The Climax of the Fall is Now in View

I am writing this post with a profound sense of unreality nagging at me. When I first wrote about the UK economy (you may want to read here for a summary of where I started), I was profoundly worried, and could see that we were heading towards a massive economic shock. A little while later the realisation that the UK was effectively bankrupt struck me, followed by the realisation that the US was in the same position.

When I first started writing, I could see no way of avoiding crisis, but could at least see a way to minimise the crisis, and plant the seeds for a future recovery. As the crisis has progressed, I have been horrified at the bank bailouts, more recently horrified at the jump into quasi-Keynesian policy, and even more horrified that quantitative easing has been proposed to finance this lunacy. Such actions, as I have argued over many posts, will serve only to magnify the scale of the economic destruction to levels that I had never imagined were possible. The cure to the disease has been to take a hefty dose of poison.

In the newspapers we can read endless reports about the 'financial crisis', which is of itself a misnomer. This is not a financial crisis, but an economic crisis, of which the banking system failures are just one symptom. Throughout this blog I have kept in mind very simple principles and applied them to the state of the world economy. I realised that the key to all of the problems is that the world had entered a period of hyper-competition. The world had changed, and countries like the UK and US complacently stood still, resting on their laurels, with no real attempt to adapt to the changes in the world.

Instead of adaptation, instead of confronting change, we have seen ever greater attempts to bury the reality that underlies this crisis. The reality is that many of the countries in the West, and I refer in particular to the US and UK, are unfit for the competition. Putting it in both simple and accurate terms - we do not produce enough value of goods and services to support our current lifestyles.

This is not a new situation, but has been developing for a long, long time. All that has happened is that the reality of the situation has been obscured from us through a series of bubbles. The dotcom bubble, the telecoms bubble, the stock market bubble, the housing bubble and the credit bubble. One after another they have come, but the greatest bubble of all will be the final bubble to burst - and it will explode our complacency.

This final bubble is the currency bubble. In the case of the £GB it has been rapidly deflating, but is now set to burst. In the case of the $US, once it starts to deflate, it will pop violently.

Of all the factors that have hid our underlying economic fragility, the currency bubble is probably the most significant. In crude terms, those who have been selling all the commodities, goods and services to us have been lending us the money to buy their output. As a result, they have amassed huge amounts of our currencies, and are now starting to realise that the paper they exchanged for goods has no meaningful underlying value.

Why did it all last as long? Part of the reason is that there was an ongoing demand for the paper, so that it could be used to lend back to us. Part of it was just a false belief in the value of the paper, an illusion.

The illusion was like a magician who, with the clever use of mirrors, manages to hide an elephant on the stage. The elephant that has been hidden is that we just can not compete, do not produce enough of value. In the meantime, the rest of the world looked on in wonder at what appeared to be the miracle of our wealthy economies. We seemed to just keep growing, becoming ever more wealthy, ever more indulged in the luxury of comfortable lives. It all seemed to be inevitable, and it was believed by many that this was our natural state.

This grand illusion meant that the rest of the world looked on in wonder at our wealth and power, and continued to take our worthless paper. In fact, the demand for the paper seemed to grow endlessly, and as the demand increased, so did the issuance of paper from our governments. The result is that more and more of this useless paper has been amassing in the treasuries of our creditors, such that there are now mountains of it.

And here comes the problem. What happens when someone tries to use the paper to buy something from us?

It is here that the light finally shines on the illusion, and reveals the mirrors that hid the elephant from sight. It is at this point in time that the realisation occurs to our creditor that we just do not produce enough for the paper to be exchanged for. To mix metaphors, they can come to the shop, but there is very little on the shelves that they want to buy. Sure, they can rummage around and find a few useful items here and there, but they will be left with a mass of paper still stuffed in their pockets, wondering how it might be used.

The truth is; the paper can not find a use, and it is therefore without value.

When I first started writing on the economic crisis, I saw a window of opportunity. If we could just grasp the reality that we were not competing, that we were not producing enough goods and service to support our lifestyles, we could start to turn the situation around. It was a question of us popping the bubble of our own illusions and seeing the result of our own conjuring. The trouble was that, if we saw the nature of our own conjuring, we would have to face the reality that there was, and is, no magic. It would mean that we would have to accept that all that we had come to expect was no longer going to be delivered. We were much poorer than we imagined. It would mean that we would have to accept reform, changes to our economy that would have made our lives that much less comfortable.

Such a reform might have persuaded our creditors that it might be worth hanging on to our paper. The paper might not have much use now, not much value at this moment in time, but they could at least see the potential for value in the future. It was an opportunity to save ourselves, an opportunity to buy time.

Instead of this, the answer of both the UK and US governments has been to seek to maintain the illusion, even as the lights shining on the stage are revealing the mirrors. The lights are brightening and are revealing mirrors everywhere, whether in the bailout of Citibank, the collapse of the financial position of RBS, the rising unemployment, the contraction in what remains of our manufacturing, the collapsing retail and service industries. In amongst all of this collapse, the relentless march of imports continues as a bright light upon our inadequacies.

Above all, the desperate measures of governments shine the brightest light of all. In their increasingly frantic attempts to rescue the illusion, they just serve to highlight to all the nature of the illusion itself. The printing of more paper is like trying to sneak another mirror onto a stage on which the lights are already shining - the illusion is already revealed.

