Financial Crisis - A Brief Review

I have been following my ritual of reading the various online news sources, and came accross an article in the Times, which they have titled '10 Mind Boggling Statistics from the Credit Crunch'. It primarily deals with the UK, but also looks at the bailout a little more widely. It is one of those articles which, whilst crude, paints a very vivid picture. I say crude, because they switch from figures per household, to figures per individual, and provide no explanation of how they found their figures. However, regardless of this, the numbers in all events make disturbing reading. For example for the Royal Bank of Scotlant bailout they give the following:

'2. £20,000,000,000

This is the amount of taxpayer cash that has gone into the coffers of the Royal Bank of Scotland, a bank which was the pride of Scotland until the suffix "troubled" was permanently attached to its name. This is the equivilent of £333 each.'

Or this for the cost of the bailout as a whole:

'1. £500,000,000,000

...or around £8,000 each. £500 billion is a conservative estimate of what taxpayers, you and me included, are paying for Gordon Brown's plan to bail out the UK banking system. [...] £500 billion is a staggering amount of money, equivalent to 4,000 brand new hospitals (at £125 million each), 16 new high speed rail links between London, the north of England and Scotland [...]'

Regardless of whether the final figure is 2000 or 4000 hospitals expenditure of capital, it is a lot of hospitals. I have to commend the Times for their objective in painting the picture in this way, but would like to see this shouted as a headline article, rather than tucked away in an obscure corner of the Money section. I commend this because it is very easy for individuals to turn figures given as £x billions into abstractions. The numbers become beyond imagination. It is for this reason that I often give full numbers rather than abbreviating them.

It is this article that has prompted me into this review. The money is now borrowed, and has now been committed to 'saving' the economy and, one way or another, every individual and business will be paying for all of this borrowing in the future.

So what have we got for these huge sums of money?

We still have a disfunctional banking sector, and there is discussion of a need for further ongoing bailouts. Unemployment is rising at record levels. Manufacturing is contracting. The service sector is contracting. The £GB is falling like a stone. There are widespread reports of a rash of retail failures. House prices are still plummetting. The government is having to bail out industry, and the car manufacturers are certainly just the tip of the iceberg. Repossessions of houses are up. Personal credit delinquency is up. I could go on...

In economics jargon, there is a term called an 'opportunity cost'. Putting it crudely, this is the idea that, if you make one choice, you forego another, and might miss a better alternative choice. Well, the government has made its choice, and there is no way of taking that choice back. It is easy to forget that the government did not have to spend money, or that there were other ways in which to spend this money. When we see the sums put so bluntly, as in the Times article, it helps keep our mind focused on the reality of the opportunity costs. For example, they give a total cost of the bailout to each individual as £8000 per person. That is enough money for each individual to buy a Ford Ka.

Whilst we know that these figures are crude, and not everyone would use that money to buy a Ford Ka, the simple fact remains that, in the future, taxation will make everyone poorer to the extent that they will not be able to purchase a Ford Ka. In bailing out the banks, that money will come from taxation in the future, and the opportunity cost is somewhere in the order of 1 Ford Ka per person.

When we think about this, we need to recognise that these figures are just the cost of the bailout of the financial system. They do not include the wider expansion of debt by the government.

In a previous post I made the point that, if a government borrows to pay a policeman today, they will not have the same money tomorrow to pay that same policeman. This is the reality of borrowing. However, when we start measuring borrowing in the lost opportunity to buy a Ford Ka in the future, it becomes possible to see how the massive expansion in government borrowing of today will constrain the ability of the economy to recover in the future. The taxation will be rising to the extent that the increases have an opportunity cost measured in foregoing purchases of Ford Kas in the future.

This represents a massive contraction in spending in the future.

In other words, in borrowing so much money at this moment in time, the government is ensuring that there will be a further even larger contraction in the economy in the future. The only way that this could be avoided is if the money was being invested in a way in which the return was greater than the investment. This is clearly not the case, and even the government does not claim this is the case (or not that I have read/heard).

It is at this point that we return to what the result of the massive bailout actually is. I have pointed out the continuing collapse of the UK economy, which has continued regardless of the bailout. I have not referenced the points that I make, as every news source is full of articles confirming what I have listed. The UK economy is falling off a cliff.

