Tuesday, June 17, 2008

So what of the UK economy now?

If you have not read my previous essay (A Funny View of Wealth), you may want to take a look. I painted a pretty gloomy picture of the UK economy back in November, and much of what I predicted will happen seems to be correct. For example, the Polish migrants are going home, and house prices are collapsing.

Have I changed my mind at all? Do I stand by my previous predictions? Sadly, the answer is 'no'.

I say sadly, as I am now of the belief that my (very gloomy) predictions were actually too positive. Even as I have witnessed all of my predictions being correct, I have felt like a dismayed onlooker watching the progress of a car crash. Whilst my rational mind is observing, my emotional self simply can not grasp what is happening. Basically, like everyone else, it is very hard for me to accept that the severity of this economic crash can be as dramatic as it will actually be. Whilst reason says that this is going to be a disaster, the underlying belief that the UK economy can't just collapse still persists. After all, the UK has had crises before, and always returned to wealth and growth. Surely it must?

I read a very interesting example of this kind of thinking when I was reading some philosophy of science (sorry, I forget where I read it). The example given was a chicken that woke up every morning, and every morning the farmer fed the chicken. As a result the chicken believed that the farmer was a good thing - right up to the point where he chopped off the chicken's head. In the same way we have come to believe that the UK has some right to have the status of being a wealthy and successful economy. It always has been in the past, so why not now? The truth is that a successful economy is not a 'right', but something that has to be earned.

The trouble with the UK is that we expect wealth as a 'right'. It is this same thinking that has infected my thinking, and stopped me from considering the depth and severity of what is now occurring in the UK economy. In my essay, I suggested that the gains in GDP over the last 10 years will be lost, as the UK economy shrinks. However, I now think it will be far worse than this.

In particular, the problems with credit and the banks are going to reach their real crisis in about six to eight months time. The reason is that the fallout of the sub-prime fiasco is just the start. The next phase will be the consumer credit crisis and the SME crisis - and the results will be equally as dramatic, but with the added pain of hitting the banks when they are already suffering severely.

So what are these crises. The first is that consumer credit was already reaching breaking point, where many households were borrowing to repay borrowing. This was, in any event, unsustainable. Added to this factor, the story of inflation needs no more retelling. Finally, we have the spectre of rapid increases in unemployment, and it will be this development that will spark the second banking crisis. In particular the number of delinquent loans will start rising rapidly as unemployment increases, and accelerating concerns about the already weak balance sheets of the banks will see even greater tightening of credit conditions. Furthermore, unemployment will see even more mortgage defaults, and the banks will be trying to sell assets into a falling market. Quite simply, their losses are going to be staggering.

The second problem will come from the Small / Medium size businesses. As the economy turns down, think of the small traders - such as restaurants, who are already only marginally profitable. These will rapidly fail, in many cases leading to losses for the banks. Even the medium size companies, with a better financial base, are going to be negatively effected by the consumer downturn, and their failures will hurt the banks even more.

Remember that these problems are going to hit the balance sheets of banks when they are already tattered, and hit the reputation of the banks when their reputations are at a low.

This, in some senses, is stating the obvious. However, what is not obvious (apparently) are the points made in my essay about the money-go-round that has been the base of the UK economy. It is the lack of any fundamental strengths in the UK economy that will make the difference. It is like the game of 'Kerplunk' where, when you pull out enough straws, the balls come crashing down. Right now, the straws are being pulled.

So what now? I guess, wait and see. The only thing I think I would suggest is to make sure that any savings that you have are not in one bank, or one organisation. There are likely to be a quite a few bank failures, with the risk commencing in about 6 months time. If the disaster has not happened in a year, then we can start smiling again.

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