Huh?

This is (as I start writing) intended to be a very short post. I was just browsing through the economics news and found this rather fabulous quote in reference to Spain's shrinking economy:

It is unclear how he can slash the budget deficit from 8.5pc of GDP last year to 5.3pc to meet the compromise target agreed with Brussels after a bruising confrontation.

“It is frankly impossible, given that it would aggravate the recession and this would crush state revenues,” said Jesús Fernández-Villaverde from the University of Pennsylvania.

This is 'fabulous' as it is a very clear illustration of a point I have made several times. It illustrates just how intellectually bankrupt a large swathe of academic economics actually is. I will just start by putting the quote in a usable format:

• Cutting borrowing will make the recession worse
• If the recession is worse, then state revenues will be lowered
• Therefore, if borrowing is cut, state revenues go down
• If state revenues go down, then payment of existing debt becomes impossible

 What this really means is something like this (this is simplified/basic principle only):

• I am borrowing 200 units of new debt per year
• I have to pay 100 units per year from tax revenue to service my existing debt
• The 200 units create activity in the economy as the borrowed money is used for consumption of goods and services
• The activity in the economy from the borrowing of 200 units sees 50 units of the borrowed money returned to me in tax revenue from the tax on the consumption of the 200 units
• If I do not borrow at all, the tax revenue from activity in the economy will only be 50 units
• If I cut borrowing to 100 units I will only see 25 units of tax returned to me from the 100 units borrowed
• Cutting my borrowing to 100 units means that I have the 50 units + 25 units of tax revenue from the borrowing
• If I only receive 75 units I can not pay for my existing debt, which requires 100 units
• Therefore I will continue borrowing 200 units so that I can pay for my existing debt which gives me the 50 units of no borrowing tax revenue + 50 units of tax revenue from the borrowing and consumption of 200 borrowed units
• If I do not borrow 200 units I cannot pay my existing debt.
• If I borrow 200 units, I increase my existing debt.
• If I cannot pay for my existing debt without borrowing, how will I pay for next years greater debt and greater annual servicing costs?

In short, the process is one in which I borrow 'x' amount for others to consume, and then tax that consumption of the borrowed money in order to return a fraction of the debt to me and pretend that this is revenue, not a fraction of the money borrowed earlier. If I do not do so, I can not support my debt. In short, I need to borrow money in order to make payments on previously borrowed money. In doing so, my debt pile gets bigger, necessitating more borrowing to pay previous borrowing. It is an upwards spiral of debt in order to keep paying existing debt. It is also a downwards spiral into greater and ever less sustainable debt. It is a good method of destroying an economy - unless a choice is made to just not pay the debt.

And this is a solution? Really? 

Note: This is a bit of rushed post, but I hope it all makes sense. If there are any errors in the logic, please feel free to point them out. Also, if (and I apologise in advance if I think it is no better) you can offer an even simpler and clearer explanation, I may use it as a post, with full credit to the author (as anonymous, or by name according to your preferences, so let me know). I really think this is one of the most fundamental examples of just plain odd thinking in economics. As such, getting it as clear and logical as possible would be great. I still feel that my explanation is not quite there, or might not quite hang together.

Update, 30 March 2012: A very good explanation from Carrew below, which integrates the fundamental problem of dishonest politicians.TheFatBigot (I really like this name) also weighs in with some good points about GDP and the underlying foundations of revenue, as does MR. Anonymous has picked up on the rather distorting economy as a medical patient metaphor, and proposes a more apt variant. In the case of Carrew and TheFatBigot, they offer some very good explanation. However, although very good, and somewhat simpler, but I am still looking for the 'killer explanation' that skewers this dangerous economic thinking (something which those less interested in economics might grasp with ease). Further efforts would be welcome.
Update, 2nd April 2012: There are some more good thoughts and explanations below.  An anonymous poster has had a good go at it as well. Perhaps between the various comments and my own explanation, someone can provide a good synthesis that takes the good points from all? As ever, I am impressed with the readership of the blog.

Lemming: Apologies, I found a comment from you which escaped the approval process for some reason. I am not sure how long it sat unpublished, but apologies if it was a long time.

Sovereign Default - Who is at Fault?

I am watching the Greek crisis as it takes its painful course, and have noted that there are some views which seem to suggest that Germany has an obligation to rush to the rescue. A Guardian article is typical, though the extract below does not really capture the overall sentiment of the article:

After days and days of hesitation and apparent indecision, when speaking to the audience at the rally in Bocholt, Merkel played the populist card. We're right to tell the Greeks: you have to save money, you have to be candid and you have to work on your honesty, otherwise we can't help you, Merkel said.

It's one thing to ask Greece for strict austerity measures in return for a bailout deal. But when Merkel implicitly said that the Greeks weren't honest and had poured money down the drain, she didn't ask for anything. She didn't even try to calm the fear among Germans that contributing billions to the Greek bailout will lead to further wage cuts and tax freezes.

Perhaps, the sentiment is best expressed with the picture of Angela Merkel that accompanied the article. The picture is quite disgraceful:

What we are seeing is a pass the parcel of blame, and Germany looks like will be left holding the package. However, all of this is to lose sight of the reality of the situation. The Greek debt is the fault of Greece, and nobody else.

