In November of 2007 year I wrote the essay that was the precursor to this blog, 'A Funny View of Wealth', and that has been the bedrock of the thinking of this blog. In the essay, I presented an argument which completely diverged from the thinking of mainstream economists. I pointed out that, in the UK (and the same could be said of the US), there had been no real growth in what I considered to be wealth creating assets over the last ten years which could explain GDP growth; manufacturing, commodity extraction, export of services, and tourism (no net growth).
Instead I pointed to the growth in debt, and asset inflation (real estate) as the source of all of the GDP growth of the last ten years. This debt, in conjunction with the multiplier effect, along with upwards levers such as immigration, created an illusion of growth in wealth. It led to the 'post industrial', 'service economy'. My argument was that this was completely unsustainable, and that a collapse in asset prices would signal a self-reinforcing downward spiral in the economy, driven by a collapse in consumer sentiment (a massive belt tightening) leading to the collapse of the service economy, higher unemployment, more belt tightening and so forth into a downward spiral. I concluded that essay with the following:
'The situation overall will be a massive contraction in thePerhaps the most important prediction within this paragraph is that I suggested the UK economy would contract back at least ten years. Since I made the predictions for the economy, mainstream economics has slowly been catching up. I watched as week by week the Economist magazine's weekly poll of forecasters ticked down GDP growth predictions by 0.1 % increments, all the while still predicting growth in the economy - at least until the full savagery of the current crisis was staring at them square in the face. The reality of the scale of the crisis is now sinking in. This sub-head from the Telegraph a few days ago:
UKeconomy, a contraction that will see the 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. The only way out of the crisis will be to alter the fundamentals of the UK economy back to producing more goods and services for export led growth, and away from debt based growth in services. It will be a long, and very painful adjustment that will see the UK lose its place as one of the worlds’ leading economies, and recovery from the crisis will take many years.' UK
In other words, they are catching up with my prediction, but not there yet. They will finally accept the reality of the scale of the contraction only when it is right before them. My prediction was that UK economy would one of the worst hit in the world, if not the worst. One of the key transmission mechanisms of the collapse of the UK economy that I identified would be a collapse in the value of the £GB. We have this from the Times:
The 2009 recession could be so severe it sets Britain's economy back five years, according to the most chilling warning yet on the scale of the looming slump.
It had become fashionable amongst many commentators to discuss currency strength in disparaging terms, talking about it being a matter of 'virility', rather than being a substantive issue. If I remember correctly, the example I gave to illustrate the nonsense of this view was a person with a preference for Belgian beer. If the £GB weakens, then that beer will cost the individual more, and that individual is therefore poorer. If the individual's income does not buy as much beer today as it did yesterday, how can anyone argue that the individual has not become poorer?
This year, however, Britain – with a GDP per head of $43,859 (the pound buys fewer dollars) – has been o v e r h a u l e d b y t h e U S ($46,993), France ($45,088) and Germany ($44,245). Only Italy, ($39,641) and Japan ($38,692) remain behind.
Worse is to come, according to the Oxford Economics projections, because of the recession and the sliding pound. “UK GDP per capita in 2009 will be 24% lower than in America and will be over 15% lower than in Japan, Germany and France,” said Adrian Cooper, managing director of Oxford Economics.
“It will even be 7% lower than GDP per capita in Italy, where economic performance has been very poor over the past decade.
The simple reality is that, as each day goes by, as the £GB slides further, every single individual holding and earning in £GB becomes a little poorer. The £GB has a long way to fall yet....
In order to understand why the £GB has so far to fall, it is first necessary to explain why it continued to ride high for so long. One element is the irrational element of confidence. However, underlying this confidence is good old fashioned supply and demand. The key question here is; why was there so much demand?
The answer is rather scary. First of all, we have run consistently large trade balance deficits for many, many years. There is therefore minimal demand for the £GB to buy our products and services. Tourism sees a negative balance, with more spent overseas by British tourists than others spend in the UK. For commodities, our major source of commodity wealth, North Sea Oil, peaked a few years ago and is in decline. The real source of demand for the £GB is very scary indeed.
We are now all aware of the massive expansion in debt in the UK over the last 10+ years. Much of that debt has been financed from overseas. In order to lend to UK consumers, business and government, overseas investors had to buy £GB in order to then loan that money. This is a huge source of demand. In other words, a large part of the demand for the £GB was demand that was driving the UK into ever deeper debt....Our creditors, such as China and Saudi Arabia, are now turning off the supplies of credit, and are no longer buying the £GB to lend to us. Demand from this source will continue to evaporate...
