Saturday, September 20, 2008

US Government Guarantees a Crash

Update: 23 Sept. Just a note. It seems that the bailout will be financed through borrowing, which is a relief. Better that than just printing money. However, not bailing out the system is the best option, but at least this is better than the worst case.........

I have had a comment in which one of the regular commentators (Lemming) on the blog has played devil's advocate, and put forward an argument that the bailout is the right thing to do. This is the argument put forward:
'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?'
The first point to make is that it is now apparent that the 'rescue' of the financial system will be financed through monetisation ('printing' money), not through government borrowing . This approach will have very serious consequences for the US and world economy.

The first problem this presents is that it will destroy confidence. I have discussed the importance of confidence in a fractional reserve banking system elsewehere in the blog. The important aspect of the post is that in a system of fractional reserve banking is that money in such a system has no value whatsoever except what we collectively believe it has. By printing money in this way, the US will certainly destroy confidence, as there appears to be no limit on what the government is willing to print.

The result of this unconstrained printing of money is that the $US will fall. This is very different magnitude of fall compared to that which would occur has the US government decided to finance the bailout through borrowing. In the latter, the bailout would be funded by the US taxpayers, but in the former the pain is shared around the world by all holders of $US assetts. This may appear to be a clever move, as it shifts the burden more widely, and moves some of the pain to the rest of the world. However, the price will be high for printing money (see article here for an example - though the article does not give a picture of the seriousness) .

As I have already mentioned the entire banking system rests on confidence, and this is a fragile base for a financial system. If you destroy confidence, money has no real value whatsoever, and this is the problem of removing a currency from exchange for a tangible asset such as gold. If you give me $1, I will only value it if I believe that the next morning I can still use it to buy the same amount of product as I could today. If I no longer believe in this, and it is just a matter of belief, then I will not accept the $1 that you give me and will want to be paid in some other way. If a government can print money with no constraint, and with nothing to back it, then I will cease to 'believe' in the value of money. The best way to understand this is to take a look at my original post, where I make a comparison between the virtual world of 'Second Life' and the real world. When you see this comparison, I hope that all becomes clear.

This is a very roundabout way of coming to the subject of the foolish foreigners who have exchanged goods for worthless paper. Yes, this is quite right, they have done this. Yes, they have been foolish to do so. However, the system is built on trust (confidence), and those foolish foreigners will learn their lesson. That is, they will no longer trust that they will ever be paid for what they provide, or at least they will lose belief that they will ever be paid in full. This means that the TVs, the toys and all of the other imports that the Western consumer has been able to buy will only be available with a massive risk premium attached to their price, as they will have no confidence that the $US they get in return for their product will be worth the same tomorrow as it is today. I talk about this as if individual firms will take this approach, but in reality it is the collective loss of belief that matters.

What of the idea that if everything is reset, we still have the same amount of resource, the same people and the same infrastructure. This is very true, that nothing has changed 'on the ground', except for confidence. It is here that we return to the massive accumulation of debt in the Western economies. In a situation of loss of confidence, who will keep the lending going? Who will lend into currencies that are devaluing, and at what risk premium?

The trouble is that when the debt ATM is shut down, how much is all of the talent, infrastructure and so forth really able to produce? Can it produce enough wealth for Western consumers to buy the latest shiny plasma TV from a Japaense company manufacturing in China? In other words, are the Western economies producing enough to have sufficient product/services to exchange for the shiny plasma TV? The answer is that most of the Western economies have not been producing enough for a very long time, and that the continued lending was built upon a false belief that they were. Once again we come back to the idea of confidence and belief. I return here to my analogy of the aristocrat who lives beyond his income, with all of his creditors lending on the basis that the aristocrat's family always having been so wealthy for so long that they just can not believe that in reality he is broke.

The reality is that the majority of the Western economies are just not producing enough value to continue to live in the manner to which they have become accustomed. We are, in reality, broke and in debt. No one is going to lend to us, and we now have to adapt to living on the value that we really produce.

Yes, the world has kept the West living in luxury, but it has been no conspiracy. It is, as I have said earlier, that the world has just 'believed' that the West was rich, and always would be. The world is waking up to the reality, that when they lend to the Western economies, that the Western are unable to produce sufficient goods and services to pay back what has been lent or, put another way, the West is unable to produce sufficient goods or services of sufficient value to make trading with them on todays' terms worthwhile. That means that the terms of trading with the Western economies will be more realistic, and that means the value of currencies must fall - and fall by a huge amount. There is no possibility of resetting the mechanism, because the mechanism was never a deliberate policy, but was built upon a collective delusion.

What can be done? What drastic action can fix the problem?

The answer is that nothing can be 'done'. Printing money will only exacerbate the problem, fuelling hyper inflation. For the Western economies, such as the UK and US, they will simply have to adapt to living within their means. The welfare states, the health services, the wasteful use of money by government will all be unsupportable. The massive boom in services, the expensive restaurants, the crystal healers, the retail expansion - all of these will shrink back to a sustainable size to reflect the contraction of the economy as the debt ATM shuts down. The result will be massive unemployment, unemployment on a scale that we have never imagined. The foreign investment will dry up completely, the cost of all the imports will surge, as well as the cost of commodities.

I have previously suggested that inflation would be held back by the rise in unemployment, that costs in the UK would be held down and that this would counter the worse effects of devaluation. I no longer believe that will be the case, as I now believe that the currency collapse will be so severe that massive inflation is the only outcome. I wrote a couple of months ago that it was hard to believe the logic, the inevitability, and the severity of what is coming. I suggested that I had been too conservative in my predictions, that it would be worse even than I had suggested in 'A Funny View of Wealth'. Now, as we stare over the precipice, the distance to the bottom is becoming ever more clear, and it is a very scary thing.

