A Letter Requesting Information on The Policy of Quantitative Easing (Printing Money)

Over my last two posts (UK Government and Money Printing - More 'Funny Business'? and It's Official - the UK Government is Now Bankrupt), I have highlighted that the Bank of England is about to finally embark on the policy of 'Quantitative Easing', otherwise known as printing money. They have suggested that, amongst the assets that they will be buying will be gilts, which is a purchase of government debt. This means that the Bank of England will be, in some way, funding government borrowing through printing money.

I took a look at the information being provided by the Bank of England on this policy, and found it lacking in any kind of detail whatsoever. One of the documents that I found on the Bank of England website was a report on a press conference on the subject, which showed that the press were simply not asking the right questions. In fact, although it sometimes appears that they are asking some cutting questions, their performance brings the word supine to mind. They failed to ask any of the most basic questions that should have been asked.

The Bank of England is about to embark on a very drastic and radical policy, and the press completely failed to ask for any detail on how the policy would operate. The policy will mean a massive increase in Bank of England intervention in various markets, and that this will have profound implications for the economy, but the press asked for no detail....???

As such, I have sent a copy of the following to the Bank of England email address for press enquiries, and a copy to their general information address:

I write for Cynicus Economicus, and have had some trouble finding clear information regarding the Bank of England's policy on Quantitative Easing (QE).

As such, I would be most grateful if you could provide the following information:

1. What quantity of money will the Bank of England be adding to base money in the period March-May, and the period June-August 2009? Please give totals or ranges under consideration, and any projected figures that you are using as the most likely scenario?
   
2. In what form are you planning to add the money? This is the question of which assets the Bank of England will buy as part of the QE operations? Can you give a projected split / proportion of which type of assets will be purchased in the period March-May, and the period June-August 2009? Please give totals or ranges under consideration, and any projected figures that you are using as the most likely scenario?
3. Can you give a clear description of how the split/proportion of assets to be purchased under QE has been determined?
   
4. If you are unable to answer questions 1,2, & 3 can you confirm that this is because you have no firm plans for what you will be undertaking in relation to quantitative easing? If there are no plans, can you give a clear description of your criteria for the decision making that you will use in determining how much you will purchase of which kind of asset, under what circumstances?
5. Can you give a clear description of the method you will use to purchase each asset class? In particular will you undertake any action to purchase gilts, or an other form of UK government bonds, directly through the UK Government Debt Office auction process or any other direct means?
6. In a recent press conference Mervyn King suggested that the reporting of QE would be undertaken in the minutes of the MPC. Can you confirm in detail exactly what information will be provided in the minutes?
7. The MPC minutes are not (I believe) intended as a reporting tool for activity such as QE. As such, why is the policy and action of QE not being reported in a formal publication dedicated to this policy? In particular, QE is widely seen as a radical policy, which Mervyn King describes as 'unconventional'. Under such circumstances, with significant implications for the operations of markets and the broader economy, why is no formal and transparent method of reporting being implemented?
   

In any reply, please do not refer me to documents that do not answer the specific questions that are being asked. The questions are very direct and very clear, as I believe that my readers would like very clear and direct answers. There is considerable concern about the policy of QE, commonly referred to as 'printing money', and I am sure that you would wish to provide the information necessary for people to understand this policy, and how it will operate.

Thank you in advance for a full reply that answers these questions in a way indicative of a desire to be open and transparent in reporting your activity.

This is the second time that I have sent a letter to the Bank of England, and the first letter was on a related subject. I asked them to confirm that they were planning to report the amount of money they created under the QE policy. They ignored the last letter, so I hope for a response this time.

The reason that I am writing the letter is that I dislike conspiracy theory, and will always seek to clarify any suspicions that I might have. In this case, if the Bank of England is doing nothing that might alarm people, I can see no reason why they might not respond. To not respond to one email might be an administrative oversight, but to fail to answer two starts to look like they do not wish to reply.

I would also expect that my questions might prompt them to issue a press release, as these are all perfectly reasonable questions that people might reasonably want answered. After all, printing money to buy government debt is something about which the public might have concerns. My email simply highlights the kind of questions that might be asked.

I will let you know next week whether I have been sent a reply.

Note 1:

I have just seen that on my last post but one, the headline was poorly written. I have now changed it. Inevitably, with no editor I will make many errors, but to make a crass error in the headline has left me rather shame-faced. The error was writing Its instead of It's ....

In light of the rather bad error, I have simply changed the headline. Normally, if I make any change to the content of the blog will add a note including the date and nature of the change. In this case, I have not left a note on the original post, but thought I should mention the change somewhere. Thus this note...

Note 2: Thank you for the many comments on the last post. I can see that many share my concerns. As you may have noticed I have been busy with posts on QE which has left me little time to reply to comments, so please accept my apologies for not responding on this occasion.

Note 3: It may actually be a good idea to start a campaign on this subject. I really do find that this opacity is quite shocking, and do not think that the government should get away with it. As such might I suggest a letter writing campaign to your local MP. You can find the email address for your local MP here (click on the map for your constituency).

This is is my suggested letter which you can copy and paste, or alternatively write your own version:

-------------------
I am writing as I have very increasing concerns over the recent Bank of England policy to implement quantitative easing. In particular, I am worried about the following:

1. There is no policy document that clearly outlines how this policy will operate, what quantity of money will be created, what assets the money will be used to purchase, and what method will be used for the purchases.
   