I had a conversation with someone the other day, and he asked me whether it would have been possible to have just left the banking system to collapse entirely. It is actually a very tough, and very painful question to be asked. I have objected to the bailout from the start, but must confront the alternative of what would have happened if the entire banking system had collapsed. Something had to be done.....did it not?

It is at this point that we need to think about what that collapse really meant. The banks has lent into inflated assets and had lent in the belief that the economy would keep on growing. What they had not realised was that the economy had only been growing due to the expansion of debt in the economy, and that there was actually no real economic growth without their irresponsible lending. I need not detail (once again) the story of the credit bubble (for new readers, I first detailed this in my essay 'A Funny View of Wealth').

So what would have happened if the banks had been left to their own devices?

I have no doubt that there would have been economic mayhem. There would have been bank runs, bankruptcy, people would have lost their savings, and there would probably have been rioting in the streets. This is why the bailouts took place, to avoid a sudden and painful collapse. In such circumstances, it is easy to see why governments took the option of the bank bailouts. The prospect of a collapse of the financial system is very scary indeed.

It seems that, at this point, I might be supporting the bailout. However, the reason why I highlight the opportunity cost is to highlight the fact that, despite the apparent relative calm, the UK is slowly but surely sinking into the same mire that it sought to escape from. The difference is that it is slower, and the damage to the economy is being moved from a short sharp collapse, to a protracted collapse from which it will be ever more difficult to recover. The difference is that we do not have the rioting in the streets today, but if the collapse takes us in any case to the same place, then it will still be rioting in the streets tommorrow (not in the literal sense of today and tommorrow - obviously).

In other words, has the bailout made any real difference to the actual state of the economy? If the borrowing was really just about a restoration of confidence, and that the economy was fundamentally sound, and the financial crisis was about panic and imagination, rather than the real state of the economy, the bailout would make sense. Under such circumstances, spending money to restore confidence would make sense. However, this is not the case, and it is apparent that the flaws and problems of the economy are very real.

One of the ongoing themes of this blog, since I made the first post, is that building a so called 'service economy' (or post-industrial) based upon endless expansion of debt is unsustainable. However, this is what has been undertaken and the result is massive structural imbalances in the economy, such that the economy is geared towards consuming more than it can actually produce. This is not an illogical statement, as the consumption has been based upon the production of other economies, and those economies have also financed a large part of that consumption.

The financial crisis was not something that happened due to the development of financial instruments such as CDOs (Collateralized Debt Obligations), but rather the development of such instruments helped to hide the problems in the structure of the economy. They simply made a debt fuelled economy appear to be sound, and allowed the structural problems to persist. The development of such products unhappily coincided with a change in the structure of the world economy, and allowed economies such as the UK the delusion of ongoing success whilst the economies were actually failing.

What we are today left with is the failure of our economies to adapt to the changed circumstances of the world.

The trouble that we now have is that the banks have been bailed out, and the cost of that bailout is the lost opportunity for economic growth in the future. The massive government borrowing represents a massive future slowdown in consumption. Nothing will stop the restructuring of the economy away from consuming more than it produces. As such, the crisis will in all events wind its way to its own sorry conclusion. That conclusion to this crisis will be mass unemployment, mass bankruptcy, and all of the social upheaval that will go with that process.

The trouble with the banking bailout is that the capital that might have been used in the future for so many constructive purposes is, even as I write, being used to artificially prop up a collapsing economy. It is therefore the destruction of future wealth. Pumping more borrowed money into an economy that has already been distorted into an unsustainable shape by past borrowing is not a solution, but the continuation and deepening of the problem.

I keep coming back to the puzzle in all of this. There are many economists out there who are far more clever than I, and I just can not see why they do not see this. If borrowing caused the problem, how will more borrowing solve it? Even now, they still do not quite seem to grasp it, but they continually touch on the edges of the reality of the situation. Take this example:

Sir John Gieve said the Bank's policy-makers were aware that dramatic rises in the price of houses and other assets were unsustainable, but underestimated the danger this posed to the long-term health of the economy.

"We didn't think it was going to be anything like as severe as it's turned out to be," he said. "I think that's because we, perhaps, hadn't kept pace with the extent of globalisation.

