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The New Normal and Global Flattening

Much has been written about the ‘new normal’ as the long, grinding and stubbornly acyclical expansions which have characterised the US, the UK and to an extent Europe in the aftermath of the implosion of Western financial institutions. For Asia, the acyclicality of the West’s post-crisis expansion, at a time when central banks have deployed extraordinary policies in attempts to spark a recognizable business cycle into life, has resulted only sharp volatility of capital flows. During the initial period of near-zero Western interest rates, the result was a flood of capital into Asian economies which bore no relation to underlying trade flows. But since the recovery of the dollar in mid-2014, this flood abruptly reversed, with the outflows again fundamentally divorced from any underlying trade dynamic.

The new and seemingly purposeless volatility of capital flows, unrelated to savings imbalances either in Western or Asian economies (since the private sectors were almost universally running cashflow and savings surpluses), has distracted attention from a development in trading patterns which, in time, is likely to have a lasting impact.

But since the beginning of this year, a new stage of quasi-stabilization has been emerging, both in terms of capital flows (as shown in the stabilization in Asian fx reserves), and in terms of the reversion roughly to trend growth of both G3 imports and NE Asian exports.

So it is time to start thinking about the likely implications of this new stabilization. I think one of its key characteristics will be a global flattening of pricing opportunities, which will gradually result in the unexpected rediscovery of Western inflationary pressures,  as well as unexpected upward pressures on Asian currencies. (Perhaps this is how the reversal of the great Western bond bull market is finally discovered.) In addition, we ought to expect something of a convergence in rates of growth and return on capital. In fact, the ‘new normal’ may turn out to usher in a great flattening.

A major part of the dynamic powering globalization has been a sharp discovery of regional comparative advantages, in which Asia discovered a its comparative advantage was for low-cost mass manufacture, whilst the West discovered it retained comparative advantage in higher value-added manufacture.  As this discovery was a dynamic and expansive process drawing in ever-larger pools of labour, so the terms of the deal underpinning this aspect of globalization were that although Asia’s (in particular) share of trade in world low-cost manufacture rose inexorably, the growth in volume of exports was offset by a fall in prices.  By contrast, although the West lost volume, it’s ability to price its remaining exports was retained.

This underlying equilibrium generated a familiar divergence in the terms of trade (ie, movements of export prices relative to import prices) between the West and NE Asia. The chart below shows how, typically, whilst terms of trade for the US and Germany have remained roughly stable since 2000, NE Asia’s slid by approximately 40% between 2000 and 2011.  NE Asia’s exporters (including here Japan, S Korea and Taiwan) could win market share, but at the cost of emphatically being unable to price their goods.

However, looking again at the chart, it becomes clear that the long-term sustained fall in NE Asia’s terms of trade relative to those of the US and Germany has stopped - and in fact if we re-base terms of trade to Jan 2010 =100, it turns out that after the final fall in 2011, NE Asia is no longer losing out in terms of trade. Rather, it is at worst holding its own, and arguably, is now raising its terms of trade relative to the West. In global terms, it seems either that NE Asia has finally won or lost the ability to price its goods according to market dynamics in ways which are no longer very different to those of West. Either way, the fundamental pricing dynamic which underpinned the globalization to which we are accustomed no longer applies. 

UK Economy's Vulnerability and Resilience

The impact of Brexit on the UK economy in the long term is, obviously, incalculable, and will remain so, since it is currently a world of infinite hypotheticals. But in the short term, it is possible to outline the template upon which will be printed a likely fall in consumer confidence, a hiatus in investment spending, and a c10% devaluation of sterling against the dollar.  It is also possible to measure the current pressures on private sector cashflows, and the cyclical pressures being experienced by business and labour markets.

In general terms they suggest that the current UK expansion, which has been fundamentally acyclical, is finally becoming a bit ‘leggy’: cashflows are slightly strained, return on capital has peaked, and labour productivity is falling.  None of these deteriorations are extreme, and within the context of an acyclical expansion this would raise the prospect of a ‘soft patch’ of slowing growth marked by slowing consumer spending, slowing investment growth and slowing employment growth.  Since the cycle has not been generated, accelerated or even supported by increases in credit, one would not expect that ‘soft patch’ to degenerate into a recession.

The uncertainties generated by the Brexit vote, however, are likely to intensify all these current mildly negative trajectories, and consequently the chance of a recession have increased.

By contrast, the c7% fall in sterling against the dollar almost certainly does not generate the potential for an inflationary break-out of any importance for monetary policy. Currently, consensus expectations for UK inflation are unrealistically high, and one cannot read any positive relationship between sterling/dollar rates and changes in inflationary momentum in the history of the last 20 years.

Current Momentum
Consider first the momentum indicators which seek to track the story told by monthly data releases.  In fact, these have little compelling to say. In 6m momentum terms:
i)  domestic demand momentum is being sustained on roughly the same course as it has for the last two and a half years;
ii) after a modestly soft patch during 4Q15 and 1Q16, industrial momentum is currently being modestly regained. There is a problem with the data, however, since the current recovery is hostage to extremely volatile results for April which stand every chance of being significantly revised down in months to come;
iii) monetary conditions have been very significantly relaxed during the last six months, helped mainly by a weakening of sterling against the SDR, a fall in real interest rates and, to a lesser extent, and acceleration in broad money supply.  In the past, there have been occasions when such a loosening of monetary conditions has been followed by a modest strengthening of domestic demand momentum, but the relationship is not compellingly strong.

Private Cashflow Pressures

Rather, to gain insight into Britain’s current position in the business cycle, we need to look first at current private sector cashflow stresses, and then also at trends in returns to capital and labour. 

There are two indicators which track Britain’s private sector cashflows: 

i) the quarterly private sector savings surplus/deficit, obtained by subtracting public sector net borrowing from the current account balance; 

ii) the flow of cash between the private sector and the banking sector.  In theory, the movements of these two should be closely related, but of course, the more complex a country’s financial system, the more  frayed that relationship will be.

