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.

Oil Prices and Retail Consumption

There has been some interesting news published, which seems to further reinforce my predictions for the future of the state of the UK economy. A while back, there were some positive figures for retail sales and these were questioned by myself (and others) as to their accuracy. On the one hand all of the reports from retailers were negative, but government statistics showed growth. My response was that this was likely to be a statistical error, and my suggestion was to 'wait and see'. Whilst conceding that there was a possibility that the government figures might be right, they simply did not make sense.

The Times has just published an article in which the government figures show the most dramatic decline in retail sales in 20 years, with a 3.9% decline. The article deals with the disputed May figures, but in a fairly inconclusive way. As such, it is still not clear whether May was a statistical anomaly or a last 'huzzah' of consumers. My view remains that is was the former.

I also recently predicted that oil prices would fall in an article written at the start of July:

'Having said that demand for commodities will fall, as the world economy slows, a counter-effect will be the ongoing readjustment of the U.S, economy, with continued pressure on the dollar for some time. Whether the increase in supply will outstrip any further weakening of the dollar becomes the question. My own view is that the increase in supply will see oil falling back in price in about six month’s time. My best guess, and it is no more than that, is that in two year’s time, oil will be back to about $US60-70 a barrel. This is based upon the provision of a small increase in capacity, a drop in demand, set against a further weakening of the dollar. Lots of ‘ifs’ - which is why it is a best guess.'

At the time that I wrote this, there were widespread predictions of ongoing rises, including talk of $200 per barrel. Such increases just did not make any sense, and I was very puzzled at the time that 'experts' could have believed this.

My only surprise is the speed with which oil prices have started to fall. I thought it would take a while for the level of demand to fall back enough to pull prices down. The speed of the fall suggests that the contraction in the world economy is far more dramatic than I had considered to be likely.

So what will the effects of a declining oil price be? There is no denying that it is a positive factor, as it will eventually feed through to consumers. In broader terms, will it effect the slide of the UK economy into depression? The simple answer is 'no', as oil prices were never a major factor in the slide in the UK economy. It was just an additional factor that pushed the slide downwards faster. On a more positive side, it may finally hasten the Bank of England to lower interest rates, which is desperately needed in a period of economic contraction. We can just hope that the bank responds sooner rather than later.

Government Borrowing and Interest Rates

I have posted a comment/question from a reader called 'Lemming' below, who is clearly not an ignoramus (as the poster said of him/herself - I suspect Lemming may be an economist feigning lack of knowledge):

'I know it wasn't your intention to write an Elementary Economics course but, for ignoramuses like me, could you quickly explain how a central bank's interest rates are related to government borrowing?

I had assumed that the central bank set domestic interest rates to create a feedback loop to keep the amount of money in its own economy at the 'correct' level i.e. to regulate inflation. I didn't think the rest of the world cared, as whatever happened, the exchange rate for the currency would reflect its true value.

I am a bit hazy on government borrowing. I assumed that a government could borrow 'money' on the financial markets at the cost of paying it back with interest (at a rate set by... some international committee or other) - like a business borrowing money within a country's economy. I have no idea in what currency this loan would be made (as I say I am very ignorant!)

The borrowed money would be used to boost short term cashflow, with the assumption being that it could be repaid in future due to improved economic circumstances, or when 'investments' reduced costs in the future. (And as a bribe to the electorate, no doubt.)'

Sadly, there is no quick answer to this question, but I will do my best in the short time I have for this post. It really requires a long answer, so I hope I will not confuse issues in a quick review.

Lemming is quite right that interest rates are set (as a target) to govern the money supply in the economy (through open market operations in the UK primarily through the London Interbank Offered Rate). The control of the money supply is managed by either buying or selling securities such as second hand government debt (e.g. bonds), or by lending to or borrowing money from banks.

However, I think Lemming is wrong to say that the 'world' doesn't care about the interest rates, as has been illustrated by the example of the 'Carry Trade' and New Zealand (see here for an academic paper which gives a useful introduction). In this case money was being borrowed in low interest countries such as Japan and being utilised in high interest New Zealand. In doing so money was flooding into New Zealand, resulting in even higher interest rates, and creating demand for the New Zealand currency, and thereby pushing up the value of the New Zealand dollar. An extreme example, but you should be aware that the UK has also been a destination for the carry trade.

Onto government borrowing....

Government borrowing results in increasing the money supply in an economy. As such, in targeting interest rates, a central bank needs to include consideration of the amount of money that a government is pumping into the economy through borrowing. The more the government borrows, the more the money supply in an economy expands. On the other hand, if a government spends revenue, the effect on the money supply is largely neutral. Instead of individuals spending the money, the government takes it from them and spends it.

