The problem with the way that the blog is structured is that it is a cumulative argument. I therefore strongly recommend that newer readers take a look through the key posts that I have linked to (these can be found to the left of this). In the meantime, I have adapted what was originally going to be a quick comment in the comments section of the UK borrowing post.
The original post discussed how low interest rates were possibly leading to a reluctance of depositors from depositing money in the banking system. I pointed out that under normal circumstances these deposits would be made available for investment, and the government was therefore constraining the supply of capital for investment through such low interest rates.
The first point I would like to address is that two commentators quite rightly identified that I was simplifying the methods by which bank deposits are channeled into the economy. This from B33ENN:
This is not exactly as I understand the mechanism. Yes, the banks do use the reserves as a basis for lending. However, the banks actually use the reserves as margin for leveraged lending. In simpler terms, they create “new money” in the form of new loans by amplifying the reserves according to the fractional reserve lending criteria. So for example, if a bank holds £10 in saved deposits, it then can create a further £90 worth of loans. These loans then become “real money” in the economy flowing out through business and individuals who borrowed and then deposit it into more banks that repeat the exercise until you reach a maximum amount that can be created from that first £10.Lemming also commented to this effect. They have have both rightly pointed out that I have simplified the method by which deposits are turned into lending. I did not want to go into Fractional Reserve Banking (FRB) as this would distract from the underlying themes of the post, which was the centralisation of the government in the economy and where the government was actually finding the money to lend. In a sense they are right that this is unavoidable as part of the discussion, but I wrongly assumed that it did not need to be detailed. The point here is that deposits create the opportunity for banks to make further lending.
For readers who have never previously heard of FRB, I strongly recommend the (controversial) Wikipedia article here as an introduction, as it also includes the role of central banks (you may also want to read the heated debate that is linked to at the top of the article if you are really interested). If you have never heard of the system, it may come as quite a surprise, or even a shock. Another interrelated point that you may want to consider is the system of 'fiat money' which I discuss here.
The reason why these are important considerations is that they are at the heart of our economic system. In the case of FRB, we have a system which is inherently inflationary, through a continual steady expansion of the money supply by central banks (printing money if you wish), and through fiat money we have a system in which the value of money is almost entirely built upon confidence (which I discuss here- not an easy post, but stick with it) and which allows for unconstrained printing of money. It should be noted that printing money does not require physical printing of bank notes and minting of coins and quantitative easing is a process in which the process of 'printing' money goes into overdrive.
My argument is simple. Flooding money into the market in the manner of quantitative easing to create money for the government to lend to the banks, in order for the banks to lend to the government, business and consumers can only lead to currency collapse and hyper-inflation. Governments/central banks are claiming that they are doing so to avoid deflation, and I will address this question for the UK.
What the government is doing is massively increasing supply of the currency at a point in time when the external demand for the currency is in free fall. A large part of the demand for the £GB has been to buy the £GB in order to then lend it into the UK, and this source of demand is disappearing. Another part of the demand is as a reserve currency, but that status is diminishing with the weakening of the £GB (the two factors are related). On the other hand, there has not been much demand for the £GB as a currency to buy goods or services from the UK, something that can be seen in the balance of trade figures. Essentially, the value of a currency rests in supply and demand, and the confidence in the currency. The confidence element needs some explanation.
Confidence is a very difficult problem as it is possible for individuals and institutions to assign a greater value to a currency than underlying supply and demand would suggest that it should have. The loss of confidence in the £GB is seeing the £GB's value declining through loss of confidence, but that loss of confidence is rooted in the reality that the UK does not produce enough goods or services that people in other countries want to buy. In other words, individuals and institutions have realised that the £GB is not very useful as a currency to exchange for goods and services - there are many pounds in the market but there is little demand for goods and services that are exchanged in pounds. In the end the value of a fiat currency is determined by how many goods and services there are that people want to buy versus how many units of currency there are in circulation.
What has happened over the last couple of decades is that this principle has been forgotten. Demand for the £GB (and the $US - though the $US is a more complex case), has been supported by demand to lend into UK consumption. What has been forgotten by all of these lenders is to ask exactly with what the UK could produce to repay this lending. This error is now being recognised and what you then have is a situation in which investors are 'getting out of'' the £GB, as they recognise that there is simply not enough being produced in the UK to support its value. It is for this reason that the £GB is falling so fast. At the same time as demand for the £GB is falling there is a situation in which government creating more £GB at a time when there are already more £GB than the market wants. This is inherently inflationary.
