One of the most interesting features of the latest moves to arrest the slide is the minutes of the Bank of England, which revealed their fears for a run on the £GB:
"The Committee discussed whether a larger cut was warranted," the minutes said. "Financial markets had priced in a cut of 100 basis points and there was a risk that going further could cause an excessive fall in the exchange rate. There was also a risk that an unexpectedly large cut could undermine confidence in the economy more widely."The £GB's recent slide was, in part, prompted by ever more dire news about unemployment, which is now surging ever higher, ever faster, in a mirror image of the US problems. The simple truth is that, as I always predicted, none of the measures to 'fix' the economies of the UK and US are working. We have this from the Telegraph regarding the UK:
I predicted when the bailouts were first proposed that the bailouts would be ongoing, and this is proving to be the case. In the US they are already printing money, and the Bank of England is now openly discussing the option. As each day goes by, as each new ever more expensive, ever more desperate measure is implemented, the relentless bad news continues. Up to now, each measure saw a brief rally in stock markets, but this time, the fed's rate cut saw a fall in the Dow Jones Industrial Average. Even the herd instinct of the markets are no longer following the scripts of government.
In comments which raise the ultimate prospect of wholesale nationalisation of the British banking system, Mervyn King said that "additional measures" are now needed to solve the crisis.
The £500bn rescue plan unveiled by the Prime Minister in October and since copied throughout the world is not encouraging banks to lend more to families and businesses, he said.
It is the most stark warning yet from the Governor that all his and Whitehall's efforts to bring the crisis to an end have not succeeded.
Banks now need extra support from the taxpayer if they are to return to normal lending, he indicated. Facing the worst financial crisis in living memory, UK banks have slashed the amount they lend out to homeowners, resulting in higher interest rates and tougher conditions for homeowners.
Just to add to the pain, it now seems that OPEC are going to drastically cut oil production, which can only serve to add fuel to the fire of the crisis. Low oil prices were one of the few true stimulants to the moribund economy that would have had a positive impact. We can only hope that their agreement fails to have teeth in practice. I still remember people arguing with me (about six months ago), that my prediction of $US 60 per barrel was absurdly low. It seems it was absurd, but not because it was too low, but because it was way too high.
There is still talk of deflation, and this is one of the justifications for the printing of money. In some respects it is correct that there are deflationary pressures. In particular, the housing bubble means that homes are returning to a more normal measure. I always argued that house prices should be included in inflation, and would still argue that they should be now. However, I am not sure how the deflation of a bubble could ever be considered to be a bad thing. Painful, yes, but bad, no.
Unemployment will also create deflationary pressure on wages. I was once shown a chart by an economist that 'demonstrated' that wages do not fall during recessions. It was one of those classic models that economists love. However, at the time, I merely pointed out that the deflation in wages was just displaced into unemployment. A company has a choice; make workers redundant or give everyone a pay cut. In most cases they will not ask for the pay cut, as it is easier to externalise the discontent through redundancy rather than trying to manage to persuade all workers of a need for a pay cut. As such there is displacement. It is at times like now that the minimum wage will have a negative impact. It makes it even more necessary for some companies to opt for redundancy rather than across the board pay cuts.
On top of these factors is the fall in the prices of commodities, such as oil. However, the prices of these items is not straightforward as, for both the US and UK, the prices of many of the commodities is tied to the exchange rate (though many commodities are priced in $US - more of that later). For example, in the UK, the prices of fresh food are on the rise again, due to the weakening of the £GB.
Perhaps I am being unfair to Mr. Archer here, as the article does not detail all that he said, but at what level does he think the £GB will fall to? This is the critical question that needs to considered in thinking about inflation. My own view is that the fall has a long way to go, and that will mean strong inflationary pressure. As commodity prices are falling, so is the £GB, and where the balance between the two might settle is still unknown. In the case of the US, the $US has only just started to wobble, so the effects of downward movement of commodities have been deflationary. However, the $US bubble will burst, and when it does, the deflationary effects will start to disappear.
Howard Archer, chief UK and European Economist at Global Insight, said: "Sterling is having an impact as most of our fruits are imported. This is not something that is going to disappear."
But he added: "There are several factors at play which will lower inflation and they will substantially outweigh the effects of the pound."
Another element in the consideration of deflation is retailing and services. I need not detail or even reference the dismal state of these sectors, as their poor state is being widely discussed in both the US and UK. Some months ago, when discussing the prospects for inflation, in relation to my prediction of a sinking £GB, I saw the collapse in services as a counter to the inflationary effects of higher import prices. This appears to be the case, as much of the fat in the service sector created by the credit boom is being trimmed.
So how does this add up in aggregate - in the prediction of inflation or deflation? It is here that we come to the really tough part, because there is the role of governments in all of this already complicated scenario.
I have already mentioned that inflation or deflation is strongly tied to currency movements in relation to commodity prices. As the world economy contracts, the supply of commodities relative to shrinking demand is rising, meaning prices should continue to fall. For regular readers, you may remember my analogy of the world economy as being like a person running forward, who then hits a wall of maximum commodity supply, bounces back from the wall, then commences running forward again (what has recently happened to the world economy). As I described it, the wall was also moving forwards, but not as fast as the runner so that eventually he would run up against the wall again, only to bounce back. In the case of OPEC's production cut, the wall is moving backwards, not forwards.
