Monday, August 31, 2009

The Dire Position of the US Economy

Yes, cheer up everyone, the 'Great Recession' has come to an end. Or so says the New York Times, in yet another positive article:
Even as evidence mounts that the Great Recession has finally released its chokehold on the American economy, experts worry that the recovery may be weak, stymied by consumers’ reluctance to spend.
Here we go again. The 'mounting evidence' that all is well in the world after all. The problem is that, having told us that all is well, the article goes on to say the following:

Given that consumer spending has in recent years accounted for 70 percent of the nation’s economic activity, a marginal shrinking could significantly depress demand for goods and services, discouraging businesses from hiring more workers.

Millions of Americans spent years tapping credit cards, stock portfolios and once-rising home values to spend in excess of their incomes and now lack the wherewithal to carry on. Those who still have the means feel pressure to conserve, fearful about layoffs, the stock market and real estate prices.

So what of the recovery? With consumers quite reasonably digging in their heels and refusing to spend, and consumer spending having been 70% of economic activity, where exactly is the recovery coming from? The basic contradiction between the opening of the article and the content is completely lost on this author. He even highlights one of the artificial props to the so-called recovery, writing:
In recent weeks, spending has risen slightly because of exuberant car buying, fueled by the cash-for-clunkers program. On Friday, the Commerce Department said spending rose 0.2 percent in July from the previous month. But most economists see this activity as short-lived, pointing out that incomes did not rise.
If this is a recovery, then I would really like to see how they might define a bad economic situation. As such, a brief review of some of the highlights of the US economy....

Let's start with the banking system. It is all tickety boo, is it not? The first problem is that, at the commanding heights of banking, there are the zombie banks with portfolios filled with toxic waste. Whilst the world appears to be sunny, this is largely down to the accounting fiddle of FASB 157 (Financial Accounting Standards Board), in which the standard of Mark-to-Market standard 'fair value' of assets was watered down. What this means in plain English is that the valuation of assets has been moved from being what they can actually be sold for in the open market, to what they might be able to make if the world was a wonderful place again.

The excuse for this change to the rules was that there was no market for the assets, due to a collapse in banking liquidity...but even at the time of the change, there was a massive pool of liquidity 'out there', for example in sovereign wealth funds (who are estimated to have over $US 3trillion in assets). If the toxic waste on the bank balance sheets were of any value, then there were plenty of potential buyers out there, so there has always been a market for these assets in principle. The problem is that they are junk, and the change to the accounting rules has simply hidden this.

As if this were not bad enough, the meltdown of retail mortgages is now going into the new phase, which is the rise of prime mortgage defaults:

The percentage of loans on which foreclosure actions were started was 1.36 percent, down from 1.37 percent in the first quarter, driven by the decline in subprime loans. New foreclosures on prime loans increased to 1.01 percent from 0.94 percent, while subprime loans dropped to 4.13 percent from 4.65 percent, Brinkmann said.

The delinquency rate for prime loans rose to 6.41 percent from 6.06 percent, and the share of prime loans in foreclosure increased to 3 percent from 2.49 percent.

To add to the misery to come, we have this from the Economist magazine (the chart referred to shows the growth in resets):
Just as worrying is the possible recurrence of “payment shock” as interest rates on adjustable-rate mortgages reset higher. Resets on subprime loans have mostly taken place, but the worst is yet to come for some other loans, especially the “Alt-A” category between prime and subprime and a nasty type of mortgage called an “option ARM” (see chart 3). The impact may be muted, but only if the Fed can keep short-term rates very low for the next couple of years—or if the borrowers can refinance as the reset approaches.
As a final addition to the nasty state of retail mortgages, there are new problems being stored up for the future, with Ginnie Mae racking up new dodgy loans:
This extraordinary resilience reflects the widespread political lust in America for subsidising housing. Anyone who doubts this should look at Ginnie Mae, another fully state-owned agency which guarantees and bundles mortgages, usually of below-average quality, that are insured by the government. Fannie and Freddie are now being conservative about writing new business, but Ginnie is enjoying its own bull market, issuing guarantees at a furious rate. It is expected to have a trillion dollars outstanding by next year. “We are seeing a gravitation of the subprime universe from Fannie and Freddie to Ginnie”, says Mr Setia. It will be a miracle if taxpayers get their money back from Fannie and Freddie. Worse, there is a chance the disaster will be repeated.
What this means is that there is an ongoing attempt to reflate, or at least stabilise the housing market, and the US taxpayer will be on the hook for the fallout. Without such irresponsible lending, the crisis in the housing market would no doubt be even worse, but the future liabilities are undoubtedly racking up.

Then there is the commercial real estate meltdown that is finally arriving. I have spoken about this in the past, but it has taken longer than expected:
Defaults of multifamily and commercial real estate loans from banks climbed to their highest rate since at least 2003, as lenders gave up hope of being repaid in full, according to a report by research firm Real Estate Econometrics.

The default rate of bank loans for shopping centers, office buildings, warehouses and hotels rose to 2.88 percent in the second quarter, up 0.63 percentage points from the prior quarter, according to the report released on Monday.

The default rate for apartment buildings rose 0.68 percentage points in the second quarter to 3.13 percent.

The results of these ongoing crises is an endless stream of bank failures, with many more to come yet. The Federal Deposit Insurance Corporation's (FDIC) latest report makes ugly reading, and there is widespread speculation that the solvent banks will shortly be tapped for huge sums of money to fund the depositor insurance for the failing banks.

Bove said the FDIC will likely levy special assessments against banks in the fourth quarter of this year and second quarter of 2010.

