Thursday, October 30, 2008

US and UK Goverments Guarantee Consumer Debt

The headline for this post is deliberately shocking, and might appear somewhat absurd. However, as I will explain that is what the governments are actually doing.

Even the most myopic economists, politicians and commentators now seem to accept that we have witnessed a debt bubble, and that the bubble is going through the process of bursting. More problematic is the explanation of what the banking bailout has been about. There has been considerable talk of the financial instruments that have been used to slice and dice debt, talk of sub-prime mortgages, toxic debt and so forth. This is then used to set the context of the debate, and the idea is that the fact that these problems are spread throughout the system has led to a loss of confidence in the banking system. The idea then is that, if the governments can just put fresh capital into the banks, then they will start lending to each other and the financial system will be fixed.

It all looks very plausible and very simple, and in some ways what I will discuss is not new. However, I thought that it is worth clarifying what exactly has happened.

The crisis has never just been about the irresponsible lending into sub-prime, but rather is about the wider lending practices of the banks, and also about the house price bubble. The banks have been lending heavily to consumers based upon the belief that house prices were a one way upwards bet, and this has driven the US and UK economies into overdrive, and has been responsible for most, if not all GDP growth in the last ten or so years. It is the foundation of the 'service economy'. The service economy is a debt based economy, and this has been reliant on banks lending heavily to consumers.

So what exactly is the banking bailout about? It is actually addressing the problem of what happens when the housing bubble bursts and the economy contracts, such that consumers stop spending borrowed money, and the economy contracts, causing higher unemployment, causing less spending by consumers and so forth into a downward spiral. Essentially, the trouble with the banks was that they were overexposed to consumer debt. The banking crisis was never about exposure to sub-prime debt, or problems that were inherently caused by CDOs and other financial instruments. The real root of the problem lay with souring consumer debt, and that souring extended beyond sub-prime and into wider lending. The banks would certainly have been aware that, with house prices falling, large portions of their debt would be progressively becoming ever more high risk debt. Equally, they would have seen the figures for rising defaults, rising insolvencies, and concluded that a storm was coming.

Sub-prime was just the trigger for a larger reassesment of risk. The reason why the banks stopped lending to one another was not due to sub-prime alone, but also due to the wider problem of poor lending.

When the situation is clarified, the bailout ceases to be about 'confidence', or getting banks to lend to one another again, but is actually about offering a guarantee against consumer default. If we actually think about, for example, the guarantees offered for bank deposits, they are being offered because of the fact that souring consumer debt is leading banks to insolvency. Therefore, what the government guarantee provides is a guarantee that, whatever happens to consumer debt, the government is acting as a guarantor for payment of that debt. In other words, huge tranches of consumer debt are being guaranteed by governments. Furthermore, by taking stakes in key financial institutions and encouraging those institutions to start lending again, they are providing financing and an implicit guarantee on new consumer debt.

It is a shocking idea, but when a person now enters a car showroom to purchase a car using borrowing, the government is acting as a guarantor for the repayment of the debt, and is also financing some of that lending, if not all of it. The guarantee has, to some extent, always been the case due to the presence of deposit guarantees, but the situation is now one in which this guarantee has been massively extended. By raising the amount guaranteed on deposits, and by showing that they will save banks at any cost, governments are effectively guaranteeing every single loan that is made. It is, of course, not just consumer borrowing that they are guaranteeing, but also all commercial debt.

So the situation that now pertains is one in which economies are falling off a cliff, with ever more debt, both commercial and consumer, turning sour, and governments have effectively stepped in as a guarantor for all lending throughout the economy.

As I said at the start, there is nothing new here, but rather a clarification of what has actually been done. I use the example of the person walking into a car showroom to highlight the reality of governments are actually doing. All of the talk about the bailouts is dressed up in complexity, and evasive language, but the simple reality is that governments are now guaranteeing every loan that is being made throughout their economies. When it is put in such black and white terms, it becomes somewhat disturbing. Not only is the government in the business of lending money for a consumer to buy a car, but they are lending on the basis that if the person subsequently defaults on the payment, they will take the losses as well.

The question I would ask at this stage, is to ask how many people would be happy with this situation when it is actually reduced to the underlying reality. Is it an acceptabel role for government?

Note 1: I have had a link from 'Death to Bubble Addicts' which may be of interest to those who have a poor view of Gordon Brown's role in the current crisis. The link is as follows:

It is a scathing attack on Gordon Brown, in which the problems that have arisen were predicted, and communicated to Gordon Brown ten years ago.

Note 2: Acrobat_747 has commented as follows:
The very suggestion that the UK could default on debt repayment before Christmas does not make sense. The UK is not even that much in debt relative to other counteries. The debt repayments should be relatively low compared with total government expenditure.