However, my prediction for commodity prices starting to rise again was about four years forward. I have mentioned before that OPEC is problematic, but it seems they are throwing a major spanner in the works with their production cuts. This is a wild card, as the price of oil is an important element in inflation for the world economy as a whole (despite some economists insisting it was not as important as before).
Another wild card is state of the $US. I am certain that the $US is the greatest bubble in history, and one of very few predictions I have made that has been incorrect is that the $US should already have sunk. I never imagined that people would be quite so irrational as to put their faith in a currency sitting on top of a collapsing economy. My error was that I expected people to act with at least some rationality. However, homo economicus was always a myth, so I should have known better. Putting my previous error to one side, the underlying weakness of the $US must emerge at some stage, so the wild card in this case is not 'if' but 'when'.
My reasons for why both the $US and £GB are fundamentally weak currencies is quite straightforward. The strength of the currencies previously rested on two platforms. One of these was inward investment, which was due to the illusion that the economies were successful, due to their credit inflated GDP growth, and the other was that creditors to both the US and UK needed to buy the $US and £GB in order to lend into each of the economies. With collapsing economies, the inward investment will evaporate, and nobody but a madman (or government) would want to be a creditor to both of these countries at present. At the same time, both countries make less and less of anything that anyone wants to buy. This is best seen in the ongoing trade deficits which, according to the Economist (print edition, 6th-12 December, p106) were $bn 851 for the US, and $bn 185 for the UK for the last 12 months. Inevitably, as the currencies of both countries sink, these deficits will diminish but, as things stand, there is is a basic imbalance (and has been for a long time).
Add to these currency wild cards are the exchange rates set for the RMB, which is a total unknown, dependent upon the wisdom (or lack of it) of the CCP in Beijing, as well as whether China seeks to rescue its own economy by attempting to redeem the I.O.U.s from the US and UK.
As if we do not have enough wild cards in the pack, we can finally add in the possibility that, if the $US starts to fall dramatically, the oil states that peg their currency to the $US might abandon the peg once the $US commences to collapse, and will the $US remain the currency of commodity pricing in general?
So where does this leave the question of inflation versus deflation? As you will note from the brief summary above, there are many factors that are inter-related. My view, based upon a heuristic evaluation (a smart expression for a 'guesstimation') is that any deflationary pressures in the US and UK at present will be strongly offset by a future currency collapse. The printing of money, in conjunction with the horrific level of government borrowing, will take a necessary and painful adjustment in currencies, and turn the adjustment into a complete collapse of the $US and £GB. In the case of the UK, the inflationary pressures have already commenced with the ever weakening £GB, but for the US, it will take a much firmer shove. However, if the $US does collapse, as I believe it will, I believe that the pegs and $US pricing will be unsustainable, leading to a 'shock' hyper-inflation.
Note 1: I am sorry to be so relentlessly gloomy, but I just can not see a positive side in anything that is going on. Even the bright point of the collapse in oil prices is now looking less positive. I am not sure I have covered all of the points here as well as I should, but I hope that the argument stands up. For regular readers, I am sure that much of what I am saying will make sense, as the foundation of what I am saying is built in many previous posts. For new readers, I would recommend the links at the top left of the blog.
Note 2: I have had some interesting comments again. Jeremy expresses complete cynicism, suggesting that whichever flavour of the politician, it will make no difference, and Steve Tierney expresses his concern that the public are buying the idea that the economy can be 'fixed' with ever more government borrowing and money printing. Steve reverses his previous optimism about people in face of the rising support for Gordon Brown due to his 'handling' of the economy. Like you Steve, I am endlessly disappointed (an anonymous poster also makes a similar point after reading the Guardian 'Comment is Free' section. I can not but help myself in agreeing with these concerns, and writing this blog is my small contribution to trying to make people face reality....
Also, an interesting comment from VKP who suggests that the UK and Greece have many similarities. I am not as familiar with the details of the economy of Greece as I would like, but am aware that they are running very large deficits. I have mentioned the possibility of the abandonment of the Euro, and the state of the finances of Greece is one factor in that consideration. I am not sure how much longer Germany will play ball.....
Note 3: If you thought I am gloomy, you might want to visit here if you want to see real gloom. An anonymous commentator recommends this blog.
Note 4: I have had some comments on my post on taxation reform. Lemming asks what I think about monopolies in my proposal. I still need to post on regulation, but I do think that one of the key regulatory roles of governments is to ensure that there is fair competition in markets. I do not have the quote to hand, but Adam Smith made a very good point about how, as soon as any group of merchants sit together, they will seek to conspire against the public. At least, that is the basic idea he is discussing...Lemming also, asks in a second comment what I think about individuals growing rich, and sucking money from the bottom to the top. In particular, he asks whether this pulling of money from consumers eventually leads to depression. It is an interesting point but, if the rich individuals invest this money into productive assets, then everyone gains. If the money is lent into consumption, then it will eventually lead to the mess that we are in now. I hope that I have not done Lemming's point an injustice, so you should read the orignial comments.
Also on the subject of taxation, Ivan makes the following point:
One thing, you mentioned tax free allowances - they would add massive complication and cost to a flat tax. I would propose that negative taxation would cover any free allowances, make the system simple and possibly finish up adding to the amount of tax collected.I am not sure that having a single fixed tax free allowance is complicated, or am I misunderstanding your point? Please feel free to clarify, and I will (time allowing) try to respond.
Note 5: I have still not started work on the reform of the banking system, so apologies for this. I hope to get started soon, but have several distractions pulling me away from the subject. I will do my best....