The Hollow Men of the EU

Here we go round the prickly pear
Prickly pear prickly pear
Here we go round the prickly pear
At five o'clock in the morning.

Between the idea
And the reality
Between the motion
And the act
Falls the Shadow


This section of T.S. Eliot's poem 'The Hollow Men' just popped into my head whilst thinking about the latest chapter in the Euro crisis, but other parts of the poem also seem oddly appropriate.  The prompt for thinking about the poem was the ongoing woes of Spain and the reporting about the Spanish budget, and the wider concerns about the Euro. Reuters gives a good overview of the budget:

Ministry budgets were slashed by 8.9 percent for next year and public sector wages frozen for a third year as Prime Minister Mariano Rajoy battles to trim one of the euro zone's biggest deficits.

"This is a crisis budget aimed at emerging from the crisis ... In this budget there is a larger adjustment of spending than revenue," Deputy Prime Minister Soraya Saenz de Santamaria told a news conference after a marathon six-hour cabinet meeting.

Beset by anti-austerity protests and threats of secession by the wealthy northwestern region of Catalonia, Rajoy is resisting market and diplomatic pressure to apply for a rescue, partly out of concern for national sovereignty but also because European Union paymaster Germany insists Spain doesn't need help.

The central government sees budget savings of 13 billion euros in 2013, with spending down 7.3 percent -- not including social security and interest payments -- and income rising 4 percent thanks to a 15 percent leap in value-added tax take.

The budget goes to parliament on Saturday and debates could last weeks. The country's 17 autonomous regions still must present budgets and find an additional 5 billion euros in adjustments to meet overall public deficit reduction goals.

Apparently, the budget was well received with the Euro gaining against the $US, and stock markets rising in response.  As I have mentioned in an earlier post, there was also an audit of the Spanish banks, with the following finding:

Spain's banks need €53.75 billion ($69.23 billion) in new capital, an independent audit showed, a figure below initial estimates that provides a benchmark for the cleanup cost of the ailing sector, the government and the Bank of Spain said Friday.

The number was lower than an €62 billion estimate Spain gave in June, providing some welcome news to the government of Primer Minister Mariano Rajoy which this week announced a series of spending cuts and tax increases in an effort to stabilize the economy amid protests and political challenges from the country's richest autonomous region.

In my last post on the Spanish crisis, I questioned whether the audit would genuinely reveal the true extent of the losses, and that more toxic debt would be revealed at a later date. I am still of that view and, as I stated before, I suspect that we will see further requests for bailouts in the future. In short, I suspect that the requests for bailout money will be given in 'bite-sized' chunks. The disclaimer of liability at the start of the report and the explanation that the report 'methodology and process' was agreed with the Spanish Government and Banco de Espana might be seen as indicative of the reliability of the report.

The devil is in the detail, of course, and a quick look through the report and raised concerns in my mind, such as the limited sample size used for the assesment due to time constraints (p.13), and crucially, the audit assumes that 2014 is the date of sale of real estate assets, but I found no real clarity on how the values were projected, and it makes heroic assumptions that the assets will sell at all. However, I have only briefly glanced through the report and may have missed details or misunderstood sections, and I am not an expert. In other words, I just looked at the report to get a 'flavour' of the approach.

The point is this; it is not the initial positive market reaction that matters, but the reaction once experts have dissected the detail and methodology. It is then that the quieter shifts in markets will take place, and at which time the real judgement on the report will be felt. In many cases, those assessments will not be make public, but will remain proprietary. An article in the FT, before the audit publication, captures the pressures for positive results from the audit:

This time, it has to work. This is the view of senior bankers in Madrid as Spain prepares to unveil on Friday the results of an audit of its financial sector. Many now consider it the Spanish government’s last chance to convince the world that it has the banking crisis under control.

[and]

The investors and analysts that Madrid is anxious to convince, however, are already questioning the integrity of the latest review, with some arguing it is likely to resemble a stage-managed announcement with few surprises.

Mr Guindos has said that the final amount of total capital required is likely to come in at about €60bn, which is close to a provisional estimate of between €51bn and €62bn made by Oliver Wyman and fellow consultant Roland Berger in June.

In what he labels “the Don Quixote approach to valuation”, Santiago López, an analyst at Exane BNP Paribas, has said it is not credible that the Ministry of Finance has already indicated no listed bank, aside from Bankia, will need new capital under the tests, even though they use aggressive economic assumptions.

[and]

“Spanish banks are not giants but windmills,” Mr López says. “The assumptions of the tests seem reasonable but the conclusion is not credible.”

We have seen plenty of similar bank reviews in the past, and the pursuit of confidence over clarity seems to be the real purpose in many cases, such at the EU bank 'stress tests' that found Dexia to need no additional capital just a few months before it ran into trouble. In summary, perhaps I am wrong about the audit but I do not believe that this is the end of this story. My own view is that it is now just a question of 'when' the next bad news will arrive as the hollow men continue to seek that the crisis resolves, Not with a bang but a whimper.

Added Just after Publication:

German Wages

I just thought I would add a quick note. I stumbled on an article in Slate which grumbles that the low unemployment of Germany is based upon wage stagnation, and could not resist mentioning it.

The real secret to Germany's job market success, though perhaps in some ways related to the labor market regulations, seems to be simpler—don't give the workers any raises:

Now you look at this and you can see why Germans aren't chomping at the bit to offer bailouts to their southern cousins. But by the same token, you can see why the rest of Europe isn't rushing to embrace this model. The pitch for more flexible labor markets is supposed to be that you'll earn higher wages if employers have more freedom to organize work relationships to maximize productivity. Less job security and lower pay is not a great slogan. It is, however, a huge exporting success story. Germany has completely reoriented its political economy around the needs of its export industries which is nice except that just like in all other rich countries the majority of Germans work in non-tradable services.

My central thesis proposes that the shock of oversupply of labour sits underneath the economic crisis. That Germany has followed the logic of this position to its conclusion might be seen as explaining why German workers are still employed. I suspect that, given a choice, many unemployed workers would be pleased to turn back the clock and follow a similar path if it was to keep them in employment. However, before we get carried away with the German success story, it should be remembered that the fallout from the wider crisis may yet pull Germany down. Nevertheless, it is interesting that the German model was the correct response; with the labour supply shock, German workers allowed their compensation to drift down such that their value remained aligned with changing circumstance. And that value still remains high, perhaps reflecting the quality of the German workforce overall.

Another addition Just After Publication:

 I nearly forgot, but there have been several people who have used the Paypal donate button, including some fairly large sums. I just thought I would express my appreciation. In particular, although traffic has remained relatively high (it dropped off during the period when I stopped posting but is climbing again), there is less commentary than before. As such, it is good to know that the blog is appreciated. Thanks!

Spain , Banks and Real Estate - Again....

After two quick posts in succession, this will be a very quick post. Just before my long pause in posting, in June I posted on the subject that Spain would be in a worse state than was being claimed. This is what I said:

My own belief is that the prospects of such a bailout are remote, and that the scale of the problems in Spain have not yet been fully acknowledged. In particular, there are concerns about the true scale of losses for Spain's banks. As the Economist reports, construction and real estate loans grew from 10% of GDP in 1992 to 43% in 2009. The same report highlights the degree and severity of the real estate bust in Spain, and the various (self-defeating) methods the Spanish banks are using to hide or delay the losses.

It perhaps comes as no surprise that there are rumours of delays of an audit of the Spanish banks, although the government denies any delays and is still promising to publish results at the end of July. Even when published, it is not clear how real estate assets might be valued in the context of the broadening problems and downwards spiral of the Spanish economy; the spiral will continue to impact upon real estate prices, and any assessment will only reflect, at best, a guess at the non-performing and underwater loans going forward. In other words, the losses in the Spanish banks are likely to be far greater than is currently accepted, and the Spanish economy likely has a long way to fall yet. When so much of an economy is dedicated to real estate, and real estate goes bust, the damage is going to be huge. As such, even if a large rescue fund were put together, however improbable that prospect remains, the scale of the rescue needed may be larger than is currently imagined.

Well, this is what has appeared in the news:

A bank-by-bank test of financial stability due on Friday is expected to conclude that Spain's lenders are dangerously over-burdened with toxic debts and need to be recapitalised, restructured or shut down. 

The stress test is expected to show a dramatic deterioration since the previous tests were carried out at the beginning of the summer which suggested a €60bn cash injection would be the worst-case scenario. 

Nomura Global Economics said in a note: "Our initial reaction to the publication of those estimates has been negative. The announced figures are well below the market expectations, which start at around €100bn, and, in our view, not only fall short of bolstering market confidence but may actually increase the risk of Spain losing market access."

Last week, the Bank of Spain said bad debts at Spanish lenders had risen to record levels, with almost one in 10 loans in arrears. It is the highest bad-loan ratio since central bank records began in 1962.

In June, Mariano Rajoy, the Spanish prime minister, negotiated a deal that secured lending from Brussels of up to €100bn to recapitalise the banks. Experts now think that it will not be enough. Amid soaring borrowing costs and a stricken economy, Spain has come under intense pressure to ask Brussels for a full sovereign bail-out.

