Today, however, I will briefly move away from these subjects, and will postpone my post on central banking. The reason for the diversion is that I have seen some interesting news today, and I have kept in mind a question on a recent comment on a post from 'Jonny'. The post Jonny commented on was made about 2-3 weeks ago, and I said the following:
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.Jonny asked what drove me to such a conclusion, and I am hoping that the reason for my concern has since become apparent. However, it should be noted that this, like any prediction, is a matter of my being confident, not certain. There are no certainties in these situations, but there are likelihoods. In the meantime events appear to be bearing me out.
The first point that supports my contention is that one of the factors in the collapse that I have proposed was the possibility of some governments being unable to continue to borrow. I have mentioned several factors here, such as the fact that, at this moment in time, governments all over the OECD are massively increasing their borrowing all at the same time. In this situation, it is apparent that there will be competition for a finite amount of money, and only the economies judged to be the strongest will win. I have pointed out in previous posts that the UK will not inspire the confidence of lenders. This returns me to the news that prompted this post.
The most interesting thing about Spain is that the Spanish banks are in difficulties, but are in much better shape than the UK banks. The Spanish economy is falling faster than the UK, but Spain is a Euro economy such that its currency is not vulnerable in the way that the £GB is vulnerable. Unlike Spain, therefore, the UK national currency is subject to the state of the UK economy.
The ferocity of the downturn has led to a sharp jump in borrowing costs for the Spanish state, which lost its AAA credit rating from Standard & Poor's last month.
A €7bn treasury auction of 10-year Spanish bond on Tuesday saw yields jump to 137 basis points above German Bunds, a post-EMU high. Foreign investors were conspicuously absent, leaving Spanish banks to soak up the debt.
As an aside, I long ago suggested that the cohesion of the Euro might be strained as the economic crisis progressed, and there have been an increasing number of articles recently mirroring this view. I still believe that the Euro may not come through this crisis, and think the likelihood of either a partial falling apart, or complete abandonment of the Euro is possible. We could yet see the return of the mighty Deutsche Mark. As such, if you hold any Euros, make sure that they are held in a German bank in Germany....
Returning to the UK, for a long while now, I have been arguing that the UK is seeing a money-go-round, in which the government finances the banks, and then the banks finance the government. This can go on for a while, provided that others outside of the money-go-round are stepping in with at least some financing. However, in the current level of competition between countries to win over lenders, the UK is going to be seen as a relatively poor risk. I do not think that the UK is going to win in the competition for financing, and the Spanish experience illustrates this. In particular, lending to Spain does not have the same level of currency risk as lending to the UK.
Meanwhile, we are already seeing the UK adopting a policy of quantitative easing - or money printing - and this of itself makes the £GB look very vulnerable. Added to this are the ever greater open ended liabilities being taken on by the government, and the rapid accumulation of reports saying that the UK is going to be one of the worst hit countries in the crisis. Just for good measure, you can add in a dose of negative sentiment, such as that expressed by Jim Rogers. The real question is this - given a choice, would you put your money in the UK at the moment? In other words continued financing for the UK from outside creditors looks unlikely.
There are two ways that this can play out. The first is that, at some point in time, the money-go-round will be unable to support a government sale of debt. There will be no other lenders wanting to step in, and without being able to raise further money the government will be bankrupt, and the £GB will fall.
The second is that the UK government starts to fund itself directly through money printing, or sees the crisis coming and speeds up the printing presses to inject ever greater money into the money-go-round. In this event, at some point, somebody will notice the impossibility of the ability of the government to endlessly finance itself by borrowing from banks that are themselves insolvent - and reliant on government lending to keep them afloat. It will become apparent that the government is, one way of another, increasingly reliant on the printing presses to fund itself, and the £GB will fall.
