Tuesday, 28 October 2008

An Order Of Magnitude

There are those of us who believe that we can now see the way out of the financial crisis (see article). To be sure, there is a long way to go until the real economy fully digests the disturbances caused by the financial economy. However, the real economy could not begin to return to normality until the financial economy has returned to something like normality. As we move forward, the question arises of exactly how big the financial disturbance might be.

The recent stability report issued by the Bank of England (see report) suggests that the cost of the financial disturbance may add up to $2.8 trillion (see article in The Independent). Is this a big number?

The answer really depends upon what we are comparing it with. On the one hand, the cost of the crisis is about as big as the cost to the US of the war in Iraq. It represents about a quarter of the annual GDP of the US. On the other hand, the cost of the crisis is slightly larger thatn the annual GDP of China, which is not a small amount. Hamish McRae estimates that the cost of the crisis is about 7% of world GDP (see Blog), which is no small amount, but certainly looks manageable.

Once we start to compare like with like, the cost of the crisis is large enough to notice, but is also a long way from representing the beginnings of a new barter age. Perhaps we should all keep a sense of proportion to this?

Friday, 24 October 2008

The Icarus Effect

As part of a wider project, we have been reviewing recently the whole issue of the BRIC economies (Brazil, Russia, China, and India). The term BRIC was originally coined by Goldman Sachs in 2001. It was used to describe a group of nations whose development potential, if fully realised, would lead them to dominate the world economy by the year 2050. In the original formulation, to be included in the BRIC group a nation would have to experience growth in GDP of at least double that experienced by the OECD nations for a sustained period. The BRIC metaphor was quite powerful at the time. Seven years on, it is worth reviewing it to see if it remains useful.

The focus on the BRIC economies is a welcome reminder that there is a world outside of OECD. However, to focus solely upon the BRIC economies is to miss an important point. That point is what Fareed Zakaria calls the ‘Rise Of The Rest’. As an exercise if we were to make the entry criteria more stringent (growth in GDP of at least three times that of OECD), who would currently qualify for BRIC status? Conveniently, as members of OECD, Mexico, Turkey, and South Korea can be discounted. If they weren’t members of OECD, they would be BRICs. However, in addition to the four original BRICs, we might like to add Indonesia, Malaysia, Pakistan (at a push), Argentina, Venezuela, and Egypt. It would appear that there is more to the ‘BRIC Effect’ than is being experienced by the BRIC economies alone as the group of emerging nations has widened since 2001.

The development of the BRIC economies has coincided with an especially benign period of growth in the world economy. As we move into a period of weaker economic growth in the near future, the question arises of the resilience of the BRIC economies to a global downturn. The downturn is already evident in the financial markets. This year, the US stock market is down by 20.9% in dollar terms, the UK by 31.7%, the Euro area by 34.1%, and Japan by 21.4% (we like these comparative figures to be in dollar terms rather than local currency terms to capture the ‘flight to quality’). The equivalent figures for the BRIC nations are Brazil down by 28.3%, Russia down by 48.1%, India down by 45.6%, and China down by 63.7%. The BRIC financial systems have been hit harder than the OECD financial systems and one can only speculate whether, as the financial turbulence seeps into the real economy, the real economies of the BRIC nations will be affected disproportionately harder than the OECD economies.

If the BRIC economies are affected by a global economic downturn harder than the OECD economies, then the inherent flaws in each of the BRIC nations may well become more apparent. Brazil has a potential weakness in its currency. The Real now looks quite vulnerable – it fell by a fifth against the US Dollar last week. Russia is a petroeconomy that is one dimensional (energy) and vulnerable to falls in the price of energy. The Gini Coefficient in India actually rose during the years of globalisation induced rising prosperity. If that process is halted by recession, so will be the development of an Indian Middle Class. China, seemingly monolithic, may prove to be the least stable of all the BRIC nations. If growth falters in China, who will the Middle Class blame for the deterioration in their incomes and the loss of their savings? All of the BRIC nations contain elements of instability that call into question their future risk ratings.

And where does that leave us? We have a group of nations who have developed fast during a period of benign growth in the world economy. Our ‘trend blindness’ tempts us to believe that this can continue indefinitely, irrespective of global factors and the internal demographics of the BRIC nations. It has also led us to ignore ‘the rest’, who are also rising as the result of an increasing pace of globalisation. There are also a group of high income countries, such as Qatar, Saudi Arabia, Singapore, and Taiwan, who are not part of OECD, who do not have high GDP growth rates, but who do have a higher GDP per capita than the BRIC nations. We have also tended to lay aside the case against the BRIC nations in our pursuit of the case for them. As we move into a global downturn, that downside risk is likely to become more prominent. The BRIC nations have risen very high, very fast. They also have the potential to fall very far and very hard.

