Wednesday, July 30, 2014

Monetary Policy Basics and QE

This post is my second in the money and banking/monetary policy/QE series. The first one is about the basics of our monetary system and can be found here. The first post was on the basics of money and banking and talks about how money gets created (loans create deposits). This post will be the basics of monetary policy, the workings of different monetary regimes, and the basics of QE. In my next post, I'll talk about the impacts and effects of QE on the real economy, but first, we'll need a basic grasp on how monetary policy functions. Note that I'm assuming all debts in the economy are in the same currency that's issued by the central bank. In other words, I'm assuming no foreign currency debt. Adding debt in a foreign currency changes the situation completely

I will start this post by talking about what QE actually is and that begins with monetary policy 101 with regards to a sovereign country that issues debts denominated in its own currency (i.o.w. anything involving countries with debts denominated in a different currency do not apply). The central bank has a choice of targeting the value of the currency in FX, the money market rate of interest, or the monetary base. The Federal Reserve usually targets the rate of interest, but has been targeting the monetary base as soon as we hit the zero lower bound (ZLB) in 2008. Whether targeting the monetary base or the short term interest rate or the exchange rate, a central bank hits those targets by intervening in the money markets. The monetary base is defined as the total number of commercial bank' reserves (held as deposits at a central bank) plus the total currency circulating in the public (this shouldn't be confused with non-bank deposits held by the public at commercial banks); the monetary base is also known as M0 or the total currency in the system. The monetary base is equivalent to the total liabilities of a central bank (in this case, the Federal Reserve).

Interest Rate Targeting:
When a central bank targets the rate of interest, the central bank will come in to buy whatever securities (usually short term bills, in the case of the Fed, these would be Treasury bills) to set the price of liquidity in the money market. If a central bank is targeting the rate of interest, it has no choice in setting the monetary base. When a central bank wants to change its interest rate target, the central bank will either expand or contract its balance sheet in order to hit the target. If the Federal Reserve wants to decrease (or increase) the price of liquidity (i.o.w. decrease/increase short term interest rates), the Federal Reserve will expand (or contract) both sides of its balance sheet by buying (or selling) Treasury bills (T-bills) and issuing (or removing) dollars from circulation in order to buy (or sell) those T-bills. The bank/dealer that the Fed is transacting with will also see a shift in its balance sheet, but only by a shift in its asset side. The bank will simply see an asset swap as it gets (or gives up) bank reserves (or deposits) in exchange for its T-bill. The transaction is shown below with the left half being a transaction where Fed decreases the money market rate of interest and the right half where the Fed increases the money market rate of interest. For the sake of simplicity, we will assume that the other side of the transaction is a commercial bank with an account at the Federal Reserve.
  Federal Reserve                 Bank                 Federal Reserve                   Bank
 +T-bills|+Reserves          -T-bills|                     -T-bills|-Reserves      -Reserves|
                                +Reserves|                                                       +T-bills|

Monetary Base Targeting and QE:
As I said earlier, if a central bank is interested in setting the interest rate, they will not usually buy long-dated assets. In the case of the Fed, the Fed will usually only buy T-bills if its interested in targeting the money market rate of interest. Note that in 2008, the Federal Reserve took short term rates to zero and entered the ZLB. Since 2008, the Fed has (thus far) abandoned interest rate targeting in favor of targeting M0. When the Fed targets the monetary base, it chooses the amount of assets it will buy and does not care about the money market rate of interest. As stated earlier, the Fed (along with other central banks) usually do not buy short term debt since hitting the ZLB and have been buying longer term assets like Treasury bonds (T-bonds) and mortgage-backed securities (MBSs). Below, I have displayed two separate scenarios where the Fed buys bonds: the one on the left depicts a situation where the Fed buys bonds from a bank in exchange for reserves and the situation on the right depicts a situation where the Fed buys bonds from a random security dealer that doesn't hold a deposit account at the Fed.
Note: If the Fed wanted to reduce the monetary base or "exit" QE, all of the pluses and minuses shown below would be opposites. The dynamics work exactly the same.
                    Fed                       Bank                                    Fed                       Bank
 +T-bond/MBS|+Reserves -T-bonds/MBS|     +T-bonds/MBS|+Deposits   -T-bonds/MBS|
                                            +Reserves|                                                   +Deposits|

