Good Layman's guide to the financial crisis

[Fuchs]

How can you have an industrial recovery while consumption falls? What do you propose to do with that increasing industrial output?

You can't look realistically at the US trade deficit without looking at artificially inflated value of the dollar that prevailed during the half century or so after WW2. These distortions tend to have an impact.

In any event it is easy to issue declarations about what the US needs or does not need to do. Developing policies to move a nation in such a direction is a good deal more difficult. Economies don't move by executive fiat.

Investment in industrial capital stock. Paying back debt with trade balance deficit.

The deficit stands, excuses don't help. A weaker dollar would make imports more expensive (thus less) and exports cheaper (thus more).
The end effect is a move towards balance and sustainability, but it also means LESS CONSUMPTION (less goods flow in, more goods leave = less to be consumed inside). Again, no cure for the illness can be built primarily on higher domestic consumption.


The problem is huge and structural. It would probably take two decades of determined policy to defeat the problem.
A necessary ingredient of any such policy is to destroy the myths that contributed to the problem; such as the "more consumption solves our economic problems" nonsense.
Equally important is to understand the role of actual investment (not what the business elite thinks is investment; financial deals, mergers & acquisitions...). You need a higher savings rate (=less consumption) to afford more investment in additional or improved industrial capacity (and infrastructure). That will lead to the production capacity that's necessary to actually justify and sustain the actual goods consumption.

A proper understanding of the importance of macroeconomic investment includes a proper understanding of the role of for example the military expenditures as unproductive state consumption. The large military doesn't help the economy; it bleeds it dry and corrupts some industries. Have a look at the extremely crappy shipyard sector. It's a joke.

The same applies to the cancerous financial sector, the overly expensive intelligence community and many, many other significant distractions from industrial performance.


Modern Western societies are rip-off societies. Groups attempt to rip off all other groups, some succeed spectacularly and others don't. The rich people and the financial sector as well as certain lobby groups (such as farmers) tend to do spectacularly well.

This ripping off is a deviation from an optimal, functioning society. It pushes our societies into unsustainability (erodes the middle class and industry) and needs to be countered.
The U.S. and UK were especially lax on the financial sector and cultivated it as a giant leech instead, misunderstanding its size for a sign of prosperity.

Germany is different; our financial industry leadership is by comparison not very powerful despite the questionable behaviour of the current government with Deutsche Bank CEO Ackermann.
Our industry - especially the middle-sized companies (SME) - is very influential, and the share of industry at the GDP is by half greater than in the U.S.. The result is a huge trade balance surplus instead of deficit (this imbalance was roughly doubled by the Euro currency which is undervalued for us).

[tequila]

Note: both German and Japanese industrial models are entirely based on the existence of trade surpluses with the rest of the world - they depend on our consumption to drive their own prosperity. A German preaching the moral deficit of overconsumption to the American is a bit like a drug dealer preaching to the addict about the moral efficacy of just saying no. Martin Wolf has been on fire about this for awhile - sorry Fuchs, but German sanctimony on this point is a bit rich.

Surplus countries insist on continuing just as before. But they refuse to accept that their reliance on export surpluses must rebound upon themselves, once their customers go broke. Indeed, that is just what is happening. Meanwhile, countries that ran huge external deficits in the past can cut the massive fiscal deficits that result from post-bubble deleveraging by their private sectors only via a big surge in their net exports. If surplus countries fail to offset that shift, through expansion in aggregate demand, the world is inevitably caught in a “beggar-my-neighbour” battle: everybody seeks desperately to foist excess supplies on to their trading partners. That was a big part of the catastrophe of the 1930s, too.

[slapout9]

Note: both German and Japanese industrial models are entirely based on the existence of trade surpluses with the rest of the world - they depend on our consumption to drive their own prosperity. A German preaching the moral deficit of overconsumption to the American is a bit like a drug dealer preaching to the addict about the moral efficacy of just saying no. Martin Wolf has been on fire about this for awhile - sorry Fuchs, but German sanctimony on this point is a bit rich.

Yep, I would add China to. It's called Mercantilism and is the root cause of all International trade problems.

[Fuchs]

You're patently wrong about German exports depending on U.S. consumption because said German-U.S. exports are too small.