He said these assessments could total $11 billion in 2010, on top of the same amount of regular assessments. "FDIC premiums could be 25 percent of the industry's pretax income," he wrote.

It appears that all is not so tickety boo in the world of finance. In fact, the crisis is just being buried away. We then have the problems of rising unemployment, which is further feeding into the downwards spiral of the US economy. Whilst there have been a few slightly positive signs of late, the trend is still firmly downwards:
The government announced that the jobless rate had fallen one-tenth of a point to 9.4 percent in July on narrowing job losses but analysts say the rate could soar to about 10 percent by year end even with an improving economy.
Perhaps the most worrying aspect is that there is no expectation of recovery in jobs in manufacturing. This from the President of the Atlanta Federal Reserve:
'Unfortunately, time may not return manufacturing employment to pre-recession levels,' he added. Between 1965 and 2000, manufacturing employment generally fluctuated between 16.5 and 19.5 mln jobs. But in the first years of this decade, the number of manufacturing jobs have fallen to just over 14 million and have continued to drift downward, Lockhart said. 'The harsh financial constraints of this recession appear to have accelerated this secular decline.'
The picture already looks pretty bleak, but the real unemployment rate is considered by many to be far higher than the headline figures suggest, according to the Economic Policy Institute:

The real unemployment rate nationally is nearly 17 percent, instead of the official 9.4 percent, when discouraged workers and part-timers who want full-time employment are factored in. Other workers have seen their hours cut or been forced to take furloughs.

Meanwhile, the number of Americans out of a job for six months or more is at a 70-year high.

The result is a huge labor glut at a time when net job gains are scarce or nonexistent. Observers celebrated when the national economy lost only 247,000 jobs in July. (Washington state even added 4,000 new jobs in July.) The U.S. number would be a catastrophe in most circumstances, but was better than the more than 700,000 lost in January. Yet the American economy must add 127,000 jobs a month just to keep up with natural population growth.

At this stage I will halt with the state of the real economy. For each harbinger of recovery touted by the media, there is a mass of data that suggests the real depth of the underlying problems. Furthermore, even where there are upticks, what we are viewing is the artificial life support being provided by the government, such as the 'cash for clunkers', the absurd lending of Ginnie Mae, or the so-called federal stimulus. That this comes at huge future cost is simply forgotten by the cheerleaders for the view that the economic crisis is at an end.

Perhaps the surest indication of the scale of the underlying problem can be found in how those outside of the US view the state of the economy. The chart below shows net capital inflows into the US, and that there is now the start of a dramatic outflow of capital.

It seems that overseas investors are not too impressed with the recovery, or the prospects for the US economy. It is no wonder really that they are reacting this way, with fiscal deficits climbing to shocking levels, monetization of government debt through money printing by the federal reserve, and an economy still in free fall. The overseas creditors can clearly see that there is no sustainability in the US economy.

The bottom line is this. Trying to borrow yourself out of a recession caused by too much borrowing is just plain silly. It would be laughable, were it not such a tragedy. The actions of the US government are attempts to turn back time. They are trying to support an economy that was always unsupportable. Consuming more than you produce is just unsustainable, and no matter how many economists line up to tell you otherwise, it is the underlying reality that must be addressed.

Perhaps the most shocking part is that the borrowing binge is not even managing to support the economy. All of the costly measures are still not enough to brake the US economy from a downward spiral. This begs the question as to how bad the US economy really is. I am guessing, and it is no more than a guess, that the answer might start becoming apparent towards the end of the year. At some point, the great unwinding must take place, and then it is time to reach for your hard hats. The ride has only just started, and it is going to get very bumpy.

Tuesday, August 25, 2009

The $US - Some Musings...

I made an error just under a year ago, in predicting an early collapse of the $US; I predicted a collapse by April of this year. When the collapse failed to materialise I was forced to look at my model of the world, and explain why I had been wrong. Up to that point, my model had been reliable, and had managed to explain what was taking place in the world economy. Having been wrong before, I will this time discuss the $US in terms of 'musings' on the future.

My conclusion on reflection of the erroneous prediction was not that I was wrong about the underlying weakness of the $US, but that I had been wrong about difficult it would be to shift perceptions about the $US in world markets. I had written an article titled "The Myth of the Eternal Status of the $US as 'the' Reserve Currency", and still stand by the discussion laid out in this article. Reserve status can only protect a currency for so long when the fundamental poor state of the economy is apparent.

As an explanation for the error of the prediction for the collapse, I adapted Dan Ariely's anchor price theory, and therefore accepted that it would be difficult to shake the 'faith' in the $US. Putting the argument in simplistic terms, the belief is that because the US economy has always been a success, it is difficult to shift market perceptions to see the US economy as it is now. Quite simply, markets are valuing the $US on past performance of the US economy, not on the performance now. People have blind faith that somehow the US must recover the economic crown that it has worn for so long.

The US government is now intent on testing that faith to the limits, and the cracks are starting to appear in the faith. The bond markets are now appearing to shift:

Figures released by the Treasury Department this week indicated that China reduced its holdings of Treasury securities by $25 billion in June, the most China had ever sold in a month.

Monthly figures can be volatile, and can be revised, so it is risky to draw conclusions from one month’s data. In May, China increased its holdings by $38 billion, according to the Treasury figures.

Nonetheless, the decline highlighted a fact shown in the accompanying graphics: Asia’s appetite for Treasury securities is not growing as fast as it once did. That means the United States will have to turn to other buyers, including American citizens, who are now saving as they did not do during the boom years, to finance the deficits.

