Saturday, May 26, 2012

The UK Economy, the Euro and the Least Ugly Contest

I have, for a while, been focused on the Euro crisis, and I will not be the first to note that, as the UK's largest trading partner, the Euro crisis is set to have an impact upon the UK. It is therefore unsurprising that David Cameron (and also notably Barack Obama) has argued for Germany taking more direct action to support the Euro, in particular as it is Germany that is in the front of the line to pay the bill. Jeremy Warner of the Telegraph speaks for many when he says:
The stand-off got a whole lot worse this week. France and Germany are now in open conflict over the way forward, if indeed there is one. For the UK, already bleeding badly from the after-effects of the financial crisis, the situation could scarcely look more threatening.
 The fiscal consolidation chosen by the Coalition was always likely to have a negative impact on output, at least in the short term. To make it work, the Government needed the following wind of decent growth elsewhere in the world economy. Instead, it’s facing a hurricane. We look set to be broken by the storm.
There are no end of commentators expressing their thanks that the UK is not in the Euro, so I will not add to these. However, in response to the Euro, of particular interest is that Bank of England is yet again likely to go down the road of further quantitative easing (printing money). This from Reuters:

Evidence that both may be needed was sharply underlined by data showing that Britons have been shopping much less and factories getting far fewer orders.

In minutes of its May meeting, the Bank of England reported that while 8 of 9 policymakers voted to end a 325 billion pound round of asset buying to keep interest rates low, they had not closed the door on more.

Separately, Deputy Prime Minister Nick Clegg said it was an "absolute priority" to get credit into the economy and pledged to "massively" amplify what the government was doing in its 20 billion pound credit-easing scheme.

Both echoed a prescription delivered on Tuesday by International Monetary Fund head Christine Lagarde, who urged the central bank to buy more assets - possibly including company bonds and mortgages - and called on the government to find money to boost infrastructure spending.
Longstanding followers of the Bank of England's policy of printing money will undoubtedly recall that the policy was put in place with the justification that it was a unique circumstance that drove the policy. As has now been reported ad infinitum, the Bank of England long ago lost all credibility with regards to their original excuse of using money printing to prevent deflation. It now seems that, whatever might produce headwinds for the UK economy, the printing presses will start rolling. What has become an exceptional policy is now becoming routine policy.

We can see the same phenomenon in the US, Europe and Japan. There are two possible interpretations for the 'routinisation' of printing money; the first is that policy makers actually believe that it works, and the second is that they are now completely bereft of any idea of how to fix the ongoing economic problems.I go with the a mix of these two interpretations. For the former, I am guessing the Bank of England aim is a defensive attempt to pull down the value of sterling, out of fear of the impacts of a strengthening of sterling against the Euro. However, as an offset to this the resultant low interest rate will only encourage further borrowing, with potentially negative impacts upon the current account balance (see later, and chart below for the current account balance from ONS).
EU/non-EU current account balance

I have previously discussed flows of capital as a least ugly contest. Investing is no longer a case of looking for attractive investments, but trying to find the least unattractive.There is a catch, though; whilst investors may look for the least ugly, sometimes it pays for countries to be a little ugly. This pulls down the exchange rate, and this in turn helps to maintain a competitive exchange rate (regular readers may recall my example of Switzerland some time ago). Printing money might help with this, but the problem is that it is becoming a universal solution to trouble; right now, nobody wants their currency to appreciate and competitive devaluations are a real possibility. As it is, the UK economy is looking rather ugly without any further money printing:
The U.K. economy shrank more than initially estimated in the first quarter after construction was revised to show a deeper slump, which may bolster the case for the Bank of England to restart bond purchases.
Gross domestic product fell 0.3 percent, compared with a 0.2 percent decline estimated last month, the Office for National Statistics said today in London. Construction output fell 4.8 percent, the most in three years and more than the 3 percent initially estimated, while services and production were unrevised. Net trade and inventories subtracted from GDP.
I say 'rather ugly', as it must be remembered that this decline is still taking place in an environment of massive fiscal stimulus, with UK  government borrowing and spending supporting the economy at the cost of an anticipated deficit of £120 billion for the year 2012/13. There is no austerity anywhere in sight, and yet the UK economy is showing declining GDP. What is, in fact, taking place, is a slowdown in the rate of borrowing, as can be seen below (from the Guardian).