Debt is overhyped, and other nations will help if debt does become an issue. Wealth is relative, and so is debt. As all developed western countries are in debt it is not a handicap. In fact, avoiding debt may be fatal and perhaps the UK should be borrowing much much more.
This is a response to my suggestion that the UK government is heading for a default on borrowing. This is correct in one sense. Debt and wealth are relative, but the problem here is that debt needs to measured against ability to pay. The UK economy is shrinking and the GDP of the UK over the last 10 years is an illusion. As such, the size of the UK economy in relation to the actual debt levels is illusory. Why all developed economies are in debt is explained here and the post will offer no comfort. Just because your neighbour is in financial trouble does not mean that you are not in financial trouble. As I have mentioned in previous posts, continued borrowing is dependent upon confidence in the ability to repay. The storm that is engulfing the UK economy will destroy that confidence, as UK debt is spiralling whilst revenues are collapsing.

Note 3: Jim G asked the following:
'Out of interest, if you had savings currently in a UK bank, what would you do? (Savings are a deposit for when I get back onto the property ladder - sold to rent 1 year ago.)'
And from anonymous:
Now I am truly scared. What do you think one expecting a government default do? Withdraw their money and hide it "under the mattresses" as they say?
For many months I have been giving the same advice. Make sure that you have multiple bank accounts, make sure that all money is instantly accessible, that the accounts have internet access, and that you are prepared to move money quickly. As new advice, you may also want to open bank accounts in other countries, and have a transfer prepared so that you can move your money. As an aside, I have read that HSBC is in a relatively strong position due to high deposit levels, but I have never analysed individual banks, so this should be considered in this context.

If the question is where to invest money, I would not want to give direct advice, but will let you draw your own conclusions from my discussions. You should also read other opinions before deciding what to do.

Note 4: I have had another comment on conspiracy theories from Toshi, who explains that there is a journalist who offers some views on conspiracy theories and the 'New World Order'. Before following his work up, I found the following on Wikipedia regarding the journalist in question:
'More recently Fulford has stated that the US have been able to alter the climate, and using high power microwave energy induce earth quakes including the Asian Tsunami, Japanese and Chinese quakes. The program he refers to is known as HAARP High Frequency Active Auroral Research Program'
I looked no futher.... but thank you Toshi for passing this on. I am always interested in hearing about the proponents of conspiracy theories, as I think that we need to address these theories.

Note 5: A belated thankyou to the anonymous poster who gave the link on the IMF printing money. Such links are always appreciated.

Note 6: There is news that credit card borrowing is climbing in the UK, but that 'experts' believe that the money is being used for day to day expenses. The worrying part (see above) is that this lending is now being guaranteed by the government, and is at least partly financed by the government. So the situation is one in which an overstretched borrower is helping another overstretched borrower. More cause for worry.....

Note 7: US interest rates are now down to 1%, which means that the US government has almost nowhere left to go. Meanwhile it has been confirmed that the US economy is shrinking. Meanwhile in the UK Alastair Darling has confirmed that he intends to borrow and spend, until the end of the recession. If you read my previous posts you will find why it is that spending is now the single worst option. Try the links at the top left of the page to find out more. Meanwhile house prices continue to fall in the UK, with forced sales expected to exert further downward pressure, in an ongoing drip-drip of bad news.

Note 8: No doubt the astute readers will notice that there is a rollercoaster in currency, commodity and stock market at present. I think we all need to be careful (including myself) of reading too much into these day-to-day movements and view the bigger picture and trends. In particular, the market gyrations are a symptom of uncertainty, and therofore the market is moving with changes in sentiment. They are therefore best regarded as indicators of sentiment rather than any underlying reality. However, the underlying realities will direct an overall trend as the market unfolds, and the overall trends are what will matter.


  1. Cynicus - the way I see it our economy has been built on three pillars:

    ~The City.
    ~Property speculation.
    ~The State.

    The City has gone bust. Property is crashing. The State is skint.

    This is why I agree with your view that the UK economy will collapse.

    Prior to finding your blog I have been searching for intellectual clarification of my sense of this doom.

    The newspapers don't deconstruct the problems in great depth and some of the punditry is truly awful: The Times, Indie, Daily Mail. I must say the Telegraph has been the best by far.

    When the Crunch broke last year I remember the FT stating it was a blip - then I knew that this was a serious problem. As the FT is awful at getting the big calls.

    My formula:

    ~V shaped recovery.
    ~U shaped recovery.
    ~L shaped non-recovery: Japanification.
    ~B shaped = bankruptcy.

    I follow the markets closely and the punditocracy has been calling for a V. The market has started pricing in a U in the last few weeks. I expect an L regardless of what the politicians do.

    At the moment the herd seems to think that with the right policy prescription we will now only get a U. I think there is nothing that can stop the L. I thought the policy response from the UK would put us through B before we got to L. Now I am more aware that the GDP has been fake and it will now collapse so we will go to B before we get to L.

    Your blog has helped me understand this formula far more clearly.

    If the policy makers accepted B & L then Britain would have a better chance of recovery.

    This is going to be epic.

