Saturday, November 29, 2008

Financing UK Government Debt - The Problems are Starting

I have a comment on my last posting, in which an anonymous poster very kindly provided a link to an article in the Financial Times. I quote from the start of the article as follows:
'The UK and Italy struggled to sell bonds on Thursday in a fresh sign of the difficulties governments are facing because of the debt needed for economic stimulus packages and bank recapitalisations.

The two bond auctions saw both governments forced to pay higher yields to attract investors and Italy scaled back the amount on offer.

Analysts say it is an “ominous” warning that debt raising is likely to become even tougher in the coming months if problems are emerging so soon after government announcements to increase issuance. A record of more than €1,000bn ($1,290bn) of debt is expected to be issued in Europe next year.'
Long term readers will know that I suggested the government would be hitting problems of default about now (as long as six months ago). I have continued in this view, and that means that my prediction was for the default to happen now. However, as you will note from the FT article, we are still at the warning shots stage. The move from warning shots to outright panic is difficult to predict, so it could be an immediate collapse, or might take a while yet.

Meanwhile, as government is going on a borrowing binge, it is worthwhile noting that this has severe knock on effects in the economy, as the government is competing with investment in private business. I discussed the problems that are caused in the wider economy in an article here, but thought it worth mentioning again as I have not discussed the subject for a long time.
If I have my history of economics right (please correct me if I am wrong), I believe that government borrowing (in the modern sense) was started to finance the Napoleonic wars. Regardless of the original purpose it has now become a very bad habit, and one that should really be prevented, by a constitutional constraint if necessary. For the moment, it appears that the problem is about to be addressed by the creditors to the UK, but better the country never got into the problems in the first place.

On a different but related subject, I was catching up on my reading yesterday, and managed to plough my way through the Economist magazine. In an article they discuss the re-ordering of the world financial system, the so called 'Bretton Woods 2'. It makes very depressing reading, as they are proposing that the solution to all of the difficulties is more regulation, and with the wisdom of hindsight criticise the Basel Banking accords (Wikipedia gives a good introduction with Basel 1 here, and Basel 2 here). Again, those who are regular readers will know that I have long 'fingered' the Basel Accords and government interventions as major contributors to the financial crisis. Essentially, the regulation in the banking system created huge distortions in the market whilst giving a false sense of security in the banking system (I discuss this in detail here).

The reason why I mention this is that the lesson being learned from the banking crisis is completely wrong. Instead of accepting that it was the regulation of the banking system that was the problem, the consensus is increasingly that it was the wrong regulation, and that more and closer regulation is the answer. Essentially, the consensus view is that it is possible to take the risk out of banking which, when you think about it, is a very odd idea. The nature of banks is that they lend to individuals, governments and businesses, and some individuals and some businesses do better than others. By nature, whenever a bank lends money, they take a risk.

Now, if we look at Basel accords, they are founded on the idea that different classes of assets have different levels of risk. This means that, for example, a UK issued bond would normally be viewed as low risk, such that banks will be encouraged to lend to the UK government, such that they maintained a balanced risk portfolio. Now, I would suggest that you stop and think about that for a moment.....

We have a system of regulation that encourages banks to lend to a government? Governments are not a productive asset class. They do not do anything to generate concrete wealth. They provide some services, which might be seen as productive activity, but they do not generate income from that activity, they just farm tax from their populace to pay for it. It is a fine distinction. For example, if we go to a restaurant, we pay the restaurant for the service of cooking our food for us. If we pay tax to the government it provides the service of health care. The real difference here is that when the restaurant borrows money, it does so with an expected return, and the restaurant owner/s are risking their own money. On the other hand, when a government borrows money, it is risking the money of the population at large and the money of businesses, with no way of calculating the return on what is borrowed. Furthermore, the business and individuals have no choice but to have the government risk their money for them.

Despite the use of word 'investment' by politicians, this is not the role of government, as their role is spending the money of other people.

So here we have a regulatory system, that encourages banks to lend to government. If they are lending to government, they have less capital to lend into productive activities that actually generate the revenue necessary for government to function. It is rather odd when you think about it.

However, there is something even more disturbing about the whole system of regulation. An inherent part of the system is prescience. Apparently, it is possible to know the future of different classes of investment. For example, the Bank for International Settlements can apparently see the future and determine what is risk and what is not, and national regulators do then do the fine detail of what they will accept as safe or unsafe investments. Amazingly, these very clever people have an insight on risk, and can determine what is a risk and what is not. They must be very clever indeed.

The trouble is that, UK government debt has long been seen as very low risk, but we are now seeing that it is actually very high risk. The trouble is that, over the last 12 months, all kinds of 'safe' investments have proven to be unsafe. Essentially, what you have is a system in which lots of apparently very clever people can supposedly determine where risk resides. However, as experience is telling us, they have absolutely no idea where risk resides.

So now we come to the answer that is being proposed. More clever people will now sit down and re-determine how risk should be calculated, having learned lots of lessons from the recent crisis. All of these very clever people will get together, and once again will strain themselves to see the future, and determine what the future might be. But the trouble is, that is what they did before.....

Essentially, there is no escaping the fact that the world is a complex place, the world is unpredictable, and individuals are fallible and make wrong decisions. No amount of regulation of the banking system will change this. There is no reason to believe that the people who determine the particular risk of asset class have any better grasp of the risk inherent in that class than the holder of that asset - the banks themselves. The simple fact is that, what was safe yesterday, can become unsafe the next day. No one individual, or group of individuals, is infallible, so why should they be able to determine risk?

