As an aside, before moving on to the $US, another commentator Lemming coincidentally posted that he has heard a new conspiracy theory in which the £GB is being deliberately lowered to parity with the Euro to allow for the UK to join the Euro. I say that this is coincidence, because the UK default will probably rule out the latter. Why would the Euro area want another economic basket case (it already has plenty). As for how such a conspiracy might have been managed, it is quite an astounding idea. I do not think that Lemming, who is far too sensible judging by his other comments, believes such ideas as these conspiracies that are circulating around to explain the financial crisis. However, the simple answer to the conspiracy theorists would be to ask why anyone in their right mind would set about destroying the UK economy in order to join the Euro. Even the most hardened Europhile would blanche at such action. Meanwhile, there are plenty of rational explanations for the drop in the £GB, which I have detailed in this blog for many months.
Returning to the Willem Buiter article, he titles his article 'How likely is a sterling crisis or: is London really Reykjavik-on-Thames?' The interesting thing about this is the underlying thought that it is tougher to see a major economy like the UK fail in the same way as Iceland. I highlight this, because my belief is that, just as Iceland signposts the possibility of the fall of the UK, so the UK fall will signpost that of the US. I have said it before, but it is worthwhile saying it again. The UK is not too big to fail, and the same can be said of the US.
Both countries have, for far too long, been living beyond their means. I have already highlighted in a couple of previous articles that the creditors to both countries are looking less willing/less likely to continue to finance the deficits of the US and UK. Both Saudi Arabia and China have indicated that they intend to use their wealth in support of their domestic economies.
In the meantime, the trade deficit with China has widened according to the New York Times:
'The United States’ trade gap with China widened in September to a record $27.8 billion as exports fell while more Chinese goods and services entered American markets.'I highlight this, because the trade deficit is growing even whilst retail sales are falling like a stone:
These quotes come from different articles, but it is interesting to put them together, as they are telling us something fundamental about the world economy. It is quite simply that, even before the economic crisis gathered pace, the US was unable to compete with the efficiency of the Chinese economy. Now that times are tough, and consumers are more cost aware, the competitive advantage of the Chinese economy is being magnified. On what appears a more positive note the US trade deficit has shrunk overall due to the decline in oil prices. However, that decline rests, in part, on the ongoing value of the $US.
“It’s just brutal,” said Eric Beder, retail analyst at Brean Murray and Company. “It’s a very bleak time for the consumer. Unless it’s something super-compelling or really necessary, they’re not going to the mall, they’re not spending.”
October’s decline was the fourth consecutive monthly drop, and was worse than Wall Street’s expectations of a 2.1 percent decline. The government also revised September retail sales downward by 0.1 percent. The October decline topped the 2.65 percent drop in November 2001, which came after the terrorist attacks.
How does this relate to the forthcoming bankruptcy of the US economy? Even as I write this, the US economy is plunging, but still the $US is holding up, and seems to defy gravity (but then so did the £GB for a long while). However, I think that there are several factors that are going to bring the crisis to a head.
The first of these is that countries like China will now start drawing on their reserves, and that will mean large chunks of $US, to finance the support for their economy. The Chinese plan is to use their stimulus package for infrastructure, and the problem nagging at the back of my mind is to ask what they will want to buy from the US. There will undoubtedly be some projects that will use the resources of US companies, but I am struggling to think of what they will be. It is just as likely that the Chinese will seek to exchange the $US for other currencies, in particular for the purchase of commodities, and engineering equipment and services. Whilst many commodities are priced in $US, that pricing is dependent on the $US being seen as a stable currency. Many other products and services are also priced in Euros. However, the US will probably only be supplying a small amount of these infrastructure projects, so much of the money will be spent in other countries. It is not a simple situation, in some ways, but I hope I can clarify.
We actually have a situation in which China has more of things that the US wants to buy than the US has things that China wants to buy. China is about to create an infrastructure stimulus in the economy, and will need to use reserves to pay for this. Many of these reserves are held in $US assets, and the only option for them will be to start to sell $US assets to pay for their stimulus. In other words, one of the major creditor nations is about to start calling in some of the debt.....
My guess is that the Chinese will act carefully, as they will know that any dumping of $US in the market will destroy the value of their holdings. However, expect to see some pressure mounting on the $US as China starts to sell $US assets.