In other words, QE is an asset swap for the private sector--nothing more and nothing less. In a world where you've hit the ZLB and increasing the monetary base has no effect on short term interest rates, how would QE create high levels of inflation? Such an idea makes absolutely no sense when there's no demand for loans. The money being created by the Federal Reserves is swapped for assets at the same market price and is having no impact on short term interest rates and almost all of this only shows up in either banks balance sheets or on the balance sheet of some security dealer. It's akin to swapping a savings account for a checking account. QE by itself cannot (and will not) directly lead to high inflation in this current economic environment. Anyone claiming that high inflation or hyperinflation is coming immediately is either lying or doesn't know what they're talking about.

FX Targeting:
There's also a different track for monetary policy whereby the central bank can also target the exchange rate. There are several countries and provinces that still do this (ex. China, Hong Kong), but most countries today now have flexible exchange rates. In a fixed exchange rate regime, the central bank purchases the net amount of incoming FX reserves necessary to maintain the exchange rate. In this type of regime, central banks have no control over the monetary base or the rate of interest. If the exchange rate is relatively high, the central bank will experience a net outflow of FX reserves until the central bank no longer has the ability to maintain the exchange rate peg.

  • There's a difference between reductions in the standard of living and inflation (which is defined as an increase in prices). We've experienced a decline in the standard of living while CPI has been quite low.
  • Please don't use bogus shadow statistics where the CPI is measured the same way it was measured in 70's. Using that measurement for CPI only makes sense if the basket of goods and services consumed today is the same as the basket of goods and services consumed in the 70's, which is obviously not the case.
  • Using the shadow statistics found here, it says inflation was at least 7-9% since 2008. Using an inflation rate of 7% would imply that prices have gone up around 50-70% in the last six years and the resulting calculations would mean prices have more than doubled in the last ten, which did not happen. As stated earlier, these numbers are flawed because the basket of goods and services consumed in the 70's aren't the same as the ones consumed today.
  • If inflation was running at 8-10%, that would mean real GDP growth would be running at around -4-(-5)%, which would mean much, much higher unemployment than the jobs numbers would imply. Scott Sumner deals with these arguments against Peter Schiff here.
You now know what QE is and about the basics of central bank balance sheet expansion along with how money gets created. In the next post, I'll talk about the impacts and real effects of QE. There's a lot of misunderstandings and myths about QE. I'll dissect those myths and then get into what impacts QE does have.

Monday, July 28, 2014

Money and Banking Basics

In this post, I'm gonna talk about the basics of understanding money and banks. When I took intermediate macroeconomics, we spoke about the market for "loanable funds" where the supply of savings in a bank and the demand for loans determined a whole host of factors. As the supply of savings or demand for loans shifted, we were told that this is what determined the rate of interest. In other words, economics assumes the interest rate is the equilibrium rate at which the supply of loans meets the demand for them. This is a load of horseshit! The interest rate is no such thing. Before we talk about what determines the dynamic that determine interest rates and effective macroeconomic models, we will first need to ground ourselves in the basics of money and banking.

There's a lot of technical aspects to money, but I'm gonna skip over a lot of that and just discuss the basics. First of all, what we consider money is primarily credit. Credit and money are two sides of the same coin. All money is some kind of a claim on real resources. What we (by we, I mean regular people) use as money are usually bank deposits (in today's world). In other words, money is a typical banking asset which means that it must be a liability on the other side. For example, my bank deposit is a liability of a bank but it is my asset. All money is both a liability and an asset. If I hold a Federal Reserve note, the note is a liability of the Federal Reserve and it is my asset. Today, almost all payments are cleared in bank deposits and it's all done electronically. However, banks clear their payments in bank reserves held at the Federal Reserve (if there's no central bank, banks clear payments at private clearinghouses). Historically, the international money was gold where there'd be a convertibility to turn bank reserves into gold at par; this is the gold standard. However, even having a gold standard really doesn't change the monetary basics all that much.

