Conformity is the jailer of freedom and the enemy of growth. JFK.
Musings of a late 18th Century Scottish political economist (and not the one called Adam Smith!)
A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by a dictatorship. ALEXANDER FRASER TYTLER
Tytler believed that, on average, the world’s greatest civilizations have had a life-cycle that has lasted about 200 years. During that period, nations tended to evolve through the following stages, starting at bondage. If so where is the West now? At Complacency, Apathy or even perhaps Dependence?
Having spent time campaigning in Britain during perhaps the most important General Election in 30 years, in the moment, one cannot help but be swept away by the excitement surrounding the event. But then, once one thinks about the deeper issues at stake, one cannot help but be appalled by it too. Juxtaposing the so-called debate that has taken place in Britain with events in Greece highlights the profound problem that all modern Western democracies (including Japan) now face.
And the problem is this. In the run-up to the British election, there was almost no acknowledgement by any of the three main party leaders of the elephant in the room – what to do about the enormous Black Hole (some £163bn large) in Britain’s finances. Watching the leaders in the economic debate quibbling over a ‘trifling’ £6bn made me realise that, like John Cleese in Fawlty Towers, they simply dared not “mention the war”, the war fighting the deficit that still lay ahead. Of course, they may have been blissfully ignorant of the enormity of the problems they faced (with Cameron at least, unlikely; with Brown I really am not so sure), and there was a touch of denial even amongst those who have recognised that a problem does indeed exist. Although relative to the size of its economy, the Greeks face a decade of (ahem!) cold turkey, in absolute terms, the British face a far larger problem. Yet, as the Institute of Fiscal Studies painfully illustrated during the election campaign, no party was willing admit to that problem’s true size for fear that the voters may punish honesty in the polling booths. Perhaps it is as if, as Jack Nicholson famously barked in the film A Few Good Men, the voters simply “can’t handle the truth!”
In Hindu cosmology, the earth rests on the backs of a group of elephants which in turn stand on the back of the turtle, Akupara. (And if you are thinking “What is beneath Akupara?”, as the quip goes, it is “turtles all the way”!) In the above phrase “voters may punish honesty” lies an indication of a far more monumental challenge than even the largely unacknowledged deficit elephant in the room, the figurative turtle Akupara on whose back that jumbo deficit stands. This Akupura is quite simply that democracy as we know it may be heading for a fall.
So heavy is the debt burden now facing Britain and indeed most Western nations and especially Japan, it is not impossible to think that before they too will start to do a Greece and threaten to break the back of the democratic foundation on which their sovereign debt now stands. (How ironic! Greece, which gave the world democracy, is now the nation most clearly revealing its limitations – that the sovereign debt of the Greek state may yet be brought low by demos by the demos.) This capitulation will happen either by way of outright default as could still happen in Greece or disguised default via devaluation as is already happening in the UK, US, Eurozone and Japan.
To put this seemingly apocalyptic forecast on a sounder footing, let me back track. Keynes’s great achievement in the Great Depression era 1930s was to devise a mechanism that could finesse the economic problems of the time and engineer a way of saving democracy from the grasp of communism or fascism. By first throwing off the fetters of the Gold Standard, he then identified an escape route – deficit spending or the creation of fiat money unbacked by gold – that would allow governments to borrow from the future in order to kick-start the present. What this enabled them to do was to re-ignite demand artificially with money borrowed from future generations; this practice gave us the term “demand management”, the predecessor to macroeconomics. Though Keynes died before the longer term (and broadly negative) consequences of Keynesian jump-starting would become all-too-apparent, there is ample evidence in Keynes’s writings that suggests he would have used the subsequent surpluses of the resultant good times to refund the temporary expediency he recommended be adopted to escape the bad times.
Sadly, and perhaps this defines the ageing gene written into the DNA of democracy, those politicians who followed Keynes’s advice as to how to end the bad times could not, when the time came to do so, bring themselves to take back in the good times (for instance Harold Macmillan’s “You’ve never had it so good” times of the 1950s) what they had effectively borrowed from that now improved future. Instead they rolled the debt they had incurred and actually added to it, even in the good times. Over the 65 years that followed WW2, in Britain as elsewhere in the democratic world, the essential pattern has been that, whatever the party in power (yes, even the parties of allegedly small government on the Right: who can forget the Military Keynesianism of Reagan or Cheney’s devil-may-care dismissal that “deficits don’t matter”?), the ruling party expanded the role of the state in the economy and so increased the accumulated debt that became the detritus of that now near-permanent fiscal expansionism.
Note that, unlike in the US where the Republican “right” often vied to be more Keynesian than the Democratic “left”, in Britain the “good guys” were usually the Tories but only because they expanded the state and the National Debt more slowly than Labour. For all her penny-pinching reputation, Margaret Thatcher’s achievement was that, during her time, the state’s share barely expanded at all: but even the tight-fistedness of the Iron Lady herself could not contract it.
Democracy as it is practiced seems to confirm – at the macro level – the central finding of the behavioural school of economics that surrounds Prospect Theory: Humans have an irrational tendency to be less willing to gamble with gains than with losses. This insight also means we are extremely reluctant, often to the point of being bull-headed about it, when it comes to giving up what we already have even if there is a high chance that, by so doing, we might get even more. Or, as the old proverb has it, humans do indeed believe and behave as if we believe “A bird in the hand is worth two in the bush“.
The political point here is that democratic electorates are loss averse: once they have something, they are extremely reluctant to give it up. In reality what this has meant is, over the past century or so, that once the democratic state has expanded into a particular economic space (frequently using deficit financing to do so), electorates have been extremely reluctant to support a party who subsequently campaigns on a policy that it intends, if elected, to then withdraw from that space. So, as time passes, democracy ratchets up a deficit-expanding state’s involvement in the economic life of its people: when Blair became Prime Minister, the state accounted for 42% of Britain’s GDP; when, 13 years later, Brown resigned as Prime Minister, that ratio had risen to 52%!. As the state expands, state spending becomes an addictive drug that the electorate seemingly cannot live without, as the Greek tragedy playing out today amply illustrates.
