The Fed Criticises Bloggers?

Over the last couple of days, in reviewing the news, I have noted that there is an increasing sense of panic and chaos in the world economy. Today, it seemed particularly bad. I typically look at the Telegraph, the Times, the New York Times, the Guardian, and Reddit as a daily routine, and occasionally the Economist. Today, I was confronted with the following economics headlines in the Telegraph (selected examples):

• FTSE 100 Joins in Global Market Tumble
• Warnings of Double Dip Recession Flash Brightly Across the World
• Bank of England Starts to Dust off its Inflation Fighting Credentials
• Roubini: Greece Needs Orderly Debt Restructuring to Avoid Default

Perhaps most shocking was a headline for a commentary by Ambrose Evans-Pritchard titled 'Time to Shut Down the Federal Reserve?' The content of the commentary was not as radical as it appears, and is a response to a rather idiotic paper by Kartik Athreya of the Richmond Federal Reserve, in which he advises that people should not take economics blogs seriously, as the writers do not have a PhD in economics from a decent school. Ambrose Evans-Pritchard, quite reasonably, points out that the experts played a major hand in the development of the economic crisis. Zero Hedge offers an even more scathing reply to the paper, saying:

Alas, all Kartik achieves is to convince the general public that feeding Fed "economists" alcohol after midnight and letting them directly upload their resultant gibberish to the Fed's broad RSS feed the second they think they have a coherent thought , is generally a disastrous idea. In his piece, which has no other intention than to discredit and outright malign bloggers such as Matt Yglesias, John Stossel, Robert Samuelson, and Robert Reich, Athreya says: "In what follows I will argue that it is exceedingly unlikely that these authors have anything interesting to say about economic policy. This sounds mean-spirited, but it’s not meant to be, and I’ll explain why." Instead in what follows, the Fed presents 4 pages of thoughts so meandering, that the author's blood alcohol level must have certainly been well above the legal norm for the duration of the writing of this ad hominem pamphlet.

I am focusing on this paper by Athreya, as it contrasts nicely with the headlines. The Masters of the Universe, sitting in their ivory towers are clearly not in control. Instead, they pull their levers, enact their policy, and it all comes to nothing but more chaos. They propped up the financial system, supporting their selected 'too big to fail' banks, they printed money and poured it into the markets via their favoured financial institutions, and they aimed to drop interest rates to the floor. Despite this, we still see a world economy racked with volatility and close to panic.

That they had a role in the blowing of the bubbles that took a crisis and brought it to the point of disaster appears to be forgotten by people like Athreya. Their arrogance is quite astounding.

What we are now witnessing is that it is not possible for the Masters of the Universe to eternally prop up a system that is structurally flawed. They can continue to pour money into the system, continue to prop up bankrupt financial institutions, but there is a limit to how long they can bury the underlying structural flaws. When money is invested unwisely, someone, somewhere is going to have to pay. It is only a question of 'who' and 'when'?

This is the problem. If you invest in a piece of commercial real estate at an inflated value of $1 million, and the value falls to $500,000, then somebody must accept the loss. For example, if it is a half empty shopping mall, it is not producing the expected return, and the valuation reflects this underlying reality. There is not enough demand for retail space out there. The capital that has been invested in the shopping mall has been misdirected. Workers have input their labour, materials and energy have been consumed, and there it is; a half empty shopping mall built with borrowed money and no prospect of returning that borrowed money. Somebody, in the end, is going to lose their money.

The only way that the shopping mall will recover is if consumers go on another debt fuelled spending binge. If they were to do so, it would only be a matter of time before the debts, wherever they originate, will finally become due, and the problems will return. If consumers are spending 110% of their income, there must come a time when they can no longer spend. If a government is spending 110% of its income, there must come a time when it can no longer spend. We have seen this happen, so why will it be different this time?

If we think of our half empty shopping mall, it should never have been built. The actual demand for shopping malls is, in reality, aligned with actual income, not income + borrowing. Whilst it is possible to build shopping malls based upon income + borrowing, the long term viability of the shopping malls finally comes down to income without borrowing. If the shopping malls are built upon an assumption that income + borrowing is an eternal state of affairs, at some point the investors must lose money. Too many shopping malls will be built, as they are servicing both present income and future income, at the cost of less income in the future. They are building capacity based upon an unsustainable structure.

The unsustainability must finally lead to a point in time where the shopping mall lies half empty. At that point in time, whoever invested their money in the shopping mall will face a loss. Whether a bank, or an individual investor, they are faced with holding an asset, one which has taken labour, energy and materials to build, and which can not return the money that it took to build. How is the money going to be paid back? Who takes the loss?