On the other hand; sure, a large trade balance surplus is just as stupid (albeit not as dangerous for yourself) as a large trade balance deficit. The German public needs to get rid of a package of its own myths and legacies as well. These necessities are very different than the U.S. necessities, though.

Now let's think for a while why some produce surpluses and others produce deficits. The problem is called competitiveness.
Exchange rates are only a part of this competitiveness. Germany did not cheer the "post-industrial services economy" for a generation. It still cheers its SMEs and their competitiveness. In fact, we underwent a series of painful industrial competitiveness-increasing reforms while we produced major trade balance surpluses. Our education system is trimmed for a huge output of skilled industrial labour and university graduate engineers.
We aren't on a shopping spree, but on a savings & industrial production fixation.

In the end, the reduction of imbalances in world trade will be painful for countries like U.S., UK, Greece, Italy and look very much like a phase of great wealth to countries like Germany, Japan, PR China (because balancing a trade balance surplus means to increase domestic consumption).


You had your consumption party, it's over. The U.S. may pretend that a return to its old ways is possible, but that will only provoke the inevitable next and extremely painful crisis that finally dispels the deficit & consumption myth because it will wreck the remaining U.S. industry beyond denial.


The population of the USA PRODUCED ABOUT 18.25 % LESS GOODS THAN IT CONSUMED AND INVESTED in 2008 (and this counts the service balance surplus as "goods produced" to be fair).
The monthly trade balance deficit was crunched to half in the crisis and is already recovering almost to the pre-crisis level.

[Dayuhan]

Herr Fuchs…

I asked:

How can you have an industrial recovery while consumption falls? What do you propose to do with that increasing industrial output?

And you replied:

Investment in industrial capital stock. Paying back debt with trade balance deficit.

I think this reveals a certain lack of comprehension about how business – not economics, but business – functions. Investment in capital stock doesn’t happen because some beady-eyed economic policy gnome decides that it ought to happen. It doesn’t happen because a government decides that investment in capital stock is desirable. It doesn’t happen because society decides to applaud investment in capital stock. It happens because individuals or companies with the capacity to invest determine that an opportunity for profitable investment exists. Decreasing consumption does not present an opportunity for profitable investment, because you don’t profit from your investment unless somebody somewhere buys the products or services that you invest in producing.

There is no choice between consumption and production because you can’t have one without the other. If production exceeds consumption, inventories rise. When inventories rise to a certain point, factory orders cease and production stops. Factories don’t produce goods because society esteems production, they produce goods because they have orders for goods… from consumers, or from people who believe they can sell the goods to consumers.

Our industry - especially the middle-sized companies (SME) - is very influential, and the share of industry at the GDP is by half greater than in the U.S.. The result is a huge trade balance surplus instead of deficit (this imbalance was roughly doubled by the Euro currency which is undervalued for us).

Confusion of cause and effect. German industry isn’t strong because SMEs are influential, SMEs are influential because German industry is strong. As you point out, this strength is supported by a favorable currency environment. The US economy didn’t assume its current shape because of policy decisions, it assumed it because an artificially overvalued currency created a long term disincentive to domestic production of goods.

You're patently wrong about German exports depending on U.S. consumption because said German-U.S. exports are too small.

Exports depend on foreign consumption. Part of this is the US, part is other places… but if German consumption is constant, German production cannot increase unless overall consumption increases or German goods take market share from other producers in other markets (meaning production somewhere else has to be reduced).

Exchange rates are only a part of this competitiveness. Germany did not cheer the "post-industrial services economy" for a generation. It still cheers its SMEs and their competitiveness. In fact, we underwent a series of painful industrial competitiveness-increasing reforms while we produced major trade balance surpluses. Our education system is trimmed for a huge output of skilled industrial labour and university graduate engineers.

Again, you confuse causes and effects. People don’t invest because they want to be cheered, they invest to make money. Societies will cheer whatever gets results, which is conditioned by the macroeconomic incentive environment. If your currency exchange rate favors export production, export production will succeed and people will cheer it. If your exchange rate environment penalizes exports and subsidizes imports, domestic production will falter, it will not attract investment, and nobody will cheer.

The problem for the US has been that because the dollar is a global currency, both produced and consumed outside the influence of US policy, the ability of policy to influence monetary factors is severely constrained.