"So the upswing here didn't involve the big increases in earnings and consumption and activity we saw in previous booms. We saw the [increases in] credit, we saw the [rises in] house prices, but we did see a fairly stable pattern of earnings, prices and output."

At least he has realised that globalisation really changed things. However, even today, they are talking about output, but without understanding that output based upon growth in consumption driven debt is not a growth in wealth, but the exact opposite. If they could just grasp this simple idea, they would realise that moving debt growth from consumers into government debt growth is not the solution. It is the problem.

At this point I will end this review, though it only covers the UK, and the UK solution to the financial crisis. I am hoping that what I am offering is a clear and concise explanation of why the bailouts of the financial system were simply acts of destruction, that they will just make a very serious situation even worse. I have posted all of these points previously, but thought it might be useful to pull them all together, and put a more direct and clear argument against the continuation of government borrowing. I have not touched upon the subject of printing money, as I have been discussing this in previous posts (e.g. here), and I will be replying to some of the comments on these posts below.

Note 1: A thanks to Alfred T Mahan who has pointed out that the feeds from this blog often only show the notes (such as this one). I checked the feed, and it works correctly. I think the problem is that, when I write notes after the original post, the 'Blogger' service re-publishes the blog, and only republishes the notes. Writing notes after the original publication is a very convenient way of responding to comments but it seems that it is not a good way of doing things...as such, there may be a slightly longer delay in responding to comments, as I will only be able to do it in follow on posts, or will need to comment myself through the comments facility (I hope this makes sense). As such I will apologise in advance if I am less responsive to comments than previously.

Note 2: Alfred also made a comment on the matter of the repeal of the 1844 Act, suggesting that the upshot will be that, when it finally becomes apparent that the money printing presses have been running, the fact that it was hidden will do more damage. I tend to agree with that view. He also points to history for comparisons of how nations fall into decline, with some apt comparisons.

Note 3: I have this comment from an anonymous poster:

'In other words, by the beginning of the'90's financial dealings and transactions had become fully electronic.

By the stroke of a key, money could be conjured from the ether, by the click of a mouse, money could traverse the globe in a nanosecond.

Money had become pixelated!'

I can understand this sentiment. However, a physical bank note has no more substance than a digital bank note. Both of these are equally built upon a foundation of confidence, and they derive their value purely from that confidence. In both cases, they rely on us all believing that they have value, but in both cases they have no objective value. This is a very difficult subject, and can not be explained in brief. As such, I would point you in the direction of my post on 'synthetic economics'. It is not the easiest of reads, but I hope it will explain the point.

Another poster on the same subject says:

'Computers are a powerful tool for certain but get the inputs wrong and the calculations will be flawed. Garbage in, Garbage out. Computer modeling breaks down by the famous "Butterfly Effect" in complex environments such as weather patterns, social or economic models, but many people can take it as gospel and not realize it can only predict broad trends, and must be verified constantly.

It makes me wonder if the economists have run models and based actions on them forgetting that their actions and others reactions change the economic environment itself, thus changing the effects of the model in unpredictable ways.

That said, some of the reaction of the UK and US seem to be based on more animalistic reasons ie panic after their delusions are shattered, their theories blown to pieces, and the stark reality of an imminent collapse'

On a personal level, I am a little bit of a computer geek, and can build databases and program, so I am sympathetic to the value of technology ( I should have built my own system for this blog, but lacked the time). However, I am also aware of the risks. I read a very good description of a scenario in a book by Sherry Turkle (I think written in 1995), in which a student presents a professor with a computer printout as a solution to a problem. The professor then asks the student something along the lines of 'well the computer knows the answer, but do you?' This is both a potentially fair comment, or completely unfair. It may well be the case that the student does not understand the answer they are presenting.....

Note 4: I have had a question from Jonny, which is very interesting:

'Whilst I appreciate predictions are difficult in such turbulent times, how can house prices fall for such an extended period if deflation will be off-set by inflation? I seem to recall reading yesterday in a Telegraph article that it would take 6 to 18 months for quantitative easing to appear as inflation.

With this in mind, and given UK inflation has effectively begun, aren’t UK house prices more likely to fall for perhaps another year or so before monetary inflation halts further falls?

Or would the effects of the severe recession/depression (e.g. mass unemployment) mean house prices would continue to fall regardless of inflation?'

