Thursday, December 11, 2008

Government Borrowing and Money Printing - The Road to Ruin

I have found an interesting quote in the Telegraph as follows:

'The latest data from the World Gold Council shows that demand for coins, bars, and exchange traded funds (ETFs) doubled in the third quarter to 382 tonnes compared to a year earlier. This matches the entire set of gold auctions by the Bank of England between 1999 and 2002.

Peter Hambro, head Peter Hambro Gold, said the data reflects a "remarkable" shift in the structure of the market. The rush to safety reflects a mix of fears about the fragility of world finance and concerns that the move towards zero interest rates could set off an inflationary surge further down the road, and possibly call into question the worth of some paper currencies.'

When reading this analysis, we need to exercise some caution, as a surge in gold demand is in the interest of the person making the analysis. However, I am not sure that he needs to create any further boost to gold prices or demand. The same article reports:

The gold markets have also been in turmoil. Traders say it has become extremely hard to buy the physical metal in the form of bars or coins. The market has moved into "backwardation" for the first time, meaning that futures contracts are now priced more cheaply than actual bullion prices.

It appears that hedge funds in distress are being forced to cash in profits on gold futures to cover losses elsewhere or to meet redemptions by clients. But smaller retail investors – and perhaps some big players – are buying bullion in record volumes to store in vaults.

The important point here is that, when governments abandon all restraints on borrowing, and either start (or contemplate) printing money, it is certain that all will go horribly wrong. We are now in a very, very serious situation. On the one hand we have governments hoovering up huge amounts of capital in competition with investment in private businesses. On the other hand we have the extreme bears, who see gold as the only store of value going into the future. The combination of these two trends will leave very little capital to be invested in business....

Again from the same article:
'"It is sheer unmitigated fear: even institutions are looking for mattresses to put their money until the end of the year," said Marc Ostwald, a bond expert at Insinger de Beaufort.

The rush for the safety of US Treasury debt is playing havoc with America's $7 trillion "repo" market used to manage liquidity. Fund managers are hoovering up any safe asset they can find because they do not know what the world will look like in January when normal business picks up again. Three-month bills fell to minus 0.01pc on Tuesday, implying that funds are paying the US government for protection.'

The fundamental principle underlying all of this is complete lack of confidence in the wider economy (buying bonds), and in many cases complete loss of belief in the value of paper money (buying gold). These two trends sit in opposition to one another. On the one hand, there is a belief that the government is a safe place to put money, and in the other there is complete loss of confidence in the ability of government, and a belief that government is going to destroy the value of currency. As regular readers are aware, the government of the UK is finding it increasingly difficult to borrow, but the US still has the confidence of investors, however misplaced that confidence might be. However, as long as governments are able to continue to borrow, the problems caused by government borrowing remain.

We are in central contradiction that, the more the government borrows, the more the economy rests on the ability of governments to borrow, and the more government borrows, the greater the fear for government ability to repay the debt will be. The contradiction will be resolved with a complete collapse. I will explain further.

The move into gold has been steadily increasing, but is now starting to look like a surge. It seems that many now believe that buying bonds is the equivalent of buying pyrite (fool's gold). To say that all of this is very worrying is an understatement. Perhaps the worst part is that government borrowing is hoovering up capital despite negative yields (in the US). In so doing, there is a destruction of wealth, combined with increasing certainty of wider collapse in the economy. By denying businesses capital, it becomes ever more certain that business will collapse, including good businesses.

To give an example of what this government borrowing means in the real world, we can take the example of the bailout of the US car manufacturers. For the moment we will ignore the printing of money, and will view the bailout of the car manufacturers as being funded by borrowing. In so doing, the government is going to the market, borrowing money in competition with investment in private enterprise. Some of that private enterprise will be well managed companies, with genuine future prospects. However, they are now in competition with the (illusory) safety of investing the money in government borrowing. As such, instead of the money going to a good company, it is instead funnelled into companies that will quite literally destroy the value of that capital. When we read stories about the car companies, they talk of the automotive companies 'burning' through their cash, and this is a rather apt metaphor.

However, most of the government borrowing will not be going to support manufacturing. Most will be going either into spending, or to support the banks.

If we take the case of supporting the banks, what is happening is that the government is a direct competitor to the banks in raising capital. If the government raises $1 billion, there is $1billion less available elsewhere. It is that simple. What you have is a vicious circle in which governments are hoovering up the capital, leaving no capital, meaning that the only source of capital is the government. In other words, the more the government borrows, the less the available capital, meaning that the government must borrow more, so that they can then provide more capital injections into the banks to support the market from collapse.