The inflationary aspect of this is twofold. On the one hand all imported goods are going to become more expensive. In a massive simplification, there is a situation in which the UK currently does not produce enough goods that the Chinese factory worker wants to buy, such that his labour on a plasma TV can not be exchanged for any goods from the UK.
In order for UK consumers to buy that plasma TV, they must produce something with a commensurate value that the Chinese worker wants to buy. If they do not, then there is nothing to exchange for that plasma TV. The only solution to the problem is devaluation of the £GB. What this means is that the UK worker must work x number of hours more in order to be able to offer something in exchange for the plasma TV. In other words, the value of the labour in the UK must be adjusted to a point at which it can produce something that has sufficient value in exchange for the Chinese worker to buy.
What you are seeing in the change in the exchange rate devaluation is the value of labour between the UK and China moving to a new equilibrium. This example, of course, is just for the UK and China but needs to be applied across the global economy which, whilst more complex, does not change the underlying question of relative efficiency in the production of goods and services between economies.
Quite simply, the UK is not efficient enough at producing goods and services to continue to compete in world markets on the current exchange rate. This has simply been hidden through a false confidence that arose out of demand for the £GB to support lending into consumption. The illusion of the £GB was built upon a false confidence in the efficiency of the UK as an economy. It is actually not very efficient.
In light of this, the £GB can only continue falling until it reaches a new equilibrium that reflects the true state of the UK's efficiency in the production of goods and services. This problem can only be compounded by the production of more currency. The underlying value of a currency can be simplified as follows (ignoring investment overseas):
The total of goods and services produced in the country which have value in exchange with other countries divided by the units of currency in circulation.
In a fiat money system, if you increase the units of currency in circulation, without increasing the value of goods and services that you produce, the value of the currency must eventually fall. As such, in printing money, you create inflation on all imported goods and services. If you print with wild abandon, then you create massive inflation in imported goods and services. A simple case in point is oil, which has been falling in price around the world as demand for oil has been reducing. In principle, as a net importer, the UK should be seeing dramatic drops in the price of this input, but the reality is that the reduction of the cost of this commodity is ameliorated by the falling £GB.
Whilst the UK is seeing an absolute fall in the price of oil, it is seeing a relative increase in the price of oil in relation to countries whose currency is appreciating against the £GB. In other words, the UK is becoming poorer relative to those countries, even though it appears that oil is becoming absolutely cheaper. In practical terms, the UK worker must now work x number of hours more than a worker in another country to fill up his car with petrol (gas if you are a US reader). However, the falling price of oil is seen as deflationary by government and the central bank, such that their solution is to incorporate this in overall inflation, and print more money to prevent this deflation.
In doing so, they increase the supply of units of currency, the value of £ goes down further, thereby increasing the cost of oil imports, further impoverishing the individual filling up their car with petrol relative to a person in another country. Although the solution has prevented deflation within the country, it has also done so at the relative impoverishment of the person filling his car up with petrol. In this case the person is poorer as the value of his £GB has been transferred to the newly printed money.
The real question however, is how all of this will balance out. Will the fall in the £GB offset the fall in the price of commodities and counteract the fall in demand for a range of goods and services. I have argued that it is more probable that the plunge of the £GB will actually counteract the deflationary effects of contraction in demand through the increased cost of all imports. However this is not certain, as it depends on where the £GB will eventually settle. This in turn depends, in part, on the government.
However, a fundamental problem in all of this is whether deflation is a bad thing. For example, if the price of a loaf of bread deflates, is this a cause for worry? The answer to questions such as this largely depend on whether you are a saver or borrower. If you are a saver, you see the value of your savings increase in relation to the price of goods and services so you do very well in a deflationary environment. On the other hand, if you are a borrower, you see the value of your debt in relation to goods and services increase. This is very bad news for you. It is also unfortunate that so much has been done to encourage you into borrowing, and discourage you from saving.
If we look at the wider economy, there has been a problem that too many people have been borrowing for consumption, and not enough people have been saving. This is a problem. Deflation creates a situation in which individuals are motivated to pay down debt as fast as possible, and people are encouraged to save. This would represent a dramatic shift in the balance of borrowing and saving, and arguably a shift that would rebalance the economy away from being consumption driven to being driven towards saving and investment.
