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.

UK Bankrupt? Does the market now realise?

Despite suggesting in my last post that I would move on to a discussion of regulation in the UK economy, I thought I should make a quick post in light of some of the latest headlines.

The first comes from the Telegraph, and the article reports:

'It is the first time a major international forecaster has explicitly said Britain is facing a technical recession, in which the economy contracts for two successive quarters.

Even more embarrassingly for Gordon Brown, the OECD forecast shows that Britain is the only major economy in the world which will face recession in the next six months. The warning severely undermines his claims that the UK is well-placed to withstand the global downturn.'

This is very much in accord with my earlier post in which I pointed out that the UK is uniquely poorly placed to weather the economic storm. However, I do believe that the OECD is being far too optimistic about the prospects for the other OECD economies. However, this is not about finding further vindication for my predictions but mentioned as further evidence of the loss of confidence in the UK economy.

The OECD appears to be waking up to the severity of the situation in the UK economy, and the market appears to be doing the same. The £ sterling is continuing to plunge, as is discussed in another article in the Telegraph:

'The pound's slump accelerated for a second day in London as traders abandoned British investments following Alistair Darling's warning that the economy is facing its worst threat for 60 years.' and 'The slump leaves the pound worth the least - against a basket of world currencies - in 12 years.'

Again, this is much as predicted but, more to the point, is a strong indicator of the loss of confidence in the UK economy. Finally, and perhaps most disturbing is yet another article from the Telegraph which indicates the terrible state of the British banks:

'The City's embattled banks packaged up the biggest amount of mortgage debt in history last quarter, in a desperate scramble to gain access to the Bank of England's Special Liquidity Scheme.'

The big question here is whether the UK government has accepted toxic waste from the banks in an effort to save the banks, or whether the swap was made against sound instruments. Even more pertinent is the question of the state of the UK banks in general. Many of these swaps have been made during the relatively 'good times', and this raises questions as to how bad the state of the banking sector might be now that times are getting tougher and tougher. I have suggested that there will be a further credit crisis in many of my posts, followed by a rash of bank failures, but perhaps the carnage will be greater than I previously thought.

I have quoted these articles and posts to highlight the gradual and accelerating loss of confidence in the UK Plc financial position. I have pointed out before that I believe that the UK is structurally bankrupt. By this I mean that the UK's ecternal debt exceeds the ability for the UK to ever repay the principle, and that it is increasingly impossible to pay the interest. There is simply not the productive capacity for export to achieve this.

The reason why confidence is so important is best explained through an analogy. The analogy is an 18th century aristocrat who is living beyond his means. He gambles, he entertains, and he has a wonderful time. All of the tradesmen extend to him long lines of credit, and he continues with his profligate lifestyle, all the time feeling that he is above the petty business of managing finance. After all, his family has been wealthy for generations, and it is his right to enjoy the good life. However, he is actually spending his family wealth, and the earnings from his estate are no longer covering the costs.

His creditors also know that his family have a long history of wealth, they see his fine house, they see his expensive furniture, his lavish lifestyle, and can not believe that he will not repay the credit that they are extending.

Then a rumour starts that he is in financial trouble. One or two of his creditors start to press for payment, and restrict his access to new credit. He is unable to make the payments. The word starts to go around that maybe he is not as solid a credit risk as everyone first thought. Creditors start to refuse to extend his credit further, and the aristocrat starts to realise that he has no money. The entertaining, the lavish clothes, all become beyond his means. He can no longer make repayments. His estate does not generate enough cash, and now that the credit has stopped, he can no longer afford anything at all. He is bankrupt.

The UK has long lived on such confidence but, like the aristocrat, it is a misplaced confidence. It is a confidence built upon an idea that wealth is a birthright. However, as the UK is about to learn, it is not a birthright, but something that requires effort and energy. You can only live so long on your inherited wealth before it is squandered away, and you can only live so long on credit before the creditors start to ask questions of your ability to make payments.

It is for this reason that I am looking so closely at news that indicates loss of confidence in the UK economy. As I have said, the UK is structurally bankrupt, and it is just a question of time before all the creditors start to notice. At that point, the UK will visit the IMF....

Note:

On another indirectly related issue, it is apparent that the government is considering a stamp duty 'holiday' in an attempt to revive the housing market. As I have pointed out in a previous post this suggests that the government has some special knowledge about what house prices should be. I will not rehash what I have already written, but would recommend you take a look at the post. It will highlight how absurd such intervention in the market actually is.

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.....