In the immediate aftermath of the financial crisis, Britain’s private sector moved negligible net surplus savings flows to a surplus peaking out eventually at around 6% of GDP in year to early 2010. This financial caution has been very steadily eroding since then, with the surplus fully eroded to the start of 2015, and moving to a deficit of approximately 2% of GDP by 1Q16. The gradual but sustained erosion of the savings surplus was one element which supported domestic demand during a time of net de-leveraging and negligible real wage growth. 

Any severe or extended spike in financial caution can be expected to reverse these trends, with the private sector moving back into savings surplus and in the process depressing domestic demand. 

The second indicator of cashflows tracks the net movement of private sector cash directly into or out of Britain’s banks: specifically, the chart below looks at the 12m change in private sector sterling deposits minus the change in private sector sterling loans.  It finds the same dramatic deleveraging undergone in 2009/09, followed by a gradual relaxation since then. As with the PSSS chart, it suggests that by the 12m to early 2015, net cashflows between the private sector and Britain’s banks turned negative, and have remained slightly negative since. 

Neither the PSSS chart nor the private sector/bank cashflow chart suggest current private sector economic behaviour is particularly extreme. Another way of seeing this is in the changes of private sector sterling bank debt/GDP, which fell from a peak of 144% in 1Q10 to 104% in 2Q15. The subsequent net rise in debt (implied also by the emergence of a private sector savings deficit) has raised that debt/GDP ratio, but only to 106%, which would still be the lowest since 2004.  

Nevertheless, since 2010 domestic demand momentum has been underpinned by a gradual easing of financial caution. If that caution is now reversed as a result of Brexit, we can and should expect a negative impact on domestic demand momentum. This is a medium-term vulnerability. 

Cyclical Underpinnings: Returns to Capital and Labour

But there are also longer-term vulnerabilities which suggest that the underpinnings of Britain’s current business cycle are already deteriorating in ways typically seen towards the end of a cycle.  Namely: returns to capital have peaked, and labour productivity is now dropping. The normal cyclical response to these two late-cycle phenomena are i) to slow investment spending and ii) to slow employment growth.

First, my return on capital directional indicator peaked at the beginning of 2015, and has been in steady decline since then. (The indicator expresses nominal GDP as a stream of income from a stock of fixed capital, with that stock being estimated by depreciating nominal capital investment over a 10yr period. It can be seen as proxy for asset turns in a Dupont analysis.)  Capital spending tends to react fairly predictably to changes in this measure, accelerating when returns on capital are rising, but slowing some time after ROC peaks.  

The lag between the peak of the ROC directional indicator and the slowdown in investment spending is not stable, however: investment mistakes get made at the top of the cycle when animal spirits are particularly inflamed and bank credit freely available. However, the post-crisis UK expansion has been unusually non-cyclical (reflecting the negligible impetus given by the crippled banking system), with animal spirits remaining cautious and a complete lack of net new sterling bank lending. So the reaction to ROC peaking arrived quickly, but has so far been mild.  In 2014, immediately prior to the peak of the ROC directional indicator, nominal fixed capital formation grew at 7.9%; in 2015 that slowed to 4.7%, with the sharpest slowdowns arriving in 4Q15  and 1Q16.  

It is more difficult to draw similar linkages between changes in labour productivity and employment, if only because of the impact of essentially uncontrolled immigration can be expected to constantly lower the supply curve in a way which will allow employment growth to survive falls in labour productivity.  Despite this, the general expectation survive that rises in labour productivity (here shown as real GDP per worker, less the change in capital per worker) are followed by rises in labour demand, whilst falls in labour productivity undermine demand for labour.  Currently, this measure of labour productivity has been in modest decline since 2014, and that decline has been followed by a slowdown in the rate of growth of employment. 

With both return on capital having peaked, and labour productivity declining, in cyclical terms, the stage is set for a downturn. However, note that in both cases, the deterioration is very moderate in historic terms: the return on capital indicator is still higher than the pre-crisis peak; in pre-crisis terms, the modest fall in real output per worker would be seen as a qualified success.  As the UK expansion has been fundamentally acyclical and unaccompanied by credit excesses, so these typical late-cycle phenomena are hardly grim enough to trigger an outright recession.  Rather, absent the uncertainties caused by Brexit, they would suggest nothing much worse than a ‘soft patch’ of slowing growth. 

Sterling Weakness and Inflation Prospects

By the end of July, sterling had fallen 7.8% from the May average valuation against the US dollar. If this devaluation is assumed to not be reversed in the coming months, might this generate a sufficiently sharp rebound in inflation to dictate a tightening in monetary policy, rather than the loosening currently being suggested by Bank of England chairman Mark Carney? 

The first thing to realize is that prior to the Brexit vote, there were negligible inflationary pressures to be found in the UK’s CPI data.  May’s CPI rose only 0.3% yoy, and in 6m momentum terms, there was still negative momentum. The chart below shows the spread of likely possibilities, based on extrapolating 5yr seasonalized trends, and deviations from them (current 6m deviations as well as 1SD above and below).  

They suggest inflation rates averaging around 0.2% yoy in 2Q, staying roughly around there for the next nine months (with a range of 0.1% to 0.3%).  This is far below current market consensus, which foresees a rebound in inflation rates to around 1.5% yoy by 1Q17. Such a rebound would represent a deviation above 5yr trends of approximately 1.5SDs - possible but unlikely. 

Moreover, weakness of sterling against the dollar is no good indicator that such a deviation against trend is likely. The chart below shows the relationship between sterling strength/weakness against the dollar and underlying 6m CPI momentum.  Generally, if sterling weakness against the dollar reliably generated inflationary forces, one would expect to see these two lines moving predictably in different directions. Rather, to the extent that they are at all synchronised, the correlation appears to be positive: a strong sterling seems to have been associated with above-trend inflation, whilst a weakening sterling looks to be associated with weak inflationary momentum.  But in neither case is the relationship statistically interesting. 

