I believe I have quoted this before, but it it is worth saying again. I had the following to say in the middle of July:
As I have mentioned, government will need to either borrow more, which will destroy confidence in the UK economy, or will require massive cuts in state spending. If it is the former, then the result will be destruction of confidence in the UK government's ability to manage the finances of the UK and the UK economy. If it is the latter, then there will be a strong downward lever on the economy (at least in the short to medium term).And the news? This from the Telegraph:
I have been giving this some thought, and I am coming to a conclusion that it is going to become increasingly difficult for the government to borrow at all. I have detailed elsewhere that the £GB will continue to fall in value. I have argued that depression is looming. The government deficit it going to balloon. This makes lending to the UK government a very, very high risk venture.
My question is this; Will anyone want to continue to lend to the UK government under such circumstances?
I think that the answer, in the coming months, will be 'no'. I am not sure at what point this will occur, but I would guess that the turning point will come in the next six months or so. It is at this point that the government will really fall to pieces. The reason will be that, in the near future, the UK will be calling on the International Monetary Fund. Quite simply, with the huge risks in the UK economy, I simply do not believe that it is creditworthy, and others are going to come to the same conclusion.
Quite simply, the UK is bankrupt. Both consumers and government have borrowed more than they can afford.
The cost of buying insurance covering the Treasury from defaulting on its gilts in the next five years reached a record high of 106.5 basis points above Libor at one stage on Tuesday.And from another article, we have this offer of reassurance:
Regular readers will, I hope, remember my aristocrat analogy, but I will re-quote it here for newer readers. I am sorry to quote so much from my previous posts, but there is a point I am coming to.
A spokesman for the Debt Management Office (DMO) said £77bn has been raised through gilt sales so far this financial year and these government assets "generally remain the preferred risk-free asset for major international investors and are in strong demand internationally and in the UK".
Commenting on the CDS spreads being less favourable than those offered on some banks, he said: "We think investors in UK Government securities will be assured by the fact that the UK Government has never defaulted on a payment since the origins of the national debt in 1694."
The reason why confidence is so important is best explained through an analogy. The analogy is an 18th century aristocrat who is living beyond his means. He gambles, he entertains, and he has a wonderful time. All of the tradesmen extend to him long lines of credit, and he continues with his profligate lifestyle, all the time feeling that he is above the petty business of managing finance. After all, his family has been wealthy for generations, and it is his right to enjoy the good life. However, he is actually spending his family wealth, and the earnings from his estate are no longer covering the costs.Now when we look at the explanation given for why UK debt is a good bet, the analogy I have given suddenly looks rather painful. More to the point, when a government official feels the need to defend the creditworthiness of the UK, it is a good sign that events are moving to a climax.
His creditors also know that his family have a long history of wealth, they see his fine house, they see his expensive furniture, his lavish lifestyle, and can not believe that he will not repay the credit that they are extending.
Then a rumour starts that he is in financial trouble. One or two of his creditors start to press for payment, and restrict his access to new credit. He is unable to make the payments. The word starts to go around that maybe he is not as solid a credit risk as everyone first thought. Creditors start to refuse to extend his credit further, and the aristocrat starts to realise that he has no money. The entertaining, the lavish clothes, all become beyond his means. He can no longer make repayments. His estate does not generate enough cash, and now that the credit has stopped, he can no longer afford anything at all. He is bankrupt.
The UK has long lived on such confidence but, like the aristocrat, it is a misplaced confidence. It is a confidence built upon an idea that wealth is a birthright. However, as the UK is about to learn, it is not a birthright, but something that requires effort and energy. You can only live so long on your inherited wealth before it is squandered away, and you can only live so long on credit before the creditors start to ask questions of your ability to make payments.
The really curious part of the articles on the troubles with financing debt is that they are not the headlines, but small articles tucked away in the finance section. The road to disaster does not even apparently merit a headline on the front page. Meanwhile, Willem Buiter has continued discussing the possibility of a 'rout' in the £GB if interest rates are lowered much further....
One of the most curious and funny (in the tragic 'it could make you cry' sense) aspects of the problem is that across the Western world governments are all competing with each other to fund their massive borrowing requirements. The supply of government issue of debt instruments is huge, and governments will have to increase the returns on the debt to attract investors into the issues. From the Telegraph again:
In addition, we once again hit the problem that the issue of this debt will crowd out investments in other areas as, in the current climate of uncertainty, some investors will still foolishly seek the (illusory) safety of lending to governments. In issuing so much debt, governments will be in a situation where they will crowd out investment into private business, and thereby hamper the private sector in being able to finance investments and operations. We are in a world of contradictions, where there are tugs on behaviour coming from different directions - as uncertainty is king.
