The importance of ability to service debt.....

I have just been reading a Times columnist, the Business Editor, who is seeking to explain why it is that the UK will not be the next Iceland. The reason why I highlight this article is that it seems to express the profound denial of the reality of the situation.

In his introduction he has the following to say:

The economy is in a bad way and government finances are in an awful state, but let's get a sense of perspective. The City is not Reykjavik on Thames. Britain is not Iceland. Sterling has fallen a long way and may fall further. But Britain is not bankrupt.

The first thing to consider is that the idea that the UK is bankrupt has now gathered enough traction that the subject is now being considered and discussed in the mainstream media. Even six months ago, this would not have been a topic for 'serious' discussion (I have been discussing this for a long while, and this would not have been considered 'serious').

The columnist goes on to point out that, whilst there are some serious problems in the UK economy, they are not as dramatic as Iceland. He then makes the following comparison:

The housing market here may be in a worse state than in America, as claimed by Jim Rogers, the US investor and former partner of George Soros. But the outlook is nothing like as dire as in Spain or Ireland.

The City will go through a terrible time, but the prospects for the German car industry look just as bad.

In this case what we are seeing is something that I have seen through several reports, and even some comments on this blog. This is the idea that country x, country y, country z, are is a worse state than the UK on factor a, or factor b, or factor c.

This is a non-argument. It is a bit like going to a casualty room in a hospital, taking a look at the patients, and saying patient 'a' is okay with his broken arms, because patient 'b' has broken legs. In both cases the patients are not in a good condition. The only way that a reasonable comparison can be made is to compare them to the notion of a healthy patient (i.e. a patient with no broken bones at all).

The columnist goes on to offer this rather extraordinary statement:

By international standards, Britain's government debt is not that high compared with the size of the economy, although the picture does change if all corporate and household debts are included.

In saying this, he is hitting the nail on the head, as the debts of corporations and households in conjunction with large government debts is exactly the point. Every section of the UK economy has been running large deficits. As for government borrowing, one of the oft cited examples is the state of the Japanese governments debt, but the people who cite this forget that much of that debt is funded from within Japan. The problem in the case of the UK is that large tracts of the debt is funded externally, including government borrowing.

We then come to another non-argument as follows:

Standard & Poor's recently reaffirmed Britain's triple A credit rating, just as it was downgrading Spain. And after the mauling the rating agencies have received, they are not in the business of giving anyone the benefit of the doubt.

This is a non-argument on the basis that Standard & Poor, and all of the other ratings organisations have got so much so very wrong, that they should be given very little credence.

Having so far given not a single good argument for the UK not being bankrupt, the commentator then goes on to a complete distraction from the subject at hand. In this case he discusses the problems within the Euro area. The interesting thing is that he should think that the woes of Euro area economies have a bearing on whether the UK is bankrupt. However, he throws in some figures, makes it all look well grounded, and so it all looks very credible.

The only trouble is that it is completely irrelevant to the state of the UK economy. From discussing the troubles of Europe, he jumps into his conclusion as follows:

Britain does not have that alternative to the IMF, but it is hard to believe that we will need it. The hard to believe does happen a lot these days, though.

I strongly recommend that, if you have not done so, you read the article in full. The reason why I am doing so is that this article is fairly typical of the kind of article that can be found claiming that the UK is not bankrupt. When you examine all of the arguments, they always come back to the same method, which is to propose that country 'x' is worse on factor 'a', and figures are then trotted out to support the case.

These arguments are quite simply missing the point. For example, there seems to be a grim satisfaction underlying the collapse in the exports of Germany, and the contraction of the German economy. Last week's Economist was highlighting how quickly manufacturing turned down in comparison to services. In another article (which I can not seem to find) they mentioned how much more resilient services were in a downturn.

What they are all missing is that these economies may suffer now, but they have the means to repay their debts when the global economy starts to recover. As I have been saying for a long time, the UK does not produce enough of value to ever repay the debts that it has rapidly accumulated, let alone the debts that it is adding.

As Jim Rogers, who is now quoted all over the media, has said:

He says his view reflects the UK's dire economic situation: "It's simple. The UK has nothing to sell."

Mr Rogers says the two main pillars of support for sterling have been North Sea oil and the strength of the UK financial services sector, in particular, the City of London's role.

But Mr Rogers says just as North Sea oil is running out, so London's standing as a financial centre is set to suffer: "I don't think there is a sound UK bank now. At least, if there is one I don't know about it."

