Saturday, November 29, 2008

Financing UK Government Debt - The Problems are Starting

I have a comment on my last posting, in which an anonymous poster very kindly provided a link to an article in the Financial Times. I quote from the start of the article as follows:
'The UK and Italy struggled to sell bonds on Thursday in a fresh sign of the difficulties governments are facing because of the debt needed for economic stimulus packages and bank recapitalisations.

The two bond auctions saw both governments forced to pay higher yields to attract investors and Italy scaled back the amount on offer.

Analysts say it is an “ominous” warning that debt raising is likely to become even tougher in the coming months if problems are emerging so soon after government announcements to increase issuance. A record of more than €1,000bn ($1,290bn) of debt is expected to be issued in Europe next year.'
Long term readers will know that I suggested the government would be hitting problems of default about now (as long as six months ago). I have continued in this view, and that means that my prediction was for the default to happen now. However, as you will note from the FT article, we are still at the warning shots stage. The move from warning shots to outright panic is difficult to predict, so it could be an immediate collapse, or might take a while yet.

Meanwhile, as government is going on a borrowing binge, it is worthwhile noting that this has severe knock on effects in the economy, as the government is competing with investment in private business. I discussed the problems that are caused in the wider economy in an article here, but thought it worth mentioning again as I have not discussed the subject for a long time.
If I have my history of economics right (please correct me if I am wrong), I believe that government borrowing (in the modern sense) was started to finance the Napoleonic wars. Regardless of the original purpose it has now become a very bad habit, and one that should really be prevented, by a constitutional constraint if necessary. For the moment, it appears that the problem is about to be addressed by the creditors to the UK, but better the country never got into the problems in the first place.

On a different but related subject, I was catching up on my reading yesterday, and managed to plough my way through the Economist magazine. In an article they discuss the re-ordering of the world financial system, the so called 'Bretton Woods 2'. It makes very depressing reading, as they are proposing that the solution to all of the difficulties is more regulation, and with the wisdom of hindsight criticise the Basel Banking accords (Wikipedia gives a good introduction with Basel 1 here, and Basel 2 here). Again, those who are regular readers will know that I have long 'fingered' the Basel Accords and government interventions as major contributors to the financial crisis. Essentially, the regulation in the banking system created huge distortions in the market whilst giving a false sense of security in the banking system (I discuss this in detail here).

The reason why I mention this is that the lesson being learned from the banking crisis is completely wrong. Instead of accepting that it was the regulation of the banking system that was the problem, the consensus is increasingly that it was the wrong regulation, and that more and closer regulation is the answer. Essentially, the consensus view is that it is possible to take the risk out of banking which, when you think about it, is a very odd idea. The nature of banks is that they lend to individuals, governments and businesses, and some individuals and some businesses do better than others. By nature, whenever a bank lends money, they take a risk.

Now, if we look at Basel accords, they are founded on the idea that different classes of assets have different levels of risk. This means that, for example, a UK issued bond would normally be viewed as low risk, such that banks will be encouraged to lend to the UK government, such that they maintained a balanced risk portfolio. Now, I would suggest that you stop and think about that for a moment.....

We have a system of regulation that encourages banks to lend to a government? Governments are not a productive asset class. They do not do anything to generate concrete wealth. They provide some services, which might be seen as productive activity, but they do not generate income from that activity, they just farm tax from their populace to pay for it. It is a fine distinction. For example, if we go to a restaurant, we pay the restaurant for the service of cooking our food for us. If we pay tax to the government it provides the service of health care. The real difference here is that when the restaurant borrows money, it does so with an expected return, and the restaurant owner/s are risking their own money. On the other hand, when a government borrows money, it is risking the money of the population at large and the money of businesses, with no way of calculating the return on what is borrowed. Furthermore, the business and individuals have no choice but to have the government risk their money for them.

Despite the use of word 'investment' by politicians, this is not the role of government, as their role is spending the money of other people.

So here we have a regulatory system, that encourages banks to lend to government. If they are lending to government, they have less capital to lend into productive activities that actually generate the revenue necessary for government to function. It is rather odd when you think about it.

However, there is something even more disturbing about the whole system of regulation. An inherent part of the system is prescience. Apparently, it is possible to know the future of different classes of investment. For example, the Bank for International Settlements can apparently see the future and determine what is risk and what is not, and national regulators do then do the fine detail of what they will accept as safe or unsafe investments. Amazingly, these very clever people have an insight on risk, and can determine what is a risk and what is not. They must be very clever indeed.

The trouble is that, UK government debt has long been seen as very low risk, but we are now seeing that it is actually very high risk. The trouble is that, over the last 12 months, all kinds of 'safe' investments have proven to be unsafe. Essentially, what you have is a system in which lots of apparently very clever people can supposedly determine where risk resides. However, as experience is telling us, they have absolutely no idea where risk resides.

So now we come to the answer that is being proposed. More clever people will now sit down and re-determine how risk should be calculated, having learned lots of lessons from the recent crisis. All of these very clever people will get together, and once again will strain themselves to see the future, and determine what the future might be. But the trouble is, that is what they did before.....

Essentially, there is no escaping the fact that the world is a complex place, the world is unpredictable, and individuals are fallible and make wrong decisions. No amount of regulation of the banking system will change this. There is no reason to believe that the people who determine the particular risk of asset class have any better grasp of the risk inherent in that class than the holder of that asset - the banks themselves. The simple fact is that, what was safe yesterday, can become unsafe the next day. No one individual, or group of individuals, is infallible, so why should they be able to determine risk?

As such we come back to the start, and have to say that, whenever we deposit money in a bank, we are taking a risk that the bank will lose that money. We need to accept that risk, because we make that risk with possible trade-off that the bank will invest the money and increase our wealth. However, any idea that this can be guaranteed is just foolish, and no amount of regulation will make that guarantee. All such regulation serves to do is create a false confidence, and thereby encourages systemic risk.

What we have now seen is that such guarantees are worthless and, as a result, we have governments having to accept liability for their former guarantees of the safety of the system. However, it is not government that picks up the tab for that guarantee, but every individual and business within the country. In other words, there is a system in which people apparently know better than banks where the risk of those banks reside, they then say that if the bank follows their rules, they will guarantee that all the money invested in those banks is safe, and they make that guarantee with the money of tax payers.

When you think about it, it is a completely absurd idea. However, lots of very clever people all think this is a great idea, and persuade us all that governments offering guarantees (based upon their mystical knowledge of future risk) using our money is a good thing.

Note 1: Thank you all for the comments on energy policy, which were interesting and challenging. I had an interesting comment from HYDROGENPHILE (his caps), who suggested that hydrogen is the answer to storage of energy. This is presumably based upon the use of fuel cells, which are an interesting emerging technology that I have followed for some while. However, until the switch to a hydrogen energy economy is made, this does not address the problem of the here and now. In other words, the switch to a hydrogen economy needs to be made before the investments in energy provision that relies on that switch is undertaken.

Wednesday, November 26, 2008

Reforming Energy Policy

I am writing this post as part of a much delayed, often promised, attempt to deal with the problem of reform of regulation in the economy. One of the reasons why I am starting with energy is that I recently needed to give a presentation to a forum on energy policy, or more specifically whether New Zealand should consider nuclear power. The only reason why I was in any way qualified to talk about the subject was because I have been trained in nuclear reactor engineering, physics, operations and so forth. As such, in many respects, I came to the subject with a relatively open mind on the economics of each of the options, with some suspicions about the economics of certain energy sources.

Energy policy is actually a matter of some importance in the consideration of economics, as it has such a substantial input to so many parts of the economy. The best way to understand how significant it can be is to imagine a situation in which, for example, the UK had access to unlimited free electricity. If we think of this idea, it is becomes apparent how much competitive advantage this would confer. Such an idea is sadly impossible, but it illustrates how important energy actually is.