We call this the ‘Icarus Effect’, after the son of Daedalus, who escaped from Crete but fell to his death because he rose too far, too soon.

© The European Futures Observatory 2008

Wednesday, 22 October 2008

The Rise Of The Rest

'The Rise Of The Rest' is an issue to which we are liklely to return in the coming months. It forms the theme of Fareed Zakaria's book "The Post-American World", which is a very good read for those interested in how geopolitics are shifting.

As I was researching this issue (it forms a chapter of a book that I am working on), I came across this video on You Tube:

I found the video quite compelling, even if I am not sure about the theme. Take a look and tell me what you think.

Sunday, 12 October 2008

Naked And PPP GDP.

As a follow up to a recent post on China and the US (see post), we have been asked about the GDP calculations that we used.

There were two real candidates for the numbers to be used. The first is simple aggregate GDP in dollar terms. We have assumed dollars at 2007 purchasing levels, but this is very much the Naked Dollar approach. The second candidate was to use a measure of Purchasing Power Parity. This is a measure that takes into account the monetary difference price differences between countries. In the end, we decided to use Naked 2007 Dollars in our calculations.

We did this for two reasons:

1. People spend real $ rather than PPP$ on the world stage. As we look further into the future, we would expect relative prices to harmonise, thus lessening the difference between the real $ and the PPP $ when applied to China and the US.

2. The PPP figures are too open to political manipulation and substantial revaluations. For example, late last year, China's GDP in PPP terms was revised downwards by 40% by the World Bank (see news story). This was caused by a change in the way in which the World Bank calculates relative prices rather than anything happening in the real economy.

It is our view that PPP values are really useful in cross sectional studies at a single point in time, but that values in real currencies are better in time series because they abstract away from the issue of changes in relative prices.

© The European Futures Observatory 2008

Saturday, 11 October 2008

Why Worry About China?

I was reading a brochure for a futures conference this week when I came across an extraordinary statement. One of the presenters claimed that “China’s GDP could overtake America’s as early as 2015”. This stopped me in my tracks. The claim seems so wild that I just had to investigate the basis on which the statement might become true. It may be true that China’s economy is growing very fast, but it is growing from a very small base and that the US economy, relatively speaking, is huge. I thought that I would look into this prediction.

According to The Economist, in 2007 America’s GDP was $12.4 trillion whilst that of China was $2.2 trillion. This century, America’s GDP has been growing at an average rate of 4.5% per annum, whilst that of China has been growing at 12.9% per annum. If the US continues to grow at an average of 4.5% per annum, then China’s economy would have to grow by 28% per annum in order to reach parity by 2015. Equally, if China’s GDP continues to grow at 12.9% each year, then the US economy would have to shrink by 8% a year in order for parity to be reached by 2015. On this basis, we are more likely to be hit by an asteroid than China’s GDP overtaking that of the US by 2015.

This does beg the question of when, if at all, the GDP of China would overtake that of the US. It would depend upon the growth assumptions we make about the two economies. We put together a small econometric model to examine the implications of differing growth rates. For the US, we assumed growth of 0.0% pa (the zombie economy), 2.0% pa (the US achieves European growth rates), 4.5% pa (the US stays on track), and 6.0% pa (a miracle occurs). For China, we assumed growth rates of 4.5% pa (China achieves US growth rates), 8.0% pa (the expected rate after 2014 when the Chinese demographic time bomb explodes), 12.9% pa (China stays on track), and 15% pa (a miracle occurs).

Running the 16 pairs of possibilities (you could say the 16 scenarios), we obtained the following results:

The date in each of the cells is the point in time when Chinese GDP overtakes that of the US in our model. The results highlight two interesting points. First, when Goldman Sachs famously predicted that the GDP of China would overtake that of the US by 2025, their model was assuming average US growth rates of between 2.0% pa and 4.5% pa. More importantly, Chinese growth rates were assumed to average between 12.9% and 15.0% pa. This latter assumption seemed heroic at the time and seems even more so today.

The second point of interest is the amount of time that it would take for Chinese GDP to overtake that of the US if the US maintained or upped its game or if the Chinese game came off the boil. We are looking at a “not in my lifetime” series of results. This is not to say that we ought not to look at them, but it is to say that the contention of China overtaking the US does need to be treated with a high degree of scepticism. After all, who is to say that China, as a political entity, will last until 2040 or 2050?

