Friday, September 19, 2008

Banking Crisis - More on Government Intervention

Another post, and I am afraid even more rushed as my 'real life' is rather busy at the moment. For the sake of my credibility, new visitors to the blog might want to read here first, as they will see that I have predicted the current crisis. You may also want to follow the links to key articles given on the left, once you have read these posts.

There is ever more fascinating news as the market has once again swung upwards in a fit of optimism. The reason for the optimism by the FT is as follows (not sure whether the link above to the FT will work):
'At the core of the plan is the proposal to create a government-sponsored vehicle loosely modelled on the 1989 Resolution Trust Corporation, which would take on the toxic assets in the financial system, allowing banks to stem their losses, recapitalise and return to business.'
The cost of the bailout for the US government, according to a Telegraph report, is up to $1 trillion, with Hank Paulson, the US Treasury secretary, suggesting that it would initially cost '$hundreds of billions' (see earlier FT link).

On top of this, short selling is now being banned accross stock markets. Happily, at least this rather silly action has received as much criticism as praise, so I will not add to the comments on this subject, except to refer you to my previous posts. Unhappily, the criticism is falling on deaf ears.

So what does this all mean? Has the financial crisis been solved? I think that, at best, the crisis is now on pause. The real difference here is that the nature of the crisis may have altered. I have said in my previous posts that the problem with such bailouts are twofold:

1. The bail outs are shifting the economic damage onto government balance sheets at a time when the governments of the OECD will need all the resources that they can get. As the world economy rebalances the Western governments will need to make structural adjustments to meet the challenges of the emerging economies, and the massive input of labour into the world economy that they represent. The bailouts will tie government finances in knots, and may actually precipitate a loss of confidence in the ability of governments to pay their debt obligations.

2. In taking on the damage from the financial system, governments are spreading contagion throughout the economy, including the healthy parts. This is due to the inescapable fact that, at some point in time, the healthy parts of the economy will be facing larger tax bills.

Notwithstanding the above two points, can it possibly work? The only way to answer this question is to look at what really caused the crisis. Most analysts now accept that the debt bubble that has been built up over the last ten years was wildly irresponsible (it is amazing how they are so clever with hindsight - those who have read my essay 'A Funny View of Wealth' and this blog will know that I am not talking with the benefit of hindsight). However, what the analysts have failed to understand is that the debt bubble has just been hiding the underlying structural problems in the Western economies. That is that their cost base is too high, and that their competitive position has been eroded by the massive entry of labour into the world market. What they do not realise is that the credit bubble not only hid the need for structural adjustment, but has crippled the ability of the bubble economies to make the changes.

The most worrying part of all of this is that, in the downward spiral, government finances in both the US and UK were always going to be in trouble, as I predicted in a 'Funny View of Wealth' as follows:
'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, they will be faced with ever more expensive borrowing, meaning higher interest rates, or massive cuts in public expenditure. There will be no room to manoeuvre. The only solution will be to cut back on expenditure. Continuing to borrow will be too expensive, and would destroy the value of the pound, as well as creating an even deeper crisis of credibility that the UK government can manage the economy. As the government is forced to cut back, many of the new state sponsored jobs that have been developed over the last ten years will start to disappear. This will not impact immediately, where funds have already been allocated, and contracts remain, but the process will accelerate over time. Some regions, such as the North East, will be hit very hard, as their economies are largely dependent on the state sector. ' (written in November last year)
I later suggest in another post that the UK will need to go to the IMF for funding (but recently have started to wonder who will fund the IMF?). I have noticed over the last few days that there is news that the deterioration of the finances of the UK government is accelerating. As an example, the Times report as follows:
'Fears that the Government’s finances will plunge into the red to an extent not seen for decades as the economic downturn deepens were fuelled yesterday as Treasury borrowing last month rose to the highest for any August in 15 years.

Borrowing by the Chancellor, to plug the gap between still fast-rising government spending and faltering tax payments hit by the downturn, jumped to a net £10.4 billion for last month – the highest August figure since 1993 – official figures showed.

The worsening state of public finances was emphasised as the latest leap in borrowing raised the Government’s deficit for the first five months of this financial year to £28.2 billion, up from £16.5 billion for the same period last year. It is a record for this period in any year since the early 1990s.

City economists sounded warnings that if this pace of deterioration were to last for the whole of the 2008-09 financial year, then Alistair Darling would see his borrowing soar to between £60 billion and £70 billion – above his planned total of £43 billion.'