The second factor that will bring the US crisis to a head is the forthcoming crisis in the UK. Just as Iceland is a signpost for the UK, so will the UK be a signpost for the US. Returning to Buiter, he offers these as a reason for exposure to default:
'(1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity'He identifies that the £GB is no longer a global reserve currency, and therefore suggests that the comparison with Iceland can be made. He has, in his analysis, pointed out that the UK is a relatively small country, and so forth.
Whilst I commend his analysis of the risk of a UK default, I am not sure that he has quite 'got it' yet. In particular he has not yet got the idea that a country is never too big to fail. As one of his criteria for default, he points to a country not having a reserve currency. He is missing the point that a reserve currency only has the backing of confidence in the value of the currency, and that confidence rests upon the economic strength of the country issuing the currency. China is about to test the economic strength that underlies the $US, and is going to find it wanting. What is about to happen is that the belief that the US is too big to fail is about to be challenged and, over the coming months, there will be a clash of reality and false belief. My guess is that the $US is about to go through turmoil, with swings of sentiment in markets as the reality starts to be digested, but also with swings back to 'the too big to fail' argument.
Over recent months, the market has persisted in the belief that the $US is a 'safe haven'. One of my (few) poor predictions was that the $US should already have collapsed. My error was to look at the real value of the $US and to forget that the value of a currency rests, in part, on confidence, as well as being based upon the underlying economic realities that pertain to the issuer. By real value, I mean the real wealth creating capacity that is needed to maintain the value of a currency. That wealth creating capacity is founded on producing more goods and services, more cost effectively, creating greater demand from your trading partners than your demand from them. At its most simple, real wealth is the ability, for example, to manufacture a product with less input costs per unit produced, sold and distributed (of a similar item) to your trading partners. This is a very crude characterisation, but I hope it makes the point, and that point is that the US is no longer doing this in many industries, and therefore is failing to sell products or services in sufficient number to support the value of their currency.
In other words, the $US has little real value in exchange, and the value therefore rests on belief alone. A long as people believed in the value of the $US it could withstand much. However, the point has now been reached where, for example, China is now going to be using $US to buy things, and will find that there is little that it wants to buy from the US. In this situation, it will try to change the $US into currencies that do have things they want to buy. The question then arises as to who will want to buy the $US for what reason? The US has a massive trade deficit, and therefore there is little overall demand for $US. The only reason for holding the $US is that it is a 'reserve' currency, and we come full circle to the conclusion that the only value in the $US is a belief that the US is too big to fail.
It is a very fragile edifice, and however many economists use clever theories, there is no escaping the fact that a currency can only defy gravity for so long before it falls to earth. Essentially, the $US has become the greatest bubble in the history of the world. It is a bubble because there is diminishing underlying value in the $US as a unit of exchange. Quite simply, there is too little demand for the $US to actually buy things from the US, as the US is just not producing enough that other countries want to buy. Just like 'Tulipmania', the 'Dotcom' boom, the housing boom, value can be sustained on irrational belief alone for a long time, but eventually something happens to challenge the belief. At that point, the bubble bursts. I believe that the problems of the UK will be just such an impetus to a collapse of belief.
In other words, I believe that the world is about to go through another convulsion, and this one will make the banking crisis look like a walk in the park. For those that are new to the blog, you may want to read here, if you doubt what I am saying, as it will explain what is underlying all of this. The collapse of the $US is going to be the most startling and shocking event so far, and the world is about change dramatically.
In the meanwhile, anyone who can offer a reason why/ justify why the $US can hold its value is welcome to post a comment. I would be happy to see some challenges to my belief that the US is moving to sovereign default and currency collapse because, as hard as I look, I can see no justification for the apparent current level of wealth of the US, and no reason for why the $US holds anywhere near its current value. Quite simply, it is a country that does not produce enough goods or services efficiently enough to sell to other countries. Just like the UK, it is structurally bankrupt.
A shocking post.
I hope I have done the subject justice. Unfortunately, I was supposed to have finished a major project I have been working on, but the size of the project is greater than I anticipated. As such, I can not devote as much time as I would like to this blog. In particular as the economic crisis heads to the inevitable unhappy ending, I would like to be doing a better job of explaining why this is all happening, as well as offering some practical solutions for the eventual recovery from the crisis.
