Tuesday, September 30, 2008

Banking Bailouts - Why they will help bankrupt the US and UK

Note Added 2nd October:

For visitors from the US, the example given below uses the UK. Except for some local details, the principles apply just as much to the US as the UK. Original post continues below......

I have written about the banking bailout several times, but thought that an analagy might help to clarify the reasons why I oppose all bailouts. However, rather than starting afresh I will continue on with the analogy that I used at the start of an essay that I wrote back in November, 'A Funny View of Wealth'. The analogy made at that time follows (note how at that time the common view was that the economy was a success! Hard to believe now...):
'I am going to start by looking at the world from the point of view of many modern economists. Whilst none of the economists would accept that what I am about to portray is their belief, when you look hard, you will find that this must be their basic belief. If not, then they have no justification for their pronouncements of success for the UK economy.

Imagine a family living in the UK, not an atypical family, not a typical family, but an ordinary middle class family. We will call them the Wilsons. The father has a job in management for a chain of retailers, and earns £30,000 per year. The mother has a good job in a local hotel where she is the marketing manager and earns £30,000 per year. They therefore have an income of £60,000 a year. They have two children at the local school.

The Wilsons have purchased a home, which cost them £300,000, which is five times their combined income, using a 95% mortgage. The house has increased in value by £30,000 a year, in each of the three years since they purchased it. They are very pleased to see their house growing in value, as it is like having another earner in the house, except this earner pays virtually no tax on the income, making it an even better earner than themselves.

The Wilsons have a relatively large mortgage, but interest rates are low. Despite this, they struggle to balance the quality of life that they enjoy against their income. As such, they make use of credit cards to occasionally purchase items. Each year, for three years, they have added £6000 to the family debts through overspending on the ‘little luxuries’ in life, such as holidays, and new goods for the house. At the end of the second year in the house, Mr. Wilson decided that he would fulfil his dream of owning a Mercedes, and re-mortgaged the house to realise £20,000 of the increase in value of this asset. He used this as the down payment on the car, and took a loan for £20,000 to pay for the remainder.

Overall, the Wilsons non-mortgage debt stands at £18,000 for the credit cards, and £15,000 remains of the loan for the car. They are starting to find the payments on these debts are stretching them, and they seem to be using the credit cards a bit more often than before.

Next door to the Wilsons live the Jones family. The Jones family know and respect their next door neighbours. They can see how successful they are. They are always doing something to the house, making improvements, and they seem to be living the good life. Only recently the Wilsons bought a new Mercedes and Mr. Jones feels a little jealous, as he would love a Mercedes too.

The Jones family, have less income than the Wilsons, but every year they save a few thousand pounds. They have no debt except for their mortgage, and only spend what they earn. They purchased their house at the same time as the Wilsons, and are steadily paying their mortgage. Their belts are tight, but they get by, and look forward to better days ahead.

Which of these two families is the more wealthy family?

The answer largely depends on whether you are an economist who has been a cheerleader for the boom of the last ten years, or whether you are a person grounded in the real world. The Wilsons have been the motor of growth in the Anglo-Saxon economies. Apparently we have gone through a period of sustained growth and, in moments of hubris (Gordon Brown in the UK being a wonderful example), we promote the ‘success’ of the Western economies to the rest of the world. The trouble arises when we ask a simple question; ‘Where is this growth?’'
At this moment in time, both the UK and US economy are at the stage where the Wilsons are now having trouble servicing their debts. They seems to be pouring more and more money into interest payments, and with the increase in interest payments, they are finding that they are now borrowing ever more just to stand still. The situation is even worse though, as the retailer at which the father works is now struggling. Business is so bad that they have stopped evening opening hours (e.g. in the real world there has been a reduction in shifts at car plants), which means that the income coming into the house is dropping. The hotel is doing badly too, and there are mutterings about shortened hours, or even redundancy there too. Every day that goes by, the equity in their house disappears and they will soon be going into negative equity. One evening the Wilsons look at their family balance sheet and fall into despair.....they can see that they can not afford to continue as they are and that they are sliding towards bankruptcy. Fewer and fewer lenders are willing to lend to them, and the terms of lending are getting more and more onerous.

However, even as they are despairing, there is a knock on the door. Mr. Wilson answers the door, and finds a man in a slick suit smiling at him. He is from the 'Slick and Friendly' loans corporation, and he is going door to door drumming up new lending business. For a small arrangement fee, and high interest payments, he will solve all of their problems with a lump sum loan.

Mrs. Wilson is excited, as she can now buy the new computer for her son, and Mr. Wilson can renew his membership at the golf club.
The question here is; should they take the loan?

The answer is, of course, obvious. The only time they should consider such a loan is if they had certain prospects of a massive boost in their income with which to pay off the loan. As far as I am aware, not even the most blind and foolish analysts or commentators are proposing that this is the case for the US or UK economies. As such, what would we recommend for the Wilsons?

There is really only one solution. They absolutely must reduce their expenditure (no more little luxuries for a long time), and they should also look at reducing their expenditure sufficiently such that they can start to repay the principle on the loan. Only through such tough action will they be able to improve their situation in the long term, and avoid the very real risk of bankruptcy. After all, their income is dropping, and with the prospect of further falls.

I can think of no clearer way of expressing the stupidity of these bailouts. As I have said before, they are just an extension of the delusion that has collectively been gripping economists, politicians and the public alike. In short, time to face reality, and it is not going to be pleasant.

Note 1: I have come accross a very interesting paper from an economist in the US. He is suggesting the US is bankrupt. It is (painfully) gratifying to see that an academic economist 'gets it', though (as always) I wish that the pessimists like myself were wrong. The paper is not easy going, but if you can get through the maths, it is powerful material.

Note2:Why is it that perfectly rational people, who would readily advise individuals not to become too indebted, will advise that a country mired in debt should seek to solve their problems by borrowing more money? I would take a guess that Paulson and Bernanke would not recommend that the Wilsons continue to borrow. Why then do they recommend such a course of action for a national economy? It is genuinely baffling......

Monday, September 29, 2008

The Economic Crisis - The Bailout and Other News

Yesterday, before I read the latest news on the bailout, I made my regular visit the various financial sections on the online news services. I was struck by one of the finance home pages, in this case the Telegraph. I would link to the page, but the page changes daily. Why would this page be of interest. Fortunately I left the page open, and here are a selection of the headlines:
'Mortgage Lending Plunges 95pc as market "Decimated"'
'UK high street banks may benefit from US bailout'
'City has B&B concerns'
'Airbus Launches in China'
Today, in the same paper, the headlines are as follows:
'US Markets in Freefall as Bailout Rejected'
'Banking crash hits Europe as ECB loses traction'
'Banks to absorb B&B losses'
'Benelux states part nationalise Fortis bank'
Why am I giving this list of headlines? The reason quite simply is that, within these headlines are expressions of the roots of the problem. As I viewed the above headlines I came across a quote from Gerard Barker of the Times as follows:
'If Congress wouldn't listen to Bush and Paulson it might at least listen to the markets'
It is a fascinating quote in light of the above headlines, because there is a fundamental disconnect in the thought. Gerard Barker is assuming that the real market is what is happening in Wall Street and the City. He is missing the point entirely. The real market is the market of the day to day decisions and activity of billions of consumers, and endless millions of companies supplying goods and services, and the choice of where real wealth creating capital is allocated. It is they that drive the markets, not Wall Street, and certainly not governments.

The City and Wall Street are just a reflection of the reality of the situation on the ground. The banks are not failing because of the lack of a bailout, but failing because of the damage in the wider economy. Even before the current crisis, the CBI survey of financial institutions in the UK found that the banks were suffering from plunging profits. This is the reality of the crisis, that both consumers and businesses were hurting, and that the result was that the banks were looking at ever more pain as a result. With consumers not borrowing, banks not lending, consumers not spending, and therefore businesses suffering, the banks are in trouble. What that actually means is that, on the ground, away from the world of finance, there are real problems. It is the downward spiral that occurs when the credit ATM shuts down. I have said it before, but the bank balance sheets will be looking ever more ugly as each day goes by, as consumers increase defaults on both mortgage and personal debt, and as commercial debt goes sour.

In other words, there is not some mystical force in Wall Street or the City driving all of this, but fundamental and deep economic problems. If the fundamentals of the economy were good, there would be no banking crisis. Companies would be generating profits, and consumers would not be defaulting on their loans, and the house market would be buoyant.

If we return to the above headlines we can see an illustration of one of the problems in the article that details the opening of an assembly plant in China by Airbus. Such an action would have been encouraged by the Chinese government, as a way of ensuring access to the growing market for aircraft in China. Airbus, in opening such an assembly operation, will ensure that China will emerge as a competitor in aviation in 10 years time. Once embedded in China, the process of sourcing components and parts locally will commence, and local Chinese companies will be taught how to serve the aviation market and, once they have learnt, will expand into broader international markets. As more and more suppliers are able to meet the high standards and technology required to build modern aircraft, the infrastructure will be put in place for a Chinese competitor to emerge. This process has been going on for many years, in many sectors. It is the combination of capital, access to markets, access to technology that I have discussed in my previous posts in the abstract.