I think you drastically overestimate the ability of policy to control economic factors, and the ability of government in a democratic society to develop policies that may not be found congenial by the voting public. It’s terribly easy to make pompous declarations about what the Americans or Germans or Chinese or anyone else should or must do. Influencing them to do it is rather more complicated.

[Fuchs]

Herr Fuchs…

I asked:



And you replied:



I think this reveals a certain lack of comprehension about how business – not economics, but business – functions. Investment in capital stock doesn’t happen because some beady-eyed economic policy gnome decides that it ought to happen. It doesn’t happen because a government decides that investment in capital stock is desirable. It doesn’t happen because society decides to applaud investment in capital stock. It happens because individuals or companies with the capacity to invest determine that an opportunity for profitable investment exists. Decreasing consumption does not present an opportunity for profitable investment, because you don’t profit from your investment unless somebody somewhere buys the products or services that you invest in producing.

Answer I

There is no choice between consumption and production because you can’t have one without the other. If production exceeds consumption, inventories rise. When inventories rise to a certain point, factory orders cease and production stops. Factories don’t produce goods because society esteems production, they produce goods because they have orders for goods… from consumers, or from people who believe they can sell the goods to consumers.

Answer II

Confusion of cause and effect. German industry isn’t strong because SMEs are influential, SMEs are influential because German industry is strong. As you point out, this strength is supported by a favorable currency environment. The US economy didn’t assume its current shape because of policy decisions, it assumed it because an artificially overvalued currency created a long term disincentive to domestic production of goods.

Answer III

Exports depend on foreign consumption. Part of this is the US, part is other places… but if German consumption is constant, German production cannot increase unless overall consumption increases or German goods take market share from other producers in other markets (meaning production somewhere else has to be reduced).

Answer IV

Again, you confuse causes and effects. People don’t invest because they want to be cheered, they invest to make money. Societies will cheer whatever gets results, which is conditioned by the macroeconomic incentive environment.

Answer V

If your currency exchange rate favors export production, export production will succeed and people will cheer it. If your exchange rate environment penalizes exports and subsidizes imports, domestic production will falter, it will not attract investment, and nobody will cheer.

The problem for the US has been that because the dollar is a global currency, both produced and consumed outside the influence of US policy, the ability of policy to influence monetary factors is severely constrained.

Answer VI

I think you drastically overestimate the ability of policy to control economic factors, and the ability of government in a democratic society to develop policies that may not be found congenial by the voting public. It’s terribly easy to make pompous declarations about what the Americans or Germans or Chinese or anyone else should or must do. Influencing them to do it is rather more complicated.

Answer VII

Answer I:
I don't misunderstand anything here. You think of a closed economy, I think of an open economy. The closed economy is the model for beginners.

The U.S. has a trade balance deficit that exceeds a sixth of its industrial production. It could easily have four huge growth years with frozen domestic consumption without even getting rid of its trade balance deficit.

The "consumption drives the economy" myth is extremely powerful, especially in combination with cognitive dissonance. People can be exposed to the fact that the U.S. industry has gone downhill for three decades and still believe in U.S. ways of developing the industry. Amazing.


Answer II:

You completely ignore investment and export. Production output moves on hold, into consumption, into investment or into export.

You forgot half of the channels, and the result is no understanding a tall.

Answer III:

You overestimate the influence on exchange rates. It's not an excuse and explanation for everything. The simple fact that all countries still export even at unfavourable exchange rates hints at the complexity.
I as a German economist are well-entitled to claim to know better about the importance of the German SMEs. Most research about them was never published in another language than German. These either very old family businesses or 1950's origin companies are way more efficient and at the same time much more long-term oriented than the big corporations. They are superior and the backbone of the German industry. We didn't allow them to be ruined by larger corporations or banks.

Answer IV:

Now you're looking too much on the national level. Export is also a business thing, and individual businesses can very well gain additional market shares and turnover on markets with "constant" consumption.
Your point is therefore completely wrong.

Answer V:

"People" rarely invest at all. Companies do most investments. "People" consume and save.

And "people" don't just save because they want to make money - that's just one explanation. Much is being saved as a precaution against risks, much is being saved for buying a house, life insurances, buying a car, pensions and in some countries even things such as being able to afford university for children.

Answer VI:

You do again use exchange rates as a simple explanation / excuse. It's not the only problem.