As I sit in my comfortable home, enjoying the comforts of the Western lifestyle, it is hard to imagine that it is coming to an end, but it is. In my case I am hoping that I have taken a course of action that will insulate me from the worst of what is to come (at least for three years), but I worry for those who will be exposed to the full force of this economic hurricane, and wonder how the world will look in two years time.

I suspect that it will not be a pleasant sight.

Note 1: Lemming also posted a link to a very interesting site. I strongly recommend it to all the readers here. It includes articles by Ron Paul, and for readers of this blog in the US I would strongly recommend Ron Paul to you. He appears to be the one potential leader who understands the situation, and knows what to do. Quite simply, you should be begging him to run for president, though sadly it is probably too late. In the UK I see no such potential leaders, and that is a very worrying thing.

Note 2: I have just taken a look at the Sunday editions and found the following:
'After a week of unprecedented financial turmoil, they predict that government borrowing is about to surge as the Treasury’s tax take is slashed by a slump in earnings from the City and the downturn.

Leading forecasters say the government will soon be forced to borrow as much as £100 billion a year, giving Britain easily the biggest budget deficit of any western country'

This is exactly as I have been predicting, though I still believe that this is conservative. It is time for structural reform. The UK can not afford to go on as it is. If you are new to this blog, take a look at the links at the top of the blog, where I outline some solutions. If you like them, recommend the blog to others, as the purpose of this blog is to try to make a small contribution to the realisation that reform is the only way through this. If we do not accept this king of reform, the alternative will be more government 'solutions' and it is the solutions of the government that led us to this crisis.

Yet another note: I have just taken time to look at the Sunday edition of the Telegraph and the coverage of the crisis is becoming ever more gloomy. A good example can be found here (I use the word 'good' very loosely):

'Power has tangibly shifted - away from the United States and the Western world generally, and towards the fast-growing giants of the East. That's been happening for some years now'

The article in question goes on to say:

'How much more can the US taxpayer take? It sounds insane, but the liabilities being taken on by the Fed and the US Treasury are now so enormous that the government itself could default. No?'


'But the ultimate financial question - until recently, unthinkable - is now being asked. Yes siree, the mighty US government could default. That's how much the world has changed.'

At the moment it is the US that is take the brunt of the pounding. However, the UK economy is far, far weaker than the US economy. I do not mean in terms of what has been taken in the past to be strength and weakness (see 'A Funny View of Wealth'), but underlying strength. We are more indebted, and lack any clear competitive advantage in most sectors. If we look at the pain of the US now, we need to multiply that pain for the UK.

In another article, it appears that the FSA is trying to find a buyer of B&B. The death roll of several UK banks is starting, but expect an acceleration of the pace, as everyone now examines the state of even the most 'sound' and largest banks.

It seems that we are now entering the final stages of the beginning. In this case, the beginning is the destruction of the economy of the UK. This is the shock of the crash. I am not sure how longer this phase will last, as there may be some more false dawns, but suspect that it will just be one or two months at the most. The time scales are very much in line with myprevious predictions on this blog. As I have repeatedly stressed over the last few months, make sure that you have your liquid assets ready to move at short notice. Ensure your accounts have Internet access and, at the first sign of rumour, move your money to another account. Be careful of using the same bank but with different brands.

After the crash will be the shock. The shock is when we contemplate the financial ruins, and see the bankruptcies multiply accross all of the economy, and unemployment sky-rocket. The outstanding questions will be the final order of the collapse. Will it be national debt default, or banking collapse, or both in conjunction. Both will happen, so it is not clear that one order of disaster is better than the other. It is only to be hoped that it all happens sooner than later, as the longer the delay, the more foolish action will be taken to avert the crisis from government.

I think I mentioned in a recent post that I am shocked at the panic. As I said, I thought others would watch dispassionately as all this occured. On reflection, I can see that it is only that this is no surprise that allows me to see it as an inevitable unfolding of events. I watch as the panic unfolds, and can imagine the late night meetings in the government as they desparately seek a solution that is not there. The momentum is now going to carry the crisis forwards, whatever they do. Instead of panicked meetings, I can only hope that someone is thinking through the aftermath, and asking how to pick up the pieces. I have always had this in mind as I have written this blog.

This is my last note today, as it is all rather depressing to think about.

(all notes written on day of original post)


  1. All very depressing......

    You state "In my case I am hoping that I have taken a course of action that will insulate me from the worst of what is to come (at least for three years)". The way you are predicting things would there be any protection.

    For my own part I am moving around what assets I have to make the majority in cash (albeit retaning some shares, ever the optimist! and a small amount of gold but I had also been considering government bonds but given you gloomy predictions not sure how wise that would be?

    Would be intested to hear how you are approaching what you hink is coming

  2. Concerning this idea of a "bad debt bank", as a simple country boy, I don't see how it works. If the said bank buys the regular banks bad securities at, say 60 cents on the dollar, the regular banks will have to declare the losses. They will therefore simply move from the category of "maybe bankrupt" to the category of "clearly bankrupt"
    what happens then? Or am I missing something?

  3. Unfortunately I have to agree with the entirety of your post. I wonder what jobs will be available in the future - Do you have any views on this? I can imagine domestic support for food production and some basic manufacturing but who is going to be buying high end electronics or will pay for frivolous extravagances like the NHS? I suppose you can think of top-level professions as being highly leveraged. There are many levels of dependencies beneath them (like a house of cards) and they are particularly susceptible to any failures in their support.


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