US and UK Goverments Guarantee Consumer Debt

The headline for this post is deliberately shocking, and might appear somewhat absurd. However, as I will explain that is what the governments are actually doing.

Even the most myopic economists, politicians and commentators now seem to accept that we have witnessed a debt bubble, and that the bubble is going through the process of bursting. More problematic is the explanation of what the banking bailout has been about. There has been considerable talk of the financial instruments that have been used to slice and dice debt, talk of sub-prime mortgages, toxic debt and so forth. This is then used to set the context of the debate, and the idea is that the fact that these problems are spread throughout the system has led to a loss of confidence in the banking system. The idea then is that, if the governments can just put fresh capital into the banks, then they will start lending to each other and the financial system will be fixed.

It all looks very plausible and very simple, and in some ways what I will discuss is not new. However, I thought that it is worth clarifying what exactly has happened.

The crisis has never just been about the irresponsible lending into sub-prime, but rather is about the wider lending practices of the banks, and also about the house price bubble. The banks have been lending heavily to consumers based upon the belief that house prices were a one way upwards bet, and this has driven the US and UK economies into overdrive, and has been responsible for most, if not all GDP growth in the last ten or so years. It is the foundation of the 'service economy'. The service economy is a debt based economy, and this has been reliant on banks lending heavily to consumers.

So what exactly is the banking bailout about? It is actually addressing the problem of what happens when the housing bubble bursts and the economy contracts, such that consumers stop spending borrowed money, and the economy contracts, causing higher unemployment, causing less spending by consumers and so forth into a downward spiral. Essentially, the trouble with the banks was that they were overexposed to consumer debt. The banking crisis was never about exposure to sub-prime debt, or problems that were inherently caused by CDOs and other financial instruments. The real root of the problem lay with souring consumer debt, and that souring extended beyond sub-prime and into wider lending. The banks would certainly have been aware that, with house prices falling, large portions of their debt would be progressively becoming ever more high risk debt. Equally, they would have seen the figures for rising defaults, rising insolvencies, and concluded that a storm was coming.

Sub-prime was just the trigger for a larger reassesment of risk. The reason why the banks stopped lending to one another was not due to sub-prime alone, but also due to the wider problem of poor lending.

When the situation is clarified, the bailout ceases to be about 'confidence', or getting banks to lend to one another again, but is actually about offering a guarantee against consumer default. If we actually think about, for example, the guarantees offered for bank deposits, they are being offered because of the fact that souring consumer debt is leading banks to insolvency. Therefore, what the government guarantee provides is a guarantee that, whatever happens to consumer debt, the government is acting as a guarantor for payment of that debt. In other words, huge tranches of consumer debt are being guaranteed by governments. Furthermore, by taking stakes in key financial institutions and encouraging those institutions to start lending again, they are providing financing and an implicit guarantee on new consumer debt.

It is a shocking idea, but when a person now enters a car showroom to purchase a car using borrowing, the government is acting as a guarantor for the repayment of the debt, and is also financing some of that lending, if not all of it. The guarantee has, to some extent, always been the case due to the presence of deposit guarantees, but the situation is now one in which this guarantee has been massively extended. By raising the amount guaranteed on deposits, and by showing that they will save banks at any cost, governments are effectively guaranteeing every single loan that is made. It is, of course, not just consumer borrowing that they are guaranteeing, but also all commercial debt.

So the situation that now pertains is one in which economies are falling off a cliff, with ever more debt, both commercial and consumer, turning sour, and governments have effectively stepped in as a guarantor for all lending throughout the economy.

As I said at the start, there is nothing new here, but rather a clarification of what has actually been done. I use the example of the person walking into a car showroom to highlight the reality of governments are actually doing. All of the talk about the bailouts is dressed up in complexity, and evasive language, but the simple reality is that governments are now guaranteeing every loan that is being made throughout their economies. When it is put in such black and white terms, it becomes somewhat disturbing. Not only is the government in the business of lending money for a consumer to buy a car, but they are lending on the basis that if the person subsequently defaults on the payment, they will take the losses as well.

The question I would ask at this stage, is to ask how many people would be happy with this situation when it is actually reduced to the underlying reality. Is it an acceptabel role for government?

Note 1: I have had a link from 'Death to Bubble Addicts' which may be of interest to those who have a poor view of Gordon Brown's role in the current crisis. The link is as follows:

http://uk.youtube.com/watch?v=qHqrBb-nRbs

It is a scathing attack on Gordon Brown, in which the problems that have arisen were predicted, and communicated to Gordon Brown ten years ago.

