Economy Basics and Real Wealth Creation

In my previous post, I discussed the importance of NGDP growth as a number and what it tells us. Keep in mind that I also (vaguely) mentioned how RGDP is a relatively useless number dependent on how inflation is measured and the measurement of inflation depends on the basket of goods and services consumed, which can vary depending on how we measure it. A single number cannot measure the health of an economy, but there are ways we can detect if an economy is healthy.

An economy is a self-organizing bottom-up organism. It's much more like an ecosystem or the human body or an animal than it is like a car or a washing machine or anything man-made. Economies have the ability to be self-regenerating and start to fade out and die when the cease to be self-regenerating. What does this imply? It implies that we cannot have regions or cities or towns that're dependent on the center. What this implies is that we cannot even have a nation that comes from the center if we want the nation to sustainably accumulate wealth.

I've just spoken about the qualities, properties of an economy without actually talking about or properly defining what an economy actually is. My view of an economy is basically like an ecosystem: an economy has inputs and outputs with the outputs effectively paying for your inputs. Economics is the study of how inputs are turned into outputs.

Definitions:
Economy—An organization of human beings (coming from a nation, city-state, etc.) that turns inputs into outputs.
Economics—The study of how the inputs of an economy are turned into the output of an economy.

Now that we've defined an economy as a self-organized mechanism for human beings to turn inputs into outputs whereby the outputs pay for the inputs, we can start to see how this kind of organism would survive. However, we first need to address the point of those who belief economics as a study/discipline is bullshit. I have often criticized the foundations of economic thought repeatedly, but being anti-economics is really just retarded. Economics is an essential part of social life and an essential part of anyone’s life. Just like an economy has inputs and outputs, so do we as people.

Most of us work jobs (or have family members that work) that produce outputs so that we can pay for our inputs. After all, feeding, providing shelter, and providing other things must be supported somehow. The Laws of Thermodynamics tell us that we cannot create something from nothing, which means that everything we do converts matter/energy from one state to another.
Since an economy turns inputs into outputs, we must first discuss what the most common/primary economic inputs are. These inputs are things like:
· Natural resources (hard commodities, energy inputs like oil and natural gas, etc.)
· Capital (including social, political, entrepreneurial, and financial forms)
· Imports from other places (capital and natural resources can be imported)
· Labor (more people means more production assuming everything else is fixed)

If an economy is a way of turning inputs into outputs, then the economy can only expand by either using inputs more effectively or by increasing the amount of inputs. Depending on how we define capital, the easiest way we can expand our living standards by either accumulating real capital (like skills, know-how, better social/political systems, better financial institutions to transfer resources from those not using them to those who can use them well, etc.) or by learning how to use other inputs like natural resources, imports from other places, or labor more effectively or by simply using more natural resources.

First, I will discuss the effects of using more natural resources. Extracting natural resources can often times be very destructive and have negative impacts down the line, which means that using more natural resources can—and often times does—create tail risk. The possible risks are:
1. Running out of natural resources (usually not an issue in market based economies)
2. Risk of environmental degradation whereby the costs are borne by the young and unborn.
3. Import natural resources

Case 1:
Case (1) usually isn’t much of a risk in market economies simply because as natural resources become scarce, the price of natural resources goes higher. This may have an impact and reduce economic growth/economic outputs, but it also shifts the incentives of economic agents and the economy can adjust by substituting inputs/imports. Economies that experience a rise in natural resource prices often either adjust systematically or they experience massive drawdowns in production (often times both as the latter can lead to the former). However, these types of adjustments must occur often and regularly—even though they can be painful—simply because delaying the adjustment causes the agents of the system to not think the adjustment is coming. The longer the adjustment is postponed, the greater the risk of the system runs of experiencing “collapse” (or a sharp drawdown in production).

The shifts in prices (volatility) effectively disseminates information for agents. If the price shift is delayed or prevented, the information simply isn't transferred and creates tail risk. Often times, authoritarian/autocratic systems run into such issues because commodity/food/energy prices are fixed and supported by subsidies on the supply-side. The prices are often fixed, which means that even though the underlying inputs become more expensive, agents still behave as if the inputs are the same. The subsidies become more and more expensive to maintain while the costs of the government begin to balloon all while economic agents still behave like input costs are relatively cheap.

Governments budgets’ balloon and politicians are forced to either borrow massively (usually causing debt/income ratios to skyrocket), adjust input costs appropriately, or cut other spending in order to maintain subsidies and support prices. If the subsidies are cut, inventories become empty and we eventually see shortages. If input costs are allowed to adjust, we see short term pain while production and employment fall sharply. There can be major political ramifications. The third option is debt/income increases, which aren't sustainable as debt servicing costs eat up a larger and larger portion of the government budget while debt grows much quicker than debt servicing capacity. If this process keeps going, we eventually see a debt crisis and a complete collapse of the economic system (this process usually takes the political system with it. The third scenario usually leads to the first scenario as the subsidies (usually) get larger and larger and eventually lead to borrowing.

Case 2:
The second case is that in order to maintain production levels, environmental degradation is allowed to take place on a massive scale. The problem with environmental degradation is that we’re playing around with what we do not know. The environment is much more robust than us (via the Lindy Effect), which means that when we damage the environment, it will find a way to adapt (as it usually does—harshly). We do not know the consequences of our actions, which means that the losses could possibly be large enough to cross the risk of ruin. In other words, the risk of ruin is bigger than zero. From here, we now apply Murphy’s Law, which makes ruin inevitable from environmental degradation.

Note that when we deal with tail risk, the lower the probability of occurrence, the higher the impact of the event. In other words, we’re risking it all on the line for a fixed benefit. In other words, such policies make no sense. We may benefit in the short run, but it’s our children and grandchildren that pay the price.

Case 3:
We can simply import more natural resources, but we need a means by which we can pay for those natural resources. If we import more natural resources, we can produce more and if our production increases by more than the cost of the natural resources, the system ends up “better”. However, the system runs the risk of being more sensitive to shifts in input costs (which can come from not only a rise in economic inputs but from a fall in the currency as well).

If the outputs do not support the cost of importing more natural resources, the gap can be filled with debt. However, we run into the problem of rising debt/income ratios until you hit debt capacity constraints. Once that point happens, the process will reverse and the results will depend on the debt dynamics of the particular economy. All we know about the debt dynamics of the economy is that the economy will not benefit, but we do not know any bounds on the possible cost of the potential outcome which leads us to tail risk issues.

From here, we have shown that the only sustainable ways to accumulate real wealth (i.o.w. improve living standards) is by:
1. Either accumulating capital
2. Using natural resources more effectively (which can be considered capital depending on how capital is defined)
3. Having a system whereby imports and exports are constantly being replaced via a continuous, never-ending process
4. Using labor more effectively (can be defined as capital accumulation)

Using debt to sustain imports or importing more natural resources without having any way to use them more effectively/having the ability to replace imports is not a sustainable way to increase living standards. Such methods will work in the short term, but if sustained, will create economic/financial crises that may turn into social/political crises. Authoritarian systems (democratic systems can be authoritarian) are, in particular, prone to such collapses by the way the incentives become aligned.

Politicians/political leaders often have incentives that favor short term benefits at the sake of a longer term loss because their job is to get reelected. Similarly, bureaucrats have similar incentives as their job is to effectively cover their ass. Centralized societies run by bureaucrats and politicians are especially vulnerable to these kinds of economic/financial collapses that can lead to social/political crises. Often times, these kinds of policies are ones that can lead to all kinds of wars between nations, empires, and even civil wars.

Expanded Definition of Capital:
The skills, know-how, entrepreneurial ability, the efficacy of social/political systems, the ability to extract and refine natural resources, and the efficacy of labor usage.

If we use the expanded definition of capital listed above, we now only have two real ways of increasing real wealth. We must either be:
1. Expanding/increasing capital inputs
2. Have an ability for the economy as a whole to have the ability to substitute inputs and diversify among those inputs and outputs while constantly substituting/replacing inputs and maintaining the diversification among outputs

This brings us to the next question: why are undiversified outputs dangerous?
An economy with undiversified outputs is at risk of seeing a collapse in production if the demand for a decline in the demand for outputs (or for a strengthening of the currency). If an economy is sufficiently diversified among its outputs, the drop in demand of a single output cannot cause an economy to go down. The economy may even benefit by being able to adjust, adapt, and strengthen to the shock

An undiversified economy, on the other hand, suffers a major shortfall of revenue which reduces output revenue and will eventually force inputs to fall. Historically, one of the most dangerous situations for an economy to be in is to be a large commodity/energy/natural resource exporter. The reason is because if the price of the commodity/energy/natural resources falls, the economy must eventually contract its inputs and will experience a sharp drop in living standards.

An economy that doesn't have capital inputs or a diversified economy that substitutes inputs and outputs constantly is an economy that’s inherently fragile. Such economies cannot be wealthy. These economies can be rich for periods of time, but they will not have the ability to sustainably accumulate real wealth.

Note: The concept of import/export diversification and capital accumulation, in the real world, usually go hand in hand. It's difficult to have one without the other. Usually, economic systems that don't have both tend to be fragile and won't exist for any extended period of time.