My own view is that the latest calculation of the losses is still probably way off the mark of the real scale of the losses. This uptick is just that. I am very confident that, in few months time, the figures for toxic debt are going to be raised even higher, and the size of the potential bailout will grow again. I suspect that those doing the audits will be fully aware of this, and that any figures given are there to try to make the scale of the bailout that would be needed less dramatic, by implementing it in small increments. However, we shall see.

Smoke on the Horizon?

A very quick post as I have had a rather odd email from a reader of the blog. I have taken out the identifying elements, but the email is as follows:

Just thought I would tell you about a letter I received on Friday from my bank,

I run a small business and bank with Santander in the UK.
The letter was to find out how big our business is.
They are creating a data base containing all small businesses eligible for the deposit protection scheme.

Smoke on the horizon?

This is some of the recent news on Santander, starting with:

Chief Executive Officer Alfredo Saenz told investors last month it may take three years for profit to “return to normal” in the face of mounting Spanish defaults and weakening earnings in the U.K. and Brazil. Santander expects to “approximately” match 2010 profit this year, he said today. The bank said it could reach a core capital ratio of 10 percent by June 2012, exceeding European requirements, without selling new shares and while maintaining its dividend policy.

“In Spain, I’m still a bit scared about the real-estate market because I still have the impression that there are more losses to come out there,” said Peter Braendle, who helps manage about $60 billion, including Santander shares, at Swisscanto Asset Management in Zurich. “Fortunately, Spain is only one side of the Santander story because they have a diversified business.”

And from the FT:

Retail and corporate customers withdrew £2.5bn of deposits from the UK arm of Santander in the third quarter of this year after the bank changed its funding strategy. Santander said it had moved to shift its funding mix away from expensive deposits by cutting interest rates on some accounts as it had been able to access cheaper financing elsewhere.

 And the UKPA:

Santander UK said it had also overhauled its customer complaints process, recruited 1,100 customer facing staff and relocated its call centres back in the UK to improve its service.
The bank admitted it still had more to do to improve customer service to levels of satisfaction in other areas of the bank. The group was the UK's third most complained about bank behind Barclays and Lloyds in the first half of the year.
The group is in discussions to buy more than 300 branches from RBS, which will add 30,000 small and medium-sized enterprise (SME) customers, which would take its share of the market to 9% from 4%. The deal is expected to complete towards the end of 2012.

 And the BBC;

The bank said it would increase its Tier 1 capital level to 9.2% by June 2012, which would bring it in line with criteria set by the European Banking Authority.

Smoke on the horizon? The most interesting part is that Santander has been losing customer deposits, and the bank's version of this is that the use of wholesale funding is a choice. This from the Financial Post:

Spain’s banks face a massive spike in their funding needs next year at a time when a credit crunch on wholesale markets and calls to increase provisioning against toxic property assets has made the sector’s liquidity a crucial concern.
Around 130 billion euros ($174 billion) of Spanish bank debt will come to maturity next year, according to Thomson Reuters figures. Many banks took on three-year, government-guaranteed debt in 2008, making up a large chunk of the borrowing.

but later in the same article:

Banco Santander SA, Spain’s biggest bank and one of the best-capitalised in Europe, issued up to 7.5 billion euros of three-month to 18-month commercial paper in September, paying between 3 percent and 3.75 percent depending on maturity.
On the covered bond side, bankers expect markets to stay closed for the foreseeable future unless a European-wide solution is introduced to deal with the sovereign debt issue.
In June, Santander struggled to place a 1 billion euro five-year covered bond, backed by a pool of loans the bank had made to regional governments across Spain.

Smoke on the horizon? You could read these articles many ways (if you read the complete articles, the picture is even less clear), but one thing that is certain is that any Spanish bank going to the wholesale funding markets is going to be treated with, at the very least, some caution. It seems odd that they might choose to opt out of the retail and corporate deposit markets in the current environment, regardless of how competitive they might claim those markets to be. It is also notable that in the environment that they are being squeezed two ways, with requirements for larger capital buffers, and facing a difficult market for raising capital. On the other hand, the letter in the email just seems odd, and might therefore be a badly timed administrative requirement, and the bank on a spending spree buying up RBS branches (but with access to deposits)?

I don't have time to go into more depth on this, as it is just an off-the-cuff article in response to the email, but I would certainly be concerned if my bank was in the Santander stable, regardless of the issue of the letter described in the email. I'll leave you to make up your own minds.

Markets Fall, But Still They Chase the Elusive Confidence...

It is a very curious thing. The pouring of taxpayers money into the banking system was supposed to restore confidence. In the event, nothing has changed. Stocks are still falling and banks are still not lending to each other. It is now apparent that the severity of the problems are very deep indeed, in particular for UK banks. Iceland is now a basket case, and is a precursor to the carnage in the rest of the western banking system. Meanwhile, in a move that he will regret, Gordon Brown is threatening legal action as a result of the Icelandic meltdown and Iceland is blaming the UK for its troubles.

Quite frankly, as taxpayers money is poured into this insatiable black hole, the reactions and events are taking on the mantle of a very, very sick farce. It is clear that the bailouts have not been working, and that pouring in more money will really make no difference. Despite this, the politicians cling on to the belief that they can turn back the tides. Their concerted action on interest rates - no effect. The continual provision of liquidity, the headline bailouts - no effect. At what point, after spending how much money in supporting the financial system, will they accept that it will not work?

Perhaps the most disturbing part is that Gordon Brown, an individual who felt that he was entitled to lecture the rest of the world on the way to run the economy, is now grandstanding on the world stage, as if he has saved the UK banking system. Whilst he lectured the world on the success of the UK economy he watched the debt bubble grow, borrowed money during the so called 'good times' and allowed the money supply to get out of control.

I could comment on every detail of the crisis here, but do not feel that I have anything to add from my previous analysis, except for an expression of complete dismay. Normally I only aim to post if I can offer some analysis. However, my sense of dismay overcame my reticence. It is all just quite unbelievably farcical.

For new readers, I would suggest that you take a look at the links at the top left of the page (I suggest starting here). If you want to find out where this crisis really came from, and why all of this 'activity' by governments is both pointless and dangerous, then you will find all of the answers in these posts. Most people who have read the blog seem to find it illuminating, and I hope you will too. If you are really interested, dig into the archives and you will find more depth.

Some Replies to Comments:

Anonymous left the following comment:

'I just wonder. US, UK, EU countries are going to borrow all that money on top of what they borrow to function. Who has all that money to lend it to them? Does Asia have that kind of money? '

A very pertinent question. Yes, the money is out there in the rest of the world, but the big question will be whether they will continue lending. As regular readers are aware, that is why I believe that governments like the UK, and possibly the US, are going to have a terrible crisis. They will not be able to borrow, and this will either mean printing money (and hyper-inflation), or savage cuts in expenditure. I think this is, in part, what is driving these desperate measures, as I suspect they realise what will happen if they do not 'fix' the crisis. It is only a suspicion, but it looks increasingly looking like a roulette gambler who believes that they have one last chance to win on number 32, red. However, we will not know what they were really thinking until the crisis comes to conclusion.

On a similar vein, another commentator asks:

'My interest is what are the likely developments on the ground from here? I fear it will mean: civil unrest, rioting and instability.

What happens if the Government defaults?'

Your own analysis points to the possible answers. I am more than a little worried that the West in general is not prepared to deal with this crisis, meaning ordinary people are not. It sometimes seems that the good life is seen as a right. However, this is idle speculation. For your second question, see above. I can not predict which way they will jump, but suspect hyper-inflation.

Lemming asked:

An interesting little aside from Polly Toynbee in her column today where she comments alarmingly "Just-in-time food delivery, paid for with what?". To the people I know, the idea that food shortages might become a problem would just not be taken seriously, but there is no reason to think that it couldn't happen is there?

Whilst I am (as regular readers will know) not the most optimistic person, I do not think that the economy will fall to a level where there are food shortages. What is coming will be bad, but I do not believe that bad. Unemployment will be the biggest single problem, and many people will see a dramatic drop in their living standards. Many of the safety nets that we have become accustomed to will look more than a little threadbare.

Another anonymous poster asks:

'What do you suppose is motivating so many people to see the world through rose colored glasses?'

I find this difficult to answer, as I can not understand why people can not see what is in front of them. As such, I am afraid I have to pass on this answer. In this case 'I just don't get it'.

Jim asks the following:

'All over the world people study subjects like History, Philosophy and to a certain extent Psychology. Does anyone ever bother asking them for some insight?'

It is quite possible that this answers the previous question. Perhaps we can see why people are behaving in the way that they are from these disciplines. However, I have studied all of these subjects to varying depths, and am not sure that I can see the answer still. With regards to one of them, it is perhaps history that explains some of the solutions. I read an article in the economist that was suggesting that, this time, it is not as bad as the Great Depression. Meanwhile, Paulson is a student of the Great Depression. There are many comparisons being made, but the danger in those comparisons is that the world, and the problems of the economy are not the same. The main commonality, is that in both cases, people believed that wealth was a one way bet. Other than this, the circumstances are very different, and the bailout is an imagined solution to a different problem, in the different world of over 70 years ago.