The essence of the actions of the central banks has been to enact policy to stop anyone taking the loss. However, it does not matter how much they try, there will still, in the end, be far too many shopping malls in relation to the actual income of consumers. What the central banks can not do is the only real solution, which is to jump back in time, and stop the building of the shopping mall or the borrowing of consumers that was the driver of the investment in the shopping mall in the first place. So you come to a point in time where the shopping mall is there as a physical reality, but the demand for the services of the mall are not there.

And what of all of the people who were employed in the shopping mall, or employed in services that supported the shopping malls' operations? The shop assistants and managers, the shop fitters, the security companies, the importers, and so forth. All of these jobs will disappear, with each new unemployed person's training and skills rendered useless (or at least less useful). They must retrain, find new employment in a sector that does not have over-capacity. However, they are not alone, as all over the economy, other sectors built upon the income + borrowing paradigm are in the same position. So it is that the consumer demand falls as unemployment rises, leading to even more contraction of the demand for shopping malls.

How is it possible for the Masters of the Universe to turn back this tide? In their arrogance, they actually believe that they can do so. Pulling this policy lever, or that policy lever, they seek to change the world such that the economy is not structured around actual income and the ability to service past borrowing. They deny that the shopping mall was built upon an unsustainable structure, and try to hide the reality that it represented excess capacity.

Returning to the PhD economists of the central banks, the Masters of the Universe, they have their mountains of theory, they have their magic formulae, they have their policy levers, they have their belief that they can control the system - but - can they really make a world in which nobody loses when an economy has been subjected to structural failures, where investments were directed into sectors that were intrinsically unsustainable?

As each day goes by, it becomes ever more apparent that the Masters of the Universe are, in reality, delusional and impotent. At best, they can delay restructuring. However, in doing so, they will just continue with the investment into unsustainable sectors of the economy, and contribute to further structural flaws in the economy. The more they seek to turn back the tide, the greater the ongoing mis-allocation of resource. And they have the arrogance to criticise those of us who do not have their approved qualifications?

Note: I use shopping malls as my example as they are an easy target. However, this is just a convenience, and does not reflect the extent of the structural problems. There are a multitude of sectors facing the same problems, with each sector with overcapacity having a plethora of downstream overcapacity.

The RMB as a reserve currency - an update

I have been discussing the steady progress of China in setting up the RMB as the reserve currency for a long while, and have proposed that it is fast moving towards success (though success is not guaranteed). Economists like Nouriel Roubini have suggested that this is going to be a long term process:

This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order. The United States must rein in spending and borrowing, and pursue growth that is not based on asset and credit bubbles. For the last two decades America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable. A system where the dollar was the major global currency allowed us to prolong reckless borrowing.

Roubini is seeing a long term decline in the $US, and sees the RMB as being unready to take the place of the $US. In an update to his article, he has this to say:

So the process that will lead - in the medium-long term - to a challenge of the US dollar as the major global reserve currency has started. The US creditors - the BRICs, the Gulf states and others - are becoming increasingly alarmed that the US will deal with its unsustainable fiscal path via inflation and debasement of the value of the dollar via depreciation. So they will not sit idly waiting for this to happen: they are already diversifying into gold, into resources (as China purchases mines and energy, mineral and commodity resources all over the world) and into shorter term maturity US Treasuries that have less market risk than longer term Treasuries. With two-thirds of US Treasuries, being held by non-residents and the average maturity of such government debt down to 4.5 years, the risk of a refinancing crisis and disorderly fall in the dollar will increase over time unless the US presents a credible plan for medium term fiscal consolidation.

Even the Chinese are approaching the issue of the shift in reserve currency with some considerable caution, so Roubini's view is mirrored by the official view of the $US replacement in China:

Yet even Chinese officials pour cold water on the idea that this might happen fast. China Vice Foreign Minister He Yafei, who is traveling with China President Hu Jintao this week to attend the G8 meeting, said Sunday night in Rome that the creation of a supranational reserve currency has been discussed “among academic circles” but that any proposal outlined “is not the position of the Chinese government,” according to China’s state-run Xinhua news agency (in Chinese here). And, at the Global Think Tank Summit in Beijing on Saturday, Li Yang, a former adviser to the PBOC and a prominent academic, said that the transition to a multi-reserve currency system could take 20-30 years or longer.

In some respects I have no argument with Roubini. I have long argued that the US deficits will eventually see the $US decline in value. However, I would argue that his implication of an orderly decline is far too optimistic. The fragility of the $US is becoming increasingly evident as each day passes. Just one example can be found in a recent article from Reuters on 26th June:

NEW YORK (Reuters) - The U.S. dollar fell broadly on Friday after China renewed its call for a super-sovereign reserve currency and as improving appetite for risk dented the greenback's safe-haven allure.

China's central bank on Friday did not mention the dollar by name but said it was a serious defect in the international monetary system that one currency should dominate.