In 55BC, Cicero warned us about the growth of the size of the state, state debt and the level of addiction of the populace on state spending arguing that: “The budget should be balanced, the Treasury should be refilled. Public debt should be reduced. The arrogance of officialdom should be tempered and controlled. The assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance.” But apparently to little avail!
Democracy would be sustainable even in the long run if it lived within its means and did not fall for Alexander Fraser Tytler’s curse and, giving in to the electorate, consistently spend more than it earned. The result is default overspending what I think of as the Keynesian rounding error, a deficit whose annual cost is typically 3%+ of GDP. But perhaps my belief in the idea of a forever young democracy without the age-lines of rising deficits is naive: given the competitive nature of democratic politics and its shortish electoral cycle of 4 to 5 years, each new election not only sees politicians promising “A better life for all” (the slogan used first by the ANC and then by Blair for Labour in the 2005 UK General Election), but also sees those few brave politicians advocating fiscal prudence being cast in the role of being political Scrooges so rendering themselves most likely unelectable.
The result has been a slow but steady rise in the accumulated national debt measured against GDP for almost all democracies over the past 70 years. And, as if this were not enough, the killer blow has been the fact that the population pyramids of these same democracies have aged materially during this same period. These democracies have borrowed more and more from their grandchildren but then had less and less grandchildren that would eventually be obliged to repay those intergenerational debts. This pincer has all the hallmarks of an accident waiting to happen.
Only more recently have the longer term, negative consequences of spendthrift Keynesianism, in good times and not merely in bad, started to be realised, and in both senses of the word ‘realise’! (To her credit, Joan Robinson, the 1950s Cambridge economist who was the unofficial guardian of Keynes’s legacy, saw the first stages of the political hijacking of Keynes’s Big Idea happening and, despite her leftish sympathies, dubbed these policy refinements to be “Bastard Keynesianism”; one imagines JMK, for his part, probably seething somewhere on a cloud Up There given how modern democracy has perverted his beautiful insight).
Meanwhile, the ticking of the demographic time bomb has got louder. The size of the accumulated debt has got bigger. And, now, for most Anglo-Saxon nations, the intermediate funders of this debt, who have been foreign, now appear to be in the early stages of realising that, rather than parking their savings surpluses in US T-Bills or UK Gilts, recycling their surpluses domestically (usually this means therefore in the East) is an increasingly attractive opportunity. If this trend continues, this redirection will gradually constrict especially the current account deficit running Anglo-Saxon nations.
Keynes actually warned of this outcome in his The Economic Possibilities of our Grandchildren albeit in a roundabout and back-to-front way. (I regard this brief, 7 page opinion piece to be one of his most underappreciated masterpieces.) The central observation he made was that, if each of us could save but a relatively small amount every year and see those savings compound at 2% real per annum, year in year out, and then let compound interest sprinkle its magic dust on our savings pot, we would have enough money to retire on. How ironic that the politicians should then take his Big Idea and subject it to this exact same logic except on debt rather than savings and instead end up with a nightmare.
Since the late 1950s, the typical Western nation (especially the Anglo Saxons) has run a deficit of at least 3%, year in year out. It has let it compound over time, rarely reducing it rather occasionally running much higher annual deficits in the wake of periodic cyclical downturns, Great Society-style programmes or wars. This has left them today with deficit to GDP ratios approaching and sometimes above 100%. The magic dust of compound interest has produced not a savings miracle but a debt monster.
What has gone wrong? Keynes’s most famous saying was “In the long run, we are all dead”. It was a response to the warnings issue against his fiscal spending, which suggested the best route would have been to let matters mend properly even if it took time to do so. One almost imagine someone saying to Keynes, “Do not intervene, the situation will right itself naturally in the long run”. To this, Keynes replied – tacitly acknowledging that this might well be true but that such delay was just not good enough –“(That may be, but) in the long run, we are all dead”.
And therein lies the fatal conceit of democratic Keynesianism. We may well all be dead, but our children and especially our children’s children will not be, and when the music eventually does stop, they will have to pay. The tragedy of the present is that today, now, is the generation of Keynes’s children’s children. And as Reinhart and Rogoff’s study points out, the music could very well stop in this generation, not in the long run, not even in the medium run but in the short run. But given the mañana of the fatal conceit, the current generation in the West bumbles on, its capitalists trying (in Karl Marx’s words) to sell the hangman the rope that will eventually close round the neck of democratic capitalism as we know it.
Perhaps I am being too hard on Western politicians. Perhaps they are all walking down the one-way street of destiny, a street from which there are no paths back to the Yellow Brick Road. Perhaps, as that great supporter if doubter of capitalism, Joseph Schumpeter, foretold and with fear in his words, the great game of democratic capitalism would eventually collapse under the weight of its own internal contradictions, contradictions that would only be revealed with the passage of time.
Schumpeter’s fear was the one above: that the more mature a capitalist democracy (underwritten or more accurately undermined as it would be by those Keynesian error accounts) became, the less pain it would be prepared to endure. To the extent that pain could be postponed, it would be through borrowings both public – think quantitative easing! – and private. Schumpeter also foresaw the result as being one where, as the lifecycle of the Janus of democratic capitalism aged, we would see more of its democratic face and less of its capitalist one. But by undermining capital by postponing destruction and instead borrowing more and more to maintain the illusion of creation, the delicate balance that required both to interact would be destroyed and so too would capitalism.
