Actually, Capital Economics has done some good work looking at this.
First of all it looked at why it doesn’t think there is a bubble in bond prices caused by QE. Its arguments are pretty straightforward. First of all is that Fed purchases of US Treasuries are actually quite modest compared to purchases from foreigners. In fact, if there is a bubble related to US bonds, then it is the huge surge of foreign governments buying US debt in recent years. You might retort, therefore, that if foreigners were to stop buying US Treasuries, then they would crash, meaning yields would rise. But actually, what is more likely is that if foreigners stopped buying US bonds, this would be a symptom of some other, deeper change, and would probably signify fewer countries are fixing their currency to the dollar. You need to bear in mind that such a development is likely to be regarded as a good thing for the US.

Secondly, there’s China and its so-called property bubble. This is what Capital Economics said: “It is always possible to find hot spots in any country, particularly in the luxury market that is all some international visitors ever see. There are some signs of problems in countries such as Hong Kong whose currencies are pegged to the dollar and monetary policy is therefore equally as loose as that in the US. But in general, even double-digit gains in property prices in the likes of mainland China are simply keeping pace with gains in nominal incomes. Even where there are dollar pegs, local measures can still be taken to restrict the availability of credit.”

So, accepting if you will there is no bubble in either China property or US bonds, why might commodities be the bubble?

Well, first of all, you need to bear in mind that China is gradually moving away from investment led to consumer led growth. To a great extent it has been demand from Chinese investment that has pushed up many of the world’s commodity prices.

Secondly, it does appear that as China develops she will become better at using certain commodities. For example, Capital Economics produced some figures to show that if China’s economy increases by 150 per cent over the next 15 years, but at the same time learns to use energy as efficiently as Korea, then her demand for energy would be virtually unchanged.

And then there’s meat. It is commonly regarded that as countries get richer, their citizens eat more meat. But apparently this is not the case in China, which has always been a nation of enthusiastic meat eaters. China’s daily meat consumption per capita is only marginally less than the UK’s, and much greater than the Japan’s.

Of course, meat eating in India is much lower. But then again there may be good cultural reasons for this.

And finally, there’s the Baltic Dry Index. This is the index that measures shipping costs for commodities. This has remained subdued for some time.
Is Capital Economics, right? Well, it could well be.

One thing that does puzzle us is that those who sign up to the Great Bubble of China theory seem to want their cake and to eat it. They say the Chinese economy is overheating, and that their investment led growth is set to falter and go into reverse, but at the same time argue inflation in commodity prices is threatening to create rapid rises in Chinese inflation. But if they are right about the Chinese bubble in asset prices, this is likely to mean less Chinese demand for commodities, pushing down their price.
Economic forecasters have this tendency to assume constant commodity prices in their models. So they may say growth will be such and such, and it will be pushed down by high commodity prices. But if growth really is what they say it will be, then commodity prices will probably fall.

Inflation hawks are not factoring in this possibility.

Our guess is that over the next few years, prices of certain commodities may well fall. That should mean we pay less for our petrol, less for our food, and manufacturers pay less for their raw materials. When will this crash occur? Here is our prediction: the end of 2011/first half of 2012.

Yesterday the government revealed plans to speed up the raising of the retirement age to 66, and the new working age limit could be applied by 2016. It is also now talking about the possibility of raising the age to 70.

Today we are taking a look at the key issues. How fast is the UK ageing? What will be the burden left by the baby boomers to their kids when they retire? Is more saving really the answer? Maybe we need more immigrants. Read on

What the numbers say

If you were born in 1960, your life expectancy at birth was just over 71. So imagine that. If they had introduced a 70 retirement age, just under half of us really would have worked until we dropped. A child born in 2008 could expect to keep going until 80. If you are 65, then today and if you are a man you can expect to keep ticking another 17.4 years. A woman can expect to go all the way to 85. (See ONS. )

According to the ONS, the proportion of people aged 65 and over is projected to increase from 16 per cent in 2008 to 23 per cent by 2033.

To put this in context, back in 1960 the ratio was 11.6 per cent. But compare this with Japan. In Japan the ratio of people over 65 was 5.6 per cent, and in 2008 it was 21 per cent. (See World Bank data .)

That is all very well, but maybe what really counts is the proportion of working people to those aged over 65. In 1960, the percentage of people aged between 15 and 64 was 65 per cent. In 2008 the percentage number had actually increased (marginally). It was a similar story in Japan, where the ratio of people between 15 and 65 has barely changed over the last 50 years.

The real firework relates to the kids. In 1960, the percentage number of kids aged zero to 14 was 23 per cent in the UK, and 24 per cent in Japan. By 2008 we had seen the percentages fall to 17 per cent in the UK, and remarkably just 13 per cent in Japan.

Or to put it another way, Japan is in the midst of seeing a quite stunning change in demographics. Economists have all sorts of theories to explain Japan’s economic malaise, but surely they miss the point. The ageing of Japan’s population is not the elephant in the living room, it is the herd of mammoths in the bedroom.

The UK is ageing too, it is just that the process lags behind Japan. According to the ONS, in 2008 there were 3.2 people of working age for every person of state pensionable age in the UK. This ratio is projected to fall to 2.8 by 2033, taking into account the future changes to state pension age. (Although, the ONS made these calculations some time ago, so they don’t take account of the new government’s plans.)

The saving bomb

We hear about the demographic time bomb, we have used the phrase here often enough. But it may be more appropriate to talk about a demographic saving bomb.

In Japan, more people are saving. They are saving for the very good reason they are going to retire soon. This has led to a crash in consumer spending, which in turn has caused twenty years of economic anaemia. Policy makers try to solve Japan’s economic ills by creating money and slashing interest rates, but it does no good. That is surely because conventional economics does not have the answer. The obvious answer to Japan’s ills would be a pill to make all women more fertile, or mass immigration.

But there is another important point here. It is high savings in Japan that is leading to economic recession, which in turn is creating the necessity for the government to borrow. The good news is, high savings means there is plenty of money for the government to borrow. So in a way, the need for government borrowing is caused by the fact people want to lend to it. There is a similar, although far from identical relationship, between growing savings and government borrowing in the UK.