If a government borrows money, it also needs to offer a yield that will exceed (expected) inflation and also be attractive against risk in changes in the value of the currency. However, as a government borrows, it will expand the money supply, raise inflation, and thereby will need to offer higher returns to compensate investors. To add to this, if there is high inflation, then a currency will devalue, further raising inflation, and creating further requirements for higher yields on government investments. The level of the impact of government borrowing will depend on how close the economy is to capacity - the closer to capacity, the greater the impact upon inflation and therefore the greater the impact on interest rates. In addition, if the government is borrowing and thereby indirectly raising interest rates, the central bank will raise interest rates restricting the money supply to business......which I will discuss for a moment..

Another reason why government borrowing is influential is best illustrated by a simplification. I am an individual investor and wish (for whatever reason) to make an investment in £GB. I will be faced with a range of choices for where I might to wish to put my money. For example, I may wish to lend into the consumer markets (e.g. putting my money into a building society account where it will be used to provide mortgages), or invest in companies (e.g. stock market), or I can lend to the government (e.g. bonds) and so forth. In each case I must make an assessment of risk and reward. If we take the example of lending of money to the government through the purchase of bonds, these kinds of bonds are considered to be 'no-risk' (a misnomer - as they do have risk) and therefore are highly competitive in the respect that they are relatively very safe investments (in some cases they even allow for inflation). By comparison non-government lending looks pretty risky.

In this situation, my investment decision would, if all investments were offering the same yield, be to go for the government bonds. Why take a risk on putting my money into unsafe instruments such as consumer lending. As such, non-government competitors must offer me a premium over lending to the government in order to give me an incentive to invest my money in their asset. As such the government becomes a formidable competitor in the market for where I invest my money, and set a benchmark on the minimum yield I will accept. In doing so, they are distorting the markets, and setting an effective minimum interest rate in the market.

So far so simple. However, life is never simple.

For example, Lemming mentions that the government wants to control inflation with interest rates. As the example of New Zealand shows , no country is a financial island, and the problems of New Zealand illustrate the problems of central banks very clearly (it is a good example because it is a small economy, and the effects can be seen more vividly as a result). On the one hand you have high interest rates to try to damp down inflation (in particular house inflation - though this is no longer an issue), but on the other hand such high interest rates are attracting the carry trade. Furthermore the carry trade is leading to the appreciation of the $NZ as there is high demand for the currency, and this means that imports are cheaper, pulling down inflation, but at the same time making New Zealand goods and services relatively expensive to imports. How can interest rates be set to manage such a situation? The answer is that it is a choice between a rock and a hard place.

Going back to government borrowing setting the minimum yield on investments. This situation means that all investments are measured relative to a baseline of lending to the government. The question to then ask is what would happen to investment decisions without such a base to measure them against. In this case each individual investment could only be measured on its merits compared with other investments.

At this point it should be noted that when lending to the government, this lending goes towards government spending. I have discussed elsewhere that we can not reasonably say that a government invests money, as there is no way of measuring the return on the investment, and no way to separate spending from investment. However, if we lend to the government, we are individually making an investment as the government provides us (as individuals) a measurable return.

As has been mentioned, an investment in the government is actually in competition for other investments. Some of these other investments might be invested into productive activities, such as company expansion and so forth. More than this, the higher the government yield offered to investors, the higher the yield needed to offer a competitive return for other investments. As such higher government yields impact across the economy. As such, if you are a company raising money, then you will need to offer a greater return than would be the case if your company were not in competition with the government. In doing so the government is indirectly raising the cost of doing business, and is also taking away sources of investment from business. With less investment finance available, this will also have the effect of raising the cost of borrowing for business, as there will be less supply of finance.

If we actually think about government borrowing, it really does not make sense. In reality there is no real justification for it, excepting in the case of national emergency (e.g. war). As soon as a government borrows, it pushes up the cost of borrowing for potentially productive uses, as well as having a whole series of effects that are indirect. As such, even in a downturn, a government borrowing will have a negative impact, as it will redirect resources away from potentially productive investments, or raise the cost of borrowing limiting the 'bang per buck' of the money borrowed (as the cost of the money will be greater).

In short, government borrowing is just a hiding place for sloppy management of the resources available to government, and represents general sloppy management of a country. It allows for government to act irresponsibly at the cost of the economy as a whole. As such, yes it is a bribe for the voters.

Note: I hope that I have not made too much of a hash of this explanation, and that it starts to illustrate the point. I have only covered some of the elements that are necessary for a full discussion, as there are so many complex interdependencies and positive and negative feedbacks in economic systems, and it is almost impossible to strip out a few isolated effects. I will welcome feedback from Lemming in particular, as I suspect that he/she may be an economist.