2. In addition to this Mervyn King has suggested that the method of reporting for Quantitative Easing will be through the MPC minutes. This is not the purpose of the MPC minutes, and there is no requirement for full disclosure of activity in such a method of reporting.
   

This is all very opaque.

I am very concerned at such opacity in consideration of the fact that the Bank of England will be using money creation to purchase gilts. In this situation the Bank of England will therefore be creating ('printing') money to purchase government debt. This might be seen as government operations being funded by printing money.

Under such circumstances, it would be reasonable to expect the Bank of England to offer a transparent and detailed discussion of the policy as a formal policy document, as well as a formal, full and transparent procedure for reporting their activity.

I would therefore be most grateful if you could, on my behalf, seek to clarify why this process is being undertaken in such an opaque manner, and clarify exactly what the policy will be. I would also be grateful if you could press for a proper method of reporting on the policy of quantitative easing.
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Additions, suggestions for improvement will be welcomed. Just leave a comment below.

It's Official - The UK Government is Now Bankrupt

You would think that news that the UK government is bankrupt would be headline news around the world. When I quote the piece of news that announces the bankruptcy, you may say 'huh?', and like the newspapers, initially find it difficult to see it. I will start with the news itself, which was tucked away in the financial section of the Telegraph:

'Charlie Bean [the Bank of England Deputy Governor] put his weight behind the pound's 25pc fall over the past year in an unusual comment on the pound. Mr Bean also confirmed that the Bank is poised to start buying government bonds in a drastic attempt to resuscitate the stricken economy.'

If we translate this, it means is that the Bank of England is going to print money to directly finance the operations of the UK government. This is the action of a government that is now literally bankrupt. The bank is not going to buy the bonds to 'resuscitate the stricken economy' but will buy them because nobody else wants to buy UK government bonds. There are not enough people willing to lend to the UK government. It is bust. It is bankrupt.

The UK government can not fund itself without borrowing - it can not service its existing debt without borrowing, and it can not pay for its activities without borrowing. When the lending stops, it goes bust. Or it prints money.

You will have read lots of stories that 'quantitative easing' (printing money) is being undertaken to fight deflation, but it is not. It is the last desperate gamble of governments to save themselves and their collapsing economies. For those that believe that printing money and lending it to the government is about fighting deflation, read on....

In July of last year, I posted that I believed that the UK government was effectively bankrupt, and that this would reveal itself as the coming crisis progressed. Ever since that early post, I have watched in horror as the UK government has poured ever more money into ever more and ever larger bailouts. In July of 2008 I had this to say:

One certainty is that, in a years time, the UK banking system will still be in crisis, as will be government finance. Unemployment will still be climbing, consumer confidence will be rock bottom, and house prices still falling. Businesses will be closing down in large numbers. All of these events were put in place over the last few years, and can not be reversed.

I identified that the first bailouts would be followed by even greater bailouts, and that the banking crisis would simply be transferred onto the government. As just one example, I asked the following at the start of September:

The reality is that the UK has been bailing out the banks for some while, through the special liquidity schemes. How long can this go on?

This was before even more money was poured into the bailouts. I then went on to say in the same post:

In the case of the UK, I wonder whether the UK government will have the financial wherewithal to actually have a choice in the matter. When the next credit crisis strikes, I expect confidence in the UK economy to be at a very, very low point, and the only way the government will be able to finance the bail outs will be through 'printing' money, with all of the negative consequences that entails.

As a sense of perspective, this was written at the time of the bailout of Fannie Mae and Freddie Mac in the US (I have added the italics in this quote). The situation that I predicted at that point in time is exactly the situation that is now confronting the UK.

In recent months I have also been pointing out the impossibility of continued government borrowing. In particular, just about every country in the OECD is going on a massive borrowing binge, and all at the same time. My question is very simple - how are all of these governments going to simultaneously raise the money to finance their borrowing? The US alone is looking to raise $US trillions. In such circumstances, potential lenders will have a huge range of choice on where they put their money, and they will look to put their money where they believe it will be safe.

As we are all aware, the £GB has been plunging in value, the UK is seen by many as the economy that will be hit hardest by the economic crisis, and (even before this article) was discussing the option of printing money. Amongst all of the choices of which country to lend to, the UK is going to towards the bottom of the list. At the same time, due to the lunatic and endless bailouts, government borrowing is spiralling ever higher. At a time when there is intense competition between countries for finance, with an ever growing need for ever more borrowing, it is inevitable that the UK government would be unable to continue to borrow enough money.

As a result, the printing presses are about to turn....

Back in December of 2007 I wrote a post called 'Money Printing Economics - the UK and US as the New Zimbabwe?'. At the time I wrote this, I could still put a question mark on the end of the sentence. This is what I said at that time:

Now we come to the crux of it. If the government prints enough money, this will provide an potentially unlimited amount of liquidity to the banking system, and the banks can then use that money to buy government debt, thus financing government borrowing. Meanwhile, the government can continue to service its expenses and keep repaying the debt owed to overseas creditors. In other words, the government will appear not to default. However, overseas investors will not see it this way. They will see it as it is - a default. Instead of failing to repay, they will be repaying the debt obligations in what can only be termed 'comedy money'.