In the case of government spending, this spending is denying investment into productive businesses. The more that government spends, the less available capital for productive businesses. It is that simple. $1 billion of lending to the government means $1billion less for business. Once again, we hit a vicious circle. The more the government spends, the more it will need to spend, as the competition for capital away from private business into government borrowing will lead to further contraction of the productive private business sector, leading to ever more need for government spending.

Quite simply, all of the government borrowing assures that the government is just going to have to keep on borrowing more and more, until the whole insane edifice collapses in on itself. In these circumstances, it is not surprising that governments are now either thinking of, or actually starting to print money. Governments, in flooding markets with government debt, are sucking the life out of investment into productive business, and redistributing that money into spending which will not create wealth, but is the spending of future wealth.

Governments are quite literally crushing private enterprise.

As that private enterprise contracts, the finances of governments will just go into ever steeper decline, as tax receipts fall, and government costs soar. As this happens, governments will just have to keep borrowing more and more, thereby exacerbating the problem.....

Or they print money.....

It is quite possible to see the insane logic in this 'solution'. Governments can not just keep on borrowing ever larger amounts of money forever. How much capital can they continue to divert from real investment and redirect into spending? How much capital is out there to hoover up, and how much will there be as business contracts? Faced with the consequences of their actions, their solution is to magic capital into existence with the use of the printing press.

The trouble is that, as fast as the money pours off the press, it will destroy the value of capital. What you then have is government hoovering up capital, whilst deploying that capital into unproductive spending, all the while slowly but surely destroying the value of capital. The more that the value of capital is destroyed, the more that government will need to print more money...

The current action of governments is to engage in the most self-destructive action that is possible, short of dropping bombs on their own cities. They are quite literally destroying their economies.

I have argued consistently on this blog that governments should not be able to borrow money, excepting in the case of crises such as war. My reason for this view is becoming ever more apparent, as we see the economies of the UK and US coming ever more under the control of governments. The more the government borrows, the greater the shift towards government spending and 'investment' as the centre of the economy. Perhaps this is most apparent in the UK, where yet another story of government control of banks has appeared:

'The Chancellor has said that ministers were studying a range of options to boost bank lending, including underwriting loans to businesses.

"I am prepared to look at a number of things that would make it more likely that banks will lend," Mr Darling said. "However, from the banks' point of view they have to understand that with billions of pounds of taxpayers' money, either invested in shares, or being made available as a guarantee, the general public and businesses are looking for something in return.

"So, yes, if we do something I think that will be welcomed by people but we've also got to make sure that is passed through."'

When the bank bailouts were proposed, this is exactly what I said would happen. The government is now taking ever more control of the economy. As money has moved from private sector investment into government borrowing, the government has become the most important source of capital. In becoming so central to the allocation of capital, the economy is now dominated by the government, and the government is seeking to 'command' the economy to do its bidding. In this case, the government is borrowing money to lend into banks, and wants to achieve a consumer spending led recovery.....

All on borrowed money....

The only way to reverse the cycle is to stop the borrowing, and switch off the printing presses. This will leave the holders of capital with no choice but to put their money somewhere else. Yes, the surge into gold will increase, and this is not a productive use of capital. However, it will not soak up as much capital as government borrowing, and investment into productive activity will commence. In particular, with government finances back under control, and the printing presses shut down, the flight to gold due to fears of currency collapse will diminish demand for gold.

I am not proposing a complete immediate stop to government borrowing, which would be impossible in practice, but an immediate return to pre-crisis borrowing levels. However, there should also be a commitment and firm plan to reduce borrowing very quickly, until the point is reached where the borrowing can start to be repaid. The only way to achieve this is to start the process of cutting government expenditure. As a ballpark, governments should be in a position where they are returning to surplus in about five years time. This is long enough to allow a transition from the current government domination of the economy, to an economy that will be based upon enterprise. Each year that government reduces borrowing, it will free up capital to be invested in enterprise, and by having a progressive reduction, it will allow business to safely absorb the new streams of available capital into productive investments. This time period would allow a smooth, but painful, readjustment. It is also not such a long period of time that it allows for government to wriggle out of the commitments and delay.

It is not a comfortable solution, and would be painful to implement. However, it is the only solution that makes sense for the future.

So there you have it, government borrowing and money printing as a solution. As I have said earlier, the only thing they could do that would be more destructive is governments bombing their own cities.

