Tuesday, December 22, 2009

The Close of 2009

As 2009 comes to an end, where does the UK economy stand? As is common practice at this time of year, I thought a review (and commentary) might be appropriate.

There is some good news. It seems that UK households have finally realised that they actually need to save money, and that they are preparing for tougher times ahead. Of course, some of the Keynesian discussion about how bad it is to save in a recession being trotted out, but even the Times is dismissing this concern:
[referring to the Keynes argument] But that does not not appear to be the case here. Instead, all the evidence points to the savings ratio improving simply because of a number of the most heavily indebted households paying down their borrowings, along with a of minority of households overpaying their mortgages. That in itself does not necessarily jeopardise growth prospects — such as they are — for 2010 and is probably worth celebrating in that it confirms a long-overdue recognition from many consumers that they were too far in debt.
One of the curiosities in the figures is that hotels and retailers have reported a 0.7% growth in spending, which is puzzling in light of the switch to savings. However, that people are paying down debt is positive, but a question remains as to where those that are saving (rather than paying down borrowing), may be going. With low interest rates, are savers taking large risks?

The remainder of the news is not so positive. The latest rating agency to express concern about the fiscal situation of the UK is Fitch:
International ratings agency Fitch on Tuesday urged Britain, amongst other nations, to put forward "more credible" plans aimed at reducing state debt or risk "pressure" to its top credit ratings.

The UK is rated 'AAA' by Fitch, meaning the agency has the highest confidence in their ability to repay borrowings.

Fitch said in a report published on Tuesday that "all major 'AAA' sovereign governments need to articulate more credible and stronger fiscal consolidation plans during the course of 2010."

Fitch added that such action was necessary "to underpin confidence in the sustainability of public finances over the medium-term and the commitment to low and stable inflation."

Should the UK be alarmed? According to an article on the BBC, the UK should not:

No wonder leading credit ratings agencies have expressed concern and suggested the UK's AAA rating - reserved for only the very safest borrowers - is under threat, sparking widespread hysteria in the media that UK debt is spiralling out of control.

Reading some headlines, you might even be forgiven for thinking UK plc is on the verge of going bust.

But are the UK's debt levels really that bad when compared with other leading developed economies?

The article goes on to show a chart, which identifies the high level of debt in other developed economies, as if this were to suggest that UK debt levels are OK. It is a curious argument that is put forward in various forms by many commentators. It is like a person who is about to go bankrupt pointing to their neighbour and suggesting that their neighbour has borrowed even more than themselves, so that means that they will not themselves go bankrupt. Of course, their neighbour might be earning more in relation to their debts, might be better able to cut their expenditures, might have borrowed from family rather than the bank and so forth. Also, there is the possibility that their neighbour will go bankrupt too. It is, in other words, a simplistic and complacent point of view.

The concern for this post is that the growing fiscal deficit goes alongside the ongoing fall in GDP.

Britain's economy shrank by 0.2pc in the three months to September, more than the 0.1pc decline expected, as stronger construction output was offset by a weakening in the services and industrial sectors.

This leaves Britain officially mired in recession, unlike most of its major trading partners, even though the previous estimate had shown a bigger 0.3pc GDP contraction.

Regular readers will be aware of the fact that GDP includes debt based activity, so it is apparent that the record levels of government borrowing are still insufficient to prop up the GDP figures. Such an outcome is quite shocking, and suggests that the underlying state of the economy is truly dire. The key question is to ask what GDP might look like without the government's huge borrowing, and the word 'ugly' comes to mind.

As for the policy of Quantitative Easing (QE - printing money to finance government borrowing), there is considerable discussion of the policy coming to an end:
All but one of the 53 analysts in a Reuters poll reckon the Bank of England will halt its quantitative easing programme when the current 200 billion pound ($320 billion) asset purchase fund, intended to help keep credit flowing, runs out in the next few weeks.
I am not so confident. As I have previously asked, who exactly will pick up the slack if the Bank of England ceases purchases of gilts? The Bank of England has expressed concern about the state of the fiscal deficits, but that is a long way from a decision to throw the gilt markets to the wolves. This is not to excuse the Bank for an irresponsible policy, but rather an acceptance of the dilemma that the Bank is facing. On the other hand, with the fig leaf of the deflationary fear receding, how might the Bank justify an ongoing policy of QE? I would guess that there are some strained meetings taking place between Alastair Darling and the Bank of England.

The scope of the problems of QE and the fiscal profligacy of the government are now having an impact on the gilts market, with yields on gilts moving to levels that are now comparable with Italy. Even mainstream economists are starting to accept that the policy of QE increasingly looks like a method of monetization of government debt, and that this will eventually lead to a crisis:

In a letter to The Sunday Times, the economists, including Tim Congdon, Patrick Minford and Gordon Pepper, warn of “heightened risk” of a downgrade of Britain’s sovereign debt rating.

The signatories, several of whom are on the “shadow” monetary policy committee, say that the integrity of UK fiscal and monetary policy is at stake because of the huge budget deficit.

They warn that international investors could see the Bank of England’s £200 billion quantitative easing programme, mainly the purchase of UK government bonds (gilts) as “driven by a politically-motivated desire to ease the government’s funding difficulties”
Regular readers will know that I have been making the argument that the QE policy is a method of funding massive fiscal deficits, and that I argued even before the commencement of the policy that the response to a growing fiscal hole would see either printing money or sovereign default. The most incredible part of the entire story is that economists, analysts and commentators have accepted the Bank of England spin on the policy for so long. I suspect history will not be kind to those that have accepted the Bank's line on this policy.

Then there is the 'real' economy. Starting with the banks, they are facing major headwinds, with losses on lending stretching out to the horizon. Commercial property is looking a particular risk, with loans in breach of agreement doubling in the first half of 2009, and expectations for the situation to become worse. Residential mortgage arrears, already at a high rate, also increased in the third quarter of the year by 3%. Some positives might be seen in the figures, even though they are still terrible:

A total of 13,987 properties were repossessed by lenders during the three months to the end of September, according to the Financial Services Authority.

But the figure was 6% lower than during the first quarter of the year, as a combination of low interest rates, Government schemes and lender forbearance helped people to stay in their homes.

The Government has launched a raft of initiatives to help people struggling with their mortgage stay in their home.


The combination of of Government support, low interest rates and lender forbearance has caused the CML to slash its forecast for repossessions for 2009 by more than a third to 48,000, although this would still be the highest number since 1995.

Of course, the question about such schemes is to ask how much they will cost, and whether they are sustainable, or simply putting off the day of reckoning for both the banks and the mortgagees. With regards to interest rates, if inflation picks up or there are problems rolling over government debt, then it is quite possible that the Bank of England will be forced into interest rate rises.

As for consumer credit, the losses in the coming year are expected to be horrendous, with the following from the Telegraph:

"Economic indicators and feedback from our collections clients suggests that the first quarter of 2010 could be the busiest period ever seen."

Experian is anticipating the worst due to the 771,000 job losses in the first nine months of the year, a 94pc increase on 2008, and the record quarterly personal insolvency rate of 41,390 for the three months to September.

There are a few points to highlight from these indicators. The first is that, with consumers saving and restricting in their spending, it is not clear where the shops, bars, restaurants, and all the other consumption based businesses are going to get their income (the puzzle of growth in spending mentioned earlier). This lack of income will in turn impact upon employment and commercial property, and this will in turn feed into more mortgage and credit defaults, and this will then impact upon the banks. The truth is that, now consumers are trying to live within their means, and are prudently saving, the adjustment can not be stopped. The move of consumers to living within their means can only mean a downward spiral, until the point is reached where businesses supported by excessive borrowing are gone.

Even the government's massive borrowing, acting as the consumer of last resort, is insufficient to hold back the inevitable adjustment - at best it is an expensive mechanism of delay.

Then there is manufacturing. Output is down by 8.4% according to the Economist of 12th December. Bearing this in mind, I read an interesting article in the Times, which was still harping on about the much vaunted theme of the knowledge economy:
The primary question, though, of where the money comes from in the future, is difficult. In 1975 55 per cent of the British economy came from services. Now 75 per cent does. Manufacturing was more than a fifth of the economy 20 years ago. Now it is less than one eighth. But this, in itself, does not mean the economy is “unbalanced”. Manufacturing is roughly the same share of the economy in the UK as it is in France and the US. In any case, outside the aerospace, defence and biotechnology industries, manufacturing is stuck in a trap of low value and low skills. These jobs will migrate to anywhere that adds low wages to the mix.
They still do not get it. This is the bankrupt model that led the UK, and other economies into the mess we are in. A quick look at the current account balance for the UK shows that this has not, and is not, working. Again, according to the Economist, the UK's trade balance is $US -126 billion, and the current account balance is $US -50 billion.