I have also had many other comments, many of which deserve replies. However, I must make my apologies, and leave it there.

The Economic Crisis - The Bailout and Other News

Yesterday, before I read the latest news on the bailout, I made my regular visit the various financial sections on the online news services. I was struck by one of the finance home pages, in this case the Telegraph. I would link to the page, but the page changes daily. Why would this page be of interest. Fortunately I left the page open, and here are a selection of the headlines:

'Mortgage Lending Plunges 95pc as market "Decimated"'
'UK high street banks may benefit from US bailout'
'City has B&B concerns'
'Airbus Launches in China'

Today, in the same paper, the headlines are as follows:

'US Markets in Freefall as Bailout Rejected'
'Banking crash hits Europe as ECB loses traction'
'Banks to absorb B&B losses'
'Benelux states part nationalise Fortis bank'

Why am I giving this list of headlines? The reason quite simply is that, within these headlines are expressions of the roots of the problem. As I viewed the above headlines I came across a quote from Gerard Barker of the Times as follows:

'If Congress wouldn't listen to Bush and Paulson it might at least listen to the markets'

It is a fascinating quote in light of the above headlines, because there is a fundamental disconnect in the thought. Gerard Barker is assuming that the real market is what is happening in Wall Street and the City. He is missing the point entirely. The real market is the market of the day to day decisions and activity of billions of consumers, and endless millions of companies supplying goods and services, and the choice of where real wealth creating capital is allocated. It is they that drive the markets, not Wall Street, and certainly not governments.

The City and Wall Street are just a reflection of the reality of the situation on the ground. The banks are not failing because of the lack of a bailout, but failing because of the damage in the wider economy. Even before the current crisis, the CBI survey of financial institutions in the UK found that the banks were suffering from plunging profits. This is the reality of the crisis, that both consumers and businesses were hurting, and that the result was that the banks were looking at ever more pain as a result. With consumers not borrowing, banks not lending, consumers not spending, and therefore businesses suffering, the banks are in trouble. What that actually means is that, on the ground, away from the world of finance, there are real problems. It is the downward spiral that occurs when the credit ATM shuts down. I have said it before, but the bank balance sheets will be looking ever more ugly as each day goes by, as consumers increase defaults on both mortgage and personal debt, and as commercial debt goes sour.

In other words, there is not some mystical force in Wall Street or the City driving all of this, but fundamental and deep economic problems. If the fundamentals of the economy were good, there would be no banking crisis. Companies would be generating profits, and consumers would not be defaulting on their loans, and the house market would be buoyant.

If we return to the above headlines we can see an illustration of one of the problems in the article that details the opening of an assembly plant in China by Airbus. Such an action would have been encouraged by the Chinese government, as a way of ensuring access to the growing market for aircraft in China. Airbus, in opening such an assembly operation, will ensure that China will emerge as a competitor in aviation in 10 years time. Once embedded in China, the process of sourcing components and parts locally will commence, and local Chinese companies will be taught how to serve the aviation market and, once they have learnt, will expand into broader international markets. As more and more suppliers are able to meet the high standards and technology required to build modern aircraft, the infrastructure will be put in place for a Chinese competitor to emerge. This process has been going on for many years, in many sectors. It is the combination of capital, access to markets, access to technology that I have discussed in my previous posts in the abstract.

This is the reality behind the financial crisis, the emergence of competitors who are taking ever larger shares of world trade. They are producing goods and services in competition with the OECD countries, and they are doing so ever more effectively. For those who still insist that it is just cheap labour, I would suggest that you listen to the following from an Economist report on globalisation (Economist Print Edition, September 20th-26th, 2008, p 12):

'Being Willing to match India's low-cost model was essential, but Mr. Cannon-Brookes insists that IBM's enthusiasm for emerging markets is no longer chiefly about cheap labour [...] Perhaps a bigger attraction now, according to IBM, are the highly skilled people it can find in emerging markets'

The reality of the markets is that we in the West have deluded ourselves that we have the better people, the better technology, the better infrastructure. Perhaps we still do, one of the points made in the Economist article, but the speed with which such advantages are diminishing is shocking, and in any case the advantages pertain to an ever smaller part of the market (the part of the market that requires only the highest levels of technology, process and know-how such as aircraft manufacture). In other words, globalisation is setting about a complete restructuring of world markets, and that restructuring is about moving business to any place where there might be any competitive advantage. This again, is the reality of the market.

Every time that a consumer enters a shop to purchase something, they are the drivers of the real market. Every time a business seeks a supplier of a component or service, they are the real market. Every time a company allocates capital, this is the driver of the real market. The financial institutions of Wall Street and the City may imagine they are in the driving seat, but the reality is that they are just responding to each of those tiny market signals. This is not to say that they have no influence, as they allocate the capital that is available, and have allocated it very poorly, leaving insufficient capital for investment in productive activity in the OECD (real wealth generation), but they still are driven by the activities of the real market.

In the current situation, the problem is that they lent to the wrong places, consumer and mortgage debt. They miscalculated, they failed to realise the real source of wealth is in manufacturing products and supplying services to support that wealth generation. They thought that debt = wealth, the fundamental point in 'A Funny View of Wealth'.

The purpose underlying this post is to reiterate that, for all of the excitement about the state of Wall Street and the City, they are really not what matters. If the underlying economy were healthy, then all of the lending to consumers that is driving the banks to bankruptcy would not be going sour. It is the underlying weaknesses, the lack of wealth generation, that means that the debt is going sour.

When we view the world as it is, instead of through the delusional filters with which we have viewed the world, it becomes apparent that the bailouts would never have worked and would just be another burden on economies that were in any case less and less fit to compete. The question that needed to be asked about the bailout is whether it could actually change the underlying reality of the economies that really drive the financial system. In other words, would the bailout do anything to create wealth? At some point wealth must be created to pay back the debt, and the bailout was just transferring debt from one place to another. It was not solving any real problem, but just shifting the problem to another place. The only solution to the real problem is for the OECD countries to respond to the real market, and that market is one in which tough competitors have emerged, and who are fast moving up the value chain.

It is for this reason that in a previous post I call the bailout a 'magic wand'. It is for this reason that I have opposed the bailout. It is just a way of pretending that the real problem is not there, of pretending that the world has not changed. It is just a continuation of the delusion.

No doubt, some readers would have expected me to discuss the events of the last few days. I hope that, having read this, you will see why I have not discussed the blow by blow saga of B&B or Fortis, or the failed bailout. They are events, they are important in their own way, but they are just a reflection of something more important. The market is readjusting, and the banks are just following the 'real' market (or at least the real drivers of the market - individual choices in the selection of goods and services) in the readjustment, albeit accepting that they are one part of that market.

I have had a comment from 'Souza', which questions some of the ideas that I have put forward. I will quote Souza in full, as he puts forward some interesting points:

'Having immigrated from an "emerging economy" to a "rich country" I experienced this phenomenon first-hand, but the explanation always seemed obvious to me: rich countries are rich because of currency imbalances. Much of the wealth of rich countries is founded upon (and funded by) artificial exchange rates. The answer to the "cigarette lighter problem" is that the New Zealand dollar is overvalued against the Chinese yuan by a factor close to the ratio between the prices of the lighter in both countries.

The fundamental question is not "why the lighter costs more in New Zealand", but rather "why the income of workers in different countries is not commensurate with their productivity". I don't know the exact figures, but I'm quite sure that a convenience store clerk in New Zealand earns at least 10 times more than one in China, despite the fact that the productivity of both workers is roughly the same. As I said, I experienced this first-hand when I moved from one country to another and saw my salary instantly multiplied by 4, despite the fact that I have not become any more productive.

So when you say that "something is very wrong and unbalanced in the world economy", I say "it's the exchange rate, stupid!". (I hope you recognize the "stupid" as an allusion to a commonly used phrase, not an insult). And even though I'm sure there is a lack of balance, I'm not sure it's necessarily wrong, for the simple reason I don't fully understand where it comes from.

The one thing I can be quite sure of is that exchange rates are a matter of supply and demand, so the currencies of rich countries can only become overvalued by creating artificial demand for them. And the most obvious way in which I see this happening is through cultural influence. To take but one example, the fact that Coke is so popular in almost every nation on the planet is highly beneficial to the American economy, but such a high demand for a product with little intrinsic value can only be created by cultural influence. Surely if exposed to it without the accompanying marketing machine, most people would find the taste of Coke between trivial and repugnant (it is, after all, nothing more than water, sugar, and CO2)

This is a complex topic and I have no room to expand on it, so I'll finish with my opinion on the future of the wealth of wealthy countries: there is not much to worry about, things won't change much. The current state of the world's economy is a product of politics and culture, not of worker productivity. A "service economy" is perfectly sustainable for as long as there are far more poor countries in the world than rich ones - a situation not likely to change in any foreseeable future. The most visible result of the "service economy" is that it creates a world market for things people in rich countries are no longer willing to manufacture; things such as cigarette lighters.'