It is notable that this excludes financial interventions, which is the government's 'preferred' measure. More worrying is the cumulative total of debt being accrued, with the UK debt clock providing a graphic representation of the growth in debt.The Daily Mail provides a good summary of the current situation of debt in the UK, and it extends beyond concerns about government debt (I do not usually cite the Mail, but they are using some good sources):
There's also the not-so-small issue of Britain's household consumer debt problem which, in relative terms, is the second worst in the developed world.
They have a point. I checked the latest statistics from the Bank of England, and it sees a slow month on month climb in consumer debt. This helps to explain small increases in consumer spending even whilst real income is in decline. Again, from the Mail:
But there's also a misconception about consumer debt. There's much talk of businesses and households 'deleveraging' - paying off debts.

But in reality, Britons are not paying off what they owe. There were hopeful signs of this happening when mortgage rates fell sharply in 2008 and 2009 - some borrowers used the opportunity to pay extra off their mortgages. But consumers soon returned to form and began borrowing again to spend.

Even the falls there have been are due to banks writing off debts, according to the campaign group Save Our Savers (SOS). It points out that total consumer debt stood at £1,461billion in November 2008 and £1,452 billion in November 2011. But banks wrote off £26.7billion of consumer debt. So excluding the bank write-offs debt actually rose by £18.4billion.

Credit card debt continues to 'run rampant', says SOS, rising from £53.3billion to £56.5 billion over that time even thought an 'extraordinary' £13billion has been written off. Total credit card debt when write-offs have been stripped out has exploded by £16.1billion.

So the clear picture is that debts are not only still rising, by bad consumer debts are also just shifting across to become financial sector company debt which, if recent history is anything to go by, could one day become state debt.

And the projection, is that UK debt is set for another explosion. According to the Office of Budget Responsibility, personal debt will grow by nearly 50 per cent from £1.5trillion today to £2.12trillion by 2015.
More interesting than any individual sector is the overall picture of debt, and the graphic below paints the picture by including government, retail, financial and business debt.
The the UK's debt level is second only to that of Japan among major economies
These figures should be a cause for worry in all circumstances, but become even more worrying when seeing the UK balance of trade and current account. This from the ONS:
  • The UK’s current account deficit was £15.2 billion in the third quarter of 2011, the highest on record.
  • The trade deficit widened to £9.9 billion in the third quarter of 2011, up from £7.2 billion the previous quarter.
  • The income surplus was £0.3 billion, the smallest surplus since the fourth quarter of 2000.
  • The financial account recorded net inward investment of £22.0 billion during the third quarter of 2011.
  • The international investment position recorded UK net liabilities of £245.5 billion at the end of the third quarter 2011
This is a chart of the trade balance from the ONS:
 Trade in goods and services balance

 A quote from the explanatory note on the chart is given below:
The trade in goods deficit increased to £27.6 billion in the third quarter of 2011, the highest on record. Exports increased by £0.1 billion to £74.2 billion and imports rose by £2.7 billion to £101.8 billion. Both exports and imports are the highest on record.
In crude terms, UK borrowing and spending is a good way to help other countries export goods and services to the UK, and in particular goods. Sure, it increases activity in the economy, as distribution of the goods and services creates activity. However, this cannot be sustained forever. Whilst this has been the case for many years, there must come a point at which borrowing can go no further, and the earlier chart from the Mail highlights that the UK is now reaching a point where the unsustainable nature of the borrowing is becoming very apparent.