Note 1: I have not responded to some of the comments on my previous post, as I need to try to put some time into finishing the post on taxation. Hopefully I will come back to them, time allowing.


  1. Mark,

    I have read a lot in the press recently about the threat of deflation - some say we are in for a bout of deflation before a surge in inflation.

    However I have also read a number of articles that claim deflation is a fallacy (for instance:

    Given it seems the printing presses are being readied, and as you say this would inevitably lead to inflation, where could this deflationary threat come from?

    Is it merely media hype about the 'menace' of deflation when in reality they are referring to the simple fact that credit has dried up - effectively a reduction in the money supply?

    Is it perhaps the deflation of asset prices they are referring to?

    Or could it be a deceptive attempt to justify lower interest rates thereby ensuring cheap credit; add to this to the anticipated increase in money supply and the result would be the government's best shot at re-inflating the bubble?

    Also how long will it take for the real effects of this monetary inflation to feed through into higher prices etc?

    Cordially yours,

  2. Here is one story that symbolises the disparity between West and East, and the pain ahead as Western workers adjust - the unions (both here and in the USA) are still in the denial phase

    My worry is the burden of mortgage debt means workers in the UK cannot easily adjust to lower salaries, even if energy and goods in the shops get cheaper (which will only be temporary IMO).

    The deflation/inflation argument is a tough one, in theory the govt controlled printing press is a powerful tool, but as companies cut back average wages will drop or at least stagnate relative to RPI - which I think will be negative in 2009, but turn positive in 2010 as the pound devaluation continues, oil bottoms/bounces and we import inflation.

    One more thing, govt and central bank engineering doesn't HAVE to end in hyperinflation. If they get it right they could beat deflation and get high (but not hyper) inflation as a side effect, which will help ease the burden for mortgage holders. We could have negative real interest rates for some time afterwards.

  3. Great post. I absolutely agree with you. In my own posts elsewhere I have consistently argued for a simple solution to the UK's problems and that is this.

    Tighten our belts.

    People look at me askance when I propose that complex economic problems can be solved just the same way you would solve simple ones.

    People who have maxed-our their credit cards, then taken out a loan because they can't afford the many repayments are faced with a simple choice. Run the cards up again and be in twice the trouble, or live lean for a few years and get the hell out of debt.

    That's exactly what we need to do. Live lean, work hard, and what spare revenue we do have must go into Industry and Agriculture (the 'big two' in my opinion.) A government that concentrated on those would be very unpopular, because times are going to be hard indeed, but in the long run it they would be vindicated.

  4. Christ you're scary CE.

    I've got my fingers crossed hoping this is Y2K all over again.

  5. There's a third possibility, at least in theory, and that is that we go to the IMF. Assuming they still have money left to lend by then, won't they expect us to do something approaching your recommendation i.e. behave a bit more responsibly?

  6. Jiri==> As the IMF is funded by Sovereign states anyone wanting their help had better get in fast because I imagine they too will soon go skint. Hungary and Belarus were quick off the mark and wisely had their collapses early!

  7. Why is there so much stuff like this out there?

    If it swims like a duck, if it waddles like a duck and quacks like .... then it's a ....

  8. Mark,

    Thanks for all your recent illuminating posts on the unfolding disaster in the UK and world economy.

    We are currently in a chaotic phase of the meltdown and it is difficult to make any short- or medium-term predictions as to how things will pan out. What does seem obvious is that the root causes of the problem are fundamentally structural. The long term solutions are not a matter of tweaking the interest rates by a few points here or there, or twiddling with the tax bands, or pumping or not pumping (borrowed) money into this or that segment of the economy.

    What we're seeing is the bankruptcy of the "New Economy" model promoted over the last few decades by the powers that be. Your numerous postings over the last year or so have pointed out many absurdities in these rosy narratives. How can you be rich (as a country) if you not only don't make anything anymore but no longer know how to make anything anymore? How can your country prosper, if you put almost the entire workforce in direct competition with a billion-strong low-wage army of Chinese or Indians? How can long-term growth be sustained by borrowing against ever inflating housing prices?

    These are not the kinds of questions you will find in the pages of "The Economist", "The Telegraph" or even (gasp!!) "The Guardian", but they have been asked by many, and with a little perseverance you can find people thinking along similar lines to yours.