Japan’s high saving ratio is also a factor behind the global economic crisis. During the noughties, Japanese saving flooded Western money markets, and today, a sudden rise in Japan’s consumer spending would go a long way to kicking life into the Western economy.

The problem with saving is that it does not do much good on its own. We keep hearing in the West of how we need to save more. But just imagine if this happened. Just imagine all baby boomers doubling the rate at which they saved. And then they retired. Yippee, they have a nest egg from which they can fund their retirement.

But would they really? The only way the UK can fund its growing army of retirees is via producing more goods and services from a diminishing pool of labour.

This is why we believe the short and medium-term implications of the ageing of the UK will be more saving and less inflation. But in the longer term, when the baby boomers have all retired, we may find too much money is chasing too few goods, and we will get inflation.

What really matters is not that we save, it is what we do with our savings. If savings is pumped into high-risk enterprises, finds it way into the pockets of risk takers, then for individual savers this is high risk, but for the UK as a whole this is a relatively risk-free way of ensuring we can meet the needs of our future pensioners. If instead, savers’ money finds it way into property, like it did in the noughties; into government bonds, like it is doing now; or worse into gold, which it may well do going forward; this may feel like it is low risk for individuals, but actually on a macro scale we will be taking the most enormous risk with our future well-being.

There is another option of course, which is that savers invest their money abroad. In which case their retirement may be fundable, but the cost will be a UK economy that limps forward for decades.

It is quite interesting to note, by the way, that according to data from the Bank of England, in 2008 UK families saved more than they borrowed. In all, £24bn was put into deposits and £20bn was taken out as loans. Last year saw the savings ratio among households rise from 2 to 7 per cent. See the Telegraph, Families saving more money than borrowing for first time in 20 years. This development is largely being greeted as if it was good news. Maybe it is, but you need to see rising saving in the context of the above few paragraphs. You may think a rising savings ratio is good news for the UK, but it also explains why economic growth is low, and why government borrowing is high. It is only good news if we see a corresponding rise in investment into risk-taking enterprises. But in an environment in which consumer demand is falling, entrepreneurs are likely to be less enthusiastic about their business ideas.

Immigration

According to an article in the FT, senior Conservatives are re-thinking the party’s policy to immigration. Apparently they fear caps on immigration will be bad for business. They are right. Do it in the correct way, with appropriate limits, then immigration can solve the UK’s economic plight, and certainly solve the problem of the retiring baby boomers. Those who say immigration has caused the UK’s woes have completely missed the point. In fact, many of the Polish immigrants, the very same people who have been slated in the media, have been a terrific boon to the UK. They work hard, they pay tax, and are only modest users of the welfare system.
See the FT – Fears force immigration cap rethink

According to an article in Foreign Affairs magazine, the solution to the baby boomer problem may be mass emigration of retirees and immigration of workers. The article said: “One somewhat daring approach to immigration would be to encourage a reverse flow of older immigrants from developed to developing countries. If older residents of developed countries took their retirements along the southern coast of the Mediterranean or in Latin America or Africa, it would greatly reduce the strain on their home countries’ public entitlement systems. The developing countries involved, meanwhile, would benefit because caring for the elderly and providing retirement and leisure services is highly labour intensive. Relocating a portion of these activities to developing countries would provide employment and valuable training to the young, growing populations of the Second and Third Worlds. See The New Population Bomb

And the grass

The big trouble with changing the retirement age is that conditions vary across the country, and across the sectors workers are employed in.

Paul Kenny, who is the general secretary of the GMB union, said: “The government knows that manual workers in the industrial regions of the UK do not enjoy anything like the same life expectancy as professionals or other classes or employees…To force someone who has done a lifetime of toil on building sites, farms or in factories to work until they are 66 is completely unacceptable.”
According to the ONS: “Within the UK, life expectancy varies by country. England has the highest life expectancy at birth, 77.7 years for males and 81.9 years for females, while Scotland has the lowest, 75.0 years for males and 79.9 years for females. Life expectancy at age 65 is also higher for England than for the other countries of the UK.”

And that’s the problem, it’s a case of horses for courses. Some people don’t want to retire until they are old indeed. Others, employed in sectors that require hard physical labour, may feel 65 is too old. Still, with horses, some of us want to be put out to grass, others think it is unfair. But what we can say is that the herd of mammoths in our bedroom won’t keep quiet for much longer.

Where are the surplus countries to cut their wealth? Forget the euro, and sterling. The dollar may be enjoying its last hurrah. China absolutely does not want the yuan to fill that role. That leaves a certain yellow metal.

According to the FT, Saudi Arabia’s reserves of gold are twice the size we previously thought.

The pink ’un said evidence is pointing to “the revival of bullion as part of emerging economies’ official reserves.”

The snag with gold is this. If the money supply is determined by the amount of gold in existence, then growth can stall permanently. Innovation can be suffocated. The rich stay rich, the poor stay poor. For centuries, while gold made up the money supply the world changed at a snail’s pace. There are some who say this was a good thing. But they are fooling themselves. In the days when gold was money, poverty, mass starvation and misery were the staple diet for all but the ruling classes across the world.

The discovery of gold in the New World by the Spanish led to a rush in the growth of the money supply which led to inflation and killed Spain’s economic dominance. But the same discovery of gold in the New World funded the industrial revolution in the US.

In short, during the days when gold ruled, economic growth was determined by how busy were the gold miners.

Now bring the debate more up to date.

During the late 1990s and the noughties, the global savings glut ultimately meant money found its way into property. Property owners borrowed against rising asset prices, so economic collapse was avoided. The bubble burst.

Then money found its way into government bonds. Governments used rising bond prices to fund their borrowing, and economic collapse was avoided.

If the bond bubble bursts, gold may be next.

And that could be curtains for the economy.

Only if measures are taken to deal with the savings glut, can the underlying problem be fixed.

If it wasn’t so sad, it would be funny. Markets are outdoing themselves with their ineptitude. Politicians are, if anything, proving even better at spilling a far worse pollutant than oil, and now company directors seem to have taken up playing the fiddle while all around them the great oil slick called economic mismanagement burns.