The Importance of NGDP Growth (as a number, not an economic target)

In this post, I'll talk about something that rarely goes discussed: what the nominal GDP (NGDP) growth actually tells us. Usually when people use GDP growth, they use real GDP (RGDP) growth and find RGDP by using NGDP and subtracting inflation--usually measured by CPI. However, NGDP tells us something very valuable: it tells us the nominal value of the economy at a given point in time. So what does NGDP growth tell us? It tells us the shift in the nominal value of the economy per unit time. In other words, it tells us, in nominal terms, the growth of the real economy, and thus the nominal return of real assets on average.

Why is the nominal return of real assets so important? There's several reasons why it's important:
1. It's the growth rate of the real economy
2. It's the "opportunity cost of capital"--by the opportunity cost of capital, I mean that it is the return capital would receive instead of being put to use somewhere else (like foreign assets, government bonds, equities, etc.)
3. The real cost of transferring capital is ALWAYS the nominal return of real assets because it is the opportunity cost of capital

Many people including economists (particularly statists, socialists, and others who subscribe to authoritarian economic ideas) often claim that when the government issues zero interest loans all the time and all the government has to do is invest in anything that returns more than 0%. Of course, such ideas are complete and utter nonsense because they don't account for the real cost of transferring resources.

It's important to note that the real cost of transferring capital is ALWAYS the NGDP growth rate. In order for a project to be economically justifiable, the increase in productivity generated by the asset must be larger than the NGDP growth rate, not cost of the liability created (assets and liabilities must be created simultaneously).

The Relationship Between the NGDP Growth Rate and Interest Rates:
Now that we have a basic idea of why the NGDP growth rate is so important, we can now move on to what interest rates tell us. For the sake of simplicity, I will be talking about the short term money market rate of interest.

Recall that a traditional bank makes money by charging interest on long term loans by paying out interest on deposits. Bank deposits don't have a term period and are short term liabilities. Basically, (traditional) banks are long the longer end of the yield curve and short the shorter end of the yield curve.

Since NGDP is the nominal return of holding real assets and the growth of the economy and an (weighted) average return of real assets, we must compare the short term interest rates to the NGDP growth rate in order to determine the real effects of interest rates. Recall that the money market rate of interest is effectively the same (assuming a negligible risk spread, which is usually the case) as the return of holding deposits. Note that bank deposits are the primary monetary assets. In other words, bank deposits are money (not the bank reserves, like most people think).

If the return of holding monetary assets is higher than the NGDP growth rate, the sector that's long monetary assets will see the percentage of the income they hold go up while other sectors must see the proportion of the income they hold fall because the growth rate of the real economy in nominal terms is the NGDP growth rate. If the return of holding monetary assets is less than the NGDP growth rate, the sectors long monetary assets will see their share of the pie fall.

Remember that we can separate an economy into roughly three sectors: households, corporations, and governments. The household sector is the primary sector that is long monetary assets while corporations/governments are almost always short. Therefore, the cost holding short term interest rates below NGDP growth is primarily borne the household sector.

Note: The sophistication of the financial system matters in terms of how much households lose out on negative real lending rates (interest rates minus NGDP growth). If there's sufficient sophistication and diversity in a financial system/economy, households have alternatives to place their savings into equities, capital backed assets, etc.. Therefore, the impact of interest rates also depends on the financial system. A country like the US imposing negative real lending rates won't see the same depreciation in the household share of income than a country like China with the same negative real lending rates.

P.S. I've had final exams and been slammed, but now they're over and I've had about a week to recuperate. I'm starting to get a lot of writing done and will probably have several posts up over the next couple of weeks.

Japan's Hyperinflationary Scenario

Recently, the BOJ came out with an announcement to turbocharge QE when the Japanese central bank was already on pace for the most aggressive monetary policy in decades. Here are posts on the basics of monetary policy/QE and on the impact of QE for those not familiar with the topic in question. I've also discussed the (structural) issues currently facing Japan, which are actually not too different from the issues the country has faced in the past.

As I've discussed, Japan has effectively been stuck in a debt deflation over the past 20-25 years as monetary policy has been very tight. Total debt/income levels have been increasing for Japan over this debt deflationary period. This process has finally led to the BOJ starting is massive QE program in 2013 which was further expanded in November 2014.

It's important to note that Japan's first QE program has succeeded as inflation (measured by CPI) has gone up considerably. However, the inflation created by the BOJ's QE program has primarily resulted in a weaker Yen, asset price inflation, and rising input costs (primarily food and energy). As I've noted several times, Japan imports almost all of its food and energy, which implies that a further depreciation in the Yen would just lead to a relative spike in food and energy costs. The Yen has depreciated over 45% vs the US Dollar during the past two years, which would translate into a relative input cost spike (controlling for shifts in the international price of inputs).

The good part is that commodity prices, energy prices, and even food prices have been in free fall over the past 2-3 years due to the beginning of the reversal process for the international global imbalances built up over the past 30-40 years. This will mean that total input costs for the Japanese economy will not shift very much from the most recent QE announcement and the current Yen depreciation that has followed and is still currently occurring. However, commodity prices will not keep falling forever and will only keep falling until the global imbalances will have finally finished correcting.

The bad part for the Japanese economy is that the Japanese debt and budget deficit has kept increasing. On top of this, Japan has what effectively mounts to flat yield curves across the zero lower bound (ZLB). As Japanese long end interest rates have kept falling over the past few decades, Japanese debt servicing costs kept falling even though the total debt kept rising because previous debt was being refinanced at lower and lower rates. In other words, the debt servicing costs were effectively being capitalized. At around 2011-12, the entire Japanese capital stack was entirely refinanced at 0%. Since that point, the debt servicing cost effectively bottomed. From now on, debt servicing costs will only go one direction (higher) and probably move exponentially. If we take a look at the Japanese budget projection from the beginning of 2014, debt servicing costs have increased 5% while tax revenues were expected to move higher, but the proposed sales tax increase (which is shown to provide revenue on the budget) will not provide any revenue because the sales tax increase was postponed. In other words, the Japanese government will not have as much revenue as it expects while its two largest expenses (Social Security and debt service) will both be higher at the next time step.

The Ministry of Finance (MOF) will be issuing more bonds than they issued last year while the debt servicing costs are higher than they were last year. Japan is currently experiencing no growth and the yield curve is flat while debt servicing costs have bottomed.

In my post on Japan's structural issues, I discussed the Japanese demographic crisis wherein Japan has the most rapidly aging population out of any developing country. What this means is much higher government outlays for Social Security while there'll be less people working to support more dependents. The massive debt of the country is clearly starting to weigh on growth as well. So we're in a situation where debt servicing costs have bottomed and will go much higher very quickly if interest rates increase at all while the large debt and rapidly declining workforce are acting as structural drags on growth. Over the next 5-10 years, we will see Japanese debt servicing costs spike while tax revenues will end up being flat in the best case scenario.

In order to counteract these problems, the BOJ has decided it'll just keep depreciating the Yen and inflating asset prices in order to create growth. Of course, relying on monetary expansion for growth is not a long term strategy and faces sharply depreciating returns on the margin. If Japan only relies on a depreciating currency, it'll be tough in a world with no demand to buy Japanese exports while Japanese import prices spike.

If Japan keeps taking up its current policy, Japan will experience a drop in both productive capacity and real demand. The Japanese economy is already experiencing a rise in relative input costs which places downward pressure on productive capacity while the rising input costs are also placing downward pressure on real demand because inputs are more expensive. What we're likely to see in Japan if the BOJ and MOF do not change course, is falling production that will end up leading to falling real consumption. However, the BOJ policy will make sure that nominal demand will stay level (and it has). In other words, real demand will fall, nominal demand will styay flat or go higher, and productive capacity will fall. What does this sound like? Well, it's stagflation.

The current path for Japan will lead to stagflation. On top of this, there's also the risk of the BOJ creating a feedback loop it cannot stop. How do we stop inflation? In order to answer this question, we must first answer the question, how does inflation start?
1. Inflation is defined as the rise in prices. We get inflation when there's too much money chasing too few goods. Recall that what we use as money comes from bank deposits and recall that loans create deposits. If there's no demand for loans, it's very difficult for an economy to experience high inflation and is likely to experience deflation. This is the situation Japan was in over the past 20-25 years.
2. The BOJ has come in and decided to take on a massive monetary expansion in order to fight off this deflation. Monetary expansion fights off deflation by creating capital outflows that cause the currency to depreciate and by inflating asset prices. However, this policy will cause input prices to rise and reduce real demand. In other words, this will cause the initial stagflationary push.
3. Over time, the yield curve will steepen if the central bank chooses not to intervene as the market will adjust to inflation by shifting longer term interest rates higher. If this process is not stopped, the country will experience a price-wage spiral if short term rates are held flat.
4. Once prices and wages start to rise together, inflationary expectations shift and the private sector will demand more loans. This will increase nominal demand while real demand stays flat or goes negative from rising input costs.
5. This process is stopped when the central bank sharply raises short term interest rates (by sharply contracting the amount of base money). When the central bank sharply constricts the base money supply, it forces banks to call in loans and tighten monetary policy by effectively creating a financial crisis. This process almost always forces the economy into recession, but it will fight off the inflation given time.

