In my post on the subject of this optimism, I highlighted that all of the indicators were negative, and wondered what might justify such optimism. For example, in the UK, there was a slight uptick in house prices, but I suggested that this was a false dawn. Since I wrote the post, house prices have continued their downward trajectory, though the rate of decline in prices is reported as slowing. Likewise in the UK there has been an improvement in consumer confidence, albeit from abysmal levels.
Perhaps the best summary of the optimism can be found in the Independent, with the headline 'US Recovery Hopes Grow Even as Economy Contracts 6.1%'. The article goes on to say:
US economic output contracted at an annualised rate of 6.1 per cent in the first quarter, almost as bad as the minus 6.3 per cent GDP figure for the final three months of last year, when consumers and businesses were reeling from the collapse of Lehman Brothers.The report went on to say:
Other "green shoots" in the report included a surprisingly strong uptick in consumer spending, which contributed 1.5 percentage points to GDP, where it had been a net negative for the two previous quarters. Information on the price of goods and services helped to ease the fear of deflation taking hold. And economists also dismissed an unexpected drop in government spending as temporary.However, we have this from the New York Times:
A day earlier, the government released figures showing an unexpected increase in consumer spending in the first quarter, offering one of the few bright spots in an otherwise dreary accounting of the country’s overall economic output. But the monthly report released Thursday showed that while consumer spending rose sharply in January, its gains tapered off in February and reversed themselves in March, declining by a larger-than-expected 0.2 percent.So what exactly is this optimism all about? Perhaps the best expression of the depth of the ongoing problems can be found in the actions of the Federal Reserve. In particular, the Fed is currently printing $1.2 trillion and using the money to buy mortgage backed securities and treasuries. Does this action look like an expression of confidence in a recovery?
The most odd part of the so-called 'green shoots' of recovery is the sudden surge in bank profits. An article in the Economic Times sums up the reality of the situation:
The first quarter results of US banks mean little. In early April, the US accounting regulator tweaked mark-to-market rules for bank assets in order to help banks show lower losses on these assets. These modified rules were applied with effect from March 15, allowing banks to show better than expected results for the first quarter.Quite simply, common sense should tell us that there is no realistic way in which the US banks can be returning to profitability. All of the US banks have massive exposures to the US economy, and every part of the US economy is heading in a downwards trajectory. How an earth can banks be making profits when real estate is falling, consumer spending is falling, insolvencies are up, unemployment is up and so forth...
The idea that banks can work their way back to good health simply by making profits hereafter is absurd. US bank losses are huge — the IMF’s latest estimate of US bank losses is $1.6 trillion. US banks have raised an additional $400 billion in capital so far, which means they need another $1.2 trillion to get back to normal health. For banks to cover this amount through profits would take years. Until then, banks will not be in a position to provide adequate .
I am increasingly of the view that we are departing ever further from reality. We are now living in a world in which insolvent banks that are living on life support from the government are apparently making profits.
I will freely admit that I have been increasingly puzzled by the optimism that is emerging. I have always accepted that commentators, analysts and markets can be somewhat irrational, but have always insisted that reality must at some point intrude. I still believe that reality will catch up with delusions, but have had trouble understanding the level of self-delusion that is taking place. I keep on wondering just what will it take for the underlying reality to sink in.
In the case of the UK, it is even more mysterious. The UK budget in particular painted an appalling picture of the state of the UK economy. In my post on the subject, I suggested that it would be interesting times for gilts and the £GB. However, the most recent gilt auction proved to be a success, albeit in a gilt that is part of the Bank of England's money printing purchase scheme. Meanwhile the £GB has gone through a roller-coaster ride:
Sterling fell against a broadly recovering dollar on Thursday after rising to a two-week high as initial optimism about the global economy petered out, even as share prices gained.I am starting to take the view that one of the problems must be that the paradigms being used in the markets is one in which the only reality is a belief in the inevitability of recovery. I suspect that, with no experience of a long term and sustained decline many people simply refuse to believe that such an eventuality is possible. Instead of asking the simple questions as I do, such as asking where the real wealth is generated, the markets hang on to figures which have no bearing on the broader reality. In this world an uptick in consumer confidence is a herald of recovery, a bank's profits are real even if they are simply an illusion. It is increasingly looking like drowning men clinging to anything that floats, even as the sharks circle round them.
An improvement in British consumer confidence had pushed the pound sharply higher, but news that U.S. automaker Chrysler would file for bankruptcy later in the day and data showing a fall in UK house prices weighed on the pound.
What I am in fact doing is dramatically shifting my view of the world. I am finding myself in a position where I must accept a new reality. That new reality is that self-delusion is a fundamental part of the human condition and that rationality is a very rare commodity indeed. I am currently ploughing my way through several books that deal with economics and psychology, as it is clear that my model of the economy is incomplete.