He is right to say that the currencies are overvalued. This is a point I have made throughout the posts, and why I predict that the 'rich world' currencies must drop against those of the emerging markets. This represents a real loss of wealth, as the commodities that are purchased will be more expensive, and the goods imported will be more expensive, the holidays that consumers take will be more expensive. A simple and crude way of looking at it is that a consumer will have to work x number of hours more to buy a Japanese branded, manufactured in China, plasma TV than they did before. This is a real loss of wealth. In answer to this point, yes, the currencies will drop, and every individual in the 'rich world' will commensurately poorer. I also agree that currencies are dictated in the long term by supply and demand. A large part of the demand for Western currencies has been driven by demand created by foreign institutions to invest in rich world economies, either to buy companies, or to lend into consumer markets. Now that such demand is falling, there will be ever less demand for the currencies. The currencies will fall. The rich countries (excepting some like Germany) are just not producing enough products that other countries want, and the result is that, without the demand for currencies for (now revealed as foolish) lending into the economies, there is little support for the current value of the currencies.

With regards to the salary differentials, that is the underlying point about the 'Cigarette Lighter Problem'. How can this differential be justified? Somewhere in the economy, there needs to be sectors that are generating huge amounts of wealth to pay for the salary differential between the Chinese shop worker and the New Zealand shop worker. Where is this wealth generation coming from. We can look for it, but it is impossible to find such a massive source of wealth (see 'A Funny View of Wealth' for my attempt to find such sources of wealth in the UK). As such, what is paying for the differential? My argument is that it is debt, lending sourced from outside the country, that is paying for a large proportion of the differential.

The Coke example is an interesting one. Coke has many meanings attached to it, not least of which is the association with the US lifestyle, the US dream and US culture. What happens to Coke when the dream goes sour? Coke is a great marketing company, and therefore will probably adapt their image to the changing circumstances, but their value at present is tied up with the culture and values of the US. There still remain in the West many great companies, but these companies are facing ever more, ever better competition. I remember sitting in front of a Unilever executive telling me about the fierceness of competition from local suppliers. Unilever were holding their own, but the battle was tough. Unilever is an example of the very best of Western companies, so what of the weaker companies?

As for the last point made by Souza, I am hoping that the post overall will have answered the suggestion that as long as there are poor countries, the service economy can be sustained.

Anonymous made the following comment (and question):

'I don't know if you are still in China, but I am! I wonder what it would take for all this to start to 'undermine' the Economy here? Is there some event, some process that is unravelling? Elsewhere people have said this is not a 'Global' crisis, just an OECD and particularly US/UK one. To what level might the Euro/GBP actually fall against the Renminbi? You say that is the easiest of the 5 options to be enacted? But would that actually help..and help who?? '

There are many points here, but I will focus on who the devaluation might help. I would not suggest that the devaluation would 'help' anyone. It is a market process that is inevitable, but is not imbued with any intentionality. It is not happening for a purpose, but because market forces seek (again with no intentionality or purposefulness, despite using a verb that suggests otherwise) an equilibrium. The mis-allocation of capital created an imbalance for so long, but eventually the market had to snap back into a balance. In this case the trace balance was pulled out of shape, and the correction is a rectification of this imbalance through currency changes, and the destruction of the value of the Western currencies is the correction.

I hope that the above is clear, as I am somewhat dissatisfied with my own answer here, and am not sure I have expressed it well. Let me know if it does not make sense.

There is much more that could be said in this post, as well as some other comments I would like to respond to. However, time is short, so I hope the other commentators will forgive my lack of response.

I also hope that this post will go some way to directing your attention away from the minutae of events, and help to focus on the bigger picture, which is what really matters.

Banking Crisis - What is REALLY Going On?

Note: Published in September

It is very easy in the current circumstances to focus on the crisis that is engulfing the financial system or the unfolding drama of the US bailout. However, this is not the real story, just an expression of the symptoms of the real story.

As I have mentioned before, the idea of a 'credit crunch' has taken root, and sometimes it appears to be a force with a malevolent intent. In other words it has become an animistic entity on which we can easily lump blame, and pretend that there is not real causation behind the crisis. The reality is that there is a real force out there, which is market sentiment. This is not, however, something with a life of its own, but rather the thoughts and feelings of real people with real concerns. Collectively they constitute market sentiment, but we should not forget that market sentiment comes from somewhere.

Bearing this in mind, we have to ask what is really scaring each of those individuals that constitute the market. Is it just an irrational fear, or is there some justification for the fear?

It is here that we must realise that these are panicked but mostly rational people. The panic stems from the realisation that they have been buying fools gold for many years. Yes, it looked like the real thing, but they have now had the material analysed, and the reality has dawned upon them. The big question is whether the financial crisis is driving events, or whether events are driving the financial crisis.

The truth is that there is an element of both. One is feeding off the other in an inevitable downward spiral. When I predicted this crisis in 'A Funny View of Wealth', I pointed to the idea that one negative factor would reinforce another, in what might be poetically called a 'death spiral'. This was not a prediction based upon an abstract entity called the 'credit crunch', but was based upon the fundamental problems in the economy of the UK. Many aspects of the essay equally apply to the US (and other OECD economies to a lesser extent). One of the central points of the essay was that the growth in GDP (at least) over the last ten years was an illusion. It was growth built upon asset prices inflation and a boom in credit. This is now widely accepted as the reality of the situation, but the 'commentariat' have still not grasped the reality of what this means. They are so busy charting the day to day crisis development that they are losing sight of the idea that something substantive must underlie the crisis.

In light of this I thought I would try to pull some of the strands of my thinking together and try to put the jigsaw together. In some respects I will be repeating ideas in my previous posts, but the aim is to try to integrate the ideas into a large picture. For those that have followed the blog from when it started (people to whom I am grateful, as their reading and comments encouraged me to continue), none of this will be new.

The first element to consider is that of the entry of the emerging markets into the world economy. I have dealt with this in the posts 'Why Do Economists Get it so Wrong?' and 'The Root of the Problem'. The argument, at its most basic, is that there has been a massive input of new labour into the world. The labour was always there, but the key difference is that the emergence of these economies has seen capital and technology, and access to markets, become available to this previously underutilised workforce. The result of this change has seen the available labour force available in the world roughly double in the last 10-20 years. This is nothing short of a revolution in the world economy, but few economists have understood what it really means. This is best expressed in simple terms of an example (using made up figures but referencing the real events) to make the point clear.

If we imagine that (to pick an arbitrary date) in 1990 there were 100 units of labour and 100 units of commodity utilised by that labour, and an available 120 units of commodity capacity (not all utilised), we can see a benign situation. It is a situation in which the commodity supply exceeds demands. We can see this, for example, in the long period in which oil prices were so low for so long. Now, if we jump to 2008, we see the oil prices spiking. This is because, whilst the supply of commodities such as oil has been increasing, they have not been increasing at the same rate as the available supply of labour. Let's call the supply of units of commodity in 2008 a total of 140, to pluck a number out of the air. At the same time we now have 200 units of available labour. At this point, it is apparent that there is a mismatch. The question arises as to why it is that the problem did not hit at the point where labour first exceeded the supply of commodity. This is because the labour entering the market was not as efficient at utilising the resource as the original labour. It is the catching up, the increase in both the efficiency of the new labour, and the increase in the use of the output of their own labour that has tipped the world into the current situation.

This is one element that explains the current situation, but it still does not seem to match the reality on the ground. For the last ten years, countries such as the US and UK have been booming, have been apparently successful. Logic says that, if we input a massive amount of new resource (in this case labour) such that supply is always exceeding demand, the price of labour should have fallen. This has not happened, and it seems that the Western world became ever richer, with rising salaries, ever expanding wealth. How can this be so? One of the key elements in this is that these new workers were relatively very cost effective, and therefore generated significant profit surpluses, which was then funneled back into the western economies, thus creating the boom in credit. Huge trade imbalances, massive government deficits, and a stunning growth in consumer debt was the result of a wall of money entering into the western economies.

The borrowed money was entering the western economies in ever greater amounts, all of it looking for investment opportunities. The problem is, what happens when the supply of good investment opportunities is used up? The money that is entering the economies must be utilised somehow. It is at this point that the money starts to be utilised in ever more risky ways. It is here that the origins of the bad lending lie. The money had to be utilised but could not be invested in productive assets, such as manufacturing, as the growth in manufacturing was focused on the more cost effective emerging markets. If you wanted to build a new manufacturing facility, then increasingly the logic dictated that you looked to the East. This left a huge surplus of money sitting around, and the end result was cheap and easy credit for consumers and governments alike.

Now, in normal circumstances, such a massive oversupply of money would lead to inflation, and then governments would seek to dampen down the inevitable expansion in activity in the economy in order to combat inflation. This did not happen, as the measures of inflation did not account for the reduction in the cost of manufacturing resulting from the massive input of labour into the world economy. Prices for all kinds of goods just kept falling. Furthermore, wage growth was not as inflationary as it might have been, due to the ongoing threat that manufacturing would move their operations to the emerging markets. The governments of the West failed to understand that these factors were muting the signals that would normally prompt them to reign in their too fast expanding economies. Instead, they deluded themselves that all was well. The worst aspect of their measures of inflation was that they failed to take into account the inflation of asset prices, in particular housing.