However, if Japan raises short term interest rates (or equivalently, sharply reduces the base money supply) the Japanese government will default from the exponentially increasing debt servicing costs. Some would say that inflation will simply increase tax revenues so it won't be a big deal. However, it's important to remember that tax revenues always move linearly to inflation while debt servicing costs move based on the amount of total debt, the shifts in the interest rates, and the maturity structure of the debt. Japan's total public debt/tax revenue ratio is around 25, which is way too high for any sort of major inflationary impact on tax revenues to offset the . The only way out would be if all of the debt was on an extremely long time horizon, but when you have debt/income ratios around 25, it's difficult for a country to sustain and keep its debt serviceable for eternity. Michael Pettis talks about the problems of the Japanese policy here.

So what we've seen is that Japan has no way to stop a price-wage spiral if one takes place. In other words, we're looking at a hyperinflationary scenario for Japan where the Yen goes lower, and lower, and lower. This will go on until the country eventually defaults.

Keep in mind that what I've outlayed is simply a scenario. As I've detailed in my post about Japanese structural issues, the Japanese government does have a lot of public assets and if it were to sell those assets, it'd make the debt burden much more serviceable. However, if Japan continues to go down its current path without selling some of the government's public assets, a default, hyperinflation, and a complete and utter collapse of the Yen will be in store for the country.

Democracy, Equality, Freedom, and Social/Political Systems

Often among those who call themselves "progressives" or statists in general (although not all progressives are statists and vice-versa), there's this idea that democracy is good. They usually favor democracy because of ideas like "equality" and "power to the people". Of course, I can't think of a single system occurring in nature that actually has "equality" (almost all naturally occurring systems have some form of a hierarchy). In other words, equality really doesn't exist--it's a mythical idea among human beings. Obviously, people have different skill sets and different capabilities, so this idea of everyone being equal at everything or the same in a system is not only dumb, but destructive and counter-productive to society at large.

Now, let's go to this idea of "power to the people" as if it's some virtue. This begs the question: do we actually want the public as a whole getting what they ask for all the time? Personally, I think that's one of the dumbest ideas I've ever heard. Winston Churchill is quoted as saying that the best argument against democracy is a five minute conversation with the average voter. Even to this day, that quote obviously holds. For lack of a better word, the average person on the street is an idiot when it comes to policy. They should have absolutely no role in determining FEDERAL policy. If they did have a role in determining policy, they'd simply choose the side that benefits them the most, even if there's massive externalities or the policy harms a particular group of minorities or, worst of all, future generations. Basically, we can think of the average person as a typical 7 year old. Is it a good idea to give most 7 year old kids everything they want and ask for? What if all he wants to do is watch TV and eat sugar? Obviously, it doesn't take a rocket scientist to figure out that giving the kid everything he/she wants is poor parenting and will make him/her worse off in the longer run. Similarly, I bring forth one of the key principles of government:
The people should not be given what they want almost all the time (on a federal level)! I'd actually argue that the people should never get what they want and have virtually no say in what they want at a national level (although local politics can be however you want to set it up as).

So this brings us to the next aspect of somewhat democratic institutions: what is the role of democracy in government and how should we limit it?
The role of democratic institutions should be to remove bad leaders. In other words, the only purpose of democracy should be to oust tyrants--nothing more. Any role of democracy beyond removing tyrants is destructive as it actually gives the average voter far too much power to decide policy.

What should the hallmark of our society be if we don't want it to be equality?
The hallmark of our society should be a society based on FREEDOM! This brings us to the next questions:
1. What am I defining as a free society?
2. Why freedom?

1. Definition of a Free Society
I'm defining a free society as one where the centralized government's main focus is on preserving the idea that anyone can do as they please as long as they don't interfere with anyone else's ability to do as they please. The main (and virtually only) role of a centralized government in a free society is for purposes of war, national defense, and to prevent environmental degradation (note that the costs of environmental degradation are borne by the young and the unborn while the benefits are taken right away). Usually, some statist/socialist will respond by saying that if we have no government, we'll turn our country into Somalia. Of course, I'm not arguing for no government or no governmental interference; I'm arguing for localized government whereby most problems are dealt with by state and local governments.

2. Why Freedom?
Why do I find it more robust for state and local governments to make most decisions while banning the federal government from making such decisions? The reasoning is rather simple, but I will start by making a simple assumption.
Assumption: We do not know what will happen beforehand, regardless of what social science theories say. This implies we do not know what the "correct" policies are to current problems. The only thing we really know is that we know/understand very little, which means that uncertainty is the key situation that we need to deal with.

Since uncertainty is the key factor we need to deal with, we basically need a system that strengthens from uncertainty, disorder, and randomness. For the finance guys/options traders, it means that we need our political system to be long volatility. For the layman, it means we need a system that benefits and strengthens from volatility.

So what we need is a system that tries a whole bunch of different things in a whole bunch of different places. In other words, you need massive amounts of experimentation on a very small, localized scale. That way, we can figure out what doesn't work quickly and effectively with minimal damage since the costs stay localized. Whatever works will stick and other states will adopt the policies, whatever doesn't work fails immediately and the costs stay minimal. In the American political system, this concept is known as the laboratories of democracy. As I've mentioned in a previous post (see the example in red on the linked post), the decentralization of decision making to state and local governments drastically reduces the risk of ruin. The only scenario for which the federal government should be involved is in war.

Notice how I've crusaded against the idea of equality earlier in this post. Each and every person is different with different skill sets and capabilities. It makes no sense for everyone to be equal or the same and doing so would be a complete waste of their individual abilities and skill sets. What you need is a system that provides each and every single person the optionality to maximize the particular skill sets and capabilities that they have. Obviously, most people cannot and will not be able maximize their abilities if you point a gun to everyone's head, tell them what to do, and tell them how to live their lives. The very idea of freedom and the concept of a free society provides different people the optionality to take advantage of whatever comes their way.

Those against freedom would argue the point about what if something goes wrong or people who are free make mistakes. It's okay for people and individuals to make mistakes as long as the costs of their actions are localized. In other words, a simple skin in the game principle where those who take actions would suffer the consequences of their actions would suffice. In a free society, you are free to act as you please, but you are not free from the consequences of your actions.

There is very little in the world that's as antifragile as freedom. The more you try to suppress the idea, the less likely it is to happen--particularly with an educated populace that's been drilled with this idea. Those that are free will not die and submit willingly. They will fight tooth and nail for their freedom because once you get a taste of freedom, you simply will not let up. In other words, freedom (and a free society) are long volatility.

Some would argue: what if certain states or local governments take up policies that are authoritarian, autocratic? In this scenario, people will simply vote with their feet. They will leave places that rule with an iron fist towards places that do not rule with an iron fist. In other words, if certain states or local governments take up dumb policies, people will simply move elsewhere.

Worldwide Supply-Demand Imbalances, Inflation/Deflation Risks, and Feedback Loops

There's been many calls for hyperinflation or high inflation, particularly from libertarians and others who don't like the Fed (but not everyone who doesn't like the Fed, including me). These statements are usually highly politically motivated comments by people who have no idea of basic balance sheets--as I've addressed before. I'm just writing this initial part to point out that not only are such calls complete nonsense, but worldwide inflationary risks are effectively at all time lows--with a few countries like commodity exporters/LDCs and Japan being exceptions.

As I've pointed out in my economic and geopolitical posts about China, it's China that's driving the demand for the world's commodities. We're seeing Chinese growth rates come down sharply and they're not going up any time soon. In other words, we're likely to see commodity prices plummet. What does this mean? It means that countries who use commodity prices as inputs are likely to get a benefit by seeing deflation on the supply side.

We're also likely to see falling energy prices as we see capacity and production levels collapse across the world. Natural resources used for energy are economic inputs in production, so falling production levels and expectations of falling production levels will place downward pressures on energy prices. Energy importers will see a boost while countries with excess capacity or those heavily reliant on exports (particularly commodity or energy exports) will get hit very hard. Although we live in a world with excess capacity and little demand, the falling production levels will only end up pushing worldwide demand even lower.

This brings up the next question: why would falling production levels cause falling demand?
As I stated, increases in supply create increases in demand, but not necessarily increases in net demand. If the supply corrects very sharply towards the downside, all of the demand that was created by the excess supply will correct. However, it is very important to notice that even though supply and demand could (and probably will) fall sharply together, net demand will go up because of how sharp the correction would be. Simply put, production and consumption will fall, but production will fall faster than consumption.

It's also important to note that, in many countries, the kind of demand increases that we've seen are exactly the kind of demand increases that we don't need. The kind of demand increases we've seen (particularly in countries like China) have come because of sharp, unsustainable increases in capacity. As you increase capacity and supply, it's natural for demand to increase as well since the increase in production (productive or not) results in more workers to produce whatever is being produced. In other words, you do get an increase in demand, but it's net demand that the world needs--not demand stemming from unsustainably rising capacity.

Example(s):
If we take the United States as an example in the Great Depression, we see how sharp this correction can be. In 1920's, the US had the highest trade surplus in history at around .6% of GDP and accounted for around 36% of the world's GDP. From 1929-1933, US NGDP fell by almost 50%. That's how these kind of corrections can occur--although the US case is an extraordinary example.

To put this in perspective, China accounted for around .5% of the world's trade surplus in the 2000's while China currently accounts for <12% of the world's production. The current investment boom in China is unprecedented in both scope and scale. China no longer runs as large trade surpluses as it used to, but it effectively replaced the export model by sticking shovels in the ground to put up high rise condos. The sharp increase in investment fueled much of the commodity price boom over the past decade or two, which has caused a massive increase in private sector debt. China has effectively turbocharged investment by massively increasing bank lending to finance this ridiculous investment boom (see my economic post on China for more details).

