens when that is switched off?). Perhaps its more a question of when - maybe it might take 2+ years for China to reduce its demand?

    Hellasious, any further analysis you could provide regarding China's demand for worldwide resouces and its possible reduction in light of a US recession would be greatly appreciated.

  21. Strange how so many economic commentators in the MSM who claim that the rest of the world can somehow decouple itself from the US economy are exactly the same people that over the last 5 years have said globalism was inevitable. It seem that like the White Queen in Alice they take pride in believing as many contradictory and impossible ideas as they can before breakfast. The sad fact is that when the heavens open on the world economy we are all going to get wet no matter where we live.

  22. I am inclined to agree with you Hell..

    According to The War of The World, China and the East have been gaining economically on the West since 1890. "Catching up" seems likely to continue for a long time. I therefore preface my views as referring to ONLY the near future (1-10 years):

    The Federal Reserve itself has said the US is bankrupt: Fed Reserve Study "Is the US Bankrupt?

    Bush himself said we were broke the other day

    China owns a lot of US debt.

    There are pressures within some Europeans nations to 'default' on their debt

    It is my understanding that there are lots of non perfoming loans within the chinese banking system.

    Though I have read this situation is improving, how much of that improvement is due to China's inflation (does anyone know)?

    The notion that China would be largely immune to the problems in the US/West seems VERY far fetched to me.

  23. I think many people here have the opinion that US (and possibly EU) are the ONLY ultimate end consumers. However, I see that EM countries are increasingly end-consumers themselves, as evident from the significant amount of consumption from EM countries' residents.

    However, this is NOT an argument for total decoupling. Rather, I do not think that the world will necessarily collapse if US goes into recession now, because EM countries now form a larger portion of global end-consumption, as compared to 5 to 10 years ago.

    Yes, here will be some negative impact if US consumers are to slow down, but I think the impact on the rest of the world will be significantly smaller this time as compared to the impact if US recession is to happen in 1998.

  24. ""Mr Roach said the US was the world's biggest consumer economy at $US9.5 trillion, compared to China at $1 trillion and India at $650 billion."

    So US consumption is nearly six -6) times China + India.""

    Of the US$9.5tr spent by US consumers, how much of these are spent on imports, and how much are spent on US-only products like restaurants, entertainment, telecoms, utilities and fuel, housing etc.?

  25. Krugman's graph is self-serving and erroneous. You'd think a tenured professor would take care to properly construct a simple graph.

    The axes are not in the same scale. Why, exactly? He never attempted to give a reason for this.. because there is none, except that an accurate graph would not allow him to make his "conclusion."

  26. Re: Krugman's graph

    I referred to Krugman's Jan 4 posting where there was a only one graph, the E-P ratio (%) vs time. Is your point that a decline in the E-P ratio from 64.5% to 63% doesn't matter?

  27. anon @ 7:10 AM,

    I've lived all over Latin America, one of my brothers just returned from eight months in China, another is a senior level executive with a German transnational. Which means that, yes, I take your unspoken point about nationalism and ethnocentrism to be correct but also know that not everybody remains trapped in such consciousness and that to do so virtually guarantees inaccurate analysis.

    Certainly EM nations have become larger end consumers but to pose that in static terms is also to suppose away the real interpenetration of economies while presupposing no contraction of domestic production/consumption takes place within those nations, or that such contraction has no price, profit, employment effects, no matter that such presupposition is contrary to economic history and logic.

  28. "I use to believe that the PTB actually had some idea of what they were doing and were simply pursuing a hidden agenda. But instead it is now becoming abundantly clear they haven't the foggiest idea regarding the extent of the economic and soon to be political mess they have made."

    Unless their "hidden agenda" is complete financial collapse followed by the US in martial law

  29. This post is one of the best I've read on the recent market turmoil. IMO you are right on in your rejection of the decoupling argument, particularly in relation to China.
    I worked in Guangdong for 8 years; it is a prosperous economy but one that has been fueled by the export boom. It is the center of the current consumer/production complex; 1000s of factories that produce the majority of goods on the shelves in American retailors; from paper clips and clothes hangers to footwear and furniture to toys, computer parts, TVs, stereos.

    You wrote:
    " is obvious that China simply cannot consume more than a fraction of what it produces."

    To that I would add that most goods produced for export in China are not sold in China, due to complex regulations. In addition foreign-made goods are subject to additional taxation which further raises their local cost.
    You're assessment that the Chinese middle class can not currently pick up the consumption slack for the American middle class is correct. Even if they wanted to they could not buy most of these products. Locals buy "local brands" of most household goods; not the overstock of foreign-branded goods made for export.

    The definition of middle class is based on income purchasing power, which is radically different in the two countries.

    The biggest source of investment $ into China has come from Hong Kong and Taiwan; as stock markets crater in those places expect $ to dry up from that side as well.

    How anyone can go to any Target or similar US retailer, where 80% of non-ag goods are made in China and still argue that it is decoupled from American is beyond reason. The countries fortunes are linked.