Note 2: Acrobat_747 has commented as follows:

The very suggestion that the UK could default on debt repayment before Christmas does not make sense. The UK is not even that much in debt relative to other counteries. The debt repayments should be relatively low compared with total government expenditure.

Debt is overhyped, and other nations will help if debt does become an issue. Wealth is relative, and so is debt. As all developed western countries are in debt it is not a handicap. In fact, avoiding debt may be fatal and perhaps the UK should be borrowing much much more.

This is a response to my suggestion that the UK government is heading for a default on borrowing. This is correct in one sense. Debt and wealth are relative, but the problem here is that debt needs to measured against ability to pay. The UK economy is shrinking and the GDP of the UK over the last 10 years is an illusion. As such, the size of the UK economy in relation to the actual debt levels is illusory. Why all developed economies are in debt is explained here and the post will offer no comfort. Just because your neighbour is in financial trouble does not mean that you are not in financial trouble. As I have mentioned in previous posts, continued borrowing is dependent upon confidence in the ability to repay. The storm that is engulfing the UK economy will destroy that confidence, as UK debt is spiralling whilst revenues are collapsing.

Note 3: Jim G asked the following:

'Out of interest, if you had savings currently in a UK bank, what would you do? (Savings are a deposit for when I get back onto the property ladder - sold to rent 1 year ago.)'

And from anonymous:

Now I am truly scared. What do you think one expecting a government default do? Withdraw their money and hide it "under the mattresses" as they say?

For many months I have been giving the same advice. Make sure that you have multiple bank accounts, make sure that all money is instantly accessible, that the accounts have internet access, and that you are prepared to move money quickly. As new advice, you may also want to open bank accounts in other countries, and have a transfer prepared so that you can move your money. As an aside, I have read that HSBC is in a relatively strong position due to high deposit levels, but I have never analysed individual banks, so this should be considered in this context.

If the question is where to invest money, I would not want to give direct advice, but will let you draw your own conclusions from my discussions. You should also read other opinions before deciding what to do.

Note 4: I have had another comment on conspiracy theories from Toshi, who explains that there is a journalist who offers some views on conspiracy theories and the 'New World Order'. Before following his work up, I found the following on Wikipedia regarding the journalist in question:

'More recently Fulford has stated that the US have been able to alter the climate, and using high power microwave energy induce earth quakes including the Asian Tsunami, Japanese and Chinese quakes. The program he refers to is known as HAARP High Frequency Active Auroral Research Program'

I looked no futher.... but thank you Toshi for passing this on. I am always interested in hearing about the proponents of conspiracy theories, as I think that we need to address these theories.

Note 5: A belated thankyou to the anonymous poster who gave the link on the IMF printing money. Such links are always appreciated.

Note 6: There is news that credit card borrowing is climbing in the UK, but that 'experts' believe that the money is being used for day to day expenses. The worrying part (see above) is that this lending is now being guaranteed by the government, and is at least partly financed by the government. So the situation is one in which an overstretched borrower is helping another overstretched borrower. More cause for worry.....

Note 7: US interest rates are now down to 1%, which means that the US government has almost nowhere left to go. Meanwhile it has been confirmed that the US economy is shrinking. Meanwhile in the UK Alastair Darling has confirmed that he intends to borrow and spend, until the end of the recession. If you read my previous posts you will find why it is that spending is now the single worst option. Try the links at the top left of the page to find out more. Meanwhile house prices continue to fall in the UK, with forced sales expected to exert further downward pressure, in an ongoing drip-drip of bad news.

Note 8: No doubt the astute readers will notice that there is a rollercoaster in currency, commodity and stock market at present. I think we all need to be careful (including myself) of reading too much into these day-to-day movements and view the bigger picture and trends. In particular, the market gyrations are a symptom of uncertainty, and therofore the market is moving with changes in sentiment. They are therefore best regarded as indicators of sentiment rather than any underlying reality. However, the underlying realities will direct an overall trend as the market unfolds, and the overall trends are what will matter.

As Expected - The UK Economy is Collapsing

For the regular readers of this blog, they will be familiar with some of the predictions made in my essay 'A Funny View of Wealth', and some follow on posts that I have made in which I have discussed other aspects of the economic outlook. It is a while since I have looked at the 'big picture' so a brief review seems to be in order.