Note that it's very possible China won't correct the same way the US did in the 30's (sharply and quickly). I think there's a good chance China corrects in a slow and orderly manner with very low growth rates over the course of 15-25 years--like we saw Japan correct after the 90's.

Inflation Risk:
Basically, we're in a situation where falling production levels put downward pressure on input costs. In most of the world, we're likely to see falling input costs combined with stalling (or falling) demand. How are we likely to see higher inflation? The reality is that we're not. If anything, we live in an extremely deflationary world.

There could be particular countries that may experience cost push inflation (like Japan or commodity exporters), but the world as a whole is in the midst of a deflationary scenario that we haven't seen anything like since The Great Depression.

Feedback Loops:
The world is littered with excess capacity and very little demand. Every country in the world has been trying to simultaneously boost production at the exact same time while there's no demand that can sustain the current production levels. In other words, most of the countries in the world are effectively stuck in situations whereby they've been locked into certain policies that have created feedback loops. In order to sustain the rising worldwide gap between production and consumption, we've seen massive increases in the real debt burden that has created a worldwide boom. We've seen a positive feedback loop, but debt cannot rise faster than debt servicing capacity forever. In other words, what we're seeing will correct.

Not only did we see a feedback loop on the way up, but we're also likely to see a feedback loop on the way down. Falling production levels will lead to falling real demand and the massive debt burden will no longer be able to keep growing. We will see massive bankruptcies (both private and public) that will put downward pressure on demand and capacity. Falling capacity will place further pressure on worldwide aggregate demand. Just like we had a feedback loop on the way up, we'll have a positive feedback loop on the way down.

All of the countries that "rose" together (these are primarily, but not necessarily, countries that have tied themselves to China) will fall together. A slowdown in one country will cause a slowdown in the other, which will again create another feedback loop. These feedback loops will, in all likelihood, continue until some event causes a shift. That event could range from a sovereign restructuring to revolutions to a war to a whole bunch of other possibilities.

Note: None of what I'm saying applies to commodity exporters. As I've previously written, these countries could actually see inflation because collapsing worldwide aggregate supply and falling demand (stemming from the falling supply) will reduce the demand for commodity prices as commodity prices will (and have been) falling. The capital inflows that came from the explosion in commodity prices in these countries has been reversing and I suspect that trend will continue. The capital outflows from these countries will put the currencies of these countries under pressure. On top of this, these countries will (and have been) experience falling production while consumption costs could very well increase from the depreciating currency causing rising input costs.

Note #2: Up until around 2007-08, much of the world's capacity was sustained by large increases in debt in order to finance consumption. In particular, this applies to the US. Due to the nature of the boom (a relatively decentralized consumption boom), debt capacity constraints are reached relatively quickly to prevent the boom from getting too out of hand. The year 2008 marked the moment that the US consumer could no longer borrow in order to consume much of the world's excess capacity (primarily coming from China).

Killing Terrorists vs Wiping Out Terrorism

For some reason, the idea that wiping out every terrorist on the planet does little to wipe out terrorism is something that many people have difficulty understanding. However, the inability of many people to understand this concept is one of the leading causes to why terrorism, particularly the radical Islamic version, continues to spread and become larger.

In order to first tackle this issue, we must ask the question: why does terrorism grow?
The primary factors for the growth of terrorism consist of (but are not limited to) ignorance, lack of basic education among the people who take up such ideologies, oppressive governments ruling minority populations with an iron fist, or even a battle for natural resources.

So how do we attack and fight terrorism?
Many would respond that if we just kill terrorists, there'll be less terrorists to kill in the future. Of course, this view completely neglects second and third order effects. In order to deal with terrorists and kill them, you need either boots on the ground (actual troops to fight insurgencies) or you can directly use airstrikes. If airstrikes are used, there is a relatively large probability of a miss. A miss can (and has) resulted in civilian casualties while the people who decide where and when to strike do not suffer any negative consequences if they miss. If they happen to hit some child or home in Pakistan that only holds civilians, then the people who were struck are the only ones to suffer. In other words, we have a typical asymmetry in incentives.

On the other side of the coin, civilians see a bomb randomly striking an innocent person's home with American shrapnel flying off. In other words, you're creating an incentive for civilians to turn to terrorism. By bombing places randomly without any proper concern, we actually end up fueling terrorism even though we may end up occasionally killing terrorists. We must recognize that poor, uneducated populations (particularly youth) without sufficient infrastructure are the ones most likely to resort to terrorism.

In order to fight and attack terrorism, what we really need are a new set of ideas. Resorting to bombing places or supporting authoritarian regimes (ex. Saudi Arabia, now Turkey) or boots on the ground--turning the US military into a nation-building force--are not the solutions. Instead, we need ways to educate the populaces of these regions. We need ways to actually change the way that the people and groups in the region think and behave.

Obviously, changing the way that the people in the region think is easier said than done. We need ways of constructing proper infrastructure so that groups like the Islamic State can't influence the hearts and minds of the populace they attempt to control by helping build infrastructure and provide social services.

What about nation-building?
As a way to fight insurgencies and terrorist organizations, we've seen the US military take a role in sending large amounts of troops to fight these insurgencies (ex. War in Afghanistan and Iraq). What the US was really doing was nation-building. The US literally tried to build stable governments as the US military provided security for the region. This is a short-term way to deal with terrorism, but the longer you stay in a foreign land, the more people will get pissed off. Again, this is a long-run way of fueling terrorism although it suppresses volatility in the short term.

Another problem with this strategy is the sheer cost. We have places in the US like California that have rapidly deteriorating infrastructure that we completely ignore fixing while we're building infrastructure in highly politically unstable countries that only show a shed of stability and security due to our military force that isn't even working as a military force (it's working as a security force). Obviously, none of these solutions make any sense and have ZERO chance of working over any extended period of time.

DO NOT GO NATIONALIST!
Basically, we need to avoid the urges to call for nationalism and worry about our problems at home. We need to throw out ideas that turn the free republic into an authoritarian empire as imperialism is inherently unsustainable and will eventually make the country poorer. Using large scale capital inflows to fund deficits and fight wars IS NOT sustainable in the long run and provides little increase in productivity to pay off the debt servicing costs.

Running up trillions of dollars in debt while simultaneously ruining hundreds of thousands of lives in order to sustain nations that really have no reason to exist doesn't make any sense. Quite frankly, it's straight up stupid. Unfortunately, this stupidity has been the hallmark of American foreign policy over the past 3-4 decades.

On Independence and Secessionist Movements

There was a vote on September 18, 2014 for Scottish independence from the UK. The vote was relatively close and required a simple majority (>50%) of the voters to grant Scotland independence, but the vote was a (close) no with around 53% of the population voting no. Similarly, the Chinese central government seems hellbent on controlling everything going on and we're starting to see peaceful protests in Hong Kong as the central government tried to place certain restrictions on candidates that run in the Hong Kong elections.

As I've spoken about in previous posts, the world is currently in the midst of a depression wherein the world is filled with excess capacity and little demand. To add fuel to the fire, China has been driving the world's economy since 2008 when the American consumer proved unable to fill the void after a massive (and unsustainable) debt bubble. As I've discussed in my post about China's economic system, China has done this by creating a massive investment, infrastructure, and commercial real estate boom and has driven commodity prices skyward during this entire process (as I discussed here). In other words, countries that're heavy commodity exporters could find themselves facing major internal struggles, particularly in regions where oppressed minorities are being oppressed by authoritarian governments.

Why do I bring up these economic issues? These economic issues create political and social unrest down the line as these booms and bubbles start to unwind and eventually burst. We're not even halfway through this depression, which means we're likely to see an increase in social and political unrest coming up. I've also spoken about the possibility of fragmentation in large countries like Russia and China while we're seeing the countries in the Middle East fragment into smaller tribal states. Both Russia and China are (and will continue to) experience difficult economic circumstances. In other words, we're likely to see an intensification of separatist movements in China and Russia. It's not just China and Russia either. As I stated earlier, China is driving many parts of the world economy. If we see economic troubles in China, we're likely to see more secessionist and independence movements across the world.

Does it make sense for a Chinese central government to control every aspect of regions that don't want to be under their control, have a completely different view of society, and don't need anything that the central government actually provides? Of course not. Similarly, Russia is having lots of issues of controlling its population in places like Dagestan and Chechnya with highly Muslim populations. In response to the oppressive nature of governance in these areas, you're seeing a rise in radical Islam. It's a similar situation in places like Xinjiang and Tibet, which are currently under Chinese control, where the population is mostly Muslim or Buddhist under the oppressive rule of an atheist leadership/government. It makes little sense for these areas to be under Chinese control for any purpose other than buffer regions. Even if they are buffer regions, is it okay for the populace of these countries to be oppressed by governments just because a few people in those governments want to hold those areas as buffer regions? Does it make any sense and can the current situation hold for an extended period of time? I find the answer to all of those questions to be a simple and obvious no.

We're also seeing secessionist movements come to power in places like Balochistan (from Pakistan), there have been secessionist movements in Eastern (heavily Shiite regions) Saudi Arabia away from the rule of the House of Saud for a while, the Kurds want to separate away from Turkey and Iran (where there have been standoffs with the Iranian government and the Peshmerga--the Kurdish military), and in many other areas. In regions like Tibet, the younger population particularly favors independence much more so than the older population.