There have been suggestions that somehow Greece was enticed into debt, that it really is not their fault. It is the view that Greece is like a consumer persuaded into a dodgy Hire Purchase agreement, without realising the consequences of signing on the dotted line. However, in this case, our consumer has lied about their level of debt on the application form. We might have less sympathy for this consumer...

However, it is not like a consumer signing a deal, as there is a critical difference. Whilst a consumer might plead ignorance, lack of understanding of the consequences of their own actions, not understanding the real cost of the loan and so forth, this is not the case with a government. In the case of governments, they employ experts whose sole job is to examine the economic consequences of the policies of government. There is no excuse of ignorance. Every time that a government metaphorically signs on that dotted line, they do so with expert advice.

What of the Greek people? Greece is a democracy, and therefore the Greek people themselves might be seen as culpable. They elected the governments that racked up the debts, and they might be seen to take a collective responsibility, as part of the contract implicit in democracy. However, I am reluctant to blame the Greek people in some respects. I do not know the role of the press in this debacle, and whether there was a sufficient momentum of criticism of the debt accumulation to give the Greek people an informed view of the eventual consequences. At the very least, the lies of the government not only hid the extent of the problem from the creditors but also from the electorate.

On the other hand, the response to the crisis is not encouraging. The strikes that are being undertaken to prevent the austerity measures are a wilful denial of the reality of the situation. Greece is broke, does not have the means to pay the bills, and are asking for credit. If they continue with their current spending, they will not pay back the money, and it is reasonable to ask that they tighten their belts, and start living within their means. It is not wickedness of Germany to ask for this, but reasonable. There is absolutely no moral obligation for Germany to bail out Greece. The government of Greece made their choices, and are responsible for the consequences.

In addition to the implication that Germany should, in all cases, bail out Greece, economic arguments have been put forwards, as in this fairly typical example:

But there are other aspects of the crisis which are common to many – most advanced economies have had their finances stretched to breaking point by the recession – and unless some kind of line is soon drawn in the sand, Greece's problems will spread to the next weakest link in the chain, widely thought of as Portugal, and then perhaps to others too.

What's more, German and French banks are big holders of Greek and Portugese debt. Default itself might trigger a second round of banking collapses, with further deflationary consequences for affected nations.

This is a variant of what I will call the chain reaction argument. This is the idea that a line in the sand must be drawn in Greece to prevent further banking crises or further sovereign debt crises. The problem is that, as has been found with Greece, even if the debtor countries massively reduce expenditure, the bailouts will be of massive proportions. The level of bailout money for Greece just keeps on climbing, and the same will apply to the next 'at risk' countries. If the creditor countries open their cheque books, where will it end?

If they start, at what point will they call a halt? At Portugal, at Spain? More to the point, the countries supplying credit are already running their own deficits. They must borrow yet more money to bail out the debtor nations, thereby creating greater risk of having their own debt crises, and borrowing money to lend to countries that appear to be reluctant to face up to the consequences of their previous profligacy; in other words borrowing money to lend to poor credit risks that insist on continuation of spendthrift ways.

I normally try to take a more objective view of the economic crisis, but there just seems to be so much complexity being overlaid over a simple situation that I am becoming more frustrated. I have just submitted a new article to TFR magazine (it should be published in the print and online version soon) and it points out that we are not looking at 'contagion' to other countries, like a disease is contagious, but rather that the doctors are learning how to diagnose the disease - and the disease is fiscal profligacy. There are a host of countries that have the same problems, including the UK and US. It is time for these countries to act, as there simply aren't going to be any saviours that will ride to the rescue. Even a small country like Greece, with a relatively tiny economy and relatively small absolute debt levels is having trouble raising a rescue package.

Above all, this is not a contagious disease, but is the fault of the profligate countries for living beyond their means. In Greece it is (at least) primarily the fault of the government, and the same can be said of the other countries that are at risk. There are no excuses - they had the resource of 'experts' to draw on, the resource to examine the risks, and the resources to make decisions. There is no risk of contagion, as there is no disease. It is, plain and simple, a self-inflicted problem, and the solution to the problem lies in the hands of the policy makers.

The solution also (to a lesser extent) now lies in the hands of the electorates of each country. The reality of the consequences of profligate debt accumulation are now evident, and even the mainstream media are facing the reality of the tough choices. The electorates no longer have an excuse - the reality of the dire situation is now being placed in front of them. In the case of the UK, it is time they demanded of their politicians real honesty over what they plan to do. If not, they are by default culpable. The UK is lucky in this respect, having an election at the very moment that the light of reality is shining on the consequences of fiscal irresponsibility. They have a moment, brief as it is, to demand a change, and demand reform.

For other countries, there may not be such an opportunity before it is too late. In these countries, it is up to the third estate - the press - to wake up and pressure for reform. They need to shift attitudes, to create a groundswell of opinion that rejects the buy now pay later profligacy, and takes the lesser pain of reform now. It is time to pressure governments to tell the truth, and accept that they can not borrow and spend forever. It is time to accept that there are going to be no saviours, that the resource for the scale of bailouts needed will never be there. It is time to wake up from this complacent slide into ruination.

Notes:

I have watched with sadness as the UK election descends into the farce about the Prime Minister's calling a person a bigot. Whilst this is unpleasant, it seems to just be another distraction from real debate - the question of what is to be done about the economy. Whilst Gordon Brown's character is a legitimate subject for debate, the greater debate is buried.