I return now to the question of the Euro crisis. As the situation stands, the situation in the UK has been continuing to deteriorate, despite talk of austerity and living within our means. Borrowing and spending is ongoing, and the UK is still consuming more than it can produce. Nothing has really changed since the onset of the financial crisis, excepting that the total volume of debt has increased, and is increasing. No real reform of the UK has yet taken place and the current account figures tell the real story.

Notwithstanding the lack of substantive action so far, the government appears to be genuinely seeking to reduce the rate of debt accumulation and, if it succeeds, as I have argued many times, this absolutely will see a fall in GDP. I have never accepted the absurd idea of expansionary austerity. However, as the earlier chart of total UK debt shows, austerity is a necessity as debt levels become unsustainable. Again, regular readers will know that I do not accept GDP as representing a useful measure of the economy, as GDP figures include activity from borrowed money. However, many take GDP seriously, and as GDP declines, the UK economy will start to look a little more ugly. In short, even without the Euro crisis, the UK was set to become uglier.

To add to these concerns, we have the accelerating Euro crisis and, on top of this, if the Bank of England prints more money, this will add a little more to the ugly factor, albeit partially offsetting this by possibly (temporarily) shoring up GDP figures. The question that this raises is how the UK will look overall in the least ugly competition. I would argue that, so far, the UK government has managed to convince the world that it is not so ugly and have done so with with the promise of future action. That action is now commencing, and doing so just as a shock is about to hit the UK economy in the form of the Euro crisis. The UK economy, as I have outlined, is in no state for this kind of shock, and the fallout of the Euro crisis will combine with the impact on GDP of genuine moves towards austerity. It is not a pretty picture. The UK may become very ugly.

The only possible offset is how ugly other economies will look as the Euro crisis accelerates, and this might allow for some kind of reprieve. In other words, the confidence in the UK economy will be measured by its relative ugliness to other economies. How ugly those economies will be will only become apparent as the Euro crisis accelerates. Perhaps the UK may yet survive a little longer in the least ugly contest, if only because some of the other contestants are going to become so very, very, ugly. Only time will tell, and whichever way this runs, the UK is heading for some very tough times.

Note 1: I assume here that the Euro crisis will not be resolved. I would never say that a resolution is impossible, but it becomes less and less probable as each day passes.

Note 2: I was hoping to respond to comments, but this took me far longer than anticipated. As such, please accept my apologies.

Thursday, May 17, 2012

Is Extend and Pretend Coming to an End?

I can't remember where I first saw the phrase 'extend and pretend' (so apologies to the originator for not citing them), but it is a good expression to the reaction to the economic crisis. Another good one is 'kicking the can down the road'. Both expressions concern the endless (and often hidden) bank bailouts, the fiscal stimuli and the monetary policy that has been the reaction to the economic crisis. What they have been attempting to bury with their policy levers is debt. Or rather, debt that is not going to be repaid. Consumer debt accumulated in the build up to the crisis, sovereign debt built up in the aftermath (and to some degree in some states before the crisis). Tied in with the rise in debt, was the rise in asset prices, as floods of borrowed money created booms.

In Europe, to add another metaphor to the many, the wheels look like they may be about to fall off the Euro bus. Yet another metaphor is contagion, but (as I mentioned before) a better metaphor is that the financial doctors have become better at diagnosis. It is not a contagious disease that is hitting Europe, but the cancer of debt fuelled consumption. We had a bust back in the days of Lehman's and, instead of taking the pain at the time, the reaction was to extend and pretend. Whatever happened, intoned our policy gurus, we must not repeat the Great Depression. And, with the magic of their policy levers, that is what they claim to have done. Avoided another Great Depression. The European Central Bank has thrown everything but the kitchen sink at the Euro crisis. The IMF and the EU, and even the Federal Reserve, have bailed out, and the bailees have to varying degrees tried to reduce their consumption.