Reflections on the Revolution in Britain

“By the deep cultural instinct of a free people, this amazing, unprecedented restoration [of parliamentary accountability] was accepted without riots, or police, or revolution. It is the most momentous thing I have seen in nearly 40 years covering British politics, and the most moving.”

               - Charles Moore

“We must learn from brexit: Elderly xenophobes will lie to pollsters to hide their racist views, then vote for destructive policies anyway.”  

                 -  Anil Dash

Revolution? It’s a big word, but justified. If you doubt it, consider the global Establishment consensus deployed for shock and awe by Remain campaign: Metternich himself could only have dreamed of such a comprehensive conservative coalition.  And consider now the response of some of those whose fates are hostage to Remain: counter-Revolutionary plans which fully deserve to be recognized as deranged and in a narrow sense, contemptible. The instinct to cut out the middle-man and send in the tanks is barely repressed.

Although there are many many things which the counter-revolutionaries don’t understand, primarily because they no longer share a language with the rest of their fellow countrymen, they are right in one thing: Brexit is a decision which threatens the extraordinary privileges they enjoy and which have now proved intolerable to their fellow citizens. In that, the outraged hostility they are now directing to their fellow citizens is understandable.

I have been, and am, pro-Brexit on the grounds that, since all policymakers are flawed,  democratic accountability matters above all else. But that’s probably not why most people voted to leave. As we look through the dust and poke through rubble, it also seems to me that this revolution is best understood as a response - the first serious response, albeit delayed - to the collapse of the western financial system in 2009.  It represents a demand for a different type of economic settlement, and that in turn demands a different type of financial system.

Language matters. One of the most perceptive readings of the current political situation came from (of all people) a Houston-based poet Anis Shivani writing in (of all places) Salon.  He was writing about US politics, but his analysis certainly extends to the UK referendum:

“The neoliberal economy has become pure abstraction; as has the market, as has the state, there is no reality to any of these things the way we have classically understood them. Americans, like people everywhere rising up against neoliberal globalization (in Britain, for example, this takes the form of Brexit, or exit from the European Union), want a return of social relations, or embeddedness, to the economy.”

He asserts that “capitalism today is placeless, locationless, nameless, faceless”, and that the difference between Mitt Romney and Donald Trump is that “while Trump’s entire life has been orchestrated around building luxury and ostentatiousness, again things one can tangibly grasp and hold on to (the Trump steaks!), Romney is the personification of a placeless corporation, making his quarter billion dollars from consulting, i.e., representing economic abstraction at its purest, serving as a high priest of the transnational capitalist class.”

You don’t have to agree with Shivani’s ultimately conclusions (for which, read the article) to see that he’s on to something. Moreover, the logical consequence of fully buying-in to the abstracted politico-economic set-up is precisely the loss of the language in which to talk to that part of the electorate for which ‘social relations’ and ‘embeddedness’ are the very stuff of everyday life.

It plays out in the US: forget the policies - Trump is (scary) funny to listen to; Hillary is a grind. And it played out in the UK referendum Boris is (absurd) funny, Nigel Farage ‘likes a pint’ and the Remain campaign kept name-checking more experts you’ve never heard of say that at some unspecified time in the future Brexit might mean a loss of family income equivalent to £4,300.  Or alternatively, it might mean World War III or the collapse of Western Civilization.  OK, thanks, mine’s a pint.

The shape of that settlement isn’t yet clear, but elements of it are, and they are not usefully explained as being ‘right wing’ or ‘left wing’, or ‘socialist’ or even ‘capitalist’. If Britain gets it right - and is there a country anywhere in the world more capable of re-inventing itself? - 23rd June may yet come to be seen as ushering in a new chapter of economic development. And London’s financial markets are likely to be right at the centre of it. We do live in exciting times, even if right now the danger is more obvious than the opportunity.

Language matters. This loss of essential language has two major consequences: it made it impossible for Remain to talk to the electorate in a language they could relate to; and second - and now more importantly - it means that the wider Establishment does not yet have the vocabulary it needs to understand what has just happened.  Currently, it merely flails. This will change in time, but right now this generates a third consequence which might lead to bad investment strategies: its forecasts about likely future developments and trajectories are unlikely to score any better than chance. 

A couple of examples of this failure of language might help illustrate the points. First, the Remain campaign was keen to persuade the electorate that British people were not ‘quitters’.  What I think they were trying to connect with was the British people’s notion of themselves that they tend to be very resistant to foreign pressure. ‘We shall never surrender’ etc. But since ‘we shall never surrender’ wasn’t available (for obvious reasons) the speechmakers substituted ‘quit’ and ‘quitters’.  But ‘quitting’ doesn’t have the meaning (use) that the speechwriters needed: Brits are proud of ‘quitting’ smoking, and they’re perfectly happy to tell you they’ve ‘quit’ a lousy job. ‘Quitting’ in these senses, is, in fact, the opposite of ‘giving up’: in fact, most of the time, for Brits ‘quitting’ is an act of virtuous though sometimes pig-headed self-assertion.  Whoever lit upon ‘quitting’ as a word is either a foreigner (an American, perhaps?) or someone who hasn’t talked with many fellow Brits over the last 20 years. 

Perhaps more seriously for current policy, and definitely for future forecasts, is the notion that leaving the EU appealed mainly to those who have been ‘left behind’ by globalization. The people being referred to here tend to be those living in Northern towns which have suffered through 45 years of de-industrialization.  But the key problem with the language used is that it quite wrongly implies that for everyone else the problem has gone away - after all, those people have been ‘left behind’.  But they haven’t: they are absolutely still here.  And in fact, that’s the most important point of all being made by the referendum. There is no sense at all in which the ‘left behind’ aren’t still right here, right now.   

What’s more, they are far more ‘embedded’ than you, dear reader, are likely to be, since you are all priests of some standing in globalized capitalism. 

The two sets of people likely to be least-embedded in their society are i) Londoners (because of the size of the place, the national and international churn of its population, and its central preoccupation precisely with the abstractions of globalization; and ii) young people, particularly students, because by definition they’ve not yet had time to become ‘embedded’ in their society. These are precisely the people who voted to Remain, and they are also the people now likely to be making forecasts about the future. 