The last few days have seen news that directors’ pay is shooting up, and US house prices are shooting down. News on UK employment was about as ambiguous as you can get.

While directors enjoy more pay, it seems wages for most of us are rising at a mere snail’s pace.

Pity the French, they have got to work until they drop, or to be more precise, their retirement age has been pushed up to the grand old age of 62. How will they manage?

Then there’s the new King. Or King King, as you could call him. The FSA is gone, and good riddance too, you might say, and the new emperor is Mervyn King.

Read on for more

Markets defy logic, and BP goes where others would tread but for the grace of God

While they have not been booming exactly, markets have being doing well over the last couple of weeks. After falling at the beginning of the month to its lowest level since autumn of last year, the Dow has since surged by 500 points, or around 5 per cent. And yesterday, news that BP would have to park a mere $20bn into escrow, that it has chosen to stop paying dividends this year and that it is to sell $10bn worth of assets, was met with glee. Shares in the company surged, although BP’s stock is still well down on where it was a few weeks ago.

It is difficult to understand why. You can accept that some might say BP is a good contrarian bet, as indeed many said Northern Rock was after its share price collapsed. But there is still enormous uncertainty over what will happen next. The $20bn the company is setting aside may not be enough. Barack Dubya Bush, sorry, Barack Hussein Obama, has warned that the money the company is putting into escrow will not be a cap on costs it will have to bear. We are ‘going to smoke those folks at BP down from the hills,’ said Mr Obama, or at least he might as well have said that, after comparing the BP oil spillage, which by the way is nowhere near the worst spillage in history, with 9/11.

Predicting where this will end is like predicting the end of the euro crisis. Barely a day goes by without some report contradicting the last one. One day Spain and/or Greece are set to go the way of Argentina, the next day they are going to be rescued. One day China is terrified of pumping more money into Western debt, the next it finds Greek bonds irresistible. And markets boom and crash like a yo-yo on speed.

BP’s catalogue of PR errors is embarrassing, from “get my life back” to yesterday’s “care about the small people”. It is enough to wish for a return of Peter Mandelson. It seems the company needs a spin doctor without peer.

But then again, paying out dividends was always a bad idea. The fact that until yesterday the company had stuck to its line that dividends would be paid as normal indicated how the company didn’t get it.

Not that Mr Obama gets it. Or maybe he does, but the political groundswell is such that he dare not own up to the truth. But, as told here earlier this week, the US House Energy Committee has slated Exxon Mobil Corp., ConocoPhillips, Chevron Corp. and Royal Dutch Shell Plc, saying their plans to deal with any future oil leak are virtually the same as those prepared at BP. See it this way, the oil industry is beset with one big problem; oil is becoming harder to get at. The new oil finds off the coast of Brazil lurk far deeper than BP’s Gulf of Mexico oil well. To put it in terms of the World Cup: the ball is odd, which is making life difficult for all teams except for Germany, where the World Cup ball was used for domestic matches during the last six months. Goalkeeper errors are inevitable, it is just that the England goalie was first. In a way, BP is like Robert Green.

There are also parallels with the banks. They didn’t get it either, and were paying out dividends and massive salaries right in the face of public anger.

Goodbye FSA

But at least the regulator has been reformed. Well, not so much reformed as torn apart. If you are one of our IFA readers, you will no doubt agree with the sentiment that the FSA was like a Rottweiler while dealing with little companies trying their best to navigate the absurdly stormy waters of financial regulation, and yet when it came to the things that mattered it was little more than a mildly discontented puppy.

The FSA engendered paranoia with some IFAs, leaving them terrified to say anything without running it past the compliance officer first. So the statement ‘two plus two equals four’ would need to be changed to ‘some analysts believe two plus two equals four, and here is a page of disclaimers.’ Yet while it was busy snarling at the little people, banks pretty much did what they liked. So goodbye FSA, but don’t expect our thanks.

Don’t get us wrong. We are not saying tighter regulation would have stopped the financial crisis. Doctor King, the Bank of England governor, or King King, whatever you want to call him, is now one of the most powerful central bankers in the world. He did a better job than some in warning of dangers ahead, and the Bank of England even made subtle noises about mortgage securitisation posing threats, but he has no magic wand, and it seems likely that even if King had ruled the roost throughout the noughties, we would still have suffered the deep sea banking spillage.

Osborne’s idea to have mortgages capped to a certain ratio of a property’s value is good, and it is most gladdening to see the new government trying to introduce ideas for ensuring we don’t get another property bubble. You may recall, Boy George has already asked Mervyn King to look at including house prices within his inflation target.

Hello bonuses for directors – goodbye wage inflation for the rest

But what is not a good idea is big pay rises for bosses while the small people down the pay ladder have to make do with a good deal less. According to the ONS, average earnings growth including bonuses decreased in the year to April 2010, from the March rate of 4.3 per cent to 4.2. Growth in average earnings excluding bonuses (regular pay) also decreased from the March 2010 rate of 2.0 per cent to 1.9 per cent in April 2010.

With wage inflation that low, it really is difficult to see how price inflation will take off as some fear. You need to bear in mind that interest rates as a tool for fighting inflation are meant to tweak demand. Right now, with wage inflation so modest, unemployment so high and taxes set to rise, there is no pressure on demand. Oil, food, VAT reversal, and the falls in the pound, that now appeared to be reversing, are what caused the recent hikes in inflation. And higher interest rates, or less quantitative easing, will have a negligible effect on these one-off factors. (The pound being a possible exception, but then the UK needs a cheap pound right now.)

As for jobs, the latest data is all over the place. The employment rate fell 0.1 per cent to 72.1 per cent,the number of full-time workers fell by 56,000 over the quarter but the number of part-time workers increased by 61,000. And while employment fell, unemployment got worse too, rising from 7.8 to 7.9 per cent.

Yet while we brace ourselves for austerity, salaries for bosses have surged. According to IDS, bonus payments to directors of FTSE 100 companies rose 22.5 per cent in the last six months, rising from an average of £456,000 to £558,000. Basic salaries increased by 7 per cent.

