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Underlying Economic Crisis Caused Financial Crisis

Armen Hareyan's picture

What has caused the current economic crisis. As soon as you have read the explanation, I would expect that you will find it to be blindingly obvious, and you may wonder why you have not heard it before. Despite this, to my knowledge, nobody else has identified or written about the real underlying cause of the economic crisis.

I first wrote about this in two blog posts in July 2008 (here and here), and expected that someone somewhere would actually pick up on the explanation. I later had an article published in a trade magazine (Trade and Forfaiting Review), in which I outlined the argument, but still it has not been picked up by economists or the mainstream media.

The story of the economic crisis starts with the opening of China and India to world trade. Whilst both of these countries opened decades ago, it is only in about the last decade that their full impact has been felt on the world trading system. This appears to be a statement of the obvious, but the real implication is more dramatic than you might imagine; the opening of these countries has seen the world labour force roughly double in a period of about ten years.

It might be argued that the labour force has always been there, such that the doubling I propose is an exaggeration. However, in this context I have a very specific meaning for labour. I am referring to labour which is combined with technology, capital, and access to the world market. When seen this way, the increase in the labour supply represents an astounding increase in one of the key inputs into all economic activity.

This of itself might be a cause for the current crisis. For example, a massive expansion in supply would be expected to result in a decrease in the price of labour. As an analogy, imagine if the world supply/reserves of oil was to have doubled in ten years. Such a massive increase in the availability of one of the key inputs into economic activity might create revolutionary outcomes. Oil prices would be slashed, the petro economies would be in trouble, and there might be a deflationary surge and so forth.

However, it is only when we consider the relative supply of one of the inputs against the other inputs that the real reason for the economic crisis becomes apparent.

It is here that we have the real roots of the economic crisis, and where it is apparent that the emergence of countries such as China and India has created a zero sum gain. In particular, the point was reached some time ago where each gain in the economies of India and China means a relative loss in the economies of the traditionally wealthy countries. How has this situation arisen?

I have already identified that the world labour force has roughly doubled in the last ten years. At the same time, there has not been the doubling of the other inputs into the world economy. In crude terms, what this means is that the amount of inputs available to each worker to undertake economic activity has been reduced per capita.

If we take the example of oil, in 1997 output was around 75 million bpd, and output had only climbed to about 85 million bpd in 2007 (a chart here shows the output - not a good source but the chart is usefully clear and conforms to charts from better sources). What we can see from 1997-2007 is an approximate doubling of the labour force, and only a tiny increase in the output of another key component of economic activity.

This quite literally means that the availability of oil per worker has seen a significant decline. In such a situation, there must be a consequence. If a worker in country A increases their utilisation of oil, then a worker in country B will have less oil available.

With regards to other commodities, it might be argued that the output has risen to meet the new demand from the expanded labour force. For example, copper has seen high growth in output from around 11 million tons to 16 million tons, and iron ore output nearly doubled. The problem with such expansion is that it is growth in a period of rapid development of the emerging economies, in which the demands on resources are particularly high. Think of the massive expansion of highways, tower blocks, apartments, airports and factories in China, and it is apparent where such increases might be absorbed.

The combination lack of increase of resource in relation to the increase in labour, and the unusually high demands for resources in emerging economies, means that there is simply not enough resource available. It is from this simple idea that it is possible to see the roots of the current economic crisis.

What we are seeing is a competition for the available supply of resources, and it is quite literally a zero sum gain. In such circumstances, the resources will flow to the labour that utilises the resource in the most cost effective way, and where there is the commensurately high return on capital. In other words, where resources are finite, where there is an increase in labour per unit of commodity, then there is a situation of hyper-competition.

In practical terms, what we are seeing is that the competition is playing out in the world economy, and the relative low cost of labour in the emerging economies means that they are winning in many sectors. The result of this is that the wealth represented by commodity usage per person is being redistributed around the world. The Western world’s share of the finite commodity supply is reducing relative to the emerging economies, such that the absolute share per Western individual is reducing due to constraints on supply.

In a perfect world, the supply of commodity would rise to meet the new demand. However, the world is not perfect and the result is that bottle necks, and even outright manipulation (e.g. OPEC and oil supply), mean that supply is having problems keeping up with labour growth. The result is a process of relative wealth redistribution, with the emerging economies growing at the cost of the traditionally wealthy economies.

The supply of labour in relation to the supply of commodities is the root of the current economic crisis.

However, most readers will have seen articles in which the cause of the economic crisis is blamed upon irresponsibility within the financial system. Having identified the underlying cause of the economic crisis, how does this financial crisis fit into the picture?

The reality is that the financial crisis is not the cause of the crisis but is a symptom. In particular, the emergence of China has seen huge swathes of manufacturing moving to China at the cost of the West. The result of this should have been seen in the lowering of wages in Western manufacturing in order to meet this emerging competition. Instead, what happened was that there was a shift into the ‘service economy’, in which services employment replaced manufacturing. The root of this shift was not an economic miracle, but the foolhardy lending of wealth into the Western economies by the Eastern economies and the rising wealth of the petro-economies (increasing demand for oil, and increased profits). This lending created a wall of money entering into the Western financial systems, and yet there were limited productive investments in the Western world.

Most of the real growth in real sustainable wealth creation (in contrast to debt fuelled growth) was taking place in the highly competitive emerging economies.

It is possible, therefore, to see a massive expansion in available credit in the Western world, but less and less productive uses for such credit. The financial institutions would have a limited number of sound investments to choose from, and would then need to lend the remaining capital into increasingly risky investments. This is the birth of the consumer credit and mortgage bubbles. Whilst it may have taken the financial alchemy of securitisation to dress up such poor lending, the underlying need for the alchemy was too much credit, and nowhere productive to put the credit.

These bubbles in turn allowed for the boom in the services economies, with the credit expansion circulating in the economy and increasing economic activity. This activity maintained high employment, rising house prices, and this in turn created more activity, in a massive upward spiral. The problem was that the increase in economic activity was based upon an expansion of credit, not an expansion in output of real wealth.

The situation as it now stands is that the credit bubbles have burst, and the financial institutions are left holding huge amounts of bad debt. The upward spiral was driven by credit, and the downward spiral is simply revealing the underlying change in the economies that was hidden by the expansion in credit.

In other words, the real shift in wealth that I have already outlined has already taken place. The zero sum game means that not only has the Western share of resource diminished, but also that the Western economies are now in a position of owing a large amount of their labour, resource and output to the emerging economies. In other words, the debt hangover means that, from a diminished share of resource, the West must allocate some of that resource to servicing debt.

It is not a pretty picture. However, it is the only picture that confronts the underlying realities that are driving the world economies.

As with any consideration of the economy, I do not want to be overly simplistic, as there are also many other factors in the current crisis. However, what I have tried to highlight is the primary factors of the change in the world labour market, and insufficient adaptation in the supply of commodities.

By Cynicus Economicus

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