The difference between London and the rest of the country which hosts it has long been globally anomalous. This is not so much an opinion as a measurable fact: one of the most robust relationships in economic geography it that there is Zipf distribution in the size of towns and cities within a given polity. London simply doesn’t fit this law: it is far bigger than the frequency of cities in the UK of smaller size would suggest.  In fact, London conforms to the Zipf law distribution of cities only if you include the rest of Europe in the sample: purely in these terms, London is revealed as the capital not of the UK, but of Europe. (Sorry, everyone, I’m not making this up, this is simply how the maths works). 

This divorce not only left London without a language with which to talk with, or even listen to, the rest of the people of the UK, but also seemingly contemptuously hostile towards them.  It was not a good starting point for a political campaign in which the vote of a non-Londoner was no less important the vote of a Londoner. 

History Matters.  I have no theory of history, but it does seem that sometimes the past can be a good interpretive guide. For instance, if the nations of the EU are split, you can be all-but certain that they divide precisely along the lines taken the Thirty Years War.  And in Britain, if you want to know fundamentally what sort of ‘political’ person you are faced with (or are yourself), you ask: ‘Which side would you have been on in the Civil War’. This breaks down between the Cavaliers (‘wrong but romantic’) which supported Charles I, and the Roundheads (‘right but repulsive’) who fought for Parliament (etc, long story). 

Right now, everyone in Britain knows the answer to this question, for themselves and for others too. The Cavaliers were all-too obviously for Remain, asserting essentially the divine right of trans-national legislators, and manned by the princes of the Establishment (in this case, the notable Labour princelings of Will Straw and Stephen Kinnock). An at the end, the found themselves, relying on an unsteady and unnatural alliance between the Scots and London aristocrats. Although Prince Rupert wasn’t actually called from the grave for one last hurrah, his descendents were in the saddle all the way through.  The Brexiteers meanwhile were, with uncanny precision, the Roundheads, asserting the primacy of parliament (long story), and even drawing strength from precisely those parts of England which brought forth Cromwell.  Before long, I expect they’ll propose union with the Netherlands and mess up Ireland. 

If you want to translate that into different views on political ‘legitimacy’, the Remainers asserted that political legitimacy was won by national and international creditation of particular ideas and policies; the Brexiteers asserted political legitimacy still rested with the people. 

Globalization. The Chinese spokesman followed that country’s oracular tradition when he told the UK papers: ‘A brick has been prised out of the mansion of globalization.’ 

I think this is right: the British decision to pull out of the EU may just represent the first decisive step in re-casting the terms upon which globalization takes place. Britain has an extraordinary and possibly even protean ability to re-invent itself quite fundamentally every few decades, and this looks and feels like the start of another re-invention. If we are all lucky, we may look back on the 23rd June vote as the first step the West took to re-invent its economy in a way which acknowledged and finessed the collapse of its financial system in 2009. If so, we are seeing nothing less than a revolution. 

To explain why, and possibly how, let’s ask a fundamental question: why do we put up with the inequalities generated by capitalism in the first place? Well, first, from a personal point of view the market provides a wonderful and, to me, natural, outlet for my creative (and destructive) energies. And, hurrah, it rewards me for it at the same time.  From a systemic point of view, however, we tolerate the inequalities of capitalism because there’s overwhelming evidence that it delivers the goods in terms of improved and enlarged qualities of life. 

This has never been more abundantly true than during the last 25 years, where (very broadly) the introduction of capitalism has lifted probably upwards of a billion people in China alone from a condition of enslaved and immiserated poverty to one of material decency. This is the great economic and moral good achieved by this round of globalisation - let no-one doubt that. We have witnessed, and participated in, the greatest improvement of the human condition any generation has ever experienced. 

But notice that there’s an implicit trade being made here, in which an increase in inequality is granted as the acceptable price of improved living standards for all. Now let’s think again about how that trade has been working out recently, in Britain.  

What is “Left Behind”?  To do so, one needs again to have some knowledge of what it means to be ‘left behind.’ I honestly doubt that most people in London have any idea (or possibly, interest) in what it means. I do, because I’ve been in flight from it all my life.  Here comes the personal history: I come from Huddersfield, the 11th largest town in Britain, with a population of roughly 164k. When I was being brought up (the 1970s), the town’s key industry, textiles, was dying, week by week, month by month - I’d count the chimneys on the way to school, and the count fell and fell. Nevertheless, the textile industry bequeathed a social and infrastructural legacy which is visible to this day: on the one hand the Huddersfield Choral Society got to sing in a splendid high-Victorian copy of Amsterdam’s Concertgebouw; on the other hand, the town invented rugby league, and spawned the Luddites. Nowhere, I dare say, was more ‘embedded’ - and even today, although saying you’re from Huddersfield has vertiginously negative social cachet, at least you are without doubt ‘from somewhere’. 

Now, consider this: whilst Londoners admire the new extension to the Tate Modern, and ponder the possibilities of a ‘garden bridge’ over the Thames, Huddersfield has been told there’s not enough money to keep open an Accident and Emergency Unit in its hospital. Reader, if you go on a field trip to Huddersfield to discover what being ‘left behind’ means, don’t collapse in shock, because there will be no A&E to keep you alive if you do. In truth, this shrinks health provision back not just to Victorian conditions, but to pre-Victorian conditions. Tell me, then, that the deal between greater inequality and ‘delivering the goods’ is working for places like Huddersfield. 

Obviously, it’s easier not to know, and not to care because, as I say, in the grand scheme of things, globalization has delivered munificently on its promise.  But the grand scheme of things is, as Anis Shivani says, now absolutely abstract. What language would you use to explain its virtues to the ‘left behind’ of Huddersfield? Tricky, I’d say. 