As it is, the government is not even using the banking system as a conduit for the printed money, but will be financed directly by money fresh off the 'printing press'. Putting the situation bluntly - the UK is now the new Zimbabwe.

I have, in many posts, discussed the results, implications and consequences of printing money. If you would like to know how a central bank prints money, I give an explanation in Note 2 at the end of a post which can be found here. However, the method is not important, and it is just as easy to think about the central bank as if it were printing money by printing physical bank notes, as the effect is exactly the same.

I will try to explain what printing money actually means, through simplifying the process (for regular readers of the blog, you may want to skip the explanation, as I have explained this before). As we are all aware, the UK has an output of goods and services in many sectors. However, for the sake of simplification, I will just use the example of milk, and will describe the UK's output as if it were only milk, and will use small numbers to make it as clear and as easy to understand as possible.

In this illustration, we will say that the UK has a total output of milk of 100 litres, and that there is a total amount of £100 in the UK economy. In this example, therefore, the price of milk will be £1 per litre. If we then imagine that the government prints another £10, so that there is a total of £110 in the economy, we have a problem. The amount of milk has not increased at all, but the amount of money available to buy milk has increased. Instead of having £100 chasing the 100 litres of milk, we now have £110. In this simplification, remember, there is only the 100 litres of milk to buy with the money.

The only thing that can then happen is that the milk will increase in price from £1 per litre to £1.10 per litre. In other words, if you increase the money supply without increasing output, then you have a situation of inflation.

In addition to this, printing money has lots of other nasty effects. The first of these is that printing money is a form of taxation, and I will explain how this works.

As we have noted from the milk example, if you print money without increasing output, you are effectively devaluing money. Yesterday, your £1 could buy you a litre of milk, today that is not possible. If you are devaluing money, where has the value gone? The answer is that part of the value of your £1 has been transferred onto the newly printed money. If you then ask who has this newly printed money, you see that it is the government that holds it. As such, what you have is a situation in which the government is placing a tax on every unit of currency, and transferring that tax into the newly printed money. This means that there is a tax on every coin and banknote in your pocket, a tax on every £1 that you have in your bank account, and a tax on every asset that you hold that is denominated in the £. In other words, it is a tax on everything.

Another effect of printing money is that it a method for governments to default on debt. If you imagine that you are an overseas investor, and you have lent the UK government £1, then the value of that money was equivalent to being able to buy one litre of milk (using the milk example again). If you imagine that the government is running out of money, so that it has only £0.90 left to pay the lender, they will have a choice. Either they can pay back part of what they owe the investor, which means partially defaulting on the debt, or they can print money and give £1 to the investor. In the case of giving the lender £0.90, this is not enough to by a litre of milk, which means that the lender has lost money. However, if the government prints money, as in the example I gave earlier, then the investor will have his £1 returned, but it still will not buy the litre of milk, as milk has increased to £1.10. In both cases the effect is exactly the same, and in both cases the government has defaulted on debt.

Essentially, however it is spun, government money printing is fundamentally dishonest.

Then there are the effects that this has on an economy. Before discussing this, I have seen a lot written about Japan, and how they managed in recent times to print money without subsequent hyper-inflation. This is given as a justification for why it will be okay to print money in countries like the UK, and the US. If you go to my post here I explain why Japan 'got away with it', and if you go to the notes at the end of the post I explain why countries like the UK will not 'get away with it'.

Returning to the effects on the economy, we have established that inflation follows money printing. This is a situation of monetary inflation, where the output of goods and services is not increasing, but where the number of units of money chasing those goods is increasing. What then happens is that the cost of living goes up, as everything becomes more expensive. In a situation of a collapsing economy (the case of the UK), many private sector workers will be very upset at seeing their standard of living eroded, and some of them may be brave enough to strike and demand more pay. Many others will not, as they will fear for their jobs. However, some of those strikers will actually get more pay. That increase in pay will feed into higher costs and eventually higher prices for the output of their sector. This is inflationary.

In the meantime, government workers will also be upset at seeing their standard of living declining. The difference here is that, they will not have the same fear for their jobs as the private sector, and will therefore be more likely to strike. As they are in the position of running 'essential services', and/or the unions in this sector are strong and powerful, they are very likely to succeed in gaining pay rises. If we remember why the government is printing money in the first place, which is because it can not afford to pay for its commitments, it becomes apparent that this will be very problematic. The government is already unable to pay these government workers without printing money, so paying them more means that they will have to print even more money......which further feeds into inflation.

All the while this is going on, the government is effectively devaluing the currency, such that on foreign exchange markets the value of the £GB will be falling. As the value of the £GB falls, the cost of all imports will climb. Again, you have substantial inflation. On top of this, as the inflation starts to kick in, you start having capital flight, which is where people realise that the value of their money is being destroyed, so that they seek to put their money in other currencies that are more likely to hold their value. In order to do this, they will have to sell their £GB in exchange for other currencies, which means that there is a flood of £GB into the world market, which in turn further pushes the value of the currency down even faster and harder. This in turn feeds into higher inflation, and the situation becomes self-perpetuating into a downwards spiral.

So what will the government do with inflation out of control and a collapsing currency? Inevitably there will be widespread discontent and hardship that results from this inflation. The government is in a position where they believe they must 'do something'. On past performance, based upon the way that they have systematically destroyed the UK economy such that they created the situation, they will yet again do exactly the wrong thing. They will try to command the economy back into shape. In order to do this, they will impose controls on international capital flows to try to lock capital into the country. They will also impose price and wage controls to try to stem the inflation.