As such we come back to the start, and have to say that, whenever we deposit money in a bank, we are taking a risk that the bank will lose that money. We need to accept that risk, because we make that risk with possible trade-off that the bank will invest the money and increase our wealth. However, any idea that this can be guaranteed is just foolish, and no amount of regulation will make that guarantee. All such regulation serves to do is create a false confidence, and thereby encourages systemic risk.

What we have now seen is that such guarantees are worthless and, as a result, we have governments having to accept liability for their former guarantees of the safety of the system. However, it is not government that picks up the tab for that guarantee, but every individual and business within the country. In other words, there is a system in which people apparently know better than banks where the risk of those banks reside, they then say that if the bank follows their rules, they will guarantee that all the money invested in those banks is safe, and they make that guarantee with the money of tax payers.

When you think about it, it is a completely absurd idea. However, lots of very clever people all think this is a great idea, and persuade us all that governments offering guarantees (based upon their mystical knowledge of future risk) using our money is a good thing.

Note 1: Thank you all for the comments on energy policy, which were interesting and challenging. I had an interesting comment from HYDROGENPHILE (his caps), who suggested that hydrogen is the answer to storage of energy. This is presumably based upon the use of fuel cells, which are an interesting emerging technology that I have followed for some while. However, until the switch to a hydrogen energy economy is made, this does not address the problem of the here and now. In other words, the switch to a hydrogen economy needs to be made before the investments in energy provision that relies on that switch is undertaken.


  1. Is it possible that the government will simply be unable to raise the money they have pledged to splurge on the economy? Or will there always be someone willing to lend, but at exorbitant rates of interest? Presumably Brown and Darling would go through with it whatever the cost, to save themselves the embarrassment of having to 'U turn'.

  2. The pressure on governments to join the bailout is considerable. It sounds as though Germany has done, and is doing, the right thing, but the following article suggests that the rest of the world is not going to stand for it.

    "What is striking is that Germany, Europe's largest economy, appears unconvinced so far, or is at least reluctant to follow the rest of the pack into a spending splurge after years devoted to bringing the country's public finances back into balance...

    German Chancellor Angela Merkel says she does not want to get into a "race for billions", which is worrying some other governments in Europe, according to officials in other capitals. And it is troubling economists too.

    "Germany's reluctance to pull its weight in fighting the global recession betrays lack of vision, lack of leadership, and a temptation to free-ride that, if widely mimicked, would truly condemn the world economy to a new great depression," says Marco Annunziata, chief economist at UniCredit bank.

    Jim O'Neill, chief economist at Goldman Sachs, notes that domestic consumption in export-dependent Germany has barely budged in what will soon be 20 years since the fall of the Berlin Wall. And that is something that should change.

    Europe's largest economy should do itself and the rest of the world a favor by raising wages, reducing sales tax, and thereby supporting higher levels of consumption, O'Neill argued in an article in the London Financial Times."

  3. Mark - another one:,opinion,bankruptcy-beckons-for-not-so-great-britain

  4. Mark, you hit the nail on the head by noticing that money lenders are so risk-averse that they want profit without loss.

    This includes us who has money in banks with the hope of receiving risk free profits (i.e. interest).

    This is unsustainable. Its interesting how you noticed that the new regulation is enacted with the same goal of removing risk from lending.

    Question. Is there some kind of regulation that can be enacted to make the following the goal. Make lenders understand the reality of profit with risk of loss and lend in that basis rather than looking for weird solutions to remove risk completely and lending like money is going out of fashion to any tom, dick and harry?

  5. The only major regulation that is needed in banking is natural regulation of precious metals and 100% reserves. You mentioned the funding of the Napoleanic war, that was why the Bank of England was started of course and central banking has been a war racket ever since, adopted by all countries.

    Combined with the ever expanding economy fueled by mispriced credit and the moronic focus on consumption and statistics to improve "economic planning", this is the reason why we are in the mess we are in. It is not simply a financial crisis it is a crisis of human reasoning. Government is a racket and the bigger government gets the more misery is wrought upon ordinary people. The life blood of government is central banking and the misallocation of wealth and production.

    Anyway, I expect that the mortgage market is going to take a big hit when yields go up. We should definitely keep an eye on this too.

    As for a solution the only sensible thing now is to forgive debts and start again. The level of personal and houshold debt in the uk has passed the point of no return. The banks are bust, we are bust. It is obscene for government to bail them out. Disgusting. We are a nation of serfs now.

  6. Hi, Mark

    Many thanks for a great blog which I check every day for new insights. For example, it would never have occurred to me that regulation would actually make banking *more* risky, but having read your articles over the last few months it now seems very clear to me.

    But try as I might, I'm still very hazy on the detailed mechanisms of banking, such as fractional reserve lending. On the face of it, much of the riskiness of banking seems to stem from the banks lending out (or 'investing') far more money than they have deposited. What would be the implications for the economy of a larger reserve ratio requirement? (Did I read somewhere that the UK has, in fact, effectively no reserve ratio requirement?)

    And everywhere I look, I see proponents of the 'gold standard'. What would be the pros and cons of this?

    (Apologies if you have dealt with these questions in the past but they have yet to sink into my skull!)


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