The article in the Times presents the aspiration for a future built upon "biotechnology, pharmaceuticals and sophisticated engineering", but we have heard this mantra in the past, and it is not paying the UK's bills. That winning in these sectors would be a good thing is not a matter of dispute, but the reality remains that the UK has, over a long period of time, failed to achieve this miracle.

Whilst it is possible to point to many successes in the creation of jobs from these industries, it has become clear that the UK also needs to compete in old fashioned manufacturing. The added value in the output in the 'creative' and high tech sectors has not been paying the bills, and this has been hidden by debt based growth. In order for the UK to succeed in manufacturing, the reality is that it must accept the necessity to compete with lower wage countries, a critical element is to remove the burdens on the UK economy associated with excessive government expenditure and debt creation.

A reduction in the size of the state is not the whole solution. A more efficient state is necessary, as is the necessity of pushing for fairer free trade, for example addressing the currency manipulation of China, or the inequities of state intervention in industry in the EU. In addition, there are many areas of the UK in need of reform, and it is beyond this post to detail all of them (see links to my suggested reform at the top left of the page). The point is that the one thing not being addressed by government is the underlying problems at the heart of the UK economy.

Talk of success in high tech and creative industries is easy. Actually generating enough to support a high standard of living in the UK are entirely different matter. History to date has shown us that it is not enough, and there is no reason to think that this will (as if by magic) change simply because people wish it to. The UK has been living on borrowing for too long, and something must change if the UK is to achieve economic success.

For those that point, for example, to the success of countries like Germany, and that we should emulate their policy, I have a simple question. If it was possible to achieve, why is it we have so stubbornly failed to do so? We have had industrial policy and it failed, we have had high government expenditure, and massive state intervention and it failed. Why will it be different this time? Economists might argue about what are the key elements of German success, but can another country - with so many structural and cultural differences - ever hope to reproduce the success? I would argue that the success of one country can not be easily transferred to another country with an entirely different structure and culture. In other words, the UK must enact policy that will work for the structure and culture of the UK.

I read an article recently (sorry, I forget where) which suggested that ongoing falls in the £GB will see trade eventually return to balance. Currency devaluation is often seen as a solution to economic problems, which is partially true. If the value of a currency falls, then the competitiveness of businesses does indeed increase. However, it does so at the cost of relative impoverishment of everyone who holds the currency. In simple terms, if you are paid in £GB and enjoy Belgian beer, then the price of the beer will go up - you are literally poorer in terms of your Belgian beer purchasing power.

As such, devaluation is a solution to a poorly performing economy, but it is a solution in which everyone in the economy is quite literally poorer. It is a mechanism of re-balancing an economy, but it always puzzles me that it is proposed as a 'successful' solution by some economists. It is just a wage cut for everyone, and the erosion of the purchasing power of savings. It is a form of achieving competitiveness that is punitive, in particular for those who have worked hard and saved.

Although devaluation might eventually lead to a re-balancing of the economy, at cost to everyone, the problems of such a devaluation are numerous. As has already been detailed, there is considerable nervousness about the UK's fiscal policy. If a government and the Bank of England seeks the devaluation solution, then there is a real possibility of a gilts strike. If investors believe that there will be an ongoing and substantial devaluation, then it will become ever more difficult for government to borrow, which means printing more money to fund deficits. In addition, inflation will continue to increase, as imports become more expensive. As inflation increases, the cost of government will increase, requiring higher levels of borrowing. I think you can see where this is heading...an inflationary spiral.

Devaluation is therefore a very, very high risk solution. It leaves only one viable solution, which is that the UK economy must just stop consuming more value than it produces. That means that government must follow the lead of consumers and stop borrowing to spend. That the solution will be very hard does not remove the necessity. Yes, the economy will go into a tailspin. Yes, it will need cuts in expenditure in every sector of the economy, even in the NHS.

The basic question to be asked is what is the alternative? A government that lives on printed money, crippling inflation and massive interest payments? Yes, the UK economy might get away with the policy of printing money and massive fiscal deficits for a little longer. But what will happen when this finally unwinds? How much worse will it be then?

As 2009 comes to a close, the deep seated problems in the structure of the UK economy are harder and harder to hide. The (neo) Keynesian solutions that so many supported are now being seen as what they are - a progression towards disaster. The idea that government can borrow and spend to infinity is being tested, and it is apparent that this can only work if people are willing to lend. This small detail escaped the Keynesian economists, who seemed to assume that governments could indeed borrow with no restraint or consequence.

You do not need a PhD in economics to know that people will only lend money if they think they have a reasonable chance of having that money returned to them. You do not need a PhD in economics to know that, if your finances are in a mess, lenders will demand ever more reward for the risk of lending you money. You do not need a PhD in economics to know that you can not continue to live beyond your means forever, and that one day the borrowing will have to stop and paying back the debt will need to start.

Perhaps the most interesting aspect of the coming year for the UK will be the election. It might be that Gordon Brown will seek an early election, hoping for re-election before the economy becomes any worse, or in fear of a coming gilt strike. The likely winner of the election is the Conservative Party, who will inherit an economy and fiscal situation that is on the brink of disaster. To date, the Conservatives have failed to persuade me that they have either the will or the courage to tackle the deep seated problems of the economy head on. Perhaps they are hiding their plans from the public, and do intend a more radical policy than they are currently proposing. This can only be speculation, but in all cases the Conservative Party should be honest with the public.

As the world enters a new year, it is time for honesty. The party is over, and the hangover must now start. When surveying the news, there are still only hints from the politicians of the severity of the situation. The time has come for the politicians to come clean, and tell people about exactly how bad the situation actually is. It is only then that people can actually accept what is an absolute necessity, and that is wholesale restructuring of the UK economy.

Note: That restructuring the UK economy alone is not enough should not stop the process from starting. The more difficult and intractable problems of the world economy must also be addressed, but the UK government can not by itself address this problem. Currency manipulation by China, for example, requires action from the US an the EU.

Sunday, December 20, 2009

Climategate and Economics

One of the longstanding themes that I have considered is that there has been a fundamental shift of wealth creation from the East to the West. In that spirit, I will wade into an area that would not normally be the subject of an economics blog; the rather contentious subject of 'climate change', or Anthropogenic Global Warming (AGW).

Longstanding readers will know that I am an AGW skeptic, as I posted to this effect in my consideration of reform of energy markets in the UK. I return to the subject following reading an article in the Daily Telegraph, which reveals the economic outcome of climate change policy. The article is by Christopher Booker, and describes how a UK steel plant is closing due to subsidies provided by climate change policy:

The real gain to Corus from stopping production at Redcar, however, is the saving it will make on its carbon allowances, allocated by the EU under its Emissions Trading Scheme (ETS). By ceasing to emit a potential six million tonnes of CO2 a year, Corus will benefit from carbon allowances which could soon, according to European Commission projections, be worth up to £600 million over the three years before current allocations expire.

But this is only half the story. In India, Corus's owner, Tata, plans to increase steel production from 53 million tonnes to 124 million over the same period. By replacing inefficient old plants with new ones which emit only "European levels" of CO2, Tata could claim a further £600 million under the UN's Clean Development Mechanism, which is operated by the UN Framework Convention on Climate Change – the organisers of the Copenhagen conference. Under this scheme, organisations in developed countries such as Britain – ranging from electricity supply companies to the NHS – can buy the right to exceed their CO2 allocations from those in developing countries, such as India. The huge but hidden cost of these "carbon permits" will be passed on to all of us, notably through our electricity bills.

The Western world is facing an era of new competition from the rising stars of the East, and the policies that are being developed to fight 'climate change' are a catalyst to the deindustrialisation of the West. It is for this reason that I am wading into the debate, despite the likelihood that I will lose readers that are 'believers'.

I would expect that, as most of my readers are well informed, they will be aware of the 'climategate' scandal, in which emails have been hacked from the Climate Research Unit (CRU). The emails suggest that there has been manipulation of climate research data, a corruption of the academic journal system, and attempts to hide the data used in climate modelling from critics. For those that have not taken a particular interest in the debate over AGW, these may have been a revelation. For those of us who have followed the debate, the hacked emails are simply confirmation of what we already believed; the 'science' has been fixed.

For those in the AGW camp, there have been attempts to minimise the fallout from climategate, with suggestions that, whilst not a good exemplar of science, the incident does not change the underlying reality of AGW. The problem that this argument faces is that climategate has revealed to the world that the evidence for AGW has been the subject of manipulation, and that the science just does not stack up. Of particular importance in this debate is the problem of the (in)famous 'hockey stick' chart of global temperature, and the removal from the chart of the medieval warm period. This is a critical part of the debate. The hockey stick chart shows an unprecedented rise in global temperature over the last century, but the medieval warm period shows that the world temperature was at the same temperature in the medieval period.