Of all of these, the most worrying of the possible actions will be the price controls. In particular, it is very likely that they will try to impose controls on the price of food and energy, as the inflation in the price of these items will be the most immediate concern. Price controls, unfortunately, will always result in even greater problems than they are supposed to solve. All you have to do is think of yourself as a dairy farmer, for example and imagine that the government decides that you can not increase the price you charge for milk (sorry, back to milk again).

In this situation, you will see the economy inflating around you, but you will not be able to inflate your milk prices at the same rate. This means that you will be becoming poorer, as the value of the milk you sell will be falling relative to everything else. In this situation, it becomes increasingly pointless to actually continue in the business of selling milk, because you will start to lose money. As a result, the output in your sector will fall, and then there will be shortages.

It is at this point that the situation is completely out of control, with the government imposing ever more 'controls' on ever larger parts of the economy. What happens then, I am not sure...but I do not think it will be a happy situation.

This last section is speculation based upon my best guess of what the government will do. It is also possible that someone will have the courage to lead the government out of its self-created crisis. The answer, of course, is to switch off the printing presses, and accept a period of significant hardship and austerity. However, my speculation is based upon the action of the government to date, in which they have continually sought to pretend that they can control the economy and turn back the clock to the 'good times'.

I have mentioned a couple of times in this blog that I sometime have difficult believing the implication of what I am myself writing. In particular, the rational part of me says 'this is the reality', but the irrational part of me refuses to believe it. Occasionally, such as seeing the article quoted at the start of this post, reality is hammered home. In this case the reality is that the government is now going to try to finance its operations through printing money. This really is the Zimbabwe solution, and however many economists witter on about various justifications, funding a government with printed money is a road to disaster.

The real tragedy of this is that it was completely avoidable. Whatever happened, the UK was going to have to face a very hard time, but there was never any need for it to become as bad as it will become. If the government had shown the courage of leadership, had accepted the underlying reality of the depth of economic problems, it could have set about the essential reform of the UK economy. Instead of this, they chose to delude themselves, and delude the public into thinking that everything could go on as before.

Another tragedy lies in the media. They should be screaming with outrage at what the government is doing, but instead they are wittering about bankers bonuses, and other populist nonsense. They have let themselves be steered away from the reality of exactly what is going on. As I said at the start of the post, the UK government has now effectively declared its bankruptcy, but the headlines in two of the major UK newspapers are 'Archbishop: Christians are seen as mad by society' and 'US agents charge cricket mogul with $8 billion fraud'.

Quite simply, I despair.....

Note 1: I found an interesting article in the Telegraph, in which they report the following:

Last month, the Institute for Fiscal Studies warned that it will take more than 20 years to pay off the debts being run up by the Government during the current crisis.

Calculating that public debt had already risen by £10,000 for every family in the country, the IFS warned of a "tightening" on tax and spending that will have to continue until the early 2030s.

If nothing else, it gives a good sense of scale to the lunacy (italic and bold added by me).

Note 2: In the unlikely event that governments were actually able to meet their insane level of borrowing, just think about the impact of that borrowing on the world economy. For simplicity, we will pretend, for a moment that there is no money printing, and imagine that the total amount of money in the world economy is therefore fixed. If you then were to imagine that the world economy has a total of 1 million units of money, and then think of what governments are doing, the insanity of their actions becomes apparent. Effectively, they taking ever larger slices of that pile of money into their hands for their various stimuli. As such, if the government borrows 500,000 of the total units of money available, then there is 500,000 less available for investment in business. If there is less investment in business, then there is less growth in the world economy.

In the meantime, the 500,000 units of the total is being spent by the government propping up insolvent business (banks, automakers etc.), and being spent in areas that will not create any long term economic growth. In other words, it will be spent on activity which will not solve any problems at all, except in the very short term. By denying this money to private business, they are simply restricting the potential for growth in business overall, and thereby destroy the chances of eventual recovery.

Note 3: Arguments against this post are very welcome. I really would like to believe that I am wrong. If you can convince me I am wrong, I will be genuinely grateful. I really, really do not want to be right.

Note 4: I remember a comment which mentioned that the blog is very popular with farmers. My suggestion to farmers is that they organise and prepare to defend themselves against price controls - have the arguments ready, and if need be, have plans to face down the government. The same for the energy sector. I could be wrong about price controls, as there is no deterministic reason for them, and this is speculating on what actions individuals might decide on. However, bearing in mind that such price controls would devastate your businesses, you may want to take a precautionary approach, and prepare anyway. My best guess is that such controls might appear in about a years time if that is the course that is followed, but that is nothing more than a wild guess.

Inflation, Deflation or Hyper-Inflation

It now seems that both the UK and US have now used up most of their interest rate ammunition, in their hopeless attempt to reverse the slide into depression. The result is a further sinking of the £GB, and even the 'mighty' $US is finally wobbling.

One of the most interesting features of the latest moves to arrest the slide is the minutes of the Bank of England, which revealed their fears for a run on the £GB:

"The Committee discussed whether a larger cut was warranted," the minutes said. "Financial markets had priced in a cut of 100 basis points and there was a risk that going further could cause an excessive fall in the exchange rate. There was also a risk that an unexpectedly large cut could undermine confidence in the economy more widely."