I am, as you may guess, frustrated. I am still not sure whether the EU will hold off the crisis for a little longer, but in all cases, the ground of the crisis is now clearly in sight. Maybe there will be a last ditch rescue, and the crisis will take another pause....but maybe this is the start of the final phase. Your thoughts, guesses are welcomed in the comments section. My gut reaction is the start of the last phase, but I have called it wrong before.

As a final note, I have taken a different approach in this post, and hope that it is coherent. Let me know what you think.

The Greek Problem

A storm has slowly been brewing in the press over recent weeks in regards to the state of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). According to some analysts, the Euro area itself might be at risk of break up.

Before going further, it is worth mentioning that the dangers that we are now seeing are hardly unforeseen. I trawled through my own blog and found several of my own references to the problem (but probably missed many others), such as the following in a post from 2008:

Also, an interesting comment from VKP who suggests that the UK and Greece have many similarities. I am not as familiar with the details of the economy of Greece as I would like, but am aware that they are running very large deficits. I have mentioned the possibility of the abandonment of the Euro, and the state of the finances of Greece is one factor in that consideration. I am not sure how much longer Germany will play ball....

And a little later, at the start of 2009:

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....

More recently, I described the problems of Greece as an 'outrider' for larger economies - as a foretaste of the coming problems. I have not been alone in these early concerns for the Euro in the economic crisis, but have no references for those that were sharing them (apologies). However, the view that I shared with such Euro pessimists was that it was not possible to have a stable currency with the huge variations in individual government policy and economic structures. It was the tragedy of the commons writ large, with the Southern European states acting as free riders. With no method of effectively enforcing discipline and rules, it was possible to free ride in the system. The economic crisis would just bring these problems to the surface (though I had not imagined in such a dramatic way).

Despite this, the Euro enthusiasts have a counter argument. In a recent outing to a bar, I was speaking with a German on the subject of the risk to the Euro, arguing that Germany would not tolerate bailing out Southern Europe when confronted with its own problems. His response was to highlight the position of Germans as 'good Europeans' (including mention of Germany's troubled history) and that Germany would therefore support the integrity of the Euro area. I expressed my doubts about this, suggesting that Germany would not support profligate spending.

The attitude in Germany is of particular interest due to the economic weight in Europe, such that their agreement is essential for any bailout to proceed. This is from Die Welt:

"The EU has given Greece a long leash for far too long. Now Brussels has no choice. All that is left is the weak instrument of budgetary surveillance and a vague hope that, somehow, everything will go well. Sanctions, such as the freezing of EU subsidies, penalties to the tune of billions of euros or exclusion from the monetary zone are not feasible. Any such step would plunge the Greeks even further into the abyss and weaken confidence in the euro even more."

"Brussels is backing strict austerity measures. That is correct, but also wrought with dangers. The planned massive spending cuts and tax increases could stifle the economy of Greece and lead to deflation -- causing a vicious circle. The Greek drama is far from finished. It may well be that a few euro countries like Germany will soon have to jump in as a savior, offering billions in bilateral aid. That would be bitter pill to swallow."

Variations on these themes can be seen from other news outlets in Germany. I strongly recommend the summary contained in Spiegel Online if you would like to understand the direction of German sentiment.

I emphasise the press reactions, as the basic question that arises from the Greek crisis is not a question of economics. The EU has always rested upon compromise, upon politicians measuring their national interest against the 'great European project'. Such compromises have always been hard to sell to domestic audiences, but the problems of the Southern European states are a scale of a different order. It is very tough indeed to justify, when you have your own problems, why you might wish to bail out those whose problems are largely of their own making. Having said this, the elites within Europe have often managed to their goals in the face of opposition. Might they manage this in the face of crisis? I am really not sure.

The point I am trying to make here is that the Euro is more a political confection than it is an economic unit. The same may be said about all currency, but the existence of the Euro relies upon a continuing process of compromise and tolerance. The indications are that Germany are increasingly unwilling to bail out Greece, despite the potential for a broad crisis for the Euro itself. A search against 'Euro' and 'Greece' paints the picture of the sense of crisis for the Euro. One headline says it all, with the Sydney Morning Herald suggesting that 'Greece Trips, Euro Could Fall'.

The crisis in Europe has profound implications. I have long argued that the continuance of the massive accumulation of government debt in the 'rich world' rests upon a flimsy premise. This premise is that delusion that the Western world (and now Japan) have always been rich, and will always be rich. Iceland could be dismissed as exceptional, Dubai was still not the 'West', but the fall of Greece risks a spreading crisis that will undermine the belief in the 'rich world'. This is a Euro economy, and whatever the particular peculiarities of the Greek situation, the cracks in the edifice of belief will enlarge. As I have also long argued, the deficits of the major debtor economies are structural, and will not disappear. The cracks in belief will refocus minds on this underlying reality, and the closer the reality is examined, the greater the cracks will grow.

Will the crisis in Greece be enough to herald the denouement to the lax and unsustainable fiscal and monetary policies that have supported countries like the UK and US? Much hangs on the response to the crisis, but a response of a bailout will only serve as a delaying mechanism. Furthermore, a bailout might further stretch the economies of those that come to the rescue of the PIIGS, with Ambrose Evans-Pritchard of the Telegraph comparing the potential damage to the absorption of HBOS by Lloyds.

