So put all that together and what do you get? Well, around 15 million spare workers. Capital Economics reckons we could be just three years away from running out of workers to migrate into the towns.

 And that means China could be close to what is known as the Lewis Turning Point. This is a state in economic development, named after former Nobel Memorial Prize in Economics winner Ken Lewis, when industrial wages begin to rise quite rapidly as the surplus labour from the countryside tapers off.

 So what are the implications of that? Well, quite a bit, actually.

 There are some other points, too. First there is the spoilt brat syndrome, or is that a generation who are unwilling to work for little more than slave labour wages. Call it what you will, but it seems that younger Chinese are less enthusiastic about living six months of the year away in dormitory-type accommodation.

Secondly, in any case the Chinese population is ageing. The Chinese baby boomers – typically born in the 1960s and early 1970s – are not getting any younger. The one-child-per-family policy was introduced in 1978, meaning the first of this generation are now 32. In fact, the number of Chinese workers between 15 and 34 is now declining quite rapidly.

 So what will happen?

In part, it seems that some companies will relocate so that they are closer to the supply of labour. This in turn will help make income distribution across China a little more evenly spread.

 But what is clear is that Chinese wages will rise. The process has already begun, and one assumes that for the next few years Chinese wage growth will be faster than the growth in China’s GDP.

 This change is a good thing. It is good for the Chinese themselves, of course, but it is also good for the global economy.

As wages rise, consumer demand will go up, imports will increase, global imbalances will, theoretically at least, start to ease.

 But does this mean inflation, not only in China, but across the world?

Well, if cheap Chinese labour over the last decade or so led to cheaper products in the West, then the obvious answer to that question is that higher Chinese labour will indeed lead to more expensive products, and that globally prices will go up.

 But you need to bear in mind that much of the pressure on commodity prices, especially oil and metals, has come from Chinese investment. If consumption takes over from investment as the driver of Chinese growth, then some commodity prices may well fall.

The Chinese are already great meat eaters, so rises in wages are not likely to lead to a significant increase in demand for meat.

So maybe we will see a reversal of the patterns seen in recent years: manufactured goods will increase in price, and commodities fall.

But two other factors may help to stop global inflation from getting out of control.

First of all, just because China is running out of labour, it does not mean she is running out of capacity to increase productivity. In fact, Chinese productivity per head is still very low relative to the West, meaning there is lots of potential to improve productivity. So, for as long as the increase in wages per hour does not rise faster than the increase in productivity per hour, inflationary pressures will be minimal.

But secondly, we forget China is not the only developing country in the world. There are plenty of workers across the developed world who could yet migrate from their countryside into towns, from farms into factories. The truth is, the global economy has lots of surplus labour.

It does seem, however, that the underlying factors that created the credit boom and then the crunch in the West are unwinding. Chinese consumption is set to rise, investment growth will slow down, meaning China’s trade surpluses with the US and Europe will surely fall.

But put these changes in China in the context of a shift in the global economy away from the great savings glut that built up over the last 30 years: see yesterday’s piece: Interest rates set to rise as economic tectonic plates shift – is this good or bad news?

Right now there are four major factors at work. There’s the shift in China. There’s the global shift towards investment and away from savings as the developed world beyond China starts to catch up with the West. There’s the retirement of the baby boomers. And finally there’s technology, as growing computing power and the Internet in turn lead to remarkable advances elsewhere, such as in genetic science.

The next decade or so will probably see more changes in the global economy than any other decade for a very long time indeed.

Before we delve into the guts of the McKinsey report, there are a couple of points you need to bear in mind.

Firstly, in a mature economy investment does not need to be that high. See it in terms of two farmers, a farmer that is well established and one that has only just set up. Our established farmer will probably have a decent combine harvester, all the necessary number of tractors, and lots of mod cons that help make the farm as productive as possible. Such a farm does not need much investment, normally requiring further input only to maintain equipment, or if a new wonder product comes out which will help improve productivity. This farm is analogous to a mature economy in which innovation, and not investment, leads to growth. The second farmer, on the other hand, has insufficient infrastructure, and every pound of investment leads to a significant rise in productivity.

It seems that when the Second World War ended, the developed areas of the world were all operating way below potential. All of the world’s economies had vast potential to increase productivity by investing in infrastructure, machinery and any other forms of capital you can think of. And so, for 25 years the global economy enjoyed a golden age. It was an age that ended in the mid 1970s.This column has argued before that inflation in the 1970s occurred because output growth slowed, but growth in demand didn’t. In Japan it was even worse, as she suffered from the triple blow of the bursting of a bubble in asset prices, an ageing population, and the ending of her period of technology catch up.

Secondly, economic theory says investment is funded by savings. So if saving is high and investment low, we get low interest rates. If investment is high and saving low, interest rates shoot up.

During the golden age of growth, disposable income per person in the developed world rose sharply. Your average household in the UK was much better off in 1973 than in 1950, and yet throughout this period, real interest rates were quite high. The fact that real rates were high was not a good thing per se, but the factor that caused them to be high was good. Or to put it another way, high real interest rates were a symptom of the fact we were becoming better off.