The most interesting thing about energy policy is how much it is rooted in ideology, and many of the people making the presentations acknowledged this. I found a very good academic paper (1) on the subject, which made the point in reference to the whole way that New Zealand energy policy is framed. It makes worthwhile reading if you believe that energy policy can be anything but rooted in ideology so I have given the reference at the end of the article.

It is impossible for example to extricate any discussion from the consideration of the Man Made Global Warming (MMGW) debate. I am aware that there are some people out there who consider that the science is 'settled', and that anyone who questions the MMGW argument are 'flat earthers'. In all cases the words 'scientific consensus' appears, along with implications that anyone who has a different perspective is 'ignorant'. For all of those that might respond to this post with such arguments, might I suggest that, before you post, you take some trouble to read some philosophy of science. However, this post is not about MMGW, but about reform of the energy provision. The reason why MMGW needs to be dealt with is that it is necessary to accept that there are two arguments, both of which are legitimate, and also that there are debates within the MMGW camp as to how severe the problem actually is, and what should be done about MMGW (e.g. Bjorn Lomborg's arguments against the Kyoto protocol).

My argument about energy reform upsets those who are passionate about MMGW for the reason that my solution does not enforce behaviour, but leaves it to individual discretion. I make no claims fore either side of the argument, but to some individuals, even acknowledging that the debate is not settled is enough reason for condemnation as a heretic.

It is necessary to deal with ideology, for the simple reason that it intrudes so heavily in energy policy, and is creating significant distortions in the role of energy supply. I made this point in the case of New Zealand, where there has just been an election. At first glance, New Zealand appears to have a relatively liberalised market. However, with the change of government, a new energy policy will be implemented, and this will mean that the structure and economics of energy are about to change. If the Conservative Party wins the next election, the same will happen in the UK. Why does this matter?

The simple reason is that, for generating companies, there is no certainty in their long term planning of energy. In particular, whatever the flavour of government, they will implement their own mix of subsidy, cross-subsidisation, planning biases and so forth. In such circumstances, with many energy projects as long term investments, it is quite impossible to plan. As such, I will later address this problem.

Returning to the economics of different energy sources, one of the other presenters looked at the question of nuclear generation in light of the experience in the UK. He pointed out that, whilst the UK government is suggesting that there will be no subsidies for nuclear power, there will in fact be subsidies. I do not have the quotes to hand, but he simply quoted government statements in which the government would make statements such as the nuclear power companies would take their 'share' in the disposal of nuclear waste. As the speaker quite rightly pointed out, who would be taking the rest of the share? One of the interesting points of agreement amongst all of the presenters was that the economics of nuclear power are completely opaque, and that the actual cost of nuclear power is an unknown. Whilst we could all find academic papers, figures from various organisations, there is considerable debate about how to put a real cost on nuclear power generation.

I am hoping that you are starting to see where I am going with this. However, having pointed out that subsidies are hidden in nuclear power provision, it may be worthwhile looking at another example where the costs are buried in cross subsidy. It is impossible not to have noticed the massive expansion in wind power in the UK and, once again, there is considerable debate on what the cost of wind power actually is. My reading on this subject provided some fascinating insights.

For example, there is a report (2) from DENA, a German energy agency, that raises some rather difficult questions about the economics of wind farms. A diagram from the report is provided below:

The green part of the diagram is the projected capacity of new wind farms in Germany, where wind power has become an increasingly important source of energy generation. I will quote from the report as follows:
'In the year 2015 the conventional power station pool can be reduced by 2,300 MW. This is 6% of the installed wind power capacity of 36,000 MW.'
They go on to say that energy storage systems are needed and that there would need to be enlargement of grid connections between regions to ameliorate the problems. However, there is no escaping the fact that wind energy requires the back up of a source of power that is not subject to the same variability of provision. With a figure of only a 6% capacity credit, there is a substantial problem that to guarantee supply, every MW of wind energy virtually requires a MW elsewhere, and thereby means that the capital expenditure for each MW of capacity needs to be made twice.

As if this were not bad enough, there are substantial problems with how wind power might be integrated into grids. For example, when the wind is blowing, what happens to the capacity in thermal plants? A report from the Irish Grid (3) looked at the economics of what happens to thermal capacity in a situation where it is necessary to adapt to the swings in provision from wind power. They point out that, if thermal plants are run on low loadings they become very inefficient, if they are shut down that increases maintenance costs, as well as being very expensive to start and stop and so forth. Equally, a consortium of energy providers in Germany have written a report (4) in which they point out that switching off capital intensive plants makes the cost effectiveness of these plants very poor (obvious really). Finally there is the cost of attaching these widely distributed plants to the grid, which requires substantial investment, with problems of the economics further hindered by the variability of the units generated versus the capital cost and maintenance of the infrastructure.

As one of these reports pointed out, some of these problems can be ameliorated, but the amelioration involves even greater investments, so does not rectify the substantial additional costs of wind power. All of these problems apply to other variable sources such as wave power and solar power. It becomes apparent that the power generated from these sources is just very, very, very expensive. It is also apparent that the only way that these sources of energy can be viable is through government diktat, direct subsidy and cross-subsidy.

In other words, the introduction of these energy sources is without any economic merit whatsoever. It is here that the MMGW debate enters the picture. For example, the argument is that the true cost of thermal energy is not accounted for, as it does not include the environmental harm that is caused by emissions of CO2. The same argument is being deployed in support of nuclear energy. This has seen the introduction of carbon trading schemes, but carbon trading schemes are actually just another way of implementing a cross-subsidy. It quite literally means that one energy source will provide money to another energy source that generates electricity at a higher cost. Whether there is a real cost to CO2 is a matter of debate, and as I have pointed out earlier there are various arguments even within the MMGW camp as to how much damage CO2 is actually doing. As such, even if accepting the MMGW argument, how can a price be fairly put on CO2 emissions?

There is an even more fundamental problem with the MMGW argument. This is quite simply that raising the cost of conventional power will just serve to further displace economic activity to countries like China. If you are a company that uses a large amount of energy, you will simply move operations to where the power is cheaper, which means countries with no CO2 emissions costs. The oft quoted point that China is building a new coal fired power station every two weeks expresses the problem.

I am hoping that I have now framed the problem. We have a situation in which ideology has seen the introduction of costly sources of energy, thereby driving up the overall costs in the Western economies. The most likely result of this increase in energy costs is the acceleration of the displacement of energy intensive economic activity to countries that have lower cost energy supplies and are likely to see many of the emissions gains offset by displacement. Furthermore, the overall increase in the cost of power will impact on every part of the economy, making almost all activity within the economy more costly. This overall will leave the economy less competitive, and will contribute further to the displacement of economic activity more broadly, such that in the long term the overall distribution of usage of energy will be further displaced to countries like China.

From this perspective, I can now discuss energy policy. The first and most important point that emerges from this discussion is that government needs to get out of the business of determining the energy mix. The solution that I am proposing is quite simple in principle, but would take some deeper consideration to implement in practice.

The first point is that there should be no subsidy, no priority, no cross subsidy of any form of energy generation as a result of government policy. The introduction of wind power, and the covert subsidy of nuclear energy explains why this is necessary. Instead of this, the government should have a role in the following:

  1. Stability of supply
  2. Free and fair competition (no cartels etc.)
  3. Immediate environmental impacts
  4. Ensuring freedom of choice in source of energy purchase
  5. Creating a consistent classification of energy source across providers
  6. Some special considerations for nuclear power
The energy mix itself should be left to individual consumers. At its most basic this is a system in which energy sources are classified into broad groups. For example nuclear, geo-thermal, wind, coal etc. The government then has a role to ensure that no company uses any form of cross-subsidy from one energy source to another. This is about free and fair competition.

The result should then be that every individual and business has a clear choice about what energy sources they are willing to pay for at what price. When presented with an energy contract, they will need to given the energy source options, the cost per unit of energy from that source, and then they select which source and then prioritise their selections. e.g. If a person is a Green Party member, they may wish to pay for wind energy, and set this as their number one priority but, because of the variability of supply, they may wish to also select hydro as their second selection and so forth. Likewise a steel manufacturer might want to choose coal, with their only concern being cost effective power. A poorer family might also be concerned with price as their priority, and their concern for the economic well being of their family their greatest concern.