Addition added after the original post but same day as original:

I have just read a fascinting and disturbing (but unsuprising) article in the Spectator regarding PFI:
'How did it come to this? As trauma continues to course through the global financial system in the wake of the Lehman Brothers crash, the PM and his colleagues reassure us constantly that Britain is ‘well-prepared’ to withstand the shock of economic crisis. In fact, the opposite is true. It is a basic principle that most governments, even socialist ones, pay off debts in times of prosperity. Mr Brown’s innovation was to reject this tradition. Since Labour came to power, the national debt has risen 25 per cent to £581 billion. During the second it took you to read that last sentence, it rose by £1,520 — and that’s by the government’s more optimistic measure. This figure does not include the layers of hidden debt, or the various IOUs made out in convoluted ways on behalf of the unsuspecting British taxpayer.' [referring to PFis]
'While this will help make an important post-election point — the malfeasance of the Labour years — it carries an obvious risk. Should Mr Osborne pull all the pieces together and take all PFI on to the books, the new Tory government will have to disclose to the public a debt burden higher than seen by any administration since Britain had to be rescued by the International Monetary Fund in the 1970s. Confronting such debt will deny him any room for manoeuvre.'
The article calculates national debt at £26,100 for each British household. I strongly recommend that you read the article in full. I pointed out the danger of the PFIs in 'A Funny View of wealth', and I think in later posts too. This article puts some meat on those bones, and explains the scope of the problem (I believe I used IFS figures that were out of date when I looked at this, and the situation has become far worse).

Original post continues.....

My worry is that these figures are conservative [not the Spectator - original post]. For example, I have seen the predictions for UK GDP growth in the Economist magazine poll of economists drop, point by point, as the current crisis has emerged. In other words the economists have still not grasped that we are in a game of financial Kerplunk, where each day a straw is being pulled, and each day that passes brings us closer to the marbles falling down. They have not understood that all of the 'economic growth' of the last ten years is built upon debt, but not that the UK economy (and the US) need to jump back in time such that the economy will return to the size of 10 years ago. However, that is not the end of the problem.

The environment of today is more competitive due to the emerging economies, and the massive pool of labour (in conjunction with capital and technology that they represent). Furthermore, the government has taken on ever more debt, and the ability of the UK economy to service that debt is built upon the current (misunderstood) level of GDP. The illusory growth is now being seen as such, but the implications are still not understood by mainstream economists.

At this point, we need to play a game of 'what if...', in this case 'what if we had never had the housing and credit bubbles?' Such 'what if' scenarios are always dangerous as an illustration of a point, but I hope that you will indulge me on this.

The first point to make is that the massive expansion in retail and service industries would never have occured. Without the financing of the credit from the East into government and consumer debt, the economy would have stagnated, unemployment would have risen, and the UK would have probably fallen into recession. Government spending would not have ballooned, as the government could not have afforded so much growth without massive increases in taxation, and the rise in the living standards of the ordinary people of the UK would have stagnated. The increase in house prices would never have happened. The massive boom in imports would not have happened, the boom in the city would never have happened, the value of the £GB would have gradually fallen back, thereby slowly correcting the imbalance between the UK economy and the emerging economies, though a fall in the value of the £Gb would have literally meant that each person in the UK would have been progressively a little poorer. The result is that the entire cost structure in the UK would have gradually rebalanced to reflect the new economic conditions of increased competition in the world. It would not have been a pleasant experience, as no one wants to become poorer, but it would have been unavoidable.

This is the scenario of what 'should have happened' but how the government might have reacted to the scenario is an unknown. When we think of the economy without the credit boom, it becomes apparent how bad things are now. However anyone tries to pitch it, when we take away the growth in debt, there is little left but pain. The difference between the scenario I have given now is that the credit bubble has happened, and it has left the UK and the US economies in a terrible position where they are really unable to make the adjustment as, on top of what was always going to be painful, they have the additional strains of their massive indebtedness built upon false confidence in the ability to repay, and economies that are day by day shrinking back, such that they become ever less able to repay.

When we bear all of this in mind, the bailout of the financial system looks ever more foolish. The US govenrmnet is not just bailing out US investors and the US banking system, but the entire world banking system. Quite simply, the US can not afford to do this. As I have said before, the governments of the US and UK desparately need to gather what resources they have left, massively cut back on expenditure, and set about the reform of the structure of their economies. The US (and to a lesser extent the UK) still thinks it is the financial giant responsible for the world economy, and that it's role in staying on top is to manage the world economy. This is delusional. It is built upon an assumption that it has a right to wealth, that it has a natural place at the top of the economic tree. This is a point that I made in one of my early posts in reference to the UK. I had this to say:
'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''
The simple truth in all of this is that wealth is not a right, but something that must be earned by competingly effectively. That can be achieved by working harder, or working smarter. It can not be achieved by just expecting it as a 'right'. We have, for so long, been the only players in the game we have forgotten what it is to compete, and we have seen the emergence of strong and agile competitors for which we are completely unprepared. Had we faced this competition ten years ago, we could still have emerged as strong players in the world economy. Instead, we faced the competition with complacency and so now face stronger competition with one hand tied behind our backs.