Here I part ways with Schumpeter – I think rather that democracy will die. Capitalism, the wily old fox that it is, will likely to live on in a different political combination or, in the title of a book by a Chinese author Kellee S. Tsai, Capitalism without Democracy.
 There is some dispute about whether Tytler ever said these exact words, but the sense is very much in keeping with what he wrote in his various treatises on the subject of democracy.
For most of Africa, the symbiotic relationship that the continent is developing with Asia – and especially with China and even India – could not come at a better time. Just as a new generation of post-post colonial leaders is reinvigorating the Continent’s political ranks and so the governance of many African nations, so too a new foreign trade relationship, this time a far more evenly balanced one with Asia, is reinvigorating the economic relevance of the African Continent as well. If these two trends can work hand-in-hand, Africa’s future will be a lot brighter. And, for the first time in over 500 years, since Vasco da Gama rounded the Cape of Good Hope and gathered up the African Continent into the European sphere of influence so drawing it away from Asia, the West may well be only marginally involved in defining that brighter future.
Africa’s road to political independence began when Nkrumah declared Ghana “free forever” in 1957. But economic independence was not so easily won with much of the Continent remaining trapped in a quasi-colonial framework, one based first on trade with the former colonial powers and then more recently on aid received from them, usually via the multi-lateral agencies closely associated with the West: the IMF and World Bank.
In recent years, this structure has started to break down as an industrializing, urbanizing, resource-hungry Asia has recognized new value in a region that had become marginalized in Western business decisions and a backwater in the Western mind, best renowned for famine, war and photogenic opportunities for Western celebrities to be seen to be “doing good”. Africa never liked this reputation – who would? – but for a time, there was little alternative open to Africa but to squeeze the Aid Cow for whatever milk it would yield.
Matters are now changing and changing fast, so much so that the cow and its herdsmen are feeling somewhat neglected. Asia wants to trade with Africa, pure and simple. And if trading with Africa also requires rebuilding the Continent’s infrastructure so as to facilitate the extraction of resources, so be it; Asia is often prepared to finance the construction of more integrated supply chains in Africa too.
Many in the West – perhaps miffed at Africa’s ‘fickleness’ and its willingness to ‘flirt with new friends’ – have been quick to suggest that Africa is replacing one colonial master with another. And, truth to tell, the relationship between Africa and especially China was not an even one at the outset. But, as Zambia and Angola can testify, rebalancing this relationship to one that is more mutually advantageous is easily done. And, to their credit, the Chinese – and now the Indians and even the Brazilians and the Russians – have accommodated these revisions on the basis that they appear to be building longer term relationships based on sounder footings as a result.
Other African countries, newer to the dance with China, have built their African partnerships on these second and third generation model revisions. And, given the competition that China is now experiencing from especially other BRIC nations and even a reawakened West now aware that its privileged place in Africa’s trade network is rapidly being disintermediated, Africa’s oil and mineral rich nations have gone from being shunned wallflowers to sought after Cinderellas at the global economic ball.
Of course the break with the old and engagement with the new has not been a smooth one – old habits die hard as do old relationships. Western oil companies in particular often have African friends in high places such as Gabon and changing this guard is easier said than done.
One of the less remarked upon redoubts of the West in Africa has been its hold on African policy making, especially with regards to macro-economic management: best practice in Africa is still taken as being that which is done in the West, notwithstanding the fiscal, monetary and financial messes the likes of the US and UK have found themselves in during the past decade or so.
Still the tenets of the so-called Washington Consensus – hypocritically often loudly preached by but barely practiced within the West as recent behaviour can testify – are often deeply rooted within the Treasuries and Central Banks of Africa. Alternative ideas, whether they come from Chile or China, are given short-shrift regardless of their merits and possible appropriateness to the African macroeconomic challenge.
In view of this, it is hard not to conclude that as Africa has, in recent years, finally loosened the silken cords of trade dependence on the West having broken the political chains in the 1950s, 1960s and 1970s, the next challenge must be to let go of the woolly economic thinking still imported from the West, thinking that was rarely appropriate for Africa in the first place and, after all, may not really have worked for the West either.
Meanwhile Africa plays the Dragon Variant in the Great Game of Chess being played for the world’s resources
Zou chuqu zhan lue is not a phrase you will hear very often on the streets of Luanda, Lusaka or Lubumbashi. But it is a phrase that is arguably changing the economic face of Africa more than any other since the colonial era, more influential even than the term “Washington Consensus”. Meaning “going out strategy”, zou chuqu zhan lue is the Mandarin expression that defines the economic policy increasingly governing China’s engagement with the world’s resource-rich regions. As such, Africa has been one of the prime beneficiaries – or, depending upon your view point, “victims” – of this Eastern approach.
Its central feature is encouraging China’s leading resource-oriented companies to invest in securing the ever-expanding global supply chains of natural resources upon which a fast growing China is, every year, becoming more and more dependent. That it can be funded out of China’s foreign exchange reserve mountain also means it potentially solves another challenge faced by China – how to recycle $2.5 trillion of mostly accumulated trade surpluses more constructively than merely parking them in an increasingly risky US bond market.
The likes of Chinalco, PetroChina, Shenhua Coal and MinMetals are but the better known examples of a host of Chinese companies that are scouring the earth for resource companies to buy or mining and energy projects to co-finance. Though there is no blank cheque that is underwriting their acquisition costs, they seem to have little difficulty in securing funding when the ‘right’ project comes along. That Chinese buyers are usually the acquirers most likely to pay the top-most dollar in any auction to secure a company or project up for grabs suggests that justifying the price to those holding the purse strings back in China is not an especially demanding task. And, given that 95% of all foreign direct investment flowing out of China in 2009 went into natural resources, it suggests that zou chuqu zhan lue as a commercial policy is being given the highest of priorities by Beijing.