The unwillingness to listen has evidently hardened among many of Britain’s Establishment into a most extraordinary inability to hear even the plainest message.  You hear intelligent, well-educated and presumably well-meaning TV reporters front up to a ‘left-behind’, who patiently explains that he/she can’t get a doctor’s appointment, a school place, a house, a job with a permanent contract, and the TV reporter duly turns to camera and says something along the lines of ‘And it’s this fear of immigration that’s been driving the Brexit vote’.  And from there it’s but a hop skip and jump to Anil Dash’s insult: “Elderly xenophobes will lie to pollsters to hide their racist views, then vote for destructive policies anyway.”

EU bureaucrats have this excuse: they genuinely do speak a different language. But what excuse does the British TV reporter have? 

What’s changed? “Globalization has been chugging along pretty well now for decades, and you yourself say that the northern industrial decline set in decades ago. So what’s changed now? Why has the previously tolerable suddenly become intolerable. What’s changed?” 

The answer is that over the last few years, two factors have combined to dramatically recast the economic foundations upon which which consent for globalization rested: 

i) The EU imposed effectively uncontrolled immigration policies at the same time as its Euro policies were beggaring much of southern Europe; and 

ii) The western financial system collapsed.  

Separately, both these would probably have been tolerable: when combined, they become very sharply toxic. 

To understand why, let’s consider first what’s happening to the meat-packing business which is the biggest single employer in my market town. It’s doing ok, but a friend who’s been working there for years tells me it no longer offers any permanent jobs at all - instead, it relays through teams of East Europeans on short-term temporary contracts.  The obvious point to make is that, of course, access to an basically infinite and therefore infinitely flexible low-skilled labour force must have a negative impact on anyone competing for low-skilled jobs. What’s more, we can be pretty certain that the negative impact can be only partly relieved by legislation. 

The less obvious point is that for a business - for my meat-packing factory - it sharply changes the terms of labour/capital substitution. If the meat-packing factory encounters unexpectedly strong demand, it will simply import more East Europeans to cope with demand.  It is easier to do, less risky, and leaves a lighter balance-sheet footprint, than to invest in new machinery. 

In short the company gains nothing by investing to raise labour productivity, and loses nothing by not investing.  But if labour productivity is not raised, ultimately real wages will not/ cannot rise either. 

As the chart shows, between 2009 and late-2014, there was effectively no growth at all in capital per worker in the UK economy, reversing the steady 3-4% growth experienced previously.  The jolt upwards seen in 2015 reflected only the slowdown in hiring, and since capital investment has since slowed sharply (it rose only 1.6% yoy in nominal terms in 1Q16), we shall probably see the flatline return. 

What is the alternative? Next door to the meat-packing factory a different factory makes meat pies: the manageress told me the other day, she spends her time shouting “ship-ka, ship-ka” (“szybko” - it’s Polish for ‘quickly’).  No doubt her enthusiasm works wonders, but even so, on an economy-wide basis, real output per worker, once adjusted for capital per worker, is declining. 

The loosening of the labour markets is one part of the equation; the other is the inability/unwillingness of the banking system to finance investment.  Loans to the non-financial corporate sector have been falling continuously since late 2008, with net repayments since then of £133.8bn.  Nor is this simply a reflection of banks’ overall asset base contraction: loans to non-financial private corporations as a proportion of the balance sheet has also shrunk by approximately a quarter during the same period. 

Remember that the key question remains: “why do we put up with the inequalities generated by capitalism in the first place?” and the answer is that it delivers the goods.  It is this combination of infinitely flexible labour markets and a financial system which is not, and quite possibly cannot, allocate savings towards corporate investment which not only is no longer delivering the goods for a majority of people right now, and, just as importantly, is unlikely to deliver the goods in the future, because its problems are systemic. In such a set-up, the inequalities generated by capitalism are no longer tolerable. That is the verdict of the referendum. 

What Happens Now 1: Economics, Corporate Behaviour and Finance

If this is what underpins the verdict, then one only has to run the film backwards to see where it ends. First take away the assumption of an infinitely expandable/infinitely flexible workforce. If growth is no longer underpinned simply by adding labour, then growth will either a) stop or slow or b) have to be generated by productivity improvements.  Once you’d exhausted the improvements brought about by shouting ‘ship-ka, ship-ka’, that means investment in capital equipment, training and, possibly, infrastructure. 

In turn, this means that the UK financial system will have to rediscover a way of financing capital investment. The experience of the whole western banking industry strongly suggests that it doesn’t currently know how to do this; the experience of Japan suggests that once you’ve lost that skill, you don’t get it back. (Financial systems can fail in two ways: it can lose money by allocating savings to the wrong assets; or conversely, it can fail by being unwilling/unable to allocate those savings into any risk assets at all.  Before 2009 western banks failed the first way; after, they are failing the second way).

In addition, however, we cannot expect companies to suddenly discover an appetite for expanding their balance sheets by investing in fixed assets. In a non-inflationary or deflationary world, everyone understand that asset-turns are king.  

So my guess is that the way forward for the financial services industry must be equipment leasing. Financial companies with unavoidably large balance sheets (ie, insurance companies) can be expected to develop equipment-leasing arms which:

i)  will allow companies to expand capital stock without expanding their balance sheets, 

ii) allow insurance companies a far larger return than is available on bonds; and 

iii) can be expected to attract extremely generous tax-treatment from a government eager to stimulate private investment. 

So, go to it, friends. 

What Happens Now 2: Game Theory and Diplomacy 

In the short term, however, there are good reasons to expect the leaving to take time. The fact that Britain has voted to leave the EU has all the force of a new fact which disrupts many of the forecasts and expectations which existed before that fact. One of the more important is that it strengthens the supposed hand Britain has to play in its negotiations to leave. The best way to appreciate this is through game-theory. 

In a predictably finite game, it always pays to defect, whilst in an infinitely extendible game, the defection strategy is merely one of mutual destruction.  Now that Britain has chosen to leave, the game itself has changed, from infinitely extendible to almost certainly finite.  So in those circumstances, it pays individual EU countries to ‘defect’, which effectively means accepting good bilateral trading terms with Britain, rather than try to impose poorer terms as a group.  For example, were Britain to offer free-trade terms to Germany’s auto manufacturers, would Germany’s government really rule this out in order to respond to the desire of, say, Belgian waffle-producers to play hard-ball?  

