US and UK Goverments Guarantee Consumer Debt

The headline for this post is deliberately shocking, and might appear somewhat absurd. However, as I will explain that is what the governments are actually doing.

Even the most myopic economists, politicians and commentators now seem to accept that we have witnessed a debt bubble, and that the bubble is going through the process of bursting. More problematic is the explanation of what the banking bailout has been about. There has been considerable talk of the financial instruments that have been used to slice and dice debt, talk of sub-prime mortgages, toxic debt and so forth. This is then used to set the context of the debate, and the idea is that the fact that these problems are spread throughout the system has led to a loss of confidence in the banking system. The idea then is that, if the governments can just put fresh capital into the banks, then they will start lending to each other and the financial system will be fixed.

It all looks very plausible and very simple, and in some ways what I will discuss is not new. However, I thought that it is worth clarifying what exactly has happened.

The crisis has never just been about the irresponsible lending into sub-prime, but rather is about the wider lending practices of the banks, and also about the house price bubble. The banks have been lending heavily to consumers based upon the belief that house prices were a one way upwards bet, and this has driven the US and UK economies into overdrive, and has been responsible for most, if not all GDP growth in the last ten or so years. It is the foundation of the 'service economy'. The service economy is a debt based economy, and this has been reliant on banks lending heavily to consumers.

So what exactly is the banking bailout about? It is actually addressing the problem of what happens when the housing bubble bursts and the economy contracts, such that consumers stop spending borrowed money, and the economy contracts, causing higher unemployment, causing less spending by consumers and so forth into a downward spiral. Essentially, the trouble with the banks was that they were overexposed to consumer debt. The banking crisis was never about exposure to sub-prime debt, or problems that were inherently caused by CDOs and other financial instruments. The real root of the problem lay with souring consumer debt, and that souring extended beyond sub-prime and into wider lending. The banks would certainly have been aware that, with house prices falling, large portions of their debt would be progressively becoming ever more high risk debt. Equally, they would have seen the figures for rising defaults, rising insolvencies, and concluded that a storm was coming.

Sub-prime was just the trigger for a larger reassesment of risk. The reason why the banks stopped lending to one another was not due to sub-prime alone, but also due to the wider problem of poor lending.

When the situation is clarified, the bailout ceases to be about 'confidence', or getting banks to lend to one another again, but is actually about offering a guarantee against consumer default. If we actually think about, for example, the guarantees offered for bank deposits, they are being offered because of the fact that souring consumer debt is leading banks to insolvency. Therefore, what the government guarantee provides is a guarantee that, whatever happens to consumer debt, the government is acting as a guarantor for payment of that debt. In other words, huge tranches of consumer debt are being guaranteed by governments. Furthermore, by taking stakes in key financial institutions and encouraging those institutions to start lending again, they are providing financing and an implicit guarantee on new consumer debt.

It is a shocking idea, but when a person now enters a car showroom to purchase a car using borrowing, the government is acting as a guarantor for the repayment of the debt, and is also financing some of that lending, if not all of it. The guarantee has, to some extent, always been the case due to the presence of deposit guarantees, but the situation is now one in which this guarantee has been massively extended. By raising the amount guaranteed on deposits, and by showing that they will save banks at any cost, governments are effectively guaranteeing every single loan that is made. It is, of course, not just consumer borrowing that they are guaranteeing, but also all commercial debt.

So the situation that now pertains is one in which economies are falling off a cliff, with ever more debt, both commercial and consumer, turning sour, and governments have effectively stepped in as a guarantor for all lending throughout the economy.

As I said at the start, there is nothing new here, but rather a clarification of what has actually been done. I use the example of the person walking into a car showroom to highlight the reality of governments are actually doing. All of the talk about the bailouts is dressed up in complexity, and evasive language, but the simple reality is that governments are now guaranteeing every loan that is being made throughout their economies. When it is put in such black and white terms, it becomes somewhat disturbing. Not only is the government in the business of lending money for a consumer to buy a car, but they are lending on the basis that if the person subsequently defaults on the payment, they will take the losses as well.

The question I would ask at this stage, is to ask how many people would be happy with this situation when it is actually reduced to the underlying reality. Is it an acceptabel role for government?

Note 1: I have had a link from 'Death to Bubble Addicts' which may be of interest to those who have a poor view of Gordon Brown's role in the current crisis. The link is as follows:

http://uk.youtube.com/watch?v=qHqrBb-nRbs

It is a scathing attack on Gordon Brown, in which the problems that have arisen were predicted, and communicated to Gordon Brown ten years ago.

Note 2: Acrobat_747 has commented as follows:

The very suggestion that the UK could default on debt repayment before Christmas does not make sense. The UK is not even that much in debt relative to other counteries. The debt repayments should be relatively low compared with total government expenditure.

Debt is overhyped, and other nations will help if debt does become an issue. Wealth is relative, and so is debt. As all developed western countries are in debt it is not a handicap. In fact, avoiding debt may be fatal and perhaps the UK should be borrowing much much more.

This is a response to my suggestion that the UK government is heading for a default on borrowing. This is correct in one sense. Debt and wealth are relative, but the problem here is that debt needs to measured against ability to pay. The UK economy is shrinking and the GDP of the UK over the last 10 years is an illusion. As such, the size of the UK economy in relation to the actual debt levels is illusory. Why all developed economies are in debt is explained here and the post will offer no comfort. Just because your neighbour is in financial trouble does not mean that you are not in financial trouble. As I have mentioned in previous posts, continued borrowing is dependent upon confidence in the ability to repay. The storm that is engulfing the UK economy will destroy that confidence, as UK debt is spiralling whilst revenues are collapsing.

Note 3: Jim G asked the following:

'Out of interest, if you had savings currently in a UK bank, what would you do? (Savings are a deposit for when I get back onto the property ladder - sold to rent 1 year ago.)'

And from anonymous:

Now I am truly scared. What do you think one expecting a government default do? Withdraw their money and hide it "under the mattresses" as they say?

For many months I have been giving the same advice. Make sure that you have multiple bank accounts, make sure that all money is instantly accessible, that the accounts have internet access, and that you are prepared to move money quickly. As new advice, you may also want to open bank accounts in other countries, and have a transfer prepared so that you can move your money. As an aside, I have read that HSBC is in a relatively strong position due to high deposit levels, but I have never analysed individual banks, so this should be considered in this context.

If the question is where to invest money, I would not want to give direct advice, but will let you draw your own conclusions from my discussions. You should also read other opinions before deciding what to do.

Note 4: I have had another comment on conspiracy theories from Toshi, who explains that there is a journalist who offers some views on conspiracy theories and the 'New World Order'. Before following his work up, I found the following on Wikipedia regarding the journalist in question:

'More recently Fulford has stated that the US have been able to alter the climate, and using high power microwave energy induce earth quakes including the Asian Tsunami, Japanese and Chinese quakes. The program he refers to is known as HAARP High Frequency Active Auroral Research Program'

I looked no futher.... but thank you Toshi for passing this on. I am always interested in hearing about the proponents of conspiracy theories, as I think that we need to address these theories.

Note 5: A belated thankyou to the anonymous poster who gave the link on the IMF printing money. Such links are always appreciated.

Note 6: There is news that credit card borrowing is climbing in the UK, but that 'experts' believe that the money is being used for day to day expenses. The worrying part (see above) is that this lending is now being guaranteed by the government, and is at least partly financed by the government. So the situation is one in which an overstretched borrower is helping another overstretched borrower. More cause for worry.....

Note 7: US interest rates are now down to 1%, which means that the US government has almost nowhere left to go. Meanwhile it has been confirmed that the US economy is shrinking. Meanwhile in the UK Alastair Darling has confirmed that he intends to borrow and spend, until the end of the recession. If you read my previous posts you will find why it is that spending is now the single worst option. Try the links at the top left of the page to find out more. Meanwhile house prices continue to fall in the UK, with forced sales expected to exert further downward pressure, in an ongoing drip-drip of bad news.