I'm gonna now talk about this idea of savings and how money gets created. There are two ways money can be created, but remember that the bank creating money is issuing a liability. Since the firm is issuing a liability, it must either be creating a new asset or swapping the newly created liability for an existing asset (for the net worth to not change). In other words, when banks issue loans, deposits get created simultaneously. This brings me to the myth about banking and money: SAVINGS DO NOT GET LENT OUT!!!!!

THERE IS NO SUCH THING AS LOANABLE FUNDS! There isn't some pool of savings that gets lent out. BANKS ARE NOT LIMITED BY THE AMOUNT OF SAVINGS! If banks want to create loans, they simply create new deposits. Also note one more thing: LOANS ALWAYS CREATE DEPOSITS. This is not a new phenomenon either. It's been there for a very long time and will continue to do so. If I want a loan, a bank expands its balance sheet on its asset and liability side simultaneously. My assets and liabilities expand simultaneously as well. My asset side now adds bank deposits and my liability side now contains a loan. The transaction is shown below. Note that the net worth of everyone involved in the transaction does not change.
      Bank                           Me
+Loan|+Deposit     +Deposit|+Loan

It's also important to notice money starts bottom up. Money isn't something that starts off with governments setting up a monopoly and working off that. Money developed in the exact opposite direction. Money starts from the bottom up. Money co-developed with developments in credit along with shifts in trade. Anyone that says there's a one way development of money that started off on a linear path beginning with some sort of a centralized structure is false. Money was something that co-developed with many other things and cannot be separated by those shifts. Remember that economic systems co-develop with geopolitical systems and money co-developed with a whole host of other factors.

Central banks (and clearinghouses) create liabilities by swapping them for assets, unlike normal banks that just issue liabilities in order to create new assets. I'll talk more about central banks and monetary policy in detail on a later post.

Wednesday, July 16, 2014

Impacts of Minimum Wage Policies

In the United States, there's talk of imposing a $10.10/hr national minimum wage policy (the vote failed). In some regions of the country, we've seen a $15/hr minimum wage established. However, there's still much conflict as to what the consequences of having a minimum wage policy are. Some people (particularly modern-day liberals and progressives) claim that not only does a minimum wage raise wages, but it also reduces unemployment by increasing demand. Others (usually libertarians and conservatives) claim that a minimum wage reduces employment by increasing costs to employers. I, on the other hand, think it's absurd to apply a single (and politically comforting) narrative to every single scenario wherein a minimum wage policy is imposed.

The impacts of a minimum wage policy will obviously depend on the location, the type of industry, the type of economy, the supply side structure of the economy, and a whole host of factors. Also keep in mind that a sensible minimum wage policy must take into account things like the cost of living, which varies heavily from state to state.

It seems obvious to say that states with different costs of living and states with different societal pressures and geographies need different minimum wage policies, but many arguments don't take that into account. For example, a state with a high youth population will need a much lower minimum wage than a state with an aging population. Another example of different states needing different minimum wage policies would be a state like Texas as opposed to a state like California. California has a very high cost of living along with one of the highest energy costs in the entire US. Since California has such a high cost of living, a $15/hr minimum wage may actually not be all that much in California. However, Texas has a very low cost of living where $15/hr would be absolutely insane. The imposition of a $15/hr minimum wage in Texas would certainly create all sorts of problems.

However, one of the most important factors in determining the suitability of a universal minimum wage policy among a locality, state, or country could end up being the supply side structure of the economy. If you were to have lots of capital intensive industries, raising minimum wages sharply will not have much of an impact on the company's balance sheet and may actually help businesses by increasing demand in the region. However, if the businesses in the region are very labor intensive, raising the minimum wage would obviously have much more disastrous consequences on employment.

Basically, all I'm saying is that there is no universal impact of a minimum wage on any sort of business, locality, state, or even country. Any sort of claim otherwise would easily be falsifiable. It depends on a host of factors including balance sheet structures, social structures, the supply side of the economy, along with others. In other words, having a non-existent minimum wage throughout every part of the country makes as little sense as having a universal $10/hr minimum wage throughout the entire country.