    If you haven't come across him yet, I would recommend the last couple of books by Eamonn Fingelton (check him out on Wikipedia), which show how "the others" (i.e. the Asians) view things. The good news is that not everyone is insane; the bad is that the sane ones are the Japanese and communist Chinese, and they certainly don't have our best interests at heart...


  9. Great post.

    The only people who can be trusted to make decisions on the allocation of capital are people whose necks will be on the line if they screw up - that's the beauty of capitalism.

    Central banking is an affront to capitalism because artificially setting interest rates by buying/selling into the market interferes with banks' assessment of risk and decisions to lend.

    The only thing I'm not sure about is your view on the impact of gold as buying gold doesn't affect the amount of currency in the system because the currency used to pay for the gold doesn't disappear, it just moves to somebody elses bank account.

    The total capital in the system is determined by central banks (measured by M1) and fractional reserve lenders (measured by M3 or M4, I think).

    A capitalist system allocates this capital to productive businesses, but centralised government intervention is always either far too coarse-grain or completely misdirected for political reasons and therefore inevitably large amounts of capital is poorly allocated resulting in either people effectively getting out of bed and doing work that nobody actually wants done, or people being subsidised to work less productively.

  10. Cynicus,

    The UK will have no problem financing the upcoming gilt issuance. There are three factors:

    1. New FSA regulation for banks to de-risk their balance sheets and own more government bonds. Current holdings are c.6%. This will rise to c.10%. In a recession/depression banks always up their gilt holdings. James Ferguson at Pali International has written about banking crisis's and how banks buy government bonds to earn the risk free spread. This could easily soak up all the new issuance over the coming years.

    2. National Pension Federation wrote to the Treasury requesting more long-dated gilts be issued. They are hungry for gilts.

    3. BoE will begin Quantative Easing and the long-end will come in.

    Richar Koo from Nomura has extensively studied the Japanese economy and he calls what we are about to experience the Balance Sheet Recession:


    “Overconfident private sector triggers a bubble--monetary policy is tightened, leading the bubble to collapse--collapse in asset prices leaves private sector with excess liabilities, forcing it into debt minimization mode. The economy falls into a balance sheet recession--with everybody paying down debt, monetary policy stops working. Fiscal policy becomes the main economic tool to maintain demand--eventually private sector finishes its debt repayments, ending the balance sheet recession. But it still has a phobia about borrowing which keeps interest rates low, and the economy less than fully vibrant. Economy prone to mini-bubbles--private sector phobia towards borrowing gradually disappears and it takes a more bullish stance towards fund-raising--private sector fund demand recovers and monetary policy starts working again. Fiscal policy begins to crowd out private investment. Monetary policy becomes the main economic tool, while deficit reduction becomes the top fiscal priority--with the economy healthy, the private sector regains its vigour and confidence returns.” The world is currently at the “monetary policy stops working” stage.'

    Sterling will probably continue to fall but I don't think the UK will go like Iceland. In fact Sterling could strengthen next year as the markets lose faith in the ECB.

    I think this piece from the Economist sums up why we won't collapse:


    'Iceland was uniquely overextended, 900% of GDP, but other countries, too, have big banking industries relative to the size of their economies supported by lots of borrowing. Britain is one. Willem Buiter of the London School of Economics, who prepared a report on Iceland earlier this year that gave warning of the risk of disaster, asked in a recent, widely discussed blog whether London could be “Reykjavik-on-Thames”.

    The balance-sheet of Britain’s banking system, at 450% of GDP, was half the (relative) size of Iceland’s at the end of last year. But that is still high. Like Iceland, Britain does not have a global reserve currency, such as the dollar or the euro, to draw on if it needs to act as lender of last resort. Its net foreign-exchange exposure is nil, but Iceland was in a similar position, and its banks have not been able to liquidate foreign assets to cover their foreign debts.

    Mr Buiter acknowledges that Britain has access to currency swap lines from the world’s biggest central banks, which would help it prevent a run on the banks. But he argues that the cost of this insurance will make London less competitive as a global financial centre. He thinks this makes a good case for Britain to adopt the euro. Among larger European countries, he says, the British government’s exposure to its banking sector is by far the highest. “Switzerland, Denmark and Sweden are in a similar pickle,” he adds.'

    There now two camps within the Depressionists:

    ~L and inflation.
    ~L and deflation.

    I belong to the L&D camp. Gold will probably fall and money will continue to go into Government bonds and stay in cash.

    Inflation will return but nor for a good while. I think reading Richard Koo's books will explain why it will be this way.

    Good fortune.