The interest rate the Government pays on its debts is based on many factors, including the Bank of England's base rate and the rates offered by other governments selling bonds.
Investors' confidence in the UK's economic prospects and Britain's ability to repay its debts also plays a key role.
Normally, that rate is relatively low, because investors are confident that the UK is good for the money.
But that confidence is being threatened by both the bleak outlook for UK economic growth and the Government's plan to flood the bond market with new gilts.
This is why we come to the really odd part. In order to meet Basel standards of capital adequacy (see post on this here), the banks will have a strong incentive to invest in financing government debt. Meanwhile the government is using borrowed money to recapitalise the banks. Where does that money come from? I would like to see the balance sheets of the banks, as it may be the case that they are buying government debt, and they will (in many cases) be using government provided capital to purchase that debt. In other words, I suspect that we have a money-go-round where the government borrows to recapitalise the banks, and the banks are then using some of that money to buy government issued debt.
Most importantly the voracious appetite of governments for credit will be swamping the market, and in doing so will be pushing out provision of credit into private markets. It is really not clear to me how this will help the economy. In order to ameliorate this situation the UK government is increasingly pressuring the banks into lending to businesses and mortgages, utilising their stakes in the banks to do so.
So, to ameliorate the flight to 'safety', the government is now putting pressure on the banks to pass on interest rate reductions for mortgages. At the same time house repossessions are climbing in number, which means that banks should be pricing in greater risks:
'Repossessions are expected to soar to 75,000 next year, according to the Council of Mortgage Lenders, while 200,000 homeowners are expected to be at least three months in arrears by the end of 2008.'These assumptions are based upon relatively optimistic forecasts for the economy, but the situation will probably be far worse. The banks need higher interest rates to compensate for the increased risk. Without that pricing of risk, they will just have ongoing crises. The details are not yet clear but, add to this the latest scheme to insulate people against repossessions, and we are moving ever closer to a command economy. The government in this case is offering a guarantee against losses made by banks if they do not repossess. More liabilities for the government and they are, of course, unfunded liabilities. The government will need to borrow more money to fund these liabilities.
The government is also pressuring the banks into lending into business. We have this from the FT:
The simple fact is that, if banks are being forced to lend into businesses that are at high risk of bankruptcy, the banks are thereby further endangering their own viability. In the end, under current government policy, the cost of this irresponsibility will end up in the hands of the government.
'A fresh sign in the deterioration of credit market conditions emerged on Wednesday when one of the most closely watched barometers of sentiment broke through an important threshold.
The Markit iTraxx Crossover index rose through 1,000 basis points for first time since it was created in 2004, implying a record number of companies are on the verge of default because of deepening financial and economic problems'
Are you starting to see the picture? We have more and more distortion in the markets, as the government follows self-contradictory policies. We have investors who may be, on the one hand seeking safety in government debt, but the more they invest in government debt, the less money available in the wider economy, and the more the economy will deteriorate. Set against this is that investors are starting to doubt the ability of the government to repay debt, and will at some point abandon financing that debt. There is a terrible situation brewing as these contradictions start to resolve themselves.
Interestingly, China's sovereign wealth fund is absolutely refusing to touch the Western banking system:
'Mr Lou contrasted recent shifts in US regulatory and government policy and efforts to rescue ailing banks with the “clearer policies” of some developing countries, where he said CIC was still “actively” pursuing investment opportunities.Although this quote refers to the US, the point applies equally to countries such as the UK. The sovereign wealth fund is investing in developing countries because they are not in the business of trying to support and manage their economies through command measures. This brings me onto the subject of China in general in the current toxic mix. Just to add to the woes of the West, from the same article as above:
I have long argued that the West needs to address the distortions being caused by the RMB, but the situation now exists where China holds the whip hand. The Western economies need Chinese finance to pay for their borrowing. They hold massive reserves of foreign currency, and have the 'nuclear' option of selling that currency if anything is done to force them to do something they do not wish. In doing so they would collapse the currency that they are selling. So China is now in a position where, when their currency should be becoming the strongest currency in the world, they are devaluing their currency in order to support their exporters. In doing so, they are going to just add to the massive trade imbalances, and there is nothing anyone can do about it without risking economic Armageddon.
China has let the currency appreciate slowly since ending its peg to the dollar in 2005. But Beijing is coming under growing pressure from manufacturers at home to change tack.
Sharp downward moves by the renminbi against the dollar in recent days have been interpreted by some analysts as a sign that China has shifted policy.
