Tuesday, November 25, 2008

US Economy - Descent into Madness, and the Politics of Desperation

Much of what I will be writing will be a mirror of my last post on the subject of the UK. It seems that economic madness is contagious and spreading throughout the western world. The seeds of the fall of the West were sown a long while ago, with the last ten years a period in which economic policies have accelerated the decline. The current economic crisis has been an opportunity to recognise the weakness of the West, and therefore an opportunity to reflect on, and correct, the errors of the past.

Instead, what we have is the collective burying of heads in the sand.

The latest news out of the US makes gloomy reading. We have this from the New York Times:
'Instead of trying to reduce overnight lending rates in the hope of influencing longer-term interest rates for things like mortgages, the Fed is directly subsidizing lower mortgage rates. It is doing so by printing unprecedented amounts of money, which would eventually create inflationary pressures if it were to continue unabated.

For the moment, Fed and Treasury officials made it clear that the sky was the limit.

Treasury Secretary Henry M. Paulson Jr. emphasized Tuesday that the $200 billion was just a “starting point” for a program that could become substantially larger, possibly including other assets like commercial mortgage-backed securities.'

So here we have the answer to the current crisis. Print money. I'm afraid, for all of those who thought Barack Obama was offering a bright new future, you should be deeply disappointed, as this is apparently the course that he is setting (same NY Times article):

'As if to underscore the transfer of power now under way, Mr. Obama introduced his economic team at a news conference in Chicago on Monday shortly after Mr. Bush made brief remarks outside the Treasury Department.

Mr. Obama expressed support for the Citigroup plan and urged Congress to adopt swiftly a major plan to stimulate spending and to reverse job losses.'

And the purpose behind the printing of money is to stimulate the economy through the encouragement of lending into home purchases, car loans and small business. In short, it is another case of consumers being unable to borrow, so the government will make up the shortfall. The difference between the US and UK is that the UK borrowed to subsidise consumer spending, and the US government is printing money. Both are acts of lunacy, both are signs of desperation.

In both cases there is the fundamental belief that when a consumer buys something, wealth is created. In the case of the UK the purchase is being made through government borrowing, and in the case of the US being made by handing over money on which the ink is still wet.

I have had a comment from a poster asking me what I mean when I say 'real' wealth creation, and this is very valid question in this context. For regular readers, they will be aware of what I mean by 'real' wealth, but for those who are new to the blog I will briefly explain what I mean. However, I would also recommend following the link to 'A Funny View of Wealth' which explains the point fully (it is long, but I hope that it is worthwhile).

In the meantime, a brief explanation of what I mean by 'real' wealth. The best way of starting is to say that real wealth is not borrowing and spending, which is just foregoing of future wealth. When a person borrows and spends, it creates an illusion of wealth in an economy. When a person goes to a restaurant and pays for their meal with a credit card, the process creates economic activity. The restaurant (if it is well managed) will make money, and they will then use that money to pay their staff, to buy materials, services, equipment and so forth. Each $1 spent with the credit card gets used many times to create activity. The staff will spend money on buying things, the equipment manufacturers will get another sale of a piece of equipment, and will therefore pay their staff, who will in turn spend that money and so on. This is the multiplier effect. Each $1 spent will create lots of activity throughout the economy.

The problem here is that GDP is a measurement of economic activity. Somehow, GDP has been seen as an indicator of wealth. However, if the activity is created through the use of borrowed money, then no wealth is being created, just future wealth is foregone. The important question that needs to be asked when considering GDP is to ask what is the source of the economic activity.

For example, if another person goes into the same restaurant, a manufacturing worker, a miner, or an architect who works in a practice that sells services around the world, and spends money from their earnings, this represents the redistribution of real wealth. In all cases the economic activity of the individuals has produced real wealth, in one case by being a part in the creation of a product, in the other case exchanging their services, and in the case of the miner extracting and making available a commodity. More to the point, as long as they keep their jobs, they can keep returning to the restaurant and keep spending their earnings. This represents real wealth because it is sustainable. On the other hand, if the same people were to use borrowing to make the same purchase then, at some point in the future, they will not have that money available to buy another meal in the restaurant.

When this is multiplied accross an economy, with 100,000s of shops and restaurants, it becomes critical to ask what the source of consumer spending actually is. In 'A Funny View of Wealth' I looked at the UK economy and asked where the economic growth came from, examining the rates of increase in manufacturing, commodity extraction and export of services. None of these showed any significant increases that could explain the GDP growth but, over the same period, there was a massive increase in debt (government and consumer). This massive increase in debt, when considering the multiplier effect, is the explanation of the increase in economic activity. The growth in debt therefore gives an illusion of wealth creation, but the reality is that there is a massive amount of future wealth being consumed. At its most simple, if I borrow $100 to go to a restaurant today, it means that in the future I will not be able to go to a restaurant one time in the future.

