Thursday, February 26, 2009

Obama's Budget - From where will the money come?

The news at the moment might be described as worrying. Today, we have the story of the 'Obama' budget, which is simply quite staggering. The link I have provided will take you to the Times version with plenty of detail, but I rather like this from the Telegraph, which illustrates the scale of the spending:
If the $3.552 billion budget is divided between all 138,893,908 American taxpayers – the 2007 US Internal Revenue System figure, the latest available – then it will each one $25, 573.48.
The Republicans are up in arms (despite their own prior fiscal incontinence), with their concerns ranging across many areas. However, their focus appears to be on taxation, rather than the idea of deficit spending (Ron Paul is a notable exception).

Inevitably - the promised return to shrinking deficits is apparently going to happen at some point in the future. In order to achieve this, there is very little detail:
Mr. Obama’s first budget was light on proposals to cut spending, despite his statement at the White House on Thursday that the government would be “cutting what we don’t need to pay for what we do.” (NY Times)
Of particular interest as illustration of the lack of clarity is that one of the ways proposed for balancing the budget is to increase taxation on higher earners. This raises a question of how many higher earners there will be, and how much they will be earning, as the economic shake-out progresses. The news reports do not give the details of how calculations have been made, but I would guess that such 'details' have not been considered. For example, this is from the NY Times:
He says he would shrink annual deficits, now at levels not seen in six decades, mostly through higher revenue from rich individuals and polluting industries, by reducing war costs and by assuming a rate of economic growth by 2010 that private forecasters and even some White House advisers consider overly rosy. [italics added]
In other words, the return to fiscal continence looks rather improbable. Perhaps the most worrying part in all of it is the proposals to tax business and increase business costs:
He would remake the energy sector to reduce reliance on foreign oil and address global warming, by requiring industries to buy permits to emit the heat-trapping gases that contribute to global warming. The revenue would pay to develop alternative energy sources and to provide tax relief for Americans facing higher prices from utilities and industries passing on their permit costs. (NY Times)
At a time when the US is on its metaphorical economic knees, this is a proposal to increase the costs of businesses that provide employment. Whatever your views on man made global warming, such action will have an impact on those industries, and will see their competitive position erode, and the businesses that rely on such industries erode in many cases (e.g. if US energy costs increase, so will the cost of steel produced in the US).

Above all else, on top of all the other borrowing and activity that has been undertaken, there is an assumption that the money will be available for borrowing. The US has managed to continue to fund its borrowing due to the 'flight to safety' towards the $US, but Hilary Clinton's visit to China with a begging bowl clutched in her hands illustrates the fragility of the situation.

Regular readers will know that my belief is that a situation of the world (and in particular China) continuing to fund US deficits looks ever more improbable. What we now have is the US attempting to raise $US trillions to finance government, the same in the UK, the same across Europe, the same in many places in the world. Governments across the OECD are going on a binge of borrowing and spending. If we then think of the creditor countries, the countries that potentially have the savings to fund such borrowing, we see that their priorities are to deal with their own troubles.

China and Japan are both in a situation in which the rapid contraction in exports are hitting them hard, and they need to rapidly act to restructure/transition their own economies away from exports. As an article in the Economist points out, there is severe pain in the Chinese industrial heartlands, and a Chinese government fearing social disorder. This is a government that must use their own resources for their own needs, not use the resource for further lending into collapsing world economies. At this point I will digress slightly, as I have seen a contrary view from an individual whose views I respect. Niall Ferguson has the following to say:
The line is very clear from China. They've consistently made their position clear. They want the status quo. They do not want this thing to break down. They were kind of appalled when Geithner said the ‘m' word. And they took full advantage of Hillary Clinton's visit to smooth ruffled feathers and restate their commitment. It's a very good bilateral relation. That bilateral will is important here. The Chinese believe in Chimerica maybe even more than Americans do.
As for my views on the situation, Niall Ferguson believes that China and the US are locked in a perverse economic embrace. However, we differ in the belief that the embrace can be maintained. My reason for disagreement is that, even if China pours more money into the US, an insufficient amount of that lending will be returned to the US through consumer purchasing of Chinese goods, as the wallets of US consumers are snapping shut. In addition the US is printing money, and the possibility of repaying debt in anything other than more useless paper looks increasingly improbable. In such a situation, China is giving large amounts of output for free, and that will in any case be unsustainable.