The Bank of England & Interest Rates

I just thought that I should make a quick post regarding interest rates. Has the Bank of England taken the right action over interest rates? Many of the points here also apply to the US economy in principle, though the fed approach appears to be more realistic.

The short answer is 'no'.

Why on earth is the BoE worried about inflation? The reason for worry over inflation should be a concern as to whether the economy is reaching or exceeding capacity, or if the money supply expands too quickly. The really tragic part is that, had the BoE joined the real world some time ago, they would have noted that real inflation had been sky-rocketing for many years. For reasons which will always baffle me, the largest part of the expenditure of most individuals is excluded - housing costs. Furthermore, the bank failed to note the massive expansion in the money supply in the UK economy and carried on as if nothing was happening.

Why was previously inflation (apparently) so low? About three years ago, in an economics lecture, I was pointing out that the entry of the BRIC countries into the world economy was the only reason for inflation being held down. It was nothing to do with the BoE or any clever management of the economy. In such benign conditions - of course the price of consumer goods was held down! That did not mean that the underlying economy was not massively overheating.

Furthermore, the entry of the BRIC countries into world trade not only pulled down the price of products, but had also placed a lid on wage increases due to the competitive threat that they presented (as well as the low inflation they created). I have noted that, in the last year, the economists have finally grasped this. However, what they have not grasped is that inflation has long been out of control in the UK - it just didn't look that way because they were looking in the wrong places.

We now have a situation where the UK economy is about to massively deflate. If we consider house prices, then deflation is already raging. As the economy sinks into depression, spare capacity will inevitably appear in the economy. It is exactly at this time that the BoE should actually be starting to relax interest rates. Whilst oil prices are feeding through into current inflation measures, the BoE needs to recognise that, as the world also goes into recession, oil prices will fall back as world growth goes into reverse. Also, the oil price is an external factor that is not a capacity bottleneck in the UK economy, but an external inflationary shock that is outside of the control of UK interest rates.

Another area for concern is food prices, and they will remain a problem. The lunacy of biofuel production is one of the root causes of this problem, but also demand has increased with the growing wealth of the BRIC countries. As such, there will likely be a time lag before food prices stabilise, partly as a result of the time it takes to expand capacity, and in part dependent on how long the silliness of Biofuels will continue. However, in the overall picture of deflation, food price inflation is a fairly minor matter in comparison with housing, oil, and the downward wage pressure that will come with recession.

Whilst everyone is focusing on oil and food, we need to consider another factor in inflation, and that is the value of the £GB (and the same goes for the $US for the US). It is inevitable that these currencies are going to continue to be weak, probably with further declines, which will make imports more expensive. This kind of inflation is actually a good thing, as the fall in the currency is part of the process of rebalancing in the world economy. The simple truth is that the Western economies are simply not as wealthy as they believed, and therefore the currency declines are just an expression of that reality. Whilst this will feed through into price inflation for some goods, I do not believe that it will have the impact that it might have had previously, as the retail sector is going to have a sharp decline/crash, making discounting ever more necessary to gain customers. Whilst such harsh conditions will not remove the effects of a weak currency, they will ameliorate them.

Furthermore, with unemployment rising, this inflation in the price of imported goods will not feed through to wages. When people fear for their jobs, wages will not rise (although there may be a slight blip up in the coming 3-4 months whilst everyone adjusts to the reality of the situation). The one potential area for wage inflation is the state sector. However, with recession/depression lowering tax revenues for the government and expenditure on unemployment rapidly rising, where will the government get the finance to pay for higher wages? The government will have enough trouble paying for the wages as they stand and will almost certainly need to implement cuts in state sector employment.

In summary the BoE is making yet another error. The fight against inflation under the current circumstances is, quite simply bizarre - but then again the economic policy of the last ten years has been equally bizarre. Despite this, I still find it astounding that the BoE treat the current circumstances as anything but a spur to lower interest rates. Underlying this BoE stance appears to be macho posturing, a response to metaphors about 'fighting inflation' or 'containing inflation'. It seems that everyone has forgotten what interest rates are used for in the context of inflation. Interest rates are used to rein back capacity and money supply in the economy when it is overheating.

The economy is collapsing, not overheating. The money supply is going through what may be unprecedented contraction. As I have said - an astounding decision!

Note: Another point I can not help making (even if a little off the topic) is to ask; why have government borrowing in the first place? There really is no excuse for it, except in national emergency. Government borrowing is at the root of the whole idea of central banks, or government, setting interest rates. In a rational world, they would have no part in the system of how interest is calculated.

So, why do governments borrow?

I will leave this point here, but hope that you will contemplate this question for yourself at your leisure.