As each selection is made, the trading companies will then be committed to using the payments (once they are received) to purchase energy from their first priority where sufficient supply is available, and by their descending priorities. The role of government in this part of the system is to ensure that the companies purchase according to allocations, and prioritise planning for energy generation methods where there is a shortfall in meeting priorities.

This has several advantages. The first is that, unlike having government determining the energy mix, the choices of individuals and businesses are more likely to be be relatively consistent. The exception to this is energy sources which have high volatility in prices, such as oil. As regular readers will be aware, oil has been something of a roller coaster in terms of price over the last year. However, if an energy company wishes to take risks and invest in and offer this kind of energy provision, the risk is their own. For example, if the price of oil rises above their expectations, then presumably very few people will select oil as a source, which would mean that it would be likely that their capacity would become underutilised, and therefore unprofitable.

In my presentation, I did suggest energy security as being within the remit of government. However, I think that, without cross-subsidy, the energy companies would in any case take this into consideration. This is a question mark, and one which I have not fully resolved in my own mind.

With regards to stability of supply, I do think that government does have a role. By stability, I mean reliably delivering energy through the grid to individuals and business without interruption. In particular, there is a role for ensuring that the overall capacity of generation is measured accurately. I have already pointed out the problems with wind, but there has also been a history of problems with nuclear power, for example 'derating' and failure to deliver on expected capacity. This presents stability of supply problems, in particular with regards to the long time frames from a decision to the actual point where a nuclear power station becomes available as an energy source.

This also returns me to the particular role of nuclear energy that does require direct government attention. There are several points that need to be addressed.

The first of these is the problem of waste. In both the UK and US there has been endless wrangling on the subject of waste storage. Until such time that these arguments are resolved, no more nuclear power should be added. In particular, without a finalised solution to the problems of storage, it is not possible to provide a cost for storage. Furthermore, such storage is over such long time periods that there needs to be some very clever arrangements to work out how to continue payments for site maintenance (a very interesting illustration of this is that there has been considerable discussion of the signage needed such that future generations will still be aware of the dangers in the storage place).

A related problem is the cost of decommissioning. This is a very costly business, and there are still significant question marks over how much it might cost. If the cost exceeds provisions made for the decommissioning, one way or another, the taxpayer will foot the bill. It is not possible to just leave a nuclear power station to rot away. The solutions to date have been to allocate revenue to the eventual clean up. However, the costs of decommissioning have generally been poorly estimated. This raises a more fundamental question; what happens if the investment is made, but the energy becomes relatively expensive. In this situation not enough revenue will have been put aside for the cost of the decommissioning. The example of Italy provides a telling case study of how the costs of abandoning nuclear power can be very high indeed. In short, until someone can come up with a way of guaranteeing these costs can be met, it does not seem that nuclear power can be seen as a viable option. You will note here that I am not against nuclear power, but I am against un-costed nuclear power. It is simply a case that, at the moment, governments are having to sign a blank cheque.

There are other particular concerns with nuclear energy that are not too problematic, such as ensuring safe design and operation of reactors. For those who mention Chernobyl, I would point out that the reactor was not designed well, and that the operations that caused the disaster were quite simply foolish. The standards of design in existing Western reactors are far safer, and the generation III reactors even more so. However, all provision of nuclear power would still need to insure themselves against accidents, and without any subsidy.

The last point I have not covered is that of a government role in local environmental impacts. Whatever the form of a utility, having a new utility built is likely to have an impact upon both business and individuals in the locality. In other words, there will be winners and losers. Government does have a role to play in trying to find a compromise between the need to build new energy sources and those who might be losers from such provision. The role should be an alternative to court action, where the parties involved seek government provision of binding arbitration over what the costs might be, and how they are resolved.

I am not sure whether I have argued this as well as I hoped, as there is only so much time I can put into this. The complexity of this issue is such that there is no easy summary, so comments and elaboration are particulalry welcomed (whether positive or negative, excepting those who would like to equate me with a holocaust denier). I mentioned at the start that one of the points in all of this was to highlight the distortions of policy, and also to highlight the element of distortion that is based in ideology.

My main point here is that the effects of these can be ameliorated by opening up the rather opaque business of energy generation to real scrutiny of the costs of each of these sources. In this way, ideological positions can be expressed in real choices. At its most simple, the approach is to delegate choices based upon ideology to the individual. If a person believes that wind power is a 'good thing' they should have the opportunity to support this method. If a person does not support wind power they do not have to subsidise the energy. More to the point, the economy will be able to function better when the real costs of all of these energy sources are explicit. In the case of nuclear power, once the subsidies are removed, it will focus attention on whether this power source really is cost effective. Finally, such a system would hopefully help to stop the displacement of economic activity from countries such as the UK to China. As I have mentioned, all this will do in the long term is move any problems of emmissions to a new place. At the very least, even if you accept MMGW, the problem of displacement needs to be resolved.

I think that, of all of my posts, this will be the most controversial. This is a highly emotive subject, and my request that it be left to individual conscience will not suffice for many. I have also not even started to touch on distribution, which is another area of great complexity. I had hoped to use some work I did on monopoly provision in another sector as a point of comparison, but do not have the time to include this. Above all else, my aim in what I am proposing is to realign energy provision with economic choices, and to remove particular ideological points of view from energy provision policy as a whole, whilst offering people the opportunity to express their ideology if they so please.

Note 1 added 29 November:

A response to the comments on energy reform. I knew, as even as I was writing the post, that it would get some negative comments. As I mentioned it is a very ideologically based subject. With regards to one point, it seems that I did not explain myself very well. I will therefore seek to clarify the point. Lemming commented that wind power just needed subsidy so that the industry could achieve economies of scale. The whole point about my post on these kind of variable sources of power is that they can never be economic, or at least not untill a way is discovered to store their power economically. In light of the fact that this was not understood, I will explain again.

The first point to note is that energy supply is just another form of manufacturing. Instead of manufacturing units of product, it is the manufacture of units of electricity. In both cases something is being converted from one thing into another thing, with (hopefully) more added value in the final product as a result of the conversion process.

I will therefore use the example of ready meals as an analogy, and for the sake of analogy, we will imagine that the ready meals have to be sold to the supermarkets within hours of manufacture (they are delivered hot and genuinely ready). Now, if we have demand for 100 units of ready meals a day, then we will normally build a factory that allows us to manufacture those 100 units per day. However, as we know, demand for products such as ready meals can vary. As such we build storage into the system (warehouses that will keep the product hot), but keep that storage to a minimum, as it increases our costs significantly. We also build a factory that will manufacture with enough of a safety margin sufficient to maintain supply of the ready meals in peaks of demand, perhaps a capacity of 110 units per day.

Now instead of this perfectly normal arrangement, how would we think of a proposal that we build our ready meal factory in an out of the way place, where the workforce were an unusual bunch of people who would only turn up to work when it suited them? Whatever you did, even asking them their views on their plans to arrive for work the next day, you could never be sure whether they would come into work, or how long they would stay. Now these rather odd workers are a vital input into to the production process, but you never know how many are going to arrive on any given day. You know that, on average, maybe 30% of the workforce will arrive for work, but some days none arrive at all. The one advantage of these workers is that they are very, very. very cheap. So cheap that they are nearly free of cost.

Another problem is that the location of these very cheap workers is that they live on a mountain top with no road. As such, you will need to build a new road from the mountain top to the valley below so that you can distribute your ready meals.

The problem that arises from all of this is that you have a contract with several large supermarkets to provide them with your ready meals. As part of that contract, you must provide them with as much of your product as is required. If you do not provide your product, they will de-list you as a supplier. In other words, your business relies upon providing the product reliably. How are we going to manage this problem.