The Southern Hemisphere in particular has been on the receiving end of this strategy though companies and projects from Kazakhstan to Canada and Mongolia to Iraq have also benefitted. In Latin America, Peru’s copper and zinc industries and Argentina’s oil and gas sectors have thus far been principal targets though, had Brazil allowed it, the Chinese would have invested even more heavily in their emerging oil sector than they already have. Australia has arguably been the country most targeted thus far. But the region whose economic prospects are most likely to benefit from this new wave of investment is Africa.
For many countries in the continent, China is already their most important trade partner with Angola, for instance, now China’s leading supplier of imported oil, ahead of even Saudi Arabia. What makes China’s involvement in Africa so noticeable and – for some at least – so controversial has been its willingness to deal with regimes like that of Sudan, regimes that have incurred the wrath of Western human rights organizations. Furthermore Chinese involvement has gone far beyond that of merely being a big buyer of oil or minerals: frequently they have got heavily involved in repairing or even building anew the infrastructure required to extract these resources, from road to railways, from power stations to ports.
To some extent, the opprobrium that Chinese interests have attracted has been little more than sour grapes emanating from Western commercial interests finding themselves outmanoeuvred in an increasingly competitive environment. Recent events in the emerging oil sectors of Ghana and Uganda would fall into this category.
The geo-economic chess game that is now being played out across the African continent is reminiscent of the Great Game played between Britain and Russia in Central Asia during the 19th Century as the Lion and the Bear sought to bring that region into their sphere of influence thus controlling its trade and resources. But what is happening in Africa today is, in one profoundly important respect, very different from that chess game: those who own the chess-board, today as sovereign and independent nations, are also playing the defence.
No doubt there remains a degree of lop-sidedness in some of the relationships being forged between China and the resource producers of Africa. But as other players – Brazil, India, Russia – enter the African game or – in the case of Western interests intent on regaining their previous privileged positions – re-enter it, the balance of economic power is slowing but decisively moving in favour of the defence and against the attack.
This is most apparent in the Sino-African relationship; though, over the past decade, it has not been without its misunderstandings, it has materially improved in recent years, and mostly in favour of the resource sellers in Africa and at the cost of the resource buyers, especially those in China. This is arguably most apparent in Angola and Zambia.
The Dragon Variation is one of the most famous and effective manifestations of the Sicilian Defence, itself one of the most powerful of all chess openings. The Black players of Africa have, in recent years, developed their own rather successful Dragon Variation in response to the zou chuqu zhan lue moves now being played by the Chinese in the geo-economic chess-game that the scramble for the world’s resources has become.
Herewith the audio link if you want to hear my views summarised in an interview with Lindsay Williams.
The written version of this interview is filed below.
Ten Ideas for 2010
Overall prognosis: A game of two halves; good for all in the first half, less good for some – especially the West and Japan – in the second.
Contrarian Question of 2010:
What letter comes after V? Hint: Ask a German car fanatic!
My essential prognosis for 2010 is that, whilst the US, Europe and Japan will NOT have a double dip recession in the sense that they will again endure two quarters of negative GDP growth, they will experience softness in the second half of 2010 creating a skewed ‘W’ growth profile for 2008-2010. Whilst this will weigh more on sentiment in the West and Japan, it will not impinge on Eastern growth. That said, in Q3/4, equity markets everywhere are likely to pause or even decline in sympathy, though again more so in the West and Japan than in the East.
- CURRENCIES: Expect a stronger US Dollar (or at least a less pronouncedly weak US Dollar) in the first half of 2010 but only against the usual suspects £, €, Sw Fr and the Japanese ¥. To blunt domestic inflation, China will again allow marginal appreciation of the RMB prompting the China Club (Sing $, Kor Won, Taiwan $ etc) to ease up on FX intervention too; stealthy India will do the same. The second half will see the US Dollar again weaken materially as an even tepid return to growth restimulates demand for imports (esp. oil) and so weighs on the US’s current account deficit. Declining participation by foreigners in Treasury auctions will weigh on the Dollar too. Commodity currencies will be firm throughout the year, but more so in the second half than the first.
- BOND YIELDS AND THE RISK FREE RATE: Continued funding of deficit shortfalls (met by continued Fed debt repurchases i.e. monetization) cause bond market indigestion and so further yield back up. Prematurely, this will start to do some of the Fed’s “Exit Strategy” work for it. Incumbent US politicians and even the Fed itself will decry this as it will boost mortgage rates and the cost of capital, especially with mid-term elections looming. With little inflation facing the West, the ECB only tightens – minimally – in Q4; the Fed blusters, blinks and stays pat.
- ECONOMIC GROWTH: In the US, the second half will be more bumpy than the first as mortgage rates and the cost of capital edge up before the recovery has gained proper purchase so becoming self-sustaining. Faltering US GDP growth requires a second stimulus package, partly negating the drag caused by the cancellation of the Bush tax cuts at the end of 2010. Expect Q3/4 data disappointments in the West especially the US. Why? A combination of the inventory rebuild boost wearing off; the banking system still not lending much to consumers; option ARM mortgage resets in the US (see chart below); fading effects of the stimulus package; bond markets suffering from indigestion and so restricting sovereign debt issues and so fiscal stimulus; weaker bond markets forcing the Fed to hint of accommodation withdrawal; trade sanctions on China rebounding via lower US dollar asset purchases esp. Of Treasury Bills; and pronouncedly positive base effect of strong Q3/4 2009 washing out of the numbers. In Europe, export-oriented economies will outperform the build-houses-and-consume brigade. But for the PIGS, the exporters would battle with an even stronger Euro. The UK will see short term growth prospects dim but longer term ones improve after a weak Tory election victory. In Emerging Markets, growth will rebound strongly, with China and India in particular beating forecasts. As the year ages, commodity-rich countries will strengthen their growth profiles too in line with rising commodity prices.
