Monday, October 20, 2008

Economic Crisis - The Eye of the Hurricane before the 'Service Economy' Collapses

It seems that we have now entered a period of relative calm, following the storm of the bailout. For a while, following the Bernanke promise of yet more support for the finance system, stock markets rallied, only to later wobble on bad economic news. This is now becoming a pattern, where governments take action, markets have a fit of optimism, then the real economy offers bad news and pulls sentiment back down. In short, governments are pouring liquidity, guarantees, and borrowed money for short term bounces in confidence, completely ignoring the possibility that the underlying economy is in deep trouble.

I have spoken about the fact that GDP measures have been inaccurately measuring economic growth previously. I think it may be time to return to this theme, and take a look at why there is no escaping the simple fact that the US and UK economies must contract by such a large amount. Below is a chart of UK GDP growth:

And additionally a chart for US and Canadian GDP Growth (it includes Canada because this was the first good chart I found):

So now we have one side of the equation. What of the increase in debt? First a chart for the UK and US as a percentage of disposable income:

And now a chart for the US of absolute debt (the UK would look a similar shape):

My apologies for the variable sources for these charts, but I hope you can get a feel for the situation from these (I am rushed so just did a Google image search - I usually use the ONS but do not have the time to find the section). I did have a very good chart for the UK which shows that there has been a close correlation in debt growth and GDP, but have been able to dig it out again. However, if you review these charts, you will see that there during the recent boom, there has been a massive growth in debt. Like any figures that correlate the charts do not prove causation of GDP growth, but causation becomes more likely if there is an explanatory mechanism that can be identified.

So how can the increase in debt translate into GDP growth. I have discussed the multiplier effect, and also illustrated examples in 'A Funny View of Wealth'. The principle is very easy, and I will use the example in 'A Funny View of Wealth', as follows:

If we go back to Mr. Smith in the restaurant, we can see that he has borrowed money to finance his restaurant visit. In doing so he has decreased his wealth in order to fulfil a short term need. This is, partly, what wealth is for, but this is Mr. Smith’s future wealth that he is spending. This borrowed money that Mr. Smith has spent in the restaurant will then recycle throughout the economy in many ways. The restaurant owner will be a little wealthier, and will then spend some of the money on buying goods and services, the restaurant staff likewise, and so on. Furthermore there will be suppliers to the restaurant who will also be beneficiaries of the spending of Mr. Smith, as his consumption of foods will mean that the stock will need to be replenished, and the process of cooking will require energy, and some of his money may contribute to decorators, maintenance people and so on through all of the restaurant support services. We can then see the same process with each of these support services spending their small share of Mr. Smith’s transfer of wealth in a host of different ways, each further helping to support another layer of businesses.

It is only when we look at lots of versions of Mr. Smith, all borrowing money, all of which dissipates through the economy in a myriad of ways, that we can see what a dramatic effect this has on the economy. Throughout the UK economy there are millions of people who, just like Mr. Smith, are reducing their future wealth daily through the borrowing of money. Each of these individuals supports a multitude of businesses through each of their purchases of goods and services. This massive dispersion of borrowed money is financing large numbers of businesses, and the transfer of their (future) wealth that occurs is apparent in what appears to be a booming economy.
The reason why I am returning to this theme is that I have, on several occasions mentioned that the way that GDP is measured is flawed. In the case of borrowing, it can either be an internal transfer of wealth from within a country, or it can be from outside of the country. Much of the borrowing in the US and UK has been funded from overseas. Each time a person goes into a restaurant, or buys something on credit, there is a transfer of wealth out of the country, and a foregoing of future wealth. I will return to 'A Funny View of Wealth' again:

What if the money that provides the loan has been borrowed from outside of the UK, and the UK bank is effectively the ‘distributor’? In this case the transfer of wealth from Mr. Smith will go to the restaurant, the UK bank and the foreign bank. In this case, there has been a real transfer of wealth from Mr. Smith in the UK to the overseas bank that provided the finance for the credit. There is therefore a transfer of real wealth to the country of the overseas bank.