Chickens are coming home to roost. And for those who say that countries who have control of their own currency are in a different situation, the answer is very simple. The only way those with control of their own currency can avoid the same crisis as Greece is if they inflate away debts. However, doing so whilst raising record amounts of debt on international markets looks to be implausible. The US might get a benefit of 'flight to safety', but only for a short while. At some point, investors will realise that they have fled the bear only to hide in the bear's cave. It is an analogy I have used before, as the US is no haven of safety.

The position now is; 'wait and see'. A cobbled compromise might serve to delay the final act of the economic crisis. However, it is possible that the economic crisis is entering the last act. If Greece topples, who will follow?

Note: I have included Ireland in the PIIGS acronym, and Ireland is certainly at risk. However, Ireland is facing the fiscal problems head on, and should really be in a different category. I am not saying that it should be considered and treated as safe, but that it should be viewed as less of a risk than the other PIIGS. I have great respect for the efforts of the Irish government to reign in the deficits, and therefore will be sorry to see that their efforts might have come too late (or the crisis too early???).

The Pause in Quantitative Easing

Finally, the Bank of England has ended the policy of Quantitative Easing (QE), albeit that they are describing it as a pause:

The Committee will continue to monitor the appropriate scale of the asset purchase programme and further purchases would be made should the outlook warrant them.

The weasel worded technical name has never hidden the underlying reality of QE; that it is identical to the running of a physical printing press to print money. The vast majority of that money has gone into the purchase of government debt, and the cumulative purchases have been enough to have funded much of the unprecedented peacetime debt racked up by the government:

The amount spent by the Bank of England on its asset-buying program since March is almost 89 percent of the 225.1 billion pounds of bond sales planned by the Debt Management Office for the current fiscal year.

The fig leaf used to justify QE was the prospect of CPI deflation, and with CPI inflation moving higher, the initial justification for QE has disappeared. The bank must now leave the UK government to sell its debt to private investors and overseas central banks. The timing of the ending of QE has both positives and negatives.

On the positive side, there is a looming general election, and the possibility of a new government that might make real cuts to the size of the government deficit. The Conservative Party still looks the likely winner of the election, and have expressed greater concern about the deficit than the Labour Party, but still with no real concrete plans for tackling the monumental scale of the deficit. Despite this, some investors might suspect that, fearing electoral damage, the Conservatives are hiding the scale of the cuts that they will undertake. The success of the issuance of government debt may well hinge upon such a weak foundation for some time yet, but the fragility of such a foundation leaves a very real possibility of a failed debt auction. Then there is the point that the Bank of England has not ruled out restarting the printing presses, which analysts believe has weighed down on the £GB.

The concerns over sovereign debt extends further, with the ongoing saga of the PIGS (Portugal, Italy, Greece and Spain):

The Spanish and Portuguese markets led the declines as investors' fears focused on whether government plans to cut their deficits are tough enough. By late afternoon, Spain's main market, the IBEX, was down more than 5pc and Portugal's benchmark, the PSI-20, was off a similar amount.

The prospect of a sovereign debt crisis has been seen as one of the biggest risks facing the global economy this year as the downturn catches up with heavily indebted countries. Attention so far this year has been on embattled Greece, where the Government's debts have jumped to 12.7pc of gross domestic product, but appear to be switching to Spain and Portugal.

Then there is also increasing concern over the size of the US deficit, with many analysts and commentators worried about a sea of red ink stretching out to the horizon. Obama's freezing of sections of spending has done nothing to dent the fears that the US deficit is unsustainable, as the freeze covers such a small portion of total expenditure. Obama's expressions of concern over the deficit mean nothing if action does not follow the words. The result is the prospect of a downgrade of US debt:

The credit ratings agency cautioned that if the US were to grow at slower pace levels than expected, the largest economy in the world’s already-extended finances could be over-stretched, in turn damaging its AAA credit rating.

This might again be seen as a positive for the UK, but the position of the ratings agencies on the UK is equally as concerned, and preceded the worries about the US. Moreover, this is a comparison of a bad situation with a bad situation, and does not detract from the underlying reality that both countries are looking increasingly risky places to invest money. It is a bit like comparing a man with broken arms and a man with broken legs, and trying to decide who is in the worse situation.

Whether the US, the UK, or the PIGS, there is a concern that there is no solution to what is becoming apparent as structural long term deficits. It is not the deficit today that is the major problem (though that problem is large enough), but the lack of any route out of the deficit spending. In fact, ballooning entitlements from demographic changes present the prospect of enlargement of deficits, and further declines in the tax base.

The solution to the problem that is proposed by governments is that they must ensure that their economies return to growth. When they say growth, they actually mean debt based growth, meaning replicating the ersatz growth that took place before the economic crisis. There is much lofty talk of the resuscitation of growth through new technology, and innovation, but it all sounds like the much vaunted service economy, or post-industrial economy, touted before the crisis hit. Whilst talking of the innovative and growing economy, the governments are simply spending and consuming the future wealth of their countries. As I showed in my last post on the US and UK, the increasing deficits being generated by governments a just a return to pre-crisis levels of consuming more in relation to what is produced.

When looking at sovereign debt, there are risks in every direction. Some analysts argue that Japan is looking high risk, others that the PIGS are ready to topple, and so forth. We can see the volatility and uncertainty in the currency markets, with endless shifting tides on each piece of data from each major economy and each policy response. It is now becoming a waiting game to see which economy will topple first, and set off a domino reaction around the world. In this context, is the UK at greater or lesser risk with the pause in the policy of QE?