The article is right to point out that one month's figures are not enough to be meaningful, but the figures will no doubt spook the market to some degree. The worry about the Federal Reserve's purchase of treasuries with printed money is already raising concerns, and the possibility of a $US rout is being discussed in the mainstream media:

Mr. Buffett worries that U.S. policy makers will fail to move decisively to curtail the nation's ballooning net debt, expected by some to rise to more than 75% of annual economic output by 2013. Instead, policy makers might tolerate higher inflation, which makes existing debt more manageable but would hurt the U.S.'s creditors, including China and Japan. In this scenario, investors would demand much higher interest when lending to the U.S. government, raising its borrowing costs and making further budget deficits harder to finance, at a time when an aging population will sharply boost the costs of Social Security and government-sponsored health care.

Doubts about the dollar are building while investors are growing comfortable with the idea of emerging economies like China, Russia, and Brazil playing a bigger role in shaping international finance. Some analysts, including Pimco portfolio manager Curtis Mewbourne, say emerging economies have an opportunity to use the crisis to reduce their reliance on the U.S. dollar, which tends to account for most of their foreign-exchange reserves.

It now appears that, with a rising savings rate in the US, the individual US investors are starting to take up some of the slack. This might be seen as a positive but, whatever happens, there still needs to be an influx of money from outside the US economy, if the US economy is to continue on the current path. In particular, the US is still running a current account deficit, and the only way to fund such a deficit is through overseas borrowing or further printing of money. Furthermore, the question remains as to whether the US savers have the resource to step into the breach in the event of an overseas exit, and whether they will continue to fund the deficits if the $US starts a dramatic fall.

Then there is the matter of yields. In the event of a shortfall in overseas purchase of US debt, can savers step up to the plate to an extent that they might hold yields down, or will they demand risk premia based upon a declining $US?

Whichever way you look, the prospects for the $US do not look good. Most importantly, the printing of money by the Federal Reserve to purchase treasuries is setting up a feedback loop; the higher the volume of purchases, the less the confidence in treasuries, and the more that the Federal Reserve must buy. It is very difficult to see how it might be possible to climb off the quantitative easing treadmill once the process has been started, in particular in the case where the policy is used to monetize government debt. Then there is the question of political influence.....with governments on a spending spree, with promises of sunny days in the future, no plan for deficit reduction, the pressure on the Fed to continue purchases will be high.

I learned my lesson before about naming a date for the $US to collapse. I am also not so sure now that a sudden collapse will be the outcome, but this is still possible/likely. It seems possible that the process might be a more steady decline, including moments of recovery, but with a declining trend. In all cases, the $US must, one way or another, decline in value relative to other currencies.

However, having said this, which currencies might the $US decline against? For example, the fundamentals underpinning sterling are perhaps weaker than the $US. The Euro area has its troubles, as does Japan. I argued before in TFR magazine that there would be a period of volatility, as investors flee in and out of different risks. I will admit that I have no clear answer to this question, and it is head spinning material trying to work out how a $US decline might play out globally. As simple example, what of the petro economies? How might a $US decline impact upon these states, and how will that impact upon oil prices. The $US remains so central to the world economic system, it is impossible to untangle how it might decline relative to other currencies, with further complications being caused by the state of the economic situation in the other major currencies.

Quite simply, the question that arises is how the world economy might pull itself out from the domination of the $US? It is a question on which fortunes will be lost, and fortunes will be made. It is a question of timing and a question of process, but the underlying problems will eventually make themselves felt, in one way or another. The $US is on the slide, and it is unlikely that the slide might now be reversed....the doubts are now cracking the walls of belief and, without 'belief', the $US has little left to support it.

Wednesday, August 19, 2009

Monetization of Government Debt Continued in the UK

The Telegraph's economics editor's latest article headlines that 'Mervyn King Wanted to Buy Half of the UK Government Debt Market'. It is a headline that, of itself, is worth some contemplation. That the Governor of the Bank of England should propose such an extreme measure is quite astounding. Conway, as I pointed out in one of my early articles on quantitative easing, had been co-opted by the Bank of England, and was 'on board' with the program. However, even Conway appears to be having some reservations:
However, the argument will reignite questions over the ultimate purpose of QE. The Bank and the Government maintain that the idea is not in any way to monetise the deficit (in other words for the Bank to print money and buy government bonds in an effort to keep it from technical insolvency). I still believe them - though I know many of you are already sceptical. However, as the next years roll on and it becomes ever more difficult and painful for the Government to raise money in the capital markets, it will become ever more difficult to convince people of this argument – unless the world really does succumb to a deflationary trap of 1930s - or at the least Japanese - proportions. And that is a sentence no-one should ever relish.
The outcome of the policy decision is that Mervyn King failed to win the argument for the massive increase in quantitative easing that he wanted, but that the amount was still increased by £50 billion to a total of £175 billion.

For regular readers of Cynicus Economicus, quantitative easing (QE-printing money) will be a familiar subject, and my opposition to the policy has been consistent. In early articles (e.g. here), I identified that QE would be used once risk of failure to sell government debt loomed, and this is what has taken place. Just as government finance commenced a severe downward spiral, QE 'coincidentally' appeared as a new policy tool.

In a recent article, I identified that QE was supporting the UK gilt (bond) market, and that even a hint of ending the program saw bond yields start to soar. I also noted in another article that the Bank of England was introducing a new 'exit strategy' for QE, which was the issuance of short term Bank of Englan bills, rather than the sale of the gilts back into the market. If QE is not about the monetization of debt, why not simply resell the gilts? This is the most simple and direct reversal of QE policy...