The counter argument is that this deferral of spending will create a self-reinforcing downward spiral of the economy, where nobody is producing anything due to lack of demand, as everybody is saving or paying down debt. However, if the economy has been balanced to much towards borrowing for consumption, and has therefore become imbalanced (the crux of my argument), then surely this is exactly what is needed. If the only thing supporting large parts of your economy is rooted in unsustainable borrowing, then the only solution is that the parts of the economy that have been artificially supported by that borrowing driven consumption must be allowed to be destroyed. They could not be sustained in any case. Deflation is just a mechanism of rebalancing.
Deflation would also have the effect of creating greater savings. In so doing the capital base of the financial system would effectively be fixed, but painfully so. Those banks that were overstretched would go to the wall, creating a period of further crisis. However, the surviving banks would end up accumulating capital, and would then be able to divert that capital into the process of economic recovery. With the £GB having fallen, and the true efficiency of the UK economy reflected in the realigned £GB, many new potential areas of business would once again become potentially competitive. Such new businesses will need capital in order to grow.
As such, B33ENN was correct when saying that if the government did not act as it is, there would be huge asset liquidations. Where he is wrong is that the government has the capability to save the economy by acting as a guarantor through printing money and borrowing. The fundamental point is that the current crisis is about the fundamental state of the economy, the inability to produce enough goods and services to exchange for our massive levels of importation of goods and services. It is the massive imbalance in the economy that is the problem. The real problem with the deflationary solution is not that it would lead to a rebalancing of the economy away from debt fuelled consumption, which is any case essential, but that it would do so in a very painful way. This is politically unacceptable, but absolutely MUST happen.
We then have to ask ourselves what will happen with the borrowing and money printing solution. As I pointed out in my last post, the banks are now offering interest rates that are a deterrent to saving. As such, the only way to fill the hole in bank capitalisation is through the government providing that capital. However, the government must either print money, causing inflation and further disincentive for saving, or borrowing. How can either of these solutions possibly help in rebalancing the economy away from consumption? On the one hand the money printing will further devalue the £GB, but that would in any case happen with the £GB falling to its natural equilibrium value. It would not really have any impact on the reduction of the value in relation to the equilibrium, it would just be a further devaluation for devaluation's sake. In other words, it will not change the equilibrium which is determined by relative efficiency in creating goods and services for exchange versus the number of units in circulation.
Printing more money just changes the number of units, not the equilibrium point.
In addition we need to remember that, as I have pointed out in many posts, the creation of fiat money in this way is a transfer of value from the existing money supply onto the new money. As such it is a form of taxation. In this situation, the government is both pointlessly devaluing currency and also massively increasing the tax burden in a time of economic crisis. In doing so they are impoverishing every investor, and every saver. The only result of such activity is eventually to kill investment activity, and create capital flight. Available capital and investment is the long term solution to the crisis, and will be needed to restructure the economy.
As for borrowing more money, the problem arises (as I have endlessly pointed out) that borrowing for consumption today (which is what the borrowed money would primarily be used for) means a contraction at some point in the future. In other words, it will delay the contraction now at the cost of a greater contraction in the future.
My argument is that what all of this money creation and borrowing amounts to is an attempt at pretending that the economy is actually still producing enough wealth to support the UK's high standard of living. Whilst the economy was previously built upon consumer borrowing, the government is seeking to replace the position of borrower and spender. One of the comments of B33ENN was the traditional role of central banks is to be the lender of last resort. In this case the government is becoming the borrower of last resort. What it is doing is pretending that we still create value in goods and services for exchange with other countries that we do not in fact do. Borrowing money is just a method to try to bury this reality.
In short, the UK has built an economy around consumption, and that consumption is built upon debt, and without the flood of credit into the UK, nothing is going to allow us to continue the service/consumption economic model. Whatever the government does, somewhere, somehow, there must be sufficient wealth creation to pay for the goods and services that we consume from our trading partners. Our trading partners have (foolishly) been extending credit to us for a long time. That has stopped. No amount of government intervention is going to prevent reality from emerging.
Whatever the government does, the bankruptcy, unemployment MUST happen, as the basic shape of the economy was directed towards unsustainable consumption built upon debt provided by wealth producing economies.