Note 1: I have had the following question from anonymous (posted 4 times - once will suffice, but thanks for the interesting question):
Am I missing a step in the argument? If the US$ collapses, doesn't that make sovereign default less likely? US debt being denominated in US$ (or so I assume), would the USA not a) have to generate less wealth to service its debt; and b) be better able to generate wealth because devaluation would boost exports?Both the UK and US governments are increasingly financed upon debt. If the lending stops, then this will lead to default, as it is not possible to fund these states on tax revenues (as they are currently structured). If the lending stops, both governments will literally run out of money. They will still need to pay for their structural costs, such as healthcare etc. so they will either print money or default on debt. You are assuming (I guess) that these things will happen over a long period of time, allowing adjustment, such as reducing state expenditure. However, exports do not appear overnight, but take a long while to pick up. Meanwhile the structural costs of governments take a long time to be be removed. The politicians do not have the courage to shut down huge parts of the government to forestall crisis - it will take the default to make them do so.
As for the value of the debt decreasing, the US government will still need to take $US1 in taxes to pay for every $US1 in debt. Although the recipient of the debt will find that they have made a loss on the $US (that is can be used to buy less for the same number of units), the people (i.e. businesses and consumers) paying the burden of the debt will still feel the pain of each $US1 that they give to the government. They will still (if they are lucky!) have the same $US income as before the devaluation so the proportion of the income to service the debt will remain the same (in the unlikely event that taxes remain the same - but they will almost certainly go up). Even though they will not be able to use the $US to buy the same value of imports, each $US1 they pay the government is still $US1 less to spend on other items. The amount taken out of the pockets of US consumers and businesses will remain the same to those people, albeit that what they are giving is worth less in relation to imported products. The relative cost in terms of their income, to the real payers of the debt, gets larger, as they need more of $US to buy imports, and therefore the impact of every loss of each $US to service the overseas debt is even greater. If my money is worth less today than yesterday, any expenditure is proportionally more costly. If you are poorer, the proportion of your income needed to buy the same thing is greater than if you are richer.
If I want to buy a Japanes hi-fi that today costs $100, but after the currency collapse costs me $150 I am $50 poorer than I was yesterday. If you then think about how people spend their income, for example buying petrol (or gas for American readers), and the currency devalues, you will have to work x number of hours more to buy the same amount of fuel. In the case of an average consumer, think of the amount of imported products that they use. Whatever proportion of their income they previously spent on imported products/services is means they will be proportionally poorer on that part of their income, according to the degree of the devaluation. Put another way, let's imagine someone who has a taste for Belgian beer. It is more expensive than US beer, but they have been able to afford it because the value of the $US was high. After the devaluation, the person decides that it is too expensive. They are poorer.
At the same time, the proportion of their income used to pay the overseas debt remains the same. This means that, they are losing the same amount of their income to pay the overseas debt that they were before. For consumption of locally produced products and services, there is no change. If I want to have a haircut, then the cost of the haircut is still the same as before the devaluation, but I still have $US1 less to to pay for the haircut if I am paying taxes to repay overseas debts.
As I have argued, the West is much poorer than it believes. One way that the adjustment to the real wealth of the West will be made is through massive currency devaluations. I can not emphasise enough - if a currency devalues overnight, everyone in the country is overnight poorer than they were the day before. They either have to work longer hours for the same imported item, or substitute the item with a product that is perceived as inferior to the one that they would like. In both cases, the people are poorer.
As a note, printing money is equivalent to a default, as it will destroy the value of the debt (where it is denominated in the national currency). It is just defaulting indirectly. So, yes, the devaluation of the $US would devalue the debt that it owes. So, yes, it will lead to improved exports and less exports, but at it will require that everyone becomes poorer in order to do this.
If there were no cost, every country would inflate its way out of debt, and devalue their currency. The cost is just that everyone gets poorer to do so, and lenders no longer trust you if you need to borrow in the future. They therefore make lending more expensive, and/or insist on payment of debt in another currency.