Obviously the current downturn is going to affect the numbers that we used. There are also a number of additional flaws in the model. To start with, it is a linear model in a non-linear world. We also presumed a low degree of multi-collinearity. This is unlikely to be the case as both the US and the Chinese economies are highly interdependent. For example, this year, US GDP growth has fallen to zero (or less). As a consequence, China’s GDP growth has fallen to 10% (and falling, and subject to downward revision). However, even with a flawed model, we can see that the forecast of 2015 as the point where China’s GDP overtakes America’s GDP is nothing more than a wild dream.

If it is the case that China is unlikely to overtake America, then why do we worry about China?

© The European Futures Observatory 2008

Have your say. You can now have your say on this issue through the EUFO Prediction Centre. Just click on the widget below to go to the Centre. You need to be a member of Predictify to take part, but joining is free and easy to set up.

Thursday, 9 October 2008

The Sound Of Schadenfreude

If you listen carefully along the eastern shores of the North Atlantic, you will hear the sound of crows-a-cawing. This is the sound of schadenfreude (the satisfaction or pleasure felt at someone's misfortune). For decades, European nations were berated by successive administrations in the US for not organising their affairs the way that America does. Indeed, it is often claimed that one of the causes of European indifference over the Iraq War was the way in which Secretary of State Albright swaggered around the European capitals during the Clinton administration, bragging about the superiority of the way in which the US organised its economy.

And now the boot is on the other foot. The US economy is heading for ruins and is having to adopt the European model in order to save itself. Indeed, The Times claims that the Bush Administration is set to follow the British example of taking some of the US banks into public ownership (see article). In a recent post, we asked if we are now seeing the end of 'capitalism' as we know it (see post). When a neo-con president adopts a socialist policy of public ownership, who could argue against the end of capitalism as we know it?

© The European Futures Observatory 2008

Monday, 6 October 2008

Who Owns Your Friends?

Who owns your friends? ‘Nobody’, we might be tempted to answer, but that would not tell the whole story. The advent of Web 2.0 has changed the landscape of friendship and is now starting to bring this issue into focus. An interesting case (Hays –vs- Ions) came across my desk recently and gave me cause for thought. It would appear that, under certain circumstances, your friends can belong to your boss.

The facts of the case are quite interesting. Mr Ions worked for Hays, a recruitment agency based in the UK. The essence of his job was to match suitably qualified candidates to situations as they fell vacant. Networking is a key skill in this area because the successful recruitment consultant has to maintain a continuous flow of good quality candidates with a flow of good quality vacancies. As part of the job, Mr Ions was encouraged by Hays to create an account on Linked-In (a public social networking site based in California) and to develop a network of contacts through the Linked-In account.

This Mr Ions did. He did so very well as it happens. So well that Mr Ions was able to leave Hays to start his own recruitment agency in direct competition to Hays. That is where the problems began. In his new business, Mr Ions used the network of contacts that he developed whilst working for Hays, using information obtained whilst working for Hays, which Hays claims to be confidential. Mr Ions counter-claimed that the information could hardly be confidential because posting it on the Linked-In site placed it in the public domain. Unfortunately, the courts found against Mr Ions (see law report).

This has two implications that speak to the future. First, we ought to note that the action, brought in an English Court for actions that wholly occurred in England resulted in an enforcement notice served and enforced in California. Whilst the web is global in scope, it is local in impact and it is important to consider the local implications of provision on the web. This is even more important now that social networking sites can be deemed to be accomplices to defamation (see law report).

Coming back to the original question, the second implication is that your boss might own your friends. Of course, we might want to redefine what we mean by ‘friends’. Friends, as in people you go to the pub with, are unlikely to be of much interest to your boss, unless, that is, you live the high life outside of work. Colleagues and work acquaintances are more likely to be of interest to your boss. However, as the relationship is between your ‘friends’ and yourself, this social capital is unlikely to be capable of being unlocked by your boss. ‘Friends’, defined as those who you come into contact with through your work life and with whom you have ‘linked-up’ on a social networking site, are more likely to be of interest to your boss. Prior to Web 2.0, we called these people our ‘business contacts’.

This problem of definition is likely to remain as long as we use social networking sites for both our social lives and our working lives. It would be nice to be able to divide the two, but this is hoping for too much. As the greater part of the financial value of modern companies lies in the relationships created by the staff of the companies, it is unlikely that the system will become less restrictive. After all, Hays pursued Mr Ions because they believed that he had taken something of value from them.

Perhaps this urges caution on us all? It may be that, when we change jobs, we might leave with our boss owning our social network account, and thus our ‘friends’.