The £GB's recent slide was, in part, prompted by ever more dire news about unemployment, which is now surging ever higher, ever faster, in a mirror image of the US problems. The simple truth is that, as I always predicted, none of the measures to 'fix' the economies of the UK and US are working. We have this from the Telegraph regarding the UK:

In comments which raise the ultimate prospect of wholesale nationalisation of the British banking system, Mervyn King said that "additional measures" are now needed to solve the crisis.

The £500bn rescue plan unveiled by the Prime Minister in October and since copied throughout the world is not encouraging banks to lend more to families and businesses, he said.

It is the most stark warning yet from the Governor that all his and Whitehall's efforts to bring the crisis to an end have not succeeded.

Banks now need extra support from the taxpayer if they are to return to normal lending, he indicated. Facing the worst financial crisis in living memory, UK banks have slashed the amount they lend out to homeowners, resulting in higher interest rates and tougher conditions for homeowners.

I predicted when the bailouts were first proposed that the bailouts would be ongoing, and this is proving to be the case. In the US they are already printing money, and the Bank of England is now openly discussing the option. As each day goes by, as each new ever more expensive, ever more desperate measure is implemented, the relentless bad news continues. Up to now, each measure saw a brief rally in stock markets, but this time, the fed's rate cut saw a fall in the Dow Jones Industrial Average. Even the herd instinct of the markets are no longer following the scripts of government.

Just to add to the pain, it now seems that OPEC are going to drastically cut oil production, which can only serve to add fuel to the fire of the crisis. Low oil prices were one of the few true stimulants to the moribund economy that would have had a positive impact. We can only hope that their agreement fails to have teeth in practice. I still remember people arguing with me (about six months ago), that my prediction of $US 60 per barrel was absurdly low. It seems it was absurd, but not because it was too low, but because it was way too high.

There is still talk of deflation, and this is one of the justifications for the printing of money. In some respects it is correct that there are deflationary pressures. In particular, the housing bubble means that homes are returning to a more normal measure. I always argued that house prices should be included in inflation, and would still argue that they should be now. However, I am not sure how the deflation of a bubble could ever be considered to be a bad thing. Painful, yes, but bad, no.

Unemployment will also create deflationary pressure on wages. I was once shown a chart by an economist that 'demonstrated' that wages do not fall during recessions. It was one of those classic models that economists love. However, at the time, I merely pointed out that the deflation in wages was just displaced into unemployment. A company has a choice; make workers redundant or give everyone a pay cut. In most cases they will not ask for the pay cut, as it is easier to externalise the discontent through redundancy rather than trying to manage to persuade all workers of a need for a pay cut. As such there is displacement. It is at times like now that the minimum wage will have a negative impact. It makes it even more necessary for some companies to opt for redundancy rather than across the board pay cuts.

On top of these factors is the fall in the prices of commodities, such as oil. However, the prices of these items is not straightforward as, for both the US and UK, the prices of many of the commodities is tied to the exchange rate (though many commodities are priced in $US - more of that later). For example, in the UK, the prices of fresh food are on the rise again, due to the weakening of the £GB.

Howard Archer, chief UK and European Economist at Global Insight, said: "Sterling is having an impact as most of our fruits are imported. This is not something that is going to disappear."

But he added: "There are several factors at play which will lower inflation and they will substantially outweigh the effects of the pound."

Perhaps I am being unfair to Mr. Archer here, as the article does not detail all that he said, but at what level does he think the £GB will fall to? This is the critical question that needs to considered in thinking about inflation. My own view is that the fall has a long way to go, and that will mean strong inflationary pressure. As commodity prices are falling, so is the £GB, and where the balance between the two might settle is still unknown. In the case of the US, the $US has only just started to wobble, so the effects of downward movement of commodities have been deflationary. However, the $US bubble will burst, and when it does, the deflationary effects will start to disappear.

Another element in the consideration of deflation is retailing and services. I need not detail or even reference the dismal state of these sectors, as their poor state is being widely discussed in both the US and UK. Some months ago, when discussing the prospects for inflation, in relation to my prediction of a sinking £GB, I saw the collapse in services as a counter to the inflationary effects of higher import prices. This appears to be the case, as much of the fat in the service sector created by the credit boom is being trimmed.

So how does this add up in aggregate - in the prediction of inflation or deflation? It is here that we come to the really tough part, because there is the role of governments in all of this already complicated scenario.

I have already mentioned that inflation or deflation is strongly tied to currency movements in relation to commodity prices. As the world economy contracts, the supply of commodities relative to shrinking demand is rising, meaning prices should continue to fall. For regular readers, you may remember my analogy of the world economy as being like a person running forward, who then hits a wall of maximum commodity supply, bounces back from the wall, then commences running forward again (what has recently happened to the world economy). As I described it, the wall was also moving forwards, but not as fast as the runner so that eventually he would run up against the wall again, only to bounce back. In the case of OPEC's production cut, the wall is moving backwards, not forwards.

However, my prediction for commodity prices starting to rise again was about four years forward. I have mentioned before that OPEC is problematic, but it seems they are throwing a major spanner in the works with their production cuts. This is a wild card, as the price of oil is an important element in inflation for the world economy as a whole (despite some economists insisting it was not as important as before).