The unprecedented warming on the hockey stick chart has been presented as the 'smoking gun' of AGW, and much of the veracity of the AGW argument must rest on this chart. The trouble is that this chart is at the heart of the data manipulation, and this has been revealed by the tireless efforts of Steve McIntyre. A summary of some of the work can be found in an article in the UK's Daily Mail newspaper, which shows how data that contradicts AGW has been hidden. The full details of McIntyre's studies can be found on the Climate Audit website, and I would recommend a long browse if you wish to understand the full argument (it is not an easy read, but worthwhile).

The climategate emails have had further repercussions, such as the publication of a paper by the Russian Institute of Economic Analysis. In the paper, they investigate the use of data by the CRU in climate models, and have found that the CRU cherry picked data in Russia such that they excluded any information which might contradict the AGW thesis. A translation of the paper is provided here, and I would again recommend reading it. It is easy to follow, and the analysis is very clear and convincing.

As one analyst in the Wall Street Journal has suggested, climategate is just the tip of the iceberg, and the full impact has yet to be felt. In particular, the refusal of the AGW proponents to share data, and the destruction of data has become an issue. The following is a quote from the article:

Which leaves researchers free to withhold information selectively from critics, as when CRU director Phil Jones told Australian scientist Warwick Hughes in a 2005 email: "Why should I make the data available to you, when your aim is to try and find something wrong with it."

An interesting question. Often, when independents obtain raw temperature data or computer codes, they do uncover flaws, thus advancing climate science—the "sunlight" now shining on CRU's data and codes is doing just that. That's what motivated Competitive Enterprise Institute scholar Christopher Horner to request a slew of information from NASA's Goddard Institute for Space Studies, which has already corrected its temperature records thanks to Mr. McIntyre's probing. Mr. Horner told us he wants "an entire accounting of rolling, relevant data, adjustments, codes, annotations and of course internal discussion about the frequent revisions."

Two years later, the requests are unmet. A NASA spokesman said "We're clearly late, but we are working on it." Probably wise, considering Mr. Horner is set to sue, and two U.S. senators have asked NASA's Inspector General to investigate.

There is also the question of the way in which research that contradicts the 'consensus' has been excluded from academic journals. Patrick Michaels, a former Professor of Environmental Sciences writes of the way in which the views of skeptical scientists have been excluded from the literature, saying:
The result of all this is that our refereed literature has been inestimably damaged, and reputations have been trashed. Mr. Wigley repeatedly tells news reporters not to listen to "skeptics" (or even nonskeptics like me), because they didn't publish enough in the peer-reviewed literature—even as he and his friends sought to make it difficult or impossible to do so.
Again, I would recommend reading the article in full, as it highlights the many manipulations of the journal system. As if this were not bad enough, there has been the doctoring of climate change articles on the Wikipedia website, with William Connolley acting as a gatekeeper on the site to prevent any skeptical arguments appearing, for example preventing the medieval warm period from appearing (see here and here):
All told, Connolley created or rewrote 5,428 unique Wikipedia articles. His control over Wikipedia was greater still, however, through the role he obtained at Wikipedia as a website administrator, which allowed him to act with virtual impunity. When Connolley didn’t like the subject of a certain article, he removed it — more than 500 articles of various descriptions disappeared at his hand. When he disapproved of the arguments that others were making, he often had them barred — over 2,000 Wikipedia contributors who ran afoul of him found themselves blocked from making further contributions. Acolytes whose writing conformed to Connolley’s global warming views, in contrast, were rewarded with Wikipedia’s blessings. In these ways, Connolley turned Wikipedia into the missionary wing of the global warming movement.
At this stage, you may note that the medieval warm period really is at the heart of the debate. The problem for the AGW proponents is that it just will not disappear. However, as the hockey stick chart's credibility collapses, the AGW proponents are now seeking to shift attention away from the problem. This is from the Financial Times:
Myles Allen, head of climate dynamics at Oxford University, explains: “The reason the hockey stick will only ever play a peripheral role in understanding current climate change is that we don’t know what the drivers of climate were before 1900. For instance, we don’t know what the sun was doing back in 1100.” Cautious scientists prefer to restrict the case for climate change to what we know from instrumental data: temperatures have been rising over the past 120 years; carbon dioxide levels have been increasing; and scientists have established that adding carbon dioxide to the atmosphere causes warming.
It is all rather convenient, is it not? As the credibility of the hockey stick dissolves, the focus shifts to the instrumental readings. However, if the medieval warm period took place before industrialisation, then there is no reason why there should be concern about warming in this century (if there has been any warming).

If you doubt the dogmatism and unreasoned thinking of the AGW proponents, you may wish to read an article which serves to highlight how the thinking of these so called 'scientists' can not be moved. It is not a skeptical article, but shows how data that contradicts the AGW thesis is rejected. A couple of extracts follow:
Some 3,000 scientific robots that are plying the ocean have sent home a puzzling message. These diving instruments suggest that the oceans have not warmed up at all over the past four or five years. That could mean global warming has taken a breather. Or it could mean scientists aren't quite understanding what their robots are telling them.


One possibility is that the sea has, in fact, warmed and expanded — and scientists are somehow misinterpreting the data from the diving buoys.

But if the aquatic robots are actually telling the right story, that raises a new question: Where is the extra heat all going?

Kevin Trenberth at the National Center for Atmospheric Research says it's probably going back out into space. The Earth has a number of natural thermostats, including clouds, which can either trap heat and turn up the temperature, or reflect sunlight and help cool the planet.

Somewhere, the obvious answer has been lost; the buoys are telling the story accurately, and there has just been no warming.

It is impossible in one short post to fully detail the many and sometimes complex arguments against the AGW thesis. I have instead (I hope) aimed to identify the problem that the 'scientific consensus' is actually based upon fraud and manipulation. I can not prove that AGW does not exist, and can not in a short article present as much detail as would be ideal. What I hope to do is shift some views in light of the economic impacts of the legislation and policy that is being enacted. The article by Christopher Booker just highlights one example of the consequences of the fraud.

The consequences go far further. As the West moves to ever more expensive forms of energy generation, the cost of manufacturing will increase. In my article on energy reform (also read the notes section), I showed why wind farms are an absolutely useless and horrendously expensive method of generating electricity. There are ever more proposals and resource being poured into these kinds of projects. It is resource which, in an increasingly competitive world, that can not be wasted. The West can not afford to follow this path.

I have consistently argued that the West is facing an economic crisis resultant from competition from the East, and that the financial crisis was just a symptom of a deeper problem. In order to face the increased competition, the Western world must become leaner and more competitive. There may have been a time when we could have afforded the senseless cost of the fraud of AGW, but that time is not now.

I can only hope that the revelations of climategate will finally see a bright light finally shine on the fraud of AGW.

Tuesday, December 15, 2009

Inflation in the UK

The UK Economy

The doubts about the future of the UK economy have been multiplying of late, prompting one commentator to seek to defend the economy, arguing that there remain competitive advantages in the UK economy. Despite such positive framing of the discussion, the doubts still remain, as in the following excerpt:
That said, we are in a mess. In type, the position we face is not so different from the early 1990s, although the government's deficit as a share of GDP is going to be about double what it was then and the stock of debt is much higher. The UK's current account deficit, though, has not been as large, even when the economy was strong, as it was during the 1980s' boom, and it is now about the same as it was in the early 1990s.
Perhaps the most interesting news for the UK is that inflation is once again climbing. Input prices have been rising for manufacturers, and continuing weakness in the £GB will have an ongoing inflationary impact, much as I predicted long ago. This from the Telegraph:

The Consumer Prices Index (CPI) - the measure of inflation used by the Bank of England to set interest rates - was 1.9pc higher in November than in the same month in 2008. Economists had pencilled in a gain to 1.8pc. On the month, CPI climbed 0.3pc.

The Bank has already said that it expects inflation to breach its 2pc target and possibly rise as high as 3pc in coming months, as a combination of higher oil prices and the reversal of the cut in VAT - it will return to 17.5pc from 15pc on January 1 - push up prices across the economy.

Inflationary expectations are problematic for the Bank of England's policy of quantitative easing, as the threat of CPI deflation has been used as a fig-leaf for the policy. This report from AP:
"The MPC [Bank of England Monetary Policy Committee] has dished out many gifts to the economy throughout the year, so it was unsurprising that at its pre-Christmas meeting it thought it had done enough," said Stephen Boyle, head of RBS Group Economics. "These monetary policy presents, from low interest rates to quantitative easing, are gifts that will keep giving and will help get the economy back to its feet in the New Year."