When a government borrows money it is doing exactly the same thing. If the government borrows money, it is foregoing future wealth, just on a much larger scale than individual consumers. If the government pays the wages of policeman out of borrowing today, at some point in the future they will have to accept that they will have to have one less policeman (actually more than one policeman because of interest) , unless they increase taxes. If they increase taxes, individuals will have less money to go the restaurant and buy the meal that will then allow all of the multiplied activity in the economy. Essentially, any borrowing that is directed towards consumption will one day be paid for by less consumption and therefore less economic activity.

The only way to overcome the problem of borrowing for consumption is to create a huge increase in real wealth, which means more commodity extraction, more manufacturing or more export of services overseas thereby transferring wealth from other economies into your own economy, or using your wealth to lend to other countries, and thereby transferring some of their wealth into your economy in the future.

Borrowing is not all bad. If the borrowing is going to pay for a new mine, a new manufacturing facility, or any other asset which produces more wealth than it consumes. Borrowing for consumption is the problem.

So now we can return to the various stimuli of economies being proposed and enacted by Western governments. They are doing nothing to address real wealth creation, as the provisions of the stimuli is to encourage a resumption of consumption. This is being achieved through borrowing, and also the debasement of the value of the currency. In the former, they are just creating new future problems, and in the latter they are destroying the value of the currency, and thereby literally destroying the value of the wealth that has been stored by every individual and business. Perhaps the US politicians should take a trip to Zimbabwe to see how helpful the printing of money is for making a country wealthy. I have talked about the value of currencies before on the blog, and I would therefore recommend reading my post on 'Synthetic Economics' to those who have not already read it. It is not easy, but I hope it will explain why printing money is so foolish.

At the risk of boring regular readers, I will reiterate that none of these solutions is addressing the fundamental problems in the UK and US economies. In both cases the economies are simply unable to compete with the emerging economies, and they are therefore structurally bankrupt. The only thing that is supporting them is the ongoing belief of creditor nations that they are 'good for' their debts. The truth is, they are not. They are just borrowing more for ongoing consumption and doing nothing to address their inability to compete with the emerging economies. In borrowing so much, they are actually damaging their ability to compete with the emerging economies in the future, as the economies will have less capital for investment into productive activity, due to the requirements of servicing the debt. In the case of printing of money they destroy the value of the currency, thereby impoverishing everyone.

I find it ever harder to accept that this is actually happening before my eyes. As each week goes by, I just see the situation become ever more dismal. I think the discipline of economics needs a new term, which is 'car crash economics'. This would be defined as the economics of slow motion destruction, in which onlookers watch helplessly as a the economy careers towards destruction.

I have now given up any hope of sanity in economic policy. My curiosity is to see whether there is anything that can be done to top the foolishness that is taking place. It is the curiosity of seeing just how mad policy can become. Each time the latest 'fix' is announced, I thought that it could not get much worse. Each time I have found my belief confounded.

How mad can economic policy become? Comments welcomed....

Note 1: I will return to the post a little later, and will address some of the comments and questions that have been posted. For a change, I have a little more time on my hands....

Note 2: Jonny posted this very interesting comment:

'Consider the following two actions by the UK Government:

1. In December 2003, Gordon Brown "changed the Government's inflation target to a new base: a CPI of 2%, from the previous target of RPIX of 2.5%."
(FAQs: The UK target measure of inflation, ONS website)
"The CPI excludes a number of items that are included in RPI-X, mainly related to housing, and as such is considerably lower ... The two indices are also calculated differently. The different techniques used to combine individual prices in the two indices also reduces CPI inflation relative to RPIX."
(http://www.moneyextra.com/dictionary/consumer-price-index-003666.php )

2. It can be seen that the growth rate of broad money rose from 7 per cent in January 2004 to above 14 per cent by the end of 2006. (http://www.marketoracle.co.uk/Article2880.html )

So, the measure of inflation was changed to omit house prices and immediately after this the money supply was progressively increased from medium to high. The result was artificially low interest rates despite both monetary inflation and soaring house price inflation.

If the UK Government did not want to exacerbate house price inflation then surely it would not have undertaken these actions simultaneously.

Is it therefore reasonable to conclude that this policy was adopted by the Government to prolong the credit bubble?'