    I have bought German Bunds, Norwegian Bonds and Canadian Bonds.

    The simple wayto get out of the pound is to buy the iShare Euro Government Bond Fund 7 to 10 year. It comprises mainly German Bunds. There is no stamp duty to pay. It is very liquid. It is an ETF. The counterparty risk is with Barclays. The ETF actually owns the bunds - it is not synthetic. The ticker is IBGM.

    You can also buy German Bunds through a stockbroker - short dated are best = 1 to 2 year in duration.


  2. Does inflation, hyper inflation loom on anyone's radar in all of this?

  3. Cynicus what do you think of Martin Wolf's analysis in the FT today:

    'So what is to be done? The starting point has to be monetary policy. My increasingly strong view is that the MPC must, at this juncture, rethink its stance from scratch. It cannot make sense for US rates to be at 1 per cent, while the UK’s are 4.5 per cent. In present circumstances, I would like to see UK rates down to 2.5 per cent.

    Obviously, there is some risk of a further sterling collapse. In current circumstances, this has to be ignored. In fact, determined action may strengthen sterling, not weaken it. In his Mais lecture on Wednesday, Alistair Darling, the chancellor of the exchequer, helpfully gave the MPC the green light to ignore short-term inflation overshoots. He went out of his way, instead, to stress that the Bank enjoys 'discretion about the horizon over which inflation is brought back to target'.

    So long as the Bank enjoys room to cut interest rates, it seems unnecessary to take any large discretionary fiscal actions, particularly since the fiscal position is sure to look ghastly."

    Seems to me he thinks a cut in interest rates will reflate the economy. It is has not worked in the States - only savers are being punished whilst the banks are being recpaitialised. There seems to be a fetish that low interest rates is the panacea.

  4. I've long been trying to work out where all the money in the UK has been coming from since our governments have pretty well destroyed all our manufacturing industry over the last 30 years. It has long seemed to me that the economy has been running on thin air, but I could never work out what was going on. Your statement that 'The service economy is a debt based economy, and this has been reliant on banks lending heavily to consumers.' puts it all in a nutshell for me.

    Thank you for all the clear and detailed explanations in your blog.

  5. I have found your blog hugely educational and accurate so far.
    I will recommend it to others.

  6. I penned the following the other day, and posted it for publication only to receive a rejoinder that the facility was not available.

    Miffed, I filed it in my documents for a rainy day. Here it is, I suppose you could say it has become off topic on this post.

    “Let me run this past you.

    Taking your Mr Smith and his visit to the restaurant.

    Permit me to extend, and at the same time switch this scenario to add one thousand, (conservative estimate) Mr Smiths per day entering the country, with nothing to support himself and his family other than the contents of his back-pack.

    Mr Smith has come to settle in Britain and will require the whole panoply of goods and services in order to support himself and his family in their every day basic living arrangement.

    His most pressing needs will be food, warmth and shelter, and source of income, (preferably a job)

    It is not difficult to see that Mr Smith's requirements are very substantial and immediate, and taken in total involve the whole of Britain's economy, both manufacturing and service industries to provide even his most basic needs.

    Let us take a closer look at the immediate requirements of Mr Smith and his family.

    Ideally he would require a house, but even if he settled for rented accommodation a new house will have to be built to compensate for his occupation of other accommodation. The house will require the basics of furnishing and equipment to start life, even so, these basic requirements are substantial, let us take a look further.

    Suits of furniture, both upstairs and downstairs, bedding, household basics like cutlery, cooking equipment, crockery, there is entertainment, television sets, phone etc and over time transport in the form of a car thereby fuelling (pun intended) more imported oil, overtime - the list becomes endless.

    You can see where this is leading, the number of people who are directly and indirectly employed servicing an additional ‘thousand Mr Smiths a day’ needs - must run into millions, nay billions.

    We are talking building and construction industry, furniture industry, government public service industry, and every other industry you can think of, indeed, encompassing the whole of the nation's economy, (both real wealth and consumer production)

    It is therefore not difficult to see this is the major source of expanding economic activity that has fuelled Britain's growth over the past eleven years.

    I'm saying it's new Labour's policy of imported population growth that is responsible for the rise and fall of the new Labour economy! I’m also saying the only future area of growth on offer by any political persuasion is the continuance of mass importation of people on an increasing scale. Under present circumstances this seems a no brainer, but our elites have no other choice.

    We live in interesting times.",-says-EU-chief.html

  7. Interesting little symptom reported by the BBC - more fifty pound notes in circulation as people hoard cash at home.

  8. It may collapse considering they just spent 9bn on the Olympics with no satisfactory returns yet. However it may be beneficial to the UK in the near future as it has given the boost the economy needs at times like this. Consumption, employment and output have all increased! You can view details on a blog I found here: Olympics and the UK Economy

    Of course the fact that expenditure is double the forecast, leads to the question we all ask - could the UK have spent these money on something more beneficial? Only time will tell.


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