Saturday 19th April 2008: Economic volatility is INCREASING, not decreasing!
Gold is still in consolidation mode, so instead, some thoughts on the state of the economy.
I listened to Jim Puplava interviewing Louis Vincent Gave from Gave-Kal research a few weeks ago. Last time I heard a Gave-Kal interview I didn't agree with much that the guy said. This time, I started off agreeing with him, but when I thought more about it, it didn't really make sense to me. I thought the guy had some good points and it seemed to be self-consistent but quite didn't ring true to me. Maybe I'm wrong! I kind of hope so. He seemed excessively optimistic on the current state of Western society. Of course, others may be excessively pessimistic, saying the world is going to end as we know it. There are others who will say that the world is going to end, period.
The Gave-Kal argument seemed to go along two main lines :-
1. Agricultural economices are volatile, i.e. subject to the whims of nature, weather, drought, floods, etc. So people have to save a lot of their income and they are poor to start with anyway. In an industrial manufacturing economy, volatility is less; the economy and day-to-day life are more stable. You can assume you get paid given amounts of wages at given intervals but in economic downturns you can lose your job, etc. The argument then went that post-industrial or 'service' economices are even less volatile, so people feel the predictability of income and cashflow is greater, and they can save less and even borrow money based on expectations of future income. He thinks this is where we are at now in the USA and possibly Europe, and the G7 type 'rich' nations generally. He thinks that since the Chinese are moving from agrarian to industrial economies, volatility is decreasing there too, although it is still more volatile than we have it in the West, i.e. they are one stage behind the West.
2. The argument came up in both Gave-Kal interviews that the West has an inherent advantage over China for example in that it is mostly Western companies that are industrialsing China by moving their factories over there and therefore most of the profits from China's industries find their way back to the West (for this, read the USA). LVG gave the example of a $500 computer that has $250 profit for the computer company (US owned) and $50 profit for the local Chinese industry. This was an argument that we are making most of the cash from the China growth story and they have the raw end of the deal. Possibly true, but what about the counter-agruments?
As Andy Looney would say on financialsense.com, "Do you buy these arguments? I don't." They sound rather like US-centric hubris to me. Who said that service economies are less volatile? Sounds good but how can it be true? Sure, healthcare is not so volatile, especially if we have lots of savings to draw down but what about when the savings run out and it cannot be funded by insurance, governments or individuals? We have fewer industrial workers so naturally we might get more jobs in healthcare, while the money lasts. Other service industries, tourism, air travel, retail stores, hairdressers, media. Aren't they saturated right now and have they not been subject to the advantages of ultra-cheap oil and other fuels throughout the 1990s?
With low costs of manufactured goods and low costs of transportation, the 'importing cheap from Asia game' has served Western retailing very well, with the opportunity for high margins. It has also served the Western consumer, increasing prosperity due to its deflationary weffect on retail prices - we are getting more for our money. However, there could be a tipping point where job losses to China depletes Western wealth and that effect could exceed the nice effect of the low consumer prices. This opportunity for high retail margins is being reduced today, when the oil price is surging and the consumer is getting squeezed by debt interest burden. Tourism, entertainment, fashion and such things are also seasonal and discretionary, so they are volatile. So is retailing to some extent. If you run out of money, are you going to buy some food or go to the hairdresser for a fancy styling? So who is subject to more volatility, the hairdresser or the farmer? The farmer can always make a futures or options trade on the commodity markets to hedge the volatility in harvests or grain prices - but you can't get a futures contract in haircuts! I see the possibility that the margins squeeze between raw material inflation, Western currency devaluation and lower consumer spending power could kill retail and all the other middleman industries.
The other thing the guy didn't mention was that a $50 profit in China probably buys as many goods and services as the $250 profit logged in the USA. And what about the other costs, the other $250 - the 'cost' of making the thing? Surely that goes in to the raw materials, the transport, the factory wages, etc. Much of that would be money going from the retail purchaser in the USA into the Chinese economy or to commodity producing countries (including OPEC oil producers) - and to pay the factory workers and for the building of the infrastructure in China.