With regards to Japan, I find the country quite a puzzle to understand. Whilst familiar with Asian culture, and Japanese business, I find the country as a whole a genuinely difficult one to understand. I promised an article on Japan long ago, but never managed to have enough confidence to plunge into the muddy waters of this subject. Some things we do know, which is that the Japanese export machine is grinding to a rapid halt, the economy is falling off a very big cliff, and the only salvation for Japan is in the huge savings of the Japanese individuals. I have read somewhere (sorry no reference) that the Japanese have started to eat into those savings to fund their day-to-day expenses. Again, in such a situation, it is hard to imagine that Japan will ride to the rescue of the West.

The big oil producers are returning to the hard realities of life in an environment of cheap oil. Even in December 2008, there were reports of problems in the finances of Saudi Arabia (although their problems might be considered slight when viewed against the problems of the West), and reports of diversification of petro money away from US treasuries in November of 2008. I believe that I have also given some further examples of an increasing cynicism towards Western investment in the last few months in several articles. As a source of finance, the petro economies look unlikely to be willing to dip into their deep pockets.

For Germany, it has its own problems due to falling exports, and is faced with the potential for disaster in the Eastern and Central European countries turning into massive losses across Europe, as well as the troubles in the evocatively named PIIGS countries (Portugal, Ireland, Italy, Greece, Spain). As a result, the future of the Euro is starting to look threatened (something I discussed as a possibility long ago), and Germany will be focusing resources into their own troubles as a priority, and the Euro area troubles as a second priority.

The essential problem is this. All around the world, economies are in free fall, and resources directed to problems at home will be the absolute priority of each country. In such circumstances, the possibility of countries being able to finance their deficits through overseas borrowing looks to be so unlikely that it remains close to impossibility. In the case of the US and China, the Ferguson thesis looks to be the best explanation for how lending might occur, but the insanity and unsustainable nature of the imbalance must be apparent to China. I just do not believe that they will continue to finance US profligacy in return for increasingly worthless pieces of paper. However, I can offer no clear evidence for this, though I have previously posted articles in which China has been hinting at their unwillingness to do so.

Regular readers will have noted my continuing campaign for clarity on the Bank of England's policy on quantitative easing (QE, printing money), and my suspicion that the Bank will be using this to directly fund government operations. I have not, as yet, looked as closely at the situation in the US, and will look at this in the future. However, bearing in mind that there just does not appear to be the money 'out there' to borrow, my suspicions that the US government is doing a 'Zimbabwe' is very strong indeed. Further discussion to follow....

Note 1: I had a comment from 'Red' pointing out that I am putting flies in the ointment in my requests for clarity on the BoE policy on QE. As one anonymous poster put it, better to get the truth out sooner than later, before the real damage is done. Another commentator suggested that I am fear mongering. To this I would respond by saying that, rather than fear mongering with no justification, I have sought to gain a clear understanding of what the BoE is up to. As such, I am giving them the opportunity to assuage my fears, and hopefully the fears of those who share my concerns. Their evasion to date suggests that they have something to hide. I have today sent an email asking them to acknowledge my email, and am still awaiting any replies to my questions. We will see...

Note 2: ChasH has sent a letter to his local Conservative MP, and received a reply. The reply really says very little at all, and as ChasH points out, it looks remarkably like a 'form' letter. The letter can be found at the bottom of this post in the comments section, and I would be interested to hear if others have had similar replies. It is a little worrying that the reply appears to be so complacent and could be summarised as 'wait and see'. As I have stressed, this may be the most radical economic policy every undertaken, and we have no idea about any details of the policy....

Note 3: I have had some interesting comments on my article on deflation, and can not reply to them all. However, I would like to some points.