This is the reality behind the financial crisis, the emergence of competitors who are taking ever larger shares of world trade. They are producing goods and services in competition with the OECD countries, and they are doing so ever more effectively. For those who still insist that it is just cheap labour, I would suggest that you listen to the following from an Economist report on globalisation (Economist Print Edition, September 20th-26th, 2008, p 12):
'Being Willing to match India's low-cost model was essential, but Mr. Cannon-Brookes insists that IBM's enthusiasm for emerging markets is no longer chiefly about cheap labour [...] Perhaps a bigger attraction now, according to IBM, are the highly skilled people it can find in emerging markets'
The reality of the markets is that we in the West have deluded ourselves that we have the better people, the better technology, the better infrastructure. Perhaps we still do, one of the points made in the Economist article, but the speed with which such advantages are diminishing is shocking, and in any case the advantages pertain to an ever smaller part of the market (the part of the market that requires only the highest levels of technology, process and know-how such as aircraft manufacture). In other words, globalisation is setting about a complete restructuring of world markets, and that restructuring is about moving business to any place where there might be any competitive advantage. This again, is the reality of the market.

Every time that a consumer enters a shop to purchase something, they are the drivers of the real market. Every time a business seeks a supplier of a component or service, they are the real market. Every time a company allocates capital, this is the driver of the real market. The financial institutions of Wall Street and the City may imagine they are in the driving seat, but the reality is that they are just responding to each of those tiny market signals. This is not to say that they have no influence, as they allocate the capital that is available, and have allocated it very poorly, leaving insufficient capital for investment in productive activity in the OECD (real wealth generation), but they still are driven by the activities of the real market.

In the current situation, the problem is that they lent to the wrong places, consumer and mortgage debt. They miscalculated, they failed to realise the real source of wealth is in manufacturing products and supplying services to support that wealth generation. They thought that debt = wealth, the fundamental point in 'A Funny View of Wealth'.

The purpose underlying this post is to reiterate that, for all of the excitement about the state of Wall Street and the City, they are really not what matters. If the underlying economy were healthy, then all of the lending to consumers that is driving the banks to bankruptcy would not be going sour. It is the underlying weaknesses, the lack of wealth generation, that means that the debt is going sour.

When we view the world as it is, instead of through the delusional filters with which we have viewed the world, it becomes apparent that the bailouts would never have worked and would just be another burden on economies that were in any case less and less fit to compete. The question that needed to be asked about the bailout is whether it could actually change the underlying reality of the economies that really drive the financial system. In other words, would the bailout do anything to create wealth? At some point wealth must be created to pay back the debt, and the bailout was just transferring debt from one place to another. It was not solving any real problem, but just shifting the problem to another place. The only solution to the real problem is for the OECD countries to respond to the real market, and that market is one in which tough competitors have emerged, and who are fast moving up the value chain.

It is for this reason that in a previous post I call the bailout a 'magic wand'. It is for this reason that I have opposed the bailout. It is just a way of pretending that the real problem is not there, of pretending that the world has not changed. It is just a continuation of the delusion.

No doubt, some readers would have expected me to discuss the events of the last few days. I hope that, having read this, you will see why I have not discussed the blow by blow saga of B&B or Fortis, or the failed bailout. They are events, they are important in their own way, but they are just a reflection of something more important. The market is readjusting, and the banks are just following the 'real' market (or at least the real drivers of the market - individual choices in the selection of goods and services) in the readjustment, albeit accepting that they are one part of that market.

I have had a comment from 'Souza', which questions some of the ideas that I have put forward. I will quote Souza in full, as he puts forward some interesting points:
'Having immigrated from an "emerging economy" to a "rich country" I experienced this phenomenon first-hand, but the explanation always seemed obvious to me: rich countries are rich because of currency imbalances. Much of the wealth of rich countries is founded upon (and funded by) artificial exchange rates. The answer to the "cigarette lighter problem" is that the New Zealand dollar is overvalued against the Chinese yuan by a factor close to the ratio between the prices of the lighter in both countries.

The fundamental question is not "why the lighter costs more in New Zealand", but rather "why the income of workers in different countries is not commensurate with their productivity". I don't know the exact figures, but I'm quite sure that a convenience store clerk in New Zealand earns at least 10 times more than one in China, despite the fact that the productivity of both workers is roughly the same. As I said, I experienced this first-hand when I moved from one country to another and saw my salary instantly multiplied by 4, despite the fact that I have not become any more productive.

So when you say that "something is very wrong and unbalanced in the world economy", I say "it's the exchange rate, stupid!". (I hope you recognize the "stupid" as an allusion to a commonly used phrase, not an insult). And even though I'm sure there is a lack of balance, I'm not sure it's necessarily wrong, for the simple reason I don't fully understand where it comes from.

The one thing I can be quite sure of is that exchange rates are a matter of supply and demand, so the currencies of rich countries can only become overvalued by creating artificial demand for them. And the most obvious way in which I see this happening is through cultural influence. To take but one example, the fact that Coke is so popular in almost every nation on the planet is highly beneficial to the American economy, but such a high demand for a product with little intrinsic value can only be created by cultural influence. Surely if exposed to it without the accompanying marketing machine, most people would find the taste of Coke between trivial and repugnant (it is, after all, nothing more than water, sugar, and CO2)

This is a complex topic and I have no room to expand on it, so I'll finish with my opinion on the future of the wealth of wealthy countries: there is not much to worry about, things won't change much. The current state of the world's economy is a product of politics and culture, not of worker productivity. A "service economy" is perfectly sustainable for as long as there are far more poor countries in the world than rich ones - a situation not likely to change in any foreseeable future. The most visible result of the "service economy" is that it creates a world market for things people in rich countries are no longer willing to manufacture; things such as cigarette lighters.'
He is right to say that the currencies are overvalued. This is a point I have made throughout the posts, and why I predict that the 'rich world' currencies must drop against those of the emerging markets. This represents a real loss of wealth, as the commodities that are purchased will be more expensive, and the goods imported will be more expensive, the holidays that consumers take will be more expensive. A simple and crude way of looking at it is that a consumer will have to work x number of hours more to buy a Japanese branded, manufactured in China, plasma TV than they did before. This is a real loss of wealth. In answer to this point, yes, the currencies will drop, and every individual in the 'rich world' will commensurately poorer. I also agree that currencies are dictated in the long term by supply and demand. A large part of the demand for Western currencies has been driven by demand created by foreign institutions to invest in rich world economies, either to buy companies, or to lend into consumer markets. Now that such demand is falling, there will be ever less demand for the currencies. The currencies will fall. The rich countries (excepting some like Germany) are just not producing enough products that other countries want, and the result is that, without the demand for currencies for (now revealed as foolish) lending into the economies, there is little support for the current value of the currencies.

With regards to the salary differentials, that is the underlying point about the 'Cigarette Lighter Problem'. How can this differential be justified? Somewhere in the economy, there needs to be sectors that are generating huge amounts of wealth to pay for the salary differential between the Chinese shop worker and the New Zealand shop worker. Where is this wealth generation coming from. We can look for it, but it is impossible to find such a massive source of wealth (see 'A Funny View of Wealth' for my attempt to find such sources of wealth in the UK). As such, what is paying for the differential? My argument is that it is debt, lending sourced from outside the country, that is paying for a large proportion of the differential.

The Coke example is an interesting one. Coke has many meanings attached to it, not least of which is the association with the US lifestyle, the US dream and US culture. What happens to Coke when the dream goes sour? Coke is a great marketing company, and therefore will probably adapt their image to the changing circumstances, but their value at present is tied up with the culture and values of the US. There still remain in the West many great companies, but these companies are facing ever more, ever better competition. I remember sitting in front of a Unilever executive telling me about the fierceness of competition from local suppliers. Unilever were holding their own, but the battle was tough. Unilever is an example of the very best of Western companies, so what of the weaker companies?

As for the last point made by Souza, I am hoping that the post overall will have answered the suggestion that as long as there are poor countries, the service economy can be sustained.

Anonymous made the following comment (and question):
'I don't know if you are still in China, but I am! I wonder what it would take for all this to start to 'undermine' the Economy here? Is there some event, some process that is unravelling? Elsewhere people have said this is not a 'Global' crisis, just an OECD and particularly US/UK one. To what level might the Euro/GBP actually fall against the Renminbi? You say that is the easiest of the 5 options to be enacted? But would that actually help..and help who?? '
There are many points here, but I will focus on who the devaluation might help. I would not suggest that the devaluation would 'help' anyone. It is a market process that is inevitable, but is not imbued with any intentionality. It is not happening for a purpose, but because market forces seek (again with no intentionality or purposefulness, despite using a verb that suggests otherwise) an equilibrium. The mis-allocation of capital created an imbalance for so long, but eventually the market had to snap back into a balance. In this case the trace balance was pulled out of shape, and the correction is a rectification of this imbalance through currency changes, and the destruction of the value of the Western currencies is the correction.