The first solution is to build lots of factories to supply our ready meals because, on average, at least one of the factories is likely to have enough workers available. The trouble is that we are then in the position of having to make lots of factories in which we know that there is going to be idle capacity. This makes the cost of capital for our factories very high. Now, the second problem is that all of these factories need a special road. This increases our capital costs significantly, with each factory requiring its own special road. However, because we have to distribute the factories over many locations, we have the problem that each factory is relatively small. Whilst this makes our factories more reliable, it makes the relative cost of the roads even greater.

The company decides that, whatever the problems, the attraction of the cheap workers is enough justification to do build all the factories. After a while however, they notice that the variability of workers coming into the factories is such that they appear to have wild swings in their capacity to make their ready meals. One of ther operations people analyses the problem and concludes that, the probability is that, on a bad day, only 6% of the workforce will show up for work. This poses a problem because, on a bad day, there will only be 7 ready meals made. This is a guarantee that the contract will be lost.

Someone then comes up with a bright idea. In addition to the factories on the mountains, they can keep a normal factory as well. Whilst the workers in this normal factory are quite expensive, they know that they will be coming to work reliably every day. Whilst they have holidays every year to recuperate, they can plan for these. Furthermore, the factory can be built right next to the highways, making distribution of the ready meals very easy and cheap. They go ahead with this solution, and build a factory with the ability to manufacture 103 ready meals per day (110 - 7). They then have a problem. What happens when there is a good day at the many mountain top factories, a day when all of the workers turn up. It makes sense to send the workers home in the normal factory and shut the factory down.

The trouble is that, when they shut the factory down, they have to switch off all of the heaters for the cooking equipment and the equipment takes a while to run up. This causes several problems:

The first is that bringing the heaters up to temparature is expensive and the other machinery needs more maintenance when it stops and starts. The trouble is that, even when the mountain top workers do show up for work, they occasionally get bored and go home anyway. In this event, the normal factory will have to restart production.

The second problem is that, whilst the normal factory is idle, it is still expensive because it utilised so much capital. Whilst the investment in the factory makes sense when it is producing between 90-103 units, if the capacity drops below this it becomes very expensive for each unit produced.

One person suggests a solution that, with the variability of the mountain top workers, it is possible to vary the output of the normal factory. In other words keep it running most of the time, but adjust the output according to the numbers of workers who show up in the mountain factories. The trouble is that, whilst this is possible, the costs of the normal factory go up, as there is less output but all of the heaters for the food, and production lines, consume a similar amount of energy, regardless of the capacity running through the factory, thereby increasing the cost per unit of ready meal.

Another solution is proposed, and that it to build a huge warehouse, which will keep the ready meals hot and ready, and this would create a sufficient buffer for when the mountain top workers failed to show up for work. The trouble is that building this kind of warehouse would cost a huge amount of money, making this a very, very expensive solution.

In the boardroom of our ready meal factory, they are very worried. They have already spent a lot of money on the mountain top factories, having been told about how great it would be to utlise the cheap workers. They have tried it out, and yet they can not make sense of how to use these cheap workers. If only they were reliable, and turned up to work every day, it would be wonderful. Instead, what they find is that they are using more than twice the amount of capital to have the capacity to provide a capacity of 110 ready meals to their supermarket customers.

Even when there is reasonably good day, when a good number of the mountain top workers arrive for work, they are not making the gains they expected, because of the increased costs in the normal factory offset many of those gains. They note that stopping and starting the factory increases maintenance costs, and that the cost of bringing all their heaters up to temparature is surprisingly high. On the other hand, if they leave them on, and run their factory at low capacity, then the cost per unit is painfully high. But they must have the full capacity if they are to stay in is no good asking the supermarkets to allow for days when there will be few ready meals available. They demand that they are always supplied reliably with the ready meals...

The only conclusion that the board can come to is that, whilst those cheap workers looked so enticing, it is not possible to use them when they are so unreliable. Any savings on worker costs are largely offset by the costs that this loads on the normal factory, and with the high cost of capital, the capital allocation to each ready meal unit has doubled. This is making their ready meals much more expensive per unit, not cheaper. If they could only find a cheap way to store the capacity of mountain top workers, it might just work, but even then the additional capital costs of having so many small factories will still make it questionable as to whether this will be cost effective.

This is exactly the problem facing wind and wave energy, and to a lesser extent solar energy. Whilst hydro and geo-thermal power can offer reliable energy, these other 'green' energy sources are like pouring money into a great big black hole. Tidal power has predictability, but has other problems. In this case it is predictable as an energy source, but it is again of variable strength, at different times. Whilst tidal energy might produce a least a little power at any given time, the efficiency of energy utilisation at low levels of tidal flow magnify the losses. In a few cases, it might be possible to engineer solutions to get around these problems, so tidal energy remains a possible source of 'green' energy. However, whether reliable schemes could be engineered that might supply energy at a reasonable cost is questionable. On this subject, each scheme needs to be evaluated on a case by case basis.

At the heart of all of these problems is that, as yet, no one has come up with a cheap solution to the energy storage problems. This is the only way that these variable generation methods might make sense, but even then there are often the increased capital costs to supply these sources to the grid (wind and wave power in particular). In other words, the problems of energy storage just make these energy sources even more capital intensive, and therefore much more expensive as a source of each unit generated. Whilst such energy storage solutions remove the need for doubling the capital cost of each MW generated, they merely displace the capital cost to energy storage. Either way, the energy cost is absurdly expensive.

One alternative proposed is the use of electric cars, with the electric car batteries acting as reserve of supply. However, until such time as everyone has switched to electric cars, this is speculative, and does not address the problem that wind power capacity is being put in place now, even though it is unusable in any economic or sensible way. I am not sure that this is a 'green' solution either, as batteries have their own negative environmental impacts. However, this is beyond what I want to discuss here, and not something I have looked into.

Essentially, as it stands, wind power is just a 'feel good' solution that offers no real solution at all.
I hope that this goes some way to clarifying my point.

Note 2 added 29 November:

Another point made was to ask how me might know whether supplies of some materials might be subsidised in another country. I have no problem with the idea that another country might want to subsidise the cost of energy in the UK. If they wish to do so it is very foolish of them, but is all well and good, as they are indirectly giving away their wealth to the UK.

Note 3 added 29 November:

A couple of posters made the point that people would vote with their wallets, and would presumably not accept the 'green' solutions. Here we come to the crux of it. For some people, they believe in MMGW, and believe that any price is worth paying to ameliorate the effects. Others are sceptical, and believe that there is no substance behind the claims. For many others, the reality is that they care more for their immediate economic concerns, having a job and so forth. This is, for example, the point made by China as a whole, but equally applies to individuals. If the Chinese government accepted MMGW, they would act in concert with other countries in acting to ameliorate the effects, as it is something that will start to effect them as much as anyone else. However, they are not acting, and presumably just do not accept the case for MMGW. Whilst they make the right noises, their behaviour is not consistent with this. It can not be emphasised enough that they will be effected equally by MMGW if it is correct, and they would not act as they do if it was going to harm themselves.

In other words MMGW is not accepted by everyone, and the cost of the solutions will be real costs upon the economy. As I have pointed out, the real cost of 'green' energy is that manufacturing will move from the countries with high energy costs to those with low energy costs. In other words, as I have emphasised, the high cost of energy in the West will just see further displacement of economic activity to economies such as China.

The really big users of energy, such as aluminium smelters, will move very quickly to another country if energy prices go up significantly. The only way this can be prevented from doing so is through heavy subsidisation of inefficient methods of energy generation. However, subsidy comes from taxation (or government borrowing in the current poor economic approach) and therefore still makes doing business more expensive, just indirectly. In the case of energy being priced without subsidy, big energy consumers will move to another country. This will be direct and visible, and would cause an outcry. On the other hand, with subsidy, the cost of the subsidy will be more evenly spread accross the economy. This means an increase in costs for every individual and business. This means the overall competitive position is weakened, and creates an aditional incentive for all business to move to the East. The effect will be the same as, for example, as big energy hungry companies moving to the East, but it will just be less visible. As such, subsidy is a more politically acceptable way of displacing jobs and businesses to the East.