Whilst such negative news dents confidence, it is still not enough to finally pull the rug out from under treasuries, as more recent news reports a rally in the face of poor stock market performance:

Treasuries rose, with the 10-year yield touching the lowest in more than a month, as investors speculated the worst recession in 50 years has further to run, tempering concern record U.S. borrowing may outstrip demand. U.S. debt gained as the U.S. sold $35 billion of three-year notes at the lowest yield since May. The auction is the second of a record four this week totaling $73 billion and stocks fell.

What we are seeing in these two reports is a process that I described in a recent article in the TFR magazine, which is that fear is driving markets, and that there is an oscillation from one place of risk to another place of risk. The problem is that there is no safety in any of the traditional safe havens. As each day passes, the underlying reality of the weakness of the $US is gaining traction, as ever more analysts are coming to realise that the current fiscal policy can no longer be sustained. An interesting example can be found in the Telegraph, which reports the analysis from the Federal Reserve's senior economist:

He added: “Similarly, a percentage point increase in the projected debt-to-GDP ratio raises future interest rates by about 4 to 5 basis points.” Economists are predicting a wide range of ratios but Mr Congdon said it was “not unreasonable” to assume debt doubling to 140pc. At that level, Mr Laubach’s calculations would see long-term rates rise by 3.5 percentage points.

The study is damning because Mr Laubach was the Fed’s economist at the time, going on to become its senior economist between 2005 and 2008, when he stepped down. As a result, the doubling in rates is the US central bank’s own prediction.

In the meantime, in the face of increasing uncertainties, one of the few remaining props for the $US is the purchase of treasuries by the Federal Reserve:

TOKYO, June 29 (Reuters) - U.S. Treasuries edged down in Asia on Monday as traders took profits after a rally pushed benchmark yields to their lowest in nearly four weeks, while the prospect of the Federal Reserve buying bonds this week underpinned prices.

It is clear that the process of printing money to purchase bonds can not continue forever. Whilst the process is currently supporting the bond market, the process of itself weakens the bond market, as it generates inflationary expectations. As such, having started the process, the Federal Reserve is now locked into the process. The more bonds that they buy, the less confidence in the $US, and the less confidence in the $US, the more bonds the Fed must buy. They are now locked into a cycle that must eventually end with the destruction of the value of the $US.

Whilst all of this is taking place, the Chinese continue to promote the idea of SDRs as a replacement for the $US:

The Special Drawing Right (SDR), a unit of account used by the International Monetary Fund, presents a viable alternative to the dollar as a global reserve currency, said Li Ruogu, chairman of the Export-Import Bank of China, a major state-run bank.

"It is a feasible plan to reform the present SDR and make it into a real settlement currency, a universally accepted 'currency basket' that would replace the dollar at the heart of the monetary system," Li was cited as saying in Financial News, a newspaper published by the central bank.

I have long argued that China is using the idea of an SDR reserve currency as a stalking horse. I positioning the SDR as the replacement for the $US, China can engage the support of other countries like Russia, India and Brazil, who might blanch at the prospect of the RMB as the reserve currency (e.g. see here for discussion of support for the SDR in relation to India and Russia).

The underlying reality behind the challenge for reserve supremacy is that China is increasingly the linchpin in the global financial system. Whatever China does with its massive reserves quite literally shapes the world financial system. China quite literally has the power to make or break any asset or any market, as can be seen in the attention paid to every utterance from China regarding the $US. When a country has such economic firepower, it is puzzling that anyone might suggest that it is not ready to take on the role of a reserve currency. I can only assume that many analysts are taking the SDR stalking horse seriously, and are not considering the vacuum that will be left when the $US finally collapses under the weight of quantitative easing and fiscal profligacy.

One argument I have read (sorry, I forget where) is that China would not want the RMB to become a reserve currency, as it would mean that the RMB would strengthen. There is some merit to this argument, as the fall of the $US against the RMB would make a serious dent in China's trade. However, the problem that underpins the current fragility is that China is currently subsidising US consumption at the expense of Chinese people.

At present, China is funding the US deficits and consumption in return for treasuries. Those treasuries are a promise of payment in $US, and yet the issuance of $US is massively expanding even as output is falling in the US. With each $US a representation of the output of the US economy, such issuance of $US currency and debt means that each currency unit is representing a smaller amount of output (I explain this in more detail here). As such, one way or another, China must eventually shift its reliance on a large US export market, and start to gain the full value of their economic output. They can not continue to literally give away a proportion of their output to the US, which is what the purchase of treasuries represents.

The only question marks that remains over the RMB as a reserve currency are largely to do with whether China can continue the present economic momentum, and the timing and nature of the collapse of the $US. When I first wrote about China for the blog in July 2008, I highlighted the risks for China, but concluded that on balance I favoured the view that China would emerge in the ascendant in the economic crisis. Whilst still issuing a note of caution, the developments since that time are even more favourable for China. With regards to the collapse of the $US, it is quite astounding that it has defied gravity this long.