This is a very good question as it is actually a very difficult question. I have read about hyper-inflation in principle, but here is a good question of the process in practice. The first thing is that, during hyper inflation, the value of cash is destroyed. At the same time the cash price of assets rise, although their real value may not change. At its most basic, what I am trying to say is that, if a pint of milk has the same value as a loaf of bread, whilst the cash value of these may change, the relationship of the value, one to another, does not necessarily change. So it is with housing. If a house is worth 100,000 pints of milk today, all other things being equal, it will be worth 100,000 bottles of milk tomorrow. However, the value of housing was over-inflated, such that all things are not equal. As such, whilst the cash price of a house may rise, the value of that asset will presumably continue to decline relative to other assets.

One of the curiosities in this is that, if you have purchased a house with a large amount of debt, in hyper-inflation the value of the debt will be destroyed. The only way that the banks can deal with hyper-inflation is through the interest rates, such that they charge a rate of interest that ameliorates the collapse in the value of cash. As such, if I am right about hyper-inflation (which is a very big 'if' - which is a warning), then the logical thing to do is to buy into a tangible asset such as property with lots of debt - but only if it is possible to fix the interest rate over the medium term (say 5 years). At the end of the period, you will have an asset which you have paid very little for. Whether this is an ethical thing to do, I am not sure. However, it does illustrate the dangers in hyper-inflation, and why it is so dangerous for an economy. How can an economy work in the circumstances where investors would potentially lose so much...?

Note 5: I have this from an anonymous poster:

The January U.S. crude oil contract settled down $3.84 at $36.22 a barrel, after earlier hitting $35.98, the lowest price since June 2004. London Brent settled down $2.17 at $43.36 a barrel.

Courtesy Oil Drum 18.12.2008

If the proposed cuts in production cause UK oil prices to increase - what then?

We have a severe problem if the cuts do lead to price rises in oil. On the one hand, we have an increase in the $US price of oil, and on the other the devaluation of the £GB against the $US (ignoring the possibility of a collapse in the $US). In such circumstances, the effect will be strongly inflationary. Interestingly, the collapse in oil prices of late has led to scaling back of investment in the industry, with potential for a future explosion in oil prices. Those who are regular readers will see the consequences of this if they think of my commodity brick wall analogy (which can be found here).

Note 6: An anonymous poster has the following to say:

'It looks that today's turmoil is a deliberate dismantling of our civilisation's lifestyle.

Our unsustainable standard of living is being taken down to converge with the raising standard of the third world. As a non economist, how easy would it be to throttle credit at source to bring this mess into being? (By TPTB)

What's next I wonder'

I do not believe that there is anything deliberate in any of this. I always have, and still do, think that this is all the result of a lack of understanding of what has changed in the world economy. As for what is next, much of that lays in the hands of politicians, and I am not sure I have much confidence left in them.

Note 7: I have been given a link to a post here. It is an interesting example of a general conspiracy theory blog, in that it is saying that the 'illuminati' have been 'caught with their pants down'. As such, it is at least novel, as most of the conspiracy theorists believe the crisis is a part of a master plan. More interestingly, there is the following discussion:

'"Some of those new financial poisons were called credit default swaps (CDS's), some sixty to seventy trillion worth that are currently reeking havoc with AIG, Lehman and Citigroup, as well as many hedge funds. But if you think these are bad, wait until you see what happens when interest rate swaps (IRS's) meet double-digit interest rates. It will be like "Frankenstein Meets the Wolf Man." This event will quite literally be a financial Armageddon from which none will escape.'

I had a very interesting discussion with a regular commentator 'MattinShanghai' some time ago on a similar subject. I think that there are still many skeletons in the financial cupboard, and it is quite possible that some of these may yet emerge in the future. However, on a specific answer to this one, I will admit that I am not sure. I will endeavour to dig around a little bit more, time allowing.

Note 8: Anonymous asks the following:

'Since it is now obvious how this is going to pan out, there is no way the govt will change direction now, in your opinion what sort of time scale are we looking at for the final collapse to occure. I'm assuming that the Quantitive easing proposed will be on a scale that will provide an immediate short term boost to the economy, thus delaying the inevitable collapse. Or it could be that this will spook the international markets so much that it will bring forward the collapse.