- GLOBAL TRADE: Generally positive for 2010 but US trade policy (tariffs, quotas) will cause China to retaliate indirectly by recycling less of its surpluses into Dollar assets, so further weakening the US Dollar. Indeed low-level ‘trade wars’ will become a feature of 2010 worldwide. Watch from China-ASEAN trade to accelerate in the wake of their free trade pact. Resource exporters will also see trade with Asia rebound strongly.
- EMERGING MARKETS: Two types of Emerging Markets will emerge this year:
- the water-skiers: those mainly current account surplus generators (plus India) who are pulled by their own growth motor-boats, often powered by an emerging Middle Class getting a taste for consuming more and saving less, and
- the wave-surfers: those dependent on foreign capital to balance their current account deficits and who are driven by the wave of liquidity that is the carry trade.
Medium term, the former group will materially outperform the latter despite some experiencing occasional pull backs driven by over-valuation; amongst the latter, a few are even likely to get dumped by wipe-outs. All will generally perform well though they could pause, even stumble, if a Western pull-back becomes contagious.
- EQUITIES: Most recoveries from severe bear markets experience a second down-leg. If this happens in 2010 – and I sense it will in the second half as there is too much gung-ho hubris around – the West will be hurt more than the Rest though all could suffer if funds return to the “safety” of US Dollar “securities”. In particular, watch out for the negative base effects of Q3 and Q4 weighing on US and European equity sentiment.
- PROPERTY: The US property crash will experience a second down-leg with economy-wide implications. The tepid strength of the economic rebound will be temporarily outweighed by the negative pull of the mortgage resets.
- COMMODITIES: Coal (coking then thermal) will be the biggest winner then iron ore then copper. Oil will do well when it breaches $100/bl later in the year, though the colder the northern winter, the sooner this might happen as stocks will be run down earlier. In the second half of 2010, when the US Dollar will again show pronounced weakness, watch gold and the platinum group metals. In this demand recovery phase, supply constraint will be the key determinant of likely price performance. World commodity demand will be ahead of forecast mostly because Asia will grow more strongly than current consensus forecasts. That growth will also be more independent from Western trends.
- WESTERN SOVEREIGN DEBT: This will be the story of 2010. Western debt issuers – and especially the deficit running Anglo-Saxons – will start to test the limit of the East’s patience and so test the capacity of debt markets to finance their seemingly never-ending and ever growing need for deficit financing. Within the Eurozone, the patience of the surplus running North will be sorely tested by the deficit running South. Sovereign bond issues from weaker members of the West and a few amongst the Rest (the PIGS, Iceland, Eastern Europe, Mexico, Argentina…) will see yields ratchet upwards and issue sizes contained.
- DEMOCRACY: Keynesian-style “Ooops! We overspent yet again…issue a bond” democracy will start to test its limits. This is a multi-year story and will play out with increasing clarity and intensity as the coming decade progresses. The back-to-front logic where the developed world core does not send net investment to the periphery but instead consumes 70% of the savings generated by that periphery will start to reach its inevitable conclusion: break down. With the Keynesian rounding error – the ongoing annual budget deficits of Western democracies and Japan – edging upwards in an era when inflation is still well contained and if anything edging downwards, the East in particular is going to start saying “enough” or at least demanding much higher yields for those savings that the West wants to borrow from them.Higher yields will compound the plight of the West as its cost of capital will concomitantly rise so weighing on its economic growth. In addition – and this is an increasingly likely and powerful proposition – the East will consume more and save less as well as instead recycle more of their own savings into their own developing bond markets, thus short-changing Western sovereign debt markets. Either way, the exorbitant privilege afforded to the Western democracies whereby its deficits are funded by outsiders will gradually be withdrawn. The result for Western democracies and Japan will be rising bond yields with aging populations, an improving Eastern skills and knowledge base relative to that of the West and the overall erosion of Western pricing power, in part reflected in a rebalancing of currency values from West to East. This combination will create a sour cocktail for those low-threshold-for-economic-pain Western political systems. And this sourness will become even less politically palatable if continued fiscal incontinence and continued commodity price strength eventually causes inflationary expectations and then inflation itself to re-ignite in both the West and Japan. Weakening Western currencies could then close the loop and turn this trend into a vicious circle against the West and in favour of the East and commodity-rich countries. This process will take time to play out. But – as the democracies of Iceland whose Parliament, the Althing, dates back to 930 and claims to be the world’s oldest) and Greece (how ironic considering democracy’s origins!) are already hinting – the systems of the West are not sufficiently robustly built so as to be able to survive and prosper on an extended diet of economic cold turkey. As if all this were not enough, at some point in this process, the dam wall of home bias which is holding back the residual savings of the West to a far greater degree than economic fundamentals would already tend to warrant will start to crumble. The carry trade we know today will pale in comparison.
…this on the critical need for South Africa to develop its export-related infrastructural capacity.
Promoting a competitive currency is the single most important arrow the South African Government can fire from its quiver if it is to hit its targets of higher growth and greater employment. But it is not the only arrow, not by a long shot. Indeed if it were the only one, we would probably lose the war.
One, perhaps less obvious, arrow that will also need to be fired in the wake of any devaluation will be the vital need to build an infrastructure designed to support an export-led economy. As we enter 2010 – a year for which South Africa has undertaken the massive infrastructure spend required to host the World Cup – we need to remind ourselves that, once the vuvuzelas have fallen silent, a very different sort of infrastructure spend needs to be prioritized.
First let’s soften the coming hammer blow with the good news. One export-oriented sector a more competitive currency would naturally promote would be tourism. Conveniently the World Cup’s expenditure programme will leave us with a modern transport and accommodation network well able to handle many more tourists. This means, post 2010, investment in tourism infrastructure can take a breather; other sectors can and must be prioritized.