A second area of demand was for inward investment, with much of that investment going into inflating assets, and the one area of growth - the service sector. With the downward spiral of the UK economy, only the clinically insane will invest in the UK, excepting the vultures who will pounce upon distressed assets at knock down prices.
As such, there is very little genuine demand for the £GB. To add to the woes of the £GB, we can add the latest in the insanity of government economic policy. The government is borrowing ever larger sums of money, and pouring it into the black hole of a bankrupt banking system. I predicted that when the government bailed out the banks, it was just the start. The banks had lent too much into an economy built on debt, in an upwards spiral of debt driven growth. It was self-reinforcing. The more the banks lent, the more the economy grew, and then the more the banks lent. I predicted that, as the spiral went into reverse, the losses of the banks would just increase. This from the Telegraph:
This is just one sector of lending. Consumer debt is going to sour ever more quickly. Commercial lending is already falling off a cliff with, for example, prediction of carnage in the retail sector. The retail sector is just the most visible part of the bust. All of this just means bad news for the banking sector, who will continue to make huge losses.
Britain's banks face up to £70bn of losses on commercial property loans, enough to force some of them into a further round of taxpayer bail-outs.
Investment bank Close Brothers forecasts massive writedowns in light of its forecast 50pc-60pc slump in commercial property values by the end of 2009 compared to the market’s 2007 peak. Most property experts believe such values have already dropped 30pc this year.
Such writedowns could again imperil banks’ capital ratios, potentially forcing them once more to go cap in hand to the Government.
In amongst all of this, the government is using its stake in the banks, and the fact that they are one of the only remaining sources of capital to bully the banks to keep lending into this mess, rather than making provisions for the next stages of debt delinquency carnage. It is a recipe for ongoing catastrophe. More bad lending into a collapsing economy.
Then we come to the real horror for the £GB, and for the UK economy overall. Everything suggests that the Bank of England and the government are planning to print money as a solution to the deep problems in the UK economy. In a post here, I have detailed how the government is seeking to hide the fact that this is their plan. If you are new to the blog, take a moment to read the post, as it is all referenced, including to Bank of England resources.
A long time ago, I predicted that the UK would default on its sovereign debt, and that default would happen at about this time (we are about a month overdue on my original prediction). As the predicted time for the default approached, there were more and more signals that the markets were less and less willing to fund UK government borrowing, and the debt default became ever more inevitable. I became more and more certain that I was right, and the default was a certainty.
It was at this point that the discussion of money printing suddenly appeared from left-field, with the Bank of England openly discussing the possibility. I was puzzled that such a dangerous policy was being considered, and gnawed at the question of why the Bank of England and government might be considering this. It was at that point that is occurred to me why this was being done. If the bank prints money, and then lends that money into the banking system, the banking system can then use the money to buy up government bond issues, thereby financing government debt. Under the Basel rules, lending into OECD governments creates tier 1 capital, and therefore means that the banks are seen as meeting capital adequacy rules. In other words, the banks return to (apparent) solvency, and the government manages to continue borrowing, and does not default on the loans. In the meantime an Act of 1844 that required the Bank of England to publish the amount of currency issued is abolished, such that the Ponzi scheme can be hidden.
All the while, the excuse for printing money is given as the avoidance of deflation. Whilst this excuse might stack up in the US, where their currency has not (yet) devalued, in the UK the devaluation of the £GB means that we are importing inflation. Whilst there may be deflationary impacts from the contraction of the economy, the imported inflation from the collapse of the £GB makes the idea of deflation very unlikely.
I have explained what money printing actually really means over several posts. The first point is that it does not create value, but transfers value from the existing supply of money. You can not create value out of thin air. If there are 100 units of currency, and you just print 10 more, all you are doing is spreading the value of the 100 units into 110, such that all of the currency is devalued. This is, of itself, highly inflationary. It is also a form of taxation. In transferring some of the value from the currency in supply into the newly printed currency, there is a movement of value to the printer of the money - the Bank of England, and eventually the government. Therefore, whilst the government makes its rather sad and pathetic VAT tax cut, they are quietly taxing ever more money to pay for their borrowing. It is the ultimate stealth tax.
What we have here is a 'double whammy'. As the demand for the £GB is in decline, the government is increasing supply. In so doing, the only possible outcome is inflation, and capital flight. The UK is now on course for hyper-inflation.
What does hyper-inflation mean? The first problem is that it will see the destruction of savings, and investments. The massive destruction of debt that comes with hyper-inflation may seem to be a good thing in a nation sinking under mountains of debt. However, when no one any longer trusts to lend, there is no investment, there is no prospect of return to growth. All of those who have been responsible and have saved are punished, and the feckless are rewarded. It is a recipe for long term pain. Meanwhile, the £GB becomes worthless, and every single holder of the currency just becomes that much poorer. As capital flees the country, there is no money left in the economy, nothing left to rebuild the economy.