It could be argued at this stage that the overseas lender only has a very small amount of the total transfer of the wealth, and that the majority of the wealth goes to the restaurant owner. This is largely correct. However, depending on the status of the individual and the type of loan, the final interest that is paid on the loan might actually be very high, and translate into a large sum of money over the period of the loan. Some of this interest is profit for the UK bank, and some of the interest is profit for the foreign bank. If we say Mr. Smith is an overstretched credit user, with a moderate credit history, and give him a £500 balance on this credit card, an 18% interest rate, and ongoing minimum payments of 5% of the balance, this £500 will cost Mr. Smith a shocking £214 over the life of the loan. This is not an atypical profile for a heavy credit card user with a moderate credit history, but better and worse examples can be created in any number of permutations. In this case a £50 meal will see a transfer in wealth of £21 to the banking system from the restaurant goer, a significant loss of wealth to the individual, and a significant transfer of wealth to both the UK bank and the overseas bank. Different profiles will produce different results, and the example given is just to give a sense of the potential scale of the transfers. In this case we might hazard a guess that Mr. Smith has just transferred as much as £8 of his wealth to another country, in order to pay for a £50 meal, a meal that might otherwise have seen no transfer of wealth outside of the UK.

This is a very expensive transaction for both Mr. Smith and UK Plc, and has a negative impact on the overall wealth of both.
Despite this, the example of Mr. Smith above will be seen in the UK GDP figures as economic growth. My purpose here is not to recycle the original essay (which I recommend reading if you have not done so).

I have also not covered government debt in the charts, as you will all be aware of the growth in debt over the last few years, and this also creates a multiplier effect once it enters the economy.

The key point here is that the GDP figures do not reflect the reality of real growth in the economy, but growth in debt. If you factor in the multiplier effect, then it is even possible that the underlying growth of the economy might even have been negative. This is why I am predicting that the economy will have to drop back at least 10 years in growth terms, but quite possibly a lot more. As I have pointed out several times, the world was a kinder place for the West 10 years ago with still relatively little competition from countries such as China.

I thought I would add this post because the symptoms are now apparently arising from the disappearance of the debt based multiplier effect. Whilst the economy has been sliding very fast towards collapse, the first signs of spinning out of control have appeared. One of the first elements to go when consumers tighten their belts is discretionary spending. This means meals out, leisure activities of all kinds, and taxis in particular might be seen as the 'canary in the mine'. The reason for taxis being of particular interest is they are a particularly vulnerable form of discretionary spending, as there are always alternatives (albeit less convenient) to their use. They are also widely used in the evening, and are therefore a good symptom in the slowdown in leisure spending, such as restaurants, bars and nightclubs. Whilst there has been plenty of 'bad news' on consumer confidence and spending, I was struck by an article in which sales of new London black cabs are described as 'tumbling'. Whilst mainstream economists look to other (often abstracted) barometers, I am always looking for these kind of signals, as taxis are such a good barometer of spending behaviour. This example only applies to the UK, but the UK and US are going through a parallel process, so it might also be suggestive of the US position in the crisis.

From here we come to the real point of this post, the destruction of the service economy. Other articles are also starting to tell the tale (though the black cab story is the best illustration). For example, in the headlines today, there are calls for a fund to help small business survive the bad times, and another commentary is highlighting the plight of small businesses. Small business is at the heart of the service economy, and these businesses will be the first to really feel the pain. We should also remember that many of these small businesses will show a time lag before they start to appear in the bankruptcy figures. Again, the black cab story suggests that the we are now at a point where the pain has really kicked in. It is sad to say, but many small businesspeople will now be facing the hard fact that they are in deep trouble. The sole traders, and other small business people, are probably already appearing in the unemployment numbers, but the drip of new claimants will very shortly become a deluge.

If we strip out the debt led growth of the last 10 years, then the scale of the coming carnage in the economy becomes painfully apparent. Quite simply, most of the economy has been supported on a life support of debt, and now that life support has been switched off, we can start to see what will happen next. As I have said, the black cabs are the canary in the mine and we can now expect bankruptcy figures to soar.