Note 8: No doubt the astute readers will notice that there is a rollercoaster in currency, commodity and stock market at present. I think we all need to be careful (including myself) of reading too much into these day-to-day movements and view the bigger picture and trends. In particular, the market gyrations are a symptom of uncertainty, and therofore the market is moving with changes in sentiment. They are therefore best regarded as indicators of sentiment rather than any underlying reality. However, the underlying realities will direct an overall trend as the market unfolds, and the overall trends are what will matter.

UK Government on Track for Bankruptcy

Today, I am just going to conduct a very quick review of some of the news that has emerged is confirming the the UK is on course for a government debt default. The strength of the US currency means that the US is safe from default at the moment, but a UK default will probably be the first step towards the loss of confidence in the US government position, and may see the US default as well.

The first piece of news is that the IMF is now running out of funds, and as I have discussed before, the idea that the IMF will be able to rescue the UK when the crisis comes is diminishing. The second piece of news is that the once mighty £sterling is in freefall against currencies around the world. This is what the Times has to say:

'The descent of the pound drew comparisons with the early 1990s. Then it fell 50 cents from $2.01 to $1.50 - but this time the downward spiral of the currency is gathering momentum.

“People are selling the pound because it’s there. There’s no reason for them not to,” said Nick Parsons, head of markets strategy at National Australia Bank, who is forecasting that the pound will go as low as $1.40 early next year.'

The most interesting part of the article, however, is that the reasons for the fall, which are given as:

“We will go down further because the problems the UK faces are worse than other countries. We are uniquely exposed because of the sheer amount of debt we’ve got.”

In other words, the markets are now realising that the UK is in very deep trouble, and that the UK debt position is unsustainable. This has been an underlying theme of the blog since the first post. The collapse of the £sterling is exactly as predicted in my November essay 'A Funny View of Wealth':

All the while this is happening the government will fall into crisis. With a falling pound, an economy collapsing around them, and an already overstretched borrowing position....'

The 'all this' that I am referring to is the collapse in house prices and consumer spending, and the downward spiral of the economy. I detailed in the essay why the £GB would fall. One factor is the collapse in inward investment that bolstered the £GB, another is that the UK simply does not produce enough goods and services to support the £GB. To this, in later posts, I added that demand for the £GB would fall due to drop in demand for the currency to lend back to us.

The implications of the fall in the £GB for the UK economy are profound. The problem that this will cause for the government will be how to finance government borrowing. With a falling £GB the UK overall is now a high risk destination for money. Nobody wants to lend into a devaluing currency, as the devaluation destroys the value of their investment. This will drive lenders in one of two directions; either they will charge extremely high costs for their lending, or will ask for repayments in another currency, thereby shifting the risk on to the borrower. In both cases, government borrowing will become unaffordable.

Meanwhile, government spending is already spiralling out of control. Add to this that the government has now taken on huge costs and liabilities in the banking bailout, and it becomes apparent that the government is on course for disaster. For example, according to the Times, repossessions have climbed by 71%. The collapse of the economy is going to see ever more defaults on mortgage and consumer credit, as well as defaults on consumer loans. These defaults will hit the financial sector hard, and that now means that they will hit the government. The government is going to need very deep pockets to support the financial sector, but it just does not have them. This is one of the reasons why I have consistently opposed the bailout, arguing that it would push and already overstretched government into the certainty of default.

As the crisis deepens, the government talks more and more of ever more borrowing, calling on the ghost of Keynes as justification. However, Keynesian economics never allowed for increased borrowing in the 'good times', and in the case of the UK the borrowing has been both by the government and consumers. In other words, even if Keynesian economic theory is accepted, this is a gross distortion of the principles. There is therefore no doubt that very few potential investors are going to buy the UK government's economic policy.

For lenders, there will be a larger question looming. How exactly will the UK emerge from this crisis, and how will the economy expand to eventually repay this borrowing. I posted a comment on a forum a while back, asking anyone to point to where the future growth to repay the debt will come from. Not one answer was provided, and this is because there is no miracle around the corner that can return the UK to wealth. There are, quite simply, no sectors of the economy that promise any growth that will provide any significant new real wealth.

All of these elements add up to the onset of the financial crisis for the UK government, and a sovereign default. It is now only a matter of time before the UK faces up to the reality. It is bankrupt.

Note: I have been asked to give a firm date (see comments below) for when the UK will default on debt. However, whilst I have predicted the timing of many of the key events of the current crisis, this does not mean that I can read the future. I first mentioned the possibility of UK defaults back in June (I believe) but gave no estimate of time. More recently, I have suggested that it would be in about 3 months time, and that was about a month ago. I believe that the guess is starting to look more ever more credible, so will stick with that timescale, so would guess at about 2 months time. However, this is no more than a guess, as the determinant is going to be something that is hard to predict - confidence.

Economic Reality Bites Back!

The crisis has, in many respects, followed the course that I predicted. Economic reality intruded on the fragile (false) restoration of confidence that followed the bailout. In the UK, the economy contracted by 0.5% in the last quarter, which will come as no surprise to regular readers here, and Mervyn King has now warned of a recession. The result was carnage for the £sterling which suffered massive falls. Meanwhile around the world stock markets plunged in a state of panic. From the US there is an endless stream of bad news, an example of which is that General Motors and Chrysler are now heading fast towards bankruptcy, and the once mighty Ford is in deep trouble too. These once unstoppable behemoths are symbolic of the underlying problems that are seeing the Western economies contract. Meanwhile, US house prices continue to slump.....

So far, all of this has played to the script that I have been writing for a long time. However, not all has followed the script. The $US should also be plunging, but instead is strengthening as funds are pulled from investments in emerging economies, seeking 'safety' in the $US and Yen. As the article I have linked to points out, there is outright panic driving such moves. An analogy that might explain this is a person running from an angry bear, only to seek safety in the Bear's cave.....where mother bear and her cubs are waiting, and where father bear will soon return. The result of the flight to illusory safety has rocked the world with for example, Russia at risk of sovereign default. Once again, this is not following my script, but any script can not account for panic and emotion driven decision making. In other words, the world financial system has left rationality behind. As with the return to panic, at some point soon, events must return to the script, as there is an underlying economic reality driving events. An explanation of that reality can be found here.

As if there were not enough problems, OPEC is seeking to reverse the one positive in the crisis, the drop in the price of oil. I predicted a long time ago that oil would fall to $60 per barrel, though not as quickly as has happened. I saw the drop in commodity prices as one of the elements in eventual recovery from the crisis. I have previously described how commodity supply is at the heart of the current world rebalancing (and crisis), and in order for the world economy to return to growth it is necessary to increase supply of commodities. As such, OPEC cuts in production are just the opposite of what is needed.

Another worry is that China is now feeling the pain of the crisis. I have always considered that China is on a knife edge, that it was uncertain how the country would ride out the storm. One of the positives that I identified is that China's huge reserves would allow them to cushion the impact, and the Chinese government has duly announced massive infrastructure spending to ameliorate the impact of the world slump. In other words, the money put away for a rainy day is already being utilised. Whether this will be enough to ensure stability in China remains to be seen, but they are in a position of having significant resource at their disposal, even if the value of that resource is heavily weighted in high risk $US. This reminds me of a comment / question that I received as follows:

Following on from Lemming regarding China stopping lending, surely the consequences for them will be a lot worse if they do suddenly stop? Your link points to an article that indicates that the Chinese authorities are trying to stimulate exports by increasing export tax rebates; surely if the West's economies & currencies collapsed it would make it even more difficult for China to compete in the world markets, as well as destroying their potential markets for an even longer period?

