Fighting on the Edge of a Cliff - The US and China

There has been some lively debate in the comments section following my posts on Fractional Reserve Banking, and it has been very encouraging to see so much response. Whilst the subject might appear to be abstract at first glance, when I come to some future posts it will become increasingly apparent why it is important in the current crisis.

Today, however, I will briefly move away from these subjects, and will postpone my post on central banking. The reason for the diversion is that I have seen some interesting news today, and I have kept in mind a question on a recent comment on a post from 'Jonny'. The post Jonny commented on was made about 2-3 weeks ago, and I said the following:

Whatever the final push, I now believe that we are on the edge and, as such, I will brave a timescale. I would now say with considerable confidence that we are within three months of the plunge. By plunge, I mean the serious collapse in either the $US or the £GB, either of which will shortly after precipitate the collapse of the other. I am not tempted to say how far they will fall, but it will be a dramatic fall over a period of about two weeks, sufficient that we will all look on in complete shock. I am not talking about 10% but tens of percent. Once the sell-off starts, I am not sure where it will stop.

Jonny asked what drove me to such a conclusion, and I am hoping that the reason for my concern has since become apparent. However, it should be noted that this, like any prediction, is a matter of my being confident, not certain. There are no certainties in these situations, but there are likelihoods. In the meantime events appear to be bearing me out.

The first point that supports my contention is that one of the factors in the collapse that I have proposed was the possibility of some governments being unable to continue to borrow. I have mentioned several factors here, such as the fact that, at this moment in time, governments all over the OECD are massively increasing their borrowing all at the same time. In this situation, it is apparent that there will be competition for a finite amount of money, and only the economies judged to be the strongest will win. I have pointed out in previous posts that the UK will not inspire the confidence of lenders. This returns me to the news that prompted this post.

The ferocity of the downturn has led to a sharp jump in borrowing costs for the Spanish state, which lost its AAA credit rating from Standard & Poor's last month.

A €7bn treasury auction of 10-year Spanish bond on Tuesday saw yields jump to 137 basis points above German Bunds, a post-EMU high. Foreign investors were conspicuously absent, leaving Spanish banks to soak up the debt.

The most interesting thing about Spain is that the Spanish banks are in difficulties, but are in much better shape than the UK banks. The Spanish economy is falling faster than the UK, but Spain is a Euro economy such that its currency is not vulnerable in the way that the £GB is vulnerable. Unlike Spain, therefore, the UK national currency is subject to the state of the UK economy.

As an aside, I long ago suggested that the cohesion of the Euro might be strained as the economic crisis progressed, and there have been an increasing number of articles recently mirroring this view. I still believe that the Euro may not come through this crisis, and think the likelihood of either a partial falling apart, or complete abandonment of the Euro is possible. We could yet see the return of the mighty Deutsche Mark. As such, if you hold any Euros, make sure that they are held in a German bank in Germany....

Returning to the UK, for a long while now, I have been arguing that the UK is seeing a money-go-round, in which the government finances the banks, and then the banks finance the government. This can go on for a while, provided that others outside of the money-go-round are stepping in with at least some financing. However, in the current level of competition between countries to win over lenders, the UK is going to be seen as a relatively poor risk. I do not think that the UK is going to win in the competition for financing, and the Spanish experience illustrates this. In particular, lending to Spain does not have the same level of currency risk as lending to the UK.

Meanwhile, we are already seeing the UK adopting a policy of quantitative easing - or money printing - and this of itself makes the £GB look very vulnerable. Added to this are the ever greater open ended liabilities being taken on by the government, and the rapid accumulation of reports saying that the UK is going to be one of the worst hit countries in the crisis. Just for good measure, you can add in a dose of negative sentiment, such as that expressed by Jim Rogers. The real question is this - given a choice, would you put your money in the UK at the moment? In other words continued financing for the UK from outside creditors looks unlikely.

There are two ways that this can play out. The first is that, at some point in time, the money-go-round will be unable to support a government sale of debt. There will be no other lenders wanting to step in, and without being able to raise further money the government will be bankrupt, and the £GB will fall.

The second is that the UK government starts to fund itself directly through money printing, or sees the crisis coming and speeds up the printing presses to inject ever greater money into the money-go-round. In this event, at some point, somebody will notice the impossibility of the ability of the government to endlessly finance itself by borrowing from banks that are themselves insolvent - and reliant on government lending to keep them afloat. It will become apparent that the government is, one way of another, increasingly reliant on the printing presses to fund itself, and the £GB will fall.