I think that the answer to the question is that, yes, it appears that the government sought to prolong the bubble. If I remember correctly, I wrote of a couple of other methods in 'A Funny View of Wealth' that were used to maintain house prices when they started to wobble. I do think that the government sought to prolong the boom, but do not think they had any idea of the price that would be paid in the end. Whilst I have no respect for Gordon Brown's economic policy, I do not think he would have acted as he did had he known what his foolishness would lead to. I think that there are very few politicians who are quite that corrupt/wicked, but there are plenty that are happy to self-justify or willing to delude themselves.

Jonny also asked the following question:

'If the UK Govt defaults how would that affect UK banks, specifically UK saving accounts?

Basically what can I do with the money I have set aside to buy a house?

Advice urgently needed as my head is in a spin....'

I think that many people will be in the same situation. I am very wary of giving any specific advice, and you should see my comment at the bottom of each page of the blog. I think that it is difficult to give any firm advice on where might be a safe place for money right now. The world economy is in a state of chaos, and that means that small events might change larger events very quickly. One question to ask is how long you want to hold the money before using it. My guess is that house price declines will hit the bottom in 2-3 years time, but that is a guess. However, after that there will be stagnation for a long time, but it is also possible that there will be very slow erosion of prices for a while after. In this kind of timescale (3 years) the world economy is going to be turned upside down. My belief is that in about 4 years time, commodities will be on an upswing, so countries with sound economic policy (minimal debt) and a strong commodity base will be a good bet over the period of house price falls.

Also emerging economies with sound economic policy and not too much political risk might be a good bet, but I can think of no country without considerable political risk in the coming years. I even think that many OECD countries are subject to political risk in the coming turmoil. Set against this, I believe that holding £GB, $US are surefire ways to destroy wealth. The Euro is more of a question mark because, as I have highlighted elsewhere, the Euro economies are such a mixed bag that it is hard to see for certain what might happen. In addition, the coming problems are likely to see strains on the continued existence of the Euro in the coming years, such that you should only put your money in Euros where it will default to stronger currencies, such as a revival of the DM.

As you can see, we are confronting a world full of question marks. The only certainty is that the decline of the West is now assured, and that will, to a greater and lesser degree according to each country's response to the crisis, lead to devaluations relative to the rest of the world. I am not sure whether the answer is helpful, but it is the best I can do.

Note 3: Steve Tierney made the following comment:

'My gut feeling says you are, sadly, right in most of what you say.

What I don't understand is why the UK Government, or the opposition, both of whom have plenty of economics "experts" on hand, aren't terrified. They MUST know how bad things are. Why is nobody saying anything?

You can understand why conspiracy theorists get so excited. It just doesn't make sense that we are balanced on a precipice and people are arguing about whether the voting methods of reality shows are right...'

I think that the trouble is that they do have so many 'experts' on hand. The experts have still not actually managed to grasp the idea that, when the world labour force doubles in ten years, there must be economic consequences, and that this has never happened in the past. In such circumstances, where they are using the past as a guide, they are going to get everything very wrong.

Note 4: An anonymous commentator left this very interesting link:

'Very interesting reading:


The article in question highlights that the bond markets are getting increasingly nervous about UK borrowing. The author ends the article with this:

'The situation is desperate, but not serious - as the Habsburgs used to say. Fingers crossed.'

I am not sure that crossing your fingers and hoping is a good response to the risk of government bankruptcy....

Note 5: Lemming has posted a provocative question, to which I think he knows the answer:

'Alistair Darling on the Today Programme this morning:

"...debt levels as we go into this are lower than other comparable countries because we did reduce debt over the last 10 years... our debt levels did fall over the last 10 years; by any measure they fell..."

(about 14 minutes into the interview)

Is what he says correct'

Let's start with the 'sunny' picture of government debt, which can be found here on the ONS website. On the other hand, as others have pointed out, this does not include liabilities such as unfunded pension arrangements, and also the ever growing use of PFI to put debt off the balance sheet. A good discussion of this can be found here. It is fairly partisan source, but that does not mean that it is not correct, as it uses the IFS for the numbers. Here is a good summary:

'Add up all the money pledged through PFI, and the independent Institute for Fiscal Studies believes that you will quickly reach the sum of £110 billion. The institute’s findings suggest that, were this PFI lump-sum added to officially acknowledged government debt, the total figure would represent 45 per cent of gross domestic product — making a mockery of Mr Brown’s ‘sustainable investment’ rule, by which government debt is not meant to exceed 40 per cent of GDP. If this seems no more than a statistical abstraction, think of it this way: the overall national debt works out as £26,100 for every British household. This amounts to a second mortgage which all of us, including our children, must eventually pay off. And this is before the consequences of the Northern Rock crash or the £1 trillion of unfunded public sector pension liabilities are factored in.'