Bit by bit, we are now seeing the result of the loss of belief. The rich are starting to move their money into gold. They are not even holding gold on paper, but holding gold as 'stuff' that can be physically held in their hands. China, one of our former creditors, has pointed that it will direct its sovereign wealth towards emerging markets. Even if we take an example of news today, we can see that the Abu Dhabi sovereign wealth fund are pulling out of a major infrastructure project in the UK:

“The economics of this project should be revisited,” Ziad Tassabehji, the director of innovation and investments for Masdar, said at a renewable energy conference in Abu Dhabi. “We are working with our partners to study the feasibility of the project.”

The economics of the project should be revisited. In that telling phrase, we can see the end. All across the world, as I predicted would happen, our creditors are 'revisiting the economics' and they want no more of our paper.

It is at this point that the bubble starts to burst. The demand for the paper was what maintained the value of the paper. When the demand disappears, the paper becomes useless, as the question arises as to what that paper might be used for. There are already mountains of it in circulation, and nobody wants any more. At just this moment in time, the governments are issuing ever more paper.....

So now we come to the crunch. We have been living on the labour of others by exchanging useless paper for goods and services. What are we going to use for those imports now? If nobody want to exchange their goods and services for our paper, what can we do? It is here that we come to the real problem.

Not only do we have too little to exchange for those goods and services, there is also a huge stock of paper in relation to the goods and services available for exchange. As those that hold the paper realise that the paper has little value, they will seek to exchange the paper as quickly as possible, before the illusion is fully revealed. They will try to exchange the paper whilst is still appears to have real value.

The trouble is that, as soon as one creditor starts everybody else will follow in a mad rush to unload the paper. More and more of the paper will be dumped ever more quickly into the market, and the faster it is dumped, the lower the value of the paper will fall. In this situation there will be ever more paper made available to chase a limited supply of goods and services.

Welcome to currency collapse and hyper-inflation.

As the currencies collapse, the goods and services that are imported will shoot up in price. These are the goods and services which we have been exchanging for worthless paper - goods and services that we have been obtaining for very little in return. It is this massive importation of the effectively subsidised labour of others that will suddenly disappear. We will be left, in practical terms, with the fruits of our own labour and will find how little fruit that labour produces.

All the while this is happening, governments will fall into crisis, and be faced with a situation spiralling relentlessly down. Their revenues will be collapsing, their expenditures escalating, but with no overseas credit available to rescue them from crisis. All the while the bills need to be paid. The military, the police, the health services, the unemployment benefits, the wages of the civil servants, the pensions and so it goes on. How will they pay for all of these people, all of these services?

For years they have been paying for all of this with borrowing. Even in the 'good times' they could not afford to pay the costs of government. In a situation of greater expenses, less revenue, and the clamour for ever more bailouts, how can they possibly pay for all of this?

The answer is the printing press. They will have no choice but to print money, and another accelerator of hyper-inflation will kick in.

I think that the path is now set, and there is no climbing off the path. All that remains now is the question of the 'push', of what will start this collapse. In an article here, Eric deCarbonnel thinks that China will precipitate the crash. I hesitate to summarise the article, which offers a sophisticated and plausible case. However, my scenario (and it is no more than that) is as follows:

One possibility is that Ireland may be the first to fall, as they are in deep, deep trouble. There is already one prominent commentator talking of default on debt, and the prospect of a rash of defaults across Southern Europe. Although this is just one commentator, there are solid reasons for why Ireland is so vulnerable, in particular a very nasty variant of the credit bubble. Alternatively, confidence in the UK economy is leeching away at an accelerating pace. The EU commissioner's report on the UK is just one of increasingly pessimistic forecasts for the prospects of the UK. On top of this, the UK government continues to stretch itself ever thinner, seeks to prop up ever larger sections of the economy, and all to no avail. All the time that is going on, the words risk will be flashing in the minds of the UK's creditors.

I have had one commentator suggest that the US will be the first to fall, and the commentator presents a convincing argument. However, I would argue that the illusion of the US is the most deeply ingrained, and therefore the hardest to shatter. There is even the factor of a 'good will' and optimism bounce of Barack Obama's new presidency as a potential pause for breath. What I am saying is that the economic fundamentals are only part of the equation, as we are also dealing in belief.

From my point of view, it will be the collapse of the UK economy that will be needed to shatter the belief in the US economy, and will be the final impetus to push the $US over the edge. Such a collapse might even see a brief run to safety into the $US, before the realisation hits that it is a run into danger.

However, this is just thinking of orders of collapse, and such scenarios are about emotional reaction and belief, as much as they are about economics. Such reactions are difficult to predict, and there is always the influence of events, such as badly worded official statement or any other small trigger. In the current situation, small events have potential for major outcomes.

Whatever the final push, I now believe that we are on the edge and, as such, I will brave a timescale. I would now say with considerable confidence that we are within three months of the plunge. By plunge, I mean the serious collapse in either the $US or the £GB, either of which will shortly after precipitate the collapse of the other. I am not tempted to say how far they will fall, but it will be a dramatic fall over a period of about two weeks, sufficient that we will all look on in complete shock. I am not talking about 10% but tens of percent. Once the sell-off starts, I am not sure where it will stop.

I have always been a 'doomster', and taken a negative view on the prospects for anything but deep, deep crisis. To date, the events that have occurred have largely agreed with such a pessimistic outlook. In this case I sincerely hope that I am wrong, and that I will be eating these words in three months time. My worry is that this will not be the case.....