Category Archives: Economic History

Clean energy – winners and losers

The impact of energy flows on the power and influence of nations has mostly been about the need for oil. Securing oil supply by ensuring its shipment, protecting the countries that produce it to the extent of going to war in an oil producing country has been prevalent in the 20th century. Oil being inelastic in demand has meant that as it becomes more scarce the price increases will result in higher revenue for the oil producing oligopoly. Countries dependent on the importing of oil have been at the wrath of higher oil prices caused by embargoes, wars, a financial crisis to name but a few – see graph below.

In fact the USA has been the most aggressive in protecting its oil supply to the extent that it saw it as their right to use military force in the Middle East – 2003 – second Iraq War. The reason given was to remove Saddam Hussein but this just disguised their real motive was to protect the oil fields. If they were so concerned about Saddam Hussein’s regime why didn’t they do anything about Robert Mugabe in Zimbabwe? The answer is Zimbabwe doesn’t have oil. Remember the Gulf War in 1990 was a UN sanctioned operation involving many countries not just the USA and UK.

However the idea of scarcity is coming to an end thanks to 3 big developments.

  1. The shale revolution in the US has lead to them being the biggest combined producer of oil and gas – the US now pumps 10m barrels a day and it is making the country less reliant on imported oil. Also increases in US supply has added to the global market reducing the price.
  2. China is now moving to a more service based economy and in the process is moderating its demand for coal and oil, slowing the consumption of electricity. More importantly though it is deploying gas and renewable energies and stopping the growth of carbon-dioxide emissions. It’s dependence on imported fossils fuels has been the catalyst to develop more of its own wind and sunlight for energy sources as well as it planner more electric vehicles.
  3. Climate change requires low-carbon energy and the Paris accord of 2015 is a start to fight climate change. To achieve this goal trillions of dollars will have to be invested in wind and solar energy, batteries, electricity grids and a range of more experimental clean-energy sources. Ultimately this creates significant competition between countries in developing these technologies but also but at risk the access to rare earths and minerals to make the hardware. It seems that energy is now driven by the technology not the natural resource we are so used to.

Energy transitions since the Industrial Revolution has seen the following:

Coal ——> oil ——> technology and clean energy.

The obvious losers from this change will be those who have an endowment of fossil-fuel reserves and have relied for too long on oil without reforming their economies.

Traditional energy system (oil etc) is constrained by scarcity
The abundant renewable energy system is contained by variability

Ultimately the challenge for countries in future will be who can produce the most energy and who has the best technology. Those that don’t embrace clean-energy transition will be losers in the future.

Source: The Economist – Special Report ‘The Geopolitics of Energy’ 17th March 2018

Spy coin and a poppy

Many thanks for this piece from good friend Jim Frood regarding a Canadian spy coin.
As a limited edition coloured 50 cent coin will go into circulation in New Zealand later this year, to mark 100 years since the end of World War I, one hopes that it doesn’t go the way of a similar Canadian coin in 1974 – see right. The ARMISTICE DAY COIN will feature a red poppy surrounded by a green wreath and silver ferns representing the past, present and future and the three armed forces of New Zealand.

Nicholas J. Saunders in his book: The Poppy A History of Conflict, Loss, Remembrance and Redemption 2013 vividly describes what happened with the Canadian coin. In 2007 in the midst of the war on terror a branch of the US Defence Department issued an alert about ‘spy coins which had appeared in Canada. The Defence Department announced that mysterious coins with ‘radio frequency transmitters’ had been discovered on defence contractors traveling in Canada. Analysis of the coin led to the idea that a transmitter was buried in the poppy inside the coin. The US government then classified all the documents relating to the ‘discovery’! That only added to the affair which Nicholas notes degenerated into farce. The ‘mystery’ was cleared up eventually. If you want to read more about the ‘spy coin’ and the poppy in general, Nicholas’ book is well worth reading.

Ten years on and is the world economy still vulnerable to another crisis?