I hope that the above is clear, as I am somewhat dissatisfied with my own answer here, and am not sure I have expressed it well. Let me know if it does not make sense.

There is much more that could be said in this post, as well as some other comments I would like to respond to. However, time is short, so I hope the other commentators will forgive my lack of response.

I also hope that this post will go some way to directing your attention away from the minutae of events, and help to focus on the bigger picture, which is what really matters.

Friday, September 26, 2008

Banking Crisis - What is REALLY Going On?

Note: Published in September

It is very easy in the current circumstances to focus on the crisis that is engulfing the financial system or the unfolding drama of the US bailout. However, this is not the real story, just an expression of the symptoms of the real story.

As I have mentioned before, the idea of a 'credit crunch' has taken root, and sometimes it appears to be a force with a malevolent intent. In other words it has become an animistic entity on which we can easily lump blame, and pretend that there is not real causation behind the crisis. The reality is that there is a real force out there, which is market sentiment. This is not, however, something with a life of its own, but rather the thoughts and feelings of real people with real concerns. Collectively they constitute market sentiment, but we should not forget that market sentiment comes from somewhere.

Bearing this in mind, we have to ask what is really scaring each of those individuals that constitute the market. Is it just an irrational fear, or is there some justification for the fear?

It is here that we must realise that these are panicked but mostly rational people. The panic stems from the realisation that they have been buying fools gold for many years. Yes, it looked like the real thing, but they have now had the material analysed, and the reality has dawned upon them. The big question is whether the financial crisis is driving events, or whether events are driving the financial crisis.

The truth is that there is an element of both. One is feeding off the other in an inevitable downward spiral. When I predicted this crisis in 'A Funny View of Wealth', I pointed to the idea that one negative factor would reinforce another, in what might be poetically called a 'death spiral'. This was not a prediction based upon an abstract entity called the 'credit crunch', but was based upon the fundamental problems in the economy of the UK. Many aspects of the essay equally apply to the US (and other OECD economies to a lesser extent). One of the central points of the essay was that the growth in GDP (at least) over the last ten years was an illusion. It was growth built upon asset prices inflation and a boom in credit. This is now widely accepted as the reality of the situation, but the 'commentariat' have still not grasped the reality of what this means. They are so busy charting the day to day crisis development that they are losing sight of the idea that something substantive must underlie the crisis.

In light of this I thought I would try to pull some of the strands of my thinking together and try to put the jigsaw together. In some respects I will be repeating ideas in my previous posts, but the aim is to try to integrate the ideas into a large picture. For those that have followed the blog from when it started (people to whom I am grateful, as their reading and comments encouraged me to continue), none of this will be new.

The first element to consider is that of the entry of the emerging markets into the world economy. I have dealt with this in the posts 'Why Do Economists Get it so Wrong?' and 'The Root of the Problem'. The argument, at its most basic, is that there has been a massive input of new labour into the world. The labour was always there, but the key difference is that the emergence of these economies has seen capital and technology, and access to markets, become available to this previously underutilised workforce. The result of this change has seen the available labour force available in the world roughly double in the last 10-20 years. This is nothing short of a revolution in the world economy, but few economists have understood what it really means. This is best expressed in simple terms of an example (using made up figures but referencing the real events) to make the point clear.

If we imagine that (to pick an arbitrary date) in 1990 there were 100 units of labour and 100 units of commodity utilised by that labour, and an available 120 units of commodity capacity (not all utilised), we can see a benign situation. It is a situation in which the commodity supply exceeds demands. We can see this, for example, in the long period in which oil prices were so low for so long. Now, if we jump to 2008, we see the oil prices spiking. This is because, whilst the supply of commodities such as oil has been increasing, they have not been increasing at the same rate as the available supply of labour. Let's call the supply of units of commodity in 2008 a total of 140, to pluck a number out of the air. At the same time we now have 200 units of available labour. At this point, it is apparent that there is a mismatch. The question arises as to why it is that the problem did not hit at the point where labour first exceeded the supply of commodity. This is because the labour entering the market was not as efficient at utilising the resource as the original labour. It is the catching up, the increase in both the efficiency of the new labour, and the increase in the use of the output of their own labour that has tipped the world into the current situation.

This is one element that explains the current situation, but it still does not seem to match the reality on the ground. For the last ten years, countries such as the US and UK have been booming, have been apparently successful. Logic says that, if we input a massive amount of new resource (in this case labour) such that supply is always exceeding demand, the price of labour should have fallen. This has not happened, and it seems that the Western world became ever richer, with rising salaries, ever expanding wealth. How can this be so? One of the key elements in this is that these new workers were relatively very cost effective, and therefore generated significant profit surpluses, which was then funneled back into the western economies, thus creating the boom in credit. Huge trade imbalances, massive government deficits, and a stunning growth in consumer debt was the result of a wall of money entering into the western economies.

The borrowed money was entering the western economies in ever greater amounts, all of it looking for investment opportunities. The problem is, what happens when the supply of good investment opportunities is used up? The money that is entering the economies must be utilised somehow. It is at this point that the money starts to be utilised in ever more risky ways. It is here that the origins of the bad lending lie. The money had to be utilised but could not be invested in productive assets, such as manufacturing, as the growth in manufacturing was focused on the more cost effective emerging markets. If you wanted to build a new manufacturing facility, then increasingly the logic dictated that you looked to the East. This left a huge surplus of money sitting around, and the end result was cheap and easy credit for consumers and governments alike.

Now, in normal circumstances, such a massive oversupply of money would lead to inflation, and then governments would seek to dampen down the inevitable expansion in activity in the economy in order to combat inflation. This did not happen, as the measures of inflation did not account for the reduction in the cost of manufacturing resulting from the massive input of labour into the world economy. Prices for all kinds of goods just kept falling. Furthermore, wage growth was not as inflationary as it might have been, due to the ongoing threat that manufacturing would move their operations to the emerging markets. The governments of the West failed to understand that these factors were muting the signals that would normally prompt them to reign in their too fast expanding economies. Instead, they deluded themselves that all was well. The worst aspect of their measures of inflation was that they failed to take into account the inflation of asset prices, in particular housing.

One of the justifications for this was that the cost of servicing the housing debt was apparently not rising. To justify this people looked at the amount that individuals were using for repayments, pointing out that interest rates were low, thus making higher prices affordable. However, they failed to see that inflation and interest rates together the make up the actual cost of a house over the lifetime. High interest rates coincide with high inflation, and low interest rates coincide low inflation. High inflation compensates for higher interest rates by eroding the value of the debt owed, such that the two factors balance out. The problem was that everyone apparently forgot this, and therefore people committed ever greater portions of their lifetime earnings to buying their houses. This in turn inflated the prices of housing, as ever greater amounts of money was entering the market. In any market, if you increase the supply of money available for purchase of a finite number of assets then there will be inflation.

This inflation of asset prices, due to an ever expanding supply of money, apparently supported by collateral, led to a belief that the money was being lent wisely. It was not, because the necessary increase in wealth needed to justify the increase in prices was not occurring. What was occurring was the debt merry-go-round.

This was a situation in which more and more money was entering the financial markets to support house purchase, and providing ever more easy credit. The 'service economy' was born, the massive expansion in retail and leisure activities for consumers. The new expensive restaurants, the shiny shopping malls, the crystal healers, personal trainers and so forth. At the same time, governments were borrowing more and more money, and creating ever more new government activities, more government jobs, and so forth. It is here that we come to the multiplier effect.

Each £1 or $1 entering an economy has a multiplier effect. When we go to a restaurant and buy a meal, we do not only support the success of that restaurant, but also the suppliers of the restaurant, the supplier of the supplier, and so forth. This means that a service economy can generate what appears to be huge amount of productive economic activity. All of the money going into purchasing the services trickles through the economy, supporting more and more activity. This keeps employment high and, as services expand, the economy appears to grow.

The problem here is that all seems well but, if the spending on the services is built upon growth in debt, then what is happening is not actually growth in the economy at all, but actually temporary growth at the cost of future growth. When we borrow money for consumption (not investment), we are foregoing future wealth. In short, the credit boom was a massive boom in forgoing future wealth. The most dangerous part of all of this boom was that, for reasons which still baffle me, the economists who were measuring economic growth included this foregoing of future wealth as economic growth, which is why we saw ongoing rises in GDP. Occasionally there were concerns expressed about the way in which manufacturing shrank as a percentage of the economy every year, but this was all answered with twittering about 'post-industrial' economies. No one seemed to ever ask where the real source of the ever expanding wealth came from. This was the purpose of my original essay, 'A Funny View of Wealth'. In that essay, I looked at all of the potential sources of real growth in wealth, and found that there were none. I also found that the GDP growth was rising in line with the growth in debt.