The real truth is that, when the printing presses turn, we are witnessing one of the greatest debt defaults in history. In printing currency, yes, it is possible to pay the debts, but paying back debt with a debased currency is just another form of default.
How is this all going to unwind for the UK?
It is a very big question. I am not really sure that I know the answer. I am not sure how bad things may yet become. Many months ago, a commentator on a post asked whether I thought that there would be food shortages in the UK in the future. I suggested that this would not be the case, and still think that it will not become that severe. However, I do think that the UK is heading towards that kind of severity, though will never reach that point. There are still enough companies in the UK that can create genuine wealth, that are competitive in the world, but they are too few in comparison to the needs of the country. This has been evident for many years in the ongoing balance of trade deficits.
So what has caused all of this mayhem? Why is the world economy, and the UK economy in particular, in such deep difficulties?
As I progressed my commentary in this blog, I started to unravel the real causes of the problems in the economy. In one of my early posts, 'The Cigarette Lighter Problem', I was grasping my way to the nature of the problem. The problem I was trying to answer was why it was that an identical cigarette lighter costs nine times as much in a Western economy as it does in China. The same distribution, the same manufacturing costs, the same shop service. Everything is the same. How can this additional cost be justified? The only answer that made any sense was to identify massive value adding industries in the West, such that they could disburse this wealth into the wider economy, and that these industries were not to be found in China. It was hard to find any examples that could explain such a differential. In a later post, I identified the differential, and it was that the lighter was being funded by the appearance of wealth, the appearance of value added, that was rooted in debt. In other words, although we might not have directly borrowed money to buy the lighter, if we trace back the sources of economic growth, and the real source of the money, it could be found in debt.
It is here that the problems arise. It returns me to 'A Funny View of Wealth', the essay at the start of this blog. We have had the appearance of wealth, as borrowed money flooded into the economy from real wealth producing countries. We spent that money, created massive amounts of activity in the economy through the multiplier effect, and all the time we were just spending our future wealth. It is this borrowed money, that paid so much of our income, that was being used to support the difference in the price of the lighter between China and the OECD country. In other words, when we purchased the lighter, through the massive input of credit in the economy, we could pay such a high price for the lighter. The sick part of this is that one country lending us the money to pay for the overinflated price of the lighter was China, the manufacturer of the lighter.
What this really means is that the wealth producing countries, the big exporters, have been lending us the money with which to buy their goods. They did so in good faith, in the belief that we were good for our debt. We are not. I have often used the example of an 18th century aristocrat to illustrate the problem. His family has always been rich, and his creditors believe that this is the natural condition. However, the lavish lifestyle led by the aristocrat has, for a long time been supported by credit. His estate no longer produces enough wealth to cover his costs. The creditors will keep lending, but only to the point where they finally realise that they are lending to him to pay back his previous borrowing.....
I have said that the creditors lent in good faith. However, all is not well in this regard. In particular the artificial value of the RMB in particular has been an aggressive and damaging factor in the mix. It is, and has been, a massive export subsidy for companies operating out of China. It has meant that China has enjoyed an export led growth boom, but at the cost of destruction of large swathes of manufacturing in the Western world. Quite simply, it is unfair trade practice, and has contributed to large imbalances in world trade, and sucked foreign currency into China, which has then been lent back to the West.
This is not to say that the only problem has been the problem with the RMB. One of the themes throughout this blog has been the question of labour supply in relation to commodity supply. I first detailed the problem in 'Why do Economists Get it so Wrong?' The argument is quite simple.
In the past ten or so years, the labour force of the world has doubled. There were always the huge numbers of workers available in countries like China and India, but they were previously under-utilised. What changed was that these workers have been given access to capital, to technology, and access to world markets. As this happened, they became a part of the world labour force.
When we look at the entry of the emerging economies in this way, it becomes apparent that we have had a massive supply shock into one of the key inputs of production. At the same time, whilst we have this massive oversupply in this one input into production, there has not been a commensurate increase in supply of another vital input into production - commodities. We saw this shock in the eventual spiking in oil prices. This spike was what finally motivated the pushing over the edge of the Western economies, which were already balancing on a precipice of debt fuelled consumption.
At its most simple, we have a situation in which, about ten years ago, commodities were supplied at a rate of 1.2 units per worker. As the emerging economies seriously entered the world economy, the supply of commodities increased, but not at a fast enough rate to match the numbers of new workers. Eventually, demand outstripped supply, and the commodity prices spiked upwards. In effect we hit the point where there were only 0.8 or 0.9 units of commodity per worker. Whilst the numbers here are made up, I hope that this illustrates the basic principle.