The best policy would be to have different minimum wages set by state and local governments differently. In some areas, a very high minimum wage actually makes sense while even a low minimum wage in other states could end up being very destructive. The only policy that doesn't make sense is a national minimum wage policy.

Sunday, July 13, 2014

China's Geopolitical Trouble

In my previous post, I spoke about China's economic troubles. China is a large and diverse country where over 90% of its population lies inside the Han core near the South and East China Seas. The borderlands of China such as Tibet and Inner Mongolia are held as buffer states. Historically, China has gone back and forth between periods of strong centralized control and decentralized fragmentation.

Geographically, China's population lives very next to the coastline of the South and East China Seas, as discusses earlier. The borderlands of China aren't only sparsely population, but they also contain very harsh terrain. It's for this reason that these borderlands were held as buffer regions to protect from invaders and it's for this same reason why control over these regions has never been permanent. The buffer regions are difficult to hold and control.

One of China's major geopolitical problems will be to keep the borderlands under the control of the current Chinese government. In many of the borderlands, there are already separatist movements that're beginning to form. Large portions of these populations are Muslim and there're even radical Islamist movements in many of these regions. Keeping all of these regions under tight, centralized control will be a key geopolitical challenge for the Chinese government.

Another major geopolitical challenge will be natural resources. Over the past few decades, we've seen a massive surge in capacity in China. This massive increase in capacity has caused a need for China to import lots of natural resources. China is the world's largest consumer of many different natural resources--particularly industrial commodities. Attached to the right is a chart from GMO that shows how much China accounts for the world's usage in various industrial commodities. Note that the chart was taken in 2011 and virtually all of those numbers have gone up. Clearly, China consumes a disproportionately large portion of the world's industrial commodities, but it's more important to notice what these commodities are used for: infrastructure and investment. In other words, the massive infrastructure and investment boom in China is driving worldwide demand for these commodities, many of whom China has to import.

It's also important to note that China not only imports large quantities of industrial commodities, but it must also import large amounts of energy, like crude oil and natural gas, in order to provide energy for its population. This drive for natural resources has led China to make investments in Africa, a natural gas deal with Russia, and conflicts its neighbors like Japan, Taiwan, and the Philippines.

Due to these conflicts and disputes over natural resource reserves, we could definitely be seeing a geopolitical fault line develop on the East and South China Seas. Also note that as China has been gaining power on the international stage, it becomes economically critical to keep supply lanes and trade routes open for transport of these natural resources we're talking about. It's in the interests of Japan, Taiwan, the Philippines, Vietnam, and even Australia to prevent China from gaining strength not only in the East and South China Seas, but in the Pacific Ocean as well. In other words, the geopolitical fault line lies along the middle of the East and South China Seas. In the map above of the East China Sea, there is the territorial dispute over a certain region that contains critical oil and gas reserves that both China and Japan need access to. In the map to the right in the South China Sea, the territorial disputes between China, Malaysia, Brunei, Philippines, and Taiwan are disputed. In both cases, the disputes aren't about any set of islands, as claimed by many media sources. The disputes are about natural resources.

Due to the threat of China gaining power in these regions, the US has also taken the side of the countries on the other side of the East and South China Seas. There is a very realistic chance of the US supporting or taking up a containment policy with regards to China. The proposal of the Trans-Pacific Partnership (TPP) could be the first step to unite Japan, Taiwan, Vietnam, South Korea, and Australia against China.

There is a real threat of China getting engaged in wars (or proxy wars) with several of these countries. If China has to deal with separatist movements on its western borders while having to fight with the countries that lie east for naval control, it could be very difficult for China. Also note that China will be going through an economic transition wherein the economic growth model that the country uses must shift. Dealing with all of these issues at once will be a very difficult problem for China. If the conflicts to the East divert more of China's attention, there is a real possibility of China fragmenting over the next 15-30 years. China's central government will be tested and it will be difficult to maintain strong, centralized control over all of its modern day borders--especially if the economic transition takes place successfully.