The most curious part of this is that the lending to the West has continued for so long. In some recent posts, I have pointed out that this is largely due to confidence. It is the belief by those that financed the boom that the West had always been rich, that the West would always be rich, and was therefore a good credit risk, and a good investment. Just as the Western economists were pointing to 'growth' in the Western economies, so could those doing the lending, all the time not realising that their lending was going into the consumption that was actually the source of the growth. In other words they were financing the luxury lifestyle of the West in the belief that the West was an ongoing economic success, without realising that the success was entirely illusory.

It is for this reason that what should have happened, did not happen. As competition from the emerging economies became ever more effective, the logical outcome was that the West should have seen their economies adapt to the new competition. As the trade balances were turning negative, there should have been a drop in the value of the Western currencies, and this would have created a re-balancing of the world economy. Instead, the flood of money pouring into government and consumer debt, meant that there was high demand for the currencies, so that the currency could then be lent back to the consumers and governments of the Western countries. For a long time ever more money pouring into the Western economies actually continued to generate returns, but the generation of those returns was in turn reliant on an ever exapanding source of finance into credit for the Western economies. In other words, the returns were reliant on more and more borrowing, such that the returns were actually coming from more borrowed money. A debt pyramid, if you will.

We can now add in some rather unusual factors for both the UK and US. In both cases they saw a massive increase in immigration, for the former the immigration of Central European workers, for the latter Mexican workers. In addition to these workers also helping to hold down wage inflation (in addition to competition from emerging economies), they also created even greater activity levels in the destination economies, adding even more growth to the GDP and also accelerating demand for housing. They came in large numbers due to the boom in the service economy, which in turn was built upon the boom in credit. In other words, the mass immigration was an upward lever on the economies, on the bubbles that were forming. The trouble is that immigrant workers are, in most cases, a negative impact on an economy, in particular if they are temporary. Each immigrant worker who comes on a temporary basis intends to return home with a cash sum. When they return home, they are therefore taking real wealth out of the economy. Furthermore, if they return home in large numbers, one of the props for the housing market price rises is removed, as demand will go down.

It is now that we come to what I call 'The Cigarette Lighter Problem'. It is not of itself a problem, but the expression of a more fundamental problem. In the post I detail how a lighter in a Western economy costs about nine time the price paid in China. In paying this price for an identical product, delivered in an identical way to the way it was delivered in China, I point out that there must be some part of the economy generating huge amounts of added value to support such a price. At the same time I consider the economy of China, which increasingly has the same infrastructure, the same technologies (at least in the cities), increasing productivity, and so forth. In such circumstances, how can the price differential be maintained? Can such a large differential be justified?

The answer to the cigarette lighter problem is actually the answer to the problems that the West is now facing. The differential is built upon the flood of money that has entered the economies of the Western world, such that it is the lending that is actually the root of much of the difference in the price. There is no part of the economy that can explain such a massive differential, and we can only conclude that a large part of the price differential is that the emerging economies are paying for a large part of the differential. I am aware that this is a difficult concept to grasp. It is the idea that when we enter a shop and do something as simple as buying a lighter, we are paying for it in part with money that was actually borrowed from other countries.

So now we return to the problems that we are seeing today. The first point of note is that commodity prices are now falling back (notwithstanding the irrational pouring of money into commodities out of panic). The reason for this is that, now that the flow of money into the Western economies is drying up as the debt spigot is switched off, the economies of the West are contracting, with a commensurate contraction in those who were exporting to them. In other words, demand is fast contracting and contracting back to a level where supply once against exceeds demand. I like the analogy here where world demand was a person racing forward, only to hit a wall, and bounce back before once again commencing progress. What will happen is that, having bounced back, the running forward will again occur at breakneck speed in the future, only for the runner to bounce back once again. All the time, the wall is moving forwarded, but never fast enough for the speed of the runner who will keep running forward and bouncing back.

It is here that we see the underlying problem for the Western economies. As I have discussed, there are many new workers in the world and, in order for them to be productive, they will need to have access to resource, to commodities. The situation is now one in which the runner has bounced back, and there is an excess of supply of commodities relative to demand. However, if we remember, the amount of commodities available to the world economy has not increased in a way commensurate with the supply of labour. As such, until such a time, not everyone will be able to have the same share of the available resource that was utilised by the West. It will not be possible, until that time, for the emerging economies to 'rise up' to the standard of living of the Western world. There is simply not enough available resource for this to be possible.

Many economists claim that international trade is not a zero sum game. They claim that everyone can benefit, as trade will help everyone get richer. This is absolutely true, but only if there is not competition for limited resource. In such circumstances of competition, the situation today, there are winners and losers. The big question that this raises is one of who will win and who will lose?

My argument is that the West is not well placed to win in this new competition. Our economies are bloated with fat, and due to the excesses of the credit boom, loaded down with debt. Our governments are inefficient and complacent, our advantages in education are diminishing as our education systems fall victim to faddish dumbing down, our technology is being exported wholesale to the emerging markets, we carry the weight of welfare systems that are unsustainable, and we tie up our businesses with regulation, and tie the hands of business behind their backs by ethical laws, so called 'green' policy, and demands for abstract notions such as 'corporate responsibility'. On top of this, you can see a culture of expectation, that government has the answers, that we have a right to wealth, and a culture or complacent expectation. Compare this with the hard working emerging economies, in particular in Asia, who revere education, who will do anything to secure the betterment of their family position, whose governments are hungry for success, and determined to find their place in the world (I am really talking of China here), and who are pursuing aggressive mercantilism policy.

In such a situation, I have to ask how we can win? It is the reason for this blog, and the reason why I have written about structural reform. However, these are the least read and least commented part of the blog. I suspect that, on the one hand, we can accept intellectually the arguments that I am putting forward, but not actually accept the reality of the inevitable consequences. Those consequences are that we must adapt to being poorer. Whilst the world overall is getting richer, a greater share of that wealth is going to move to the emerging economies, and it will happen at the expense of the West (or OECD if you prefer). The way that the wealth is redistributed will not be even. Some countries will fare better than others. I have always argued that the UK is going to be one of those hardest hit, and everything that I have seen in the last few years, and more recently confirms this. On the other hand, I used to believe that the US would hurt, but the flexibility and dynamism of the US culture and economy would pull it through (such that there would be pain, but not as bad as for example the UK). However, events of the last week appear to suggest that the path being taken is to try to magic away the problems with ever more borrowing. I am now very pessimistic.

As I said at the start of this very long post, the crisis in the financial system is actually based upon an element of rationality. It is not some strange force, but a reflection of the underlying economic problems, and the shock of the intrusion of reality into the delusions that have been held by so many. I have said many times that what we are witnessing is the inevitable rebalancing of the world economy. Everyone will hurt in the process and we will enter a period of economic chaos, with possible political chaos flowing from the pain.

Pure and simple, the world economy is a mess. The reactions to date are not encouraging. It seems that nobody has yet accepted that the errors of the past can not be fixed overnight, that the gross misallocation of capital in the Western world must have consequences, and that the West must come out of this poorer than it started, and considerably so.

In this post I have not done full justice to all of the points that have been made in previous posts. I have just sat down at my computer and churned this out without any plan or structure, so I hope that it makes sense to you. In places I have oversimplified, and not accounted for the many inter-connections that have driven all of this disaster. I have not referenced much of the post. I apologise for all of these faults, but I am (as ever) constrained by the demands of my 'real life'. I hope that you will understand.

If you do find that the argument put forward here makes sense to you, then I would suggest that you take time to look through the blog, as there is far more in depth explanations and discussions. I have given links at the top of the post, which take you to some key posts. However, do not neglect the archives. I had myself forgotten some of my previous posts, and on occasion have been pleasantly surprised to find some of my own explanations that I had forgotten, but which helped me make sense of the current situation.

Note for Regular Readers: I will not be posting as often as in recent times as my 'real life' will be very busy for the next month and a half. Also, I want to avoid getting sucked into 'punditry' and would rather focus on the wider issues. As such I will continue to post, but will try to restrict my posts to implications as the crisis unfolds.

Note added 28th September:

I have just posted a comment in a forum, which may be worth adding here:

The justification for the bailout is to avoid a repeat of the Great Depression. However, the world is not in the 1930s, so why would an imagined solution to a 1930s problem fit the circumstances of 2008. . There is no evidence that it would have worked then, and even if had worked then, would that suggest that this would solve the different crisis that is occuring today?

As I have detailed above, the crisis actually stems from some very particular circumstances.