One of the justifications for this was that the cost of servicing the housing debt was apparently not rising. To justify this people looked at the amount that individuals were using for repayments, pointing out that interest rates were low, thus making higher prices affordable. However, they failed to see that inflation and interest rates together the make up the actual cost of a house over the lifetime. High interest rates coincide with high inflation, and low interest rates coincide low inflation. High inflation compensates for higher interest rates by eroding the value of the debt owed, such that the two factors balance out. The problem was that everyone apparently forgot this, and therefore people committed ever greater portions of their lifetime earnings to buying their houses. This in turn inflated the prices of housing, as ever greater amounts of money was entering the market. In any market, if you increase the supply of money available for purchase of a finite number of assets then there will be inflation.

This inflation of asset prices, due to an ever expanding supply of money, apparently supported by collateral, led to a belief that the money was being lent wisely. It was not, because the necessary increase in wealth needed to justify the increase in prices was not occurring. What was occurring was the debt merry-go-round.

This was a situation in which more and more money was entering the financial markets to support house purchase, and providing ever more easy credit. The 'service economy' was born, the massive expansion in retail and leisure activities for consumers. The new expensive restaurants, the shiny shopping malls, the crystal healers, personal trainers and so forth. At the same time, governments were borrowing more and more money, and creating ever more new government activities, more government jobs, and so forth. It is here that we come to the multiplier effect.

Each £1 or $1 entering an economy has a multiplier effect. When we go to a restaurant and buy a meal, we do not only support the success of that restaurant, but also the suppliers of the restaurant, the supplier of the supplier, and so forth. This means that a service economy can generate what appears to be huge amount of productive economic activity. All of the money going into purchasing the services trickles through the economy, supporting more and more activity. This keeps employment high and, as services expand, the economy appears to grow.

The problem here is that all seems well but, if the spending on the services is built upon growth in debt, then what is happening is not actually growth in the economy at all, but actually temporary growth at the cost of future growth. When we borrow money for consumption (not investment), we are foregoing future wealth. In short, the credit boom was a massive boom in forgoing future wealth. The most dangerous part of all of this boom was that, for reasons which still baffle me, the economists who were measuring economic growth included this foregoing of future wealth as economic growth, which is why we saw ongoing rises in GDP. Occasionally there were concerns expressed about the way in which manufacturing shrank as a percentage of the economy every year, but this was all answered with twittering about 'post-industrial' economies. No one seemed to ever ask where the real source of the ever expanding wealth came from. This was the purpose of my original essay, 'A Funny View of Wealth'. In that essay, I looked at all of the potential sources of real growth in wealth, and found that there were none. I also found that the GDP growth was rising in line with the growth in debt.

The most curious part of this is that the lending to the West has continued for so long. In some recent posts, I have pointed out that this is largely due to confidence. It is the belief by those that financed the boom that the West had always been rich, that the West would always be rich, and was therefore a good credit risk, and a good investment. Just as the Western economists were pointing to 'growth' in the Western economies, so could those doing the lending, all the time not realising that their lending was going into the consumption that was actually the source of the growth. In other words they were financing the luxury lifestyle of the West in the belief that the West was an ongoing economic success, without realising that the success was entirely illusory.

It is for this reason that what should have happened, did not happen. As competition from the emerging economies became ever more effective, the logical outcome was that the West should have seen their economies adapt to the new competition. As the trade balances were turning negative, there should have been a drop in the value of the Western currencies, and this would have created a re-balancing of the world economy. Instead, the flood of money pouring into government and consumer debt, meant that there was high demand for the currencies, so that the currency could then be lent back to the consumers and governments of the Western countries. For a long time ever more money pouring into the Western economies actually continued to generate returns, but the generation of those returns was in turn reliant on an ever exapanding source of finance into credit for the Western economies. In other words, the returns were reliant on more and more borrowing, such that the returns were actually coming from more borrowed money. A debt pyramid, if you will.

We can now add in some rather unusual factors for both the UK and US. In both cases they saw a massive increase in immigration, for the former the immigration of Central European workers, for the latter Mexican workers. In addition to these workers also helping to hold down wage inflation (in addition to competition from emerging economies), they also created even greater activity levels in the destination economies, adding even more growth to the GDP and also accelerating demand for housing. They came in large numbers due to the boom in the service economy, which in turn was built upon the boom in credit. In other words, the mass immigration was an upward lever on the economies, on the bubbles that were forming. The trouble is that immigrant workers are, in most cases, a negative impact on an economy, in particular if they are temporary. Each immigrant worker who comes on a temporary basis intends to return home with a cash sum. When they return home, they are therefore taking real wealth out of the economy. Furthermore, if they return home in large numbers, one of the props for the housing market price rises is removed, as demand will go down.

It is now that we come to what I call 'The Cigarette Lighter Problem'. It is not of itself a problem, but the expression of a more fundamental problem. In the post I detail how a lighter in a Western economy costs about nine time the price paid in China. In paying this price for an identical product, delivered in an identical way to the way it was delivered in China, I point out that there must be some part of the economy generating huge amounts of added value to support such a price. At the same time I consider the economy of China, which increasingly has the same infrastructure, the same technologies (at least in the cities), increasing productivity, and so forth. In such circumstances, how can the price differential be maintained? Can such a large differential be justified?

The answer to the cigarette lighter problem is actually the answer to the problems that the West is now facing. The differential is built upon the flood of money that has entered the economies of the Western world, such that it is the lending that is actually the root of much of the difference in the price. There is no part of the economy that can explain such a massive differential, and we can only conclude that a large part of the price differential is that the emerging economies are paying for a large part of the differential. I am aware that this is a difficult concept to grasp. It is the idea that when we enter a shop and do something as simple as buying a lighter, we are paying for it in part with money that was actually borrowed from other countries.

So now we return to the problems that we are seeing today. The first point of note is that commodity prices are now falling back (notwithstanding the irrational pouring of money into commodities out of panic). The reason for this is that, now that the flow of money into the Western economies is drying up as the debt spigot is switched off, the economies of the West are contracting, with a commensurate contraction in those who were exporting to them. In other words, demand is fast contracting and contracting back to a level where supply once against exceeds demand. I like the analogy here where world demand was a person racing forward, only to hit a wall, and bounce back before once again commencing progress. What will happen is that, having bounced back, the running forward will again occur at breakneck speed in the future, only for the runner to bounce back once again. All the time, the wall is moving forwarded, but never fast enough for the speed of the runner who will keep running forward and bouncing back.

It is here that we see the underlying problem for the Western economies. As I have discussed, there are many new workers in the world and, in order for them to be productive, they will need to have access to resource, to commodities. The situation is now one in which the runner has bounced back, and there is an excess of supply of commodities relative to demand. However, if we remember, the amount of commodities available to the world economy has not increased in a way commensurate with the supply of labour. As such, until such a time, not everyone will be able to have the same share of the available resource that was utilised by the West. It will not be possible, until that time, for the emerging economies to 'rise up' to the standard of living of the Western world. There is simply not enough available resource for this to be possible.

Many economists claim that international trade is not a zero sum game. They claim that everyone can benefit, as trade will help everyone get richer. This is absolutely true, but only if there is not competition for limited resource. In such circumstances of competition, the situation today, there are winners and losers. The big question that this raises is one of who will win and who will lose?

My argument is that the West is not well placed to win in this new competition. Our economies are bloated with fat, and due to the excesses of the credit boom, loaded down with debt. Our governments are inefficient and complacent, our advantages in education are diminishing as our education systems fall victim to faddish dumbing down, our technology is being exported wholesale to the emerging markets, we carry the weight of welfare systems that are unsustainable, and we tie up our businesses with regulation, and tie the hands of business behind their backs by ethical laws, so called 'green' policy, and demands for abstract notions such as 'corporate responsibility'. On top of this, you can see a culture of expectation, that government has the answers, that we have a right to wealth, and a culture or complacent expectation. Compare this with the hard working emerging economies, in particular in Asia, who revere education, who will do anything to secure the betterment of their family position, whose governments are hungry for success, and determined to find their place in the world (I am really talking of China here), and who are pursuing aggressive mercantilism policy.

In such a situation, I have to ask how we can win? It is the reason for this blog, and the reason why I have written about structural reform. However, these are the least read and least commented part of the blog. I suspect that, on the one hand, we can accept intellectually the arguments that I am putting forward, but not actually accept the reality of the inevitable consequences. Those consequences are that we must adapt to being poorer. Whilst the world overall is getting richer, a greater share of that wealth is going to move to the emerging economies, and it will happen at the expense of the West (or OECD if you prefer). The way that the wealth is redistributed will not be even. Some countries will fare better than others. I have always argued that the UK is going to be one of those hardest hit, and everything that I have seen in the last few years, and more recently confirms this. On the other hand, I used to believe that the US would hurt, but the flexibility and dynamism of the US culture and economy would pull it through (such that there would be pain, but not as bad as for example the UK). However, events of the last week appear to suggest that the path being taken is to try to magic away the problems with ever more borrowing. I am now very pessimistic.