I have suggested reforms to the structure of the UK economy (see links top left of the page). In light of current events, perhaps these are too mild and in any case still may be unaffordable. I can only reemphasise yet again that deep structural reform is the only way out of the current mess. Bailing out the financial system will just make the reforms ever more difficult.

As for the upsurge of optimism, historians who have studied the Great Depression will tell you that there were similar false dawns at that time (sorry, no time to reference this). As such, as for the last upswing in confidence, I will repeat what I said following the nationalisation of Fannie Mae and Freddie Mac:
'It will be interesting to watch the reaction to the nationalisation in the coming weeks. I suspect there will be a brief bounce in confidence, but that the underlying economic problems will quickly dent that confidence. The trouble is that there is no escaping the reality that there must be a massive rebalancing in the world economy, and no amount of intervention can stop that process. In such circumstances, it is quite possible that, in the long term, such bailouts will only create more pain than gain.'
In other words, we are back to waiting to see when sentiment will once again turn, as the reality of the situation intrudes on the optimism. I keep asking myself when will everyone wake up to the fundamentals of the problem???

Note: I forgot to mention. Goldman Sachs appear to be next in the firing line. Will the ban on short selling save it - I think probably not, but do not pay that much attention to the condition of individual institutions.

Note 2: On rereading this post I see I have once again jumped about in the post, moving from the very general, to the specific to the US, to the specific for the UK. I hope you will forgive this stylistic blundering, but my 'real life' is making demands, such that I do not have time to correct this. I hope that the post is still clear.

Note 3: I forgot to mention. One of my original intentions in this post was to highlight the absurdity of one individual teetering on the edge of bankruptcy lending to another person teetering on the edge of bankruptcy. Would it not be better for the individual to use the remaining lines of credit to buy time while they sort out their own financial problems?


  1. Mark

    I'm very glad you're posting more than usual at the moment. The implication on Radio 4 this morning is that "it is all over". The headlines say that the US is going to quarantine all the bad debts in one organisation, and sell them off in the distant future which, to the casual listener, sounds like "decisive action" and almost plausible. Ken Clark says there will be "some downsides", but at least "people will always trust the dollar", so it should hold its value. (Is the US dollar going to hold its value? Surely not.)

    I'm trying to work out what it all means! Being a bit of a devil's advocate throughout the following comments, is it possible that although the US has been living beyond its means for decades, it has somehow "got away with it"? Ron Paul thinks that:

    "The central banks of the world secretly collude to centrally plan the world economy. I'm convinced that agreements among central banks to "monetize" U.S. debt these past 15 years have existed..."

    Aside from external debt, does a country's internal debt matter, anyway? If most of the bad debts which are being monetized were as a result of over-inflated house prices it won't matter if they vanish into thin air, will it? It's just good for some people, and bad for others, with a net result of zero. (People spent money on imports with the dollars they raised against their houses, however, but more fool the foreigners who were taken in and who exchanged real goods for worthless paper.)

    Is the same true for derivatives 'de-leveraging'? That is, if the debts and 'assets' had never existed nothing material would change?

    At the end of the day, if the world's economy was 'reset', we would still have the same level of prosperity we have today, wouldn't we? There would still be the same natural resources, the same number of people with the same talents, and the same infrastructure. The financial system has got itself gummed up, and technically some people have enjoyed a standard of living they did not deserve, (financed by others who were seemingly happy to pay for it) but if the whole world can see that by insisting on following through on every failed loan and transaction, that it drags everybody down into the mud, it might be best to 'start again' and reset the mechanism. Sure, some people in far away lands are owed some money for past productive activity, but even they might see that they must 'let go'?

    Is this the logic that has led to the US dollar being artificially propped up by the world for years, i.e. that it is better to keep the mechanism running, even if it results in undeserving people living in luxury, than for the mechanism to grind to a halt. Have we reached the stage where it is impossible to keep the mechanism running whatever we do, so more drastic action is needed?

  2. ...And if there is any logic at all to my previous ramblings, it might then lead on to the suggestion that if a shadowy, sinister organisation had wanted to engineer a 'New World Order' they might be about to achieve their goal.

    Just kidding, I think...


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