These calculations become even more advantageous to UK negotiators if there are, in any case, doubts about how long the EU will maintain its current membership. This is a different type of the same game: no country would want to be a member of the hold-out group imposing mutually damaging trade barriers if significant other currently EU economies had already defected. 

The most obvious way for the EU to avoid these game-theory negotiating pitfalls is to hurry the process as much as possible, in the hope that no-one notices that the game itself has fundamentally changed.  For Britain, of course, the opposite is true: the longer it takes to play the hand, the stronger that hand is likely to be.  There’s no surprise that the EU wants a quickie divorce; but unless the terms are good, any UK games-playing negotiator worth his salt will want to drag things out.  

And there’s a further element to the time-dimension: the longer the time taken, the more likely the unity underpinning the EU’s negotiating strategy will be undermined anyway by the eruption of other crises (Greece again?  Refugees? Budget problems? The demands of domestic politics in Italy, France, Spain, Germany etc). 

For all these reasons, although the EU institutions and some of its members may fervently desire a punitive settlement of scores with the UK ‘pour encourager les autres’, not only economic self-interest, but the logic of the changed game suggests they will ultimately be unwilling and probably unable to impose it. 

(As I write this, the news tells me that six of the founding EU countries have met in Germany and are ‘putting pressure on Britain’ to settle the terms of the divorce quickly. It’s difficult to determine who realizes the game has changed and who doesn’t, although certainly the reporter doesn’t.)  

Time to Take China's Official PMIs Seriously

China’s PMIs, compiled monthly by the China Federation of Logistics and Purchasing, are among China’s most useful monthly indicators,  as they are not just timely, but also detailed and plausible both for their internal consistency and because they have a track record of getting major turns in trend right.  Looked at in detail, May’s Manufacturing PMI paint a coherent picture of China’s manufacturers beginning to gear up in response to an improvement in the external trading environment which is nowhere to be found, yet, in other official data. This otherwise hidden upturn shows up dimly but consistently across  export orders, imports, buying of inputs, inventory policies, work backlogs and pricing. 

PMIs are too a good an idea to be left to fulfil their potential. The idea of surveying managers who have to run their businesses responding to perceived short-term changes in the market environment is obviously attractive. If anyone feels the cross-currents of an economy, it must surely be them. They also hold out the promise of producing a speedier verdict on current and near-future market conditions than is possible for the fuller surveys demanded by the production of conventional industrial indicators (eg, industrial output, exports etc).

So when done properly, they are extremely valuable. The best examples come from the US, where the timely ISM manufacturing index and to a lesser extent the extremely timely various regional industrial surveys have earned the right to be trusted.

But problems surface in Europe. There is certainly room for good PMIs in Europe, since official data tends to surface slower than in either the US or Asia, and in certain countries - the UK for example - the official statistics organizations currently seem incapable of generating stable series, even granted the extra time they take to produce them.  A commercial organization, Markit, has encamped on the space vacated by Europe’s official statisticians, and the beginning of every month litters Europe with a confetti of PMIs. To put it mildly, I am sceptical about their worth. I will confine myself to two observations. First, the minute sensitivities suggested by the results (the Eurozone manufacturing PMI, for example, has a standard deviation of only 0.6pts out of 100 during the last 12 months) is undermined by a lack of transparency about they are arrived at. Second, there is no significant statistical relationship between movements in the manufacturing PMI and movements in Eurozone industrial output.

The problems of Markit’s European PMIs tend also to cast a shadow over the credibility of the surveys it constructs in Asia. This is a shame, because in several countries, including India and Indonesia, credible manufacturing PMIs could be very useful.

Some Asian countries produce their own, and of these, there’s no doubt that China’s is potentially the most important. I believe China’s official manufacturing PMI is becoming a genuinely useful tool which provides timely, detailed and plausible information about the state of China’s economy.

The reason why I think China’s official manufacturing PMI should be taken seriously is that the headline figure is accompanied by 12 subindexes covering different aspects of the production phase, and that in the five cases where those subindexes can be checked against subsequently-released industrial data, they tend to tell similar stories. Moreover, those aspects which check out are central to our understanding of China’s industrial cycle: output, exports, imports, inventories and pricing.

First, we can compare the PMI subindex for output with year-on-year movements in industrial output. Since 2012, the changes in the PMI output subindex have generally moved in line with changes in the yoy changes in industrial output. Most recently, since the middle of 2015, the output PMI has signalled growth in output stabilizing at historically low levels. May’s subindex extends this trend, but signals no new deterioration.

The convergence between the export orders subindex of the PMI and actual US$ export growth is less clear, but captures well the deterioration in trading conditions endured since the middle of 2014. Currently, there is a recovery in the export orders PMI emerging that has yet to be seen in China’s raw trade data. 

Much the same can be said of the relationship between the imports PMI subindex and the imports reported in the trade data: there appears to be a general overlap of changes in trend, and currently there is a rise in imports recorded in the PMI subindex which is not yet coming through in the trade data.

When it comes to pricing, the relationship between the input prices PMI subindex and the monthly PPI yoy is much closer: both record the intensification of price deflation seen since the middle of 2014, and both are now signalling a recovery in price pressures since the end of 2015. 

Finally, we can compare the finished goods inventories PMI subindex with changes in inventories of finished goods contained as a line item in the monthly industrial profits data release. Again, the stories they tell mostly complement each other, although over the past few months, the PMI subindex has signalled a modest recovery in inventory-holdings which is not yet showing up in the industrial profits series.  

In none of these cases is the relationship between the PMI subindex and the reported data exact, but in each case it seems that the same trends and changes in trend are captured in both.  Because of that, we should be paying close attention to the official monthly PMIs: they seem genuinely to provide both an early lead on forthcoming data, and another source from which to triangulate other Chinese data.  Moreover, given the difficulties and uncertainties surrounding China’s official data, triangulating for internal consistency is always central to any interpretation of the data. 