As I said at the start of this very long post, the crisis in the financial system is actually based upon an element of rationality. It is not some strange force, but a reflection of the underlying economic problems, and the shock of the intrusion of reality into the delusions that have been held by so many. I have said many times that what we are witnessing is the inevitable rebalancing of the world economy. Everyone will hurt in the process and we will enter a period of economic chaos, with possible political chaos flowing from the pain.

Pure and simple, the world economy is a mess. The reactions to date are not encouraging. It seems that nobody has yet accepted that the errors of the past can not be fixed overnight, that the gross misallocation of capital in the Western world must have consequences, and that the West must come out of this poorer than it started, and considerably so.

In this post I have not done full justice to all of the points that have been made in previous posts. I have just sat down at my computer and churned this out without any plan or structure, so I hope that it makes sense to you. In places I have oversimplified, and not accounted for the many inter-connections that have driven all of this disaster. I have not referenced much of the post. I apologise for all of these faults, but I am (as ever) constrained by the demands of my 'real life'. I hope that you will understand.

If you do find that the argument put forward here makes sense to you, then I would suggest that you take time to look through the blog, as there is far more in depth explanations and discussions. I have given links at the top of the post, which take you to some key posts. However, do not neglect the archives. I had myself forgotten some of my previous posts, and on occasion have been pleasantly surprised to find some of my own explanations that I had forgotten, but which helped me make sense of the current situation.

Note for Regular Readers: I will not be posting as often as in recent times as my 'real life' will be very busy for the next month and a half. Also, I want to avoid getting sucked into 'punditry' and would rather focus on the wider issues. As such I will continue to post, but will try to restrict my posts to implications as the crisis unfolds.

Note added 28th September:

I have just posted a comment in a forum, which may be worth adding here:

The justification for the bailout is to avoid a repeat of the Great Depression. However, the world is not in the 1930s, so why would an imagined solution to a 1930s problem fit the circumstances of 2008. . There is no evidence that it would have worked then, and even if had worked then, would that suggest that this would solve the different crisis that is occuring today?

As I have detailed above, the crisis actually stems from some very particular circumstances.

Note 2, added 28th September:

One comment on this article accepted the principles of what was said in the post as saying

'Absolutely wonderful post. Although I am somewhat more optimistic than you that people in OECD countries can bounce back and become competitive when they are under greater competitive pressure'

Whilst my posts are unremittingly gloomy, I also believe that the OECD (Western) economies can bounce back. However, the first step is the recognition of the reality of the changed world, and it is the lack of recognition that concerns me. Another comment noted that there was a problem of arrogance in the US, and this is perhaps a related point to the one I am making here.

Another poster has added a comment against 'A Funny View of Wealth' asking:

'What will be the effect(s) of continued mass unskilled imigration from third world countries?'

My answer to this is that I suspect that, as the economy turns down, the borders will probably close to any significant immigration (Central European immigration notwithstanding). However, this is a matter of politicians making choices, so it can only be a guess. However, if the borders remain relatively open, it is likely that numbers will diminish as the Western economies will start to look less attractive. Whilst the West will still be relatively wealthy comapred with many countries, economic migration probably needs fairly strong motivation, and the prospect of arriving in a country with surging unemployment is probably not going to help with that motivation.

Lemming (a regular commentator), asks a perceptive question as follows:

'The brave, clever and perceptive thing to have done would have been to stifle 'growth' (debt) with the future in mind. But at what point would such a suggestion stray into the realms of 'socialism'?'

This raises the question of how much intervention governments should undertake in markets. My argument has consistently been that the problem actually arose as a result of government regulation (see 'The Market and the Crash') which caused a false sense of security. I have also been critical of the very idea of government borrowing and the setting of interest rates by central banks (see 'Government Borrowing and Interest Rates'). Removing regulation, and the ability of central banks to set interest rates would probably have avoided this crisis. In particular, without the regulation the activities of the banks would have caused alarm much sooner than was the case when they met regulatory requirments (implying that they were 'sound') and would have also prevented the need for off-balance sheet structures, CDOs and all of the other problematic activities.

Lemming goes on to ask:

'Did any government in the world conspicuously do the right thing over the last decade?'

I can think of no example. However, I am a market purist, where I believe that the only role of government is in the prevention of market concentration and monopoly, fraud, insider trading and so forth. This serves to remind me that I still need to finish my post on regulation, which will discuss such issues in more depth. Hopefully this will answer your question as this is too big a subject for a quick comment.

King Canute and the Banking Crisis

I very rarely post this often, but it is an unusual point in time. I have long predicted this crisis (for new visitors to the site see the links to the left and browse the posts in the archive), knew what would happen but, somehow, now that it is here, there is a sense of unreality about it. I predicted this crisis but now we are in the situation, it seems less real than it did in my imagination and thoughts. In my imagination I did not have a sense of the panic that would ensue, but imagined the world looking on with the same dispassionate perspective that I take in considering these matters. A strange point of view with hindsight.

The reason for this quick post is that I have just browsed onto the Times website and found the following news:

'The Bank of England today joined forces with five of the world's most powerful central banks to inject up to $180 billion (£100 billion) into the world's financial system in a concerted bid to ease the funding pressure on international markets.'

From the title of this post, it is probably fairly obvious what I think of this action. More to the point, how much money are governments going to keep pumping into the markets before they realise that there is no stopping the crisis. They may delay it, but nothing can alter the fact that the fundamental problems that have caused the crisis will still be there.

The reasons that the banks are not lending to each other is that they all know that they are all holding toxic debt. This is not just CDOs etc. but also fast deteriorating commercial debt, unsecured consumer debt, and old fashioned mortgage debt (held on devaluing assets with people with ever more insecure job prospects). Furthermore, the sources of liquidity from the East are drying up as confidence in the 'rich world' banking system is evaporating.

The trouble is that, government balance sheets were already looking ugly and were getting uglier by the day as revenues will have been falling like a sone. Government are now piling more toxic debt onto the balance sheets, hastening the day when governments start to default. Had they accepted the reality of the situation, then there was a real possibility that they could have cut back on expenditure, reformed structurally, and perhaps have scraped through (just). Instead they are pouring money into black holes, and daily raising the likelihood of default.

Of all of the actions that governments could take, I can not think of a worse solution. There is going to be a very, very painful period of adjustment. Governments need to hold whatever resources they can for when their economies go through restructuring. It will not be possible to reform the cost bases of the world economy overnight, and that means that there is a need for as much of a breathing space as possible. Every $ that is poured into the black hole of the banking system shortens that breathing space. Furthermore, as I have said in my previous posts, it will eventually be repaid from the healthy sectors of the economy.

I am starting to find myself repeating myself, but it also needs to be said that the current crisis is not the real crisis but the symptom of the imbalances in the world economy. The only way to address these imbalances is to actually address the structure of the Western economies such that they are once again able to compete.

As I suggested at the start of the post, what we are witnessing is blind panic - and an irrational belief that something can be done. The trouble is that what is being done will be both ineffective and costly, and can (at best) delay the adjustments. It is a tragic waste of resource just at the time when those resources will be needed most.

Note:

The Telegraph also has article on the rescue package here, and the FT offers the best summary here...

Note 2:

We are currently undergoing an experiment in seeing whether governments can hold back economic reality. It is, when you think of this, very much like Canute holding back the tide. However, in the case of Canute, he knew that he could not really do it, and that was the point. Do the central bankers think they can really hold back the economic tide?

Note 3: In my last post I answered a question on what was a safe investment, and suggested that gold was a reasonable bet (I had mentioned a similar sentiment in an earlier post). I have just noticed that gold had already been posting record gains (not surprising under the circumstances). I have never looked closely at the gold market, so have no sense of how these gains can be measured, but perhaps it is too late to buy into gold. As such I would strongly recommend a long look at the history of gold prices before jumping into the market. However, as I mentioned before, gold prices are driven by sentiment, and any positive sentiment on the latest bailout is not likely to last that long.

The Banking Crisis is as Much a Symptom as a Cause

It seems that my post on reform regulation will have to wait a little longer, so I apologise to regular readers who may have been waiting for the post. It seems that the news of the moment is worth further comment.

A good starting point is to refer you to some commentary in the Telegraph newspaper:

'In a year's time, consumers may look back on the past 48 hours as a bit like the first few minutes after the Titanic struck the iceberg, when high-spirited passengers played snowballs unaware of the danger they were in. '

It seems that people are finally waking up to the reality of the dire situation that we are in. The current banking crisis has arrived a little sooner than I expected (about one or two months earlier than I thought), and is actually just the start of the carnage. In a related story The Times today reports that unemployment has now reached a 9 year high, and with the highest increase since 1992. Once again, it is very much as predicted. The return home of Central Europen workers has acted as a dampener, but it could only slow the growth in unemployment so long. There is also a growing recognition that house prices have a long way to fall yet.

Following the Northern Rock fiasco, the first of the second tranche of UK banking problems is HBOS, with the government scrabbling around for a rescue package. I have not looked at individual banks closely, so I will not give a long list of those at risk. However, a good way of looking at the question of which bank is at risk is simply to ask which banks have seen massive growth in profits and expansion over the last ten years. Banks such as Royal Bank of Scotland come to mind, but I emphasise that I have not looked closely at individual institutions.