Meanwhile, in the US, reportedly they are pressing Fannie Mae and Freddie Mac to boost lending, in a desperate attempt to regain credit driven growth. The same will happen in the UK, and there are already, for example, reports that pressure and/or legislation will be put in place to slow down the mortgage repossession process. We can expect to see more and more of such measures in the coming months. However, all they will do (at best) is create further losses for the financial institutions, and in many cases that will mean losses for governments.

Meanwhile, as time progresses, the fiscal position of both the UK and US government will deteriorate very rapidly, as the full savagery of the crisis are unleashed in the service sector. I am taking the black cab story as the signal that a new phase is starting in the economic collapse. I predicted the state of the economy as it now stands, as an ever faster downward spiral. I recently identified that all of the elements of the collapse were in place. I think that we are now about to see an even more rapid acceleration. The unemployment figures are going to rise at an ever faster rate, along with a massive rise in government expenditure, and government receipts are about to fall through the floor.

As such, I am very sorry to say that we are moving on track for the first government credit crisis, which I predicted a couple of weeks ago (as coming within three months). I suspect that the UK will go first, as the position in the UK is far more acute, and the US will follow shortly after. At the moment, the pattern of disaster is starting to emerge into reality, just as it did for the bank failures. Just as when I predicted the bank failures, the failure of (at the very least) the UK government is now probably irreversible. There was a brief period during which they could have built a buffer of confidence for creditors with a tough program of reform, but I believe that the moment has passed and the course is set.

At this stage, you might consider that this a fairly extreme analysis from the news about purchases of new taxis. However, if you think about the behaviour of your friends and family in their use of taxis, you will see why this is such a stark warning. If the money is drying up in the taxi business to this degree, then the rest of the economy is very likely freezing very fast.

Note 1: I have had an intriguing post from a regular commentator, who posts under the name Lemming. Lemming had the following to say:
Are you absolutely sure that our creditors will be turning the taps off any time soon? Is China, in fact, happy to fund our lifestyles indefinitely so they can simply 'buy' the West in the long term? To me, that sounds like a perfectly rational explanation, and Western politicians who espouse globalisation would be more than happy to facilitate it, I imagine, even if they were unaware of exactly what they were signing up for.
I have to admit, this a fair point. If China keeps lending, they will gain formidable economic power in the long term. As such, it is a very real possibility, and I can not discount that this might be a reason for continued lending. However, as China slows down, they might need to start to redeem some of that lending in order to support their own economy through the crisis, and will want to use whatever resources for that purpose, restricting their ability to lend. In this situation, depending on what happens with the Chinese economy, they may not have the option of continued support for the West. Another commentator kindly posted the following link, and I will repost it here as it applies:

Note 2: Another poster has kindly posted a link here. It makes interesting reading, in particular the article of 1998, financial capitalism vs industrial capitalism. I recommend it to all readers.

Note 3: Jeremy commented as follows:
Darling's plan of bringing spending forwards is truly dreadful. I can only imagine that he thinks that it might boost the economy prior the the next election as a last ditch effort for labour to avoid complete wipeout. I suspect the chances of that are nearly as small as the grey nobbly organ situated between his ears. Either way, we can reasonably expect sterling to get trashed in the process and look forward to some serious inflationary pressure moving into 2009.
This was a prescient comment, as £sterling has been tanking. The curiosity is the $US is still acting as a 'safe haven'. How much longer? Not much longer, I believe, though perhaps it will take the default of a major rich world government to finally do it? Meanwhile, would you lend into anything demoninated in £sterling at the moment? I think others will have their doubts too - which means that demand for £sterling to lend back into the UK will probably fall back, creating a stronger downward spiral.

Note 4: LordSidCup has the following to add to some other interesting comments:
My point is; if the politicians and financial elites could use whatever means to get confidence high again, is it possible that after after a correction things could stay the roughly the same/ a lower level ) for many more years, if not indefinitely?

Also, there are all these interbank debts looming, Credit Swaps etc, why don't the most important banks get together and write them off? I assume that would be painful, but as its all abstract wealth created as debt, what would it matter?
For the first point, others widely share this idea, but confidence is not a magic force but has to be rooted in something. If every day brings news of an ever slowing economy, ever smaller government receipts, then how can a government maintain confidence. Without the fuel of debt, it is impossible that confidence can be maintained, as I have outlined here. This is why every attempt to pour money into the economy sees a subsequent later fall in confidence. Reality just keeps on intruding and governments just do not have the resource to bail out both the financial sector and the rest of the economy.