Forever blowing bubbles

Now, we have no philosophical problem with high wages for bosses, but we do have an economic problem with it. Surging salaries and bonuses for those at the top is a symptom of rising corporate profits. In the US during Q1, annualised profits expanded by 24 per cent.

The rise of corporate profits while wage increases remain modest is part of a worldwide problem. Okay, we accept that in some countries such as Greece and Spain there is the necessity for the agony of falling wages.

But worldwide, the real problem of the noughties was that wage growth was being outstripped by the growth in productivity for workers everywhere.

As a result, spending that was not backed by debt lagged behind production. Under different circumstances recession would have been the result. Instead, money saved bounced around the financial system, until eventually it found property. German money pumped up Greek and Spanish property prices. Chinese, Japanese and corporate savings pumped up house prices everywhere.

When that bubble finally burst, investors looked for a new home for their money, and that home was government bonds. And so the government took up the baton and maintained the economy (up to a point), because consumers could no longer afford to do so.

This is creating a new bubble, this time in government bonds.

Some say this time it is different, because the money has to go somewhere and there is nowhere safer than government bonds. To which others will reply ‘Ah ah,’ and add ‘this time it never is different, not really.’

So where will investors go if bonds crash? Gold, maybe, in turn fuelling another bubble.

The argument that governments will inflate their way out of debt has one thing going against it. At the moment debt is doing no more than ensuring aggregate demand is matching capacity.

The only way we will get inflation is if governments print money, and at the same time savers decide they have had enough of saving and start spending it.

If, instead, savers’ money was invested in business, and helped to increase productivity, or better still fund entrepreneurs, the result would be sustainable economic growth.

That is why the latest idea from Japan’s central bank to pump money into business is interesting. See Japan – central bank finds the plan that UK needs

Talking of bubbles, in the US, housing starts are down. They dropped no less than 10 per cent in May. Yes, that’s right, 10 per cent. That’s not annualised, it is month on month. Last year the US government ran a tax credit designed to boost the market. These schemes are over now, and crash, down will fall house prices. In the UK, the end of HIPs may have a similar impact.

So let’s put it all together

The underlying causes that led to the credit bubble of the noughties have not gone away. Overreaction has begat more overreaction, and now we are told we all need to save more. Wages must go down to improve productivity. David Cameron and Co. want to see debt levels fall.

That’s fine, providing the austerity drive is being accompanied by investment. Saving is dreadful for the economy, unless the money being saved is invested into business.

During the noughties you could borrow money to spend on a jolly, but if you wanted your bank to lend to your business, then that was a non starter. Your only hope was to lie on the application form, and instead of saying you wanted the money to create wealth, say you wanted it to boost the tourist industries of other countries. Then the bank would have given you the money.

Still, the French are worse off. Apparently they have got to get used to the idea that retirement at 60 is too young. The retirement age is being pushed all the way up to 62.

As regular readers here will know, the demographic challenge facing the developed world is enormous. Workers across the world have got to retire at an older age. Upping the retirement age from 60 to 62 its analogous to BP apologising and saying how sorry it is to have let down the “small people”. See The demographic time bomb

The truth is, the way out of economic Armageddon lies with the so-called small people becoming more engaged with wealth creation, and until the government starts introducing policies that support this, the chances become greater that the economic spill of the last couple of years will just carry on.

He was revealing the sordid secret to a Treasury Select Committee.

Maybe John Terry should try a similar line of defence.

Lord Turner said: “We were often led astray in the past by complicated mathematical rules. Regulators failed to notice the inherent weakness in that position. History tells us that it could happen again.

“Complacency was not a problem now, because the shock to the financial system was still fresh in the memory.”

Then came the warning: “In the long term we have to try to stop society falling in love with another dominant intellectual theory.”

Ummm, well, the Lord is partly right. Love is blind, and we are too inclined to fall in love with ideas that can cause our ruin.

But the love is not just with so-called “intellectual theories”.

Crowds get it wrong over and over again, and they get it wrong with simple ideas as well as with intellectual ones.

The following is taken from Bubbles and Wisdom, a new book co-written by Michael Baxter – editor of Investment and Business News –

“The psychologist Solomon Asch conducted a famous experiment to investigate the extent to which we comply with the crowd. The subject of each sample group was placed beside a table, sitting amongst a number of other individuals. Unknown to the subject, the rest of the individuals at the table were actors. The group were asked a series of simple comparison questions. For each question the group were shown two pieces of paper. On one piece there were three vertical lines of different length; on the other, just one line. Each member of the group had to identify which of the three lines on the one piece of paper was the same length as the line on the other piece.

“The judgement was easy to make and separate tests had shown that when questioned individually, most people got all questions 100 per cent right. But the results were different in a group situation. Each person around the table was asked to give his or her answer out loud for the rest of the group to hear. Unknown to the subject, the actors were instructed to occasionally provide an incorrect answer. On 32 per cent of occasions, when the same wrong answer was given by the rest of the group, the subject complied with the others, also giving the wrong answer. Furthermore, no less than 74 per cent of subjects conformed with the group on at least one occasion, even though the answer was obviously wrong.”

It seems that in a group situation we are easily seduced. It can be that we are taken in by a complex mathematical formula that hardly anyone understands, as was the case with mortgage securitisation, or with Long Term Capital management in the 1990s. But the crowds get it wrong over and over again. The crowd got it wrong in Nazi Germany, and again in Rwanda. The madness of crowds led to the spectacular self-destruction of a civilization that once flourished on Easter Island. It could be argued that civilizations from Ancient Sumer and Ancient Athens, right the way through to the modern day, have been victims of the madness of crowds That is surely the real reason why we have bubbles.

The irony is, however, that crowd madness can charge our big successes too, for example the spirit of the Blitz.

To buy the book click here

Here is an extract

Prologue: In a nut shell

Evolution is like a miracle worker. Innovation is the product of its spell. From the sorcery of the spider’s web with its remarkable strength and flexibility, to the mystique of the sonar system that enables dolphins and bats to navigate with such precision, science looks with envious eyes at the way nature has solved the same challenges it faces.

It is the same with the economy. Most of the great advances that have been mankind’s good fortune to experience were not planned. They came by chance, and were thrown up by the force of economic evolution.