Like a bank lending to a business, I can see that it's in their interest long-term to stop lending so much to the West but surely it would be in their own interest to stop lending gradually, rather than suddenly, so they can recoup at least a portion of their previous lending?

As I have previously discussed, economies such as China which have been financing Western economies have a dilemma. If they stop lending, then the value of their holdings will collapse, along with Western economies. However, they must realise that any continued lending will throw good money after bad. My feeling is that the comment is very sensible, but China will need to utilise the resources at its disposal in the support of its own economy. They are, in effect, between a rock and a hard place. If they divert their surplus to the US and Western economies, they will help avoid a general collapse, but at the risk of a collapse in their own economy. In addition, such a diversion will only delay the onset of the rebalancing of economies. It may be possible that they can balance both internal and external problems, but I am not sure that they have enough resource to manage both. Do they have the will to do so? Recent news suggests that they do, but it is difficult to be sure.

As I have discussed before, at this point in the crisis, it is increasingly the decisions of individuals driving events, and how China acts in the crisis will be driven by a few leaders at the head of the CCP. Perhaps the most telling article in the latest round on the financial crisis is an article on the 43-nation Asia-Europe Meeting, in which the following was said:

Mr Miliband said the meeting had highlighted the significant shift in economic power towards the east but also how interlocked everybody's interests were in tackling "deep imbalances" in the system.

"I don't think it's just the fact that we are meeting in The Great Hall of the People and we listened to the general secretary of the Chinese Communist Party talking about the need to prop up global capital markets that brings home to one that there is this big shift in economic power," he said.

This has been the point at the heart of this blog. World economic power had shifted to the East, and now we are witnessing the global rebalancing. Bailouts, international talks, action plans and all of the rest of activity of Western politicians directed towards saving the Western economies are fighting against this shift. In other words, all of the activity to 'save' the economies is entirely pointless.

As I have long, and consistently argued, the only thing that will save the Western economies is reform that will allow them to compete with the emerging economies. Bailouts, more borrowing, Keynesian boosts to economies will only serve to make the economies more debt laden, and less able to adapt to the economic reality that wealth has moved East. Still, despite this reality, the politicians and economists are scurrying around, scrabbling for solutions, and imagining that there are magic wands that can change reality.

Note for new readers: I strongly recommend that you take a look at the links at the top left hand of the page. These will explain why it is that the world has changed, and why the change has led to this crisis. As far as I know, this is the only place that has a comprehensive explanation of the underlying roots of this crisis that actually explains the question of 'why?' I would expect that, if you read the explanation, you will understand my pessimism. You may want to start here....

Note: I have had a very pleasant comment (see below). However, I would caution readers to read other opinions before making investment decisions. Whilst to date my track record of predicting the economy has been extremely good I am, like anyone, fallible. As such, I would suggest looking at a variety of sources. I am personally very confident that I have understood the situation more clearly than many economists, but my views would be contested by any number of economic 'experts'. I will add this warning to each of the pages in the blog.

Economic Crisis - The Eye of the Hurricane before the 'Service Economy' Collapses

It seems that we have now entered a period of relative calm, following the storm of the bailout. For a while, following the Bernanke promise of yet more support for the finance system, stock markets rallied, only to later wobble on bad economic news. This is now becoming a pattern, where governments take action, markets have a fit of optimism, then the real economy offers bad news and pulls sentiment back down. In short, governments are pouring liquidity, guarantees, and borrowed money for short term bounces in confidence, completely ignoring the possibility that the underlying economy is in deep trouble.

I have spoken about the fact that GDP measures have been inaccurately measuring economic growth previously. I think it may be time to return to this theme, and take a look at why there is no escaping the simple fact that the US and UK economies must contract by such a large amount. Below is a chart of UK GDP growth:












And additionally a chart for US and Canadian GDP Growth (it includes Canada because this was the first good chart I found):

















So now we have one side of the equation. What of the increase in debt? First a chart for the UK and US as a percentage of disposable income:

















And now a chart for the US of absolute debt (the UK would look a similar shape):














My apologies for the variable sources for these charts, but I hope you can get a feel for the situation from these (I am rushed so just did a Google image search - I usually use the ONS but do not have the time to find the section). I did have a very good chart for the UK which shows that there has been a close correlation in debt growth and GDP, but have been able to dig it out again. However, if you review these charts, you will see that there during the recent boom, there has been a massive growth in debt. Like any figures that correlate the charts do not prove causation of GDP growth, but causation becomes more likely if there is an explanatory mechanism that can be identified.

So how can the increase in debt translate into GDP growth. I have discussed the multiplier effect, and also illustrated examples in 'A Funny View of Wealth'. The principle is very easy, and I will use the example in 'A Funny View of Wealth', as follows:

If we go back to Mr. Smith in the restaurant, we can see that he has borrowed money to finance his restaurant visit. In doing so he has decreased his wealth in order to fulfil a short term need. This is, partly, what wealth is for, but this is Mr. Smith’s future wealth that he is spending. This borrowed money that Mr. Smith has spent in the restaurant will then recycle throughout the economy in many ways. The restaurant owner will be a little wealthier, and will then spend some of the money on buying goods and services, the restaurant staff likewise, and so on. Furthermore there will be suppliers to the restaurant who will also be beneficiaries of the spending of Mr. Smith, as his consumption of foods will mean that the stock will need to be replenished, and the process of cooking will require energy, and some of his money may contribute to decorators, maintenance people and so on through all of the restaurant support services. We can then see the same process with each of these support services spending their small share of Mr. Smith’s transfer of wealth in a host of different ways, each further helping to support another layer of businesses.

It is only when we look at lots of versions of Mr. Smith, all borrowing money, all of which dissipates through the economy in a myriad of ways, that we can see what a dramatic effect this has on the economy. Throughout the UK economy there are millions of people who, just like Mr. Smith, are reducing their future wealth daily through the borrowing of money. Each of these individuals supports a multitude of businesses through each of their purchases of goods and services. This massive dispersion of borrowed money is financing large numbers of businesses, and the transfer of their (future) wealth that occurs is apparent in what appears to be a booming economy.

The reason why I am returning to this theme is that I have, on several occasions mentioned that the way that GDP is measured is flawed. In the case of borrowing, it can either be an internal transfer of wealth from within a country, or it can be from outside of the country. Much of the borrowing in the US and UK has been funded from overseas. Each time a person goes into a restaurant, or buys something on credit, there is a transfer of wealth out of the country, and a foregoing of future wealth. I will return to 'A Funny View of Wealth' again:

What if the money that provides the loan has been borrowed from outside of the UK, and the UK bank is effectively the ‘distributor’? In this case the transfer of wealth from Mr. Smith will go to the restaurant, the UK bank and the foreign bank. In this case, there has been a real transfer of wealth from Mr. Smith in the UK to the overseas bank that provided the finance for the credit. There is therefore a transfer of real wealth to the country of the overseas bank.

It could be argued at this stage that the overseas lender only has a very small amount of the total transfer of the wealth, and that the majority of the wealth goes to the restaurant owner. This is largely correct. However, depending on the status of the individual and the type of loan, the final interest that is paid on the loan might actually be very high, and translate into a large sum of money over the period of the loan. Some of this interest is profit for the UK bank, and some of the interest is profit for the foreign bank. If we say Mr. Smith is an overstretched credit user, with a moderate credit history, and give him a £500 balance on this credit card, an 18% interest rate, and ongoing minimum payments of 5% of the balance, this £500 will cost Mr. Smith a shocking £214 over the life of the loan. This is not an atypical profile for a heavy credit card user with a moderate credit history, but better and worse examples can be created in any number of permutations. In this case a £50 meal will see a transfer in wealth of £21 to the banking system from the restaurant goer, a significant loss of wealth to the individual, and a significant transfer of wealth to both the UK bank and the overseas bank. Different profiles will produce different results, and the example given is just to give a sense of the potential scale of the transfers. In this case we might hazard a guess that Mr. Smith has just transferred as much as £8 of his wealth to another country, in order to pay for a £50 meal, a meal that might otherwise have seen no transfer of wealth outside of the UK.

