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......


  1. Mark

    Yesterday I saw a discussion in some blog comments over whether the money for the bailout would effectively be borrowed, or printed. I think in an earlier post you suggested that it would be printed. I think you also suggested in another post that by printing dollars the US could 'get away' with their past debts, but would create the problem of no one ever wanting to invest in the dollar again.

    Is there something the US could do to absolve them of their past sins (debts) *and* divert attention away from their fundamentally unsound economy?

    Could they print the dollar like there's no tomorrow, trashing it - and their debts - in the process, then come up with a new currency, which is somehow engineered to debut in a way favourable to the US?

    As you have pointed out, the rest of the world *wants* to believe that the US is rich, and always will be rich. I think people could be persuaded that the previous problems lay with the banking system and the dollar itself, and not the US economy fundamentally. With a clean, fresh new currency 'normal service' would have been resumed.

    Is it possible?

  2. Mark,

    Just saw that you had added an update to this post


    saying that the US was intending to borrow the money for the bailout as opposed to printing it. Ignore my fanciful comments on trashing the dollar earlier!

  3. But what about all the foreign investors who lose money as a result - would they be keen to lend again? And if they won't then how does the US get access to the natural resources that it needs without taking them by force?


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