Analysts now expect the bank to wait until its quantitative easing program, which boosts the money supply by effectively creating new money to buy assets, is completed in another two months before considering whether to expand the program.

"The scale of the program will be kept under review," the committee said. Detail on how the nine members voted will be revealed when the minutes of the two-day meeting are posted on Dec. 23.

The Bank of England's November inflation report makes interesting reading, with considerable caveats on inflation expectations. I will quote their discussion at length:
Inflation is likely to rise sharply in the near term, primarily reflecting the reversal of the VAT reduction, while sterling’s past depreciation continues to push up on inflation. Thereafter, downward pressure from the persistent margin of spare capacity is the dominant force. This pressure acts to bear down on CPI inflation, although it gradually fades as the economy recovers.

The extent to which CPI inflation will deviate from the 2% target is highly uncertain and depends on a number of factors. The degree of downward pressure from the weak demand environment will depend on the timing and strength of the recovery, the impact of the downturn on the supply capacity of the economy, and on the sensitivity of inflation to the degree of economic slack.

The profile for inflation will also depend on the extent to which companies need to adjust further to the higher import costs associated with sterling’s depreciation and on whether there are further substantial movements in energy and commodity prices. There is a range of views among Committee members about the relative strength of these factors. On balance, the Committee judges that, conditioned on the monetary policy assumptions described above, the risks of inflation being above or below the target are broadly balanced by the end of the forecast period. The outlook for inflation in the medium term is somewhat higher than in August, reflecting the stronger projected distribution for GDP growth.
Despite such caveats, the MPC chose to continue with the anounced asset purchases, otherwise known as quantitative easing (QE), or better described as printing money to purchase government debt. That this is a radical policy has been acknowledged by the Bank of England, and that it was to forestall deflation was the original purpose of the policy. The fig leaf of deflation is disappearing but the policy continues.

The problem faced by the Bank of England is a very basic one. There is a flood of government debt issuance around the world, and the UK is just one of many countries expanding borrowing at an astounding rate. However, as a county with one of the fastest rising government deficits, the UK is one of the higher risk governments for risk of default. Furthermore, the pre-budget report appears, as one commentator puts it, to rely on 'hope' for a future fiscal deficit reduction. The pre-budget report was widely seen as being wildly optimistic, and presented many fiscal holes, further eroding confidence in the UK:
Government spending on defence, higher education, housing and transport is likely to bear the brunt of sharp cuts planned over the coming years, the non-partisan Institute for Fiscal Studies said on Thursday.

The IFS estimated that based on Chancellor Alistair Darling's pre-budget report on Wednesday, departmental spending outside protected areas such as health, schools and overseas aid would fall by 5.6 percent a year between 2011 and 2014.

This would require 35.7 billion pounds of savings, equivalent to just over 1 percent of national income. Around 15 billion pounds of this had not been identified, the IFS said.

Moreover, 12 billion of the 35.7 billion pounds in savings are planned to be achieved by efficiency gains, despite evidence that three quarters of the efficiency gains claimed by the government earlier this decade were questionable or did not occur, the IFS added.

One of the most interesting reports is not directed at the UK alone, but is very applicable to the UK economy. Moody's is contemplating the impact of social unrest as part of the inevitable fiscal retrenchment that must take place in the 'stimulus' economies. The underlying point of the report is that there are doubts about whether governments might be able to press home any fiscal retrenchment, and such questions might be raised about the UK.

As if these headwinds against ongoing funding of government debt were not enough, concerns are growing about unfunded pension liabilities and the hiding of government debt through Public Finance Initiatives. These factors will no doubt be added to the mix when investors contemplate their confidence in the UK government.

As such, in an increasingly competitive environment for access to credit, the UK government looks to be uncompetitive. If the Bank of England ends the policy of QE, it is uncertain as to whether the UK can continue to finance the massive spending it has enacted. It is a question of who, in an increasingly competitive government debt market, might choose to fund UK fiscal deficits. There are no obvious contenders to absorb the record levels of debt issuance, and any pull back on Bank of England purchases might see the start of failed debt auctions. On the other hand, if the Bank of England continues purchases of government debt, they will support an unsustainable position, and allow government to continue with incontinent fiscal policy.

The Bank of England will be damned if they end QE, and damned if they do not. As the situation stands, the only foundation for confidence in the UK economy is the prospect of a change in government. However, the likely winners of the next election is the Conservative Party, and they are still holding back on plans that will substantially and credibly reduce the fiscal deficits. Hope for improved fiscal policy will therefore be a gamble for potential purchasers of gilts.

If the government fails to sell debt, then the crisis that will follow will be truly breathtaking.

On the other hand, if the Bank of England continues down the path of QE, the size and scale of any future crisis will be larger, as the government will be allowed to continue with irresponsible fiscal policy. Furthermore, with CPI rising, how long will it be before the fig leaf justification for QE falls off, leaving The Bank of England with no hiding place for their Zimbabwe like policy? As for reversal of QE, the selling of the Bank of England's gilt holdings, this appears as a very, very distant possibility.

The UK economy has been miraculously floating on air. How much longer it can do so largely sits in the hands of investor confidence in a future change of government, and with a change of government a substantive change in fiscal policy. As Liam Halligan, a Telegraph columnist puts it, current UK government policy is 'leading the UK down the road to sovereign default'. Can the UK economy float on air until the election? Such a hope is a poor foundation for an economy, but is all that supports the UK economy at the moment.

The $US - More Cracks in the Edifice

I would like to start this post with a quote:
The Gulf states remain divided over the wisdom of anchoring their economies to the US dollar. The Gulf currency – dubbed “Gulfo” – is likely to track a global exchange basket and may ultimately float as a regional reserve currency in its own right. “The US dollar has failed. We need to delink,” said Nahed Taher, chief executive of Bahrain’s Gulf One Investment Bank.
I seem to have been arguing a lonely position for a long time; that the $US as the world's reserve currency is fast coming to an end. As each month passes, the doubts about the stability and value of the $US multiply, and it is evident that some of the main actors in the world economy are starting the process of retreat from the $US. Whilst the move towards the 'Gulfo' does not constitute the end of the $US as a reserve currency, it is yet another metaphorical nail in the $US coffin.

My argument has been straightforward. A reserve currency must have a value created by wealth generation, and that issuance of a currency beyond the expansion in wealth generation will eventually see a retreat from the currency. This is what I had to say about the $US in August 2008:
As such, the dollar may rally for a while, but in the end it can only last for so long before economic reality trounces market sentiment. At some point there needs to be an economic justification for a stronger dollar, and force of habit is a poor justification.
In January of this year, I discussed the 'myth of the eternal status of the $US as a reserve currency'. I would recommend that you read the article, as it seeks to look at the underlying and fundamental reasons why the $US can not continue as the reserve currency. In an article for Trade and Forfaiting Review, I made the argument in a very simple and digestible way, saying the following:
Imagine a world in which there was no international reserve currency, but that an organisation was proposing that the US dollar ought to be the future reserve currency. Would you take such a proposal seriously?

Your response might be that the US dollar sits atop mountains of debt, a shrinking economy and you would point out that the US monetary authorities are printing money to fund record government borrowing. You might actually laugh at such a prospect.
It is very simple - if the $US were not already the reserve currency, who in their right mind would propose it as such? If the currency can not stand upon its merits, then there is only sentiment and habit as foundations. These are extremely fragile foundations for a reserve currency, and I would suggest are foundations that will not bear the weight of negative factors bearing upon the $US. The question is not 'if' it should lose the reserve status, but how quickly sentiment might shift. I once prematurely called the demise of the $US, and am therefore reluctant to place a firm date on the demise, except to say that it will be sooner than many people think.

Note 1: Sorry for the lack of response to comments, and also replies to my Yahoo email address. I am still pressed for time, but take an interest in all of the comments.

Tuesday, December 8, 2009

The Crisis is Steadily Moving Towards Denouement

First of all, apologies for the lack of posts recently. I have simply not had the time to post.

Are others seeing that there is a slow and steady unwinding of the economic situation? There now appear to be signs of substantial cracks the edifice of the illusion economy. A review of the news sees several apparently unrelated stories, but nevertheless they cumulatively represent the underlying flaws in the attempts to hold back the underlying reality of the world economy.

First of all, there is the ongoing saga of Dubai, the exemplar of the worst excesses of property speculation:

Fresh fears about Dubai's ability to resolve its huge debt mountain returned to global stock markets today as shares across America, London and Europe tumbled.

In America, the leading Dow Jones industrial index fell 111.63 points to 10,278.48 at 3.40pm in New York.