This is a very expensive transaction for both Mr. Smith and UK Plc, and has a negative impact on the overall wealth of both.

Despite this, the example of Mr. Smith above will be seen in the UK GDP figures as economic growth. My purpose here is not to recycle the original essay (which I recommend reading if you have not done so).

I have also not covered government debt in the charts, as you will all be aware of the growth in debt over the last few years, and this also creates a multiplier effect once it enters the economy.

The key point here is that the GDP figures do not reflect the reality of real growth in the economy, but growth in debt. If you factor in the multiplier effect, then it is even possible that the underlying growth of the economy might even have been negative. This is why I am predicting that the economy will have to drop back at least 10 years in growth terms, but quite possibly a lot more. As I have pointed out several times, the world was a kinder place for the West 10 years ago with still relatively little competition from countries such as China.

I thought I would add this post because the symptoms are now apparently arising from the disappearance of the debt based multiplier effect. Whilst the economy has been sliding very fast towards collapse, the first signs of spinning out of control have appeared. One of the first elements to go when consumers tighten their belts is discretionary spending. This means meals out, leisure activities of all kinds, and taxis in particular might be seen as the 'canary in the mine'. The reason for taxis being of particular interest is they are a particularly vulnerable form of discretionary spending, as there are always alternatives (albeit less convenient) to their use. They are also widely used in the evening, and are therefore a good symptom in the slowdown in leisure spending, such as restaurants, bars and nightclubs. Whilst there has been plenty of 'bad news' on consumer confidence and spending, I was struck by an article in which sales of new London black cabs are described as 'tumbling'. Whilst mainstream economists look to other (often abstracted) barometers, I am always looking for these kind of signals, as taxis are such a good barometer of spending behaviour. This example only applies to the UK, but the UK and US are going through a parallel process, so it might also be suggestive of the US position in the crisis.

From here we come to the real point of this post, the destruction of the service economy. Other articles are also starting to tell the tale (though the black cab story is the best illustration). For example, in the headlines today, there are calls for a fund to help small business survive the bad times, and another commentary is highlighting the plight of small businesses. Small business is at the heart of the service economy, and these businesses will be the first to really feel the pain. We should also remember that many of these small businesses will show a time lag before they start to appear in the bankruptcy figures. Again, the black cab story suggests that the we are now at a point where the pain has really kicked in. It is sad to say, but many small businesspeople will now be facing the hard fact that they are in deep trouble. The sole traders, and other small business people, are probably already appearing in the unemployment numbers, but the drip of new claimants will very shortly become a deluge.

If we strip out the debt led growth of the last 10 years, then the scale of the coming carnage in the economy becomes painfully apparent. Quite simply, most of the economy has been supported on a life support of debt, and now that life support has been switched off, we can start to see what will happen next. As I have said, the black cabs are the canary in the mine and we can now expect bankruptcy figures to soar.

Meanwhile, in the US, reportedly they are pressing Fannie Mae and Freddie Mac to boost lending, in a desperate attempt to regain credit driven growth. The same will happen in the UK, and there are already, for example, reports that pressure and/or legislation will be put in place to slow down the mortgage repossession process. We can expect to see more and more of such measures in the coming months. However, all they will do (at best) is create further losses for the financial institutions, and in many cases that will mean losses for governments.

Meanwhile, as time progresses, the fiscal position of both the UK and US government will deteriorate very rapidly, as the full savagery of the crisis are unleashed in the service sector. I am taking the black cab story as the signal that a new phase is starting in the economic collapse. I predicted the state of the economy as it now stands, as an ever faster downward spiral. I recently identified that all of the elements of the collapse were in place. I think that we are now about to see an even more rapid acceleration. The unemployment figures are going to rise at an ever faster rate, along with a massive rise in government expenditure, and government receipts are about to fall through the floor.

As such, I am very sorry to say that we are moving on track for the first government credit crisis, which I predicted a couple of weeks ago (as coming within three months). I suspect that the UK will go first, as the position in the UK is far more acute, and the US will follow shortly after. At the moment, the pattern of disaster is starting to emerge into reality, just as it did for the bank failures. Just as when I predicted the bank failures, the failure of (at the very least) the UK government is now probably irreversible. There was a brief period during which they could have built a buffer of confidence for creditors with a tough program of reform, but I believe that the moment has passed and the course is set.

At this stage, you might consider that this a fairly extreme analysis from the news about purchases of new taxis. However, if you think about the behaviour of your friends and family in their use of taxis, you will see why this is such a stark warning. If the money is drying up in the taxi business to this degree, then the rest of the economy is very likely freezing very fast.

Note 1: I have had an intriguing post from a regular commentator, who posts under the name Lemming. Lemming had the following to say:

Are you absolutely sure that our creditors will be turning the taps off any time soon? Is China, in fact, happy to fund our lifestyles indefinitely so they can simply 'buy' the West in the long term? To me, that sounds like a perfectly rational explanation, and Western politicians who espouse globalisation would be more than happy to facilitate it, I imagine, even if they were unaware of exactly what they were signing up for.

I have to admit, this a fair point. If China keeps lending, they will gain formidable economic power in the long term. As such, it is a very real possibility, and I can not discount that this might be a reason for continued lending. However, as China slows down, they might need to start to redeem some of that lending in order to support their own economy through the crisis, and will want to use whatever resources for that purpose, restricting their ability to lend. In this situation, depending on what happens with the Chinese economy, they may not have the option of continued support for the West. Another commentator kindly posted the following link, and I will repost it here as it applies:

Note 2: Another poster has kindly posted a link here. It makes interesting reading, in particular the article of 1998, financial capitalism vs industrial capitalism. I recommend it to all readers.

Note 3: Jeremy commented as follows:

Darling's plan of bringing spending forwards is truly dreadful. I can only imagine that he thinks that it might boost the economy prior the the next election as a last ditch effort for labour to avoid complete wipeout. I suspect the chances of that are nearly as small as the grey nobbly organ situated between his ears. Either way, we can reasonably expect sterling to get trashed in the process and look forward to some serious inflationary pressure moving into 2009.

This was a prescient comment, as £sterling has been tanking. The curiosity is the $US is still acting as a 'safe haven'. How much longer? Not much longer, I believe, though perhaps it will take the default of a major rich world government to finally do it? Meanwhile, would you lend into anything demoninated in £sterling at the moment? I think others will have their doubts too - which means that demand for £sterling to lend back into the UK will probably fall back, creating a stronger downward spiral.

Note 4: LordSidCup has the following to add to some other interesting comments:

My point is; if the politicians and financial elites could use whatever means to get confidence high again, is it possible that after after a correction things could stay the roughly the same/ a lower level ) for many more years, if not indefinitely?

Also, there are all these interbank debts looming, Credit Swaps etc, why don't the most important banks get together and write them off? I assume that would be painful, but as its all abstract wealth created as debt, what would it matter?

For the first point, others widely share this idea, but confidence is not a magic force but has to be rooted in something. If every day brings news of an ever slowing economy, ever smaller government receipts, then how can a government maintain confidence. Without the fuel of debt, it is impossible that confidence can be maintained, as I have outlined here. This is why every attempt to pour money into the economy sees a subsequent later fall in confidence. Reality just keeps on intruding and governments just do not have the resource to bail out both the financial sector and the rest of the economy.

For the second, the Credit Default Swaps are guarantees against default. They are therefore an insurance policy that moves real damage in the economy to a different place. Whatever happens, somebody will make the loss, and it is just a question of who will suffer. Note added approx 1 hour after the post: MattinShanghai has commented below on this answer and has pointed out that I have blundered. One of the wonders of the online world is that, when we make an error, we are soon corrected. Apologies to LordSidCup, for an incorrect answer....I will rethink and hopefully, if I have enough time enough to get my facts straight, will reply again.