In the event that this happens, the gains in reduction of CO2 emmissions will be minimal, but with the commensurate damage to the economy. This brings me back to the point about energy users voting with their wallets. If a business thinks that it can afford 'green' energy, and still stay in business, then they have that option. They might even promote their business as being 'green' for doing so, and gain competitive advantage in doing so. On the other hand, if a company does not believe that they can afford the high costs of 'green' energy, they can continue to use conventional sources of energy.

Equally, in the case of individual choices, for a family who may be on low income, where energy use is a large percentage of their expenditure, they have the choice of where their priorities are. The economics of energy is that high energy costs fall disproportionately on the poorer members of society, as it makes up a greater part of their income. Added to this, the disappearance of manufacturing jobs disproportianately impacts upon the less well educated, so has a greater effect on the less wealthy.

The point I am trying to make here is that expensive energy is a luxury. If one group of people think that their priority is 'green' energy, they should be allowed to pay for it, but if another group does not have that priority, then why should they have to pay for it, and pay for the consequences to the economy. The cost of 'green' energy is fine, as long as it can be afforded. I am simply saying, let individuals and businesses decide whether they can bear that cost. After all, for every increase in the unit cost of power, there will be a percentage increase in displacement of industry and economic activityto the East, meaning the impact of 'green' energy policy will be minimised.

Were the introduction of 'green' energy universal, including places like China, the net effect would be a reduction in output around the world, as energy input costs would go up. However, I would be far more amenable to such a situation, as the cost would not be falling disproportinately upon the Western economies, with the minimal effectiveness caused be the displacement of economic activity that goes with such a scenario.

I am aware that this is a contentious subject, and knew that it would upset some people. However, I would rather that we faced up to the real costs and minimal impacts of adopting expensive energy production. I hope that the blog does not lose readers because of what I am saying but, alas, I try to view the world as it is, not how we would like it to be. I therefore just see 'green' energy as another element that will contribute to the decline of the West relative to the East. Even if accepting MMGW, the 'green' policies of the West will make very little overall impact. And the cost will be high in terms of economic decline.

(1) Gunn, C 1997, 'Energy efficiency vs economic efficiency? : New Zealand electricity sector reform in the context of the national energy policy objective', Energy Policy, vol. 25, no. 2, pp. 241-54.

(2) Tiedemann, A 2006, Grid Integration of Wind Energy - Results of Dena's Gridstudy, IEA Workshop on 'Integration of Renewables into Electiricty Grids'

(3) ESB National Grid 2004, Impact of Wind Power Generation in Ireland on the Operation of Conventional Plant and the Economic Implications

(4) DEWI, E.On, EWI et al (2005), Planning of the Grid Integration of Wind Energy in Germany Onshore and Offshore up to the Year 2020

Note 1: Sorry I have not referenced more, which was my original intention, but the time this has taken is longer than I had hoped. If I have time I may return to this and add some more references. If I do so, I will as always note that I have made changes.

Note 2: Kecske, thanks for the link. I had come accross this outfit through my reading of the Economist but had not looked into the subject further. Very interesting. The link is to a site that has a pragmatic and interesting approach to environmentalism. However, they still accept subsidy and distortions as part of their philosophy.

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."
( )

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. ( )

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:
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?

Monday, November 24, 2008

UK Government - More Madness

The madness of UK economic policy has ratcheted up another notch. It is impossible to have missed the latest headlines. This is what Alastair Darling had to say about the cut in VAT:
"This temporary reduction is the equivalent of the Government giving back some £12.5 billion to consumers to boost the economy. It will make goods and services cheaper and, by encouraging spending, will help stimulate growth."
I will translate this statement as follows:
'This temporary reduction is equivalent to UK consumers borrowing £12.5 billion, and will replace the borrowing that consumers are no longer able to obtain with government borrowing instead. Government borrowing will allow less tax to be levied on the sale of goods and services, making them appear to be cheaper, but really it is buy now pay later credit, and this will help stimulate more shopping for goods and services, because consumer shopping = economic growth'
In other words, if consumers can no longer borrow to buy their brand new plasma TVs, the government will now subsidise the purchase of the TV through government borrowing. Buy now - pay later becomes government policy. The real worry is that, at the heart of this economic thinking, there is a belief that consumer spending equals economic growth. Whilst consumer spending creates more activity in an economy, it is only represents real economic growth if it is not funded by borrowing. In other words, economic activity only equals wealth when the economic activity is derived from the transfer and distribution of wealth from productive activity such as manufacturing, the the export of services, or the extraction and processing of commodities. Economic activity built upon borrowed money is spending of future wealth.

Assuming that this cut creates an increase in economic activity (which I doubt), it is fools gold.

The result of this particular foolishness has been a record rise in the FTSE, which just provides further evidence that the city needs to find some new economists. However, we have been here before. If we look back at the banking bailout, the same reaction, then the same evaporation of confidence as soon as the reality of lack of real effect kicked in. Regardless of the bailout, banks were still tightening their lending.

This brings me on to the other subject of my post, which is that (as I predicted) the strings attached to the banking bailout are that the banks must now do the governments bidding. Over a series of articles it is apparent that the government is bullying the banks into lending against their commercial judgement. Just as the banks have (rightly) understood that their previous profligate lending was foolish and unsustainable, the government is telling them to unlearn the lesson, and is therefore storing up future problems for the banks, by forcing them to lend recklessly.

Meanwhile the first of the banking rescues is (again as predicted) showing that the government liabilities are rising. It seems that Northern Rock is going to need more state funding to survive. Even without the government encouraging reckless lending, the same will happen with the other banks that the government has rescued. With the reckless lending the bill can only get ever larger.

On top of all of this, it appears that the relentless growth of the state continues:

'Independent specialists published forecasts showing that an extra 50,000 public officials will have been recruited in the six months to the end of the year.

The Centre for Economic and Business Research (CEBR) forecast that over the same period 300,000 private sector workers will have lost their jobs.'

I am not sure whether I wrote about this on this blog, or somewhere else, but this is an ongoing problem that feeds upon itself. The more people the state employs, the more tax that the government needs to take from the productive parts of the economy. The more tax that needs to be taken from the productive part of the economy, the less able the productive part is to compete. The loss of ability to compete leads to less employment. Less employment in the productive part of the economy means that more government jobs are created to take up the slack, as politicians know that high employment means electoral success. And so the cycle continues....

In this case, if we make a conservative estimate (does anyone have figures, I could not find any) of the cost of these 50,000 new public sector jobs costing £40,000 each (ignoring deferred costs such as pensions), the total cost to the economy is £2,000,000,000 per anum. All of these individuals are not involved in wealth creation. Add in other costs, such as pensions.....

Essentially, what we are seeing is the government putting itself at the centre of the economy, literally trying to borrow itself out of trouble, when the trouble itself has been rooted in the borrowing of both consumers and government. The government reaction to the crisis is to try to replace consumer borrowing with government borrowing. In this case, they are borrowing with the target of increasing consumer spending, a sector of the economy which at best can only redistribute wealth, but can not create wealth.

When the money is borrowed, it increases activity at the cost of future activity. At its most simple, if I spend £50 of borrowed money now, I will not spend that same £50 in the future, because it is already spent. As such, borrowing to encourage consumer activity now may support that activity now, but at some point in the future, it must mean a reduction in activity. It just becomes a question of when that activity must decline. Furthermore, when I spend the £50 with borrowed money, it costs me more than £50 because the cost of the borrowing. As such, not only do I withdraw the £50 from future activity, but I also reduce the future activity by the cost of the interest. As such, a boost to consumer spending through borrowing now means a reduction in future activity of £50 + the interest on the loan. In the case of the borrowing, large amounts (in particular if the source of the borrowing is government debt) are funded externally to the UK, meaning that some of that interest is an export of wealth out of the country - a direct cash loss.