From the mid 1970s onwards, investment in the developed world slowed. McKinsey estimates that total global investment between 1980 and 2008 was round $20 trillion less than it would have been had total investment as a proportion of GDP stayed at the level seen during the 1950s and 1960s.

By the late 1990s and noughties, saving had risen too. Saving rates were high in Japan, and the money saved flooded into the US and Europe via the carry trade. And then as China started to save, in part as a reaction to the shoddy treatment handed out by the IMF to the Asian Tiger economies after their 1997 crisis, we saw the emergence of a global saving glut.

This saving glut fed the credit boom in the West.

It seems that during the period we also saw an increasingly uneven distribution of wealth, but the populace were placated largely because of the combination of cheap interest rates and ready supply of credit, which led to rising property prices and made people feel better off.

And then for the final act in this chapter came the credit crunch and the global economic crisis.

But maybe the global economic crisis was little more than the death-knell of that particular economic era.

And death-knell suggests a new era is beginning.

McKinsey Global put it this way: “Developing economies are embarking on one of the biggest building booms in history. Rapid urbanisation is increasing the demand for new roads, ports, water and power systems, schools, hospitals and other public infrastructures. Companies are building new plants and buying machinery, while workers are upgrading their housing. At the same time, ageing populations, and China’s efforts to boost domestic consumption, will constrain growth in global savings. The world may therefore be entering a new era in which the desire to invest exceeds the willingness to save, pushing real interest rates up.

Higher capital costs would benefit savers, and perhaps lead to more restrained borrowing than we saw during the bubble years. However, they would also constrain investment and ultimately slow global growth somewhat.”

In other words, investment across the world is set to explode. The report went on to say: “The world is now at the start of another potentially enormous wave of capital investment, this time driven primarily by emerging markets. We predict that 2020 global investment could reach levels not seen since the post-war rebuilding of Europe and Japan in the era of high growth in mature economies.”
McKinsey predicts that by 2030 global investment will be around $24 trillion, compared to $11 trillion today.

But as investment rises, suggests McKinsey, savings are set to fall.
Firstly they will fall as China’s consumers begin to save less and spend more. We have written about this many times, so we don’t need to go into more detail here today.

Secondly, suggests McKinsey, savings will fall as the ratio of retired to working population rises, meaning more money will be spent on healthcare, and less saved.

The result, says McKinsey, will be higher real interest rates, but at the same time the global economy may embark on another golden age of growth. One assumes that during this transition period, we will see default by a number of individuals, companies, banks and countries with high debts.

That leaves us with just one comment: the baby boomers.

Several times before, this column has argued that as the baby boomers approach retirement, saving rates will rise, creating deflationary pressure. Then, once the baby boomers have all retired, those savings will be eaten into, and inflationary pressures will be created.

The McKinsey report is fascinating indeed, and the report’s key assumption is surely right.

We suspect, however, that the baby boomer effect muddies the picture, and as yet it is not clear how the combination of ageing in the West will interact with an investment-led boom in the developing world.

For the McKinsey report, see:
Farewell to cheap capital? The implications of long-term shifts in global investment and saving

Does it matter? If you have a social conscience, it may seem to matter. But how does this lack of trickle down affect the economy? Well, actually, we would argue this was disastrous for the economy. Maybe the single biggest cause of the 2008 financial crisis was the way the gap between the super rich and the rest grew. So it has got nothing to do with what is right or wrong. Rather, if you look at this from the point of view of wanting an efficient and growing economy, then the rich should pay more tax; tax on dividends should go up; inheritance tax should rise; we should see a property tax; and actually, corporate tax should go up, too.

Demand matters

Economic theory says that GDP is made up of consumption, investment, exports and government spending.

That might be true for an individual economy, and it might be true at a single point in time. But for the global economy, and over an extended timeframe, that is not true. For one thing, across the global economy, exports and imports cancel each other out. But, for another thing, in the long term, demand drives investment. Take as an example Moore’s Law. Computers double in speed every 18 months. This has happened because as computers fall in price, and their applications grow, demand goes up, and this in turn justifies higher investment and allows new economies of scale, so that computer chips either fall in price or become more powerful.

So, actually, for the global economy, demand really is vital.

Keynes once came up with the idea of the paradox of thrift. In an economic depression, such as the 1930s, argued Keynes, consumers tend to save more, because they are worried about the future. But as the rate of saving rises, aggregate demand across the economy falls, and the depression gets even worse. Keynes advocated channelling wealth into the poorer households, because poorer families tend to save less. So, Keynes argued that in times of a depression, money should be taken from the rich and given to the poor. He said this not because he was a socialist, in fact he was no such thing, but because, under certain circumstances, he saw this as the best thing for the economy.

Paradox of toil and paradox of flexibility

Post-credit crunch and two new theories have emerged, building on the Keynes idea of the paradox of thrift.