In 2007 the world economy was thrown into turmoil as the subprime housing crisis in the USA started a chain reaction around the world. Although developments dating back to the 1970s led to increased risk-taking as markets became less regulated. In total it is estimated that the loss to the global economy was US$15 trillion. But it could have been worse if it wasn’t for the lessons learned from the Great Depression of the 1930’s.

What did policymakers do better in 2008 compared to 1929?

Government’s in 2008 were a lot more active in pumping money into the circular flow and their budgets became a much bigger share of the economy, thanks partly to the rise of the modern social safety net. As a result government borrowing and spending on benefits did far more to stabilize the economy than they did during the Depression. Also policymakers stepped in to prevent the extraordinary collapse in prices and incomes experienced in the 1930’s. Although unpopular government’s bailed out banks and prevented panic like that in the Depression were there was a ‘run on the banks’ – about half the banks in the USA closed after 1929. This prevented an implosion of the global economy. But after the Depression government’s were forced into radical reforms to correct the economy which ultimately led to 50 years of economic stability. This wasn’t the case with the GFC in that the success of government policies meant that they avoided the radical reforms of the 1930’s – the disposing of the gold standard. So does this mean that the global economy is still vulnerable to the same variables that caused the problem in the first place?

Financial Reforms
To explain the root cause of the 2008 financial crisis George Soros uses an oil tanker as a metaphor. In the movie documentary “Inside Job” he basically said that markets are inherently unstable and there needs to be some sort of regulation along the way. The oil tanker has quite an vast frame and, in order to stop the movement of oil from making the tanker unstable, shipping manufacturers have designed them with approximately 8-12 compartments, depending on the size. This maintains the tanker’s stability in the water.

After the Depression the Glass Stegal Act was passed in 1933. This act separated investment and commercial banking activities. At the time, “improper banking activity”, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors’ money. Therefore to use Soros’ metaphor, a compartment was put into the tanker to make it more stable.

However, in 1999 Gramm–Leach–Bliley Act effectively removed the separation that previously existed between investment banking which issued securities and commercial banks which accepted deposits. The deregulation also removed conflict of interest prohibitions between investment bankers serving as officers of commercial banks. Therefore, the tanker had a compartment/s removed which made it very unstable and it eventually capsized. Consequently the deregulation of financial markets has led to the end of compartmentalisation.

Post Depression Roosevelt restored growth and made up for what was lost during the depression years but post GFC there have been no major reforms of capital flows and the concentration of the financial sector’s weight in the global economy hasn’t changed. Also central banks have not tried to make-up the lost output and as a result the recovery has been weak. Monetary policy has had to remain very much expansionary and will take time before it returns to a neutral rate. This means when the next recession comes around monetary policy will become ineffective with little ammunition left as rates are so low. However, the main issue is that the fundamental problems that caused the GFC are still there.

Source: A lost decade – The Economist December 16th 2017

Central Banks could cause next financial crisis

A Buttonwood piece in the Economist (30th September 2017) looked at how central banks can trigger the next financial crisis. Deutsche Bank have looked into long-term asset returns in developed markets and suggest that crises have become much more common. They define a crisis when a country suffered one of the following:

  • a 15% annual decline in equities;
  • a 10% fall in its currency or its government bonds;
  • a default on its national debt; or
  • a period of double-digit inflation.

Pre the Bretton Woods system of fixed exchange rates and a central bank’s limited ability to create credit, very few countries suffered a shock in a single year. But since 1980 there have been numerous financial crisis of some kind. Under the Bretton Woods system a country that expanded its money supply too quickly would encourage an increased demand for imports which would ultimately lead to a trade deficit and pressure on its exchange rate; the government would react by slamming on the monetary brakes. The result was that it was harder for financial bubbles to inflate.

But with a floating exchange rate a country has more flexibility to deal with economic crisis as they don not have to maintain a currency that is pegged to another. A weaker currency makes exports more competitive and imports more expensive. But it has also created a trend towards greater trade imbalances, which no longer constrain policymakers—the currency is often allowed to take the strain. See flow chart below.