Yet we often fall into the trap of seeing evolution as a metaphor for a straight line of unremitting progress. It is not like that all.

Sometimes the world can change only very gradually. In the case of nature, aeons; in the case of the economy, centuries. Then something can happen, and this in turn can spark off a new chain of events with unpredictable results. Just as evolution sometimes works in spurts, charged by some external shock, the evolution of wealth creation is often dependent on a form of trigger akin to a Darwinian economic shock.

We are in the process of experiencing such a shock now. But the outcome is not easy to predict. We may see a remarkable lift in the standard of living, or we could plummet into chaos as if we had been riding the greatest bubble of all, but which has burst in terrifying fashion.

How can we manipulate this Darwinian shock to our advantage? It seems we must first learn wisdom, to recognize that trends change. To recognize that, on close examination, what we thought were patterns may actually be illusions. And above all, we must learn to ditch our hubris without losing the magic of our courage.

Our error – the lesson of history

We are a gullible species.

If you go along with Mr Darwin’s theories, then you probably believe we have been around for around 150,000 years, and most likely began our short period of existence in the Rift Valley region of Africa.

‘Wise man’ – that’s what Homo sapiens means. Yet for this modern, incredibly complex world we now find ourselves in, we are terribly badly adapted.

The late journalist Miles Kington once described knowledge as knowing a tomato is a fruit, and wisdom as knowing not to put it in a fruit salad.

The truth, though, is that right now we are neither wise nor knowledgeable.

Perhaps one of the wisest men who ever lived was the Ancient Greek philosopher Socrates, and yet, his special claim to seer-like wisdom was this: Socrates claimed ignorance; to his way of thinking knowledge was something we can rarely possess.

On the other hand, it may be true to say that wisdom is a function of the scale of the survival challenge. In the days when we were busy avoiding leopards and dancing around a fire, we knew what we needed for our communities of 150 or so souls to survive. Wisdom was thrust upon the elders who, by the time they had made old bones, appeared to know just about all that could be known.

The laws of natural selection say we need to survive only long enough to bring our children up to the point where they are strong enough to look after themselves. But maybe ‘wise man’s’ unique selling point was that for him, or her, wisdom was a valuable commodity. It was useful to have tribe members who were old and wrinkled, and slow and oh, so very wise.

The world has changed profoundly since that time.

If wisdom is indeed built upon our past experiences, then what use is this wisdom when experiences are changing so fast?

They say history repeats itself, and yet the changes we have seen in recent years are without precedent. Take the credit crunch. Alan Greenspan called it a ‘once in a hundred years credit tsunami’. Yet surely he was wrong. For one thing, it seems the modern economy is less than 200 years old. There simply isn’t enough data to say whether the credit crunch is a once in a hundred years event or not. Besides, there was nothing once in a hundred years about it. The crisis had no precedent. So, if wisdom is born of experience, how can it help our understanding of this unique event?

Winston Churchill once said: ‘The further backward you look, the further forward you can see.’ But on this occasion, Britain’s war-time leader was only partially right. History is the story of random events that were unpredictable before they happened.

The economist Galbraith once cynically opined: ‘The only possible benefit of economic forecasting is that it makes astrology look respectable.’ The same can be said of those who try to forecast the future by looking into the past.

History only repeats itself with the benefit of hindsight. In other words, the repetition of history is an illusion. But that does not mean there is no lesson in history. If we take a broader view of how things develop we can at least see recurring themes.

See it in musical terms. History is not like classical music following a formal structure, but is more like jazz, full of improvisation.

For that reason, Mark Twain was the closest to the truth when he proclaimed: ‘History never repeats itself, but it rhymes.’

And as we all know, for a rhyme to work, it must follow a beat.
So maybe by listening to the rhythm of history, and then by throwing in some ideas from economics and evolutionary theory, we can start to understand – and we can, after all, acquire wisdom. So, to recall the words of the songwriters Jimmy Page and Robert Plant: ‘If you listen very hard, the tune will come to you at last ….’

The opportunity

Put yourself into these shoes. They contain the feet of an investor about to step into a Californian elevator during the height of the dotcom craze. These are feet that belong to a cynic. The shoes may shine with polish, but the soul of their wearer is pragmatic and shrewd.

Into the elevator a couple of pairs of trainers also tread. Both pairs support students, young, fresh faced, with naïve charm. And as the nine of you, that’s you, the two students and the six items of footwear travel to the top floor a sales pitch is begun.

It’s the classic elevator pitch, and you are on the receiving end.
These students have some hare-brained idea for a search engine. For your pragmatic mind this is a no go. Dotcoms are over priced, you correctly reason. Not for you another investment into a wing and a prayer and dotcom idiocy.

You are right, of course; dotcoms crash soon afterwards, but you are right only up to a point. For these two young men are none other than Larry Page and Sergey Brin. The company they are trying to get backing for goes by the name of Google. If only you had been one of those early backers, then today you would have seen a thousandfold return on your money. Your shoes could have been coated in gold.

Innovation is like that. It is not predictable, and yet there is a rhythm. We may not know what form it will take, or where or when, but we do know that if we set the right environment, the beat of innovation will stretch on.

The Darwinian shock

Imagine that the story of our economic evolution is represented by a torch, the kind of torch we see athletes carrying during the build up to the Olympic games. Now, imagine that the torch from the time our evolution diverted from the rest of the apes, through to the point when many of our ancestors migrated from Africa and then later into cities, and then right on to the Industrial Revolution, was carried by a tortoise.

Natural evolution operates at three speeds: slow, dead slow and stop. It seems that for much of our history the trajectory of our economic evolution was akin only to the latter two of these categories.

Then, around 1820, something extraordinary happened. It was as if a rocket was inserted inside the tortoise’s shell, or perhaps as if the torch was passed on to a hare. From that moment, it all seemed to change. Most of the wealth creation that has ever occurred took place over the last 190 or so years.

This begs the question, of course, what kind of hare was it? Was it like the creature from Aesop’s fable, which was moved by its arrogance to stop its run, so that eventually the pace set by the tortoise proved faster? Or for that matter, will the hare move so fast that it fails to spot the road and the oncoming traffic, and runs straight into an oncoming carbon-fuelled disaster? Then again, it could pass the baton on, perhaps to a cheetah, or even to a bird such as a swift, which combines speed with stamina.

