Saturday, May 5, 2018

  American voter ignorance of the fire sector
  puts the U.S. real economy constantly at risk
  as China acts to provide for its next generation

As we discussed in the first post of this series, ignorance of economics is not bliss but rather exposes the children and grandchildren of the ignorant to "black Misfortune's baleful train!"

Bill Clinton adviser James Carville famously coined as a campaign strategy for the 1992 Presidential Election “The economy, stupid,” a phrase that stuck in the minds of politicians since that time. Yet, despite its frequent repetition, it is an empty phrase that offers advice on how to get elected but no good advice for government action regarding the economy.

Since then regarding the economy, while corporate giants focus on yesterday's earnings American politicians and government have become even less effective at providing for your children and grandchildren.

In the case of 21st Century economics, meaningful new terminology has entered the discussion including:
  • Black Swans
  • Gray Rhinos
  • shadow banking
  • the real economy
  • the fire sector
In the 21st Century if you...
  1. believe in democracy, 
  2. live in a democratic nation and participate in elections, and 
  3. want your children and grandchildren to be able to live in at least a “moderately prosperous society,” 
...then you must know enough about these terms to determine if who you are voting for wants that for your children and grandchildren.

Let us begin with the Black Swan/Gray Rhino, terms which conceptually derive from the commonly used "elephant in the room."

The Baleful Spectres of The Black Swan and The Gray Rhino

Economic theory today has incorporated the concepts of Black Swan and Gray Rhino events. Using the black swan and gray rhino as metaphors for threats to the one's well being somehow seems Asian to an American. Indeed, the Chinese government embraced the terms Black Swan and Gray Rhino in a front-page editorial in the official newspaper, China Daily, on July 17, 2017, which said:

    Since the 18th National Congress of the Communist Party of China in late 2012, the top leadership has attached great importance to guarding against financial risks and taken a range of financial regulatory measures to bring financial risks under control in China.
    Given that the [financial] sector is susceptible to any uncertainties, acute risk awareness is needed. Precautionary measures should be taken to prevent not only "black swan" but also "gray rhino" events, and any measure introduced should achieve tangible effects.
    China should better control the "chief valve" of credit to defuse a financial risk at the source. At the same time, it should improve its emergency response mechanism and put in place a set of complete contingency measures to preempt and address liquidity risks, credit risks, the risk of shadow banking business, abnormal capital market fluctuations and real estate bubbles. It should also better supervise emerging online financial products and services, which have largely fallen outside the current supervisory system.

Black Swan events were discussed by Nassim Nicholas Taleb, a Lebanese–American essayist, scholar, statistician, former trader, and risk analyst, whose work and 2001 book Fooled By Randomness focus on problems of randomness, probability, and uncertainty.

Based on the Taleb's Black Swan event criteria:
  1. The event is a surprise (to the observer).
  2. The event has a major effect.
  3. After the first recorded instance of the event, it is rationalized by hindsight, as if it could have been expected; that is, the relevant data were available but unaccounted for in risk mitigation programs. The same is true for the personal perception by individuals.
Michele M. Wucker, an American author, commentator and policy analyst specializing in the world economy and crisis anticipation,  introduced the term "Gray Rhino" at the World Economic Forum Annual Meeting in Davos, Switzerland in January 2013. Unlike highly improbable "Black Swans", Gray Rhinos are highly probable, high impact yet neglected threats.

Recently in an interview Michele Wucker explained how the American government gets it wrong:

    In Wucker’s opinion, the expansionist monetary policy applied by central banks around the world is a “Gray Rhino”. The policy intends to “help economies come back to life, after the great crisis”.
    “Unfortunately most of that money has gone into financial markets, into circulation, into real estate. Actually, into rhino horns. The price of the rhino horns is a bubble,” she said.
    Only a small part of that money has gone into the real economy, “to help create jobs and to move things forward."

Economists refer to her rhino horns as the fire sector   which we will explore later. But first we need to understand "shadow banking."