There are many factors at play, which is the relative risk of UK debt in relation to other countries, as well as confidence in the overall economy. The UK does have a trump card in the forthcoming election, and the pause in QE may be seen as a positive. An alternative view is that the end of QE will now hasten a failed bond auction, and thus prompt the crisis. However, even if the UK does not lead a crisis, will a contagion from, for example the PIGS, just mean that the UK becomes a follower rather than just a leader? The UK is looking very vulnerable, and therefore is at great risk of contagion. This from Edmund Conway of the Telegraph:

Greece, in other words, is the fiscal Petri dish that reveals in gory detail what could happen in the UK if this Government – or the next – fails to maintain the confidence of investors. It is not merely that those interest rates are already inflicting an awful toll on borrowers in Athens and beyond. It is that they are sending the national government towards a full-blown debt spiral, in which the cost of its annual interest bill becomes so unmanageable that it can hardly afford to supply its citizens with basic services.

I take Edmund Conway's analysis with a very large pinch of salt but, in this case, his analysis is reasonable. Unsustainable borrowing will lead to problems, one way or another. The difference between the two countries is the UK can print its own money, but that of itself does not alter the need to eventually live within your means. It only serves to translate the nature and timing of the crisis (with potential for greater damage). However, will the Bank of England really end QE, or will the prospect of a failed bond auction see the Bank of England cave in, rather than see the crisis that follows such an event?

Perhaps the most curious aspect of the looming risk of sovereign debt crises is that, even as we read of them, we hear talk of economic recovery - albeit with many caveats. One of those caveats that is often mentioned is that governments can not sustain massive deficit spending forever. The problem is this; the 'economic recovery' is not a recovery but a rerun of debt induced growth, and the debt that is producing the growth is the driver of the potential sovereign debt crises.

If governments actually act to reduce their deficits, the so called 'economic growth' will disappear, and with it the confidence that the economies might service their existing debts. Their economies will contract rapidly, and with the contraction the debt to GDP ratios will soar and their currencies plunge. With the plunging of the currency, there will be the onset of rapid inflation, and loss of confidence by overseas creditors. For example, in a previous post, I estimated that, if just the overseas portion of US borrowing were to stop, the economy would contract by about 17%. That is just the impact of the end of overseas borrowing.

In this context, the US and UK policy of QE becomes clearer. Governments are on a debt treadmill - damned if they do, and damned if they do not. However, QE does not alter the underlying reality that an economy is consuming more than it produces, it simply alters the scope and nature of the crisis. It is a last gamble that something will turn up in the meantime to save the economies from the real underlying crisis. If all else fails, printing money to stave off a crisis in government funding looks more attractive to policy makers than the alternative being faced by Greece, on whom austerity measures are being enforced. The discontent within Greece has already started.

The reality is that Greece must now learn to live within its means. This is the reality that is being avoided with QE. Greece can not devalue, can not print money, and must actually accept that it is poorer than it would like to imagine. It literally means a lower standard of living than they have come to expect. In this context, I have to wonder just how permanent the pause in QE in the UK will actually be.

Note:

I read the interesting debate on the last post. I did however note some comments that were an attack on the person, rather than on their beliefs/views. I would prefer to see the issues debated, rather than the person, and generally think that the high standard of debate and thought (that contributes so much to the blog) would be better served by this approach. Many thanks, as ever for the links and contributions. I would like to respond to some of the points, but seem to have less and less time to do so, but will try to do so.

The Winds of Change

Since first starting to write on the economy I have slowly developed a picture of the world economy, and that picture has alarmed me. As I wrote recently, it is a picture in which policymakers have an illusion that they are in control, but a reality that they are not really able to predict the consequences of their own actions within a dynamic and interconnected system.

I have also long highlighted the problem of the use of GDP figures, on the basis that they do not really signal anything of value in relation to the underlying health of the economy. All the figures provide is an illusory sense of comfort, in which borrowing by governments and consumers, as if by magic, is recorded as income. A typical example can be found for the UK on the BBC news website:

The National Institute of Economic and Social Research (NIESR) predicts that the economy returned to growth, bringing an end to the recession.

[and]

NIESR said the pace of growth appears to be increasing. It estimates that there was a 0.2% increase in GDP in the three months ending in November.

The fact that the 'growth' is accompanied by massive government fiscal deficits is not apparently an issue. I sometimes feel that I am repeating myself endlessly in highlighting this problem, but the trouble is that it will not go away. GDP 'growth' is widely believed to signify that an economy is moving in the right direction, and it is believed by policymakers, economists and (of course) much of the general public. Even as governments rack up ever more unsustainable debt, analysts scrutinise every minute shift in this largely useless metric.

There are many excuses made for fiscal profligacy made on behalf of governments. There is the idea of stopping a 'downward spiral'. The argument goes like this; if we can only spend enough, then we will put money in the pockets of consumers, and they will continue to shop, and continue to pay their mortgages, and this will halt the downwards spiral. The reason for the problem, which is that (in aggregate) nations were spending more than they were earning is ignored. The solution is, in the end, founded upon an idea that it is possible to borrow and spend your way to wealth. Note, not borrow to invest, but borrow to spend.