For the second, the Credit Default Swaps are guarantees against default. They are therefore an insurance policy that moves real damage in the economy to a different place. Whatever happens, somebody will make the loss, and it is just a question of who will suffer. Note added approx 1 hour after the post: MattinShanghai has commented below on this answer and has pointed out that I have blundered. One of the wonders of the online world is that, when we make an error, we are soon corrected. Apologies to LordSidCup, for an incorrect answer....I will rethink and hopefully, if I have enough time enough to get my facts straight, will reply again.

A note to my note, added a little later.....MattinShanghai is quite correct to say that there is no knowing the size of the market, due to the private nature of the transactions. However, the products are an insurance contract, according to a reference I quickly checked: 'The seller sells protection (buys risk) and generally receives a fee for this protection' ('Credit derivatives and Synthetic Structures', J Tavakoli, 2001, p5). A note of caution however, as this in derivatives terms is a little dated as a reference. Apparently they are called swaps to avoid regulation as an insurance, which I dug out from Wikipedia, as I could not find anything more substantive in the economics journals on why they are not classified as an insurance. However, they still appear to be an insurance, whatever the legal niceties that determines their name. I think Matt is referring to the fact that:

'Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can "naked short" the debt of companies without restriction.' from here.

It is, as Matt said possible to buy an insurance against another person's house burning down. The point I think that Matt is making is that, in principle, it is possible for LordSidCup suggests to happen. This is I believe the comment Matt made about the fact that the counterparties being on the line for more than the value of the original debt - the ability to profit from debt default....

However, the complete abandonment of the CDS contracts would presumably hit some institutions harder than others. In the current situation, where the banks are so exposed to wider damage as a result of defaults, in principle I can not see why it would not be possible to write them off if they could see a common interest in their survival as a group. The trouble is that the institutions who stand to gain would have a very tough time being able to justify their giving up their positions. Such a position moves into game theory, and requires trust and cooperation from all parties to secure a common good - it is not a zero sum game. It would face problems of imperfect information, due to the private nature of the transactions. Who does hold what, and what is their exposure, or their potential for gain? I am probably doing injury to game theory here, but hope that the answer helps. Thank you Matt for your clarification, and thank you LordSidCup for what was a far more challenging question than I originally considered. I also think that there is more to the point being made by Matt, so any further clarification will be welcomed. In the meantime, time allowing I will look at this a little more, and may add a further note if I have anything more to add. I am not sure that I have yet got to the root of the question, or the operation of CDS contracts. Even as I am writing, I have found a helpful quote on the underlying principle of CDSs which I hope will help others (The Journal of Finance, Volume 60, Issue 5 (p 2255-2281)'An Empirical Analysis of the Dynamic Relationbetween Investment-Grade Bonds and CreditDefault Swaps'), & a good introduction to first principles.
'Single-name credit default swaps (CDS) account for around half of the credit
derivatives market. They are the most liquid of the several credit derivatives
currently traded and they form the basic building blocks for more complex
structured credit products.1 A single-name CDS is a contract that provides
protection against the risk of a credit event by a particular company or country.
The buyer of protection makes periodic payments to the protection seller until
the occurrence of a credit event or the maturity date of the contract, whichever
is first. If a credit event occurs, the buyer is compensated for the loss incurred
as a result of the credit event, which is equal to the difference between the par
value of the bond or loan and its market value after default.
2. CDSs provide a very easy way to trade credit risk. Many corporate bonds are
bought by investors who simply hold them to maturity (Alexander, Edwards,
and Ferri (1998)). Secondary market liquidity is therefore often poor, thereby
making the purchase of large amounts of credit risk in the secondary cash
market difficult and costly (Schultz (1998)). Shorting credit risk is even more
difficult in the cash market. The repurchase agreement (repo) market for risky
bonds is often illiquid, and even if a bond can be shorted on repo, the tenor of
the agreement is usually very short. Credit derivatives, especially CDS, allow
investors to short credit risk over a longer period of time at a known cost by
buying protection.'
Matt may well be right that they are another bomb about to go off. No doubt they will add to the damage, but I still think that they are more likely to just relocate it. Defaults may melt one institution's balance sheet, but will improve that of another (assuming that the institution can pay). It all depends on the how many times the same house has been insured by whom, and that is not clear. This returns to LordSidcups question - as the lack of knowledge is a source of fear and that threatens stability further. In writing off the credit default swaps, the system as a whole would benefit, and that would be big plus for all instituions. However, I was not previously aware of some aspects of these derivatives, and suspect my knowledge is still imperfect. I would like to look at this more closely, but that is it for time for the moment.