Either way, I'm factoring this scenario into the direction I'm taking my business so any comments from you will give me more food for thought'

The short answer to this one is 'I just don't know'. What all of this hinges on is confidence and information. It is like house prices. Millions of people had confidence they could only rise - until they stopped. My personal view is that the real world of job losses and business failures is fast moving the situation to a tipping point. In other words, I think confidence is at the point of collapse.

Note 9: Steve Tierney writes:

'So what do you call a state where everybody is the same, working on behalf of the government, for subsistence-level supplies? Where government keep control with draconian powers? I'm sure there must be a name for that...'

And received a gentle chiding from Lord Sidcup, as did I, so I will reproduce the comment in full:

'It seems that Steve Tierney is trying to allude to "socialism" in a way that is neither accurate or useful. I don't see how what is happening now connects to socialism (rather than facism, State corporatism, totalitarianism, fraudism ) in practice or theory -- no more than UK / US 'conservatives' have espoused financial conservatism for the last +/- 15 years. F.eks => Nouriel Roubini calls it the socialisation of losses and the privatisation of profits.

As CE suggests in the article, we are in desperate times -- it seems to me that any pretence at ideological motivations has been abandoned long ago.
It's a minor point, but there is so much irrelevant waffle, posturing, obfuscation and bullshit surrounding the financial crisis that accurate, definitions and thought should be used to describe and deal with it.

Using emotive terms like socialism or capitalism to describe what is happening seeks to hide the reality of our situation rather than reveal it.

I have appreciated your contributions, but found this one less intelligent than your previous posts.'

I am sympathetic to the view that 'isms' can sometimes cloud our thinking, so thank you for that point. However, I appreciate Lord Sidcups' comments (he is a regular commentator), so I was disapointed to read the last lines. As such a little explanation. I am assuming that the comment was directed at my discussion of a conspiracy to hide the truth.

At the start of my post, like most of my posts, I had no clear direction. Normally, over several days, I read a wide range of articles, noting stories that are interesting (selective bias?). I later then write my post incorporating the articles (or easily found articles reporting the same story), often pulling them together in a theme as I go. I had no intention to write about what I am describing as a conspiracy to hide the extent of the crisis. However, as I wrote, the pieces fell ever more clearly into place. I acknowledge at the end of the article that I may be wrong, and hope that I am wrong. However, the coincidence of the repeal of the 1844 Act, the discussion of printing money, and the other factors, led me to my conclusions. I may be wrong, but there is a good possibility that I am right. If this is the case, the sooner we are all aware of it, the better.

I have also recently been offered the possibility of writing an article for a magazine based upon the blog. It is very flattering to be asked, but it occured to me that, even as I wrote the article, that such an article might preclude the continuation of the offer (I do not know yet), due to the controversial nature of the post. However, I do think that it is better to put these ideas into the open, and the aim of this blog is to give my best interpretation of the reality of the situation. As such, I published anyway.

Note 10: Lemming has gently nudged me to get on with my discussion of banking system reform. If I am honest, the complexity of this question is troubling me. As such, I would prefer to delay a little longer until I have, in my own mind, managed to answer some of the questions that my solutions leave unresolved. I have the start of a solution, but I am still gaming that solution in my imagination, and still finding outcomes/questions that I can not answer. It is not entirely satisfactory as an answer to the delay, but normally I find that all of the pieces fall together at some stage. As such, sorry for the delay.

Note 11: Nick asks:

'I know you don't like to give advice on this, but you seem like the best guy to ask- I've been working very hard the past year to save money and have around £15,000 tucked away. The idea of all my work turning to nothing with the pound crashing scares me, and I would really appreciate some advice about what would be (in your opinion I know) the best place / the best commodity to put my savings into to avoid their value being wiped out.'

You are right about advice. I can only give scenarios, and how you respond has to be your own decision. A few months back I suggested gold might be a good idea, but was already concerned at that time that the price was already rising very high, so with lots of caveats. I could give the same advice, but the price is already very high, and I do not know for certain how high it can go. Also, there is the problematic question of when to get out. The price is built on sentiment and emotion. Such drivers are not very helpful in assessing risk...

Note 10: I am afraid, that enough is enough for today. Thank you for all of the comments, and apologies to those that I missed (e.g. Call me Ishmael, whose comment deserves an answer).