What should the role of foreign governments and, in particular, the US be?
It makes sense from almost every single perspective for other foreign governments and the US to support these movements, especially if these movements are peaceful.

Why should these secessionist movements be supported?
The most obvious argument is a risk argument. Decentralized systems are more robust because the costs remain localized. In decentralized systems, failure is small and localized which means that the error of a state or group of people don't have the same systemic impacts as would otherwise be the case.

Example:
If you have one centralized state with a 10% chance of failure/unit time (we'll use one year in this example), the expected time of survival is 1/10%=1/.1=10 years (or whatever units of time). If you have n decentralized states where the probability of failure is 10% and the failure of each state is independent, the failure rate for the collective system is .1^10=10^(-10) while the expected time of survival for the unit as a whole goes to 1/(.1^10)=10^10.

If we generalize the case to n different states each with an independent probability of survival p (p<1), the chance of failure for the system as a whole is p^n. The expected time of survival for the system becomes 1/(p^n)=p^(-n)>1. In other words, the more decentralized the system the more robust the system becomes at an exponential rate with respect to the number of states as long as the states are run independently.

Secondly, there are certain events that we want to completely eliminate (like the risk of world war). Any time we have large centralized units in control over large areas, we create risks of conflict between two or more large, powerful regions at once. The consequences for not just these regions, but for the planet as a whole, can be disastrous. If there's irreversible damage, we (as the human race) could potentially end up being screwed. Trying to eliminate events like war is stupid because you can't control every part of the world all at once. Rather than trying to prevent events that're obviously out of our control and understanding, we need to work to limit their impact. So having individual states fight small wars with one another doesn't create the same level of tail risk as having large states fight in large scale wars. It's important to note that we may see more small scale wars this way, but that's okay. We cannot (and should not) try to control everything and try to prevent it with naive interventionism as we do not know the costs of such policies. What we should do is to prevent the costs of any possibility to be much larger than anything we can handle. In other words, we shouldn't focus on the probability of being wrong and instead focus on the maximum costs IF wrong. Encouraging large-scale decentralization is the first step to realizing this goal.

Thirdly, authoritarian regimes that oppress peoples and other societies shouldn't be tolerated. Why shouldn't they be tolerated?
1. They don't share our views of a proper society
2. It's common to see authoritarian regimes not have any sort of fluctuations in their political systems. What ends up happening is that the oppressive nature of these regimes leads to pushing all small fluctuations underneath the surface while hidden risks are allowed to accumulate.
3. These regimes often have less changes, but when the changes do happen, they happen suddenly, unpredictably, and the changes are often very costly (both monetarily and in terms of human casualties).

Nassim Taleb has an excellent paper called The Black Swan of Cairo where he discusses the issue of volatility suppression with regards to matters of oppressive authoritarian regimes and foreign policy.

US, Russia, EU, and Ukraine

In Ukraine, we're basically seeing a civil war. Eastern Ukraine consists of a mostly Russian speaking population that's, in large part, ethnically Russian. Western Ukraine speaks Ukrainian and is, ethnically Ukrainian. Seeing this divide, it makes sense why there's currently a civil war in Ukraine. There's a natural divide within the country and, quite frankly, it makes no sense for the country to exist any more.

The pro-Russian Ukrainian rebels are being funded by Putin in Russia while the current Ukrainian government is getting support from the US and the EU (colloquially called "the West"). In effect, what's going on in Ukraine is a proxy war between the Russians and the "West". This brings us to the issue of why Ukraine is important.

There's several reasons why Ukraine is important. One of the reasons Ukraine has been important in the past is because of the natural gas pipelines that run through the country. However, there's also pipelines that runs through the Gulf of Finland called the Nord Stream. On top of this, Russia in conjunction with the EU is working on the South Stream--which is a pipeline that runs through the Black Sea into Bulgaria where it's supposed to branch off to Italy in one direction and the Balkans in the other direction. In other words, the importance of the natural gas pipelines that go through Ukraine have diminished.



However, there are key weapons factories in Eastern Ukraine and it's also important to note the importance of Ukraine in control of the Black Sea (a map of the Black Sea along with current and proposed pipelines is shown above). Many important trade routes go through Ukraine and Russia doesn't have any warm water ports, which means having control over the Black Sea is extremely important for Russia. Due to these factors, Ukraine plays a critical role for the Russian national interest.

With regards to the conflict between Russia and the EU, it's important to remember that about two thirds of the Russian government's revenue came from natural gas exports in 2013. Now, there's talk of Russia even shutting off natural gas that goes through Ukraine to Europe, but it probably won't be a very large factor because of the North Stream and South Stream pipelines. There is a tail risk possibility that Russia could shut off all the gas to Europe, but the chance of that happening is, in my opinion, low (although the consequences could be huge).

It's also important to understand what's going on from a historic perspective. Ever since the fall of the Soviet Union, Russia has been (and is) at its weakest in centuries. It's important to understand that throughout its history, Russia has had to deal with European autocrats (ex. Napoleon, Hitler) that have tried to unite Europe and take over the world. Since two-thirds of the Russian population lives west of the Urals and the region of the world that ethnic Russians originated from is in modern day Ukraine (Kievyrus). The old Soviet border stretched as far west as Germany towards Berlin, which is where the Berlin wall was destroyed in 1991. Now, the Russian border is within 400 miles of Moscow. The depth of Russia that held off Hitler and Napoleon no longer exists. To really hit this point home, we must understand that the Ukrainian-Russian border lies within 100 miles of Stalingrad, which was the key battle of World War II.

So what is the role of the US in all of this? In this particular conflict we're seeing over Ukraine, the US (and the West) is the aggressor, but both sides want the Russians to look like the aggressors. Ukraine has historically been a part of Russia, the current border is within 100 miles of Stalingrad, and the Russian people actually originated from the region. So it makes perfect sense why Russia is so scared about what's happening in Ukraine. The former government of Ukraine was deposed to make way for the current, pro-West government in Ukraine. The borders of NATO have been pushed from what used to be West Germany, all the way to the Baltic countries and now there's talk about Ukraine joining NATO. It's the US and the EU that want to expand NATO to weaken Russia permanently.

What we're effectively seeing is that we're seeing a new Containment policy form against Russia. We're effectively looking at a mini-Cold war between the US and EU towards Russia. The people of Ukraine are just caught in a proxy war. The coalition the US is trying to build will probably come to include countries like Poland, the Baltics, Romania, Azerbaijan, Georgia, and other countries located near the Russian border.

With all that being said, we have a real possibility of Russia fragmenting. As I detailed in my post last week, commodity exporters are getting smashed (including the Russian Ruble). Russia is heavily reliant on commodity exports and a further slowdown in China (who, as I've discussed on previous posts, is driving commodity prices) could easily send the Russian economy in a tailspin. On top of this, the sanctions towards Russia have caused Russian production to tumble even further. The next decade or two will be very difficult for the Russian economy. If Russia doesn't rebalance its economy away from being reliant on commodity exports, we could be looking at a non-existent Russia in a decade or two.

Another realistic possibility is an intensification of war. The further weakening of the Russian economy combined with the other long term structural disadvantages of Russia (ranging from economic to geographic) could force Putin into a situation where he has to try and expand Russia's borders before the Russian economy collapses. We're already effectively seeing proxy wars, but we could see even more proxy wars across Russia's borders, including in areas like Azerbaijan and Georgia. There has also been a problem of radical Islam near the Russian border in places like Dagestan, Chechnya, and maybe even other parts like Ossetia (a map is shown below). Many of these problems are rooted in ethnic conflicts and we'll see ethnic tensions only increase as the economic situation in Russia gets worse.


A third possibility is the recreation of the old Russian empire. Putin has been working on a Eurasian Union, which is really just a code for a Russian empire. This Russian empire would effectively be an empire of nations which would include the countries Belarus and Kazakhstan while possibly including the countries Armenia, Tajikistan, Kyrgyzstan, and several other countries located in the middle of the Eurasian landmass.

The basic point I'm trying to make is that there's a lot more going on in this Ukraine conflict than just Ukraine. Really, this is a battle between the US and, as of right now, most of the EU against Russia in order to weaken Russia. This is likely to be the first in a series of conflicts that pits an alliance of various states (ex. Poland, Lithuania, Latvia, Estonia, Azerbaijan, Georgia, Germany, and a few other countries) led by the US against Russia. The rise of insurgencies and radical Islam in places like Dagestan and Chechnya combined with Russian economic weakness mean that we'll probably see an intensification of conflicts along the Russian border over the next decade or two.

Economics/Financial Consequences of Heavy Commodity Exporters and LDCs

Since the 1970's and particularly the 80's and 90's, we've seen the rise of countries like Brazil, Russia, India, China, and South Africa (the so-called BRICS). I've had a previous post on the rise of China during this period, but this post will entail the other emerging markets/less developed countries (LDCs). These countries are primarily Brazil, Russia, and South Africa (India needs to be discussed separately), but I'll also discuss other key commodity exporters like Australia and Canada.

It's important to notice that countries like Brazil, Russia, and South Africa are heavy commodity exporters. In the case of Russia, almost half of the Russian government revenue comes from natural gas exports (much of it to Europe). Countries like Brazil, South Africa, Australia, and Canada are also heavy commodity exporters. As I mentioned in my post detailing the workings of capitalism, it's common to see specialization lead to certain economies across the world that become reliant on commodity exports. Usually, we see this kind of specialization happen in countries that're either rich in natural resources or countries without proper capital inputs (or both).