If only we had not imposed 'austerity' is the cry of many. But who was going to continue to fund the borrow and spend policies? In Europe, the only taker stepping up was the ECB, who lent money to insolvent banks so that they could buy the debt of their insolvent governments. You may note here that there is something very wrong with the concept of austerity; it still includes huge amounts of borrowing by governments. No country is stopping their borrowing, they are just trying to decrease their rate of borrowing. That borrowing is going to support ongoing unaffordable consumption. In the meantime, the background is one of accumulation of mountains of debt.

Alongside the attempt to reduce the rate of borrowing, there has been shrinkage in many economies. As the economy shrinks, so does the ability to service the existing debt. It is not, as the growing legions of anti-austerity commentators claim, that austerity is causing the crisis. Their answer is to return to growth in the rate of debt accumulation in order to hide, for a little longer at least, the underlying fundamental problem. Many countries are consuming more than they produce, and have no real prospects of being able to pay back the money they have borrowed to over-consume, or to continue to live at the level they have become used to. They are, to quote my first ever post, poorer than they think. They mistook debt for wealth, and must now learn to live based on their own productive output.

The only real step that can solve the European crisis is to just stop borrowing. Alongside this, there needs to be a recognition that many countries have, in the most basic terms, an unaffordable lifestyle. It is very simple. They must accept that they are poorer than they think. In order to return to stability, that relative poverty must be accepted. In crude terms, over the economy as a whole, the borrowed and consumed money is the equivalent of adding to the salary of every individual within that economy. As the borrowed money flows through the economy, it is adding unaffordable goods and services for consumption. The borrowed money indirectly subsidises consumption, and in some cases does so directly.

The solution is simple, and always has been. Stop borrowing money. The Greeks complain of Germany forcing them into austerity by diktat. However, Germany is not forcing any country into anything. It is saying that, if you wish to continue to borrow, you must do something to ensure that you can repay the money. If Greece wishes to restore its sovereignty, the answer is to stop borrowing. It really is that simple.

However, in Greece, and in so many countries, there is a reluctance to accept this. The standard of living that they have enjoyed on borrowed money is seen as a right. Civil servants protest, unions protest, and anti-austerity leaders demand the lifestyle that the country cannot afford. They all demand the status quo of pre-crisis borrow and consume, but just do not accept that the lenders are no longer there. They are all demanding the impossible, and their populations believe that the impossible is possible. We can see how seductive the calls for greater borrowing and spending are. If you are a civil servant thrown out of work, and you have a mortgage and family to support, it just seems unfair.

However, when faced with pay cuts, the same civil servants will protest, even though their collective salaries are unaffordable. The same with the workers throughout the economy. They simply are not, collectively, productive enough to support their lifestyle. The answer is unpalatable. It is cuts in wages and benefits to the point where the economy as a whole returns to competitiveness. How these are spread over the economy is an issue of politics, but the reality is that this is the only answer. The reality is that, for all but the most productive economies, the price of labour must fall. There is a glut of labour in the world, and this is resultant from the emergence of the emerging economies. Unless labour is exceptionally productive, there is no other way out.

If we take the example of Germany and Spain, German workers and Spanish workers are in direct and indirect competition with one another. German workers are, in aggregate, more productive than their Spanish counterparts, but this is not reflected in the costs of workers. If it were, then Spain would be able to balance their trade with Germany. There are no trade barriers, and we have to just conclude that, in aggregate, Spain's companies cannot compete with those of Germany. I am not just talking about wages here, but the overall structure and cost of the economy as a whole. This is why I included benefits in my earlier point. The many benefits provided by governments are an indirect cost of labour. The cost of labour in the economy is a critical factor in competitiveness. It is the productivity of the collective output of the economy in relation to competing economies.