As if the fiasco were not bad enough, there are calls for the prevention of short selling of stocks (see here for a good description of what this means). This makes me think of the analogy of a person saying that they want to ban the use of thermometers for patients with a fever. It reveals the ignorance of those in power. The short selling is just an indirect indication of the underlying problems.

As for the whole idea of bailing out the financial system, I have suggested that government bailouts are not the solution. I am now ever more confident in that view. The reality is that the governments are just taking on liabilities from a stricken sector, and will then have to use the remaining healthy sectors of the economy to pay back the debt that they accept. Taking on such liabilities will also add to the coming crisis of government finances, as governments find that confidence in their ability to repay debt wanes, or collapses. They are, in other words, spreading the 'sickness' into other parts of the economy. Furthermore, where will governments stop, and how much can they bail out? The following makes the point:

'Fears that America's central bank – the Federal Reserve – may have over-stretched itself in agreeing to bail out AIG were underlined after the US Treasury announced plans to raise $40bn to allow the Fed to "better manage their balance sheet."'

Incidentally, the Economist reported a long time ago about the potential risks in insuring credit, but I am afraid that I do not have a reference for this (despite a quick search of the Economist site). We can expect more problems to emerge amongst the insurer and reinsurance companies.

The bail outs, I'm afraid, amount to a philosophy of 'something must be done', whether the something makes any sense or not.

In amongst the emerging realisation that the crisis is not going away, and the realisation that it will get much worse, there is no sign yet that anyone has yet realised that the banking crisis is not the problem. The mainstream economists, governments, and bankers still do not understand what is happening. The foolishness of the credit bubble has just been a mechanism of delay in the rebalancing of the world economy, putting off the inevitable restructuring of the world economy. There is no doubt that the credit bubble will have made what was always going to be a painful adjustment much worse. But it is not the cause of the problem.

For those who are new to the blog, I would suggest that you take a look at the recommended reading at the top left of the blog for an explanation of why the world economy needs to rebalance. The reasons are pretty straightforward, and blindingly obvious once you read them. The shocking thing is that none of the 'experts' seem to have grasped the nature of the problem.

The purpose of this post is, as much as anything else, to re-empahise that the banking crisis is not the real crisis. It is as much a symptom as a cause. It has taken such a long time to wake up to the fact that the economies of the OECD have been built upon foundations of sand, it makes me wonder how long it will take for everyone to wake up to what is the real cause of the problems. No doubt, for a long time yet, the symptoms will be confused for the cause.

Without understanding what the root cause of the problems might be, the solutions provided to solve the crisis will continue to be misguided. The UK, and other Western economies, can not afford to continue to try to navigate whilst blind.

What of New Zealand?

I had a comment from someone asking the prospects for the New Zealand economy. My apologies for the belated reply, and that I do not have time to find the original comment.

The answer is that, like the rest of the 'rich world' New Zealand will suffer in the current crisis, but there will be some countries that will feel the pain more than others. I do not know the New Zealand economy that well, (due to the size of the economy, it is not well reported on) but will hazard an opinion nevertheless (so treat what I suggest with caution). As a second apology I am rather pushed for time, so can only go on memory rather than checking facts and figures (so I reemphasise treating my comment with caution).

New Zealand has strengths and weaknesses. The first weakness is that, as the world globalises, scale of businesses will increasingly matter. New Zealand is just too small an economy, and lacks the large companies that will increasingly be dominant in the world economy. Another problem is that the New Zealand economy has a large tourism sector, and that this will be hurt by the current financial turmoil. However, this can be ameliorated by finding ways to appeal to new markets, such as China and India. The question is whether New Zealand can find an appeal that will resonate with these markets, and that is a question of marketing. At the moment New Zealand is very good at promoting itself as a 'clean green' location. The trouble is that the environmentalism that New Zealand loves may hobble other sectors of the economy, in particular agriculture and forestry.

As for the rest of the OECD, New Zealand has had a housing and credit bubble, but the size of the bubble is not as large as, for example, the UK. I have not looked in a long while, but I believe that the government debt is very high. and overall external debt, allowing for population and size of economy, is at a similar level to a country such as Germany (based upon a quick back of a cigarette packet estimation - please do not take this too seriously).

On the positive side of the balance, New Zealand has a large commodity sector, and this is a good thing in the world economy now, and in the future. Whilst commodities will have a bumpy ride, as the world economy swings wildly, the demand for commodities is, on balance, going to increase. Of particular note is the New Zealand agricultural sector, which has more potential than is currently realised. In particular, New Zealand has potential to develop a stronger food industry, and move up the value chain. If New Zealand is to realise this potential, they need to start to switch their added value food products to products that will service the Asian market. This will need a shift in the thinking of the people who run the large New Zealand food companies. The current milk scandal in China will not help matters much, but hopefully that is just a blip.

Overall, I think that New Zealand has the potential to fare relatively well, but I would like to reemphasise again that I speak from a position of relative ignorance.

Note for Lemming (a regular commentator on the blog):

Anatole Kaletsky still seems to have retained his job as a columnist, despite getting it all so wrong. He is still opining with complete confidence, and still seems to think he knows the answers. I wonder whether he reflects on his previous errors and suffers doubt? See his latest article here.

Note For Tin Hat:

Tin Hat, thanks for your question which I have edited and added below:

What are your views on how bad will it get. Lots are suggesting another Great Depression, that bad? Is there anything that can be done to protect your savings. On the basis of your assessment government bonds do not even sound appealing and gold buried in your back garden seems extreme! Your thoughts would be appreciated

Right now, I am afraid that I would be a very foolish person I were to be giving firm advice on where to invest. The trouble is that, in the short term there is no place of safety. The reason for this is that world economy is going to become more and more chaotic in the coming year. Much will depend on the actions of governments and politicians, and they are individuals who carry all of the faults of people anywhere. How will they react? So far, not very well. However, as the situation worsens, and the demands for action multiply, they will likely act upon their economies in increasingly irrational ways.

The other problem, at least in my mind, is what the instability will do to China. I have discussed this in another post, and the problem is that, if China's economy is pulled down enough by the turmoil, it is quite possible that the country will see civil unrest. The real question is whether China can sustain itself through the current turmoil, and I confess that I do not know the answer to that question. It is too opaque an economy to have any certainty. However, if the current crisis tips China into recession, then the world really will be in for a period of chaos, including civil unrest in China and the possibility of war as well.

As a general point I would suggest commodities, as they are likely in the medium term to gain in price, but holding commodities is not easy. I do not know enough about futures to know the maximum length of contracts, but suspect that they would not meet your needs, and would any case be too complex for most people. However, as the world economy absorbs the current blows, it will shrink back, lowering commodity demand in the short to medium term. I do not know what your time scales are.

As for putting gold in the garden, that seems as good a bet as any (just don't tell your neighbours). But seriously, as mindless as it is, gold does do well in periods of turmoil. The danger with gold is the very fact that it is a safe haven, and that means sentiment is the real driver of value. However, in the current climate, I can not see sentiment turning positive (on aggregate at least) for some time yet. However, I have to reiterate that, in the current situation, there really is no safe investment (there never has been, but I speak in relative terms). It seems that your instinct appears to be in accord with mine. Maybe you need to get out and buy that shovel (or spade if you are from Yorkshire).

UK Debt - Is it a problem?

Note: I have made an error below - the second comment was not Arlo, but another person. Apologies to Arlo and the other poster for the confusion. I have left the post as it stands, however, as I was trying to address the themes in both comments (I have to admit that the two perspectives did not quite tally, so should have realised).

Original post below...

I have had two comments from a 'Arlo' in my post 'UK Bankrupt?' which I think I should respond to (apologies for the time taken, but my 'real life' is rather hectic at the moment). Arlo has made two challenging comments as follows:

'This raises the philosophical question of whether you can "realise" something that isn't true.

UK has a big external debt but is also a big external lender. Whether we're bankrupt or not depends on the net position. UK external assets are about 95% of UK external debt, so the problem is about 5% the size you claim.

Your 18C aristocrat has a portfolio of shares almost as large as his debt, so his net annual payments to creditors is a tiny fraction of his income from non-financial activities (GDP). That's why they keep lending to him.

Sorry it's not as exciting as a financial apocalypse, and it doesn't really add much to big-picture arguments about a postindustrial economy or whatnot. But that's accounting for you.'

And

'If the 18C aristocrat had a load of shares he could cash in, why would he borrow money at interest? Wouldn't he use up his cash first?

With regards to the UK, what happens if the people 'we' have been lending money to cannot repay the loans? Presumably we are still liable for the 12 trillion dollars in debts?'

Note: For new visitors to this blog, I would suggest that you read my essay 'A Funny View of Wealth' before continuing here. The essay is quite long, but I hope it is worthwhile.

The first thing to say is that I appreciate comments, and enjoy challenging ones. With regards to the current state of the UK's net position, according to a paper by Whitaker (1), the position is as Arlo describes. According to the paper, the following is the case:

'Official data suggest that the United Kingdom’s financial liabilities exceed the value of its financial assets — net foreign liabilities were equal to around 14% of GDP at the end of 2005.'