The paradox of toil was suggested by Gauti Eggertsson, an economist who works at the Fed in New York. He argued that under certain circumstances, if workers start to work harder, then the result can be a rise in unemployment and falls in wages. The theory is based on certain conditions: that the economy is suffering from deflation, there’s declining output, and interest rates are zero.
See: The Economist, Double, double, toil and trouble

Of course, such circumstances would be especially worrisome if consumers, or indeed the government, are highly indebted, because falling wages would be rather bad news for individuals in debt.

You don’t need to be a genius to see the parallels between the conditions that apply to this theory, and conditions today.

Another theory is the paradox of flexibility. This one, from Lynne Gouliquer, a sociologist, draws similar conclusions, but from a scenario in which labour market flexibility leads to falling wages. See: Pandora’s Box: The Paradox of Flexibility in Today’s Workplace

The point about these theories is that they hinge on the idea that demand drives corporate profits, and demand is determined by wages. So if the cost of labour falls, companies may make more money in the short run, but in the long run aggregate demand falls, and profits then decline.

The globalisation of labour

But then there’s globalisation. This column is pro-globalisation, but just because you are in favour of something, it doesn’t mean you can’t recognise its disadvantages.

This is what Ernst & Young had to say on the matter earlier this year: “The household sector’s share of national income is counter-cyclical and last year this shot up from 70.3 to 73 per cent. However, comparing this with the two previous low cycle values of 77 per cent in 1991 and 76 per cent in 2001 reveals a clear deterioration. Similar downward trends in the labour force’s share of national income are evident in all western countries. This seems to reflect what IMF economists have dubbed the ‘globalisation of labour’. Immigration, import competition and off-shoring affect the provision of services as well as goods and the demand for skilled as well as unskilled labour, and these effects have clearly been at work in the UK. These adverse trends help to explain why the recent ‘consumer boom’ was so modest compared to the Lawson boom and other historical episodes – and why households had to borrow so much to sustain this.” See: Did globalisation cause the economic crisis?

The paradox of innovation

Here is a theory, made up here. Maybe, paradoxically, innovation can also create problems for the economy. Innovation can lead to a fall in prices, and innovation may lead to a requirement for less labour, driving down wages. Innovation can lead to higher profits, without necessarily leading to higher wages. Meaning, innovation can create a scenario in which demand lags behind capacity.

Or to put it another way, under certain circumstances the Luddites were right.

This does not mean innovation is bad, of course not. But it must be recognised that sometimes even good things can carry a sting in their tail.

This column has argued before that a possible underlying cause of the Great Depression was that all the innovation that had occurred during the previous fifty years (a period, by the way, that may have seen more innovation than in any other period in history), may have created an environment in which potential capacity was greater than aggregate demand. Then the economic boom of the 25-year period after the Second World occurred, as we finally found a way of turning that innovation into wealth and distributing the proceeds efficiently .

Economists under-estimate the importance of the Internet. Why the Internet is so important has also been covered here before. See: What is the Internet really worth to UK economy?

On more than on occasion it has been said here that for feeding innovation, there have been four great advances: the evolution of language, the development of writing, the invention of the printing press, and now the emergence of the Internet. Interestingly, Chris Anderson, author of ‘Free’ and ‘The Long Tail’, and former editor of Wired, has said something similar. He has coined the phrase ‘Crowd-accelerated innovation’, and has argued that the development of online video has done for face-to-face communication what Guttenberg’s printing press did for the written word. See this excellent video: Chris Anderson: How web video powers global innovation

Steven Johnson, author of ‘Emergence’, one of the most interesting books published in the last few years, has penned a new book entitled ‘Where Do Good Ideas Come From?’ His hypothesis overlaps with Anderson’s idea in that, actually, the great breakthroughs don’t come when inventors sit on their own, beavering away at an idea, but, rather, they come via communicating with others. And since there has been no greater medium in history than the Internet for enabling communication with others, you can see why an awful lot of good ideas are likely to emerge over the next few years.

But, with innovation comes greater capacity, and unless demand grows in tandem with greater capacity, the result could be mass unemployment.

When doctors become too expensive

When equal pay for women was advanced, education may have deteriorated. The argument here is not, repeat not, saying women should not have equal pay. Rather, that there can always be unpleasant side effects of good developments. Before equal pay, one of the best careers a women could pursue was teaching, and so the teaching profession attracted the crème de la crème of women graduates. Today, instead, the women who may have become teachers head for that place where the roads are seemingly paved with gold, the City.

When you have a sector of the UK economy in which financial rewards are simply huge, it becomes harder, or perhaps more expensive, to attract top people to other professions. And so, doctors and dentists become more expensive. And since the rich and poor alike need doctors and dentists, and since these health professionals are increasingly demanding salaries that are competitive with City salaries, it means that unless the super rich pay more tax, quite a bit more, it will be simply impossible to fund decent provision of medical support for the majority of people.

Increase inheritance tax

If you believe in capitalism, and believe pay should reflect ability and effort, then you should believe in 100 per cent inheritance tax. This point was covered here almost three years ago: see: Inheritance tax – there’s votes in changing it, but is there prosperity?

The paradox of success

It seems there are times when we can become victims of our own success.

This column is in favour of encouraging innovation, so how can the problems above be fixed?