This is the story of why that change of pace happened, and whether it will continue, stop or go into shuddering reverse.

Equilibrium

Evolution can be a gradual process, in which ideas build upon ideas. This is what most of us think of if the word evolution is mentioned.

It is like that with the economy, too.

But sometimes evolution can take us down a blind alley. We can progress so far, and then stop. It is as if we run into a kind of equilibrium.

Evolution is like Homer Simpson. The famous TV cartoon character displays a personality which seems preoccupied with the present. There seems to be no memory, and absolutely no vision.

Evolution can only deal with the here and now. It has proven to be an extraordinary mechanism, and has thrown up adaptations that are the wonder of science, and yet always it is limited to finding the best adaptations for the current circumstances. As such it is not perfect.

See it like a chess player. The grand master may plan several moves ahead; evolution can only make a move which optimizes immediate benefit. Evolution has no way of noticing that if it moves a pawn to take the opposing side’s queen, the result may be checkmate for its own king three moves down the line.

Consider the account of Danny Hillis and the local maxima. Hillis investigated whether he could generate a number-sorting program through imitating the mechanism of natural selection. He programmed his computer to generate a large variety of mini-programs by random. They were all hopeless for the task he had in mind, but a handful were less inadequate than the rest. Hillis introduced certain parameters. The ones that were most able to sort numbers survived, crossbred and mutated. The rest were deleted. After a few thousand cycles, the computer created a number-sorting program that was actually quite effective. The program had evolved.

But alas, the program which resulted was only quite good. It was inferior to code that could be produced by a competent programmer. Hillis repeated the experiment several times and always came up with similar results.

His solution was ingenious. Hillis programmed a predator into the system which could destroy code that had stopped evolving. This forced the code to evolve in more radical ways, and ultimately led to a much superior number-sorting program.

In other words, the predator forced the evolution process to go down paths it might otherwise have rejected, and some of these alternative routes threw up an even better adaptation down the line.

In short, sometimes we have to make something worse before we can improve it. Evolution is not good at allowing for this.

As a result, catastrophes can prove to be essential tools for creating new adaptations. Extinctions can be essential building blocks in evolutionary history.

Frequently, a major shock is the catalyst for change.

It may follow, then, that economic evolution is powered by two forces. The slow, dead slow and stop kind of force that Richard Dawkins referred to, and then sudden change that may occur as if the torch has been passed on.

This shock can be in the form of a new disruptive technology, a change in global order, or merely the coming together of two different cultures that were formerly isolated. The result can be a puncture in the equilibrium we had appeared to settle into.

Hubris and wisdom

But while history does not repeat itself, there is a constant. Maybe this is the constant that gives history its rhythm. The constant is called human nature.

It seems our wisdom is born from our experiences. We acquire behaviour, we acquire our views. When we lived a more simple life, the range of likely experiences was more restricted than it is in the modern age. But today we live in a global village consisting of almost seven billion inter-connected souls. Today, unlike in the past, a new innovation, idea, or perhaps a new virus or disagreement between two cultures, can spread and affect us all at a pace that leaves us breathless. When risk goes wrong, it can turn into a contagion.

Over the time of our existence the nature of risk has changed. Yet we still have to make do with the tool kit nature provided us with as we became human. One of our most common habits is to extrapolate trends and project them into the future. Maybe during our hunter-gatherer days, when the environment changed only slowly and the variety of each tribe’s likely experiences was quite limited, this trait worked to our advantage.
This characteristic is surely the reason why we have bubbles. Bubbles occur when we see a trend and expect it to continue, and our behaviour becomes self-reinforcing until there’s a crash.

History tells us we are not good at spotting our error until it is too late. As a bubble grows, we hear no end of reasons why: ‘This time it is different,’ or ‘Why, it’s a new paradigm now.’

Bubbles can suck the very life-force out of an economy, and in a world of seven billion people where risk is correlated, they could ultimately prove to be our undoing.

And yet, within this Pandora’s box of ills that our hubris can create, we find hope.

For the law of unintended consequences has been the driving force of our social evolution. And just as bubbles may be our undoing, our tendency towards irrational exuberance may be our salvation.

For more details, go to www.bubblesandwisdom.com
To buy the book click here

And yet data out yesterday does appear to blow one almighty hole in the Chinese bubble theory.

If you sign up to the idea that the real cause of the economic crisis of our times is global imbalances, then at first glance Sunday’s data would appear to represent the strongest evidence yet that we are seeing a fix. So if true, that really would be good news, very good news.

It’s just that when you take a closer look, the bubble theory comes back to life. But, then again, maybe the Great Chinese bubble isn’t such bad news after all.

James S Chanos is a rich man. He is one of the top investors in America. He built his fortune initially by correctly predicting the fall of Enron. And now he has turned his prescience on China. He is not exactly predicting a fall for the world’s number two economy on a par with the fall of Enron, but he is saying China is in for a very nasty shock.

The big snag he says, is that too much money is going into investment. In China, credit markets are brimming over with cash. The Chinese property market, reckons the guru is “Dubai times 1,000 — or worse.”

So while Dubai has been building a latter day Tower of Babel, and a man made archipelago of islands that look like a map of the world, it seems Chinese excess is even more extreme.

He told CNBC “Bubbles are best identified by credit excesses, not valuation excesses…And there’s no bigger credit excess than in China.”

His theory is not new. This column has remarked upon the phenomenon of roads in China that appear to go nowhere. The truth is, China has to put its enormous savings somewhere.

It is probably impossible for an economy to grow at the extraordinary rate seen in China without problems occurring. Imbalances are no doubt inevitable. So does this mean China has got a nasty surprise coming its way? Strangely enough, at face value, the latest data on China’s balance of payments would appear to say no.

China’s imports jumped by no less than 55.9 per cent in December, over the year before. Exports were up too, but by nowhere near as much, surging by 17.7 per cent.

In fact, while the rise in China’s exports were altogether more modest than the jump in imports, they were still enough to lift China from being the world’s number two exporter, to number one, leaving Germany in its wake.