Note 2, added 28th September:

One comment on this article accepted the principles of what was said in the post as saying
'Absolutely wonderful post. Although I am somewhat more optimistic than you that people in OECD countries can bounce back and become competitive when they are under greater competitive pressure'
Whilst my posts are unremittingly gloomy, I also believe that the OECD (Western) economies can bounce back. However, the first step is the recognition of the reality of the changed world, and it is the lack of recognition that concerns me. Another comment noted that there was a problem of arrogance in the US, and this is perhaps a related point to the one I am making here.

Another poster has added a comment against 'A Funny View of Wealth' asking:
'What will be the effect(s) of continued mass unskilled imigration from third world countries?'
My answer to this is that I suspect that, as the economy turns down, the borders will probably close to any significant immigration (Central European immigration notwithstanding). However, this is a matter of politicians making choices, so it can only be a guess. However, if the borders remain relatively open, it is likely that numbers will diminish as the Western economies will start to look less attractive. Whilst the West will still be relatively wealthy comapred with many countries, economic migration probably needs fairly strong motivation, and the prospect of arriving in a country with surging unemployment is probably not going to help with that motivation.

Lemming (a regular commentator), asks a perceptive question as follows:
'The brave, clever and perceptive thing to have done would have been to stifle 'growth' (debt) with the future in mind. But at what point would such a suggestion stray into the realms of 'socialism'?'
This raises the question of how much intervention governments should undertake in markets. My argument has consistently been that the problem actually arose as a result of government regulation (see 'The Market and the Crash') which caused a false sense of security. I have also been critical of the very idea of government borrowing and the setting of interest rates by central banks (see 'Government Borrowing and Interest Rates'). Removing regulation, and the ability of central banks to set interest rates would probably have avoided this crisis. In particular, without the regulation the activities of the banks would have caused alarm much sooner than was the case when they met regulatory requirments (implying that they were 'sound') and would have also prevented the need for off-balance sheet structures, CDOs and all of the other problematic activities.

Lemming goes on to ask:
'Did any government in the world conspicuously do the right thing over the last decade?'
I can think of no example. However, I am a market purist, where I believe that the only role of government is in the prevention of market concentration and monopoly, fraud, insider trading and so forth. This serves to remind me that I still need to finish my post on regulation, which will discuss such issues in more depth. Hopefully this will answer your question as this is too big a subject for a quick comment.

Thursday, September 25, 2008

Now the US is in Real Trouble - Paulson and Bernanke Succeed

The breaking news in the Times is that the bailout of the US banking system will go ahead. Now, it looks like it is just a matter of detail, and the devil of how bad the decision will be will lie in the detail.

I have noted that, whilst visitor numbers are up, the percentage of returning visitors to the post is not keeping up (though is still high). That possibly means that some of the new visitors who are coming to this blog do not like what they are reading. I suspect that the reason for this is the belief that I am too pessimistic, that they just can not believe that governments can not 'fix' the problems. After all, 'something has to be done'. Government, apparently, can wave a magic wand of debt and fix the stored problems from at least ten years of erroneous financial management. If you reread the last sentence, the absurdity of the idea is self-evident.

Whatever the details, this magic wand will be damaging to the long term prospects of the US economy. When I first saw this crisis, the one thing that was impossible to predict was going to be how individuals would react to it. Whilst thinking that the US would go through some very unpleasant pain, I believed that the US economy would adapt and reinvent itself in light of the new market conditions. My optimism has significantly diminished.

For some reason I have not been discussing some of the hidden negatives in government borrowing. I suggest that you read here before continuing. The point is that government borrowing distorts the economy in more ways than you might imagine, in particular by hoovering up capital, by competing with productive uses of the capital. On top of this, there are the reasons I have outlined in several other posts as follows:
1. The bail outs are shifting the economic damage onto government balance sheets at a time when the governments of the OECD will need all the resources that they can get. As the world economy rebalances the Western governments will need to make structural adjustments to meet the challenges of the emerging economies, and the massive input of labour into the world economy that they represent. The bailouts will tie government finances in knots, and may actually precipitate a loss of confidence in the ability of governments to pay their debt obligations.

2. In taking on the damage from the financial system, governments are spreading contagion throughout the economy, including the healthy parts. This is due to the inescapable fact that, at some point in time, the healthy parts of the economy will be facing larger tax bills.
I have mentioned several times why this deal will do harm, even if it gives markets and confidence a lift in the short term. However, again as I have repeated many times, there are more problems in the banking system than just the toxic mortgage debt. The Times report has this to say about Paulson's purpose for the bailout:
'Mr Paulson hopes that once the market recovers, the Treasury will be able to sell the bonds back into the market and recoup taxpayer funds. He is also hoping that once the banks are able to rid themselves of such assets, they will begin lending to one another again and America's capital markets will return to normal.'
There is an assumption here that, if the current bad mortgage debt is cleaned off the books, that will be the end of the crisis. However, such a scenario does not account for the downward spiral of the economy - as it weans itself off consumer credit and house price growth, the drivers of the so called 'service economy'. Whatever is done to bailout the immediate bad mortgage debt, nothing will change the fundamental underlying problems, and those problems are going to reappear in the banking system. As the economy continues to spiral down, there will be a new tranche of mortgage based debt going bad, huge swathes of consumer credit going sour, as well as commercial lending going bad. Will the US government be able to continue with the bailouts? I think not.

A good example of the unwinding can be seen in the UK at the moment, in the troubles of B&B, a UK buy-to-let lender (for US readers, this means providing mortgages, often to private landlords, to rent out property). The Telegraph reports the following:
'Credit Suisse said: "Ultimately, B&B's biggest issue is asset quality and we doubt any major bank will want exposure to a £40bn mortgage portfolio with arrears almost double the industry, and where over 40pc of loans will be in negative equity if house prices fall 30pc peak-to-trough.'
The interesting point here is that B&B is particularly heavily exposed to a high risk part of the market, and they are therefore acting as a weathervane. Mortgage and consumer credit arrears are up (see here and here - both out of date so the situation will be far worse now), and will get far worse as unemployment climbs. This applies equally to the US and UK. The arrears are increasingly going to spread into what was seen as the safe lending, or the lending to those who were in employment and could previously manage their payments. Under normal circumstances, this would be a problem but would be a manageble problem. However, with balance sheets already in tatters, this becomes another crisis. The trouble is that the debt bubble has hidden the underlying weakness of the economy, and the banks have been acting and lending on a belief that the economy was strong. That has been a fatal miscalculation, and nothing can soak up the sheer scale of bad lending.

So will all of the financial institutions suddenly start lending to one another again? The answer is that they will continue to hoard capital, as they will be aware that they will need the capital to offset the losses in the coming months/year. The bailout will give them a breathing space, will prolong the life of the weaker institutions, but nothing can stop the ongoing losses and the next tranche of failures.

So what will this bailout, this 'doing something', achieve? It will just act to hobble the US economy, and at best delay the progess of the crisis without stopping it. It will buy time, but at the cost of the future speed of recovery of the US economy. The only upside will be that it will speed the devaluation of the $US, which will allow the US economy to become more competitive, albeit at the cost of the relative impoverishment that this implies.

It is not a good day for the US economy, and that also means that it is not a good day for the world economy.

Note: In some of my previous posts I have been discussing that the emerging market currencies will increase in value compared with those of the West ($US, Euro, £GB). I have neglected to mention that the same might be said of the big commodity producers. An interesting question will be whether the currencies that are pegged to the $US will free their currencies? My guess is that it will only be a matter of time, and I have noted others have a similar opinion (sorry, no refernces to hand on this point, as this note is a rushed afterthought).

Note 2: I recently discussed a report that was pessimistic about China, and have just found a new report that is far more positive about the prospects for China. As I keep saying, China is very opaque, and this means that it is a 'wildcard'. Even with $US devaluation they have significant resources available to carry them through the downturn, but will it be enough. See my post here for a discussion a discussion of why China is a question mark.

Note 3: Some time ago, I promised that I would write a further post on reform (in this case regulation), but have not managed to do this. The current events have been a bit of a distraction and I hope to return to reform in the future, as this is one of the main purposes of this blog. It is all very well to consider the problems, but what is really needed is solutions.

Note 4: I have found this in the Telegraph:
'Meanwhile, ratings agency Fitch said the vast bail-outs agreed yesterday by the US Congress do not add significantly to America’s public debt of 57pc of GDP since the money is being used to buy assets, which are backed by collateral. '
So let's get this clear. Nobody wants to buy this toxic waste, not even the sovereign wealth funds, even though the debt is available at firesale prices. Despite this, apparently the is backed by collateral, even though the collateral becomes worth less with every day that goes by. It is a bit like securing a loan against a burning building - fine if someone can put the fire out, but otherwise not really much use.