As the current situation stands, the RMB is looking very much like the new reserve currency, and it is not going to become the reserve currency in ten or twenty years time, but in the near future. It may be that SDRs will be implemented as a reserve on a temporary basis during the transition, for long enough for China to satisfy the aspirations of the other supporters of the SDR. However, unless China's ascent is halted (e.g. through civil unrest), it is almost certainly going to succeed in the ambitions for the RMB.

Note 1: I have recently seen an article which agrees with my view that the SDR is a stalking horse, though he is using the expression 'smoke screen'.

Note 2: I have had some negative feedback on the new comments system. More feedback would be welcome, as I am starting to think that I need to revert to the old system (which might be a bit tricky to actually do, but I will work it out if necessary).

Central Banks and Their Role in the Crash

As many readers will be aware, central banks are playing a central role in the management of the current economic crisis. As such, I thought that it may be worth reviewing their role in the creation of the crisis itself. After all, if they contributed to the crisis, it might be reasonable to question what role they may be playing in the attempts to fix the crisis.

Before starting , I had better start with a brief description of the role of central banks, and exactly what they are (for conspiracy theorists see note 1). As an example, the Bank of England (BoE) gives its core purposes as financial and monetary stability and similar explanations for other central banks can be given. In order to allow them to achieve their purpose, they are normally given a monopoly on the issue of currency so that they are able to control the supply of money in the economy. To these, I would also add that they have a secondary and perhaps just as important purposes. This is to support government borrowing (not an overtly stated purpose), as well as being the banker's bank. I am simplifying here, but that is the basics.

For the purposes of this post I want to focus on central bank targeting of interest rates. If I have time I will post a couple of notes at the end to explain the process, but suffice to say that an underlying purpose of interest rates is controlling the amount of money in the economy, meaning that the central banks either 'create' money, or 'destroy' money'. One of the key measures that drives interest rate targeting is the rate of inflation - too high and they reduce the money supply. It is here that we come to the first problem.

We have all come to accept the official rate of inflation as being a relatively uncontroversial measure of the change in the cost of living, but this acceptance of the official rate is very questionable. An excellent explanation of why this is the case can be found in an article which details the many manipulations of the method of calculation of inflation. I strongly recommend reading the article in full, as it shows an excellent case study of how it is in the interest of governments to manipulate official rates of inflation.

One point of particular note in the calculation of inflation (e.g. in the UK) is what it does not measure, and that is property prices. This is a most curious omission, as a house is one of the largest items of expenditure for most individuals, whether renting or through buying a house. As we are all very aware, we went through a period of massive house price inflation, and the problem is that this did not show up in the statistics.

It should be recognised that arguments against including house prices might be put forward, such as the idea that the cost of owning a house is in part dependent on the interest rates charged on mortgages, and that is a valid measure. However, this becomes a circular argument as, if house prices are inflating and are not measured in inflation, interest rates will remain low despite the actual inflation, thereby keeping the cost of the mortgage repayments relatively low whilst the asset price inflates. However you look at it, having to borrow £200,000 this year to by a house, and having to borrow £300,000 next year is inflation. The day to day cost of servicing the loan may change, but the cost of the good has still inflated.

You will find the UK Office of National Statistics personal inflation calculator here. You will note that they do not calculate the rate of inflation by the interest rate paid on borrowing when buying, for example, household goods. They measure it against the price of the good itself. It seems that they have not noticed that a house is a 'good', or more likely they have decided that the inflation of house prices is something they would rather not measure.

In consideration of inflation, it is important to move away from the official figures, and actually understand what inflation really is. It is actually very simple. Inflation is a an increase in prices resultant from an increase in the amount of money chasing a particular good or service. The causes of inflation can come from an increase in the supply of money, changes in the demand for a good or service, a reduction in the supply of a good, or a combination of these.

In the case of house prices, one of the primary factors in the inflation was an increase in the supply of money, which can be seen in the mortgage markets with increased multiples of income being considered, 'ninja' mortgages, self-certification and many other means of softening lending criteria. In other words, there was a significant increase in the money supply creating inflation. This, even by the self-defined purpose of central banks, should have been a matter which would be of concern to them. Instead, they merely looked at the official inflation and ignored the reality of real inflation 'on the ground'.

To this problem of the measurement of inflation, I should also add another problem with one of the measures used by central bankers which is GDP. However I will not discuss this again, as I have done so in some depth in other posts (e.g. here).

As such we have a situation in which, for example, central banks in the UK and US showed negligence. However, it is not just these central banks that are to blame, and I will give the rather curious example of the influence of the Japanese central bank in the housing bubbles of the UK and US. Japan's central bank is just one central bank that played a role, but it is a very interesting example.