Earlier today, Abdulrahman al-Saleh, Dubai's finance minister, admitted that six months may not be enough to restructure Dubai World, the state-owned conglomerate which owns Nakheel, the property developer.

It later emerged that Nakheel made first half losses of $3.65 billion, according to Bloomberg, after taking a huge writedown on the value of its land and developments. Two weeks ago, the Dubai Government asked creditors to grant Dubai World a six-month standstill on its repayments of nearly $60 billion of debt. Dubai World then announced plans to restructure $26 billion of its liabilities.

Likewise, there are the ongoing problems of Greece, perhaps an outrider for the larger Western economies. Greece presents another crack in the edifice of confidence in government debt:
The agency placed the country on credit watch negative, meaning it is likely to lose its A- rating within months. The country already has the lowest credit rating in the eurozone, but has come under greater scrutiny amid fears that its newly-elected government may avoid imposing significant cuts on the public finances


Following the recent crisis in Dubai, investors have become doubly sensitive to the risks of sovereign debt crises, with others warning that the UK is similarly exposed.

S&P also revised its outlook on Portugal’s sovereign-credit rating to “negative” from “stable”, blaming a deterioration in public finances.

As I have previously argued, if the UK falls, the US will soon follow. In the meantime, President Obama is reacting to a swathe of bad news with yet more 'stimulus' spending, at a time when the creditors to the US are already very nervous:

WASHINGTON – President Barack Obama called for a major new burst of federal spending Tuesday, aiming to jolt the wobbly economy into a stronger recovery and reduce painfully persistent double-digit unemployment.

Despite Republican criticism concerning record federal deficits, Obama said the U.S. must continue to "spend our way out of this recession" as long as so many people are out of work. More than 7 million Americans have lost their jobs since the recession began two years ago, and the jobless rate stands at 10 percent, a statistic Obama called "staggering."

Congressional approval would be required for the new spending, the amount unspecified but sure to be at least tens of billions of dollars.

This new stimulus comes on top of the news that the fiscal situation in the US is already in an absolutely appalling state:

In October and November, the government spent $292 billion more than it took in, the nonpartisan Congressional Budget Office said.

That was even worse than the same period last year, when the government was on its way to posting a record $1.4 trillion deficit for the fiscal year that ended Sept. 30.

The federal budget has been battered by the worst economic downturn since the Great Depression of the 1930s, as tax revenues have plunged and spending on safety-net programs like unemployment insurance have skyrocketed.

What we are seeing is the ongoing unwinding of the many bubbles, and that the forecasts and announcements of the end of the crisis are indeed premature (which has long been my argument). Even Bernanke is admitting that there are ongoing and deep problems, and the $US continues to decline:
The dollar resumed its slide against the yen, euro and other currencies after climbing in recent days amid hopes the US might stage a quicker-than-expected rebound.

On Monday, however, Fed Chairman Ben Bernanke said the world's largest economy was facing "formidable headwinds" — including a weak job market, cautious consumers and tight credit — that would limit the pace of recovery.

Obama expressed shock at the relentless rise in unemployment, but around the world a dire situation continues to deteriorate. This is just one example from the Times:

London traders were also unnerved by new data on industrial production, revealing flat output in October, signalling that Britain, which is still in recession, has made a weak start to the fourth quarter. The CBI also published its industrial trends survey, which showed factories expect output to fall in the coming months.

The weak data was released ahead of the Pre-Budget Report tomorrow when the Chancellor is widely expected to reduce his forecast for Britain's economic growth this year from a decline of 3.5 per cent to 4.75 per cent.

Meanwhile, European markets were unsettled by Fitch’s decision to cut Greece’s sovereign debt rating to BBB+ from A- with a negative outlook - the first time in 10 years a major ratings agency has put Greece, the eurozone's weakest economy, below an A grade. Fitch cited fiscal deterioration as the reason.

Also weighing on European stock markets was worse-than-expected German industrial production data. German industrial output fell 1.8 per cent in October, largely as a result of weaker production of machinery and cars, against expectations of 1.1 per cent growth.

As ever, the nervousness about the situation continues to be seen in the price of gold:
GOLD soared through US$1,200 (S$1,657) as investors and speculators feared renewed US dollar weakness following President Barack Obama's decision to substantially boost the war effort in Afghanistan.

Other factors that have boosted the demand are worries about quantitative easing, that is, money printing in the US and UK, punitively low interest rates for savers seeking a home, fears of renewed inflation and persistent turmoil in the Middle East.

Uncertainty in Dubai with expectations of bailouts and a general rise in oil and other commodity prices are other reasons.

There are some curiosities in the news, such as the ongoing rise in house prices in the UK. One just has to ask why house prices might be rising in a sinking economy to know that this is yet another illusion. After all, with unemployment rising, where is the money coming from? One article suggests that it is a lack of supply of houses for sale as the driver, but it is certain that the rise in prices does not reflect the real economy.

Essentially, any review of the news shows that the attempts to reflate economies with printed money and massive government borrowing are simply not working. The cash for clunkers, the massive spending on 'make work' projects are a dead end. Printing money with no economic foundation will simply not work.

The one thing that might work, the reforming of the economic structure of the troubled economies, is the one thing that is never considered. In the early days of the blog, I wrote some examples of how the UK economy might be reformed. I am not sure that the UK will be able to even afford to support the reformed economy that I proposed. It is too late. Instead of using credit to manage the transition to a more lean and competitive economy, credit has been used to try to hide the reality of the economic situation. The same might be said of other economies, such as the US.

I keep on asking how long can this continue? How long before the illusions shatter? I am amazed that it has lasted this long.

Note 1:

In an early post during the bailouts, I mentioned that all of the money given to support the UK banks was not to protect little old ladies' savings, but to support overseas creditors. This is what I had to say in a post titled 'The UK and the Silent Bank Run' (written March 2009, but I think I argued this point at the outset of the bailouts, but can not find the article):
If we think of the numbers that we are looking at, it becomes self-evident why the endless bailouts by the government are falling into a black hole. The government is having to bail out the banks to repay these overseas investors such that, as fast as the money is pumped in, it is pumped straight back out to meet the demands of overseas depositors. With the banks sitting on mountains of toxic debt, with no market left for the sales of these toxic assets, there is nowhere to turn except to the government.

It is as I have long suspected. I have always been of the view that this is not really just about bailing out little old ladies with their savings held by RBS, but also about bailing out all of the overseas investors who stand to lose so much money.
This is an article in the Telegraph:

British taxpayers stand behind more than £167bn of toxic assets in the US, Ireland, the Middle East and beyond, it has emerged as the Treasury disclosed details of what Royal Bank of Scotland has dumped in the state insurance scheme for bad debts.

Most of the £281.9bn of assets RBS has placed under taxpayer protection are based outside the UK, with loans secured against everything from negative equity properties in Dublin to hedge fund assets in Caribbean tax havens and container ships docked in ports around the world.

I suspect that this is just the tip of a very large iceberg, and the same will be found for the US. What we have witnessed is the salvation of the banks to protect overseas creditors. These were the same creditors who flooded the economies of countries like the UK and US with money, which in turn created the asset price bubbles and credit bubbles. In the case of the banking industry, it is heads I win, tails I win. It was never about protecting the small domestic depositors, but bailing out overseas investors.

Note 2:

A slightly rushed article as I am still pressed for time. However, I hope it provides some evidence that we are a long way from any real or sustainable recovery.

Saturday, November 21, 2009

The King Canute Economy

I have had a good day in browsing through the economic news, as I found three very interesting articles which together represent a consistent theme (although I say lucky, I mean only in the finding but not the implications of the content). The first of these comes from Ambrose Evans-Pritchard, the second Peter Schiff, and the last Liam Halligan. For the former, Ambrose Evans-Pritchard, I often disagree with his analysis, but can not dispute that he often identifies some fascinating stories on the economy. Today, I came across an article which is of particular interest, and some highlights are given below:
In a report entitled "Worst-case debt scenario", the bank's [Societe Generale] asset team said state rescue packages over the last year have merely transferred private liabilities onto sagging sovereign shoulders, creating a fresh set of problems. [this was exactly my argument at the time the first bailouts were being undertaken]


Governments have already shot their fiscal bolts. Even without fresh spending, public debt would explode within two years to 105pc of GDP in the UK, 125pc in the US and the eurozone, and 270pc in Japan. Worldwide state debt would reach $45 trillion, up two-and-a-half times in a decade.


Inflating debt away might be seen by some governments as a lesser of evils.