Final Note: I thought perhaps some light relief is in order; this from the Spectator:

'If you had purchased £1000 of Northern Rock shares one year ago it would now be worth £4.95. With HBOS, earlier this week your £1000 would have been worth £16.50, £1000 invested in XL Leisure would now be worth less than £5, but if you bought £1000 worth of Tennents Lager one year ago, drank it all, then took the empty cans to an aluminium re-cycling plant, you would get £214. So based on the above statistics the best current investment advice is to drink heavily and recycle.'
In current circumstances, this might be a popular investment tip......

Tuesday, September 23, 2008

Bernanke and Paulson - the Dynamic Duo?

The world is waiting nervously to see whether the bailout of the financial system will actually go ahead, with ever more dissent coming from congress in the United States. If the article I have cited is correct, it is not economics in the driving seat, but politics. Bearing in mind that the economists have got it so wrong in the past, perhaps (for once) that is a good thing.

Meanwhile, one of the curiosities of recent days is that oil has risen in price. This really is quite baffling, though not in the sense that it is rising through hidden unknown mechanisms. The baffling part is that oil is not something that can be stored, and has to be sold according to a price that is set by demand. Unless those investing in oil know that there will be a cut in supply, it is not entirely clear how they seek to profit, or even find safety in this commodity. Oil prices were falling previously for a good reason; that demand across the OECD was falling back. As such, they now have the oil, but they need to actually sell it to end users at a price that will cover their buying price. As ever, those who got in early stand to profit from this, but the followers will surely lose money - unless I am missing something critical here? On the other hand the flight to gold makes more sense, as gold is currently being driven by sentiment (a flight to safety), and can be held over the long term. At this point, you may ask for the difference. In crude terms, gold can be locked away and be held over long periods of time, whereas oil can not be stored in significant quantities. As I have said, perhaps I am missing something here, but I do not think so.

This situation perhaps illustrates the underlying fear in the market. On a related issue it appears that there are tremors over the state of the emerging markets:

'"The big surprise in store is what could happen in China. The potential for a deep recession in the US is already on the radar screen, but people will be stunned if China's economy contracts, as I believe it will. Investors could be massively caught out," he said.

"The consensus has a touching belief that emerging markets will prove resilient despite a deep downturn in developed economies. My view is that an outright contraction in global GDP is entirely possible next year."'


'The gloomy forecast comes as Fitch Ratings warns of mounting distress for banks in China, where debt has been shunted off books to circumvent state limits on credit growth.

The pattern looks eerily like the use of "conduits" by Western banks at the height of the credit bubble'

I have mentioned before that China is opaque, and whether it would be pulled down by the crisis was not entirely clear. I recommend you read my original post on China, as it covers both the positives and negatives in the Chinese economy, and explains why it is that it is so difficult to see the economy clearly.In my original post on China, I had the following to say in conclusion to my discussion of Chinese banks (having pointed out that their commercial and domestic property were looking like a bubble):

'In light of this, I must conclude that there may still be some suspect lending from the Chinese banks. This is pure speculation, but is based on experience 'on the ground'. This raises the possibility that there is also bad lending into business, in particular to the state owned firms. Such lending is not so visible, so it is impossible to say if this is the case.'

However, before writing off the Chinese economy, I would suggest taking a look at the post, as there are significant strengths. The fact that the problems of the US and Europe would hurt China was always evident (and something I predicted). However, whether the damage from the West is enough to pull back the Chinese economy into recession was my question. If it is correct and, as I suspected, the Chinese banks have continued their poor lending, then the balance tilts towards serious problems for China. This is a very worrying thought, as the legitimacy of the Chinese Communist Party is built largely on economic growth and nationalism. If economic growth fails.....

The same article is suggesting that there may be a worldwide recession, and readers of my posts will find this to be no surprise. The real question is how the pain will be spread, and it has always been my belief that the West is going to be where the real hurt happens. However, if we throw unrest (Revolution? War?) into the Chinese equation, then all bets are off. At that point we will enter a state of chaos from which anything may emerge. It was one of the points made in my original post. However, this is just one report, and as I have emphasised, China is opaque; call it a wild card if you will.

What of investing in Asia? I have already suggested that their markets will fall along with Western markets, but that there currencies will see strengthening, which should offset the pain of the falls for those who move their money into the emerging economies early. However, if China does fall, then political risk across Asia will be sky high. It is for these reasons that I have been emphasising that there is no real safe haven at the moment, except possibly gold. In the short term I suspect that we will see some strange market movements. The flight to safety into oil suggests that there is a considerable degree of panic, and panic does not aid rational thought.

In the meantime, the world waits on the success or failure of the 'dynamic duo' of Paulson and Bernanke. However, their intervention does not promise to save the day, because no super heroes are large or powerful enough to overturn economic reality. The curious point for them is that, whatever they do, history will be kind to them. If they fail, and the anyway inevitable crisis ensues, everyone will suggest that 'if only they had been listened to', and if they succeed the economy will still crash, and it will be seen as a valiant effort, but just not enough. In short, the idea that something could be done will persist.

An analogy for this is to think of a company that has long been successful. The management of the company changes, and they cut back on investment, increase the pay of their workers, and enjoy the comfort of market leadership. As time goes on, they fail to note that new companies are entering their markets, taking market share, and fail to react. Instead, they raise ever more money on the markets, and the market keeps paying. However, they are loading up with debt, and they are starting to use debt to pay back debt. Can anything be done to stave off disaster in the short term? They are broke - their revenues are falling, they have lost market share, and their lack of investment has left them poorly equipped to fight back. No one wants to lend anymore...

So, can our dynamic duo save the day? I will let you draw your own conclusions.

Note 1: I was posting on a forum and dug out one of the useful resources that I occasionally dig into for information. The resource can be found here. It is the Bank of England document on recent developments:
'Chart 1 shows the extent to which the United Kingdom’s gross external assets and liabilities have grown since 1990. In this 13-year period, both assets and liabilities
have increased by more than £2.6 trillion, at an average annual rate of more than 11%. This easily outstripped the 5.4% average annual growth rate of nominal UK
GDP over the same period. At end-2003, external assets stood at £3.55 trillion and external liabilities stood at £3.60 trillion.'
When we factor in that they include the multiplier effects from increase in debt are factored into economic growth, such that the GDP figures are completely removed from the the reality of real growth, then we have a very worrying situation indeed (these are problems discussed through various places in the blog).

Note 2: Just a quick comment on Gordon Brown cleaning up the City and the world financial system:
'Mr Brown will call today for global regulation. "Because the flows of capital are global, then supervision can no longer just be national but has to be global. And if we make these changes I believe London will retain its rightful place as the financial centre of the world.'
The first problem is that (as I have argued previously) it is actually regulation causing all the problems. The second problem is one of practicality. How can different systems across the world all find a common standard. The third problem is that, if all the world uses the same system, then the entire world system will all go down at once if there is a major failure in that system (an analogy that comes to mind was a historical calamity in which the whole of the US used the same variety of wheat, such that when a disease struck the whole years crop was devastated). As it is the system is interconnected, but at least different systems will have different vulnerabilites and exposures.

Happily, as trying to set up such a financial system will be akin to herding cats, it is very unlikely (I hope) to succeed. As such it is probably just grand standing, to be seen to be doing something; and an attempt to portray gravitas. As for the idea of regulation of banking pay, I have yet to see any solid proposal that goes beyond rhetoric, but the idea of government control of remuneration is one which brings the word 'despair' to mind. The banks may have been foolish, but much of the root cause for the foolishness was that all the banks were 'sound'.....and the reason that they were sound was because they met regulatory requirements. The fact that their capital base was built upon toxic waste slipped the regulators by....and now there is talk about regulation of remuneration?

Note for Tin Hat: In reply to your question, I have no secret investment tips. I just arranged my life such that (hopefully) the crisis will mostly pass me by.

Last Note: Just a point on the valuation of emerging market investments. A simple way to look at it is imagine you invest $1 in a US stock, and $1 in an asian stock, and both stocks fall equally in percentage terms in their markets. If the Asia currency is appreciateing against the dollar, even though the Asian stock has dropped in value, at least part of your wealth has been retained through the fact that when you sell that stock, the currency will ameliorate the effects of the fall in the stock value, as the value is measured against local exchange rates. Sorry, to mention this if it is obvious to you all, but just in case....

Monday, September 22, 2008

Money Moving to 'Safety in Asia'?

It seems that Alastair Darling is declaring no tax rises in the UK, despite the deterioration of the government financial position. Other comments by Gordon Brown have been supportive that this will be the UK government position. Of course, what this means is that the government will continue to borrow, and borrow ever more heavily. Estimates of borrowing for all kinds of figures are floating around, but most of the have been far to conservative (but nevertheless alarming enough - I would reference this but am having troubles accessing some websites). Those that are predicting massive increases in borrowing are not accounting for the scale of the coming contraction.