The result is that whilst consumer activity may be supported now, it means a larger shrinkage in activity later.

In amongst all of this activity, is it possible to see any single point which will see the encouragement of new real wealth creating activity (i.e. economic activity that is not centred around funding more consumer shopping, more government activity)?

It is unsurprising that the government have continued on this path of ruin, but I also have an irrational hope that, at some stage, someone in the government will have the courage to call a halt to this madness.

Note 1:

As part of my rooting around for civil servant costs I found a strange chart. Can aynone make sense of this chart (below), taken from a government website? Is it because they are using contractors, more flexi-time and job sharing? How is it that they can create these figures?

Note 2: Sorry not to respond to the many recent comments, but I will do my best to respond in my next post.

Thursday, November 20, 2008

Economic Crisis - As Expected Government Finance in Tatters

It has been a while since I last posted, for which I must apologise. I have just been looking through the news, and it is apparent that UK government finance is sinking fast. Regular readers of this blog will know that I have long been predicting a government default, as a result of creditors losing confidence in the UK government, and that I have been tracking the steady erosion of confidence. Even the most optimistic investor will be looking at the latest government figures and will be wondering whether the UK government can sustain payments. In particular, it does not take much imagination to see that the UK economy has not even begun to reach a low point, even if you believe mainstream economists.

In other words, although potential creditors to the government do not yet realise how bad the UK economy will get, they will still realise it has a long way to fall. Perhaps in response to the emerging loss of confidence the government has admitted that taxes will have to rise in the future to pay for the borrowing now, which is a politically painful thing for the government to say, but necessary as a measure to keep creditors on board. The final point of note is that the Yen is strengthening, as the carry trade is now unwinding. It appears that one of the sources of finance in the West is evaporating. For those that are unaware of what the carry trade is, the article explains this, but the important point is that one of the sources of the wall of money that fuelled the credit boom, the service economy and government debt is disappearing. The effect will be less finance available to the West, as well as further downward pressure on Western currencies.

Another piece of news is that inflation is now plummeting, in part on the back of plunging prices in the shops as a result of deep discounting. The result of such discounting appears to be that retail sales have only fallen by a small amount (0.4%), presumably as shoppers think they are being offered bargains. By contrast, retail sales in the US are in a dire state, and it can only be a matter of time before the UK follows suit.

The plunge in inflation was also something that I predicted many months ago, and the I predicted that the driver for the plunge would be the discounting of shops that would be desperate to keep sales in the face of loss of consumer confidence, as well as falling oil prices. Oil prices are now around $50 per barrel, with my original prediction at $60, and a later prediction suggesting that $50 was possible. The fall in oil prices is the best indication of how much trouble there is in the world economy, as the drop in demand for oil is an excellent indicator of the drop in economic activity overall. In my guesstimation for inflation I balanced the factor of retail discounting against the fact that the £GB would be falling, making imports (including oil) more expensive, and concluded that the balance would not be inflationary. It is, however, a fine line, and continued deflationary pressure will in part be determined by how far the £GB falls.

Perhaps one of the interesting points in all of this is that the 'bargains' available in UK shops is probably what is supporting retail sales at the moment. One of the drivers behind my thinking on the UK and Western economies was the experience of living in China. If you are able to speak Chinese, and know China well, it is apparent how overpriced just about everything is in the West. The best illustration of this is the habitual overpricing Westerners are faced with in China, as the Chinese know that they can offer a very high price, and that 'dumb' Western people will still think they are getting a bargain. We are so used to paying outrageous prices for everything, we simply have no idea of how cheap things can be when they go through the supply chain of a low cost economy.

On a completely different subject, I have been watching the saga of the 'Big Three' US motor manufacturers unfold. I found an excellent article on the subject in the New York Times, which I recommend that you read. It is, of itself, an excellent lesson in the importance of manufacturing as the base of real wealth creation. The author looks at the numbers of jobs that would be lost with loss of these manufacturing giants, and it is somewhere in the region of 2.5-3 million. The author quite rightly makes the point that the foreign owned manufacturers within the US would, in part, take up some of the slack, but how much remains a question of debate. The important point here is that the manufacturing industries support a raft of other economic activity throughout the economy.

Whilst many economists have imagined a dreamy scenario in which the West designs and sells products, with high waged workers doing all the design and management, this does not, and never has been anything but a dream. Even were this sunny scenario to be true, how many of this high earning jobs would be needed to support the less well educated workers in productive activity? How many such high paid jobs could ever be supported? The madness of these dreams is part of what has allowed so many to believe that the 'service economy' was sustainable. I have argued before that this was in any case a dream, as the service jobs would anyway follow manufacturing. I gave the example of a product designer. If the designer does not understand the manufacturing processes intimately, then how can they design well. In other words, how will a designer in the West be able to compete with a designer in China, who is cheaper, increasingly as well trained, and has the 'on the ground' experience of the manufacturing processes. As I said, it was always a dream.

The last point is that I have read a commentary in the Telegraph in which they mention that the government is going to 'force' banks to lend. Again, this is much as I predicted would happen, and one of the many reasons why the bailout of the banks is just going to get ever more expensive. What this means is the government is going to force the banks to make very high risk loans, and will sow the seeds for an ongoing bad debt problem for the banks. Any notion that the government will ever make a profit on their banking bailout was always going to meet the problems of political interference in commercial decisions.....

As you may have noticed, there is no particular theme to this post. If I was to pick any theme at all, it is apparent that the dream world that the West has been living in is evaporating before our eyes, but the politicians and public still believe in the dream. With every day that goes by, more news of reality impinges upon their dreams, but still the politicians, and it seems large sections of the public, are turning their faces from reality and comforting themselves with the dream. Even as the UK government pushes the UK economy into destruction, the public appear to be increasingly backing the government in this action. I think that the only thing which will finally shatter the dream is the coming default of the UK government. It is no longer a question of if, but when....

Note 1: A note for Death to Bubble Addicts - Thank you for your invitation, which I will accept when I have time. I have not published your message, as I do not know whether you intended it for publication.

Note 2: I have just found an article on the problems in Ireland. It seems that I may be wrong in thinking that the UK government will be the first to fall into default. It seems that Ireland may be about to reach the finishing post first:
Michael Klawitter, a strategist at Dresdner Kleinwort, said the cost of insuring Irish sovereign debt through credit default swaps (CDS) has surged to 133 basis points. "The markets have begun to see a risk to the solvency of the Irish government. They are questioning whether it has the financial muscle to back up the guarantees," he said.
The problem it seems, is that the Irish guarantee of the Irish banking system is breaking the government's financial position. This is what I have said would happen with the UK bailout (though it is not the only factor, just one of many), but it seems that Ireland is going to be the first to be pulled down. If Ireland does go down, it is a further impetus to the loss of creditor confidence in the UK, and when the UK goes down, the US will follow. Call it economic dominoes if you wish.

Friday, November 14, 2008

$US Collapse and US Bankrupt - the Value of the $US

Today, I would like to take a look at the $US, in part inspired by an anonymous commentator, who has very kindly posted a link to the FT blog of Willem Buiter. I am an occasional reader of Buiter's blog, and have even commented on the blog a couple of times. However, I missed that he shares with me the belief that the UK is at risk of sovereign default. Unlike myself, he is not predicting the possibility of a US default.

As an aside, before moving on to the $US, another commentator Lemming coincidentally posted that he has heard a new conspiracy theory in which the £GB is being deliberately lowered to parity with the Euro to allow for the UK to join the Euro. I say that this is coincidence, because the UK default will probably rule out the latter. Why would the Euro area want another economic basket case (it already has plenty). As for how such a conspiracy might have been managed, it is quite an astounding idea. I do not think that Lemming, who is far too sensible judging by his other comments, believes such ideas as these conspiracies that are circulating around to explain the financial crisis. However, the simple answer to the conspiracy theorists would be to ask why anyone in their right mind would set about destroying the UK economy in order to join the Euro. Even the most hardened Europhile would blanche at such action. Meanwhile, there are plenty of rational explanations for the drop in the £GB, which I have detailed in this blog for many months.

