Economic Crisis - Panic and Lack of Solutions

Once again, it is possible to survey the headlines, and once again the headlines show that there is no real recognition of the underlying cause of this crisis. In amongst the headlines it is possible to discern a central feature of the reaction to the crisis - outright panic.

This is very worrying. It is evident that what is happening now is not driven by any underlying thought, but panic reaction to each and every event. In this situation, there is no prospect of anything positive coming from governments around the world. It seems that the politicians, bankers and economists are endlessly repeating to themselves ' we must save the banking system, we must save the banking system'. They do not seem to be able to consider that the system can not be saved, and that the cost of salvation will simply be to move the damage into government finance.

This can be partly explained by a report in the Telegraph which has this to say about the sale of Lehman credit default swaps:

'There was fear in the City and on Wall Street that some parties would not be able to settle the contracts. This could have a domino effect through the financial system, leading to a string of defaults. Analysts and investors said the main problem was that it was not clear where the problems would end. The bill could total about £233 billion, according to one leading banking analyst.'

For those not familiar with this idea, this is an insurance against defaults in payments (Wikipedia as ever gives a good introduction here). I discussed this briefly as one of the problems that was at the heart of the financial system at some point in 'A Funny View of Wealth'. This is one of the drivers of the financial crisis, that the institution issuing loans no longer took the risk in the case of default. In doing so, they could then lend irresponsibly, thinking that they were safe from harm. The trouble is that the scale of bad lending means that these guarantees of the debt are now useless, as the losses are to great for the insurers to cover. I had this to say in 'A Funny View of Wealth':

One of the problems at the heart of the credit bubble is that the risk has been separated from the lender, who can lend with impunity, whilst packaging the debt into financial instruments that can then be sold to third parties. This would appear to be a wonderful way to make money for the banks undertaking this process, but the problem is that, as fast as one division was selling the debt through the front door, another division has been buying similar debt through the back door. This is to massively simplify the mass of transactions that represent debt markets, but the principles are simple and clear. If you separate the issuer of borrowing from risk, then the lender will issue debt that is of much higher risk. The whole situation has been further complicated by the Basel banking rules, such that certain instruments have been used to support a banks capital adequacy ratios. The repackaging of debt into new instruments has probably been a response in part to these regulatory challenges. In repackaging the debt it has been possible, as has been shown by the US sub-prime crisis, to turn low grade debt into high grade debt - right up to the point where the defaults start.

As can now be seen, the problems were passed out of the front door, and have indeed reappeared through the backdoor. Another point to highlight in this story is the sheer scale of the bill. Alastair Darling is proposing a massive £500 billion to bail out the banks, but the scale of the losses now, and the further massive losses to come, mean that this will barely make a dent in the problems.

The reason that the stock markets around the world are in freefall is because there is now a recognition that all of the actions of governments will not defy the scale of the losses. They are just starting to join the dots together. They have realised that the losses mean no more lending, which will further destroy the house market, will mean that consumers will stop spending and that businesses will not have the money for investment. Alongside this, unemployment, corporate defaults, and consumer defaults will all rage upwards. As I pointed out in 'A Funny View of Wealth', once the boom started to unwind, it would create a self-reinforcing downwards spiral. There is simply no stopping it now.

The response of governments are ever more pledges of action to fix the crisis. The G7 meeting has seen more pledges, more coordination, and more delusion as below:

'Ministers meeting for the Group of Seven (G7) meeting in Washington were expected to pledge to part-nationalise the entire Western financial system in one of the most dramatic possible responses to the crisis. '

But the question that they are not answering is exactly who is going to finance the governments in order to allow for such a dramatic course of action. In the same article it reports the following:

'It also emerged that the International Monetary Fund has sent emissaries to Iceland, and may arrange a bail- out package within days – the first IMF rescue of a major economy since Britain in the 1970s.'

Iceland is a particularly bad case, but the message is clear. It is not possible for governments to bailout a collapsing financial system. I long ago predicted that the UK would end up at the doors of the IMF. Once again, I will ask the question as to who will in turn be financing the IMF? It will not be long before the US is knocking on that same door, along with the Europe and a host of other countries. The IMF is built on the assumption that there are economies powerful enough to support it with finance, but what happens when the providers of finance are the ones in need of finance? This is an interesting quote from another article:

'The trigger for the latest round of capital flight has been the lightning implosion of Iceland. BNP Paribas warned clients yesterday that the island is heading for "sovereign default" with contagion risks for other economies that have been living beyond their means on foreign credit.'