These underlying differences in the real productivity and competitiveness of economies were both obscured by debt accumulation. They can continue to be obscured by debt accumulation, but this simply prolongs the moment when reality must finally emerge. At this stage, we cannot know whether the ECB, EU or IMF might just pull some new lever to extend and pretend a little longer. However, it is starting to look like extend and pretend has reached the limits. It is starting to look like there is no road left to kick the can down. The cuts in wages and benefits looks to be the next step. This process looks likely to be disorderly, and that is the real pity. It could have been gradual, controlled, and less painful. The way it will take place, the degree of pain, can be laid directly at the door of extend and pretend. 

Tuesday, May 15, 2012

Greece, Spain and Germany, and the World

This is the latests on Greek GDP:

ATHENS—The Greek economy shrank further at the beginning of the year, official data showed Tuesday, confirming that the country remains deeply mired in recession even before new austerity plans are due to be implemented in the months ahead.

Greece's gross domestic product contracted by an annual rate of 6.2% in the first quarter of 2012 compared with a year earlier, the country's statistics office said Tuesday. This follows a year-on-year decline in economic output of 7.5% in the previous quarter.
The relatively slower pace of decline reflected, in part, a boost to business and consumer confidence following Greece's recent debt restructuring and promises of new aid from its European partners and the International Monetary Fund.

Still, even if the figures do show some mild improvement and were better than economists' estimates for a first quarter contraction of between 6.7% to 7.9%, many forecasters say the economy shows no signs of recovery with some estimating a decline of 7% or more this year.
The equation was very simple. As long as growth in the rate of borrowing continued unabated, the Greek economy could appear to be in growth mode, activity in the economy continued to grow, and government had the revenue from taxing the growth in activity in the economy to pay for previous borrowing. The apparently virtuous cycle had to stop sometime, as there comes a point at which the debt mounts to such a degree that repayment starts to look increasingly impossible. Then comes the downward spiral as the borrowing slows and activity slows, and then reduces, with commensurate reductions in government revenue, and the inability to meet the terms of previous borrowing. It is not a lesson for Greece, but for all who think that borrow and spend is the way to economic prosperity. Apparently, the Greeks themselves know that the game has now come to an end. This is the news on the Greek banking system:

ATHENS—Greek depositors withdrew EUR700 million from local banks on Monday, the country's president said, and warned that the situation facing Greece's lenders was very difficult.

In a transcript of remarks by President Karolos Papoulias to Greek political leaders that was released Tuesday, Papoulias said that withdrawals plus buy orders received by Greek banks for German bunds totalled some EUR800 million.

Citing a conversation he had with Greek Central Bank Governor George Provopoulos earlier in the day, Papoulias said: "Withdrawals and outflows until 4:00 p.m., when I called him, exceeded EUR600 million, they reached EUR700 million. That doesn't include all those orders that the banks received to convert to German government bonds and other such things. Taking those into account it sums up to about EUR800 million."

Again citing Provopoulos, the president added: "that the strength of banks is very weak right now."
This is not new, but the scale may be. And who can blame those people running for the exit. They compound an already dire situation, but each individual who is looking for a safe haven has good reasons to do so. Of course, the 'safe havens' are actually not so safe, they are just less unsafe. It has not taken much imagination to see the roll-on consequences from the deteriorating situation in Greece, for countries like Spain and Portugal, and for all of the 'at-risk' countries. When (and it now looks like 'when', not if) the Greek economy finally collapses under its own mismanagement, the massive losses to the holders of anything attached to Greek debt will send shudders of fear around the world. The problem is that there are more 'at-risk' countries than currently acknowledged, and this means that the consequences will ripple out into the wider European economy. 

The problem is this; rather than accept that the economic crisis was about something truly fundamental, governments and policy were directed towards saving a system that was unsustainable. The European economy is a micro version of the macro of the world economy. You have the big export creditor countries lending to the import and borrowing countries. To be simplistic, think Germany to Greece, China to the U.S. There are, of course, major differences, with the EU tied together by a dysfunctional currency union. The real difference here is that the union makes the problem more apparent more quickly. The fates of the lender and borrower become tied together, as the failure of the borrower country directly impacts upon the lender. The more money that is lent to the borrower, the greater the potential damage to the lender.