Of course, this could work both ways - a ceasing of this abitrage of cheap manufacturing in China (which may be starting, as the allow their currency to rise against the US dollar, a process that started 3 years ago and is gradually accelerating) could lead to the $50 profit disappearing from China as the $250 profit disappear in the US, with equal damage to both countries, i.e. everybody loses and the Chinese don't escape the effects of a US recession or depression. The incredibly intelligent investor Paul van Eeden has pointed out that China may not escape the US downturn, probably partly for the abover reason but in his view mainly because the Chinese GDP is still a lot lower than the US GDP and a 1% fall in US GDP translated over to China might produce a 5-10% drop there.
Another surely important factor that is a disadvantage to the West is that that all this infrastructure has been created in the East and demolished over in the West. And on the transfer of technology and skills in that direction, too. Once occupied Japan had been making goods for the US market after World War II for a decade or so, there came the ascendancy of those manufacturing industries into designing and making their own invented and developed products - and gigantic Japanese industries and companies were born that still exist today and are world leaders. The same is possible for China in the future. The technology and infrastructure transfers are one-time events, to the advantage of whom? China put men in space recently, the first one was sent up while the USA was catching lifts on Russian Soyuz rockets to the International Space Station! What happens then, in a future war situation when manufacturing capability needs to be ramped up rapidly and adapted to produce large numbers of weapons and vehicles? Er, we lose! The Iraq and Afghanistan wars were not won in 21 days with US technological advantage - in fact, they were not won! They are still going on and need manpower, fuel and 'gear' in huge amounts. Technological leadership is no guarantee of victory; it's not enough. And who says that US technological leadership will last or has lasted?
I personally believe (and I don't have much to substantiate it) that the post-industrial service/financial economy is likely to be merely a transitional phase, not a lasting thing. It may mark the transition between wealth and poverty. From riches to bankruptcy. It coincides with the drawing down of the savings of Western nations to nothing. A great opportunity may come soon for the dollar-rich Arab oil exporters and Chinese/Japanese gadget exporters to buy up much of the West at knock down prices, to get rid of their depreciating dollar earnings and buy something real, perhaps to buy natural resources and that 'best' US technology for their own use!
Yet another factor is that the 'original' Industrial Revolution took place in the period of a metallic monetary standard with highly stable currencies: either a bimetallic standard as in the USA before 1873 or under a gold standard as in the USA post 1873 and the UK post 1817 (well, much of Europe had gold and silver money in various forms from the time of the Greeks and Romans 2000+ years ago). This resulted in the lower economic volatility. If you then look at the time since the inception of the Federal Reserve in 1913, the first ending of the Gold Standard in England in 1914, the final endings of the Gold Standard in England in 1931 and the USA in 1933 and the final and complete depegging of the US dollar from gold for international transactions in 1971 (phew), we have faced ever-increasing volatility in the markets, except perhaps for 'stability' engineered by direct government intevention in the financial markets. Please take a look at my earlier post about the Dow-Gold ratio and the accompanying chart. The ratio between the value of the stock market and gold has oscillated wildly since the early 1900s in a pattern resembling a positive feedback type loop with increasing amplitude; that is, increasing volatility, with a period of 30-40 years, perhaps reflecting the 60-70 year Kondratieff cycle, with half the period.
Therefore, the markets have less and less idea of the value of anything, it seems. The Dow:Gold ratio has been 1:1 (1980) and it has been 43:1 (2000). This is ridiculous! How can there be so much uncertainty? This is part of the reason we have had the Internet stock market bubble and the absurd housing bubble recently, together with interest rates set by central banks ranging from 0% to 20% in the time between 1980 and 2008. Evidently, in our fiat paper money system, real values are becoming incalculable. This creates tremendous malinvestments in the economy as there is overinvestment in one sector followed by a crash and then overinvestment in another sector. Who benefits? Of course, whoever is moving the money around and taking commissions benefits! Also, those who can read the trends could benefit by timing investments and switching between stock, bonds, housing and commodities at the right times. However, the benefit does not go to any productive citizens. This is probably the number one reason why the rich get richer all the time - and of course it is fuelled even more by monetary inflation, because they can benfit by investing their high disposable income, whereas the working class and middle class cannot (they don't have any)! It is insane. In the longer term view, we are therefore surely in a period of greatly increasing volatility, not decreasing volatility!