It is tempting to suggest charging more tax on the income enjoyed by the super rich, and less on the rest of the income scale. Although, unfortunately, it seems that higher income tax is not likely to achieve much. Even if the super rich paid 90 per cent income tax, the money raised would not be significant enough to make a huge difference.

Besides, such a tax would be counter-productive, and a 50 per cent income tax rate for the super rich is probably about as high as is desirable.

The income distribution problem could possibly be solved by encouraging more people to take part in the innovation process, perhaps by encouraging more entrepreneurs.

But maybe a tax on property, especially at the point of inheritance, may be the key. And if you believe that booms in property prices lie behind most economic bubbles, such a move would have the added bonus of restricting future bubbles. See: Property tax: dynamite fuse is lit by Bank of England man

It seems there are two theories on oil. One theory says that oil goes up and down in price following a regular cycle. This theory looks at what economists call elasticity of demand, and the idea goes like this. In the short run, oil is something we just must have. So, as price goes up, demand is barely affected – or, if you will, we have inelastic demand. But, the theory continues, in the long run, demand is actually quite elastic. If oil stays high in price, we change our habits. We buy more fuel-efficient cars, for example, or insulate our lofts.

And this is how the theory pans out. Oil goes up in price – the reason does not matter, just take this one as a given. To begin with, we all suffer, and recession may even be the result. But over time we learn to adjust, and bit by bit demand starts to fall. But oil companies, being run by people who have no understanding of economic cycles, don’t realise this. They can see price is high, then their finance directors enjoy something of a high from counting all the profits, and so they engage in an orgy of exploration.

A few years pass. Thanks to the oil exploration splurge, supply of oil is up. Thanks to the way we changed our habits and learnt how to be more economical with our use of oil, demand was lower. And all of a sudden price crashes. By the late 1990s, oil was around $10 a barrel, having fallen dramatically from its price of a few years earlier.

At this point we enter the next stage in the cycle. Oil is cheap, and bit by bit we become more careless in the way we consume it. Fuel efficiency goes out of fashion. We yearn for Ferraris, or other fuel-guzzling beasts. Meanwhile, oil companies suffer from cheap oil and they slash their exploration budgets.
And so the cycle turns again, and oil shoots up in price like it did during the second half of the noughties.

Those who sign up to this theory tend to laugh off the idea of peak oil. It is not that they don’t believe a permanent decline in the supply of oil would be dangerous, they just don’t see it as very likely.

The peak-oilers, on the other hand, reckon we are running out. And some then go on to argue that black gold, or oil as some people call it, is the lynchpin of the modern economy. Within a few years of peak oil, we will see an irreversible descent into a new Stone Age.

Their critics see this as ridiculous. They point towards the tar sands of Alberta, Canada, for example, and say there is plenty of oil out there, just begging to be drilled into.

Two other developments make the issue more complex.

First there’s the credit crunch. It seems this may have had a twofold effect. As recession descended upon the world, demand for oil fell, and therefore so did its price, with a barrel of oil falling from around $145 in the summer of 2008, to less than $40 six months or so later. So the credit crunch pushed down on demand. But maybe the lack of credit also meant less money was available to fund further oil exploration. So in the short run, the effect of the global economic crisis was less demand for oil. But in the longer term, the effect may be less supply. So the anti peak-oilers can argue that the fall and rise in oil can still be explained by their economic cycle theory.

The second development relates to a certain Deepwater Horizon oil rig. The peak-oilers see this disaster as evidence of how oil is becoming harder to reach. Most people probably agree by now that BP has applied quite breathtaking technology in dealing with this disaster, but the fact remains that despite this, oil is becoming so hard to get at that disasters such as this increasingly are inevitable.
Those who dismiss peak oil simply argue that the BP oil spillage is a blip. And furthermore, a blip that is being compounded by the US. They argue that our expertise in learning how to tap into oil lurking in the deep places of this planet is improving. And that if we see an oil drilling ban in the Gulf of Mexico leading to a fall in supply, then this is not evidence of peak oil, merely evidence to show the US is a fickle beast.

It seems that the UK Industry Taskforce on Peak Oil and Energy Security (ITPOES) falls into the peak oil camp. Well, frankly, judging by its name, you would expect that. It warns of the “increasing importance of deepwater drilling to global oil supply,” which it says is “expected to constitute 29 per cent of new capacity by 2015, up from only 5 per cent today.” And argues that “the result is that any future delays or problems associated with deepwater drilling will have much greater impact on supply than is the case today.”

The taskforce has been set up by various businesses, and counts Sir Richard Branson, among others, as a patron.

In a report out earlier this year it said: “Having assessed the systemic changes caused by the global economic recession, coupled with the projected growth from non-OECD countries, ITPOES predicts Peak Oil will occur within the next decade, potentially by 2015 … The study finds that the recession has delayed the oil crunch by two years.”

The taskforce reckons peak oil will occur at around 95 million barrels per day, against production levels of 85 million barrels per day in 2008. In other words, demand only needs to increase by just over 10 per cent, and wham, oil goes shooting up.