The problem is this; someone, somewhere is providing their savings to lend to the borrowers. This is not the abstraction that is so often reported. Economies are abstractions rooted in the actions of individuals and companies. I will grossly simplify here. When a bank lends the savings of a German worker to a Greek worker, and the Greek worker loses his/her job, that means that the German worker has just lost some money. But its much worse than this. When the German bank lends the savings of a German worker to a Greek worker, some Greek workers then use the borrowed money to buy German goods. This sends a signal to the German company to invest more money in production to meet the demand from Greece, and to hire more workers. These very same newly hired German workers are the ones who then provide further savings that will then be lent to the Greek workers.

The problem is this; it all appears as a virtuous circle, right up to the point where it is not. To illustrate this, think of Greece and Germany not in terms of financial flows, but in terms of goods. To illustrate, think in terms of Germany as producing BMW's and Greece producing Ford Fiestas. The value of these two cars are different, but imagine that each is making the same number and exporting the same number cars to each other, on a one for one basis. The Germans do so on the basis that, in the future, their workers will be able to call on Greece to provide more Ford Fiestas than they provide BMWs. When German workers, for example retire, they have a call on a Ford Fiesta which Greece is obliged to produce, in return for a Greek worker being allowed to drive in a BMW now. As long as this situation is one where there is the belief that Greece will provide future Fords, the Germans continue to provide BMWs for now, even expanding their capacity to meet the new demand from Greece.

This is all very well, right up to the point at which the entire capacity of Greece's Ford Focus manufacturing capability is unable to produce enough Ford Focus cars to meet their growing obligations. The German worker is alarmed to hear that, when push comes to shove, Greece is not going to provide the Ford Focus that they promised him in retirement. Even worse, the problem is that, as it becomes apparent that Greece is not going to return the promised Ford cars, workers stop lending money to Greek workers to buy BMWs. The demand for BMWs drops, and some BMW workers start to lose their jobs.

This is a highly simplistic illustration. It omits the aggregated way in which this process has developed, with governments and banks and other countries/economies sitting in the middle of the process. However, it is an illustration of what sits beneath the abstractions we are continually reading about. When an economist suggests that the solution is to lend ever more money to Greece, they mean that they will take the savings of German workers, or income from taxation, and will forward it to Greece so they can continue to buy their BMWs, and this will continue to support German employment of BMW workers. This does not alter the fact that Greece is only returning a Ford Focus for every BMW, and Greece continues to grow its future obligation in provision of the Fords.

I read today about an estimated cost of a Greek Euro exit to Germany, which is around Euros 90 billion. This is a recognition of the imbalance (to continue the illustration) between the consumption of BMWs and Greece's Ford Focus production capacity. For years, Greece has been exchanging a Ford Focus for a BMW, and has promised to provide more Fords than it could ever produce. The capacity in Greece will never grow enough to provide the Fords that it owes. The loss is simple to see. When our German worker goes to the bank at some point in the future, and asks for his 'Ford Focus', he will be told that it does not exist or, if he is fortunate, that he must accept a Ford Fiesta. A German bank received a promise from a Greek bank that the Ford Focus would be there for our German worker, and in turn the German bank promised the German worker the Ford Focus. Along the way, a Greek worker enjoyed driving his BMW.

The loss to the German worker is real, and nothing is ever going to change this. It is the reality of the problem. The losses are real. They cannot be wished away. Extending further credit just extends the losses even further. Lending more of the German worker's savings can only put the problem into the future, and make the problem worse. As for imposition of austerity on Greece, this is an attempt to free more capacity in the Greek economy towards 'Ford Production' for export, and a reduction in the import of BMWs (sorry to stretch the illustration this far, but I hope you get the point). However, even with austerity, the backlog of owed Fords is now so high, that no realistic increase in capacity will ever be enough to clear the backlog.