A few people have suggested that division of a unit of currency into smaller units is expanding the money supply. This is a very different process, as you are not changing the number of units of the actual currency. If we were to imagine that we followed the idea of a fixed money supply, and imagined that we froze it at £1000 units of currency (for the sake of illustration), we could have the following:

We start with £1 units of currency with a total of £1000 units as £notes. As deflation occurs, we subdivide the currency into each £1 = 100 pence. In practical terms, if we imagine that £1 at the start buys 1 litre of milk, and as deflation occurs it is not possible to use that £1, because the price of milk is now £0.5. We have a problem. How can we exchange the currency for the milk, if we only want 1 litre? We can now only exchange the £1 for 2 litres.

To overcome the problem, we are not diluting the value of the £1, we are merely allowing it to be chopped up into smaller units, for example coins. If you hold a £1, the £1 will still buy 2 litres at £0.5 each. Alternatively, if you decide to exchange your £1 for 100 pence in coins, the £1 will be replaced by 100 pence. Any holder of £1 is not losing anything, as this has absolutely no effect on the £1 that they hold. The important part is that, as the new units are called upon, each 100 pence issued sees the removal of a £1 note. The money supply remains the same, and is always equal to £1000. At any time in the future, although it would become an increasingly impractical unit, you could return to a bank, and exchange the 100 pence back into a £1 note.

However, if you want to really increase the overall supply of money, you would print £1 notes. In this case, every holder of £1 sees the £1 erode in value, because there are now more than 1000 £1 notes. When the new £1 notes are printed, some of the value of those notes is transferred to the new £1 notes. In this situation, if we start with our £1 litre of milk, and more £1 notes are printed, there are more £1 notes chasing the milk, and the price of milk goes up, thereby reducing the value of each £1 in exchange.

The example I give uses physical notes and coins for ease. However, if we think of this in terms of electronic currency, in terms of accounting, large numbers of pence will still be accounted for as £s. All sub-units of currency are measured against the fixed number of £1000 that were there at the start. That number never changes. Whatever happens the number of 1000 x £1 never changes.

I hope this answers the question? Let me know if not.

On a related issue, I have had comments on the fact that this is another fiat currency. The answer is both yes and no.

It is not fixed against an individual commodity, but is fixed against the total output of an economy. Fiat currencies make this claim, but the ability to increase the units means that they can, and actively do, produce more units of currency than the growth in the value of output. In fixing the units of currency, you fix the value of the currency against actual output of value. If output increases, then the value of the currency increases, and if output decreases the value of the currency decreases.

As such, in the example I have given, each £1 = 1000th of the total output of the economy. In normal fiat systems, each £1 = 1000th of output but we would have to add that it would need the proviso that the value would be a feature of time, such that the value is determined not as fixed, but as measured against time (inflation). In other words, the value will become £1 = 2000th of the value of output at some stage in the future. In the fixed money system, whatever happens, £1 = 1000th of the total value of output.

I hope this is clear...

With regards to commodity currencies, they also have inflationary potential (e.g. new gold source found) but are better than ordinary fiat systems, as they create some kind of constraint on the expansion of money. Moreover, they offer a default value as a contract, such that whatever happens you can exchange this money for x amount of gold. A standard fiat currency simply implies that at some point in the future, it may be exchanged for 'something', including another unit of the same currency. However, as we may be about to find out, it may be useless to exchange for 'things', because the value is destroyed by oversupply of units of money. In the case of the fixed money supply, there is a contractual commitment that (staying with the 1000 unit example) you will be able to exchange the £1 for 1000th of total value of output. That is a strong contractual commitment.


  1. Additional Note for Steve Tierney:

    Steve, regarding your offer of a forum, another commentator 'Tiberius' has mentioned an interest, so I am happy to play a part, if you are still interested. Thank you for your offer.

  2. Another Note: I have just checked the Yahoo mail account for the blog. Alan, thanks for your comments.

    I also found an email from Don (many thanks), who has provided an reply from Mark Hoban MP (Conservative) regarding QE policy. It seems to be very, very similar to that sent to Chas H.

