A CHANGE OF
1 The party's over By Chan Akya
The idea of paper money having a vague intrinsic value can be highlighted in
the age-old story of the two brothers who owned equal shares in a pub. Whenever
one wanted a pint of beer, he would pay the other a dollar, who would then pay
him back for his own draw of beer. Pursued ad nauseum, this meant that the same
dollar could account for unlimited quantities of beer; provided of course
neither brother ever used it to buy something other than beer from his sibling.
More importantly, the game could continue until the brewery sent its chap
around to collect money for all the beer that had been drunk by the brothers.
As a general rule, the brewery would have wanted to get paid a little more than
one solitary dollar for the whole keg of beer.
In essence, this story captures the idea of what happens when
stated transactions do not produce incremental cash flows, or when increased
liabilities are disguised as new cash. Students of corporate balance sheets
will look for these glaring examples of cash mismatch; unfortunately, most
economists seem to misunderstand the difference between expenditure and
In the above example, the dollar changing hands wasn't the payment - it was an
exchange of liabilities; that is, each brother owed the pub a dollar for every
pint drunk. Coming up with the aggregate of all the payments meant totaling up
the liabilities, not simply exchanging the instrument of exchange, which is to
say the dollar note, once again. All of this is particularly important because
the brothers deferred their payment for their beer from the brewery - they had
themselves benefited from credit.
How then would the brothers pay for the beer in a normal situation? Simply by
selling more beer at a profit to their customers than their own consumption
would warrant. In other words, as long as the sum total profits of the pub were
in excess of the accrued liabilities of the two brothers, the pub remained
solvent at the end of the month. If on the other hand the brothers had drunk
more than their profits for the month, the pub was insolvent at the end of the
month, liable to be taken over by the brewery while the brothers went from
being owners to mere employees.
Small beer in economics
In the world before 2008, this brotherly love was best exemplified by the
US-China pair, wherein the former would buy billions in consumer goods from the
latter and pay with a series of IOUs. As long as China continued to accept the
IOUs rather than real money as payment for the goods, the cycle continued.
While this describes the supposed cash flow situation, how does the picture
change if we look at the balance sheet, that is to say, the relative value of
assets and liabilities?
In this case, slightly different from the brothers above, Americans were using
their borrowed money only partly for consumption, with the balance for
speculation on assets such as houses, stocks and so forth. For the Americans,
as long as the value of their assets increased faster than their liabilities,
the overall balance sheet situation remained acceptable. Effectively, the
increased consumption was warranted by the increased wealth. In turn, the
assumed positive net worth of American households engendered further credit
provision by China and other emerging markets, in turn boosting the value of
American assets as well as further consumption.
Since the collapse of the bubble from the middle of last year, the game has
changed dramatically. No longer do American households think of themselves as
having positive net worth; many if not most Americans probably consider the
size of their liabilities to be in excess of their asset values.
Added to this, the loss of jobs and reduction of corporate profits means a
dramatic decline in the income expectations of most Americans. Given all that,
the priority for many of them will be to reduce the size of their total
liabilities - their mortgage and credit card balances - otherwise the
all-important credit scores will become meaningless.
Unlike the citizens of most European countries, Americans pay attention to
their credit scores because not only do these cover their ability to borrow,
the score also provides flexibility to start new businesses: the basic engine
of profit generation in America, which is vastly different from what we can see
To counteract the decline in their net worth, Americans will try to become net
savers from being net spenders. This will push the economy further into a
recession: this is why comparisons to the Great Depression of 1929 are apt.
None of the above should be surprising to readers of Asia Times Online, given
the commentary on these subjects by various authors on the website from the
beginning of last year.
Many American companies are also stung by the higher costs of borrowing and
will be reluctant borrowers, if at all. That leaves only the government as the
sole agent to avail of credit in coming months and years.
Keynes, the barbaric relic
Confronting this situation, the new US administration along with its
counterparts in Europe appears to have embarked on a Keynesian vision of
monetary and fiscal expansion. The rapid rate cuts in Europe and the US in the
past two weeks point to the idea of turning monetary policy into "super-easy".
Meanwhile, various governments have announced an expansion of fiscal spending
to counteract the expected decline of the overall economy due to cuts in
consumer spending. This is also classic Keynes, namely the notion that
governments must act to counter the economic cycle.
Anyone reading through the above paragraphs with a grasp of the lessons of the
two pub owners will immediately recognize the fatal flaw in the Keynesian
design. This is the fact that governments no longer have the credit quality to
As I have written before on these pages, the best thing about John Maynard
Keynes is that he is dead. For no other branch of economics sprouts quite as
much voodoo logic as the Keynesians manage in their short, pointless lives (or
worse, long, pointless lives).
The United States along with a bunch of European countries is rated at the
highest triple-A category. Yet, pretty much none of these countries has an
ability to repay its debt from organic cash flows, that is tax revenues, any
time soon. The ONLY source of repaying American and European debt that
will be incurred in this new Keynesian expansion is new borrowings: essentially
what bankers call the refinancing risks.
(There are different reasons between the Americans and Europeans for this.
While the sheer size of government deficits run in the past eight years by
George W Bush adds to the woes of the US effort, the new socialization of risk
suggested by president-elect Barack Obama's team implies lower profit
generation than would be consistent with tax revenue increases. As for the
Europeans, my series of articles in Asia Times Online makes clear the idea that
demographic and profit challenges will push many of these countries to default
within our lifetimes.)
A whole bunch of banks went bust in the past 12 months for their failure to
properly comprehend refinancing risk. The same is true for American and
European governments which will attempt to sell new debt to fund their
expansionism. The parlous state of their balance sheets means that anyone
contemplating purchases of such debt is basically foolish.
The march towards the Washington summit in a couple of days seems bereft of any
references to the balance sheets of US and European governments. Much like the
vaunted triple-A ratings of various fixed income instruments in the past few
months turned out to be bogus, Asian investors must be cognizant of similar
risks for the bond ratings of the US and European governments in years to come.