Lending more money to countries to continue to import goods is just a problem extension, not a solution. It grows the problem. The real solution is to accept the real losses now. It is painful, but miracles do not happen. Greece, Spain, Portugal and all of the rest of the 'at risk' countries are not, as far as I can see, going to have a productivity/competitiveness miracle that will increase their capacity to allow debt repayment. The extend and pretend policies that have been the business of governments have just made the situation worse, and the costs to the creditors are still growing. Whilst my account given here is simplistic, it is exactly how a trade imbalance really works. It is not some magical entity, but rooted in the exchange of value of goods x for value of goods y, with a deficit in the exchange amounting to z. The z is then supported by lending. The lending is expected to be repaid. If the country taking the deficit cannot repay z, the loss must be realised by somebody.

How is this so difficult, and how do so many suggest that this can fixed by continuing to lend to those who cannot repay, and will never be able to repay? The only question is the size of the losses, when they will be realised, and by who? These are the questions that are being evaded. The evasion of these questions is why we keep growing the problem. It is not just a problem of Europe, but a wider problem in the world.

Thursday, May 10, 2012

Europe Crisis: Where will the lenders come from?

In a recent post, I pointed out that it was all very well for the anti-austerity movement to demand more government spending, but asked about who the lenders might be. As a very brief update, hot on the heels of the post comes this news from Bloomberg:

Gao Xiqing, president of China Investment Corp., said the nation’s sovereign wealth fund has stopped buying European government debt on concerns about the region’s financial turmoil.

CIC will continue to look for new investments in Europe as part of its strategy to boost allocations to infrastructure, private-equity assets as well as emerging markets to help boost returns, Gao said. CIC, with an estimated $440 billion in assets, is the world’s fifth-largest country fund, according to Sovereign Wealth Fund Institute.

“What is happening in Europe right now is of course of concern,” Gao said in an interview in Addis Ababa, Ethiopia, during the World Economic Forum on Africa. “We still have our people looking at opportunities in Europe, even though we don’t want to buy any government bonds.”
The problem is simple. No external investors believe that there is any real commitment to policy that might allow borrowers to pay back their debts. The only way any sane person will purchase the debt is if it sold at fire-sale prices, which means big losses for current holder of 'periphery' European debt. Instead, the only way forwards is for the European Central Bank (ECB) to continue its backdoor bailouts, by continuing to lend to bankrupt European banks so that they can buy their home country sovereign debt, and thereby expose themselves to ever more bad debt.

Having bought so much euro zone debt, banks in the periphery are now major holders of their governments’ liabilities and will be sitting on losses, given recent selling of peripheral debt, according to Das.

“As with the sovereigns, the LTRO does not solve the longer term problems of the solvency or funding of the banks, which now remain heavily dependent on the largesse of the central banks,” said Das, who fears deep recession. “It is a government-sponsored Ponzi scheme where weak banks are supporting weak sovereigns, who in turn are standing behind the banks — a process which can be described as two drowning people clinging to each other for mutual support.”
The analogy in the quote is quite apt. For those that have not read about it, the LTRO (Long-Term Refinancing Operation) is the ECB's complete abandonment of Germanic prudence, whereby bankrupt European banks are being bailed out by the ECB. As one wag put it, the ECB is accepting bus tickets as security for the lending at below market rates. The really stunning part of this is that it is possible to find commentators and analysts who support this lunacy. I mean really, bankrupt sovereigns supported by bankrupt banks, which in turn are supported by bankrupt sovereigns? And this is a good idea?

Note: I found that the Paypal donate button on the right of the page was still not working (the second time I have fixed it). I have (I hope) now fixed this. 

Monday, May 7, 2012

Anti-Austerity in Europe

I watched the outcome of the French election with considerable interest. It seems that anti-austerity is becoming a major force in Europe. Even more interesting is the collapse of the will for austerity in Greece.