So it seems that the irresponsibility goes on; the lack of any grasp of the severity of the situation continues. As I keep saying, the only way out of the crisis is structural reform (see solutions to the left), but the government answer is to continue to bury its head in the sand of debt. To mix my metaphors slightly, it seems that the solution is move ourselves ever deeper into the quagmire, and this can only delay the possibility of recovery. Furthermore, this is a very loud signal the UK's creditors, and will at the very least hasten the drying up of lines of credit, and speed the decline of the £GB. Both of these will naturally feed off the other, as they are both effects are based in lack of confidence, and one will reinforce the other. The day of default moves nearer.

I have also just seen some news over the shifts in the stock markets. It seems that London and European markets have been dropping, whilst the Asian markets were rising.

It is far too early to tell, and I do not normally bother commenting on short term fluctuations in markets (as you really need to be 'within' the markets to see the thinking behind the short term movements). However, in the context of what has been happening, could this be a process of money moving from West to East. In the current climate, this would be a reasonable reaction. If, as I expect the $US, £GB and Euro (to a lesser extent) are about to take a further battering, then we have to ask whether the markets are moving ahead of the declines (but will also precipitate the decline they are fleeing from). The Western currencies will almost certainly devalue against the emerging economy currencies overall (ignoring the China currency problem) so this could be strategic manoeuvring. Clearly, those who move their money early, will stand to gain. The nature of the downward slide in currencies may be bumpy along the way (sentiment being one of the drivers), but the slide will certainly happen. Is the market thinking this way (markets do not, of course, have their own intentionality, so I hope you will forgive the metonymy)?

This would appear logical, but there is some illogic in the activity. Whilst I do not believe (and I do not know enough about these countries to be certain) that they will be hit as hard as the UK and US, Australia and New Zealand are also going to suffer in the crisis. Bearing this in mind, it is curious that their markets also gained, though this could be positive sentiment on the back of other Asian gains.

It is, of course, too early to tell, but it would certainly be a natural thing to move money into Asia at this stage in the crisis. Of course, if this happens on any scale, then a bubble in Asian stock markets is the next logical outcome.

However, I am moving into speculation here which is not the general aim of this blog. I think we need to sit back during this period, and let the markets absorb the final details of the bailout in the US before we can see how quickly sentiment will turn back to the negative. I am guessing that markets are on a knife edge of irrational optimism, or complete despair, and they might move any direction in the short term. However, short to medium term the only direction of Western markets (US and UK in particular) is down......

If that happens will money be safe in the East? I think that the Eastern markets will also follow the West down at some point, but how much by is a less clear issue, and the falls would need to be considered in the light of the currency movements. Whatever the case, I would speculate that the Eastern markets do present a better prospect overall due to the currency movements, but present risks as well (as I have discussed in previous posts). As I have also emphasised previously, in this kind of turmoil, there is no safe place for money. Too much hangs on sentiment, and that is not a very safe thing on which to risk money.

Note Added 23 September: With regards to the above post, a small apology. I am not sure that it is as clear as it should be - perhaps a little too rushed on this occasion, and also it is a little too speculative. However, I will leave it as it is, as one of the underlying principles of the blog is to leave each post untouched except for dated notes and additions. It does, however, raise an interesting question. What will the market do to try to save the value of their money before the currency devaluations?

The inevitablility of devaluations are becoming evident to the market; the $US will devalue, as will other Western currencies (the £GB in particular). This is no secret, as a recent Telegraph article points out:
'But as investors scrambled to make sense of last week’s events, already one conclusion was all but irrefutable – the US dollar will have to take another major fall'
With regards to the £GB, some may be taking comfort in the headline strengthening agains the $US, but this is only temporary, as the £GB is going to be found to be weaker even than the $US. Also, as I have pointed out before, it is not the measure of the Western currencies against each other that should be watched, but how they measure against the currencies of the emerging markets. The same Telegraph article says this of the £GB:
'Ironically, despite the pound’s comparative strength against the dollar – having risen from just above $1.75 in the past few weeks – it remains extremely weak against other world currencies, due to investors’ fears about the UK’s own home-grown problems.'
In a crude analagoy, measuring the sick against the sick is not the best way to understand the health of a person. Just because both are suffering from an acute fever, but one person's temperature is higher than the other, does not make the less sick person healthy.

What of the Euro? The Euro economy is such a mixed bag of basket cases (e.g. Italy) and stronger economies (e.g. Germany), that it is difficult to see how this currency will move long term, except that it will also fall against the emerging market currencies. How far is a difficult question. In the short term, it might strengthen, as the market clings on to the lifeboat of past certainties.

Returning to the original post, what happens if money starts to move out of the West into the East (and emerging markets). Whilst the early movers into these markets will retain their wealth, the movement of money out of the Western economies will precipitate currency falls. At the same time, the movement of money into the emerging markets will destroy wealth within the emerging markets, because the assets purchased with a falling currency will leave someone holding devalued currency. As such, as the money moves out, the currencies will drop ever faster....but will still manage to inflate asset prices in the emerging economies.

This means that the more that money is transferred to the emerging markets, the more that the investors will be buying into overinflated assets with ever greater sums of devaluing currency. As such, as the underlying value of the assets will not justify the prices, the value of the transferred money will in any case be destroyed in the future. The only winners will be those that buy into the assets early. They will lock in the value, even if the asset bubble bursts at a later point. However, even these assets will be at some risk because as the debt money-go-round collapses, the exporting countries will see exports fall, and therefore will suffer their own pain. As I suggested in the original post, the upside is that some of this pain will be ameliorated by having assets in a stronger currency.

All of this is to ignore the political and other risks in the emerging economies, which makes all such investments risky (e.g. what happens if the damage in the West does tip China into recession? See post on China).

As you will note, as I have mentioned in previous posts, in the current turmoil there is no safe haven, excepting possibly gold, and I have already warned one reader to make sure to look closely at the history of gold prices before jumping into that market (I have not followed gold prices such that I have a sense of where the price can or will go in the current circumstances).

The bottom line in all of this is that the correction is ongoing, and there is no real way to stop the 'wealth' destruction that was always inevitable. Only the most astute, and fastest moving in the West will manage to hold onto the current vale of their assets.

Note 2: It seems that Paulson is now pressuring other countries to follow him on his course of bailouts and that the US stockmarket suffered from falls today. The wildcard at this stage of the crisis was always going to be the question of how governments would react. Instead of addressing the underlying problems, they are trying to 'magic' them away. Such actions can only delay and, as I have pointed out many times, worsen the crisis. As such, it seems that the wildcard of government action has proven to be action to exacerbate the crisis. With such action, the situation can only go downhill.

Saturday, September 20, 2008

US Government Guarantees a Crash

Update: 23 Sept. Just a note. It seems that the bailout will be financed through borrowing, which is a relief. Better that than just printing money. However, not bailing out the system is the best option, but at least this is better than the worst case.........

I have had a comment in which one of the regular commentators (Lemming) on the blog has played devil's advocate, and put forward an argument that the bailout is the right thing to do. This is the argument put forward:
'Aside from external debt, does a country's internal debt matter, anyway? If most of the bad debts which are being monetized were as a result of over-inflated house prices it won't matter if they vanish into thin air, will it? It's just good for some people, and bad for others, with a net result of zero. (People spent money on imports with the dollars they raised against their houses, however, but more fool the foreigners who were taken in and who exchanged real goods for worthless paper.)

Is the same true for derivatives 'de-leveraging'? That is, if the debts and 'assets' had never existed nothing material would change?

At the end of the day, if the world's economy was 'reset', we would still have the same level of prosperity we have today, wouldn't we? There would still be the same natural resources, the same number of people with the same talents, and the same infrastructure. The financial system has got itself gummed up, and technically some people have enjoyed a standard of living they did not deserve, (financed by others who were seemingly happy to pay for it) but if the whole world can see that by insisting on following through on every failed loan and transaction, that it drags everybody down into the mud, it might be best to 'start again' and reset the mechanism. Sure, some people in far away lands are owed some money for past productive activity, but even they might see that they must 'let go'?

Is this the logic that has led to the US dollar being artificially propped up by the world for years, i.e. that it is better to keep the mechanism running, even if it results in undeserving people living in luxury, than for the mechanism to grind to a halt. Have we reached the stage where it is impossible to keep the mechanism running whatever we do, so more drastic action is needed?'
The first point to make is that it is now apparent that the 'rescue' of the financial system will be financed through monetisation ('printing' money), not through government borrowing . This approach will have very serious consequences for the US and world economy.

The first problem this presents is that it will destroy confidence. I have discussed the importance of confidence in a fractional reserve banking system elsewehere in the blog. The important aspect of the post is that in a system of fractional reserve banking is that money in such a system has no value whatsoever except what we collectively believe it has. By printing money in this way, the US will certainly destroy confidence, as there appears to be no limit on what the government is willing to print.