Shadow banking is explained by The Economist as follows:

    Politicians and economists who often have little in common, unanimously agree that shadow banking, left to its own devices, has the potential to trigger another financial collapse. What are shadow banks?
    The term "shadow bank" was coined in 2007 by Paul McCulley of PIMCO, a big bond fund to describe risky off-balance-sheet vehicles hatched by banks to sell loans repackaged as bonds. Today, the term is used more loosely to cover all financial intermediaries that perform bank-like activity but are not regulated as one. These include mobile payment systems, pawnshops, peer-to-peer lending websites, hedge funds and bond-trading platforms set up by technology firms. Among the biggest are asset management companies. In 2013 investment funds that make such loans raised a whopping $97 billion worldwide. Companies looking for cash also lean on bond markets that offer extraordinarily low interest rates. Globally, between 2007 and 2012, firms thus raised $1.7 trillion by issuing corporate bonds. Money-market funds that invest in short term securities like US treasury bills have taken off too.

The phrase "shadow banking" contains the pejorative connotation of back alley loan sharks. Many in the financial services industry find this phrase offensive and prefer the term "market-based finance." The problem is shadow banking has many of the features of loan sharks. They tend to create an over-leveraged economy. But instead of breaking legs to collect, shadow banking breaks the economy as we saw in 2008 when high-risk real estate loans created an inflated market price for housing in the United States.

Unlike in the United States, China's leaders, and particularly President Xi, are focusing financial regulation on this segment of the economy as explained by the China Daily in Asset managers enter new era. While not yet as over-leveraged as the United States, China's shift to a market economy has created the potential for a crash, with impacts comparable to the 1930's Great Depression in the United States and Western Europe. It is clear that in Xi's mind if the leadership cannot minimize the risk in China, and mitigate any impact should an international debt-based crash occur, they have failed.

In January from the privately owned Hong Kong newspaper South China Morning Post reported China’s asset-management growth plummets after sweeping regulations rain down on shadow banking sector which seems to indicate that the new regulatory program is working. Of course, unlike in the "freedom-loving" United States where in the banking industry rich white executives received seven figure bonuses following the 2008 Great Recession, some corrupt finance executives have been prosecuted and jailed in China during the process of review.

The International Monetary Fund (IMF) April 18, 2018, Global Financial Stability Report Press Briefing advised:

    Vulnerabilities may make the road ahead bumpy and could put growth at risk....
    This all suggests that policy actions are needed in several spheres. Central banks should continue to normalize monetary policy gradually, and they should communicate their decisions clearly. Regulators should address financial vulnerabilities by deploying and developing prudential tools. Policymakers should ensure the post-crisis regulatory reform agenda is implemented, and they should resist calls for rolling back reforms.

The last sentence was really targeted at Americans, particularly the United States Congress and President. Although the Dodd-Frank Act (Wall Street Reform and Consumer Protection Act) is now seven years old, its requirements have yet to be finalized and take effect in all the ways that were originally intended. On Wednesday March 14, the Senate in a bipartisan vote quietly approved plans to roll back key banking rules in the Act. When the House also approves the bill, President Donald Trump is expected to sign it into law further setting the U.S. economy up for a "Great Depression" level failure.

The ascendance of a FIRE economy in the United States

A problematic difference within the structure of the American economy had become established at about the time of the beginning of the Reagan administration - the real economy versus the fire sector.

Simply put, as shown in the top graph by the beginning of Clinton's first term manufacturing output was valued lower than the fire sector  (Finance, Insurance, Real Estate which also includes shadow banking). In 1950 manufacturing is the largest component of the real economy. By 2015 it was less than 10% of the U.S. economy.

I don't have a PhD in economics, but I do understand the real economy concept, as opposed to the paper economy. Simply put,  the real economy is that part of the economy that is concerned with actually producing goods and services (which does include construction), as opposed to the part of the economy that is concerned with transactions in the fire sector  (which does not include construction).

In the second chart above, we have the economy broken down in sectors, the three of which not colored red are considered the real economy.

First we have the "Production Sector" which includes all activity related to producing things:
  • beginning with activities like farming, mining, ranching, logging, etc., that involves obtaining raw materials; and
  • then moving on to all manufacturing, construction, etc., that involve creating goods from raw materials to be utilized by folks.
Then we have the "Goods Handling Sector" which involves transporting and storing raw materials and goods plus wholesale and retail activities which ultimately get the goods to the general population.