It is a quite fascinating situation, which is also quite alarming. It is fascinating as the 'Krugmanesque' vision of economics may finally be put to the test. That is, it seems that it may now be the case that the borrow and spend spigots will open for already 'in trouble' economies. As regular readers will know, I do not deny that borrow and spend will indeed create employment. After all, it is not difficult to spend somebody else's wealth on make-work activity or paying for activities that would otherwise not be affordable. I do not deny that this will create more tax revenue. If more people are working, and more are spending, then indeed this will indeed create the activity in the economy that will garner greater tax revenue. Likewise, this increased activity will appear to either slow economic shrinkage, stabilise, or even grow an economy.

The problem is that it is very, very easy to spend the wealth of others in generating activity. The problem is that this borrowed wealth will eventually need to be returned to the lender. This in turn generates the problem that, if people doubt the borrower's ability to repay, then they will not lend. The question then arises as to whom, exactly, these want to be borrowers might actually borrow from. It is all very well for people to march on the streets and demand an end to austerity, but they are demanding that governments spend money that they do not have. However much these marching/protesting individuals and their political leaders demand borrow and spend, they have a problem. The problem is simple. They simply do not, within their own country, create the wealth that they desire. That is why they must borrow.

The wealth that is desired by the protesters and their political leaders only exists external to their own economy. It is not theirs, and short of going to war, they can only access this pool of wealth if the holders of the wealth choose to allow access to it. No amount of protest, political rhetoric, demands, tantrums and so forth, will change this.

Of course, there is always the possibility of raising taxation in a country to pay for all of the government spending. It is always possible to squeeze the pips out of the wealthy. Or at least, as long as the wealthy hang around to be squeezed. However, the term capital flight is not abstract; there comes a point at which people feel that the redistribution of their wealth to others is unacceptable, and they will choose to remove their wealth to a place where such a redistribution will not take place.

Even if accepting that the wealthy can be squeezed, the 'in trouble' economies will have to squeeze very hard  to make up for the loss of borrowed wealth from external sources. And that is the problem; even if increasing taxation for the wealthy, will governments be able to manage without the borrowing of external wealth to pay for all of their reinstated/increased spending programmes? I mean really; can this do the trick? I very much doubt it. 

The plans of the anti-austerity movement are quite remarkable. They are remarkable in that they assume that there is some hidden source of wealth that is the right of their country. They do not have, or produce, this wealth themselves, but are apparently entitled to it. If the anti-austerity movement wins out, we will be able to see whether the Krugman approach actually really works in practice. I read recently that Krugman's view is influencing political leaders in Europe; that his proposed remedies are believed to be the solution.

Of course, there is nothing to say that some of the 'in-trouble' economies might not borrow a bit longer. For a while at least, the Krugman solution may appear to work, and encourage others to speak out/act against austerity.The success of anti-austerity will, if this takes place, be trumpeted as a solution - at least up to the point that the lenders of wealth lose all confidence. As an analogy, think of the Jurassic Park films; there is a sequence in which the lead character says something along the lines of; 'That's how it always starts, with the oohs and aahs, but then the biting and the eating starts'.

So, if the anti-austerity movement wins for a while, those in favour of the movement will sound out their 'oohs and aahs', but when all confidence is lost, the picture will change dramatically. It is quite possible that we are about to witness a real world economic experiment, in which the theories of individuals such as Krugman will finally be tested. They believe that wealth can simply appear by borrow and spend/tax and spend. They believe this will create a virtuous cycle that will fix economies.

I, on the other hand, believe that wealth is, in the end, created by creating a framework in which individual endeavour creates real wealth. This individual endeavour, whether from a bricklayer or a the CEO of a multinational, is the real source of wealth creation. They make products and services that people want, and can pay for the goods and services as a result of their own individual endeavours. The relative success of these individual endeavours, in aggregate, in terms of productivity, and in relation to other countries, determines the real wealth of a country. Not borrowing.

I suspect that we are about to find which vision of economics is correct. I hope I am wrong. If I am not wrong, then the outcome may be very disturbing.