Then there is the deflation scare that is used as the justification for the policy. In each Bank of England report, deflation is just around the corner, but never seems to materialise. As I discussed in one article, inflation has not yet even reached a level far enough from the 2% target to require a letter of explanation from the Bank of England. Despite this, a radical and highly unconventional policy has been implemented. Furthermore, there is no evidence that deflation is actually a 'bad thing', as I explained in a recent article, with no empirical evidence or justifiable explanation for the scare.

Finally, there is the convoluted justification for why the Bank of England is buying gilts, rather than other assets, as a means of expanding the money supply. Quite frankly, the Bank of England explanation makes no sense at all (discussed here). There is simply no justifiable explanation for the necessity to buy gilts over other assets.

The Bank of England has nevertheless reached a point at which it is expanding QE, and the Monetary Policy Committee (MPC) minutes make fascinating reading. I strongly recommend that you read them in full, as you will find frequent use of terms such as 'may have', 'could have', or 'possibly' in reference to the outcome of the policy to date. It is very clear that there is considerable uncertainty about the actual effects of the policy but, despite this, the policy is being continued.

Even more interesting than the MPC minutes is the most recent Bank of England inflation report, which is full of caveats and speculations. This section is typical of the general thrust:
The upward pressure from sterling’s depreciation depends on the extent to which companies need to adjust further to the higher import costs and on whether this adjustment comes through higher prices or lower wages. There may also be upwards pressure on inflation from rising global energy and commodity prices if world growth picks up by more than expected. There are risks in both directions that inflation expectations may become less firmly anchored, although the committee’s commitment to maintain inflation close to target should help to limit those risks.
At least the August inflation report shows the Bank of England has finally accepted that the weakening of the £GB will push up import prices and therefore impact upon inflation. In December 2008, I reviewed the prospects for inflation and concluded that 'In the case of the UK, the inflationary pressures have already commenced with the ever weakening £GB, but for the US, it will take a much firmer shove.' Even at that time, it was obvious that a falling £GB would have a counter effect to the deflationary impacts within the UK economy, and I 'guesstimated' that the impact would be broadly neutral overall.

In this latest inflation report, the Bank of England suggests that there will be volatility in inflation, and on this occasion I find myself in agreement. However, the prospects for volatility once again raises the question about why the policy of QE is being continued. From the outset, the Bank of England admitted that QE was an unconventional policy, and the MPC minutes show that the Bank of England is uncertain about the outcome of the policy in action. Even were it accepted that this policy was positive in principle, it seems that any justification must require a greater degree of certainty than the volatility and uncertainty discussed by the Bank of England.

The continuation of QE is once again built upon flimsy justifications. The simple truth is that the Bank of England is now on a treadmill in which it must continue the policy to prevent a collapse of the UK gilts markets. However, the further the Bank of England goes, the greater the build up of inflationary pressures, and the greater the danger when the policy finally unwinds. The Bank of England is supporting the fiscal irresponsibility of a bankrupt government, which is both bankrupt in terms of money and bankrupt in terms of ideas (the opposition are still not much better).

I had a brief moment of optimism that perhaps, just perhaps, the Bank of England was going to rebel, and withdraw support for the government's fiscal irresponsibility. I can now only conclude that the institutions of the UK are now all firmly intent on a path of that can only damage the UK economy. I have lost all confidence that there may finally be a stepping back from the brink. The UK economy is heading towards disaster. It is now just a question of when, and how the disaster will actually play out. After all, government deficits are still growing, the bond market is already fragile on the current issuance, and there is no prospect of a return to balanced budgets, let alone surplus. At what time could the Bank of England step off the treadmill? One years time, two years, or three....?

Saturday, August 15, 2009

The Waiting Game

The headlines have now largely disappeared, and the financial crisis sits quietly humming away in the background. The sense of collapse, the immediacy of the crisis seems to have dissolved and economics has been returned to the finance pages, for the interest of the economics 'nerds' only. The New York Times headlines with a story about Myanmar, and the Times headlines a story about curbing bonuses in the UK. The obsession with banking bonuses continues, but the state of the British economy barely gets a mention.

It also appears that those that follow the crisis have now settled into two distinct camps. On the one side there are those (like myself) who believe that the government pouring of borrowed money into the economy and printing of ever more money is a catastrophe, and those who believe that the action has 'saved' us from a far worse fate. Some, like Krugman, worry that the spending and printing are insufficient, and advocate more government intervention. How much 'enough' might be is never clear, and the source of the flood of money to be used is not discussed.

Occasionally a story still breaks into the headline news, for example the relentless rise in the numbers of the unemployed. However, most of the important stories fail to gain any traction, such as the ongoing bank failures in the US, or the melt down in commercial property. In the meanwhile organisations like the IMF are predicting economic growth (albeit sluggish) for the coming year. This is the same organisation that has just approved $250 billion in Special Drawing Rights to provide 'liquidity' to the world economy.

It seems that the headline writers believe that we have indeed turned the corner, and that all will eventually end well.

Part of the problem is the ongoing belief that what has taken place is rooted in irresponsible bankers creating dangerous financial instruments. It is the belief that the crisis was simply a matter of poor banking practices, rather than an underlying economic crisis with the financial crisis as a symptom. For those of you who are new to this blog, you may wish to read my article on the underlying causes of the economic crisis here (a link to an article on Huliq). The simple fact is that the world changed in the last ten years, and many 'developed' economies have failed to adapt to a more competitive world. The full entry into the world economy of countries like China and India changed the game, but the rich world is playing according to an out of date rule book.

The problem is that the excess borrowing of recent times simply hid the underlying change in the world economy, and the process of more borrowing by governments seeks to do the same. The borrowing does not alter the competitive position of the developed world (see note 1), but simply hides the lack of ability to compete, and does so at the cost of hobbling the economies in the future. The one thing that needs to be changed, the reform of economies such that they can return to being competitive, is nowhere to be seen in government policy. Instead of government action to make the developed economies leaner, they seek to maintain the fat in the economy.