One commentator on the blog insists that government debt is different to personal debt. For example, the suggestion is that government debt is supported by the tax base, and the size of the tax base is large enough such that, if need be, the money might be repaid. This is the argument that government might put money in consumers' pockets to save the economy now, only to take more out of their pockets in the future. This will happen, of course, once the economy returns to 'growth'. The 'growth' that is created is, of course, the 'growth' created by government borrowing and spending rather than the kind of growth that will lead to exports and a return to current account surplus.

It seems that the policymakers recognise this, as lax fiscal policy is accompanied by lax monetary policy, including printing money. This serves to debase the value of currency, and allows for the (potential) rebalancing of trade, and the erosion of the value of debts held in the devaluing currency. It is the hope that governments might borrow and then stealthily default on the debt by reduction in the value of the debt. The fiscal stimuli act to tide the economy over and the intention is that the true value of the debt will never be repaid. As the country emerges from the crisis, as exports once again pick up, all will be well as the debt is repaid in currency that is devalued and export growth will pick up the slack.

That is the theory, but no policymaker speaks of it openly.

The problem is this; the policy can only work if the providers of credit are willing to be duped. That is the essential flaw in the policy. To date, the governments following this kind of policy have gotten away with it so far, and I am thinking of the UK and US in particular.

I have talked about the steady erosion of belief that is the foundation of these kinds of policies. It is the belief that the rich world countries will always be rich - that one way or another the wealth will always be there as if by some divine right. The rich world has always been rich, and always will be. This is simply a question of belief, and has no logical or empirical foundation.

Wealth is something that is created through hard work, dynamism, creativity and investment. It is achieved by out-competing the competition. There are many ways in which this might be achieved, but nonetheless, it is the bedrock of wealth creation. It is the aggregate of each individual's contribution within the economy to the creation of value.

What wealth creation is not is borrowing to spend, or creation of money with no foundation in an increase in output of value. Both of these are illusions of wealth, although the former might allow for a sense of real wealth for a while - if the country can get away with not repaying the money. As an analogy, we might think of a person borrowing to finance going on an expensive holiday. They really gain the benefit and enjoyment of the holiday whether they do, or do not, repay the loan that funded it. The fiscal profligacy of governments is providing the benefits in the hope that the full cost will never need to be repaid.

The problem is this; governments have promised their electorates that the 'holidays' are permanent, that we might continue with the lifestyles financed by borrowed money. Even as they are making such promises, they are quietly and surely defaulting on their borrowing. As I said earlier, the whole edifice rests upon creditors being duped. They must continue to believe that being paid in devalued currency is an acceptable deal.

The illusion really is coming to an end now and this is the reason for this post. The continuation of the policy maker's game all hinges on 'belief'. That belief is now being eroded as, day by day, more and more questions are being raised about what the policymakers are doing. The expression 'sovereign default' is appearing ever more frequently, and the policy maker's economic flim-flam is starting to be being seen for what it is; a fraud. I have just been reading the World Economic Forum's (WEF) report on the risks within the global economy. The following quote is of note:

The worst case scenario of overlapping economic recessions with political instability and social turbulence, triggered by untenable fiscal deficits and unsustainable government debt burdens, might not, after all, be impossible.

In their highlighted risks section, they say the following:

In response to the financial crisis, many countries are at risk of overextending unsustainable levels of debt, which, in turn, will exert strong upwards pressures on real interest rates. In the final instance, unsustainable debt levels could lead to full-fledged sovereign debt crises.

They express particular concern for the UK and US, saying that "Governments, in the US and the United Kingdom in particular, are now faced with a set of tough choices, all with consequences for future global risks." They highlight the increasing of structural costs, such as the ageing of populations, and the absolute necessity for credible plans of how the fiscal deficits might be reduced. They point out the problems with formulating such plans; that the politicians need the courage to tell their electorates of the tough choices.

Their assessment of risk in reality hinges upon the idea that countries like the US and UK are living beyond their means. They are borrowing more than they can repay, and the only way to resolve the situation is for the countries to live more modestly (if you can excuse the metonymy). In saying this, they are replicating the argument that this blog has made from the first post.

The WEF is not alone. Many others are expressing their concerns, such as Nouriel Roubini. In a recent article in Forbes, he says the following:

The severe recession, combined with a financial crisis during 2008-09, worsened the fiscal positions of developed countries due to stimulus spending, lower tax revenues and support to the financial sector. The impact was greater in countries that had a history of structural fiscal problems, maintained loose fiscal policies and ignored fiscal reforms during the boom years. Going forward, a weak economic recovery and an aging population is likely to increase the debt burden of many advanced economies, including the U.S., Britain, Japan and several eurozone countries.

Roubini highlights the risks for countries such as the UK and Spain for sovereign default, but suggests that the reserve status of the $US will allow it to be amongst the last of the 'at risk' countries to face 'investor aversion'. I am not so sure, but believe that, if a country like the UK defaults, the initial reaction will be to flee to the 'safe haven' of the $US, before a rapid realisation that this is jumping out of the frying pan into the fire.

Roubini and the WEF are just some of the increasing number of analysts who are questioning the activities of policymakers. The voices talking of the unsustainable deficits are increasingly loud, and they will be making an impact. The nerves of investors in sovereign debt will be jangling. It is no longer just bloggers such as myself who are raising these concerns, but commentators with high profiles.