Note that if China does fragment, the Han core will stay together. Throughout its history, China has gone back and forth between strong centralized control and fragmentation. Right now, we could be in the middle of a shift back towards seeing some sort of a fragmentation of the country. I'm not saying that a fragmentation will happen, but there is certainly a risk of fragmentation. And the risk of fragmentation increases as the amount of war the Chinese government takes on increases.

If China does go to war, maintaining control of those trade routes required for the importation of natural resources will become much more difficult. If China refuses to adjust economically in the necessary manner and instead chooses to become imperialistic in order to fund its desire for the natural resources needed to keep its current production and growth levels at current rates, it makes the likelihood of fragmentation more likely. What's happened to China over the past few decades has never happened in the same size, scale, or scope throughout world history. There are negative consequences for such actions, but it's difficult to know what they are. But rest assured, those consequences will display themselves and soon become obvious over the course of the next months, years, and decades.

Monday, July 7, 2014

China's Economic Problems

I'm going to split this piece into six different parts:
1. China's Growth Model
2. China's Debt Problem
3. China's Geography and Urbanization
4. China's Demography
5. Environmental Degradation in China
6. China's Future Growth Prospects

China's Growth Model
China's current economic model is actually a very old economic model that has its roots in Alexander Hamilton's economic program for the US in the late 18th century. Both models rely on the use of a central bank to issue currency and debt, a strong central government to help fund domestic investment like infrastructure/public works or "internal improvements", and some form of protectionism in order to develop productive capability within the country. However, Hamilton's economic program also targeted high wages in order to support strong internal demand. China's current growth model relies heavily on cheap labor and suppresses internal demand while trying to boost capacity.

China's current growth strategy has three main parts:

1. Financial repression/high negative lending rates (lending rate=nominal interest rate-NGDP growth)
2. Wage suppression to boost exports
3. Undervalued currency
Notice that all of the three points above are just transfers. Financial repression is a transfer from those who are net long monetary assets to those who have a net short position. In other words, financial repression transfers real resources from those who are net savers to those who are net borrowers. Note that we can split an economy into three separate parts: households, businesses, and governments. Financial repression allows borrowers to get capital at very cheap costs while savers get ripped off by getting low returns on their savings. Financial repression effectively functions as a tax on households along with small and medium enterprises (SMEs) since SMEs tend to be more labor intensive. The beneficiaries of the tax are net borrowers. In China, the primary beneficiaries would be the corporate sector or the government sector. Since China follows a state capitalist model, almost all of the corporate sector IS the government sector. An IMF 2014 working paper estimated that the total value of the SOEs in China was around 190% of GDP in 2012.

Note: In the Chinese financial system, the only well functioning part is the banking system and, unlike in the US or in most of the developed world, savers have very few options on where they can place their savings. Since households are net savers, the design of the Chinese financial system transfers massive amounts of money from households to the government and corporates (who are really just a proxy for the government). Also note that households are not just net savers, but they also tend to consume most of their income. This means that the Chinese economic model has an extremely low household share of GDP with most of GDP coming from other sectors. Since governments and corporates consume a much smaller percentage of their income, when the household share of GDP is low, we end up seeing extremely high savings rates.
Note: S=Y-C so a low consumption share of GDP results in a high savings rate since C+S=Y

In addition to financial repression, the Chinese government also uses wage suppression in order to make it easier for large scale manufacturers to compete on an international level. So large Chinese firms not only get access to extremely cheap capital, but they also get access to cheap labor. Wage suppression also reduces the income that households get, which also holds down household income and results in a higher savings rate.

The third aspect of the Chinese economic model, the undervalued currency, acts as a tax on those who consume foreign goods. The proceeds of the tax go to large scale manufacturers and exporters. Those who are most likely to consume imported goods are primarily households in the middle class. Again, we're seeing a suppression of household income where the proceeds go to large scale manufacturers. This is another policy which will drive up the savings rate.

The historical precedents for China aren't too pleasing either. Today, China has the highest savings rate ever recorded with a savings rate of around 60%. The only time savings rates have reached near those levels in the past century was Japan in the late 80's, the US in the late 20's, Brazil in the 50's, and the Soviet Union in the 60's and 70's.