In my last post I reviewed the fundamentals of the UK economy, and looked for any source of real and sustainable growth in the economy, and found none. There is no productivity miracle taking place, we are still seeing unemployment climbing, and we are still consuming more than we produce. All this is taking place while the economy sinks ever deeper into debt.

The question that is rarely (if ever) asked is this; where is the real and sustainable growth going to come from? Which industry, which sector, is going to return the economies to surplus - such that the money borrowed from overseas might be paid back. For those, like Krugman, who advocate more borrowing and spending, this small detail eludes them. I have yet to see any of the advocates of borrow and spend identify how the economies might return to a current account surplus, an absolute necessity if an economy is to repay overseas borrowing. Instead, they simply advocate more borrowing, and an ongoing deficit as that borrowing translates into more imports, more interest repayments, and a greater charge on the future output of the economies.

So now we are in the waiting game. There is no prospect of return to surplus, ever more borrowing, ever more printing of money. There is no explanation of how economies such as the UK or US might ever repay the money, no reform, just more spending, more consumed than produced. In the end, only time will tell which side of the argument is right. The argument boils down to this; how long can an economy consume more than it produces?

Note 1: There are, of course, 'developed' countries such as Germany who run current account surpluses and which are still competitive.

Thursday, August 6, 2009

A Recovery in the UK?

A recent comment on the blog suggested that perhaps there was not much to write about, as the UK economy appears to be recovering. Bearing in mind that such stories are now appearing in the press, it is not surprising to see that this point of view is gaining some traction. For example, we have this from the Telegraph, reporting on the National Institute for Economic and Social Research (NIESR):
NIESR’s optimism was echoed by the Royal Institute of Chartered Surveyors (RICS), which expects house prices to rise this year, in a startling reversal of its forecast that prices would plunge 10pc to 15pc in 2009.

A slew of positive economic data and an upbeat trading update from Carpetright – often seen as a bellwether for the economy – prompted analysts to predict the UK could emerge from the recession as early as the third quarter.
From David Wighton, of the Times, we have the following:
Still more convincing, the purchasing managers’ survey of services, the most timely and respected gauge of the economy’s most vital sector, shows expansion for a third month, and at the fastest pace since February last year.

The equivalent manufacturing survey shows that industry is rebounding too, and the fightback is affirmed by official data, with the biggest monthly output jump since October 2007.

Markets seem convinced — the FTSE 100 is up by a third from its lows plumbed at the start of March.

It all appears to be compelling evidence of recovery, does it not?

The truth is that we are witnessing a mirage. My first article for this blog was entitled 'A Funny View of Wealth', and I return in this post to the theme in this (very long) essay. The essay was written before the economic crisis struck in full force and, in the essay, I tried to find the apparent source of wealth in the UK, but found that there was no explanation except for a massive expansion in credit. Output of commodities were in decline, manufacturing output had remained static for many years, and export of services provided no explanation for the massive 'growth' that had apparently taken place in the economy. The remaining explanation was that the UK's growth had been built upon borrowing, and in particular borrowing from overseas.

We can now fast forward two years in time, and I can ask the same questions. Exactly what is the source of the current 'recovery'? Which sector is producing the growth in wealth creation to justify the 'recovery'. Let's start with manufacturing:

The chart above is the production index from the Office of National Statistics (ONS). It seems that, even with an uptick now, we are now producing significantly less than ten years ago. This is what the index of production covers:
The Index of Production (IoP) measures the volume of production of the manufacturing, mining and quarrying, and energy supply industries, which covered 17.2 per cent of the UK economy in 2005.
How the word 'recovery' might be applied to this is very puzzling. With regards to productivity, the picture is as bad, with this from the ONS.

As can be seen here, the UK is not in the midst of any kind of productivity miracle that might explain the sudden recovery.

The other potential source of real growth in an economy is in the exports of services. In the essay at the start of the blog, it was apparent that financial services were at the heart of the growth in services export, and the decline of the sector has been reflected in recent services export figures, with a negative trend appearing in the figures (raw data taken from the ONS here - series IKBB & IKBC & IKBD). Curiously, 2008 did see a moment of increase in the positive balance (in part as a result of an expansion in financial services exports! - see data here), but quarter 1 2009 reversed this. Overall, the picture is one of a continuing positive balance in the export of services, but still with nothing that might offer an explanation of the current 'recovery'. On the latest figures from the ONS, which takes us to Quarter 1 of 2009, there is no explanation for the recovery.

Then there is the overall trade balance, which has seen a shrinking of the deficit, but still an ongoing deficit. This from TradingEconomics:

The trade deficit continues, despite a substantial devaluation of the £GB since the crisis began, such as the decline against the $US (apologies for the poor chart). Devaluation has the effect, for example, of reducing the purchasing power of consumers within a country, and is therefore a real reduction in wealth of the individuals whose income is derived in the currency.

However, it is when we see the current account that the scale of the problem becomes really apparent, with the following chart from TradingEconomics:

If taken together, what we are seeing here is no growth in output from manufacturing that might explain a 'recovery', no growth in the export of services, and an ongoing current account deficit. It is hardly a picture of a 'recovery'. To this happy picture of 'recovery', we can add unemployment, with this from the ONS:

It is worth thinking about the underlying meaning in this chart. The proportion of working age people in employment is falling off a cliff. If people are not working, where is the output in the economy coming from? We know that there is no productivity miracle, so how exactly can an ongoing decline in working people explain a recovery? Where can real increases in output in the economy come from except from either a growth in productivity or a growth of the numbers in the workforce actually in work?