The article refers to Pakistan, Ukraine, Argentina and other non-OECD countries. The interesting part is the complete lack of self-awareness that this is describing the Western economies. This is the view that the Western economies are 'too big to fail' that I discussed in a previous post. It is quite extraordinary that Paribas has not made the connection with the situation of these economies and the economies of the west. It is the unique blindness that is at the very heart of this crisis. The belief that, whatever happens, the west is so rich and powerful that it will come out on top in the end. It is the reason why all of the reactions to the crisis have been so utterly wrong-headed.

What all of this means is that, in reality, nothing can be done that will not either shift the dramatic effects of this readjustment or cause even more damage. There is no escaping the conclusion that I made in 'A Funny View of Wealth', as follows:

The situation overall will be a massive contraction in the UK economy, a contraction that will see the UK step back in time in terms of economic development. The contraction will need to be deep and severe enough to reverse the illusory gains of the previous ten years (or even longer), and will require that the UK restructures its economy from top to bottom. It will, in effect, be the most significant crisis to hit the UK since the World War II.

For the above, we can add the same conclusion for many of the 'rich world' economies, though the UK was always going to be one of the hardest hit. It is rather odd to read my own words from November of last year as, at that time, I think that many people viewed my views as those of a 'crank'. Few would now disagree with the assessment of the severity of the crisis. One of the interesting points is that my focus in the essay was the UK economy. I was aware, for example, that the US economy was in a similar position, but I never considered small economies such as Iceland, which were metaphorically off my radar.

There is now no question that the world is going through a period of revolutionary change. The shift in the world economy is of such a magnitude but, even though it is now in plain view, there is a sense of denial from the leaders. Whether economists, politicians or bankers I can only conclude that they do not have the intellectual capacity to deal with the reality that is confronting them. I saw an article a while ago by the UK Guardian columnist calling for social justice, and read the article in despair. It is not that the article was especially bad; rather it was the idea that the blind delusion on which it was founded is shared by so many, including the leaders of the Western world. The columnist simply could not see that the world had changed, and that her demands now appear foolish. She is like the child who is told by her parents that they can not afford to keep paying for her dancing lessons, leading the girl to stamp her feet and endlessly repeat 'but I want it, but I want it'.

So it is now with the leaders of the Western world, but instead of demanding the continuation of dancing lessons, they are demanding the continuation of their wealth and power.

It is a very sad thing to see.

Note:

I have had an anonymous comment which points out that David Cameron is just as complicit in this mess as Gordon Brown. The question that follows is why vote for David Cameron? It is a very good question, and I can see no proposals from David Cameron that are radically different from those of Gordon Brown. As such I can find no reason to recommend him, other than the idea that nobody can do worse than Gordon Brown (I hope). Whilst still not agreeing with what they are proposing, the best of a very bad bunch at the moment appears to be the Liberal Democrats. However, I am only looking at the least bad economic policy, not any of their other policies. As you may note, this is hardly a ringing endorsement of any of them. My blog only looks at economic policy, and I really have nothing much positive to say about all of their policies. This is why I am writing this blog, because I think there needs to be serious changes in economic policy. For readers from the US, I would say the same for the presidential contenders, neither of whom are offering anything that approaches the beginnings of accepting the reality of this situation.

I really have little respect at the moment for the policy of any of the leaders, whatever their political flavour (or flavor for the readers from the US), whether potential or actual leaders. As such, how can I endorse any of them?

Note Added 12 October:

I have had a comment from Dan (good to see him commenting again), who suggests that there may well be runs on some banks shortly, possibly even caused by the spreading of false rumours. I think he may be right as I think that, at this stage, it will be easy for a rumour to get out of control. In this kind of situation it is quite possible that a bank that might otherwise survive the crisis will be taken down through panic alone. Dan has been commenting on this blog from the early days, so will (no doubt) already have arranged several instant access online bank accounts to allow quick movement of his money. I gave this advice months ago, but for new readers, I would strongly recomend this course of action - as soon as possible. Have your accounts set up so that you are ready to move from one account to another, and keep an eye on the news. At the first sign of rumour, move your money.