"The City of London is finished, the financial centre of the world is moving east. All the money is in Asia. Why would it go back to the west?" says Mr Rogers.

This has been one of the central themes of this blog from the very posting. In other words, it is not just a question of comparison of country 'x' on factor 'a', which is always about relative levels of debt, relative state of housing markets and similar arguments. It is also about the ability to pay off debts. What matters is the ability to generate income with which to pay the debts.

As an analogy, we can imagine a person with a £100,000 a year salary job who holds debts of £200,000 and person with a £50,000 salary with debts of £160,000. To look at the absolute debt level would considered to be an unusual method of making a comparison. The only way to look at the debt is to consider the ability to repay the debt, and in the case of the UK that is a very poor prospect.

As a summary, I have yet to see an argument that persuades me that the UK is not in reality structurally bankrupt. Whilst the arguments presented all look very plausible on the surface, they are either comparing basket cases with a basket case, or they are not offering a serious consideration of debt in relation to income.

Note 1: I have had a large number of comments on my last post, and will therefore just have time to answer a few of the comments and questions.

Note 2: Lord Sidcup has the following question:

If the government is printing money and giving it to the banks, but the banks don't circulate it (won't lend) isn't this money irrelevant in causing inflation?

This is a perfectly reasonable point, which is actually quite challenging. Yes, if the government is lending to the banks and the banks are not lending, it would appear that the money will not have an impact. However, the banks do not sit on that money, but are using it to buy government bonds and other so called 'safe' investments to restore their base of capital.

The government then uses the money lent to it by the banks to lend into the banks, and it appears that the money goes in merry-go-round, albeit with the supply of money steadily inflating. This is why the government needs to print more money, to break this cycle, and create a greater impetus to get money into activity in the economy. They are literally going to deluge the banks with so much liquidity that there will not be enough government debt to buy with the money.

The only trouble with this plan is that so many other countries are also selling huge amounts of debt into world markets. As fast as the government might print money, the amount of debt being issued by governments across the OECD will be able to mop up that money. The bottom line is that the banks do not want to lend to business and consumers because they rightly recognise that there are considerable risks in doing so. This is why the government is considering measures to 'force'/encourage the banks to lend into the UK economy, such as reductions in capital adequacy requirements and so forth.

As I have pointed out many times, the problem with government borrowing is that it crowds out lending to the private sector.

In this circumstance, how will the money printing lead to inflation? The printed money is still going to be used but, instead of being used by business and consumers, it will now go through the intermediary of the government, as the printed money eventually ends up back on the government's books through their borrowing. This creates a time lag, as the government must find ways of using that money in various guises of 'stimuli'. There is also a time lag as the money goes through the lending / borrowing merry-go-round.

Within this rather odd scenario is a possibility that the banks in the UK will start to worry about the solvency of the government, and will therefore stop lending to the government. They might instead use the borrowed money only to finance debt of other governments. This is, in principle, possible, but is also highly unlikely. The banks are now effectively clients of the state, so I believe that they will be expected/forced to support the state with continued lending. I do not know this, but I think it is a reasonable assumption.

What we have in total is a situation where some of the printed money will be returned to the government, and some of the printed money will be used to finance the governments of other countries, and some will eventually find its way into private lending in the UK. In all cases, the money will appear in the market place.

If, for example, the banks use money to finance borrowing of overseas governments, this is a net outflow of currency, which will further weaken the £GB. If the money remains in the UK, it will eventually reach the economy in the form of loan guarantees, and various other government stimuli measures. In all cases, the money does eventually reach the market. The important point in all of this is that there is a significant buffer in all of this, which is the ability of the government to actually utilise the money such that it reaches both businesses and consumers in the UK.

The most disturbing part of this scenario is the impact of the government which acts as a buffer for some of the money that is created. In acting as a buffer it is possible in principle that the effects of the increase in supply will not be immediately apparent, encouraging a belief that the government can 'get away' with printing money, thereby further encouraging an acceleration of the speed of the printing presses.

What can not be hidden is that there will eventually be an increase in the quantity of £GB in the market. As I have often stressed, printing money just transfers the value of the existing money to the new money, which dilutes the value of money. This is inflation.

However, I do not think that that people are quite foolish enough to believe that printing money can be a solution to the underlying problems of the UK. This is why I believe that the £GB will collapse sooner rather than later. I do not believe that holders of the £GB will hold on to the currency, as they will start to price in the effects of both the underlying weakness of the £GB and the impact of money printing. At that point, there will be inflationary surges due to substantial increases in the costs of imports.