Note 2: I have just been reading some of todays' editions of new on the web, and came accross an article from Roger Bootle of Capital Economics. He 'sort of gets it', but can not quite bring himself to say openly how inevitable the default in the UK might be. However, worth a read.
Note 3: Even more depressing news. Gordon Brown, who is currently accelerating the UK off a cliff, or digging the debt hole ever deeper if you prefer, appears to be increasingly influential. I am afraid that I am increasingly cynical about his motives in his selling of his more debt, more intervention solutions. For example, there is this:
'The other two main planks of his policy hopes are that the International Monetary Fund – which has played a key role in bailing out the economies of a number of countries in recent weeks, including Iceland and Hungary – should be given more money.'
Now, from a cynical point of view, I might ask whether he wants to have an insurance policy in place for the UK. As I have pointed out, the IMF is going to have severe funding problems as the Western economies such as the UK and US sink further. With the UK likely as the first domino to fall, maybe he is setting up a situation in which the UK will be rescued with IMF money, before the rest of the tottering system collapses. All of this assumes that Gordon Brown has any inkling of the depths of the problems in the UK economy, and is therefore highly speculative. I can not make up mind at this stage whether he is a Machiavellian without compare, or just plain incompetent.
Note 4: Another article here questioning the spending splurge of the government, and the possibility of complete collapse..... It seems that the media worm is turning. However, not all are yet convinced. An article in the Times is proposing that house prices will not fall as far as cynics (such as me) have proposed. The article is, of course, delusional and is worthwhile if you would like some humorous light relief from the sense of gloom I may be causing.
Note 5: Yet another article in the Telegraph is asking whether the bailout of the financial system was all a waste of money, but still cautions that it might still work. As I have pointed out repeatedly, the bailout does nothing to address the fundamental problems in the economies of the West, so I do wonder at what point the pointlessness of this activity will be recognised. Plan A has failed, and now we are on to the Keynesian plan B (and without ever having saved during the 'good' times). At what point will any of these people actually address the underlying problems in the economy?
Note 6: I will admit that I am increasingly despairing of all the leadership of the Western economies. I am not sure that the world has ever been presented with such a rag-tag collection of vapid and unintelligent individuals. Lots of activity and grandstanding, but essentially as unsatisfying as a weak cup of tea. I am not normally so strident, but see not one single individual in power with the courage to face this situation, and just see that they all believe more borrowing is the solution to all ills. I am angry because their activity means we can say goodbye to the West as we know it. Even more worrying, the chaos that they are causing will lead the world to a state of complete instability, and that kind of instability can lead to war, to the rise of extremists, and a host of other unpleasant outcomes. I rarely comment on such matters, and readers may be better served by reading other commentators on such matters. However, my frustration is overcoming my restraint. The consequences that might flow from the actions of these 'leaders' have potential for so much harm.......
Note 7: An apology, as there have been some interesting comments again recently. They are all in my inbox, and if I have time I will go through them again to address them. However, I really am very, very short of time, and this more general post was a little more pressing.
Note 8: I seem to have been cited on an economics course in the UAE. I only know this as my visitor tracker has shown links from the course's online component. I have no idea, however, what they think, as I could not find the orignal reference on the site. For all I know they may be giving me as an example of a mad man. Anyone from the economics course wish to enlighten me? It rather stoked my curiosity, as I am sure that most economists would take a dim view of what I write.
Note 9 added 16 November: I have just found an article in the Telegraph that has the following to say:
'Concerns over the deal helped to drive down stocks already hit by worse than expected retail figures. Yesterday’s economic numbers also showed that car sales fell by 34 per cent in the past three months, as Americans grew more fearful of losing their jobs and banks slashed overdraft and credit card limits. Consumer spending has a critical role in the US, accounting for two thirds of economic growth.'They just do not get it. Consumer spending does not equal economic growth. If consumer spending is based upon spending the proceeds of wealth generating activity, then yes. If the spending is based upon borrowing, then no. However, it is still possible to see the media, politicians and economists still talking about the need to get consumers borrowing to spend in order for the economic crisis to be resolved. They never directly put it this way, but re-read what they are saying and it is clear what they are saying.
In the same article, there is a summary of all of the proposed solutions to the economic problems. In none of these is there any discussion of reforming the Western economies, the only viable solution in the medium to long term.....