An export-oriented expenditure focus may not seem to develop what politicians crave: ‘delivery’. Not necessarily; President Zuma’s expanded rural road network would, if geared to the development of an export-oriented agricultural sector, serve a dual purpose: delivering transport connectivity to the rural poor plus promoting South African exports.
The funding demands that this new focus would place on the South African Treasury – and the balance sheets of our already overstretched parastatals – will be monumental. Yet, if a more competitive Rand were to drive the healthy repositioning of the South African body economic, meeting these demands would still be of paramount importance. Of course, the public sector can and must carry its share of the burden and, in their efforts, they must pursue every funding avenue possible. Why not, for instance, as has been done in Kenya, issue very-popular-with-investors infrastructure bonds to help fund the state’s share?
But where Government cannot fund, say, another rail-link between a new coal project in Mpumalanga and Richard’s Bay, the private sector should be heavily encouraged to do so. A new rail link dedicated to facilitating coal exports would, by not diverting existing transport capacity, only complement the current network. And if new mines need water and electricity capacity, why not use tax incentives to help develop this capacity, so building new dams and solar power grids? By doing this as a country, we lose nothing and gain enormously: something of something is always more than 100% of nothing.
India – employing an economic model that is finding much favour in Pretoria – has encouraged its steel companies to develop their own integrated networks, from independent power and water supplies to dedicated rail and port capacities. Bottom line? These private sector networks supercharge India’s exports. But even in India, this open approach is not always enough; as Sunil Bharti Mittal, MD of Bharti Televentures, has noted: “Weak infrastructure is costing India about 3 or 4% of lost GDP growth a year”. Would it not be a disaster if, following a devaluation in South Africa, our inappropriate infrastructure prevented South Africa from growing 6% and more?
Letting the private sector build new infrastructural capacity in direct support of export growth is an absolute ‘no-brainer’ in today’s hypercompetitive world. All over Brazil it is happening – local heroes like iron ore mining Vale now own the Centro-Atlântica Railway and Vitória-Minas Rail and Praia Mole port facilities; foreign investors like the Noble Group have funded extensive grain and sugar export facilities in Santos. Indeed, the Chinese even allow foreigners to fund import-oriented infrastructure! Our own Kumba has financed the upgrading of its iron ore handling facility in the port of Qingdao.
Why burden the South African taxpayer with financing new infrastructure projects destined to sell product to foreigners? Let private capital do it instead; ultimately foreign consumers will pay for it. The South African Government should applaud loudly if someone else will bear such a burden. (Note too that funding expensive infrastructure projects can even work when the consumer is local – isn’t this how we built up our successful profit-earning, tax-paying, rural area-reaching mobile phone industry?)
Not all South Africa’s parastatal-driven infrastructure projects have underperformed. Thus far the Spoornet/Kumba Sishen-to-Saldanha-Bay rail-link has worked well. Iron ore export volumes have risen and capacity expansions continue. But it is becoming abundantly clear that if annual capacity is to jump from 60m to 90m tonnes (including ore from Assamang), the public sector cannot cover all the additional investment alone. So let the private sector fund it instead! Kumba no doubt wants to run their own mine-to-port rail operations as do competitors BHP-Billiton, RTZ and Vale. Who knows? Kumba may even attract a Chinese co-investor for such a project. Where the private sector or a foreign investor is willing and able, generally speaking, the public sector should say “Be my guest”.
South African coal exports now face similar hurdles. Richard’s Bay Coal Terminal is a successful private sector infrastructure model deserving replication throughout the country. Yet coal shipments via RBCT have fallen 10% since 2006 even as the Terminal’s capacity has recently risen by over 30%. At fault is Spoornet, unable to provide the rail capacity to maintain tonnages. The execrable result is that South Africa’s coal industry – which has ample coal reserves – has only been allowed to play the price game in recent bonanza years, missing out on the volume game completely. A devaluation which only achieves higher revenues via the price effect would be missing the ultimate objective – to foster a supply side revolution that sees us producing more as a nation and, much more importantly, employing many more people to do so.
Other infrastructural requirements include (dare I say it?!) more electricity. We cannot grow an export-oriented industrial side without a reliable and increasing supply of electric power to those mines and factories that will need it: in particular, we cannot allow a repeat of power rationing to the gold and platinum sectors. The woeful saga of aluminium smelting in South Africa – culminating in the cancellation by RTZ of the Coega Smelter – centres on the lack of availability of competitively priced electricity. So why not – and here is a radical thought – let private capital fund, say, 100% of the proposed Kusile Power Station?
Enough said; indulging in the national sport of kicking Eskom has crowded out much-needed comment on other areas where criticism is also due. For instance, Johannesburg cannot become the central aviation hub serving our tourism industry without an absolutely reliable supply of AVGAS – one reason, among many, why the construction of the Transnet Pipeline from Durban to Gauteng must proceed without further delay. And using massive tariff increases to fund heavy capital expenditure is a risky, inflationary and ultimately absurd way to proceed. Why not emulate Russia here? The pipeline network currently being built throughout Central Asia has high private sector involvement. Surely a Durban-to-Gauteng pipeline project can also be funded by private capital? And if this meant Transnet were not even to be a minority investor in the project, so be it: public interest can always be protected by the regulator, in this case NERSA.
If, via a competitive currency, South Africa were to develop an export-led growth strategy, government must rethink exactly what role they must play in reshaping the economy to get the most out of this new focus. Absolutely critical to this approach would be supporting the creation of a complementary infrastructure. And if our parastatals cannot fund all the new needs – as even now they cannot without forcing through huge increases in administered prices – they must be prepared to stand aside and let the private sector do it for them. After all, this approach is now very common in the BRICs – Brazil, Russia, India and China. So why not in South Africa as well?