The first point to make is that, as predicted, house prices are not just falling but plummeting, and this was very much in line with predictions for this period in time. However, my prediction was, and remains, that they have a long, long way to go down still. In a later post I suggested that my already extremely gloomy predictions were too conservative, and I would suggest that my later more pessimistic outlook is more realistic. I do accept that there may be a very small upward blip at some point, a false recovery, but see the chances of this diminishing with time. However, there are still a few optimists out there, but I would suggest that such optimism is self-delusion.

Another element in the downward spiral that I predicted was that consumer confidence would evaporate, which is now the case, and that this would start to hit the service sector hard and fast. The knock on effect of this would be that many businesses would start laying off workers and that unemployment would start to rise. I mentioned the likelihood of the Central European workers going home or to other parts of Europe as the economy contracted and other labour markets in Europe were opened, and that this would ameliorate the rise in unemployment. As predicted unemployment is rising, the Central European workers are going home in large numbers, and unemployment is not rising as fast as would be expected in a sinking economy. However, also expect the rate of rise in unemployment to increase more quickly in the coming months. Whilst the return of immigrants can dampen the effects, it will not be enough to hold back the tide.

The predicted (and inevitable) rise in personal insolvencies is well under way, and will also accelerate with unemployment, with further stresses on finance caused by inflation in oil and food prices (both of which I did not predict!), as well as higher taxation. Expect a personal loan and credit card debt meltdown in the coming months. It has already commenced in the US, and the UK will soon follow. The banking sector is about to enter the second credit crisis, and banks such as Royal Bank of Scotland are already showing their vulnerability. Expect more runs on banks - Northern Rock was just round one, and round two will be even more ugly. The second round will see mortgage defaults rising with a sinking market providing negative equity, personal debt rapidly turning sour, and business insolvencies all hitting together. The banking system is toxic (spread your risk over several institutions, and make sure that you can move your money fast using online banking).

As expected business insolvency is rising, and as expected it is hitting the service sector first and hard (as well as house builders). Expect these numbers to now accelerate hard and fast, in particular pulling in the retail sector. The whole UK economy, as predicted, will be pulled down with the service sector and this is already taking place. The destruction of businesses is only just starting - prepare for much worse to come. If you are wondering where to put your money, keep out of retail, banking, and anything to do with leisure, excepting those companies that service home leisure. Solid exporters with unique technologies are the safest bets.

As for Sterling, I suggested that this would also start to fall, which it is doing (if you will excuse the metonymy), even against the US dollar, which has been tanking. I stick with my prediction that it has a long way to go yet. As confidence in the UK falls, it will fall off a cliff. I would suggest that there will be a steady decline for another couple of months, and then a steep drop.

As predicted the drop government receipts are making havoc with government finance, and this will get much worse as the economy sinks further. As I have predicted in a previous post, cap in hand to the IMF appears to the the likely scenario in the near future, though not for a while yet. I am really not sure that many people are aware yet of the Tsunami about to hit government finance, but it will be very ugly indeed. To misuse Alistair Darling's phrase, we are uniquely misplaced to weather the economic storm.

In other words, the UK economy is following the path that I predicted. As such, if I have been right before, I have to accept the uncomfortable idea that I will be right about the next phase of the collapse. This is not a pleasant idea. I am afraid the next phase is one of acceleration of the downturn, as each negative reinforces the others. The only remaining question is to ask at which point will other countries lose confidence in the UK economy? This is a matter of sentiment, of feeling, of intuition, of 'groupthink', and therefore hard to predict. It is when the sentiment goes that the banks will start failing, and the IMF becomes the saviour. I think that this is not far off, but am slightly less certain than in my previous predictions that this will be within 6 months. However, this is only a case of slightly less certain.

Not a happy post, and I have a feeling they will become ever more gloomy in the coming months.
Note: When I discussed the Chinese economy I suggested that China may be able to weather the world economic storm, but also suggested that China is on a knife edge on this subject. The early news is suggesting that China may not be that resilient. In my post I pointed to worries about their banking system and construction. It appears that these worries may have been well founded. See here for why. Having said this, I am still not confident to jump one way or another. China has many economic strengths, and may pull through this okay, although it will certainly feel negative effects of the global downturn.

At some time I may talk in detail about the US, if there is interest from readers on this subject.