As many readers may be aware, Japan had its own property crash in 1990 as a result of its own bubble. The result of this crash was to see a period of economic contraction in Japan, with the Japanese central bank eventually responding with a long period in which interest rates were virtually zero, and also with the Japanese central bank following a policy of quantitative easing, or printing money.

As regular readers know, I warn of the danger of hyper-inflation when central banks print money. Printing money has two impacts; on the one hand it transfers the value of the existing money supply onto the new money, such that the value of each unit of money is reduced (inflation), which has the effect of more money chasing the same goods (inflation). So why did Japan not have a bout of hyper-inflation?

The answer is rather odd. As fast as the Japanese central bank pumped out newly printed money, Japanese banks also pumped money out of Japan into Western banks. Having reduced inflation to virtually zero, any holdings of the currency were moved into countries with higher interest rates in what was known as 'the carry trade'. In other words, the lack of the ability to earn interest in Japan drove Japan into diverting lending outside of Japan.

In this trade, what was happening was that you could borrow at no cost in Japan, drop the money into a Western economy, and be paid interest on money that you borrowed for nothing. In doing so, even though the money was being devalued by the government printing more money, you could offset the devaluation by the interest you gained through investing it in Western countries. The following is a (grossly) simplified explanation:

If you are printing money such that the base money supply increases by 5% per year, and interest rates are zero, you can borrow that money, invest in a country offering 7% interest, and actually make a currency whose value should be falling, increase in value. In investing the money overseas, you are actually creating an improvement to your current account that offsets the impact of the increase in units of your currency. You are creating greater foreign reserves as a result of the return on that overseas lending, such that you are accumulating ever more foreign reserves, thereby strengthening your currency. If you look at a chart for the value of the JPY against the $US, you will see that the rate fluctuated but has only recently fallen significantly.

The story is not as simple as I paint it here, as Japan also has a large trade surplus and considerable savings, other countries were inflating their money supply and so forth.... The reason for pointing this out is that we have in principle is a system in which it is possible for a central bank to print money, flood that currency into another market, and still retain the relative value of the currency. It is quite an extraordinary notion and I therefore find it hard to believe myself and, as such, comments on this are welcome.

As an aside, the only problem in such a scheme is currency risk, where you expose the lending to fluctuations between your home currency and that of the destination currency. i.e. if the destination currency falls in value, then you risk your money.

What we then have is a situation where there are several results. The first is that, as fast as the money is printed, it is pumped out such that the money supply in the economy never expands, and the country remains in a situation of deflation or very low inflation. By keeping the interest rate so low in Japan, the central bank defeated its own purpose. The second result is that an ever larger 'wall' of money leaves Japan for the Western economies in the carry trade.

A good example of the results of the carry trade in the destination economy is provided by New Zealand, whose size makes the effects more apparent. The curious thing about New Zealand is that, unlike the US or UK, New Zealand kept interest rates relatively high and still created a house price bubble. When we think about the carry trade, it is apparent why this would be the case. In particular, the New Zealand central bank was between a rock and a hard place....

If the central bank increased interest rates, it would encourage the carry trade, and the carry trade means an injection of more money into the economy. However, if the bank reduced interest rates, thereby discouraging the carry trade, then you have a situation in which the central bank is itself increasing the supply of money into the economy. In other words, whichever way the central bank jumped, it would not reduce the money supply. It is almost enough to make you feel sorry for the central bankers (almost).

What I am trying to paint here is a picture in which central bankers are pulling their various levers to control the economy, but the measures that they use to guide their lever pulling are actually faulty. Furthermore, the problem that arises is that, even as they are pulling their own levers, other central banks might be pulling levers that will confound their own actions. In essence, you have a situation in which there is an illusion of control, but a reality of very little control.

At the heart of the problems is that the central banks have control over the monetary supply, and that money supply is therefore subject to their manipulations. In particular, the problem is that they are able to create money, and in creation of money they create ripples of distortion both in their local economy and in the wider world economy. It is perhaps for this reason that the central bankers are calling for ever more co-ordination between the central banks.

However, co-ordination between the central banks creates even greater risks than the current system. If we remember that the central bankers have made basic mistakes in the management of their local economies, and that these have contributed to the current crisis, it is more than likely that co-ordination will make the mistakes systemic, and create even greater distortions in the world economy. A good example of international co-ordination creating systemic risk can be seen in the Basel banking regulation frameworks, which have played a major part in the development of the current crisis (see posts here and here for how).

The only real solution to the endless and distorting tinkering of these central banks is to actually remove from them their facility to create money from nothing. In practical terms, that means to go back to a commodity based standard - whether gold, platinum or silver really does not matter. I have explained the benefits of such a system, and why it is better than a fiat currency in another post.