But that is surely good, you could be forgiven for saying. If Global imbalances are the real cause of today’s hard times, then the fact China’s imports are rising faster than exports must mean the trade gap between the rest of the world and China is closing.

It is just that closer examination of the figures tells a different story, and if anything supports the bubble theory. Much of the increase in imports was for goods and raw materials used in re-processing. So it seems the goods being imported now will be assembled into complete products ready for consumption and re-exported.

The rise in imports then, may simply be down to Chinese manufacturers preparing for an even bigger export drive.

So how much damage could the bursting of the Chinese bubble do?

Now the picture becomes murky. In the short term the bursting of the Chinese bubble could be most unpleasant. Back in December, it was estimated that the average Chinese worker would produce around $4,000 worth of goods and services in 2010, compared to just $3,500 in 2009. In other words, productivity is rising at an extraordinary rate.

Normally, improvements in productivity are seen as good news, but for China the real challenge is finding a market for the extra goods and services it produces. The west is satiated. The debt stricken westerners just can’t afford to absorb all these extra goods and services. And while consumer demand in China is rising, it is just not realistic to expect internal demand to keep pace with the extraordinary rise in capacity.

The danger is that, therefore, mass unemployment will result. The Chinese government is terrified of the social unrest this will bring. The great investment bubble, then, is the result of government policy with surging unemployment the only alternative.

But in the very long run, the investment boom may be no bad thing.

And by the way, the same argument can be made for Dubai. In the case of the little land in the Middle East, the property bubble may have led to a viscous debt crisis, but it has also produced an infrastructure that has transformed a bit of desert with few natural resources into a Mecca for tourism. The money that will flow into Dubai over the course of this century will ensure great riches, even if the riches don’t necessarily go to the men and women who got the ball rolling.

The same is true in China. Years after the bubbles bursts, the capital infrastructure that was created will serve the country for decades.

Although they wouldn’t put it in these terms, this is in effect what Chinese authorities mean when they say we are mistakenly applying western values to Chinese practice. In the west we focus on the short term, in China, the approach is more long term. And the long term result of the investment bubble will be a richer country.

Bubbles and like that. Daniel Gross, author of the book “Pop! Why bubbles are great for the economy,” argues that the US economy has thrived in part because of bubbles exaggerating the potential for exciting new technology, then crashing and creating cheap capacity. For example, Google was able to buy a network of servers big enough to feed the US market, on the cheap. Or, further back in time, Dun Bradstreet was able to benefit from a bubble in the creation of a US-wide network in telegraph wires; this market crashed, but the end result was low cost communication. Later that century business benefited when an over supply of railroads led to cheap transport, and trade across the states then boomed.

See also:
China and the West: the lesson of history

Google China row: Why this really does matter

Now China is number one for car sales

The Great Bubble of China

China gets slammed over software piracy

He argued that the last 12 or so years have seen three major crises, and all were related.

First off, there was the Asia crisis of ’97. Then the dotcom crash and then the bursting of the debt bubble. He argued all three crises have the same thing in common. Banks and other financial institutions messed up. They thought they had found some wonderful new idea, and herd behaviour led to an unsustainable boom, followed by crash.

First off, the view that the so called Tiger economies could carry on growing indefinitely seduced banks. Then they were sucked in by the lure of the Internet, then the new wonder product became mortgage securitisation.

He concluded on a scary note. What will be next, he asked?

It was a good piece, but we think the argument runs deeper.

It is probably true that the boom of the last few years was built on something of an illusion. Debt levels had probably reached unsuitable levels at the end of the last century.

The likes of Alan Greenspan and Gordon Brown tried to manipulate the economic cycle. In reality they probably delayed the inevitable, which in turn made the inevitable more serious.

Gordon Brown promised to end boom and bust, but maybe bust is essential. Bust enables the economic system to purge itself of the bad ideas. This never happened. Banks were bailed out by cheaper interest rates. When Long Term Capital Management went belly up in 1988, it seemed as if the entire banking system was close to collapse, but Alan Greenspan made a call here, a call there and rescued it. The result, banks didn’t learn their lesson.

But there is another point, too.

The Internet and the power of modern computers must not be ignored.

Long Term Capital Management failed because winners of the Nobel Prize for Economics mistakenly thought they had found an algorithm which could eliminate risk. Putting this algorithm into practice was only possible thanks to computers.

The dotcom boom and bust was directly related to misplaced hope over the Internet.

Then we have mortgage securitisation and the credit crunch. The Internet was essential in enabling the market for CDOs and other instruments of mass financial destruction to evolve. The Internet means information was transmitted around the world at lighting pace, which in turn may have accelerated the pace of the crisis.

The fact is, we are new to computers, the Internet and the instantaneous transmission of highly complex information. We are learning, and mistakes are inevitable.

It is possible modern technology was the real common denominator to the three big crises that have descended upon us over the last 12 years.

Alan Greenspan was wrong when he called the credit crunch a once in a hundred years financial tsunami. The Internet meant a crisis along the lines of what we experienced was inevitable.

But this does not mean computers and the ‘Net are bad. It works both ways. They are also transforming productivity, charging globalisation and accelerating the pace of innovation.

If you like this article, you may be interested in the author’s book, to be published in the next few days. Click here: www.bubblesandwisdom.com

What with Greece, wilting under debts, closer than ever to travelling the road to the economic river Styx; what with Latvia and Ireland looking desperately at the black holes that are their fiscal deficits; what with Uncle Sam printing dollars like it was fun; and what with Mervyn King a fan of quantitative easing, money markets are nervous. Where is the world going to look for its currency?

There’s the euro of course, but that’s expensive, and besides… it’s the euro!

So some are saying gold is set to become the new global currency. Hence that yellow metal is flying high.

China bought itself a King’s, Queen’s and Emperor’s ransom worth of gold earlier this year. Now its holdings weigh in at around 1,000 tonnes. That’s enough gold to deck a bankers party with all the bling they could possible want.

But now China is worried that she has too much influence. She buys more gold, the price may rise some more. And she doesn’t like that idea.

“We must keep in mind the long-term effects when considering what to use as our reserves,” said Hu Xiaolian, who is number two to China’s equivalent of Mervyn King.