For regular readers, they will be aware of my cynicism about what GDP figures actually show, as they include activity from debt based consumption (see here for a full explanation). However, even this indicator, which potentially massively overstates the positive in an economy, looks like this:

So exactly what is the source of this recovery? Here is a summary of where we are at:
  1. There is no productivity improvement but a decline
  2. The number of workers in the workforce is in rapid decline
  3. Production is below the levels of 1998
  4. The trade balance of goods and services is negative, the trade in services remains positive but with no growth, and the current account balance is negative. On balance, we are still consuming more than we produce.
  5. GDP growth, a poor measure that exagerates the positive, is still negative. Even if it were to move to the positive, how much of the activity recorded comes from growth in debt?
Altogether, this simply shows that there is no sustainable recovery. A shrinking UK workforce is still consuming more than it produces, and productivity and output are still in negative territory.

So where exactly is the recovery? The indicators given as evidence of recovery are the slight uptick in manufacturing, which I have already dealt with, house price recovery, and the stock market recovery. The recovery proposed appears to the return to price inflation of two asset classes, but with no underlying economic justification for these that might be seen as sustainable.

So where is this 'recovery' coming from? Once again, I return to the theme outlined in 'A Funny View of Wealth'. The only real reason for any signs of 'recovery' is that there is yet another increase in debt. The only real difference this time is that the source of the borrowing is primarily the government, and that borrowing is expanding at a record rate. Again, from the ONS:

And how is the government funding that borrowing? By the Bank of England printing money, which is then used to purchase gilts (UK government bonds). The Bank of England has just announced yet another expansion of the so called 'quantitative easing' (QE - printing money) programme, which is primarily being used to purchase government debt. I have previously shown that the QE purchase of debt is propping up the UK bond market, and that it is the monetization of government debt.

What we are looking at is simply more delusion, more hiding from the underlying dire state of the UK economy. The 'recovery' is founded on printing money and more debt. I will quote myself from an earlier blog post, which in turn quoted an even earlier blog post. It is shocking that nothing has actually changed:
Quite simply, aside from the fact that a failure to fund the deficit would be catastrophic, what kind of 'recovery' is it, if it is being financed by borrowing 13% of GDP?

A long time ago, I made an analogy with a household to explain the absurdity of this notion. A household has been racking up huge debts due to too much expenditure on the 'good things in life', but continues spending. All the time the family's debt is increasing, and then the bad news comes. The wife's job is under threat, and the husband's working hours are being reduced. Their income is declining, but the cost and size of the debt is increasing. They are in deep financial trouble, and are borrowing more and more money in order to keep their lifestyle and also to make payments on previous debt.

It looks like the household is in crisis, and they will soon go bankrupt if they continue their profligate spending. Fortunately, so it seems to our irresponsible family, a visitor comes to their house from 'Dodgy Loan Corporation' and offers them a further and much bigger new loan. They look at the figures, and it appears that, if they accept the loan, the family will be able to continue to live the same lifestyle as they had before. A massive weight lifts off their shoulders, and they live happily ever after.....

We can all (I hope) see the problem in the happy ending. I have not mentioned the prospects for the family's income increasing in the future, and without a massive increase in income, bankruptcy will just be delayed. Sadly, for the family, there is no identifiable prospect of such a massive increase in income in the future, and they are just hoping that 'something will turn up'.
I keep wondering how long this can continue. How long can we delude ourselves that all will be ok if we just keep on borrowing more and more, even as our income declines. I keep on asking myself, 'when will we wake up to reality?'

Sunday, August 2, 2009

The Deflation Scare

I have several times in this blog questioned why it is that deflation might be a bad thing, including in my discussion of a new form of money. Having presented my arguments, I thought it might be useful to find out exactly why economists insist that deflation is something to be feared. Having read through some academic literature, I found an excellent paper which clearly shows that the deflation scare is exactly that - a scare.

There is absolutely no evidence that deflation will cause depression. I have therefore written a summary of the paper in question below, which is by Gregor Smith (reference at end). It might be noted that his paper is written in the polite tones of academic discussion, but the message is clear. He divides up his paper into some basic arguments and I will follow the format.

1. Deflation is associated with depression

Smith reviews the study of Atkeson and Kehoe (2004) who considered the empirical evidence for a link between the deflation and depression. He summarises their work by concluding that only ‘for 1929-34 is there a positive relationship between the inflation rate and the output growth rate’ and that ‘excluding 1929-34, there is virtually no link [between deflation and depression], even though there were other periods of deflation, especially under the gold standard’ (p1046).

My comment: The important point here is that there have been many, many deflations in which there has been a growth in output.

2. Unexpected deflations are associated with depression

In a contrast to the work of Atkeson and Kehoe, Smith reviews the work of other researchers have utilised different analytical models which have found a relationship between depression and deflation, for example in Canada 1870-96. However, when models take into account other shocks in the economy, the correlations found appear to be coincidental rather than causal, and such shocks also serve to explain the only correlation found by Atkeson and Kehoe.

My Comment: Again, it appears that that there is no evidence that deflation and depression are connected and as Atkeson and Kehoe identify, there are many examples that directly contradict the idea that deflation and depression are linked.

3. Sticky nominal wages

In his review of the literature, Smith finds some problematic findings on the relationship between wages and deflation, such that each of the studies fails to fully explain the relationship between wages and deflation. For example, he reviews the work of Bordo, Erceg and Evans (2000) which explains wage stickiness for the period of the early 1930s, but fails to explain wages in the slow recovery for the period of monetary growth after 1933. His conclusion is that there is a need for further research if there is to be a meaningful debate on how wages might be determined in deflations. In summary, there is a general lack of research that might present any firm conclusions on the relationship between deflation and wages.