If so, gold would go "up, and up, and up" as the only safe haven from fiat paper money. Private debt is also crippling. Even if the US savings rate stabilises at 7pc, and all of it is used to pay down debt, it will still take nine years for households to reduce debt/income ratios to the safe levels of the 1980s
I strongly recommend reading the article in full. All in all, this is not far from the kind of scenario that has long been painted on this blog. Shifting debt from the private sector onto the public sector, at exactly the time that the public sector would be starved for revenues, was always going to be a disaster.

In another article Peter Schiff, a long term bear, touches on another theme of this blog - the role of China in the world economy, and the artificial low level of the RMB in relation to the $US. The SocGen report and Schiff's report are actually just looking at two sides of the same equation. If we put the two reports side by side, it is apparent that both of the reports are actually discussing exactly the same problem - which is that governments have sought to replace private debt with government debt, and that the only route out of the debt is eventual currency devaluation. In replacing private debt with public debt, the imbalances in the world economy will be maintained. This is an extract from Schiff's article:
While the peg certainly is responsible for much of the world's problems, its abandonment would cause severe hardship in the United States. In fact, for the U.S., de-pegging would cause the economic equivalent of cardiac arrest. Our economy is currently on life support provided by an endless flow of debt financing from China. These purchases are the means by which China maintains the relative value of its currency against the dollar. As the dollar comes under even more downward pressure, China's purchases must increase to keep the renminbi from rising. By maintaining the peg, China enables our politicians and citizens to continue spending more than they have and avoiding the hard choices necessary to restore our long-term economic health.


As demand falls for both dollars and Treasuries, prices and interest rates in the United States will rise. Rising rates will restrict the flow of credit that is currently financing government and consumer spending. This change will finally force a long overdue decline in borrowing. So, not only will Americans lose access to the consumer credit that funds their current spending, but the things they buy will also get more expensive.

Our short-term loss will be in sharp contrast to the gain felt by foreigners, who will be rewarded with falling consumer prices and a more abundant supply of investment capital. In other words, the American standard of living will fall while that of our trading partners will rise.
As for Liam Halligan's article, he reports on a report from the OECD as follows:
Less prominent was the admission that: "The upturn in the major non-OECD countries, especially in Asia and particularly in China, is now a well-established source of strength for the more feeble OECD recovery". So the Western world is relying on the emerging markets – the far-flung economies of the East – to pull them out of this slump.

The West's debt-soaked consumers, firms and governments badly need to "de-leverage" – which channels resources into interest and repayment costs, rather than expansion. The likes of Brazil, China, India and the others, meanwhile, have far, far lower debts than their Western rivals, so can spend the next few years "levering-up" – taking on more credit, in turn fuelling growth even more.

All of these articles relate to and article I wrote a long time, explaining the underlying change in the world economy, and which explained the economic crisis as the shift in wealth generation from West to East. In particular, the opening of the East saw a sudden massive expansion of the labour force (labour meaning with access to capital, markets and technology).

My argument was that the massive credit and housing bubbles were simply masking the underlying change in the world economy that flowed from the supply shock of new labour into the world economy. I have written several versions of the article, but my version on Huliq is a short version and can be found here (note: there is an error - zero sum 'gain' should be 'game'), or a fuller discussion can be found here.

What we are seeing in the reports and the analysis of the three articles cited here, is the process of governments seeking to hold back and resist the fundamental change that has taken place. The change that I am referring to is that there is a massive redistribution of wealth, and that there is now a situation of hyper competition throughout the world. In an article for Trade and Forfaiting Review magazine, I explain this in simple terms by making a comparison between the fortunes of SUV car manufacturers and the Tata Nano car:

While the US and, to a lesser extent, Europe are seeing catastrophic contractions in their car markets, the Tata Nano has a massive waiting list among Indian car buyers, keen to upgrade from two wheels to four. The contrast between the old industry, perhaps best exemplified by General Motors, and this innovative upstart illustrates the new shape of the real-world economy.

The important point about the Tata Nano is that it is meeting a new demand from a rising middle class in emerging economies. In the interim, the credit-fuelled demand for SUVs, the mainstay of US car industry profits (until recently), is collapsing. On the one side there is a car that rests upon an unsustainable credit-fuelled consumption boom, a car that flattered the aspirations of the indebted and, on the other, there is a car that meets the rising aspirations of the world’s new wealth generators.

The point is that SUVs represent a concentration of car-owning wealth in the hands of the few, and the Nano is the shift of that car-owning wealth into the hands of the many. It is representative of the underlying shift in real wealth, which is redistributing towards the East, and levelling down the West in the process.

It is a crude characterisation of the change in the world economy, but many large companies such as GE are already changing their product lines to meet these changes. The middle of the market has shifted down whilst broadening. The problem is that these changes are real, and are taking place now. Governments are seeking to withstand the reality of the changed circumstances of the world. The trouble is that, as much as any government might resist the change, it is unstoppable. Nobody is going to put the 100s of millions of new workers back in a box - and there are still large reserves of labour ready to enter the market.

It is only when the economy is seen in this light that we can truly see the madness of government policies - whether the policy of China, the US or the UK. Each country is seeking to maintain an equlibrium that never actually existed. The credit and housing bubbles in the West flattered the underlying condition of economies such as the UK and US, and the world economy was misdirected to feed the illusion of wealth in the West. The overall structure of the underlying economy is the Tata Nano economy, but all governments are seeking to maintain the SUV economy. In doing so, the imbalances are becoming ever larger, as ever more is owed by the current account deficit countries to the surplus countries. The growth in the imbalances is simply going to make the final adjustment ever harder.

I call this the 'King Canute Economy'.

In the legend of King Canute on the sea shore, it is popularly represented that King Canute was so arrogant that he actually sought to hold back the tides. However, King Canute was actually demonstrating that, for all his power, there were some forces which he could not overcome. As we contemplate the actions of governments around the world, it is possible to wonder whether they have ever heard King Canute's story.

In the case of King Canute, he ended up with wet feet. In the case of the world economy, the consequences might not be so mild.

Friday, November 13, 2009

Who Might Run Industrial Policy?

It has been a while since I have last written a post, and the choice of subject matter for this post has proven to be a difficult decision. On the one hand, there is the ongoing tremors in the financial system, and on the other there are the global shifts, such as the unsubstantiated suggestion by China that they may allow the RMB to appreciate. Added to this, there is the ongoing ascent of the gold price, as investors and governments move into the asset of last resort, and the progressive decline in value of the $US. This from the Wall Street Times:
"The gold market is kind of surprising here," as it holds on to the psychologically important $1,100 level, said Ralph Preston, senior market analyst with Heritage West Financial.

Watching the dollar's next moves will be crucial, Preston said. "It's going to be interesting whether the dollar is developing a bottoming formation or if it is about to fall off a technical cliff."

I will leave such matters alone for this post, as they are being covered elsewhere. Instead I would like to focus on one of the widely utilised government stimuli; the cash for clunkers schemes. I am focusing on this subject, as the scheme has appeared to give a temporary reprieve in the downwards trajectory of many economies. My inspiration was an article in the Telegraph, in which Jeremy Warner analyses the impact of the stimulus on the UK economy.

The purpose of my post is to highlight the absolute foolishness of such government measures in relation to arguments for more government interventions in economies. A long while ago, in a discussion of GDP measures, I pointed out that Hurricane Katrina would have seen an uptick in US GDP. The destruction of infrastructure, housing and other assets would have led to increased activity in the economy, as business and government sought to replace the assets that were lost. In other words, the destruction of a hurricane would appear to be a positive boon for an economy. On such logic, bombing your own cities would be good for the economy.

As it is, we have seen a natural disaster replaced with a man made disaster. Each of the cars that has been scrapped early is an asset with a real value, and useful life. Just as a bridge being destroyed in a hurricane still has a useful potential lifespan, the same might be said of the cars that have been scrapped. Quite simply, the result is just the same.

In some ways it is an identical process to running a production line with a garbage compactor at the end of the production line. As each unit comes off the production line, the compactor simply crushes the item. The result of such a measure would be that the demand for the item might never be met, and the production line would be kept endlessly busy. Output would be maintained, GDP figures would be positive, and the economy would apparently be doing well as the result of this ongoing activity.

What I am discussing is not particularly original, and many other commentators have made similar observations. On this occasion, I am reiterating the point due to comments on my previous post. One of the regular commentators, writing under the name of Lord Keynes, made a robust defence of government intervention in the economy, proposing that governments develop industrial policy. What followed was a heated debate about the relative merits of government interventions, with both sides of the debate arguing their points vigorously.