In the case of Brazil, Russia, and South Africa, we've had natural resource rich countries who are still developing the capital inputs necessary in the post-industrial world of today. Keep in mind that much of the natural resource extraction that occurs in the developing world is banned in the developed world because either the extraction or refinement of certain natural resources can be extremely damaging to the environment. Developed countries often have restrictions on such kind of behavior because the risk coming from possible environmental degradation usually outweighs the short term benefits from importing those materials while these countries often have the capital inputs required for a post-industrial economy. LDC's, on the other hand, don't have those inputs while their social and political systems are often not developed enough to respond to these long term risks.

The reason I bring up countries like Australia and Canada is because of the global mining boom that's been happening. In my economic and geopolitical posts on China, I speak about how China has effectively been driving the market for commodities--particularly industrial commodities like iron ore, tin, copper, and a whole host of other metals. These raw materials are being exported from countries like Brazil, Russia, South Africa, Australia, and Canada. As China becomes forced to rebalance its economy and growth rates start to fall (as they already have), the worldwide demand for industrial commodities will fall. Iron ore prices already peaked at around $190/dry metric ton and iron ore is currently trading at around $100/dry metric ton.

This brings us to the next question: what are the consequences of falling commodity prices on these particular countries? As the prices of commodities falls, the demand to hold currencies of countries who export commodities will fall. In other words, we're likely to see the currencies of these countries (Brazil, Russia, Australia, Canada, etc.) fall in terms of foreign exchange (FX). Not only are the currencies of these countries likely to fall, but these countries are also likely to experience decreases in production stemming from a world with falling aggregate demand and falling production. So the countries in question (Australia, Russia, Canada, Brazil, and South Africa) will see input cost inflation stemming from their falling currencies while simultaneously seeing falling output and rising unemployment.

Keep in mind that many of these countries (ex. Australia, Canada) have large asset bubbles stemming from capital inflows and their currency strength over the past decade or so. These countries will have to deal with falling production and falling currencies while their asset bubbles would be bursting. On the plus side; however, Australia and Canada will experience inflation that could help prevent the real debt burden (debt/NGDP ratio) from ballooning.

I suspect that many of these countries are likely to experience stagflation or stagflation-like effects. They're likely to see falling real growth combined with input price inflation, falling output, and falling employment levels. In the case of Brazil, Russia, and South Africa, we could see significant social and political unrest.

Japan's Got Issues

In one of my previous posts, I discussed Europe's problems. In this post, I'm gonna discuss Japan's problems in a rather similar fashion. This post will be split up into eight different parts:
1. Japan's Geography
2. Japan's #1 Problem: Japan Imports All of its Food and Energy
3. Japan's Economic Model
4. Japan's Debt Problem
5. Japan's Demographics
6. Abenomics
7. What Can Japan Do?
8. Conclusion

1. Japan's Geography:
Japan is stuck on a set of islands that start in the East China Sea and touch the border of Russia from South to North). Japan consists of thousands of islands, but the four major islands of Japan are (from North to South) Hokkaido, Honshu, Shikoku, and Kyushu. As we can see in the geographical map below (left), most of these islands consist of harsh terrain that isn't hospitable to large populations (right). The small Kanto plain on the very right side (bordering the Pacific Ocean) contains the city of Tokyo and is also home to a third of the population, but notice how small the land mass is. The rest of the Japanese population is spread out in a similar manner with most of the population living on a very small space of land as most of the Japanese land mass is home to very few people.

Also note that in the geographical map above shows how most of the Japanese land mass consists of very rough and rugged terrain, which tells us that there's little arable land mass in Japan. It's also important to notice that there's little natural resources in Japan as well. So Japan has the economic problem of sustaining a relatively high population with little arable land and few natural resources. This is why Japan has, historically, gone back and forth between isolationism and imperialism. When Japan has united under strong centralized control, the result has usually ended in imperialism.


2. Japan's #1 Problem: Japan Imports Most of its Food and Energy
Due to Japan's geography, Japan is in a situation where it imports most of its food and virtually all of its energy. Before the 2011 Fukushima disaster, Japan received about a third of its energy from nuclear power. Post-Fukushima, Japan is now importing all of its energy. Japan was already importing much of its food as well and is now importing almost all of its energy. As I spoke about with China's geopolitical problems, there's serious tension between China and Japan over the natural resources (primarily oil and gas) that lie in the East China Sea.

Japan holds very little natural resources and the terrain across most of Japan is also very harsh. This is why Japan has historically alternated between periods of imperialism and periods of isolation. When Japan has come under strong centralized control, the country usually goes imperialistic and often begins to expand out into either the Korean Peninsula, Eastern China, or Manchuria (examples of time periods include the 16th century and the 20th century before World War II).

3. Japan's Economic Model:
Economically, Japan's growth model USED to be to China's current economic growth model. This culminated in extremely high growth rates in the 80's and early 90's, but also led to a massive increase in private debt and a massive asset bubble--the worst since China's asset bubble today. In the case of Japan, the Nikkei peaked near 40,000 and is still only near half of what it's peak was back in the late 80's. The Japanese Imperial Palace and the land within it was worth more than the entire state of California during this period.

The resulting crash led to a collapse of growth rates while the leadership in Tokyo decided to deal with the resulting fallout by having the public sector take on all of the bad private debts that led to the asset bubble. By taking this course of action, Tokyo rebalanced the Japanese economy over the following 20 years after the bursting of the bubble which led to the two lost decades Japan has faced. On top of this, Japan is still having difficulty growing at any significant speed while private debt has been transferred to the public sector.

Recall that the Chinese (and former Japanese) growth model works by turbocharging investment and growth by reducing the household share of income, which causes the national savings rate to go up. This forced Japan to rebalance its economy after the investment driven growth model resulted in a debt crisis. Recall that negative real lending rates were critical to the initial boom and Japan transferred resources back to the household sector by positive real lending (and interest) rates from 1990-2013. This led to a steady increase in the household share over the past two decades, but the lower growth rates resulting in the decade ending up as a "lost decade".

4. Japan's Debt Problem:
We must remember that when we think about debt, we must understand that all debt is a transfer of real resources. We must also remember that debt is created out of thin air as debt and money get created simultaneously by the banking system. All debt (and money) is, in some form or another, a claim on real resources. This means that every time debt or money is created, real resources are simply being transferred. What really matters is whether or not the productivity gains from the transfer of real resources outweighs the real debt servicing costs of the transfer. Note that the real cost of transferring real resources is the NGDP growth rate since the NGDP growth rate is the opportunity cost of not holding real assets.

Below, I've shown a chart of Japan's total debt/income ratio over the past few decades. As we can see, this prolonged deflation has actually increased the real burden of the Japanese debt. I'm also of the belief that the massive Japanese debt taken on over the past 40 years or so hasn't been used very productively. In other words, the Japanese debt burden is slowing growth because the transfer of resources hasn't (and still isn't IMO) being used productively. Japan cannot address its stagnation if it doesn't address its massive debt problem.


5. Japan's Demography:
Like much of Europe, Japan's fertility rate has been less than 2 since 1970 and has been less than 1.8 since 1974. In other words, Japan's population is rapidly aging while fertility rates continue to stay low. The Japanese workforce size peaked simultaneously with the bubble in 1990 and has been in steady decline ever since. In terms of demography, Japan was basically in the same situation in 1990 that China is in today. The workforce started to steadily decline as what became a boost to growth eventually turned into a larger and larger drag on growth. Also notice that this trend shows absolutely no signs of ebbing as fertility rates have stayed depressed.

The rapidly declining demographics doesn't just mean a drag on growth from a falling workforce, but it also means more dependents that have to be taken care of by a falling workforce. This implies larger and larger outlays into things like social security while tax revenues fall from a falling population and a falling workforce. In other words, the demographics will increase the structural budget deficit and place upward pressure on the national debt.

Basically, Japan's worsening demography makes all of their underlying problems a whole lot worse. Also note that due to Japan's rapidly aging population, we should expect to see household savings rates go negative as more people retire and pull out their savings.

6. Abenomics:
In order to fix the Japanese stagnation of the past 25 years or so, Prime Minister Shinzo Abe has laid out an economic platform that's supposed to get Japan out of its stagnation. Abenomics has three arrows and these arrows consist of:
1. Aggressive monetary policy to devalue the Yen sharply while stimulating exports
2. Fiscal stimulus involving a reduction in corporate tax rates to increase investment
3. Structural reforms

With regards to the first arrow of Abenomics, aggressive monetary policy will increase asset prices and devalue the Yen (it already has), but the impact on exporters really isn't all that clear. Recall from earlier that Japan imports almost all of its food and most of its energy. This implies that a further devaluation in the Yen would just cause a corresponding increase in food and energy costs. Although this policy of aggressive monetary easing will (and has) caused equity prices to rise while sending the Yen plunging, the result has been inflation led by a rise in input costs. Aggregate demand in nominal terms may rise as a result of this policy, but real demand will fall (and has been falling) from soaring input costs. On top of this, the people who get hurt the most from the devaluation in the Yen will be the elderly and we already discussed Japan's population.