This brings me to another point. In my original post I pointed out that a collapse in the currency would result in hyper-inflation. I should clarify this, as I have noted comments (not made on this blog) which have imagined that the moment the currency collapses is the moment at which hyper-inflation appears. This was not my intended meaning. There will be a time lag, as existing contracts are fulfilled and so forth. Some products will see price inflation very quickly, such as imported foodstuffs, whilst other products may take a while for prices to inflate. However, the process will still be surprisingly rapid, just not immediate.

It seems that a very short question has demanded a very long answer. It is not a simple answer but I hope I have managed to be clear and consistent. Please let me know if I have been either unclear, or missed any key points.

Note 2: I have had several questions regarding the impact of hyper-inflation on ordinary people. Steve Tierney, for example, asks about the social effects, but that goes beyond the remit I have given myself in this blog. I will let others consider such impacts. However, with regards to the economic position of individuals, this is more within my scope. The problem here is that the question becomes huge, and is not suitable for a brief answer. As such, I will apologise for not addressing this question at this time, and may discuss it later. I also need to look at a few case studies of inflation to have a better understanding, as my concern to date has been where and how we are getting there, rather than what happens when we arrive.

Note 3: ChasH asks the following:

'One thing continues to puzzle me though, and perhaps you can see your way to explaining it. China is our major creditor, but they have been lending us the money to buy that which they have produced. As we cannot repay the money, they have effectively given us the fruits of their labour. Moreover as we (i.e. the west) are their main market they have no one else at present to sell to. Is China then in just as dire straits as we are?'

The answer is both 'yes' and 'no'. China has particular problems, which is the potential for instability, which could see the country fall into chaos.

However, a good way of looking at this is to think of yourself in the position of Hu Jintao. He is seeing that his exporters are collapsing, and that the growth necessary for stability is dropping away. Set against this, he has huge piles of foreign currency, a strong position to spend to support his economy. However, he has a difficult problem.

All the while his economy has been growing, it has accumulated massive reserves of foreign currency. In order to enact a stimulus, he really needs to utilise some of these reserves in order to prop up his economy. However, in order to utilise those reserves, they need to be sold into the market place to buy, for example, the commodities that will be required in support of infrastructure projects. If China starts trying to sell those reserves, he is in a position where there will be a flood of the currencies onto the markets. That flood of currency will depreciate the currency, as there are not enough goods to be purchased in the currency, and likely little demand at this time to use the currency as a reserve. During the downturn, others will equally want to use their reserves to finance their way through the trouble, rather than accumulating greater reserves.

If we look at the $US, if this is sold into the market, and sees the resultant depreciation, then there will be further troubles for exporters. Although the RMB is not a free floating currency, if the $US depreciates, and the RMB does not appreciate, the US will (quite reasonably) howl with rage, and will take protectionist measures. If that is the case, China can say goodbye to one of the major export markets.

In other words, what China has done is accumulate currency that it dare not use as, if it uses the currency, it will destroy the currency. The only solution available will be to try to discreetly sell as much of the currency as it can without 'spooking' the markets.

The trouble is that, with so many countries holding these $US reserves, most of whom have their own economic problems, it is likely that everyone is having the same thoughts, and confronting similar problems. What you have is a situation in which there is something like a Mexican stand-off. As soon as one starts selling, then everybody must start selling. They are all, at the same time, terrified of selling, because in doing so, they destroy the value of what they are selling. It is a time bomb just waiting to go off.

As such, the answer to ChasH is that 'yes', China is in potentially deep trouble, as their best route out of their own problems will create a whole set of new problems. On the other hand, they are also in a position where, if they manage the situation well, they might be able to at least use some of the value in their reserves to ameliorate their internal problems. The question is how much, and whether they can pull off this fine balancing act - using the reserves without destroying them.

Like so much in the current situation, it is apparent that there are real contradictions, and that the situation overall might be described as a mess.

Note 4: I am afraid I have run out of time, so that will have to be the end of this post for today. The answers to the comments are a little rushed, so I hope they make sense.

Note 5: I note no comment from Lemming on my last post, which is a surprise - are you not in agreement with the post? If so, your comments are always welcome, even if critical. Also, I have not seen a comment from Matt in Shanghai for a while. As a person actually located in China, the subject of so much discussion, your thoughts on the situation would be welcomed.