Sunday 10 October 2004

Pic of the day: Not much customers around here these days. (Screenshot from Sims2.)

Economy and trust

At its core, all trade is based on trust. If not directly in the one you trade with, then in a higher authority that will take action if your trading partner does not honor his obligations. At the simplest level of barter, the only cheating possible is outright faking the nature or quality of the goods traded. But with an ever more complex economy, there are ever more opportunities to weasel out of one's obligations.

In daily life, this is usually not a big concern. Well, when buying a new home it is, and people typically spend some time making sure all relevant facts are on the table, or that there is some kind of legal recourse if things are not what they seem. To a lesser degree you will do the same when buying a car.

But what do you do when you come to international trade? For most of us, this is limited to shopping while on vacation or ordering books from the UK (if we are Norwegian) or Viagra from Canada (if American). But what about the really big deals, where the nations themselves trade in large quantities of strategically important goods, services or knowledge?

The same rule applies there, except there is often not a higher authority to call your partner on his misdemeanors. Trust is of the essence. And it does not only apply to contracts between governments. Even corporate deals across borders depend on some trust in the governments of the countries. For instance, if one of them decides to debase its currency by letting the printing press run, it will hurt all who have claims in that currency. And if a country is borrowing so heavily that it may in the future not be able to pay its bills, its currency becomes basically worthless.

Unthinkable as this has been for the last couple hundred years, this could conceivably happen to the sun on the business sky, the rock in the ocean of trade, the lighthouse of market economy, the United States of America.

***

Over the last decade and more, private savings have been shockingly low in the USA. Normally people save up some money in one way or another. The most obvious is middle-aged people saving for retirement, and you would expect there to be a lot of that right now with the baby boomers passing through their most affluent years. But such saving will be reversed once people reach retirement age, unless they overshoot and die with money left. (By far most people do that, because by far most people are taken by surprise by the shortness of their life. There is a lesson in this, but probably not a lesson of economy.)

There are also less obvious means of saving, such as getting a larger home or upgrading the one you have. While many capital goods degrade over time, the lifetime of a home tends to far exceed that of its owner, and therefore much of the home improvement counts as saving.

But all these things considered, the American families on average have saved very little. It is still more than nothing, but only barely. During the Long Boom, this was partly compensated by public saving: The famous budget surplus, which famously has been reversed during the current government. By now, both the government and its citizens are both plummeting into debt. The private savings are not enough to tide the people through their future expenses, if life expectancy is anywhere close to today's standard. The government won't be in a position to help them out, or indeed pay its civil servants if things continue down this road long enough.

A main reason for this conundrum is the seemingly reasonable idea that you get richer when your house becomes more expensive, or when your shares rise on the stock exchange. This is true in so far as you have the good sense to sell these objects while their price is high, and stow away the money in some safe form. Some people actually do this. Most don't, but still feel rich. They borrow against the higher value of their property, and spend the money. And then some: A recent poll showed that American consumers expect housing and stock prices to increase by double-digit levels (at least 10% a year) for the foreseeable future. This is horribly optimistic. And in fact it would be a disaster if it came true.

As most of you have noticed -- even those who don't play Sims2 – kids grow up and eventually need a home of their own. If, in the meantime, housing prices have risen with 10% each year, they won't be able to afford a home. It's not like wages rise by 10% a year; in fact, lately they have stayed mostly put. Remember that the price increases are cumulative. Say a small town apartment costs $100,000 when this process starts. After one year, it costs $110,000. After two years, $121,000. After 5 years – the time it takes to get a decent college education – it is up to $161,051. There is no way the kids can magically raise the money needed to follow this upward spiral. And the parents can't help out unless they sell their own home ... well, they could take out a mortgage, but they already did that and spent it all on fun things.

So unless there is somehow created value, prices cannot continue to rise, or people will no longer afford the objects. A productivity growth of 3% a year is considered impressive; it goes without saying then that not everyone can get 10% richer if there is only produced 3% more value. Something has got to give.

***

The US Treasury is also selling "bonds", basically it is borrowing money. Here in Norway, where state and nation are one and the same, we refer to these bonds as "statsobligasjon", which I trust needs no translation. Basically the treasury is obliged to buy these papers back at a later date at a certain price. The interest paid on these bonds is one part of setting their price, another is the risk of the government not honoring their obligation. In the case of third world countries, that's a pretty important consideration. With the USA, this used to be of no concern. China has been buying heavily in these bonds, thus freeing capital in the USA to import more goods, not least from China itself. And after all, they will get their money back when the time limit of the bond expires. Well, this has been assumed until now.

Now economists and investors are beginning to toy with the idea that the USA might, conceivably, at some future date, default on its debt. And this worry is what makes it highly unlikely, almost impossible, that it will actually happen.

When a country goes into bankruptcy, it is normally because of a system shock such as a revolution or an overwhelming disaster. In this case, its currency becomes worthless overnight. If you know beforehand that this will happen, you won't sit on the worthless paper formerly known as money, when that day comes. You will have sold it all, along with any bonds that will be repaid (or not, as the case may be) in that currency. When more and more people try to sell a specific currency, its value slides compared to other currencies. This is "currently" happening to the US dollar.

Of course, no matter how bad things look, something good might happen. Some bored hiker could find the world's largest zirconium deposits in the desert. A medical breakthrough might lift people with Bush-level intelligence to Einsteinian levels, without brain cancer taking hold after two weeks. Traders from Alpha Centauri might land in Peoria and make it an interstellar trading nexus. OK, not likely, but as long as there is life there is hope. The further away the disaster, the more likely that something good might happen first. Americans may even repent and take up a simple, honest, hard-working lifestyle, paying their bills on time. (Though I would rather bet on the Centaurians.)

The net effect is that the slide of the currency is gradual. The dollar is a little less worth tomorrow than yesterday, and a lot less worth ten years into the future. But the marvel of the market economy, the invisible hand and whatnot, is that such things have consequences. As the currency gets weaker, imports get more expensive. People import less and use more local products. At the same time, exporting gets easier. This is just what the doctor ordered! If it is allowed to work long enough, it will eventually reach a balance where it is not necessary to slide any longer. The new trade balance means the country can afford to pay its debt after all!

But all things have a price. When imports get more expensive, people will have to do with less of them, or use something of lesser quality. Likewise, the local products they buy instead of the imports are probably not as good, or they would already have bought them from the start! So the standard of living declines, as people have to live with less of the things they want.

However, all is not darkness and pain. If there is still the usual productivity growth, let's say 3% a year, then this might be enough to compensate for the slide of the currency. At first a loss of growth is almost as painful as shrinking, but you soon get used to it. The country comes to a kind of standstill, like Japan did during the 1990es. It is not like you are stuck with your 10 year old fridge: You can still buy a new fridge, but it will be no better than the previous was 10 years ago. Of course, some things get better anyway (like computers) while other things grow scarce (like imported luxuries).

So this is the paradox: The more the world distrusts the economy of a country, the better its chance of surviving the troubles ahead, as long as it starts early enough.

I would say the USA has already started. The dollar is softly sliding, wages have come to a near standstill, and trading partners are getting cautious. This is all good. Now the housing bubble has to be burst in the kindest, gentlest manner possible; Alan Greenspan and the Federal Reserve are already working on this, by gradually raising interest rates. The Fed is feeling its way trough the marshy economic terrain, but it might still go reasonably well. Perhaps. If we don't expect too much.