China's Debt Problem
Notice that the most important part of China's growth model is financial repression. Financial repression allows producers to borrow at very real rates while households get diminished returns on their savings. This incentive allows the corporate/state sectors in China to borrow very heavily to finance virtually anything. In turn, this policy (along with the undervalued currency) allows companies access to very cheap capital and has created a borrowing binge by Chinese corporates.

What's been the consequences of this borrowing binge? China has undergone one of the largest, if not the largest, debt bubbles in economic history. We've seen ghost cities spring up the size of Paris in parts of China that are completely uninhabitable where no one lives.

In terms of sheer size, the expansion we've seen in the Chinese banking system has been absolutely insane. In terms of banking assets/GDP at the end of 2011, the size of the (formal) Chinese banking system was 240% of China's GDP according to this report. Another report shows that bank loans (not total assets) of the Chinese banking system expanded at a rate of 15-20% since 2011 while NGDP has been growing at around 9% (officially from the Chinese government). This tells us that the minimum size of the formal banking system in China is over 300% of GDP and could be reaching 400%. On top of this, we've seen a surge of the shadow banking assets from <20% of GDP two years ago to around 50-70% of GDP today. In other words, the total Chinese banking system is now almost four times China's GDP and this is a lower bound, not an upper one. We're probably dealing with a country whose total banking assets range from 400-500% of GDP. There is no country nearly as large as China that has seen a credit expansion that large. Even the US didn't come close to having a credit bubble that size.

The reason why this economic growth model creates problems is because investment is driven by debt. 

China's Geography and Urbanization
We've seen urbanization in a scale that's never even been close to matched in world history. Note that urbanization is very pro-cyclical. During the boom, more people move into the cities which increases demand in the are and creates jobs--whether productive or not. During the bust, we see the opposite impact where a fall in demand leads to people leaving the city.

In the picture below, we can see how China's population is spread out throughout the country's landmass. In China, almost all of the country's population lives on the mid-Pacific coast in or near the Han core of the country. However, much of this investment and infrastructure development has come in the Western part of China. Note that the Western (and Northern) part of China is largely mountainous, the terrain is very rugged, and most of the area is not livable. Many compare the infrastructure and investment in Northern and Western China to that of the US in the 19th century, but there really is no comparison. When the US expanded west, the US was expanding into one of the most fertile areas in the world into a region that was easily hospitable with plenty of natural resources. With regards to China, the situation is very different. China's situation is much closer to when the Soviet Union went east or when Brazil went north in the mid-20th century, which was largely considered a waste.

There are massive Chinese ghost cities, real estate development, and infrastructure projects that are popping up in these completely uninhabitable areas where it's extremely expensive to maintain these projects. The idea of moving the entire rural populations to cities where maintenance of these high rise condos, large scale cities, and infrastructure is extremely expensive is simply not realistic or possible. On top of this, transportation of basic necessities like food or energy would be nearly impossible--especially considering the terrain we're dealing with.

China's Demography
China also has one of the world's worst demographics out of any country. Due to unintended consequences of China's one-child policy, there will soon be a rapidly aging population that will start to decline in about 15 years. However, the Chinese workforce has already started to decline while there were 18% more boys born than girls in 2013 according to CNBC. All of this is happening while the Chinese population will continue to grow until 2030, which implies a rapidly rising dependency ratio.

Note that until this year, China's one child policy actually caused a surge in growth rates by reducing the dependency ratio. If people all of a sudden have less children (one child policy), the immediate impact on the demographics is that the dependents start to fall because children don't have to be taken care of. As time proceeds however, the economic benefits will soon become an economic handicap and will do so very rapidly.

Another unintended consequence of the one child policy is that it's forced families to choose between having boys and girls. This policy has caused there to be many more boys being born than girls, even as of 2013. There are negative consequences to these policies that have driven up growth in the short term while effectively stealing growth from the future.

Environmental Degradation in China
Another factor that means reduced growth for China's future is the environmental degradation that's occurred in China. Pollution in China is probably the worst in the world with cities like Beijing and Shanghai having massive smog attacks, but the pollution isn't just limited to air pollution in the large cities. The amount of pollution in the water supply of China has led to massive amounts of the Chinese water supply being completely unusable. It leads to water that can't be used to grow crops or as drinking water.