There follows the Op-Ed piece I recently wrote for South Africa’s Business Day.
As the Rand debate moves centre-stage, the flak of misinformation that accompanies this migration is increasing in intensity. Indeed a veritable flock of canards have taken flight, all needing to be shot down and roasted if a proper, well-reasoned debate is to be had.
One canard in particular is regularly seen aloft: were the Rand to be fixed at a lower level, South Africa does not have enough foreign exchange reserves to defend it. This canard keeps company with another: if we do fix the Rand, the market will take us on.
Both reflect the unpleasant experience South Africa endured during the 1990s, when the SARB tried to defend the Rand’s value and, for its folly, ended up losing us over R30bn on our forward book. Lesson learned: never intervene in the FX markets. Once bitten, forever shy. Case closed.
Not so fast. The reason why we were caught in the market’s crossfire was that we tried defending the Rand – and here’s the rub – at an exchange rate that still meant running twin deficits on both trade and current accounts. And let me state unequivocally, were a future policy of our Treasury to envisage fixing the Rand at a rate which did not turn our twin deficits into twin surpluses, I would unhappily sympathise with the “Rather do nothing at all” cop-out crowd.
When recommending that South Africa engineers a more competitive exchange rate for our currency, I am always talking about a rate that would, over the full course of our economic cycle, generate a trade and current account surplus.
Most of the new converts to the cause of “the Rand is too strong so perhaps a more competitive rate would bring recession-ridden South Africa some relief” would most likely envisage a minor tweaking of the Rand’s cross rates downwards. Indeed even existing advocates of the devaluation idea probably do not imagine us adopting an exchange rate that would generate twin surpluses.
By moving into this twin surplus camp, most South Africans will have to undergo a profound rethink as to what they accept as the right exchange rate policy for a resource-exporting, recession-ridden, grossly unemployed emerging market in today’s fast-shifting-East world.
A good friend – steeped in the received wisdom of standard neo-classical economics textbooks – recently upbraided me “But South Africa should run a current account deficit”. And according to those textbooks, he is right: we should be that capital importing, developing country yin to the yang of a developed world core; in turn that core should be running a current account surplus, a savings surplus they should be investing in us, the developing world.
If only. We live in an upside-down world: this year, the US, with only 4% of the world’s population, will consume over 60% of the world’s mobile savings through that giant sucking straw that is its current account deficit. Add in the deficits of the UK and the Eurozone and this ratio exceeds 80%. Do traditional textbooks have it back-to-front? Some leading economists like Joseph Stiglitz now believe so.
So if the West is abusing the purportedly natural order of neo-classical economics and consuming the world’s savings when they should be producing them, why then should South Africa stick to those now outdated economic ‘rules’ by running a current account deficit? Surely not for the honour of vying with the West for those savings? Or some sort of mistaken sense of quasi-Anglo-Saxon solidarity?
Why not instead learn from Asia which, in 1997, discovered how fickle foreign savings flows can be? The New Asia now saves for itself by purposely and purposefully running twin surpluses; this has increased its monetary independence and, in case you have not noticed, allowed it to prosper even as the West chokes.
The New World we live in favours a New Normal for emerging markets: if you want to be sustainably successful, run a current account surplus. Furthermore, successful resource-rich countries – even the developed likes of Canada and Australia – run, at the very least, trade account surpluses. This suggests that doubly qualified South should run a current account surplus, not – as many in South Africa deem to be our divine duty and destiny – a current account deficit.
All this brings me back to those canards. If South Africa does intervene to engineer the Rand down to a more competitive rate, we must be prepared to go beyond the swampy no-man’s-land of still not running a current account surplus to the dry land on the other side where we will. Why? Because if we live exposed in the open of those middle ground marshes, we will be easy game for trigger-happy speculators. Far better to be on the far side of those firing ranges grazing on those greener pastures on which South Africa should be thriving. That landscape will also suit us far better than sheltering in the dreary economic shallows where we take cover today, at the mercy of the Scylla of fickle foreign capital and the Charybdis of our own credit cycle. Our present-day hide-out remains an economic backwater from where it is next-to-impossible to emerge into the bright sunshine of high GDP growth and material generation of new jobs.
We desperately need to target that rich dry earth of structural current account surpluses, a territory wholly unfamiliar to South Africans: it will allow our country to become export-oriented and foreign demand-led, not import-intensive and domestic demand-dependent as now. Rest assured, this terrain is one where those ‘amorphous markets’ would be pursuing a very risky course of action if they tried attacking a currency rooted in the terra firma of a current account surplus. (The only time such madness occurred – when speculators attacked the Hong Kong Dollar in 1998 – the Hong Kong Monetary Authority ‘won’. The speculators – Bank-of-England-slaying Soros included – ended up with very bloody noses.)
Why is this? Because it is far harder to drown a man if he is initially sitting on dry land. A current account surplus implies that, far from having a daily quota of foreign capital one needs to attract, one has a positive balance at the end of every average day, a balance that would be added to the sandbags of one’s foreign exchange reserves.
Why would speculators attack the Rand if it was already deliberately competitively priced? As the SARB is the Rand’s monopoly issuer of the last resort, our Reserve Bank cannot really lose. If speculators shoot US Dollars at us, we catch them and add them to our reserves. And if – bizarrely – they were to shoot Rand, in extremis, our best response is to let them. The ‘worst’ that can happen is that the Rand becomes more competitive, our current account surplus widens and our foreign exchange reserves increase.
My central point is this: most of the Rand debate thus far presupposes any new lower exchange rate would still not be low enough to generate a current account surplus. And were that to be the case, the canards I identified above would indeed be sitting ducks guaranteed to attract the crosshairs of any half-awake speculator. If this swampy no-man’s-land rate is all that is being envisaged then we might as well give up even before we have started.