  11. Cynicus -

    I'm a concerned amateur struggling to understand what's going on. I am trying to work out how "quantitative easing" takes us from deflation to inflation. Forgive the ramblings of a bumbling illiterate in these matters but here are my uneducated thoughts. Corrections would be welcome!

    In normal times, central banks tweak GDP by tinkering with interest rates. I recently learned that there's an equation linking nominal GDP (Y) with money supply (M) and the velocity of money (V), namely Y = MV (although I imagine this is really a definition of V, a measure of the keenness of people to spend, since both Y and M can be measured directly.)

    In the last few months, M has contracted sharply (Lehman Brothers + domino effect) and this has sparked a recession, which has made people reluctant to spend i.e. V too has diminished. So Y gets a double whammy. In normal times, if the BoE wanted to increase Y it would do so by lowering interest rates. That would increase V (people would spend more freely) and that in turn would have an effect on M (people would take out new loans). Y would increase as required, the increase being on account of both of its increased factors.

    Given the sharp decrease in M, no amount of tinkering with V (i.e. fiscal stimulus, interest rate reduction) will be able to compensate for the scale of decline. The powers that be have decided that instead of resetting equilibrium at a lower level, M has to be increased come what may. M cannot be increased through the issuance of new debt - the banks are unlikely to do that to the extent needed - so the Bank of England looks like it plans to increase M directly instead i.e. with no underlying assets to back it (I imagine this is what is meant by quantitative easing).

    It is obvious that simply increasing M is capable of restoring Y to its former value since no matter how small V gets, M can be made sufficiently large to overcome it. (Note that V cannot be zero since we must still buy essentials.) Thus it will always be possible to restore nominal GDP by this method.

    There will be a lag while M is being increased but at some stage, peoples' perceptions will flip - after all, more money will have been made available and they will now have more of it themselves. So V too will increase. Because of the lag, it is only after too much money has been added that V responds and when it does, it'll be off to the races with the newly turbocharged M. Of course Y is the nominal GDP but nothing much will have happened to the real GDP (except in all likelihood it will have shrunk) and the discrepancy between the two will show up as higher prices. Increasing prices will in turn encourage people to spend quicker ("it will be more expensive next week"), i,e. V will increase further.

    Does this sound a reasonable account? The system is evidently unstable and to emphasise that, if M is not increased sufficiently, deflation remains.

    I have an analogy that helps me visualise this possibly (probably) flawed account. Imagine trying to balance one ball on top of another, an example of unstable equilibrium. You will succeed providing that if/when the equilibrium is slightly disturbed, your inputs are sufficiently timely and accurate to get the ball to the top again and thereby restore equilibrium. That's what the MPC seeks to achieve at its regular monthly meetings. It seeks to nudge interest rates gently in the direction they need to go to.

    What we have now is a sudden shock to the system where the ball has moved way out of kilter. The MPC pushed interest rates hard in the "right" direction but this has had no noticeable effect. Nudging is no longer an option. The ball is moving fast and the only thing left to do is to clobber it hard and hope. Of course there's every likelihood that the timing and force will be wrong - the ball will fall back if you hit it late or don't hit it hard enough or it will get knocked into orbit if you overdo things: continued deflation or raging inflation, a happy medium is near impossible. The Japanese were late and cautious and the Japanese ball keeps falling back as a result. We are keen to avoid the Japanese mistake at all costs so we'll be there early with our king-sized baseball bat just to make sure.

  12. Jiri,

    You say the Japanese were late and cautious. The same is said about Herbert Hoover in 1929. If you dig deep and get beyond the soundbites and spin you will find that they threw the kitchen sink at the problems. But because they were Balance Sheet Recessions the actions only tempered the liquidation.

    There is massive deleveraging going on in:

    ~Hedge Funds.
    ~Private Equity.
    ~Investment Banks.
    ~Commercial Banks.

    This will run and run. I am afraid that we are heading into an L shaped economy. GDP will collapse, find a floor and then go sideways.

    The Anglo economies have been prospering on asset price inflation - equities & property - equities have been in a bear market since 2000 and to counter that the Central Banks pumped up property. Trillions have been vaporised in the last year and all the pump priming will do is cushion the fall. They will be unable to reflate another bubble until the Balance Sheets are repaired. In fact, Casino Capitalism has died and we are now moving toward Capitalism II. Banks will become utilities, leverage and liquidity will shrink. Growth will be lower and slower. We ain't going back to the old days. This is a new paradigm.

    I strongly recommend looking into Richard Koo's work.


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