Returning to the Willem Buiter article, he titles his article 'How likely is a sterling crisis or: is London really Reykjavik-on-Thames?' The interesting thing about this is the underlying thought that it is tougher to see a major economy like the UK fail in the same way as Iceland. I highlight this, because my belief is that, just as Iceland signposts the possibility of the fall of the UK, so the UK fall will signpost that of the US. I have said it before, but it is worthwhile saying it again. The UK is not too big to fail, and the same can be said of the US.

Both countries have, for far too long, been living beyond their means. I have already highlighted in a couple of previous articles that the creditors to both countries are looking less willing/less likely to continue to finance the deficits of the US and UK. Both Saudi Arabia and China have indicated that they intend to use their wealth in support of their domestic economies.

In the meantime, the trade deficit with China has widened according to the New York Times:
'The United States’ trade gap with China widened in September to a record $27.8 billion as exports fell while more Chinese goods and services entered American markets.'
I highlight this, because the trade deficit is growing even whilst retail sales are falling like a stone:

“It’s just brutal,” said Eric Beder, retail analyst at Brean Murray and Company. “It’s a very bleak time for the consumer. Unless it’s something super-compelling or really necessary, they’re not going to the mall, they’re not spending.”

October’s decline was the fourth consecutive monthly drop, and was worse than Wall Street’s expectations of a 2.1 percent decline. The government also revised September retail sales downward by 0.1 percent. The October decline topped the 2.65 percent drop in November 2001, which came after the terrorist attacks.

These quotes come from different articles, but it is interesting to put them together, as they are telling us something fundamental about the world economy. It is quite simply that, even before the economic crisis gathered pace, the US was unable to compete with the efficiency of the Chinese economy. Now that times are tough, and consumers are more cost aware, the competitive advantage of the Chinese economy is being magnified. On what appears a more positive note the US trade deficit has shrunk overall due to the decline in oil prices. However, that decline rests, in part, on the ongoing value of the $US.

How does this relate to the forthcoming bankruptcy of the US economy? Even as I write this, the US economy is plunging, but still the $US is holding up, and seems to defy gravity (but then so did the £GB for a long while). However, I think that there are several factors that are going to bring the crisis to a head.

The first of these is that countries like China will now start drawing on their reserves, and that will mean large chunks of $US, to finance the support for their economy. The Chinese plan is to use their stimulus package for infrastructure, and the problem nagging at the back of my mind is to ask what they will want to buy from the US. There will undoubtedly be some projects that will use the resources of US companies, but I am struggling to think of what they will be. It is just as likely that the Chinese will seek to exchange the $US for other currencies, in particular for the purchase of commodities, and engineering equipment and services. Whilst many commodities are priced in $US, that pricing is dependent on the $US being seen as a stable currency. Many other products and services are also priced in Euros. However, the US will probably only be supplying a small amount of these infrastructure projects, so much of the money will be spent in other countries. It is not a simple situation, in some ways, but I hope I can clarify.

We actually have a situation in which China has more of things that the US wants to buy than the US has things that China wants to buy. China is about to create an infrastructure stimulus in the economy, and will need to use reserves to pay for this. Many of these reserves are held in $US assets, and the only option for them will be to start to sell $US assets to pay for their stimulus. In other words, one of the major creditor nations is about to start calling in some of the debt.....

My guess is that the Chinese will act carefully, as they will know that any dumping of $US in the market will destroy the value of their holdings. However, expect to see some pressure mounting on the $US as China starts to sell $US assets.

The second factor that will bring the US crisis to a head is the forthcoming crisis in the UK. Just as Iceland is a signpost for the UK, so will the UK be a signpost for the US. Returning to Buiter, he offers these as a reason for exposure to default:
'(1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity'
He identifies that the £GB is no longer a global reserve currency, and therefore suggests that the comparison with Iceland can be made. He has, in his analysis, pointed out that the UK is a relatively small country, and so forth.

Whilst I commend his analysis of the risk of a UK default, I am not sure that he has quite 'got it' yet. In particular he has not yet got the idea that a country is never too big to fail. As one of his criteria for default, he points to a country not having a reserve currency. He is missing the point that a reserve currency only has the backing of confidence in the value of the currency, and that confidence rests upon the economic strength of the country issuing the currency. China is about to test the economic strength that underlies the $US, and is going to find it wanting. What is about to happen is that the belief that the US is too big to fail is about to be challenged and, over the coming months, there will be a clash of reality and false belief. My guess is that the $US is about to go through turmoil, with swings of sentiment in markets as the reality starts to be digested, but also with swings back to 'the too big to fail' argument.

Over recent months, the market has persisted in the belief that the $US is a 'safe haven'. One of my (few) poor predictions was that the $US should already have collapsed. My error was to look at the real value of the $US and to forget that the value of a currency rests, in part, on confidence, as well as being based upon the underlying economic realities that pertain to the issuer. By real value, I mean the real wealth creating capacity that is needed to maintain the value of a currency. That wealth creating capacity is founded on producing more goods and services, more cost effectively, creating greater demand from your trading partners than your demand from them. At its most simple, real wealth is the ability, for example, to manufacture a product with less input costs per unit produced, sold and distributed (of a similar item) to your trading partners. This is a very crude characterisation, but I hope it makes the point, and that point is that the US is no longer doing this in many industries, and therefore is failing to sell products or services in sufficient number to support the value of their currency.

In other words, the $US has little real value in exchange, and the value therefore rests on belief alone. A long as people believed in the value of the $US it could withstand much. However, the point has now been reached where, for example, China is now going to be using $US to buy things, and will find that there is little that it wants to buy from the US. In this situation, it will try to change the $US into currencies that do have things they want to buy. The question then arises as to who will want to buy the $US for what reason? The US has a massive trade deficit, and therefore there is little overall demand for $US. The only reason for holding the $US is that it is a 'reserve' currency, and we come full circle to the conclusion that the only value in the $US is a belief that the US is too big to fail.

It is a very fragile edifice, and however many economists use clever theories, there is no escaping the fact that a currency can only defy gravity for so long before it falls to earth. Essentially, the $US has become the greatest bubble in the history of the world. It is a bubble because there is diminishing underlying value in the $US as a unit of exchange. Quite simply, there is too little demand for the $US to actually buy things from the US, as the US is just not producing enough that other countries want to buy. Just like 'Tulipmania', the 'Dotcom' boom, the housing boom, value can be sustained on irrational belief alone for a long time, but eventually something happens to challenge the belief. At that point, the bubble bursts. I believe that the problems of the UK will be just such an impetus to a collapse of belief.

In other words, I believe that the world is about to go through another convulsion, and this one will make the banking crisis look like a walk in the park. For those that are new to the blog, you may want to read here, if you doubt what I am saying, as it will explain what is underlying all of this. The collapse of the $US is going to be the most startling and shocking event so far, and the world is about change dramatically.

In the meanwhile, anyone who can offer a reason why/ justify why the $US can hold its value is welcome to post a comment. I would be happy to see some challenges to my belief that the US is moving to sovereign default and currency collapse because, as hard as I look, I can see no justification for the apparent current level of wealth of the US, and no reason for why the $US holds anywhere near its current value. Quite simply, it is a country that does not produce enough goods or services efficiently enough to sell to other countries. Just like the UK, it is structurally bankrupt.

A shocking post.

I hope I have done the subject justice. Unfortunately, I was supposed to have finished a major project I have been working on, but the size of the project is greater than I anticipated. As such, I can not devote as much time as I would like to this blog. In particular as the economic crisis heads to the inevitable unhappy ending, I would like to be doing a better job of explaining why this is all happening, as well as offering some practical solutions for the eventual recovery from the crisis.