As if this is not bad enough, everybody is measuring debt as a percentage of GDP as an indicator of the sustainability of debt. The trouble here is that GDP has been measuring activity that has, in part, been inflated by debt, as I have already outlined. Under these circumstances, my estimate of non-borrowing based economic activity means that the real output of the UK economy is around a 'guesstimated' 30% less than GDP states. In other words, the level of debt in relation to output of the economy is quite simply shocking.

I think that Lemming was already aware of this and asked the question so I could make the point for others.

Note 6: I have had this comment from an anonymous poster:

'If the US continues on this course of printing money, what will be the likely reaction of those nations holding large dollar reserves. Given the implications of inflation on the value of the dollar, wont those countries dump like crazy as soon as US inflation climbs.

IMO if the americans are up to this, it wont be long before the UK follows suit. Given the much weaker UK position re sterling, would this cource of action precipitate an immediate collapse of the currency.'

To the first question, 'yes', is the short answer. Printing money just destroys the value of money, so why would anyone want to hold it. To the second point, I have speculated that the UK will print money to try to get out of trouble, but as we know it just creates a whole new set of even worse problems. With the US leading the way, this is quite likely. However, I am not sure the BoE, however many errors it has made in the past, is going to go along with the idea of printing money until there is nothing else to be done. That will be at the point of default. However, as I have already mentioned, there does not seem to be any limit on what foolishness might be enacted next, so perhaps I will be proven wrong.

Note 7: Chas H has kindly provided an explanation of how a chart I found (last post) shows a decline in the number of civil servants. His comment and link is as follows:

The explanation for the strange bar chart at the end of your 24 November 2008 post may be found here: http://www.civilservant.org.uk/numbers.pdf
The pie chart at the beginning of the document and the graph at the very end are particularly revealing. The distorting visual impact of the bar chart you found is heightened by it's use of a false zero and the cunning way it starts at 1999 instead of 1997.

Thank you for that. If you check the orignal chart here, and compare it with what Chas has provided, you will see how 'playful' the numbers actuall are.

Note 8: Steve Tierney suggests the following:

'Most people are afraid, first of all, of losing their home. Some protection to prevent this during the crisis would go a long way to settling public nerves, if not resolving hardship. Perhaps by protecting people who lose their jobs from repossession (if they bought the house before the start of the current crisis.)'

I can understand Steve's concern. There will many people who lose their job as a result of circumstance, rather than their own behaviour. I think the answer to this problem can be found in my post on benefits, which can be found here. The system I am proposing is largely self funding, so would offer a route to achieve the objective without increasing unfunded liabilities significantly.

P.S. Please do not joke about faeries being enlisted to solve the crisis. Someone might read your comment and think that it is a good idea......

Note 9: I have had the following question from an anonymous poster:

'Given the recent lunacy by the government and the extra £ 450 bn borrowing figure, which will be wildly exceeded as its based on what can only politely described as optimistic growth figs.

Have you revised your forecast for a UK sovereign debt default ie brought it foreward'

It is a good question. I think that we are coming very close to the point now. When commentators in the mainstream media start to ask the question (see earlier note), then I think that the situation is coming to a head.

Note 9: I have had so many comments that I have not been able to cover them all, so accept my apologies if I have not responded to you individually. Whilst I have more time, for once, there is still a limit to how much I time I can put into the blog. I am hoping (events allowing) to make my next post on the subject of reform. I have just had to prepare and deliver a presentation on energy policy so, whilst it is a quite specific, I thought it may be worthwhile posting on how to make the energy sector more efficient.

Note 10: I have just read an interesting article in the NY Times which suggest that the UK government has adjusted its policy on Tibet as a quid pro quo for financial support from China. I think that the point being made is quite believable. Maybe the UK government has managed to buy some time at the cost of abandoning principle?


  1. cynicus

    If the US continues on this course of printing money, what will be the likely reaction of those nations holding large dollar reserves. Given the implications of inflation on the value of the dollar, wont those countries dump like crazy as soon as US inflation climbs.

    IMO if the americans are up to this, it wont be long before the UK follows suit. Given the much weaker UK position re sterling, would this cource of action precipitate an immediate collapse of the currency.

  2. Mark, if you are going to present on energy policy, I wonder if you are familiar with the work of Amory Lovins at the Rocky Mountain Institute?

    He has some very interesting ideas indeed.


    Here in Hungary the situation is terrible - it makes the UK look like a model economy.

  3. Kecske

    I am curious to know what changes you have oserved and felt in everyday day life; are there consequences already manifest?


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