As well as companies and consumers taking on debt, government debt has also been rising as a proportion of GDP since the mid-1970’s:

  • Japan – a deficit every year since 1966
  • France – a deficit every year since 1993
  • Italy – only one year of surplus since 1950

This has resulted in significant credit expansion and collapse – by allowing consumers to borrow more money the cost of assets (esp. houses) is pushed higher. However when lenders lose confidence in borrowers ability to repay they stop lending and mortgage sales follow. This is then reflected in the credit rating of borrowers. In order to try and rectify the problem the central banks intervene and reduce interest rates or buy assets directly. This may bring the crisis to a temporary halt but results in more debt and higher asset prices.

Deutsche Bank suggest that could mean another financial crisis especially if there is the withdrawal of support from central banks who saved the global economy when the GFC started. Indicators suggest that this may be the case:

  • US Fed – has pushed up interest rates and cut back on asset purchases
  • ECB – likely to cut asset purchases next year
  • Bank of England – has recently pushed up interest rates

However rates are still at a stimulatory level and developed economies have been growing for several years. According to Deutsche Bank any kind of return to “normal” asset prices from their high levels would constitute a crisis. This would then force central banks to once again lower interest rates again but they will not want to appear to be the ambulance at the bottom of the cliff every time this happens. Remember the bailouts of AIG and the investment banks. It seems that the investment banks are happy to privatize the reward but socialise the risk – when it all “turns to custard” they need to be bailed because they are too big to fail. The question that people are now asking is what is the vulnerable asset class? Mortgage-backed securities was the cause in 2008.

The Ancient Art of Economic Forecasting

I came across this piece from a colleague on economic forecasting. The article below appeared in the Sydney Metropolitan Press in the late 1920’s. Although economic cycles don’t run to an exact time period the graph below would indicate that this model is not too far out of kilter.

The top line = years in which panics have occurred and will happen again

The middle line = years of good times, high prices and the time to sell stocks

The bottom line = years of hard times, low prices and good times to buy stocks

The past panic century of dates are 1911, 1927, 1945, 1965, 1981, 1999, 2019. Except for 1981, these were all pretty good years to sell stocks – The Big Picture blog. 2016 suggests the top of the present cycle with 2019 being a year of panic.

“The Ancient Art of Economic Forecasting” – Sydney Metropolitan Press 1920’s

The attached graph professes to forecast the future trend of Australian business conditions, was first brought under the notice of the public in 1872. It was prepared by a Mr Tritch, whose origin and activities are shrouded in mystery.

The top line shows years in which panics have occured, and will occur again. Their cycles are 16, 18 and 20 years. The centre line shows the years of good times and high prices; the cycles are 8, 9 and 10 years. The bottom line shows the years of depressions and low prices; the cycles are 9, 7 and 11 years.

The panic which occurred in 1893 is shown in 1891. Nevertheless, that year witnessed the beginning of the depression. 1915, just after the war started was a year of depreciation, and 1919, the year following the cessation of hostilities, was a period charcterised by good times.

As this chart was published in 1872, it is interesting to note the forecast of the depression now existing. It will be seen that there has been a general upward trend since 1926 with the panic occuring in 1927 after the high is reached. The bottom of the depression is reached at the end of 1930 and the upward trend begins in 1931.”

Art of forecasting2.png

Russia – economic concerns.

Part of the excellent Al Jazeera documentary series about Russia, which addresses the problems facing many Russians today. The global economic crisis, conflicts with neighbouring countries and the drop in oil prices all played their part in the demise of the Russian people. There is a very good interview with the former Central Bank Chairman Viktor Gerashchenk who held the position during Yelstin’s reign. He explains very simply how you grow your economy and that there must be money in the banks so that companies can borrow and invest. Buying US Treasury Bills was loaning money to the US and paying for their deficit. Meanwhile the infrastructure and public services declined rapidly causing a lot of anguish amongst the people. You can’t suddenly jump from a socialist system into the free market. Worth a look.

Brexit and trade – UK can learn from New Zealand’s experience

With the departure of the UK from the EU there have been many questions asked about the future of UK trade. No longer having the free access to EU markets both with imports and exports does mean increasing costs for consumer and producer.