Note 1: I have had the following question from anonymous (posted 4 times - once will suffice, but thanks for the interesting question):
Am I missing a step in the argument? If the US$ collapses, doesn't that make sovereign default less likely? US debt being denominated in US$ (or so I assume), would the USA not a) have to generate less wealth to service its debt; and b) be better able to generate wealth because devaluation would boost exports?
Both the UK and US governments are increasingly financed upon debt. If the lending stops, then this will lead to default, as it is not possible to fund these states on tax revenues (as they are currently structured). If the lending stops, both governments will literally run out of money. They will still need to pay for their structural costs, such as healthcare etc. so they will either print money or default on debt. You are assuming (I guess) that these things will happen over a long period of time, allowing adjustment, such as reducing state expenditure. However, exports do not appear overnight, but take a long while to pick up. Meanwhile the structural costs of governments take a long time to be be removed. The politicians do not have the courage to shut down huge parts of the government to forestall crisis - it will take the default to make them do so.

As for the value of the debt decreasing, the US government will still need to take $US1 in taxes to pay for every $US1 in debt. Although the recipient of the debt will find that they have made a loss on the $US (that is can be used to buy less for the same number of units), the people (i.e. businesses and consumers) paying the burden of the debt will still feel the pain of each $US1 that they give to the government. They will still (if they are lucky!) have the same $US income as before the devaluation so the proportion of the income to service the debt will remain the same (in the unlikely event that taxes remain the same - but they will almost certainly go up). Even though they will not be able to use the $US to buy the same value of imports, each $US1 they pay the government is still $US1 less to spend on other items. The amount taken out of the pockets of US consumers and businesses will remain the same to those people, albeit that what they are giving is worth less in relation to imported products. The relative cost in terms of their income, to the real payers of the debt, gets larger, as they need more of $US to buy imports, and therefore the impact of every loss of each $US to service the overseas debt is even greater. If my money is worth less today than yesterday, any expenditure is proportionally more costly. If you are poorer, the proportion of your income needed to buy the same thing is greater than if you are richer.

If I want to buy a Japanes hi-fi that today costs $100, but after the currency collapse costs me $150 I am $50 poorer than I was yesterday. If you then think about how people spend their income, for example buying petrol (or gas for American readers), and the currency devalues, you will have to work x number of hours more to buy the same amount of fuel. In the case of an average consumer, think of the amount of imported products that they use. Whatever proportion of their income they previously spent on imported products/services is means they will be proportionally poorer on that part of their income, according to the degree of the devaluation. Put another way, let's imagine someone who has a taste for Belgian beer. It is more expensive than US beer, but they have been able to afford it because the value of the $US was high. After the devaluation, the person decides that it is too expensive. They are poorer.

At the same time, the proportion of their income used to pay the overseas debt remains the same. This means that, they are losing the same amount of their income to pay the overseas debt that they were before. For consumption of locally produced products and services, there is no change. If I want to have a haircut, then the cost of the haircut is still the same as before the devaluation, but I still have $US1 less to to pay for the haircut if I am paying taxes to repay overseas debts.

As I have argued, the West is much poorer than it believes. One way that the adjustment to the real wealth of the West will be made is through massive currency devaluations. I can not emphasise enough - if a currency devalues overnight, everyone in the country is overnight poorer than they were the day before. They either have to work longer hours for the same imported item, or substitute the item with a product that is perceived as inferior to the one that they would like. In both cases, the people are poorer.

As a note, printing money is equivalent to a default, as it will destroy the value of the debt (where it is denominated in the national currency). It is just defaulting indirectly. So, yes, the devaluation of the $US would devalue the debt that it owes. So, yes, it will lead to improved exports and less exports, but at it will require that everyone becomes poorer in order to do this.

If there were no cost, every country would inflate its way out of debt, and devalue their currency. The cost is just that everyone gets poorer to do so, and lenders no longer trust you if you need to borrow in the future. They therefore make lending more expensive, and/or insist on payment of debt in another currency.

Note 2: I have just been reading some of todays' editions of new on the web, and came accross an article from Roger Bootle of Capital Economics. He 'sort of gets it', but can not quite bring himself to say openly how inevitable the default in the UK might be. However, worth a read.

Note 3: Even more depressing news. Gordon Brown, who is currently accelerating the UK off a cliff, or digging the debt hole ever deeper if you prefer, appears to be increasingly influential. I am afraid that I am increasingly cynical about his motives in his selling of his more debt, more intervention solutions. For example, there is this:

'The other two main planks of his policy hopes are that the International Monetary Fund – which has played a key role in bailing out the economies of a number of countries in recent weeks, including Iceland and Hungary – should be given more money.'

Now, from a cynical point of view, I might ask whether he wants to have an insurance policy in place for the UK. As I have pointed out, the IMF is going to have severe funding problems as the Western economies such as the UK and US sink further. With the UK likely as the first domino to fall, maybe he is setting up a situation in which the UK will be rescued with IMF money, before the rest of the tottering system collapses. All of this assumes that Gordon Brown has any inkling of the depths of the problems in the UK economy, and is therefore highly speculative. I can not make up mind at this stage whether he is a Machiavellian without compare, or just plain incompetent.

Note 4: Another article here questioning the spending splurge of the government, and the possibility of complete collapse..... It seems that the media worm is turning. However, not all are yet convinced. An article in the Times is proposing that house prices will not fall as far as cynics (such as me) have proposed. The article is, of course, delusional and is worthwhile if you would like some humorous light relief from the sense of gloom I may be causing.

Note 5: Yet another article in the Telegraph is asking whether the bailout of the financial system was all a waste of money, but still cautions that it might still work. As I have pointed out repeatedly, the bailout does nothing to address the fundamental problems in the economies of the West, so I do wonder at what point the pointlessness of this activity will be recognised. Plan A has failed, and now we are on to the Keynesian plan B (and without ever having saved during the 'good' times). At what point will any of these people actually address the underlying problems in the economy?

Note 6: I will admit that I am increasingly despairing of all the leadership of the Western economies. I am not sure that the world has ever been presented with such a rag-tag collection of vapid and unintelligent individuals. Lots of activity and grandstanding, but essentially as unsatisfying as a weak cup of tea. I am not normally so strident, but see not one single individual in power with the courage to face this situation, and just see that they all believe more borrowing is the solution to all ills. I am angry because their activity means we can say goodbye to the West as we know it. Even more worrying, the chaos that they are causing will lead the world to a state of complete instability, and that kind of instability can lead to war, to the rise of extremists, and a host of other unpleasant outcomes. I rarely comment on such matters, and readers may be better served by reading other commentators on such matters. However, my frustration is overcoming my restraint. The consequences that might flow from the actions of these 'leaders' have potential for so much harm.......

Note 7: An apology, as there have been some interesting comments again recently. They are all in my inbox, and if I have time I will go through them again to address them. However, I really am very, very short of time, and this more general post was a little more pressing.

Note 8: I seem to have been cited on an economics course in the UAE. I only know this as my visitor tracker has shown links from the course's online component. I have no idea, however, what they think, as I could not find the orignal reference on the site. For all I know they may be giving me as an example of a mad man. Anyone from the economics course wish to enlighten me? It rather stoked my curiosity, as I am sure that most economists would take a dim view of what I write.

Note 9 added 16 November: I have just found an article in the Telegraph that has the following to say:
'Concerns over the deal helped to drive down stocks already hit by worse than expected retail figures. Yesterday’s economic numbers also showed that car sales fell by 34 per cent in the past three months, as Americans grew more fearful of losing their jobs and banks slashed overdraft and credit card limits. Consumer spending has a critical role in the US, accounting for two thirds of economic growth.'
They just do not get it. Consumer spending does not equal economic growth. If consumer spending is based upon spending the proceeds of wealth generating activity, then yes. If the spending is based upon borrowing, then no. However, it is still possible to see the media, politicians and economists still talking about the need to get consumers borrowing to spend in order for the economic crisis to be resolved. They never directly put it this way, but re-read what they are saying and it is clear what they are saying.

In the same article, there is a summary of all of the proposed solutions to the economic problems. In none of these is there any discussion of reforming the Western economies, the only viable solution in the medium to long term.....