The report’s authors may or may not be right, but there is one respect in which we agree with them.

Peak oil does not have to be the disaster some say it will be. The problem with oil is that trillions of dollars have been invested into it. But there are alternatives out there. Critics of wind and solar say they are nowhere near as efficient as means for generating our energy needs as oil, but can we really say that. If wind and solar power had a fraction of the money spent on them that has been thrown at oil, it seems pretty reasonable to argue they would become far more efficient.

In some ways peak oil may prove to be a good thing. If we turned out attention to other, renewable, forms of energy, or maybe heaped resources on genetics research, so that the maverick geneticist Craig Venter faced competition in his efforts to turn algae into a cheap form of energy, then in the long term we may end up with a source of energy that is much cheaper than oil is at the present, and which would not be subject to the vagaries of the economic cycles based around the folly of human nature.

The taskforce says that more urgent action is needed from government to address the threat of peak oil following the Gulf of Mexico oil spill. It urges the UK coalition government to take action to reduce the impact of the oil crunch by 2015.

See Peak Oil – Implications of the Gulf of Mexico oil spill, for the ITPOES report and see click here  for Investment and Business News articles on the alternatives to oil

In all, the Russian government is hoping to raise US$59 billion from next year through to 2015, selling off stakes in around 900 companies.

It is not the first privatisation programme, of course. It also sold off state assets during the Yeltsin era, but it seems on that occasion utterly failed to take a leaf out of Mrs Thatcher’s book. If you are of a certain age, you may remember the famous advertising campaign, “Tell Sid,” for British Gas. See this clip if if you want to see the ad again, or, if you are a younger reader, to see what we are on about. The snag of course with the first privatisation programme is that the Russian government told Roman, Mikhail, Oleg and a few other would-be oligarchs, but forgot to tell everyone else.

Actually, there is an interesting power struggle developing in Russia. When he first became President, Dmitry Medvedev was seen as a puppet, moving and dancing to the strings pulled by Vladimir Putin. But since then, things have changed. Vlad pulls the strings, but Dmitry doesn’t necessarily respond. The president talks about Russia as a backward economy, and wants to accelerate the pace of change. Mr Putin is in favour of the more gradual approach.

Mr Putin recently revealed plans to re-stand for president in 2012, but this begs the question, will we see a contest between the two men?

Right now, the tide is with the tiger shooting, judo expert former president. And there are powerful lobbies in Russia who don’t want to see rapid change. They rather like the status quo, represented by the more conservative Putin. When Yeltsin came to power his policies led to a bubble and the Russian crisis of 1998. At one point in 1998, the entire market capitalisation of the Russian stock market was lower than the value of Sainsbury’s.

But sometimes the relationship between cause and effect can be quite elongated. The Russian economy boomed between 2000 and 2008, and the foundations may have been laid during that period of rapid reform.

Mr Medvedev is far more popular in the West; Putin seems to arouse memories of the older style Soviet premier, flexing his muscles, and doing down the West at every opportunity. A couple of years ago he offered to teach Nicholas Sarkozy judo; can you imagine that?

But the privatisation programme, one assumes, is very much Mr Medvedev’s baby.

Capital Economics reckons Russia has the potential to be Europe’s biggest economy by 2035, but Neil Shearing, Senior Emerging Markets Economist at the economic forecasting group, says: “But with economic progress ultimately dependent on political progress, it seems that the next twenty years will mirror the past twenty and that Russia will remain a story of unfulfilled potential. In the absence of policy reform, while growth will fluctuate with the price of oil, we doubt it will average much more than 2-3% per annum over the next twenty years or so.”

But maybe, just maybe, if the privatisation programme can start paying dividends in time, things will be different. And Mr M will find he is able to remove himself from under the shadow of Vlad the Impaler that is old style Russian mismanagement.

PS: Russia may be embracing the ideas of Thatcher, but the bear is not alone. Even Cuba recently revealed plans to adopt market practice. See: Capitalism sees new birth in Cuba

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

There is a famous equation: PT= MV. Average price times number of transactions equals money supply times velocity of circulation of money. The thing is, the money supply has many different definitions. Maybe broad money is really MV, but that is just a matter of semantics. The fact is that it is broad money, not narrow money, that determines inflation; broad money has contracted in the US every month this year, and its growth in the UK is anaemic. See: Bank of England rate setting committee

But then again, it is clear why broad money is performing so poorly; it is because of low lending levels. The question is, will this be a temporary thing, and will lending return to old levels. If this happens, then all that extra money created by the Bank of England will multiply out, and we will have problems.

But, for a variety of reasons, we think this is unlikely.

First off, bank regulation, including the new Basel accord, is likely to keep lending lower.

Secondly, the boom in asset prices, and especially house prices, encouraged borrowing as people felt they could afford to borrow more because their extra borrowing was fundable from the growth in the value of their property. I think there are good reasons to believe it will be a long time before we have another property boom, hence demand for credit should remain low. This partly explains what happened in Japan 20 years ago; asset prices crashed, and we saw 20 years of deleveraging.