In addition, the fact that these subindexes seem reasonably plausible lends credibility to other of the subindexes. This is particularly important because the employment PMI subindexes reported both in the Manufacturing PMI and the Non-Manufacturing PMIs provide practically the only timely and regular pointer to changes in China’s labour market that we have access to. The health of the labour markets is one of the top two economic priorities of China’s policymakers (the other is inflation). As the chart shows, currently these subindexes suggest the declines in the manufacturing sector during 2015 have been moderating since the beginning of the year, whilst employment in the services sector is largely unchanged. The net result suggests that the deterioration in China’s labour markets is moderating, though conditions are not yet improving. 

So what do these official PMIs tell us about the state of China’s economy? May’s Manufacturing PMI was unchanged at 50.1, suggesting nothing better than stagnation - although this is an improvement from the deterioration signalled between August 2015 and February 2016. The non-manufacturing PMI retreated 0.4pts to 53.1, suggesting expansion has slowed towards the lower end of a trend growth seen over the last year.  

The Manufacturing PMI subindexes, however, contain clear positive signals for both exports and imports, and slightly improved signals for both output and inventory policies. This slight improvement also shows up in quite strong upturn in trend for buying of inputs, and a noticeably slower erosion of work backlogs. In addition, there is a clear retreat in deflationary pressures reported since 2H2014.  

China's Frantic Policy Pulse and the Inflation Threat

The recent stop-start yo-yo of China’s monetary policy reflects not just the attempt to keep policy loose enough to stabilize the economy without fundamentally de-railing the strategic necessity of fundamental reform. It also reflects the fact that China’s inflationary potential is far greater, and is looming far sooner, than is recognized. So far, in a world concentrated on deflationary threats, an inflationary outbreak is on virtually  no-one’s horizon. Except, perhaps, in the People’s Bank of China.

Financing slowed very sharply in April: the addition to aggregate financing was a mere Rmb751bn, which was the lowest monthly gain since October 2015; bank lending slowed to Rmb 556 bn, on a monthly movt which was 0.6SDs below consensus.  Over the last four months, the monthly aggregate financing total has been  unprecedentedly volatile: January’s Rmb 3,425bn feast was followed by February’s Rmb 825bn famine; in turn that was followed in March by surprise gains of Rmb 2,336bn, whose largesse was revoked by April’s shockingly feeble Rmb 556bn.

This yo-yo accurately reflects the unprecedented volatility of PBOC’s open market operations. The chart below shows PBOC’s weekly interventions, and it resembles nothing so much as a cardiac arrest followed by defibrillation. It is a mistake simply to view this volatility primarily as a seasonal phenomenon, although the need to finance the end of the tax year, and then Lunar New Year holidays does drive some of the volatility. But even accounting for these flows, the volatility of the last few months is unprecedented. Twice PBOC has flooded the market with liquidity (end-January, middle of April), only subsequently to claw back the money over the succeeding weeks.

There are two main reasons why the central bank is unwilling to commit to the sort of grandiose monetary relaxation we’ve become used to elsewhere in the world, and indeed, in China during the slowdown of 208/09. First, there are the well-rehearsed set of strategic reasons why no repeat of the credit splurge of 2009/10 is to be expected. An excessively generous monetary policy do nothing to foster the transformation of the economy from an excessive investment/low return on capital model, to a model based on improving returns on capital and sustained growth in consumption. And in practical terms, it probably wouldn’t deliver the goods: in the 12m to December, the efficiency of finance had deteriorated sufficiently so that Rmb 100 of new aggregate financing was associated with only Rmb 25 of extra GDP growth. So not only would a 2009-style credit splurge subvert core strategic policy goals,  it wouldn’t even work particularly well. 

At the same time, however, China’s authorities have long blamed the collapse of the USSR on the disruption caused by the ill-considered and clumsy haste of structural economic reforms, and the need to avoid anything similar is axiomatic. As a result, in order to advance the long-term strategic goals, sufficient support must be given by monetary and fiscal authorities in the short term to sustain the economy in reasonable health. Whilst in the West there is a tendency to see the policy choice as binary (either tough reforms or monetary accommodation to flunk them), the Chinese authorities say they see things very differently: accommodation now in order to underpin the viability of reforms in the medium term.

There is, however, an additional factor which circumscribes how generous PBOC can be: inflationary pressures have to be contained, and they are stronger than consensus wishes to acknowledge. A previous post explained how the absence of viable savings products and vehicles was driving surplus savings into real assets, notably real estate and commodities, in a way which was already producing speculative bubbles. This highlights the need to accelerate financial reforms, including effective regulation. But these speculative bubble are also hinting at the likely emergence of wider inflationary pressures. 

This is only just beginning to surface in the data. April’s CPI stayed steady at 2.3% yoy, and the current deflections against trend suggest that it will stay above 2% throughout the year. This will be a surprise to a consensus which still expects it to fall to around 1.8% by 3Q.  A more worrying straw in the wind was China’s PPI, which  fell only 3.4% yoy in April, with consumer goods down only 0.2% yoy.  Not only was this less deflationary than expected, but looked at more closely, the index rose 0.7% mom, which was the steepest rise since Feb 2011, and was 2.9SDs above historic seasonal trends. 

But this may be only the tip of the iceberg. Historically, the relationship between China’s CPI and monetary policy has centred on growth in M1, with inflections in M1 growth coming usually around six months before inflections in CPI. In momentum terms, M1 growth bottomed out in the middle of 2015, and has been accelerating moderately at first, but quite vigorously since the latter part of 2015. By April, M1 growth was running at 22.9% yoy and the underlying momentum was still accelerating sharply, with April’s monthly gain 0.9SDs above seasonalized historic trends.  Unless the relationship between M1 And CPI breaks down, we should now be expecting inflation to pick up by 4Q to nearer 4% than 2%.  

Will it be different this time? Currently, the consensus apparently thinks so. That’s where the risk lies. 