I have already found one interesting insight, which can be found in 'Predictably Irrational', by Dan Ariely. He points out that when making a valuation of something, we develop what he calls an anchor price. Through a series of experiments he shows that the first price that we see for an item becomes an anchor for valuations, and that it is very hard for us to adjust to a new reality, to adjust our perceptions of price. Interestingly, for some of his research he used bankers as his experimental subjects, though the principles he establishes have wider relevance. In particular it is possible to stretch his insight, and see that we might have made a broad brush evaluation of whole economies, so that we have a fixed view of the Western economies. We have anchored our valuation of the economy to a certain level, such that it is very hard for us to adjust to a new valuation.
Whilst this is stretching the findings, I do not believe it is over-stretching them. He is reporting an underlying factor in human thinking, and there is no reason to think that his examples of decisions about individual valuation might not apply to a broader valuation. As a non-experimental illustration he cites the example of a DVD player, which starts out very expensive, thereby creating an anchor price that is high. When we later buy a DVD player, when the price has fallen, we believe that we are buying a bargain. However, as we know with these kinds of goods, our bargain of today will still look expensive tomorrow. Perhaps what we are seeing in markets now is this kind of process?
Essentially, what we must take from these examples is that there is a reluctance to adapt ourselves to new underlying realities, and that our sense of value is 'sticky'. This in part may explain the stock market rallies of late, and similar rallies that took place in the great depression. However, as in the DVD case, there is no reason why valuation and therefore price will not eventually move, even if our perception of value is sticky. The question that this does not answer is exactly how that shift might finally come about.
On that subject, I am increasingly wary of making predictions....
Note 1: I only have a brief moment to reply to some of the interesting comments on the last post. As such, apologies if I do not reply to your comments.
Escaping Eastwards: You raise an interesting question which I will try to address in a future post.
Anonymous (who posted a massive comment): I hope that you take note of the comments of other commentators, and try to format your comments in a way that will better express your point of view. I publish all comments, but was not happy to publish your comment simply because of the format problem. However, I published anyway on principle. I will echo Lord Sidcup, and suggest that perhaps you might start your own blog? Gina, thanks for a great job of 'translation' on the comment. I would like to answer the comment, but it is rather a large subject for a simple reply.....
Lord Keynes: I am glad that you use the term 'neo-liberalism' rather than liberalism for the record of Labour. Liberal would not be an accurate description.
Chas H: In answer to your question, the problem for the future of the UK economy in the medium to long term is that we simply do not know what the politicians are going to do. As such, it is impossible to guess at outcomes. For example, it is always possible for a 'great' leader to emerge, who might lead the country back to economic strength. Alternatively, it is just as possible that a populist demagogue might emerge. As for the social consequences, I will leave that to other commentators, except to say that my view is that there will be serious problems.
Lemming: Maybe the 'reset' will be the default and collapse of the £GB? As I have discussed before, such a reset has a price....
Acrobat_747: The problem with your thesis is that you are looking at debt in absolute terms rather than relative terms. It is possible for a country to rack up debts if they have prospects of growth, or rather there is a perception that a country has prospects for growth. The problems arise when there is no apparent method for that future growth, and when the markets realise this. In the case of the UK, there is no such prospect for growth. My question has always been 'where will the growth come from?' On one occasion I asked this question on the Guardian's CiF forum, and nobody was able to come up with an answer. I have, to date, still not seen any explanation of where the growth might come from. If you have an answer, you might wish to add it in a comment. When I asked this question, I was asking for specific sectors, rather than answers that amounted to 'it will just happen'.
At the moment, the best case for growth I have seen is growth based upon a falling currency. This is not real growth but a process of adjusting to relative impoverishment. Whilst this may make the UK more competitive, it is done at the cost of reducing the cost of UK labour, and therefore reducing the standard of living of everyone in the UK. It is also not a form of 'growth' that would please holders of UK debt that is denominated in £GB. Under such circumstances, would you invest in the UK or in government debt?
This is why the level of debt is relative. The growth in debt in the UK can not be paid back, as there is no growth that can provide a route out of debt, or to continue to service debt. The UK is structurally unable to service debt without incurring more debt. This is a scenario of ever expanding debt, with no means of payment in sight. Quite simply the output of the UK economy can not pay for the consumption within the UK economy, and there is no prospect of this situation changing (unless you believe Alastair Darling). As Lemming said in a comment; 'I have to ask, are we really serious about getting out of debt?'
As a note, there is no reason why the UK might create a new technology or process and achieve substantial growth in this way. However, this is highly speculative. Why might the UK come up with such innovations? It has the same prospects as other developed economies, but no particular advantage over and above them. I am not sure that creditors would invest on the basis of such a 'hope'.
Tiberius: An interesting point of view. It is interesting to see such diverse perspectives on the blog.
Gone: You mention that people will continue to buy bonds as long as they believe that they can sell it on. That is a matter of confidence, and that in turn is a matter of belief in the stability and sustainability of an economy. Just because there are buyers now does not mean there will be buyers tomorrow. Even though the government is still having success in selling their debt, confidence is waning, and this can be seen in the rising CDS premiums.
I am afraid I have run out of time, and apologies for rushed responses.