A note to my note, added a little later.....MattinShanghai is quite correct to say that there is no knowing the size of the market, due to the private nature of the transactions. However, the products are an insurance contract, according to a reference I quickly checked: 'The seller sells protection (buys risk) and generally receives a fee for this protection' ('Credit derivatives and Synthetic Structures', J Tavakoli, 2001, p5). A note of caution however, as this in derivatives terms is a little dated as a reference. Apparently they are called swaps to avoid regulation as an insurance, which I dug out from Wikipedia, as I could not find anything more substantive in the economics journals on why they are not classified as an insurance. However, they still appear to be an insurance, whatever the legal niceties that determines their name. I think Matt is referring to the fact that:

'Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can "naked short" the debt of companies without restriction.' from here.

It is, as Matt said possible to buy an insurance against another person's house burning down. The point I think that Matt is making is that, in principle, it is possible for LordSidCup suggests to happen. This is I believe the comment Matt made about the fact that the counterparties being on the line for more than the value of the original debt - the ability to profit from debt default....

However, the complete abandonment of the CDS contracts would presumably hit some institutions harder than others. In the current situation, where the banks are so exposed to wider damage as a result of defaults, in principle I can not see why it would not be possible to write them off if they could see a common interest in their survival as a group. The trouble is that the institutions who stand to gain would have a very tough time being able to justify their giving up their positions. Such a position moves into game theory, and requires trust and cooperation from all parties to secure a common good - it is not a zero sum game. It would face problems of imperfect information, due to the private nature of the transactions. Who does hold what, and what is their exposure, or their potential for gain? I am probably doing injury to game theory here, but hope that the answer helps. Thank you Matt for your clarification, and thank you LordSidCup for what was a far more challenging question than I originally considered. I also think that there is more to the point being made by Matt, so any further clarification will be welcomed. In the meantime, time allowing I will look at this a little more, and may add a further note if I have anything more to add. I am not sure that I have yet got to the root of the question, or the operation of CDS contracts. Even as I am writing, I have found a helpful quote on the underlying principle of CDSs which I hope will help others (The Journal of Finance, Volume 60, Issue 5 (p 2255-2281)'An Empirical Analysis of the Dynamic Relationbetween Investment-Grade Bonds and CreditDefault Swaps'), & a good introduction to first principles.

'Single-name credit default swaps (CDS) account for around half of the credit
derivatives market. They are the most liquid of the several credit derivatives
currently traded and they form the basic building blocks for more complex
structured credit products.1 A single-name CDS is a contract that provides
protection against the risk of a credit event by a particular company or country.
The buyer of protection makes periodic payments to the protection seller until
the occurrence of a credit event or the maturity date of the contract, whichever
is first. If a credit event occurs, the buyer is compensated for the loss incurred
as a result of the credit event, which is equal to the difference between the par
value of the bond or loan and its market value after default.
2. CDSs provide a very easy way to trade credit risk. Many corporate bonds are
bought by investors who simply hold them to maturity (Alexander, Edwards,
and Ferri (1998)). Secondary market liquidity is therefore often poor, thereby
making the purchase of large amounts of credit risk in the secondary cash
market difficult and costly (Schultz (1998)). Shorting credit risk is even more
difficult in the cash market. The repurchase agreement (repo) market for risky
bonds is often illiquid, and even if a bond can be shorted on repo, the tenor of
the agreement is usually very short. Credit derivatives, especially CDS, allow
investors to short credit risk over a longer period of time at a known cost by
buying protection.'

Matt may well be right that they are another bomb about to go off. No doubt they will add to the damage, but I still think that they are more likely to just relocate it. Defaults may melt one institution's balance sheet, but will improve that of another (assuming that the institution can pay). It all depends on the how many times the same house has been insured by whom, and that is not clear. This returns to LordSidcups question - as the lack of knowledge is a source of fear and that threatens stability further. In writing off the credit default swaps, the system as a whole would benefit, and that would be big plus for all instituions. However, I was not previously aware of some aspects of these derivatives, and suspect my knowledge is still imperfect. I would like to look at this more closely, but that is it for time for the moment.

Origninal post continues below......

I'm afraid that is all I have time for today.

Note 5: Despite my assertion of having finished, it should be noted that the LIBOR has fallen, which will hearten those who supported the bank bailout. However, is this because the state owned banks are now lending again because it is required, or because they think it is wise to do so? I do not know the answer, but in any case, the bad news in the economy feeding into more losses will drag the rate back up, unless the government has very deep pockets indeed....

Note 6: Oil has now dropped into the $60-70 per barrel level, as I predicted would happen. However, much, much sooner than I expected. For once, the news is positive, as the drop in oil prices will be a major positive for the world economy - as long as OPEC does not spoil the party by cutting back on production.

World Economy - What Happens Next?

As I mentioned in my last post, I thought it might be worthwhile to take a pause from the news and try to pull together what all of this means. By coincidence I finally had time to read my copy of the Economist from last week, which included their review of the situation. It was surprising to see how far they had moved towards the interpretation of events discussed in this blog. However, in several critical respects they differ.

For example, the Economist is broadly supportive of the bank bailouts and coordinated action of governments to try to fix the crisis. Across many posts I have listed many reasons to be against the bailout, so I will try to summarise the reasons for why this is an error. In one post I illustrated why this was a bad decision with an analogy of a family. The family have been spending more than their income for many years, and were already in severe financial difficulties. They are increasingly reliant on borrowing to sustain their lifestyle, are using borrowing to pay back previous borrowing, and are slowly but surely heading to bankruptcy. Meanwhile, the husband is having his working hours reduced, and the mother is facing the possibility of redundancy. In other words, their income is about to drop. In such circumstances, who in their right mind would suggest the solution is to borrow yet more money? The answer is obvious - nobody would give this advice. Instead, the advice would be to accept the reality of the situation, and tell them that they urgently need to change their lifestyle such that they can live within the means of their income. Ideally, they would also need to change enough to start paying back their debts.

For some reason, when it is a country in this situation, the solution to the problem is to borrow more money, the method of financing the bank bailout. This is the simple reality. Nobody disagrees (now) that the Western economies, in particular the UK and US, have been borrowing more money than was sustainable, but for some reason it is acceptable to get out of the situation through increased borrowing. Rather than accepting the reality that we must live withing the means of our (diminishing) income, the solution is to just borrow more money.

In a more recent post, I asked what the borrowing would be used for. We know that the money is being pumped into the banking system, but to what end? Were it to be used to invest in wealth creating assets, then I would have no argument with the Western governments extending their borrowing (whilst they still have the means to do so). However, the news suggests that the purpose of the bailouts is just to pump new sources of credit into the wider economy. In other words, it is just being pumped in to restore the supply of money to maintain the 'service based economy'. Will this money see the development of manufacturing companies, or be used for investment in new plant or technology, or be invested to develop services for export? There is no indication that this will be the way that the money is used. It is just an increase in overall debt, and is digging a deeper hole for the economy to sink into.

Governments are claiming that they will eventually recoup the money that they are lending, but the reality is that they will be encouraging the banks to lend the capital that they are injecting into the system. In so doing, they will be encouraging lending into a failing economy, which means lending against devaluing assets, lending to consumers who are increasingly likely to made unemployed, and businesses with ever greater risk of bankruptcy. In other words, the money will be used for lending into high risk, and will therefore see yet more mis-allocation of capital. In encouraging lending for the wider economic good, the governments are likely to just encourage yet more bad debt to be developed.