As it is, we can see that these tinkerers are not really to be trusted, and that their current tinkering in each individual economy can only set up new ripples and distortions in the world economy, whilst all the while the ripples and distortions of the activities of other central banks will only serve to confound their own plans.

Note 1:

First of all, despite what conspiracy theorists suggest, they are not institutions that are in the hands of a few wicked and clever individuals with huge power to shape the world. Instead, they are rather mundane institutions that have an illusion of power...

I watched one of the conspiracy theorist videos listed in Google, and they presented a picture in which the federal reserve was run and owned by a group of shadowy international bankers. However, I noted that they never actually revealed who the shadowy owners actually are, or that many central banks have been nationalised. If you have any doubts, take a look at this site, which details the ownership of the federal reserve......and how much money goes to the shareholders, and how much to the government. They are not part of an international secretive bankers conspiracy. A two minute search on Google found a paper that revealed the structure and ownership of the federal reserve, and it seems funny that this was excluded from the three and a half hour video....

Note 2:

For those who wonder how a central bank creates money, the process is shockingly simple. If they decide they want to increase the money supply they simply buy something (normally some kind of government securities), and do this by simply doing the equivalent of writing a cheque for it. This means that a credit appears in an account of whoever accepted the cheque and money has appeared. The trouble is that central bank has not actually used anything to pay for the securities - it just creates the credit, and the money supply has increased by the amount of that credit. Money from thin air....if a central bank wants to decrease the money supply, it simply sells the asset, and the money simply disappears...

I was tempted to go into a more comprehensive explanation, but hope this serves the purpose for this post.

Note 3:

It occurred to me that, with the explanation of the Japanese money printing, some might think this offers a justification for printing money. It should be noted that this system only worked due to the differential available in the interest rates, and the ability for Western countries to soak up the money in their asset bubbles. In the current climate, the only place for money to go is into lending to governments. Lo and behold, governments throughout the OECD are on a borrowing binge of epic proportions. Not only that, but every country central bank in the OECD is targeting low interest rates, the US is printing money, the UK is printing money....In other words, around the world there is a massive inflation in the money supply.

The problem here is that, unlike the past, there are no assets that are going to soak up the excess of money. Although the house price bubble represented real inflation, it did not 'feel' like inflation because people believed that they held an asset that offset the inflation. I am misusing the term, but the housing bubble partially sterilised the money that was entering the economy. However, as the governments start to absorb and utilise the massive increases in the monetary base, this money will start flooding into activity in the economy that is measured by official inflation, and that is when hyper-inflation kicks in. The increase in the money supply has nowhere to go but into the purchase of goods and services.

Note 4:

I must be a little careful about the use of the word inflation in general. The problem is that there is a situation of real inflation, and official inflation. For example, right now, there is real deflation if house prices are included, as the cost of this good is dropping very rapidly. I will try to ensure I make a distinction in future posts, but it is easy to use the word without thinking whilst meaning 'official' inflation.

Note 5:

With regards to using measures like inflation and GDP I should add that any such measures are of themselves subject to problems, regardless of whether they are correctly applied/understood. A couple of years ago, I read a very good illustration of this (I think the author's name was Neeley), in which a visitor to an airport saw a very strange sight. A plane came to a halt, the baggage handlers opened the hold and one of the baggage handlers then grabbed a bag, ran across the runway at breakneck speed, before depositing the bag on a carousel, and then starting the carousel. It turned out the performance measure for baggage was a measurement of the time that it took from the plane coming to a halt, to the first bag arriving at the carousel, and the carousel starting....the figures looked good, but the underlying real performance remained very poor.

The point here is that if you focus on a particular measure, you will end up distorting behaviour to meet the outcome of what is being measured. As such, in the case of GDP, the focus of so much attention, nobody stopped to think about the underlying meaning of the measure, such that debt driven activity was encouraged - after all, such activity increased GDP.... in other words, the way the measure was used was no different from the principle of the baggage handlers...

Note 6:

I have hesitated to hit the publish button on this post, whilst I have tried to think through the issue of the Japanese money printing.

However I look at it, it appears that it really is possible for a central bank to print more money and see the value of the currency increase (even if only in the short term). Eventually such a system is unsustainable, as it must lead to some kind of inflation, even if it is not in the domestic market. In this case, in the end the lenders lose, as they have accepted IOUs in return for their money which are actually of equally dubious value as the money that was lent, and this is due to the inflation created in the source of the IOUs. In other words, they exchanged debased currency for debased IOUs. I hope this makes sense and, as I have mentioned before, comments are welcome, in particular any challenges to the idea that I have put forward.

Note 7:

I am re-reading The Wealth of Nations again, and for those of you who find economics a puzzle, I can not recommend this book enough. It is clearly written, free of jargon, and just makes excellent sense. The language is a little archaic in places but, as you read it, you find that you stop noticing as you are so absorbed by what he is saying. It really is an outstanding book. Perhaps a copy posted to all of the OECD leaders might help?