Finally, the "Services Sector" reflects all activities of value in the form of services. Care needs to be taken when considering services. We hear about a "service economy" but we don't give it much thought. In economics, a "service" is a transaction in which no significant physical goods are transferred and for which:
  • services cannot be stockpiled or securely stored for later consumption;
  • it is not possible to objectively assess the value gained from a service activity as services are produced and consumed simultaneously;
  • the service provider must deliver the service at the time of service consumption;
  • the service consumer is inseparable from service delivery;
  • when the service has been completely rendered to the consumer, this particular service irreversibly vanishes; and,
  • the service can never be exactly repeated as the time, location, circumstances, conditions, current configurations and/or as signed resources are different for the next delivery.
This is not to say services have no value. But when you have your hair cut, you cannot resell the hair cut. Of course, the same can be said for goods that are consumed immediately which is why restaurants are the food service industry as they really cannot be said to sell goods. And there is what is being called the "virtual economy" which somehow seems exotic. In fact, it is social media, gaming, etc., simply an element of the "service economy" conducted on the internet.

The fire sector indicated in the red bar is not part of the real economy.

Economist Michael Hudson has for a number years been trying to communicate with Americans that this is a lurking disaster. As Hudson explained in 2016:

    FIRE is an acronym for Finance, Insurance and Real Estate. Basically that sector is about assets, not production and consumption. And most people think of the economy as being producers making goods and services and paying labor to produce them – and then, labor is going to buy these goods and services. But this production and consumption economy is surrounded by the asset economy: the web of Finance, Insurance, and Real Estate of who owns assets, and who owes the debts, and to whom.
    So a financialized economy is a debt-leveraged economy, whether it’s real estate or insurance, or buying an education, or just living. And debt leveraging means that a larger proportion of assets are represented by debt. So debt equity ratios rise. But financialization also means that more and more of people’s income and corporate and government tax revenue is paid to creditors. There’s a flow of revenue from the production-and-consumption economy to the financial sector.
    ...Wall Street is interjecting itself into the economy, so that instead of the circular flow between producers and consumers, you have more and more of the flow diverted to pay interest, insurance and rent. In other words, to pay the FIRE sector. It all ends up with the financial sector, most of which is owned by the 1%. So, their way of formulating it is to distract attention from today’s debt quandary by saying it’s just a cycle, or it’s “secular stagnation.” That removes the element of agency – active politicking by the financial interests and Wall Street lobbyists to obtain all the growth of income and wealth for themselves. That’s what happened in America and Canada since the late 1970s.

The difficulty in the United States is that people sense that something is wrong, but whether they are on the left or right or in the center of the political spectrum most Americans buy into some sort variation on the BS from folks representing  the fire sector advocating for "Free Market Capitalism". And if those people ask questions, they get a chart like the one on the right buttressing the idea that a services sector is picking up the slack.

But as can be seen in the bar chart above comparing 1950 to 2015 and the graph to the left, while the real economy has grown, unfortunately  the fire sector continues to grow faster and it is benefiting "the wealthy 1%" by expanding the debt and siphoning off revenue from the real economy which reduces the ability of the real economy to grow.

And while both political parties have embraced this trend, President Donald Trump's personal wealth derives from not only real estate but from incurring debt which he has a history of failing to repay.

The current reality is that within the United States no branch of the federal government would ever effectively address  the fire sector growth as a systemic problem.

China, however, has developed policy on this which the American press either doesn't understand or chooses to ignore in deference to the American fire sector.

In October of 2017 the Communist Party of China (CPC) held its 19th National Congress (they are held every five years) during which policy guidelines were outlined. The CPC expects the private sector as well as the government to implement those guidelines and expects the government to enforce those guidelines when privately owned or publicly owned businesses do not comply.

Most Americans confuse the government of China with the CPC because of their unfamiliarity with China.

In the last post, the personage holding the position that nominally heads the Chinese government, its President, was introduced. But it is important to understand that one man cannot govern 1.4 billion people. China has local, provincial, and national government, the latter of which has four separate branches. And China has politics which as mentioned in the last post can sometimes result in chairs being thrown.

The government system of China will be outlined in the next post.

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