What would an unexpected outbreak of accelerating inflation do to China’s policy choices? It would produce the worst of all possible world for China. To be very blunt, it would compel exactly the combination of necessary credit crunch and subsequent hard landing, followed by far-reaching structural reform, which China’s leaders are so keen to avoid. Perhaps it is this realization which is behind the dramatic gyrations of monetary policy. 

China's Balance of Payments - The Gaps Telling the Story

China has published its 1Q balance of payments data, and it’s fairly obvious that the most interesting element of them is the billions of dollars missing. In fact, the gap between what’s claimed in the balance of payments and what’s revealed in the movement of China’s foreign reserves would itself be the biggest single line-item in the presentation.  And there is an even bigger gap between the cashflows implied by the private sector savings surplus - which is partly calculated via the current account - and the cashflows reported by China’s banks.

In fact, movements in these gaps during 1Q tell us a great deal about China’s current position and policy choices. They are suggesting that:

• China has had a degree of success in stemming the outflow of cash which peaked in 3Q15 and 4Q15, but also
• With most domestic savings avenues currently closed or discredited (equities, deposits, wealth management products, P2P vehicles), the flow of excess private savings are necessarily being pushed out of financial assets and into real assets, including real estate (again) and commodities (again).

If so, the conclusion is clear: the need for financial sector reform in order to deal with the savings surplus remains urgent, because the lack of viable savings vehicles not only generates bubbles in non-financial assets, but simultaneously puts pressure on PBOC to supply the liquidity private savers no longer wish to entrust to the vehicles available.

Last week brought two pieces of news from which to judge whether the flow of cash out of China seen since the middle of 2014 has been successfully checked. First, foreign reserves rose by US$6.4bn in April to US$6.4bn to US$3.219tr, the second consecutive monthly rise following  18 months of nearly-uninterrupted decline. Second, China’s 1Q current account balance was announced to have been a US$48.1bn surplus, which was roughly in line with what was expected in the light of 1Q’s US$125.7bn trade surplus, although down by US$37.2bn yoy.

The balance of payment data ought, in theory, be the place to start to assess whether the rush of cash out of China has been checked.  And on the face of it, the situation is encouraging: China reported a current account surplus of US$48.1bn in 1Q, with a goods trade surplus of US$104.9bn partly offset by a services deficit of US$57bn, and with net international income receipts of US$1.9bn almost fully offset by the US$1.7bn recorded in net transfers out of China. On this accounting, the current account surplus was equivalent to 2% of GDP in 1Q, with 12m surplus retreating go 2.7% in 1Q from the 3% recorded in 4Q15.

But the preliminary estimates also reported that the capital and financial accounts ran a US$48.1bn, completely offsetting the current account surplus. As a result, we should have expected no change in China’s foreign reserves during 1Q. But the reserves data shows China’s reserves fell US$117.8bn in the 3m to March.

The gap between the balance of payments data and the movement in reserves can be seen as one measure of the size and direction of movements of cash and capital into and out of China without attracting the attention of China’s central authorities. When China’s economy is under stress, this gets glossed as ‘capital flight’; when times are good, it tends to just get called ‘hot money’.  In most countries, these differences tend to get logged under ‘errors and omissions.’ In China, however, the amounts involved are now so large that such ‘errors and omissions’ would be the biggest line item in the balance of payments.

Between 2005 and the middle of 2014, this difference was almost always sharply positive; since the middle of 2014, when the dollar surged, the difference has always been sharply negative. This reached a peak in 3Q15 and 4Q15, with deficits ot US$243.1bn and US$225.1bn respectively. In that context, the US$117.8bn missing from the accounts in 1Q16 is an improvement. But the unacknowledged outflow is only moderated, not yet checked or reversed. 

The mild rises in foreign reserves during March and April suggest that the situation continues to improve.  

With all its faults, if one takes China’s current account data at face value we can do a second check, by comparing movements in China’s private sector savings surplus to the net flow of cash into (or out of) China’s banking system. The theory here is that if the private sector is generating a net flow of savings after having done all the consumption and investment it intends, the result is must be a flow of cash into the financial system. By definition, the financial system can use that cashflow only to buy public sector or foreign assets. 

During 1Q, the current account showed a surplus of 2% of GDP, whilst the government was also running a fiscal surplus equivalent to 0.6% of GDP (down from 2.4% in 1Q15). As a result, China’s private sector surplus can in a 1.4% of GDP, up from 1.1% in 1Q15, and stabilizing the 12m PSSS at 6.4% of GDP.   

• In Rmb terms, the 1Q PSSS surplus amounted to Rmb 220.8bn, and the 12m surplus came to Rmb4,400bn.. 
• In 1Q, banks saw a net inflow of deposits of Rmb 813bn, but during the 12m, there was a net outflow of Rmb4,731bn. 

In the 12m to March, the gap between the surplus savings generated (Rmb 4,400bn) and the net outflow of cash from the banking system (Rmb4,731bn) came to Rmb9,131bn. Taking an average Rmb rate of 6.32 for the period, that is an amount equivalent to US$1.445tr. Meanwhile, the amount ‘missing’ from difference between the balance of payments and movements in reserves comes to US$653bn. In other words, the balance of payments and reserves data may yet be understating the extent of capital outflow, quite considerably.

This is not the only explanation, however: deposits can rise in the absence of bank lending if the private sector becomes a net seller of non-financial assets (such as property) and banks the proceeds. Conversely, deposits can grow more slowly than lending if the private sector becomes a net buyer of non-financial assets, such as property or commodities. During 1Q, the turnaround in real estate markets in first and second tier cities has been marked, and the recovery in China’s commodity markets has been strong enough to prompt concern among regulators of China’s commodity futures’ market. 

At this point, it is surely clear that it is dangerous to reach firm conclusions. However, the balance of evidence suggests that the peak of capital outflow from China has probably been reached, but that China’s savers have yet to be persuaded that the products and services available to savers (deposits, equities, bonds, wealth management products) offer acceptable rates of return. Consequently, the hunt is redoubled for real domestic assets in which to invest the surplus savings the economy continues to generate. 

The case for continued financial reform could hardly be more obvious.