Thirdly, saving is coming back into fashion. Who knows how long this new fashion will last, but it will be a while before we return to the recklessness of the boom years.

Fourthly, during the boom Western markets were flooded with credit from Japan and China. The Japanese carry trade is over. If China does indeed consume more, then we should see the gradual end of that era of Chinese money propping up Western credit.

Fifthly, the twin forces of globalisation and technology have created a big leap in global capacity, and when capacity rises, the money supply must rise too, or we will get deflation. We may have seen an early example of this effect in the period that central bankers refer to as NICE.

But the sixth reason is the main factor. In fact, it makes the other points quite trivial, and it relates to demographics and the retirement of the baby boomers. The fact is, across the West, and indeed China where the population is ageing too, and very much In Japan, demographic changes mean it is essential we save more and borrow less. The demographic change is about 20 years ahead of us in Japan. This surely is the real cause of Japan’s 20 years of economic malaise and deflation.

Unless central banks can find a way of channelling quantitative easing into areas that will create wealth and promote business, i.e. venture capital, or more business friendly banks, it will be ineffective.

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

The reason why gold has done well over the last couple of years surely relates to uncertainties over the currency markets and the beginning of the end of dollar hegemony.

As the Brazilian finance minister recently said; as Dominique Strauss-Kahn at the IMF seemed to confirm; and as even Mervyn King hinted; there is a real chance of a currency war. Regardless of the rights and wrongs, the fact is that China’s policy in regard to the yuan is massively unpopular in the US. But, equally, QE is massively unpopular within China. Right now, it seems the entire world wants to get rich by exporting more than they are importing, and this just isn’t possible. Everyone wants a cheaper currency, and so we are seeing a race to the bottom, and risk seeing an overwhelming wave of beggar thy neighbour trade policies.

Japan sees the yen rise, as China, fretting over QE, ditches US treasuries. Japan frets over the rising yen and tries to pull it down by buying dollars, meaning she ends up buying the US treasuries that China stopped buying.

Germany sees exports surge on the back of a cheap euro, made cheap by the problems in Greece and the other PIIGS.

Meanwhile, the fiat money conspiracy says central bankers are the cause of all our ills, and that the economy is fundamentally flawed because all money represents debt, and every time central bankers create money, they are creating debt too.

And so, as a result of all this, the belief grows that the only currency system that makes sense is one based on a gold standard. Hence, gold surges. The logic may be based on a faulty premiss, but little things such as truth rarely get in the way of religious zeal, and buying gold is a new religion.

Others say QE is a con, and that central bankers have entered into a kind of a devil’s pact with their government to inflate debt away. Whether they are right to hold this belief, or whether they are wrong, fears over QE debasing currencies has led to surging gold. Fears that QE will lead to hyperinflation are, in all probability, wrong, but then again even Nassim Taleb (author of the Black Swan) reckons hyperinflation is a real danger. Hence, gold rises.

China’s doubts over QE have led to her buying gold in huge quantities.
China has been talking about replacing dollar dominance by using a new international currency based on IMF special drawing rights. The sneaky suspicion is that gold will form a part of this new international currency.
Global imbalances will probably only come to an end with Bretton Woods mark II. It took a war for us to get the first Bretton Woods; maybe it will take a trade war to get the next one.

But if we see the emergence of a new international currency based on a gold standard, it will be an unmitigated disaster. Any system in which the money supply is limited by the supply of a rare material whose availability has more to do with mining expertise than with economic requirements, is a system which will ultimately see growth sucked away.

The belief that we are heading for hyperinflation, and that gold is the only currency that makes sense because it removes temptation from central bankers to create money, is based on a false assumption. It is based on the assumption that QE is creating unprecedented rises in the money supply. In fact, in the two countries where QE has been introduced with most enthusiasm, the UK and the US, the money supply, or at least the broad money supply, is contracting. In the US, dollar M3 has contracted every month this year.

Fears over hyperinflation leading to surging gold are built on a myth.

Globally, the problem is one of demand lagging behind potential supply, and this is creating underlying deflationary pressures.

How does it make sense for gold, the safe refuge against inflation, to rise at such times?

The gold bubble has probably got a lot of life left in it, and yes, gold may go up much further. It could even double from current levels. But it is a bubble, nonetheless, surging on the back of a false belief. And the bubble will burst eventually, and then gold will be half its current price.

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

Here is one way of looking at this famous mathematician. The B which forms his middle initial doesn’t stand for anything. The B was added to his name by Mandelbrot himself. Perhaps this illustrates the nature of his character. The word maverick may not do him justice.

Here is another way: these days a popular word among kids is “random”. If anything happens which is a little out of the ordinary, they will describe it as “random”. Well, maybe, just maybe, their usage of this word is down to Mandelbrot, for it seems that the famous mathematician has made the word random fashionable.
Remember what Keynes once said: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”

Well, Mandelbrot is not long dead; he left this world on 14 October 2010. And since his biggest fan is probably Nasim Taleb, author of The Black Swan, who is busy evangelising him, his is certainly not defunct. Even so, his ideas are probably more important than we realise. It is not just kids saying “random” to anything that takes them by surprise, but practical men, too, may be influenced by him by far more than we realise.