New Zealand’s Experience

A similar situation arose in 1973 when the UK joined the then called European Economic Community (EEC). As part of the Commonwealth New Zealand had relied on the UK market for many years but after 1973 50% of New Zealand exports had to find a new destination. However with the impending loss of export revenue New Zealand had to make significant changes to its trade policy. In 1973 the EEC took 25% of New Zealand exports and today takes only 3%. Add to this the oil crisis years of 1973 (400% increase) and 1979 (200% increase) and protectionist policies in other countries and the New Zealand economy was really up against it.

What did New Zealand do?

1. It negotiated a transitional deal in 1971 with agreed quotas for New Zealand butter, cheese and lamb over a five-year period, which helped to ease the shift away from Britain.

2. New Zealand was very active in signing trade deals of which Closer Economic Relations with Australia was the most important in 1983. The other significant free trade deal was with China in 2008. Below is a list of New Zealand’s current free trade deals and a graph showing the changing pattern of New Zealand trade:

NZ Free trade Deals

NZ exports goods 1960-2015.png

With brexit around the corner it will be imperative that the UK starts to develop trade links with non-EU countries of which New Zealand might be one. The UK is the second largest foreign investor in New Zealand and its fifth largest bilateral trading partner.

Macroeconomic models – a new approach needed.

In 1776 Scottish economist Adam Smith talked of the economy as the invisible hand. Here he emphasized the self-regulating nature of the economy as individuals, firms and companies independently seek to maximize their gain which may produce the best outcome for society as a whole. The capitalist systems seems to rely more on the relentless growth of consumer spending and, although it can lead to dramatic improvements in standard of living, it does require people to become resolutely addicted to products/services and be prepared to get into significant debt.

Today, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy.

DSGE.png

Therefore it assumes that all individuals and firms have identical needs and wants which they pursue with total self-interest and complete knowledge of what they desire. DSGE also takes into account the impact of shocks like oil prices, technological change, interest rates, taxation etc. However a couple of areas that it doesn’t represent accurately is the financial sector and the instability of markets – booms and slumps. A new task will be to include the banking sector into the models as macroeconomists assumed it to be a screen between savers and borrowers rather than profit orientated organisations prepared to take big risks with increased leverage and sub-prime lending. For example as house prices increase banks are willing to lend more money to speculators who bid up the price above what is the fundamental value. The opposite applies if banks become more risk adverse and marginal buyers are forced out of the market causing prices to drop. By representing the financial sector in an economic model you go some way to help solve the major problem with DSGE and other models in that they are useful only if they are not unsettled by external factors like a banking crisis.

Keynes said “If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!”. To achieve this there needs to be structural reform in the discipline.

Agent-based modeling

An emerging field called agent-based modelling has grabbed the attention of some economists. This is where large amounts of data is collected from individuals who are unique to each other in they have different motives and actions in the market place. The behaviour of these individuals overlap and interact which generate predictions through a messy process but similar to what happens in real life, unlike DSGE and the clean old-fashioned macroeconomic models. Agent-based modeling has also shown promise in other disciplines like Physics and involve real-world problems. The example used by John Lanchester (New York Times magazine) is how Brazil nuts seem to end up towards the top of the mixed-nut package and nut research has since found real-life applications in industries such as pharmaceuticals and manufacturing.

With a better sense of what is influencing behaviour in the economy, economists might become less blinkered by their own theory, and better able to foresee the next crisis. Meanwhile, they would be wise to repeat (daily) the words: “My model is a model, not the model.”

Final thought

Macroeconomic models need to be adapted to take account of the events of the last 20 years. For so long typical macro model has been DSGE but as yet no model includes the impact of recessions and the eighty-year depressions. Economics failed to predict or prevent the GFC and this was based on conceptual faults which included a refusal to engage with the role of the banking and finance system in the economy.

Dani Rodrik of Harvard University splits economists into two camps: hedgehogs and foxes.

Hedgehogs take a single idea and apply it to every problem they come across.

Foxes have no grand vision but lots of seemingly contradictory views, as they tailor their conclusions to the situation.

Maybe more fox like behaviour is needed.

References

New York Times Magazine – The Major Blind Spots in Macroeconomics

The Economist – A less dismal science