    It looks like the Conservatives have an official response prepared, and that response does not include asking difficult questions of the Bank of England.

    I have become more and more worried about this issue. I find myself even more worried.....if the opposition are not willing to ask the questions, who is?

    Or do they already have the answers?


  3. The important part is that, as the new units are called upon, each 100 pence issued sees the removal of a £1 note. The money supply remains the same, and is always equal to £1000. At any time in the future, although it would become an increasingly impractical unit, you could return to a bank, and exchange the 100 pence back into a £1 note.

    Thanks for this explanation. I can see now that this is the crucial point I did not grasp. It was entirely my fault in failing to understand it.

    Thanks again for giving an in-depth description of the system.

    A very interesting overall post by the way!

  4. In your 1000$ system. If that country, keeps exporting 50$ of goods while importing 100$, then the whole amount will be out of there in 20 years.

    The only way to do it, is to do it globally. Guess where those 1000 global $ will end up again.


  5. Inflation (in a democracy) is required in the current paradigm, the alternative is lackluster future development.

    would you give up the last 60 years of progress in return for a stable economy and the risk of stagnation for the next 100 years?

    On another note: all capitalist democracies will run a deficit, good luck to those governments that try to run a surplus when they try winning the next election...they'll need all the luck they can get.

    Good capitalists will usually vote for the party that gives them (the individual) more than the other party, unless they're scared of course then they'll go for whom ever offers a cure (real or imagined).

    The worst thing is that in just the last 15 to 20 years our technology has reached a sort of "critical mass"
    where some (not all) of the fundamentals underpinning these ideas/methods of nation building can be brought into question, we need new paradigms, but everyone just goes back to the same old ones...the new millennium indeed!

  6. Just an observation on the party politics of the UK debacle & the Tories' response.

    All the conservatives have to is wait. No difficult questions, no big pressure to get rid of Brown. This massive lump of a crisis is tied to the foot of Labour and will drown them for ever, with just a bit of patience...

    If they stay bland, they can't lose. The last thing the Tories want is to inherit this mess prematurely, like poor old Obama ...

  7. I have not, as yet, looked as closely at the situation in the US, and will look at this in the future.

    You would do well to listen to these podcasts featuring Andrew Gause

  8. And you thought you were running out of stories to comment on? ;)

    As far as China is concerned, their January trade surplus was at $40bn which was almost a record, considering that Japan's exports tanked it's fair to assume that China's surplus for this year will be at around $300bn. With the lower oil price the Middle East will have little money anyway to invest in US Treasuries.
    Jim Rogers recently said during an interview that he covered his shorts of the US bonds 'because of Mr Bernanke'.
    Which would also explain why the yield is still so incredibly low on the ten-year-bond (3%).
    How much money is there sitting on 'the sidelines' anyway? 2009 year's spending seems like utter bizarre and totally mad. I wouldn't lend any of these governments any of my money but the big players need to get somewhere as they can't hold cash due to inflation, but which asset is there?
    All I can say is that I'm fully spending my student loan, no point in saving if it's going to be inflated away in a couple of months...
    If I had savings I'd get into gold, hold out until properties in quality areas plunge and get in there.

  9. China goes shopping. They found something they want in Germany and Germany gets to keep it's automobile industry, at least for now. Let us see what they'll buy in the rest of the trip.


  10. Could such a divisional currency be backed by digital gold?

  11. Taxing the rich at 100% won't pay for Obama's budget. The Wall Street Journal has reported that taxing the rich at 100% won't pay for Obama's budget. Barack Obama promised not to raise taxes on anyone making under $250,000 per year. Where is he going to get the money? The numbers indicate Obama will need to take 100% of the income of everyone making over $75,000.

  12. Will you blog on Europe west/east sometime.Difficult as this is.We dont see much re total debts,liabilits facts and figures as to the euro zone in total.

  13. Brutal stuff from the Telegraph:

  14. The money will come from IOUs till Asia says no.


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