The country’s foreign exchange market was dominated again on Wednesday by expectations that Chinese authorities are now eager to see the renminbi depreciate against the US dollar.
We have an unfolding picture in which, to use a cliche, chickens are coming home to roost. The problem of the RMB should have been dealt with at least five years ago, when it was still possible to act. The distortion created by the RMB allowed the massive foreign exchange reserves to be accumulated, and now nothing can be done about the problem. The trouble is that, in depreciating the RMB, China is now going to contribute to the economic collapse of the West, and this in turn is going to eventually lead to a dramatic slowdown in the Chinese economy. When I discussed China before, I pointed out both the strengths and weaknesses of the Chinese economy, and suggested that the effect of this crisis on China was on a knife edge. My hope was that China would pull through using their reserves to insulate them from the worst of the shock.
The behaviour of the Chinese government in depreciating their currency is the surest sign that it is all going badly wrong for China. An article in the NY Times has this to say:
In recent weeks China’s once unstoppable economy has slowed sharply. Export growth, one of the main contributors to China’s expansion over the past decade, has receded and seems likely to reduce overall growth next year, according to the World Bank. The stock market is in the doldrums and property values in many cities are off 30 to 40 percent.When I wrote about China, I mentioned that they had a property bubble, that there were severe risks following in the collapse of exports to the West. Set against this, I had hoped that the massive reserves of China, and a switch to internal growth, might see China through. It appears that this hope was forlorn.
The Chinese government knows that, without economic growth, the chance of social unrest in China is very high. This has always been my greatest fear. As I have discussed before, the Chinese Communist Party's legitimacy rests upon the provision of economic growth and nationalism. Their response is a desperate attempt to keep their economy moving, but will just further contribute to massive imbalances in the world economy that caused the mess in the first place. More to the point, in making the Western problems even greater, this will eventually come full circle and contribute to ever greater problems in their own economy. As the West sinks, China will be pulled down behind them. In the case of China, that will mean that the Chinese government will be left clutching at nationalism, and that is a very dangerous situation.
The real problem is that, in any case, the West is heading towards economic Armageddon. The collapse of the UK and/or Ireland will be the start, and the US will follow. In my early posts I was arguing that if governments commenced major structural reform immediately, there was a hope of avoiding the unfolding disaster. I am very sorry to say that there is now no hope of avoiding the disaster. Every new action by the UK and US governments just accelerates the inevitable catastrophe.
We are now coming to the worst case scenarios that I have contemplated since commencing this blog. The actions of governments are taking a crisis and turning it into catastrophe. We are about to see the collapse of the Western economies, and the downfall of the West.
In summary, the Western economies are about to collapse, taking the world economy into chaos. China now has a very high chance of massive social unrest. The response of the Chinese government will be to commence a nationalistic and aggressive policy. At the extreme of the possible outcomes will be an attack on either Taiwan or Japan (in the case of Japan still improbable, but....). These are both extreme scenarios, and once again I hope that I am wrong, but they are starting to look ever more probable and realistic. From the foolish responses to this crisis of governments around the world, we are moving ever closer to wider chaos and disaster.
There is no guarantee of what will happen in China, but the situation is going to be very high risk in the coming year. I will admit to being at a complete loss for how this situation might be improved, or how the risks might be mitigated. I am equally not sure that it is possible at this stage to do anything at all to reverse the economic disaster.
As such, my posts will now focus on reform and ideas for recovery once the crisis has been reached. It seems strange to talk of this now, in light of the unfolding disaster, but what else can be done? In the current situation, many of my suggestions will be viewed as unacceptable but, in light of what is about to happen, might be viewed as increasingly necessary. However, set against the ideas that I have already put forward, and the ideas that I will be proposing, will be the siren call of populist measures. These will be the measures of ever more government intervention to 'fix' the economy, the refusal to accept that times have changed and that the UK must adapt to a changed world. In other words, I want to propose measures which accept the diminished state of the UK economy, and which will prepare the UK for the hard slog back to wealth. No magic bullets, just a lean and tough economy ready to compete with the rest of the world.
The subject of the next post will not be to review the state of 'events' (unless they are of sufficient import), but the weird and wonderful world of taxation. My aim now, wherever possible, will be to try to offer alternatives to the populist calls, and to offer alternatives that solve the deep structural problems in Western economies. The original subject of this post was going to be taxation, but the news of events just intruded (my sense of gloom took over.....).
Sorry for such a gloomy post. I have been making this same apology ever more frequently, but that just reflects the worsening situation.
Note 1: Lemming, a regular commentator on the blog, has asked me to discuss the gold standard. Time allowing, I will devote a whole post to this, rather than a brief comment.