My Comment: It is worth noting that, if wages were to remain static in monetary unit terms during a period of steady deflation, the recipient of the wages would find the purchasing power of their wage increasing. As such, the person would, in real terms, see an increase in their wealth. Even if the person’s wage were to decrease in a period of deflation provided that the decrease is less than the rate of deflation, they would still be seeing an increase in their wealth. Why such outcome might be viewed as problematic is entirely unclear. Actual wages in monetary unit terms are irrelevant without relating them to what they might purchase in terms of goods and services.

4. Debt deflation

Smith identifies Fisher (1933) work as being the key work on debt deflation, whose theory Smith summarises as ‘depressions begin with debt liquidation, leading to deflation and then to bankruptcies, and to a fall in output and employment’ and that there is an association between these events and ‘a nominal fall in interest rates and a rise in real interest rates’ (p1050). Smith then identifies that Fisher is rarely cited in empirical studies, that the majority of studies cover the period of the Great Depression, and that the studies that cite Fisher provide ‘little empirical evidence on the mechanisms Fisher outlined’ (p1051). From this starting point, Smith reviews many studies, and concludes that ‘the historical research does not seem to me to provide much evidence on the debt deflation mechanism in the 1930s’, and that no recent studies are identifying debt deflation in a deflationary environment that might support a ‘spectre’ of deflation hypothesis.

5. Deferred Spending

The idea that deferred spending is a result of deflation is described by Smith as the worst argument made against deflation, noting that the saving from deferred spending will lower the rate of interest and increase investment. Smith is quite right to question the principles of deferred spending, but his questioning might be taken further.

Smith later looks at some modern deflations, such as Hong Kong coming out of the Asian crisis, and finds that there is a correlation in these cases with unemployment. However, in some of the cases that he examines, the deflation appears to be resultant from shocks (i.e. the shock of the Asian crisis itself for Hong Kong and the collapse of property prices, the property and equity melt down in Japan). In two cases, Britain and Canada in the 1920s and 30s, the explanations are less clear, though some of the deflationary episodes followed episodes of high inflation, and other parts of his analysis again cover the Great Depression. Without more detail on the episodes in these countries, with which I am not familiar, I am unable to comment on these.

It should be noted here that he is presenting a very limited number of examples in which there is a correlation between unemployment and deflation, and his conclusion is that, whilst he has found a link between deflation and depression (in the form of unemployment), he can not square this with the other studies. Most importantly, he points out that there are 'different kinds of deflations', meaning that there is no reason to link deflation to depression. His own examples, are therefore not indicative of the idea that deflation will cause a depression, or that deflation must be accompanied by depression. Even Smith, despite a genuine intention to examine deflation from a firmly empirical point of view, appears to have a basic confusion in the cases that he studies. The confusion arises from trying to impose economic theory on to the evidence.

The source of the unemployment in Japan and Kong Kong was, in both cases, the result of unwinding bubbles in which resources were allocated in unsustainable ways. The bubbles in the economies led to the destruction and misallocation of capital, and labour being directed into unsustainable businesses. Unemployment is inevitable. It will take a considerable amount of time for the bubble based businessed to unwind, and further time for retraining and redeployment/retraining of workers who are laid off as a result. It is a simple and logical explanation. Why on earth would deflation result in unemployment? As Smith himself identifies, there is a lack of evidence for this mechanism.

The interesting thing about Smith's work is that it is a review from academia (interestingly including work of Ben Bernanke). As was mentioned at the start, he uses polite academic language, which is the language of polite questioning and requests for further study. Nevertheless, he presents a compelling demolition of the idea that there is any evidence that deflation will lead to depression, or that depression accompanies deflation.

The most important point in the paper by Smith is that it shows that deflation can take place during periods of growth in output, that the deflations associated with depressions are mostly the result of shocks and were not causal. At the moment the world economy is undergoing a shock. That this shock might cause deflation does not make deflation a 'bad thing'. It would simply means that it is associated with a 'bad thing'. However, the scare of deflation has been used to justify the printing of money, low interest rates and the fiscal stimuli.

As I argued in an earlier post, it is not deflation that is a problem, but the move from inflation to deflation, or even high inflation to low inflation. What we are seeing in the stimuli and money printing is an attempt to prevent such an occurance. For any borrowing undertaken at a fixed interest rate before the change, these result in real increases in the burden of debt for the period of the fix. Preventing this problem might be seen as a justification for the policy, but the broader cost of these policies is a risk of hyper-inflation. The scale of the potential problem of the increase in the debt burden has never been spelt out, but it is the only legitimate reason that might be used to justify the deflation scare. More to the point, the transition from high inflation to low inflation has an identical effect upon debt burdens (see notes for further explanation), but we have never heard arguments against moving from high to low inflation. Why is that?

At the moment, the depression is already taking place. That depression might create deflation is not to say that the deflation is itself problematic. When looking at the deflation scare, it is a genuine puzzle that the scare has been allowed to gain so much traction. There is simply no evidence that a deflation would take the economy deeper into depression. Despite this, all over the OECD there is a huge experiment in monetary exansion, and an explosion of debt, with the fight against deflation as one of the explanations for this policy.

It just does not add up.


Atkeson, A. and P. J. Kehoe (2004), "Deflation and depression: is there an empirical link?," American Economic Review, 99-103.

Bordo, M. D., C. J. Erceg, and C. L. Evans (2000), "Money, sticky wages, and the Great Depression," American Economic Review, 1447-63.