The only problem with this rather rosy scenario, is the nature of the financial assets. In particular many of the assets that the UK can point to are actually assets owned by UK based companies, representing foreign direct investment (FDI) or portfolio investment, and those companies are not necessarily UK owned. This may present some problems. The first is that the companies may be based in the UK, may be listed on UK stock markets, but that does not imply that the ownership is UK based. Are the figures for FDI calculated on the basis of the companies being owned by UK individuals, or are they calculated on the basis of UK based companies? I suspect the latter and that means that many of the UK's overseas assets are not actually UK owned (I am open to being corrected on this, but I believe this to be the case).

Of course, we could make the same point as the above for other countries and ownership of assets, but the important point to make here is that the UK economy is very open, and the UK has had one of the highest levels of inward investment of any of the countries in the world, suggesting that the UK will be in a position where international ownership of companies is particularly high.

The second is that a company is not tied to the UK, and has the freedom of relocating itself to another country where there is a better business environment. This has recently been happening in the UK, with companies relocating to Ireland for example.

Another problem is that our net assets are largely based in Europe and the U.S. and I have discussed at length the underlying problems with the OECD economies, in particular the U.S. and Europe. As such, these assets are not necessarily going to hold their value. For example, it will be interesting to see what happens to the value of commercial property held by the UK in the U.S. However, set against this, the value of assets in the UK will also drop, as will the return on those assets for overseas investors.

Another problem is the question of how the figures are calculated, which is in part why I have cited Whitaker. He points to the following rather strange effect:

'net investment income has improved at the same time that the United Kingdom has become more indebted'

By way of explanation he says the following:

'Two factors are behind the United Kingdom’s ability to obtain net investment income despite increasing net indebtedness. First, the yield that the United Kingdom pays on the bonds and equities issued to overseas investors — termed portfolio debt and equity — appears to have declined relative to the yield that the United Kingdom earns on the bonds and equities issued by the rest of the world that it owns. Second, there has been a shift in the composition of UK external assets towards foreign direct investment (FDI). FDI assets generate a higher yield than the United Kingdom’s predominantly debt-like liabilities.'

To quote my own tag-line 'I just don't buy it'. It just seems too close to the idea of 2+2=5, but my purpose here is not to discuss his thesis. Interestingly, he also acknowledges that the figures that are used for the paper are somewhat problematic, but believes that they are understating the UK's assets.

Another way of looking at this is the current state of the balance sheet of individuals in the UK. With regards to debt, it is no secret that individuals in the UK have shockingly high levels of debt (see here for an example break down - it is out of date and therefore understates the scale of the problem, but is interesting nonetheless). On the other side of the balance sheet, savings have been falling back and are at the lowest level for 50 years, such that on a chart the lines are going in the opposite direction (see here - sorry, again out of date as I am as ever pressed for time, and it is the first useful chart I could find, but hopefully you will get the picture). Savings represent the accumulation of assets, both in the UK and overseas. As such, if the savings rate is low, there will be a commensurate drop in aggregate ownership of overseas assets by individuals in the UK. What we are therefore seeing is increased borrowing by individuals, and a significant proportion of that from overseas sources (the sub-prime crisis has demonstrated the international nature of lending to consumers), compared with less investment overseas.

A good summary of the state of the UK household balance sheet can be found here (an IFS powerpoint presentation). Whilst it shows a positive overall balance sheet, the trouble is that it is a snapshot of the value of assets, and does not account for a downward spiral in the OECD economies. As the banking system has discovered, even the Basel capital adequacy ratios can not assure assets can be valued accurately - until it is time to sell them. It is here that matters become complex, because we have a situation of mutual interdependencies. The balance sheets of households are dependent upon the overall state of the economy in the OECD, and the state of the OECD economies is, in part, dependent on the balance sheet of households within the OECD. What happens when, for example, stockmarkets fall? Or what happens when the value of assets such as housing fall? What then happens is that the interdependencies kick in, causing a downward spiral. As I have pointed out, most of the overseas assets held by the UK are within the OECD, with particularly high exposure to the U.S. and Europe. Throw in the complication of an abstract idea of confidence, and there are ever more feedback loops that will push the economies downwards.

If we actually look at what has been happening in the UK we see consistent balance of payments deficits over a long period of time, and even invisible earnings are now in deficit. I have already discussed inward investment and questioned whether it is a 'good thing' in 'A Funny View of Wealth'. This is now reflected in our position on invisibles.

'The continued weakness of manufacturing exports and the strength of import demand, fuelled by the consumer spending boom, have led to a widening current account deficit, put at £57.8 billion or 4.2% of GDP in 2007, not far short of double the level of £30 billion two years earlier. Indeed, the deficit would have been closer to £70 billion but for a surge in investment income in Q4, a one–off result due to the impact of the credit crunch as foreign banks posted record losses. The surge in the deficit is largely the result of consumers living beyond their means, lured into more spending by offers of cheap credit, in turn sucking in greater imports. As a result, the merchandise trade deficit widened to £87.6 billion (6.3% of GDP) last year from £77.4 billion (5.9%) in 2006, with the deficits for finished manufactured goods, basic materials and food, beverages and tobacco all rising significantly. But, at the same time, the current account has also been hit by falling net invisible earnings. The deterioration in portfolio investment income has been fairly modest but the traditional surplus on the income account fell to £5.3 billion in 2007, far below the level of £25.8bn just two years earlier, primarily the result of sharply lower net inflows of direct investment income (although the latter rose to £37.5 billion last year after the very strong Q4). On top of this, net outflows of transfers have continued to climb, reaching nearly £14 billion compared with around £12 billion in the two previous years.' (2)

Looking at another part of the equation, UK government debt is fixed an firmly attached to the UK. Also, if we look at individuals, there is considerable outward migration from the UK. As I have discussed in my essay 'A Funny View of Wealth', those migrants will be taking all of their assets with them. They are very unlikely to be in debt, whereas the state of individual debt in the UK is, as is being widely discussed, parlous. This debt is also firmly attached to the UK as these individuals are unlikely to leave the country taking their net debt with them. In short, for individuals, those in debt are tied to the UK and those that are leaving are taking their net assets with them. Unlike the assets held by companies, that are able to relocate, or where those assets are often partially owned by overseas investors, the consumer and government debt are not going to go anywhere. They are 100% UK owned debts.

Quite simply, as I have discussed in 'A Funny View of Wealth' the UK economy has been supported by a net increase in debt, and sterling has been supported in part by a flood of inward investment. However, as I pointed out at some length, such inward investment is not necessarily a good thing, unless it is investment in business that generates income from outside of the UK.

As I have stated previously, the UK economy is in a very, very bad position. I have mentioned before the problem that we include in GDP economic activity that is resultant from increase in debt. This makes the UK economy appear much larger than it is in reality. As such, whilst it may look like we have a size of economy that might be able to service our liabilities, the simple fact is that, when an ever growing debt mountain is stripped out of the GDP (remember the multiplier effect), then the UK economy is actually going to be nothing like the size it is reported to be.

We have massive external liabilities, and I do not believe that we have the ability to service these liabilities. We have assets that are declining in value, a negative net income, fast expanding government debt, a shrinking economy that MUST shrink back to a level with debt growth stripped out, and increasing competition in the few sectors in which we have competitive advantage, and finally the (albeit illusory/temporary) support of inward investment is disappearing.

To quote Arlo again:

'Your 18C aristocrat has a portfolio of shares almost as large as his debt, so his net annual payments to creditors is a tiny fraction of his income from non-financial activities (GDP). That's why they keep lending to him.'

The first question is who owns the shares? Even if he does sell the shares that he owns, then there is still not enough to cover his liabilities. The second point is that, even if they were all sold, his income does not begin to cover his expenditure. There is no prospect of his income increasing, so creditors will see no way of his paying back any future lending. The only way they will lend to him is if he savagely cuts his expenditure such that his income is enough to repay the debt. However, his income is actually declining, so who would take a risk on him?

As I have said before, the UK is structurally bankrupt. By this I mean that it is not clear how we can pay off our external debt in our current situation. This is why I am proposing structural reform.

(1) Whitaker, Simon,The UK International Investment Position. Bank of England Quarterly Bulletin, Fall 2006, Available at SSRN: http://ssrn.com/abstract=932523
(2) (2008). "Are the UK's twin deficits a risk to stability?" Economic Outlook 32(2): 14-19.

Other Useful references

http://www.bankofengland.co.uk/publications/quarterlybulletin/qb070401.pdf
http://www.le.ac.uk/economics/research/RePEc/lec/leecon/dp05-5.pdf
http://ec.europa.eu/economy_finance/publications/publication1449_en.pdf
Kirsanova, T. and J. Sefton (2007). "A comparison of national saving rates in the UK, US and Italy." European Economic Review 51(8): 1998-2028
Vladimir Klyuev, Paul Mills. (2007). Is Housing Wealth an "ATM"? The Relationship Between Household Wealth, Home Equity Withdrawal, and Saving Rates. IMF Staff Papers, 54(3), 539-561. Retrieved September 12, 2008, from ABI/INFORM Global database. (Document ID: 1330902681).