The result of that commodity spike was to expose the impossibility of the ongoing imbalances. The output of the world was being consumed in the West, but increasingly the production was in the East. The East was lending the money for the West to continue to consume a disproportionate amount of world resource, at the cost of the wealth of their own more productive populations. Something had to give.
What gave was the Western economie, and they have taken with them the emerging economies - who built their structures to support Western consumption. Having geared their economies to the West, they now no longer have markets for their goods. The imbalance is correcting in a very painful way.
As world trade collapsed, so did the demand for commodities. I make an analogy here of a man running towards a brick wall of commodities. The wall is moving forwards, but not as fast as the runner. Eventually, the runner hits the wall and bounces back, only to later start to run towards the wall later. We have just bounced back. The running will resume later....
Today, economists are finally starting to 'get it'. However, I think that it may be economic historians who finally grasp what has happened. The simple truth is that the world moved out of balance with the massive input of labour many years ago. The massive boom in debt simply hid the imbalances. It was not complex financial instruments that created the problems, but rather they were the reaction to the wall of credit that flowed into the Western economies from the ever more productive East.
As more and more credit flowed in, there were few opportunities to invest that money into wealth creating assets. The Western economies were bloated in comparison to those of the East, and in many sectors were unable to compete. If you wanted to invest in manufacturing, you looked to the East. As such, there was a wall of money entering the economies of the West, with limited opportunity for investment into productive assets. Instead, the money was lent into consumption, and into asset price inflation. If you have a limited supply of assets, and an increasing supply of money chasing those assets, you will have asset price inflation. When you have a huge supply of money, and limited investment opportunities, the quality of the investment will suffer. The first tranches of money will go into low risk, high return investment but, as the money keeps flowing in, these good investments will disappear, leaving the investor only the option of pouring money into ever more risky investments. This is the source of sub-prime, and the financial instruments that were developed were just a method of hiding the poor quality of those investments. The financial crisis was caused by the imbalance, not the other way around.
In other words, the catastrophic failure of the banking system was simply a result of too much capital with no good place to go. All the while that the money was pouring into black holes of investment, economists, bankers and governments could point to GDP growth to show that their economies were miraculously growing. However, GDP is a measure of economic activity, not a measure of wealth creation. Where that activity is generated through growth in debt, it is not economic growth, but the destruction of future wealth. The delusion was that activity meant wealth creation.
What we therefore had was a massive imbalance in the world economy. The East was increasingly producing goods for the West to consume. Meanwhile, the East lent money into the West so that the West could continue to enjoy a lifestyle of comfort. The East, in other words, worked hard to support the lifestyle of the West....
It was always impossible that such a situation might be sustained. At some point, at some time, the massive imbalance had to be corrected. This is the process that we are witnessing now. The only element still missing is the collapse of the mighty $US.
In this matter I have been wrong. I long predicted a collapse in the $US. It has not happened.
However, if we look at what has driven events, what has caused this crisis, it is apparent that the $US must finally collapse. The US is just one huge deficit, and has long since ceased to pay its way. When I made the analogy of the aristocrat, we can extend this analogy to the US, but in the case of the US, the US is the King. How much more difficult to imagine that the King is broke. After all, the King's head appears on money.
At this moment in time, the $US is the biggest bubble in history. In my previous post I discussed money and the banking system. The important point about fiat money is that there is absolutely no support for its value excepting confidence. At present, as the reserve currency of the world, the $US is holding onto its value, despite ever more issuance of the currency - they are printing money too. With the US as the 'King' it is hard to imagine that it is bust, that the US is in as bad a state as the 'aristocrat' that is the UK. However, the two countries are running paralell, and there is only a difference of scale. If we compare the two economies, they are very similar in all of they key points that I have discussed so far.
As such, the $US will collapse. It is just a question of when.....
When I first started writing on economics, I wrote with the optimism that, once the nature of the problem was recognised, we would take action to reform our economies to meet the challenge, the hyper-competition of the East. The one thing I have not seen since is any single policy or initiative with this purpose. All I have seen is policy that seeks to replace the lost consumer borrowing with ever more borrowing, and an attempt to recreate wealth through the use of the printing press.
There has been a collective burying of heads in the sand. The only possible outcome for this is that, what would always have been a painful adjustment, is going to be agonising.
I am very sorry to say this, but the situation can only get worse. The next stage of the crisis is hyper-inflation, and that can mean only one thing.
What we will witness in 2009 is the fall of the West.