We then come to the question of how the money will be repaid. In my early posts on the bailouts, I emphasised the fact that this is spreading the damage done to the financial system into the wider economy through the necessary (eventual) increases in taxation. This means that the genuinely productive parts of the economy will be saddled with greater taxation, and will reduce their ability to compete. In other words much of the money being borrowed will be poured into the non-productive parts of the economy, and the cost of the borrowing will hurt those parts that have genuine wealth creating capacity. It is a recipe for long term economic damage.

So what is the bailout actually for? There is endless talk about restoration of 'confidence'. This is a very curious idea. What is the point of confidence? Does it produce wealth, does it change the underlying economic circumstances? The reason that there is no confidence is for the very reason that the underlying economic circumstances are so poor . As such, the $2 trillion being used to prop up the banks in the Western world is being used to create a false sense of confidence. This is a frighteningly irresponsible way to utilise this money, as the restoration of confidence can never be anything more than temporary, because the underlying economic reality is so poor. As it is, these massive borrowings being poured into the financial system are not even achieving this foolish aim in the short term. The rate of interest for inter-bank lending is barely moving, stock markets are still teetering on the edge of collapse, and so forth. At this stage, it is impossible to say that there will still not be an upturn in confidence, but such an upturn is unlikely, and in any case will eventually be destroyed by ever more bad economic news. (Note: I discuss why the value of money is built on confidence here, which would suggest that confidence is important. This may seem self contradictory, but the reason it is not is that confidence must have a foundation in economic reality)

So where does this leave the economies of the Western world? At the moment, the rest of the world is still lending into the Western economies. I forget which was the post in which I made this analogy, but this is a situation like the creditors to an 18th century aristocrat. His family has always been wealthy and his creditors continue to lend money in the belief that he will always be wealthy. However, the reality is that he has no prospect of ever paying back the borrowing. All it takes is for one creditor to ask for repayment, and the result will be a loss of confidence in the aristocrat's ability to pay. At that point, when the credit stops, bankruptcy will quickly follow. His income does not cover his expenditure, and without the continuation of lending, he is seen for what he is - a bankrupt who has been living on the success of his forbears.

The collapse of the economy of Iceland will probably be raising questions about the creditworthiness of other Western economies. The UK government in particular is making it very clear that the intention is to increase borrowing, and is therefore declaring that it intends to borrow its way out of trouble. Rather than trying to cut back on spending, it fully intends to pretend that there is no underlying economic problem, with no need for reform. It is business as usual, all the while with income dropping, and borrowing increasing. No explanation is being given for how this increase in borrowing is to be repaid, what source of new wealth is around the corner to allow the repayment of this ever-growing debt. The question this raises is how it is that the rest of the world will continue to lend? At what point will they ask the question of how this debt will ever be repaid?

The fundamental problem is this. As long as the rest of the world keeps lending, there is demand for the Western currencies. As long as this demand continues, it helps to prop up the value of the currencies. This in turn protects the value of the money that is being lent. What happens if the amount of lending decreases is that the demand for the currency will drop, and with it the value of the currencies. The trade balances of the US and UK in particular have been negative for a long time. Put another way, the demand for the $US and £GB is driven by lending, not by demand to buy goods and services. For those that are creditor countries, they face uncomfortable choices. If they cease lending, then the currencies of the West will collapse. If the currencies of the West collapse, they will lose huge amounts of money on the lending they have already made. On the other hand, if they keep lending, they are faced with the problem of how the money will ever be repaid. In crude terms, do they continue to throw good money after bad?

It is for this reason that I have predicted that it will not be long before the lending stops, and that this will lead to government defaults. I can only guess the time scale because, at the end of the day, it requires that the creditors of the West ask the right question - the question of how their money will ever be returned to them. It will also require them to accept the losses on their previous investments, which will be a hard pill to swallow. Finally, they will know that, with the collapse of the Western economies, they will be pulled down with along with the West. For countries like China, with very real prospects of social unrest, they will be balancing the cost of continued lending against the survival of the Chinese Communist Party. Do they continue to finance the Western world's ability to live in comfort, do they continue to lend their hard earned money to prop up a decadent and bloated Western world - for that is how they will see it. They produce, and the West consumes and does not ever pay the bill for the consumption. It is hardly a good deal for them.

So what happens if countries like China decide that enough is enough. It is at this point that the Western governments find that they can no longer pay the bills. At this point they must either print money, or dismantle huge parts of the state. The $US, the Euro and £GB will fall through the floor. The peg to the £US used by the oil states will be dropped, and the cost of oil will soar. Even without printing money, the rate of inflation in the Western economies will soar, and the result will be complete economic chaos. The reality will be that oil will be oversupplied, but the shift in the currencies of the Western world will mean that, for the West it will become relatively very expensive. The same will happen with other commodities. This is the rebalancing of the allocation of commodities that I discussed in previous posts. I spoke of the competition for finite resources between the emerging economies and the Western economies, and that the West would lose out, and find its share of world resources decline. This will be the mechanism by which this decline will be transmitted.

I have not spoken very much about the social and political consequences of what will happen, as this blog is focused on economics. However, at this stage, it is worthwhile discussing this briefly, as there will be a feedback into the economic situation. If I am right that the lending into the West must end, and the result of this end to lending is as I have predicted, then we will all be in for a roller-coaster ride. The shock to the Western world will be dramatic and painful. In these circumstances, it is an ideal environment for demagoguery. It is the moment of the populists and the rabble rousers. There is a real chance of massive social upheavals, and even challenges to democracy and capitalism. In the rest of the world, there will be similar upheavals. The biggest worry is China, which already has a state that already looks like a worrying hybrid of pre-WWII Japan and Germany. There are many flashpoints for conflict, such as Taiwan. With a government with legitimacy built upon economic growth and nationalism, what happens when the economic growth stops? The Economist magazine is optimistic about the prospects for China in this upheaval, and we can only hope that they are right. I have always been very slightly optimistic that China will pull through this period with only moderate damage, but still have many serious reservations.

I mention the political and social dimension for the reason that the result of the next stage of the crisis will lead to a situation of chaos, by which I mean chaos theory (no doubt serious chaos theorists will shoot me down on this usage, but I hope that you will understand my meaning). By this, I mean that even small events or factors may have profound consequences. The right person being in the right place at the right time, a decision of bureaucrat, a rumour - all of these offer opportunities for dramatic changes in the situation. In other words, there will be a period of huge instability, and that instability creates opportunities for small events to have profound consequences.

As you may gather, I am profoundly worried by the current situation. I was able to predict this crisis, but was not able to predict the way in which governments would react. The way they have reacted is a way that will ensure that the crisis leads to economic disaster. In choosing to try to borrow their way out of trouble, in failing to reform their economies to lower costs and prepare the way for real wealth creation, they have sent a message to their creditors. That message is that they must continue paying for the comfort of the Western lifestyle, at the cost to their own people, or they must face the consequence of massive economic upheaval, and consequent chaos. I believe that creditor governments will be trying to work through this question, trying to see how this can all end. I can not be the only person raising these questions. At some point in time, the complete lack of logic in the current situation must come to an end. There is no way that the creditors to the West can be happy to be supporting the Western economies, with little prospect of ever gaining any return. At some point, it just must come to an end.

I am sorry for such a gloomy post, but my aim has always been to try to analyse situations in as realistic way as possible. For new readers, there are many points in here that require deeper explanation, such as the role of commodity supply in the world economy. You may want to take a look here to understand why the situation is as I say it is. You may also want to take a look at the other posts that I link to at the top left side of the blog. This all may sound like an extreme take on the situation, but there is a disturbing logic in this analysis to be found throughout this blog. Even as I write this, it is a sunny day, and the world outside appears normal and unchanged. The best way to understand how deceptive this calm might be is to imagine the tourists sunbathing on the beaches of Phuket, just before the Tsunami struck. In a matter of minutes, their world was turned upside down.