Economic Crisis - The Elements of Collapse are all in Place

Note Added Later: For US readers, there is a (slightly) more in depth discussion of the US bank nationalisations at the end. However, many of the points are the same as in my previous post on the UK...similar solutions, similar problems.

It seems that the US government is indeed going to follow the lead of the UK on bank nationalisation. In more news The Telegraph reports that the total (so far) committed to the bailout is in excess of £2 trillion (note for US readers, that is £GB!) if EU countries, the US and UK are added together. This is just the headline figure, and does not include all of the other measures that have been taken to increase liquidity. Meanwhile the UK stock market commenced a rally, only for the US stock market to pull the rally back down to earth. As I mentioned in my last (or a recent) post economic reality would bite into the false optimism. The Telegraph gives the reason for the fall as a slew of bad news from various companies, indicating that reality is just not playing to the script that governments would like:

US investors ignored comments from Mr Bush that the equity purchases were an “essential, short-term” measure and exhortations from Mr Paulson urging the banks receiving capital injections to use the funds to spur economic growth. Instead they focused on gloomy corporate news from soft drink group Pepico and software company Microsoft.

The reality is that economies are contracting, and no government action is able to stop the process. This from the Telegraph:

'World trade has already stalled. The Baltic Dry Index measuring freight rates for shipping has crashed by 82pc since May, touching a five-year low yesterday. Container vessels are leaving Asian ports with 20pc spare capacity. "We're heading into a global recession," said Simon Johnson, the IMF's former chief economist.'

No doubt, the tiny fall in the Libor (London Interbank Offered Rate - the interest rate at which banks lend to each other) will be taken as a positive sign, and will be hailed as evidence that the bank nationalisation is working. It is early days yet, but the tiny fall is a very poor result considering the dramatic action of nationalising major banks, and the cost of the bailout. Furthermore, even if the banks do start lending to one another, it will not stop the ongoing financial problems of the banks, which will see considerable worsening of their situation in the coming months (see previous posts). Once again, any growth in optimism will be short lived. I have said this many times, and it seems that others are nervous of the state of the banks, even after the bailout. For example the UK Treasury Select Committee Chairman:

'John McFall called on the rescued banks to provide much more detail of their exposure to derivatives and other complex assets, many of which have been plunging in value. He said: “It's a minefield we are tiptoeing through. That £37billion might not be enough.” '

However, there are those that think the financial crisis has come to an end:

If the history of financial crises is any guide, the violent credit shock of 2007-2008 has largely run its course. The sovereign states of the US, Britain, France, Germany, Italy, Spain, and Holland have broad enough shoulders to carry their load of fresh liabilities – even if Iceland does not.

This is a fascinating point of view, because the article goes on to say that phase 2 will see the damage to the rest of the economy. The delusion in such a view, I hope, is obvious. As the consumers default on personal credit, mortgages, and commercial borrowers go bankrupt, are the banks somehow going to be insulated? They have massive exposure to the state of the real economy (what else is there?) and, in many cases, have security in assets whose value is falling. The state of finance is linked to the rest of the economy and is not some island of activity. An end to the financial crisis? I think not - at best, a pause.

Meanwhile, the UK government finances are looking ever more threadbare, and the spending deluge into the public sector is being called to a halt. There are already discussions in government of lack of money being unavailable to follow through initiatives, as is detailed in the Times.

'A confidential presentation made to officials by Suma Chakrabarti, Permanent Secretary at the Ministry of Justice, detailed the savings required from the department 18 months after it was set up. They include the loss of 9,891 jobs in the prison, probation and court services – more than a tenth of the workforce – with one in three coming through redundancies. These cuts, along with a freeze on new recruits or the use of agency staff, could lead to the closure of up to 100 courts.'

No doubt, these kind of discussions are taking place within the US government as tax receipts fall, and costs rise. As I originally predicted in 'A Funny View of Wealth', as the government finances decline, there will be tough choices, and the shrinking back of the state sector will further ratchet down an already shrinking economy. The continued bailout of the financial system is likely to make borrowing for the government ever more difficult, and the crisis in government finances is just months away (I believe in three months time).

My guess is that, in the next couple of weeks, there will be a roller coaster ride of optimism, followed by pessimism, with stock markets continuing to swing in different directions according to changes in sentiment. As such, I do not think that too much attention should be paid to each swing, as it is not a reflection of any underlying economic reality, but dictated by emotional reactions to the situation.

Meanwhile, in the UK, an economist had this to say about the UK house market:

'David Miles, Visiting Professor of Finance at Imperial College Business School in London, said that the property market should stabilise once house prices lost 20 per cent of their value from the peak of the market last summer, which would translate as a further decline between 5-10 per cent.'