© The European Futures Observatory 2008

Sunday, 5 October 2008

Living Without Electricity

We recently wrote about the prospect of an electricity shortage in the UK from about 2012 onwards (see post). It now appears that we might have been a litle optimistic in our thinking. A recent article in The Independent On Sunday tells us that:

"The majority of the [nuclear] power stations are in dire trouble, and their failure is leading to the most acute concern in years that the country may run short of electricity this winter." (See article).

What are we to do? As a family, we have taken the view that energy shortages could well be a feature of our immediate future. We have installed an open-hearth fire so that we can keep warm in atleast one room. Actually, we installed it in the summer of 2007. With the way that gas prices have risen this year (up 50%), we expect the installation to pay for itself - from savings on our gas central heating - after the winter of 2009. As a precaution for the winter of 2008, we are also stocking up on candles.

Isn't that romantic? An open fire by candlelight, listening to a battery powered radio. This certainly brings some upside to a potentially dark future.

Thursday, 2 October 2008

The sun rises as well as sets!

It has been one of those weeks where there is a sense that immense changes are afoot and that we are seeing a major turning point in history. I remember seeing the Berlin Wall falling late in 1989 and knowing that the world would be different from then on. Collectively, we have the same sense today. When the House of Representatives rejected the first bail-out plan, it just became evident that the United States had reached a central turning point in its history. What comes next is a matter of conjecture that futurists are currently debating. A more pressing question faced by a more general public is when are these horrible days going to end?

An interesting clue to the way out was placed before us last Tuesday. Circumstances forced me out of bed much earlier than could be called respectable. This gave me the chance to watch the afternoon trading in the Far East. On Monday, the US markets fell by 7%-8%. The Far East responded by falling by 4%-5% in morning trading. However, by lunch time, buyers entered the markets to leave the markets down only 2%-3% on the day. This wave of buying rolled across to Europe (FTSE 100 up 85 points on the day) and then on to America (the Dow up 485 points on the day). All in all, the losses were starting to be clawed back.

It is interesting to consider why this might be. Reports so far indicate that value investors (those who buy when good quality assets are priced at an unreasonably cheap level) were coming back to the market to snap up bargains. Indeed, Warren Buffet (the biggest value investor in the world) entered the market last week to buy $5 billion worth of equity in Goldman Sachs. As an example from the UK, the commercial bank Lloyds TSB was trading at a dividend yield of about 15% (i.e. three times the rate of retail deposit accounts) earlier in the week. If the bank’s balance sheet is as robust as it appears, if it can maintain an acceptable profitability, if it fares well in the downturn, and if it can maintain its dividend, then we can readily see why investors are considering the stock cheap and buying them.

This is all very promising. We are now seeing weak signals that indicate that the worst might be coming to an end in the financial markets. The prospects for the ‘real economy’ continue to be bleak for the next few months, and a lot of hardship has yet to be felt, but at least we can start to see a way out of the crisis. There is still scope for us to be blown off course. There is still the possibility of our political masters doing something silly, which will only prolong and deepen the downturn.

The probability of political mistakes in Europe is low and falling. Over the weekend, the UK authorities handled the collapse of Bradford and Bingley (a UK mortgage bank) and the European authorities acted decisively to shore up Fortis (a commercial bank with extensive interests in the Benelux countries and France). The monetary authorities in Europe are starting to appear to be up to the job of handling the crisis. Christine Lagarde (the French Finance Minister – France currently presides over the EU) looks particularly masterful. Even Gordon Brown has started to look as if he knows what he is doing! This appearance has substance; a model has now developed to allow the monetary authorities to manage the crisis.

The same cannot be said across the Atlantic. The House of Representatives voted against the first Bush Plan, the Senate has voted for the second Bush Plan. Perhaps this reflects that the Representatives are closer to main street USA, whilst the Senate are closer to the international partners of the US? This story still has some way to run, but one thing is clear – the credibility of the US Government as an international partner has been damaged. If the US is perceived as an unreliable partner, then it will have to pay a risk premium in future dealings. And this really brings us back to where we started – the long term impact of this crisis.

At present, the jury remains deadlocked. Events suggest that the current downturn could be of a temporary nature. It could be that the long decline over the past ten years could be reversed and the fortunes of the US improve. However, it is also possible that the US is locked in a long term decline and that the current crisis is just one more milestone on the downward path. What is becoming evident is that the weaknesses and flaws in the American system of government are increasing the likelihood of long term permanent decline. When nations across the world are seeing politicians pulling together in acts of national unity, the US still retains its partisan politics. If this hypothesis is correct, then the House of Representatives rejecting the first bail-out plan would mean that the United States had reached a central turning point in its history.

It is up to the politicians to choose whether to experience the sun rising or setting.

© The European Futures Observatory 2008