Perhaps the greatest indication of the severity of the situation for the UK was that Gordon Brown felt that he needed to defend the UK against the charge that it was 'the next Iceland'. That a prime minister feels that there is such a necessity is a clear indication of the state of the economy is very, very fragile indeed. Another indication of the state of desperation is the official UK change of status of Tibet to a status that appeases China. As one article points out, a cynical interpretation of such an action would be that the UK has 'sold' the status of Tibet - in other words this change of policy has been exchanged for a better prospect of continuing Chinese credit for the UK (possibly indirectly by ensuring that the IMF is able to fund a UK bailout). Whatever might be thought of Gordon Brown, I do not think he would make such a move except in extremis. The question that this raises - has he purchased a breathing space?

If he has, then it may be that China will step in with the finance when needed, but we will see. Such factors are not visible, and this is why nothing is certain.

So far I have just been looking at the UK. In the case of the $US I have devoted a whole post to the vulnerability of the $US, so will not repeat it all here. Instead, what I will note is that the tensions of issuing endless $US are starting to show. At Davos, Putin was calling for an end to the $US hegemony, and China is increasingly taking a negative view towards the endless issue of $US. Add in the war of words started by U.S. Treasury Secretary Tim Geithner on China's currency manipulation and you have a heady cocktail. As a final problem there is the ever more controversial 'Buy US' measures that are looking to be included in the US 'stimulus'.

What this is starting to point to is the inevitable 'showdown' that I have identified at many points in this blog. The US can not allow China to continue to subsidise exports, but in order to confront China the US risks China selling some of the massive $US reserves into the market . If China starts this sale, the $US will collapse. The tension that is inherent in the current system must come to a resolution at some point. However you look at it, it is impossible to sustain.

This is the actual situation. The US needs overseas finance to continue to fund government borrowing and those borrowing requirements are increasing. At the same time, the US government is printing money, such that they are diluting the value of all $US holdings. Those $US holdings are already unusable, because if they are sold, they might precipitate a $US slide, thereby destroying the value of the holdings. If the lenders do not continue to lend, then the US government will be unable to fund its borrowing requirement. If the US can not fund its borrowing it must either print ever more money, or default. Both will destroy the value of all $US assets, of which the creditors to the US hold monstrous amounts, and amounts they must increase to support the value of the $US.

The US is presenting the world with the choice of continuing to lend in return for paper whose value will decrease, or not lending and seeing the value of their current $US assets fall. Both sides are locked together - the US and their creditors are tied together in a very uncomfortable embrace.

If we see the argument between the US and China over currency manipulation in this context, it is possible to see that both sides are about to fight on the edge of a cliff, with both sides likely to fall off the edge of the cliff if they put a foot wrong. However, knowing that the cliff is there does not mean that they will not enter the fight. China needs to keep the export machine turning to save its economy, which means that the US will see the imbalance of trade and hollowing out of its economy continue. If it allows this, then the ability to ever service the debt will become ever more impossible. On the other side, China must continue to accept ever more useless $US assets to support the irresponsible and profligate spending of the US government.

Quite simply it is all madness. It can not continue. The whole situation is fraught with contradictions. The war of words between the US, the rise in protectionist measures all point towards a climax. The collapse of the £GB, I believe, will be the push that gets it all started. When a major economy, with a similar underlying economy to the US, fails it will be the shove for people to revise their view of the sustainability of current contradictions. The UK is just such an economy and is an economy on the edge of failure.

What we have in essence is a situation which is impossible to sustain. It is just a question of 'when' rather than 'if' it unwinds.

I have to emphasise that nothing is certain. The direction at the moment does point towards a climax, in particular as every side is starting to absorb the horrible nature of the problem. I have no doubt that the various sides are talking and trying to find a solution in which the contradictions resolve without disaster, but can see no such solution myself. It is always possible that a compromise will be made which will delay the collapse, but delay is the best outcome that I can see from a compromise - and the cost of delay will be a greater problem later.

However, I may be wrong. Maybe there is a solution to the impossibility of the current situation, a way to unwind the imbalances without pain. If so, then it needs to be found fast....

Barack Obama or John McCain - Who Will Address the Reality of Economic Crisis?

It is impossible to ignore the US election, and whoever wins will face the current economic crisis. As such, how do the economic policies of the two candidates stack up? This from the Economist back in October:

'Both plans are costly. Long before this week, Mr Obama had proposed sending cheques to the middle class, to be partially paid for with a tax on oil companies’ “windfall profits”. But with the collapsing price of crude, the package’s net cost has now shot up from $50 billion to $115 billion. Jason Furman, Mr Obama’s economics director, estimates the latest round of proposals will take that up to $175 billion over the next two years. Mr McCain’s pre-existing tax plans would have caused the deficit to balloon more than Mr Obama’s, and his campaign says his latest proposals will cost another $53 billion. The timing is awful: the Treasury announced on October 14th that the government’s fiscal 2008 deficit was $455 billion, not the $389 billion projected in July.'