In my mind, it is just a question of timing now. When will the dominoes start to topple? It is still possible, in principle, that crisis might be averted. It is possible that the policymakers will pull back from fiscal irresponsibility. It is possible, but looks increasingly unlikely. They have promised to 'save' their economies. The big questions now are the questions of when it will start, and what will provide the push.

Note: At the start of last year, I made a prediction of crisis for April, and was proved to be completely wrong. The underlying principles I highlighted were the same as here. Why might I be right this time, when wrong before? The problem in my first discussion was that, I had simply not factored in the strength of 'belief' in countries like the UK and US. A sovereign crisis requires loss of belief in the creditworthiness of the country, and that belief has proved to be far more resilient than I imagined. It is why I have emphasised the high profile of commentators who are raising the concerns. It is more difficult to shift firmly held beliefs than I thought, but nevertheless it is possible for belief to shift. I believe that the process is now rapidly advancing.

Inflation in the UK

The UK Economy

The doubts about the future of the UK economy have been multiplying of late, prompting one commentator to seek to defend the economy, arguing that there remain competitive advantages in the UK economy. Despite such positive framing of the discussion, the doubts still remain, as in the following excerpt:

That said, we are in a mess. In type, the position we face is not so different from the early 1990s, although the government's deficit as a share of GDP is going to be about double what it was then and the stock of debt is much higher. The UK's current account deficit, though, has not been as large, even when the economy was strong, as it was during the 1980s' boom, and it is now about the same as it was in the early 1990s.

Perhaps the most interesting news for the UK is that inflation is once again climbing. Input prices have been rising for manufacturers, and continuing weakness in the £GB will have an ongoing inflationary impact, much as I predicted long ago. This from the Telegraph:

The Consumer Prices Index (CPI) - the measure of inflation used by the Bank of England to set interest rates - was 1.9pc higher in November than in the same month in 2008. Economists had pencilled in a gain to 1.8pc. On the month, CPI climbed 0.3pc.

The Bank has already said that it expects inflation to breach its 2pc target and possibly rise as high as 3pc in coming months, as a combination of higher oil prices and the reversal of the cut in VAT - it will return to 17.5pc from 15pc on January 1 - push up prices across the economy.

Inflationary expectations are problematic for the Bank of England's policy of quantitative easing, as the threat of CPI deflation has been used as a fig-leaf for the policy. This report from AP:

"The MPC [Bank of England Monetary Policy Committee] has dished out many gifts to the economy throughout the year, so it was unsurprising that at its pre-Christmas meeting it thought it had done enough," said Stephen Boyle, head of RBS Group Economics. "These monetary policy presents, from low interest rates to quantitative easing, are gifts that will keep giving and will help get the economy back to its feet in the New Year."

Analysts now expect the bank to wait until its quantitative easing program, which boosts the money supply by effectively creating new money to buy assets, is completed in another two months before considering whether to expand the program.

"The scale of the program will be kept under review," the committee said. Detail on how the nine members voted will be revealed when the minutes of the two-day meeting are posted on Dec. 23.

The Bank of England's November inflation report makes interesting reading, with considerable caveats on inflation expectations. I will quote their discussion at length:

Inflation is likely to rise sharply in the near term, primarily reflecting the reversal of the VAT reduction, while sterling’s past depreciation continues to push up on inflation. Thereafter, downward pressure from the persistent margin of spare capacity is the dominant force. This pressure acts to bear down on CPI inflation, although it gradually fades as the economy recovers.

The extent to which CPI inflation will deviate from the 2% target is highly uncertain and depends on a number of factors. The degree of downward pressure from the weak demand environment will depend on the timing and strength of the recovery, the impact of the downturn on the supply capacity of the economy, and on the sensitivity of inflation to the degree of economic slack.

The profile for inflation will also depend on the extent to which companies need to adjust further to the higher import costs associated with sterling’s depreciation and on whether there are further substantial movements in energy and commodity prices. There is a range of views among Committee members about the relative strength of these factors. On balance, the Committee judges that, conditioned on the monetary policy assumptions described above, the risks of inflation being above or below the target are broadly balanced by the end of the forecast period. The outlook for inflation in the medium term is somewhat higher than in August, reflecting the stronger projected distribution for GDP growth.

Despite such caveats, the MPC chose to continue with the anounced asset purchases, otherwise known as quantitative easing (QE), or better described as printing money to purchase government debt. That this is a radical policy has been acknowledged by the Bank of England, and that it was to forestall deflation was the original purpose of the policy. The fig leaf of deflation is disappearing but the policy continues.

The problem faced by the Bank of England is a very basic one. There is a flood of government debt issuance around the world, and the UK is just one of many countries expanding borrowing at an astounding rate. However, as a county with one of the fastest rising government deficits, the UK is one of the higher risk governments for risk of default. Furthermore, the pre-budget report appears, as one commentator puts it, to rely on 'hope' for a future fiscal deficit reduction. The pre-budget report was widely seen as being wildly optimistic, and presented many fiscal holes, further eroding confidence in the UK:

Government spending on defence, higher education, housing and transport is likely to bear the brunt of sharp cuts planned over the coming years, the non-partisan Institute for Fiscal Studies said on Thursday.