In light of this debate, the purpose of this post is very simple. I have outlined the principles of a government policy, adopted in many countries, which is just a process of destroying useful assets - governments destroying something and suggesting that this is good for the economy. These governments include the same people in whom Lord Keynes appears to profess so much faith. These masters of our economic destiny actually think that premature destruction of assets is good for an economy. These are people who would count Hurricane Katrina as having had a positive impact upon an economy. Few would say such a thing directly (though I do recall that the Economist magazine came close to actually saying it), but they would see the positive GDP growth from the activity from Katrina as a 'good thing'.

My question is very simple. How can anyone have faith in these people? It is extraordinary that anyone might have faith in people with such bizarre beliefs. Really, can we trust these people with the widespread interventions in the economy, as proposed by Lord Keynes? The very same people who instigated the cash for clunkers policy would be the same people who would devise 'industrial policy'. Lord Keynes is not alone in having such faith in government interventions, and the worry is that those with his views are gaining ground. The advocates of ever more interventions, ever more shift of resource into government hands, are becoming ever more plentiful. That such beliefs are gaining ground is a real cause for worry.

Friday, October 30, 2009

The UK: Individual Liability for Government Debt

My original plan for this post was to highlight the disconnect between the stock market and the underlying state of the UK economy. However, there may be the start of a panic in stock markets, so it may be that the disconnect is starting to correct itself (see here for the UK and here for the US). As such, I will devote this post to a more general discussion of the current state of the UK economy, and the relationship between government debt and you as an individual.

Before starting, it is worthwhile providing some context on the UK economy. UK GDP sunk again in the third quarter, and the following are some of the reactions of analysts to the news:

James Knightley, ING

"UK 3Q09 GDP is awful with no positive news within the report ... More worryingly from sterling's perspective is the fact that the UK may be the only major economy to have contracted in 3Q09."

Brian Hilliard, chief economist at Societe Generale

"Very disappointing, the surprise comes in services where the business surveys seem to have been a little over optimistic. So we are significantly lagging the euro zone in terms of exiting the recession."

Unlike these analysts, I would not have been encouraged even if there had been 'growth' in GDP, as I do not believe that 'growth' derived from government debt accumulation is 'growth'. It is simply the foregoing of future wealth. I have written on this subject many times, and you may wish to read my most recent post on the subject (in relation to the US, but the principles are applicable to the UK). The key point is that GDP measures flatter the underlying state of the economy, as government debt accumulation drives GDP upwards.

As for more general indicators, over the last 12 months we have had a $bn 130 trade deficit, industrial production is down 11 percent on a year ago, and the official unemployment rate is just under 8% (from the economic and financial indicators in the Economist print edition). For the last indicator, I think that most people now recognise that the official measure is a fiction, and real unemployment is actually much higher.

Although there has been a brief uptick in sterling, the general trend appears to be relentlessly down:
But given the extent of the pound's rebound this week and lack of any major UK economic data or event on Friday, some analysts say the pound may give back some of those gains as attention turns to the Bank of England's policy meeting next week.

[and] "We have little doubt that the long-term fundamentally based sterling outlook has remained convincingly bearish, but there is a window where sterling could develop a `dead cat bounce'"
At present, the only significant increase in output comes from the Bank of England's printing presses (not literally, as they no longer physically print the money), and this may well be about to accelerate:

The Bank announced yesterday that it had reached its current £175 billion limit in asset purchases under its scheme of QE [quantitative easing, or QE - a euphemism for printing money], but the majority of City economists expect that it will seek permission from the Treasury to extend this limit next week.

Two thirds of the 62 economists surveyed by Reuters this week said that they expected QE to be extended by at least £25 billion, with many forecasting a £50 billion increase.

Yesterday’s money supply figures came after dire gross domestic product (GDP) figures last week, which showed that the economy was still in recession in the third quarter, contrary to economists’ expectations.

Regular readers will know that this printed money is being used to purchase UK government debt, and that it is therefore supporting the government's expenditure. It must be remembered that this printed money does not represent any kind of real growth in the UK economy, and simply (temporarily) hides the underlying state of the economy. I highlight this point because of the complete irresponsibility of government borrowing is being supported by the Bank of England (more of that later).

So what is the state of the government debt in the UK. The first problem is the matter of how to calculate debt. In a recent post on Conservative policy, I was encouraged to have identified that they are going to include Private Finance Initiatives (commonly known as PFIs) in the national accounts, a these have been used to hide government liabilities:
The Financial Reporting Advisory Board (FRAB), a body which advises the Government on its accounts, has indicated that the Treasury's previous definition of what PFI debt should fall on its books should be scrapped. A FRAB working group said the way the Government accounts for PFI makes it too easy for it to manipulate the figures so they either fall inside or outside its own debt totals.

The finding, which is expected to be endorsed by the FRAB, undermines recent calculations from the Office for National Statistics finding that only £5bn worth of PFI debt should be added to the national accounts. Its figure was far shy of the combined £48bn value of all PFI projects - but only because NHS debts were classified as belonging to the private sector.

The FRAB's working group warned that many of the PFI debts were being left off the balance sheets of both private and public sectors. It has urged the department to withdraw the system no later than 2008-09.

In addition to this, there are the many liabilities that are simply unfunded and unacknowledged. This is a report that describes the analysis of total government liabilities by the Centre for Policy Studies:
Brooks Newmark, the Conservative MP for Braintree, Essex, says in The Hidden Bombshell, published today by the Centre for Policy Studies, that government debt is actually £2,200 billion. In the book, Mr Newmark argues that the UK’s public sector net debt is equivalent to £85,610 per household and in the last year has risen by £346 billion — or by £11,000 a second.

Mr Newmark arrives at his figure by saying that official numbers do not take into account the full cost of projects financed through the private finance initiative (PFI), which by his calculation adds £139 billion to the public debt. “A major attraction of PFI is that, in theory, it transfers the risk of failure of a project from the Government to the private sector. However, in reality, the Government carries most of the risk ... £139 billion is a cautious figure as it does not include local PFI projects, some of which may fail,” Mr Newmark says.

Unfunded public sector pension liabilities, which the Government will need to pay, are also omitted and add a further £1,104 billion. Contingent liabilities, such as Network Rail, add another £22 billion. Finally, the £130 billion cost of recent interventions in the financial sector needs to be factored in — bringing the total “hidden liabilities” to £1,395 billion and the total debt to £2,200 billion.

You will note that there is some significant variation in the figures between the two reports above. However, whichever way the problem is regarded, the liabilities of the government far exceed the official liabilities. As such, the official figures for UK government debt and liabilities are gross distortions, if not outright lies.

We are now (I hope) all aware of the rate of growth in the UK's debt, which is increasing at an astonishing rate. The latest news suggests that the government does not think the rate of debt accumulation is enough, and are planning to further increase spending:

GORDON BROWN is planning a final public spending spree to help pull the economy out of recession and put pressure on the Conservatives over their plans for deep cuts.

The prime minister is keen to use the autumn pre-budget statement to announce a new “fiscal stimulus”, with billions of pounds of extra money for housing, infrastructure projects and training.

Recent figures showing that Britain is still in recession have convinced Brown that more spending will be required next year to support any faltering recovery.

However, perhaps the most worrying part of this is that the overall debts have been generated both through the 'good' and 'bad' times, and the recent spending spree just accelerates the trend. The worry this creates is that the deficit is structural and, looking forward, there is every sign that the problem will get worse. For example, the figures given above do not address the problem of government revenues, which will be strained due to demographic changes:
The population of the UK is ageing. Over the last 25 years the percentage of the population aged 65 and over increased from 15 per cent in 1983 to 16 per cent in 2008, an increase of 1.5 million people in this age group. Over the same period, the percentage of the population aged 16 and under decreased from 21 per cent to 19 per cent. This trend is projected to continue. By 2033, 23 per cent of the population will be aged 65 and over compared to 18 per cent aged 16 or younger.

The fastest population increase has been in the number of those aged 85 and over, the ’oldest old‘. In 1983, there were just over 600,000 people in the UK aged 85 and over. Since then the numbers have more than doubled reaching 1.3 million in 2008. By 2033 the number of people aged 85 and over is projected to more than double again to reach 3.2 million, and to account for 5 per cent of the total population.

As a result of these increases in the number of older people, the median age of the UK population is increasing. Over the past 25 years the median age increased from 35 years in 1983 to 39 in 2008. It is projected to continue to increase over the next 25 years rising to 40 by 2033.
This is a dual problem. As people get older, they demand more resource from the state, and as the population ages, the size of the tax base also diminishes. In other words, the output within the economy is going to be constrained at the same time as government costs will rise. If the UK currently has a structural deficit, this structural deficit is going to grow. Even if, and it is a very big if, the UK were to return to genuine economic growth, it will need to be very significant growth to offset the effects of demography.