Another wild card is state of the $US. I am certain that the $US is the greatest bubble in history, and one of very few predictions I have made that has been incorrect is that the $US should already have sunk. I never imagined that people would be quite so irrational as to put their faith in a currency sitting on top of a collapsing economy. My error was that I expected people to act with at least some rationality. However, homo economicus was always a myth, so I should have known better. Putting my previous error to one side, the underlying weakness of the $US must emerge at some stage, so the wild card in this case is not 'if' but 'when'.

My reasons for why both the $US and £GB are fundamentally weak currencies is quite straightforward. The strength of the currencies previously rested on two platforms. One of these was inward investment, which was due to the illusion that the economies were successful, due to their credit inflated GDP growth, and the other was that creditors to both the US and UK needed to buy the $US and £GB in order to lend into each of the economies. With collapsing economies, the inward investment will evaporate, and nobody but a madman (or government) would want to be a creditor to both of these countries at present. At the same time, both countries make less and less of anything that anyone wants to buy. This is best seen in the ongoing trade deficits which, according to the Economist (print edition, 6th-12 December, p106) were $bn 851 for the US, and $bn 185 for the UK for the last 12 months. Inevitably, as the currencies of both countries sink, these deficits will diminish but, as things stand, there is is a basic imbalance (and has been for a long time).

Add to these currency wild cards are the exchange rates set for the RMB, which is a total unknown, dependent upon the wisdom (or lack of it) of the CCP in Beijing, as well as whether China seeks to rescue its own economy by attempting to redeem the I.O.U.s from the US and UK.

As if we do not have enough wild cards in the pack, we can finally add in the possibility that, if the $US starts to fall dramatically, the oil states that peg their currency to the $US might abandon the peg once the $US commences to collapse, and will the $US remain the currency of commodity pricing in general?

So where does this leave the question of inflation versus deflation? As you will note from the brief summary above, there are many factors that are inter-related. My view, based upon a heuristic evaluation (a smart expression for a 'guesstimation') is that any deflationary pressures in the US and UK at present will be strongly offset by a future currency collapse. The printing of money, in conjunction with the horrific level of government borrowing, will take a necessary and painful adjustment in currencies, and turn the adjustment into a complete collapse of the $US and £GB. 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. However, if the $US does collapse, as I believe it will, I believe that the pegs and $US pricing will be unsustainable, leading to a 'shock' hyper-inflation.

Note 1: I am sorry to be so relentlessly gloomy, but I just can not see a positive side in anything that is going on. Even the bright point of the collapse in oil prices is now looking less positive. I am not sure I have covered all of the points here as well as I should, but I hope that the argument stands up. For regular readers, I am sure that much of what I am saying will make sense, as the foundation of what I am saying is built in many previous posts. For new readers, I would recommend the links at the top left of the blog.

Note 2: I have had some interesting comments again. Jeremy expresses complete cynicism, suggesting that whichever flavour of the politician, it will make no difference, and Steve Tierney expresses his concern that the public are buying the idea that the economy can be 'fixed' with ever more government borrowing and money printing. Steve reverses his previous optimism about people in face of the rising support for Gordon Brown due to his 'handling' of the economy. Like you Steve, I am endlessly disappointed (an anonymous poster also makes a similar point after reading the Guardian 'Comment is Free' section. I can not but help myself in agreeing with these concerns, and writing this blog is my small contribution to trying to make people face reality....

Also, an interesting comment from VKP who suggests that the UK and Greece have many similarities. I am not as familiar with the details of the economy of Greece as I would like, but am aware that they are running very large deficits. I have mentioned the possibility of the abandonment of the Euro, and the state of the finances of Greece is one factor in that consideration. I am not sure how much longer Germany will play ball.....

Note 3: If you thought I am gloomy, you might want to visit here if you want to see real gloom. An anonymous commentator recommends this blog.

Note 4: I have had some comments on my post on taxation reform. Lemming asks what I think about monopolies in my proposal. I still need to post on regulation, but I do think that one of the key regulatory roles of governments is to ensure that there is fair competition in markets. I do not have the quote to hand, but Adam Smith made a very good point about how, as soon as any group of merchants sit together, they will seek to conspire against the public. At least, that is the basic idea he is discussing...Lemming also, asks in a second comment what I think about individuals growing rich, and sucking money from the bottom to the top. In particular, he asks whether this pulling of money from consumers eventually leads to depression. It is an interesting point but, if the rich individuals invest this money into productive assets, then everyone gains. If the money is lent into consumption, then it will eventually lead to the mess that we are in now. I hope that I have not done Lemming's point an injustice, so you should read the orignial comments.

Also on the subject of taxation, Ivan makes the following point:

One thing, you mentioned tax free allowances - they would add massive complication and cost to a flat tax. I would propose that negative taxation would cover any free allowances, make the system simple and possibly finish up adding to the amount of tax collected.

I am not sure that having a single fixed tax free allowance is complicated, or am I misunderstanding your point? Please feel free to clarify, and I will (time allowing) try to respond.

Note 5: I have still not started work on the reform of the banking system, so apologies for this. I hope to get started soon, but have several distractions pulling me away from the subject. I will do my best....