The government can guarantee all kinds of things, but in doing so the government will just transfer the damage from private companies and individuals to the government, making the government ever less solvent. The government can, of course, just keep printing more and more money to address this. However, in doing so they just destroy the value of money, and this MUST lead to hyper inflation. If you doubt this is the case, you may wish to read this article in the Telegraph. Quite simply people are losing their confidence in money, even in the 'mighty' $US. In the case of the article, the rich are moving into having physical holdings of golds - literally buying gold as an 'in the hand' physical asset. The rich have the ability to get sophisticated advice on how to invest their money, and are therefore in the vanguard of the collapse in confidence.
The whole point of this blog is to point out that there is something fundamentally wrong in the UK economy. It is no longer able to generate the wealth to support itself at the current standard of living. As such I was surprised to see B33EN suggesting that the government can somehow turn back economic reality. He is not alone in this. Many clever economists are effectively telling us that you can create something from nothing, but at some point the illusion must disappear. Creating money from thin air does not create value, it transfers value. At some point, somehow, you have to create value, and that means engaging in activity that creates something - wealth creation through selling goods or services that our trading partners want.
We are simply not doing enough of this. How can government guarantees, borrowing money, and printing money change this reality?
B33ENN is falling into the trap that many mainstream economists fall into, by looking at the situation as if it were complex. It is not. It is very simple. A strong economy is one in which you create things that others want exchange with you. Without that, there is nothing.
Government can not make wealth. It can not produce anything, it can only spend the money of those that create wealth, which is those who create something with value in exchange. The only role government can have in wealth creation is to set up an environment in which wealth creators can thrive. Destroying the value of money is not such a situation, and nor is the taxation implicit in money printing. It is simply a way of pretending that the fundamental problems do not exist. If you do not sell enough goods and services that people want, eventually they will not want to sell you anything, as you do not have anything they want in return.
It can not be put more simply than this. All the rest is nonsense. All the rest is window dressing that hides this reality.
It has been a bit of a meandering post (again), but as usual I have simply been writing my thoughts as they occur to me. I hope, however, that this makes sense. I hope that I have illustrated that any illusions of endless government interventions is just (at best) a delaying mechanism. The economy must change, and that change will under all circumstances be painful. I am not sure that I have given the post a good title, but I hope that it is roughly right.
Update to the Post: 14 January 2009
I mention a couple of times in the post that the fundamental problem of the UK economy is that it is just not very good at the creation of goods and services that other countries want to buy. The result is revealed painfully in this Telegraph article:
The trade gap ballooned to £8.3bn from £7.6bn in October, the highest level since records began in 1697, reflecting the fact that Britain is importing more from other countries than it is exporting. Economists had expected the deficit to narrow to £7.5bn because of sterling's sharp slide in the final few months of 2008.This is a reflection of the underlying problems in the UK economy. Just as poor economic conditions expose the weakness of companies, it is the same with the economic position of countries. Even with a sinking currency, we are still importing more than we are exporting. However, we should also remember that there will be a time lag from currency change to the shift in the balance of trade. As such, whilst these figures probably reflect the exchange rate of the £ a few months ago, rather than now (e.g. in long supply chains, there will be delay before contracts expire, and new contracts sought)
A Note for one of the Regular Commentators, Steve Tierney: Steve, apologies but your post appears to have been lost by the Blogger system. I have had no email notification (I have checked through my inbox), and there is nothing in the system. Please be assured that your comments are seen as a welcome contribution to the blog, and I would not, in any case, not publish just because someone said something that I did not 'like'. As such please accept my apologies.
As a general note to all readers, I publish all comments provided that they are not spam, do not use bad language and...that is pretty well it. I am a follower of the political philosophy of Mill's 'On Liberty' on the issue of free speech, so do not undertake any censorship. Bad language is unacceptable, as it is unnecessary to express a point of view but can be offensive, so this is why this would not be published. Spam is deleted as it is just using the site for advertising for which the writers do not wish to pay, and adds nothing to the site.
I have had a complaint from a person for deleting a post which I believed was spam. I flicked through their very long web pages, and found that they were recruiting individuals into some kind of new form of investment. I read no further, and the person has complained that I did not understand what was written. My answer is simple - any offer of any kind of investment requires the capital of individuals. It is therefore treated as spam.