Perhaps the greatest indication of the severity of the situation for the UK was that Gordon Brown felt that he needed to defend the UK against the charge that it was 'the next Iceland'. That a prime minister feels that there is such a necessity is a clear indication of the state of the economy is very, very fragile indeed. Another indication of the state of desperation is the official UK change of status of Tibet to a status that appeases China. As one article points out, a cynical interpretation of such an action would be that the UK has 'sold' the status of Tibet - in other words this change of policy has been exchanged for a better prospect of continuing Chinese credit for the UK (possibly indirectly by ensuring that the IMF is able to fund a UK bailout). Whatever might be thought of Gordon Brown, I do not think he would make such a move except in extremis. The question that this raises - has he purchased a breathing space?
If he has, then it may be that China will step in with the finance when needed, but we will see. Such factors are not visible, and this is why nothing is certain.
So far I have just been looking at the UK. In the case of the $US I have devoted a whole post to the vulnerability of the $US, so will not repeat it all here. Instead, what I will note is that the tensions of issuing endless $US are starting to show. At Davos, Putin was calling for an end to the $US hegemony, and China is increasingly taking a negative view towards the endless issue of $US. Add in the war of words started by U.S. Treasury Secretary Tim Geithner on China's currency manipulation and you have a heady cocktail. As a final problem there is the ever more controversial 'Buy US' measures that are looking to be included in the US 'stimulus'.
What this is starting to point to is the inevitable 'showdown' that I have identified at many points in this blog. The US can not allow China to continue to subsidise exports, but in order to confront China the US risks China selling some of the massive $US reserves into the market . If China starts this sale, the $US will collapse. The tension that is inherent in the current system must come to a resolution at some point. However you look at it, it is impossible to sustain.
This is the actual situation. The US needs overseas finance to continue to fund government borrowing and those borrowing requirements are increasing. At the same time, the US government is printing money, such that they are diluting the value of all $US holdings. Those $US holdings are already unusable, because if they are sold, they might precipitate a $US slide, thereby destroying the value of the holdings. If the lenders do not continue to lend, then the US government will be unable to fund its borrowing requirement. If the US can not fund its borrowing it must either print ever more money, or default. Both will destroy the value of all $US assets, of which the creditors to the US hold monstrous amounts, and amounts they must increase to support the value of the $US.
The US is presenting the world with the choice of continuing to lend in return for paper whose value will decrease, or not lending and seeing the value of their current $US assets fall. Both sides are locked together - the US and their creditors are tied together in a very uncomfortable embrace.
If we see the argument between the US and China over currency manipulation in this context, it is possible to see that both sides are about to fight on the edge of a cliff, with both sides likely to fall off the edge of the cliff if they put a foot wrong. However, knowing that the cliff is there does not mean that they will not enter the fight. China needs to keep the export machine turning to save its economy, which means that the US will see the imbalance of trade and hollowing out of its economy continue. If it allows this, then the ability to ever service the debt will become ever more impossible. On the other side, China must continue to accept ever more useless $US assets to support the irresponsible and profligate spending of the US government.
Quite simply it is all madness. It can not continue. The whole situation is fraught with contradictions. The war of words between the US, the rise in protectionist measures all point towards a climax. The collapse of the £GB, I believe, will be the push that gets it all started. When a major economy, with a similar underlying economy to the US, fails it will be the shove for people to revise their view of the sustainability of current contradictions. The UK is just such an economy and is an economy on the edge of failure.
What we have in essence is a situation which is impossible to sustain. It is just a question of 'when' rather than 'if' it unwinds.
I have to emphasise that nothing is certain. The direction at the moment does point towards a climax, in particular as every side is starting to absorb the horrible nature of the problem. I have no doubt that the various sides are talking and trying to find a solution in which the contradictions resolve without disaster, but can see no such solution myself. It is always possible that a compromise will be made which will delay the collapse, but delay is the best outcome that I can see from a compromise - and the cost of delay will be a greater problem later.
However, I may be wrong. Maybe there is a solution to the impossibility of the current situation, a way to unwind the imbalances without pain. If so, then it needs to be found fast....