As Expected £Sterling Tumbles

It would be hard to have missed the furore over the recent comments of Alastair Darling. In the original interview he said:

'Britain is facing "arguably the worst" economic downturn in 60 years which will be "more profound and long-lasting" than people had expected'

Regular readers of this blog will know that I will applaud such frankness and recognition of the economic reality that is now confronting the UK. It is not that the loss of confidence that such a statement suggests is a good thing of itself, but rather that the people of the UK need to be prepared for the changes that must be made to the way in which the UK economy is structured. I have already made some suggestions for ways in which the UK might be restructured, for example in health, benefits and education. The big question remains as to whether anyone will grasp the reality of the necessity of change, or whether the politicians will retreat into populist 'head in the sand' measures.

Of particular note in the furore that followed Darling's statemnt was discussion of whether he was making a comparison with the right period of time. A good example of such discussion can be found in the Times. As is usual, what all of these commentators are missing is the profound and unique changes that have occured in the world economy, notably the massive increase in the supply of available labour. As I have discussed before, we can use the past as a starting point in understanding the economy, but we also need to be aware of the particular circumstances that apply in each case. No situation is ever the same, and until the economists and politicians wake up to the real differences this time, then nothing will be done to resolve the problems.

One of the outcomes of Darling's comments has been to accelerate the fall in the £sterling. The £GB is falling against the Euro, the Yen and the $US, and is likely to fall further relative to these currencies. I emphasise the word relative, as both the Euro and $US will also come under pressure, as the inevitable adjustment in the world economy continues (the Yen may be more stable). The £GB will just be in a situation where the weakening will be greater than the weakening of the other currencies. The curious point here is the mindset that the $US, £GB and Euro (and the Yen) are measured largely one against the other, but that it will be how these perform against other currencies that will really matter. The weakening of all of these currencies will not make sense unless they are measured against a wider basket of currencies, in particular the Yen and RMB (the problems of the RMB I have detailed elsewhere).

Meanwhile the UK economy is plunging further into gloom, almost exactly in line with my predictions. As each day passes, the headlines become more and more gloomy. For example, in the Times they report that mortgage approvals have sunk 71% to an all time low. A Guardian columnist has the following to say:

'Adding to the gloomy picture, a CIPS survey showed today that the manufacturing sector shrank for the fourth month in a row. Mortgage approvals fell to 33,000 in July, the lowest since the data series began in 1993, according to Bank of England figures released this morning. House prices fell in August for the eleventh consecutive month, according to a separate report from property consultants Hometrack. '

I have, of late, been making less posts than in the past. This is in part because the progress into economic collapse is very much in line with my previous predictions. I am in a situation where I am now just watching the inevitable collapse of the UK economy. The remaining question marks are when it will be that the UK economy will sink far enough to need the support of the IMF, as I predicted some months ago. The UK is structurally bankrupt, and it is just a question of when, not if, the UK will need support. The other question mark is when the next credit crisis will occur, at which time there will be several bank failures.

It is very likely that the current plunge in confidence in the UK economy is the beginning of the end. As I have discusssed elsewhere, confidence is the magic commodity of economics, and loss of confidence is the precursor to the collapse of the banks and the precursor to a 'cap in hand' visit to the IMF.

There are several outstanding questions that I have not yet covered and the state of the Chinese and Indian economies will need to watched carefully, as there is still a question mark over how these will fare in a situation of falling demand for their export of goods and services. In particular, there is potential for unrest in China if Chinese growth stumbles with the fall in Western demand. China is balanced on a knife edge, but I still feel that the Chinese government is in a position to ameliorate the fallout from the damage being done to the OECD economies. However, regular readers will know that I am very cautious on this issue.

The other question that needs some attention will be the supply and price of commodities. The world economy has metaphorically bounced back from the wall of commodity restraints, such that demand will fall back for a while yet. I have, for example, predicted that oil will continue to fall back in price over the next two years (wars and other potential blocks to supply allowing - I add this in light of Russia's recent behaviour). However, the overall trend in demand is going to increase upwards in the coming years, and the question then is at what point we will next hit the commodity wall. My best guess at the moment is that we will hit the wall again in about 3-4 years time. Key in this will be the growth in supply, so this needs to be watched carefully. However, in the current state of adjustment, the world economic system is going to go through a period that may be described as chaotic, such that any such prediction is dangerous (e.g. if China falls into unrest, then what will happen to the economy in China?)

I have several posts that are still outstanding. One of these is a review of UK government spending, another is the position of Japan. However, I would also like to continue with some solutions to the structural problems within the UK. As such, I will try to address the problems of regulation in the UK economy for the next post, provided that there is no compelling news that deflects me from this aim.

More on UK Government Borrowing - The UK is Bankrupt

I have already posted once on this subject today, but thought I would add something more, as I have been giving some thought to the latest news on UK government borrowing. Having accurately predicted that there would be a crisis in government finances, I am still surprised by the speed of the collapse of the government's position.

As I pointed out in November, in 'A Funny View of Wealth', as the economy tipped into depression, government finances would suffer. It is both inevitable and obvious. As an economy turns down the sources of taxation shrink; VAT, income tax, corporation tax, stamp duty and so forth. At the same time costs will go up as unemployment rises and so forth. The situation at the moment is that the crisis in government finances has already started, but still at the point where unemployment is still in the early stages of the massive rise that will inevitably occur. In other words, if the government's financial position is this bad at this point, how bad can it get?

As I have mentioned, government will need to either borrow more, which will destroy confidence in the UK economy, or will require massive cuts in state spending. If it is the former, then the result will be destruction of confidence in the UK government's ability to manage the finances of the UK and the UK economy. If it is the latter, then there will be a strong downward lever on the economy (at least in the short to medium term).