The second arrow involves fiscal policy in a country where the real transfer of real resources caused by the massive debt is placing a heavy burden on growth. Keep in mind that none of this debt was ever written down as most of it has just kept being rolled over onto the government's balance sheet. Notice that Abenomics never deals with the debt problem and instead tries to reduce corporate tax rates in an effort to boost investment. It was these kinds of policies that created the misallocation of capital in the the late 70's and 80's in the first place and misallocating more capital doesn't fix anything. All it does is postpone the problems into the future.

The third arrow is really nonexistent. There hasn't been any structural reform--it's all been political hogwash.

7. What Can Japan Do?
The one advantage of Japan is that the Japanese government does hold a lot of different assets. The total amount of assets held by the Japanese government is about $6.6 trillion or around 130% of GDP. Japan can privatize some (or even all of these assets) in order to pay down its debt. That being said, the only problem this helps fix is the Japanese debt problem.

Japan can also try to take some natural resources that lie on the East China Sea, but there's a border dispute with China on this issue. Much of what happens depends on whether war breaks out or not. I discuss this issue in larger detail in my post on China's geopolitical problems.

8. Conclusion
Japan is in a very difficult situation both geopolitically and economically. The massive debt burden combined with a rapidly declining population represent a massive economic challenge that'll make it difficult to reverse the Japanese economic stagnation of the past 24 years while Abe and his economic program (Abenomics) don't (and can't) address the major problems.

The geographical situation of Japan doesn't help anything as Japan relies heavily on imports for key economic inputs. In order to maintain economic activity and sustain economic growth, the leadership in Tokyo will have difficulty maintaining a low cost of economic inputs for the country. In order to make sure Japan has these economic inputs, there's a real risk of war with China. However, Japan is building ties with the US and India to contain China and may very well have access to the natural resources that lie in the East China Sea.

Japan's primary advantages lie in its technological prowess and in the assets held by the national government. Japan should start privatizing some of those assets in order to pay down the debt while Japanese technology combined with US support could help Japan access many of the natural resources in its dispute with China.

Why Does Capitalism Work?

This post is about the important topic of why capitalism works. The most common answers to why capitalism works usually has to do with concepts like economies of scale, the advantages of specialization and how specialization strengthens economies, and the idea of capitalist economies being more "efficient". These reasons for why capitalism works is complete nonsense. First off, economies of scale doesn't show in the data: as firms get larger, they become more fragile. Secondly, specialized economies are not a sign of strength but a sign of weakness as small shifts in international supply/demand in the aggregate or in a few goods can cause the economies to blow up. Thirdly, economic efficiency means nothing without talking about geopolitical risk.

Let's start off by talking about the idea of economies of scale. As firms get larger, they usually gain a greater and greater control of the market share. This may seem like a good thing, but it's really not. Why is firms gaining a larger and larger singular share of the market not a good thing? The reason becomes clear when we look at the upside vs the downside. As firms get larger, their upside becomes limited because the markets often become saturated while the downside remains the same (they can go to zero). In other words, as firms get larger, their possible upside reaches some kind of a limit while the downside remains the same at zero. So, by definition, the larger firms become, the more fragile the firms actually become. Eventually, when firms become large enough, small shifts in consumer preferences or supply side shifts or any small shock can doom the firms. This is why, in many cases, economies with a few large firms often buy out politicians and bureaucrats while using government agencies in the name of "regulation" to start controlling economies. These kinds of ideas are what usually gets called as "free market" ideas, but this kind of economic system usually ends in a rentier economy where a few people control the entire economy. This also leads to burgeoning economic inequality as the middle class gets completely wiped out while the families of a few oligarchs run the entire society. Over the past 40 years, we've seen this procedure play out in the US starting in the late 70's and early 80's with Jimmy Carter and Ronald Reagan. These ideas are about as crony capitalist as they get.

Not only is the idea of economies of scale hogwash, but specialization in an economy isn't a sign of strength. Why is specialization not a sign of strength? Usually, this specialization argument leads to emerging markets and less developed countries (LDCs) specializing in things like commodity production. The reason is because LDCs don't have the ability to compete directly with developed countries on the production of goods and services that require capital inputs. Not only do LDCs usually specialize in commodity production or low wage labor, but we must remember that commodities and raw materials are primarily used as inputs in other economies. It's also important to note that commodity prices and the demand for raw materials is highly sensitive to shifts in the worldwide demand for raw materials, the current production levels of other countries, the geopolitical climate, and a whole host of other factors. In other words, the specialization theory actually makes economies extremely fragile as any shock can blow up these economies. Specialized economies aren't even close to robust and are often banana republics.

Expecting LDCs to remain specialized is usually used as a theoretical justification for an elite to extract rent from these much poorer countries while leaving the mass populace of these countries repressed. Diverse economies, on the other hand, are much more robust. Small shocks not only don't affect diverse economies on the same scale, but they actually strengthen diverse economies. Due to their diverse nature, economies that are diverse will experience some volatility in the system, but other industries are able to brace and even strengthen by the negative impacts caused by the shock. In diverse economies, shocks lead to volatility that allows the system to adjust rapidly and quickly--although there may be a small short term cost, the small short term costs create long term structural benefits. The people who really get hosed in a diverse economy are the rent-seeking, unproductive elite. Basically, we can think of specialized economies as being short volatility and diverse economies as being long volatility.

We must remember that economic systems codevelop with geopolitical systems. What this means is that the tradeoff between economic efficiency and geopolitical risk is an important one. It may be more "efficient" in the short run for an economy to specialize in certain types of production, but small international shocks can have a major impact for specialized economies. In other words, specialized economies are actually highly leveraged and can be extremely fragile. History hasn't been kind to highly specialized economies and has led to famines and depressions in many countries when exports or worldwide demand suddenly collapses.

So this bring us to the next question: why does capitalism work?
Capitalism works primarily because it allows an economic system the ability to adjust automatically to shocks in a decentralized and robust manner. The shocks happen instantly to any sight of volatility as short term shocks allow the system as a whole to develop longer term structural advantages. In other words, decentralized capitalist economies are robust, and even antifragile, because they adjust automatically to shocks. Centralized or centrally planned economies are often the opposite. They often get locked into single policy options while the primary players (usually a non-productive elite) often have little skin in the game and are usually worried more about covering their own ass than they are about the actual health of the economy overall.

Another strength about capitalist economies is that they're the only economies that actually have the capacity to become diverse, and thus robust. Due to the decentralized nature of capitalism, all sorts of different ideas and industries can co-develop together. As shocks hit the economy, the economy adjusts very rapidly and quickly. If something does go wrong, individual agents in the economy can come together, cooperate, and voluntarily work together in ways that centrally planned economies simply cannot. We must remember that economies are systems with many different moving parts. Having fragility at the localized level is a requirement to having antifragility, and sometimes even being robust, at the systemic level

We must understand that uncertainty plays a critical role in economic systems (and in almost all organic, complex systems). Decentralized economies can adjust to, and benefit from more uncertainty and unpredictability. Centralized systems, on the other hand, do not have the same response to uncertainty. We must also remember that centralized systems are built from the top-down, which implies that one small policy error at the top can blow the entire system to smithereens. Decentralized capitalist economies do not have to worry about the same problems because the decision making isn't centralized.

Another important note about centralized systems is that there is no volatility at the surface due to their centralized, top-down structure. In other words, there's a build-up of risk underneath the system while the system exhibits no visible risks at the surface due to the suppression of volatility. This is the exact same phenomenon we see occur in forests when all of the small forest fires of a forest are put out quickly. Flammable deadwood builds up at the forest floor and the forest fires, although they occur less often, are much larger in size, scope, and damage. This is why we see controlled burns occur in most forests that're managed by human beings now. Economic systems exhibit the exact same phenomenon because, like environmental systems, they've got an organic, bottom-up structure.

Europe's Conundrum

Anyways, Europe has many (major) problems and upcoming hurdles. This post will detail the hurdles I find to be the most important hurdles. I will separate this post into various parts with the parts being:
1. Introduction
2. The Euro and the Gold Standard
3. The Question of Austerity
4. The European Banking System
5. Asset Bubbles in Northern Europe
6. The Question of Germany
7. European Demographics
8. Conclusion

Introduction:
Europe is in the middle of an economic crisis (if that isn't blatantly obvious). There is simply too much debt across Europe. The fundamental problem in Europe is that they tried to set up a unified currency when there's absolutely no reason for a unified currency for Europe. The bureaucrats/politicians in charge of the European Union (I'll refer to them as Eurocrats from now on) wanted to create a geopolitical alliance to merge Europe socially and politically. They thought the best way to do this was to create a unified currency and a unified monetary authority. Of course, they also decided to completely ignore a fiscal alliance between the countries, which now leaves all of Europe with a major problem.

The Euro and the Gold Standard:
I like the Euro today to the gold standard of the 1930's. We've got countries (Portugal, Italy, Ireland, Greece, and Spain) having debts denominated in currencies they can't control. These countries find themselves with very high levels of unemployment and absolutely no demand while they've got massive debt burdens in both the private and public sectors. Also note that their debts are assets of some financial institution. In the case of Europe today, the debts of the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) are primarily held by German and French banks. So we've got countries with massive and unsustainable debt burdens on one side while we've got countries who hold those debts on the other side.