In other words, both candidates have their own version of continuing the delusion that government borrowing is the solution. The Economist also gave a more detailed briefing on their respective economic policies, but I will not detail their policies here as their policies are unlikely to be realised. The situation is such that, whatever they say on the stump will have to be adapted to the realities that they are about to confront, which is the ongoing collapse of the US economy. In such a situation, what their individual policies have been, becomes irrelevant. What matters is who is better able to adapt, be pragmatic, and accept the reality of the situation.

This comes down to a judgement call about the character of the individuals, and I have no insight on this subject that I can offer readers, and therefore will remain neutral on the subject. I can only suggest that, for US readers, you ignore what the candidates said they will do, and ask yourself how they might respond to an ever worsening economic situation. Will they bury their heads in the sand, or will they confront the reality, and devise a policy that will address the fundamentals of the economy. Are they likely to heed the populist calls, or will they have the courage to lead the US people and confront them with a need for real and fundamental change? This is a question of realism and character, rather than an analysis of their policy record.

As I have said, these are judgement calls about the character of the individuals in question. I am happy to offer my opinions on questions of economics, but in no way feel that I have any greater insight than anyone on this question. I only know the right question to ask, but do not know the answer.

I have had some interesting comments in the last day or two. In particular MattinShanghai offered an insightful comment on the change in the common understanding of wealth as follows:

'What seems to be happening in developed countries is the taking over of the real productive economy by rent-seeking finance capital, which basically tries to "squeeze" it for all its worth. This applies to companies (via M&As and LBOs), prospective landlords (via mortgages) and individuals, who are encouraged to take on ever-increasing levels of personal debt. According to current economic orthodoxy, asset stripping, outsourcing and offshoring, "creates wealth", so its all for the best, isn't it?'

Matt's discussion is based upon the thinking of Adam Smith, and you can read the comment he makes in full at the end of 'A funny view of wealth'. To all of the readers of this blog, I would strongly recommend a reading of Smith's 'The Wealth of Nations'. I have always felt that all the economists since Adam Smith have been trying to fight with his ghost. It has been a long while since I have read 'The Wealth of Nations', but it was an inspiration for me, and is probably the inspiration for much of my thinking on economics. In other words, if you find that this blog makes sense, then you would almost certainly appreciate the work of Adam Smith (I may reread it myself, and see how much my thinking actually is founded in his impressive work).

Ignatius also made the following comment, regarding 'A funny view of wealth' (it is heartening to see that people are still reading it):

'A critical remark, though: You argue that immigration as well as emigration is bad for the UK economy. Obviously, ceteris paribus, both statements cannot be true at the same time: You either have too many or to few young workers - given the age distribution of the "native" UK population, I'd rather vote for the latter ...'

The key difference is that immigration is often from countries which are economically less developed than the UK. As such, they are likely to be providing remittances to their country of origin, thereby removing wealth from the UK to their country of origin. I also divide immigration into 'good' and 'bad' (I am simplifying here). In particular all temporary migration is bad, as the migrant is likely to return home with a large cash sum, removing wealth from the economy. UK workers going to another country to work, and returning home with a lump sum is a positive for the UK. The trouble is that much of the recent emigration from the UK is to settle permanently in another country, and they take their wealth with them, thereby removing wealth from the UK. By contrast, immigrants from less developed economies are unlikely to be bringing such wealth with them (excepting the super-rich 'non-doms'). Also, emigration from the UK is to countries such as Australia, where entry requires high levels of education/skills meaning that most of the migrants are exactly the people that are a positive for the economy. Equally, immigration of unskilled migrants into the UK is a bad thing, but immigration of highly skilled/educated migrants is a good thing on balance. These are generalisations, and do not do the subject justice, but a re-reading of my original post will hopefully clarify the matter. As such, I recommend reading the original essay. With regards to the age distribution, the introduction of an effective points system, and actively promoting immigration of highly educated and highly skilled workers would be a partial way to address this problem.

I hope that I have covered the criticism, but would also like to emphasise that I welcome any criticism, as it helps me to focus on any weak points in my analysis or my communication of that analysis. Therefore, thank you Ignatius for your comment.

Two anonymous posters have asked what will happen if the UK defaults on debt, and focus on the external consequences rather than the internal. This is a very large question.