I have been giving this some thought, and I am coming to a conclusion that it is going to become increasingly difficult for the government to borrow at all. I have detailed elsewhere that the £GB will continue to fall in value. I have argued that depression is looming. The government deficit it going to balloon. This makes lending to the UK government a very, very high risk venture.

My question is this; Will anyone want to continue to lend to the UK government under such circumstances?

I think that the answer, in the coming months, will be 'no'. I am not sure at what point this will occur, but I would guess that the turning point will come in the next six months or so. It is at this point that the government will really fall to pieces. The reason will be that, in the near future, the UK will be calling on the International Monetary Fund. Quite simply, with the huge risks in the UK economy, I simply do not believe that it is creditworthy, and others are going to come to the same conclusion.

Quite simply, the UK is bankrupt. Both consumers and government have borrowed more than they can afford.

It is like a household that has been borrowing to pay back previous borrowing. The household has been based in a good neighbourhood, and the household has continued to enjoy holidays, new cars, and all the luxuries of modern life. All this has been paid for with every increasing borrowing. Every month, more borrowing to pay back previous borrowing. Every month, the burden of debt has risen, but still the spending remains the same. Finally, the lenders will look at the household and notice that the amount of borrowing is creating a need for repayments that is exceeding earnings after expenditure. Do they throw good money after bad? The answer is, of course, 'no'. At some point they know that they must cut their losses. The UK is in a position where the earnings can not possibly meet the borrowing without severe cuts in expenditure, and there is only the prospect of decreased earning in the future requiring ever deeper cuts.

Time has run out on the UK economy. It is bankrupt. It will need to rely on the charity of the IMF. The IMF will demand that the UK government cuts expenditure. A wind of terrible change will have to blow through the UK economy.

Our analogous household will have to cut back, move into a poor neighbourhood, into a tiny run down house, and stop the spending on luxuries. The only spending the lenders will allow will be the necessities of life. It will be very tough. That is the price of reckless borrowing - having charitable lending bail you out, and biting the bullet of living within your means while you try to repay the debt. It is tragic.

UK Government Borrowing

In my essay 'A Funny View of Wealth', written last November, I had the following to say about government spending:

'All the while this is happening the government will fall into crisis. With a falling pound, an economy collapsing around them, and an already overstretched borrowing position, they will be faced with ever more expensive borrowing, meaning higher interest rates, or massive cuts in public expenditure. There will be no room to manoeuvre. The only solution will be to cut back on expenditure. Continuing to borrow will be too expensive, and would destroy the value of the pound, as well as creating an even deeper crisis of credibility that the UK government can manage the economy. As the government is forced to cut back, many of the new state sponsored jobs that have been developed over the last ten years will start to disappear. This will not impact immediately, where funds have already been allocated, and contracts remain, but the process will accelerate over time. Some regions, such as the North East, will be hit very hard, as their economies are largely dependent on the state sector.'

The part about 'All the while this is happening' refers to the slide of the UK economy into depression (you will find the full context for the quote towards the end of the essay).

Today you will find articles showing that government borrowing is now at record levels. For the news articles see The Times and The Telegraph.

This is the final element in the predictions I have made for the UK economy; Unemployment, housing, the drop in the £GB, and consumer spending are all following the path that I predicted almost perfectly in 'A Funny View of Wealth'.

I am not mentioning this to be smug, though it is nice to be proven right (as much as I wish I were proven wrong). The point in mentioning this is that the essay, and some of my subsequent posts, make predictions further out than now. As such, if I have been right up to now, it suggests that I may be right about the next phase.

So what have I predicted? I will summarise.

First of all, the contraction will accelerate. In the original essay, I suggested that what will happen next is that the economy will contract such that GDP will fall back to the levels of 10 years ago 'or even longer'. In a post, when I first started this blog in June, I suggested that it may be worse than I originally thought. In short, the contraction is going to be of a degree that the economy will contract back to a point even earlier than ten years ago. I hesitate to say where this will be.

My prediction was that the current downward spiral is just the start; that the UK economy has a long way to go down before it can start to even level off. I have, since the original essay, been emphasising the fragility of the banks, and that a second credit crisis is brewing. Consumer and business defaults are going to accelerate into a deluge, and these defaults will take several financial institutions to bankruptcy.

As such, if you are reading this, now is the time to get your finances in order. Spread your money across several institutions, and watch the news carefully. Get into banks with online accounts, and be prepared to move your money at very short notice. If a crisis occurs, you will need to be among the first to move your money, and online accounts give you an option to do this.

Is there any investment that is safe at the moment?

In the turmoil that is taking place, the short answer is 'no'. The key to getting through this crisis will be cash, and the ability to move it to safety. For financial institutions, look for the institutions which have had the most conservative lending policy. I do not have the time to do this, so it will be up to you (do not look at policy now, look at their history).

As a note on cash, the £GB has a long way to fall, but I can not recommend any currency as safe, excepting the RMB, and that presents particular difficulty. I also have some niggling doubts about the RMB. If exports start to fall, will the Chinese government seek to boost exports through currency manipulation?

I would like to give more firm advice, and tell you there is a way to protect your assets, but this is the best that I can do. Flexibility, and an eye on the news. Things are going to get much, much, much worse in the coming months.....