The fundamental problem that the UK is facing is that there is no sector of the economy that is currently offering such opportunities for real economic growth. I have, on several occasions (even in the Guardian newspaper Comment is Free section) asked for answers on where the growth in the economy might come from. The problem was that I asked for specifics; which sector, and why the sector might grow? I have never once had a clear answer.

Without such growth, the borrowing of the UK government can not be sustained. Moreover, the current contraction in the economy may linger for many years to come (and I believe will become far, far worse). In sum, the structural size of the deficit is likely to continue to grow. In the face of this politicians of all hues simply hope that (as if by magic) the UK will grow itself out of debt, without ever explaining how. This is a hope with no foundation whatsoever. The world has changed and is a more competitive place, and there is nothing to indicate that the UK is well placed in the competition. It returns to the question of which sector will produce the growth.

All of this serves as context for the current state of government borrowing. Even with the massive levels of government borrowing, which flatters the actual state of the UK economy, the UK economy continues to shrink. Not only is the borrowing expanding at unprecedented rates, it is expanding faster than forecast, and that is before the latest proposed increase in spending:
Figures from the Office for National Statistics show that national debt is now equivalent to 59% of the UK's gross domestic product after borrowing grew by £14.8bn in September, compared with £8.7bn for the same month a year ago.

Total net public borrowing now stands at a record £824.8bn, up from £695.2bn (48.4% of GDP) a year earlier.

The £14.8bn borrowing in September was, however, lower than economists' expectations of £15.3bn.

The Treasury has officially stated that it expects borrowing for the current financial year to reach a record £175bn but economists expect it to be revised higher in the Pre-Budget Report, expected next month.

Vicky Redwood of Capital Economics said: 'At this rate, borrowing still looks likely to reach over £200bn, compared to Alistair Darling's £175 billion forecast.'

The fiscal position is indeed dire, and the problem is just going to get worse. Furthermore, even as government revenues continue to collapse, along with the collapse in the UK economy, there are still no firm plans to address the gaping deficit. The Conservative party is making some vague gestures in the direction at reducing the rate of debt accumulation, but not actually addressing actual reduction of the debt:
George Osborne, the shadow chancellor, laid out a detailed “austerity package” at the Conservative conference last month with £23 billion of cuts to Whitehall spending, quangos and public sector pay.
This is hardly an 'austerity package' but represents some tinkering at the edges, and I suspect that much of it will disappoint if enacted. I would normally give a figure for the debt that is accumulating, but will instead point you to the UK debt clock here. When you look at the clock, you should note that this is based upon treasury forecasts, not the real size of the actual debt. You will note the speed of the accumulation. Even on such inaccurately low figures, the debt is as follows:

£13,536 for every individual in the UK. That includes children, pensioners and the unemployed, none of whom contribute to servicing the debt. And it is growing at a record rate.

If the Centre for Policy Studies is correct that the real liability is three times the official figures, then the liability is nearly £40,000. However, within these figures there is a mix of potential and actual liabilities, so that it is hard to see where the final debt might lie. Even if we were to accept that the real liability is just half as much again, then the figure would jump to something like £20,000 per individual. And I repeat, it is growing at a record rate.

The purpose of this discussion is to highlight something about government borrowing - that the borrowing is actually being undertaken in your name, and that you are liable for the borrowing. Barring a few quasi-commercial entities, the only income the government has is the income of individuals and businesses. I highlight this point, because it always sounds more comforting when we hear the abstracted terms 'government borrowing' and 'government spending'. The terms hide the essential reality that the government is adding debt that you will pay. It seems an obvious thing to say, but I am not sure that most of us really overcome the abstract way that government debt is presented.

A useful way of thinking of government debt is if the government borrowing were to appear in your letter box every month in the same format as a credit card statement, with your individual share of the debt allocated to you. Although there is considerable argument about the real state of the overall debt, imagine if each person in your household were to receive a statement showing a debt of £20,000, and a demand for repayment of a percentage of the total debt (to continue the credit card analogy). This is what you would see on the credit card type statement over the last year:
  • Your monthly payments on the debt
  • The debt increasing faster than your payments
  • The minimum payments on the debt increasing in absolute terms
  • The increase in debt reflecting in a higher amount of interest repayments per month, as you are paying more and more just to service the previous debt
  • The speed of the increase in the size of the debt accelerating at an ever faster pace
  • An overall massive increase in your debt
  • That a greater proportion of your income will be needed to service the debt, month on month
If you were to see this on a real credit card statement, and if you are financially responsible, you would want to know that your future income would certainly increase, your costs were about to decrease, or a combination of the two. Without this you would be worried. The trouble is that there is every indication of increasing costs and decreasing revenues, so most sensible people would call a halt, before getting into deeper debt. The answer of the UK government is to increase the rate of debt accumulation.

Returning to the arrival in the letterbox of our personal portion of the government's debt obligation, how might your children feel if they saw their statement suggesting that they already hold a debt of £20,000, and they can see that the obligation is growing at an ever faster rate? Furthermore, how might they feel if you tell them that their share of the debt, by the time they start working, will grow as there are ever less people actually servicing the overall debt. The demographic change means that they will see more and more debt loaded into their statement, as the numbers of individuals retiring from the workforce increases. Their debt burden is set to explode, unless there is a magical period of hyper-growth of real output within the UK economy.

The debt on the statement that you hand to your child will already be something like £20,000, and, I am guessing that they will not have too much optimism about the future. Not only will they have to pay for the huge interest on the debt, maintain repayments on their share of the debt, they will also have to pay taxes for current expenditure.

The problem is that we have simply become used to thinking about these government debts as abstracted from ourselves as individuals. If you think of opening your credit card type statement, and seeing this actual debt accruing, you would be outraged. The way that the government gets away with profligacy is by abstracting away from the reality that they are putting you in debt. It is in their interest that you never see the debt in this way, but the reality is that this is what is actually happening. For example, when the government spends money to stimulate the economy, it is like you spending money on your credit card. In both cases your personal debt obligation has increased, in both cases activity in the economy increases. Whilst government pays a lower interest rate than you might (for the moment at least), in both cases your personal debt burden has increased.

The point of this post is to serve as a prompt for you to think about the underlying reality of what the UK government's debt means for you as an individual. It is not really the government's debt, but is in fact your debt. The government will not pay back this debt, you will. The politicians pretend that debt accumulation is a solution. But how convincing a solution would it appear if the consequences were to appear every month in your letter box, in the same form as a credit card bill? I suspect that the pseudo-intellectual arguments that are presented to the public would never withstand such an open approach. If the reality were presented in this way, not as an abstraction, you would see the justifications for the accumulation of the debt for what they are. Fantasy or outright lies.

Whatever your personal political affiliation, my suggestion is very simple. When the government borrows money, take it personally. It is you that they are putting in debt. When minister 'x' of minister 'y' self-importantly makes an announcement of spending more on 'a' or 'b', think of how it might look on your credit card type statement.

Take it personally because they are adding to your personal debt

Note 1: The credit card type statement is, of course, an impossibility due to the overly complex tax system, and changes in each individual's life circumstances seeing alterations in their share of the obligation. Also, for some individuals, such as the retired and unemployed, they would not see any obligation at all on their statement. However, I hope that it is an interesting way of seeing government debt.

Note 2: There are more calls for expansion in quantitative easing, and I am certain that the Bank of England will continue. Inflation has finally fallen close to the 1% point at which they must write a letter of explanation. This from the Telegraph:
The Bank's Monetary Policy Committee, which is meeting this week, will be pushed by economists to raise the amount of bonds and gilts it plans to buy by a further £50bn, following the recent news that unlike almost any other major economy Britain remains mired in recession. The increase would mean the Bank would soon be holding bonds worth more than 15pc of Britain's entire economy in its balance sheet – unknown territory for any developed world central bank in modern history.
The only problem with the scenario of falling inflation is the weakening £GB, which will see inflation imported in higher prices for goods from overseas. Just as I predicted a continuing inflation before QE, specifically because of the fall in the value of the £GB, the same will happen again. Just as before, there will be a time lag due to orders already in the system, but inflationary pressures will reappear. Whilst the $US has also been suffering, and trade is still (for the moment) largely priced in $US, the UK economy is in a worse state than the US, is printing proportinally more money, and the £GB will therefore trend lower against the $US over the short to medium term. Comments on this welcomed.

Note 2: It seems that the UK is about to break up the too big to fail banks, which is a rare piece of good news. It appears that this is being imposed upon the government by the EU, rather than being domestic policy. However, it is happening, and it is finally something with which I can agree. On the other side of the coin, I suspect that there may be some further interventions and other shenanigans, but have not had a chance to look into the detail. If you have more details, please feel free to add something on this, as it may be a while before I post again.