You're also wrong about the "attract investment" thing. For one, many if not most direct investments are for marketing purposes. Trade balance deficit countries therefore experience much foreign investment. The U.S. does experience much foreign investment. The problem is that the savings rate of the U.S. is close to zero and therefore the U.S. itself does not contribute to substantial domestic net investment.

Answer VII:

Competent politicians with guts can influence the economy very much. Disunity of top politicians can lead to political impotence, but the state itself is extremely powerful. It's the ultimate power in regard to the economy - the politicians merely need to decide to use that power. Those politicians who claim that the state cannot set the direction for the economy are incompetent or liars or both.
The U.S. could pull itself out of the mess in two decades, maybe even just one if the policy is very unusual.
There are thousands of levers to be used, and new instruments can be introduced. The laughable trajectory and result of the health care debate shows the real problem, and probably explains why you don't believe that policy can change much: The U.S. political elite and the political system is dysfunctional.

The same is true in Greece, Italy, Iceland, Poland and several Eastern European states.
The German political elite is dysfunctional as well, but only so if you have above average expectations.

[Dayuhan]

The U.S. has a trade balance deficit that exceeds a sixth of its industrial production. It could easily have four huge growth years with frozen domestic consumption

This is really an extraordinarily bizarre statement. How is the US supposed to “easily” have four huge growth years with frozen domestic consumption? Where are all the products of this industrial production supposed to go?

Of course I know about open systems, everyone does. I also know, as does anyone paying attention, that in this case it doesn’t make any difference at all. There are only three things that can happen to the goods you propose to produce. Either they are sold domestically, or they aren’t sold at all, or they are exported.

If we assume frozen domestic consumption, the only way increased domestic output will be sold domestically is to take market share from other locally produced goods or to take market share from imported goods. The latter is an attractive option on paper, but barring self-destructive protectionism it isn’t likely to happen in the real world, unless the US suddenly discovers some miraculous and hitherto unknown competitive advantage.

Not selling product isn’t an option: the factory won’t have revenue and will be unable to cover its costs.

But of course it’s an open system, and we can export… if you’re an ivory-tower economist with no connection to real world constraints. Realistically, who is going to buy the stuff? For the US to export its way into “four huge growth years with frozen domestic consumption” there would have to be either an extraordinary increase in global consumption or US goods will have to seize market share from somebody else’s goods. Again, this would require US goods to US to suddenly discover some miraculous and hitherto unknown competitive advantage.

The export “solution” doesn’t exist, outside the realm of theory. Individual businesses will be able to find or create niches and increase market share. Other individual businesses will lose. On a larger scale, driving up US exports to the level you’re discussing is simply not going to happen. If US goods were export-competitive this situation wouldn’t exist in the first place. Classic example of the old economist joke… “assume a can opener”. You might get a competitive US export economy if you could drop the dollar another 30% and wait a couple of decades for previous distortion to unwind… but the US doesn’t even have an effective way to control the value of the dollar, which has become a global currency and is not fully responsive to US policy.

At the end of the day you can talk all you want about investing in capital plant and boosting industrial output, but you can neither compel nor persuade companies to invest in capital plant that aims to produce goods that the investors don’t believe they can sell.

Then of course you get into policies designed to increase competitiveness… but these take time, and most of the ones recommended offer a whole range of side effects and potential unintended consequences, many of them unpleasant.

You overestimate the influence on exchange rates. It's not an excuse and explanation for everything. The simple fact that all countries still export even at unfavourable exchange rates hints at the complexity.

What other country has to cope with having its currency used as the medium of international trade, completely divorcing demand for currency from domestic economic conditions or domestic policy? What other currency has had to cope with 40 years or so of being the world’s default medium for investment? There hasn’t been a currency as radically overvalued as the dollar since the British Pound of the late imperial era… and the US doesn’t have an empire to shove its goods on.

These distortions can be managed up to a point, beyond which the impact becomes overwhelming and they start to control the direction an economy takes. Why do you think the Chinese are so determined to suppress the value of their currency? Because it matters. It may not be the ony factor, but it’s the herd of elephants in the drawing room.

The U.S. could pull itself out of the mess in two decades, maybe even just one if the policy is very unusual. There are thousands of levers to be used, and new instruments can be introduced.

Possibly you should consider revealing them. We wait with bated breath.

[slapout9]

Possibly you should consider revealing them. We wait with bated breath.

I would like to see some of this new stuff myself.