Note 1:

Ishmael asked the following question:

'My question was in regards to the system of fractional reserve banking and the criticisms that have been made in a few documentaries especially "money as debt" and "zeitgeist" and "zeitgeist addendum"

This article can explain the debate better than I.
http://en.wikipedia.org/wiki/Criticism_of_fractional-reserve_banking

I was wondering on your opinion on this matter as my financial knowledge is a little basic, Is a crash inevitable or is there another mechanism at play that mitigates the effect of exponential debt plus interest?'

I have not seen either of these documentaries, but I do discuss fractional reserve banking and my post on the subject can be found here. It is a rather unusual perspective, but if you stick with it, I hope that you will find it interesting. My article on government borrowing and interest rates may be of interest as well.

Note 2: An anonymous poster has mentioned how easy it is to make fake coins, in reference to my cynicism about the Amero conspiracy theories. Thanks, for the contribution, which is helpful.

Note 3: I have the following from an anonymous poster (edited):

'I know the idea is to get the banks and mortgage providers lending again, but they cannot go back to lending to people who will never be able to repay the loan.(sub prime)

With the economy about to take a dive, (and I suspect never to recover to pre crash levels) what sort of an economy will follow?

The only exponential growth in the Western world is people, Britain (and America's) populations are rocketing and it is my guess this is where the growth is to be conjured, as I suspect it has for the past eleven years. '

The answer to this is relatively simple and also terribly complex. The one certainty is that the economy of Western countries will be considerably smaller. As to what kind of economy, that is the complex question. Increasingly socialised, protectionist, or lean and mean and ready to face the competition in the world? That, to a large extent, is in the hands of the politicians and where democracy is in play, that is in part in the hands of each individual with a vote. Will the voters look to the state to 'fix' the problems through protection, endless state interventions, or will they decide that they want to regain their place in the world? This ceases to be a question of economics, but becomes a question of politics.

Note 4: A very late reply to Phil (apologies)

I’d like to offer a further point of reflection: while in the West we continue the “Debt Economy Delusion”, what the biggest producer of real wealth - China - will do?
12 October, BBC News website had an article, “China agrees land reform package”.
The article quotes Xinhua news agency:
"The Communist Party of China Central Committee on Sunday approved a decision on major issues concerning rural reform and development," Xinhua said.
Its commentary added: "The global credit crisis freezing up the world's finances may be a blessing in disguise for China as it aims to modify its economic structure after three decades of breakneck growth."
My take is that, as the global crisis will restrict external demand for Chinese goods, China will expand its internal market, the biggest single market of the world.
And what will happen then, monetary speaking? Will the Yuan increase its (now artificially lowered) value?
And, as we are at it, what will happen to major world currencies?

This is a very interesting comment. The RMB will certainly have to significantly increase in value, at some stage or another. I tried to keep my own money in RMB for that reason, but holding money in China is problematic. There are many possible drivers for a large upward revaluation, including threats of protectionism, and it is difficult to say when the CCP will allow a major revaluation. Add into this mix the questions about internal stability, and what might happen if China falls into recession, and life gets more complicated.

One of the interesting things about an artificially low currency is that drives economic growth through export led growth, but at the cost of the relative wealth of all the individuals in that country. To give an example, a Gucci bag may be significantly more expensive than it otherwise might be with a balanced exchange rate. That differential means that, in real terms, the potential purchaser of that bad in China is poorer. In short, the people in the country do not get a 'fair' price for the imports that they buy. If you look at it this way, China could overnight become significantly more wealthy, just by revaluation. However, in doing so, could they maintain their economic growth? It is not certain at the moment that this is, in any event, possible. It really is a very complex point. How much of China's success is due to the artificial currency rate? I am not sure on this, but think that it is significant a factor. However, the cost of this approach is now coming at them through the back door, through the damage that the undervaluation has helped create (unbalancing the world economy).

As you can see, a very involved answer, and one that illustrates the inter-connectedness of the world economy. I think I have already answered the questions on currencies in the main post, so will not answer that question further.

Note 5: Another anonymous poster asked this:

This whole business has led to a potential cataclysmic political sea change.

Is neo Liberalism dead in the water?

The ramifications to the answer to this question is mind boggling.

If the answer is yes - What next?

I have answered one of the questions in the main post. Neo liberalism dead? Another one for the politicians, I believe.

Note 6: Hilly asks the following:

'Is the extent and volume of the losses incurred internationally (100s of billions of $) simply due to this over-lending, over-valueing, over-selling etc.. not just in housing (which does incur the losses) but in the levels of borrowings bothprivate & commercial that are being defaulted currently or are anticipated to be so, plus governmental overspending of future incomes?'

I am not sure I grasp your underlying question here, but if you can clarify it, I will try to answer it (time allowing).

Note 7: In reply to a question below:

It's just occurred to me. (I'm not the sharpest tool in the shed) Are we, (West) in the absurd position of being lent money by China to enable us to buy their goods?

It's a sort of merry-go-round that could continue for ever.

This is something I have discussed previously in this blog. You are absolutely right, except about the ability for this to go on forever. The lending will only go on as long as the lending creates a return. As soon as the returns diminish, the merry-go-round stops. It was an unsustainable economid model and part of what we are seeing is the collapse of this model. It was not just China, but all of the creditor nations who have funded the West to buy their products. It sounds mad when you think about it, but this is why I make the Aristocrat analogy. Think of the situation where the aristrocrat buying his tailoring on credit.

Note 7: More questions (see below). I only have a little time so I will just answer a couple of those raised (all too briefly). Answers are in italics.

'The economic backdrop to the 21st. century is the mantra of ever increasing growth in a world of diminishing supplies of raw materials. (is this the same as your commodities?) The production of raw materials (commodities) relative to demand are decreasing even though output in absolute terms has increased. See post here.

Where has all the money gone? Has it been consumed on trips to Disneyland, McMansions, SUV's, snowmobiles, second homes, etc.etc. The short answer here is yes. Much of the money has gone into consumption, and therefore has been spending now at the cost of foregoing future wealth.

With the present arrangement of China having become the workshop of the world, they have amassed shed-loads of dollars amounting to hundreds of billions, what are they supposed to do with this mountain of money? Not hundred of billions but fast heading towards $2 trillion. That is one of the problems that they face (and other creditors are facing). The West is not producing enough of what they want to buy at a price they are willing to pay. That means that the value of the currency must devalue. Once it is no longer used to fund Western borrowing, then there is no demand for the currency, and the value of the currency falls.

The only thing they can do with it is lend it back to the West or buy up Western assets as investments. Yes, see above. But they will no longer want to lend it, as their little prospect of the ability of the West to repay. We are not making enough goods that they want etc. (see above answers). This is one of the points in the above post, so I think I will need to rewrite it, to better explain this.

With the World's dwindling resources I cannot see manufacturing returning to the West, which again prompts the question, where is the wealth generation to come from? Please do not buy peak oil and the rest of the scare stories out there. oil must peak at some point, but there is no firm uncontested evidence that resources are dwindling, and peak oil has been predicted since the 1930s. It could be now, or it could be later. I was posting months ago that oil would drop to $60 when the peak oil believers were predicting $200. Last time I checked it was at $75. Overall demand has outstripped the ability for suppliers to meet the demand, but demand is now falling back as the Western economies contract. Again, see post here. The main problem is bottlenecks, not the amount of material (a curious example is the inability to produce the huge tyres for the monster trucks used in open mining)

As an aside, how can the West (Britain) embark on an economy of manufacturing when the have just announced another round of cuts on carbon emissions? Expect 101 ways for this to be quietly abandoned in the coming years. I think that you will find hard times will diminish the enthusiasm for action which damages economic prospects.

Naive question perhaps, what is the difference between borrowing money and the government printing its own? In other words why borrow when you can print it? This one is not a short answer, so I will (time allowing), try to address is another time. The simplest answer...Both options are bad, but printing money is worse.Not a naive question, but a very good one deserving a proper reply.