How long do you think the coastline of Britain is? Well, that may seem like a simple question, but actually, the answer depends. It depends entirely on how much you drill down. If you were to use a ruler that is a mile long, then you will miss many of the bays and peninsulas that frequent the coast. If your ruler is a metre long, then all of a sudden the coastline will appear to be a lot, lot bigger. But supposing your ruler is a centimetre long, or a millimetre long, won’t this make the distance around the coast that much further again. Supposing your ruler is a nanometre long, how big the coastline then? Back in 1967, Mandelbrot published a paper looking at this very question, which he entitled: “How Long Is the Coast of Britain? Statistical Self-Similarity and Fractional Dimension.”

Mandelbrot invented something called a fractal. Apologies for this, but the source for the next sentence is Wikipedia: a fractal is a “rough or fragmented geometric shape that can be split into parts, each of which is (at least approximately) a reduced-size copy of the whole.”

Mandelbrot found that when you zoom in on a shape, such as a coastline, then the new patterns you observe are almost identical to the large patterns you observed at first. So, if you look at a map of the south coast of England, you will notice bays, peninsulas and rocky formations. But supposing you then zoom in on one particular bay and examine its coastline. You will notice smaller bays, and peninsulas within the larger bay, and so it goes on. Mandelbrot also suggested we would have no way of judging the level of scale when we observe this coastline.

But these fractals don’t just apply to shapes we see when we examine a coastline. They could apply to a snowflake, or a leaf, or static in a computer cable.

And here is another example of a fractal – a graph plotting price movements. Look at the graph plotting the share price of IBM during the course of one day, and compare it with a graph plotting the share prices over a year. Sure, the scale of extreme changes varies, but the graph may well look pretty similar.

Mandelbrot’s theories effectively relate to chaos. And he even came up with a formula to try and make the chaos more predictable (zn+1 = zn2 + c).

Taleb is perhaps Mandelbrot’s most famous disciple. And by the way, one of Taleb’s big fans is David Cameron.

In his book, “The (Mis)behaviour of Markets: A Fractal View of Risk, Ruin and Reward”, Mandelbrot, helped by his co-author Richard L Hudson (former editor at the Wall Street Journal, who was charged with the job of creating lively prose to frame Mandelbrot’s ideas), attempted to provide an entertaining and surprisingly easy to read account of why market prices can vary so hugely, and how we can make a better job of quantifying risks.

The problem with markets is that for much of the time, they work the way we expect them too. For much of the time they are efficient, and the efficient market hypothesis holds true. The snag is, on occasion markets go awry, and we get Taleb’s Black Swan events, such as the banking crisis of 2008, or the stock market crashes of 1929 and 1987. The crash of 1987 should not have happened, at least not according to traditional theory. When LTCM went down in 1998, and nearly dragged the international banking system with it, two Nobel winners saw their credibility blow up in smoke, and a shed load of PhDs who worked for the firm were left scratching their heads. And yet the crisis of that year was predictable, or at least the possibility of the crisis was predictable, according to Mandelbrot’s theories.

For more on Mandelbrot see this video on YouTube which illustrates the idea of fractals rather well, although be warned, it will make your eyes ache And if you want to try and understand Mandelbrot and have a laugh at the same time, see this video:
And, finally, here is a video of the pupil Taleb and the master Mandelbrot predicting doom, just before the banking crisis

Investment and Business News is a succinct, erudite and informative roundup of today’s top news stories on business and the economy, with analysis thrown in. Sometimes amusing, frequently contrarian, often thought provoking, and always informative, Investment and Business News is free. To subscribe, click on the subscribe function at the top right hand corner of this page. By the way, did we say it’s free?

The first thing that the US has in its favour is simply this. Any war will ultimately be won by the side with weapons of mass destruction, unless, that is, both sides are armed to the teeth with these destructive instruments of war. But in the economic world, the equivalent weapon is quantitative easing (QE), and the latest Fed minutes dropped a hint that the powers that be at the Fed are ready to press the QE button.

Actually, the hint was quite subtle.

It all boils down to the difference in meaning between the words ‘many’ and ‘some’.

The minutes from the Federal Open Market Committee, or FOM as it is more snappily called, said that “many” participants thought that unless there was a pickup in growth inflation or an improvement in unemployment, then more monetary stimulus is required. The minutes also said “some” participants would only be willing to see more stimulus if they saw evidence that inflation and growth were likely to fall further. And since most of us consider the word ‘many’ to imply a greater number than ‘some’, this would suggest the majority of the members of the Fed’s rate setting committee want to see more QE, and very soon indeed.

And since the dollar remains the world’s number one currency, and since the world’s greatest creditor holds massive reserves of dollars, the US can do pretty much what it likes.

So while on one hand the US hates China’s policy of maintaining a weak yuan, but at the same time China hates the US policy of QE, Uncle Sam holds all the cards. It can boost the dollar supply as much as it likes.

What we are really seeing are the forces of deflation and inflation clashing.