Another problem with environmental damage in China has to do with the refinement and extraction of certain minerals from the ground like rare earth metals. Rare earth metals aren't actually rare, but they're used in making devices like computers, smartphones, and tablets. These metals are extracted/refined in China and exported to other parts of the world. The extraction and refinement of these metals is extremely damaging to the environment. It's so damaging that most countries do not allow the extraction and refinement of these (and other similar) minerals on their soil. However, China does allow such behavior, which causes front-loaded growth at the expense of future growth.

Let's not forget the building of large cities in the middle of nowhere near very harsh terrain. There are environmental costs to doing so. China has wiped out massive mountains in order to build those cities no one will live in. Scientists have already warned the Chinese government about consequences like soil erosion, massive flooding, and other consequences

China's Future Growth Prospects
The biggest driver of growth for China, as discussed earlier, was the economic growth model. The primary mechanism of driving growth was through financial repression, although other methods were significant too. The unsustainable growth in China's debt burden guarantees that China is very close to running into debt capacity constraints, especially for a developing country. Using very generous numbers and assumptions about China taking up a new growth model, Michael Pettis says the maximum growth China can attain is 3-4%. Of course, Pettis doesn't take into account all of the other factors I've discussed in this post, which could mean a realistic chance of China's actual growth ending up as less than the growth of the US over the next 10-15 years.

China has undergone a massive transformation over the last 30-40 years that has never been done by a country this large on a scale like this before in history. Previous examples show a bleak future for China over the next 15-20 years, but China's current path is not close to sustainable. Something will break in China; something crazy will happen. The question is what.

Wednesday, July 2, 2014

Geopolitics, Natural Resources, and Economics are Intertwined

In an economics class, we're told that it's possible to have exponential growth forever. There's very little talk in economics about the role of natural resources or about the risks that natural resource issues can create. To think that we can have infinitely (and exponentially) rising productivity without taking into account natural resources is inherently flawed.

Let's take a look at the devices that have given us the most productivity gains over the past few decades. It's inventions like the computer, cell phones, smartphones, etc.. The computing power of these devices combined with their relatively light weight and durability comes, in large part, from the natural resources and metals used to make them. Many of these metals are rare earth metals or something similar (ex. Beryllium). The metals used to make things like smartphones often have very low substitutability and supply risks are created. Below is a map of the production of "critical raw materials" as determined by the European Commission.

Due to the "progress" and "growth" that we've had coming from inventions like smartphones and computers, the supply of many of these metals--include rare earth metals--are critical for economies to function. It's also important to note that the extraction and refinement of these kinds of metals can be very damaging to the environment. There's a reason why most developed countries (and most countries period) tend to not allow or carefully allow the refinement and extraction of these metals that are so important for maintaining global demand.

Although the extraction of these metals increases GDP growth, technology, and production in the countries supplying these metals, the costs of such policy affect the whole world in the long run. In other words, all of the costs are hidden in the tails while the benefits are obvious and immediate. If we were to take China as a classic example, there's a real possibility that China could wipe out entire mountain ranges in order to continue its extraction and refinement of these kinds of metals. This kind of thinking and behavior creates major tail risks.

Basically, what's called "progress" and "growth" is heavily dependent on the supply and transport of natural resources. Almost all of the developments in technology and productivity have relied on natural resources. Keeping supply lanes and trade routes to certain metals is extremely important with regards to maintaining "growth" around the world.

If there's a disruption in supply lanes and trade routes or if there's some kind of event that reduces our ability to extract, refine, distribute, or trade natural resources, global growth will come smashing down. In other words, there are major economic/financial risks created when we realize the importance of natural resources. In this post, I primarily described the relationship of minerals used in making certain technological devices (ex. smartphones); however, similar arguments apply to the transportation and shipping of things like oil and natural gas.

We cannot look at risks towards economic systems if we do not look at natural resources or geography or geopolitics of some kind. All of these factors are critical to the success and failure of economic systems.

P.S. I've got nothing against smartphones. I actually own a smartphone. It's just a very good example for the point I'm trying to make.