The problem for the PIIGS is that if they were to leave the Euro and devalue, their debts would remain denominated in Euros. So if Spain were to leave the Euro and return to Pesetas, the drop in the value of the Peseta would mean that the real debt burden for Spain would go up. If the Peseta dropped 50% overnight vs the Euro, that'd imply a 100% increase in the real debt burden for Spain. In other words, there's really nothing Spain can do to relieve its debt burden. However, some people would argue about the merits of austerity and say that the austerity taken up in these countries can fix their problems. This is nonsense.

The Question of Austerity:
AUSTERITY IS NOT THE PROBLEM OR THE SOLUTION! These countries are stuck in a situation where there is absolutely no demand for goods and services in the country. The reason the fiscal deficits in these countries are so large is primarily because the falling demand is putting a massive downward pressure on tax revenues. Trying to fix Europe's problems by trying to cut deficits is useless because deficit cutting reduces the turnover of money (and thus aggregate demand) in the private sector. The austerity proponents would argue that countries like the UK and (to a lesser extent) the US have been able to deal with austerity and they've been just fine. Of course, they completely miss that the US and the UK are sovereign currency issuers. In other words, the US and UK can simply have their central banks expand their balance sheets in order to prevent a bank run or simply increase the base money supply and provide cash as necessary for the private sector so that there isn't a total collapse in the financial system. None of the countries in Europe can do this and if there is a problem with the financial sector in Europe, they get screwed. Austerity clearly doesn't help reduce the public debt burdens of any of the PIIGS (as shown below).


The European Banking System:
Another major problem in Europe is the banking system. There's been much talk about how bad the situation is with the US banking system and how things were in 2008. Europe's situation is about 1000 times worse. First of all, the European banking system is much larger as a portion of GDP. Secondly, the European banking system is also much more leveraged with much lower capital standards (ex. the bank capital/assets ratio in Germany is 5.5%). The lower capital standards imply that there's less of a cushion for the potential losses of the banking system while the large size of the banking system as a whole imply that the risk of a fall in their assets has more potential downside. In other words, the risk of a loss in bank capital is much greater for the European banking system while the costs of recapitalizing the European banking system would be much greater on the sovereign governments involved.

So what does the European banking system have to do with the creation of the Euro? Well, the creation of the Euro meant that the banking system of all of the European countries effectively came together (monetary union). During the boom period, the spreads between German sovereign debt and the debt of the PIIGS collapsed, as shown in the chart below. In other words, the risk of holding German debt vs the debts of countries like Ireland and Greece was considered to be effectively the same. Also note that in the early to mid 2000's, it was the countries of Portugal, Italy, Ireland, Spain, and Greece that were booming while the German economy was in the doldrums. So we basically had economies that were booming see interest rates collapse which caused liquidity to expand. Naturally, this led to large, unsustainable asset bubbles where capital flew out of the European interior (primarily Germany and France) and into the periphery. During this process, German and French banks ended up acquiring the debts of various sovereign governments in the periphery. In other words, many of the assets of the German and French banks are the sovereign debts or other liabilities of the European periphery.

Note: All of the lines shown above are 10 year bond yield spreads between the PIIGS and Germany where Portugal is dark blue, Italy is brown, Ireland is green, Greece is purple, and Spain is light blue/turquoise.

Remember how I earlier stated that the debt burdens of the PIIGS are getting larger and larger while the budget cuts are having little effect on the debts and deficits of these countries. I do not think there's a way out for any of these countries unless a good portion of these debts are written down and the losses are taken. The problem is that while a debt restructuring would help the PIIGS, the holders of the assets of the PIIGS (primarily German and French banks) would be hurt more than anyone else. Also note that credit has effectively been socialized (ex. deposit insurance), which means that the losses of the banks of Germany and France are effectively the losses of the sovereign governments. So a debt restructuring (or even the PIIGS leaving the Euro) for the PIIGS would force Germany and France into recapitalizing their banking systems--a loss that will eventually show up in the debts of those sovereigns in one form or another. The cost of a default/devaluation of the PIIGS would end up being borne by the rest of the countries who remain in the Euro.

Also note that if the PIIGS started to leave the Euro, we'd likely see a strengthening of the Euro as all of the weaker countries drop out. In other words, the Euro will strengthen while newly issued currencies like the Peseta and Drachma would fall. It's important to notice that a Euro strengthening in such a scenario would imply that the real debt burdens of the PIIGS would soar much higher than expected.

Asset Bubbles in Northern Europe:
There's also a problem of asset bubbles in Europe. Countries like France, the Netherlands, the UK, along with Finland and a few other countries currently have asset bubbles as price/rent ratios (chart shown below) have surged and house prices haven't come back down to sustainable levels. Once house prices and private debts (in nominal levels) start to fall, the debt increases that were adding to growth and incomes will start to detract from growth and incomes.

Note: The chart above starts from Q1 of 1996 and goes to Q3 of 2012. The chart is (obviously) taken from The Economist and the app can be found here. A more recent app that details similar statistics can also be found here. 

In these countries, aggregate demand will start to fall and the fall in incomes will make it more difficult for people in these countries to be able to handle their large debt burdens. Unemployment will rise as tax revenues take a dive while government spending will increase (particularly towards automatic stabilizers). We're likely to see rising unemployment, rising public debts, and falling incomes and aggregate demand in much of Europe over the next 5-10 years. So while the periphery of the Eurozone is currently mired in a depression due to a lack of demand, much of the other half of Europe is stuck with excess capacity fueled by debt. When the excess capacity (asset bubbles) starts to fall, the demand in these regions will take a hit as well. In other words, we're likely to see falling demand in Europe as a whole and the Northern parts of Europe will end up with a major correction in asset markets. The falling capacity will worsen the demand problem in all of Europe since falling capacity and rising unemployment will imply less income, and thus demand, for all of Europe.

The Question of Germany:
When people talk about the positive aspects of Europe, they bring up Germany. Often, the argument goes that Germany is fiscally responsible and that Germany, by itself, can completely save all of Europe. This argument is complete bullshit. Germany has >80% government debt/GDP while the German banking system holds less capital than the US banking system, the assets of the German banking system are highly questionable with regards to their quality, and the German banking system is also much larger (with respect to income and production) than the banking system in the US. If we add in the cost of recapitalizing the German banking system into Germany's government debt, Germany's national debt could already be larger than the US by that single addition alone. Also note that Germany's track record of fiscal responsibility doesn't have very much behind it, particularly considering that Germany has defaulted on its own debt twice in the past 100 years.

Remember when I said that if the PIIGS left the Euro, the Euro would strengthen. Well, that's a very important point because Germany has been the largest benefactor of the Euro since its inception. The trade disadvantages of the PIIGS really ended up as trade advantages for Germany as Germany was working with an undervalued currency. When the PIIGS leave the Euro (they will end up leaving the Euro or suffer at least another 5-10 years of extremely high unemployment), they'll effectively force much of their unemployment towards Germany as Germany will end up losing its trade advantage from the Euro. So not only will Germany's banking system be on the hook for the losses on its debt ownership of the PIIGS, but Germany will also lose its trade advantages as the unemployment will eventually rise. The drop in capacity and rise in unemployment in Germany will decrease German demand and tax revenues while the German deficits and debt continue to increase. Germany is not, and will not, be the savior of Europe. The reality shows that Germany is one of the sickest countries in Europe, but the sickness is being hidden.

European Demographics:
In the developed world, we're starting to see population decline and Europe isn't the exception. Fertility rates in most of the European countries (particularly Western and Northern Europe) have plunged over the past 40 years. In almost all cases, the fertility rates are below 1.6 and, in some cases, have been <1.6 for over 40 years (a graph of European fertility rates is shown below). With the exception of the Scadinavian countries and a few others, most of Europe is in population decline. Obviously, less people means less future productive capacity and less people working. Also note that the worsening European population demography implies rising dependency rates as the elderly portion of the population surges relative while the population workforce size starts to fall. The falling dependency ratio implies less future growth and lower debt capacity for every single one of these countries. Also note that entitlement systems in many of these countries tend to be rather generous which just implies either higher future costs for a smaller workforce to bear or less benefits for future retirees from the governments.

Note: The chart shown above is the total fertility rate for selected European countries over the past 40 years. This data comes from the world bank and can be found here.

Conclusion:

When I look at the economic factors and combine all of the upcoming hurdles of Europe, I find it difficult to find any solution other than massive debt writedowns. Even writing down all the debts will not fix Europe's problems and there is no real way against future pain. Since around the 17th century to until 50-60 years ago, the European powers were the ones to really rule the world. Now, those same European powers find themselves in secular decline and there's no real easy way out. The pain has to be taken and there's a good chance that European living standards could even drop over the next few decades. The current levels of (both public and private) debt in Europe also make war a realistic possibility, which would further weaken the geopolitical power of these countries.

The real problem in Europe has been the ideology that runs these countries. In many of these countries, the left side effectively consists of hardline self-described socialists on the left while the other side consists of fascists or similar ideologies. We see this political fault line starting to develop or already have developed in many European countries (ex. Front National in France, Golden Dawn in Greece). Over the next few decades, we're likely to see Europe lose power and influence on the world stage while there's a realistic chance of rapidly dropping living standards in these countries.

In the end, I believe the only solution is to completely wipe out the debts and start from scratch. I don't really see an easy way out and there's an increasing risk of Europe breaking into war (I'm NOT saying Europe will go to war, I'm just saying that the risk exists and the risk is getting larger and will continue to do so if this can-kicking continues). Unfortunately, there aren't any easy solutions or quick fixes for these countries.