I am afraid that time has run out (explaining the rushed responses above). I will try to put more time to answering questions but must balance my limited time against the general posts. As such I will do my best to keep answering as many comments as possible.

Gordon Brown as Saviour? How Did That Happen?

In my post of yesterday, I suggested that I would not be posting so often. However, there is a disturbing acceptance, even amongst the critics of Gordon Brown, that the bank nationalisation has 'saved' the banking system. I will not rehash my arguments over why the bank nationalisation is a disaster, which can be found in a post here.

Here is an example from the Times columnist Daniel Finkelstein:

'Gordon Brown is enjoying himself so much at the moment that it is sometimes hard to recall whether the aim of the exercise is for him to save the banks or vice versa. But to have to spend billions of pounds of taxpayers money to save the entire British banking system from collapse is an odd sort of triumph,'

Daniel Finkelstein is quite rightly critical of the record of Gordon Brown but, as can be seen in the above quote, but is accepting that the UK banking system has been 'saved'. There are two basic problems with this assertion. The first is that it is very, very early days yet, so one must ask on what evidence the system has been 'saved'. The second is to ask at what cost? By this I mean, at what cost to the viability of the wider economy. That second question may be answered in the near future by government default on the debt it has accumulated, and by the costs imposed upon business and consumers to pay for this bailout. It is borrowed money that has 'saved' the system, and that means it must be paid for, and that means the UK economy has new structural costs. These additional costs will, of course, be buried amongst a host of other costs, such that their effects will be hard to strip out and isolate. However, the difficulty of isolating them will not mean that they are not there.

The really dismal part of the news is that Gordon Brown apparently has gained 'political capital' and is now proposing leadership of an exercise to rewrite the rules of the international trading system. This is like asking the captain of the Titanic to rewrite the rules of seamanship on the basis that he arranged the evacuation of the ship efficiently. However, in this case, we still do not know whether Gordon Brown has even saved the 'passengers'. As just one example, there is news that unemployment is soaring in the UK (exactly as I predicted), and rose at the fastest rate for 17 years in the three months to August.

The idea that Gordon Brown has gained 'political capital' is very worrying, and further increases my doubts about leadership through this crisis. I have consistently been worried about the leadership in the Western world, but this is very worrying indeed. I can only hope that the leaders of other countries start to see through vacuity of Gordon Brown's thinking. In the meantime, with Gordon Brown ascendant, what hope for the UK economy?

A very short post but I am very disturbed by this sudden lift in the reputation of Gordon Brown. It does not bode well at all for the future, but suggests that the reality of the economic situation will continue to be ignored in favour of the magic wand solution of debt led recovery. As I have said so many times, this is just postponing the disaster, and postponing at a price.

Note for Ishmael (comment below): I am afraid that I did not receive your last comment, so I am unable to reply to it. It seems that some comments are not getting through to me (though most are). I am not sure why this is the case. I have had one other commentator mention that their post did not appear. All I can do is apologise. I chose Blogger on the basis that it was a well known service, and has a good reputation. It seems that, despite this, it has some glitches. Please accept my apologies for inconvenience as, at the end of the day, I chose this service, and therefore my poor choice is responsible for causing this inconvenience. Unfortunately at this stage, it is a little late to change services, so I am in the unhappy position of having to accept these gltiches will occur. I can only apologise for this again.

Note 2: Another commentator has posted on the New World Order conspiracy theory as follows:

'Do some more research on NWO,
This conspiracy theory had been planned since before 911, 2001. One World Bank , One world currency standard.
The only way this could happen was through a melt down or collapse of the market, not just our but a world market.
There are only a few that can plan such a thing, but those are the ones pulling all the strings. (Men in Black)
Don't be foolish. I knew this was going to happen years ago.
Remember we only get what is spoon fed by the media.

Here take a number SS or CC and be a part of a system, if not good luck in surviving in Babylon.'

Who are the conspirators, how are they operating, what have they actually done, and why is this conspiracy theory more convincing than the reasons I have detailed throughout this blog?

Once again, I would ask anyone who believes in the conspiracy to offer some evidence from a reputable source. I followed a link given to me and found that it led to a video of a white supremacist showing an 'Amero' coin. This was hardly convincing. I am genuinely open to being persuaded on this, but would appreciate any references that the conspiracy theorists might be able to offer to convince me. Until such a time, I can only assume that there is no conspiracy. In my original post on the subject, I presented an argument as to why a conspiracy is unlikely. Having followed up the subject, I have yet to have my mind changed.

Note 3:

LordSidcup (see comment below) makes a perfectly fair point in saying that Gordon Brown is not alone in making the errors that have led to this crisis. The reason for my worry that he is in the ascendent is that he represents a good example of the delusions that have been at the heart of the cause of the crisis. Were it George Bush, Bill Clinton, or any other of the world leaders, who failed in their analysis, I would make the same comments, were they striding high on the world stage. My selection of Gordon Brown is without any partisan basis, but is based upon his record in running the economy, and on the basisthat he seems to be taking a lead in the management of the crisis.

Yes, others made the same errors. This does not mean that Gordon Brown did not have the opportunity of making a correct analysis of the economic situation all those years ago. In this sense it is not personal, and my point is that it is indicative of the problems of the leadership in the Western world. The same leaders who made the wrong analysis, are now the same leaders analysing the results of their first failed analysis, and proposing solutions to the problems they helped to create. It is hardly encouraging.

However, a perfectly fair comment. I should have been clearer in why I selected Gordon Brown as the basis for my critique. It is because he is in the ascendent. My worry is that there should be economists and politicians who are striding the world stage who are offering the media and public a more realistic evaluation of the situation. In short, the ascendency of Gordon Brown is symbolic of the continuation of the dream that more debt is an answer, and yet more poor analysis of the situation.

I write this blog in the probably vain hope that the blog, and views of other commentators who share more realistic views, will eventually have some influence. It is the hope that politicians/ the media / the public will finally look at the underlying reasons for this crisis square in the face, and look to remedies that will help reconstruct the economy in the medium and long term. Gordon Brown's ascendency is the symbolic antithesis of such hopes.

Note 4: I have just made a (very quick) survey of the new editions online. It seems that any hope that there is any boost in confidence from the bailouts is diminishing fast, as economic reality bites (as I proposed in a previous post). I also proposed that markets might go through ups and downs, but perhaps the sheer scale of the bad economic news will lead to a negative tracjectory only? Meanwhile there is more news of high borrowing countries crumpling under the weight of their own loans, and more calls on the IMF. Nervousness about the UK and US will no doubt be mounting in foreign creditors, even as I am writing. I proposed that a crisis in government insolvency was about 3 months away, but am now thinking that, just possibly, it may be sooner. As for the EU, I think Hubris comes to mind, when reading the following quote:

'The monetary blitz was welcomed in Brussels, where EU leaders were meeting yet again, just days after agreeing to the most comprehensive bank bail-out in history. "We are not at the end of the crisis, we are still living in dangerous times," said Jean-Claude Juncker, Luxembourg premier and Eurogroup chair.

He issued a stark reminder that life is going be very different for the banking elite as governments move to restore the lost discipline of the Bretton Woods financial order and attempt to "civilise" capitalism, the code word for clamping down on the City – dubbed "the Casino" in Europe.

"Let everyone remember after this crisis, who solved it. Politicians did, not bankers," he said. Mr Juncker added that this episode would have a profound effect on the euro debate in Britain.'

Yet again, apparently, the crisis is being solved. Perhaps some of these politicians should read the news?

I will try to write a proper review of the situation soon, as ever more problems are emerging, and the situation appears to be moving in an even worse direction than my own already very pessimistic predictions. I will try to round up all of the news, into a more integrated picture, and see where it will leave the world economy, and the economies in the UK and US, and to a lesser extent Europe.