One wonders on what basis he has made such a calculation. Exactly what factors are going to halt the slide? Perhaps he knows some positive news that everyone else does not know about. I read another similar prediction from one of the banks, but have not been able to find the article. I have to ask, why are these people still taken seriously? I have even found an article that is suggesting that stocks are cheap at the moment, such that they are currently a good buy.

So now to pull all of these stories together. The first point to make is that, as I previously suggested, the first nationalisation is almost certainly just the start of the drain on government finances. The governments in the UK and US, as well as the rest of Europe, will need to be digging into their pockets on an ongoing basis in the coming months, including providing ever more money to support the nationalised banks. The cost of these bailouts is already simply astounding, and yet they so far have done very little to improve the situation, again exactly in line with what I predicted. Also, as expected, the governments are now starting to cut back, and the final downward levers in the economy are starting to come into play. In short, all of the elements of economic disaster that I predicted in a 'Funny View of Wealth' are now finally enacted. What I did not (and could not) predict were the actions of governments when the crisis finally came. Regular readers will be aware of my very negative views to all that has been done so far.

Now, at this early stage, in particular with the actuality of the bank bailout in the US mired in ineptitude and confusion, the full results of the bailout are not apparent. No doubt, when the US bailout eventually fails, it will be suggested that the problem was 'implementation' rather than the reality that it was never going to work. However, the effects of the bailout can be predicted in one respect, even at this early and confused stage. They will not work.

The real question is how long governments will continue to pour money into the financial system before the reality of failure sinks in? Or perhaps, it will be the creditors to the West who will call a halt by freezing lending? I am not sure which will come first, abandoning the effort or a forced halt. If I were a betting man, I would put my money on the latter.

I will continue to watch the unfolding of events, but may not post as often. As I have mentioned there may be swings of sentiment, and these are not going to be linked to underlying causation or changes in the situation. If I see something that does reveal something new, or anything which profoundly impacts on the situation, I will of course return to my keyboard. In addition, I have had some questions, and would like to answer these, if possible and time allows (apologies in advance if I can not manage this). For new visitors, I suggest a look at the links at the top left of the blog, which I hope will be more informative than just following a series of events. They will (I hope) give context and understanding of what is happening.

Note:

I have just been taking a look at the New York Times, which I do fairly regularly to get fresh perspectives from US (though it is on my secondary reading list). What I always seem to find is that the UK and US are running down parallel tracks, give or take some finer details, and small matters of timing. For example, today there is an article on the US bailout (no surprise there), an article on falling consumer spending, and even an article on a non-profit hospital unable to borrow (not quite public sector but....), and so forth.

As for the bailout, the major news, the NYT reports the potential cost of the bailout is put in stark terms as follows:

'All told, the potential cost to the government of the latest bailout package comes to $2.25 trillion, triple the size of the original $700 billion rescue package, which centered on buying distressed assets from banks. The latest show of government firepower is an abrupt about-face for Mr. Paulson, who just days earlier was discouraging the idea of capital injections for banks.'

The real costs will only become apparent in the next few months, as if these numbers are not enough cause for concern. Existing debt will likely prove far more toxic than imagined. The additional liabilities over the $700 bn spend are for guarantees for new debt. I have already detailed how any encouragement to lend from government is dangerous in a previous post, so the devil will be in the detail here, and that initial detail looks alarming:

'How would the government’s stake affect other preferred shareholders? Would the Treasury Department demand some control over management in return for the capital? How would the warrants work? [...] He [Bernanke] told the bankers that the session need not be combative, since both the banks and the broader economy stood to benefit from the program. Without such measures, he added, the situation of even healthy banks could deteriorate.'

In other words, it appears that the idea is that the banks must lend in the interests of the wider economy or 'wider good' (see my previous post for a discussion of why this is wrong headed). Once again, the parallel with the UK is clear.

An interesting point of difference between the UK and US appears to be that there is a more negative sentiment overall about the nationalisation of the banks, with even Paulson appearing to be (possibly disingenuously) apologetic. By contrast, in the UK, there seems to be more bovine acceptance of the situation, and the politicians pushing through the bailout appear to be enjoying their own sense of importance.

I will step out of more solid economics and speculate a moment. In this contrasting perspective, it is possible to discern an additional reason why the US might come out of this faster than the UK - a difference in outlook. In the UK there is a more firm belief that the government can 'fix' the problems, and that solution lies in the hands of government. In the US, there is more cynicism about the role of government and this is seen in the strong sense of unease about the bailouts. It may be that the US will turn away from magic wand solutions far faster than the UK. However, this is determined in the end by fickly politicians and public mood, as much as by circumstance.

On that note I will leave the post, and hope that the US readers will have some food for thought to the use of their tax dollars - bailing out banks and to be put to use in lending in the 'wider interest' of the economy. Can you imagine a more sure fire way to see money poorly invested?