Origninal post continues below......

I'm afraid that is all I have time for today.

Note 5: Despite my assertion of having finished, it should be noted that the LIBOR has fallen, which will hearten those who supported the bank bailout. However, is this because the state owned banks are now lending again because it is required, or because they think it is wise to do so? I do not know the answer, but in any case, the bad news in the economy feeding into more losses will drag the rate back up, unless the government has very deep pockets indeed....

Note 6: Oil has now dropped into the $60-70 per barrel level, as I predicted would happen. However, much, much sooner than I expected. For once, the news is positive, as the drop in oil prices will be a major positive for the world economy - as long as OPEC does not spoil the party by cutting back on production.


  1. Credit Default Swaps are not insurance (otherwise they wouldn't be called CDSs). If I insure my house for 400k and it burns down, my insurer stands to lose 400k. With CDSs it is different - there is no requirement that the party taking out the "insurance" has anything to lose from the house burning down and there is no limit to the number of people who can participate. So for example a hundred different people can buy CDS-like "insurance" for my house and if it burns down, the counterparties are on the line for a total payout of 40 million against the loss of a single 400k house.

    CDSs are unregulated private contracts, there is no central clearing house for them and so nobody knows how many of them are out there, who holds them and what the real exposure to them is. They are truly evil and toxic and I guess they are the next bomb to go off in the financial world. Some say that the last wave of bank collapses/nationalizations was triggered by the CDS situation brought upon by Lehman Bros. going bust.

    Thanks for the very interesting comments you posted recently.

  2. I'm glad that the question of Credit Default Swaps is as confusing to others as it is to me.

    The way I was thinking of it was that if a million people each place a bet of one GBP on a million-to-one event happening e.g. aliens land in London, and it does occur, then if the bookies go bankrupt the total effect on the country is minimal, even though, in one sense, a trillion pounds has just disappeared.

    Is that a valid way of looking at it?

  3. Mark,

    Thanks for your kind comments. Insurance has been around for hundreds of years and plays a valid role in society. Hell, I've spent countless thousands on various insurance policies in my life and (thankfully) have never had to make any claims (with an exception of some j###ks stealing the hard top from my convertible)

    There are absolutely valid reasons why insurance is regulated the way it is. If insurance was as unregulated as CDSs, there would be nothing to stop me from taking out multiple insurance policies on my Ford Fiesta (or getting friends and family to do so), and upgrading to a Mercedes after I totaled the former. I mean, why else would a "disinterested" party want to take out "insurance" against an event that has no financial impact on that party except conspiracy or insider information?

    Having said that, I think the 65 trillion USD CDS problem will be solved simply by the US government declaring all such contracts "null and void". The few who used these contracts as a "real" form of insurance will learn to get proper insurance in the future...

    All the best

  4. The economic crises someway effect the the UK as will,i'ts global virus,
    there is more information...

  5. Thanks for an extremely interesting and thought-provoking blog. I really hope that your direst predictions are wrong. Please excuse the naivety of my question - I'm not an economist.

    Following on from Lemming regarding China stopping lending, surely the consequences for them will be a lot worse if they do suddenly stop? Your link points to an article that indicates that the Chinese authorities are trying to stimulate exports by increasing export tax rebates; surely if the West's economies & currencies collapsed it would make it even more difficult for China to compete in the world markets, as well as destroying their potential markets for an even longer period?

    Like a bank lending to a business, I can see that it's in their interest long-term to stop lending so much to the West but surely it would be in their own interest to stop lending gradually, rather than suddenly, so they can recoup at least a portion of their previous lending?


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