I have previously detailed the options for governments in the case of no longer being able to borrow, and it is not a pretty picture. With regards to countries that trade with the defaulting government, there are some obvious consequences. One of those is that lending to the government would probably continue, but come with hefty (IMF-like) strings attached, and would probably require rescheduling of previous debt under onerous terms including rescheduling in a different currency. The default would also make trading with the defaulting country high risk, as the currency would be considered unstable. In these circumstances, trade would not be conducted in the domestic currency, but in another more stable currency. This would be a way of shifting the currency risk towards the country in default. It is a short answer, but I hope that it suffices. In other words, the reform that should anyway be undertaken within, will be forced from without. A better solution is/would have been to implement the reforms now. This would allow for a more gradual and less painful adaptation to the changed world economic circumstances and would be a controlled reform rather than a shock.

In both cases the country would have to learn to live within its means, but internal reform offers the opportunity to make the transition with less pain. As I have long argued, it is only reform now that will allow creditors to continue to support economies such as the UK economy as it makes the transition to a leaner and more competitive economy. Every day that goes by with ever more borrowing just digs a deeper hole, and governments desperately need to reduce expenditure such that the depth of the hole is minimised and allows that we can eventually climb back out. If creditors can see that we are reducing borrowing, and can see the prospect of an eventual return to surplus, then they will keep lending. Instead, what they see is an increase in the size of the deficits, and will be wondering at what point the deficits might ever reverse.

For those that doubt that the creditors are getting cold feet, this from the Times:

The domestic priorities of Saudi Arabia could well be put before helping Western economies, which have been put at risk by global economic turmoil.

“Saudi Arabia does not want to be seen as a milch cow,” said a senior British government figure. At a three-hour meeting with King Abdullah on Saturday night, Mr Brown secured his agreement to attend the summit on November 15 to discuss reform of the international financial system. The pair dined, then talked long into the night through an interpreter

This is the question that I raised some time ago. The creditor countries are faced with tough choices. Do they keep throwing good money after bad? If they stop lending, they see the market for their products/commodities collapse, but if they keep lending, they are effectively subsidising the wealth of the West with their own wealth. More from the same Times article:

Privately Saudi officials have acknowledged that in recent decades the state has failed to invest in the country’s infrastructure and public services and now want to rectify this. They intend to invest in education and skills, as well as to improve the living conditions of ordinary families.

In other words, bailing out the Western economies comes at the price of denying their own people the benefits of their wealth. It is very much as I have suggested before. The big question is how they will chose to proceed. If they cut the lending, then they will suffer, and if they keep lending they have to live with the idea that they must just continue to support the wealth of others at the expense of themselves. It is a classic 'rock and a hard place' situation. However, it illustrates how fragile the current economic situation actually is. As a note, thanks to Stephen for the link on the subject of the visit to the Gulf by Gordon Brown.

Jim G, on a related subject asks the following:

'I now watch Gordon Brown, smug faced, tell everyone that the UK's debt is lower than most if not all of the Europeans. Is this true? Is he including in his figures, the off book stuff, such as nuclear decommissioning, PFI deals etc. Is the UK really in a better position than the rest of Europe or is this another "no more boom and bust" statement? I've looked for some stats, a report, anything but can not find any comparisons between countries.'

This is a very pertinent question. There are two issues. One is that the measure of debt is made relative to GDP, and as I have argued previously, GDP is overstated by around a third (a 'guesstimation'). With regards to the real liabilities of the government, the Economist thinks that all of the liabilities would roughly double the real levels of debt. It also reports that 'Britain's deficit as a share of GDP was among the highest in the 15 old member of the European Union' (Economist print edition, November 1-7, 2008, 'So Long Prudence. We had Fun but....', p55-56). In other words, there is absolutely no comfort to be found in the UK debt situation. Also, even were it the case that we were not as bad as others, this would be a relative measure and would not alter the simple fact that the situation is bad. If one person has a broken leg, and another has a broken leg and arm, we would not say that either person was in a good condition to play a game of rugby.

This has been a slightly rambling post, and has covered a lot of subjects. I hope I will be forgiven for this, but there were a lot of interesting comments. Of all of the points in this post, I think the most important is that it appears that my belief that creditors are getting cold feet is correct. I have taken a single comment in an article as the basis for this, which is hardly overwhelming evidence, but I think that it may be a good indicator, and fits with my previous speculation.

In the meantime, no doubt, everyone will watch the outcome of the US election with great concern. I do not know the right choice, and hope that the judement of the people in the US will be correct. The handling of the US economy will have a profound effect on the world economy as a whole, so that the choice made in the election will have profound effects for us all - for good or for ill.