Writing in the Telegraph this morning, Ambrose Evans-Pritchard quoted her as saying “We must watch out for bubbles forming on certain assets and be careful in those areas.”

So China is worried about the danger of a gold bubble.

The truth is, the dollar is adjusting. For too many years it was too expensive. It needs to fall in value. This is a key need in correcting global imbalances.

But China is shadowing the dollar; as the greenback falls, so too does the yuan.

So China is worried about the formation of a bubble. Well she should. There are lots of potential bubbles forming on the other side of the Great Wall.

But for as long as the yuan and dollar are tied to each other, the markets will be troubled.

It has been said here before, but it is worth saying again. Back in 1944 at Bretton Woods, Keynes called for an international currency system. He called it the Bancor. Essentially a basket of currencies made up the Bancor. Keynes’ idea was that there should a kind of world central bank  holding Bancors, and any country’s surplus in trade would be held at this bank, and the Bancors lent to fund other country’s deficit. But Keynes wanted both deficit and surplus countries to be charged a fee. In this way there was a strong incentive for the surplus countries to buy goods from the deficit countries

The US hated that idea, in part because back then the US was the world’s big creditor. To the US delegation it smacked of a dubious attempt by this too clever by half Brit to find a way of allowing Britain to wheedle out of paying her debts

If the system had been adopted the problems we are seeing today would have been avoided.

The IMF system of special drawings rights is along the line of the Keynes plan. China has mooted the idea of a global currency being formed based on this IMF instrument.

Logically, it seems inevitable this will probably happen, eventually.

It is hard to see how gold will have any part at all to play in this.

The Fed is printing money, the Bank of England is creating new money faster than you can say Mervyn King, and that’s why gold is rising high. There is only one possible answer. Return to the gold standard, remove temptation from government, stop inflation in its tracks; then everything will become sustainable.

As for deflation, what deflation? Inflation is going up again. The deflation scare is a con trick. Deflation was never a threat, but by printing money the government is fuelling a crisis that could become far more serious than the credit crunch.

We repeat the call, return to the gold standard and exorcise the demon that is quantitative easing. Destroy the myth, once and for all, that you can end a crisis created by too much debt, by running up even more debt.

Or so goes the argument presented by those who fear that economic policy is being determined by the devil incarnate and who argue that the gold standard is a kind of economic holy water.

There are three problems with that argument. Problem number one, it is wrong. Problem number two, it is dangerous. And problem number three, it’s most definitely wrong.

Here is a riddle for you. If central banks are creating inflation through boosting the money supply, explain how it is that the Bank of England’s preferred measure of the broader money supply, that’s sterling M4 intermediate, fell by 0.8 per cent last month, after posting a similar drop the month before. Explain how it is that consumer credit fell by £0.6bn last month, the biggest drop since 1993.

The big snag is that critics of modern banking, who insist we are storing up problems for the future, are actually using contradictory arguments.

Strap yourself in, the next couple of paragraphs are tad complicated, but they are important, too.

If you pick up any decent economic textbook there will be a section on how banks create money. The argument runs like this: assume there is only one bank, and assume its customers like to hold 10 per cent of their money in cash at any one time. Say for example, for a short while, all this money is held in their bank. So, there’s say £1,000 sitting in the bank. The bank knows that only £100 of this amount is likely to be withdrawn at any one moment, so it can lend £900 out. This £900 is then spent on goods and services, and the companies which receive this money pay it into their bank. As there is in only one bank this bank now has deposits of £1,900. It knows that of this new £900 paid in, only £90 is likely to be withdrawn at any one time, so it can lend out £810. And so the process continues.

This mechanism for banks creating money has fuelled a conspiracy theory. They call it Fiat Money, or Fractional Reserve Banking, and it is supposed to be a con trick, the route to our ruin.

The opposite of such a system would be a gold standard, a system in which by law there has to be the equivalent value of gold sitting in a bank’s vaults for every penny it lends.

There is a problem with the gold standard. It means our wealth is dictated by the amount of gold we are able to mine, and there is no correlation between the money supply and productivity. So the when the Spanish discovered gold in the New World their economy was ultimately ruined, as this growth in money supply was not matched by a growth in production. But in the UK, where a banking system based on debt developed early on, the industrial revolution was funded. In fact, the economic historian Niall Ferguson argued in his book The Ascent of Money that the reason why the industrial revolution occurred in Britain and not in France, was down to the French turning their back on a debt based banking system after the great and good in the French economy were ruined by the Mississippi bubble.

In a static world, where there is no innovation, no economic growth, and wealth is held by the few, the gold standard is fine. But in an economy which is seeing innovation driving forward productivity, you need a way to expand the money supply.

Winston’s Churchill biggest mistake was to ignore the advice of Keynes when he was chancellor and re-introduce the gold standard to Britain in 1925. In fact it could be argued that slavish devotion to the gold standard among the world’s authorities is why the Great Depression lingered so long; maybe it even caused the Second World War.

Now the proponents of the gold standard argue that all the new money being created will inevitably lead to hyper-inflation.

They miss an important point. The Fiat system they so hate depends on the willingness to borrow. If people just don’t want to borrow, or banks become cautious, the growth in the money supply slows, or may even go into reverse.

The latest figures from the Bank of England on the money supply show the relationship between M4 and M0 (that’s notes and coins in circulation and bank’s deposits at the Bank of England,) now stands at 10.5, whereas a ratio of 25 is normal.

The credit crunch has surely changed banks’ attitude to risk for a very long time ahead. The credit crunch may also have changed our attitude to borrowing, and made savings fashionable. Such changes in psychology can be disastrous for the economy, because the end result could be a rapid contraction in the broader money supply. This in turn could spark of decades of economic malaise.

Quantitative easing then, was actually essential. If the ratio between M0 and M4 falls, then the Bank of England has to boost M0. It is that simple.

And that is one of the reasons why the harbingers of doom are wrong.

There is, however, a second reason: and this relates to a crazy attitude adopted by the markets to the US economy. And to find out what that is click here: Is Uncle Sam finished, or is it the wisdom of the markets that is finished