The IFS estimated that based on Chancellor Alistair Darling's pre-budget report on Wednesday, departmental spending outside protected areas such as health, schools and overseas aid would fall by 5.6 percent a year between 2011 and 2014.

This would require 35.7 billion pounds of savings, equivalent to just over 1 percent of national income. Around 15 billion pounds of this had not been identified, the IFS said.

Moreover, 12 billion of the 35.7 billion pounds in savings are planned to be achieved by efficiency gains, despite evidence that three quarters of the efficiency gains claimed by the government earlier this decade were questionable or did not occur, the IFS added.

One of the most interesting reports is not directed at the UK alone, but is very applicable to the UK economy. Moody's is contemplating the impact of social unrest as part of the inevitable fiscal retrenchment that must take place in the 'stimulus' economies. The underlying point of the report is that there are doubts about whether governments might be able to press home any fiscal retrenchment, and such questions might be raised about the UK.

As if these headwinds against ongoing funding of government debt were not enough, concerns are growing about unfunded pension liabilities and the hiding of government debt through Public Finance Initiatives. These factors will no doubt be added to the mix when investors contemplate their confidence in the UK government.

As such, in an increasingly competitive environment for access to credit, the UK government looks to be uncompetitive. If the Bank of England ends the policy of QE, it is uncertain as to whether the UK can continue to finance the massive spending it has enacted. It is a question of who, in an increasingly competitive government debt market, might choose to fund UK fiscal deficits. There are no obvious contenders to absorb the record levels of debt issuance, and any pull back on Bank of England purchases might see the start of failed debt auctions. On the other hand, if the Bank of England continues purchases of government debt, they will support an unsustainable position, and allow government to continue with incontinent fiscal policy.

The Bank of England will be damned if they end QE, and damned if they do not. As the situation stands, the only foundation for confidence in the UK economy is the prospect of a change in government. However, the likely winners of the next election is the Conservative Party, and they are still holding back on plans that will substantially and credibly reduce the fiscal deficits. Hope for improved fiscal policy will therefore be a gamble for potential purchasers of gilts.

If the government fails to sell debt, then the crisis that will follow will be truly breathtaking.

On the other hand, if the Bank of England continues down the path of QE, the size and scale of any future crisis will be larger, as the government will be allowed to continue with irresponsible fiscal policy. Furthermore, with CPI rising, how long will it be before the fig leaf justification for QE falls off, leaving The Bank of England with no hiding place for their Zimbabwe like policy? As for reversal of QE, the selling of the Bank of England's gilt holdings, this appears as a very, very distant possibility.

The UK economy has been miraculously floating on air. How much longer it can do so largely sits in the hands of investor confidence in a future change of government, and with a change of government a substantive change in fiscal policy. As Liam Halligan, a Telegraph columnist puts it, current UK government policy is 'leading the UK down the road to sovereign default'. Can the UK economy float on air until the election? Such a hope is a poor foundation for an economy, but is all that supports the UK economy at the moment.

The $US - More Cracks in the Edifice

I would like to start this post with a quote:

The Gulf states remain divided over the wisdom of anchoring their economies to the US dollar. The Gulf currency – dubbed “Gulfo” – is likely to track a global exchange basket and may ultimately float as a regional reserve currency in its own right. “The US dollar has failed. We need to delink,” said Nahed Taher, chief executive of Bahrain’s Gulf One Investment Bank.

I seem to have been arguing a lonely position for a long time; that the $US as the world's reserve currency is fast coming to an end. As each month passes, the doubts about the stability and value of the $US multiply, and it is evident that some of the main actors in the world economy are starting the process of retreat from the $US. Whilst the move towards the 'Gulfo' does not constitute the end of the $US as a reserve currency, it is yet another metaphorical nail in the $US coffin.

My argument has been straightforward. A reserve currency must have a value created by wealth generation, and that issuance of a currency beyond the expansion in wealth generation will eventually see a retreat from the currency. This is what I had to say about the $US in August 2008:

As such, the dollar may rally for a while, but in the end it can only last for so long before economic reality trounces market sentiment. At some point there needs to be an economic justification for a stronger dollar, and force of habit is a poor justification.

In January of this year, I discussed the 'myth of the eternal status of the $US as a reserve currency'. I would recommend that you read the article, as it seeks to look at the underlying and fundamental reasons why the $US can not continue as the reserve currency. In an article for Trade and Forfaiting Review, I made the argument in a very simple and digestible way, saying the following:

Imagine a world in which there was no international reserve currency, but that an organisation was proposing that the US dollar ought to be the future reserve currency. Would you take such a proposal seriously?

Your response might be that the US dollar sits atop mountains of debt, a shrinking economy and you would point out that the US monetary authorities are printing money to fund record government borrowing. You might actually laugh at such a prospect.

It is very simple - if the $US were not already the reserve currency, who in their right mind would propose it as such? If the currency can not stand upon its merits, then there is only sentiment and habit as foundations. These are extremely fragile foundations for a reserve currency, and I would suggest are foundations that will not bear the weight of negative factors bearing upon the $US. The question is not 'if' it should lose the reserve status, but how quickly sentiment might shift. I once prematurely called the demise of the $US, and am therefore reluctant to place a firm date on the demise, except to say that it will be sooner than many people think.

Note 1: Sorry for the lack of response to comments, and also replies to my Yahoo email address. I am still pressed for time, but take an interest in all of the comments.

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.