For as long as the likes of China and Germany push for massive trade surpluses, the US can either respond by deflating wages, making its self more competitive but suffering economic agony in the process, or it can respond by printing money and scattering it from virtual helicopters across the land.

Martin Wolf in the FT covered this very topic today, comparing the US–China clash with the situation in Europe. In his scenario, the Eurozone equivalent of China is Germany, and the problems in Greece are similar to those faced in the US. There is a difference of course; Greece can not resort to the money printing press, and will suffer years of deflation and economic depression.

The second reason why the US is likely to enjoy victory is simply this: Uncle Sam is far too important to the rest of the world. If Greece suffers years of depression, the rest of the Eurozone can carry on regardless. In much the same way the UK boomed for most of the noughties even though cities such as Hull were in economic depression. But should the US go the way of Greece, then it is hard to see how the global economy can avoid depression, too.

So China’s policy will ultimately backfire. The global economy is still reliant on the US consumer. If China tries to punish the US, then China will be the ultimate loser.

And yet it won’t always be like this. Decoupling has been exaggerated, but the world is gradually becoming less reliant on the US.

Dollar hegemony will come to an end eventually. This has important implications, but there is a way of stopping the transformation being too painful.

See: End of US hegemony, why the Bancor and not gold will be the new currency.

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So, who are the latest winners, what did they do, and is the whole thing a farce anyway? And finally, by the way, there may be an interesting point in this relating to the value of immigration.

The latest winners are Professor Peter Diamond of MIT; Dale Mortensen of Northwestern University; and, here in Blighty, Professor Christopher Pissarides of the London School of Economics.

The award was handed out for their research that showed how the labour market does not operate all that effectively, and that generous benefit payments can have an adverse effect on unemployment. Or, to put it in the words used by the Royal Swedish Academy of Sciences, the people who hand out the prize: “The Laureates’ models help us understand the ways in which unemployment, job vacancies, and wages are affected by regulation and economic policy. This may refer to benefit levels in unemployment insurance or rules in regard to hiring and firing. One conclusion is that more generous unemployment benefits give rise to higher unemployment and longer search times.” See The Prize in Economic Sciences 2010 – Press Release. Nobelprize.org. 12 Oct 2010

Of course there are those who would say the professors’ work smacks of using complicated maths to prove the bleeding obvious. And let’s face it, the discipline known as economics has suffered a right hammering recently, and for good reason; after all, it totally failed to warn of the economic crisis in the making.

This is what Nassim Taleb, author of The Black Swan, said to Bloomberg recently on this theme: “I want to make the Nobel accountable … Citizens should sue if they lost their job or business owing to the breakdown in the financial system.”

He then focused on three particular Nobel winners, Harry Markowitz, Merton Miller and William Sharpe, whose work on portfolio theory has been blamed for causing much of the financial disasters of the last ten years or so. Taleb said: “People are using Sharpe theory that vastly underestimates the risks they’re taking and overexposes them to equities … I’m not blaming them for coming up with the idea, but I’m blaming the Nobel for giving them legitimacy. No one would have taken Markowitz seriously without the Nobel stamp.”

So Taleb is not saying to sue the academics, rather to sue the body that awards the prizes.

It is a bit of a puzzle, however. On one hand we are told the Nobel prize is awarded for stating the obvious, while others say economics is useless and contributes nothing we can use. On the other hand, Taleb is saying sue the Nobel prize people because they encourage legitimacy of economic views that are very dangerous.

Well, you can’t have it both ways. You can say economics is irrelevant or it is dangerous, but not both at the same time.

This is what Keynes had to say on the subject: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”

He is right, and those who dismiss economics as irrelevant are deluding themselves. From Adam Smith’s invisible hand, Ricardo’s Law of Comparative Advantage, even including the ideas of Karl Marx, economic thought has shaped the world we live in.

And so any attempt to try and understand the economy is important.

Sure, if you look at the surface of the theories put forward by our trio of economists, they may seem obvious. It is just that if you were to take the time and drill in deeper, you would find there is a lot more to their work than stating the obvious. Their ideas build upon older ideas, and other economists will build upon their ideas. And eventually, as a result, we will improve our understanding of these incredibly important fields.

Here are some other observations. Peter Diamond was recently nominated by Barack Obama to fill a vacancy on the US Federal Reserve Board, but Republicans were uncertain he was sufficiently qualified. Presumably Diamond can now wave his Nobel award and quash that particular criticism.

Secondly, Professor Christopher Pissarides is a British Cypriot. In short, he is an immigrant to this land. Okay, since he is an EU citizen he would not have been affected by the new measures the government is bringing in to curb immigration, if they had been in force years ago. But the point is this: immigration brings in real talent to this country. And by reacting so hard against it, we risk turning away Nobel prize winners of the future, not to mention potential winners of the X Factor.

Thirdly, some say the award of the Nobel is political, and cite the award given two years ago to Paul Krugman, who has strong Keynesian views which he outlines in his weekly column in the New York Times. But the Nobel was not awarded to Krugman for his New York column; it was, rather, for other work on trade patterns, which was unrelated to his views on Keynesian economics.

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