The result of this unconstrained printing of money is that the $US will fall. This is very different magnitude of fall compared to that which would occur has the US government decided to finance the bailout through borrowing. In the latter, the bailout would be funded by the US taxpayers, but in the former the pain is shared around the world by all holders of $US assetts. This may appear to be a clever move, as it shifts the burden more widely, and moves some of the pain to the rest of the world. However, the price will be high for printing money (see article here for an example - though the article does not give a picture of the seriousness) .

As I have already mentioned the entire banking system rests on confidence, and this is a fragile base for a financial system. If you destroy confidence, money has no real value whatsoever, and this is the problem of removing a currency from exchange for a tangible asset such as gold. If you give me $1, I will only value it if I believe that the next morning I can still use it to buy the same amount of product as I could today. If I no longer believe in this, and it is just a matter of belief, then I will not accept the $1 that you give me and will want to be paid in some other way. If a government can print money with no constraint, and with nothing to back it, then I will cease to 'believe' in the value of money. The best way to understand this is to take a look at my original post, where I make a comparison between the virtual world of 'Second Life' and the real world. When you see this comparison, I hope that all becomes clear.

This is a very roundabout way of coming to the subject of the foolish foreigners who have exchanged goods for worthless paper. Yes, this is quite right, they have done this. Yes, they have been foolish to do so. However, the system is built on trust (confidence), and those foolish foreigners will learn their lesson. That is, they will no longer trust that they will ever be paid for what they provide, or at least they will lose belief that they will ever be paid in full. This means that the TVs, the toys and all of the other imports that the Western consumer has been able to buy will only be available with a massive risk premium attached to their price, as they will have no confidence that the $US they get in return for their product will be worth the same tomorrow as it is today. I talk about this as if individual firms will take this approach, but in reality it is the collective loss of belief that matters.

What of the idea that if everything is reset, we still have the same amount of resource, the same people and the same infrastructure. This is very true, that nothing has changed 'on the ground', except for confidence. It is here that we return to the massive accumulation of debt in the Western economies. In a situation of loss of confidence, who will keep the lending going? Who will lend into currencies that are devaluing, and at what risk premium?

The trouble is that when the debt ATM is shut down, how much is all of the talent, infrastructure and so forth really able to produce? Can it produce enough wealth for Western consumers to buy the latest shiny plasma TV from a Japaense company manufacturing in China? In other words, are the Western economies producing enough to have sufficient product/services to exchange for the shiny plasma TV? The answer is that most of the Western economies have not been producing enough for a very long time, and that the continued lending was built upon a false belief that they were. Once again we come back to the idea of confidence and belief. I return here to my analogy of the aristocrat who lives beyond his income, with all of his creditors lending on the basis that the aristocrat's family always having been so wealthy for so long that they just can not believe that in reality he is broke.

The reality is that the majority of the Western economies are just not producing enough value to continue to live in the manner to which they have become accustomed. We are, in reality, broke and in debt. No one is going to lend to us, and we now have to adapt to living on the value that we really produce.

Yes, the world has kept the West living in luxury, but it has been no conspiracy. It is, as I have said earlier, that the world has just 'believed' that the West was rich, and always would be. The world is waking up to the reality, that when they lend to the Western economies, that the Western are unable to produce sufficient goods and services to pay back what has been lent or, put another way, the West is unable to produce sufficient goods or services of sufficient value to make trading with them on todays' terms worthwhile. That means that the terms of trading with the Western economies will be more realistic, and that means the value of currencies must fall - and fall by a huge amount. There is no possibility of resetting the mechanism, because the mechanism was never a deliberate policy, but was built upon a collective delusion.

What can be done? What drastic action can fix the problem?

The answer is that nothing can be 'done'. Printing money will only exacerbate the problem, fuelling hyper inflation. For the Western economies, such as the UK and US, they will simply have to adapt to living within their means. The welfare states, the health services, the wasteful use of money by government will all be unsupportable. The massive boom in services, the expensive restaurants, the crystal healers, the retail expansion - all of these will shrink back to a sustainable size to reflect the contraction of the economy as the debt ATM shuts down. The result will be massive unemployment, unemployment on a scale that we have never imagined. The foreign investment will dry up completely, the cost of all the imports will surge, as well as the cost of commodities.

I have previously suggested that inflation would be held back by the rise in unemployment, that costs in the UK would be held down and that this would counter the worse effects of devaluation. I no longer believe that will be the case, as I now believe that the currency collapse will be so severe that massive inflation is the only outcome. I wrote a couple of months ago that it was hard to believe the logic, the inevitability, and the severity of what is coming. I suggested that I had been too conservative in my predictions, that it would be worse even than I had suggested in 'A Funny View of Wealth'. Now, as we stare over the precipice, the distance to the bottom is becoming ever more clear, and it is a very scary thing.

As I sit in my comfortable home, enjoying the comforts of the Western lifestyle, it is hard to imagine that it is coming to an end, but it is. In my case I am hoping that I have taken a course of action that will insulate me from the worst of what is to come (at least for three years), but I worry for those who will be exposed to the full force of this economic hurricane, and wonder how the world will look in two years time.

I suspect that it will not be a pleasant sight.

Note 1: Lemming also posted a link to a very interesting site. I strongly recommend it to all the readers here. It includes articles by Ron Paul, and for readers of this blog in the US I would strongly recommend Ron Paul to you. He appears to be the one potential leader who understands the situation, and knows what to do. Quite simply, you should be begging him to run for president, though sadly it is probably too late. In the UK I see no such potential leaders, and that is a very worrying thing.

Note 2: I have just taken a look at the Sunday editions and found the following:
'After a week of unprecedented financial turmoil, they predict that government borrowing is about to surge as the Treasury’s tax take is slashed by a slump in earnings from the City and the downturn.

Leading forecasters say the government will soon be forced to borrow as much as £100 billion a year, giving Britain easily the biggest budget deficit of any western country'

This is exactly as I have been predicting, though I still believe that this is conservative. It is time for structural reform. The UK can not afford to go on as it is. If you are new to this blog, take a look at the links at the top of the blog, where I outline some solutions. If you like them, recommend the blog to others, as the purpose of this blog is to try to make a small contribution to the realisation that reform is the only way through this. If we do not accept this king of reform, the alternative will be more government 'solutions' and it is the solutions of the government that led us to this crisis.

Yet another note: I have just taken time to look at the Sunday edition of the Telegraph and the coverage of the crisis is becoming ever more gloomy. A good example can be found here (I use the word 'good' very loosely):

'Power has tangibly shifted - away from the United States and the Western world generally, and towards the fast-growing giants of the East. That's been happening for some years now'

The article in question goes on to say:

'How much more can the US taxpayer take? It sounds insane, but the liabilities being taken on by the Fed and the US Treasury are now so enormous that the government itself could default. No?'


'But the ultimate financial question - until recently, unthinkable - is now being asked. Yes siree, the mighty US government could default. That's how much the world has changed.'

At the moment it is the US that is take the brunt of the pounding. However, the UK economy is far, far weaker than the US economy. I do not mean in terms of what has been taken in the past to be strength and weakness (see 'A Funny View of Wealth'), but underlying strength. We are more indebted, and lack any clear competitive advantage in most sectors. If we look at the pain of the US now, we need to multiply that pain for the UK.

In another article, it appears that the FSA is trying to find a buyer of B&B. The death roll of several UK banks is starting, but expect an acceleration of the pace, as everyone now examines the state of even the most 'sound' and largest banks.

It seems that we are now entering the final stages of the beginning. In this case, the beginning is the destruction of the economy of the UK. This is the shock of the crash. I am not sure how longer this phase will last, as there may be some more false dawns, but suspect that it will just be one or two months at the most. The time scales are very much in line with myprevious predictions on this blog. As I have repeatedly stressed over the last few months, make sure that you have your liquid assets ready to move at short notice. Ensure your accounts have Internet access and, at the first sign of rumour, move your money to another account. Be careful of using the same bank but with different brands.

After the crash will be the shock. The shock is when we contemplate the financial ruins, and see the bankruptcies multiply accross all of the economy, and unemployment sky-rocket. The outstanding questions will be the final order of the collapse. Will it be national debt default, or banking collapse, or both in conjunction. Both will happen, so it is not clear that one order of disaster is better than the other. It is only to be hoped that it all happens sooner than later, as the longer the delay, the more foolish action will be taken to avert the crisis from government.

I think I mentioned in a recent post that I am shocked at the panic. As I said, I thought others would watch dispassionately as all this occured. On reflection, I can see that it is only that this is no surprise that allows me to see it as an inevitable unfolding of events. I watch as the panic unfolds, and can imagine the late night meetings in the government as they desparately seek a solution that is not there. The momentum is now going to carry the crisis forwards, whatever they do. Instead of panicked meetings, I can only hope that someone is thinking through the aftermath, and asking how to pick up the pieces. I have always had this in mind as I have written this blog.

This is my last note today, as it is all rather depressing to think about.

(all notes written on day of original post)