Note 1: Death To Bubble Addicts posted a link to a very funny video. Whilst the situation is serious, humour about it is not a bad thing, so thanks for the link.

UK Government on Track for Bankruptcy

Today, I am just going to conduct a very quick review of some of the news that has emerged is confirming the the UK is on course for a government debt default. The strength of the US currency means that the US is safe from default at the moment, but a UK default will probably be the first step towards the loss of confidence in the US government position, and may see the US default as well.

The first piece of news is that the IMF is now running out of funds, and as I have discussed before, the idea that the IMF will be able to rescue the UK when the crisis comes is diminishing. The second piece of news is that the once mighty £sterling is in freefall against currencies around the world. This is what the Times has to say:

'The descent of the pound drew comparisons with the early 1990s. Then it fell 50 cents from $2.01 to $1.50 - but this time the downward spiral of the currency is gathering momentum.

“People are selling the pound because it’s there. There’s no reason for them not to,” said Nick Parsons, head of markets strategy at National Australia Bank, who is forecasting that the pound will go as low as $1.40 early next year.'

The most interesting part of the article, however, is that the reasons for the fall, which are given as:

“We will go down further because the problems the UK faces are worse than other countries. We are uniquely exposed because of the sheer amount of debt we’ve got.”

In other words, the markets are now realising that the UK is in very deep trouble, and that the UK debt position is unsustainable. This has been an underlying theme of the blog since the first post. The collapse of the £sterling is exactly as predicted in my November essay 'A Funny View of Wealth':

All the while this is happening the government will fall into crisis. With a falling pound, an economy collapsing around them, and an already overstretched borrowing position....'

The 'all this' that I am referring to is the collapse in house prices and consumer spending, and the downward spiral of the economy. I detailed in the essay why the £GB would fall. One factor is the collapse in inward investment that bolstered the £GB, another is that the UK simply does not produce enough goods and services to support the £GB. To this, in later posts, I added that demand for the £GB would fall due to drop in demand for the currency to lend back to us.

The implications of the fall in the £GB for the UK economy are profound. The problem that this will cause for the government will be how to finance government borrowing. With a falling £GB the UK overall is now a high risk destination for money. Nobody wants to lend into a devaluing currency, as the devaluation destroys the value of their investment. This will drive lenders in one of two directions; either they will charge extremely high costs for their lending, or will ask for repayments in another currency, thereby shifting the risk on to the borrower. In both cases, government borrowing will become unaffordable.

Meanwhile, government spending is already spiralling out of control. Add to this that the government has now taken on huge costs and liabilities in the banking bailout, and it becomes apparent that the government is on course for disaster. For example, according to the Times, repossessions have climbed by 71%. The collapse of the economy is going to see ever more defaults on mortgage and consumer credit, as well as defaults on consumer loans. These defaults will hit the financial sector hard, and that now means that they will hit the government. The government is going to need very deep pockets to support the financial sector, but it just does not have them. This is one of the reasons why I have consistently opposed the bailout, arguing that it would push and already overstretched government into the certainty of default.

As the crisis deepens, the government talks more and more of ever more borrowing, calling on the ghost of Keynes as justification. However, Keynesian economics never allowed for increased borrowing in the 'good times', and in the case of the UK the borrowing has been both by the government and consumers. In other words, even if Keynesian economic theory is accepted, this is a gross distortion of the principles. There is therefore no doubt that very few potential investors are going to buy the UK government's economic policy.

For lenders, there will be a larger question looming. How exactly will the UK emerge from this crisis, and how will the economy expand to eventually repay this borrowing. I posted a comment on a forum a while back, asking anyone to point to where the future growth to repay the debt will come from. Not one answer was provided, and this is because there is no miracle around the corner that can return the UK to wealth. There are, quite simply, no sectors of the economy that promise any growth that will provide any significant new real wealth.

All of these elements add up to the onset of the financial crisis for the UK government, and a sovereign default. It is now only a matter of time before the UK faces up to the reality. It is bankrupt.

Note: I have been asked to give a firm date (see comments below) for when the UK will default on debt. However, whilst I have predicted the timing of many of the key events of the current crisis, this does not mean that I can read the future. I first mentioned the possibility of UK defaults back in June (I believe) but gave no estimate of time. More recently, I have suggested that it would be in about 3 months time, and that was about a month ago. I believe that the guess is starting to look more ever more credible, so will stick with that timescale, so would guess at about 2 months time. However, this is no more than a guess, as the determinant is going to be something that is hard to predict - confidence.