Fisher, I. (1933), "The debt-deflation theory of great depressions," Econometrica: Journal of the Econometric Society, 337-57.


Note1: I have included a previous discussion of deflation from a previous post in the notes below, and have added an additional example that shows that consumers do not defer spending:

In the following examples, it will be shown that the reality is that people do not delay purchases in the expectation of lower prices.

Example 1 – Fast Moving Consumer Goods

If a shampoo manufacturers were to improve their output by 5% through a manufacturing innovation each year, their output of shampoo would increase, and this would reflect in a decrease in the price of shampoo. In other words, there will be a steady and continued deflation in the price of shampoo. According to the idea that consumers will delay purchases in an environment of deflation, in such a situation, consumers would choose to walk around with greasy hair, never buying shampoo in the expectation of further price decreases. Such a proposition is fatuous.

Example 2 – Hedonic Goods

Over the last few years countries such as the UK have seen the emergence of many discount airlines, such as Easyjet. The emergence of these kinds of airlines, and the increase in competition within the sector, has seen the price of air travel deflating. Much of the utilisation of these airlines has been by consumers using the discount airlines to have cheap foreign holidays, and this can be described as a hedonic good. It is an entirely discretionary expenditure as there is no necessity to go on holiday to another country. Despite the continual deflation, there have been many years of continual expansion in the discount air travel market. The deflation has not prevented consumers from taking flights to go on holiday, but rather has had the opposite effect.

Example 3 – Computers

Personal computers (PCs) are an interesting case, as they have year on year improved performance and year on year seen deflation of actual prices. It is also an example that includes both business purchases and consumer purchases. Despite the ongoing deflation in the prices, the market for PCs has had a long period of explosive growth throughout this deflationary period. It seems that the steady deflation in prices has had no impact through the postponement of purchases.

Example 4 – Special Cases

Remaining with the example of PCs, it is possible to construct a hypothetical example of how consumers might indeed delay their purchase in expectation of deflation. If one of the large computer manufacturers were to announce that they would be introducing a new type of computer in the coming year, and that the computer was to offer twice the performance at half the cost, it is quite likely, assuming their claim were credible, that consumers might delay their purchase of computers in expectation of this future deflation.

Example 5 – Purchasing on Credit

The example of purchases on credit with interest of goods and services suggests that there is a fundamental flaw in the deferred purchase argument; that theorists have misunderstood the psychology of consumers. Purchasing a product on credit at interest is a real increase in the cost that will be paid for the good, whilst saving the money with interest paid is a real decrease in the cost paid for the good. Despite this, many consumers do not defer the purchase, but instead choose to purchase the good at greater cost now, than the cost in the future. Furthermore, in sectors such as computers, the deflation of the good does not prevent purchases utilising credit.

If the thinking of those who argue against deflation is considered, such a deflation is a ‘bad thing’ as consumers withhold their money in expectation of lower prices. If this logic is followed, then the new and more effective design of computer is not a good thing for the economy, as it has created a deflation in the price of computers, and has caused a delay in the purchasing of computers. However, once the computer is introduced, it will make more computing power available to more people. How this might be a ‘bad thing’ is not entirely clear. Everyone who purchases a computer sees their wealth increase, as they are able to enjoy relatively more computing power in relation to their income. They are quite literally wealthier.

Debt and Deflation

There is an argument that suggests that deflation causes problems with the servicing of debt, as the value of the debt sees relative increases through the deflation. This is a scenario that appears to be very plausible, and can be backed by some solid calculations and formulae. However, what is missed in such arguments is that it is not deflation that is problematic, but the move from inflation to deflation. It is not the change in the value of money that is problematic, but the change in inflation/deflation from the original inflation/deflation position from the time of the issuance of the loan.

A good example of this can be seen in private mortgages on housing. If a loan is taken out in a high inflation environment, the interest rate will be relatively high. The targeted central bank interest rate will be high, and the lenders will seek to account for the high inflation by charging a rate of interest that will overcome the devaluation of the money that they are lending, such that they can achieve a positive return. If the interest rate is fixed over a period of, for example, five years and at year four the rate of inflation has fallen by a half, the holder of the debt is effectively seeing the value of their debt inflating. The earlier rate of inflation was eroding the value of their overall debt, and this was accounted for in the interest rate. However, with inflation falling, their debt value is no longer declining at the same high rate, but they are still servicing the debt as if this were the case. Their payments in relation to the actual value of the debt have increased.

If we think of this example and think of a change in the rate of inflation from 5% to 2%, and compare this with a change from 2% inflation to deflation of 1%, we can see that there is the same process taking place. In both cases we are seeing the relative burden of debt in relation to income moving in exactly the same way. In the inflation and deflation environment, interest rates will move to reflect the underlying changes in the value of money, and debt burdens will be locked into repayments that are based upon an out of date criterion.

In other words, it is not inflation or deflation that is problematic, but rather it is the change in inflation/deflation that alters the burden of the debt. As such, any monetary system should aim to achieve either stable inflation or stable deflation.


Note 2: I am currently trying to convert my concept of a fixed fiat currency system into an academic paper. In doing so, I have given it much more thought, and have challenged many of my own ideas. The result is considerable refinement of the idea, and it appears to be an even stronger system than I first thought. I also worked out that the idea was probably inspired by my study of PWR nuclear reactors many years ago. For those that are interested, the money is represented by the neutrons, and the primary and secondary loops are the economy. The moderating effect is similar, and the control rod position might be the point at which the money supply is fixed. There are, of course, points which do not translate from one system to another, but I hope you can see the similarities.