Instead what I am recommending is a whole new way of thinking for a Brave New South Africa struggling to make its way in a world where the Old Order – from who is the ruling hegemon to which economics textbooks apply – is giving way to a brand new one.
Alternatively, we can continue skulking amongst the bulrushes in today’s economic backwaters, missing out on the opportunities of that exciting New World, naively reading and believing in the economic textbooks of yesteryear. You choose.
If, according to Bernanke, the East is saving too much and, so by extension, the West is saving too little, what is the ‘just right’ Goldilocks level of savings in the world? The equilibrium of nothing? Then there would be no investment and so no growth.
And if, according to Friedman, an individual can have a life-cycle savings hypothesis, can a nation have one too? If so, then China as a young economic power presumably SHOULD save more? But how much is too much for China to save? And how do you measure the ‘just right’ level of savings given where a nation is in its life-cycle?
Or are the Americans bleating because they have eaten all their sweets but China hasn’t?
I focus heavily on devaluation as a cure for South Africa’s economic ills because I know – in the quiver of arrows that will be necessary for Treasury to use so as to hit its growth and employment targets – it is always the one arrow that the Already Haves are most unwilling to see used. Yet in my opinion, it is by far the most important arrow we have; indeed, were we to fight the war on poverty in South Africa without it, I am convinced we would lose.
That said, it is by no means the only arrow we must carry in our macroeconomic quiver – indeed were it the only one, I suspect we would also lose the war.
This piece highlights the next two most important arrows we must use: one which limits the exercise of monopolistic behaviour by capital and the other which does the same for labour.
Remember, the object of any devaluation is to realign the relative price structures prevailing in a country so as to suppress certain undesirable features – such as domestic demand for imported goods – whilst stimulating other more favourable responses – foreign demand for domestic goods, for instance. And when a country is devaluing rather than revaluing its currency, this means within that country prices will tend to rise in its aftermath, with some much more than others. As horrifying as it may seem, the object of devaluation is precisely to generate inflation. The ‘aha’ aspect of this provocative claim however is that one tries to generate more inflation in ‘bad’ products than in ‘good’ ones – imported Italian shoes become more expensive so persuading domestic consumers to switch to Made-In-South-Africa takkies. Some ‘good’ products will also unavoidably increase in price – oil perhaps – but this is a price we have to pay for all the other more beneficial consequences of devaluation.
The flip-side to this story which we do not immediately see but which should be to our advantage over the medium term is the deflation of South African goods and services prices to foreigners and, yes, the fall in South African wages as measured in US Dollars to levels that are more competitive globally. Some goods – gold for example – have their prices set internationally and whose dollar price will not fall . Others – South African wine, forestry products and tourism for example – will likely fall in price to the foreign buyer. This should lead to increased demand and so to a positive supply side response domestically.
Devaluations succeed if and when, over time, their gains exceed their losses. They do not succeed – and here critics of a devaluation strategy in South Africa’s case are 100% right to be wary – when the short to medium term advantages are frittered away over the long-term.
This again leads me those other two arrows we must carry. If, in the aftermath of a devaluation, a supplier to the domestic market operating out of a heavily concentrated industry then uses their pricing power to force through price rises that essentially cancel out the gains and only result in higher profits to that supplier, a problem arises. The solution – and some quarters of South African business will not like this – is aggressive use of windfall taxes or strong intervention by the anti-trust authorities or both.
But just as Government should penalize any monopolistic behaviour by capital after a devaluation, so too – and here’s the rub – should they do so were labour to behave likewise, being equally aggressive towards both unionized and ununionized labour in South Africa.
These two arrows must be used without fear or favour on all those parties in South Africa that would try and undo the benefits flowing from devaluation. Invariably, there will be some slippage – we would want to see export-oriented sectors prosper in the aftermath of a devaluation, for instance, so stimulating new investment and job creation – but all in all the success of a devaluation is ultimately measured by minimizing that slippage.
If however all the advantages accruing from a devaluation were to be given back in its aftermath, then I have enormous sympathy with those cynical carpers who chant from the side-lines “Don’t do it at all”. Rather wait until a crisis finally breaks the currency – as it surely will – and then rebuild from the other side, having learned from our national mistakes. That is, after all, the essence of what happened in East Asia beginning with the crisis in Thailand in July 1997. Asia learned that overvalued exchange rates, accompanying current account deficits and overdependency on foreign capital flows will eventually end in tears.
South Africa should learn from Asia’s fall and subsequent rise. Unless we can find the courage to fire the arrow of devaluation – and to do so with a full quiver of ready-to-use secondary arrows – that arrow will end up firing us.
One of the most oft cited reasons why China might be unwilling to revalue the renminbi is that this would mean losses on their FX holdings and especially the 70% held in US Dollars.
It would mean losses, and perhaps China’s accounting rules would force their immediate recognition.
But what about all the RMB assets that would gain in value in the wake of this move? Should not these gains be set against those FX losses? And would not these gains in time exceed those losses?
When Japan revalued the Yen throughout the 70s, 80s and 90s, this eventually-win-more-than-you-lose scenario played out. Japan’s mistake was to allow the yen’s revaluation to go too high, too quickly, especially after the Plaza Accord of 1985.
My forecast? China will begin to revalue the RMB again in early 2010, albeit at a snail’s pace. Why only a snail’s pace? They have read and understood the recent history of Japan!
- 2010 prognosis
- Abroad thoughts from home
- All Aboard the Orient Express
- Asia Trip continued
- Books and films I recommend
- Democracy at bay
- East and West: Where the Twain do meet
- Examining the passenger cars of Eastern Europe
- From Santiago to Medellin
- Great Quotes
- Jo'burg to Beijing
- Modern Africa
- My Mission – not impossible!
- Odd thoughts
- South African Economic Policy
- The Business of Fund Management
- Thoughts economic